This post highlights some of the ideas we have been talking about on the “RED” side.
- YUM – Yum has several attractive attributes making it an appealing investment vehicle: international opportunities, the Dollar doldrums, and significant cash to return to investors. YUM has consistently posted strong results in both its China and YRI segments, which has helped support the stock despite the U.S. business being in a secular decline. As China is becoming a more important part of the story (made up 5% of operating income in 2000 and expected to represent about 25% in 2008), I voiced some concerns about the company’s new dependence on China growth. Although these concerns did not manifest in 2Q08 as same-store sales were up 14% in China, it should be noted that on the same day YUM reported its results, Chinese 2Q GDP was reported at +10.1% (making it the second consecutive quarter of decelerating economic activity). And YUM is up against difficult comparisons in 2H08 in China with management stating “we cannot expect mid teens same-store sales growth and 30 to 40% profit growth to continue.” Additionally, the company’s currency benefit has grown over time for both China and YRI and helped segment operating profit growth by 12% and 9%, respectively, in 2Q08. Investors have become accustomed to these high, double-digit reported operating profit growth results and this favorable currency impact may not be around forever.
The U.S. margin story is also concerning (and that might be an understatement as the business is in a secular decline) as YUM raised its FY08 U.S. same-store sales guidance but took down its operating profit target, which implies the company will see more, less profitable traffic as a result of its Why Pay More initiatives at Taco Bell and its pasta introduction at Pizza Hut. - CMG – Right now, CMG is the only restaurant company with double digit EBIT margins and given the current economic environment, CMG's same-store sales are in a class of their own. Over the past two quarters the company has posted same-store sales of 10.6% and 10.2%, respectively. Looking out over the balance of 2008, CMG's same-store sales are likely to slow to mid-single digit growth. In 1Q08, CMG did benefit from an easy 8.3% comparison due to a tough winter last year. For the next two quarters comparisons get more difficult at 11.6% and 12.4%, respectively.
- RRGB – RRGB will now be the poster child for how difficult the operating environment is. In 1Q08, RRGB's traffic declined 0.4% despite incremental advertising (and up against easiest comp from 1Q07 of down 3.6%). Despite a Q1 miss, management raised their guidance but mainly to reflect the acquisition of 15 restaurants from franchisees. Since then, the company announced that recent top-line results may trend to the low end of its previously guided full-year sales assumption.
I continue to be concerned about the company’s aggressive price increases, which could be detrimental to traffic. The company will be running at about 6% price from late June through mid-August and average at about 4% for the year. I am also not yet convinced that the company’s increased advertising spending will yield the necessary returns. Additionally, RRGB is accelerating its capital spending in a very difficult operating environment and not bringing the cash home to shareholders. - SONC – SONC’s primary issues result from the company’s new reliance on discounting (Happy Hour promotion) to drive traffic. Management indicated that traffic is only growing in the afternoon when the company is discounting the most, and restaurant margins have suffered as a result (down 140 bps YOY in 3Q08). The company’s margins will also be hit by minimum wage increases and the company’s renewed focus on customer service as the company had recently cut back on labor expenses, which resulted in lower partner drive-in same-store sales. The company also stated that its overly aggressive price increases in the past led to the deteriorated traffic results at its partner drive-ins so the company will not be able to use price to help protect margins going forward. And then, there are rising commodity costs. Management stated that it is buying its beef requirements on a month to month basis at double-digit YOY increases. Needless to say, SONC’s margins are being hit from all directions.
- CBRL - During the late 1990's, as CBRL endeavored to maintain its strong, historical rate of growth, a number of issues led to a deterioration in the company's financial performance. Increased capital spending strained the CBRL system. More importantly, aggressive menu pricing and tight management of restaurant expenses threw the consumer value out of balance. The decline in operational performance, coupled with declining customer counts caused a significant decline in profitability.
Now, the same management team is aggressively raising prices again at a time when the typical CBRL customer can't afford to fill his tank with gas (87% of the company’s restaurants are located along interstate highways). CBRL reported its 6th consecutive quarter of negative traffic, with 3Q08 posting the biggest decline of -3.3%. And the trends are not improving in the company’s most critical summer months with June same-store sales results down 1.2%. As a result, the company lowered its FY08 EPS guidance to $2.77-$2.87 and is now guiding to 60 bps of operating margin contraction from FY07’s reported 7.0%. - GMCR –As the company’s growth has skewed more to its Keurig at home brewers and related K-Cups, which have lower gross margins than the most of the other company’s products, gross margins have suffered significantly (down 220 bps in its most recent quarter). At the same time, operating margins have improved as the company has lowered its SG&A as a percent of sales, which is not sustainable relative to the company’s current growth rate.
The profitability of GMCR’s K-Cups is critical to the company’s overall profitability and on the most recent conf call management did not argue against prices in the wholesale channel at $0.30, with a 20% contribution margin. That implies a $0.06 profit per K-Cup. For licensed roasters, GMCR raised the royalty rate to $0.064 per K-Cup. The conclusion we can draw from this, is that on the surface there does not appear to be enough margin in the K-Cups for the supply chain to make any money. - MCD – Everybody loves MCD and the valuation reflects it. In addition to the top line momentum in Europe and Asia, part of the bull case is the company’s move to sell more beverages. I have been saying for some time now that the specialty coffee rollout would not prove to be another silver bullet for MCD’s U.S. business as I do not think MCD will be able to change consumer perception enough to steal meaningful share from Starbucks. Additionally, it will be difficult in today’s environment to convince the average MCD customer to spend $3 for a cup of coffee (as evidenced by SBUX’s recent traffic trends). This new beverage platform requires franchisee investment (costing the entire system more than $1 billion to implement nationwide) at a time when franchisees’ bottom lines are already under pressure from rising commodity costs and increased dollar menu transactions.
YUM USA is in a secular decline
The CMG Story
