- 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.
- DPZ - Looking at the overall industry, DPZ was not the only company to leverage its balance sheet at exactly the wrong time; they just took leverage to whole new level and the stock is down over 40% in the last 12 months as a result. The company’s business model generates cash, which should allow DPZ to pay down debt over time and start to reverse its current capital structure in the next 6-12 months. Additionally, overall pizza category trends have ticked up in 2Q08 so as the company’s top-line results improve going forward; investor concerns over leverage should dissipate.
- SBUX - Starbucks is currently taking the right steps to reverse the issues that stemmed from its excessive capital spending over the last three years, most notably, declining U.S. operating margins and lower returns on incremental invested capital. Although the company’s decision to slow U.S. growth and close underperforming stores is not yielding immediate results (as did MCD’s plan to win strategy in 2003), the current consumer environment is working against the company. SBUX is changing the things it can control, which will reward shareholders in the coming quarters.
- CKR - I have been voicing my concerns about the level of G&A spending at CKR for some time, highlighting the fact that although the company’s system-wide store count had declined by 8% since 2002, G&A per store had grown nearly 40%. Additionally, CKR’s aggressive capital spending over the past 2 years has not led to incremental returns for shareholders and said that management needed to change its long-term unit growth strategy in order to reverse declining returns.
Management lowered its capital spending plans at its annual meeting and Ramius LLC’s recent letter to CEO Andrew Puzder appears to have motivated management to focus on bringing G&A expenses down. I am not completely convinced that management will lower both its growth capital spending G&A spending down enough, but they are headed in the right direction. And, looking out over the next few quarters, things should to improve for CKR as the company is lapping some easier revenue and margin comparisons in 2Q and in the back half of the year. From a margin standpoint, CKR should see some benefit in 2Q because it will be lapping the initial spike in food and packaging costs that it experience last year, particularly at Hardee’s.
- HSY – Hershey recently announced its new long-term growth initiatives, signaling that the company is on the path to rightsizing its business model on its own. Prior to the announcement, I had highlighted that the company had been under investing in the business and lowering advertising spend in an effort to keep margins stable. This led to a period of extended market share declines and a severe decline in margins in 2007.
The company’s new initiatives include increasing total advertising spending by at least 20% in both 2008 and 2009 with a focus on its core brands, which make up 60% of total U.S. sales. This increased spending will further pressure margins so they could get worse before they get better, but it should help drive sales momentum and is necessary to the long-term sustainability of the business model and more importantly, the Hershey brand. Additionally, management is expecting 2009 to be another tough year from a commodity cost standpoint but the company is now managing for the long term, rather than managing expectations.
- EAT – Brinker is focused on the things it can control and has significantly reduced its planned domestic company-owned restaurant openings. The company only expects to open about 70 restaurants in FY08 and is reducing that number further in FY09 and FY10 to 15 or less. In its most recent quarter, the company’s capital expenditures as a % of sales came down significantly, which I use as one measure of capital efficiency. Additionally, EAT saw an uptick in same-store sales trends at its most important concept, Chili’s. The company is currently making the right capital allocation decisions and has situated itself to outperform its competitors who are still growing despite declining returns.
- PNRA - We have done a proprietary grass roots survey on the state of the new Panera breakfast sandwiches. We surveyed over 30 stores in the following states - CT, ME, MA, NY, DE, SC, FL, GA, IA, IL, KY, TN, TX, CO and CA. The following conclusions can be made from the survey data: (1) the stores generally indicate the new breakfast sandwiches are well received. (2) In about half the calls, we were given a wide range on the number of sandwiches sold per week - 200 to 500 per week. (3) On the margin, it appears that the new sandwiches are bringing in new people, but there are clearly people switching over from the soufflé.
- CKR’s management has chosen not to react to today’s tough environment with “margin impairing low prices and discounting” and addressed on its last conference call its concerns around raising prices too much at the expense of growing traffic. I am encouraged to see that management is acknowledging the risks of both discounting and increasing prices and the impact both actions can have on margins and driving increased traffic. If anything, the company is wavering closer to the risk associated with increasing prices too much, but we will not know the real traffic impact until the company reports its 2Q09 results. That being said, comparable sales results are trending up in 2Q09, on tougher comparisons, which should help margins in the quarter at the same time the company is lapping the initial spike in food and packaging costs that it experienced last year in 2Q.
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Per the Shanghai Daily, "China's social security fund will stabilize its stock investments to lay a foundation for better returns during the next two years, according to Dai Xianglong, chairman of the National Council for Social Securities Fund."
I am starting to warm up to getting long China ahead of the inevitable Olympic hype. I have not owned anything China in over a year, so this statement should be considered within the bearish view I've held.
*Full Disclosure: I own the Chinese ETF (FXI)
The GDP slowdown news in Asia is historical fact now, and inflation readings for July to date seem to be cooling off, alongside the Chinese Yuan taking a breather. This is all positive, directionally, for a stock market that's in dire need of less than bad news.
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