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Rose Colored Kool-Aid

Brian McGough has been clear about our negative multi-year apparel thesis, where the industry will lose 3 points of margin over 2-3 years. As noted in his post yesterday ‘The Song Remains the Same’ it’s clearly playing out this quarter -- organic sales are under pressure, order cancellations ticking up, FX benefits are easing, cost inputs are rising, pricing power is nil/negative, GM% eroding, and SG&A is heading higher. This has been extremely consistent with most companies thus far.

While it might be tempting to think that our view is now consensus – guess again. These headwinds are going to strengthen before they subside. This is not a fast moving storm front, and the Street still does not get it.

Current estimates across every publicly-traded apparel retailer and brand suggest that the worst is already over. Consensus is looking for a 31bp decline in margins this year, and for nearly all of that to be recaptured in FY09. It looks like most analysts are keeping on the rose-colored glasses and drinking managements’ Kool-Aid.

Stay tuned for further developments on the earnings front, but expect downward revisions as analysts ditch the glasses, dump the Kool-Aid and start to see the light. Until then, be very cautious about which EPS estimates you believe.


Casey Flavin
Director
Global Softlines Team
RESEARCH EDGE, LLC
Gross Margin expectations are looking past the fact that a massive sourcing tailwind reverses.
Same holds true for Operating Margins.

Deflating Inflation: Nat Gas Loses 1/3 of its Value, In 3 Weeks!

Nat Gas got hammered this week, closing Friday at $9.08, down from the early July highs of $13.50. When a commodity loses 1/3 of its value in 3 weeks, it gets the market’s attention. Within the deflating inflation narrative we’re were beating on all week, the attached chart of the September contracts over volume traded is the one we’d like to highlight.

On the supply/demand front, the weekly storage report from the EIA came in at an increase of 84 billion cubic feet. This was higher than anticipated supply increase provided sellers with all the excuse they needed to keep the pressure on the September prices.

Within the construct of the longer term view, one interesting data point did cross the tape this week that was actually bullish for Nat Gas prices. On Tuesday, congressman Dan Boren and Democratic Caucus chairman Rahm Emanuel introduced legislation which includes incentives designed to get the number of NG fueled vehicles on the road to 10% by 2018.

KM
Chart by Andrew Barber, Director (Research Edge)

The Bankruptcy Cycle Continues: Two More Banks Go Under This Weekend

The bankruptcy cycle continues to pick up momentum. This morning the Wall Street Journal reported that “Federal regulators shut down two national banks, First National Bank of Nevada, based in Reno, Nev., and First Heritage Bank of Newport Beach, California.”

These banks fall under FDIC protection, but don’t forget that insurance is generally only up to the first $100,000. The FDIC is basically a mutual insurance company. The FDIC has to fund any deficits by laying higher premiums on the banks that they continue to insure (i.e. premiums are going up).

This is what we have been pounding into the summer sand as of utmost importance to the US economic systems. Access to Capital is tightening as Cost of Capital is going to continue to rise.

I’ve attached the “Bankruptcy Cycle” chart that we used for our conference call on July 16th. We’ll re-run the data driving the chart on Monday, but the math is straightforward – 7 banks have now gone belly up in 2008 and 3 of the 7 had assets exceeding $1 Billion.

This is not good.
KM

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Big Chain Players Should Win at the Expense of the Little Guys

According to the NPD Group, the restaurant segments which are experiencing the most severe traffic declines in the March-May 2008 timeframe are the full-service restaurant categories and those dominated by independents. The pizza category is one such category that is dominated by independent players. Domino’s highlighted in a recent presentation that small chains and independents accounted for 54% of pizza delivery dollar share in 2007, and in line with NPD’s comment, the QSR pizza category has faced significant traffic declines with negative YOY traffic trends in the last 5 quarters and down again through May in 2Q08.
  • On DPZ’s 2Q08 conference call earlier this week, when asked about independent closures, the company’s CEO David Brandon said:
    “Our belief, and it’s more anecdotal than it is statistical, is that the pressure that’s happening out there is clearly creating closures. I mean we’re seeing a few of them and we’re stronger and we can buy cheaper and we’ve got a better brand, and a 47-year track record. We are in a position where we feel the pressure with our weaker operators. We can only conclude and we’re witnessing that same pressure translating in an even bigger way to a number of the smaller operators out there. But it will take a couple of quarters for that to show up in some of the data that we can share with you and certainly when it’s available we will be talking about it.”
  • DPZ management has stated in the past that overly aggressive pricing actions across the industry are to blame for the fall off in traffic. Although more disciplined pricing should help traffic trends (but not necessarily margins), a reduction in supply could only help as well. I don’t want to root against the small players, but if more independents are forced to close their doors as a result of their not having the scale necessary to deal with both lower consumer spending and higher commodity costs, the bigger chains should emerge as winners.

Trouble Brewing in Europe?

China’s renewed pricing power in apparel/footwear exports is showing up left and right. China imported 211,000 tons of Cotton in June –off 16% vs last year. Why the decline? It probably has something to do with the fact that 50% of the 20,000 factories in the Dongguan province in China have closed year-to-date. It does not take much to do the math there. Lower production = diminished need for inputs. This plays into my theme of China passing pricing power through to marginal US players. I should note that India, Thailand and other Asian countries are picking up the slack production, but thus far are following China’s pricing lead. I’ll be keeping a close eye on whether anyone breaks rank.

An interesting call out is the rather meaningful shift we’re seeing over the past few months in Chinese exports by destination. The growth rate in shipments to the US is slowing meaningfully, but we’re not seeing carry through into the EU. The European retail environment has been strong enough to accept price increase to a certain degree, but that’s starting to turn. I’m starting to scout out potential losers vs. winners in Europe. Stay tuned.
EU and US imports from China are diverging at the wrong time for European retailers and those with exposure to the region.

CURRENT TRENDS IN CASUAL DINING

The current NPD data suggest that despite the gloomy economic situation, Casual Dining posted a 1% increase in traffic this quarter (The Knapp data suggest a 3.8% decline in traffic trends). Two key factors are driving the trends at casual dining.

First, the consumer environment looks bleak (consumer confidence hit a 16-year low) and consumers have very little disposable income in their pockets. Contributing to slightly better trends in the most recent quarter was the government’s stimulus package, which supported a +4.0% increase in Real Disposable Personal Income in Q2. Second, restaurant operators increased their promotional efforts and consumers took advantage of them.

  • According to NPD, customer deal traffic rose 6% while non-deal traffic was down slightly. Looking at Casual Dining, the segment was weak during its core business segments with no growth at the important dinner daypart. Lunch traffic grew significantly with 4% more customer visits this quarter. The increase at lunch included improvement on both the weekday and the weekend time periods.
  • Importantly, discounting and Combo Meal visits accounted for half of Casual Dining growth this quarter supported by promotions from major chains and increased visits with kids. The Bar and Grill category posted the largest gains this quarter. The casual dining “varied menu” lost traffic, which suggested a trade off to Bar and Grill. When consumers decided to go out to eat, side dish items were left off, while beverages posted solid growth supported by gains in healthier beverage options. Consumers are also cutting back on consumption of alcoholic beverages.
  • Some areas to consider looking forward: 1) it’s unlikely that another stimulus package will be passed by congress to help buoy consumer spending. Fortunately, gas prices have begun to ease up a little, which may help improve consumer confidence and free up some discretionary dollars. 2) Consumers will continue to look for promotions, a trend that was evident over the past three months. It’s critical that restaurant operators engineer promotions to provide attractive offers to consumers (possibly with new offerings) while trying to preserve margins.
  • My guess is that EAT’s quarter will look better than most in the casual dining space.

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