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Franchisee Bankruptcy Risk Emerges

Consistent with our bankruptcy theme and my comments from the bankruptcy conference call that the biggest risk to the QSR companies is franchisees going bankrupt, Midland Food Services, LLC, one of the largest Pizza Hut franchisees in the U.S. filed for Chapter 11 bankruptcy earlier this week. YUM is particularly exposed to this franchisee risk due to the massive amount of stores the company has sold over the last five years (YUM has a target to reduce its company ownership mix to below 10% by 2010 from about 20% currently and nearly 30% in 2002). Franchisees have used significant leverage to buy stores, which already puts them at greater risk. Making matters worse, YUM’s U.S. company-owned store base has recently experienced significant margin declines. KFC has been particularly weak recently, and chicken prices will only be moving higher.

Another phrase that will join the list of commonly used phrases by the restaurant industry is “the health of the franchise system.”

Good As Cash?

At least that’s what some of the brokers at UBS, Citigroup, and Merrill used to say – these auction rate securities are “as good as cash”. When you lie to people, it usually catches up with you. That’s what we started seeing yesterday with Citigroup’s $7.3B settlement where they agreed with the SEC to “make investors whole.” John Thain’s alleged exposure here is another $10B, and UBS somewhere between $20-$25B (yes, billions).

Of course, not all of these people flat out lied, but at a bare minimum they were unaware of what they were selling. Being unaware doesn’t work when you are managing my money, and I assume that is a general statement I can make for Main Street America. Your cash remains king. Letting other people get rich off of incentive fees on your cash… well… not so much anymore.

It’s one thing for Wall Street to have compromised the long standing trust they were assigned as America’s fiduciary. It’s another altogether for global investment banks to no longer trust each other. One of my first year analysts, Zach Brown, asked me a very simple question yesterday – “what can my Mom get for LIBOR?” Now that’s a much better question than hedge fund A, B, or C is asking their favorite CFO at a hotel conference “one on one”. What’s the point in asking CFO’s macro questions anyway? LIBOR is marked to market daily, and you can take out the “body language” risk!

This morning 3 month LIBOR (the rate at which banks lend to each other) is trading close to its highest spread over the US Fed Funds rate since 1999. Zach was the sailing captain at Yale last year. When the waters are rough, he knows how to manage risk. He doesn’t need me to make him “aware” of what spreads widening means.

Getting back to your cash – the waves in the global currency markets have heightened materially this week. I have an 85% position in the US Dollar, and that looks to be the one currency that is afloat. The rest of the world’s currencies need some Dramamine!

At 75.35, the US Dollar Index has charged forward by +4.9% since July 14th, and looks to be finally breaking out of its long term base. Since it’s an Index, the other side of the “Trade” is a collapse in both the Euro and the Japanese Yen that are trading down to 1.51, and 110 versus the US$, respectively. It doesn’t stop there. Asian currencies are getting clocked (yes, growth is slowing – China’s stock market was -4.5% last night, ahead of the Olympics), and currencies levered to commodity deflation are under massive selling pressure. The Canadian Dollar is down to 1.06 after trading at parity for most of 2008, while the Australian Dollar is having its 9th down day in a row – it’s longest losing streak since 1980!

Within their “it’s global this time” investment banking narrative of October, 20007, bankers don’t need one of these super secret “one on one’s” with a CFO who runs a global business to tell them that stagflation is bad. This morning’s facts are all on the table: Italy reported a negative GDP number, Czech Republic printed an accelerating inflation number for July (wage inflation!), and Egypt raised rates by 50 basis points to 11% after seeing their year over year inflation spike to +20%.

I know, I know… who cares about Egypt, LIBOR, and Cash? I think a better question is who is managing your cash in this interconnected global economy? If you think the "Tech Bubble" settlements were bad for Wall Street, wait until the lawyers get their nails under this moldy rug.

Have a great weekend,


The dispersion is growth between apparel retailers and discount stores was 9.3% for the month of July – which is the 2nd biggest number in the 20-year period for which I’ve collected this data. The biggest gap was the post 9/11 fall-off (-10.7%). We’re edging out levels hit in the 90/91 recession.

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TBL: Hold The Line!

I remain a fundamental bull on TBL. I like the margin and cash flow direction over 12 months, as noted in my 7/29 and 5/12 posts. But when my Partner Keith McCullough (and his factor-based pricing models) tells me "TBL faces critical support of 15.23 or watch out below" my short-term capital preservation radar goes up.
TBL stock chart courtesy of FactSet.

WRC: Peaks Are Processes, Not Points

The bull case here is best represented by the reported financials. The company smoked numbers for the 7th quarter in a row, appears, printed a 22% sales growth rate, 236bp improvement in GM rate, AND levered SG&A on top of that. Mix those together and out pops a 74% EBIT growth rate. Layer on incredibly bullish statements about the global business, input cost containment, and that WRC is not feeling the impact of any form of regional slowdown. A very powerful concoction indeed.

It’s very easy to get caught up in the ‘beat/miss vs. expectations game’ as well as all the noise around door openings and product launches. I sat on this thing for way too long today trying to make sense of it. But there are several MAJOR questions I have that are better answered by simple mathematics.

The key questions I have revolve around FX, sourcing, and margins. WRC noted that FX was a 3.4% boost to revenue in the quarter. What I want to know is how a company with a 22% sales growth rate and 50% of sales outside of the US could only benefit by 3.4% when weighted FX change is 10-15%??

My math gets me to something closer to a $65mm top line benefit. Assuming a 30% incremental margin, this is about $20mm, or 4 points of margin. In other words, excluding this FX impact we’d be looking at 6% sales growth (not 22%), margins closer to 6% (not 9.7%) and operating profit that is flattish with last year.

How can this be good if the Euro continues to roll? What if cotton goes to a buck vs. the sub-0.70s? What if the sourcing environment continues to erode as factories close in Asia to the tune of 5-10 per day? WRC management noted that costs are under control. Everyone says that. What no one says is how they are planning for the unexpected – the extent to which they will be in the pole position when the industry acts irrationally as margins go away for the companies that have underinvested at the peak.

It’s tough for me to fight the tape on this one. Heavily shorted stocks that beat numbers don’t go down. In fact, a close above 45.01 is a bullish signal from a quantitative standpoint per Keith. Not as bullish as we see with RL. But bullish enough. Could we see WRC’s multiple defy gravity for a while longer? Yes. Ultimately, however, something’s gotta give. And when it gives, run.

Asset sales have helped margins, but not as much as FX and sourcing.

From Harvard to D.E. Shaw, Without Love

In the Financial Times today, D.E. Shaw’s Managing Director, Larry Summers, wrote one of the more impressive and well rounded treatises on the US economy. The article was called “The Big Freeze”, and it’s definitely on the macro required reading list.

On most mornings when my alarm goes off at 4am, I have no idea what I am going to write my “Early Look” about. I am data dependent, and that’s just the way that it is. Summers, however, looks to have had plenty of time to coagulate a lot of the thoughts that I have alluded to in my 2008 missives.

I’m an aspiring Yale economist, of sorts – at least that’s what the B.A. on my resume says. Summers is an established Scribe, and the former head of both the US Treasury and Harvard University. If you think I am too negative on the “Trend”, read his take.

Summers correlates today with the central banking credibility issues associated with the 1970’s, but he points consistently to the 1930’s in the US and the 1990’s in Japan. “Just as the bottom was called a number of times in Japan in the early 1990’s and in the US in the early 1930’s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past”, he wrote.

Other quotes by Larry Summer’s that I wanted to highlight:

• “Then there is the problematic situation of the banking system. Where traditional non-mark to market accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses… they have instead assumed that the market’s valuation of their assets reflects transient liquidity factors rather than underlying problems.”

• “We do not have a framework in place in which authorities can do what is necessary to counter systemic risk”

• “Government involvement in recapitalizing financial institutions is like devaluation: a very unattractive last resort”

Article at (http://www.ft.com/cms/s/0/794801a8-63e8-11dd-844f-0000779fd18c.html)

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