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BKC – The Commodity Cost Outlook Disconnect

BKC’s 4Q08 5.5% same-store sales growth at its U.S. and Canada division looked impressive at first glance, particularly when you consider the strong 4.8% comparison from last year. But, this solid top-line growth did not translate into restaurant margin growth. Instead, BKC reported a 360 bp decline in company restaurant margins in the U.S. and Canada. Management attributed 200 bps of the decline to higher food, product and paper costs and 130 bps to non-cash expenses related to restaurant reimages (net of the reimaging program, margins would have declined 230 bps).
  • On its earnings call, management commented on its commodity cost outlook, saying “In the fourth quarter, beef cost increased 11% and chicken costs remained unchanged largely due to our multi-year fixed price contract compared to the same period last year. We believe commodity cost peaked last month and it appears over the next six months the general economy is likely to support a decline in food cost…Consequently, over the next six months we expect our commodity costs to decline 2 to 3% from where they are today. But still up 5 to 7% over the prior year. This is our best forecast given the ongoing volatility in the commodity market and what we know today. “
  • This was the first time I have heard any restaurant management team say that they think commodity costs have peaked. For the most part, most companies have said they continue to see prices moving higher so BKC runs the risk of having set expectations that commodity costs have peaked. BKC’s FY09 guidance includes the expectation that company restaurant margins in the U.S. and Canada will be unchanged from FY08’s adjusted level, and management anticipates offsetting its 5%-7% food inflation with strong comp performance and pricing initiatives. BKC will need its favorable commodity cost outlook to hold true for that to happen, particularly with a chicken contract that is set to expire in December.
  • Below are recent comments made by a handful of management teams that I think would disagree with BKC’s favorable commodity cost outlook:
  • June 26 – CKR CFO Theodore Abajian: “Really, I think everybody is starting to see beef prices go up again, with feed prices having gone up. And you know, that’s something that everybody is going to have to deal with. We are going to certainly look at taking additional price increases as needed to offset incremental costs.”
  • July 17 – YUM CFO Richard Carucci: “To your point, John, we don’t know what’s going to happen to commodities but we are planning as if they are going to stay high and what we’re going to try to do is just make sure we don’t get behind on it. You know, quite frankly, this year we went into the year assuming it was going to be $55 million. It ended up being $100 million in the U.S. and we got a little bit behind on pricing.”
  • July 23 – MCD CFO Peter Bensen: “Obviously you hit it that the beef costs will be higher the second half of the year than we experienced in the first half, and again we have a lot of confidence that our supply chain folks will help to mitigate the impact as best they can, but the reality that we are all dealing with is that we expect them to be higher in the second half of the year.” McDonald’s raised its beef cost outlook for FY08 to up 8%-9% (from its prior guidance of relative flat). Management also stated that its dollar menu would look different next year than it currently does due to current cost implications.
  • July 29 – BWLD said they would want to lock in chicken wings at the current prices but that suppliers are not interested (implies that they think prices will be going up).
  • July 28 and 29 - Two chicken processors reported and for the first 9 months of fiscal 2008, Tyson’s chicken segment and Pilgrim’s Pride have collectively lost $263 million. This trend can’t continue. Pilgrim’s Pride’s average breast meat price in 3Q was $1.47 per pound and management stated that based on its current expectations, breast meat prices need to reach $2.15 per pound just for the company to breakeven. That means prices need to increase over 60% just for PPC to cover its costs. Chicken prices are inevitably going higher for restaurant industry.

Dear Hank

``I believe in substance… I don't believe that you get things done just by getting together and having a drink or laughing, or interacting personally. While that's never a negative, you need to bring value.'' –Hank Paulson

For those of you who have been to Jackson Hole, Wyoming, and do “interact personally” with other human beings, you’re probably familiar with the “Million Dollar Cowboy Bar” – the St. Nick’s Hockey Club of New York most certainly is!

As their website notes, the Cowboy Bar “has a long and colorful history that began in the late 1890’s”. It was actually both a doctor’s office and a bank before Joe Ruby built it into his now famous “beer garden”. Hank Paulson doesn’t drink or smoke, and I must say that’s something I wish I could say, but he might reconsider after he endures the realities of this weekend’s discussions with everyone from Warren Buffett to Ben Bernanke.

All eyes are on the head of the US Treasury at this point, and Buffett himself kicked this morning’s meetings off out West suggesting that Hank’s Fannie and Freddie ideas aren’t so swift. Buffett is supporting what was once considered my “overly bearish” US and Global Economic outlook, saying he sees at least another 6-7 months of what we are seeing today and that Fannie and Freddie’s respective “equity” is probably worth zero.

Zeroes aren’t always good. Zero faults are - if you’re a Chinese gymnast - but then we have to figure out whether or not you’re really above the legal competing age of 16 years old. Zero Russian troops in the Georgian capital would be good, but that would imply that Putin isn’t speed bagging the Bush Administration like a staggering 150lb drunk at the Cowboy Bar.

Dear Hank,

For the sake of the sobriety of those of us holding greenbacks, we need you to eat your own cooking and show us that we can “believe in substance” again. Give us some transparency and accountability. This is not a time to bail out your old buddies on Wall Street. You don’t care to “laugh or interact personally” with these people anyway, remember? It’s time to level with Main Street America and get on with the program before Buffett’s 6 months turn into 18 painfully protracted ones.

At 10AM Eastern Time, your pal Ben Bernanke will be ‘You Tubed’ and broadcasted across the world with an opinion that will concern us more than it builds confidence. The US Federal Reserve has been politicized, and finally everyone knows it. It’s the US Treasury’s turn to step up. At 2% interest rates, and commodity led inflation having its biggest weekly gain (CRB Commodities Index) since 1975 this week, Ben is in a US Stagflation box. He may very well head to the Cowboy Bar later on this evening. If I had to manage my way out of this mess, that’s where I’d be headed.

Hank, we are depending on you. The time is running out on your clock as head of the US Treasury. History has a not so funny way of writing itself accurately. I am 85% in cash, and my savings account earns an embarrassing rate of return for my son and family because you’re overseeing a US Financial system with increasing risk to the downside. I’m not “laughing”. “You need to bring value”, soon.

Best of luck “getting things done” this weekend,


Another impressive quarter put a little squeeze on the shorts. I’m surprised that investors continue to short this stock and this management team. I’m not saying it will never be a short but you better have a catalyst. BYI beating yet another quarter, particularly in an environment where everyone else is lowering guidance, is not exactly the kind of catalyst to short.

  • I wish I had put out a long call ahead of this quarter but I think there is still upside in this stock. Take a look at the quadrant chart. Management has certainly put in an impressive 2 year performance, operating the company mostly in the sweet spot. Since Q1 2006, BYI consistently generated sales growth in excess of inventory growth and improved gross margin in all but 2 quarters. Gross margin has increased the last 3 quarters. In Q2, gross margin expanded over 400bps and sales grew slightly faster than inventory. One could argue that inventories are catching up to sales but BYI does have an impressive backlog. I for one am not worried about the inventory picture.

  • BYI reported EPS of $0.54, slightly ahead of consensus. I tend to watch the SG&A line pretty closely to make sure companies are still investing but also to monitor how they are managing earnings. Most companies maintain the ability to manipulate SG&A somewhat. Making the quarter because of a big SG&A drawdown is not typically a good sign. BYI actually spent 17% more on SG&A than last year, a good sign in my opinion. This was a solid revenue and gross margin quarter.

  • Turning to the 2nd chart, the deferred revenue picture looks solid. Deferred revenue stayed at roughly the $183 million level experienced in Q1 2008. Moreover, deferred revenue growth YoY remained above sales growth with a spread between the two of 18%. The high level of deferred revenue and strong backlog provides visibility on the upcoming revenue picture. Significant profit growth should continue to “Reign O’er” BYI.

Operating mostly in the sweet spot
Unearned revenue remains at high levels and the YoY increase exceeds sales growth

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They are getting "fired up" in Jackson Hole

At least that's what Tom Keen just said on Bloomberg (he is their Editor at large) - "there is a fervor out here - people are fired up".

That's all good and great for them. For we free market capitalists, the thought of government getting "fired up" to re-regulate financial markets is one of the scariest thoughts in my head.

Find me the 'Cowboy Bar'. This is going to be painful to watch tomorrow.


• Macau Financing: This situation may not be as dire as the market perceives. Less demand certainly contributed to the scaled down financing effort from $7bn to $5.25bn to below $5bn. However, it may not be the type of demand problem people think. Apparently, there is interest from the banks in providing funds to LVS but the company may be scaling back its development on lots 7 and 8. Given the uncertain demand picture in Macau, less capex is probably a good idea.

• Four Seasons: Yes the property opened in August but no, it is not fully open. As far as my guys can see, only 50 rooms are open and the website is still not taking reservations until September 15th.

US Dollar Getting Hit Hard Today

Since the US Dollar put on such a big move in such a compressed period of time (+8% in a month), it has the potential to correct expeditiously. Today the US$ Index is down 94 basis points at 76.22, which is the biggest down move we have seen in weeks. Immediate term support was at 76.57, so that line is broken. Next stop is 75.70, then we have the more meaningful support line at 74.17. If Bernanke panders to the easy money crowd tomorrow in Jackson Hole, this move down in the US$ and coincident re-flation of crude oil, gold, etc. will continue.
  • US$ Support is way down at the $74.17 level