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RESTAURANT ANTHOLOGY – PART 1

I find myself writing the phrase “a sign of the times” a lot recently to describe negative trends that have emerged that in the past, I would have described as daunting, but today, are merely commonplace or the standard against the backdrop of today’s difficult economic environment, particularly as it relates to restaurant operators. Such “signs of the times” would include severe traffic declines, rising prices to offset higher costs at the expense of traffic and the flip side, discounting at the expense of profitability, margin-crushing commodity costs, higher management turnover, an increased number of companies at risk of defaulting on debt covenants and increased leverage within the industry. Unfortunately, all of these “signs” and trends continued to be relevant over the last two weeks.

For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.

  • Traffic declines - Recent NPD data shows the 18-24 year old age group has been scaling back on their restaurant use over the past few years, with the decline from 2007 to 2008 being quite striking. While restaurant use overall has slipped a bit, no other age group has scaled back to the extent young adults have, and although they are a relatively small group in terms of population, 18-24 year olds are responsible for a sizeable number of industry visits. For the year ending June ’08, young adults 18-24 accounted for nearly seven billion visits to commercial restaurants and spent $42 billion dollars with the majority of that spending at Quick Service Restaurants – posted August 11.
  • Rising prices to offset higher costs at the expense of traffic… – The China Daily reported this week that KFC raised its prices in China for the second time this year due to increasing commodity costs. The magnitude of this second price increase was greater than the first one implemented in March, ranging from 0.5 yuan to 2.5 yuan (versus 0.5 yuan to 1.5 yuan in March). For reference, the price of a medium coke is now 6.5 yuan, up from 6 yuan (an 8% increase). One KFC customer responded to these recent price increases, saying “Its products are quite small in size, and not worth the money if prices continue to go up.” This price vs. traffic relationship is one that I have talked about a lot and if customers begin to think the price increases are too great, YUM’s traffic growth in China will begin to suffer – posted August 21.

    Speaking to the press in Japan, Eiko Harada Chairman and President of McDonald's Co. (Japan), said "rising food prices will force McDonald’s to raise prices for the second time this year. We'd like to implement it (the price hike) as soon as possible” – posted August 11.

    RRGB has been aggressively raising prices at the expense of traffic. This trend was magnified in 2Q when traffic declined 4.4%, down significantly from 1Q’s 0.4% decline. Thankfully, CEO Dennis Mullen stated on the conference call that “we’re nervous about pricing in this economy.” Restaurant margins should deteriorate further in 3Q as the company is up against its most difficult same-store sales growth comparison from 2007 and will not have has much price to offset these declines. That being said, I think the company’s decision to be more disciplined with its pricing strategy is the right one as margins will not improve until RRGB gets more people in its restaurants. – posted August 19.

  • And the flip side, discounting at the expense of profitability – The $5 price point is becoming popular within QSR. A few weeks ago, I pointed out that Subway was having big success from a traffic standpoint with its $5 price point, and now Arby’s is moving in the same direction, with its 5 for $5.95 promotion – posted August 11.

    Within casual dining, Applebee’s and the Outback are using a $9.95 price point to drive traffic. This appears to be a desperate move for Outback. The last I checked, Outback’s average check was over $20 so this $9.95 promotion will inevitably cut into margins – posted August 11.

  • Margin-crushing commodity costs – BKC posted 5.5% same-store sales growth for 4Q08 at its U.S. and Canada division and a 360 bp decline in company restaurant margins. Management attributed the majority of this decline (200 bps) to higher food, product and paper costs (net of the reimaging program, margins would have declined 230 bps). Although this lack of top-line flow through was daunting, even in today’s environment, I was more surprised to hear management say they think commodity costs have peaked relative to what other restaurant operators have been saying. I am calling this the BK Disconnect – posted August 22.
  • Higher management turnover – Last week, the London Times reported that Starbucks U.K. and Ireland managing director Phil Broad resigned. This is not a healthy sign for SBUX, but relative to the news flow over the past two weeks, management changes should not come as a surprise. This announcement followed Starbucks’ recent elimination of the COO position and Martin Cole’s (formerly the COO) appointment as president of Starbucks Coffee International Inc., replacing Jim Alling – posted August 10.


Price Versus Traffic: An Important Relationship

ASCA: REFI AND EAST CHICAGO UPDATE

Unlike most of the sell side, I’ve recently focused on the balance sheets of gamers. ASCA has been of particular interest given the proximity to tripping the senior leverage restriction in its credit facility. As I pointed out in the post “ASCA: TOEING THE COVENANT LINE” on 8/14/08, unless the company refinances some of its debt, it is likely to bust a covenant by Q2 2009 if not sooner. ASCA has pulled a few levers as of late to ensure it doesn’t, including cutting costs and maintenance capex. Management knows this is not a sustainable strategy. Its customers are accustomed to a high level of quality and service which will quickly deteriorate under the current low level of spending.

For the aforementioned reasons, look for ASCA to refinance sooner rather than later despite the current credit environment. The least painless approach is to float a subordinated bond indenture. My best guess is an offering of $200 to $250 million at 12%. The rate would be consistent with where Boyd Gaming’s sub debt trades. As shown in the following chart, this scenario results in an EPS hit of $0.10 to $0.20 or roughly 12-25% of my forward 12 month earnings estimate. It could be worse. EPS would be cut in half with a full refinancing of the credit facility or a covenant waiver. A subordinated debt offering buys the company some time. The current, attractive facility does mature in 2010, so the company has a maximum of 2 years left of over earning.

Another topic of interest for ASCA investors is the performance of Ameristar East Chicago following the opening of the new Horseshoe Hammond. It’s only been two weeks but Ameristar may be holding up a bit better than the company expected. We continue to believe property revenues will fall between 5 and 10% at East Chicago and the first two weeks are probably in that range. Stay tuned for more updates.


Sub debt financing will drive EPS lower

LVS: BOFA DOWNGRADE MAY PROVIDE SHORT COVERING OPPORTUNITY

LVS is down 29% in the past week including 6 straight daily declines. I’m no fan of the Macau stocks but the Bank of America downgrade may provide a near-term short covering opportunity. The stock appears oversold if it goes below $39 per Keith McCullough’s quantitative model. Moreover, we may get a fundamental positive catalyst as soon as next week. My Macau guys think LVS is close to finalizing a credit facility to finance some of its Macau development. An agreement here could provide a little support for the stock considering investor concerns around financing.

I still think the trend is lower on the Macau stocks.


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Lehman (LEH): Is Korea The Answer To The Transparency Problem?

So now Singapore is going to own Merrill Lynch and Korea is going to own Lehman Brothers. Hmmm... Sounds like we are definitely on the right track to solve the transparency problem in the US Financial system, doesn’t it!

If you think that selling our said trophy Wall Street investment banks to governments who don't disclose anything is a good thing, run out and buy yourself some US Financials today.

This looks like a game of ‘Monopoly’ where we are parceling off Wall Street due to foreclosure.
KM

Thanks Ben

Bernanke's boilerplate statement on the US Economy this morning out of Jackson Hole doesn't have any proactive or predictable value for the US market. The slight change in his wording was that he expects "medium term” inflation to abate somewhat, but guess what, he has been predicting a slowdown in inflation since 2006!

Obviously Ben's “call” on inflation has been one of the worst macro calls in recent memory. That said, eventually even a broken clock gets the time right. Surely using his new "medium term” definition gives him room to call inflation abating before the year 2010, but who cares.

Bernanke's crystal ball has had zero predictive value. I am not sure why the media and traders think it does today, other than they have no context.
KM

Taiwan joins Singapore, Japan, etc in the Asian Slowdown camp

Asian growth slowed materially in Q2 of 2008. That will be a historical perspective that most investors look back on when this year is all said and done. Unfortunately, a large % of them didn't see it coming ahead of time.

The Harvard Endowment, for one, went on an ETF buying binge, and loaded up on Taiwan too early (the ETF for Taiwan is EWT). This morning the Taiwan government reported Q2 GDP slowing to +4.3%. That's down sharply versus prior expectations and down from +6.3% since Q1 of 2008. It is global this time, indeed.
  • The TAIEX Index has dropped -26% since May 19th, 2008 to 6,911.
    KM
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