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Loved by the street, management may have set the bar high for 4Q.


The sell-side analyst community loves PNRA with 65% of analysts recommending the stock as a buy (there are no sell ratings).  It is easy to figure out why with the company posting +10% comparable sales growth and north of 200 bps of YOY operating margin growth in the first half of the year.  The comparisons get more difficult from here, however, with the company lapping sequentially better same-store sales growth in the back half of the year - particularly in 4Q10.  Additionally, PNRA is facing its toughest YOY margin comparison during 3Q10. 


This is not new news as the company guided to lower, yet still impressive, comp growth of +5-6% growth in 3Q10 and +4-6% growth in 4Q10 with flat to 50 bps of margin expansion in the back half of the year.  Based on recent top-line trends, the +5-6% same-store sales guidance for the third quarter seems achievable as the high end of the range only implies a 20 bp acceleration in two-year average trends from the prior quarter.  The fourth quarter comp guidance is more concerning, however, as it implies a 125 to 225 bp acceleration in two-year average trends from the reported level in 2Q10.  Based on management’s guidance, this sequential improvement in trends is expected to be driven by a sharp increase in 4Q10 transaction growth on a two-year average basis while average check growth is expected to decelerate slightly. 


Transaction growth ran positive for PNRA during the first half of the year but average check growth has accounted for about 7% of the 9.8% comp growth.  Average check growth held steady on a two-year average basis during the second quarter whereas transaction growth decelerated 70 bps.


This recent level of average check growth is impressive but is likely unsustainable.  We have seen other restaurant companies in the past use pricing and average check growth to support same-store sales growth, but this often takes a toll on traffic growth (please refer to the charts below that highlight the similarity in trends between the relationship of average check growth and transaction growth for Panera and Chipotle).  Ultimately, restaurant operators need to get more people in their restaurants. 


Panera management attributed the 2Q10 average check growth to the strength of the company’s summer salads, its meal upgrade program (offers the customer the opportunity to get a baked good for $0.99 with the purchase of an entree and a beverage) and to its growing catering sales, which carry higher average check per transaction.  PNRA will begin to lap the increase in catering sales during 3Q10 as catering sales first turned positive in 3Q09 (+3.0%) and quickly accelerated from there (+14% in 4Q09, +20% in 1Q10 and +24% in 2Q10). 


This, combined with the fact that the company is lapping 4.2% average check growth from 4Q09, will put increased pressure on average check growth during the fourth quarter.  Management guided to 3.0% average check growth in 4Q10 relative to its expectation for 5-6% growth in 3Q10 and the reported 6.5% and 7.7% growth in 1Q10 and 2Q10, respectively.  The company expects to offset this lower level of average check growth with +1-3% transaction growth, which I said earlier assumes a significant increase in two-year average trends.  I am not convinced management will be successful in achieving this targeted transaction growth so I am currently modeling +3.0% comparable sales growth for 4Q10 (relative to management’s guidance of +4-6%).  My estimate still implies a 75 bp acceleration in two-year average same-store sales trends and a 110 bp improvement in two-year average transaction growth trends from 2Q10 levels. 


New MyPanera Loyalty Program:


Panera is rolling out its new loyalty program system-wide during the fourth quarter and expects the program to lift comp sales by +1-2% during the quarter.  Management’s comp and transaction growth guidance assumes this sales lift.  The company is confident in the success of this program after testing it in 23 markets where results have shown that it strengthens customer relationships and has a meaningful impact on frequency of visits.  I do not doubt that over time, this program will drive frequency, but a +1-2% lift in the first quarter it is rolled out seems like a stretch.  Like I said, I am assuming transaction growth will get better during the fourth quarter, but based on the deceleration in trends during the second quarter, getting to +1-3% growth in 4Q10 seems aggressive.  Time will tell.    






Howard Penney

Managing Director




TODAY’S S&P 500 SET-UP - September 17, 2010

As we look at today’s set up for the S&P 500, the range is 23 points or -1.21% downside to 1111 and 0.83% upside to 1134.  Equity futures are trading above fair value as markets respond positively to earnings and guidance from RIMM and ORCL.

Today's macro focus will center on August CPI and the Michigan Consumer Sentiment survey.

  • Alkermes’ (ALKS) drug Vivitrol should be cleared as a treatment for opiate addition, outside advisers to the U.S. FDA said.
  • Arena Pharmaceuticals (ARNA) failed to win a U.S. panel’s backing to sell lorcaserin, the experimental diet pill that would be the company’s first drug.
  • Boeing (BA) said it would boost the production rate of 737s to 38/mo from 35/mo
  • Massey Energy (MEE) forecast a 3Q operating loss and 2010 operating results at the low end of its projections.
  • Oracle (ORCL) reported 1Q EPS that beat estimates.
  • Research In Motion (RIMM) reported 2Q revenue and profit that beat estimates.
  • Texas Instruments (TXN) boosted its dividend and said it plans to buy an additional $7.5b of its stock.


  • One day performance: Dow +0.21%, S&P (0.04%), Nasdaq +0.08%, Russell (0.72%)
  • Month-to-date: Dow +5.79%, S&P +7.18%, Nasdaq +8.95%, Russell +7.6%
  • Quarter-to-date: Dow +8.4%, S&P +9.12%, Nasdaq +9.2%, Russell +6.29%
  • Year-to-date: Dow +1.6%, S&P +0.86%, Nasdaq +1.5%, Russell +3.58%


  • ADVANCE/DECLINE LINE: -485 (-659)
  • VOLUME: NYSE - 906.14 (+0.55%)  
  • SECTOR PERFORMANCE: Mixed to poor performance - 3 sectors rose and 5 declined - Tech and Materials sectors outperformed; Financials and Energy led the decline. Economic data sent a mixed message, and limited corporate news flow on the day.
  • MARKET LEADING/LAGGING STOCKS YESTERDAY: Ford +4.80%, Gamestop +4.36% and Expedia +3.86%/Helmerich -4.49%, Pulte -3.85% and Fed Ex -3.75%
  • VIX: 21.72 -1.72% - YTD PERFORMANCE: (+0.18%)            
  • SPX PUT/CALL RATIO: 1.03 from 1.53 -32.66%  


  • TED SPREAD: 14.94 0.812 (5.746%)
  •  3-MONTH T-BILL YIELD: 0.16% +0.01%
  • YIELD CURVE: 2.29 from 2.24


  • CRB: 278.69 -0.13%
  • Oil: 74.57 -1.91% 
  • COPPER: 349.35 +0.78%
  • GOLD: 1,272 +0.41%


  • EURO: 1.3074 +0.56%
  • DOLLAR: 81.241 -0.31% 



  • European Markets: FTSE 100: +1.00%; DAX: +0.88%; CAC 40: +1.29%
  • European markets opened higher and subsequently extended gains to currently trade close to session highs.
  • M&A activity again dominates with Johnson & Johnson (JNJ) negotiating to buy Crucell (CRXL.NA).
  • All industry groups trade higher with miners and technology shares amongst leading gainers. Defensive groups dominate the laggards. Mining shares were buoyed by higher metal prices whilst technology shares received a lift from Oracle (ORCL) results and guidance overnight, ORCL trading up over +4% in Germany.
  • A generally weaker US dollar also benefitted commodity prices that saw gold trade at a record high $1,280/oz.


  • Asian Markets: Nikkei +1.2%; Shanghai Composite (0.15%)
  • Most Asian markets followed Wall Street up today, despite some hesitation before pending holidays in Japan and South Korea.
  • Japan rose on a weaker yen
  • In South Korea, LG Electronics rose 5% after CEO Yong Nam resigned to take responsibility for poor management, to be replaced by Koo Bon Joon.
  • Banks rose slightly in Australia on successful bond issue by Asciano.
  • Taiwan rose when Beijing approved four banks including Chang Hwa Bank to open branches in China.
  • Declines in financials and heavyweights outweighed technical buying in individual stocks, taking China to a slight loss even though the central bank said it would keep monetary policy loose. 
Howard Penney
Managing Director

THE DAILY OUTLOOK - levels and trends














One year expensing of capital purchases could be a boon to slot suppliers.



Casinos are about to get a new incentive to upgrade their slot floors.  HR 5297 would allow accelerated depreciation of new equipment for tax purposes, although not at the 100% proposed by President Obama last week.  Still, for slot floors that are aging fast and nearly fully depreciated, this bill could be the tonic to expedite that inevitable acceleration of replacement demand.


According to the Internal Revenue Code of 1986, slots are depreciated under a 7-year recovery period, though there is a pending proposal (HR 5465) to change the recovery period to 5 years.


On Sept 8, 2010, President Obama proposed increasing the bonus depreciation policy to 100% for 2011. The policy will allow firms for the first time to apply an immediate, full write off of the cost of new equipment purchased between Sept 8, 2010 and Dec 31, 2011. Expensing legislation has been enacted in the recent past.  In 2002, Congress passed a 30% bonus depreciation allowance through the Job Creation and Worker Assistance Act of 2002.  A year later, it raised the limit to 50% through the Jobs and Growth Tax Relief Reconciliation Act of 2003 for investments made before January 1, 2005.  The Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 both renewed the 50% rule but that expired on 12/31/09.


The Small Business Jobs Act (HR 5297), which was passed in the Senate today, will allow firms to retroactively apply the 50% rule for equipment purchased before Sept 8, 2010.  HR 5297 will also increase Section 179’s depreciation limit from $250k to $500k for 2010 and 2011—Section 179 is a provision allowing taxpayers to expense 100% of certain types of acquired assets. Now, HR 5297 returns to the House for approval before being passed to Obama for his signature.


Let’s look at history.  As the following chart shows, the enactment of accelerated depreciation during 2002-2004 coincided with a big jump in replacement demand.  Of course, that was also in the middle of the Ticket In/Ticket Out (TITO) technology implementation so it is difficult to determine the direct impact.  What we do know is that for tax purposes, the current slot floors are pretty close to being fully depreciated.  Slots purchased pre-2004 will be fully depreciated by the end of the year.  Very little remains of the 2004 slots due to the accelerated depreciation in that year.  The 2005-2007 slots are still being depreciated over a 7 year life.  Due to 50% expensing, the 2008-2010 classes of slots have low tax basis.




We are not ruling out 100% expensing either.  The President wants it; it is politically feasible; and it could garner bipartisan support.  Accelerated depreciation alone is probably not enough to create a big replacement cycle but it could spark one.  The long-term dynamics are in place, however, which is why we are excited about the prospect of a spark.  Here are the reasons why replacement acceleration could be fast and big:

1.       Floors are not old yet but they will be soon – end of TITO was 6 years ago

2.       Operator balance sheets are in much better shape

3.       More certainty in the casino business – revenues are stagnant but at least the world isn’t ending

4.       More competition from new markets

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Athletic Zigs While Retail Zags

Trends since August have turned decidedly more positive in the athletic industry since marking a near-term bottom from June through July during a period of declining trends in footwear and apparel. Here are a few noteworthy observations:

  • While the impact of BTS has occurred later than expected this year, it has also come in stronger than most expected as well driving the v-bottom and hockey-stick like move in August on the 1yr and 2yr trends respectively.


  • With trends moving sharply higher, it’s worth noting that footwear anniversaries its toughest comps over the next two-weeks – when sales came in +3.7% and 4.8% on a trailing 3-week basis before falling off sharply over the next 2-months – until we hit holiday driven December sales. Importantly, this period of favorable compares comes at a time when basketball begins to sell through on the heels of improving trends and new product is hitting the market.


  • While toning has contributed to athletic footwear sales particularly in the summer months, the recent improvement in trends is at a time when the contribution from toning is on a decided decline and driven instead by core categories like running as well as basketball.


  • Price still matters. After increases both in footwear and apparel heading into August, footwear trends have responded more favorably to less aggressive price increases over the last 6-weeks while apparel prices took longer to ease after which sales improved.


  • On a regional basis there are two key callouts since the beginning of August. First, the relative outperformance in the South Central, which coincides with recent commentary out of DKS on the strength of the Texas market relative to its core business. The second is the Pacific region, which is the only region to slow over this period of considerable strength in the industry.


  • With favorable Running and Basketball trends in footwear, Nike (both Brand and Jordan) and Saucony remain strong while Running, Compression, and Outdoor Outerwear have been the key categories of strength in apparel driving solid numbers at Nike, Under Armour, Columbia and VFC (The North Face).

Athletic Zigs While Retail Zags  - FW App Industry Data 1yr 9 16 10


Athletic Zigs While Retail Zags  - FW App Industry Data 2yr 9 16 10


Athletic Zigs While Retail Zags  - FW Core ExT 9 16 10


Athletic Zigs While Retail Zags  - AppFW regional trends 9 16 10


Athletic Zigs While Retail Zags  - App by Chan 9 16 10


Casey Flavin


CRI: One of the Worst Stories in Retail

CRI: One of the Worst Stories in Retail


I tried to think of a clever title. But with CRI there’s really no more appropriate way to tee up the story. This company is over-earning by 400bps in margin.


Let’s be clear about something. The Carter’s brand is dominant, and the core business is extremely defendable. Everyone reading this who has a child under the age of 2 probably has Carter’s layettes, onesies and booties all over the place.  Our point in this note is not that the business is a fade, but simply that the sustainability of the current revenue trajectory at a 13% margin is an absolute pipe-dream.  Our model is at $1.87 in FY11 – the consensus is $2.51. Our confidence in this number is high. Timing and sizing of the position will depend on Mr. Market. Keith shorted CRI in the Hedgeye Virtual Portfolio yesterday. Game on…


Macro Chimes-In:  Before we lay out the research behind why margins need to come down, here’s Keith McCullough’s view on CRI from a Trading/PM perspective.


“CRI is bullish immediate term TRADE and bearish intermediate term TREND /long term TAIL. Immediate term bullish is what I call a short selling opportunity. The long term TAIL line of resistance for this stock is where it collapsed from this summer = $27.91; use that as your stop. From an intermediate term TREND perspective, there is a wall of resistance at the $26.68 line and I’d short it all the way up to that level, averaging in. Immediate term TRADE support is $23.69, and a breakdown/close below that line will put lower all-time lows in play.”




 As we usually do, let’s start off here with some historical context. It’s vital to the call.


Nov ’03: Carter’s goes public. The ‘pitch’ crafted by the bankers at Morgan Stanley was that the company was reaccelerating growth around its core baby business to playwear, mass channels, and company retail. This was being facilitated and funded by a deeper sourcing relationship with Li&Fung.


May ’05: Carters buys Osh Kosh for a staggering 312mm. As a frame of reference, that’s 10.8x TODAY’s EBIT.  It’s old hat that this deal was a complete failure. But the context matters.


You gotta hand it to the MS Bankers. Their pitch at the time was spot on. That’s probably why the stock ended up being a 3-bagger in 2-years.


But there was one very big problem brewing beneath the surface. Simply put, the company was morphing its business model from that of a stable and predictable packaged goods company, to one that is more fashion related.


C’mon McGough…Isn’t it a stretch to call Carter’s fashion??? The answer is No. The core wholesale baby (onesies, blankets, etc…) used to account for 75% of cash flow. Now it is closer to a third. The stone cold reality is that the Playwear business competes with Old Navy, Children’s Place and Gymboree. The retail segment is a completely different ball game, has extraordinarily low visibility, and added significant volatility to internal forecast accuracy. The mass business can be a great asset, as the Target partnership has proven to be. But Wal*Mart woke up one day in 2009 and decided to shrink Carter’s. Not good for a company that’s never had to deal with key customer risk.


This all adds up to a business that has changed so much at the front-end as it relates to product and customer mix. That’d be great, but unfortunately the back-end of this company still looks and functions like a packaged goods business.


That’s why it was so amazing to see the business deteriorate from ’06-’08, and yet margins still never moved more than 100bp off of 10%. The reason is that CRI cut infrastructure – almost entirely on the creative side of the business – to keep margins and EPS high.  An example is that when CRI bought Osh Kosh it had over 400 employees, and by the time of the management shake-up the Osh Kosh employee count was well below 200. Philosophically, I don’t see how any consumer business can reaccelerate growth by cutting heads by 50%.


The punchline is that this is what led to the shake-up in top brass in the summer of 2008. I was a big fan for all the above reasons, and specifically noted at the time that a guy like Mike Casey (then CFO) would ‘get it’ that margins needed to come down due to infrastructure investment before they could go back up to a level that would sustain profitable top-line growth. But I could not have been more wrong. Over the past 2-years margins have come up by a full 500bp. This is the same time over which the spread between consumer prices for apparel and input costs widened to 3-standard deviations above the mean – implying about $10bn of profit was freed up in the supply chain of an industry that’s only $280bn in size.


CRI: One of the Worst Stories in Retail - Apparel Kity Margin 


 CRI: One of the Worst Stories in Retail - CRI  Industry  and CPI Apparel Import Spread


That brings us to today… What do we know? We know that we’re in a margin bubble, and in YouTubing management, synching with changes on the margin in the Macro and Retail landscape, and applying some analytical muscle – it paints a story where margins appear to have meaningful downside. 


1)      There has been a disproportionate shift in talent in Carter’s from product/merchandising towards finance and accounting. Is it bad to have better accounting? NO!!! But it needs to be additive to headcount, not replacement for creative talent.  This is one reason why margins popped like they did over 2-years. A nice bonus, but not sustainable.


2)      During this period, Carter’s had its little run-in with Kohl’s over accounting for markdowns – something that did not make KSS happy in the least. It also ran out of steam with Wal*Mart and subsequently had a 25% decline in WMT revenue. We’re seeing a pick-up at WMT this year per CRI. But with WMT completely uprooting apparel merchandising organization, this business is hardly a lock. The bottom line is that a question mark behind WMT and KSS is not something I want to see when I’m incrementally concerned about product.


3)      Here’s management’s comment on cost inputs as of the conference call in July vs. our take (in bold).  

    • CRI: “The cotton cycle has typically run some portion of a year.  Nothing cures high prices like better-than-high prices, so as prices are up, people plant more cotton and the prices will come down.  So cotton and freight will settle down in the next year or so.”
      Hedgeye Retail: Since this statement – by far and away the largest component of COGS at CRI – is up 19% sequentially. That’s 56% year on year, 56% year on year, 56% year on year.  Get the point? The company is planning for 10%.
    •  CRI: Higher labor rates will continue with us. Li & Fung says to expect higher labor rates to continue as there will be an inflationary cycle in the foreseeable future.
      Hedgeye Retail:  This is the second-highest input cost.

 4)      Pricing/Promotional Considerations


a.      CRI On prices: “So going into spring ‘11 where products costs have gone up, 10%, we’ve raised prices in both wholesale and retail, I would say selectively. We’ve raised in where we thought unit velocity wouldn’t be significantly impacted and that’s a balance. We could take prices up on everything tomorrow, but if you take that spread beyond what makes sense relative to private label, you’ll start to lose unit velocity. So we’re trying to find the right balance between what price would the consumer be willing to pay, what continues to drive very strong top line growth because growth – sales growth solves a lot of issues.”
Hedgeye Retail: We know that this company needs pricing power to keep margins high. The price/cost gap has turned meaningfully against CRI over the past 3 weeks.


b.      Promotional Flexibility: CRI: 50% of business is in retail, so [we have] plenty of flexibility.  Typically the day new product hits the floor in owned stores its 40% off, only when the product is selling really well will they moderate the level of promotion to 25%-30% off.  If traffic is better, product performance is better, if traffic is weak, it’s easy to get promotional.
Hedgeye Retail: 40% off on day 1! Does this sound like a business with pricing power? And this represents 50% of CRI’s business. 


c.      Long-term Cost Cycle: CRI: “Li & Fung has said publicly, listen, we’re probably going to be in an inflationary cycle whereas over the past 10 years it’s been a deflationary cycle, on product costs, probably going to be in an inflationary cycle. People got to have to figure out how to get paid more because we’re all public companies, we are not interested in lower margin, business isn’t making less money. So it’s going to – the consumer ultimately is going to have to pay a bit more for the product that they’re buying. Yeah, so I think it has more of an inflationary issue than it’s what Target and Wal-Mart are doing.”
Hedgeye Retail: JC Penney and Kohl’s are also out recently saying that inflation will be good for the apparel industry. It seems like everyone is banking on all of us paying higher prices. SO let me ask you this…with a 56% boost in the primary cost input, you’re looking at paying $11.50 on a layette that would otherwise cost $10. Not a chance… 


d.      CRI on what we’ll refer to as Anniversarying a Temporary Pricing Bubble: “Everybody was running very lean over the past 12 to 18 months. [Are people shifting] to be more aggressive with building inventories? I hope not, because when they were running lean, they were running out of goods, calling us to say hey, we’re too light on inventories. Can you ship the – that third delivery earlier? Can you get us some things? What do you have? Can you dip into the safety stock levels and get us product earlier. And for us, it was a beautiful thing. We had a strong consumer pull model and the sales were better, margins were better.”
Hedgeye Retail: Kind of ironic that this happened during the period when the new management team was put in place and margins went up 500bp. 


e.      On Private Label: CRI: “We’re most conscious on the spread between Carter’s and Osh Kosh brands vs. private label.  Private label is primary competitor and as long as management keeps the price $1 to $2 above private label, consumers will pay the premium for the branded product.”
Hedgeye Retail: Again, pricing for this company will be based on the least common denominator in the competitive landscape. CRI is not planning for this. Nor are the retailers. Who in their right mind would step up now on a conference call and say ‘we’re preparing for a price war with our competitors’ or ‘we’re going to break rank with retailers and breach price integrity’? 


The bottom line is that we’re just coming off a 2-year period where margins skyrocketed by 500bps despite no change in the trajectory of revenue. Input costs and supply chain dynamics worked in CRI’s favor, as did an accounting-led management team. Along the way product has suffered relative to strengthening competition, relationships with key retail partners became strained, and input costs have done nothing but go up. The level of price increase that we as consumers need to pay without department stores or Li&Fung picking up the tab in order for CRI to protect margin is something they’ve never seen – ever. The sell-side has adopted an extend-the-trend model here and has the company reaching margin levels in 2011 that are above Nike, Ralph Lauren, Under Armour, Columbia, and a host of others who have something called sustainable top line growth. We’ve got high conviction that this is a blow-up waiting to happen. 


Where could we be wrong? 

  • CRI is seeing a rebound in its Wal*Mart business next year. They’re budgeting $125mm – which is up roughly $15mm vs. this year, and over $25mm in 2009. Even though there is new leadership in Wal*Mart’s merchandise org for apparel who has little brand loyalty, this is a good direction. If the brand performs and the desired price and margin, there’s no reason why it can’t head higher.
  • CRI brought in a new product leadership team at Osh Kosh earlier this year. They plan to strut their stuff for the Street at an analyst event in October. Wholesale orders are currently up about 10% at Osh Kosh – that’s about $10mm, or less than 1% incremental growth to the company.
  • Dot.com is an opportunity for CRI. They’re investing in this business and are likely to see an acceleration therein. Dot.com makes sense here.  Think about it – you’re a new mom and you need a bunch of booties. Do you want to haul all the way to a Carter’s store? Probably not.  That said, it makes more sense to us to leverage the dot.com model of a Baby’s-R-Us or Buy Buy Baby – where you’re likely doing one-stopping for the wee one beyond apparel.
  • Pricing: If the industry as a whole pushes higher pricing and no one breaks rank, then our numbers next year may be too low. It would be one of the first times in the modern history of the apparel retail industry that this happened. But it’s a risk we can’t ignore.
  • The 3Q print is the most challenging one from a top line perspective. Then the 4Q compare is quite easy before the margin story really starts to unwind. Whether CRI lets the margin story out of the bag with guidance in the 3Q call is questionable. We’re probably going to have to wait til 1Q for the big blow-up. 

Where could the stock go?


If you think that our work is completely off-base and you believe that the company can earn $2.51 next year and continue to grow sales in the mid-single digits, EBIT at 10, and EPS in the teens, then be my guest and buy it at $25.  But if I’m ultimately right on the model, then we’re looking at Under $1.90 in EPS. We can slap a 10x p/e on that, but the reality is that I’m looking for a severe event that will blow earnings credibility out of the water. At that time, I’m not so sure how many people will be so rational or fixed on price target methodology. If the event makes $1.87 apparent, then there will be times where the market will wonder – why not $1.25? Why not $0.50? That’s not what I’m calling for, mind you. But simply to use 10x $1.87 as a floor would be irresponsible from a risk management perspective. Realistically, this has $5-10 downside. As noted, Keith is likely to trade around this for a quarter or two based on his own risk management parameters. Stay tuned. 





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