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‘The Question’

The purpose of “The Question” is to get to the bottom of key issues of investment significance, and to call out those companies that are particular standouts (+ and -).

My approach to the question this week was specifically geared to McDonald’s. I believe that the McDonald’s system faces many challenges, the extent of which is not being felt in Oak Brook. Having been a McDonald’s observer for the better part of 15 years now, I wanted to put franchisee anxiety into historical context. With that in mind, we set out to survey the McDonald’s franchise system to see how the general population is feeling.

If "1" is 100% contentment and "10" is wanting out as fast as you can, what is your level of anxiety with how Oak Brook is handling the issues franchisees are facing today? For historical context, to the extent they could, they were asked to rate past periods too.

(1) Overall in the history of MCD – 3.7

(2) In the 1980s – 4.3

(3) In the late 1990s to 2002 – 6.9

(4) Today – 5.2

The late 1990’s to 2002 was one of the worst periods for McDonald’s franchisees. While we are not seeing those levels of discontent today, the trend is not working in management’s favor.
Herb Peterson, McDonald’s franchisee and the creator of the Egg McMuffin, showing off his invention in April 1997 in California.

Game Time

The Chinese machine of athletic perfection picked up its 51 gold medals and the Beijing Olympics have ended. The US Presidential election is set to take (or drop) the baton in the global news flow relay this morning. The Democratic National Convention will launch into the spotlight tonight.

What matters here is timing. This week will refocus traders on the compressed duration that exists between now and November’s Election game time. From an economic, racial, and class perspective, this is setting up to be one of the most divisive elections in US history. Alongside this reality comes heightened potential for market tail risk.

Within the construct of our ‘RIPTE’ US Economy macro “Theme” (Re-regulation, Inflation, Protectionism, Taxes, and Employment), there are plenty of reasons explaining why McCain’s recent rebound has been beneficial for the market. We have issued our regression analysis in past portal postings, so I won’t rehash the “t”-stats in this morning’s note, but the math says that Obama’s popularity has a statistically significant inverse correlation to the S&P 500. Alongside his recent month-long-slide in the polls, the US market has levitated to the high end of its trading range.

Considering the re-flation “Trade” of last week (CRB Commodities Index was +3.1%; US Dollar down -0.51%), Friday’s weight-lift in the US stock market was impressive. That said, from a quantitative perspective, we have moved to a critical crossroad in global commodities and currency markets, where volatility looks primed to pick up. Last week’s US market volume was as bone dry as it has been all year.

Now that commodity driven inflation is understood domestically, I think global growth and geopolitical risk move to the top of your macro focus list. Asian growth in particular remains misunderstood by US centric investors. This morning we had another negative GDP report out of South East Asia’s 2nd largest economy, Thailand, and stocks in Bangkok closed down another -0.55% as a result. Thailand’s GDP for Q2 came in below expectations at +5.3%, and this is not good considering that inflation for July was last reported at almost double that rate. Government officials in Thailand raised rates last month for the 1st time in 2 years. Alongside inflation, cost of capital in Asia continues to rise in the aggregate – this continues to drag down Asian equity prices.

Thailand’s inflation partly reflects the regional dynamic of wage inflation. This is something that US economists have not had to worry about, yet. Enter an Obama government, and that changes – hence the negative correlation the US market has to his chances of victory. Asia’s inflation story is misunderstood largely because it is much more like that which the US had to deal with in the 1970’s, with both prices and wages rising in tandem. If you look at an economy like Pakistan’s for example, which is running with close to 30% year over year inflation, you can understand, partly, why the masses are literally stoning the Karachi Stock Exchange. Pakistan’s stock market bounced for a day post the Musharraf ousting, but has since lost -11% in the 4 trading days that have followed.

Russia is also dealing with misunderstood wage inflation, and this will eventually put Putin in a domestic political pickle. When you have +20-25% annual wage inflation, you have a problem! Despite oil’s rise last week, the Russian stock market continued to decline. Russia’s RTS Index is trading down another -1.1% so far this morning, and has lost another -14% of its value in August alone. The lower house of Russian Parliament is calling on Medvedev and Putin to recognize South Ossetia as an independent state this morning as well. That’s only going to create more confusion in what continues to be an alarming geopolitical situation.

With the US political stage being moved to front center, do not forget that domestic fires are burning in political hotbeds throughout the world. Geopolitical factors matter to markets that trade on global macro. The summer is ending - it’s almost game time – get ready to “Trade”.
KM



US Market Performance: Week Ended 8/22/08...

Index Performance:
Week Ended 8/22/08: Dow Jones (0.3%), SP500 (0.5%), Nasdaq (1.5%), Russell2000 (2.1%)
2008 Year To Date: Dow Jones (12.3%), SP500 (12.0%), Nasdaq (9.0%), Russell2000 (3.7%)

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LAS VEGAS: OMINOUS JULY AIRPORT DATA

For the gaming industry, McCarran Airport data is the first import metric to be released. Historically, the passenger data has proven to be a very powerful and statistically significant predictor of Strip revenues. The first chart displays the high correlation between slot handle and air passenger traffic. I’ve developed a quantitative model to predict slot, table, and RevPAR growth based on the enplaned/deplaned McCarran Airport passenger data released well in advance of the other metrics. I will report my estimates on a monthly basis soon after the passenger data comes out.
  • On Friday, the airport announced that July passenger volume declined 8.6%, the largest monthly decline since 2002. Assuming normal hold percentages (luck factor), July gaming revenues will likely decline at a faster rate. Last July (2007), the casinos held above normal on both slots and tables. This factor is likely to exacerbate the overall decline. As can be seen in the second chart, I calculate slot and total volume could decline 5% and 4%, respectively. However, total revenue could fall 12% due to the above average hold percentages last year.
  • For those math enthusiasts, my model’s predictive power is very high. While I have no way of predicting luck, the McCarran monthly passenger variable explains 68% of total gaming volume (aka handle or drop). Barring another month of good luck on the tables, July gaming revenues are not likely to look pretty when they are released in 2-3 weeks. Coming soon, I will put my modeling skills to work on room rates. This profitable revenue driver is likely to look even worse.
Correlation between Strip slot handle and air passenger traffic of 0.89
Revenue declines likely to exceed air passenger drop

FL: 99-00 Revisited

I think that FL’s current positioning mirrors where it was in 1. It came out a dark period, looked expensive all the way, and the stock still tripled. Timing and sizing are key.
  • You’ve seen us put up our inventory/margin roadmap charts – and FL recently checked in to the ‘sweet spot,’ where sales growth is outpacing inventory growth, and margins are positive. Yes this is a great place to be – but that’s especially the case for Foot Locker.
  • I’m hard pressed to find any retailer that has spent so much of its history in a negative inventory position and simply living in a world of swapping margin for comp. In fact, the only two I can find are Sears and K-Mart when they were stand-alone companies (and now the combined entity, of course).
  • But when things turn positive, they stay there for more than a quarter or two. Looking at FL’s 10-year trend, it was in a negative inventory/sales position 90% of the time. But the one time it came out of its funk was in mid-99 through the end of 2000. This was also after a 2-year period of fashion shifting away from athletic, the Asian currency crisis, and overcapacity at retail – not unlike what we have today.
  • During the time period where its income statement and balance sheet synched in the ‘sweet spot’, FL’s stock went from $5 to $16 – and yes, it appeared expensive every step of the way.
  • I’m not suggesting we ignore valuation, as there are plenty of issues that have yet to be resolved. One of the biggest is dynamics in Asia and flow through to the US (we’re published a ton on this, and I still think that FL can triple margins from here in that context). Also, 3Q is an easy compare, but less so than what was just reported, and less than what we’ll see in 4Q.
  • My confidence level remains high. This is a question of timing and sizing.
Tough to read, I know. But showing the 1 period vs today is vital.

Restaurant Anthology – Part 2

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.
  • An increased number of companies at risk of defaulting on debt covenants - On July 20th, I published a list of 13 restaurant transactions that have taken place over the past three years and asked the question; how many companies on this list will need to raise equity or file bankruptcy in the next 12-18 months? Last week, the WSJ highlighted some of the companies on the list. According to the WSJ, the parent of Uno Chicago Grill was expected to skip a bond payment as it tried to negotiate more financial breathing room. The issues at Uno are a common theme in restaurant land – UNO is being squeezed by declining customer counts, rising food costs and an overleveraged balance sheet. The article also cited that Chevy’s Fresh Mex, Perkins and Marie Callender's chains are in talks with their lenders - posted August 13.
  • Increased leverage within the industry – I just don’t understand the reasoning behind the capital allocation decision to borrow money to buy back stock. RRGB’s board recently authorized an additional $50 million share repurchase effective through 2010. The company’s lowered new unit growth for FY09 will free up additional cash, but I would not like to see RRGB offset this shareholder-friendly capital allocation decision by then borrowing money to buy back more stock than it should – posted August 19.

    YUM’s cash flow story is changing with the company’s debt levels increasing to keep up with increased cash burn (in the last 12 months, YUM has burned through $1.4 billion in cash and its interest expense has increased 8%). Additionally, YUM has been allocating more cash toward capital spending (up 13% in the last year), which increases YUM’s risk profile and drives lower incremental returns for shareholders. YUM’s capital spending needs are growing and that will come at the expense of the share repurchase program. The question that remains is if interest expense in up 8% (due to higher debt levels to buy back stock) and the share count has only declined by 2%, how is that accretive to shareholders? – posted August 14.
  • Other Company-Specific Highlights:

    YUM – I recently reviewed YUM’s proxy and the metrics used to determine how management gets paid. Including the leverage factor, EPS growth of at least 10% can account for more than 50% of the bonus. System sales growth and system net new restaurant builds (easily achieved by accelerating capital spending, which has been steadily increasing for YUM) collectively account for another 40%. There is no incentive for management to improve the operating performance of the company. In light of the poor operating performance in the U.S., it is very clear why management wants to leverage the balance sheet and reduce the share count by 8% - posted August 21.
  • MCD – As of 2Q08, MCD said specialty coffees is in more than 1,600 restaurants (up from 1,300 in 1Q08). If we assume the company accelerates the conversion process in 2H08 and converts 1,200 stores, the total number of McDonald’s stores with the ability to sell specialty coffee in the U.S. would be 2,800, which is only 25% of the system. Management has set expectations for a national launch for the specialty coffee program in mid-2009, but if only 25% of the store base has the ability to sell specialty coffee, how can the company justify spending the marketing dollars in 2009? More importantly, will the franchise system embrace the move? – posted August 15.
  • CKR - CKR posted solid period 7 same-store sales growth at both Carl’s Jr. and Hardee’s, up 4.2% and 1.4%, respectively, closing out 2Q up 3.8% at Carl’s Jr. and up 3.3% at Hardee’s. Both concepts experienced sequentially better 2-year average trends in 2Q from 1Q (100 bp improvement at Carl’s Jr. and 250 bps better Hardee’s). CKR also provided restaurant operating cost guidance for 2Q and expects restaurant operating margins to be up 20-50 bps year-over-year. The company is facing an easy comparison from last year when restaurant margins fell 300 bps (primarily as a result of higher food costs), but margins growing YOY is favorable, nonetheless, as CKR’s margins have declined for the last 6 quarters – posted August 20.
  • LDG – During my career as an analyst and an investment banker, I spent a lot of time looking at real estate transactions for a number of different companies. In most cases, the business model was better off owning the real estate, as it provided a level of stability to earnings. I will go as far to say that selling a company’s real estate portfolio is about as effective in creating shareholder value as an activist shareholder telling a company to use leverage to buy back stock! I guess if Bill Ackman can prove to the world that LDG’s real estate can add incremental value, it will validate his other consumer holdings. Selling a company’s undervalued real estate creates an enormous tax burden, which limits the cash available to maximize value for shareholders. I truly believe that Bill Ackman knows this, and I have yet to see a structure from him that would get around the tax issue completely – posted August 18.
  • GMCR – The bull case for GMCR is compelling but the case for demand destruction is even greater. Taken together, the combination of Keurig brewers, patented K-cups and Green Mountain specialty coffee has provided the company with strong top line growth. However, the K-cup -razor/razor blade model is a long way from generating the type of revenues needed to drive overall profitability. This is already showing up in the company's consolidated results with 3Q08 gross profit margins declining to 36% from 41% last year – posted August 12.
Restaurant Transactions Over the Past Three Years
YUM Compensation

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