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Integrity what?

A few months back, when we held our "Bankruptcy Cycle" conference call, I had plenty of feedback suggesting that I was wrong in concluding that we are early in the cycle. A good debate is what gets my feet on the floor in the morning, and on this front, the facts continue to play into our thesis' favor...

Integrity Bancshares filed for bankruptcy this week, taking the number of belly ups to 10 on the US banks chart. I have attached the old one below, and my analysts will have the new one on Tuesday, but the point here is that there is very little integrity in this US Financial banking system that you can hang your hat on right now. It all started at the top, with Bear, Citigroup and Lehman – now the avalanche is moving downhill.

This week, the Federal Deposit Insurance Corp (FDIC) told us that they were nervous – they’re definitely going to have to tap into ole uncle Hank (Paulson) for some of that liquidity he has at the US Treasury. They have identified 117 banks at risk. It was not too long ago that Sheila Blair's team (she's head of the FDIC) had an estimate that was under 10!

Times are a changin' out there folks. As cost of capital rises, globally, and access to capital continues to tighten, locally, there is plenty of tail risk remaining in the USA - don't forget that there are almost 8,500 banks in this clear and present danger line of fire.

August Divergences Paving The Way For American Capitalists?

In our Friday morning investment team meeting, I asked whether or not anyone could make sense of the continued divergence between mid/large cap stocks vs. their small cap brethren... With the S&P 500 -12.6% YTD and the Russell2000 only down -3.5% YTD, this remains a critical question. Can the divergence hold? Will small caps underperform in September and revert to the mean? Etc…

Hindsight is always crystal clear… now that virtually every US "strategist" is back pedaling on their expectations for large caps to outperform in 2008, there are a few, but simple question to ask yourself - are we seeing the insulated US centric American Capitalist emerge out of this financial mess in small cap outperformance? are large caps the best way to play the "its global this time" Wall Street narrative of yesteryear on the short side?

Until proven otherwise, I think the answer to both of these questions is yes. There are a variety of other stylistic factors to consider in terms of explaining the smaller cap index outperforming big brother, but I will leave those for another time. With crisis, opportunity is always born. Here’s to the new American leadership that is forming on Main Street.

Charts below courtesy of Stockcharts.com, showing the Ausgust scorecard: SP500 +1.2% vs. Russell2000 +3.5%.

US Market Performance: Week Ended 8/29/08...

Index performance:
Week Ended 8/29/08:
Dow Jones (0.7%), SP500 (0.7%), Nasdaq (2.0%), Russell2000 +0.3%

August 08 Final:
Dow Jones +1.5%, SP500 +1.2%, Nasdaq +1.8%, Russell2000 +3.5%

2008 Year To Date:
Dow Jones (-13.0%), SP500 (12.6%), Nasdaq (10.7%), Russell2000 (3.5%)


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Let’s face it. 2009 lodging estimates need to come down. I know I sound like a broken record but the data continues to deteriorate. A stronger dollar, weakening global economic conditions, and creeping room supply may finally touch the Teflon Don of Starwood’s portfolio: New York City. Starwood maintains the highest exposure to NYC of all the major hotel companies. As can be seen in the first chart, NYC represents about 7% of total owned hotel rooms and 16% of owned hotel EBITDA.
  • The same conditions that pushed hotel demand much higher than the national average (see 2nd chart) are now moving against the lodging environment in NYC. The dollar recorded the highest monthly gain in 15 years in August and global GDP growth is slowing rapidly. Since 1/1/07, the dollar index fell 15% to the end of July 2008 while international visitation to NYC grew over 20% against the backdrop of strong global economies. Meanwhile, the spread of NYC RevPAR growth vs the national average remained significantly positive throughout the period in the range of +5-9%. I believe the recent sharp reversal of the dollar and slowing global economies will narrow that gap considerably, and quickly. Considering the recent national RevPAR trends, this is not good for the NYC hotel market. August RevPAR probably fell 1% nationally.
  • In my 6/26/08 post, “NOT BEARISH ENOUGH? NOT EVEN BEARISH”, I estimated that 2009 lodging company EPS estimates were too high on average by 30%. At the time, the consensus HOT estimate was $2.92. Two months later, the consensus estimate has fallen 25% to $2.19. Unfortunately, the data has deteriorated further and forward looking indicators are worsening. I now think 2009 EPS estimates need to be reduced by another 25% and EBITDA by about $150 million. We’ll probably have to wait for the next “beat and lower” quarter come October to actually see the reductions.

Casual Dining Top-Line Trends

According to Knapp Track data, July was the worst month (by at least 100 bps) for casual dining operators from a traffic standpoint (biggest decline on a 2-year average basis as well). Earlier this week, Sanderson Farms commented that foodservice and restaurant demand has been weak with August shaping up like July. Darden’s weaker than anticipated same-store sales results for 1Q09 (ended August 24), particularly at Olive Garden, which has held up relative to other concept, reaffirmed this comment and signals that trends had not yet bottomed in 2Q for the overall industry.

Some companies might be better prepared than others. According to recent comments by management, the following casual dining companies’ guidance may be more realistic about trends in 2H08.
  • EAT 4Q08: Relative to current momentum, management stated, “You know, we didn’t see the exact same momentum continuing in Chili's. It’s sort of flattened out a little bit as we got through the first part of July. We think some of it was related to the way the holiday was and the calendar shifts there. But I would say that we went in and made some changes to our advertising and promotion, schedule. We were doing Create-Your-Own fajitas, which had a much higher price point. And we didn’t see the same kind of response from consumers that we had in the past.

    I think the other issue we were facing in July was we were lapping over a highly successful promotion from last year where we had some of the best same store sales performance in Q1. So, we made some changes to the advertising and promotion schedule. We went to the Bottomless Express Lunch again and back with our Big Mouth Burger Bites, which have done very well and we started seeing a bounce back again. So I would say that the environment is pretty choppy out there right now.”
  • CPKI 2Q08: “Despite our outperformance in the second quarter, we are making only modest changes to our full year guidance by raising our range to $0.65 to $0.70. The way we feel is, until we see consistent upticks in traffic, we'll remain cautious and believe that a negative 1% to 0% comp number for the full year is still the right range for us to forecast.”

    “When I look at our revenues and our profits, I feel very, very good about the current state of our business, even though we're very cautious about the back half of the year and lack of visibility that we all have, and that makes us conservative.”

  • RRGB 2Q08: “We continue to believe we have good visibility generally on the cost side of our business for the balance of 2008 but our visibility for revenue in the second half of the year is less clear. We will be lapping our toughest comp of the year in Q3 with the consumer environment remaining under pressure from macroeconomic influences. We will be on advertising in three weeks in the fourth quarter this year when we were dark in all of the fourth quarter last year. As we have laid this out in our press release, and as Katie will share with you later in the call, we have updated our fiscal 2008 guidance to reflect this top line uncertainty and related deleverage.”

Casual Dining Top-Line Risk

According to Knapp Track data, July was the worst month (by at least 100 bps) for casual dining operators from a traffic standpoint (biggest decline on a 2-year average basis as well). Earlier this week, Sanderson Farms commented that foodservice and restaurant demand has been weak with August shaping up like July. Darden’s weaker than anticipated same-store sales results for 1Q09 (ended August 24), particularly at Olive Garden, which has held up relative to other concept, reaffirmed this comment and signals that trends had not yet bottomed in 2Q for the overall industry. According to recent comments by management, some casual dining companies’ guidance may be at risk as they thought trends had stabilized and that the worst was behind them.

Management teams that were optimistic (or at least communicated their expectation that trends would not worsen further in 2H08):
  • MSSR 2Q08 earnings call: “Similar to last quarter we have seen stabilization at our suburban restaurants as well as some Friday day parts and Saturday dinner part which indicates to us that the decline in these guests’ dining frequency has at least plateaued and we do not see further erosion in this consumer base.”

    “We’ve definitely seen, as we said earlier, that middle income, aspirational consumer, we’re no longer seeing a continuation decline of that customer. We’ve also seen continued strong results from the business traveler which I, as you’re aware, hotel occupancies and flights are down but I think because of our national advertising campaign and our price point relative to some of the higher end options in the industry we’re holding up that consumer pretty well. So as we’ve implied earlier we’re definitely seeing stabilization and I think the initiatives we put in place are in fact very improved.”
  • RUTH 2Q08: Although management acknowledged that current trends could persist, guidance assumes an improvement in same-store sales growth. “Coming back to 2008 guidance. We now expect comparable sales declines to be in the minus five range, which is at the low end of our original range. We believe that the above-mentioned cost-cutting initiatives will largely offset the drop in earnings associated with the sales shortfall and, as such, at this time we still believe that we can deliver EPS from continuing operations without an -- within our original guidance range of $0.55 to $0.60, excluding charges associated with our CEO transition. However, if negative sales trends persist at the level we experienced in the first half or if cost savings do not materialize as quickly or as significantly as we expect, we will likely come in below this range. We will update this guidance at the end of the third quarter.

    “I won't -- we won't make any comments about -- on a go-forward basis, if you will. But what the guidance does imply is that we will have improvement in the second half of the year over the first half of the year, in part due to the easier comparison, but also in part to what we believe are very effective marketing initiatives that are in place.”
  • CAKE 2Q08: Relative to comp guidance, management stated, “Really what we’re saying is as of today, best guidance that we have and that contemplates the fact that we started to see some of the consumer slowdown in the fourth quarter of last year, and so really it would just be a nominal lapping of that, if we maintain as of today. “
  • BWLD – The Company was very optimistic about the 2H08. "Same-store sales continue to be strong in July, with increases of over 6% at company-owned and over 2% at franchised restaurants. We are in final preparation for the start of football season, with a redesigned menu rolling throughout the system this week, our HDTV and remodel projects nearing completion, our media and local marketing plans set, and our operations team trained and energized. We expect the purchase of our nine Las Vegas franchised locations to close in late September. With the momentum continuing from the first half of the year, we are confident in our ability to achieve our 15% unit growth, 20% revenue growth, and 25% net earnings growth targets for 2008."

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