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FILL ‘EM AND THEY [INVESTORS] WILL COME

Trading opportunities aside, the trend for hotel stocks won’t be positive until occupancy turns. The good news is that occupancy will move into positive territory before average daily rate. The bad news is that we are probably still a long way from a sustained up move in occupancy rates.

We are not breaking any new ground by revealing that lodging is a highly cyclical business. The demand cycle is generally driven by economic growth. Fortunately, supply growth looks tame for years to come which should limit this lodging downturn to the duration of the economic downturn.

The stock market is a discounting mechanism and the same applies to lodging stocks. While ADR is the more important metric for profitability, occupancy is the optimal leading indicator of sustained moves in lodging stocks. Since the flow through on room rates is so high, hotels hold rate as long as possible. Typically, occupancies drop long before rates and so while revenues and profitability will continue to accelerate, this is a signal that the industry is on the back side of the cycle.

Similarly, and more germane to the current environment, a positive turn in occupancies signals the beginning of the cycle and usually rates will follow. The following chart clearly shows the relationship between the stocks and occupancy. In the supply led downturn in the mid-90s, occupancy declined well before rate and the stocks soon followed. After the supply situation worked its way out, occupancy and the stocks began a short-lived ascent, cut short by the 00/01 recession and 9/11 attacks. Occupancy recovered in mid-2002 and the stocks commenced a four year bull market in early 2003. Finally, occupancy again began its current descent in mid-2006 and the stocks peaked in May of 2007, no doubt kept afloat by the hope of private equity involvement.

So what are the takeaways for the current environment? We are currently at an occupancy rate around 60% which leaves about 2-3% downside to the post 9/11 low. It could take 9-12 months to get there which probably means we are still a long way from a sustained recovery in lodging stocks. We had gotten more positive on lodging into the New Year, particularly MAR, due to the winding down of timeshare (more cash flow) and unprecedented bearishness. There will be other trading opportunities but for those investors looking for a sustained rally, watch occupancy levels. We don’t appear to be there yet.


CONFESSIONS OF A LEASE JUNKIE

Ok, I admit it. I am a lease junkie. I don’t mean to beat a dead horse on issues like differences in rent escalators and contract terms, but the reality is that they matter – a lot. The difference between a 10 year duration and 5 year duration equates to a multi-point swing in margins for most retailers. That can’t be looked over when some of these guys are operating in the mid-single digit margin range.

A client asked me to deliver a comparative analysis of lease structures for different retailers. Note that such projects are a regular part of our business, and upon completion are ‘embargoed’ for a period of time specified by the client – after which I can share if I so choose. This is one where the results were clearly worth sharing. It brought several questions to the forefront for me that I previously did not appreciate.

The analysis looks at the total duration of lease portfolios for different retailers, which we calculate using disclosure of minimum obligations by year on off balance sheet assets (Y Axis). Then on the X axis, we plot the 2-year change in portfolio’s duration. It other words, what is the duration, and are recent actions by management extending or shortening that duration.

There’s no right or wrong place to exist on this chart, but it definitely opens up a few questions regarding management’s growth philosophy where such investments are being accounted for, and how they are funded.

Making sweeping statements based on the analysis would be intellectually dishonest, as there’s no right or wrong place to exist on this chart. This is really more of a tool to ask management teams the right questions regarding growth philosophy, where such investments are being accounted for, and how they are funded. Some observations…

1) Generally, I like shorter durations, as it suggests that the companies have the most optionality lengthen it if they’d like and boost margins vis/vis deferring payments. Not a strategy that I recommend, but it is a lever available nonetheless. Some companies (DKS, DSW) will argue that they are confident enough about their business plan such that they can model sales far enough out to warrant at 10-15 year lease. I find that tough to stomach. The only time I prefer longer-tailed agreements like this is when companies that have ample liquidity take advantage of suffering landlords and lock in longer agreements on the cheap (i.e. we just leased our new San Diego office for a buck a foot. How? It is a new space originally built for Lehman. Enough said…).

2) CAB: How scary is Cabela’s? 20-year duration in its portfolio, with a whopping 4-year growth rate in that over 2 years. Yes, this suggests that new stores are being added to the tune of about 25 years in duration. Good luck with that.

3) LULU: I’m a very big fan of LULU. But this is a negative datapoint for me. A 10.5 year duration is not horrible, but the fact that this grew by 2.25 years at the same exact time the company meaningfully broadened its exposure to the US suggests to me that US stores are being added at a rate far higher than 10 years. It makes me wonder what margins would look like with terms on these new stores closer to a high single digit rate. Definitely something to look in to.

4) UA: Under Armour originally concerned me with a doubling of its rate over the past 3 years to 6.25 years. But this is largely because a) UA is building a retail store network that previously did not exist (which takes up off balance sheet liabs), and b) athlete endorsements are growing at a rate disproportionate to sales as UA invests in businesses like basketball and training. I’m ok with this.

5) HIBB: How could I do this analysis and not mention Hibbett? 4.2 years and has not budged in years. These guys have the ultimate flexibility with their ‘Wal-Mart remora’ real estate strategy. I particularly like HIBB in ’09 bc it should see a reversal in almost every pressure point of the P&L and balance sheet. Consider this…Aside from weak urban business, sales have slowed because of HIBB’s inability to close on new deals over the past 2 years at a rate to facilitate its’ stated growth goal. At the same time HIBB built a DC and installed JDA (ERP system) which are well-needed operational investments. On top of that, the product cycle has been lousy. Now UA is sparking a healthier product cycle, JDA and DC investments are done, and the weakness in credit markets and business trends is making better real estate available at a greater number of mom and pop locations. Not only should growth accelerate in ’09, but margins should go up and take incremental ROIC with it.

6) COLM: I like Columbia, and with a 7-year duration I am not worried. But a 2year boost in duration over 2 years (as it opens more retail) bugs me.

7) DKS: DKS much look good with a 2 point improvement, but that optic is driven by Golf Galaxy. Strategy remains risky.

8) Nordstrom, Kohl’s and JC Penney all hovering around 9 years. But JWN duration improved by a year, KSS was relatively flat, and JCP eroded by a year. I like KSS, have been warming to JWN, and despite a strong near-term incentive structure at JCP, am so grossly uncomfortable with the story that I need to hold out and be greedy on that one.

So many more questions to ask and answer here. Let me know if you’d like to discuss.

The analysis looks at the total duration of lease portfolios for different retailers, which vs. the 2-year change in the portfolio’s duration.

Hunting American Bear...

Much like yesterday’s Chinese PMI chart, today’s ISM non-manufacturing chart found itself a little hook higher (see chart). What happens on the margin matters most to our macro models, and this, on the margin, was another better than toxic economic report.

The bears traps are still land locked in a thesis that bottomed in November, not only locally here in the USA, but globally. In December/January, things started to get “unstuck”, and that’s why equity markets, globally, continue along this path that we have been calling for – “Re-flation”…

Keith R. McCullough
CEO & Chief Investment Officer

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SP500 Levels Into The Close

With the SP500 now +25% from its deflated “Depression” lows, there are a lot of bulls out there asking themselves why they are so bearish. This is a very good thing – it’s bringing liquidity back into a market that’s earned herself lower volatility and more predictable trading ranges.

The US$ had an important intraday reversal and now higher beta assets like commodities and stocks continue to “re-flate” as a result. This is what happens after asset bubbles pop and new ones in terms of negative sentiment form. The bears have doubted this move from the start – we should be thankful for that.

My new trading ranges are outlined below. They are, on the margin, more bullish than they were prior to this morning’s open. That’s just how the math works.

Topside resistance for this market’s immediate term “Trade” moves up to the 951 line, and intermediate “Trend” resistance remains formidable at the 963 line (see chart).

On the bullish side of the “Trade”, your support line has built itself up to 896, and there is considerable support below that line at 884. Keep moving.
KM

Keith R. McCullough
CEO & Chief Investment Officer

CHUX – NEW LEADERSHIP

O’Charley’s announced today that it named Philip J. Hickey Jr., the former CEO of RARE Hospitality International, to its Board of Directors. Mr. Hickey’s appointment was recommended by Crescendo Partners, CHUX’s largest shareholder, pursuant to an agreement Crescendo Partners entered into with CHUX in December. Mr. Hickey was the CEO of RARE Hospitality when it was acquired by DRI in October 2007 for about 10x NTM EBITDA, a significant premium to the FSR group’s current average 5.9x multiple and to the group’s 5x multiple for the better part of 2008. Mr. Hickey was instrumental in selling RARE at a 39% premium to the company’s stock price prior to the announcement of the acquisition in August 2007 before FSR stock prices declined an average of 48% in 2008. Making this appointment more interesting is the fact that Crescendo Partners has engaged in discussions in the past with certain members of CHUX’s senior management regarding “various strategic alternatives to maximize shareholder value, including (i) a significant repurchase of shares, (ii) the sale-leaseback of [CHUX’s] real estate assets, (iii) a sale of [CHUX’s] Stoney River restaurant concept, (iv) the refranchising of company-owned restaurants in under-penetrated markets and (v) the outright sale of [CHUX].” Relative to these alternatives, Crescendo Partners’ choosing Mr. Hickey as its Board appointee signals that CHUX’s largest shareholder is pushing for real change, including a possible sale of the company.
Mr. Hickey’s appointment comes only two weeks after CHUX announced the retirement of its Chairman and CEO Gregory Burns. The company’s Board of Directors is currently undergoing a nationwide search for his replacement. CHUX has underperformed its FSR competitors in recent times with EBIT margins down over 560 bps since the end of FY06 to -0.3% in its most recently reported quarter. Over that same time period, the company has increased its leverage from about 3.4x to over 4.5x on a debt/EBITDAR basis (more than the FSR group’s average of about 4.2x). That being said, new leadership in both the CEO position and at the Board level should prove favorable.

Dr. Copper is Poking Up His Head

In global macro circles, the metal copper is more commonly known as, “Dr. Copper” for its ability to predict economic cycles, much like someone with a doctorate in economics should be able to do.

The differentiating factor between Doctor Copper and the typical Doctorate in Economics is that the former has been around for millions of years, while the latter is a much more recent creation. In fact, the first Nobel Prize in economics was awarded in 1969.

Copper is known for its predictive ability due to overwhelming use in building construction and industrial production. According to copper.org, building construction is ~46% of copper use, electrical products are 23%, and transportation, consumer, and industrial product production comprising the remaining 31% of use.

Given its broad base use in many different sectors, we have had been focused on the pick-up in copper pricing over the last five weeks, which we believe is an early indicator of reaccelerating global growth and industrial production heading into Q1 2009. This pick up in pricing is shown graphically in the chart below. To be sure, bottoms are processes, not points… but this “re-flation” process continues to fortify itself.

Daryl G. Jones
Managing Director

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