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HOT: THE CREDIT IMPLICATIONS OF OUR FORECAST

Yesterday we posted a note “HOT: THE MOTHER OF ALL ESTIMATE CUTS” discussing a potential 50% earnings cut in 2009 consensus estimates. In this note we address the credit implications of our projections. If our numbers are close to being correct, Starwood will likely violate its 4.5x Consolidated Leverage covenant in the 2Q09 and certainly breach this covenant in the 3Q09 when Consolidated Leverage could peak at 5.2x.

Despite the breach, bondholders shouldn’t necessarily lose a lot of sleep over Starwood’s credit situation. Although a covenant violation is never ideal, at approximately 5x leverage the banks will give Starwood an amendment (6th time on this facility) and simply increase their thin credit spread to something more juicy. At our TTM Consolidated EBITDA calculation of $765MM at 3Q09 and only $1.9BN at the bank and secured debt level, the banks are also sleeping well at night knowing that leverage through their paper is only 2.5x.

A shareholder, however, shouldn’t sleep so soundly. If HOT breaches, cost of borrowing will skyrocket and EPS and cash flow will go down, again. The company does have some trophy assets that could be sold but the number of potential buyers has dwindled. It’s not exactly a seller’s market. Buying back discounted bonds is also an option to help de-lever.


HOT must do something to avoid a Q2/Q3 covenant breach

EYE ON AUSTRALIA: CPI

The Bureau of Statistics released Q4 CPI data today, with a -0.3% quarter-over-quarter level that confirms the trend indicated by last month’s Melbourne Institute Inflation Gauge data. This confirmation sets the stage for Governor Stevens to cut rates sharply when the Reserve Bank’s board meets next Tuesday.

Australia is now showing clear signs that it is slipping into its first recession in two decades, after the economy grew 0.1% in Q3. Currently the mood down under is growing increasingly grim with consumer confidence declines in January and a business sentiment index level for December that marked the twelfth consecutive decline. A two-year high unemployment rate of 4.5% is expected to increase over the next two quarters.

Currently median forecast come in at a cut of 100 basis points, taking the benchmark rate down to 3.25% while leaving Stevens with several bullets left to use. We continue to think that Stevens and his team are doing an admirable job –but the external issues faced by the Australian economy cannot be overcome by deft policy alone.

Matthew Hedrick
Analyst

Andrew Barber
Director

EYE ON THE IMF

The IMF released its updated “World Economic Outlook Update” today, with revised global projections for 2009 and 2010. In it, IMF Chief Economist Olivier Blanchard states bluntly, “we now expect the global economy to come to a virtual halt.” While our macro view is not as bearish as Blanchard’s holistically, we questions if some estimates are padded, in particular India.

A few main call-outs from the Report: World growth is projected to fall to 0.5% in 2009, the lowest rate since WWII, a downward revision of about 1.7% from the November 2008 WEO update, with a gradual recovery projected in 2010 to 3%. Advanced economies are expected to suffer the deepest recession with a 2% contraction this year. Inflation is expected to fall to 0.25% in 2009 from 3.5 % in 2008, before edging up to 0.75% in 2010. Emerging and developing economies are expected to slow from 6.25% in 2008 to 3.25% in 2009, with inflation in these countries expected to decline from 9.5% in 2008 to 5.75% in 2009 and 5% in 2010.

We took special note of the projections for India: at 5.1% the IMF projection for growth is well below the 6.5 - 7% that the ministry of Industry has been hyping in the press, but still strikes us as very optimistic. We re-shorted the Indian equity market via IFN today and continue to think that growth could slow more than many expect there.

The graph below taken from IMF data presents country specific, commodity, and import/export forecasts for 2009 juxtaposed with predictions from their last report in November.

Matthew Hedrick
Analyst

Andrew Barber
Director

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US HOUSING - BULLISH BOTTOM FORMING

Earlier this week we learned that this month’s existing home sales came in +6.5% higher than last month’s number (see Keith McCullough’s post titled US Housing: Bullish Bottom Forming? - 1/26/09), and more importantly, inventories declined significantly. The supply of homes came down to 9.3 months, down significantly from the peak and the 11.2 months recorded in November 2008.

The second positive data point came yesterday. It was reported that the S&P/Case-Shiller 20-city index fell 18.2% year-over-year, the biggest drop since it began 2001. Less attention was paid to the fact that the October decline was 18.1%. Yes, it was the worst month on record, but the rate of deceleration continues to slow. On the margin, this is a positive. As we noted in our MEGA note, we believe that as we reach the spring, we will have reached the peak in declining home prices. Home prices will continue to decline but at a much lesser rate.

The bears point to the fact that home values will continue to decline contributing to what’s already been the biggest destruction of American household wealth in many generations. Consequently, the decline in home prices makes banks even more reluctant to offer mortgages. We know all this!

How many times have you heard everything has its price? Clearly, the decline in home prices is now leading buyers back into the market. At the same time, we are seeing a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30-year mortgage rates. The combination of significantly lower home prices and lower mortgage rates will have a positive impact on the US real estate market in 2009!


US HOUSING - BULLISH BOTTOM FORMING PART II

Earlier this week we learned that this month’s existing home sales came in +6.5% higher than last month’s number (see post US Housing: Bullish Bottom Forming? - 1/26/09), and more importantly, inventories declined significantly. The supply of homes came down to 9.3 months, down significantly from the peak and the 11.2 months recorded in November 2008.

The second positive data point came yesterday. It was reported that the S&P/Case-Shiller 20-city index fell 18.2% year-over-year, the biggest drop since it began 2001. Less attention was paid to the fact that the October decline was 18.1%. Yes, it was the worst month on record, but the rate of deceleration continues to slow. On the margin, this is a positive. As we noted in our MEGA note, we believe that as we reach the spring, we will have reached the peak in declining home prices. Home prices will continue to decline but at a much lesser rate.

The bears point to the fact that home values will continue to decline contributing to what’s already been the biggest destruction of American household wealth in many generations. Consequently, the decline in home prices makes banks even more reluctant to offer mortgages. We know all this!

How many times have you heard everything has its price? Clearly, the decline in home prices is now leading buyers back into the market. At the same time, we are seeing a zero percent Fed funds rate, and an Obama administration focused on getting banks to lend to those seeking new lows in 30-year mortgage rates. The combination of significantly lower home prices and lower mortgage rates will have a positive impact on the US real estate market in 2009!

Howard Penney
Managing Director

MCD - DECELERATING

MCD’s U.S. same-store sales growth remained surprisingly strong throughout 2008 despite the tough economic environment. The company states that half of this comparable sales growth has been driven by traffic with the remainder coming from increases in average check. The growth in average check in 2008 was driven solely by MCD’s 3%-4% price increase, which was partially offset by negative mix contribution in each quarter. Please refer to the charts below, which assume 50% of MCD’s quarterly U.S. comparable sales growth is driven by traffic and 3.5% pricing for each quarter in 2008. One obvious explanation for MCD’s negative mix in the U.S. is that customers are trading down to the Dollar Menu, which has also helped to support traffic growth. Management has said, however, that the Dollar Menu has remained within its historical range of 13%-14% of sales.

Instead, management commented on this negative mix issue on its 3Q08 earnings call, saying, “I wouldn’t call it negative mix. The problem with an average check is you have a lot of different transactions in there. So our breakfast business, as we have said, in the U.S. continues to grow faster than the rest of the day and breakfast is a lower average check but a higher margin transaction. The same way with drinks. We were strong in our drink promotions through the summer, as we have talked about. Coffee is up more than 30% and a lot of those end up being transactions that are during off-peaks which are also smaller average checks, or they are only individual versus family purchases.”

When asked earlier this week about its pricing plans for 2009, management said in reference to Europe that MCD will most likely not be taking the level of pricing in the first half of the year that it normally would because “you’ve got to consider how the consumer is feeling and during these times the consumer is looking for deals and we want to make sure that we’re out there.” Although the company did not make any specific comments about pricing in the U.S., I believe the same line of thinking must hold for the U.S. as consumers are under increased pressure. I do not think the company will reduce its pricing but it may be become more difficult going forward to maintain its 3%-4% price increases. In 2008, MCD relied on these price increases to offset its negative mix and support same-store sales growth.

Also hurting average check in 2009 will be the increased contribution from specialty coffee sales. I continue to believe that MCD is launching its specialty coffee platform at exactly the wrong time (with people cutting back on these more discretionary purchases) and that it will not provide the expected sales lift. The bulls on MCD continue to believe that the company will be able to flawlessly execute on the launch of this new beverage platform, but specialty beverages are just that for MCD; a new platform. The company is not maintaining its strict focus on its core products, and I think these beverages will add complexity to a system that in the recent past has consistently improved its operations. That being said, increased coffee sales have resulted in lower average checks in the past so I would expect any incremental off-peak specialty coffee sales to put further pressure on average check growth.

Going forward, MCD’s ability to maintain its same-store sales momentum in the U.S. may be at risk as it becomes more difficult for the company to raise prices and as its average check is hurt by increased Dollar Menu, breakfast and coffee sales. Although increased breakfast and beverage sales would be good for margins, investors have become accustomed to consistently superior same-store sales results. Additionally, it should not go unnoticed that some of MCD’s biggest competitors, Wendy’s and Sonic in particular, are increasingly focused on their value offerings, and based on its recent success, MCD has the most to lose should these companies experience improved traffic growth. Remember, the restaurant industry is a zero sum game!

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