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LVS: MIRIAM STEPS UP (SO DOES SHELDON)

Sheldon Adelson and his wife each purchased 7.8 million shares of LVS for a total of around $45 million.  This is not chump change.  He and Miriam met with investors at an investor conference last week and by all accounts the meetings were positive.  In this space, we’re used to managements selling stock after they talk their stock up.  To his credit, they bought stock after the conference.  Bravo.

Are they throwing good money after bad?  It’s hard to believe that Sheldon would be buying that much stock if LVS was on its way to a major covenant breach and bankruptcy.  At the current price, the stock implies that bankruptcy is a realistic probability. 

The takeaway here is generally positive.  However, one note of caution is in order.  The purchase of stock diminishes the possibility of a near-term transaction announcement.  We still expect LVS to pursue the sale of the Macau malls and possibly casino assets but we can safely assume that nothing is imminent.  Nevertheless, it’s hard to find much negative in a Chairman doubling (not quite) down.


HOT: NOT CHEAP ENOUGH

Based on our numbers, Starwood is trading at 8.5x 2009E EBITDA and 9.5x 2010 EBITDA.  Putting these multiples into historical context, HOT’s average EV/EBITDA multiple from 2000-1Q09 was 10x.  However, if we exclude the 2007 multiples which were predicated on take-out speculation and 2008 prices that factored in a much higher 2009 EBITDA estimate, the average EV/EBITDA multiple falls to 9.0x.   For those looking to bottom feed, the duration of that fishing expedition will be longer.  As can be seen in the following chart, HOT’s EV/EBITDA multiple troughed at 6.5x in 2003, which is well below the current trading range.  While the company is certainly less asset intensive than in 2003 and arguably deserving of a higher multiple, the gap to trough remains very wide.

HOT: NOT CHEAP ENOUGH - hot ev ebtida

Valuation is just one of the compelling reasons to be cautious on this stock.  Estimates are too high, industry occupancy needs to stabilize, and barring an asset sale or amendment, HOT will surely trip its 4.5x leverage covenant in 3Q09.


Retail Narratives Don’t Get Much More Powerful Than This

I’m convinced that supply chain pressure of the past 2 yrs will ease. Perhaps temporarily…but it will ease. And Soon. Add SG&A/capex cuts, positive sales delta and cheap stocks… You get the picture.

This might be the longest note I’ve ever posted, but the narrative must be spelled out in every detail. To ignore this will be to ignore a potentially meaningful second leg of a retail rally (but this time driven by fundamentals – augmenting my 3/5 call).


China accounts for 87% of US footwear consumption, and 30% of apparel (and growing). Let’s think about history for a minute…


2000-2007

1) From 2000-2007, margins for Asian manufacturers went down by 8 points. Margins for the brands went up by 8 points. Retail margins have been flat. There's only so much margin to go around, so the direct inverse correlation is no coincidence.


2) In the early 2000s Asian manufacturers had around a 15-20% gross margin, which was more than enough to offset the roughly 10% in SG&A and capital costs to turn a profit. This was especially the case given that the Chinese government rebated the VAT tax, which added between 3-7% in net profit for the manufacturers. All said, life was good as a manufacturer, which is why capacity grew at a mid-single-digit clip. Excess capacity = more pricing leverage on the part of the front-end of the supply chain.


3) Starting in early 2007, factory gross margins approached the break-even hurdle, Chinese VAT tax rebates were phased out to stimulate local consumption as opposed to export, and costs headed higher across the board.


4) The result? Capacity growth slowed meaningfully, and was flattish by the end of the year. This meant that the pendulum swung back into the hands of the US supply chain with $3-4bn annually to pad the supply chain.

Retail Narratives Don’t Get Much More Powerful Than This - 3 31 2009 2 09 04 PM


2008

Then came last year, which caused a massive reversal in the Asian side of the equation – and came alongside (and intermingled with) the US Great Recession.


1) 2008 started out with the biggest snowstorm in China in 100 years. It completely shut down the Eastern provinces and the logistical infrastructure of the country was put to (and failed) the stress test. Factories were boxed into a corner.


2) The tragic earthquake in the spring was a double whammy. Not only did this test the infrastructure once again, but the ‘human factor’ prompted migrant workers – that account for about a third of production in the Pearl River Delta factories – to simply not show up. Migrant workers that don’t migrate? Yes, that’s a problem.


3) A third important point is that in advance of the Olympics, the Chinese government cracked down on sweat shops, and started to mandate that factories pay employees back-pay for unused vacation time. You know how Americans take 2-3 weeks of vacation per year at best? And how the Brits will commonly ‘go on Holiday’ for a 5-week clip at a time? Trust me; compared to the under-vacationed US workforce, the Chinese factory-worker culture makes us look like Americans are on permanent vacation.


4) What does all this mean? Natural disasters stressed output and tightened prices for exports in aggregate. Then the government decided to wipe out the ‘sweat shop’ factor to appease human rights activists. You might say ‘the Chinese don’t ‘appease’ anybody.’ Well, in the months alongside the Olympics – otherwise known as China’s coming out party – I’m willing to bet that China reigned in its pride and cleaned itself up a bit.


5) Oh yeah…did I mention that not only did the VAT tax rebate come down, but absolute export taxes went up at a steady clip in 2007/08 as China changed its tax system to encourage local consumption over export?


6) China went through a 2-year capacity tightening phase, which pressured pricing in the US supply chain for this industry (and others). Using footwear as an example, there were 12,000 factories in the Pearl River Delta 2-years ago. Now there are about 6,000.

2009

Ok smarty pants…so now what?


1) We’re looking at a teens rate of import taxes…that has been recently reduced to zero. Yes, a donut.


2) Today China announced that its VAT (Value Added Tax) tax rebates on garments go up to 16%. Yes, this means that local factories are incentivized again to export product as the government funds enough of their P&L so they can sell product at a break even rate and still be cash flow positive.


3) Within hours of China’s announcement, Vietnam proposed to cut its Value Added Tax (VAT) on VAT on yarn, fabric, and garments, as well as reduce the corporate income tax rate by 30 percent for textile, garment and footwear industry.


4) As a kicker we see Nike pulling out of four Asian factories – three in China and one in Vietnam. This is part of Nike’s restructuring, but is pretty darn well timed given geo-political events. I guess Nike ‘does macro.’

The bottom line: I am convinced that the supply chain pressure we’ve been feeling over the past 2 years will ease. Perhaps temporarily…but it will ease. Add on SG&A/capex cuts, a positive sales delta and cheap valuations… You get the picture. Names I like best in retail include BBBY, RL, LULU, LIZ, UA, and DKS. I don’t like those who are cutting into bone to print profit, such as Ross Stores, Iconix, Sears, Carter’s, Jones and Gildan. The challenge here is that this latter basket of companies will also show a reversal in cash flow trends, temporarily masking the damage they are doing to their base business.


I’ll be working closely with Keith to game the sizing and timing on these fundamental ideas when the group looks more ‘shortable’ and/or when the near-term fundamentals for each of these names present an opportunity.


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Chaos!

As market practitioners, we wake up every day with a hunger to find order in the markets.  And to Benoit Mandelbrot’s (the Father of Fractals) point above, order does not come by itself. Global markets are complex and to some seemingly unpredictable.  

In the Early Look today, we wrote:  

“Across asset classes, global markets have revealed themselves as being as interconnected across a multiple of interacting fundamental factors as they have ever been. Mathematicians call this chaos theory.”

It is our fundamental belief that while markets are complex, they are neither random, nor uniformly unpredictable.  

Our idea of applying chaos theory to markets was probably first and most widely used by Bruce Babcock, a Yale graduate, former State attorney in California, and prolific trader of commodities.  He wrote as it relates to chaos theory and markets:

“According to respected authorities, the markets are non-linear, dynamic systems. Chaos Theory is the mathematics of analyzing such non-linear, dynamic systems. Chaos analysis has determined that market prices are highly random with a trend component. The amount of the trend component varies from market to market and from time frame to time frame. A concept involved in chaotic systems is fractals. Fractals are objects which are "self-similar" in the sense that the individual parts are related to the whole.”

As outlined in Bruce Babcock’s quote above, chaos theory is used to describe the behavior of a system that is constantly evolving, a dynamic system.   The stock market is, for its ever evolving nature, the perfect system for utilizing chaos theory as a framework to analyze and forecast.  

When we make a market call, it is based on a proprietary 27-factor model, in which the primacy of the factors evolve, much like a chaotic system, with time.  But the basic organization, the 27-factors, remains largely constant, even as certain factors become more important over different market periods.  While we don’t disclose our proprietary methods, or all 27 factors, clearly we are focused on both the US dollar and volatility currently as primary deterministic factors.

In some sense, the term chaos is at contrast with the theory.  Chaos suggests disorganization, while chaos theory itself implies that there is a pattern, or initial deterministic conditions, behind the seeming randomness.  That is, there is actually a method and reason to the madness.

In 1890, while studying the three-body problem, Henri Poincare found “that there can be orbits which are non-periodic, and yet not forever increasing nor approaching a fixed point.” As result of this discovery, Poincare is considered the father of chaos theory.  If Poincare is considered the father, then Edward Lorenz would have to be considered the person most responsible for inserting the theory back into modern scientific thought.

Lorenz was studying weather prediction in 1961.  He was using a basic digital computer to run his simulations.  In an attempt to see a prior sequence of data, he started a simulation in the middle by entering data from a print out.  In contrast to the prior simulation, this simulation produced a completely different set of data outputs.  The key difference was that the revised simulation used only printouts, which had 3-digit numbers versus the original simulation which used 6-digit numbers. The key conclusion was that small changes in initial conditions can lead to large changes in the long-term outcome.

As a start-up business, we have also applied chaos theory to internal organization.  When Keith, Michael, and Brian started Research Edge over a year ago now, the Company was much less complex, in fact it was a concept on a whiteboard. In less than a year’s time, we have evolved to three offices and over thirty full and part time employees, and a great client base of savvy investors who continually keep us challenged and add to our research network.

A key way in which we try to differentiate ourselves is to be first to market with information that is meaningful on the margin.  As we say repeatedly at Research Edge, when the things change that matter, they change on the margin, so this is where we want to focus.  Marginal changes will predict much larger changes in the future, which is consistent with chaos theory.  

Only time will tell whether we will be proven right on the ability to make stock market calls based on a foundation of chaos theory or whether our internal organization based on a fractals is as effective as we expect it to be, but as the Father of Fractals also said:

“When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed.”

Indeed.

Daryl G. Jones
Managing Director

Chaos! - blue orb


Shiller: As In, The Man, Gives Our Housing Call A Bone!

As we have been saying every month since early January, when we made our call on housing bottoming, the S&P/Case-Shiller index is a lagging indicator and housing prices will bottom in 2Q09.

To be clear, I said that housing would bottom in terms of sequential price declines and inventory growth in Q2 of 2009.

We are getting closer by the day!

According to the S&P/Case-Shiller index, home prices in 20 U.S. cities fell -19% in January from last year.  The decline was more than the -18.6% decline in December. The index has declined every month since January 2007.

There are two new incremental data points since the December S&P/Case-Shiller numbers were reported that support our call. First, while the glut of foreclosed homes will keep prices down, sales of new and previously-owned homes rose in February, indicating the housing slump could be at an inflection point.  Second, Robert Shiller himself said on Bloomberg TV this morning that "the rate of decline of the rate of decline" will begin to turn shortly.

Arresting the slide in residential real estate should become the leading indicator that the worst of times is over; or at the very least, that the bottom is near.  Increased confidence in the real estate asset class will allow the assets to obtain higher prices.

Howard Penney
Managing Director

Shiller: As In, The Man, Gives Our Housing Call A Bone! - HP11

Shiller: As In, The Man, Gives Our Housing Call A Bone! - hp12


HOT: Q1 ANOTHER BEAT AND LOWER

Starwood has beaten quarterly expectations 6 straight quarters.  We call that sandbagging, since the company knows that the analysts robotically model to management guidance.  What is more important though is that management also lowered full year guidance on five of those quarters.  We’re predicting that the streak won’t end in Q1.

We estimate 1Q09 EBITDA of $170MM and full year 2009 EBITDA of $750MM.  Our quarterly estimate is 11% higher than the mid-point of HOT’s guidance and consensus.  However, even with a projected Q1 beat, our 2009 estimate is 11% below the street and 14% below company guidance.  The gap between our EBITDA expectations vs. the Street widens further to 19% in 2010, as we project EBITDA of $675MM.   

Using a weighting of HOT’s top 10 US cities and reported Smith Travel data through March 21st we estimate that HOT’s US RevPAR will be down 24.5% in the 1Q09.  International RevPAR is tracking down 20% in local currency, while Mexico is flat-ish and Canada is negative -13% QTD, before layering in the FX drag.  As we wrote about in our MAR note “KEEP A TRADE A TRADE” (03/30/09), now that ADR is making a larger % of the RevPAR drop, the margin impact should be materially greater than what HOT experienced in 2008.  We assume no easing in RevPAR drop until 4Q09.  In 2010, we expect ADR to be down in the 3-5% range with occupancy increasing 1%. 

Our estimates assume cost cutting at both the SG&A level and at the property level. We assume that cost per occupied room “COSTPAR”, will decrease 5% in local currency and around 12% on an FX adjusted basis for 2009.  For 2010, we assume modest cost increases in the 50-100bps range at the property level.  However, we don’t think that there will be much room to cut costs, and therefore we expect another year of margin erosion.   We assume that SG&A decreases 15% in 2009 and remains flat in 2010.

Based on these assumptions, we expect owned, leased and consolidated JV margins will deteriorate 750 bps in 2009 and 340 bps in 2010.  As a reference point, the chart below shows what happened to margins during the last lodging downturn which began in 2001. HOT’s owned/ leased/ JV margins peaked in 2000 at 33.5%. Margins bottomed in 2003 at 22.5% after an 11% decline from peak to trough on a 15.9% cumulative RevPAR decline.  In the years to follow, cost growth ate away at the much of the RevPAR increases, with peak margins only recovering to 25.7% in 2007 on a cumulative RevPAR increase of 35.5%. 

HOT: Q1 ANOTHER BEAT AND LOWER - hot revpar vs margins

Fortunately, we’ve been on the right side of this story, first calling for margin and estimate cuts in our 06/23/08 post, “IF YOU DO MACRO YOU WON’T DO THESE STOCKS”, and continuing with the theme throughout the rest of 2008 and 2009.  We’ll take a shot trading these stocks from time to time but for right now, HOT and the sector are not likely to sustain any rally until estimates come down and occupancy stabilizes.


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