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Starwood’s Maximum Consolidated Leverage Ratio calculation simply divides gross debt at the end of the period by Adjusted EBITDA (Reported Adjusted EBITDA less JV interest expense add-back plus adjustments for asset dispositions).  We estimate that HOT’s leverage ratio at the end 4Q08 was 3.6x, giving the company a 21% cushion on its EBITDA at its current debt balance of $4BN. 

Given Starwood’s reduction in capital expenditures and IRS refund, and a likely timeshare note securitization, we believe that the company will be able to reduce gross debt by $400MM by 4Q 2009. However, the debt reduction alone will not be enough to offset our projected 35% decrease in Adjusted EBITDA.  At 4.9x Leverage, HOT will violate the leverage covenant by $70MM or $320MM of debt capacity.  In other words, in order to make the 4.5x covenant, Starwood must generate reported Adjusted EBITDA of $820MM or reduce gross debt to $3.3BN on our EBITDA number.


We believe, barring an asset sale, that Starwood will seek a credit amendment to increase leverage to 5.5x or (more likely) completely re-do its credit facility.  Since September 2008, there have been three relevant credit facilities amendments in the lodging space:  Ashford 12/24/2008, Strategic 2/25/2009, and Interstate Hotels: 3/30/2009.  Based on the comps, we believe that such an amendment would increase Starwood’s cost of borrow by approximately 150 bps. We also believe that the banks will ask HOT to discontinue its dividend in 2010 and seek to reduce the facility size by a $200-$500MM. 

However, given that the revolver matures April 2010 (including an extension option to Feb 2011), with a $500MM term loan maturing this June and another $500MM term loan maturing in June 2010, HOT will probably seek a complete refinancing of its bank facility.  A new credit facility is likely to be smaller in size ($1.25BN), and is likely to cost closer to 7% all-in (LIBOR Floors), which would represent $40MM in incremental annual interest expense or $0.15 in EPS.   

As we wrote about in past notes (“HOT: THE CREDIT IMPLICATIONS OF OUR FORECAST”, 01/28/09), we don’t see this as a big concern for the credit – but equity holders tend to get skittish on bad credit news.



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.


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.

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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…


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


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.


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.


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.”


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

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