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We won't see the words NO and VACANCY anywhere on the Strip in 2010. Hotel supply growth has been on a tear since late 2007 while demand has cracked. And we're not done yet.

The chart below shows that Las Vegas Strip visitation levels are back to 2004 levels, on a TTM basis.  Over the same period, room inventory increased 10%.  The supply/demand situation is about to get much worse.  With visitation still potentially falling, room inventory will jump another 9% by the end of 2010.  Is the CityCenter/Fontainebleau/Cosmopolitan triumvirate enough of a draw to drive a 9% increase in visitation?

PLENTY OF ROOMS AVAILABLE AT THE STRIP INN IN 2010 - strip vis vs room supply

While visitation to Las Vegas may have gotten "less bad", it will need to improve materially to offset the new supply that is on the way. CityCenter is opening in December 2009 with 5,900 rooms, followed by Fontainebleau and Cosmopolitan, both likely to open sometime in 2010, adding another 6,800 combined.  CityCenter is billed as being "destined to be one of the great urban places of the world", according to its website.  It will need to live up to that billing and more to attract the 1.1 million incremental visitors necessary (assuming two guests per room) to offset the new supply.  Unlike The Mirage and Bellagio before it, CityCenter is more of a residential product that may lack the "wow" factor to drive significant incremental visitation to Las Vegas.

High-end properties will be hit hardest by the new supply.  The cumulative supply additions represent a 57% increase in the current number of high-end rooms on the Strip. It is difficult to imagine that the market will be able to absorb this increase in the current economy with, at best, a "tepid" recovery on the way in 2010.  We believe that the incremental rooms will generate little new demand and will end up diluting the market for the existing Strip players particularly impacting WYNN, LVS, and MGM. 


As a reminder, RevPAR is already on a big time decline.  YTD RevPAR is down around 30%.  The only question now is whether 2010 or 2011 will be the RevPAR trough, because it doesn't look like it will be 2009.


It seems that once a month someone spreads the rumor that Beijing is loosening the strings. We've said it before but Beijing is always tinkering but never fully opening or closing the spigot.

As can be seen in the following chart, it didn't take long for Beijing to stabilize the Mass Market.  Beijing began controlling the border in June of 2008 and by September Mass Market revenue growth was reduced to 5%.  From September to the present, growth was consistently in the range of +9% to -5%.  We don't have the data but our guess is the volume was even more stable.  I'd say the Beijing powers are quick learners.

VISA REFRESHER - macau mass market rev

It has been my belief that Beijing is interested in keeping Macau growth consistent with the growth in China GDP; that is, mid to high single digits.  The evidence certainly bears that out.  This is good and bad for the operators.  Certainly, over the long-term, this kind of stability warrants a high valuation in terms of cash flow multiples.  Unlike most gaming markets there is excess demand for Macau and Beijing is the stabilizer.  The downside is more near-term.  As Macau approaches a 6 month period of 25%+ Mass table supply growth beginning in December, same store revenue will plummet.  It is unlikely that Beijing is targeting mid to high single digit same store growth for Macau.

So don't believe the rumors that Beijing is somehow going to completely pull its big finger off the big hole in the dike to Macau.  Moderation is the likely goal here and to date, Beijing has succeeded.


Research Edge Portfolio Position: Long CAF

The NBSC Q2 GDP release registered at 7.9% year-over-year growth for a total of CNY 7.4 trillion (based on current price, production approach).

FULL STEAM - barber345

This headline growth data was accompanied by slew of other positive data points: Industrial Output increased by 10.7% Y/Y in June, Fixed Investment rose to 33.6% (cumulative) and Retail Sales register a 15% increase for the month.  On the heels of this data, the Shanghai composite rose by 1.4%, lifting the total capitalization of Chinese public equities above Japanese stocks to retake the status of second largest global equity marketplace.

On the heels of yesterday's blockbuster M2 and Reserve figures the rearview mirror for Q2 supports the bullish thesis we were espousing at the time: that the enormous amount of money being put to work by the central government would shock the system back into motion through sheer force while tax incentives and subsidies would encourage increased internal consumer demand.  Now that the stimulus is baked into the equation and our Q1/Q2 thesis has played out, we face a diverging path ahead.

As I commented yesterday, the massive infusion of credit has created real systemic risk and consumer demand -though resilient, will not be able to broaden to the extent necessary to offset the decline in external demand in the near future.  As we move forward, our focus will be on identifying specific sectors and industries in the Chinese market and we will be proactively managing risk as the likelihood of a short term correction has increased significantly in our opinion.

Andrew Barber


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SBUX - Breaking Out of the Past

SBUX is scheduled to report fiscal 3Q09 numbers after the close next Tuesday, July 21 and I would expect the company to continue the trend of beating EPS expectations ($0.22E vs. consensus of $0.19) despite continued weakness in top-line numbers. Fiscal 3Q09 should mark a return to double digit operating margins, the first quarter of YOY operating margin improvement for SBUX since 4Q07 and the company's U.S. segment should post its first quarter of margin expansion following 12 quarters of declines. And, this is based on my expectation of a 5%-6% decline in U.S. same-store sales, which would signal a sequential improvement from the 8% decline in 2Q09.

The real benefit to margins in the quarter and going forward will stem from the company's goal to eliminate $500 million of costs in FY09, $345 million of which should be implemented by the end of 3Q09. Although SBUX will continue to feel some pressure on the cost of sales line as a result of the fixed cost nature of occupancy costs, lower dairy and coffee prices should minimize the deleveraging effect of continued same-store sale declines.

With the company having launched its first national advertising campaign in May (mid Q3), I am most interested in hearing about how the campaign is being received and the impact it is having on driving customer traffic. Specifically, was the company successful in continuing its trend from 2Q of reducing traffic losses on a sequential basis? My 5%-6% U.S. same-store sales decline estimate relies on a quarterly sequential improvement in traffic. Easier YOY comparisons, new advertising, the company's first limited time promotion of iced coffee for $1.95 (initiated in May through the end of the quarter) and the results from my May "Grass Roots Survey" all make me comfortable with this assumption.

SBUX management commented on last quarter's earnings call that the marketing campaign "will build over time" so I am not expecting that the marketing will have made a big impact on Q3 results, but increased communication to consumers can only help. The company did state that it is not significantly increasing its advertising spend and instead, it is making a long-term investment. As I have said before, I think SBUX needs to spend $300-$400 million in the U.S. to have a share of voice that will make it competitive with its peers. Although Starbucks will not get to this level of spending right away, I would like to hear more about the direction and magnitude of the new advertising campaign, which I think is essential to the long-term success of the brand.

From a cash flow perspective, SBUX should continue to demonstrate its ability to generate significant cash even in a tough environment. With an estimated 25% YOY decline in capital spending, SBUX should be able to pay down more debt in the quarter and further strengthen its balance sheet.

SBUX - Breaking Out of the Past - SBUX EBIT Margin 3Q09E



Key Takeaways:

  • Cost cutting has run its course
  • Margin pressure will accelerate as rate declines continue
  • International RevPAR declines are intensifying
  • Transient rates below group rates are a very bad thing - group rates are usually lower. Points to further downside in 2010
  • Rate driven RevPAR declines will hurt a lot more than occupancy driven RevPAR declines
  • On a positive note, defaults by owners will have no effect on MAR and other franchisee companies since the last thing to go is the flag



General Commentary:

In NA they saw stabilization in occupancy

Mix of business remains skewed to leisure transient travel

  • Corporate rate travelers decline 18% while leisure increase 12%
  • Personal group up 7%
  • Weekend occupancy was actually better than weekday occupancy

Expect pricing power to return only as occupancy recovers

Leisure the strongest, expect business travel to follow as the needs presents itself

Swine Flu is negatively affecting their 17 hotels in Mexico

Properties are aggressively controlling costs

Timeshare promotion offering 15% discounts to new owners and 25% off to existing owners

  • May consider becoming more aggressive on residential and fractional projects going forward which may result in further write-downs

Expect to continue to reduce debt levels throughout the years

Have eased brand standards where it makes sense, and deferred capital expenditures

Opened 8,000 rooms in the quarter and have 110,000 hotels in the pipeline (50% under construction)

  • Expect that US growth will be driven by conversions


Second Quarter Results:

Timeshare - some sales were likely pulled forward from future periods

Tax rate higher as revenues from lower tax jurisdictions lower

Transient room nights only declined 4% in the quarter as they replaced that business with lower rates business (government / etc). Rate decreased 19% here.

Room nights from group declined 19%.  While cancellations have subsided in recent months, however, attrition continues to deteriorate.  RevPAR declined 25% from this segment

  • Room night bookings are down 18% for the rest of the year

House profit margins only declined ~530 bps, despite the steep drop in RevPAR

  • management wages down 16%

Mexico and Asia where badly affected from the swine flu

Ritz had the worst RevPAR performance, but had a large increase in leisure travel (59%)

Delinquency rate on timeshare loans was 10% in June down from 10.2% in May.  Triggered change in payments, which reduced cash flow by $20MM.

  • FASB 166 & 167 will make them consolidate off-balance sheet loans
  • However, the covenant calculations won't be affected and don't expect any change from rating agencies in the way they look at the debt
  • Won't change the fact that its non-recourse


3rd Quarter Guidance:

 International lodging markets have significantly weakened

  • Impact from swine flu doesn't help

Much of the NA RevPAR decline will come from rate and lower rated mix

While unit expansions will help their fees, tough comps will also hurt them

Seasonality more pronounced as well in the 3rd quarter

Believe that they pulled forward some sales with the promotional activity in the 2nd quarter, therefore impacting their 3rd quarter results


Full year 2009 Guidance:

Confident that timeshare business will be cash flow positive in 2009

Reduced total fee income by 5 cents per share (weaker international and incentive fees)

Higher tax rate reduces outlook by 4 cents

Higher diluted share count due to stock dividend reduces EPS by 2 cents



Think that the impact of political rhetoric is gone, but clearly the economic pressures haven't lessened. Don't see any rebound from the economic pressures anytime soon

How much room is left to cut costs (non-occupancy related?)

  • Going forward the pricing pressures will make it more difficult to maintain margins, especially as cost cutting comps become more difficult
  • On the corporate front they continue to look at overhead - doesn't sound like it

How are they positioning themselves for future growth opportunities?

  • Maintaining a strong balance sheet to take advantage of any opportunities that arise
  • Paying attention to asset trades that drive conversions and reflagging fees
  • Expect more defaults or the number of delinquent loans to increase... still not a lot out there yet

Seeing transient rates fall below group rate - how will this effect group rates?

  • Pace of decline in rate is still accelerating while occupancy has stabilized... could be a big issue for group business

Impact of more cuts from airlines?

  • Corporates just aren't traveling

Timeshare - top-line is the same but profitability is worse

  • As default rates accelerate they don't get interest on their residual, they also had the write down this quarter
  • Services revenues related to unused rooms that are sold have also dropped as rate has dropped
  • Plus the tax item (8-9MM)
  • Rating agencies - each one looks at the timeshare business a little differently (left it vague)


International Commentary:

  • China - high supply growth and travel restrictions have outweighed stronger economy
  • India - very small market, also has very weak RevPAR
  • US: DC is still one of the best markets
  • Middle East is a relatively strong performer (Saudi & Egypt stronger)
  • Europe is average

If RevPAR stays negative will they get little to no incentive fees going forward?

  • When they report incentive fees they do it on a run-rate basis and then have to make adjustments if it results deteriorate on a TTM basis. (basically we think that they are paying back fees that were previously accrued)
  • Don't need to have positive RevPAR to get incentive fees because some contracts pay them off the top (like in some international markets). But generally negative RevPAR will have negative impact on incentive fees.

How does a recovery look like?

  • It is not unusual for leisure customers to be pursued more aggressively and respond more quickly to discounting and therefore fill in lower demand periods
  • Will not be able to drive pricing through leisure though - group/business will really need to drive pricing

Incentive fees lower, why?

  • International much worse
  • Rate is worse so margins (even if occupancy is better) will be worse (that's why we're negative on 2010 for owners)

Occupancy (mid-60's) is starting to level off, but rate continues to weaken. But until occupancy improves they don't have any pricing power.

Courtyard is all transient business travel - hence it's performing worse than many limited service brands

Business on the books for next year is down significantly (about 20%).

  • Not a meaningful number because a lot of the business booked in 2008 for 2009 was cancelled
  • Right now they have a very short booking window. Meeting planners are all sitting on the sidelines looking for better deals

Composition of development pipeline

  • 50% under construction
  • 6-7% conversions
  • 30% is international
  • 60% is limited service in North America, predominantly franchise
  • Balance is international and mostly management
  • Think that they will continue to add rooms in 2010 - don't know how many
  • Conversions vs new builds - only had 2 conversions in the 2nd Quarter, expect 8-10% for the balance of the year to be conversions

What percentage of management or franchised hotels is in some state of default?

  • Cash defaults on debt payments - very few
  • Hotels financed in 2005-2007, and if they were financed aggressively may be in trouble, but most of that was floating rate debt - so those owners have also benefitted from very low rates
  • Defaults will depend on how long this malaise will continue... if the recovery is fast there will be less defaults because owners will fund the shortfall... we take the other side of that though.. we don't think it'll be a fast recovery
  • We would note that even if a hotel defaults on its bank financing this DOES NOT mean that the property will be de-flagged. Normally banks will keep the flag and pay the fees.



The number of U.S. workers filing new claims for jobless benefits fell sharply last week to the lowest level since January (the seasonally adjusted data was again distorted by an unusual pattern of automotive industry.)  The claim figure is now 23% below the peak they hit in March.

We now have jobless claims getting better BIG TIME in the last three weeks!  Two weeks ago the jobless number came in at 617,000, last week 565,000 and this 522,000.  That trend speaks to a real improvement not deterioration in claims. 


Our view is that the rate of change in jobless and unemployment is in the rear view mirror and is a lagging indicator.  The point we are trying to make is that we are passed the apex in job losses, something most people disagree with. 

While we are focused on what happens on the margin, which means people are losing their jobs at a slowing pace, it is still as hard as ever to find a new job.  As more people join the ranks of long term unemployed or underemployed, we run the risk of a 90's Japanese style period of job stagnation.

 Ultimately, consumer spending and sentiment will be buoyed by rising employment rather that declining job losses. Last December, President Obama went on record saying that he aimed to create 2.5 million jobs over two years.  He has some work left to do!


Howard Penney

Managing Director