Research Edge Portfolio Position: Long CAF

The staggering 28.4 % year over year increase in June M2 data released by the PBOC today took a back seat  in the media to the news that foreign currency reserves have topped $2 trillion (see charts below).  For the US, this data means that China will continue to buy treasuries. For China this data may mean that more speculative money is flowing into already extended markets.

HOT MONEY - barb1

HOT MONEY - barb2

By all measures the liquidity sloshing through the system is having a pronounced effect, and concerns over the negative impact of these easy money policies are beginning to loom ever larger. With no clear indication that regulators are moving rapidly enough to fully reign in speculative asset bubbles or that any capital injections are being planned for AMCs in order to handle fresh "special mention" loans there is real concern among observers on the ground that there is not enough being done by authorities to prepare for the pain in the pipeline.

From our perspective, the issue is fundamental: China's stimulus program was and is an attempt to buy growth -and growth is always very expensive to purchase. If data shows that internal demand is broadening -in other words that that consumers are buying more than just replacement trucks and vans with government tax rebates and factories are turning out more than just girders and beams for state infrastructure projects, then these measures will likely prove worthwhile despite the negative impact of the inevitable defaults and popping bubbles.

Bullish for the economy in the longer term, but underscoring the risk of correction in the equity and real estate markets in the near term, today's data leaves us with many unanswered questions. In the coming days we will receive Q2 GDP and Industrial Output data that will provide us with more solid answers.

Andrew Barber



When looking at Europe we've cautioned against reading too much into aggregate EU/Eurozone data as we believe markets there are often uncorrelated and influenced by varied underlying fundamentals.  Today's report from EuroStat estimated that June inflation in the Eurozone fell 0.1% from a year earlier will give investors a general metric of guidance for Europe, yet the averaged number misses the mark for further understanding the divergence between economies.

One important take-away from today's report is that, as with the US, energy was a major driver -down by 11.8% Y/Y in this latest reading. The deflationary pull from energy should come as no great surprise based on last year's spiking oil price. Core inflation, which excludes energy and food prices, slipped to 1.4% on an annual basis, from 1.5% in May. Conversely, total CPI rose on a monthly basis 0.2%.

This year we've held the position that countries with economic leverage will outperform those with financial leverage. Sticking to inflation, we're seeing countries with financial leverage (think loan leverage combined with a real estate bust in Ireland and Spain) see measured deflationary pressure on an annual basis (Ireland -2.2% and Spain -1.0), whereas Germany, a country we've been bullish on due in part to its fiscal conservatism, posted annual inflation at 0.0%, a level we believe is healthy on a relative basis as the country works through the constraints of reduced export demand.  In contrast we see disinflationary pressure in the UK (outside the Eurozone) on an annual basis, with CPI at 1.8%, from 2.2% in May.

In an environment in which output and wages have decline greatly, with soaring unemployment rates and credit tightening, we're likely to see deflationary pressure continue in the immediate term through much of the Eurozone. June's retail sales number declined for the 13th consecutive month; it's clear that retailers are lowering price to move inventory while consumers have tightened spending and are anticipating lower prices going forward. 

We'll continue to monitor the patient on an individual country basis, while recognizing the importance of the collective health of the EU for individual countries.

Matthew Hedrick


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June CPI was released today, with the index registering at an increase of 0.7% for the month versus 0.1% in May with a 17% increase in gasoline costs as the primary driver of the broad sequential increase.  Make no mistake; this is having an impact on the consumer: gas prices and interest rates are up, confidence is down and that is the reality of our current situation.

Regardless of reality, year-over-year numbers are where we need to remain focused because that is where it becomes a "political" football and will ultimately impact the market.  The CPI was reported down 1.4% Y/Y today -a modest sequential rise from last month when we saw the worst number since 1955. Reality vs. politics:  what would be an increasing inflationary measure on an absolute or monthly basis becomes a deflationary figure when measured year-over-year basis and that means that rates will stay at zero for the foreseeable future as Bernanke & Co. keep the free money train rolling. 

We have been making the call that the CPI numbers will go positive in Q4, and that that will represent a return of true inflation which it looks increasingly likely that the Fed will not be prepared for. Right now we are experiencing REFLATION which is just taking us from one point to the next.  As I look at my screen right now the REFLATION trade is alive and well; the Dollar is down and the best performing sectors are Financials (XLF), Energy (XLE) and Materials (XLB). 

We are still looking at a "politicized" short end of the yield curve.  The FED right now has no choice but to be the "deflation fighter."  Next week, when Chairman Bernanke is in front of the politicians, he can't very well tell them that he sees inflation coming in Q4.  

What does all of this mean?

  • (1) We will have an inspirational yield curve - the FED will keep rates at ZERO longer!
  • (2) Rates are not going to stay there forever!

Howard Penney

Managing Director


YUM - Not Making Any Real Changes, Despite Slower Sales

Earlier today, I highlighted the fact that YUM was trading down despite it having beat 2Q EPS expectations and how this marked a change in pattern to how the restaurant names have been trading following quarterly earnings. For the most part, restaurant companies have been posting better than expected bottom line numbers by cutting costs to offset soft revenue trends, and their stocks have been rewarded. I think a couple of things are at play here:

1.) Investors have become accustomed to revenue misses from the casual dining operators and other restaurants in this more challenging environment, but this was the first significant same-store sales miss for YUM's China and YRI businesses, forcing YUM to take down FY comparable sales guidance.

2.) Financial engineering helped YUM to offset its weaker than expected top-line results (a lower tax rate and lower share count).

Relative to how other restaurant names have traded, I think the second point is the more important one as we have seen a lot of companies offset soft sales trends with significant cost cutting. These reduced cost structures, however, have created more operating leverage and stemmed from increased labor efficiencies and G&A savings. These companies have made real changes to how they operate their businesses and the benefit of the savings will continue to be realized going forward. A significant portion of the cost reductions have resulted from slowing new unit growth.

YUM, on the other hand, is maintaining its full-year 10% EPS growth guidance despite lowering its same-store targets as a result of a lower tax rate, a less negative foreign currency impact and improved restaurant margins in China and the U.S., largely as a result of more commodity deflation than initially anticipated. None of these earnings drivers is sustainable. YUM is not offsetting its top-line weakness by making significant changes to its operating model.

YUM is targeting $60 million in G&A savings in the U.S. but even with these cost savings, YUM had to take down its U.S. operating profit growth target to up high single digits from about 15%. In the U.S., YUM is taking real costs out of the business, primarily as a result of its refranchising strategy, but these cost reductions are not enough to offset the same-store sales shortfall. This is a big difference relative to what we have been hearing from other restaurant companies.

I have been saying for a couple of quarters now that YUM is growing too fast, particularly in China and YRI. This rapid growth will make it difficult for YUM to reduce costs and could prove a challenge to margins should sales deteriorate further.

YUM's CEO David Novak closed the call by saying that he is fixated on 3 shareholder value drivers: first, driving new unit growth; second, improving same-store sales and third, being the industry leader in return on invested capital. He highlighted the fact that the company has the most work to do around growing same-store sales. I would argue that YUM's sustainability and returns would improve dramatically if the company focused on fixing same-store sales first and growing new units second.

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 EBIT

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 CFFO




In addition to discussing current trends, Marriott will likely highlight the strength of its balance and cost cutting efforts.  The company will likely discuss its debt reduction plans ($600 to $650MM), upcoming notes sale, reduced investment spending, SG&A and property level cost cuts.

2Q09 overview

When MAR reported its 1Q09 results on April 23, 2009, they guided to North American comparable systemwide RevPAR to be down 20 to 25% in 2Q09 and RevPAR outside North America to decline roughly 17 to 20%.  We estimate that total RevPAR will decline 22% in 2Q09.

  • Since April 23rd the Euro has been roughly 3% stronger, benefitting USD international ADR's
  • Lower end brands have had less severe RevPAR declines than Luxury and Upper Upscale, and limited service rooms make up 52% of Marriott's system-wide rooms.

We're at $0.23 cents and $210MM of EBITDA for Q2.  Despite our assumption of a 60% decline in incentive fees, we still think that fee revenues will come in a little better than management guidance, given our projected room count growth of 5%.  We have owned, leased, corporate housing and other revenue at $10MM, at the lower end of company guidance.  As MAR alluded to on June 2nd at the Goldman conference, margin declines will become worse throughout the year as they begin to annualize the cost savings initiatives that were put in place starting 2Q08.  Our timeshare estimates are in line with management guidance.

Full year 2009

We expect the company to keep its RevPAR guidance flat for full year 2009 and suspect that full year may come in a touch better given the depreciation in the dollar since initial guidance. For the balance of the year, occupancy will be stable to improving from its lows; however we believe that ADR will continue to be weak.  Since MAR doesn't own many hotels the flow-through issue is less of a concern for them than REITs and operators.  For this reason we think that MAR's EPS will likely trough in 2009, while most other c-corp and REIT operators will face further declines as occupancy and therefore directs costs increase, while rate is likely to still remain weak. For 2009, our EPS estimate is $0.95 and our Adjusted EBITDA estimate is $855MM.

  • Total fee revenues: we're in line with management guidance of $1,050 -$1,100MM
  • Gross margin from owned, leased, corporate housing & other: We're below management's guidance $55-$65MM
  • We're in line with timeshare guidance


YouTube from 1Q09 call

General Market Trends:

"As we've discussed before, our industry typically lags heading into a downturn and to recover, so we're obviously far from being out of the woods. However, there are some initial signs of demand stabilization even if at today is very low levels."

"We've seen gross booking trends for transient travelers flatten during the first quarter, and new group bookings, while still declining, are doing so at a lower rate. Of course, while demand may have bottomed, there is still risk in pricing and therefore RevPAR."

"To buttress transient occupancy, we added business from the federal government, travelers using AAA and senior citizen discounts and other contract customers. Despite this, we continue to see occupancy declines reflecting weakness across most corporate rated business."

"Nevertheless we are already seeing significant competitor discounting of room rates for corporate business in many markets. As we discussed last quarter Marriott will not lead the market down on rate but we also do not intend to lose share by failing to respond. Room rates are likely to remain weak until the economy shows meaningful improvement."


Group Business:

"recent cancellations are running at more normal levels."

"meeting planners are showing a greater preference for urban and suburban hotels rather than luxury and resort locations for new business. Another lingering impact of both the rhetoric and the economy is the continued hesitancy on the part of meeting planners to book new meeting though we note that the rate of year-over-year decline has been improving for the past 16 weeks."

"Attrition in meeting attendance remains a significant problem, but it too appears to be stabilizing."


Lease/ Owned business:

"While we own or lease 41 hotels, seasonally softer performance, combined with the weak economy, should continue to constrain profits. Results will also likely be affected by tougher comparables since contingency cost cutting for North American hotels began in the second quarter of 2008."



"In our time share business new sales in the first quarter were consistent with our expectations and we were pleased with the relative strength all be it within small volume of our fractional sales."

"We've seen some stabilization [in delinquency rates] in early April which gives us some cautious optimism in this area."



"On the cost side, we revived purchasing specs, shortened restaurant menus and hours, and reduced food waste. At some hotels we've temporarily shut down floors, reduced the number of restaurants and shortened retail outlet hours. Many associates were working in multiple departments and often at multiple hotels as we work hard to give associates as many hours as possible."

"Since cost reductions began in the second quarter of 2008 margin comparisons will become more difficult for the rest of the year."


Balance sheet/ Cash flow related:

"We continue to aggressively manage our balance sheet and our cost structure to meet whatever challenges may present themselves. During the quarter we reduced our debt by about $150 million and expect to reduce debt by $600 million to $650 million in full year 2009."



"We're also relaxing some brand standards for hotels and capital expenditure guidelines for new initiatives and renovations."

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