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The bottom line – SONC continues to deliver on those initiatives that are within the company’s control.  The MACRO environment for QSR remains challenging.  The franchise model (SONC refranchised 205 partner drive-ins in fiscal 2009), margin improvement and continued unit growth will allow SONC to rise above the rest over time.  As I have said before, SONC’s return on incremental invested capital (ROIIC) has already turned and is becoming less negative.  The timing on the improvement in sales trends, however, will be a key driver to short-term sentiment.


Positive and Negative takeaways from the quarter/earnings call…




YOY operating margin improvement came in better than my expectations.


Traffic came in about flat (strong relative to peers).


New store openings in new markets are sustaining average unit volumes above the system average (always a strong indicator of future performance).


We should see continued improvement in restaurant margins in FY10 (turning positive despite continued pressure from promotional activity with COGS flat as a % of sales on a full-year basis). 


Restaurant –level and operating margins will be benefited by recent refranchising activity.


SONC will continue to generate free cash flow in fiscal 2010, which the company said it will use to generate shareholder value.




Management stated that weather has been a challenge, implying no improvement in sales trends in early fiscal first quarter.


Average check continued to decline in the quarter (so traffic improvement coming at the expense of average check).


Management said there were no changes to guidance provided on Sept 17 but when questioned specifically about flat same-store sales growth guidance, management said it would have to revisit this guidance following the first quarter results.


The current credit environment is delaying franchisee unit openings.  The company is offering deferred and reduced franchise fee and royalty requirements to spur new franchisee development, particularly multi-unit development.





Given that Street numbers have come down over 10% since the second quarter, we think this will be another quarter where Starwood beats and moderately lowers expectations.



Street expectations have come down more than 10% for 3Q09 since the last time we updated the consensus table in our model.  Therefore we won't be surprised if Starwood manages to eke out another small beat vs lower Street expectations. 


We are projecting Q3 Adjusted EBITDA of $182MM vs Street estimates of $175MM and company guidance of $165-$175MM.  We estimate that adjusted EPS will be $0.12 vs guidance of $0.06 to $0.10 and Street estimates of $0.10. Below are some of our assumptions for the quarter:

  • Branded Owned Hotels Worldwide: while our numbers aren't same store, our -24.5% RevPAR assumption compares to HOT's  guidance of  -24% to -26% (21% to 23% in constant dollars) for same store Branded Owned hotels worldwide
    • Since the dollar weakened against all currencies save the Argentinian Peso and Mexican Peso in Q3 vs Q2, we estimate less currency drag in the quarter than the first half of 2009
  • We estimate that total RevPAR (not SS) will decrease 21.4%, which compares somewhat to HOT's guidance of SS worldwide company operated hotels of -20% to -19% (-17% to -19% in constant dollars)
  • We are projecting that Owned, Leased and Consolidated JV hotel margins will decrease 970 bps and that total expenses for Owned, Leased and Consolidated JV hotels will decrease 22% y-o-y (vs 28% last quarter)


Last year in the 3Q08 release, HOT gave some "broad parameters" regarding how to think about 2009.  Given that Starwood has traditionally been more aggressive in providing its outlook than MAR, we expect them to give us a preview for 2010 expectations.


Going forward, a few things to keep in mind:

  • Starting 4Q09, FX will once again become a tailwind for Starwood. More than 50% of HOT's owned EBITDA comes from outside the US.  A weak dollar will strengthen reported RevPAR numbers but make cost comparisons more difficult as well.  We estimate that in 4Q09 FX will benefit international ADR's by as much as 7.5% at current FX rates for the owned portfolio.  For 2010, if FX rates stay constant, international ADR's will be aided by an estimated 5%
  • Starwood also has high international exposure in its managed and franchised business, so their system wide reported RevPAR statistics will also benefit from a weak dollar
    • 56% of HOT's managed and unconsolidated JV rooms are outside of North America (even higher when you exclude Canada)
    • Almost all of HOT's incentive fees are coming from international hotels at this point since international contracts typically don't have an owner's priority clause (where the brand doesn't get paid until the owner earnings a minimum return each year)
    • 26% of HOT's franchised hotels are located outside of North America
  • Aside from FX benefits, international RevPAR may recover faster than US RevPAR (barring more natural disasters, terror attacks and worsening swine flu outbreaks) given several unusual events in 2009:
    • H1N1, which heavily impacted travel starting April 2009
    • Supply overhang in China post Olympics
    • Mumbia attacks in India and bombings in Indonesia
    • Political instability in Thailand and Fiji
  • We've noticed that the number of new hotels opening in 2010 advertised on Starwood's website is roughly 50% less than what we counted opening in 2009.  However, these are gross hotels vs net, but nevertheless this is worth noting

Despite the likely favorable FX benefit, we think Street estimates remain too high due to unrealistic margin assumptions.  See our 10/15/09 post, "LODGING: HISTORY REPEATS", for details.



"YouTube" from 2Q09

"It appears to be a slow recovery so far. While the RevPAR decline is moderating in relative terms, it is still deep decline in absolute terms. The pace of improvement at this point is dependent on rate..."


Business conditions/ Outlook:

  • Occupancy stabilized in Q2 in North America and Europe... The fact that rate trails occupancy is fairly typical for [what] happens at this stage in the cycle. What is hard to pin down is the pace at which rates will stabilize. History would suggest it will be one or two quarters after occupancy does.
  • In North America, mix is skewing towards more price sensitive leisure business. Weakened demand, which is also more price-driven, is stronger than weekday, especially Monday through Wednesday demand.
  • Corporate room nights are down, leisure room nights are up, but there are early indications that corporate business is slowly coming back.
  • Group production in June was the best so far this year, and there are more leads coming in than we had earlier in the year. But so far, this feels more like a slow recovery than a sharp pickup from pent-up demand.
  • [Regarding group bookings] cancellation piece of this should abate and, at the same time, we are starting to see some pickup in activity that will certainly help as you get to the later part of 2010 and beyond.
  • RevPAR declines will be lower  than in Q2, but the absolute level of decline, at over 20%, is still deep by any historical measure. As such, we remain very focused on cost control. Our guidance implies that the rate of decline moderates even more in Q4, as we left the 15% decline last year. The situation is very similar in Europe with one major difference. Through the first three quarters, we face significant foreign exchange headwinds.
  • So if you look at it on a two-year basis, our expectations for the fourth quarter are really not that different from roughly where they are today. Clearly, the Forex in dollar reported terms dramatically changes. And in the second quarter, our entire international portfolio had a Forex headwind of around 800 basis points, and that becomes a tailwind of about 100 basis points. And if you say international is roughly half, that’s a 400 basis point benefit right there just from translation.
  • 4Q09 RevPAR thinking: close to high-single digit, double-digit decline in Q4.


Cost Commentary:

  • The contracted wage growth would probably be in the range of 3% to 4%



Pipeline commentary:  

  • Our reported pipeline now stands at 90,000 rooms. We pulled 25 deals from the pipeline based on financing issues experienced by our owners.


Asset sale commentary:  

  • We have some non-core assets that we are in discussions on. These include hotels we do not plan to retain our flag on, non-hotel businesses and land. Our preference would be to sell non-core assets at this point if we can realize good values.






Sep same store rev increased 15% in Louisiana. However, the comp was easy (-23% last year) due to the hurricane and the Labor Day shift. The 2 Yr comp fell 12%.



On the surface, the Louisiana market looks very strong.  Same store revenue increased 15%, but off of a -23% comparison.  Hurricane Gustav hit in September of last year resulting in the closure of several properties including L'auberge du Lac, Boomtown New Orleans, Delta Downs, and Treasure Chest.  Moreover, as we wrote about in our 10/02/09 post, "APPLES TO APPLES", gaming markets were aided by Labor Day weekend falling in September of this year versus August of last year.



Looking at Louisiana over a two year perspective is more instructive.  The following delta chart shows gaming revenue growth over that period.  Not only was two year same store revenue down 12%, the delta line (3 month moving average) does not appear to be improving. 




PNK maintains the most exposure to Louisiana and Q3 numbers look pretty good.  However, for all of the regionals we continue to be concerned with the prospect of a more prolonged downturn.  As we've written about, gas prices will reverse to a significant headwind beginning in December - projected to be up as much as 50% nationally - and running through May 2010.  We previously determined that gas prices are statistically significant in predicting gaming revenues.


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Going into the quarter, I stated that EAT needed to eliminate some questions around its long-term strategy changes at Chili’s.  Management did outline some of its plans around introducing menu enhancements which will come in stages and will work to remove some menu items while improving its core items.  Specifically, management said that the casual dining space has gotten crowded and the company needs to emerge from the “sea of sameness” by improving execution and providing better food, value and service. 


Based on the fact that the stock is trading down significantly today despite EAT’s reporting better than expected 1Q earnings and sales, my key takeaway from the earnings call is that management did not do a good job laying out its plans for the Chili’s brand.  Instead, most of management’s plans could be inserted into almost any casual dining company’s future plans, thereby only increasing the perception of industry “sameness.”  The fact that the company did not provide updated full-year guidance (and implied that prior EPS guidance is no longer a good number) is definitely weighing on the stock today as well, but the strategy changes at Chili’s will be important on a go-forward basis.


Focusing on execution, value and the core menu is very important and lies within the boundaries of what I think the company should be doing, but Brinker did not provide enough brand-specific initiatives.  It does not show them going for the jugular.  I know Brinker needs to be vague for competitive reasons, but in today’s tough economic environment, investors need more answers. 


We all know that the questions asked during a conference call often highlight investors’ primary concerns, and I was the sixth analyst to ask a question and the first to ask about Brinker’s specific plans for Chili’s.  So I just may be wrong.  People may not be too concerned with what management is saying about Chili’s because it will not matter until the changes yield actual results. 


Sales and margin performance will always drive stock price performance and although Brinker posted sequentially better sales in August and September, these sales numbers were only less bad and margins declined.  And, management hinted that restaurant margins would continue to decline in 2Q.  If Brinker is able to replicate MCD’s success by reenergizing its brand (as management referenced), then Chili’s sales are moving higher and will outperform its peers, but the company did not say anything today that leaves me convinced of this outcome in the near-term. 


Brinker has one of the best management teams in casual dining so it could surprise me, but I need to learn more and as they say, “the proof is in the pudding.”  To that end, Brinker was one of the first casual dining operators to really cut growth.  It was also one of the first to really create a leaner business model by implementing cost saving initiatives.  And, now, EAT is really focused on improving its core business and improving 4-wall execution.  This type of strategy often leads to better margins and returns (as we saw with MCD’s Plan to Win strategy and more recently, at Starbucks).  Although management’s comments did not leave me any more confident about near-term sales trends, EAT will be better positioned going forward based on this unit by unit in-store focus.


Can lawmakers in Washington justify extending the homebuyer tax credits with such obvious abuse from consumers?


While Keith covered the short on the XHB today, we continue to expect that the recent enthusiasm around the housing recovery and the homebuilders will continue to wane.  As such, we will look to an up day to re-short the XHB. 


The trend toward a stabilization of home prices and the improvement in new and existing home sales is self evident, and the consensus belief is that the bottom is in the rear view mirror.  The question at this point is the trajectory of the recovery in the housing market and what happens on the margin.  While there is significant reason to be optimistic about the recovery, the data flow over the next six months is likely to show a slowdown in the magnitude of improvement relative to what we have seen recently.   


The decline in mortgage rates and lower home prices has made housing more affordable than at any point over the past 2 decades. Additionally, the tax credit for first time home buyers has helped create significant incentive to jump start purchase activity.  


Today, it was reported that the National Association of Homebuilders housing market index dipped to 18 from 19 in September, falling below market expectations for a reading of 20.  Home builder sentiment is waning, as the November 30 expiration of the government's $8,000 tax credit for first-time buyer's approaches and there is no resolution for its future. 


The WSJ also notes today that the IRS is examining more than 100,000 suspicious claims for the first-time home-buyer tax break.  This is not a good sign and makes it less likely that the program will be extended. 


Also, construction of new homes rose 0.5% in September to a seasonally adjusted annual rate of 590,000 units; weaker than the 610,000 economists had thought.  The all important applications for building permits fell by the largest amount in five months. 


As an industry, the homebuilders are in the business of building new homes, which helps to support the nation’s economy.  Unfortunately, the bottom line is that we don’t need any more new homes.  Using data from the Mortgage Bankers Association, there are more than 7 million homes that are in some state of distress.  Given the pace of new homes being built, the current inventory of unsold homes and the potential number of homes that are in distress is likely to increase. Put simply: the housing overhang is here to stay. 


With the market now up 62% from the March 9 low, consumers may feel better, but it does not completely offset the fact that unemployment is approaching 10%+ and job security remains  an issue.  Today, most consumers need a substantial discount to motivate them to spend their hard earned paychecks.  Without government tax incentives, the housing market is on shaky ground.  Even if the government comes to the rescue with more aid, it does not fix the heart of the problem – most consumers are having a hard time making ends meet.


Howard Penney

Managing Director




US CPI/PPI: Reflation's Rotation

Our Q3/Q4 2009 call on Reflation Rotation is much like the call that we made on US Housing Bottoming in Q2 of 2009. Back then, we weren’t calling for a booming housing market, nor are we calling for massive inflation readings now. We are simply calling the turn. We call this what’s happening on the margin. In our macro models, this is what matters most.


Now that we have both the September CPI and PPI reports in the rear-view, it’s easier to see the Reflation Rotation that we have been calling for. This means going from the lowest readings of deflation (which you can see happened in July of 2009 in the chart below) to lesser levels of year-over-year deflation.


The green arrow that Andrew Barber and I show in the chart below is our forecast. As we move ahead to the October and November CPI and PPI reports (reported in November and December), these deflation readings are going to continue to REFLATE.


We think the Street is starting to figure this out. New highs in the prices of both TIP and GLD confirm these expectations.



Keith R. McCullough
Chief Executive Officer


US CPI/PPI: Reflation's Rotation - PPIKM

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