US Strategy – Owning up to higher interest rates

On Tuesday, the S&P 500 closed at 1,091, down 0.6%.  While yesterday was a down day on accelerating volume, the S&P 500 held support and remains positive on both TRADE and TREND. 


Yesterday’s weakness was consumer related.  On the MACRO front housing starts rose 0.5% month-to-month in September to a 590,000 unit annualized pace, while consensus expectations were for a 610,000 rate.  Importantly, building permits, a leading indicator for construction activity, fell 1.2% month-to-month to a 573,000 annualized rate vs. consensus expectations of 595,000. Coming into the day we were short the XHB, as housing-related stocks came under pressure, with the XHB (2.3%).  We covered our short on the XHB, but remain cautious on housing in general. 


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. 


The earnings onslaught continued this morning and last night with Morgan Stanley, Boeing, Freeport McMoran and Yahoo.  From the Research Edge perspective, the Yahoo earnings report (stock currently up 5% pre-market) was another feather in Rebecca Runkle’s cap as earnings were better than expected at $0.13 versus $0.07 for the quarter.  Another notable call out is Freeport McMoran, which is the world’s largest copper miner and reported earnings of $2.07 versus $1.31 in the year ago quarter.  This earnings report is important in that it is a leading indicator of our reported inflation increasing in Q4, as compares for many commodities year-over-year are setting up to be very easy, which will spike reported inflation.


Other portfolio activity included buying Utilities (XLU), the Canadian dollar (FXC) and Adobe (ADBE).  We also shorted the US Dollar (UUP).  


On the positive side 80% of the S&P 500 is beating analyst expectations, with another fairly upbeat showing yesterday from AAPL, CAT, TXN, and UNH. 


The momentum behind the “currency creditability crisis” waned as the UUP was up 0.4%.  The VIX declined 2.7%. 


Yesterday, only two sectors (XLP and XLK) outperformed the S&P 500 and every sector was down on the day.  The three best performing sectors were Consumer Staples (XLP), Technology (XLK) and Energy (XLE), while Utilities (XLU), Consumer Discretionary (XLY) and Materials (XLB) were the bottom three. 


Yesterday, the Materials (XLB) was the worst performing sector.  There were a number of factors behind the underperformance of the Materials sector yesterday, though much of the focus appeared to be on the dollar rally.  Gold stocks were among the worst performers and DuPont weighed on the diversified chemicals stocks. 


Today, the set up for the S&P 500 is: TRADE (1,083) and TREND is positive (1,003).   Day 8 of perfection - the Research Edge quantitative models have 9 of 9 sectors in the S&P 500 positive on TREND and 9 of 9 sectors are positive from the TRADE duration.         


The Research Edge Quant models have 1.5% upside and 1% downside in the S&P 500.  At the time of writing the major market futures in the U.S. are lower.


The Research Edge MACRO team.




US Strategy – Owning up to higher interest rates - S P500


US Strategy – Owning up to higher interest rates - s pperf

US Strategy – Owning up to higher interest rates - s plevels




October 21, 2009





Instant shopping gratification appears to be a growing trend, following Amazon’s announcement a few days ago that they would offer same day delivery in select metro markets.  Now comes which is launching ProductExpress (seems like a horrible name for an online retailer of shoes and accessories).  The site offers an edited assortment of the Shoebuy inventory with free overnight shipping on every order.  I’m sure it won’t be long before other competitors are forced into the free shipping game as the holiday season approaches.  As a consumer, it’s tough to ignore on-sale merchandise with free next day delivery.


Why do I think this matters? I think it is an important stage in the evolution of the consumer-direct model. Keep in mind that ‘consumer direct’ for many brands often meant building expensive outlet networks, selling to off-price retailers (TJX, ROST), or relying more heavily on their friendly neighborhood department store to clear goods. That stage of evolution was glacial. This one is much much faster, and the math is not equal for all.


Why? There's got to be a break-even hurdle from a product perspective as it relates to absolute price point where ‘free shipping’ makes sense. For an in-line brand/retailer (RL, NKE, GES, UA, etc…) their $$ margin on Free Shipping can still be solid. For example, if RL has a list price on a $100 item at its own retail store, its’ cost to manufacturer and source the item is probably $25-$30.  If it is not selling, they can take down price in their own store by 40% to sell overnight and get $30 in gross profit (pre occupancy and selling). That’s actually not bad, all things considered. But on the flip side, they can take the excess product, do free overnight shipping (let’s say at a $10 cost bulk discount cost), lower price by 25%, and have a $35 profit. Yes, that makes even more sense.


For a department store, or someone that sells another’s brands, the math is different. That same $100 product has a $50-$60 cost to the retailer. That immediately wipes away $25 in potential profit that could be realized by going direct to consumer.  They’d need to sell the product next day at full price in order to retail the same margin that the brands could get if they otherwise go direct with clearance. Good luck with that…





Some Notable Call Outs


  • Despite slightly positive traffic increases, SuperValu continues to struggle with converting customers to increase their basket sizes. Management noted that there has been a fairly notable drop in the number of items customers are putting in their baskets. While the overall economy is a key factor, management also noted that “regular” pricing still needs to be adjusted to avoid cherry picking. It seems to me that SuperValu is being shopped for its promos while the customer shops elsewhere for better value on non-promo items.


  • Coach management indicated that sourcing cost reductions have resulted in an 8% decrease in average unit costs. Savings will be used to offset sharper pricing as well as potentially fund promotional activity at the Factory Stores. The company believes it has good visibility on sourcing costs through fiscal 2010 although as the economy turns, inflation will likely return. Raw material and input costs are now at the low end of the range the company has seen historically.


  • Instant shopping gratification appears to be a growing trend, following Amazon’s announcement a few days ago that they would offer same day delivery in select metro markets. Now comes which is launching ProductExpress (seems like a horrible name for an online retailer of shoes and accessories). The site offers an edited assortment of the Shoebuy inventory with free overnight shipping on every order. I’m sure it won’t be long before other competitors are forced into the free shipping game as the holiday season approaches. As a consumer, you can’t beat free next day delivery!





-Trinity Details IPO - Trinity Group, a subsidiary of privately held Li & Fung (1937) Ltd., expects to raise between 485 million Hong Kong dollars to 664 million Hong Kong dollars by listing on the stock exchange here, although the plan could raise up to 889 million Hong Kong dollars. In U.S. dollar terms, the initial public offering could raise anywhere from $62.6 million up to $114.7 million. The firm, which was acquired three years ago by Li & Fung, will offer about 452 million shares, to be priced at 1.30 Hong Kong dollars, or 17 cents, to 1.71 Hong Kong dollars, or 22 cents, a share. Trinity manages six high-end and luxury men’s wear brands in the Greater China region, namely Kent & Curwen, Gieves & Hawkes, Cerruti 1881, D’urban, Intermezzo and Altea. <>


-Remington Parent in 'Advanced Preparations' to Go Public - The Wall Street Journal is reporting that Cerberus Capital Management, a private equity firm best known for its ill-fated acquisitions of Chrysler LLC and GMAC LLC, is in "advanced preparations" for an initial publc offering of Madision, NC-based Freedom Group, Inc., owner of Bushmaster Firearms, Remington Arms Co., and Marlin Firearms, among others. The Journal reports that over a three year span, Cerberus has acquired at least seven U.S. gun and ammunition manufacturers which have consolidated in Freedom Group Inc. Furthermore, the Journal reports that Cerberus will try to take Freedom Group public amid "a flurry of private-equity-backed companies hoping to exploit and improved IPO market." <>


-China: Textile industry steps Up rhetoric on US-China Trade - The US textile manufacturing industry, led by the National Council of Textile Organizations, is continuing to wage a determined lobbying campaign in Washington, in an effort to persuade Congress and the Obama administration to establish restrictions on imports of sensitive textile and apparel products from mainland China. NCTO’s current position on China is perfectly showcased in comments submitted to the Office of the US Trade Representative on 22 September regarding China’s compliance with its WTO commitments. NCTO’s comments identify a range of protectionist and mercantilist policies allegedly being pursued by the Chinese government and seek to make a case for a more robust US trade enforcement policy against imports from the mainland. <>


-EU: Forging trading details with South Korea - The European Commission(EC) has unveiled details regarding South Korean-European Union(EU) trade agreement, that is expected to benefit textile and clothing manufacturers in both regions. According to the new agreements, duties on EU imports of most clothing products, which are now mostly between 5.3% and 12%, will disappear, while duties on South Korean shoe imports, that ranges between 3% and 18%, will vanish. <>


-Philippines: Urges for duty-free status to US - The Philippines has been stepping up efforts to lobby an apparel duty-free access to the US by early next year. Under the proposed bill, the Philippines will be given preferential duty treatment for certain apparel articles sold to the country as the Philippine garment factories will be allowed to import and use US textiles for eventual garment shipments back to the US in order to save the standard 30%-40% tariff. <>


-Bill Eases Pressure on Cargo Scanning - The Senate approved a $42.8 billion bill Tuesday by a 79 to 19 vote that boosts funding for the Customs & Border Protection agency and possibly delays a 100 percent cargo scanning deadline. The measure provides funds for the Department of Homeland Security, which includes Customs, for the 2010 fiscal year that began Oct. 1. It requires President Obama’s signature. The House passed the legislation last Thursday. Retailers argued the scanning technology does not exist and feared foreign ports could not comply as a result, which would lead to delays in shipments. They praised language in the bill that calls into question the feasibility of meeting the 2012 deadline to scan all U.S.-bound cargo containers at foreign ports to determine if they contain terrorist weapons. Lawmakers said the deadline for implementation presents “practical difficulties.” <>


-Survey Forecasts Lower Holiday Spending - Holiday shoppers can be counted on to check their gift lists more than once or twice — with a sharp eye on bargains because of plans to spend less than they did in 2008, according to two new polls. About two-thirds of consumers surveyed this month by The Zandl Group for WWD anticipate cutting outlays for holiday gifts, while the National Retail Federation’s 2009 “Holiday Consumer Intentions and Actions Survey” showed 43 percent of shoppers will be bargain hunting. The 8,431 people polled by NRF this month expect to spend about $682 a person on average, or 3.2 percent less than the $705 spent last year. <>


-Target zeroes in on its own price cut for books pre-ordered online - Target Corp. isn’t going to sit still on the sidelines in the online book price war ignited last week by and Target, which operates, No. 20 in the Internet Retailer Top 500 Guide, announced Monday that certain pre-ordered books will be sold online for $8.99, essentially matching the prices of its two big online rivals, and qualify for free shipping. Target is the latest big chain retailer or web-only merchant trying to become the lowest priced online bookseller. In a bid to be the web’s low-price leader for all types of products, Wal-Mart Stores Inc. on Friday started offering some pre-ordered popular titles for $9 each on <>


-Cabela's Partners with Credit Card for Another Retailer - Cabela's Inc. announced a partnership with with CHS, an energy, grains and foods company, to create a new credit card and loyalty program for customers of Cenex filling stations, a brand of CHS. It's the first credit card and loyalty program created with another retailer by World's Foremost Bank, Cabela's credit card unit. The new Cenex co-branded Cabela's CLUB Visa card offers the same benefits as the Cabela's CLUB Visa credit card, with additional points for every purchase made at any of the 1,600 Cenex fueling centers and for other non-Cabela's purchases. <>


-Barnes & Noble Unveils Nook for Same Price as Kindle - Barnes & Noble Inc., the largest U.S. bookstore chain, introduced a device for reading digital versions of books, entering a market dominated by Inc. and Sony Corp. Barnes & Noble’s Nook will sell for $259, matching a recent price cut for’s Kindle device. The Nook will start shipping by Nov. 30 and will be available in all Barnes & Noble stores, the New York-based chain said today at a press conference in Manhattan. <>


-Online spending growth at all time low - Online spending growth dropped to a record low in September as etailers were hit by heavy high street discounting and localised postal stikes. Year-on-year online sales growth was ahead just 8% to £3.9bn for the month - a record low - while month-on-month growth at 1.9%, was an unusually low rate for September according to the IMRG Capgemini e-Retail Sales Index. Online clothing, footwear and accessories sales stuttered in September with sales rising by just 10% against last year. Average growth this year for the sector has typically been 20%. However, sales were hit as many high street retailers launched promotions early this year and the recession continued to influence consumer spending. <>


-Austria: New application of eco-friendly Tencel fibre on cancer-care - Natural fibre Tencel has found a new application for cancer and long-term patients due to its non-toxic and sustainable nature. RoyallWear dba Jazzy Johnnys, an organisation dedicated to providing cancer patients with an attractive, well designed garment, has recently tied up with Tencel producer Lenzing Fibres to develop a new clothing line for itsanti-wicking, anti-moisture and temperature-sensitive properties that keep moisture off the skin and inhibit bacterial growth. <>


-Puma's Q3 Sales Slump 11.4% in Americas - Puma's sales dropped 5.5 % to €673.4 million ($1.005 bn) in the third quarter. At constant exchange rates,  sales were down 9.8%. Sales in the Americas fell 11.4% due to a "difficult economic environment."According to a report from its parent, PPR, sales for Puma in Latin America declined mainly as a result of tightened customs and the slowdown of tourist activity. Sales in Asia-Pacific were down 8.3% despite the strong performance in China and India. Activity in Eastern Europe/Middle East/Africa continue to see "good momentum" while Western  Europe recorded "another difficult quarter." <>


-PPR Sales Drop 7.6 Percent In Q3 - PPR SA reported a worse-than-expected slump in third-quarter sales, reflecting the continuing economic crisis, a decrease in tourist flows and a slowdown in wholesale orders as retailers preferred to keep inventories low. The French retail-to-luxury group said sales in the July to September period declined 7.6 percent to 4.56 billion euros, or $6.58 billion. Sales were down 8% on a comparable basis versus forecasts of a 6 percent drop. Dollar figures were converted at average exchange rates for the period. <>


-Guadagno Leaves Versace USA - Patrick Guadagno has exited as president and chief operating officer of Versace USA after four years. In recent months, Guadagno made strides to broaden the designer label’s standing in New York. Saks Fifth Avenue has reinstalled the brand on the third floor of its Fifth Avenue flagship. And Versace recently shored up its presence at Bergdorf Goodman with last month’s opening of a 400-square-foot shop for ready-to-wear, accessories and shoes. The brand had been absent from the store for three years until 2007, when it reentered with its runway collection and was afforded less than optimum space. <>


-Gucci Launches iPhone App - Gucci will today unveil its first iPhone/iPod Touch app, aimed at entertaining and enlightening consumers with a 24-hour music channel, hotel and restaurant tips, playlists and a turntable for mixing tracks designed by the music producer Mark Ronson. The free app also gives iPhone/iPod Touch users the opportunity to purchase an exclusive model from the limited edition Ronson sneaker collection when the Gucci Icon-Temporary store opens in their respective cities. <>


-Anthropologie Opens First European Store Friday - Anthropologie will plant its first flag in Europe on Friday with the launch of a 10,000-square-foot clothing, accessories and homeware emporium on Regent Street, halfway between Oxford Street and Piccadilly Circus. The bright and airy store, with soaring ceilings, central skylights and white oak flooring, spans three levels and features a 50-foot-high wall of evergreen plants fed by rainwater that’s been collected on the roof. <>


-Iconix to Pay Fine to FTC - Iconix Brand Group Inc. will pay $250,000 and post notices about its information collection practices under a settlement reached with the Federal Trade Commission. The FTC had said that the company didn't comply with certain provisions of the Children's Online Privacy Protection Act with online promotions it ran for brands last year. Iconix said its non-compliance was inadvertent and did not harm children but said it would pay the settlement to avoid a protracted dispute. <>


-ILGWU Retirees Allege Raynor Misused Funds - Retired members of the International Ladies Garment Workers Union entered the legal scrum between UNITE HERE and Workers United when they accused the breakaway group’s president, Bruce Raynor, of mismanaging their pension plans in a lawsuit filed Tuesday. The retirees are seeking an injunction that would give control of the plans to UNITE HERE. Computer records of the suit were not immediately available, but an attorney for the group provided a copy of the complaint to WWD and said they filed their action in U.S. District Court in Manhattan. <>




RESEARCH EDGE PORTFOLIO: (Comments by Keith McCullough): KR


10/20/2009 10:01 AM


The bulls got me this time on KR, but I'll be back. Booking the loss on a down day in order to manage risk. KM






NKE: Phillip Knight, Director sold 1.4mm shares ($88.5mm).


BGFV: Steven Miller, President & CEO, sold 9,900 shares ($156k).


BBY: Richard Schulze, Chairman, sold 23,700 shares ($971k).


BKE: Hanson Kyle, Gen. Counsel, sold 3,700 shares ($120k).


FINL: Steven Schneider, President & COO, sold 5,000 shares ($34k) after exercising the right to buy 5,000 options.


Historical Perspective

“The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes and yet everything is completely different.”

-Aldous Huxley


On the days Keith writes the Early Look and provides historical context to the current period we are in, it’s always enlightening and helpful to have that context. Yesterday’s Early Look titled “Confirmation Bias” was one of those notes. 


The bottom line for me from yesterday’s Early Look was: stick with what you know and do not fight the tape.  Dollar down = Stocks up; stick with what works.  The dollar will continue to be subject to unprecedented budget deficits, near-zero interest rates and anemic economic growth.  That means capital will flow to hard assets and will find a rate of return that is greater than zero. 


There is no reason to think that President Obama is going to change his policies any time soon.   President Obama’s efforts to lead the world economic recovery by spending his way out of the recession will continue to undermine the dollar.  This will continue to trigger the REFLATION trade and is the reason why Materials (XLB) is the best performing sector year-to-date, up 41.6%.  Rounding out the top three performing sectors year-to-date are Technology (up 38%) and Consumer Discretionary (up 31%). The performance of technology is more understandable, due to growth and innovation, but consumer discretionary is puzzling.


I appreciate history as much as the next guy, but obviously, there are some significant differences between 1933 and today.  President Obama is not FDR, the unemployment rate is not 24%, and one quarter of the population in the U.S. is neither hungry nor starving.


In fact, the opposite is happening. Between 1933 and 1937, employment did not implode.   In 1933 the unemployment rate was 24.9% and by 1936 it was 16.9%.  It bottomed at 14.3% in 1937 before rising to 19% in 1938.  So although the absolute rate of unemployment was much higher then, the rate was coming down, not going up like it is today.


In September 2009, the unemployment rate stood at 9.8% versus 7.6% in January 2009.  In September alone, the economy lost 263,000 jobs, bringing the total number of Americans out of work to 15.1 million.  If you want to play with the number and include the 500,000 unemployed people who gave up looking for work in September, the unemployment rate would be 17%, the highest on record since 1994.


So how is the “Burning Buck” good for consumers, who account for 70% of the nation’s economy?  It’s NOT!  And the latest reading on consumer confidence has turned decisively negative. 


Yesterday, the ABC Consumer Confidence reading came in at (50) for the week of Oct 18th vs. (48) the prior week.  For a historical perspective - (54) is the worst reading ever.  Last week, The University of Michigan confidence index fell to 69.4 in early October from 73.5 in September.  In November 2008 the reading was 55.3.


The other big issue that more and more consumers are facing is housing.  While the government is trying its best to shore up the housing market, the efforts do not get at the heart of the problem –the rising unemployment is making it hard for consumers to make ends meet. 


The REFLATION trade is real and needs to be fully appreciated, but underneath the surface there are some real issues with the consumer that need more time to be worked out. Simply Burning the Buck is not the answer.  Yesterday could be a classic example of what will happen when the buck stops burning.  The S&P was down 0.6% and the two worst performing sectors were Materials and Consumer Discretionary, both down 1%.


I’m not trying to be bearish, just practical.  The S&P 500 is up 61% since the March 9th low and the Federal Reserve has spent TRILLIONS to fight the worst U.S. recession since the 1930s.  Operating stories like Yahoo can have a great quarter in this environment, as comparisons are easy across the board.  It’s staggering to see that 80% of the S&P 500 has beaten analysts’ estimates this earnings season.  That figure is not going to 90% or 100% next quarter. 


The most important headline today is that the Bank of England Governor Mervyn King is talking about higher interest rates.  I love the British because everything is so proper - “it would be wise to take account of the prospect of rising borrowing costs.”  Can Ben be far behind?  Rising borrowing costs are good for the dollar, bad for the consumer and bad for stocks.  It’s looking more and more like 2009 was the eye of the storm – the front wall hit in 2008 and the back side is coming in 2010.


1933 is in the past!


Function in disaster; finish in style.


Howard Penney 





XLU – SPDR UtilitiesWe bought low beta Utilities on discount (down 1%) on 10/20. Bullish formation for XLU across durations.  


FXC – CurrencyShares Canadian DollarWe bought the Canadian Dollar on a big pullback on 10/20. The currency ETF traded down -2%, but the TRADE and TREND lines are holding up next to Daryl Jones’ recent note on the Canadian economy.


EWG – iShares GermanyChancellor Angela Merkel won reelection with her pro-business coalition partners the Free Democrats. We expect to see continued leadership from her team with a focus on economic growth, including tax cuts. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; with fundamentals improving in a low CPI/interest rate environment, we expect slow but steady economic improvement from Europe’s largest economy.


CAF – Morgan Stanley China Fund A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the more volatile domestic equity market instead of the shares listed in Hong Kong. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth. Although this process will inevitably come at a steep cost, we still see this as the best catalyst for economic growth globally and are long going into the celebration of the 60th Anniversary of the People’s Republic.


GLD – SPDR GoldWe bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.  


XLV – SPDR Healthcare We’re finally getting the correction we’ve been calling for in Healthcare. We like defensible growth with an M&A tailwind. Our Healthcare sector head Tom Tobin remains bullish on fading the “public plan” at a price.


CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.


TIP – iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.




UUP – PowerShares US Dollar We re-shorted the US Dollar on strength on 10/20. It remains broken across all 3 investment durations and there is no government plan to support it.


FXB – CurrencyShares British Pound Sterling The Pound is the only major currency that looks remotely as precarious as the US Dollar. We shorted the Pound into strength on 10/16.


XLP – SPDR Consumer StaplesStrong day for Consumer Staples on 10/16, prompting a short versus our low beta long position in Utilities (XLU).


USO – US OIL Fund WTIC Oil traded just north of our overbought line on 10/12. With the US Dollar hitting another higher-low, we shorted more of oil’s curve.


EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.


SHY – iShares 1-3 Year Treasury Bonds  If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.


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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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