prev

US Market Performance: Week Ended 8/22/08...

Index Performance:
Week Ended 8/22/08: Dow Jones (0.3%), SP500 (0.5%), Nasdaq (1.5%), Russell2000 (2.1%)
2008 Year To Date: Dow Jones (12.3%), SP500 (12.0%), Nasdaq (9.0%), Russell2000 (3.7%)

LAS VEGAS: OMINOUS JULY AIRPORT DATA

For the gaming industry, McCarran Airport data is the first import metric to be released. Historically, the passenger data has proven to be a very powerful and statistically significant predictor of Strip revenues. The first chart displays the high correlation between slot handle and air passenger traffic. I’ve developed a quantitative model to predict slot, table, and RevPAR growth based on the enplaned/deplaned McCarran Airport passenger data released well in advance of the other metrics. I will report my estimates on a monthly basis soon after the passenger data comes out.
  • On Friday, the airport announced that July passenger volume declined 8.6%, the largest monthly decline since 2002. Assuming normal hold percentages (luck factor), July gaming revenues will likely decline at a faster rate. Last July (2007), the casinos held above normal on both slots and tables. This factor is likely to exacerbate the overall decline. As can be seen in the second chart, I calculate slot and total volume could decline 5% and 4%, respectively. However, total revenue could fall 12% due to the above average hold percentages last year.
  • For those math enthusiasts, my model’s predictive power is very high. While I have no way of predicting luck, the McCarran monthly passenger variable explains 68% of total gaming volume (aka handle or drop). Barring another month of good luck on the tables, July gaming revenues are not likely to look pretty when they are released in 2-3 weeks. Coming soon, I will put my modeling skills to work on room rates. This profitable revenue driver is likely to look even worse.
Correlation between Strip slot handle and air passenger traffic of 0.89
Revenue declines likely to exceed air passenger drop

FL: 99-00 Revisited

I think that FL’s current positioning mirrors where it was in 1. It came out a dark period, looked expensive all the way, and the stock still tripled. Timing and sizing are key.
  • You’ve seen us put up our inventory/margin roadmap charts – and FL recently checked in to the ‘sweet spot,’ where sales growth is outpacing inventory growth, and margins are positive. Yes this is a great place to be – but that’s especially the case for Foot Locker.
  • I’m hard pressed to find any retailer that has spent so much of its history in a negative inventory position and simply living in a world of swapping margin for comp. In fact, the only two I can find are Sears and K-Mart when they were stand-alone companies (and now the combined entity, of course).
  • But when things turn positive, they stay there for more than a quarter or two. Looking at FL’s 10-year trend, it was in a negative inventory/sales position 90% of the time. But the one time it came out of its funk was in mid-99 through the end of 2000. This was also after a 2-year period of fashion shifting away from athletic, the Asian currency crisis, and overcapacity at retail – not unlike what we have today.
  • During the time period where its income statement and balance sheet synched in the ‘sweet spot’, FL’s stock went from $5 to $16 – and yes, it appeared expensive every step of the way.
  • I’m not suggesting we ignore valuation, as there are plenty of issues that have yet to be resolved. One of the biggest is dynamics in Asia and flow through to the US (we’re published a ton on this, and I still think that FL can triple margins from here in that context). Also, 3Q is an easy compare, but less so than what was just reported, and less than what we’ll see in 4Q.
  • My confidence level remains high. This is a question of timing and sizing.
Tough to read, I know. But showing the 1 period vs today is vital.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.28%
  • SHORT SIGNALS 78.51%

Restaurant Anthology – Part 2

I find myself writing the phrase “a sign of the times” a lot recently to describe negative trends that have emerged that in the past, I would have described as daunting, but today, are merely commonplace or the standard against the backdrop of today’s difficult economic environment, particularly as it relates to restaurant operators. Such “signs of the times” would include severe traffic declines, rising prices to offset higher costs at the expense of traffic and the flip side, discounting at the expense of profitability, margin-crushing commodity costs, higher management turnover, an increased number of companies at risk of defaulting on debt covenants and increased leverage within the industry. Unfortunately, all of these “signs” and trends continued to be relevant over the last two weeks.

For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.
  • An increased number of companies at risk of defaulting on debt covenants - On July 20th, I published a list of 13 restaurant transactions that have taken place over the past three years and asked the question; how many companies on this list will need to raise equity or file bankruptcy in the next 12-18 months? Last week, the WSJ highlighted some of the companies on the list. According to the WSJ, the parent of Uno Chicago Grill was expected to skip a bond payment as it tried to negotiate more financial breathing room. The issues at Uno are a common theme in restaurant land – UNO is being squeezed by declining customer counts, rising food costs and an overleveraged balance sheet. The article also cited that Chevy’s Fresh Mex, Perkins and Marie Callender's chains are in talks with their lenders - posted August 13.
  • Increased leverage within the industry – I just don’t understand the reasoning behind the capital allocation decision to borrow money to buy back stock. RRGB’s board recently authorized an additional $50 million share repurchase effective through 2010. The company’s lowered new unit growth for FY09 will free up additional cash, but I would not like to see RRGB offset this shareholder-friendly capital allocation decision by then borrowing money to buy back more stock than it should – posted August 19.

    YUM’s cash flow story is changing with the company’s debt levels increasing to keep up with increased cash burn (in the last 12 months, YUM has burned through $1.4 billion in cash and its interest expense has increased 8%). Additionally, YUM has been allocating more cash toward capital spending (up 13% in the last year), which increases YUM’s risk profile and drives lower incremental returns for shareholders. YUM’s capital spending needs are growing and that will come at the expense of the share repurchase program. The question that remains is if interest expense in up 8% (due to higher debt levels to buy back stock) and the share count has only declined by 2%, how is that accretive to shareholders? – posted August 14.
  • Other Company-Specific Highlights:

    YUM – I recently reviewed YUM’s proxy and the metrics used to determine how management gets paid. Including the leverage factor, EPS growth of at least 10% can account for more than 50% of the bonus. System sales growth and system net new restaurant builds (easily achieved by accelerating capital spending, which has been steadily increasing for YUM) collectively account for another 40%. There is no incentive for management to improve the operating performance of the company. In light of the poor operating performance in the U.S., it is very clear why management wants to leverage the balance sheet and reduce the share count by 8% - posted August 21.
  • MCD – As of 2Q08, MCD said specialty coffees is in more than 1,600 restaurants (up from 1,300 in 1Q08). If we assume the company accelerates the conversion process in 2H08 and converts 1,200 stores, the total number of McDonald’s stores with the ability to sell specialty coffee in the U.S. would be 2,800, which is only 25% of the system. Management has set expectations for a national launch for the specialty coffee program in mid-2009, but if only 25% of the store base has the ability to sell specialty coffee, how can the company justify spending the marketing dollars in 2009? More importantly, will the franchise system embrace the move? – posted August 15.
  • CKR - CKR posted solid period 7 same-store sales growth at both Carl’s Jr. and Hardee’s, up 4.2% and 1.4%, respectively, closing out 2Q up 3.8% at Carl’s Jr. and up 3.3% at Hardee’s. Both concepts experienced sequentially better 2-year average trends in 2Q from 1Q (100 bp improvement at Carl’s Jr. and 250 bps better Hardee’s). CKR also provided restaurant operating cost guidance for 2Q and expects restaurant operating margins to be up 20-50 bps year-over-year. The company is facing an easy comparison from last year when restaurant margins fell 300 bps (primarily as a result of higher food costs), but margins growing YOY is favorable, nonetheless, as CKR’s margins have declined for the last 6 quarters – posted August 20.
  • LDG – During my career as an analyst and an investment banker, I spent a lot of time looking at real estate transactions for a number of different companies. In most cases, the business model was better off owning the real estate, as it provided a level of stability to earnings. I will go as far to say that selling a company’s real estate portfolio is about as effective in creating shareholder value as an activist shareholder telling a company to use leverage to buy back stock! I guess if Bill Ackman can prove to the world that LDG’s real estate can add incremental value, it will validate his other consumer holdings. Selling a company’s undervalued real estate creates an enormous tax burden, which limits the cash available to maximize value for shareholders. I truly believe that Bill Ackman knows this, and I have yet to see a structure from him that would get around the tax issue completely – posted August 18.
  • GMCR – The bull case for GMCR is compelling but the case for demand destruction is even greater. Taken together, the combination of Keurig brewers, patented K-cups and Green Mountain specialty coffee has provided the company with strong top line growth. However, the K-cup -razor/razor blade model is a long way from generating the type of revenues needed to drive overall profitability. This is already showing up in the company's consolidated results with 3Q08 gross profit margins declining to 36% from 41% last year – posted August 12.
Restaurant Transactions Over the Past Three Years
YUM Compensation

RESTAURANT ANTHOLOGY – PART 1

I find myself writing the phrase “a sign of the times” a lot recently to describe negative trends that have emerged that in the past, I would have described as daunting, but today, are merely commonplace or the standard against the backdrop of today’s difficult economic environment, particularly as it relates to restaurant operators. Such “signs of the times” would include severe traffic declines, rising prices to offset higher costs at the expense of traffic and the flip side, discounting at the expense of profitability, margin-crushing commodity costs, higher management turnover, an increased number of companies at risk of defaulting on debt covenants and increased leverage within the industry. Unfortunately, all of these “signs” and trends continued to be relevant over the last two weeks.

For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.

  • Traffic declines - Recent NPD data shows the 18-24 year old age group has been scaling back on their restaurant use over the past few years, with the decline from 2007 to 2008 being quite striking. While restaurant use overall has slipped a bit, no other age group has scaled back to the extent young adults have, and although they are a relatively small group in terms of population, 18-24 year olds are responsible for a sizeable number of industry visits. For the year ending June ’08, young adults 18-24 accounted for nearly seven billion visits to commercial restaurants and spent $42 billion dollars with the majority of that spending at Quick Service Restaurants – posted August 11.
  • Rising prices to offset higher costs at the expense of traffic… – The China Daily reported this week that KFC raised its prices in China for the second time this year due to increasing commodity costs. The magnitude of this second price increase was greater than the first one implemented in March, ranging from 0.5 yuan to 2.5 yuan (versus 0.5 yuan to 1.5 yuan in March). For reference, the price of a medium coke is now 6.5 yuan, up from 6 yuan (an 8% increase). One KFC customer responded to these recent price increases, saying “Its products are quite small in size, and not worth the money if prices continue to go up.” This price vs. traffic relationship is one that I have talked about a lot and if customers begin to think the price increases are too great, YUM’s traffic growth in China will begin to suffer – posted August 21.

    Speaking to the press in Japan, Eiko Harada Chairman and President of McDonald's Co. (Japan), said "rising food prices will force McDonald’s to raise prices for the second time this year. We'd like to implement it (the price hike) as soon as possible” – posted August 11.

    RRGB has been aggressively raising prices at the expense of traffic. This trend was magnified in 2Q when traffic declined 4.4%, down significantly from 1Q’s 0.4% decline. Thankfully, CEO Dennis Mullen stated on the conference call that “we’re nervous about pricing in this economy.” Restaurant margins should deteriorate further in 3Q as the company is up against its most difficult same-store sales growth comparison from 2007 and will not have has much price to offset these declines. That being said, I think the company’s decision to be more disciplined with its pricing strategy is the right one as margins will not improve until RRGB gets more people in its restaurants. – posted August 19.

  • And the flip side, discounting at the expense of profitability – The $5 price point is becoming popular within QSR. A few weeks ago, I pointed out that Subway was having big success from a traffic standpoint with its $5 price point, and now Arby’s is moving in the same direction, with its 5 for $5.95 promotion – posted August 11.

    Within casual dining, Applebee’s and the Outback are using a $9.95 price point to drive traffic. This appears to be a desperate move for Outback. The last I checked, Outback’s average check was over $20 so this $9.95 promotion will inevitably cut into margins – posted August 11.

  • Margin-crushing commodity costs – BKC posted 5.5% same-store sales growth for 4Q08 at its U.S. and Canada division and a 360 bp decline in company restaurant margins. Management attributed the majority of this decline (200 bps) to higher food, product and paper costs (net of the reimaging program, margins would have declined 230 bps). Although this lack of top-line flow through was daunting, even in today’s environment, I was more surprised to hear management say they think commodity costs have peaked relative to what other restaurant operators have been saying. I am calling this the BK Disconnect – posted August 22.
  • Higher management turnover – Last week, the London Times reported that Starbucks U.K. and Ireland managing director Phil Broad resigned. This is not a healthy sign for SBUX, but relative to the news flow over the past two weeks, management changes should not come as a surprise. This announcement followed Starbucks’ recent elimination of the COO position and Martin Cole’s (formerly the COO) appointment as president of Starbucks Coffee International Inc., replacing Jim Alling – posted August 10.


Price Versus Traffic: An Important Relationship

ASCA: REFI AND EAST CHICAGO UPDATE

Unlike most of the sell side, I’ve recently focused on the balance sheets of gamers. ASCA has been of particular interest given the proximity to tripping the senior leverage restriction in its credit facility. As I pointed out in the post “ASCA: TOEING THE COVENANT LINE” on 8/14/08, unless the company refinances some of its debt, it is likely to bust a covenant by Q2 2009 if not sooner. ASCA has pulled a few levers as of late to ensure it doesn’t, including cutting costs and maintenance capex. Management knows this is not a sustainable strategy. Its customers are accustomed to a high level of quality and service which will quickly deteriorate under the current low level of spending.

For the aforementioned reasons, look for ASCA to refinance sooner rather than later despite the current credit environment. The least painless approach is to float a subordinated bond indenture. My best guess is an offering of $200 to $250 million at 12%. The rate would be consistent with where Boyd Gaming’s sub debt trades. As shown in the following chart, this scenario results in an EPS hit of $0.10 to $0.20 or roughly 12-25% of my forward 12 month earnings estimate. It could be worse. EPS would be cut in half with a full refinancing of the credit facility or a covenant waiver. A subordinated debt offering buys the company some time. The current, attractive facility does mature in 2010, so the company has a maximum of 2 years left of over earning.

Another topic of interest for ASCA investors is the performance of Ameristar East Chicago following the opening of the new Horseshoe Hammond. It’s only been two weeks but Ameristar may be holding up a bit better than the company expected. We continue to believe property revenues will fall between 5 and 10% at East Chicago and the first two weeks are probably in that range. Stay tuned for more updates.


Sub debt financing will drive EPS lower

GET THE HEDGEYE MARKET BRIEF FREE

Enter your email address to receive our newsletter of 5 trending market topics. VIEW SAMPLE

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

next