old soldiers fade away; what about old hotels?–how overcapacity shrinks

supply/demand imbalances…

In many cases, imbalances between supply and demand resolve themselves relatively quickly.

–Fresh produce goes bad.

–Clothing wears out, or is lost or damaged–or fashions shift–constantly creating new demand.

–Workers retrain and change careers.

–Technological change makes production equipment, as well as their output, obsolete.

…are difficult with long-lived assets like real estate

But what happens with real estate?

…where structures can be very expensive, are typically funded with borrowed money, may take years to build, generally can’t be relocated and can last for fifty years or more.  They’re also relatively low tech.

In this post, fresh from my visit to Las Vegas, I’m going to write about what happens with hotels/motels, a special case of this real estate question.

motels

These are easier to analyze than hotels, since they cost less and can be built faster.  Often, they’re designed in modular fashion so they can add extra wings of rooms at relatively low expense, if needed.  They also tend, in the US at least, to draw most of their customers from people who have business within a few miles of the motel.

Therefore, new capacity comes in lower increments and is visible to potential new entrants faster than with hotels.  So overcapacity tends to be less severe.

cost pressure points

There are two big costs for a motel operator that I don’t think are readily apparent–the price of affiliation with a national chain, and the need for periodic refurbishment of rooms.  These expenses end up being the big factors in eliminating existing capacity.

Chain affiliation, which may cost 5% or more of revenues, brings two benefits:  a brand image and access to a reservation system to direct potential guests to the motel.

Although guests don’t think about it much, hotels and motels suffer a lot of wear and tear, both in the rooms themselves and in common areas.  So they require a considerable amount of spending on maintenance.  In addition, to keep the rooms new looking in a way that justifies a higher rate, rooms have to be refurbished periodically–say every five years.

The two expense items are interconnected, since maintaining a specified standard of appearance will also be a condition for retaining affiliation with a chain.

When profits are under pressure, in my experience the first area to suffer cutbacks will be maintenance/room refurbishment.  Once these expenditures begin being postponed, it becomes progressively more difficult to catch up, since returning to the former standard is increasingly more expensive.  At the same time, less favorable online user reviews translate into less repeat business.  This compounds the financial problem.

At some point, a motel may fall below the standards necessary to maintain its affiliation with, say, the Marriott chain.  It may, however, still qualify to be a Best Western or Comfort Inn affiliate.   So it “solves” its maintenance/refurbishment problem by switching affiliations.  The motel effectively removes capacity from a higher-price market segment and introduces new capacity to another, lower-price one.

For a given motel, this journey to less expensive market segments may have several steps.  At some point, the building may be sold for alternate use as, for example, a nursing home.  If so, the capacity disappears entirely.

hotels

The same principles apply.  Three differences, however:

–hotels need to achieve a certain amount of occupancy–generally thought of as 30%–regardless of profits, so the building will feel “alive” and safe

–hotels are much larger in scale

–there are no alternate uses.

In Las Vegas, scene of immense overcapacity currently, two additional patterns are evident:

–older and new, but not as conveniently located, properties had been competing on lower price.  Given the new hotels’ need to generate occupancy to create a favorable ambiance, that advantage is diminished.  WYNN, for instance, had been planning to charge $300+/night for its new rooms.  But average room rates are currently around $200, with mid-week rates considerably below that.

–in the case of WYNN, LVS and to a lesser extent MGM,  management fees from Asian operations to the US are supplementing US cash flows, thereby enhancing the location advantage the three have.

signs of strain

You can already see signs of strain–and of capacity leaving the premium segment of the market.  The Wall Street Journal reported yesterday, for example, that Hilton is planning to end its affiliation with the Las Vegas hotel owned by private equity investor Colony Capital.

And MGM is also hoping to be able to blow up its as yet unopened Harmon hotel on the Las Vegas Strip.

walking around in Las Vegas last week

My wife and I went to San Francisco to see the Giants play two weeks ago.  Then we drove down the coast to Los Angeles to visit relatives.  And we stopped in Las Vegas for a day on the way home, just to see how the city looked compared with our last trip early in the year.

Over the years, I’ve learned that you have to be careful in drawing any firm conclusions about the hustle and bustle you see.  As I’ve already mentioned a long while ago in this blog, I once was in Caesars in Atlantic City at a time when the casino was packed to the gills.   (By the way, I’m not a big casino gambler myself.  I find it too much like work.  But the stocks are simple to analyze and usually generate huge amounts of cash flow.)

I called the company the next day and found out that their profits in Atlantic City were weaker than usual, not stronger.  A main set of doors had broken and no one could get in or out easily.  Few people were actually gambling; most were just stuck, and preventing fresh money from getting in.

Nevertheless, for what it’s worth:

–the city seemed to have far more foreign visitors than in January

–WYNN had a lot more casino patrons

–the Fashion Mall across the street was bustling

–the Bellagio seemed quieter; the visibly worn carpeting in retail areas hasn’t been replaced

–CityCenter appeared a lot quieter than in January

–I didn’t detect much difference with LVS

–every retail complex I saw had at least one vacancy, even WYNN;  CityCenter, understandably had the most empty space.

 

One of the odder aspects of my trip was the controversy that flared up last week over the yet-to-be-completed Harmon hotel in the CityCenter.  MGM is proposing to blow the structure up. (VegasInc has a comprehensive account).  It says the building is a potential hazard in an earthquake, because of construction defects.  Contractor Perini Building Co., which says MGM owes it $200 million+ for its work on the building, asserts any problems are design defects caused by MGM.   Just another day in the desert.

Is the US the new Japan?: stock market implications

the Lost Decades

Today, I’m going to expand on yesterday’s post by writing about features of the “Lost Decades” in Japan that I think might be repeated in similar circumstances elsewhere.

Before I start, however, I want to make two points:

–I don’t think the US is the new “Japan”;  the EU would be a better candidate, in my opinion, based on its behavior toward its banks, its money policy regime and the way many countries intrude into the workings of their equity markets.  But I don’t think it’s anywhere close to being another Japan, either.

Instead, I’m reading the current downdraft in world markets as an adjustment to two realizations:

that economic growth in the US and EU will potentially be much slower in the next two or three years than in 2009-10, and

that no more government support for markets is forthcoming.

The removal of the implicit safety net is the bigger deal, to my mind.  I’ve been thinking–and writing–for a long time that the slow growth/high unemployment problem is a social and political one that won’t affect corporate profits much.  I still think so.

–To (my) Western eyes, the Tokyo stock market was a very peculiar place twenty-odd years ago.  Back then, the government was actively involved in controlling the stock market, in much the same way that governments typically control their bond markets.

For instance:

at times, Japanese brokers were not permitted to accept sell orders for domestic commercial banks–at least from foreigners.

Large amounts of trading were done in specially segregated trusts, to make it clear that the parties were not disrespecting one another by liquidating stockholdings established to cement business relationships. These tokkin “portfolio managers” typically worked in large smoke-filled rooms that housed scores of them, all trading off price movements posted on large electronic “scoreboards” erected along one wall.  No research, no portfolio planning–just trading on hunches or “hot” tips.

Women were legally barred from purchasing warrants (don’t ask me why).

If you want to see something really weird, read my post on tobashi.

Despite these unique quirks, I think there are aspects to the Japanese experience that I think would apply elsewhere.  And, of course, it’s always good to think out alternate scenarios, just in case they become more probable, or because you find your initial assessment was wrong.

Three  factors stand out to me:

Continue reading

is the US the new Japan?

the question

That’s the question of the day for many stock market commentators.  Most are probably aware that Japan boasted the second largest economy in the world in 1989, and at the same time the world’s largest stock market by far.  The prevailing mood in the US back then was that Japan would soon eclipse us as #1, and we’d be left with selling our armed forces as mercenaries to the rest of the world to get foreign exchange (hard to believe, but true).

Yet, the following two decades saw only economic stagnation for Japan, with its economy long ago surpassed by China and its stock market shrunk to less than a quarter of its relative size.

What went wrong with Japan?

Most of those suggesting the US is starting down the same path don’t have a clue.

To my mind, having watched the Japanese economy and stock market for over 25 years, is that those in power in Japan deliberately chose to preserve the status quo–and the traditional semi-samurai way of life that that implied–over the “creative destruction” that would likely have secured a better economic future.  This stands in stark contrast to the behavior of the prior generation, which rebuilt Japan from the ashes of World War II.

There are parallels between Japan then and the US now.  But there’s already been one major difference in approach.  My guess is that Americans will continue to make substantially different choices than Japan did, but, trite as it is to say, it’s too soon to tell.

the parallels

–The most obvious–and possibly the reason for all the talk–is that both countries have extremely low nominal interest rates, which have failed to turbocharge either economy.

More than that, however,

–Japan experienced a substantial bubble in property and financial assets in the late 1980s, caused by reckless bank lending and regulatory neglect.  (In contrast to the American sub-prime housing bubble, which eventually collapsed under its own weight, the Bank of Japan ended that country’s period of speculative excess by raising interest rates).

–Like most nations, Japan believed in the innate superiority of its way of life.  Japan also believed it received special favor from the divine through the mediation of the emperor.

–The legislature was (and still is) dominated by money politics, with legislators’ influence in the Diet based on their ability to raise funds from special interests.

–Neither major political party had a relevant contemporary social agenda.  The Socialists, now the Democratic Party of Japan, opposed the use of nuclear power and drew their emotional appeal from the WWII bombings of Nagasaki and Hiroshima.  Oddly, the party also supported North Korea and pachinko parlors.  The anti-nuclear weapons platform later transmuted into anti-nuclear power.  The Liberal Democratic Party, the dominant force over the past 50 years, favored protection of domestic agriculture and policy support for export-oriented manufacturing–in other words, it maintained positions appropriate for Japan only as the developing country is once had been.

differences, so far

–Japan covered up its banking problems for a decade.  The government pressured (successfully) the banks not to call loans made to bankrupt firmsIn fact, it encouraged them to extend more credit, in the vain hope that time would heal what management incompetence, and sometimes corruption, had created.

The propping up of what became known as “zombie” firms had two very negative consequences:

it continued to degrade the financial strength of Japan’s commercial banks, and

it shifted sales away from healthy firms, weakening them as well.

–Through formal and informal means, the government discouraged mergers and acquisitions that would have brought new management into troubled firms. In particular, a series of new laws made it virtually impossible for a foreign firm to take over a domestic one.

–At the time the bubble popped in late 1989, about 10% of Japan’s workforce was employed in the construction industry.–an unusually high proportion for an advanced economy. Rather than attempting to retrain workers (by the way, a task made more difficult by Japan’s kanji-based written language), the Diet chose to launch a continuing series of infrastructure construction programs to keep these workers employed. Later studies seem to show that these projects had no lasting positive effect on the economy. They appear to have served mostly to line the pockets of politically connected companies, raise the national debt and delay the adjustment of the workforce to the new economic realities.

–Throughout this time, Japanese voters, who are generally highly economically sophisticated, remained surprisingly passive. Although the situation is a bit more complicated than this, voters tolerated LDP mismanagement of the economy for twenty years before voting for change. Unfortunately, the DPJ which replaced the LDP has proved as inept today as its predecessor was when it was briefly in power in the late 1980s.

–The Tokyo government snuffed out a nascent economic rebound twice during the Nineties, once by raising interest rates, once by raising taxes.

what about the US?

Will the US make the same errors as Japan? In a narrow sense, it’s too soon to tell. However,

the US has acknowledged its banking problems from the outset.

We can already see substantial merger and acquisition activity underway.

Certainly, “creative destruction” is regarded in a positive light in the US.

Also, I can’t imagine that American voters would be as tolerant of government ineptitude as Japan has been.

The more relevant question will likely be whether the new politicians voted into office will be any better than those voted out.

Tomorrow: stock market implications.


earnings surprisingly strong, sales a little light–the stock plunges: why?

strong eps, light sales

Sometimes the way that the mind of Wall Street expresses itself in stock prices strikes casual observers as odd.  A prime example of this is when a company (DELL is a recent example) reports earnings that exceed the Wall Street consensus handily, yet the stock doesn’t go up the way you’d expect.  Instead, it drops like a stone.  The market seemingly ignores the strong earnings and points to revenues as the cause of its unhappiness.

Seems kind of petty.

Is there any sense to this reaction?

Yes  ….and no.

the yes part

Remember, the growth stock investor’s mantra has two features:

–surprisingly strong earnings

longer than the market expects.

In situations like the one I describe above, it’s the assumed lack of permanence in the earnings gains that the market is making a negative reaction to.  The argument is this:

Companies make money either by selling more stuff, in which case revenues will rise, or by cutting expenses, in which case they won’t.  So earnings without revenues = cost-cutting.  Cost-cutting opens the door to two bad outcomes:

–sooner or later (probably sooner) the company will run out of expenses to cut and earnings will drop back to their pre-surprise level

–the firm may reducing crucial expenditures, such as research and development or customer service to an extent that future earnings prospects are harmed.  Therefore, earnings won’t just drop back to the pre-surprise level, they’ll fall below that.

the no part

The knee-jerk reaction that earnings growth without revenue growth isn’t a good sign will probably turn out to be right in the majority of cases.  But there can be instances where this is a mistake.

As I’m writing this, I’m struggling to find a plausible concrete example to illustrate what I’m about to say–which tells you (and me) something.

Anyway, it’s possible that a company is composed of a fast-growing, high-margin component and a slower-growing, lower-margin (or loss-making) one.  It may be that new products in the high-margin component are what’s creating the slow revenue, fast profit-growth pattern.  It’s even possible that the company in question is preparing to separate into two parts, either by sale or spinoff, in a way that will remove barriers to investors seeing the full potential of the growth component that the mature one creates.

for a positive market reaction?

For the market to have a positive reaction to strong earnings, light sales, I think three things are necessary:

–the company has to communicate clearly what the dynamics of the earnings situation are (it may have competitive reasons for not wanting to do this)

–professional analysts have got to trust what the company is saying and/or find confirming evidence, and

–investors have to be in a relatively bullish mood, so they’re willing to overlook the bearish signal and believe the bullish story.