Lodging and Leisure chapter. Global Gambits The Right Moves for Right Now. See jpmorgansavant.com for global sector valuation tools

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1 June 28, 2006 Global Gambits The Right Moves for Right Now Lodging and Leisure chapter The following is a chapter from, dated June 28, This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.

2 Global Sector Coordinator Harry C. Curtis, CFA (1-212) J.P. Morgan Securities Inc. Full sector coverage details on page 6 Lodging and Leisure Checking In, Tumblin Dice, and Eating Out Key Drivers Lodging and Gaming Limited supply growth in lodging and strong corporate profits driving RevPAR and margin growth. Supply growth of less than 1% in urban markets and 4% demand growth are producing 8%(+) pricing power, yielding 200bps of margin expansion, both of which should continue for several years. Consumer spending, particularly at the mid- and upper-level, is impacting gaming revenues positively. We expect revenue growth to exceed real GDP by several hundred basis points, also due to limited supply additions in existing casino markets. Restaurants Recent QSR performance has been solid as quality product offerings paired with value-oriented items are allowing casual dining customers an opportunity to trade down. We believe DPZ offers investors relatively low-risk operating income growth and very high free cash flow yield in a difficult consumer environment. Additionally, we believe that YUM s (Overweight/$51.40) high-growth Chinese business warrants an upward multiple revision based on a sum-of-the-parts analysis. MCD (Overweight/$33.35) continues to be another lower risk idea in 2006 supported by its high free cash flow yield, solid US business, and opportunity for continued improvement in Europe. Lower consumer spending trends have negatively affected traffic across casual dining. We continue to favor APPB (Overweight/20.08) given the easier upcoming comparisons in 2H06. It is our belief that if weak traffic persists, the company could benefit from slowing its unit development and be able to grow operating income at 10%. EAT ($36.68) remains an Overweight as we believe the stock s current CY07Y P/E multiple reflects an overly pessimistic view of near-term sales and earnings performance despite a continuation of product-focused advertising, generally easy comparisons, and potential benefit from a reduction in casual dining supply growth. Our Non-Consensus Views Lodging and Gaming Lodging recovery should be longer and stronger than expected. We believe occasions of investor jitters about the impact of higher oil prices or interest rates should be used to buy lodging stocks. Strong corporate profits are the key to continued outperformance, in our view. Gaming comparisons become easier in 2H06. Strong RevPAR growth in Las Vegas in 1H05 makes for difficult comparisons in the near term, but it moderates in the later half, and we expect a resumption of 5-10% pricing power. Restaurants We maintain our Overweight rating on the CBRL Group ($37.63) given the recent share price weakness and completion of the modified Dutch tender offer for million shares (over onethird of the company s outstanding equity). While the consensus call is focused on weak near-term fundamental visibility and the secular challenges of managing the Cracker Barrel brand, we still see substantial long-term value in CBRL s shares based on the high potential cash flow of the core Cracker Barrel business and significant real estate ownership (about 70%). 2

3 Lodging and Leisure: Top Picks Company Key Financials Rationale and Catalysts Felcor Lodging Trust Rating: Overweight Fiscal FFO/Share (Local): Year-end Dec. Ticker: FCH US / FCH E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 1.2 bn Analyst: Harry C.Curtis, CFA EV/EBITDA (Calendar) Phone: (1-212) E 2007E harry.c.curtis@jpmorgan.com Penn National Gaming Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: PENN US / PENN E 2007E Exchange: NASDAQ P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 3.1 bn Analyst: Harry C.Curtis, CFA EV/EBITDA (Calendar) Phone: (1-212) E 2007E harry.c.curtis@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVanT. Prices as of June 15, We believe the Street has not recognized the growth potential and leverage of FCH s asset and financial restructuring. We expect 20% FFO growth through 2008, and we think our assumptions are conservative 7% RevPAR growth in E and bps of margin expansion. In the last quarter alone, FCH s 15% RevPAR and adjusted margin growth of approx. 300bps led the lodging industry s numbers. We expect Street estimates to move higher over the next several quarters as we believe analysts and investors are not fully accounting for the operating leverage of the remaining assets. In May, we added Felcor Lodging Trust to JPMorgan s Analyst Focus List, with a 12-month (May 2007) price target of US$30 per share, 49% above its current level. Given the operating leverage in FCH s model, we believe the stock could increase by over 60% in 18 months when discounting 2008 cash flow. The central risk to our rating and price target involves lodging demand undergoing a sustained period of depressed demand; we believe increased costs would result in cash flow deterioration. A revenue shortfall could result from a slowdown in the US economy, which could lead consumers and businesses to cut back on discretionary spending as well as on the group and convention business. In addition to a poor economy, external events such as terrorism, disease, and war could impact the consumer desire to travel, which would likely spur increased marketing expenses and reduced revenues, leading to an earnings shortfall from our expectation. PENN is our favorite small-mid-cap gaming stock. We estimate that its EBITDA will grow from approximately US$600 million in 2006 to over US$800 million in 2008, and that EPS growth should compound annually at 25% for the next three years. Its 2007E EBITDA multiple (adjusted for construction in progress) of 8.2x should expand considerably in an improved environment, and its 2007E EPS multiple of 15.8x compares to an average of 20x in the last two years. PENN s 12-month forward multiple of 16x is the lowest since July In our view, given the expected EPS growth rate of 25%, the stock warrants a substantially higher multiple that would produce considerable upside from current levels. 3

4 Lodging and Leisure: Top Picks (cont d) Company Key Financials Rationale and Catalysts Rare Hospitality Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: RARE US / RARE E 2007E Exchange: NASDAQ P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 1.0 bn Analyst: Steven Rees EV/EBITDA (Calendar) Phone: (1-212) E 2007E steven.rees@jpmorgan.com On May 17, 2006, we upgraded RARE from Neutral to Overweight. While we do not think RARE is immune to consumer pressures of higher gas prices, we think LongHorn s positioning towards a slightly higher demographic based on a more mainstream site selection strategy (versus its closest competitor, Outback) and exposure to the high-end steak segment with its Capital Grille concept will limit overall sales weakness from higher gas prices. We do not believe the full value of the Capital Grille business is adequately reflected in the current valuation. Assigning a 20 30x earnings multiple to the Capital Grille business (at about 20% of operating profit and long-term operating income growth of about 20%), leaves the core LongHorn and Bugaboo creek businesses undervalued at between 11.3x and 13.7x 2007E earnings ex-options, below other casual dining companies such as APPB, DRI, and EAT. We do not believe this discount is warranted given the underlying strength (for both comp and new unit volumes) and the long-term growth potential of LongHorn relative to these other traditional casual dining companies. Potential beef cost relief in 2007 remains a major potential catalyst for shares. After being up over 10% in FY04 and up about 3.5% in FY05, beef costs were locked in at slightly higher Y/Y prices for FY06, resulting in slightly higher COGS guidance for 2Q06-4Q06. The company will have an opportunity to renew contracts for about 25% of its beef needs in summer We estimate that a 1% change in beef prices equates to about US$0.03 in annual EPS. Domino s Pizza Inc. Rating: Overweight Fiscal EPS (Local): Year-end Dec. Ticker: DPZ US / DPZ E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 1.5 bn Analyst: John Ivankoe EV/EBITDA (Calendar) Phone: (1-212) E 2007E john.ivankoe@jpmorgan.com Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVant. Prices as of June 15, We upgraded DPZ to Overweight on June 1, We believe the company offers investors relatively low-risk operating income growth in a difficult consumer environment. We also believe the highest current free cash flow yield in restaurants provides further stock support if not upside. In addition to the combination of 6-8% operating income growth and expected 8% free cash flow yield on 2007 estimates, we believe modest multiple expansion is possible as the current 13.4x (including options) 2007E P/E multiple compares to its 12-month forward average multiple of 15x. DPZ provides relative stability of cash flow and earnings in a generally unstable sales environment. Given that the system is approximately 90% franchised, the company bears less earnings risk relative to other restaurant companies in our coverage universe with a higher percentage of company ownership. A 1% change in systemwide US samestore sales is worth only US$0.04 to annual EPS. Our current expectations are down 1% for 2Q and up 2% for 2H. Following the same level of national advertising weights in 1Q versus last year, we expect the last three quarters of the year to benefit from the additional one percent of sales (from 4% to 5%) to be spent on national advertising this year. In addition, sales comparisons ease significantly beyond the current 2Q. Currently, low cheese prices further reduce near-term earnings risk. Current cheese prices are US$1.21 a pound, and we are modeling US$1.20 a pound for 2Q06, US$1.30 a pound in 3Q06E, US$1.35 a pound in 4Q06E, and US$1.40 a pound thereafter. A US$0.10 change per pound for the year is worth about US$0.02 per share. 4

5 Lodging and Leisure: Stocks to Underweight Company Key Financials Rationale and Catalysts Bally Technologies, Inc. Rating: Underweight Fiscal EPS (Local): Year-end Jun. Ticker: BYI US / BYI E 2007E (0.02) Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 0.8 bn We remain Underweight on shares of BYI because we believe that the domestic replacement market will remain intensely competitive through 2007, and that demand from new markets could be weaker than expected in the near term. BYI s new products such as Cinevision, S9000, Hot Shots progressive and iview are finding success with customers, but we expect much of the top-line growth to be offset by higher operating expenses (accounting, legal, SG&A). Legal expenses could increase significantly given the three patent lawsuits pending against BYI from competitors. A source of upside, however, could be CDS installations in Mexico. Analyst: Harry C.Curtis, CFA EV/EBITDA (Calendar) BYI is currently trading at 41.5x FY06E and 21.0x FY07E a premium to IGT, which we believe is unwarranted. Phone: (1-212) E 2007E harry.c.curtis@jpmorgan.com Darden Restaurants Rating: Underweight Fiscal EPS (Local): Year-end May Ticker: DRI US / DRI E 2007E Exchange: NYSE P/E (Calendar) Price (Local): US$ E 2007E Mkt Cap (US$): 5.4 bn Analyst: John Ivankoe EV/EBITDA (Calendar) Phone: (1-212) E 2007E john.ivankoe@jpmorgan.com Darden remains a relative Underweight to our other casual dining coverage, more specifically Applebee s, Brinker, and Rare Hospitality. We believe it is a well-managed company, as it is the only casual dining name to consistently post strong comps and meet and exceed our earnings expectations. However, we struggle to see earnings upside beyond our current expectations given the peak operating margins, continued difficult comparisons, and the lowest potential free cash flow yield amongst its casual dining competitors. We believe that many catalysts that exist as potential action points for other casual dining businesses (intense focus on brand management at existing business to produce peak AUVs and margins instead of new unit development resulting in consistent operating income growth and high FCF yield) have already been successful at Darden. In fact, we hold Darden as a model for other casual dining names to follow. Given the highest year-ago sales comparisons and already peak store margins, we believe EPS upside is unlikely. Additionally, we believe it is not possible for the company to increase its FCF yield as unit development of 3-4% a year is already the lowest in casual dining by 50-75%. Source: Company data, Bloomberg, JPMorgan estimates, JPMorgan SaVant. Prices as of June 15,

6 JPMorgan Global Lodging and Leisure Team Research Equity Research Credit Research Gaming and Lodging Leisure Restaurants Harry C. Curtis, CFA Americas Americas Americas Americas Global Sector Coordinator United States Harry C. Curtis, CFA Mario Kontomerkos C. Patrick Scholes Amir J.Markowitz United States Dean Gianoukos Gopal Vemuri United States John Ivankoe Steven Rees Joseph Genco United States Ralph Elliott (HG/HY-Gaming, Lodging) Marissa Ballan (HG/HY-Gaming, Lodging) Adam Feldheim (HG/HY-Gaming, Lodging) Michael Pace (HY-Leisure) Leslie Sturgeon (HY-Leisure) Zafar Nazim (HY-Restaurants) Akiva Steckler EMEA EMEA Pan Europe Tejpal Dhami Nachu Nachiappan (HG) Alex Ayoub (HG) Asia Pacific Australia Cameron McKnight Terry Couper Philippines Kelly Lim South Korea Mingoo Kang 6

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