Supply Constraints in Commodity Land

Conclusion:  While we will continue to pick our spots across the commodity complex, broadly speaking supply data points continue to support elevated prices, which in turn drives higher inflationary readings globally. 


There is a well know adage when it comes to advice in the stock brokerage industry, which is:


“Advice is the only commodity on the market where the supply always exceeds the demand.”


While this adage no doubt is true, we believe that the commodity markets themselves may be an area where supply continues to be constrained, which is supporting higher commodity prices.


As we wrote on January 4th, 2011:


“Interestingly, despite our view of slowing growth into 2011, it seems that we are seeing evidence of supply constraints across the commodity complex that are poised to drive commodity prices higher in the face of a sequential slowdown in growth.  Higher commodity prices and slower growth mean one thing: stagflation.”


Since that note, the agricultural commodities have continued to increase in price.  In fact, the commodities we highlighted in that note specifically are up as follows since January 4th, 2011:


-          Sugar +0.9%;

-          Soybeans +1.8%;

-          Cotton +14.1%; and

-          Rice +4.6%


In the meantime, we continue to collect global data points that highlight supply constraints in the commodity complex, specifically:

  • Australian authorities expect coal production to be down 10% in the coming year due to the flooding in Queensland;
  • Corn inventories in the United States are the lowest levels since 2007;
  • Ivory Coast is limiting exports of cocoa;
  • Based on the latest reports, US cow and bull (non-fed) slaughter for the past seven days (Jan 13 - Jan 19) was 131,000 head, about 13,000 head or 9% lower than the same  period a week ago and also 10.9% lower than the previous year;
  • A looming shortage of milk stares Kenya in the eye. The North Rift region, which produces 80 per cent of the country’s milk for sale, has registered a 40 per cent drop in supply;
  • Indonesian exports of coffee are down year-over-year and Brazilian production fell sequentially from November (3.5MM tons) to December (3.15MM tons). As well, Colombia’s largest growing province is expected to post lower production this year due to less sunlight;
  • The Uzebekistanian cotton crop is expected to be down 5% year-over-year; and
  • Natural gas inventories in the U.S. continue to decline and are now only 1.9% above the 5-year average.

The last point on natural gas is an important one to highlight.  The bear case for natural gas is well known and, in the long term, we support it.  In fact, in the longer term we believe investors may not be bearish enough on natural gas supply growth (which is driven by an acceleration of horizontal drilling and shale projects) in the United States.  In the short term, price is driven by fundamental changes on the margin.


As it relates to natural gas, the primary change on the margin is rapid declines in the way of U.S. inventories, which we’ve highlighted in the chart below.  In the last month, natural gas is up almost 10%, which is the third best performing commodity we track.  (Only orange juice and milk are ahead of natural gas.)  The drive is colder than expected weather in the U.S. and as a result natural gas has gone from being well oversupplied to being marginally oversupplied.  Two weeks ago natural gas inventories were 5.8% above their 5-year average, which declined to just 1.9% last week.  Still oversupplied, but less so.


As always, what happens on the margin drives prices.


Daryl G. Jones

Managing Director


Supply Constraints in Commodity Land - natty 2


In preparation for WMS's FY Q2 2011 earnings release tomorrow, we've put together some forward-looking commentary from the company's FY Q1 2011 conference call and subsequent conferences.




  • “While standing at the threshold of entirely new revenue streams from our suite of Networked Game Enablement Portal applications and online gaming, we still see meaningful opportunities to grow our revenues, earnings and cash flow.”
  • “Our full-year guidance for fiscal 2011… underscores our expectation that we will continue to achieve top and bottom line growth throughout our fiscal year in the face of the continued impact from the slow replacement cycle, consumer uncertainly leading to no real increase in discretionary spending and our current expectation for the delay in the opening of the Illinois VLT market until fiscal ‘12.”
  • “I sense an improving sentiment among gaming operators. We’re seeing continuing willingness by the large multi-site operators to invest in the future and freshen their floors by increasing the size and breadth of their orders with WMS, large orders that would have been fulfilled over several quarters and that cover both new unit sales and recurring revenues in gaming operations.”
  • “In total, Bluebird xD and Bluebird2 cabinets accounted for 90% of our total global unit shipments, with Bluebird xD cabinets totaling almost 1,900 units or a healthy 35% of total global shipments.”
  • “Penn’s new Maryland casino are not in our September quarter shipments, but should be in the December 2010 quarter”
  • “Overall, higher shipments into the international markets we entered in fiscal 2010, Mexico and New South Wales, Australia, more than offset ongoing weakness in Europe.”
  • “We also experienced the meaningful increase in other product sales revenues, up 7 million or 47% from the prior year. The increase was led by significantly higher used gaming machine revenue and higher hardware and software conversion revenues.”
  • “Our daily average revenue per gaming machine was down slightly, both on a year-over-year and quarterly sequential basis, mostly reflecting the impact of lower consumer discretionary spending and the launch of new web products focused primarily at refreshing our footprint not expanding during the September 2010 quarter.”
  • “Our initial Bluebird xD gross margins were lower than the targeted launch goal. We have identified significant opportunities to improve the xD gross margin through cost reductions and supply chain efficiencies and we have a plan in place to accomplish this throughout the balance of fiscal 2011. We expect to reach margin parity between the Bluebird xD and Bluebird2 cabinets in the June 2011 quarter, even as we anticipate raising the bar by improving the margin on the Bluebird2 cabinet during the same period” 
  • “We expect depreciation to increase in total dollar expense over each of the remaining quarters in fiscal 2011, as we invest capital to continue to transition our gaming operations base from Bluebird to Bluebird2 units, place our first units into the new Italian VLT market and selectively invest in other high-return lease opportunities.”
  • Guidance:
    • “Annual… revenues of 830 million to 850 million.”
    • “For the December 2010 quarter, we expect to generate revenues of 198 million to 205 million, which would represent 5% to 9% increase over the prior-year quarter and approximately 23% to 25% of our total expected annual revenues.”
    • “We expect revenues for the first half to be 45% to 47% of our annual revenues, which is consistent with the initial overall revenue guidance that we provided of 44% to 48% of the fiscal year’s revenues being generated in the first half.”
    • “We sold approximately 1,250 gaming machines for new casino openings and expansions in the December quarter last year. In the December quarter this year, there are far fewer expansions and new openings.”
    • “We continue to see an acceleration of revenues in the second half as a result of the commercial launch of our WAGE-NET networked game enablement portal applications and online gaming business in the U.K.; ongoing penetration in the Mexico, New South Wales and Class II markets; market share growth in both domestic and international markets; and our entry into the Italy VLT market.”
    • “We expect to see operating margin improve on a quarterly sequential basis throughout fiscal 2011 and for the December quarter, we expect operating margin to improve over the September quarter to a range of 19% to 19.5%.”
    • “For the year, we are maintaining our operating margin guidance of 22.5% to 23%.”
  • “Upon receiving final regulatory approval by GLI, projected to be later this quarter, we expect to begin earning revenues from this product at the beginning of next quarter. The momentum will continue with the launch of PiggyBankin’, the second theme in the Ultra Hit Progressive portal family, followed by PENG-WINS, the first theme in the second portal family called Winners Share.”
  • “Our fiscal 2011 revenue guidance assumes only very modest revenues from our new online business. And consistent with our prior comments, our margin guidance anticipates running at a small loss”
  • “Recently launched in July, we already have nearly 500 of THE LORD OF THE RINGS games installed in more than 150 casinos”
  • “Near-term, as a result of the already identified cost reductions from proving the Bluebird xD cabinet, we expect to achieve our targeted run rate of a 55% product sales margin beyond the next few quarters, even without the benefit of an improving replacement cycle.”
  • “We’ve got four WAPs coming out in the Q2 and Q3, which will really drive second half revenues for the year.”
  • “The order size is still in the, call it, 15 to 18, Joe; it’s in that ballpark, so the order size hasn’t really by market or by quarter or year-over-year has not changed a whole lot. We’re having to work harder for the same results … Class II is maybe a little bit bigger because it’s a new market for us and we’re entering the floors for the first time, but not significantly bigger than those numbers.”

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JCP: Vintage is a Byproduct, Not a Strategy

Today’s announcement that JC Penney is granting board seats to two of its largest shareholders, activist Bill Ackman and real estate guru Steve Roth, is certainly something for the bulls to chew on.  Or is it?  After all, these are the guys who are supposedly going to “shake things” up at the middle-market department store at time when margins are headed south and sales growth remains in a holding pattern.  Additionally, the company announced a  series of “strategic” moves aimed at improving profitability (over time).  The key here is the “over time” part.  This is neither a quick fix, nor a near-term margin and/or sales enhancing strategy. Instead, this is an example of addition by subtraction.


JCP plans to do the following over the course of 2011:

  • Close 5 under-peforming stores. 

Closing just .0045% of the store base is hardly worthy of a press release let alone a conference call.  Importantly, management remains convinced that the rest of the store base meets acceptable performance hurdles. In other words don’t expect a major store closing effort.  The focus from management remains on growth.  Recall that the company’s April analyst day set out a 4% CAGR for comps over the next 5 years.

  • Finish the wind-down of the company’s legacy catalog business, including the closure of 19 catalog clearance centers.

For a company that was early in building out e-commerce it has been slow to let go of its legacy.  Perhaps this is because of an aging customer demographic or a reluctance to let any more sales walk out the door. Either way, this is a good move albeit one that is three years too late.

  • Close two call centers by consolidating operations into the remaining three facilities.

We’re not sure many people even realize JCP was operating 5 call centers nationwide to deal with customer service issues stemming from an aging catalog division.   For fun, try calling Zappos and then JC Penney. Compare and contrast.

  • Re-org the custom decorating business, which includes focusing on key markets (300 studios down from 525) as well as consolidating fabrication facilities into one location.

We know that JCP has long been known as a destination for window treatments (thanks to Sears for exiting the biz a few years back as well) but decorating too?  This announcement makes us wonder what other 1960’s era efforts are still being performed within the organization.  We understand that “vintage” can be a retail strategy, but we’re pretty sure that is not the intention here.

  • These efforts are expected to generate $0.07 in EPS in 2012, after cumulative costs of $0.13 over 4Q10 and F2011 to exit the abovementioned businesses.

On current earnings of $1.47 or the Street’s consensus of $1.71 for next year, these savings barely amount to much.  Yes they help, but the company by its own admission is still a long way from peak EPS earnings of $4.75 in 2007. 


Management’s conference call to discuss these (minor) tweaks to the company’s operations over the next twelve months as well as any insight into the “expertise” that Mr. Ackman and Mr. Roth bring to the boardroom were scant on details.  In fact, the biggest take-away from the call was not what might be on the horizon in terms of big strategic moves (like a DDS REIT structure?) but rather what’s not on the horizon.  The message continues to be that the organization needs productivity improvements (i.e sales) to leverage a legacy fixed cost infrastructure (i.e 1,100 stores) at a time when the company’s core middle-income consumer remains under pressure from many different angles.  So to paraphrase, it’s all about topline.


As such, with sales on the forefront and real estate and financial engineering near the bottom of the CEO’s priority list, we believe the fear of being short has been alleviated substantially with today’s announcement.  The newest board members, in our view, will have little impact on mitigating rising costs, accelerating the topline via merchandising prowess, or figuring out a way to jumpstart the company’s large but largely stagnant e-commerce businesses.  There is no doubt that new influence is better than no influence, but the big event that many have been waiting for seems to have occurred.  It’s now time to focus on the company’s earnings, which even in a great year are unlikely to approach $2.00 in the near term.  To get even close to $2.00, we would need to see a 120bps improvement in EBIT margins to 5.7% driven by sales growth.  Recall that 2010 will mark a peak gross margin year for the company as we head into the first year of apparel inflation in the modern era.  Even at $2 we would argue a multiple of 16x on the current share price seems rich for a no-growth department store.  In our view, the shares appear to be overdone on hope that this is just the beginning of big things to come, be it some hugely accretive sales driving plan or one in which the company shrinks it’s 1,100 store base to a meaningfully smaller size.  We don’t see this happening.


Instead, we believe that 2011 for JCP will be a year in which the Street realizes there is actually little that can be done in the near term to drive earnings measurably higher, or at least high enough to justify the current share price.  We’re modeling $1.33 for 2011 driven primarily by a flat topline and modest gross margin erosion equating to 24x earnings.  If there is one company that truly needs a job-driven macro recovery it’s JCP. Unfortunately, this is not a scenario we can predict with any confidence, any time soon.


Eric Levine


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