Conclusion: The quantitative setup in Chinese equities reveals a lot about the current state of the Chinese economy and its lack of clarity surrounding the magnitude of any potential economic slowdown. Additionally, China’s January inflation data reveals a few incrementally bearish nuggets regarding the slope of global growth.
Position: Long Chinese yuan via the etf CYB.
Looking at a chart of Chinese equities, we see that it’s very indicative of China’s current economic backdrop: binary with a lack of clear direction. Trading between its bullish TRADE line of support and its bearish TREND line of resistance, Chinese equities are trapped in between the proverbial “rock and a hard place” and we’d like to see a decisive move beyond either of those lines to solidify our view on Chinese assets and Chinese growth:
Looking at today’s inflation data, we see that today’s +30bps acceleration in headline CPI to +4.9% YoY and the +70bps acceleration in headline PPI to +6.6% YoY brings with it a slew of changes and meaningful incremental data points.
China adjusted both the weightings and composition of both its CPI and PPI baskets. Thought it did not show the full updated breakout, China did provide the following re-weightings:
- Rent and utility costs increased +422bps;
- Food and beverage decreased (-221bps);
- Alcohol and tobacco decreased (-51bps);
- Clothing decreased (-49bps);
- Household equipment and services decreased (-36bps);
- Health care and personal products decreased (-36bps);
- Educational products and services decreased (-25bps); and
- Transportation and communication decreased (-5bps).
All told, the re-weighting ended up being largely benign (adding only +2bps to the YoY rate of +4.9% and +4bps to the MoM rate of +1%) and generally reflects current consumer sentiment around exorbitant and largely unaffordable housing prices – so much so that the central government plans to increase its development of low-cost homes over +72% YoY in 2011.
Unofficially, Chinese Property Prices posted the largest MoM gain in six months in January (+1%), according to SouFun Holdings Ltd. – the nation’s largest property website. The government’s unofficial report is due out later this month; it will be interesting to see if the slope of the YoY growth in Chinese property prices reflects this unofficial re-acceleration.
Diving more deeply into the components of China’s January CPI report, we see that:
- Residence-related price growth accelerated to a 29-month high of +6.8% YoY;
- Food price growth accelerated to +10.3% YoY; and
- Non-Food CPI accelerated to at least a six-year high of +2.6% YoY; this reading is +174bps above the average for the data series, which begins in January 2005.
The +50bps sequential change in the YoY growth rate of Chinese Consumer Prices ex-Food confirms exactly what we’d been fearing over the past few months: food and energy inflation is spilling over into the broader economy. This officially means two things: Chinese consumers will start demanding (and receiving) higher wages and the PBOC has to tighten more aggressively on the margin to bring inflation back towards the government’s +4% YoY target for 2011.
YTD, we’ve already seen signs of wage growth throughout China:
- Beijing plans to raise its minimum wage +20.8% by the end of this year;
- Tianjin plans to raise its minimum wage +150 yuan per month;
- Shanghai plans to raise its minimum wage over +10% from the current 1,120 yuan per month by April 1;
- Jiangsu plans to raise its minimum wage +15%; and
- Guangdong plans to raise its minimum wage +19% by March to 1,300 yuan per month – currently the country’s highest.
Combined, these cities and provinces have a population roughly equal to 220 million people – equivalent to the fifth largest population in the world after Indonesia. While not all of their respective citizens are earning the minimum wage, we are willing to bet the slope of broader wage growth throughout these areas and the Chinese economy at large continues to trend positive, adding to already robust demand-side inflationary pressures and compounding the central bank’s fight with accelerating inflation, on both a reported and expectations basis.
Hidden beneath this trend of labor cost inflation is the margin compression by Chinese corporations who are having to deal with the ill-effects of rising input prices on the gross margins (Chinese Import growth accelerated to +51% YoY on rising raw materials costs), as well as the pinching effect of rising wages on their operating margins.
To compound the issues facing Chinese manufacturers, a rapidly growing labor movement in Southern China has the makings of a large cultural shift in China’s employee-to-employer relationship. According to Longguan Human Resources in Shenzhen, one of the largest recruiters of inland labor for China’s coastal factories in the Pearl and Yangtze River deltas, millions of workers are refusing to return to factories until their wage demands are met – in many cases in excess of what we detailed above.
Lui Hong, manager at Longguan had this to say regarding the recent trend: “I'm 1,000 percent sure the factories won't be able to find enough workers… there will be a shortage of millions.”
It’s worth noting that the recent costs pressures facing Chinese manufacturers will have to be passed through to global brands like COH, VFC, and JNY or they will be forced reduce production and/or move it abroad, curbing both Chinese growth and any potential near-term topline growth for such brands with a Chinese production footprint. On the topic of shifting growth to other “low(er)-cost” regions like Vietnam or India, we caution that:
- Shifting production into new factories in new countries is not an overnight process and could take as many as 2-5 years to complete the desired shift (four years in COH’s case);
- Inflation is dragging up wages throughout the region – particularly in India, which is the only other country in the Asia with enough bodies to make up for a meaningful loss of Chinese labor headcount; and
- The infrastructure throughout Asia in potential “low(er) cost” regions like India is notoriously shotty and far from developed enough to prevent massive bottlenecks and delays in both production and shipping.
The crux of this is that:
- Growth is slowing: Inflation is starting to meaningfully slow unit production growth in China’s factories;
- Inflation is accelerating: Global brands and retailers with a Chinese production footprint will be increasingly forced to either take the price increases offered by Chinese manufacturers or reduce unit demand for new inventory; and
- Interconnected risk is compounding: Sneakily, rising costs and/or a declining labor pool will continue to make investment in China’s manufacturing and export sector less attractive on the margin.
To point #2 specifically, we’re already seeing that with China’s YoY Export growth accelerating +1,980bps sequentially in January to +37.7%. China is exporting inflation. This trend will be increasingly compounded if and when the yuan appreciates meaningfully (+1-3%) in the coming quarters.
It’s not uncommon for consensus to misinterpret economic data points like the jump in China’s Import/Export growth because they lack a Global Macro Process to properly contextualize the relevant changes on the margin; an example of this is was the recent bullish mosaic painted around China’s January Crude Oil Imports, which accelerated to +27.4% - a four-month high.
Careful analysis reveals that much of the demand increase is fueled by speculation that China may soon increase retail gasoline and diesel costs throughout the country, which is bullish for Chinese refiner’s margins – all things being equal (Shanghai Daily, Feb. 11). To the aforementioned trade data specifically, China’s Trade Balance contraction accelerated in Jan (-$7.71B) YoY vs. (-$5.35B) in Dec – an explicitly bearish YoY and QoQ growth data point for China’s 1Q11 GDP.
Unfortunately, with the current inflationary headwinds, all things are not equal. As we have maintained since October, we see Chinese growth slowing for at least the duration of 1H11 – and perhaps more (time and data will tell).
A further look at today’s data reveals additional headwinds to China’s intermediate term growth momentum. New Loan growth accelerated in January as it typically does at the start of each year to +1.04T yuan, an increase of +559.2B yuan over December’s reading. While it fell short of consensus expectations of a +1.2T yuan increase, it was high enough to give China bulls some confirmation that China isn’t headed for a near-term crash after aggressively hiking reserve requirements and interest rates over the past 3-4 months.
Analyzing the loan growth on a YoY basis tells a more daunting tale for the slope of Chinese growth. The amount of New Loans extended in January fell (-25.4%) YoY – a large sequential deceleration from December’s +26.6% YoY growth rate and an even more precipitous drop from November’s +91.3% YoY growth rate. Money Supply (M2) growth confirmed this trend, falling to levels not seen since its July ’10 and December ’08 lows at +17.2% YoY.
At the end of the day, the slope of China’s economic growth may or may not matter at all to the direction of Chinese stock prices. It’s important to remember that mainland Chinese investors have an incredibly limited selection of investment opportunities and the bulk of them have been weak in recent weeks/months:
- Savings deposit accounts – the returns of which are being completely eroded by inflation;
- Gold – which just had its worst January in over 20 years;
- Real Estate – both the Chinese premier and the PBOC leadership have pledged to crack down on property speculation in 2011, starting with the long-awaited implementation of a nationwide property tax trial;
- Chinese equities – which are sneakily up +3.2% YTD.
In China’s case, this time the “flows” could trump the fundamentals. For now, however, China remains stuck between a rock and a hard place.
Position: Long Sweden (EWD); Short Euro (FXE)
Although a lagging indicator, today Eurostat reported 4Q10 GDP for most European countries. As we’ve flagged over the last 18 months, the Sovereign Debt Dichotomy continues to drive divergence in economic performance across the region. In short, we’re of the belief that excessive levels of sovereign debt structurally impair long-term country growth.
Reinhart and Rogoff have helped defined these “excessive levels” of debt in their book titled “This Time is Different”, which proves with data over the last 8 centuries that the probability of default and significant GDP contraction occur when a country’s public debt exceeds the 90% of GDP level. While we’ll be the first to recognize that the austerity packages issued throughout Europe are an important step to improve debt and deficit imbalances and restore confidence from market participants, the PIIGS (collectively) have a long road ahead of them to pare back their fiscal imbalances that exceed this mark.
Paradoxically, the peripheral European equity indices are some of the best performers across global indices year-to-date, supported by the hope (and initial commitment) of China and Japan to buy European debt issuance, and optimism that a permanent bailout fund and new fiscal policy provisions will be agreed upon by the member states by the time leaders convene at the European Summit on March 24-25.
We’re managing risk around a downside correction in European equity markets; at a price we are comfortable owning countries with stable balance sheets, including Sweden which is in the Hedgeye Portfolio, and Germany.
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Conclusion: Slowing growth and accelerating inflation indeed have interconnected risk compounding in India as the “flows” are currently working against its equity market(s).
Position: Short Indian Equities via the etf IFN.
After making the research call loud and clearly back on November 9th, we added a short position in Indian equities to the Hedgeye Virtual Portfolio this morning, largely in conjunction with our position to short the US Dollar yesterday – an implicit sign of our view on the slope of global inflation: up.
Nothing has changed meaningfully in the supply/demand picture for many commodities that would support prices deflating from current elevated levels in the near term absent dollar strength. To the contrary, panic buying and stockpiling of food in developing nations across the globe only exacerbates the current supply/demand imbalances that are being exploited by a weak dollar in the form of higher prices from Fed-sponsored speculation.
In Bernanke's defense, the dollar can blame its current instability on fiscal policy fundamentals (see: Obama’s weak budget), rather than an Arthur Burns/BOJ-esque monetization of US debt.
Irrespective of Washington politics and global central planning out of the Federal Reserve, Indian stocks will continue to get squeezed in all areas where it matters:
- On the topline: growth will slow from topping out in 4Q10;
- In the margins: +8.23% YoY inflation at twice the government’s projections (and perhaps 3x corporate expectations) and Brent crude oil prices are up +30% YoY (India imports ~70% of its crude oil needs); and
- On the bottom line: short-term interest rates will continue to trend higher as the RBI continues its sluggish reaction to fighting inflation; Yields on 2Y gov’t notes have backed up +74bps since the start of 4Q10.
Our daily analysis of news flow reveals a level of buy-side capitulation on Indian equities:
“Nobody expected the inflation issue to hit so hard so fast.” – Harsha Upadhyaya, PM at UTI Asset Management.
While we’d normally try and fade capitulation, the permanently bullish storytelling around India’s demographics and growth potential will always keep a bid under this market, especially in times of low volatility. Given this, we view the lack of capitulation by some investors such as Mark Mobius as a shorting opportunity into the recent 5-day, +4.6% up move.
On Friday, Mobius had this to say regarding the recent trend in broader emerging markets: “The trend of investors pulling money from emerging markets and increasing bets on stocks in the U.S. and Europe is a short-term event and investors will return because of developing nation’s growth prospects… We are seeing a tremendous inflow in our emerging market funds.”
To Mark’s point about the “flows”, international investors have pulled (-$1.7B) from Indian equities this year, a stark reversal from last year’s 2010 inflow of +$29.3B. It’s paramount to keep in mind that the 2008-09 crash in Indian equity markets was aided by a (-$12.9B) outflow of international capital in 2008.
Domestically, the “flows” are working against Indian equities as well: rising short-term interest rates have Indian money market funds attracting record inflows (+$16B in Jan; roughly 10x the inflow of full-year 2010) as investors shift out of stocks (-$3.5B) and long term bonds funds (-$4.3B) in the first ten months of the fiscal year ending March 31.
As Keith says on nearly every Morning Macro call for the last few months, when the “flows” start going the wrong way, they go fast and it hurts. India's SENSEX is down (-10.9%) YTD already and we see further downside from here.
I think PEET is one of the best positioned, small-cap growth names in the restaurants/coffee space. Unfortunately, the surge in coffee prices is an overhang, but not a deal-breaker to the growth story. We would use any commodity concern-induced dips as an entry point. PEET is scheduled to report 4Q10 earnings after the close tomorrow.
PEET’s current FY11 EPS guidance range of $1.53 to $1.60 represents an effective doubling of the company’s EPS from 2008. Guidance includes a price increase already implemented in the retail and home delivery businesses at the start of 4Q10 and an announced price increase to foodservice and office customers, most of which will occur at the start of 2011; they have not taken any pricing in the grocery channel at this point.
- The guidance also includes expectations that PEET has locked in 40% of their coffee needs for 2011 and the assumption that they will be buying significantly higher cost coffee over the balance of the year. As of the company’s 3Q10 earnings call, PEET guided to a 15% increase in total 2011 coffee costs.
- Sales are targeted to grow in the 8% to 10% range, driven by a mid single-digit rate growth in retail and a higher growth rate in specialty.
- Gross margins are expected to decline by about 100 bps, due to higher coffee costs and an increase in mix of specialty sales as a percent of total sales. For reference, the Specialty business yields lower gross margins than the retail business, but as a result of relatively lower operating expenses, it generates higher operating margins (estimated 27% operating margin for FY10 relative to 10% for the retail business).
- Operating margins are expected to improve about 50 to 100 bps driven by the mix shift towards the Specialty business, the continued optimization of the retail channel and leveraging of fixed costs.
The company is working to offset higher coffee costs and improve retail margins by continuing to focus on initiatives to reduce waste in coffee, milk and based goods. Secondly, retail margins should continue to benefit from improved efficiencies in all areas of the store, including labor productivity, supplies and maintenance.
What does SBUX see in PEET?
PEET is firmly positioned at the high end of the specialty coffee category and the company’s continued growth within the grocery channel is key to its overall growth rate going forward. As the specialty category becomes mainstream, there will continue to be new opportunities for the company to grow, geographically, through new channels, and to customers that would not have been possible a decade ago when specialty coffee was still in its infancy.
Relative to new channels, in early 4Q10, PEET began shipping to 600 Wal-Mart stores using its DSD network. Although the company only expected the new distribution to contribute modestly to business in 4Q10, it expects the contribution to be more meaningful in 2011. We are looking forward to getting an update on the Wal-Mart trends on tomorrow’s 4Q10 earnings call.
- PEET has posted strong double-digit sales growth in its existing traditional grocery store business for the past eight years. Growth within the grocery channel had been driven by the selling, merchandising and person-to-person marketing approach inherent in a DSD system. PEET is a leader in the specialty coffee segment in its most established markets with 32% share in California (#1) and 20% share in the West (second only to SBUX), according to IRI. SBUX has witnessed PEET’s success with direct delivery and now wants control of its own distribution system. SBUX could easily leverage PEET’s DSD experience and infrastructure.
- As the specialty coffee category continues to become more mainstream, the Peet's brand would be ideally positioned within the Starbucks portfolio. Although some would argue that Starbucks would not want to buy a premium brand that would compete with its own brand, it is important to note that the Peet’s brand would add another price point to SBUX’s coffee portfolio as it is priced about 15% higher than the Starbucks brand in the grocery channel, according to IRI. Peet’s would give SBUX three price points within the grocery channel when you include Seattle’s Best, which is priced about 20% lower than the Starbucks brand. With Peet’s, SBUX would dominate the growing specialty segment and have complete ownership of the grocery aisle.
- PEET’s operating margins have improved nearly 240 bps since 2008 (based on my FY10 estimate), as a result of the company’s decision to slow down retail unit growth and focus on in-store execution and from the growing sales contribution from the specialty segment, which as I highlighted earlier, is a significantly higher margin business. For reference, the specialty segment accounted for 34% of PEET’s total sales in 2008 and about 39% in 2010. Most of this growth has been driven by the grocery segment. Based on my estimates, I expect the specialty segment’s sales mix to increase to about 43% in 2011, which will have a positive impact on margins. I am sure the recent strength in PEET’s margins has not gone unnoticed by SBUX.
- PEET has “built an infrastructure that is delivering increasingly profitable growth without requiring significant new capital investment.”
The future of the single-serve category is Starbucks’ to shape. While the company may engage in several philanthropic endeavors, I do not see GMCR as one of their causes.
The importance of social and digit digital media channels and investments in technology to our overall strategy is increasing and becoming a significant competitive advantage as we create rich, emotional engagement with consumers and enhance their Starbucks experience, while at the same time benefiting from the lower cost of customer acquisition. -Howard Schultz, 1Q11 Earnings Call, 1/26/2011
I’m not privy to the thought process or grand strategy of Starbucks but I have been covering the company since the day it came public. A few weeks ago, I spent a weekend reading The New Rules of Retail, by Robin Lewis and Michael Dart, a tour de force that I believe offers a tremendous look-back and look-forward at the past, present, and future of retail. I highly recommend it.
Without wanting to spoil the book, the key shifts in the consumer that Lewis and Dart outline pertaining to the new, third “wave” of retail are:
- From needing “stuff” to wanting experiences
- From conformity to customization
- From plutocracy to democracy
- From wanting new to demanding new and demanding now
- From self to community
The shift from ubiquitous brands such as GAP and Levi’s to niche brands, from large chains to small brands, and from (perceived-to-be) socially irresponsible firms to (perceived-to-be) socially responsible firms certainly corroborates with The New Rules of Retail thesis. I see the first bullet as being most crucial here; the chains that offer an experience, and the anticipation of such, are thriving while those standing still in this regard are faltering. Starbucks offers an addictive product and Schultz has succeeded, for many people, in creating a “third place” between work and home.
LESSONS FROM THE PAST – IT’S THE EXPERIENCE, STUPID
Starbucks has learned some lessons the hard way. Simply by way of human nature, confidence can grow to outsized proportions and a company’s store base can grow in step with that. Lewis and Dart, in discussing Starbucks, references an internal memo from Schultz to then-CEO Jim Donald from 2/14/07 that was highly self-critical, lamenting the concept’s move towards standardized, aroma-less, uniform stores that were seen as “sterile” and “cookie cutter”. Moving back towards former practices and restoring the experience has yielded positive results for Starbucks. On new channels of growth, and Via in particular, Lewis and Dart have this to say (page 194), “If Via, it’s new instant coffee brand, is going to have sustained resonance in the supermarkets, it will be because people associate it with the Starbucks experience in the stores. If that experience remains strong and powerful, Schult’z wholesale strategy for growth will succeed.”
If Lewis and Dart’s argument is credible, and I believe it is, the idea of Starbucks putting their coffee through the Keurig machine does not make sense.
THIS REALLY ISN’T MUCH OF A PREDICTION, IT IS ALREADY HAPPENING
Starbucks has certainly been taking up a lot of airtime of late, beginning with the dispute with Kraft, then with their most recent strong earnings release, and now with the speculation around the myriad possible avenues they may take towards growth in the single-serve market. I believe that the quote in the last paragraph is crucial to this whole story; customers have to associate the consumption of Starbucks’ products with the Starbucks in-store experience for it to truly gain traction and serve as a vehicle for earnings growth.
Earlier in The New Rules of Retail, on page 149, Lewis and Dart outline control as a key attribute of successful retailers heading into the next phase, or third wave, of retail. Having maximum control, if not outright ownership, of their entire supply chains from creation through consumption, is a key characteristic of the winning brands.
The dissolution of the agreement with Kraft fits neatly into this framework. Both sides have been outspoken in their public and mutual admonishments. Starbucks, for its part, has alleged that Kraft failed to meet certain provisions of their arrangement, including keeping Starbucks involved in major marketing initiatives. Whether or not one agrees with this statement – I have no insight to how true or untrue it is – what is clear is that Starbucks are expressing a frustration at a lack of control over the distribution segment of their value chain. In extricating itself from the agreement with Kraft, Starbucks will likely take a charge that will ultimately prove to be an investment in that it will allow the company to assume more control of its distribution chain in perpetuity.
Given the healthy nature of Starbucks' balance sheet, I think any incurred cost will be kept firmly in perspective; the company appreciates the importance of control.
The single-serve saga is just another act in this play and I do not believe the overall theme will change. Starbucks is a company that is forward looking and our view is that the coffee machine will be revolutionized by the entrance of the company into the business. Here is my prediction of what the new Starbucks machine will be like (if not at first, then version 2.0, 3.0 etc.). Notice that while some of these attributes seem fanciful, they all have founding in both Starbucks’ quest for control and the overall direction of retail, as described by Lewis and Dart and as confirmed by the trends within the space:
- The design of the machine will evoke the design and feel of the Starbucks store and experience. I would think black and green, as well as the Siren logo, will feature. (experiences)
- The name will also likely evoke the store. “My Barista”, “The Siren”, or other names along those lines are likely. (experiences)
- The experience will be customizable, perhaps a touch screen or another user interface that allows the user to provide the machine with specific instructions as to the composition of the coffee they would like. (customization)
- A “menu” (like a playlist in iTunes), where one can save a recipe or style of coffee for repetitive use and save it with a name like, “Jim – morning coffee”. (customization)
- Connection to the internet via home computer system to allow the sharing of “menus” and reception of coffee ideas from Starbucks and fellow machine-owners. This also allows a direct tap into social networking for the new machine. (community)
I’m sure this imagining of ours will be received by many with a high degree of skepticism. I have two questions and a quote for you. First, the questions: If not Starbucks, who? If not now, when? This machine, or something like it, will happen. Starbucks has the ambition, financial muscle, and forward-thinking management team to make it happen. And I believe they will want to be in the driver's seat, they didn’t seem overly content sharing control with Kraft. Second, the quote, from ex-Hedgeye Technology Sector Head and friend of the firm, Rebecca Runke’s Black Book in November 2009: “Mobile phones won’t get a lot smaller than this. After all, they have to reach from your ear to your mouth.” – Fortune magazine, 1989, about the Motorola TAC mobile phone.
I believe Starbucks will ignore the naysayers and enter the single serve market by revolutionizing it. As we have outlined in the prior “parts” of this post, beginning in January, “Starbucks will do to the single serve coffee maker what Apple did to the market for portable mp3 players”. In The New Rules of Retail, Lewis and Dart write the following on Apple, “Each purchase, be it an iPod, iPhone, iPad or otherwise, is then customized by each customer to reflect their individual tastes. This is one of the best examples of a co-creation of experiences with Apple as the platform.” Starbucks will create a co-creation of experiences between the office, the home, and the store in the same fashion.
To finish, I would like to cite a press release from Starbucks that, at least by our interpretation, further corroborates with our thesis:
“The single-serve coffee category in the U.S., and much of the world for that matter, is in its beginning stages of development. At this very early stage, there are numerous contenders and no demonstrated, long-term winners related to either format or machines. Following our very successful introduction of Starbucks VIA® Ready Brew in the U.S. and into a growing number of international markets, Starbucks will continue to explore the many single-serve and on-the-go solutions and options available to us, and to participate in those where we can better and more conveniently serve our customers wherever they may be. Look for further announcements from Starbucks as we continue to expand our presence in the premium single-serve category.” - Jeff Hansberry, president, Starbucks Consumer Products Group.
Starbucks wants to control the supply chain from creation to consumption to best serve their customers. This is clear from the thesis I have laid out, and it is also underlined by Mr. Hansberry’s statement this morning. At the most recent Annual General Meeting, the global nature of Starbucks’ business was emphasized again and again. Keurig is, in my view, a more U.S. centric brand than Starbucks would like for a partner in the global single-serve market. I believe Tassimo, a brand with global penetration, would be a more suitable partner.
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