"Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible."
- John Maynard Keynes
That’s a quote from Chapter 12 of Keynes’ General Theory, “The State of Long-Term Expectation.” Much of Keynes’ work was marginalized by the economists that were influential shortly after him – namely John Hicks – particularly the existence and importance of uncertainty in investment. As a result, what is today considered Keyensian Economics is hardly the economics of Keynes (Steve Keen, 2011). Hyman Minsky – the preeminent economist on fragility in financial markets – wrote in 1975 that, “Keynes without uncertainty is something like Hamlet without the Prince.”
This Early Look is not on Keynes – you’re welcome – but on uncertainty and oil prices.
As an energy analyst, I read a lot about oil markets. One of the latest topics #trending on the subject is the price of oil approaching the marginal cost (MC) of production; this one always seems to get popular when oil prices drop precipitously, as it’s a go-to reason to ‘buy-de-dip,’ say the perma-bulls.
The MC of production is the change in total cost that comes from producing one additional unit of a good – a bicycle, a bushel of corn, a barrel of oil. It is an important economic concept that determines the price of that good for a given level of demand. On a long enough duration, the price of oil will converge around the MC because should price fall below the MC, the MC producers will not put incremental capital to work to arrest natural production declines, leading to a shortage and rising prices; and should price rise above the MC, it incentivizes production above what is demanded, leading to a surplus and falling prices.
Yes, MC matters, and yes, oil prices will track it over the long-term. But the idea that the MC of oil production, and with it the oil price, is permanently headed higher – a popular opinion – is a fallacy. Consensus is comfortable, and after a decade-long rise in the MC from $25/bbl in 2001 to $90/bbl in 2011 why would the next ten years be any different? But the future is, of course, unknowable, and to deal with that inherent uncertainty “the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations” (Keynes, 1937). In other words, only after oil prices have increased 15% p.a. since 2001 does a deflating oil price seem implausible.
In general, though, commodities – even non-renewables (fossil fuels) – do not tend to hold their real value over the long-term, proving poor investments. New technologies, greater efficiency in extraction and production, and the substitution of one commodity for another (at one time our primary fuel was wood, then it was coal, today it is oil) drive the MC of production lower, and with it real prices. After adjusting for inflation, major industrial commodity prices fell 80% between 1845 and 2002, though regained some of that lost ground over the last decade in a fantastic commodities bull market (The Economist, 2011). Only gold and oil have held their value in real terms, and, indeed, oil has been a spectacular investment over the last decade, gaining 300%. It is easy to forget, though, that the real price of oil in 2000 was no higher than it was in 1950.
We can point to a number of reasons why the MC of oil supply and the nominal price of oil have meaningfully outpaced inflation over the last decade, though easy money and China’s incredible investment boom top our list. Others point to the decline in easily accessible oil reserves and rising social costs of Middle East nations, but we see less validity in those theses. New technologies and greater efficiencies can counter harder-to-reach reserves; and oil exporters’ government budgets are pro-cyclical.
In fact, most costs are pro-cyclical. The relationship between the MC of oil production and the oil price is a classic example of mutual causality. Is the price of oil higher because rig rates, steel pipe prices, production taxes, and labor costs are higher? Or is it that rig rates, steel pipe prices, taxes, and wages are increasing because the oil price is? Both occur simultaneously and as a result, the MC of oil production is just as much a moving target as the price is – not some Rock of Gibraltar level of support.
We’ve seen this movie before. In constant dollars (year 2000) the price of US coal decreased from $31.40/short ton to $16.84/short ton between 1950 and 2003; in other words, after adjusting for inflation, coal prices have fallen more than 1% p.a. since 1950. This trend is due to a decline in the MC, or “marked shifts in coal production to regions with high levels of productivity, the exit of less productive mines, and productivity improvements in each region resulting from improved technology, better planning and management, and improved labor relations” (Edward J. Flynn, 2000). Those trends persist today, and the high cost coal producers are gasping for air (pull up a 5Y chart of PCX or JRCC).
And of course, we have US natural gas, which has fallen in nominal terms from $12/Mcf in 2008 to $2.50/Mcf today in a stunning display of how technology and innovation can lower the marginal cost and price of a fossil fuel. Visions of permanently high natural gas prices prompted a build-out of LNG import facilities in the mid 2000’s. Alan Greenspan (clearly an expert on the subject!) said in 2003 that, “high gas prices projected in the American distant futures market have made us a potential very large importer.” With impeccable timing, Cheniere’s Sabine Pass received its first cargo of imported gas in April 2008, and now that same visionary company will spend $6.5B to export gas by 2017 (nat gas bottom?). And this wasn’t the first time the gas bulls were fooled. After years of rising natural gas prices in the 1970’s, four major LNG receiving terminals were constructed only to see gas prices peak in 1983 and decline for the next 15 years; three of those plants were eventually mothballed.
Is the rapid increase of the MC of oil production and oil prices any more “secular” than it was for natural gas in the 2000’s? Will Chinese demand for commodities grow at the same pace over the next ten years as it did for the last ten? What would sustained US dollar strength do to commodity prices, oil in particular?
The confidence one can have in answering such questions is limited, perhaps even “negligible” (Keynes), but few in this Game accept that. It’s funny – you don’t often hear investors or analysts say, “I don’t know,” but when consensus is proven really wrong, the all-too-common excuse is, “How could I have seen this coming?”
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1, $91.20-96.79, $81.21-82.02, $1.24-1.27, and 1, respectively.
TODAY’S S&P 500 SET-UP – June 21, 2012
As we look at today’s set up for the S&P 500, the range is 29 points or -1.67% downside to 1333 and 0.47% upside to 1362.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: on 6/20 NYSE 10
- Down from the prior day’s trading of 2074
- VOLUME: on 6/20 NYSE 751.15
- Decrease versus prior day’s trading of -2.71%
- VIX: as of 6/20 was at 17.24
- Decrease versus most recent day’s trading of -6.20%
- Year-to-date decrease of -26.32%
- SPX PUT/CALL RATIO: as of 6/20 closed at 1.90
- Up from the day prior at 1.54
CREDIT/ECONOMIC MARKET LOOK:
2YR – this came up last night; we talked about it as the leading indicator for the US Fiscal Cliff; this morning, the 2yr popped above our intermediate-term TREND line of resistance of 0.30%. This will be very interesting to watch as US GDP Growth continues to slow (the denominator in deficit/GDP drives the #1 fundamental risk ratio higher).
- TED SPREAD: as of this morning 39
- 3-MONTH T-BILL YIELD: as of this morning 0.08%
- 10-Year: as of this morning 1.64
- Decrease from prior day’s trading at 1.66
- YIELD CURVE: as of this morning 1.34
- Down from prior day’s trading at 1.35
MACRO DATA POINTS (Bloomberg Estimates):
- 8:30 am: Initial Jobless Claims, June 16, est. 383k (prior 386K)
- 8:30 am: Continuing Claims, June 9, est. 3278k (prior 3278k)
- 9:45 am: Bloomberg Consumer Comfort, June 17 (prior -36.4)
- 9:45 am: Bloomberg Economic Expectations, June (prior -1)
- 10am: Philadelphia Fed, June, est. 0.0 (prior -5.8)
- 10am: Existing Home Sales, May, est. 4.57m (prior 4.62m)
- 10am: House Price Index M/m, April, 0.4% (prior 1.8%)
- 10am: Leading Indicators, May, 0.1% (prior -0.1%)
- 10am: Freddie Mac mortgage rates
- 10:30am: EIA natural gas change
- 11am: Fed to purchase $4.25b-$5.25b notes in 6/30/2018-5/15/2020 range
- 1pm: U.S. to sell $7b 30-yr TIPS (reopening)
- Supreme Court issues decisions today
- CFTC holds open meeting on regulation of swaps, derivatives
- House, Senate in session
- Senate Banking hears from SEC Chairman Schapiro on proposals to overhaul money market mutual funds, 10am
- House Financial Services panel holds hearing on supervision of money services businesses, 9:30am
WHAT TO WATCH:
- Samaras to name new Greek govt., Vassilios Rapanos, chairman of National Bank of Greece, to become finance minister
- WTI crude oil falls below $80 for first time since Oct.
- Spain 2014 bonds avg yield 4.706% vs 2.069% in March sale
- Sales of previously owned U.S. homes probably fell in May
- U.K. retail sales rose 1.4%, beating est. 1.2%
- SEC said to depose SAC’s Cohen in insider-trading probe
- Philip Morris cuts 2012 EPS forecast on currency swings
- Onyx wins FDA advisory panel backing for blood-cancer drug
- Invensys says it’s no longer in any discussions after approach by Emerson
- BlueMountain said to help unwind JPMorgan’s losing trades
- MSCI puts Greece on review for potential reclassification as Emerging Market
- China manufacturing may shrink for an eighth month in June
- EMA expected to make drug-safety/approval decisions today/tmw
- UPS to begin offer in $6.5b TNT Express takeover tomorrow
- New Zealand GDP rises 1.1% Q/q, fastest in five years
- Euro-area finance ministers meet in Luxembourg to discuss financial transaction and energy taxes and the debt crisis
- Rite Aid (RAD) 7am, $(0.04)
- ConAgra Foods (CAG) 7:30am, $0.50
- CarMax (KMX) 7:35am, $0.53
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG
OIL – is it a bird, a plane, or demand? Or is it the Dollar? Or supply? The crash in oil (WTIC -26% from $108) is highly correlated to the USD. Currently, on a 2-mth duration, USD/WTIC = -0.94. Get the Dollar right, you get oil right. Immediate-term TRADE oversold lines for WTIC and Brent at $80.57 and $91.20. Sell all bounces. It’s a Bernanke Bubble.
- Founder of $125 Billion Gold ETPs Stymied on Copper: Commodities
- Oil Drops Below $80 to Eight-Month Low on U.S. Supply, Europe
- Commodities Slump to 19-Month Low as U.S. Growth Outlook Weakens
- Copper Reaches One-Week Low on China Index and Fed Forecast Cut
- Gold Drops for Third Day as Fed Opts to Extend Operation Twist
- Sugar Falls as Rains May Ease in Top Grower Brazil; Coffee Drops
- Corn Drops as Slowing U.S. Economic Growth May Cut Ethanol Use
- Marcellus Gas Cuts Price Premiums to Decade Lows: Energy Markets
- Gazprom Bond Sale Biggest Since ’09 as Yields Dip: Russia Credit
- China Looks to Build Rare-Earths Reserves to Stabilize Prices
- Coffee Harvest in India Seen Falling From Record on Dry Weather
- Subsidies Boost Ambani With Record Diesel Sales: Corporate India
- China’s Hungry Pigs Lead to Surfeit of Soy Oil: Chart of the Day
- Crude Drops Below $80 to Eight-Month Low
- Bauxite, Nickel-Ore Imports by China Climb to Record in May
- Palm Oil Declines From Three-Week High on Fed’s Operation Twist
- Chinese Seek Duty on U.S. Silicon Expanding Trade Fight: Energy
CHINA – down another -1.4% last night after another bad PMI number and ongoing #GrowthSlowing signals on the East side of the world. Germany’s PMI print of 44.7 for June reflects this global slowing; so does the long end of the UST curve. It’s only a matter of time before Equities mean revert lower.
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The Macau Metro Monitor, June 21, 2012
CONSUMER PRICE INDEX FOR MAY 2012 DSEC
Macau May 2012 increased 6.76% YoY and 0.66% MoM.
Darden reports 4QFY12 earnings on Friday the 22nd of June at 7:00 am. The earnings call begins at 08:30 am. We have adopted a stance of “casual dining caution” since April 20th as sales trends and underlying macro fundamentals for the casual dining group seemed to be softening. Darden's stock has long been considered the bellwether of casual dining but, beyond our concerns about the broader group’s outlook, we believe there are additional company-specific factors working against Darden as we move into FY2013. We believe that besides initial FY13 guidance, commentary on Olive Garden – specifically traffic trends and additional guidance on the remodel program – will be the primary focus for investors when the earnings release hits the tape. We would not be buyers of the stock ahead of earnings.
Consensus estimates for 4QFY12 have declined by roughly $0.02 over the past month but expectations for FY13 have remained unchanged, suggesting that the Street expects the company to push through the recent slowdown in sales. Any deviation from this narrative, on the part of the company, will likely cause the stock to sell off. Excluding one-time items that the Street may not traditionally pay for (like cutting G&A), there is still a chance the company misses $1.15 4QFY12 EPS expectations. Overall, we believe that the company is in "investment mode", attempting to bolster its appeal to customers at all of its concepts.
Casual Dining Backdrop
Below, we show the Hedgeye Casual Dining Index versus Initial Claims (inverted) and also Darden versus Initial Claims (on the right). The soft employment backdrop is negative for both casual dining and Darden; we expect management to allude to this during the conference call.
3QFY12 Recap and Look Ahead
Macro: Management referred to the "choppy" environment during the earnings call on March 23rd. At that time, according to the company, improving employment was being offset by the impact of rising gas prices. Given that employment trends have softened since March, and gas prices peaked in early April, it will be interesting to hear which of these management weighs more heavily in its outlook for the rest of the calendar year. In late April, CFO Branford Richmond, speaking at a conference, stated that “that’s [the broader industry] really driven … by job creation.” We expect the tone to be negative if/when management touches on the macro environment as the employment picture has deteriorated since the most recently reported quarter.
Olive Garden: Weak traffic trends at Olive Garden are a concern for investors and will be one of the first numbers we look for when the press release hits on Friday morning. Although promotions helped Olive Garden to narrow the Gap-to-Knapp during 3QFY12, we expect the sequentially weakening industry sales (Knapp Track) to weigh on Olive Garden trends.
According to Consensus Metrix, the Street is anticipating Olive Garden’s 4QFY12 comps to come in at 0.48%, which would imply a two-year average trend of 0.2% versus 1.0% in 3QFY12. While this two-year average decline would be a negative, we estimate that 0.48% would imply a sequential improvement in the Gap-to-Knapp metric: we estimate that it would imply +0.8% versus Knapp Track. Olive Garden has underperformed Knapp for six consecutive quarters and, while the gap has been closing, we do not think that the pace at which the gap narrowed during 3QFY12 continued into 4Q. The promotions offered during 3QFY12 at Olive Garden compared very favorably to the 3QFY11 promotional offerings which performed poorly. We think that the Street is overly optimistic in expecting 0.48% same-restaurant sales growth at Olive Garden in 4QFY12.
Red Lobster: Red Lobster posted a 6% same-restaurant sales growth number for 3QFY12, as preannounced, which benefitted by 480 basis points due to an earlier start to Lent 2012 versus 2011. According to Consensus Metrix, the Street is expecting 1.28% same-restaurant sales growth in 4QFY12 as the Lent benefit reverses. This implies a two-year average decline in comps of 60 basis points and sequential decline, we estimate, versus Knapp Track. During the most recent earnings call, management stated that “Red Lobster's fourth quarter same-restaurant sales will be adversely affected because of the shift forward in Lent and Lobsterfest.”
LongHorn Steakhouse: LongHorn remains a key focus for the company; the chain has been growing comps in the mid-single digit range for six consecutive quarters and new LongHorn units continue to exceed sales and earnings targets set by the company. LongHorn is likely to continue to perform strongly. While the chain is important for the longer-term TAIL story, we see Olive Garden and Red Lobster as being more important for the stocks near-term TRADE and intermediate term TREND price action.
A note on weather: Looking at top line trends for Darden’s restaurants versus 3QFY12, we see a risk that the street underestimates the boost that weather provided to the company during the winter months. As we wrote on 2/22 in a post titled “WINTER WONDERLAND”, the state of Texas was heavily impacted by the adverse weather conditions for an entire week in February in 2011. A year later, there was little-to-no snow in the Southern Region of the United States, according to data from the National Operational Hydrologic Remote Sensing Center. According to a New York Times article of 2/4/11 titled, “Snow and Ice Paralyze Texas From Rio Grande to Oklahoma Border”, a snow storm on that morning hit much of Texas and created chaos for travelers traveling ahead of the Superbowl that Sunday. During a conference on 4/24/12, Darden’s management team included Texas as a state that does not "traditionally see much of a weather impact", the implication being that the market there had improved its sales during 3QFY12 without any significant boost from weather, as occurred in the North East during January and February of 2012. We think that the weather data and media reports suggest otherwise. In light of the dramatic year-over-year change in weather conditions within Texas (a state with 148 of Darden’s 1,849 restaurants), we think that 3QFY12 comps may have been helped aided by weather more than management has implied.
BBBY showed its TAIL risk after the close with comps decelerating nearly 400bps sequentially, producing the greatest negative deviation relative to our home furnishings index we’ve seen since its inception. On top of 2 non-core acquisitions over a 1 month time period this is a complete validation of every concern we’ve had for BBBY.
Our Home furnishings index, which we use as a leading indicator for BBBY comps, implied a +6.5% comp. The +3% print was simply a massive miss. Our model is based in large part on Personal Consumption and Retail Sales for different home goods products. It’s proven to be extremely accurate over time, with a 0.75x correlation, and if you ex-out the period when it was putting Linens ‘n Things out of business (and posted outsized comps) the correlation is closer to 0.90x. Directionally, something went very wrong this quarter. Yes, there’s definitely the on-line share loss factor , but it’s also no mistake that this is happening in conjunction with BBBY’s headquarter move. The margin of error there is too great to ignore – especially with the company integrating two acquisitions.
We’ve remained negative on the intermediate term TREND and long term TAIL and are reiterating our stance. Consider the Following:
- After adjusting for the $0.06 tax benefit, BBBY 1Q12 EPS came in a penny below expectations driven by light revenue growth (+5.1% vs. +6.4E) and weak gross margins (-65bps vs. -25E)
- The Gross Margin decline in the quarter was driven by both an increase in coupon redemptions & redemption amount as well as the continued shift to lower margin product categories. In light of BBBY citing AUR as a driver of the +3% comps, the shift to lower margin product categories suggests the pricing mix may also be shifting upwards, driving a greater coupon redemption dollar amount. Notably, per our in store AMZN/BBBY sku overlap analysis (see chart below), AMZN has 10-15% lower prices in higher ASP product categories suggesting a shift to higher price point categories could keep BBBY at risk of additional couponing or online attrition pressuring margins further.
- The sales to inventory spread declined 5 points sequentially to -1% in Q1 after having popped into positive territory last quarter. This creates a somewhat bearish gross margin setup over the intermediate term TREND especially given the incremental coupon use at a time when PIR highlighted a balance in full price and promotional selling with no major negative change in the discounting environment relative to last year.
- BBBY said that it remains focused on enhancing its omni channel experience and expects its new 800,000 square foot e-commerce fulfillment center to be operational in 2H12. Today, e-commerce accounts for ~1% of total sales and has been declining over the past 3 years. Customer demographics continue to be a key issue here. 65% of BBBY’s current online consumers are above the age of 35. Industry data suggests that BBBY’s exposure to the 55 & up demographic increased nearly 300bps in 2011 vs. 2010 to 26% putting BBBY 9th in terms of the most exposed to the older demographic relative to the 95 companies we’ve analyzed. It is nearly impossible for e-commerce to really gain traction without investing and while not a direct comp, WSM’s omni channel model currently boasts e-commerce nearing 40% of sales.
- Although BBBY reiterated its full year EPS growth of HSD-LDD and comp of +2-4%, operating margins are now expected to be down vs. flat to down slightly previously. Despite the net negative change in outlook on the margin, this still seems aggressive. At a minimum, it seems like the time where we can all give them a free pass on beating guidance is gone.
- BBBY has leveraged operating expenses nearly 200bps over each of the last 3 years with operating expenses up only ~1% in Q1 and down 2.2% on a per square foot basis. BBBY had originally guided advertising activities to remain flat in F12 however if BBBY expects a reacceleration in the business and traction online, they will have to spend to get it.
We remain bearish here – not because of what happened, but because of what the quarter and recent strategic actions signify. The company’s model remains exposed to the online threat (with a 93% direct sku overlap with amazon.com) with its competitive advantage remaining in its in-store experience. Though it seems demand is slowing (per our Home Furnishings Index below) BBBY’s current share is slipping for the first time in many years -- which will require incremental investments back into the business following 3 years of opex leverage. Not good with BBBY sitting at peak ~17% operating margins. We remain negative on the long term TAIL call here.
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