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Be The Mustache

“They complain that I’m robotic, abrupt, I’m not cheerful and smiley, and you know what? That’s not my problem,”

Arthur Chu

 

On the back end of a 14-hour work day yesterday, after dinner time, bath time, story time, bed time and the host of other daily, toddler parenting “times,” I swilled back some late night espresso and fired up the DVR to watch something I’ve been itching to review for a while now  - Jeopardy!. 

 

Jeopardy is still on?  The White House Petition to deport Justin Bieber only got 275K signatures? ….that fat guy is the kid from The Sixth Sense?  

 

The story is a bit stale now, but if you didn’t follow its procession last month, controversial Jeopardy contestant, Arthur Chu, emerged out of the arithmetic ether like some sort of sagely, evil game-show probabilist savant. 

 

Be The Mustache - chu

 

Using math and a game theory based playing strategy, he managed an 11-game win streak and ultimate winnings of $298K – good for 3rd all-time (Wikipedia). 

 

Alongside terseness and less than conventional congeniality, Chu’s most noteworthy exploit was his innovative use of the “Forrest Bounce” - whereby you jump quickly from category to category – across the bottom three rows of the board in an attempt to locate the “daily doubles”. 

 

The daily double sits as the singularly largest source of uncertainty in the early rounds of the game.  If that uncertainty can be systematically eliminated, the odds of winning increase provided one’s knowledge of the other trivia is marginally better than that of the other two contestants.

 

Here's the clip of Chu ferreting out a daily double, dismissively betting $5, answering “I dunno” after 1 second and summarily continuing on.

 

Chu’s challenge of conventional contestant etiquette inspired the ire of Jeopardy ‘purists’ nationally who took to social media en masse to voice their discontent and defend the game’s storied, 3-decade tradition from the emergent nihilist.   

 

Applied mathematical innovation challenging preconceived wisdoms and conventional orthodoxy…..sound familiar? 

 

Fortunately, in the end, #Evolution has a sneaking ability to overcome both antiquated conventionalism and institutional (ivory tower) obstructionism.   

 

Back to the Global Macro Grind….

 

When hearing economists discuss markets in terms of rational agents, benevolent dictators, and other nonsensical simplifying assumptions, the economy becomes something largely abstract and intangible. 

 

Certainly, the dynamic, complex system that is globally interconnected macro is difficult to comprehend (let alone forecast) in full, but a coherent understanding of the drivers of significant parts of the economy over defined periods isn’t inaccessible.  

 

Consider the largest part of the domestic economy  – consumption, in the short run. 

 

Broadly speaking, the drivers of Consumption aren’t overly complicated.  In short, consumer spending growth is a function of the growth in income, the marginal propensity to consume or save that income, and the net change in household credit. 

 

Asset appreciation and credit growth matter, but they are somewhat indirect drivers.  We discuss the wealth effect further below and leave the discussion and analysis of credit for another missive.  

 

So, what do income and savings trends tell us about the slope of consumption growth?

 

Together, growth in disposable income and the change in the savings rate explain most of the change in nominal consumption (PCE) growth.  Indeed, over the last 30 years, the multiple regression between PCE growth vs. nominal Disposable Income growth and the change in the Savings Rate produces an R-squared of 0.99.  #tight

 

While that ultra-strong correlation doesn’t provide much insight into how to actually go about fostering significant, sustainable real income growth, it does provide a means of reasonably nowcasting the 68% of the economy that is consumption. 

 

For instance, under a baseline assumption that the 3 primary input variables (Disposable Income growth, the Savings Rate and PCE inflation) come in at their respective QTD averages in March, the regression model suggests year-over-year real consumption growth of 2.2% in 1Q14 – down 10bps sequentially from 4Q13, but +20bps ahead of the TTM average

 

Nothing revolutionary or proprietary there - just the gravity of a few numbers to which consumption growth remains inextricably hostage. 

 

What about the Wealth Effect?  

 

The wealth effect ‘theory’ posits that when real wealth increases, consumer spending permanently increases by some fraction of that wealth increase in every subsequent year.

 

Consumers, on balance, don’t immediately convert 100% of a wealth increase into current consumption.  Instead, in annuity like fashion, they tend to spread that ability for increased consumption out over their lifetime.

 

In general, studies examining the marginal propensity to consume show that consumer spending increases between 2 and 7 cents for each dollar of wealth increase.

 

It makes intuitive sense that an increase in real wealth, be it from housing or financial asset appreciation, lends itself to increased consumption. 

 

Again, when hearing analysts and pundits discuss it in the media, one is left feeling that the wealth effect occurs via some mystical monetary transubstantiation whereby higher net wealth is somehow cleanly and instantaneously transformed into higher consumption.

 

In reality, a number of key, very mechanical conditions must be satisfied for increased housing/financial asset wealth to translate into higher consumer spending on non-housing related goods and services

 

Practically,  increased real wealth needs to drive a behavior shift such that households decrease savings or other investments, increase home equity/other collateralized borrowing, or downsize to a cheaper residence (liquidity event freeing up cash for spending), for that wealth increase to be effective in driving higher consumption growth.

 

With the value of corporate equities and the aggregate housing stock up $3.52T and 2.0T, respectively, in 2013, the case for wealth effect spending has some residual legs.  However, with equities down YTD and housing in the midst of a discrete deceleration, we expect wealth effect support to consumption to continue to ebb. 

 

While consensus continues to make the pro-growth, pro-consumption call that should have been made last year, we think the consumer slows sequentially in 1H14.  We layed out ‘the why’ in our 2Q Macro themes call on Tuesday.  Ping if you’d like the replay/presentation. 

 

Like Alex Trebek’s facial hair, the forward slope of consumption growth remains the subject of ongoing conjecture and speculation.  Both continue to fascinate and confound consensus onlookers on a regular basis.  Understanding both will remain central to generating global macro alpha in 2014.    

 

Be the mustache, don’t be consensus…..or something like that.

 

Our immediate-term Global Macro Risk Ranges are now as follows:

 

VIX 14.72-16.67

Nasdaq 4007-4203

UST 10yr Yield 2.61-2.73%

SPX 1

Gold 1 

 

Enjoy the weekend.    

 

Christian B. Drake

Associate

 

Be The Mustache - Consumer


BNNY: INTERMEDIATE-TERM DOWNSIDE

We recently added BNNY to the Hedgeye Best Ideas list as a SHORT.

 

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BNNY’s core business is the marketing and distribution of natural and organic food products under the Annie’s brand name.  BNNY has the number one natural and organic market position in four product lines: macaroni and cheese, snack crackers, fruit snacks and graham crackers.  The natural and organic segment of the food industry is the fastest and most dynamic part of the industry – and BNNY is a key player.

 

BNNY operates three main business segments: meals; snacks; and dressings, condiments and other.  While the company has shown admirable topline growth, the growing pains of managing this growth as a publicly traded company are beginning to take their toll on the margin composition of the company.

 

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The company has faced numerous issues since coming public in April 2012, including executive departures, product recalls and balance sheet issues (excess inventory growth, inventory write-downs, accounts receivable).  In addition, a viable competitor, WhiteWave (WWAV) has emerged and is going after both BNNY’s core macaroni & cheese and cracker businesses.  On top of all this, significant commodity inflation in organic wheat has recently emerged as another notable headwind facing the business.

 

The company has not provided guidance for FY15, but will do so when they report earnings on June 10th.  We think the current EPS estimate of $1.13, or 22% growth, is very aggressive.  Although estimates were revised down significantly following 3QF14 earnings, we believe they have not come down nearly enough.

 

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INVESTMENT POSITIVES

Great Brand in the Right Category – As advertised, the Annie’s brand authentically honors social responsibility and environmental sustainability by selling products with clean ingredients and giving mom a healthy alternative to mainstream packaged foods.

 

Strong Volume Growth – The company has reported significant volume growth in its grocery and mass distribution segments since coming public, driven by deeper penetration in the main aisle of the grocery store.  Additional volume growth is being driven by innovation and expansion into new categories.

 

Broader Popularity – A big shift for Annie’s is the pivot to selling more products in the main aisle of the grocery store.  Historically, natural and organic foods were primarily only available at independent organic retailers or natural and organic retail chains.  Mainstream grocery stores and mass merchandisers have expanded their natural and organic food offerings to meet the increasing consumer demand for natural and organic products, which generally command a higher margin for the retailer.

 

New Products – FY14 marks a year of accelerated innovation for Annie’s, as the company launched two new products.  On the 4QF13 earnings call, management announced a “highly incremental” platform extension to the mac & cheese business – the entry into the single serve microwaveable cup segment.  This segment represents approximately 20% of the total mac & cheese category and is growing at twice the rate of the overall category in conventional distribution channels.  On the 1QF14 earnings call, management said they’d secured over 15,000 points of distribution for microwaveable cups, adding that sales so far have been incremental to the base mac & cheese business.

 

During the same call, management also announced BNNY’s entry into the Family Size segment of the Frozen Entrée category with the launch of four items: Lasagna with Meat Sauce, Classic Mac & Cheese, Shells & White Cheddar with Chicken and Butternut Squash Mac & Cheese.  This segment is nearly a $3.5 billion category that’s dominated by large, conventional brands and lacks an established, authentic natural organic offering.

 

INVESTMENT NEGATIVES

The Pivot to an Asset-Based Model – Since becoming a publicly traded company, BNNY has had a difficult time meeting earnings guidance.  Clearly, managing a rapidly growing business is a challenge for management.  In FY15, the company is taking on incremental operational risk by acquiring hard assets.  Historically, the company utilized contract manufacturers or co-packers to manufacture the company’s entire product line.  In FY13, BNNY’s four largest contract manufacturers accounted for 75% of the company’s sales.

 

Last week, the company announced the closing of its acquisition of the Safeway snack factory in Joplin, Missouri.  We believe both the company and the street have inadequately accounted for this acquisition.  In our opinion, it is prudent to assume the pivot to an asset-based model will present operational issues in FY15.

 

Our first concern is regarding the geographical location of the plant – Joplin, MO is a considerable distance from Berkley, CA.  Second, and more importantly, BNNY is currently an asset-light business model.  Given that the company uses all contract manufacturers to source its product, owning a manufacturing plant could present new, unexpected operational issues.  Third, any inefficiencies stemming from the plant will be significantly dilutive to EPS in FY15.  On the positive side, the plant already produces close to 100% of Annie’s product and the company has signed a three-year supply deal with Safeway to help ensure consistent demand.

 

Commodity Inflation – According to management, FY15 is going to be “a tale of two halves.”  The inflation headwinds that pressured margins in FY14 will persist, particularly with regards to organic wheat and cheese prices.  For the time being, commodity inflation is expected to moderate over the course of FY15, with overall pressure being more modest on a year-over-year basis.

 

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Decelerating Sales Trends – Two-year sales trends are set to slow in FY15, as the company rolls over the introduction of two new product launches in FY14.

 

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Margin Pressure – We expect increased complexity, new products and food inflation to all lead to a significant decline in gross margins.  With 4QF14 yet to be reported, we estimate gross margins will be down 200 bps for the full fiscal year.  While some of this can be labeled as “one time” in nature, it is likely that the company will be operating at a lower gross margin for a significant period of time.  In FY14, the majority of gross margin pressure came from inflation, sales mix and inventory management.  More recently, there has been material commodity inflation due in large part to a surge in organic wheat and cheese prices.  We don’t expect this to ease until sometime in 2HF15.

 

While inflation pressures may lessen in the back half of FY15, channel issues and a sales mix shift due to new products will likely persist for the balance of the year and potentially longer.  We also see “aged inventory” as a troubling sign and believe this signals weak internal controls.

 

Operating margins only declined 150 bps in 3QF14 due to aggressive expense management.  For a growth company, this decline in SG&A is not a net positive and can be labeled as “one time” in nature as well.  The company remains on a very aggressive growth curve and is transitioning its business to an asset-based model.  We question how much wiggle room they have left on the SG&A line.

 

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Balance Sheet Issues – For a company such as BNNY, which is seeing tremendous volume growth, we find it very odd that it needs to write down old inventory and has trouble converting sales into cash.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 11

 

 

Employee Turnover – Former CFO Kelly Kennedy announced her resignation back in November 2013.  Former EVP and Chief Supply Chain and People Officer Amanda Martinez tendered her resignation at the end of March 2014.  We suspect Ms. Martinez may be taking the fall for the companies issues to-date in 2014.  It’s an odd move, considering she was only promoted to the position a few months ago.

 

Increased Competition – WhiteWave, through its Horizon brand, has recently introduced a new mac & cheese business as well as a snacks & crackers business to compete directly with Annie's products.  While this is not new news to the market, it continues to be an overhang on BNNY.  Annie’s FY14 results thus far have not shown a significant slowdown in Mac & Cheese sales trends, but the pressure will not be going away any time soon.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 12

 

SENTIMENT

Generally, the street is rather cautious on the name, with 80% of analysts rating the stock a hold and short interest comprising 23% of the float.  However, with the street looking for 22% EPS growth in FY15, we believe this is a prudent call.  

 

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VALUATION

At 34x NTM EPS, the stock trades at a substantial premium to the group, which is trading closer to 22x.  To its credit, BNNY is showing significantly stronger top line growth than its peers; however, we have legitimate concerns with the company’s ability to manage EPS.

 

We believe BNNY represents an attractive risk/reward setup for short sellers, offering notable downside in the intermediate-term.

 

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Howard Penney

Managing Director

  

Fred Masotta

Analyst


BNNY: INTERMEDIATE-TERM DOWNSIDE

We recently added BNNY to the Hedgeye Best Ideas list as a SHORT.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 17

 

BNNY’s core business is the marketing and distribution of natural and organic food products under the Annie’s brand name.  BNNY has the number one natural and organic market position in four product lines: macaroni and cheese, snack crackers, fruit snacks and graham crackers.  The natural and organic segment of the food industry is the fastest and most dynamic part of the industry – and BNNY is a key player.

 

BNNY operates three main business segments: meals; snacks; and dressings, condiments and other.  While the company has shown admirable topline growth, the growing pains of managing this growth as a publicly traded company are beginning to take their toll on the margin composition of the company.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 1

 

 

The company has faced numerous issues since coming public in April 2012, including executive departures, product recalls and balance sheet issues (excess inventory growth, inventory write-downs, accounts receivable).  In addition, a viable competitor, WhiteWave (WWAV) has emerged and is going after both BNNY’s core macaroni & cheese and cracker businesses.  On top of all this, significant commodity inflation in organic wheat has recently emerged as another notable headwind facing the business.

 

The company has not provided guidance for FY15, but will do so when they report earnings on June 10th.  We think the current EPS estimate of $1.13, or 22% growth, is very aggressive.  Although estimates were revised down significantly following 3QF14 earnings, we believe they have not come down nearly enough.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 2

 

 

INVESTMENT POSITIVES

Great Brand in the Right Category – As advertised, the Annie’s brand authentically honors social responsibility and environmental sustainability by selling products with clean ingredients and giving mom a healthy alternative to mainstream packaged foods.

 

Strong Volume Growth – The company has reported significant volume growth in its grocery and mass distribution segments since coming public, driven by deeper penetration in the main aisle of the grocery store.  Additional volume growth is being driven by innovation and expansion into new categories.

 

Broader Popularity – A big shift for Annie’s is the pivot to selling more products in the main aisle of the grocery store.  Historically, natural and organic foods were primarily only available at independent organic retailers or natural and organic retail chains.  Mainstream grocery stores and mass merchandisers have expanded their natural and organic food offerings to meet the increasing consumer demand for natural and organic products, which generally command a higher margin for the retailer.

 

New Products – FY14 marks a year of accelerated innovation for Annie’s, as the company launched two new products.  On the 4QF13 earnings call, management announced a “highly incremental” platform extension to the mac & cheese business – the entry into the single serve microwaveable cup segment.  This segment represents approximately 20% of the total mac & cheese category and is growing at twice the rate of the overall category in conventional distribution channels.  On the 1QF14 earnings call, management said they’d secured over 15,000 points of distribution for microwaveable cups, adding that sales so far have been incremental to the base mac & cheese business.

 

During the same call, management also announced BNNY’s entry into the Family Size segment of the Frozen Entrée category with the launch of four items: Lasagna with Meat Sauce, Classic Mac & Cheese, Shells & White Cheddar with Chicken and Butternut Squash Mac & Cheese.  This segment is nearly a $3.5 billion category that’s dominated by large, conventional brands and lacks an established, authentic natural organic offering.

 

INVESTMENT NEGATIVES

The Pivot to an Asset-Based Model – Since becoming a publicly traded company, BNNY has had a difficult time meeting earnings guidance.  Clearly, managing a rapidly growing business is a challenge for management.  In FY15, the company is taking on incremental operational risk by acquiring hard assets.  Historically, the company utilized contract manufacturers or co-packers to manufacture the company’s entire product line.  In FY13, BNNY’s four largest contract manufacturers accounted for 75% of the company’s sales.

 

Last week, the company announced the closing of its acquisition of the Safeway snack factory in Joplin, Missouri.  We believe both the company and the street have inadequately accounted for this acquisition.  In our opinion, it is prudent to assume the pivot to an asset-based model will present operational issues in FY15.

 

Our first concern is regarding the geographical location of the plant – Joplin, MO is a considerable distance from Berkley, CA.  Second, and more importantly, BNNY is currently an asset-light business model.  Given that the company uses all contract manufacturers to source its product, owning a manufacturing plant could present new, unexpected operational issues.  Third, any inefficiencies stemming from the plant will be significantly dilutive to EPS in FY15.  On the positive side, the plant already produces close to 100% of Annie’s product and the company has signed a three-year supply deal with Safeway to help ensure consistent demand.

 

Commodity Inflation – According to management, FY15 is going to be “a tale of two halves.”  The inflation headwinds that pressured margins in FY14 will persist, particularly with regards to organic wheat and cheese prices.  For the time being, commodity inflation is expected to moderate over the course of FY15, with overall pressure being more modest on a year-over-year basis.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 3

 

 

Decelerating Sales Trends – Two-year sales trends are set to slow in FY15, as the company rolls over the introduction of two new product launches in FY14.

 

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Margin Pressure – We expect increased complexity, new products and food inflation to all lead to a significant decline in gross margins.  With 4QF14 yet to be reported, we estimate gross margins will be down 200 bps for the full fiscal year.  While some of this can be labeled as “one time” in nature, it is likely that the company will be operating at a lower gross margin for a significant period of time.  In FY14, the majority of gross margin pressure came from inflation, sales mix and inventory management.  More recently, there has been material commodity inflation due in large part to a surge in organic wheat and cheese prices.  We don’t expect this to ease until sometime in 2HF15.

 

While inflation pressures may lessen in the back half of FY15, channel issues and a sales mix shift due to new products will likely persist for the balance of the year and potentially longer.  We also see “aged inventory” as a troubling sign and believe this signals weak internal controls.

 

Operating margins only declined 150 bps in 3QF14 due to aggressive expense management.  For a growth company, this decline in SG&A is not a net positive and can be labeled as “one time” in nature as well.  The company remains on a very aggressive growth curve and is transitioning its business to an asset-based model.  We question how much wiggle room they have left on the SG&A line.

 

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BNNY: INTERMEDIATE-TERM DOWNSIDE - 8

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Balance Sheet Issues – For a company such as BNNY, which is seeing tremendous volume growth, we find it very odd that it needs to write down old inventory and has trouble converting sales into cash.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 11

 

 

Employee Turnover – Former CFO Kelly Kennedy announced her resignation back in November 2013.  Former EVP and Chief Supply Chain and People Officer Amanda Martinez tendered her resignation at the end of March 2014.  We suspect Ms. Martinez may be taking the fall for the companies issues to-date in 2014.  It’s an odd move, considering she was only promoted to the position a few months ago.

 

Increased Competition – WhiteWave, through its Horizon brand, has recently introduced a new mac & cheese business as well as a snacks & crackers business to compete directly with Annie's products.  While this is not new news to the market, it continues to be an overhang on BNNY.  Annie’s FY14 results thus far have not shown a significant slowdown in Mac & Cheese sales trends, but the pressure will not be going away any time soon.

 

BNNY: INTERMEDIATE-TERM DOWNSIDE - 12

 

SENTIMENT

Generally, the street is rather cautious on the name, with 80% of analysts rating the stock a hold and short interest comprising 23% of the float.  However, with the street looking for 22% EPS growth in FY15, we believe this is a prudent call.  


BNNY: INTERMEDIATE-TERM DOWNSIDE - 13

 

VALUATION

At 34x NTM EPS, the stock trades at a substantial premium to the group, which is trading closer to 22x.  To its credit, BNNY is showing significantly stronger top line growth than its peers; however, we have legitimate concerns with the company’s ability to manage EPS.

 

We believe BNNY represents an attractive risk/reward setup for short sellers, offering material downside in the intermediate-term.


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Howard Penney

Managing Director

 

Matt Hedrick

Associate

 

Fred Masotta

Analyst


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Walmart’s Organic Push Hits BNNY, HAIN, KRFT, SJM & Others

This morning WMT announced it plans to beef up its non-fresh organic presence and, in the process, undercut its smaller brand-name organic competition by at least 25%.

 

We think WMT’s strategy to carry the Wild Oats label (owned by Yucaipa Companies, a private investment firm) is properly aligned with the surging consumer demand for organic products.

 

By offering organics at a lower price, the company stands to reach two distinctly different audiences:

  • Traditional consumers looking to trade up to affordable organics
  • Existing organic consumers looking for a discount to their current spend

Given that WMT is the largest retailer in the U.S., the move stands to create winners and loser across both organic and non-organic markets.  On the company side, we’d expect severe shelf space competition for the current largest players in the WMT’s pantry sections, which including KRFT and SJM (26% of revenues for each company come from WMT).

 

This push also has implications for the current organic players including, but not limited to, BNNY, WWAV, HAIN and POST, as Walmart stands to offer overlapping products at cheaper prices.  Considering the scarce supply of organic growers and the recent spike in organic commodity prices, smaller premium players may be hard pressed to lower prices.  If true, the spread between premium organic products and conventional organic products could prove detrimental to current players in the organic market as customers begin to trade down to more affordable products. 

 

We expect these pressures to impact BNNY, which we currently view as a best idea short.  To get a better understanding of this short thesis, we encourage you to listen to our podcast  and review our presentation.

 

WMT has stated its intentions to launch Wild Oats in its pantry section in half of its 4,100 stores in the coming months, before rolling it out system-wide.  According to Walmart’s internal company research, 91% of customers said they would buy “affordable” organic products if they were available. 

 

We think today’s sell-off from current organic players was a direct result of WMT’s announcement, as the potential loss of shelf-space or customers has materialized as a serious threat for a significant number of companies.

 

Howard Penney

Managing Director

 

Matt Hedrick

Associate

 

Fred Masotta

Analyst

 


Poll of the Day Recap: Need a Loan For Groceries?

The Los Angeles Times reported that beef prices in the U.S. have hit an all-time high and aren’t expected to come down any time soon. The retail value of "all-fresh" USDA choice-grade beef jumped to a record $5.28 a pound in February, up from $4.91 the same time a year ago. Meanwhile, coffee prices are up almost 70% YTD as the CRB Foodstuffs index itself is up approximately 20% YTD.

 

Not pretty.

 

So, in today’s poll, we wanted you to sound off: Are you seeing higher prices at the grocery store?


The results weren’t even close—it was a total landslide. At the time of this post, the overwhelming majority agreed that food prices were rising with 93% voting YES and  just 7% saying NO.


Hedgeye CEO Keith McCullough tweeted today, “Freshly squeezed YTD highs in commodity #InflationAccelerating (CRB Index +10.7% YTD)…Coffee +3% rips another #InflationAccelerating move - eat an iPad.”

 

Of the loads of YES comments we received, here are a few that paint a clear picture:

  • “Of course prices are higher. I don't ever expect them to come down, but ever increase. The problem is salaries aren't increasing at the same pace..”
     
  • “Everything I buy is up.  Fruit, vegetables, coffee, everything.  My grocery bill on average is about 15% higher.”
     
  • “Prices are higher. Period. And let's face some facts – if we notice, then the average American (who is far more important than the Wall Street crowd is) definitely notices. The key is not the fact that prices are up, but in that behavior is changing. People are trading down in where they shop. Less Whole Foods, more Trader Joe's. Anecdotally, it seems like the spread between the cost to eat at home vs eat out is compressing. Restaurants seem slower to pass through costs than supermarkets do. That can't be a good margin event.”
     
  • “The prices are ridiculous. There seems to be no ceiling, which is the most frightening part.”
     
  • “I am seeing SALE prices higher than the old regular prices.”
     
  • “My strategy is to avoid the foods that are up big by substituting with other foods try to avoid inflation as much as I can.”
     
  • “Higher food prices come not just from prices, but also less portion. Essentially, it's a double whammy, higher prices for less portion. The only thing I see that is experiencing deflation is Keynesian Crack. The Fed will acknowledge inflation when that is going up in prices.”

One of the only NO voters to explain their choice said this: “The prices on most of the things I buy [have] stayed about the same, including coffee but I'll be paying more attention now.”

 

But, it might be this YES voter who said it best, “Seriously, anyone who says NO does not shop, for anything!”

 

Indeed.

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1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS

Takeaway: Top line pressures should take a back seat as loan growth accelerated in 1Q14, but fading credit tailwinds will likely more than offset.

Overall, we expect this earnings season will be lackluster for the banking sector. Outside of some modest acceleration in loan growth and ongoing credit tailwinds from an improving labor market and inflating collateral values, there will be little good news for management to discuss. Margins are likely to be flat sequentially, while credit tailwinds, vis-a-vis provision expense/reserve release, will show more pronounced signs of fading. Offsets will be expense reduction initiatives, though these have now been ongoing for some time, and falling sharecount from active repurchase programs. Another offset may be relatively upbeat guidance with respect to a reduction in future costs, both legal and operational, relating to legacy mortgage troubles. We think 1Q results are likely to set expectations fairly low for the duration of 2014.

  • Loan Growth - Status Quo - Overall, loans grew by 1.4% QoQ in 1Q14, which was up vs 0.5% QoQ growth in 4Q13. 
  • Margins Likely Unch'd - 1Q14 saw essentially no change in the average yield spread QoQ. Banks have pulled most of their available levers at the short end of the curve, but the pressure on earning asset yields has abated somewhat for now.  
  • Credit - Fading Tailwinds - Credit quality is still improving (lower DQs & NCOs), but provision expenses are actually beginning to rise as reserve release shrinks. The modest uptick in loan growth will add modestly to the pressure here to grow provision expense. 

 

1Q14 Revenue: Better Loan Growth, Flat Margins and Non-Interest Income Pressure.

* Loan Growth - Total domestically-chartered commercial bank loan growth grew 1.4% QoQ, which was roughly triple the QoQ growth in 4Q13 (+0.5%), based on the Fed's H8 data through March 26, 2014 (the most recent available). This is an important inflection as the preceding 7 quarters were showing pretty consistent sequential deceleration in loan growth. It remains to be seen whether 1Q14 is the start of an upturn or a false dawn, but it's deviation vs recent trend is definitely noteworthy. Loan growth is now running at +3.3% year-over-year, which is up from +1.5% y/y just three months ago.

 

The strongest categories of loan growth remain C&I (+8.4% y/y) and "Other" (+7.0%), which is powered primarily by auto loans. CRE lending is where we're seeing the fastest acceleration in growth. CRE loan balances are up 6.4% y/y, but have accelerated +579 bps over the past 12 months and +122 bps over the past three months. 

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - LOAN GROWTH TABLE BY CAT

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - QoQ loan growth

 

The chart below shows the year-over-year growth rate of loans by category at a slightly more granular level.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - loan compendium chart

 

Taking a step back, the recent positive inflection in loan growth has helped the trend get almost back to trendline. The chart below shows loan growth back to 2002 and breaks it into three distinct periods. The CAGR since Feb 2011 - the most recent inflection - has been +4.4%.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - 10yr cagr chart

 

Here's a more detailed look at each loan category vis-a-vis growth.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - QoQ loan growth by category

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - total loans chart

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - C I

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - cre

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - resi re

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - consumer

 

* NIM - Net interest margin trends should be uneventful this quarter as the average 2-10 yield spread in 1Q14 was 239 bps vs 241 bps in 4Q13. The same is true for the long end of the curve, where the average yield on the 10-year treasury was similarly lower by a few basis points quarter-over-quarter. 

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - 15

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - 16

 

* Non-Interest Income - Mortgage banking is one of the primary drivers of Q/Q change in non-interest income, and the news here isn't great. Total application volume in 1Q14 was down 12% QoQ, though primary/secondary spreads were relatively unchanged at 93 bps in 1Q14 (avg) vs 91 bps in 4Q13. Taken together, this implies sequential declines of roughly 10% in production revenue. There is unlikely to be any offset to this from the servicing side as rates ended the quarter flat to down with where they started (4.42% on 30YR FRM at 3/31/14 vs 4.54% at 12/31/13). Meanwhile, spreads have not widened since the end of the quarter.

 

1Q14 Credit Tailwinds: Slack Sails

* Credit quality continues to improve, but at a decelerating rate. Take a look at the chart below showing the sequential change in NCOs for the money center banks and large card operators. The point is that losses have been steadily converging towards a steady state for the last four years and appear to have reached their nadir as evidenced by the last two data points, which average roughly zero.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - QoQ NCO change for companies

 

Meanwhile, on the other side of this, provision expense is beginning to rise. Expectations are that 1Q14 provision expense for the 7 firms shown in the chart above will rise to $4.2 billion from $3.3 billion in 4Q13. That would be the first rise since the beginning of the credit cycle recovery. NCOs are still outpacing provisions by $2.0-2.5 billion for these firms, but that's down sharply from almost $5 billion in reserve release just a few quarters ago.

 

In the chart below we show the sequential change in allowance in the H8 data for Large Banks (blue) and the actual total for the large caps above (in red). The current quarter reflects the atual H8 data and the consensus estimates for reserve release in 1Q14.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - allowance money centers by qtr

 

The chart below shows the sequential change in total allowance across all domestically chartered commercial banks.

 

1Q14 BANK EARNINGS PREVIEW: LOW EXPECTATIONS - allowance QoQ

 

 * The only good news on the credit front is that the labor market continues to improve, as evident from the recent claims data, JOLTS data and ongoing, steady-as-she-goes ADP numbers. Moreover, collateral values have continued to inflate at a rapid clip, namely residential and commercial properties, in the first quarter of this year. While the tailwind of reserve release will definitely slow, it's at least some comfort that the fundamental measures of credit quality are still improving.

 

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA


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