As the new year begins, it's a fair wind for some sectors and a perfect storm for others.
Takeaway: Anything short of the best case scenario won't be good enough. P may have to exit certain markets in 2016, curbing its long-term prospects.
- WORLDS APART: In mid November, P disclosed the progress of its Webcaster IV proceedings with SoundExchange regarding music licensing rates starting in 2016. The two sides are world apart, particularly on ad-supported music, where SoundExchange is proposing rates 125% above that proposed by P. We estimate that roughly 90% of P's music is streamed by ad-supported users.
- A COMPROMISE WON'T BE GOOD ENOUGH: We're not suggesting that SoundExchange gets the rates it's proposing. But anything short of the best case scenario for P won't be good enough. P's model can't absorb any more cost, and we expect P will have to cut listener hours to curb content costs in 2016. Once P cuts the chord on those users, it will much tougher to get them back, especially with growing competition for listener hours.
In mid November, P disclosed the progress of its Webcaster IV proceedings with SoundExchange regarding music licensing rates starting in 2016. The two sides are worlds apart.
- Pandora: Greater of 25% of revenue or $0.0011-$0.0013 for ad-supported streams and $0.00215-$0.00240 for Pandora One subscribers.
- SoundExchange: Greater of 55% of revenue, or $0.0025-$0.0029 for all streaming music.
The most glaring difference between the two sides is that SoundExchange is not distinguishing between ad-supported and subscription hours, which is a deviation from the current agreement.
SoundExchange's proposal translates to an increase of roughly 125% in ad-supported licensing rates, which is a major concern given that roughly 90% of P's listener hours are ad-supported.
If SoundExchange's proposed rates were in effect in 2014, we estimate P would have paid out nearly all its YTD revenues in licensing costs (at least 91% under the SoundExchange proposed rates vs. the 52% P actually incurred YTD).
A COMPROMISE WON'T BE GOOD ENOUGH
We're not suggesting that SoundExchange gets the rates they're proposing. But anything short of the best case scenario for P won't be good enough; P can barely support its business model at its current content cost structure.
It is important to note that P has to pay for every song it streams regardless of whether it is monetizing that listener. Management had previously suggested that is monetizing less than 50% of its listener hours, so any material increase in content costs would drain a lot of cash out of the model. While P's relatively low monetization levels suggests a ton of runway for future revenue growth, incremental monetization of those hours will require incremental investment in its salesforce.
Below, we aggregated P's content acquisition costs and sales & marketing expenses (net stock-based comp) into a single expense line (expressed as a percentage of revenue). Whatever leverage P has achieved in content acquisition costs over time has been lost to incremental investment in its salesforce. That essentially means there is no leverage in its model.
So, what are P's options when its largest single expense is facing a considerable rate hike, prior to the company achieving any meaningful operating leverage, or generating consistent positive operating or free cash flow?
The most likely outcome is that P will have to directly cut it content costs, especially since it is monetizing less than half of the associated hours. That likely means implementing listening caps, or exiting certain geographies altogether. Once P cuts the chord on those users, it will much tougher to get them back, especially with growing competition for listener hours.
We are hosting our P Short Best Ideas call this Thursday at 1pm EST. Please let us know if interested in joining the call.
Hesham Shaaban, CFA
Editor's note: This is a brief excerpt from our morning research. For more information on becoming a subscriber click here.
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The 10-year Treasury yield is at 1.88% now. It started the year at 2.17%. And yet, Old Wall consensus is still saying it’s going to 3.06% by year end?
Significantly, the non-commercial net SHORT position in futures/options contracts (CFTC data) is as big as it’s been in six months at -250,163. Meanwhile, consensus is long SPX Index and Emini contracts on the other side of that!
Please. Whatever you do. Don’t be consensus.
Our most important macro call remains: Global #GrowthSlowing + #Deflation = Long The Long Bond
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Hedgeye CEO Keith McCullough shares the top three things in his macro notebook this morning.
Takeaway: In today's Macro Playbook, we check in w/ the Chinese economy and officially introduce our bullish bias on the Chinese A-Shares market.
THEMATIC INVESTMENT CONCLUSIONS
Long Ideas/Overweight Recommendations
- Consumer Staples Select Sector SPDR Fund (XLP)
- Health Care Select Sector SPDR Fund (XLV)
- PowerShares DB U.S. Dollar Index Bullish Fund (UUP)
- iShares U.S. Home Construction ETF (ITB)
- iShares 20+ Year Treasury Bond ETF (TLT)
- LONG BENCH: Vanguard REIT ETF (VNQ), Utilities Select Sector SPDR Fund (XLU), Vanguard Extended Duration Treasury ETF (EDV)
Short Ideas/Underweight Recommendations
- iShares TIPS Bond ETF (TIP)
- CurrencyShares Japanese Yen Trust (FXY)
- SPDR Barclays High Yield Bond ETF (JNK)
- Industrial Select Sector SPDR Fund (XLI)
- iShares MSCI Emerging Markets ETF (EEM)
- SHORT BENCH: SPDR Oil & Gas Exploration & Production ETF (XOP), CurrencyShares Euro Trust (FXE), WisdomTree Emerging Currency Fund (CEW)
QUANT SIGNALS & RESEARCH CONTEXT
Checking In With China: Overnight, China reported its DEC trade data, which came in much stronger than anticipated:
- Exports: +9.7% YoY from +4.7% YoY in NOV vs. a Bloomberg consensus estimate of +6%
- Imports: -2.4% YoY from -6.7% YoY in NOV vs. a Bloomberg consensus estimate of -6.2%
- Trade Balance: $49.6B from a $54.5B in NOV vs. a Bloomberg consensus estimate of $49B
Aside from the obvious sequential strength and positive surprises, there was another “positive” data point embedded in the release: China imported record volumes of commodities – across the spectrum – in 2014.
You mean the same ‘commodities’ that dropped -17.9% in 2014 (CRB Index) or crashed -26.5% from their TTM closing high on June 20th? Yes, those same ‘commodities’. It would appear counter to the lazy Consensus Macro narrative that Chinese demand is not getting investors paid on the long side of commodities. Hopefully you sold down your commodity exposures when we began making this asset allocation call back in early August.
But, of course, you already knew that Chinese demand is far less important to commodity prices than consensus among the investment community assumes. Whether you’ve followed our work since the beginning (2008) or you’ve been reading our research for only 2-3 weeks, you know that we’ve proven the U.S. dollar is factors #1, #2 and #3 in determining last price, as well as the outlook for both supply and demand in/across global commodity markets:
Generally speaking, both supply and demand for commodities as we have come to know them over the past decade or so are both functions of cheapening-USD credit expansion in and across emerging market economies. How this interplays with China specifically is three-fold:
- The confluence of the CNY’s peg (now managed float) vs. the USD and China’s 2001 entry into the WTO allowed the country to dramatically boost its export base, effectively creating massive inflation of the current account surplus
- Those USD’s were transformed into CNY liabilities in the Chinese domestic banking sector due to China’s capital account restrictions
- Those CNY liabilities were then levered and transformed Chinese domestic banking sector assets, which largely financed the greatest fixed assets investment bubble the world has ever seen
Well, as we show on slides 42-44 in our recent bearish presentation on emerging markets, all three of those factors are being unwound, at the margins:
That unwinding is perpetuating a broader slowdown in Chinese growth, which you can see by the general hue of red across the following tables:
- The smoothed, amalgamated YoY rate of change for iron ore, rebar and coal prices – arguably the key leading indicator for the Chinese economy – continues its trend of crashing
- Official manufacturing PMI data slowing on both a sequential and trending basis
- Capital flows, money supply growth, fixed assets investment growth – all three of which remain forever linked – are all slowing on both a sequential and trending basis
- The Chinese property market is an unmitigated disaster at the current juncture; the only indicator that is accelerating on either a sequential or trending basis is finished supply (i.e. housing completions)
- Continuing with the 'disaster' theme, housing starts and unit demand are tacking down -9% YoY and -8.2% YoY, respectively
Shhh! Don’t tell any of that to the A-Shares, which continue to melt-up on a trending basis (up +58% since the end of June). It’s pulled back a full -4.1% from its 1/7 high on recent official rhetoric that was counter to consensus expectations for perpetual monetary and fiscal easing.
At best, this is the equivalent of throwing a cold towel upon a blazing inferno; our expectations for the “downward pressure” upon the Chinese economy continue to be as bearish as anyone’s with actual credibility in calling China’s economic cycle. As such, we expect cries for stimulus and subsequent stimulus measures to continue dominating macro news flow headlines over the intermediate-term as policy makers are forced to defend their +7% real GDP growth floor.
With this note, we are officially introducing our bullish bias on the Chinese A-Shares market, having effectively authored the thesis two weeks ago. U.S. domiciled investors can play this trade via the Morgan Stanley China A-Share Fund (CAF).
***CLICK HERE to download the full TACRM presentation.***
TRACKING OUR ACTIVE MACRO THEMES
Global #Deflation: Amidst a backdrop of secular stagnation across developed economies, we continue to think cyclical forces (namely #StrongDollar driven commodity price deflation) will drag down reported inflation readings globally over the intermediate term. That is likely to weigh heavily upon long-term interest rates in the developed world, underpinning our bullish outlook for U.S. Treasury bonds.
The Hedgeye Macro Playbook (1/12)
#Quad414: After DEC and Q4 (2014) data slows, in Q1 of 2015 we think growth in the US is likely to accelerate from 4Q, aided by base effects and a broad-based pickup in real discretionary income. We do not, however, think such a pickup is sustainable, as we foresee another #Quad4 setup for the 2nd quarter. Risk managing these turns at the sector and style factor level will be the key to generating alpha in the U.S. equity market in 1H15.
Long #Housing?: The collective impact of rising rates, severe weather, waning investor interest, decelerating HPI, and tighter credit capsized housing in 2014. 2015 is setting up as the obverse with demand improving, the credit box opening and 2nd derivative price and volume trends beginning to inflect positively against progressively easier comps. We'll review the current dynamics and discuss whether the stage is set for a transition from under to outperformance for the complex.
Best of luck out there,
Associate: Macro Team
About the Hedgeye Macro Playbook
The Hedgeye Macro Playbook aspires to present investors with the robust quantitative signals, well-researched investment themes and actionable ETF recommendations required to dynamically allocate assets and front-run regime changes across global financial markets. The securities highlighted above represent our top ten investment recommendations based on our active macro themes, which themselves stem from our proprietary four-quadrant Growth/Inflation/Policy (GIP) framework. The securities are ranked according to our calculus of the immediate-term risk/reward of going long or short at the prior closing price, which itself is based on our proprietary analysis of price, volume and volatility trends. Effectively, it is a dynamic ranking of the order in which we’d buy or sell the securities today – keeping in mind that we have equal conviction in each security from an intermediate-term absolute return perspective.
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