This note was originally published at 8am on December 31, 2014 for Hedgeye subscribers.
“The only thing worse than being blind is having sight and no vision.”
Earlier this week I made my annual visit to my eye doctor. As per usual for someone that has just eclipsed their 40th year, my eyes were a little worse this year compared to last. The doctor also had an interesting diagnosis, he told me I’m the perfect example of someone with environmental myopia.
Luckily enough this “problem” is not just mine and in some respects Darwin should be proud. According to Freakonomics.com:
“It has long been thought that nearsightedness is mostly a hereditary problem, but researchers led by Ian Morgan of Australian National University say the data suggest that environment has a lot more to do with it.
Reporting in the journal Lancet, the authors note that up to 90% of young adults in major East Asian countries, including China, Taiwan, Japan, Singapore and South Korea, are nearsighted. The overall rate of myopia in the U.K., by contrast, is about 20% to 30%.”
According to the aforementioned study, and others, there is an increasing prevalence of near sightedness globally and it is primarily the result of people spending too much time inside focused on small screens. Specifically, the bright indoor light stimulates the retinal transmitter dopamine, which is the structural basis of myopia and, for all intents and purposes, makes the eyes grow too big.
In the world in which many of us live working indoors and focusing on computer screens, this idea of environmental myopia is fine. That said, to the extent Armageddon actually arrives and our lives change meaningfully, long haul truck drivers would have a real advantage over many of us in a hunter gather world.
Back to the Global Macro Grind...
As the stock market year of 2014 winds down, environmentally caused near sightedness is really a good topic to contemplate as we head into 2015. It is actually, whether clinically diagnosed or not, an ailment that already effects many stock operators. Specifically, that is the over focus on short-term trends when thinking about and contemplating the future.
According to a summary from about a year ago, the venerable investment bank Goldman Sachs (and no offense to Goldman, as we probably could have picked on any major firm) made a number of key predictions for 2014, which included the following:
1) Oil – Oil will remain stable at current prices due to falling supply in some areas and political uncertainty in others;
2) China – Stable growth in China of 7.5% will be enough and give investors enough confidence to propel China higher in 2014;
3) Emerging markets – Expectation of rate hikes in emerging market as growth continues to accelerate.
Now to be fair, one area in which Goldman nailed it, at least according to this article, is that the Fed would remain on hold.
But in aggregate it reinforces the point, which is that the biggest challenge many stock operators face is actually themselves. Whether we call it environmental myopia or short termism, the risk is that we put too much credence in the recent past and project it forward. The classic example of this is probably oil.
While signs were emerging at the start of 2014 of an emerging production glut and strong U.S. dollar environment, very few, if any, prognosticators, predicted a total collapse in global energy prices. But as outlined in the Chart of the Day, this is exactly what happened.
So as we look forward into the stock market year of 2015, this biggest mistake we can make is likely to project the most recent past into the future. So does that mean that utilities are going to crash, oil is going to rally, and the ruble is set to become a safe haven? Likely not, but it does mean that if we all have one resolution in 2015 it is that we should become more aware of our person fallibilities.
As one of Hedgeye’s favorite academics Daniel Kahneman said about short termism:
“If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea. It's the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you'll be miserable.”
Despite the stress of short-term performance that many of you have to endure by the nature of the fund management business, Kahneman is definitely spot on as it relates to the emotional impact of focusing on short-term results in investing. This is the exact emotion, in fact, that causes many investors to sell low and buy high.
On a closing note, we’d like to thank all of your for continuing to support Hedgeye and our efforts to recreate Wall Street research in an accountable and transparent way. It’s been almost seven years since we started the firm and without the support of all of you it wouldn’t have been possible.
Our immediate-term Global Macro Risk Ranges are now :
UST 10yr Yield = 2.10-2.23%
Oil (WTI) 52.96-55.91
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
Takeaway: A rash of estimate cuts has the Street closer to us. But every day we lose more confidence in our numbers.
THE CALL TO ACTION
Street estimates are being lowered but there is no evidence that “the bottom is in”. Relief rally following earnings notwithstanding, significant risks remain and further downside to estimates is likely. As a Macau pure play and with the cheapest valuation, MPEL looks like the best long trade into earnings to benefit from another relief rally. Our Q4 EBITDA estimate exceeds the Street. On the other hand, WYNN may post the biggest miss in Q4 and looks to be the most at risk in 2015 as well.
Please see our detailed note: http://docs.hedgeye.com/HE_Macau_1.13.15.pdf
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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.
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.
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).
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
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