Apologies Signor Draghi, but try as you may, you can't stop economic gravity.
Hedgeye CEO Keith McCullough appeared on Fox Business’ “Opening Bell with Maria Bartiromo” this morning to weigh in on the growing bubble in technology stocks like Alibaba (BABA).
Takeaway: Longer-term trends, the current position in the business cycle, and the outlook for the U.S. Dollar all line-up for more downside risk.
There is one thing we can be sure of with regards to long-term commodity prices over the long run:
They will continue to go up and down, falling just as far as they rose in real-terms, from cycle to cycle.
In the shorter run, which is where we all make our tactical investing returns, we think there are two key reasons commodity prices, especially in the raw material and metals space, could move lower from here:
1) The Hedgeye macro view is that the U.S. dollar, WHICH HAS ALWAYS LED THE BIG TURNS IN CYCLES ACROSS DURATIONS, looks like it will continue to strengthen over the intermediate to longer-term even if we briefly transition from QUAD 4 to QUAD 1 and back again; and
2) There is a cap-ex cycle in the commodities space which lasts longer than the normal business cycle on average, and we are now on the back-end of BOTH cycles.
The table below is separated into 6 periods of large inflections in dollar and inflation adjusted growth, spanning across 8 business cycles. In this period of time we’ve experienced 2 longer resources-related capital investment cycles (back-end of the 2nd currently):
1. 1970s inflation (Bretton Woods)
2. Early 1980s recession and contractionary policy
3. Mid-1980s-mid-1990s expansion
4. Clinton – tight policy, strong dollar deleveraging
5. Greenspan de-regulation, low interest rate era (post tech-bubble through 08’ and still currently a part of the commodities bubble)
6. Great recession-to-present (commodity prices down from 2010 bubble but still room to run)
There is a clear pattern that emerges, which seems to be very similar to our current cycle:
USD/Growth Inflection --> inflection in metals (early cycle materials) --> inflection in Ags. And Energy (consumer-based)
Clearly, as the dollar goes, so too goes the price of many key commodities. Not to view the dollar as the only factor to consider, but certainly getting the direction of the USD right will enable us to get the price direction of many of these commodities right.
The existence of “super-cycles” as some call it, are longer than business cycles because of the capital intensive nature of bringing product online.
We thought the following quote from Otaviano Canuto of the World Bank was a good description of the normal chain of events:
“Reports on previous cycles and price volatility have been more convergent. These works tend to agree on the localization of at least three super-cycles of commodities since the 19th century, as well as one initiated at the end of the 1990s. Typically 20-year boom periods have reflected strong demand associated with moments of rapid industrialisation and urbanisation – as in the case of the US in the 1890s, or China in the 2000s – in which supply takes a long while before matching that demand. When this happens, periods of much lower commodity prices follow.”
Now that iron ore capacity has matched that demand, we have observed the end result several years after the demand picture turns sour. In other resource-heavy areas, this downside is just beginning.
Simply put, the amount of time elapsed between making an investment decision (capital spent), bringing production online, and getting those top-line revenue streams often spans over multiple business cycles. Supply does in fact take longer to match the demand and investment decisions tend to be made at times when the spread between the cash cost of production and per/unit selling price are the widest (that NPV picture looks most attractive).
Look no further than this current cap-ex cycle. Investments that were made before the Great Recession are just now being finished:
Mid-cycle commodity bubble investment decisions --> Great Recession --> investment goes on through the next cycle to the 2010 bubble highs and beyond --> the over-investment is now unraveling in some areas, (iron ore and copper) with others to follow
The aftermath will bring more pain:
- How much further can the Fed lower interest rates to “fight deflation”? Rates are already near zero yet we are in a deflationary environment and the dollar is getting stronger (we believe it will get even stronger). Can the Fed out-Ease the BOJ and ECB? Nevermind lowering rates. The question consensus is asking is WHEN will a rate HIKE occur? Could a surprise "kicking-of-the-can" crush the dollar? Probably not for any more than a short-term correction.
- Projects that were implemented at the commodity bubble highs circa 2006-10 are still being brought online. Just look at the fertilizer space (which is a monopolized industry in some products)
Like iron ore and copper, fertilizer is a mature industry that pivots on a number of very accessible and very abundant resources, and the demand for fertilizer (both nitrogen, phosphate, and potash-based) has followed a slow and steady climb for a long period of time. Given this dynamic, the above table tells the picture of “supply coming late” to meet demand. However the question we would ask is:
Were low-interest policies inflating commodities prices circa Greenspan deregulation (selling vs. cash cost) or was there as long period of under-investment lagging a demand increase for some of the most abundant resources on earth?
There is quite a bit of evidence for the former...
The charts re-purposed below, and sourced from the World Bank and OECD, also provide support for the existence of this longer-cycle with the previous two evidenced in the tables above.
Pulling back the magnifying glass gives a peek at where we are in the longer cycle. There are a few key takeaways we would like to point out:
1) Commodity prices go down over the long-term driven by a surplus of investment in inflationary periods (Oil is the only commodity that has appreciated in real-terms over the long-term)
2) Not surprisingly the metals (early-cycle materials specifically) segment tracks global GDP pretty closely
A risk management strategy molded by predicting how long the current cycles will last is not something we subscribe to, but we acknowledge that longer cap-ex cycles do exist in the industrials, materials, and mining space and they take longer to manifest than a business cycle.
Considering we’re on the back-end of both of these longer-term cycles, we remain bearish on the space in a QUAD 4 set-up where both growth and inflation are decelerating. The fundamental matches our bearish quantitative view which is what we want to see for picking good shorts in the commodity and commodity related space.
We have been in and out of copper on the short-side over the last couple of weeks (ETF: JJC) in Real-Time Alerts and continue to expect downside in the commodities complex over the intermediate to longer-term.
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Consistent with our short thesis, MCD gave an uneventful presentation this morning at the UBS Global Consumer Conference. Despite the stock being bid up since the announcement of former CEO Don Thompson’s retirement, there has been little incremental news suggesting radical change. With the stock well ahead of the fundamentals, we think it offers an attractive short-term trading opportunity. MCD is currently trading at a seven-year peak multiple of 20x P/E, despite the numerous challenges the business continues to face across the globe.
While we do understand the hype, we believe it is misplaced. We don’t see any near-term catalysts on the horizon; a belief that, in our view, was validated during today’s conference by the following:
- MCD continues to face challenges in important markets, such as the US, France, Russia, China, and Japan
- MCD will take a while to turn around and results will remain volatile
- MCD still has an image problem
- MCD will continue to expand the Create Your Taste platform
- MCD is facing a lot of pressure to raise wages
- MCD is playing “catch up” on the technology front (digital, mobile, loyalty, etc.)
- MCD’s owner operators are still struggling
- MCD is unlikely to increase its leverage
- MCD is unlikely to pursue an “OpCo-PropCo” split (at least in the near-term)
The business is facing too many headwinds for the stock to be trading at such a premium multiple. Given the lack of major news flow we see coming out of McDonald’s in the near-term, we believe the stock is ripe for a trade on the short side. Considering high expectations, those hoping for a major strategic announcement are likely to be disappointed.
03/02/15 03:06 PM EST
MCD: LONG ROAD AHEAD
We’re confident MCD will return to being a great company one day. But right now, it’s too early to call that turn – there’s a significant amount of work to do. More important, it’s yet to be determined if the new CEO is willing to make the difficult decisions necessary to move forward.
With that being said, we are adding MCD to our Investment Ideas list as a short.
MCD has risen ~11% since Steve Easterbrook was named the new CEO on January 28th, 2015. This week, he’ll be communicating his vision for the future of MCD at the “Turnaround Summit” in Las Vegas. Importantly, Mr. Easterbrook has only had ~32 days to circle the wagons and come up with a plan that will convey change and layout a vision for the future.
We suspect we won’t see the radical changes needed to set MCD on a better path anytime soon and, as a result, believe the stock is way ahead of itself.
Below is a laundry list of issues, or questions, the company is facing:
- The Board, similar to the menu, needs to be overhauled.
- Franchisees are clearly disgruntled – will they support the new CEO?
- Over the past 10 years, MCD has systematically and regularly added costs to the franchisees’ P&L without considering the long-term impact of these costs. These expenses are over and above rising wage rates, beef inflation, etc.
- Wage inflation for MCD and all quick service peers will accelerate for at least the next two years.
- MCD has the highest AUVs in the quick service space – why do they have issues with franchisee profitability?
- MCD could sell company-owned stores, but will it have an impact on profitability? Will they actually do it? Should they be closing stores instead?
- MCD has an image problem.
- MCD’s direct competitors (both traditional quick service and new fast casual upstarts) are well managed, well capitalized, and growing.
Recent action in the market appears to be signaling high expectations for the MCD “Turnaround Summit” in Las Vegas this week. We suspect the news flow exiting this event will be lacking the detail needed to support the current move in the stock.
In our view, the news needed to support the stock move would be:
- Leveraging the balance sheet to recapitalize the company.
- Intent to significantly selloff a significant number of company-operated stores.
- A new product silver bullet.
- A significant cut in G&A and downsizing of the home office.
We don’t think any of these are a real possibility in the coming weeks. Instead, we believe we’re likely to hear something closer to the following:
- A revamping of McCafe – exiting the business of selling espressos.
- Ending the Create Your Taste test.
- Slowing unit growth – which has already been announced.
The real issues the company needs to address will likely not be addressed anytime soon:
Board of Directors
For the most part, MCD’s board has served the company well, but significant change is long overdue. Andy McKenna, the current executive chairman, is 84 years old. While Mr. McKenna has served the company very well over the years, it is time for him to pass the torch to the next generation. Once the board is reconfigured with new thinking, it then must decide what the McDonald’s brand represents to consumers – and aggressively go after it.
As soon as MCD begun feeling pressure from SBUX, the brand has lost its focus and evolved into trying to be all things to all people. Therefore, many of MCD’s wounds today were self-inflicted and, in fact, many are reminiscent of the issues the company faced 10 years. How did this board let history repeat itself?
McDonald’s Image Problem
The perception of the McDonald’s brand is worse now than ever before. This perception cannot be fixed quickly and will likely be very expensive. The question some are asking is: is MCD to fast food what IBM is to technology? For the past five to six years, there has been no clear direction coming from the executive suite, leaving the business in a hole that will be very costly to dig out of.
The biggest “public perception” problem the brand faces has been from over-indexing the brand on discounting and selling cheap fast food. The $1 menu has been very destructive to the company and will be difficult to change. This suggests the company may need to put part of its past behind it. Does MCD need to move on from the Ray Kroc era of selling cheap food fast?
The owner operators are the key to a potential McDonald’s turnaround. Currently, a majority of owner operators are in a difficult position thanks in large part to increased debt levels. It’s clear to use that when the owner operators are making money and growing their business, shareholders are rewarded. Owner operators are struggling mightily in the current environment; morale is at historically low levels as increased rent, wages, etc. are increasingly difficult to pay.
Higher wages, which are inevitable, will only erode franchisee profitability. Ironically, at the same time, it will benefit McDonald’s profitability, since franchisees will be forced to raise prices. But franchisees must be very prudent with their price increases, because a significant percentage of McDonald’s employees are value conscious and will adjust their spending patterns accordingly. Owner operators are the best brand ambassadors and their lack of enthusiasm will make a turnaround very difficult to achieve.
Takeaway: There have been 36k announced layoffs in the energy sector in the last two months. That works out to ~5% of energy employment (780k).
This week we take a look at the Challenger job cut announcements for the Energy sector and for non-Energy (i.e. the rest of economy).
Job cut announcements in energy in January and February surged, rising to 20k and 16k, respectively, up from a run rate of 0-3k/month. While this is an enormous jump for energy layoffs, the rest of the economy seems to be doing okay.
Energy jobs account for around 60 bps of employment nationally and slightly more than that (~1%) when weighted for their higher average earnings. An offset, however, is that lower energy prices are marginally benefiting every family in America that drives a car. Once again, concentrated harm meets diffuse benefit.
Here's some context for Energy's role in the broader labor market:
Oil Sector Employment: The BLS catalogues oil & gas related employment within four major subsectors: Oil and Gas Extraction, Oil & Gas Pipeline Construction, Support Activities for Oil & Gas Operation and Mining/Oil/Gas field Machinery.
- Share of Total: Collectively, BLS estimates these industries employed 780K people as of November 2014. Relative to Total Nonfarm employment of 140MM, those most directly employed in Oil and Gas extraction represent 0.6% of the NFP labor force.
- Growth From Trough: Relative to the NFP employment trough in February 2010, Oil and Gas related employment is up +274K – a remarkable 54%. This compares to growth of +8.1% for total NFP employment over the same period. Further, Oil related employment gains represent 2.6% of the total increase in employment since trough (274K of 10.4MM total increase in employment) – certainly an outsized contribution relative to its share of total employment.
At just 60 bps of Nonfarm employment, even if the oil and gas sector were cut in half (along the lines of what's happened to the price of oil), it would only have modest repurcussions on the labor force at the national level (~30 bps). That said, energy jobs tend to pay better than non-energy jobs. For instance, the Oil & Gas Extraction sector, according to the BLS, pays an average of $40.59/hour. This compares with $24.57 for the average private sector job, a premium of 65%. In other words, every energy job equates to roughly 1 and 2/3 non-energy jobs from an income-weighted standpoint.
Taking a look at state-by-state announced layoffs, Texas tops the charts at 42.5k YTD. For context, there have been 103k announced layoffs YTD nationally, so Texas accounts for 41% of those, whereas Texas only accounts for 8.5% of the US population. Even so, Texas' total nonfarm employment is 11.8 million, so 42.5k / 11.8mn = 36 bps. While 36 bps isn't enough to get excited about, if this rate of layoffs continues for several more months then Texas will begin to have an employment problem.
Turning to initial jobless claims, last week was another week of slowing improvement in the labor market. Year-over-year change in NSA claims decelerated to -9.2% from -12.1%. Meanwhile, rolling SA claims rose from 295k to 305k.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
Hedgeye Internet & Media analyst Hesham Shaaban will be hosting a special call outlining our SHORT thesis on Alibaba Group Holdings (BABA) today at 1pm ET. Since our last call on BABA, we saw validation of the core tenets of our thesis within its last earnings release, as well the emergence of a new trend, which will compound pressure across its model.
Ping email@example.com for access.
In case you missed it, here's a complimentary look at some of Shaaban's research we unlocked earlier this week.
In addition, CNNMoney's Paul La Monica picked up on our short BABA thesis and wrote about it here.
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