All eyes on the Fed today, ahead of the release of the FOMC minutes.
Takeaway: Be very careful out there.
Think first quarter earnings are growing gangbusters? Think again.
Here's the latest from our Macro team in a note sent to subscribers this morning:
"Q1 earnings season kicks-off next week with the bulge bracket banks leading the way (JPM next Wednesday). If you think we’ll follow-up an awful Q4 2015 reporting season (S&P revs -4.0% Earnings -6.9%) with a rebound, think again. We won’t be lapping bad comps until at least Q3 of this year (reported in Q4). In Q1 of 2015, 8/10 sectors saw Y/Y earnings growth, and the one sector with awful earnings was energy, where WTI averaged $48.57 vs. $33.63 in Q1 0f this year. Don’t get excited about Q1 earnings season. It will be more of the same. #thecycle."
While many on Wall Street cheered an expectations-beating sequential uptick in the ISM Services index, one data point does not make a trend. More importantly, the Services index and its individual components continue to trend lower year-over-year.
Here's some brief analysis from our Macro team in a note sent to subscribers earlier this morning:
"While industrial activity has stabilized against 13 months of negative comps, domestic service sector activity continues to slow off its mid-2015 highs. Headline ISM Services along with the Employment and New Orders components improved sequentially in March but the 9-month trend remains one of lower highs and lower lows. On the Labor Front, the trend has been similar as yesterday’s JOLTS data for February showed Job Openings decline by -159K, continuing the 8-month retreat off the mid-2015 peak."
(Notice the peak in July 2015 and the year-over-year slowing in the data)
Stick with the process. Don't get sucked into Wall Street's storytelling.
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Editor's Note: Below is a brief excerpt and chart from today's Early Look written by Hedgeye Director Darius Dale. Click here to learn more.
"... In light of all the above, it’s easy to see why European and Japanese capital markets are imploding. The EuroStoxx 600 Index and TOPIX Index have crashed -20.7% and -25% from their respective 52-week closing price highs. Bank stocks are feeling the brunt of the pain amid NIRP-fueled scrutiny of their business models. Specifically, the EuroStoxx Banks Index has crashed -24.6% YTD, while the TOPIX Banks Index has crashed -22.6% from the BoJ’s 1/29 announcement of NIRP."
“In the Bayesian framework, how much you believe something after you see the evidence depends not just on what the evidence shows, but on how much you believed it to begin with.”
That’s a more thoughtful way of stating the simple fact that preconceived notions matter – especially when it comes to data analysis and subsequent decision-making. In a very important chapter in a book I’ve been studying titled: How Not to Be Wrong: The Power of Mathematical Thinking, the author (Ellenberg) offers a succinct-yet-robust support of Bayesian inference, which itself is a core tenet of our macro research process.
On this specific subject, Ellenberg goes on to say:
“Just as the prior describes your beliefs before you see the evidence, the posterior describes your beliefs afterward.”
With respect to financial markets, one could argue that both the prior and posterior are fairly congruent – in #BeliefSystem terms, that is. Specifically, the belief that monetary easing, in all its increasingly glorious forms, is causal to the nominal growth needed to sustain and support risk asset prices is a very important prior that many investors tacitly assume.
And glorious they are. From ZIRP to NIRP, from QE to QQE, to explicit exchange rate targeting, to my personal favorite: “helicopter money”, central bankers the world over are digging deeper and deeper into their respective policy toolkits – and coming up with “the best acronyms” (Trump joke) – in order to instill one very important belief needed to keep the game going: that you can’t fight city hall.
The posterior – at least in the U.S. and specifically within the equity and credit markets – is that asset prices go up when the Fed eases, which is what Janet Yellen effectively did twice last month (once by communicating negative revisions to the FOMC’s Summary Economic Projections and Dot Plot and again two weeks later via explicitly dovish rhetoric during a lengthy speech at the Economic Club of New York).
Back to the Global Macro Grind…
Actually, no. Let’s pause for a minute to reflect upon the phrase “helicopter money”. I’m guessing most of you aren’t familiar with the hip-hop ensemble Cash Money Millionaires (from which Grammy Award winning artist Lil’ Wayne spawned), so allow me to explain. They effectively rose from the nothingness that is the slums of New Orleans to mega-fame in the early 2000s rapping mostly about money and things you could buy with money. The following is an excerpt from their 1999 hit single, “Bling Bling”:
“It’s the playa’ with the Lex[us] bubble…
Candy coated helicopter with the leather cover”
In the context of former hoodlums rapping about owning helicopters with tacky paint jobs, the phrase “helicopter money” seems a bit ridiculous, doesn’t it? If it doesn’t, now imagine a shirtless B.G. (group member) next to Janet Yellen hanging out the side of a helicopter “making it rain” with crisp twenty dollar bills.
Putting the humor of rap music videos aside, let’s revisit the #BeliefSystem in the U.S. one last time:
In correlation terms, the SPX has a tight inverse correlation of -0.87 with the DXY over the past month vs. a fairly meaningful positive correlation of +0.70 over the trailing 3Y. This new data is important to evaluate in the context of updating the posterior belief highlighted above.
In that light, it is reasonable to conclude that the market has moved back into some version of the reflation-centric regime that prevailed for much of the early part of this economic expansion when monetary easing bore the greatest burden of the three principle components of relative and absolute factor exposure performance (i.e. growth, inflation and policy).
But is it reasonable to conclude that the implied directionality (i.e. dollar down, stocks up) is sustainable? Recall that a core tenet to Bayesian inference is to evaluate all relevant data in the context of prior beliefs and that the underlying prior belief underpinning reflation is that monetary easing can inflate nominal GDP growth irrespective of cyclical and secular headwinds. But how sound is that #BeliefSystem in light of the most recent evidence?
What do these respective central banks have to show for such aggressive monetary easing?
In light of that, I think it’s safe to conclude that “ex-U.S.” the central planning #BeliefSystem has decidedly broken down.
We’ll be discussing what we view as an elevated risk that the #BeliefSystem in the U.S. collapses over the intermediate term as it already has in Europe and Japan on our Q2 Macro Themes Call tomorrow at 11AM EST. Email for access.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.70-1.83% (bearish)
SPX 2020-2077 (bearish)
Nikkei 150 (bearish)
DAX 9 (bearish)
EUR/USD 1.11-1.14 (neutral)
YEN 110.19-112.95 (bullish)
Oil (WTI) 35.09-38.12 (bearish)
Gold 1 (bullish)
Keep your head on a swivel,
Takeaway: P could be a massive long under the right strategy, but remains on our bench until mgmt shifts its priorities (chart series at end of note).
The problem with the ad-supported model is that its growth drivers are effectively double-edged swords. Simply put, there are two drivers to the model: ad-load (aka sell-through) and expanding into Local Radio (price).
The problem with increasing ad load is that has been pushing P’s users away, which there is no denying anymore after down y/y users in 4Q15. We estimate that P has churned through nearly 70% of its accounts since 2011, which can’t be explained away by duplicate accounts (see notes below).
P’s Local Radio expansion allows P to sell higher priced units, but that requires heavily investing in local reps. Note that P’s Sales & Marketing expenses have consistently grown as a percentage of revenue since at least 2011. The problem with the Local Radio push is that its sales reps' benefit wanes after the initial year or two after migrating ad load into the higher-priced local ad unit; in turn, becoming more dependent on ad load to drive growth.
For context, P’s 4Q15 Local Ad Revenue growth of 34% was lower than the rate that it onboarded local reps at any point in the last 5 quarters, which is as far back as we can calculate y/y local sales rep growth. There couldn’t be a scarier omen for the long-term viability of the Local Radio push, regardless of whatever explanation mgmt offers to justify it.
In short, P has already shown us the longer-term limitations of the ad-supported model. We’re not suggesting that P sunset that model, but it would be better served as funnel to an expanded subscription offering that it could create overnight (point 3).
Ticketfly could have some promise, but for now it’s an unprofitable business growing at a slower rate than its core (at least before organic 4Q15 results). By P’s own admission, the long-term opportunity of the business is fairly limited (5-Yr target of $300M); it’s almost not worth paying attention to.
P’s plan to expand into the interactive market (e.g. Spotify) is definitely a promising opportunity. But the longer the negotiations go on, the greater the opportunity cost since it just allows for time for P’s interactive competition to poach those prospective users.
Also remember that any negotiated terms will ultimately serve as precedent to Web V since the interactive agreements have always been used as benchmarks. In short, we suspect the labels are proceeding with caution in striking any deals, and P needs to strike deals with all three to offer an interactive product. That said, there’s no guarantee that P will be able to offer an interactive product by 1Q17.
The only two streaming music products that P is offering today is the ad-supported product and a $5/month all-you-can eat non-interactive subscription, with nothing in between. If P wants to own this space, and more importantly defend its turf, it needs to start offering something in the middle before somebody else does (i.e. tiered non-interactive subscription plans). The reduced Web IV subscription royalty rate and clarity around annual rate increases gives P a lot of options to offer a tiered product that it can throttle by usage.
The big question is demand since we’ve all been conditioned to believe that the user will never pay for music. If we go back to the last time P implemented a listener cap, we can see a clear surge in demand for the subscription product, so we need to consider that availability of the free option is in some part facilitating that dynamic.
We also ran a small survey (n=1000) asking an open-ended question to gauge if there is a market for a tiered non-interactive subscription service. Currently, only 35% would be willing to pay more $1/month to listen to Pandora ad-free, but given the APRU differential b/w those rates and P’s monthly Ad-Supported ARPU, the opportunity would be considerable (see table & scenario analysis below). But even at a $1, there could be an opportunity to introduce an ad-lite product, especially in regions where sell-through (aka ad load) is tougher to achieve.
The other potential obstacle is the 30% “Apple Tax”, but all P really needs to do bypass that tax is to incentive potential subs to register for the service outside of the app (e.g. a discount on its website). For context, P’s subscription commission payments as a % of Subscription revenue averaged only 19% in 2015, so P has been able to work around that tax. As an aside, S&M expense as a % of Ad Revenue (net commissions, direct marketing expenses, & SBE) averaged 26% in 2015.
The other potential risk is cannibalizing existing Pandora One plans via downgrades into lower-tiered plans. Naturally that is a risk, but it wouldn’t take much conversion of P’s Ad-Supported users into a lower-tiered subscription product to offset that risk given the considerable ARPU differential. In the scenario analysis below, we detail the incremental upside to P’s NTM revenues assuming various levels of conversion into a tiered non-interactive subscription product. We’re using very restrictive assumptions, including full cannibalization of its Pandora One user base into a lower tier. We’re also bounding the upper range of conversion based on what Spotify has disclosed for conversion rates into its interactive product. In short, we believe the opportunity is well worth the risk.
But most importantly, offering tiered non-interactive subscription plans would be a defensive strategic move with potential upside. Locking a user into an annual subscription inherently limits attrition, particularly of those would-be interactive subs into a competitor’s current product. And whenever it is that P can actually offer the interactive product, the up-sell becomes that much easier for those users P has conditioned to pay for music through a cheaper subscription plan.
As a reminder, we’re out of the short. We're almost tempted to go long now that sentiment has all but troughed following the CEO departure. But the longer mgmt waits to shift its priorities, the worse P’s prospects will become. Outside of the potential churn and opportunity cost mentioned above, P is heavily levered to a cyclical Advertising industry, including Radio Advertising, which has been in secular decline. Our Macro team suggests we could be moving into a recession this year. If that’s the case, P is the last place we want to be. But if P branches out into low-cost subscription model (today), it could be one of the only accelerating revenue growth stories on the street.
Please see chart series and selected notes below for supporting detail/analysis. Let us know if you have any questions, or would like to discuss further.
P: New Best Idea (Short)
12/22/14 03:56 PM EST
P: User Penetration Survey (N=20,000)
08/28/14 04:12 PM EDT
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