US Research Trip March 2016 Commentary
I have recently returned from my annual investor trip to the USA and what follows are my observations of what is happening in the US and global economies. Like prior years I met with companies operating across Energy, Technology, Industrial, Homebuilding and Consumer related industries. However, unlike prior years I spent more time on the Energy sector than with the others. This is because it is key (along with China) to the deflation scares besetting markets and also has had a severe knock on effect to the industrial complex not just in the US but around the world.
The energy industry has seen a ‘catastrophic meltdown’ lamented large independent company Apache. Drilling contractor Patterson merely said that the industry was ‘hugely challenged’. Basic Energy Services have reduced their workforce from 6,000 to 3,500 over the last 18 months and earlier this year were forced to issue debt at an interest rate exceeding 13% in order to stave off a liquidity crunch. They added that at last local banks were pulling in loans from indebted small companies after ‘giving them a lot of latitude for a long time’. Please note that none of the Energy companies depicted in the table below are expected to be profitable in 2016.
The table below shows the decline in and rig count mentioned by the companies I met:
And so to the good news! Raymond James are the most optimistic they have been on the Energy sector for 10 years. In 2013 when oil was $105 a barrel they said it should be trading at $65. With current prices at $35-$40 they still think it should be closer to $65 despite their acknowledgement that the next couple of months could be ‘crappy’. Nabors, the largest onshore drilling contractor agreed oil should be $65 by year end. They said the next spending cycle will be delayed because the independent oil companies would initially concentrate on debt pay down and balance sheet repair. Basic Energy feared the recovery would be further impacted by a labour shortage given the magnitude of layoffs. They said with the overall economy close to full employment most of the workers leaving the oil industry ‘won’t be back’. They also opined that the stock of fracking equipment was deteriorating rapidly. It has a natural life of about four years but the stacking of the last 12 months “was like leaving your car in the driveway for a year with the bonnet up and expecting to be able to drive off straight way afterwards”. This is because companies have not had enough cash flow to service working rigs and maintain idled ones. Patterson chipped in that several companies were cannibalising their equipment for spare parts thus further reducing the amount of equipment that could quickly come back into use.
Nabors piqued interest by saying both Saudi Arabia and Kuwait had idled rigs in the very recent past and were looking to idle more imminently. This would be the first such moves in a long time from these OPEC stalwarts.
Grainger Industrial Supply, the industrial distribution behemoth, uttered a comment I think could be pertinent across the global economy, not just their segment. Their COO confessed “we had underestimated the positive tailwind from oil and gas in prior years”. They were now facing headwinds from slow industrial growth, a strong dollar, weak commodities and low inflation (i.e. weak pricing). Railroad companies Kansas City Southern and Union Pacific are both expecting volumes and overall pricing to be down in 2016 after a weak 2015 but affirmed that non commodity related pricing has remained in the +4% range. Overall Union Pacific described the current environment as the “perfect storm of falling commodity prices, a strong dollar and a somewhat weaker economy”. Unsurprisingly shale oil related shipments are down by a third. Heavy equipment distributor Wesco described current market conditions as ‘very challenging’ and are another company who see revenue for the year down 0 to 5%. Both January and February have been worse than this. Truck leasing and logistics company Ryder Systems said they expect US truck production to be down this year and the price of second hand trucks have already fallen 20%, a magnitude of decline that is usually associated with recessions.
Gold miner Agnico Eagle is confident that gold production will fall this year and that demand from China and India will hold up well. The CEO said the company began receiving unsolicited calls from investors last August after an absence of two or three years so he is convinced investor perception has changed. Another change is that last year traders were borrowing to sell the gold index. This practise has now ended thus alleviating the downward price pressure for now.
A rare ray of hope came from smaller ticket industrial distributor Fastenal who saw sales climb 3% in January and 2.6% in February after a poor end to last year.
For years now many commentators have been forecasting a peak in corporate margins in the US and that the era of ever improving productivity is over. However, one of the biggest takeaways of the meetings was that US business is not giving up without a fight. Of the twenty nine companies I met with across all the sectors mentioned above, twenty six had formal cost cutting and/or productivity enhancing plans in place. Focus on the bottom line is alive and well in America and it has been augmented in many instances (some forced) by better stewardship of capital.
Home building companies were more optimistic, especially for starter homes and first time buyers (they are not necessarily the same market, so we were told). Affordability is off the lows but still below the 35 year average. Lennar, the most diverse US homebuilder says seven straight years of below trend growth has led to a shortfall in supply of over four million homes in the US. Rising rents and the return of mortgages with only 3% deposit for those with decent credit ratings should ensure that demand stays healthy. Appliance maker Whirlpool affirmed the under-supply of houses thesis and expects to see 5% to 7% growth in housing sales over the next couple of years. With household formations rising slightly after multi-year declines their confidence is emboldened. Indeed the US was the only market where Whirlpool achieved their sales target last year as both Europe and the Emerging Markets disappointed.
For anyone considering buying a new carpet world leader flooring company Mohawk said carpets were on average kept for nine years now versus the long term average of seven!
Homebuilders are examples of companies who are better stewards of capital. National company DR Horton claimed last year that they became the first ever large homebuilder to grow 30% and be cash flow positive. Both Lennar and DR Horton said they were going to slow their land purchases from here after building them up when land was cheaper. This is another example of good capital management. Both commented that only upscale houses in Houston had been hurt by the oil collapse and that the rest of Texas was good. DR Horton believes that the last cycle was unusual in that all US markets moved (down) together and then recovered. The market will return to local idiosyncrasies from here, as is the long term norm. Lennar told us that they were now using digital marketing extensively in order to squeeze concessions from the estate agents. Another sign of the pervasiveness of digital commerce!
Walmart congratulated themselves on having six consecutive quarters of positive same store sales and five of increased traffic in stores. They then went on to say people who only shop at their stores spend an average of $1,400 per annum (p.a.). with them. Those who shop only at Walmart online spend a mere $200 p.a. Those who use both spend an average of $2,600 at Walmart p.a. Walmart and Home Depot each stressed the importance of integrating online and physical retailing. Home Depot called it ‘interconnected retail’ and informed us that whereas a typical store has 35,000 Stock Keeping Units, customers can choose from over 1 million items online. Investors have been worried that Walmart’s online sales had only been growing at 8% p.a. of late compared with growth of 22% for Amazon so digital strategy concerns are at the forefront of investor and management thoughts. Home Depot also coined the phrase ‘Productivity & Efficiency Flywheel’ and epitomised the ongoing quest for financial improvement in Corporate America.
Walmart is a turnaround story and had falling profits as it added $2.7 billion to its wage bill by giving big pay rises to its lowest paid workers and hiring more staff to improve customer service. Now they have completed this programme they are going back to their practice of competing on price and using their superior buying power to undercut competitors. There will therefore be little inflation in 2016 for competitors of the world’s largest retailer.
So what are my conclusions?
With regards to Energy I am convinced the price cannot stay below $40 for long. As Apache said “the world is a very different place with $40 oil than it is with $50 oil”. The sheer scale of capacity destruction described above makes a supply side response (decline) inevitable. Nabors said there has been a further sharp decline in activity in January and February that has yet to show up in the numbers and said investors grossly underestimate the cost and hassle of reversing a declining production function. This is why companies have tried to avoid it for so long. But now most have no choice.
So that brings us on to the industrial side of the economy. There will be a lag of one or two quarters but if commodity prices stabilise then price pressure on industrial goods will abate. This in turn will engender confidence on companies to replenish orders, initially for maintenance products but ultimately capital too. This should lead to at least a small virtuous circle emerging for the industrial sector- not just in the US but globally.
An interesting observation from the conference is that although all the energy presentations had for the first time been relegated to the small side meeting rooms they were still generally well attended. It was the consumer facing companies that in my opinion had significantly lower number of attendees than in prior years. This implies a change in where investors are looking to find opportunity after being so consumer (and domestic) orientated for the last thee years.
I will end on a more optimistic note.
The last observation is that non US investors completely underestimate the zeal for cost cutting and productivity enhancements within American companies. As energy and industrial profits are a bigger part of publicly listed company profits than they are of the overall economy this could lead to pleasant surprises for investors when the downward spiral is reversed. We think we are at most months away from this happening, not years. This is very important as last year I commented that many of the companies I met, particularly domestic orientated ones, had very high valuations. Most share prices are down 20% from their highs (after being down 33%+ in mid February). This means there is more latitude for positive profit surprises to be rewarded (unless the Fed takes the punch bowl away).
Chief Investment Officer
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