US Research Trip March 2018 Commentary
I have just returned from my ninth USA investment trip and below I will share my key observations with you.
In a nutshell the industrial recession caused by the collapse in energy prices seems to be ending and with it the deflationary environment that accompanied it.
I met with companies in the industrial distribution, technology, distribution, waste management, energy, banking, furniture, house building, railroad and hotel industries and the themes of rebound (or potential thereof) reflation and renewed confidence ran through them all, with the exception of furnishing.
I met with several industrial distributors including Wesco, Fastenal, MSC Industrial and WW Grainger. What is interesting is that even by the end of this year none of the companies will be making much (if any) more in earnings per share than they did in 2015 (2014 in some cases). They all spoke about the severity of the industrial downturn witnessed both in the US and globally over the prior two years and how much it had been caused by the downturn in commodity prices and then commodity related capital expenditure.
Within industrials Grainger broke ranks by saying they had cut prices recently because they were uncompetitive and therefore losing market share in the segment for mid size clients. They also stated that their internet pricing is 15-25% below their list prices (before discounts) and this needs addressing. So this is a company that will see gross margin pressure in 2017 even if the economy improves. They stated December had been a very strong month for volumes but January less so. They are, however, cautiously optimistic on the year as a whole. MSC Industrial have actually enacted some small, targeted price increases of late so are obviously not concerned about Grainger. MSC’s CFO was encouraged by the fact that they have already seen an improvement in their capital goods segment. Although this initially decreases margins, it is a great lead indicator of a general improvement in demand. The new Fastenal CFO said it seemed as if the environment was becoming more inflationary but pricing had not yet played a big part in results. Fastenal will only pass on pricing when higher commodity prices actually hit their Cost of Goods Sold directly. Wesco are actively going after price increases and are employing software analytics to ascertain where to optimally introduce them. Results have been tough of late and although they have seen some signs of recovery they do not yet have enough confidence to change their guidance of industrial revenues being ‘a little either side of flat’ for the year. Wesco are also one of the many companies with an ongoing policy of continual improvement in efficiency.
As Energy is at the epicentre of the industrial economy it was encouraging to note just how much things have turned in the US. Apache’s capital budget is $3.1 billion for this year versus $1.9 billion last year and production will trough in Q2 2017 at 384 Million Barrels Per Day (MBPD) before rising to 455 MBPD by Q4. This is against a Q4 2016 run rate of 421 MBPD, so year over year growth in production returns (with the attendant increase in employment and operating expenditure on sand, water, equipment etc). Pioneer Natural Resources will grow production 15-18% this year and are prepared to spend $2.8 billion on cap ex despite cash flow only being $2.25 billion. They are very optimistic on their own future as they claim to have the best balance sheet in the industry. At $55 oil they hope to be cash flow break even in 2018. Pioneer expect the industry to incur 10-15 % cost inflation this year but expect to contain their own at 5% due to vertical integration benefits.
Nabors, a leading drilling company, have 12,000 employees now versus 22,000 in November 2014! Nabors expect ‘plenty of price traction’ in the latter half of the year in the US as the rig count is already 98% above the trough. To put their efficiency gains in context, Nabors expect in future to achieve peak EBITDA with only two thirds of the prior US rig count and two thirds of prior gross margins. This quarter US margins will trough at $4,000 per day versus $10,000 at the peak. For the whole year $6,000 margins are expected so the rebound is large.
I met with management of the two leading waste management companies. Republic Services are now seeing ‘very strong pricing on the open market’. This is after several years of ‘CPI and commodity headwinds’. The Waste Management Inc CEO simply said “pricing has one direction and that is up”. He is relieved at the moment that his company is enjoying 1.2% volume increases accompanied by 2% price gains and says the environment is a lot different from the prior one of volume contractions.
Electronic distributor Avnet’s new CEO proclaimed the company had changed more in the last seven months than it had in the last ten years (partly due to acquiring the UK’s Premier Farnell whilst divesting another large division and partly due to his other initiatives). He added that they are ‘seeing good optimism right now’ with lead times extending and the book to bill ratio rising. One development that bears close watching though is that two large semiconductor companies, namely Texas Instruments and Analog Devices, have started to market direct to customers in some areas rather than use distributors. If this is the start of a trend it will meaningfully harm the whole industry. Avnet’s biggest competitor Arrow, commented that ‘2017 appears to be a strong operating environment’.
Railroads and truckers are very good barometers of the economy in that they move goods that are being made and bought within the economy. Quite simply the industry has been struggling of late with commodities shipments and intermodal (where rails and trucks are used to complete a shipment) suffering fallout from the energy complex malaise and knock on effect on industrials.
Trucker JB Hunt complained that capacity has not left the industry in the way it has in prior downturns and this has further depressed pricing. Another trend affecting trucking is that large retailers are being impacted by the increased penetration of online shopping. This is affecting the way goods are being shipped i.e. more small parcels direct to consumers as opposed to large containers to warehouses.
Railroad Union Pacific expects Q1 to remain tough but to then improve assuming the economy gathers steam. They are already attaining 2% pricing ex commodities and intermodal are hoping overall pricing will be up above inflation this year. They estimate rail inflation will be 3% in 2017. Management also expect volume to be up slightly for the year as a whole despite being flat in Q1. This compares to a volume drop of 7% last year. Fellow railroad Kansas City Southern just experienced their first growth in seven quarters despite sharing the problems of poor intermodal and excess trucking capacity. They agree with UNP that pricing should exceed inflation in 2017 and reiterated that what they had lacked of late was volume but it now looks as if it is back. Trade with Mexico is a key part of the railroad story. KSU’s CFO said that since NAFTA was signed in 1994 USMexico trade had increased 400% and that the average US family had $10,000 more spending power because of it. He added that Mexico is in the process of opening up her energy markets and that US product was beginning to flow there. He opined this would be the best way for the US to reduce her trade deficit. This CFO was just one of several who said they just did not believe any US government would do anything to hurt trade. Others said they hoped any bad news on trade would be offset by lower taxes, so management are definitely taking a sanguine view of political change.
House builders continue to feel optimistic about demand given that the number of new homes being built is still 15% below the sixty year average – the 8th year in a row it has been below. Both the companies I saw were of the view pent up demand still existed and that with continued employment gains and rising wages the future looked bright. Clouds on the horizon include rising interest rates but Toll Brothers said demand has risen 22% despite the interest rate on a thirty year fixed mortgage having risen fifty basis points to 4.25%.The Pulte Home CFO added that whilst the rate hikes have affected affordability they have not yet affected demand. He did postulate that consumers were not spending as much on furniture and fittings post rate increases but still buying the homes. However both agree they rely on Mexican workers and that wages for skilled labour are already increasing at a 5% clip, so the US government had better be very careful about this policy or a key industry could be severely affected. Lawn and golf care company Toro also mentioned the negative impact that restrictive immigration policies would have on their customers.
Plumbing and windows company Masco, furniture and bedding company Legget & Platt and upholsterer La-ZBoy all agreed that housing turnover, house price increases, wage growth, improving consumer confidence and age of housing stock should all have helped their industry last year. Problem was that they did not. Each company had tough times re sales although Leggett & Platt did say that since September ‘we have moved from a deflationary to an inflationary environment and thus have announced a price increase’. Their CEO also said Europe was coming back and indeed had a strong 2016. La-Z-Boy made the point that although almost all their manufacturing takes place in the US, they import most of their component parts as they cannot source them domestically. Their CEO definitely wants clarity on President Trump’s Border Adjustment Tax!
The two hotel companies I met with are both feeling confident: lower end La Quinta because the oil rebound helps consumer confidence in their South West footprint and because attendant business users are making more stopovers as oil activity picks up. The CEO proffered that hotels in general had experienced a ‘Trump Bump’ but that there was still considerable uncertainty as to actual policy outcomes. Hilton consider themselves to have the best portfolio of hotel brands globally and state that their occupancy rates at the moment ‘are the highest ever and by several hundred basis points’. Their CEO played down the importance of price increases but observed prices were running up 1-3% at the moment.
Both the banks I met were too small to infer nationally from but both are in the process of integrating acquisitions which have increased their size significantly. One has already agreed terms on another large deal whilst the other is actively talking to other target companies. Confidence is therefore high about the outlook.
I listened to a panel of RJIS bank analysts discuss the sector and they concluded that the 32% rally in US Bank shares witnessed since the election was merited. This is based on the fact that domestic US banks will be the biggest beneficiaries of any reduction in headline tax rates (assuming relief of debt interest is not changed for banks) whilst their customers will be less likely to default if they experience an increase in after tax cash flow. Apropos the two banks discussed above the analysts reminded us that there are still 6,000 banking companies in the US and that acquisition activity would likely accelerate after a slow 2016. They also expected Net Interest Margins to pick up meaningfully in 2018 as the policies of the new administration kicked in. The analysts are aware the valuations of bank stocks are already three to three and a half PE points above their long term average in absolute terms but argued that against the overall market they were average. Their optimism thus rested on the fact they expected profit estimates for the sector to be revised upward more quickly than the overall index.
They also noted that their analysis is that there will be a slowdown in regulatory creep for banks but it is unlikely we will see an actual reduction in regulation.
So in conclusion confidence is up and the main reason for that is the rebound in both energy prices and energy related activity in the US (the US is now the marginal producer of incremental oil as shale can be profitable at lower prices than big non US fields ex the Middle East).
US consumer and business confidence have been given a further boost since the election as promises of lower taxes, less regulation and more infrastructure spending have been gratefully received. What bears watching is that none of the companies I met with can accept they will be a loser on a net basis – not even the ones dependent on Mexican trade, Mexican labour or on imported goods. Several believed themselves to be net winners. There is likely to be a more even spread of winners and losers as the details are announced this bears close watching.
I concluded last year’s trip notes by saying that we were at the most months away from the downward spiral of energy and industrial markets being reversed and that this was important as such profits make up a bigger part of S&P earnings than they do the overall economy. I then added that most stocks had fallen 20% from when I met them in 2015 (after being 30%+ down in mid February) so positive profit revisions were likely to be rewarded.
My only caveat was that they Fed might spoil the party. They didn’t – they only raised rates 25 basis points and waited until December to do so. This was at the low end of expectations.
This is why we significantly increased our US weighting last year i.e. Valuations and expectations had fallen just as things were about to improve. This is a near perfect scenario for us.
However, the S&P 500 has returned over 20% in dollars (over 40% for sterling investors) since my trip last year and analysts are much more confident now than they were a year ago. The threat of the Fed is, if anything, more potent now than then.
So although the US has some short term momentum which should last at least through the summer, gains from here are going to be harder fought for than in the last twelve months and I will be looking to top slice on any further exuberance. This will be a gradual process as momentum markets almost always rise further than expected with the final moves often being considerable in magnitude.
Chief Investment Officer
14th March 2017
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