US Research Trip March 2019 Commentary
I attended the 2019 RJIS Investment Conference in Florida during the first week of March. Whilst there I met the management (mostly CFO’s) of twenty seven companies spanning the house building, retail, railroads, industrial manufacturing, consumer goods, technology distribution and energy industries.
The takeaway themes are that inflation really hurt the profitability of many industrial and distribution companies last year as they were constantly playing catch up with their own pricing. Secondly, tariffs played a big role in both pricing and volume last year and ten companies specifically mentioned their negative impact. Somewhat ironically a handful of companies admitted they had already included full tariff imposition in their 2019 sales and margin guidance and if tariffs ended up going away then revenue and perhaps even profit estimates would need to be guided downward as they would need to roll back scheduled price increases. This was a surprise to me.
More colour was also put on the housing slowdown with Toll Brothers explaining that mortgage rates had increased from a low of 3.5% to over 5%. They added that they have subsequently fallen to below 4.5% and early signs of stabilisation have appeared. Pulte Home more or less concurred with Toll and said that an 80 basis point mortgage rate increase over a six month period hurt demand even though the rates in absolute terms are still low (what I would have done for a 30 year fixed mortgage at 4.5% – 5% when I was in my 20s and 30s!). Pulte added that rate sensitivity is high at the moment as house price appreciation had significantly exceeded wage growth for several years in a row until last year. Both companies viewed this as a pause that refreshes rather than the start of a collapse. The reasons for this are firstly new home starts and sales have persistently remained well below the long term trend since 2009 and secondly the US housing stock is now 40 years old versus 22 years in the 1980s, so needs replacing (I hope my house lasts more than 40 years). Pulte added that demographics, job creation and wage growth were all still positive. In fact, in construction there is a shortage of workers with choices of millennials and immigration policy both hurting. Indeed the company want to try and move to a system whereby more pieces are put together in a factory by robots thus reducing reliance on labour.
Housing related manufacturing companies such as Mohawk (flooring), Masco (faucets, kitchens and bathrooms) and Whirlpool (washing machines etc.) were hit by a confluence of negative factors last year. A strong dollar, rampant cost inflation and weakening demand all pressured results. Mohawk complained that cost inflation cost them $250 million last year and contributed to the end of their streak of five consecutive years of record EPS. However, management optimistically forecast that results will improve sequentially every quarter in 2019.
Whirlpool were also bemoaning cost pressures, lamenting that 2.5 years of productivity gains had been lost due to $700 million of raw material inflation and Europe failing to hit target (they aggressively raised prices in Europe but no competitors followed so volume fell meaningfully – it has rebounded 5% year to date). Whirlpool only expect US volumes to be up 1% maximum in 2019 and are one of the companies who may need to pare pricing should further tariffs be shelved. Masco also put a brave face on 2019, expecting 3%-5% revenue growth with similar margins to 2018. They premise this on the US consumer being in good shape from each of a balance sheet, wage growth and job security perspective. They were another who added price increases would be pared back upon a tariff truce.
Stanley Black & Decker also blamed commodity inflation, currency and tariffs for a weaker end to 2018, highlighting both housing and autos slowed in the second half. However, they added that overall business has now stabilised with housing even improving a little. They expect autos to be down a touch in 2019 but overall business to be up low single digit. They are positioned for slow growth but not recession as their indicators are not currently pointing to recession.
Railroads are another industry that is seeing cost pressure but also a decent pricing environment, which is bolstered by firm pricing in trucking due in no small part to the ongoing shortage of drivers. Indeed leading truck company JB Hunt confirmed the inflation issues of 2018 are continuing into this year. They added that pricing would be very positive in 2019 (up mid single digit) after an “unbelievable 2018”.
On demand management commented that retail customers are expecting a big year but other sectors (unspecified) not so.
Union Pacific Railroad expected wage inflation of 2.5% this year but overall cost increases to be contained at 2%. At least in dollar terms they expected positive pricing to more than offset higher costs. Unlike peers they said the very strong truck pricing may be waning a little but rails have not had the strength enjoyed by truckers. They put the slight fall in auto sales at 2% for the year but expected overall US industrial production to be strong.
Home Depot and Walmart embodied JB Hunt’s assertion that retailers were upbeat about the coming year. Home Depot remain confident they can hit a 5% same store sales gain, split evenly between volume and price. Last year’s gain was more skewed by price increases. They predicated this on low single digit house price increases, housing turnover falling slightly to 3.8%, a continuation in the belated pickup in household formation and the ageing of the housing stock, as mentioned above. Indeed management optimistically expect overall US GDP to advance 2.6% and add that the severe lumber inflation has now reversed.
Walmart are settling for a 2.5% to 3.5% same store sale advance in their US stores, framing it by saying they have enjoyed 2.5% volume increases per store in each of the last two years. Management made clear they would always invest in price as they want to be the price leader. On tariffs they said prices have been affected but not by much – freight inflation was more of an issue.
Leading auto parts retailer Autozone had a different slant on inflation. They said they had experienced circa 2% inflation for each of the past fifteen years and were not seeing much change. Wage pressure did spike but has now levelled off. The CFO said he had answered lots of questions on recession probability from investors of late but merely commented that traditionally they perform well in such conditions. The company is a poster child for share buybacks. Over 20 years they have reduced shares outstanding from over 120 million to only 24 million today. It is in no small part due to such actions that sales increases of under 2% can be turned into earnings per share growth of over 10%!
Hilton Hotels had an interesting aside. When they entered the Indian market Hilton was the established number one brand recognition in the country – despite the fact they had no hotels there! More currently they confirmed the economic slowdown in China but remained confident that the ongoing rise of the middle class would create good growth for branded hotels. In the US they guided down revenue per available room to 1-2% from 2-4% in the year ahead whilst wage pressures should remain in the 3-4% range.
Furniture maker Ethan Allen said China had softened in the last seven months on the economy and “unfounded concerns on tariffs”. Back home margins had been hit by a competitor teetering on bankruptcy and, perhaps relatedly, internet companies selling online at a loss. Troubled consumer goods company Spectrum Brands said both that incremental tariffs would cost them $9 million per month but they could fully recover via price increases and that they would delay scheduled price increases if tariffs stayed as they are.
Technology distribution behemoths CDW, Avnet and Arrow agreed that almost all the slowdown in Asia has been caused by tariffs and that a sharp snap back will occur in China once clarity emerges. Arrow said the fact that order cancellation rates remained low backed up this theory and that orders have picked up of late. Both the US and Europe have seen positive trends throughout (i.e. Book to Bill above 1). From an industry perspective Arrow management shared that 40% of all semiconductors consumed were from the top ten customers but most of the growth came from the other 60%. This would jive with CDW policy of adding 60-70 new suppliers every year but many of them ended up being bought by the big Original Equipment Manufactures (OEMs).
Despite the fact that three of their four divisions (Industrial, Construction and Utilities) meaningfully slowed in the second half of 2018 industrial disruption company Wesco remain upbeat about the prospects for both public and private capital projects in the US and predict growth of 2-5% this year. Another positive contributor to the US story is previously offshore business being brought back onshore. However, International is expected to fall mid to high single digits. Management reminded the audience that they did not return to growth until Q3 2017 post the industrial downturn which began in early 2015. Across the spectrum of industrial products inflation was an issue last year and Wesco was no exception, highlighting that their suppliers had enacted two and a half times the number of price increases last year as they had in 2017. They noted that commodity prices have moderated but they expected inflation to continue.
MSC Industrial lamented on worsening shortage of manufacturing workers in the US amidst a metalworking recovery that had been consistently strong since the end of the industrial/manufacturing recession they timed at November 2016. Management informed us they had over ordered ahead of tariffs in the last few months so they will under order for a period and that they had enacted price increases of 2-3% in February. However, they stressed all their price actions are a function of what their suppliers are doing. Fastenal are another industrial supply company who have routinely grown double digits since the industrial rebound began. For them it was June 2017. They said “only oil and gas is shaky right now”. Unusually the CFO said the onset of tariffs did not affect demand so he saw no impact from any cessation. He added they have already told clients about price increases and enacted the first round in January. They will roll them back three months after tariffs end. He added the company struggled with negative price – cost variance last year as price increases kept accelerating with the number of increases in Q4 two and a half times the Q1 rate. He did admit they had to give more and quicker information to field staff so they could react to price changes in a more timely manner.
The sharp fall in oil prices in Q4 brought the typical reaction of capital expenditure and cost cuts e.g. Nabors are taking another 10% out of SGA as they want to be able to generate $600 million of free cash flow over the next three years at an oil price of $50. RJIS estimate US Exploration and Production capital expenditure has fallen 10% with Services companies cutting theirs by 25% since the recent peak.
National Oilwell Varco further demonstrated the extent of the retrenchment by reminding us that when they had peak EPS their revenue was c$22 billion versus c$9 billion now. However, a combination of cost cutting, productivity enhancements and twenty two acquisitions made during the downturn means that only $16 billion in revenue will enable them to beat the EPS they managed with $22 billion.
So what conclusions should I draw from my trip?
Firstly, it is that although tariffs may not have had much of an impact on the US economy they did significantly affect the technology, manufacturing and industrial sectors which are a much bigger part of the stock market. Company behaviour was impacted and clear indications were given that pricing and ordering behaviour will be stopped or reversed should tariffs not be escalated further.
Secondly, the Chinese economy has slowed and tariffs have played a big part in this with regard to the technology sector. Again US companies expected a sharp snap back should trade tensions ease.
Thirdly, commodity and wage inflation affected many companies last year in a way not seen in ten years. However, as is normal in the US, most managements are responding with renewed cost cutting and productivity efforts.
Fourthly, with regards to domestic demand it is mostly the energy, auto and housing sectors that have experienced a slowdown thus far and the latter is seeing early signs of stabilisation in what all managements agreed was a temporary stall.
So I think the slowdown many, including myself, were expecting to occur in the US has already begun and whilst price increases will continue in the first half of the year it is very likely raw material related ones at least will tail off in the latter part of the year. Companies in general are prepared for slower growth (ex the retailers) but not a recession. The semiconductor slowdown has already lasted longer than some thought after saying only last year that future downturns would be less severe than prior ones due to consolidation and the march of the digital economy!
China is likely to come back later in the year as the tariff situation improves (as most managements think it will) and the measured policy easing kicks in.
Finally as a U.K. citizen it was a welcome relief not hear the dreaded ‘B’ word mentioned once. This week will probably make up for that I imagine.
Chief Investment Officer
12th March 2019
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