The Bottom-Up Economist Q4 2018 – ValueWalk Premium
economy Monetary Policy

The Bottom-Up Economist Q4 2018

In my December post, “Are All Bets Off?”, I wrote, “To what extent has the decline in equity markets influenced economic activity and corporate profits?” To answer this question, I noted I needed more information from the frontlines of business. Fortunately, that’s exactly what we received during Q4’s earnings season – a very thorough and informative update of the current economic and profit cycle.

Q4 hedge fund letters, conference, scoops etc

economy Monetary Policy

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As I made it through last quarter’s earnings reports and calls, it became clear to me that the Q4 operating environment was less consistent than the first three quarters of 2018. Based on my bottom-up analysis, the majority of business and industry results were trending higher throughout most of 2018. However, in Q4 2018, the dispersion in operating results and trends appears to have increased. For example, during my Q4 review, I’d read one conference call and results and outlooks were strong:

Packaging Corporation of America (PKG): January started out very strong. Through the first 18 days, we’re up 5.3%. Bookings continue to look strong going into February. So we’re very pleased with the start of the year.

And then I’d read another conference call and results and outlooks were slowing:

Matthew International (MATW): One area of particular concern for us is our traditional product identification and consumables business, historically known as our marking products. Traditionally,order rates in this segment have been the proverbial canary in a coalmine for upcoming slowing economic activity as a whole. Our orders have slowed for both our traditional printer products and the inks that they consume. So we’re cautious about the cadence of that business as we progress through the year.

In my opinion, the sudden and sharp decline in the financial markets in Q4 contributed to the growing inconsistency of corporate operating results. Several companies indicated they experienced a decline in demand as the markets fell. However, given the short duration of the decline, the negative effects may have been temporary and in some cases have reversed (along with asset prices):

Ethan Allen Interiors (ETH): We were doing extremely well to the middle of December, and then all of a sudden, with the issue of a number of factors, the stock markets were down substantially, the government shutdown, the tariffs — you could — we could see it that customers really held back in the last — and most of our — this change took place in the last 2 weeks of December. And as we said in our press release, the good news is that in January, people started coming back. And we’ve had sequential increases in traffic in our design centers so far in January.

Simpson Manufacturing (SSD):  We believe demand may have been impacted by uncertainty in regards to economic factors given the extreme market volatility and decline experienced in December.

So we had a December that was pretty low on a volume standpoint, as we’ve mentioned. We’ve seen it come back in January not only from just the price increase, but also, we have seen organic volume growth in January.

Sherwin Williams (SHW): In this case, the improving cadence of our business late in the fourth quarter was encouraging, and January has given us a solid start to the first quarter.

Monro Inc. (MNRO): …the softness we experienced around the holiday period was temporary and we are encouraged by the stronger top line trends we saw in the back half of January, which have led to comparable store sales growth of approximately 2% so far in the fourth quarter.

Another noticeable theme in Q4 2018 was the continuation of rising corporate costs and increasing pricing power. I was a little surprised by this as I was expecting some relief in costs and pricing given the increasingly mixed operating environment. Nevertheless, signs of inflation continued to show up in many of the Q4 2018 conference calls and earnings results. As I noted in past posts and podcasts, inflation is a process. As such, there is considerable evidence that cost and pricing pressures continue to proceed through the pipeline:

Flowers Foods (FLO): Good top line performance was offset by continuing margin pressure from cost inflation, primarily in commodities and transportation.

In 2019, we expect continued inflationary pressures in commodity, transportation and labor of approximately 150 basis points as a percentage of sales.

And the consumer understands that the costs are going up. And the pricing that we’ve taken, it’s encouraging to see the reaction so far. As we look forward again, pricing will continue to be an opportunity for us to address issues as costs continue to run up.

When you look at the commodity basket, I mean, again, 2018 was the first inflationary year we had seen in some time. So it’s fairly significant at high single-digit commodity inflation or input cost inflation for 2018. We do expect inflation to continue, and we don’t really see that turning in the near term.

Oil-Dri (ODC): In the quarter, we experienced higher costs of freight, packaging and non-fuel manufacturing costs.

Helen of Troy (HELE): As expected, this quarter, we also started to feel the impact of tariffs ahead of the pricing actions we began implementing in the third quarter and which will largely take effect over the next two quarters. Retailers and consumers are just now beginning to digest higher prices, which could affect short-term shipments and consumption.

While retail price points have been relatively stable for years, retailers will likely pass on some of the increases, testing consumer’s price sensitivity.

Our pricing actions so far have been successful. We have been able to take pricing in categories that traditionally do not have price increases as part of their normal cycle and that’s a statement measured in years.

…more people are working. So all those things put money in people’s pockets and now they go to the shelf. But for the first time in years, they’ll see products that have a bit of inflation in them and there has not been inflation in this country of any meaningful way in the last couple of years, and certainly not in our categories.

Matthew International (MATW): From a cost standpoint, unfortunately, it appears that commodity and freight cost increases will continue to be a challenge, but we will seek opportunities to mitigate them to the extent possible.

Hubbell (HUBB): …dealing with inflationary pressures, including tariffs. But we’ve exited the year with positive momentum and committed to offsetting the material cost inflation in 2019.

Church & Dwight (CHD): Our price increases have been well executed for ARM & HAMMER cat litter, baking soda and carbo deodorizers, and OxiClean prewash additives. Those price increases hit their shelves late in the quarter and will benefit 2019 gross margins. And the good news is, that competitors are raising prices in those categories as we speak.

Bridgford Foods (BRID): Overhead spending increased due to significant increases in hourly wages, healthcare expenses and indirect operating supplies.

Central Garden and Pet (CENT): A third factor impacting operating margin and EBITDA were higher freight, labor and raw material costs. However, a range of price increases were implemented in January, which will help mitigate the cost inflation pressures. 

Mid-America Apartment Communities (MAA): And projected average blended rent pricing, which is new leases and renewals combined of 2.7% for the year, which is a modest improvement over 2018. We expect operating expenses to grow at 3.1% at the midpoint coming off of two years of very low expense growth.

Martin Marietta Matrials (MLM): Annual price increases have already widely garnered market support, most importantly, in Texas, the Carolinas and Southeast. To that end, we expect aggregates pricing to increase in the range of 3% to 5%.

While there were many examples of cost and price increases in Q4, several companies reported declining or stabilizing raw material costs:

Kennametal (KMT): As expected, margins compressed mainly due to the timing of customer raw material pricing index adjustments. As material prices have now effectively stabilized since the start of the fiscal year, this timing issue should abate in the second half. Consequently, we expect that full year operating margins will improve year-over-year.

Badger Meter (BMI): We continue to see favorable impact of manufacturing absorption from the higher sales volume year-over-year, along with positive net pricing as brass input costs remained stable sequentially.

H.B. Fuller (FUL): Lower raw material cost provide the biggest potential positive impact that could enable us to deliver above the midpoint of our guidance range.

Lennar (LEN): As the lumber market dropped from $650 to $330 per 1,000 board feet in the fall of 2018, we aggressively renegotiated lumber pricing for our fourth quarter starts. We’ll begin to see the benefits of these lower prices with deliveries in – late in the first quarter and receive the full benefit of this lower pricing in the second half of the year.

On the other hand, the labor market remains tight with several companies commenting on rising labor costs:

Darden Restaurants (DRI): Total labor inflation of over 3.5% and incremental workforce investments drove restaurant labor 50 basis points higher than last year despite continued sales leverage and productivity gains.

Tractor Supply (TSCO): We are forecasting slight pressure on SG&A due to the ramp-up of our new distribution center, ongoing wage pressures and higher depreciation expense.

Simpson Manufacturing (SSD): We’ve noted that it’s a tight labor market and we’re seeing that impact on our gross margin there, particularly in the fourth quarter, that was one of the elements there.

Packaging Corporation of America (PKG): We anticipate higher labor and benefit costs with annual wage increases and other timing-related expenses.

Sealed Air (SEE): We’ll see some pricing that we’ll be able to go after because of increases in freight and labor cost.

United Natural Foods (UNFI): …like many distribution companies, we continue to be challenged with higher labor costs and productivity issues related to serving this busy holiday season and the addition of temporary labor where needed.

Cullen/Frost Bankers (CFR): While employment growth has begun to plateau, due to labor market constraints, unemployment continued to decrease to record lows. According to the Federal Reserve’s Dallas branch, Texas employment had expanded by 2.4% year-to-date toward the end of 2018.

UniFirst (UNF): during the quarter, we experienced larger-than-anticipated increases in our production and service payroll costs as well as our merchandise amortization.

…with an employment environment that’s very challenging…we’re finding ourselves chasing it a little bit. And I think we’re trying to get ahead of it in terms of the wages…there was a fair part of the year that we were understaffed quite a bit in particularly the service area, but even in the production area, which forced us to rely on in the production area a lot of temporary labor, and in the service area scrambled

Brown & Brown (BRO): We’re seeing a lot of construction going on around the country, and there’s a general shortage of qualified labor for many industries.

Transportation and logistics expenses remained elevated in Q4 2018, however, the outlook was unclear. Some companies expect transportation costs to moderate (mainly due to elevated comparisons, not demand), while others expect further increases:

Big Lots (BIG): Additionally, we continue to expect the transportation market to be challenging and do not see rates slowing down.

Oil-Dri (ODC): The cost of freight increased more than 2 million dollars, or greater than 20%,compared to the first quarter of fiscal 2018. While portions of the freight increase were one-time, we expect the majority of the increase to continue for the remainder of the year and beyond. This increase is not specific to Oil-Dri, but widespread in the market.

J&J Snack Foods (JJSF): If you look at our transportation costs as a percent of sales, if you do your calculation in that way, we’re talking about — that’s roughly $2 million a quarter higher than last year…this year than last year and we think that should be leveling off. And perhaps, it’s too early to really tell, but we may have no increase in that regard starting with this quarter that we’re in.

J.B. Hunt Transport Services (JBHT): We have had good conversations through the bid season. Early indicators for us is in the mid-single digits on price, but I think that depends customer by customer. I think as the year plays on, we’ll be able to have this conversation. It’s too early to tell for the full bid season.

Werner Enterprises (WERN): 2018 was a year buoyed by strong rate improvement. And as we think about 2019, knowing that the rate environment will not be the same as ’18, but we still believe has upside.

As we sit in January, freight is strong as we indicated, not as strong as 2018 but stronger than the majority of the preceding 5 years and it has remained so. It’s also been more orderly. So I feel capacity is tighter than people think. Our conversations with our customers continue to be positive, and we continue to have conversations about securing more capacity, not about an abundance of overcapacity.

Norfolk Southern (NSC): Our year-over-year pricing was the highest in 7 years with strength in all business units. Throughout the year, the trucking industry experienced capacity constraints and high truck rates, which supported strong growth in intermodal.

And yes, we’ve seen some loosening in the truck market. Although the market is still tight, and we’re encouraged by what we’re seeing so far in bid season.

Pricing discipline also remained a theme in Q4, with several companies reporting higher average unit prices and less promotions:

Tractor Supply (TSCO):  Our strong average ticket growth of 3% was driven by strength in product mix, inflation and, to a lesser extent, growth in big-ticket categories.

Cracker Barrel (CBRL): Cracker Barrel comparable store restaurant sales increased 1.4%, as a 3.0% increase in average check offset a 1.6% decrease in comparable store restaurant traffic.

Monro (MNRO): Similar to the last quarter, our comp performance was driven by a higher average ticket from improved in-store execution and sustained strength in our tire and brake categories.

Dick’s Sporting Goods (DKS):  We see that the — our inventory is in great shape. We don’t see needing to be as promotional.

Darden Restaurants (DRI): We felt it was with the demand environment being strong. It was a good opportunity to remove some of the incentives.

United Natural Foods (UNFI): Additionally, supplier promotional spending is also down significantly, driven primarily by very limited price elasticity at retail.

Regis (RGS): The same-store sales improvement was driven by a 5.2% increase in tickets, partially offset by a 4.7% decline in year-over-year transactions or what we have historically referred to as traffic.

Skechers USA (SKX): As we have mentioned previously in the retail environment, we had reduced some discounting activity and taking some limited pricing. That continues to power through the retail business, and they performed exceedingly well on a gross margin basis.

Signs of weakening demand showed up in more interest rate and asset price-sensitive markets such as residential housing and the automotive industry:

Toll Brothers (TOL): Despite a healthy economy, we are seeing a moderation in demand. Fourth quarter contracts declined 15% in dollars and 13% in units compared to a difficult comp from 1 year ago.

In November, we saw the market further soften, which we attribute to the cumulative impact of rising interest rates, rising home prices and the effect on buyer sentiment of well-publicized data of a housing slowdown.

Lennar (LEN): Overall, the housing market continued to slow through the fourth quarter of 2018 as higher home prices and rapid interest rate increases combined to create a mismatch between prices and buyer expectations. As we entered the seasonally slower fourth quarter, purchasers remained on the sidelines awaiting the market to adjust. Sales rates were slower than expected and increased incentives were needed to adjust pricing to entice a reticent market to transact.

Gentex (GNTX): At the beginning of the fourth quarter of 2018, vehicle production estimates from IHS Markit showed a net growth of approximately 2% in the combined regions of Europe, North America, Japan and Korea, and a slight decline for the China market. The actual unit production for these markets in the fourth quarter combined for a decline of nearly 6%.

…2019 will likely continue to have headwinds in overall vehicle production levels and the combination of tariffs and component costs will create additional cost impacts to the business versus last year.

Given the sharp drop in oil prices, it’s not surprising the outlooks provided by energy companies became less certain. Also during the quarter, several energy firms reaffirmed their commitment to keeping spending in-line with their internally generated cash flows:

Helmerich & Payne (HP): Discussions with several customers regarding CapEx outlook indicates a mix of increasing, decreasing and flat spending budgets. However, the consistent theme is discipline, principally keeping 2019 spending within cash flow.

RPC Inc. (RES): Revenues decreased compared to the same period in the prior year due to lower activity levels caused by year-end budget depletion among many customers.

We believe that oil prices fell at a difficult time of the year because it was our customers’ budgeting season. So the oil price decline happened as they were budgeting. Now in January, oil is up a little bit, but they’re extremely uncertain about what 2019 looks like.

Patterson-UTI (PTEN): The sharp drop in oil prices in December resulted in some of our customers notifying of us of their intent to release rigs. Recently, with the sharp rebound in oil prices above $50, we have seen an improvement in operator sentiment and discussions with operators about putting rigs back to work is slowly increasing.

Carbo Ceramics (CRR): In the oilfield sector, E&P operators’ focus on free cash flow, coupled with recent oil price volatility, creates a less than certain environment with regard to drilling and completion spend in 2019. Current expectation by some industry analysts are predicting 2019 drilling and completion spend to be down high single digits on a percentage basis compared to 2018.

Currency is a growing headwind:

H.B. Fuller (FUL): Currency will have a negative impact on revenue in the first half of the year at a similar level to Q4 of 2018.

Graco (GGG): The effect of unfavorable currency translation at current rates is more pronounced for the first quarter of 2019 when compared to the first quarter of 2018 with an unfavorable effect of as much as 3% on sales and 6% on earnings.

And of course, China and tariffs remain an issue:

Kennametal (KMT): Yes. We did see a significant decline in China. Everyone understands the situation there and the fact that the automotive industry is actually depressed at this point.

Regal Beloit (RBC): The Commercial and Industrial business will have more of a headwind out of China and out of Europe.

Helen of Troy (HELE): While we currently anticipate achieving our fiscal 2019 revised full year outlook, the current U.S.–China trade environment is certainly a concern and could provide a meaningful headwind next fiscal year if we ultimately realize the full year impact of tariff changes in their current form.

Ethan Allen Interiors (ETH): China was impacted, as we know, by number of factors. First, the Chinese economy has slowed down. Secondly, the tariff situation also created a big problem, they held up.

H.B. Fuller (FUL): In mid-September, due to the timing of our quarter-end, we were one of the early companies that called out the slowdown in China and a shift in currencies as a headwind in the second half. These impacts were seen in the fourth quarter, but the impact was somewhat more than we expected.

A.O. Smith (AOS): We are assuming continued weakness in the China economy and relatively flat consumer demand for the full year in 2019.

…the Chinese consumer is no different than a U.S. or any other consumer when their job has slowed down, when they’ve seen maybe some layoffs in various parts of the industry and their friends, that they simply just pulled back. And so we believe that tariff has had some impact on consumer confidence, on their spending patterns just for the fact that that’s what we would do here in the U.S.

While there are signs of a slowdown in certain industries and uncertainty remains, overall, many companies in a variety of industries continue to report positive organic growth and outlooks:

Hubbell (HUBB): All markets up again in the quarter across the board, and particularly, some major end markets: core industrial, outside-plant communication, gas distribution, and most particularly, positive towards Lighting. It’s real stronger than anticipated, particularly on the residential side. And we expect this end-market growth overall to continue into 2019.

Darden Restaurants (DRI): Right now, we think the consumer is in a really good place. I mean, we’re operating the lowest unemployment in 50 years. Confidence remains high. As we watch the guests, they continue to buy across our menu, they’re adding on to their entrées, they’re buying up, it feels like it’s a really good environment.  

AMETEK (AME): We expect overall sales in 2019 to be up high single digits. Organic sales are expected to be up 3% to 5%, with a similar level of organic growth across each reportable segment.

So overall, we feel very good about the environment we’re operating in. And we feel good what we’re hearing from our business and our customers. And we continue to see a solid underlying demand.

Sherwin & Williams (SHW): I’d say that it’s — when you speak with our customers, it’s a very bullish discussion that we’re having. Our customers remain very confident about the year, the bidding that they’re doing and the backlog that they have had as well as what they see going forward.

Moog Inc (MOG/A): Our major markets are doing well with defense particularly strong across all our applications. Commercial aerospace is also very healthy and our industrial markets remain solid. With one quarter in the bank, we are increasingly confident about our forecast for the full year.

CSX Corp (CSX): Over the past few days, I’ve spoken to a number of large customers across different industries. General customer feedback has been positive and is consistent with the demand levels we are seeing today. While it’s hard to ignore the volatility in the equity markets, I cannot call out any trend in our business today that would point to a significant slowdown in our business.

Graco (GGG): We saw sales growth in all segments and regions in the fourth quarter, with an increase of 8% from the prior year, including 2 percentage points of growth from acquisitions. Currency translation was a headwind for the quarter and reduced sales growth by 2 percentage points.

It has seemed to be the case here for at least the last 6 months that we’re doing the very best we can to talk ourselves into problems, right? The headlines are negative. All the political back and forth that has been going on has been creating a lot of negativity. In reality, in most of the areas that we’re selling, business is good. So there is a bit of disconnect there from my standpoint.

Pentair (PNR): Today, we are introducing our 2019 outlook. We expect core sales to grow 4% to 5%, which is comprised of about 3% of price and 1% to 2% of volume.

Arthur J. Gallagher (AJG): Looking forward, 2019 Brokerage organic growth feels like it will be around 5%.

Cintas (CTAS):  Our second quarter rental organic growth rate of 6.6% rebounded as expected from the first quarter’s rate of 4.9%. In fact, this organic growth rate of 6.6% exceeded our internal expectations.

We — I think from — based on our results, which we believe are pretty good, we’ve seen a pretty good economic environment for the last quarter and we’re not hearing signs of slowdown right now. And I would suggest that our guidance is pretty strong as well and reflects confidence that we’re going to finish the year pretty strong, so no.

Kennametal (KMT): …we are confident in our assumption of organic sales growth of 5% to 8% for fiscal year 2019.

Martin Marietta Materials (MLM):  In summary, for 2019, we expect aggregates shipments to increase 6% to 8%, with growth in all 3 primary construction end-use markets.

Underlying market demand should continue to support ongoing pricing momentum.

Mid-America Apartment Communities (MAA): I mean, our confident — our confidence if you will as it pertains to 2019 rent growth despite the supply pressures is really based in what we see as continued very strong demand. And we see no evidence that the demand side of the equation is weakening. We continue to see very low move-out occurring and the job growth numbers continue to be encouraging.

In conclusion, based on my review of Q4 2018 results, I believe the corporate operating environment has become increasingly mixed versus Q1-Q3 2018. However, on average, organic sales and earnings growth remains positive. As such, I do not believe the decline in asset prices in Q4 was severe enough or lasted long enough to push the economy and profit cycle into recession. That said, I believe there is sufficient evidence to conclude the financial markets’ recent decline created hesitation and uncertainty among consumers and businesses. In effect, I believe the economy and financial markets are increasingly becoming one and the same. If true, while 2019 corporate outlooks are generally positive, I’m viewing them as stable, or as unstable, as the underlying foundation of the current economy – asset prices.

Article by Absolute Return Investing with Eric Cinnamond

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