Takeaways from Last Week’s Earnings Calls 9.19.16

This week we’re starting a new experiment. We’re going to try to run a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback!

Each week we pack a lot of information into our company notes digest.  Any given week there are probably five or more themes that are worthy of further discussion.  Last week there were a couple of themes that we thought were worth highlighting:

1) Deflation wont last forever

Our most recent struggle with deflation was renewed in earnest in late 2014.  The fall of 2014 was when the Fed began to wind down QE and the dollar began to strengthen.  In turn, the Euro declined and oil prices also collapsed.  We have been living with the consequences of this deflationary episode for the last couple of years.  Because the sharpest legs of the decline happened in late 2014, 2015 was a year in which the “comparisons” to the year before showed the sharpest divergence.  Because of this, the deflation looked most severe in 2015.  These dynamics alone were responsible for the majority of the decline in S&P 500 earnings last year.

So far in 2016 we have continued to experience follow on effects of this deflationary headwind; however the sharpness of the decline has abated and it appears that we may be seeing at least a floor in commodity prices. For this reason, investors should be on the lookout for a reverse dynamic of 2015-16 to come into play in 2017.  Whereas comparisons were certain to be negative in 2015, the low bar that has been set in 2016 makes it easier for comparisons to look larger in 2017.

If we do have small increases in commodity prices next year, it could translate to larger readings in inflation indexes like CPI.  This is especially important considering that the Federal Reserve is now watching inflation closely.  If CPI were to print a 3%+ number next year, then it would be very difficult for the Fed to continue to justify an easy money policy.  Keep in mind that because Fed policy remains mildly accommodative, a perceived need to shift towards a restrictive policy could result in a large swing in interest rates and therefore asset prices.

What could cause price increases next year?  Kroger, which is among the top quality operators in the grocery space explained that price changes have a way of curing themselves over time:

“as we know from past experience, the environment won’t be deflationary forever…historically, I always like to say high prices solve high prices and low prices solve low prices, because capacity will start changing. And if you look at farmers, they’re very smart, and they’ll start producing less of the things where they don’t make money. So historically, that’s what’s caused inflations to swing…as you get toward the latter part of the year and early next year, you’re starting to cycle the deflation. So I would — certainly, we would guess that it would start to moderate just because you’re starting to cycle some of the deflation”

When it comes to inflation or deflation, time really is something that does tend to heal.  Deflationary forces, especially in commodity industries will eventually be corrected by market forces.  Lower prices are met with a supply response that eventually leads to price stability.  We are seeing this play out in the oil industry already.  Rig counts have fallen, leading to lower oil supply growth, which is helping to stabilize price (for now at least).  Oil is a particularly challenged industry, but this dynamic could lead to real lasting price floors in many other industries as soon as 2017.

Investors also shouldn’t discount the impact of policy change on inflation.  The coming change in Presidency could represent a catalyst for a change in inflation expectations.  In particular, a Trump presidency is likely to stoke inflation through trade policy.  If Trump is elected, tariffs would raise the cost of imports to the United States and increase demand for domestically produced goods.  This would not only shift production to a higher cost region, but it would also cause capacity utilization to expand in the US, causing an inflationary surprise.  A Clinton administration could also stoke inflation expectations with continued stimulus or increased government spending and deficits in an attempt to continue to boost a flagging economy.

2) Luxury does not always mean highest margin

Restoration Hardware has lost its appeal as a glamour stock in the last year as growth has not lived up to expectations.  For the last several quarters, management has blamed a slowdown in luxury spending for the shortfall.  However, this quarter management acknowledged that furniture is a tough business even as a luxury player.  Gary Friedman had this to say:

“Designers get 25% to 40% off the business. That’s why we can’t be like a luxury brand like HERMES that has no promotions, right, because at the highest end of luxury apparel, there is no promotions. At the highest end of luxury furniture, it’s 100% on promotion…I have always said…being in the furniture business, it’s an ugly baby, but it’s ours” —Restoration Hardware CEO Gary Friedman (Home Furnishing)

Gary Friedman is an eccentric CEO, but his bold vision for Restoration Hardware always intrigued us (we have no position in RH).  Seeing the challenges for retail, Friedman has been attempting to remake RH’s locations into luxury showrooms to appeal to the highest end clientele.  Friedman has not only invested heavily in flagship stores, but has also built unique supply chains to source “authentic” foreign made merchandise for his customer base.

In most other consumer goods industries this is a recipe for success.  Staking out territory as a truly premium aspirational brand leads to higher margins and durable competitive advantages.  Think Tiffany or Cartier in jewelry, Hermes in apparel and even Apple in consumer electronics.  However, Friedman appears to be finding that this doesn’t seem to hold quite as true in the furniture business.

What we found especially interesting about Friedman’s quote is that one reason that it doesn’t hold true in furniture is because at the luxury price point, furniture is primarily purchased by designers, i.e. professional buyers.  A small group of professional buyers has more buying power than an individual consumer and therefore is able to negotiate for better prices.  This is very different from how jewelry, apparel or a smartphone is purchased.

The interesting point is that this example helps highlight the fact that luxury in and of itself is not enough to guarantee higher margins.  In fact, a better guarantor of high margins is to have a relatively uneducated and disparate customer base that is driven by emotional appeal.

Our theory here is that the professional buyer is driven more by “business-rational” thinking rather than emotional attachment to a product.  Professional buyers conceivably have a better understanding of the cost of production and will therefore tend to push the price of a product closer to its commodity value.

Conversely a single consumer, who is purchasing a product that he or she has limited understanding of, may be less likely to push for the best price.  This is especially true when emotion is factored into the equation through brand.  The reason that Apple can sell iPhones at very high margin is because buyers are less conscious of the cost of production of an iPhone and also generally less educated buyers of technology and therefore value a solution that “ties things together” in a user friendly package.

There is also likely an absolute price component to this dynamic as well.  Consumers are more willing to “overpay” for goods below a certain price threshold because it’s not worth the time to become an educated buyer.  This may explain why consumers frequently overpay for things like soft drinks or chewing gum, but usually negotiate margins much lower on products like automobiles or houses.  When the price tag gets high enough, consumers spend the time to know what is a fair price and therefore negotiate for it.  Luxury home decor may sit at or near that threshold at which a buyer becomes educated or hires someone who is.