Acuity Brands: Wage and Tariff Inflation and Resulting Business Uncertainties

(Originally published on One-Twenty Two by Dr. Duru)

I last mentioned Acuity Brands (AYI), a lighting and building management solutions company with $3.7B in net sales in 2018, three months ago. At that time, I described a good risk/reward setup to go long the stock post-earnings. AYI shot nearly straight up from there. The stock broke through resistance at its 200-day moving average (DMA) and gained as much as 34.7% before peaking intraday in September. While I only participated in a portion of that run-up, I am glad I did not overstay my welcome. Fast forward to last week: AYI suffered a massive post-earnings gap down. The stock lost 16.3% and sliced right through 200DMA support after the 50DMA gap down. Sellers closed the week confirming the bearish breakdown. AYI has now almost erased its entire incremental gain from July earnings.

Source: FreeStockCharts.com 

This moment is critical for the stock. AYI hit an all-time high in August, 2016 and sold off pretty steadily from there (on a monthly basis) until reaching a 4-year low in May, 2018. If AYI completes a full reversal of its gains from July earnings, then the stock greatly increases its risk of resuming the downtrend from the all-time high.

AYI’s earnings report was interesting for a lot more than the technical disaster. The company also delivered some telling remarks about today’s inflationary environment. The company begain its conference call by launching right into the bad news. From the Seeking Alpha transcript:

“While our results for the fourth quarter and the full year were records, we had higher expectations coming into 2018. Market conditions for growth were far more subdued than most had originally anticipated, especially for larger commercial projects and deflationary pricing persisted throughout the year, while cost pressures were far more significant than most had forecast, particularly in the fourth quarter.”

The general market environment hindered the business:

“Based on the information from various data collection and forecasting organizations, we believe the overall growth rate for the fourth quarter as measured in dollars for lighting in North America was flat to slightly down, continuing the sluggish trend over the last several quarters…

We believe the lighting industry will continue to lag the overall growth rate of the construction market, primarily due to continued product substitution to lower priced alternatives for certain products sold through certain channels.”

For the fourth quarter and full-year, the company sported record revenues and diluted earnings but significantly lower operating profit and margin. The cost pressures came from multiple inflationary fronts including tariffs and wages. Emphasis mine…

“Another significant factor impacting our adjusted gross profit and margin was higher input cost for certain items, including electronic and certain oil-based components, freight and certain commodity-related items, particularly for steel. Many of these items experienced dramatic increases in price in the fourth quarter due to several economic factors including enacted tariffs and wage inflation due to the tight labor markets.

We estimate the inflationary impact of these items reduced our adjusted gross profit in the quarter by more than $20 million, lowering our adjusted gross profit margin by 200 basis points and reduced adjusted earnings per share this quarter by $0.38…

…we expect employee-related costs will continue to rise as we enter fiscal 2019 as markets for certain skills remain tight contributing to a rise in wage inflation…”

AYI also explained that it sources from China about 15% of its components and finished goods which are subject to the new import tariffs.

Freight costs are an increasing burden. The combination of rising oil prices and the rising wages that come from a severe shortage of truck drivers are driving freight rates skyward. Shipping a lower-value product mix is exacerbating the shipping burdens.

As we would expect, AYI is scrambling to mitigate these costs by finding alternative suppliers and production sources, improving productivity, and increasing prices. The company announced price hikes last month and new price increases go into effect on October 15th. Assuming the new 25% bump in tariffs on Chinese imports goes into effect on January 1, 2019, AYI will raise prices yet again. IF AYI makes these price hikes stick without losing much demand, then the stock could represent a great buying opportunity. Better margin numbers should start appearing by the second fiscal quarter 2019.

AYI cautioned that a lot uncertainty surrounds the potential impact of the cost pressures. For example, the inflationary pressures from tariffs caught the general industry by surprise as participants have experienced a deflationary environment for a “handful of years.” The demand impacts are hard to assess: “It is not possible for us to precisely determine what the potential impact tariffs will have on demand as it is a very complex situation impacted by numerous factors including currency fluctuations and political outcomes.”

As the inflationary adjustments unfold, I will watch the technicals for signs of renewed buying interest. The company itself is one source of buying. AYI repurchased 2M shares at a cost of $298.4M in its fiscal year 2018. AYI still has 5.2M shares left under its repurchase authorization. I have to assume the company will aggressively buy shares in the coming months given the current stock price of $130.99/share is well below the average cost basis of $149.20/share of the to-date repurchased shares.

Finally, it is possible tariffs could HELP AYI although the company did not specifically say so. In the conference call AYI pointed out that the Chinese government is subsidizing lighting companies who are undercutting price for lower-value fixtures. This competitive pressure is important because, as noted earlier, some of AYI’s customers are downshifting to these lower-valued products. AYI is determined to compete – “We will not yield this space for many strategic reasons” – and this competition represents one more important risk factor for the business.

Overall, AYI is one more cautionary tale about the unanticipated impacts of today’s new inflationary environment. Given that financial markets are generally ignoring most potential fallouts from the expanding trade war between the U.S. and China, this earnings season should deliver many more surprises like AYI’s.

Be careful out there!

Full disclosure: no positions

On the Ground Measuring Inflation

Ever wondered exactly how the government measures inflation via individual products? Planet Money ran a segment explaining the process in 2010 that was rebroadcast last year. I caught “The Price Of Lettuce In Brooklyn” sometime early last year. I was absolutely amazed to learn that the government actually sends surveyors into the field to sample prices from various stores on very specific goods. The surveyors have to exercise particular care to measure prices for the exact same goods over time. That basket of goods is then aggregated across products and locations into what we know as the Consumer Price Index (CPI).

I highly recommend this 15-minute podcast for anyone who wants an introduction to inflation monitoring at the ground level.

Source: NPR Planet Money

Cross-Post: The Canadian Dollar’s Rapid Devaluation Presents An Inflation Predicament for the Bank of Canada

(This is a cross-post from my blog One-Twenty Two)

A year ago, the Bank of Canada (BOC) delivered the first of two rate cut surprises for the year. So with oil still cratering ever lower, I can understand why the market seemed braced for yet another rate cut last week. Instead, the BOC not only stood still on rates, but also it expressed an implied reluctance to reduce rates any further unless absolutely necessary. The result was an immediate jump in the Canadian dollar (FXC) featuring a drop in USD/CAD. USD/CAD continued to sell off right into the week’s close.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.

Here is the key quote from Governor Stephen S. Poloz’s opening statement:

“It is fair to say, therefore, that our deliberations began with a bias toward further monetary easing.”

The on-going collapse in oil and all its destructive consequences for the Canadian economy still justify further easing. BUT…

“First, the Canadian dollar has declined significantly since October, which means that the non-resource sectors of our economy are receiving considerably more stimulus than we projected then. Let’s remember that it typically takes up to two years for the full effect of a lower dollar to be felt.

Second, past exchange rate depreciation is already adding around 1 percentage point to our inflation rate. This is a temporary effect, and is currently being offset by lower fuel prices—another temporary effect. However, we must be mindful of the risk that a further rapid depreciation could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations.”

In other words, financial markets have pounded the Canadian dollar so thoroughly that most of the BOC’s goals for easing have been accomplished already. The potential 2-year lag in impact means that the BOC must proceed with extreme caution when deciding to add more kindling to the raging fire of currency devaluation.

Moreover, this devaluation is now exerting inflationary pressures on the Canadian economy – to the tune of an incremental 1 percentage point. While current inflation may still be within tolerance, the pace of the increase could be strong enough to send future inflation expectations soaring past the BOC’s comfort zone. Given the lagging impact of the devaluation, the BOC could find itself fighting stubbornly high inflation expectations for an uncomfortably long time. During the press conference, Poloz clarified that the BOC does not think this process is underway. The Bank is simply keeping an eye on this potential – which is clearly enough to give them caution about doing anything that further drives down the value of the Canadian dollar.

Given these cautionary caveats, the BOC decided to leave rates just where they are. From the press release:

“The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1/2 per cent. The Bank Rate is correspondingly 3/4 per cent and the deposit rate is 1/4 per cent…

…All things considered, therefore, the risks to the profile for inflation are roughly balanced. Meanwhile, financial vulnerabilities continue to edge higher, as expected. The Bank’s Governing Council judges that the current stance of monetary policy is appropriate, and the target for the overnight rate remains at 1/2 per cent.”

As usual, the BOC is cautiously optimistic about economic prospects. Despite a disappointing 2015, the BOC still expects the global economy to resume “gradual strengthening” in 2016. Expectations incorporate an assumed transition to a 6% annual GDP growth rate for China, and continued “solid” performance from the U.S. Even with weak exports to the U.S. in the fourth quarter, the BOC expects export activity to turn right around in 2016. While downgrading its forecast for Canada’s GDP growth in 2016 to 1.4%, the BOC emphasized that year-over-year, growth should be 1.9% for the fourth quarter of this year.

Even though the BOC did not cut rates in this last meeting, make no mistake about its bias. The BOC thinks it could take up to three years for the Canadian economy to fully adjust to the complex structural changes wrought by the collapse of the oil complex. The Canadian economy may not absorb excess capacity in the economy until late 2017. The BOC also acknowledged the growing magnitude of the shock from this collapse. The BOC called this reality a “significant setback compared with our October projection.” During the press conference, Poloz also admitted that the odds of a recession are higher than they have been in a very long time. All these realities imply a notable bias toward weakness for the Canadian dollar for quite some time.

When I wrote about the Canadian dollar’s fresh milestone of weakness, I described a small counter-trend bet that USD/CAD would return to 1.40. As the chart above shows, the USD/CAD just continued to spring higher after the 1.40 breakout. The Bank of Canada’s stasis on rates combined with the forex response was my signal to finally add to that bet. Without a promise to cut rates again, I fully expect USD/CAD to reverse most if not all of recent gains assuming oil does not resume its rapid plunge in the interim.

I will continue to try holding out for that return to 1.40, but I am perfectly fine bailing on the position if renewed strength shows up ahead of this week’s Federal Reserve’s meeting. On a technical basis, the counter-trend momentum in USD/CAD looks like it could easily retest the uptrending 50-day moving average (DMA). At the current pace, this would happen around 1.39. After I close out this short position, I will be quite eager to get back to trading with the trend.

During the press conference, Poloz would not commit to a specific level past which weakness in the Canadian dollar will no longer help the Canadian economy. He would only say that the assessment depends on the nature of the decline. If the currency is declining “on its own,” then there is a problem. An adjustment from economic realities makes sense – the current decline is mostly about the collapse in the oil complex. However, trends beget trends, and I can see several scenarios of overall financial turmoil and volatility that could send USD/CAD hurtling ever higher even independent of a fresh plunge in oil prices.

So, the Canadian dollar presents a precarious predicament for the Bank of Canada. Its devaluation is a necessary part of the Canadian economy’s adjustment to lower oil prices. The potential inflationary impact of this rapid decline could constrain the Bank’s ability to provide more assistance to a wobbly economy. Yet, without this assistance, the weakness of the economy could drive even more weakness in the currency. Currency traders will easily seize upon the trend above all else.

In coming weeks I will be reviewing the Monetary Policy Report (MPR) and a soon-to-be-released BOC paper on the complex impact of the oil shock to find any additional (tradeable) insights.

Be careful out there!

Full disclosure: long FXC, short USD/CAD

Housing Bubbles: An Ounce of Prevention is Worth a Pound of Cure

The Persistence of Deflationist Psychology

Seven and a half years after the financial world as we know it almost completely blew up, deflation remains the biggest fear across the land. Some major central banks across the globe have had to double down on their efforts to fight deflation. For those like me who expected central bank activism to quickly lead to rampant inflation, this world of persistent deflationist psychology is a wonder to behold.

Along this vein comes a fascinating article in the New York Times called “A Prediction Market for Inflation, or Deflation” by Justin Wolfers, a a senior fellow at the Peterson Institute for International Economics and professor of economics and public policy at the University of Michigan. Wolfers warns that the Fed’s focus on hiking rates runs counter to declining expectations for inflation:

“Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.”

Incredulous, I read on….

Opinion is skewed to a Fed miss of its 2% inflation target in the next 5 years

After seeing this chart, I feel that Wolfers far over-stated the case for a “deflationary rut.” This chart shows that 49% of the prediction market expects the Fed to deliver. That is a pretty good percentage although we of course would prefer higher. Wolfers focuses in on the skew of expectations; that is, the people who think the Fed will miss the mark on inflation are predominantly expecting an undershoot. Note that only 1% of the prediction market currently expects deflation in the next 5 years. I do NOT equate an expectation of missing the 2% the target as a deflationary risk.

The main lesson for those of expecting Fed policy to lead to excessive inflation is that we remain a distinct minority. Very few people are worrying about inflation in financial markets.

Wolfers provides this good caveat on interpreting prediction markets:

“Of course, the specific probabilities inferred from market prices should be taken with many grains of salt. In particular, traders may not be betting that prolonged deflation is probable, but rather be buying insurance against such a grim occurrence. Thus, prediction market prices might overstate the probability of bad outcomes. Nonetheless, these prices embed a powerful message for policy makers: Just as people buy flood insurance when they’re concerned that a storm might do terrible damage, traders might be buying deflation insurance because they fear the risk of vast economic damage if the economy were to enter a deflationary rut.”

And a nice message for those of us expecting problems with inflation in the near future:

“Next time people tell you that higher inflation is coming, remind them that they can get rich in the derivatives markets if they’re willing to put their money where their mouth is.”

In the end, seeing Wolfers turn relatively mild data into a warning on deflationary risks is yet one more example of how deflationist psychology persists in economic thinking despite years of accommodative Fed policy, lots of money printing, and more printing to come…

It’s a wonder sometimes that gold has been able to hold on as high as it is…

Full disclosure: long GLD

Hike in minimum wage goes to the ballot in San Jose

Residents of San Jose, CA will vote in November on whether to raise the city’s minimum wage 25% from $8 to $10. The proposed law includes annual adjustments for inflation. This law will be similar to a minimum wage ordinance put into law in San Francisco.

I expect to hear a lot of economists weigh in on this issue, but it was interesting to read one councilwoman say that this is an economic AND a moral issue. Given these higher wages will be paid by businesses and consumers (that is, the law will nt suddenly create new money that was previously non-existent), I think introducing morality will cloud proper analysis.

I am also now interested to know whether anyone has studied the impact of the minimum wage law in San Francisco. It seems strange to me that cities in the same metro area could have dramatically different minimum wages. For low margin businesses that can move, they will prefer to go to lower wage cities. Workers will tend to look for work in the higher wage city but will also face impossibly high housing costs, resulting in commutes that can nullify wage gains. These are just a few examples of things that economists might study.

For more details see “San Jose City Council leaves minimum-wage hike to voters” in the San Jose Mercury News.

Bank of England Admits Currency Depreciation Contributing to Stubborn UK Inflation

Inflation in the United Kingdom has been stubbornly and persistently high since the recession ended –  it is currently 3% and above the Bank of England’s (BoE) target of 2%. The UK has been unique amongst the major economic partners in experiencing high inflation and slow growth since the recession. Through this period the BoE has insisted that it expects inflation to eventually (and soon) decline towards target. Every year that passes without the target getting hit, produces another year of frustration and impatience. Now that the UK has recorded two quarters of negative GDP growth, stagnation has  descended upon the economy.

In last week’s Inflation Report, the BoE made an admission I do not think I have heard before. A reporter asked the expected and on-going question about  the inflation problem. A BoE member answered that the depreciation of the British pound has contributed to driving inflation higher than expected. He noted that the BoE expected currency depreciation to behave as it did in the 1990s when it seemed not to contribute to inflation. Instead, the UK is getting the experience of the 1970s and 1980s. There was no discussion about the lessons learned or what features of all these periods are similar or different. However, I think this is huge progress that at least the BoE has officially recognized that a less valuable currency can still contribute to high inflation.

Used car prices at 16-year highs

As early as July, 2009, we cautioned readers that a crash in used car prices was nowhere on the horizon. Today, we get news that not only has a crash NOT occurred, but instead used car prices have jumped to 16-year highs. From the Toledo Blade:

“Prices of previously owned vehicles began increasing in March as a reaction to slowed new-car production by Japanese automakers hurt by natural disasters in the island nation. But the rise has been exacerbated by soaring gas prices and a used-vehicle shortage.”

From the Detroit Free Press:

“People are holding on to cars and trucks for about a year longer than they did before the recession, which has created a tight supply of used vehicles. So few are on the market that prices have risen to their highest in at least 16 years.

Dealers are paying an average of $11,660 for a used car or truck, up almost 30 percent since December 2008.”

Click here for archives on pricing in the auto industry.

Wal-Mart’s “Always Low” prices starting to edge up.

Patrick McKeever of MKM Partners says prices at Wal-Mart have edged higher in recent months:

In a note last week, retail analyst Patrick McKeever of MKM Partners, identified what he calls a “small, but meaningful increase” in the price of 86 Wal-Mart items he tracks on a regulator basis. The average price is up 0.6 percent in the last two months. On an annual rate, that’s about a four percent inflation rate.

Photographic evidence here.

Get ready to pay more for a Big Mac

The Wall Street Journal’s Paul Ziobro reports that McDonald’s Corp. is planning to raise menu prices in the U.S. and Europe:

The company expects to increase prices in the U.S. and Europe amid projections that commodity costs will rise between 2% and 3% in 2011, Chief Financial Officer Peter Bensen said Thursday during a conference call after McDonald’s reported a 10% increase in third-quarter earnings and added that October sales appear strong.”

U.S. dollar at nine-month low

The greenback isn’t looking too strong of late:

Declining Dollar

Most likely, the sinking U.S. dollar means that American consumers will soon be paying more for imported goods. It will also raise the cost of manufacturing in the U.S. to the extent that American manufacturers rely on imported inputs, such as oil.

Disney and Universal raise price of theme park admissions

The Orlando Business Journal reports today that Universal Orlando is raising its one-day, one-park admission price to $82 from $79. Walt Disney World raised its prices yesterday.

The U.S. dollar is dropping

The U.S. dollar has declined nearly 10 percent in the last three months.

U.S. Dollar Index

It’s hard to imagine deflation if this continues, since U.S. consumers will soon be paying more for imported goods.

Passport fees to rise 35 percent

CNN:

Get ready to open your wallet a little wider to satisfy your travel bug: It is soon going to cost more to apply for a new U.S. passport or renew an old one — a move criticized by the public and some lawmakers.

Starting next Tuesday, adults applying for their first passport book will have to pay $135 — a 35 percent increase from the current $100 fee.