How much does weather effect financial results in sectors where one might not expect a significant meteorological effect?

Earlier this week a brief story flitted across the news wires citing a Brunswick Corporation (boats, boat engines, bowling & fitness equipment and billiards kit) spokesperson attributing weakness in marine demand to the impact of weather conditions. Interestingly, this scribe has yet, in the good length of time he has followed the firm, to hear Brunswick attribute success at their “fun centers” (bowling, billiards and eating) to poor weather driving punters indoors. Good management obviously knows when and where to give credit.

Certain UK retailers, for example, rejoiced in crediting the recent sunny Easter weather: supermarkets (picnic items), garden centers, DIY merchants and spring fashion got a big fillip: retail footfall was up 6% to 10% according to some analysts.

Yet the same sun also, it seems, hurt large ticket items such as flooring and sofas. At least that is what sofa makers like SCS upholstery plc and flooring specialist such as Carpetright plc claimed in trading updates. In the case of the former, Chief Executive David Knight said:
"We have to blame the weather. The retail parks were extremely quiet and if you look at the travel news it seems people spent the holiday travelling to the seaside."
There is some history here. SCS also moaned about hot weather in 2002, 2003 and 2004. However, wet Easter/May holiday weather in 2005 was (commendably) mentioned by management as a bonus (although similar meteorological aid in 2006 was not).

Graphing weather data against SCS equity performance (exhibit 1) only appears to show that management, when scratching around for explanations, can sometimes make the data tie in with performance as a commentary point. But the SCS statistical case for the relationship, happily for non fatalists, is weak. In 2002 for example, all the principal April/May shopping holidays saw fair or good weather and SCS’s shares did not suffer. Yet this year they are being crucified (and the May Day forecast, for what it is worth, is for sun).

Exhibit 1: Rainfall over Easter and May Bank holidays vs SCS Upholstery's share price change

The truth is that the weather, for retail firms like SCS, sometimes ices the cake and sometimes leaves it plain. It may cause a purchase deferral for big ticket items but probably does not cause meaningful profit warnings or benefits over successive reporting periods.

The larger question, of course, is whether big ticket retail spending on household items is slowing in the UK (cf Exhibit 2) and that is not clear yet.

Exhibit 2: Household goods retail sales (volume) vs SCS Upholstery's rolling 3 month share price change

SCS is a prudent, very well run outfit with cast-iron financials. But it is unemployment, wage settlements, interest rates and inflation rather than the weather it should be concerned with.

NB: The author holds SCS equity
Sources: UK Met Office
; UK National Statistics

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The semiconductor cycle is widely accepted to run 4 years and is generally considered to be at its peak in its current cycle. This common knowledge makes some of the reaction to the sector results coming through odd.

For example, Ultra Clean Holdings (NASD: UCTT) disappointed analysts last Monday and has since been knocked back over 20%. This is not simply company specific (the ridiculously heavy cost of Sarbox here claims another victim; and the VC firm that IPO'ed the company has moved on) for the financials are attractive despite a tiny customer base (cf below).

No, this is a reflection of ambitious investor expectations based upon faith in the miraculous powers of liquidity. That the Ultra Clean management commentary has to confirm that its growth is moderating (albeit with some optimism of new market offsets) in order that investors take fright is remarkable.

Ultra Clean is, it is true, a new-boy-stealing-market theme, not a pure call on the sector. But well over 80% of its sales are to three mature semiconductor companies: all-pervading giant sector generalist Applied Materials (AMAT) and smaller specialists Novellus Systems (NVLS) and Lam Research (LRCX). Ultra Clean plays largely on the cost side of its clients - it offers subsystem outsourcing without having itself to carry the capex requirements of component manufacture. Nonetheless, it is usually difficult to expand in a cyclical trough: its fortunes are greatly tied to those of sector proxies AMAT, NVLS and LRCX.

These three, especially the under leveraged AMAT, appear to have battened down the financial hatches and prepared themselves for a storm. While this is marvellous for a subcontractor like Ultra Clean who depends on healthy clients, it is also an acknowledgement of the severity of the last serious trough, triggered in December 2000 when the TMT sectors crashed shrinking the semiconductor industry by 30%. Comfortingly, though, Citi has produced research suggesting the next semiconductor trough, like that of 2005 (if you blinked you missed it), will be short and shallow.

Citi argues that the end-user TMT sector sells short replacement cycle products (mobiles, set-top boxes, playstations etc) and is in a sweet-spot driving semiconductor demand. Further, the TMT sector has matured itself to the point where it actually tracks what it is their customers want as well as running a tight operational ship. That is, they are good semiconductor industry clients unlike in late 2000 when, collectively, they were the Flaky Bunch.

Citi also provide supporting data suggesting bottoming trough trends are already in place for capacity utilisation, inventories and memory pricing. Which is interesting once the 4-year cycle is dissected. A paper by Tan and Mathews produced last January would class these Citi factors in two of three sub cycles of the 4 year circle itself: annual seasonality and the “true” two year industry specific cycle. The third factor - the ghost at the feast – is the global economic cycle.

And so, as with much in the world of finance today, it boils down to soft or hard US landing coupled with, or not, decent decoupled non-US demand. Benign (or more likely, delayed) ghostly denouement and firms like Ultra Clean et al, in an industry prepared for trouble, are already attractive (given the lack of subtlety of gimme liquid investors). On the other hand, a few more consumer shocks like that in the subprime US and what appears to be the beginning of a property tumble in Spain and prudence will win.

Sources: Semiconductor Industry Association; Alfonsa Velosa, Semiconductor Manufacturing: Booms, Busts and Globalisation; Hao Tan and John A Mathews, Semiconductor Industry Cylces

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For a small cap with negligible press coverage Empresaria plc equity has done well since January when mentioned here at 95p. It currently trades at 146.5p (midprice).

A day before this shareholder’s Easter break the firm announced its purchase of 60% of private German recruitment firm Headway Holding gmbh (with an option to take 100% later). Here the cliché “company transforming” is apt: Headway turns over the equivalent of about 70% of Empresaria’s sales; and in net asset terms (exc intangibles) is 15% larger. The price appears fair (x3.2 sales) given growth rates and the macro outlook in the new Empresaria’s two key markets of Germany and the UK (so long as it lasts, but that is another post).

As presented in the acquisition document the Headway accounts are generally sound and shed light on its operations, but are hardly comprehensive (no full group P&L or B/S - extraordinary). The dreaded category “Other” makes up 15% to 20% of the Headway totals depending which P&L line item is considered – and much more when it comes to B/S creditors. Even within the broken out divisions some items still glare in the absence of explicative prose: for example, the headwayjobcenter division's “Other operating expenses” mysteriously totals some 19% of sales. That is a boatload of sundries.

German GAAP rules emphasize prudence, substance over legal form and creditor protection rather than the exhaustive detail of US GAAP or the “true and fair” principle of UK GAAP. Part of the consequence of this is that no cash flow statements are included in the acquisition document (they are not obligatory for unlisted German firms) and can only be derived for the three largest divisions (about 80% of revenue). Unfortunately, this makes building a picture of how effective overall cash-management is difficult to assess.

Nonetheless, some observations can be made:
  • The headwaypersonal division is cash generative thanks (this cyle at least) to robust debt collection. Cash generation would have been markedly better but for large provisions for legal and compensation costs associated with a failure to employ "disabled individuals". It is not clear if these are one-off although that would seem a reasonable assumption.
  • headwayjobcenter has eaten cash at the operating level (partly funded through intercompany loans) in support of a doubling of turnover. The cash bleed of this one division is such that it has almost certainly made the entire group cash flow negative in 2006. Should Empresaria care to hire the scribe, he would happily draw on previous-life experience, immeadiatly review provisions and put a credit control team in place to chase debtors. Or flog the unit.
  • headwaylogistic has also grown the topline impressively and achieved positive operating cashflow in so doing. However, the level of intercompany loans it carries may suggest some lumpiness in its cash conversion through the year.
  • All three main divisions look likely to provide positive debtor-to-cash surprises should rigourous working capital initiatives be instituted.
  • Absence of full group statements hides, most notably, retained earnings. Derived owners equity, assuming retained earnings are zero, suggests a debt to equity ratio approaching 10. Realistically retained earnings is probably negative and Headway appears over leveraged,
  • The new group is forecast to have a debt to equity ratio of 1.7. Based on the incomplete data presented that looks a sporty number.

As for the acquisition finance, it is via a placement (an excellent sign, if academic studies are to be believed) 70% of which is to be paid in by 3 existing institutions and a new fourth one (Insight Investment, part of the bank HBOS plc). The 30% difference is taken up by the Chairman (Anthony Martin) and the CEO (Miles Hunt). Thus, at a stroke, key insiders maintain significant equity (>30%); the shareholder base has been broadened; and 15% of the proceeds are to go towards reducing the new group’s overall debt levels.

The deal is attractive; and the purchase ought to be approved by shareholders at the 30 April EGM.

NB: The author owns Empresaria equity.

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Panorama of the Bay of Figari, looking towards the estuary

First time visitors to Corsica may observe a number of striking things beyond the unremitting coastal beauty and mountain scenery (sometimes reminiscent of the Cévennes) for which the island is known best. Notwithstanding, that is, Asterix in Corsica (see comment 1 below) siestas, vendettas, pungent salamis and cheeses, striking ferry-men or assasinations of French préfets.

Two (other) such things impressed this observer in particular during the Easter break: the quantity of elaborate mini town-house sized family tombs sitting in prime scenic locations (known, in London property development speak as “off-plan holiday studios”); and the frequently implanted roadside ad for Editions Duhmane’s Corsican Encyclopedia in seven volumes. Gibbon, covering a slightly larger subject, managed to produce his masterpiece in six. But it is cruel to begrudge the verbosity surrounding l’île de beauté.

When it comes to relating this sojourn to investing the best the scribe can offer (besides “avoid the over-priced beach front real estate”) is a short Corsican illustration on the role of chance.

Until the eighteenth century the island had been part of the Republic of Genoa for 200 years. Essentially the banker of Spain, Genoa's fortunes declined with the successive debt defaults of its main client. Coupled with its harsh, unsuccessful (socially and economically) administration of Corsica (run at the time, incidentally, by a Genoan bank – vive la finance) it was forced to sell the island to the French in 1768.

A scant year later Napoleon was born in Ajaccio and born French - not a citizen of Genoa. His formerly nationalist father had already set about ingratiating himself (successfully albeit under false pretences) into the French nobility with all the rights of education such status conferred upon his children (including scholarships).

Thus the weight of hazard set about, as it does with finance, shaping the subsequent course of European history.

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“Six bucks and my right nut says we’re not landing in Chicago”

John Candy to Steve Martin, Planes Trains & Automobiles

China's expansion of its ship building capacity is the obvious wing-clipper for a soaring Baltic Dry Index (BDI).

Veterans of the shipping industry often cite the collapse of freight rates in the 1970s as an example of the havoc chronic over capacity can wreak. But the capacity issues of the 1970s arose because of two shock events: the 1967 Six-Day War and the 1973 OPEC oil price shock. The war forced oil transport around the Cape of Good Hope (the Suez canal would be closed until 1975), drove up freight rates and encouraged construction (by a factor of three) of larger ships too big for Suez. When OPEC cut supplies in 1973 freight rates fell out of bed and a lot of large, empty tankers were left at anchor.

Are trends in Chinese shipbuilding a shock or potential shock of similar scale?

Probably not - but it is ironic that shipping, about as economically liberalised an industry as exists, is entirely at the mercy and influence of a centrally-planned economy. That alone makes significant the risk that accelerated shipyard creation by China doubles global shipping capacity much faster than free markets would thereby depressing freight rates.

And that is before any consideration of potential concurrent problems posed by generous global liquidity, the end of Olympic preparations, possible steel market gluts and a macro-economic slowdown.

Background & tour d'horizon
In the year to end March 2007 the Baltic Dry Index has more than doubled. The drivers:

Chinese steel exports

Despite the efforts of China’s National Development and Reform Commission (NDRC) steel production continues to expand. China has been a net exporter since 2005 and in 2006 increased them by 92%.

Where is all this metal going? The US is the number one global importer of steel but with housing starts off dramatically is clearly a softening market. Against this, however, Malaysia, the number two importer of steel (by some distance) embarked in 2006 on its "Ninth Malaysia Plan” (jargonified as 9MP over there). 9MP involves ambitious infrastructure works in support of its objectives and is a price support for steel and freight rates. Although a neat immeadiate offset to US developments it is not likely to be in the medium term enough to soak up the startling increases in China’s steel output.

Chinese iron ore imports
The thriving counter party to China’s steel exports.

Chinese cement exports
China exports 3 million tonnes a month.

China's coal consumption
Energy hungry China has steadily increased consumption of its own coal leaving less to export. This has compelled Japan and Korea to seek supplies from Australia - action that has caused in Q1 2007 the worst port congestion in 3 decades. Clarksons, the shipping broker, reports that up to 70 bulkers are waiting 3 weeks to load coal.

International & Chinese politics
China’s iron and steel industry employs 2 million people. Political pressure to maintain jobs is a formidable obstacle to the NDRC’s desire to reduce capacity. China does not want people in the streets and its obvious response to the threat – and US led WTO pressure – is to shift its export subsidies from low to high value-added steel products. The NDRC has itself revealed this intention to be enacted, ah, sometime soon.

An important indirect consequence of this policy shift may well be the increasing capacity of Chinese shipyards. High value-added steel products like hot rolled coil and sheet serve industries such as car and fridge manufacturers, construction and, crucially (see below), shipbuilding. Expanding its shipyard capacity offers China a neat solution to its excess steel production, potential social problems and perennial search for new markets to conquer.

Chinese shipbuilding & capacity trends
China is already the second largest ship builder in the world after South Korea. Since 2003 and the start of this latest BDI boom global ship orders have leaped ahead of deliveries. South Korea has taken the lion’s share of these but, with its low cost base, China has pushed to expand its capacity in response. It has 14 yards under construction and another 9 due for completion by 2010 which are already taking orders. Delivering all actual projects would mean China’s yards will double current world freight capacity. Clearly, the pace of completions is one of the keys to future freight rates. And with backlogs such that yards are able to turn down lower-margin builds swift output is of the essence in the race for market share.

Exhibit A: South Korean, Chinese and Japanese shipyard deliveries and orders, 1996-2006

Sources: Clarksons plc; Lloyds List; Iron & Steel Statistics Bureau; Malaysian Industrial Development Authority (MIDA)

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