<February 15, 2023>
Two years ago, our local animal shelter sent out a plea for residents to adopt a cat or dog. After COVID-related increases in pet adoptions, shelters were once again overflowing. Out of curiosity, my son and I went to the shelter to see what types of dogs were available.
Walking through the aisles of cages, dogs were barking, jumping, and whining for our attention. It was complete chaos. As we turned the corner to walk down another aisle, there was an odd-looking, but calm, mixed breed. I asked the shelter volunteer in amusement, “What in the world is that?” The volunteer said, “We think he’s part American Bulldog. He’s a really nice dog. Do you want me to take him out, and you guys can hang out?” My son and I discussed and agreed to meet this unusual looking canine. His name was Mack.
As those that have toured an animal shelter know, it’s tough to visit without coming home with a new friend! Before we knew it, Mack was in our back seat smiling, tongue hanging out, and throwing his slobber all over my car. Besides his overwhelming big-dog smell, poor eating manners, excessive shedding, and old-man snoring, Mack has been a great dog.
Given his above average weight and tendency to remain immobile once comfortable, he’s earned the nickname Jabba the Mutt. Weighing 120lbs, he’s a handful on walks. His size and unique appearance can also be intimidating. To provide adequate room and comfort, I’ll usually pull him off the sidewalk when pedestrian traffic is approaching. However, to avoid him, sometimes people will turn around before I’m able to move him from their path. “That’s okay, Mack,” I tell him, “Not everyone understands how beautiful you are on the inside.”
One day on our walk, I noticed a lady coming toward us. I pulled Mack off the sidewalk to allow her to pass. To our surprise, instead of walking by at a safe distance, the lady stopped, looked Mack in the eyes and said, “Look at you! What a beautiful dog! Can I pet him?” Mack wagged his tail in excitement. The lady pet him and returned to her walk. While I knew Mack wasn’t beautiful by traditional dog standards, the stranger’s kindness was appreciated. Mack’s tail continued to wag as he walked home with pride, a smile, and, of course, slobber running down his face.
Recent economic data has been deemed pretty by Wall Street. Three major reports were issued in January and early February. On January 12th, the Bureau of Labor Statistics (BLS) released the Consumer Price Index showing the rate of inflation declined 0.1% in December 2022. The year-over-year inflation rate declined to 6.5%, down from 7.1% the previous month. On January 26th, the Bureau of Economic Analysis reported real gross domestic product (GDP) increased at an annual rate of 2.9% in Q4 2022. While down from 3.2% in Q3 2022, growth was above expectations, reducing concerns of recession. And finally, on February 3rd, the BLS reported nonfarm payroll employment rose by 517,000 in January, with the unemployment rate remaining low at 3.4%.
While we acknowledge recent reports appear favorable, we avoid using government data to form our macroeconomic opinions. Instead, we rely on the operating results and analysis of the hundreds of publicly traded businesses we follow. Over the past three decades, we’ve found our bottom-up views sometimes differ from government reports and most economists.
For example, in October 2020, when central bankers and Wall Street were obsessed with deflation, we began noticing signs of rising inflation (Loose Teeth and Tangible Assets). We wrote, “While recent events driven by COVID-19 certainly caused many prices and costs to decline earlier this year, last quarter’s operating results and conference calls provided many examples of shifting inflationary trends. In particular, several companies we monitor reported rising average selling prices, fewer promotions, supply disruptions, and even labor constraints.” Eventually, the inflation that businesses were experiencing made its way into the government data, with the deflation myth finally being debunked in 2022.
Our bottom-up view is again conflicting with economic data and the consensus. As investors celebrate the decline in the rate of inflation and continued expansion, we’re noticing cracks beginning to form in the economy. It isn’t a sudden shift or collapse in demand like we saw at the end of the housing bubble in 2008. The changes are more subtle, emerging, and partially camouflaged by inflation masquerading as growth. It feels more like 2007 than 2008. In 2007, we were also noticing shifts in business trends as the corporate earnings cycle was showing signs of weakening. Interestingly, for most of 2007, GDP, inflation, and employment were also considered healthy just as the operating environment began to change. Similar to 2007, we do not believe today’s developing trends are being reflected in the government’s data or the consensus view.
One of the more noteworthy themes we’ve been documenting recently is companies reporting rising revenues while also reporting declining volumes, traffic, or transactions. This trend has become more apparent this earnings season with a variety of businesses reporting healthy sales growth with much of the growth coming from pricing. While many businesses do not disclose volumes, we appreciate those that do, as we find it very helpful in forming our opinion on economic activity net of inflation. We’ve listed several examples.
H.B. Fuller (FUL): “Revenue was up 6.4% with pricing having a favorable impact of 11.4% year-on-year in the quarter and volume down 5%, reflecting a slowdown in end market demand…”
Scotts Miracle-Gro (SMG): During the quarter, sales in Scotts’ U.S consumer division increased 8% with 13% coming from price and 5% being subtracted due to lower volume and mix. Scotts’ noted similar trends in its outlook, saying, “So the first half of the year will be slightly up on revenue. However, again, volumes slightly down…but pricing coming through.”
CSX Corporation (CSX): “Merchandise revenue increased 7% in the quarter, as a 9% increase in revenue per unit more than offset a 2% decline in volume. 2022 merchandise growth was driven by higher fuel surcharge combined with an increasing pricing environment as inflation accelerated through the year.”
Sherwin-Williams (SHW): “For the full year 2023, we expect consolidated net sales to be flat to down mid-single digits, inclusive of a mid-single-digit price carryover from 2022.”
Ethan Allen (ETD): “Our consolidated net sales of $203.2 million were helped by strong backlog, pricing actions taken and the positive effects of product mix, partially offset by lower unit volume.”
Hubbell (HUBB): “You see sales growth of 11%, up over $1.2 billion. That 11% is comprised of high single digits of price, low single digits of volume and 1 point from acquisition.”
A.O. Smith (AOS): “North America water heater sales grew 10% in 2022 due to 2021 pricing actions implemented in response to rising material and logistic costs, and acquisition-related revenue that was partially offset by lower residential volumes.”
Pentair (PNR): “We delivered fourth quarter sales growth of 1% with core sales declining 3%, as strong price contribution was not enough to offset volume decline. In the fourth quarter, Consumer Solutions sales declined 1% with core sales declining 11%, comprised of 15% price, offset by 26% of volume decline.”
United Parcel Service (UPS): “In the fourth quarter, average daily volume was down 3.8% versus the same time period last year. Revenue per piece increased 7.2%, driven by revenue quality, which more than offset the decline in volume.”
The Toro Company (TTC): “And we do expect to see 7% to 10% sales growth in the year for our full year guidance. We will probably see more price than volume…”
Starbucks (SBUX): “Global comparable store sales increased 5%, primarily driven by a 7% increase in average ticket, partially offset by a 2% decline in comparable transactions.”
Packaging Corporation of America (PKG): “Corrugated product shipments were down 8.7% per workday. Inflationary pressures on the consumers have also added to the problem by reducing the consumers discretionary spending capabilities.”
“Prices and mix [in the Paper Division] were up 21% from last year's fourth quarter and moved 3% higher from the third quarter of 2022 as we continue to implement our previously announced price increases. Sales volume was about 11% below last year's fourth quarter…”
Procter & Gamble (PG): “Organic sales grew 5%, pricing at 10 points to sales growth and mix was up 1 point. Volume declined 6% driven by a combination of market contraction, trade inventory reductions and portfolio reduction in Russia.”
Brinker International (EAT): “Chili's comp store sales increased 8%. We executed incremental pricing actions in the quarter, both on the menu and in third-party delivery channels, resulting in year-over-year pricing of 10%. Negative traffic at Chili's of 7.6% was in line with our expectations and was clearly more than offset with the ability to incrementally price and drive mix.”
While the rate of inflation has moderated, price increases continue and remain an important contributor to corporate revenue growth. Further, the significant amount of inflation accumulated over the past two years has not receded and continues to influence consumer and business decision-making. Put simply, accumulated inflation has reduced discretionary cash flows and the affordability of many goods and services. In such an environment, it’s not surprising many companies are reporting lower activity (volume, traffic, and transactions) even as they report positive sales growth.
Higher prices combined with lower activity—also known as stagflation—is not something recent economic reports are communicating. Instead, economic data is supporting the narrative of continued economic growth with declining inflation and strong employment. Similar to 2007, we believe there is a growing disconnect between government economic reports and the operating results of the businesses we follow. Based on our bottom-up view, we do not believe economic activity, net of inflation, is as robust as recent economic reports indicate. And while it’s too early to determine if we’re heading into a lethargic and ugly Jabba the Mutt recession like 2008, current economic conditions certainly aren’t the award-winning purebred investors appear to be pricing into risk assets.
Eric Cinnamond
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