By Ward Davis
This past Valentine’s Day, the crew of BMW Oracle achieved owner Larry Ellison’s ambition to win the America’s Cup and bring the sailing regatta back to its namesake waters. It only took $300 million dollars of investment in multihull and wing technology and years of court appeals to secure the victory held off the coast of Valencia, Spain. The BMW Oracle sported a wing mast that cost $5 million alone – the price of an entire America’s Cup campaign ten years earlier!
Ernesto Bertarelli’s Alinghi 5 was so light that she was unable to sail effectively in winds over 15 knots or with waves much over a few feet high. Ellison’s boat was much heavier and more capable of handling the rough conditions. Despite a costly botched start in the first race, BMW Oracle blew by Alinghi (literally) and swept the best of three series two to nil. The Oracle CEO will likely bring the 34th America’s Cup series back to his home Golden Gate Yacht Club in San Francisco. However, San Diego and Newport are preparing big legal and PR battles to bring the regatta to their respective waters.
Was it all worth it? Certainly Ellison and his team think so. Yet, the integrity of the sport has been marred by the gross amount of money needed to mount a challenge. The America’s Cup may be back on U.S. shores, but at the current pace it may cost over a half billion dollars to compete. Perhaps the Italian team, Mascalzone Latino, accepted as challenger of record for the 34th America’s Cup, could finance the cost by selling future proceeds from Italy’s national lottery.
The startling rally of the U.S. dollar has caught many in our circles by surprise. It was just a few short months ago that economists and strategists on Wall Street and especially abroad were calling the U.S. a Banana Republic and predicting the demise of the dollar. But the aftershocks of the global credit crisis proved too much for the European Union, its weaker members and its proud currency.
Like Bertarelli and his Alinghi 5, Trichet and his PIIGS had difficulty navigating in unpredictably rough conditions. Billions of dollars of monetary stimulus and centralized decision making by the Fed “won out” in the end for the U.S. currency. Like Ellison hoisting the Auld Mug in celebration, Chairman Bernanke ran his own victory lap of sorts recently by raising the discount rate 25 basis points. Given the fragility of the global economy, let’s just hope this is pure bravado and not a sign of a tightening bias.
The surging dollar
Since late November 2009 the dollar has risen over 10% versus the euro and 5% versus the Japanese yen. These moves may seem somewhat inconsequential, but don’t say that to multinational businesses headquartered in the U.S. With stubbornly high unemployment that appears to be worsening in light of recent continuing claims data, inflation of material costs highlighted by the Producer Price Index and a recent retreat of existing home sales, a surging dollar may not be so welcomed.
Companies with sizeable sales and profit exposure to Europe will soon have to anniversary the benefits of uplifting currency translation from last year. Multinational consumer staples companies are particularly vulnerable to this headwind over the next few quarters. We have identified a handful of companies where the reversal in currency trends has not been appropriately factored into earnings estimates. Moreover, the steep decline in cost of goods given last year’s deflation trend has pushed many of these companies to peak and unsustainable rates of profitability. This is fertile ground for short selling.
Eating inflation
Bernanke’s move to raise the discount rate may have been a response to the strong upward trend of the Producer Price Index, particularly the food component. We continue to see food inflation creep back into the finished foods component of the Producer Price Index and Food-at-Home component of the Consumer Price Index. Food-at-Home increased 1.5% in January, representing both a sequential improvement to December (+1.1%) and a second consecutive month of positive print after seven months of deflation.
Food distributors and retailers will no doubt be thrilled to see moderate inflation, as the current deflationary environment has pressured margins significantly. However, over the past several quarters, restaurants have benefited from two broad themes: the ability to push pricing strong in 2008 and early 2009 (as evidenced by mid-single to high-single digit Consumer Price Index food-away-from-home data, and deflation in most food input costs.
This combination of factors, along with general cost-cutting, has helped some restaurants generate near-record operating margins, despite weak traffic levels and declining unit productivity. Looking across the restaurant sector, McDonald’s, YUM! Brands, Chipotle and Buffalo Wild Wings are setting new record operating margins while Darden Restaurants and other casual diners are at near-peak margins. These peak margins are being achieved while same store sales are running negative against easy comparisons to the previous year.
We believe that these factors are about to abate as restaurants return to more-moderate pricing levels and food costs inflate. Given sustained weakness in restaurant traffic (principally because we remain over-stored in the U.S.), we expect to see sharp margin erosion in the quarters ahead for many of these operators.
Ward Davis is founder and portfolio manager of global long/short equity hedge fund Caerus Global Investors in New York. This column was adapted from a recent letter to his investors.