Strong GDP Growth Continues

from The Wall Street Journal

Oct. 28, 2005

U.S. economic growth sped up in the third quarter despite the impact of
Hurricanes Katrina and Rita. Gross domestic product rose at a seasonally
adjusted 3.8% annual rate, the Commerce Department reported.

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Timothy Burger
timothyb(at)timothyburger.com

New Chipolte Documents Out

Chipotle released some additional details about their planned IPO, which will take place early next year.

The registration statement tells us they are planning to sell 100 million shares, or McDonalds' 92% stake in the company. It is probably the most colorful and descriptive registration statement I have seen recently, it is everything you would expect from Chipotle (except you can't eat it).

Doing a little back of the envelope math, it seems to me that EBITDA per share will end up somewhere around $.48 for 2005, leading to the most important question: how much is this one going to cost? Unfortunately the price per share has not been announced yet, so stay tuned.

Timothy Burger
timothyb(at)timothyburger.com

Merck Earnings Up

Merck announced earnings yesterday morning, net income was up 7.2%, despite a 2.2% fall in sales.

The stock was up a little yesterday, down by a fraction today, still the cheapest big pharma stock out there.

Timothy Burger
timothyb(at)timothyburger.com

China's Labor Pains

McKinsey has a new article about the quality and quantity of China's engineering and managerial talent. For all of the hype surrounding China's growth (9% plus again this year), I believe that serious questions still remain about the sustainability of the China miracle.

The Chinese still have major issues to deal with regarding banking, political stability and intellectual property rights. While the Chinese have taken major steps, they still have a long way to go.

"China's pool of potential talent is enormous. In 2003 China had roughly 8.5 million young professional graduates with up to seven years' work experience and an additional 97 million people that would qualify for support-staff positions.

Despite this apparently vast supply, multinational companies are finding that few graduates have the necessary skills for service occupations. According to interviews with 83 human-resources professionals involved with hiring local graduates in low-wage countries, fewer than 10 percent of Chinese job candidates, on average, would be suitable for work in a foreign company in the nine occupations we studied: engineers, finance workers, accountants, quantitative analysts, generalists, life science researchers, doctors, nurses, and support staff.

Consider engineers. China has 1.6 million young ones, more than any other country we examined.¹ Indeed, 33 percent of the university students in China study engineering,² compared with 20 percent in Germany and just 4 percent in India. But the main drawback of Chinese applicants for engineering jobs, our interviewees said, is the educational system's bias toward theory. Compared with engineering graduates in Europe and North America, who work in teams to achieve practical solutions, Chinese students get little practical experience in projects or teamwork. The result of these differences is that China's pool of young engineers considered suitable for work in multinationals is just 160,000—no larger than the United Kingdom's. Hence the paradox of shortages amid plenty."

Timothy Burger
timothyb(at)timothyburger.com

The Housing Bubble vs. The Consumer Spending Bubble

I am starting to think that the real impact of rising interest rates will not be the much anticipated crash in housing prices that everyone expects. While I still believe that rising rates will affect housing prices, I think the big impact will be on consumer spending.

This weekend I was looking at some economic data on Bloomberg, specifically data on mortgage rates and the average rate on all outstanding mortgages. While looking at a chart, I started to think: this doesn't seem to be the inverse of housing prices, or the change in housing prices, since housing prices continued to rise in the face of rising rates in the seventies.


While there are probably a lot of other reasons that explain that rise (baby boomers establishing households and buying homes), I started to compare other charts. I eventually looked at personal income and the change in personal income. Personal income seems to match housing prices very well. While I haven't done the analysis to determine the actual correlation and determine how much of housing prices can be explained, a from-the-hip look at the charts makes me think the is a fair chance the numbers will turn out well.

The graph is a little hard to read, white is personal income year over year % change, orange is housing prices (adjusted for changes in housing quality) yoy % change, yellow is housing price, green is personal income. It will be a busy week, so I may not come up with the actual numbers this week, but I will let everyone know what I find out.

My working thesis goes something like this: rising long term rates will help stunt the growth of, but not cause a crash in housing prices. Unfortunately, the real driver of housing prices, personal income, also stagnates due to increasing global competition for all types of labor. This results in flat to moderately lower housing prices.

The effect is the elimination of growth in home equity. Most people don't realize the magnitude of the home equity market. John Mauldin, citing economy.com research, says that home owners have withdrawn $700 billion in home equity to fuel additional spending and pay down other debts. Less home equity growth means less home equity to borrow against, coupled with higher rates, means less money coming from home equity borrowing.

From here on I will let the fine people at Hoisington Asset Management take the ball:

"The housing sector's critical role in sustaining consumer spending is also illustrated by contrasting the growth in real disposable personal income (DPI) with real Personal Consumption Expenditures (PCE). Over the last twelve months, real PCE gained 3.5% while real DPI was up a slim 1.4%. Housing equity cash "takeouts" played an important role in closing this gap. The main factor suppressing DPI has been a severe squeeze on wage earners. In the past twelve months, average real weekly earnings declined 1.1% as nominal wages trailed inflation. Without a continuing fresh supply of funds from the housing sector, consumer spending growth could slow precipitously.

"Responding to Fed rate actions, the household debt service ratio was an unparalleled 13.6% in the second quarter, 1.3% greater than the old mark set three years ago. Short-term interest rates have increased since spring, so debt burdens are destined to climb, and the current record high readings of credit card delinquencies and bankruptcies may soon be broken.

"The consumer must also confront bulging energy prices. In August, total consumer fuel expenditures were 9.1% of total wage and salary income, a level not seen in nineteen years. Total fuel expenditures now total $527 billion versus $298 billion in February of 2002. Relative to wage and salary income, consumer fuel expenditures have advanced 3.1% from the 6% low of 2002. This change is larger than all previous oil hikes including the Arab oil embargo of 1973-74 and the embargo of the late 1970s with the fall of the Shah of Iran and the Soviet Union invasion of Afghanistan. Prior to the Arab oil embargo, the U.S. imported about 33% of its oil, versus over 70% currently (Chart 6). Over time, the pattern of consumer energy purchases being recycled into the domestic economy has been dramatically curtailed, leaving higher energy prices today a dead weight on the economy.

I think the end result is a squeezed consumer that has less money to spend on discretionary items. My take away: make sure that the companies you own can sell their goods and services, and keep some pricing power even during a squeeze on consumer spending.

Timothy Burger
timothyb(at)timothyburger.com