In this podcast, Motley Fool senior analyst Asit Sharma discusses:
- FedEx cutting $1 billion in costs to make up for weak demand.
- UPS solidly outperforming FedEx (for years).
- Nike getting past inventory problems and increasing digital sales.
Motley Fool senior analyst John Rotonti and Motley Fool producer Ricky Mulvey analyze the implications of interest rates being higher for longer and one company that’s benefiting.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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This video was recorded on Dec. 21, 2022.
Chris Hill: I don’t know about you, but I was today years old when I learned that Nike’s original name was Blue Ribbon Sports. Motley Fool Money starts now.
I’m Chris Hill. Joining me today: Motley Fool Senior Analyst Asit Sharma. Thanks for being here.
Asit Sharma: Chris, I appreciate you having me on.
Chris Hill: We will get to Nike’s latest in a minute, but we’re going to start with FedEx. Second-quarter revenue was about a billion dollars lower than Wall Street was expecting, and coincidentally, $1 billion is what FedEx management says they’re going to cut in terms of costs. On the bright side, their profits were better than expected, but right now, Asit, it looks like FedEx has a demand problem.
Asit Sharma: I think so. Chris, last-quarter management wanted to blame that weakened demand on the economy at large. I think there’s some argument to be made there that all the carriers in this space are going to grapple with weakened demand. But FedEx just seems to be giving up market share. That’s what many market watchers think. I think it’s what many industry analysts think.
This quarter, by upping this cost-reduction program, they came back to investors and said, well, we don’t really know. We think it’s macroeconomic. Either way we’re going to go ahead and reduce our overhead expenses to match these lower volumes and I think investors applaud that.
They’re making some moves that remind me of the rail industry. When you have a bunch of fixed costs, what can you do? Well, you can park planes the same way that rail companies will park there locomotives when volumes decline. They will furlough some employees. They’ll do everything in their power to match that top line and be able to produce profits free cash flow for investors.
All in all, I think this was a good report. But I hear it in your voice, Chris, I hear maybe some skepticism, like that’s a big number; $3.7 billion is the total goal at this point. I look at the last trailing 12 months of FedEx operations. Their total operating income was $6.3 billion, so you’re saying that you can add another 3.7 billion bucks to that take-home. I don’t know about this.
Chris Hill: I don’t, either, and it seems like UPS has not just had a better year than FedEx , they’ve had a better five years than FedEx. And not to say that UPS as a business and a stock is having a great 2022; it’s down about 16% or so. FedEx is down twice that, and I’m wondering if just fundamentally… because I think about these two businesses the way I think about Coke and Pepsi, the way I think about Home Depot and Lowe’s. Fundamentally, it just seems like UPS is a better operator and has been for a while now.
Asit Sharma: I’d be inclined to agree with you. I’m no expert on the freight logistics/air package industry, but I will say even to an armchair observer, the fact that UPS has stuck to its knitting over the past several years and just tried to optimize their operations versus FedEx, which expanded in Europe. They’ve tried to expand their different modalities of transport.
I think sometimes it’s a virtue in just getting better. That way, you already have your cost structure optimized. You don’t have to come back to investors when your express is falling off and then say, look, we’re going to try to operate in a more rational manner. I would have to agree with you there. UPS has certainly shown that it’s the more consistent performer of the two. That’s been highlighted over the past few quarters in this really volatile economy that we have.
Chris Hill: Nike is ending the calendar year on a positive note. Second-quarter profits were much higher than expected. Revenue looked good, inventory is up year over year, but it is down from the previous quarter, and CEO John Donahoe says Nike is past its inventory peak and I think investors as a group believe him, because shares of Nike are up more than 13% today.
Asit Sharma: Yeah, shares are off to the races. I think this only tells part of the story. When we look at the fact that the inventory is down sequentially 3%, there’s something else that is probably underneath this, propelling both institutional investors, retail investors to buy shares today. That’s the fact that Nike was able to generate 17% on its top-line growth year over year.
You’ve got this equation where they’re sacrificing gross margins. Gross margin was down about 3 percentage points to close to 43%, but sales are still growing pretty quickly. We’ve got the direct business, so Nike’s direct-to-consumer business that has growth of 16% this quarter year over year. The digital business: 34% growth when you adjust for foreign currency translation.
What you’ve got here is a company that’s telling you, look, we’re slashing some prices on the older stuff. We’re trying to get the inventory under control. But if you look under the hood, this business is still growing pretty quickly, and in fact, our average selling price of Nike brand products is still moving in a positive direction.
When you put all those pieces together, you’re like, okay, I’ve got a company here which spends 8% to generate it’s sales, that’s their demand-creation expense as a percentage of sales. Think marketing, advertising, what they spend on endorsements. You’ve got a pretty good business proposition here with this hit the stock has taken this year. So I think people want to pour back into what’s been a fairly stable company except for this one issue with the inventory.
Chris Hill: I’m glad you mentioned that digital sales growth, because as you said, even with the rise today, the stock is down more than 25% year to date. But this is such a quality business. It is a premium brand. And it’s not just that I look at everything that comes with this quarter and the comments from Donahoe and his team and think to myself, were are the good outweighs the bad.
No, the good substantially outweighs the bad. As you said, there are some gross margin pressure that they’re hitting. The inventory is still up, I think it’s 43% year over year, but the trend line. When you take the trend line for the inventory, the digital sales growth, all the other factors here, combine it with the fact that the stock has been hit the way it has, it makes perfect sense that as you said, we’re seeing individual investors and institutional investors loading up on the stock today.
Asit Sharma: I think there’s one other thing that really jumps out at me here when I look at this report, and that’s the fact that this is still basically a footwear company. In their breakdown of divisional revenues, you see that apparel and equipment, they grew in every geography, but not like the footwear division. Sneakers propels this company forward. If the inventory is bulked up past 9 billion bucks, so much of that is in footwear.
We know it’s going to sell, and the numbers also show that we’ll pull back on stuff like equipment, clothes, technical apparel, but we’re still going to replace our sneakers. That’s what these numbers tell us, I know that sounds very basic, but sometimes these really basic equations and business model are what make a company like Nike great year after year after year.
Chris Hill: It’s a great reminder, because this is a business that has, in the past, expanded into other areas and not all of them have worked. I forget the exact year, I want to say it was maybe 2018, maybe it was 2017, where Nike basically said, we’re going to fold up our golf line. They made a big push into golf with Tiger Woods, and ultimately, the business just didn’t work for them to the point where they said, we’re shutting this down.
Asit Sharma: For them, like a small experiment. That’s fine, they’ll take that any day. They’ve got the balance sheet, they’ve got the distribution. We can expect them to push in and pull out of certain subcategories. But again, Nike is known for its footwear. They pointed out in the earnings conference call, I think this was Donahoe, that Nike shoes, with a little adjustment to the technical specs this year in the World Cup, were responsible for more scored goals in the World Cup versus any other sneaker, which I read this and I’m like, corporate-speak celebratory.
But there’s something there to athletes all over the world. You can’t replace the brand presence they still exercise in the marketplace and that’s another reason why, if you’re thinking, well, will Nike keep going would keep increasing sales year after year. The stock keep rising, there are some good reasons why underneath there.
Chris Hill: Asit Sharma, great talking to you. Thanks for being here.
Asit Sharma: Thanks so much, Chris. It’s a lot of fun.
Chris Hill: You’ve probably heard the phrase “Don’t fight the Fed.” But what does that mean in action? Motley Fool Senior Analyst John Rotonti joined Ricky Mulvey to talk about the implications of interest rates being higher for longer and one company that’s benefiting from it.
Ricky Mulvey: “Don’t fight the Fed” is this common trope that we hear. But in your view, what does it mean for an investor to fight the Fed? What’s that actually mean beyond something you see on Twitter?
John Rotonti: I’m pretty sure Martin Zweig coined the term “Don’t fight the Fed” in his very popular book, Winning on Wall Street, published in the early 1970s. At least I think that’s when it was published. What it really means, Ricky is that our economy is not as laissez-faire or free market as you may read in the textbooks. Rather, we have a manipulated, interventionist economy, and a primary institution doing the manipulation is the Federal Reserve.
To be clear, I am not prepared to share whether I think this manipulation is positive or negative. I’m not smart enough to even determine that. I do think that our current Fed, led by Chair Jerome Powell, is at least now doing the right thing to get our economy back on track, because it went way off the rails for a while.
Zero-percent interest rates is just not normal for so many reasons, some of which are that it leads to slow growth. That’s No. 1. Its zombifies the economy, that’s No. 2. No. 3, it leads to the creation of weak business models that are very fragile. No. 4, it leaves no room to decrease rates in times of crisis. No. 5, it absolutely crushes savers.
It’s undeniable that this manipulation is taking place. What’s also undeniable, Ricky, is that at times, it contributes to the inflation of asset prices, which is bubbles. At times, it also contributes to the misallocation of capital by keeping zombie companies alive for longer than they should be. When you keep zombie companies alive for longer than they should be, that slows the flow of capital into other better, more productive businesses.
Ricky Mulvey: The zombie company has to do with their debt ratio, right?
John Rotonti: Companies that have too much debt that they can’t afford, and they’re not making any money or they’re making very little money, not enough to cover their debt service. But when interest rates are zero, they’re put on life support indefinitely. That’s not how a free capital market should work. Free capital markets should penalize dying companies so that capital can flow to growing more productive companies that can hire more people and pay higher-paying jobs and contribute to the growth of the economy.
Some winners and some losers, at least in the short term, Ricky, are not determined by competitive dynamics and free market forces but rather by Fed policy. It’s this idea that investors should position their portfolios in a way and determine the amount of risk-on or risk-off that they want to take based on Fed policy. That’s what “Don’t fight the Fed” mean.
Ricky Mulvey: Moving on to the businesses though, what are some examples of how businesses’ decision change when the cost of capital rises like it is right now?
John Rotonti: It affects businesses in so many ways. First of all, higher interest expense, higher interest rates. All else equal leads to higher interest expense on your debt. That’s an income statement line item. So that decreases earnings. When earnings decrease, all else equal, valuations fall. That’s the first thing, it affects the P&L.
The second thing is when interest rates are rising, cost of capital is rising. That means two things. One, it means it’s more expensive to get financing to finance projects. If you want to build a new plant, you want to build a new facility, that’s more expensive to do. Your hurdle rate to decide whether to make that investment or not, it’s higher.
We have this situation right now. You can’t make this up, Ricky. We have this situation right now where the U.S. massively underinvested in infrastructure for the last 12 years. Let’s say, since the Global Financial Crisis. The U.S. massively under-invested in energy, in oil and gas, specifically massively. It massively underinvested in housing. We’re anywhere from 4 to 5 to 7 million homes short, depending on what source you’re looking at. Then we massively underinvested in infrastructure. Massively. Roads and bridges are crumbling before our eyes.
After a decade-plus of underinvesting in infrastructure, what’s going to happen now? Interest rates are going up, cost of capital is going up. That’s going to decrease investment in infrastructure even more.
It’s a really precarious situation that we’re in. Really precarious, after 10-plus years of underinvesting in three extremely indispensable and critical parts of our economy: housing, energy, and infrastructure. After 10-plus years of underinvesting, we’re now making it more expensive to invest in those areas. I’m not saying this is right or wrong. I’m just calling it as I see it, Ricky.
Ricky Mulvey: So when you think of a company that’s not fighting the Fed — we’ll move to those trends and talk more about one of those trends in a sec. What do you think of when you think of a company that’s not fighting the Fed?
John Rotonti: Non-earning, cash-burning, high-growth businesses that design their business models to be based on stock-based compensation. Literally, they design their business models for their main source of financing to come from their employee base through equity issuances in the form of stock-based compensation.
That is a very, fragile business model in a time of rising rates and increasing cost of capital. Because companies only have three sources of capital, three and only three. Internally generated free cash flow.
Well, I just said that a lot of these companies are cash-burning. Not generating free cash flow, so that source goes out the door. Debt is No. 2. Well, if you want to raise debt, it’s going to be higher interest rate, it’s going to be more expensive. That’s not as ideal as it was when interest rates were zero.
Equity is No. 3. Well, higher interest rates drive down equity prices. Stocks have gotten crushed. If you want to issue stock, it becomes much more expensive and much more dilutive to existing shareholders. Those companies that are not self-funding don’t have any really good options. A company like Blackstone, however, has $182 billion in dry powder. That’s undrawn capital, it’s cash that they have collected from investors sitting in a fund that they have not yet invested.
I can’t think of a firm, including Berkshire Hathaway and Alphabet, that has more capital available to invest countercyclically in distressed assets in a downturn. I can’t think of a company better positioned to deploy large amounts of capital and downturn, to plant the seeds for higher growth and even higher returns coming out of a downturn, than really well-run alternative asset managers like Blackstone.
I just said that we have massive underinvestment in infrastructure in this country. Well, guess what? Blackstone has a massive infrastructure business. When all these assets go on sale, Blackstone is going to be there to scoop them up. Blackstone has the largest real estate business in the world. Real estate, which we can get into, is an excellent place to be in a time of high inflation and rising interest rates. Contrary to what some people may think, it’s a very, very good place to be.
Ricky Mulvey: Let’s get into real estate. Because homebuilders is one where one might think that they’re fighting the Fed. Or did you have a point you wanted to wrap up before we moved on?
John Rotonti: No, we’re talking about real estate and homebuilders in the same vein.
The real estate that Blackstone owns, Ricky is, first of all, it’s in great areas in the Sun Belt, Texas, and Florida. Seventy-five percent of their real estate is in Texas and Florida, and 75% of their real estate is rental housing, logistic warehouses, really for e-commerce deliveries. Seventy-five percent of the real estate portfolio.
That real estate is not only in places in the Sun Belt with great population inflows and good demographics and good growth. But these are short-duration leases. They can reprice them higher, and that gives them pricing power. Housing is typically rented for one year, so they can reprice their housing every year.
Warehouses and logistics, they start with three- to five-year initial terms. But then after the three- to five-year initial term, those reprice yearly as well, so they can increase prices in their warehouse portfolio yearly.
Importantly, Blackstone has disclosed that their warehouses and their residential leases are well below market rates. Those are going to reprice significantly higher. They have pent-up pricing power in their rental housing portfolio and in their logistics portfolio. I’ll get to housing in a second.
They also own hotels. Guess what? They own the Bellagio and the Cosmo in Vegas, for example. Hotels reprice nightly. Blackstone’s real estate portfolio has the ability to rerent higher very quickly, and that gives them pricing power.
The other thing with real estate is in a high-inflation environment like we’re in now, the replacement cost to build a brand-new competing property from scratch is much higher because the input costs to build that piece of property is much higher.
Existing properties become more attractive then become more valued. Yeah, Blackstone is a great place to be. Real estate is a great place to be.
Oh, before we go into housing. Blackstone also has the credit business. Ninety percent of that is floating rate debt, which means it floats higher, adjusts higher when interest rates go up. Which means investors in Blackstone’s credit funds actually make more money when rates go up. Yeah, Blackstone would be my answer.
Look, housing, I was talking about rental housing with Blackstone, but homebuilders, Ricky. We need to take a step back. It’s really important now to share what the Fed is doing, It’s also kind of fascinating. What the Fed is doing is that Fed needs to decrease the wealth effect. It needs to decrease the wealth effect, because when people feel less wealthy, they may decide to buy fewer goods and services.
When they decide to buy fewer goods and services, that drives down demand for goods and services, and when demand for goods and services goes down, that drives down prices, and when prices goes down, that helps to bring down inflation. What the Fed has to do is decrease how wealthy people feel. Well, why do you think they started with housing, Ricky?
Two really important reasons. Let’s make no mistake about it. The Fed wanted to crush the housing market. One reason is because it’s a low-hanging fruit. Why? Because people buy their houses with debt, they take out a mortgage, they use leverage, and those mortgages are driven by interest rates. Housing is very interest rate sensitive. That was low-hanging fruit.
The other reason is if you want to make people feel less wealthy, go after their largest financial asset. For the vast majority of people in the U.S., their home is their largest financial asset. It is no surprise that the Fed crushed housing. That’s just textbook 101 how to bring down inflation.
What’s the next big-ticket item, Ricky? The next big-ticket item, high priced item that is interest rate sensitive, that people use debt. Cars first. Cars. What happened to cars? Cars get crushed. Used-car prices shot up, and now they’ve fallen back down.
Then stocks, you’re exactly right. If you want to bring down household net worth, you want to make people feel less wealthy, you go after the stock market.
Those are the tools that Fed has. It’s not that they want to go after the stock market. It’s just that when rates go up, stocks go down. Why? It’s very simple. Because you could think about it in two ways. One is when bond rates go up investors will sell stocks to get higher equity-like returns from bonds, but with taking less risk. You can get less risk, higher return for a bond if you sell stocks. That’s one way to think about it.
The other way to think about it is when interest rates go up, the cost of capital goes up; when the cost of capital goes up, the discount rate in your discounted cash flow model goes up; when the discount rate in the discounted cash flow model goes up, the present value of future free cash flow goes down; and when the value of free cash flow goes down, the value of the business goes down; when the value of the business goes down, stocks fall. That’s what’s happening.
Now, we’ve talked about why the Fed went after housing. Let’s talk about housing. We underbuilt coming out of the global financial crisis. I don’t know if it’s Freddie Mac or Fannie Mae. I get them confused. But one of them estimated we’re 3.7 million homes short of where we need to be to meet household formation, to meet demand. Other industry-specific, like the real estate Association and other Homebuilders Association, have estimated where as much as 6 or 7 million homes short of where we need to be. Anywhere from 4 million to 7 million homes short, based on current build rates, that’ll take us like five to seven years to build. We are dramatically underhomed in the U.S. We have dramatic underdevelopment.
Right now home prices are getting crushed. But I think long term, homebuilders are one of the three most attractive industries, in my opinion, because of the massive under-investment.
If you read the asset management investor letters, they talk a lot about the capital cycle and how almost all industries go through a capital cycle. You don’t want to invest when everyone is plowing money into an industry like we saw with software. That’s not when you want to invest. Returns don’t come from where capital is plentiful. Returns come from where capital is scarce and homebuilders is capitalist scarce.
We underbuilt, we underdeveloped for a decade-plus, we are undercapacity, we are underutilized, and so we have to rectify that. Especially when the largest age cohort in U.S. history, millennials, are in their prime homebuying years. At the same time when you have less homes than we need to meet demand is at the exact same time when demand for homes is going to go up.
I think in the next 10 years, even shorter than that. I think in the next five to seven years, homebuilders is an excellent place to be, and I’ve put my money there. I own two pure-play homebuilders in the portfolio that I lead for The Motley Fool.
Ricky Mulvey: John Rotonti, I think we have a lot more to talk about, but unfortunately, we are at time. Always great chatting with you.
John Rotonti: Thank you, Ricky. Thanks, Fools.
Chis Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based on what you hear.
I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.