Friday, August 24, 2012

How China drives commodities down

It looks like the slowdown in commodities consumption by China in Australia and Canada is drawing closer as I predicted nearly a year ago. Aivars Lode IT Capital

Australia's resources minister, Martin Ferguson, has caused a stir with his assertion that the country's mining boom, one of the biggest drivers of its economic growth, is "over".
As he acknowledged, the state of the global economy has depressed demand for Australia's minerals and led to sagging commodity prices.
But those commodity prices have not just taken a tumble in Australia.
They have fallen globally, seemingly because Chinese economic growth has finally started to slow.
That is in part because European demand for its products has slowed. So China has started to produce less of those products, and needs smaller quantities of raw materials such as iron, copper, zinc and gold to do so.
Could Mr Ferguson's call on Australian commodities also be true for the global commodities market at large?
Exit the dragon
You know how you so frequently see "Made in China" stamped on the back of your toys, phones, in clothing labels, and on your food packets?
To make that volume of products that quietly dominate our lives, China has had to suck in a huge amount of the world's commodities.
According to the International Monetary Fund (IMF), in 2010, China consumed 40% of the world's base metals - aluminium, copper, lead, tin, zinc or nickel, all widely used in manufacturing the gadgets and goods we use every day - and 23% of the world supply of major agricultural crops like wheat and corn.
And to build the cities, roads, ports and factories needed to produce that stuff, China has staged a construction boom - upping its need for commodities even more.
But Chinese policymakers have decided it is time for their economy to move away from that.
Thomas Helbling, a research chief at the IMF, said that China's latest five-year plan for growth "strives to move the economy from investment- to consumption-driven growth".
In other words, it wants to stop pumping cash into importing commodities and building infrastructure, and focus on selling products and services to its growing middle class instead.
Changing it up
As China buys less raw material, the effect of its dominance becomes apparent and global prices are now going down.
That is having an impact on economies as a whole, as Australia's Mr Ferguson suggested.
Australian mining giants recently disappointed the country's politicians. One, BHP Billiton, said it would put on hold its Olympic Dam extension project, reportedly worth as much as $30bn, which it was hoped would create 25,000 jobs in South Australia.
Some thought BHP Billiton's decision was evidence of China's change in growth expectations beginning to impact global demand, and other economies as a whole.
And having been protected from global recession by their mining boom, Australians do not want to hear that this is now under threat.
But BHP Billiton said it thought shrinking commodities demand would stabilise in 2013, including from China.
Ruchir Sharma, head of global emerging markets equity at Morgan Stanley, told the BBC that China's economy was simply maturing, but that resulting lower global commodity prices could be good for emerging markets.
"China is moving to a much lower growth trajectory," Said Mr Sharma.
"It is maturing, just as Japan did in the 1970s, [South] Korea in the 1980s and Taiwan's economy in the 1990s.
"It has become too large to grow that quickly, and it is becoming less commodity intensive."
Mr Sharma thought lower commodity prices would benefit a lot of developing countries such as Turkey and India, and even developed countries including the US.
And he added that the price of oil was more likely to fall than to keep rising, in his view.
"If China's slowdown is managed right, it will be OK," he said.
Supply and demand
One thing that has kept commodity prices high has been the lack of supply to meet a huge growth in demand.
The demand has been fuelled by China's stellar growth, as it has become a major producer of the mobile phones and cheap T-shirts we use daily.
Commodities businesses all over the world have grown quickly off the back of that demand, making investments in mines, oil exploration, and boosting soybean production in Brazil, among other things.
But those investments often take time to bear fruit.
So commodities companies such as BHP Billiton are now deciding that the reduced demand for their products from China make it harder to justify investing in those projects for the moment.
For example, Jim Rodgers, co-founder with George Soros of the Quantum Fund, told the BBC that a lack of farmers played a starring role in a recent spike in food prices - grain, corn and soybean being critical parts of the food supply chain.
"The main determinant to commodities is supply and demand," said Mr Rodgers. "We are running out of farmers because nobody has gone into agriculture for the past 30 years."
The US, France and Mexico have said they may convene an emergency meeting at the end of August to address the high price of grain.
But Mr Rodgers does not think commodity prices will decline.
"I don't see any significant new supply to bring this bull market to an end," he said.

Tuesday, August 21, 2012

Deutsche Bank Warns of Australian Recession Risk

As I have discussed previously now, Deutsche bank predicts of Australian Recession. Aivars Lode IT Capital

SYDNEY—One of Europe's biggest banks on Tuesday warned against the growing risk of recession in Australia in 2013, as prices for commodities such as iron ore and coal spiral lower.
The warning by Deutsche Bank DBK.XE +5.09% comes amid rising concern that Australia's mining investment boom, which has insulated the commodity-rich economy from a global slowdown, is waning, leading to mine expansions being scaled back and mounting job losses.
Deal Journal
Policy makers are "dangerously complacent" about the risk now arrayed against the 1.4 trillion Australian dollar (US$1.5 trillion) economy, which relies heavily on prices paid for its biggest exports—iron ore, coal and gas—for its prosperity.
Australia's terms or trade, or the difference between what the country is paid for exports and what it pays for imports, may collapse by as much as 15% in 2012, said Adam Boyton, Deutsche Bank chief economist in Australia.
"Over the past 50 years such declines in the terms of trade have been seen only five times. In three out of those five instances the economy entered recession," he said, adding that there was "overconfidence that the investment pipeline is locked in."
An investment pipeline valued at close to A$500 billion is expected support economic growth over coming years, but cracks are increasingly showing in the country's mining industry.
Prices for exports of coal and iron ore have slipped to multiyear lows as growth has cooled in China, the country's biggest trading partner.
Problems for Australia's exporters are being deepened by a soaring Australian dollar, which is near 30-year highs as the world's central banks seek a haven for currency reserves in the country's triple-A-rated bonds. Calls have gone out for the Reserve Bank of Australia to weaken the currency either through interest-rate cuts or direct market intervention.
Mr. Boyton said a sharp drop in the terms of trade would have immediate consequences for the mining investment pipeline.
"History would counsel some caution on the investment outlook. Indeed, an average response to a circa 15% decline in the terms of trade would see business investment falling in year over year terms by early 2013," Mr. Boyton added.
The assessment stands in contrast to the upbeat one by the RBA, which earlier this month raised its forecast for economic growth in 2012 to 3.5% from 3.0%.
With confidence flagging, RBA Gov. Glenn Stevens has called on business and consumers to start to seeing Australia's economic position as a "glass half full."
The RBA said Tuesday it expected the mining investment boom to peak during 2013-14, but added the timing of the peak was uncertain.
Also Tuesday, corporate insolvencies hit a record in the year to June 30, according to the Australian Securities and Investment Commission. Mining states are among the worst hit, it said.
"We see one of the mining boom states, Queensland, showing one of the most dramatic increases in corporate failures," ASIC said. "Western Australia's financial year company failure figure is also the highest on record for that state."

Globalization and the Income Slowdown

This article is about the global shift of services resulting in income stagnation in the USA. Interestingly it identifies that education and health services are more local and difficult to disintermediation. Many insurance companies are sending patients overseas for procedures and even  MIT is committed to making all of its course ware available on line. Aivars Lode IT Capital

When I write about income stagnation apart from the Great Recession, I typically rely on a trio of explanations: Globalization, technology, and health care.
Competition drives down costs. Shoppers understand this, intuitively. One reason that flat-screen TV prices have fallen so much in the last ten years is that so many electronics companies have gotten efficient at making them. Similarly, competition for jobs in tradable goods and services — manufacturing that could be done in China; retail that’s simpler on Amazon — competes down the price employers pay workers in those industries. It makes many workersborderline-replaceable and nothing borderline-replaceable is expensive. Those forces drove down wages, and employer-side health care costs gnawed at the rest of it.
In my exchanges with economists so far, globalization is certainly among the most commonly cited factors for the income slowdown. American workers today face vastly more competition from foreign workers — especially foreign workers who earn much less money than the typical American — compared with past decades.
Benjamin Friedman — a Harvard professor and the author of the ambitious economic history “The Moral Consequences of Economic Growth” — told me that he would put global competition and technological change at the top of his list of causes, with the education slowdown (which, he noted,interacted with technological change) and cultural norms not far behind. Mr. Friedman pointed to Lucian Bebchuk’s research on soaring executive pay as an example of how much norms had changed.
In his next bucket of importance, Mr. Friedman listed health costs, an innovation plateau, the minimum wage, family structure and immigration. Immigration, he said, largely affects workers at the bottom end of the income spectrum.
Stephen S. Roach, the longtime Morgan Stanley economist and China expert who now teaches at Yale, offered a list with some strong similarities to Mr. Friedman’s. Mr. Roach put global competition, the educational slowdown and the innovation plateau at the top of his list, followed by automation, deregulation, rising health costs, immigration and the falling minimum wage.
He also said that the supply chain explosion — “rapid growth of integrated global production platforms that squeeze labor income at all stages of the production process” — deserved a place on the list. I’d probably argue that the supply chain was a subset of either globalization or automation, but I see why someone else might list it as a separate factor.
Mr. Thompson, in his post, included a chart — of employment by sector — that underscored the importance of globalization:

Employment by Industry Since 1939

Employment in each sector by year, in thousands.Chart courtesy of Derek ThompsonEmployment in each sector by year, in thousands.
As he notes, only one line defies the business cycle and just keeps going up: education and health care. He writes:
What do those sectors have in common? They’re all local. You can’t send them to Korea. As Michael Spence has explained, corporations have gotten so good at “creating and managing global supply chains” that large companies no longer grow much in the United States. They expand abroad. As a result, the vast majority (more than 97%, Spence says!) of job creation now happens in so-called nontradable sectors — those that exist outside of the global supply chain — that are often low-profit-margin businesses, like a hospital, or else not even businesses at all, like a school or mayor’s office.
This chart measures jobs, not incomes. I think it’s possible that parts of other sectors have delivered big average pay gains (most likely, the high-skill jobs) even if overall employment in those sectors hasn’t grown as fast as in education and health care. I also wonder how much technological innovation explains these lines: education and health care are notoriously inefficient sectors. But no matter how you look at the picture, globalization seems to be one of the biggest changes that has accompanied the great American income slowdown.

Monday, August 20, 2012

Why Groupon Is Poised For Collapse

A retrospective view which was accurate based upon where the share price has ended. I have friends in the restaurant business they confirmed how Group On operated  before this article came out. Aivars Lode IT Capital

Imagine you're a small business owner. You have to choose between two

1. You can pay $62,500 for marketing. You'll get a whole lot of
customers coming through your door. No guarantees if they will ever come
back, but they'll come once.
2. I'll pay you $21,000. You get $7,000 in about 5 days, another $7,000
in 30 days and the remainder in 60 days. In exchange, you'll give my
customers cheap products for the next year.

I've been working on local for a long time and I know it's hard to get small
businesses to spend money on advertising. Really hard. Even getting $200 a
month ($2,400 a year) is a high hurdle to meet.

There's no way a business will sign up for #1. Most merchants would laugh
you out of the store if you asked for $60,000.

Except they are. In droves.

Although they sound completely different, #1 and #2 are really the same-it's
the Groupon business model.

Businesses are being sold incredibly expensive advertising campaigns that
are disguised as "no risk" ways to acquire new customers. In reality,
there's a lot of risk. With a newspaper ad, the maximum you can lose is the
amount you paid for the ad. With Groupon, your potential losses can increase
with every Groupon customer who walks through the door and put the existence
of your business at risk.

Groupon is not an Internet marketing business so much as it is the
equivalent of a loan sharking business. The $21,000 that the business in
this example gets for running a Groupon is essentially a very, very
expensive loan.  They get the cash up front, but pay for it with deep
discounts over time.  (This post applies to Groupon operations in the United
States and Canada; it's different in other parts of the world.)

In many cases, running a Groupon can be a terrible financial decision for
merchants. Groupon's financials also raise questions about its ongoing
viability. Buying Groupon stock could be as bad a deal for investors as
running a Groupon offer is for merchants.  This is my opinion, but I have
some facts to back it up.

Traffic is not necessarily profitable traffic

Groupon can clearly deliver customers. But in order to know if it makes
financial sense as a customer acquisition tool, merchants need to know two
key numbers:

1. The proportion of Groupon customers who are already their customers
2. How often new customers come back.

The higher the first number, the worse their deal will perform. The higher
the second number, the better their deal does.

But for most businesses, these critical numbers are impossible to know.
Groupons haven't been out long enough to generate this data.  And Groupon's
tracking methods aren't collecting this data. (My intuition is that Groupon
doesn't want to know.)

Groupon touts a win-win proposition. But the reality is that Groupon usually
wins and merchants usually lose. The merchant agreement is one of the most lopsided I've seen.

It's rare that Groupon loses . . . until merchants figure out how to cheat.

The hidden auction

Underlying Groupon's success is an auction. It's not explicit, like Google's
AdWords bidding platform, but the economic effects are similar. The fact
that Groupon runs daily deals creates artificial scarcity and drives up
pricing to absurd levels. Even with four deals a day in a given market,
you're talking about fewer than 1,500 deals a year.

The "bid" in this auction is the total revenue that goes to Groupon. That's
a function of the value of the voucher, the negotiated revenue share and the
number of deals that will be sold. The number of deals that will be sold is
a function of, among other factors, how deep a discount and how commonly
needed the product is. The larger the discount, the greater the volume.

All of this creates an incentive to drive up Groupon's revenues. It also
provides an incentive for salespeople to sell bigger and bigger deals, some
of which might not be suitable for a small business. Because of all the hype
around Groupon, salespeople are able to use the "Who's Who" model-sell what
an honor it is to be specially selected to be featured on Groupon.

Groupon's process for selecting which deals it runs has little transparency.
It's not always the highest bids that win; sometimes, lower value bids win
just to keep subscribers opening their emails. (In this case, think of
merchants bidding with discounts, so the deeper the discount, the higher the
bid).  I've also heard from merchants who say Groupon has changed their
deals at the last minute to make them more profitable for Groupon.

Cash is king

Many small businesses are struggling for cash and the Groupon sales pitch
resonates. Marketing with no upfront payment. You get cash within days. A
steady stream of customers. This is not a new idea. Rewards Network has been
offering restaurants cash upfront in exchange for discounted meals over time . (But on more
generous terms than Groupon.)

Groupon  S-1 calls tough economic times a risk; but the recession was really their
opportunity. As other forms of credit dried up, struggling businesses jumped
at the chance to get cash now in exchange for discounting their product
later. The real risk for Groupon is that the economy improves to the point
that businesses don't have to resort to deep discounting.

Repeat Groupon businesses

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Some of the analysis of Groupon's long term prospects has pointed to repeat Groupon
offers from merchants as evidence of a viable long-term model.

How can a repeat customer be bad, right? For a Groupon merchant, a repeat
customer is a great thing. But for Groupon itself, a repeat customer can be
a sign of trouble ahead.

I had been struggling to understand why some businesses ran repeat Groupons
or cycled among the various daily deal vendors, given that the economics
clearly suck if you can't drive repeat traffic. Some let the same customer
buy 3 or more of the same deal. That's a clear no-no for a loss-leader
designed to acquire new customers.

A conversation with Forkfly(a Groupon Now
competitor) CEO Paul Wagner was enlightening. He suggested that they were
doing what struggling families do when they max out a credit card-they get
another one.

That makes perfect sense. Revenue from subsequent daily deals help pay for
the obligations created by the first one.

Receipts look like the one at right. Lots of product going out, staff to pay
and little cash coming in. Taking out another Groupon loan is a quick fix.
(If I were a sales rep, I'd have that date marked on my calendar for follow
up. "I know we did 50/50 last time, but I'm thinking Groupon gets 70% this

Hacking Groupon

How would you exploit an overpriced loan? Don't pay it back.

Assume that you're a business that is unscrupulous and you're looking to
make a quick buck. You could create a wildly generous deal that would sell
like crazy. In about 30 days, you'll have 2/3 of your share of the deal.
Then you shut down operations.

It also works for businesses that are just having a tough time. As critical
as I am of Groupon, the slam dunk case is to sign up with Groupon if you're
going bankrupt. I strongly encourage every business that is about to go
under to call Groupon. (Don't tell them Rocky sent you.) It makes total
financial sense-as a Hail Mary play. If you're lucky, the upfront cash will
be enough to help you stay afloat. If not, well, you were already going out
of business. It may be your best option. In the short term, you're actually
helping Groupon because they're being valued on revenue and no one is taking
into account risk.

Groupon is essentially holding a portfolio of loans backed by the
receivables of small businesses. If a business goes under, consumers will
come back to Groupon for their money back. Unless Groupon is actually doing
credit assessments on businesses that it chooses to feature, this is a big
risk for Groupon.

The onerous terms for participating in Groupon also create an adverse
selection  problem. The most successful businesses don't need Groupon for customer acquisition or

The assumption is that nothing will go wrong and all of these "loans" will
be paid back. (At least the subprime mortgage lenders were able to sell that
risk off to Wall Street and AIG.)

Like the mortgage lenders, Groupon doesn't know exactly how much risk it has
piled up. Because some merchants track redemptions on paper, Groupon has no
way of knowing how many unredeemed Groupons are outstanding. If a business
goes under and the records are unavailable, every buyer of that Groupon
could try to make a claim against it. (The risk is mitigated by the fact
that a lot of redemption occurs within the first 60 days, but we don't know
how much.)

Google, with more than $36 billion in cash on hand, is uncomfortable enough
with that risk that it dumps it onto Google Offers buyers. Groupon could
mitigate this risk by changing its terms and conditions so that the consumer
is responsible in case a merchant goes bankrupt.

Relying on float

Where does Groupon get all the money to give to these merchants? Credit
cards-yours. Groupon gets paid within a couple of days by its banks. It then
takes that money and gives it to the merchant in three chunks. From Groupon.

Our merchant payment terms and revenue growth have provided us with
operating cash flow to fund our working capital needs. Our merchant
arrangements are generally structured such that we collect cash up front
when our customers purchase Groupons and make payments to our merchants at a
subsequent date. In North America, we typically pay our merchants in
installments within sixty days after the Groupon is sold.

We use the operating cash flow provided by our merchant payment terms and
revenue growth to fund our working capital needs. If we offer our merchants
more favorable or accelerated payment terms or our revenue does not continue
to grow in the future, our operating cash flow and results of operations
could be adversely impacted and we may have to seek alternative financing to
fund our working capital needs.

Translation: They're using money from new deals to pay for previous deals.
They need to keep growing revenue. As of March 31, they owed merchants
$290.7 million.

In the agreement I've seen, the first installment is 33% in 5 days. If they
have to pay merchants faster, that could lead to problems.

And Google might force that to happen. According to Google Offers payment terms, merchants receive 80% of their share in 4 days-more
than twice as much, 1 day earlier.

There's no way that was an accident.

If Groupon matches these payment terms, they'll need cash faster and need to
grow faster. (Google Offers accelerates the rate at which Groupon's scheme
has to draw in new suckers.)  If Groupon doesn't match, it gives Google a
key differentiator to win deals. If those businesses  go with Google's more
generous terms, that too will starve Groupon of the cash it needs to pay
earlier merchants.

Now here's the crazy part.  Not only is Groupon effectively giving loans to
merchants, but it also works the other way around.  The merchant is on the
hook for the entire value of those deals until Groupon pays the merchant
back its portion.  Unlike other loan providers, the merchant is making a
short-term loan to Groupon. (Not technically, but effectively.) They buy
inventory in advance of the Groupon run. They also serve the initial rush of
customers. The business is in a hole before they get their 30- and 60-day
Groupon payouts.

While the chances might be small, Groupon merchants should know that they're
taking on the risk of Groupon's collapse. If Groupon collapses, a lot of
small merchants could be left holding the bag.

Dollar bubble faces the needle

My comment. As I have discussed previously Australia is in for a rocky ride as infrastructure projects come to a halt as Chinese cancel contracts for resources. Aivars lode IT Capital

While global markets and the Australian media continue to celebrate a high Australian dollar, the truth is that the currency is facing weakening fundamentals.

The prime culprit is iron ore, which is dragging down the terms of trade much faster than anyone in authority has predicted.

In fact, our number one commodity export, which many grey beards of Australian economics have nominated as the primary cause of the high dollar, has fallen 20% in the last month and is down almost 40% on last year's highs.

Iron ore by itself represents more than 20% of Australia's terms of trade so the recent falls constitute a 5% hit to the terms of trade. More worrying, however, is that there appears no immediate relief in site for the commodity.

A technical analysis of iron ore shows a head and shoulders topping patterns on both the spot price and the 12 month swap price:

The downside targets implied by these charts are below $US100.

Technical analysis is a tool not a forecast but the fundamentals look weak enough to take this seriously. An excellent report in the AFR this morning shows just how weak, with a series of bearish quotes from analysts:

The managing partner of research firm J Capital in Beijing, Tim Murray, said that while official data indicated steel production was flat, he estimated it fell by as much as 10 per cent over the first 15 days of August.

“This is the first indication of significant cuts,” he said. “There are some seasonal factors at play, but the volume coming off is unusual.”

…But many analysts are doubtful existing stimulus measures will be enough to underpin demand. “The present malaise [in the iron ore market] is likely to continue for the rest of the year,” CLSA commodities analyst Ian Roper said.

…“The property and ship-building sectors are sluggish,” said Qiu Yuecheng, a senior analyst at Xiben New Line, a steel trader. “Purchases of steel in Shanghai fell 15 per cent in July from the previous month.”

Since last year, there has been some offset to declining prices in rising volumes but there is little hope of that continuing in this environment. Chinese steel prices remain weak:
As are other marginal indicators, such as Chinese bulk shipping prices.

Iron ore's twin is coking coal which is also used in the Chinese steel boom (between them they represent almost half of Australia's terms of trade). Coking coal also sold off again last week, down another 3% to $US177 in sympathy with iron ore. It is also 20% down since June. Still, according to ANZ, contract negotiations for the September quarter have gone better, yielding $US220 per tonne:

Wesfarmer’s 2011-12 financial year results showed coal production increased 23% to 12.4 million tonnes, driven by the successful expansion of coking coal output from Curragh.

The company also announced it had mostly concluded September contract negotiations for coking coal, securing a 4% average increase in prices to USD220/t, which is about 27% higher than the current spot FOB prices (although other major producers struck at USD225/t). This suggests that coking coal prices are expected to improve in the coming quarter.

Recently, the RBA claimed that, after the last few years of shifts to shorter term contract pricing, roughly half of iron ore volumes are now sold in the spot market. Similar changes in contract pricing have occurred in coal markets.

Putting all of this together, we can say that the bulk commodities alone have dealt a blow to the terms of trade (ToT) in the upper single digits in the couple of months with further damage done to real export revenues by the recent bubble in the dollar. This is coming on top of a similar fall in the second half of last year and is a much faster retracement than the 6% fall in the terms of trade forecast in the Budget for all of the 2012/13 year.

Unless imports also reverse (which is very unlikely) Australia's trade and current account deficits will blow out throughout the second half. Gross national income has fallen for consecutive quarters and will retrench further.

Cancellations of iron ore and coal capex projects will accelerate and by the time we get to the MYEFO in November the government will be looking for a big new round of spending cuts if it wants to deliver its projected surplus. Unemployment is going to slowly rise.

Calls made last week that we’ve seen the bottom of this rate cycle are premature, to say the least. The dollar is a bubble.