HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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March 13, 2022

The 1970s Revisited & The Future of Cake

The 1970s Revisited

Stagflation & Wage Price Spirals 

 

Much recent commentary has been about how our current economic predicament compares to the 1970s. While there are similarities, there are more significant differences. Among the most pronounced are our energy mix and labour market. The main economic memories of the 1970s are OPEC’s rise and more than twentyfold increase in the oil price. However, the UK political battle was largely over the supply of coal and the power of the trade union movement. When Ted Heath called an election a year after the first oil shock by asking the electorate, “who rules Britain?” the question wasn’t directed at OPEC but to the trade unions and the National Union of Miners in particular. Coal powered two-thirds of Britain’s electricity and 100% of its gas. It took the British electorate two attempts, but in the second election in 1974, they answered Heath’s question, it wasn’t him, and Harold Wilson became PM. The trade unions immediately demanded significant wage increases to meet or beat inflation. Collective wage bargaining was the accepted means of determining most pay and conditions, which was the enabler of the “British Disease”, otherwise known as stagflation.

Sharply rising costs, including real wage increases, crippled UK industry costing it international competitiveness. UK labour relations were hostile and expensive. In 1972 there were 2m days lost to strike action in the UK, which grew to 4.5m by the 1979 Winter of Discontent. Today the figure is about one-twentieth of that level. The whole structure of our labour market is different. While the Great Resignation may sign a swing back in the balance of power from capital back towards labour, its impact will be more muted and transitory today.

Financial Consequences 

 

In the 1970s, Arab oil wealth gave the banks the petro-dollar recycling opportunity, leading to the Eurodollar market and the subsequent Latin American Sovereign Debt Crisis. The Eurodollar market was also a precursor to the financial deregulation of the 1980s. I can remember an American friend telling me in the early 1980s how they had never seen so many Rolls Royces in one place before they visited London. Russia was still part of the USSR and behind the Iron Curtain. London’s ostentatious wealth was predominantly Arab. Significantly, the dollar retained its reserve status. Oil and most other internationally traded goods and services remained priced in dollars.

The picture is different now as oil prices reach levels last seen, albeit briefly, in 1978 and 2007. North America, broadly self-sufficient in oil and gas, is not being squeezed in the same way as Europe, while Russia is on the brink of default. The freezing and seizure of Russian assets and the prospect of both primary and secondary sanctions are about to cause a Russian economic and financial collapse. The last time this happened was in 1998 after the oligarchy’s expropriation and extortion had hollowed out Russia’s economy. The unexpected consequences included the collapse of LTCM and the Asian debt crisis. This time there will be similar unexpected outcomes as those holding frozen assets are forced to sell whatever assets they can. This process is the root cause of contagion and typically leads to a liquidity crisis.

China's Position is Pivotal 

 

One way for Russia to fend off the financial and economic consequences of the West’s sanctions is via its friendship with China. In supporting Russia, China can form a powerful economic alliance. China is a manufacturing powerhouse and the world’s largest commodity importer. Russia is a major commodity exporter with strong aerospace capabilities. Already, Russia and China are outlining new pipelines that, if completed, would redirect gas towards China. If China supports Russia, the West faces a severe loss of power. China could buy Russian commodities and accelerate Remimbi central bank digital currency adoption, enabling the circumvention of SWIFT. In all this China can exert significant negotiating power.

China is the largest trading partner for most countries in the world, is a natural ally with Russia against the US and NATO, and can give Russia an export outlet for its oil, gas, and other commodities (at prices suited to China). China has the most installed industrial capacity and the most electricity generation and consumption to support that industrial capacity, but it needs to import commodities. China could also buy the Russian joint ventures that European oil majors need to offload. These are large energy deposits worth tens of billions of dollars. “Western companies sell long-term commodity deposits to Chinese companies at a steep discount” is not the headline most of us want to read, but it could happen.

The Future of Cake

Cake in a Diversified Portfolio

 

I try and run a balanced portfolio of quality companies and real assets. I want to benefit from the long-term growth offered by quality companies with strong market positions and solid financial models. At the same time, the ownership of real assets protects against the consequences of inflation, geopolitics and other macro-economic disruptions. Two UK AIM-listed stocks I own characterise my strategy, and they both supply different types of cake. They are Yellow Cake and Cake Box.

Yellow Cake - A Strategic Real Asset 

 

Yellow Cake is an alternative investment vehicle that holds uranium oxide (U3O8), the fuel source for nuclear power generation, for investment gain. I mentioned Yellow Cake last year to play the energy transition amid the developing energy crisis that the UK faced with petrol shortages and surging wholesale gas prices. If you cast your mind back just six months, our fears centred on the absence of wind and sunshine that might jeopardise our COP 26 commitments. How innocent we were. We now face an energy supply crisis not seen since the 1970s.

Everything to do with nuclear energy is complex and political. For the past 20 years, the world has been producing less uranium than it consumes. However, uranium has been in structural oversupply since the end of the cold war and the overhang of secondary product (recycled and enhanced strategic stockpiles and tailings held by government defence establishments). Unlike the oil price, the uranium price has lagged well below its commonly accepted marginal cost of supply. This anomaly has started to correct, and since the invasion of Ukraine, increasingly rapidly.

As of the January 31st, 2022 update Yellow Cake owned 15.83 million lb of U3O8 valued at a spot price of US$42.00/lb and with cash, other current assets and liabilities of US$153.6 million, delivering net assets worth £3.31 per share. As of Friday, the spot price of uranium closed at $58.51/lb, giving Yellow Cake a net asset value of £4.49 per share, a six-week gain of 35%. Nearly all of this gain has occurred since the Russian invasion of Ukraine. While there has been much discussion on how the war has impacted oil and gas, there has been no real mainstream media attention on the supply of the fuel source for our nuclear power stations.

The reality is that since 1990 uranium has become a more globally traded commodity, and as the role of nuclear weapons has diminished, the political sensitivities around its trade have reduced. The largest supplier of uranium is currently Kazakstan’s Kazatom which has a valuable JV with the Russian Uranium One. Together they account for about 30% of the world’s production. Canada is also a large producer, with the US and Australia. Kazakstan might not be Ukraine. However, in January this year, some local difficulties required Russian military assistance to quell.

However, it is the demand for uranium that is more interesting. Nuclear is (arguably at least) a green and sustainable energy source, unlike oil and gas. Since Fukushima, the world has slowed developing more nuclear sites. However, this is changing. China has more nuclear sites in planning than exist today in Europe. There is an outbreak of technological advancement, including the development of small scale modular reactors. (See Rolls Royce for details).

The Yellow Cake investment case has played out more rapidly than I had expected a year ago as the share price has followed the NAV of its uranium assets from around £2.40 per share last year to reach £4.30 last week. This value reflects a uranium price approaching its commonly accepted marginal cost of supply of c. $60 lb. My inclination is not to chase it, but there is no doubt that the uncertainty of supply created by the Ukrainian invasion changes risk dynamics to the upside. The uranium bulls like to point out that in 2007, when oil last gapped above $100, the uranium price peaked at $140 lb, more than twice the current level.

Cake Box - Quality Business with Growing Pains 

 

By contrast, Cake Box is an altogether more parochial business supplying fresh cream cakes via a chain of franchised owned and operated stores specialising in customised egg-free celebration cakes. I have been following this business for several years and have held the shares for a couple of years. I highlighted the investment case of Cake Box in an interview with the Capital Employed podcast, and I interviewed the Founder / CEO, Sukh Chamdal, in Episode 2 of my In The Company of Mavericks podcast last year. I like it for several reasons, not the least of which is Sukh’s infectious if somewhat raw entrepreneurial way he has attacked a genuinely differentiated niche of the UK food retail market.

However, while this business has grown strongly and consistently since its inception in 2008 and IPO in 2015, its share price has more recently reversed sharply. Indeed from its peak in October last year of 440p, Cake Box fell to about 350p in November and December. No surprise there, you might think, as the valuations of quality growth companies have all typically retraced circa 30% as the world reopened, and the prospects for rising interest rates and inflation have taken hold.

However, in the case of Cake Box, there have been some company-specific factors at work too. At the end of January this year, analyst and popular financial blogger Maynard Payton published a stinging report on several accounting and reporting issues within Cake Box’s annual report and financial statements. None of these individually amounted to a great deal but collectively pointed to a sense of “no smoke without fire” type concern. Matters were arguably amplified by a larger than usual private investor shareholder base and unwarranted comparisons to the infamous Patisserie Valerie corporate fraud. A couple of weeks later, Cake Box shares had fallen to below 150p, a decline from its peak of 65%. Last week as we approached Cake Box’s financial year-end, the share price recovered to 200p, valuing the company at £80m.

Last financial year, Cake Box produced net revenue of £22m. It should increase that to over £30m this year. Due to its attractive operating model and margin structure should grow EPS 40% to 14p, putting the PE ratio on c14x and a 3.5% dividend yield. Reassuringly Cake Box’s performance has always been backed up by solid cash flow and a cash positive balance sheet absent any long term leasehold liabilities or financial commitments. This valuation is highly attractive, albeit the “no smoke without fire” cloud remains hanging over the company. Arguably there is scope within this valuation for a corrective imposition of more financial controls and higher costs to be built into future expectations. I am inclined to add to my position while keeping an eye on the overall position size given Cake Box’s small market cap and limited liquidity.

Jeremy

Ealing

13/03/2022

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