Everyone calm down about CPI

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Good morning. A day after we questioned whether Arm was properly an AI stock, the shares fell 20 per cent. Apologies! More generally, markets were shaken by yesterday’s consumer price index data. Unhedged, on the other hand, is taking it in stride, as you will see below. Email us: robert.armstrong@ft.com and ethan.wu@ft.com. 

Reserving judgment on inflation

Markets took yesterday’s hotter-than-expected CPI inflation report hard. The two-year Treasury yield rose 17 basis points. That sent the S&P 500 down 1 per cent, and the small-cap Russell 2000 down 4 per cent. Futures markets now price in fewer than four 25bp interest rate cuts in 2024, down from five a week ago.

This looks like an overreaction to us, but look at it from the bond market’s point of view. The Federal Reserve can wait for more data before making a call; traders can’t. Yesterday’s CPI numbers showed core inflation jutting higher, rising 0.4 per cent on strong increases in services prices. “Supercore” inflation (core services ex-shelter) was up a blistering 0.9 per cent. This fits with a recent uptrend in the three-month moving average of core CPI, putting it close to 4 per cent annualised (see chart below). It makes sense that traders would give more weight to the possibility of rising inflation than they were on Monday.

But it’s just one month. In context, the numbers look less scary. Consider:

• January inflation reports tend to be volatile. Many employment and supplier contracts update at the beginning of the year. Spencer Hill of Goldman Sachs (who forecasted yesterday’s core CPI reading almost exactly) spots this “January effect” in labour-intensive price categories such as medical services, personal care and daycare, all of which rose 0.7 per cent. This should fall away in February, he thinks.

• Recent news is much better for personal consumption expenditure inflation, which is what the Fed targets. Even if core PCE prices, published at the end of the month, come in hot, the three-month and six-month trends appear benign. In the chart below, we use Goldman’s (relatively pessimistic) forecast for a 4.2 per cent annualised rise in core PCE inflation in January. That would lift the recent trend above 2 per cent, but not by too much:

• Shelter inflation should still cool further, though the timing is anyone’s guess. It’s well known that official rent inflation data lags rents on newly signed leases, which have plummeted. When this inflation surge began, we were told the lag was on the order of nine to 12 months. That proved wrong. But it would be odd indeed if rental inflation did not converge to current market rents eventually. A soothing chart from Pantheon Macroeconomics (the green line refers to an abrupt 0.6 per cent jump in homeowners’ imputed rents):

Put simply: we are more relaxed than the bond market. We’ve long argued that inflation would grind down slowly but that it would be bumpy. That still looks right. The Fed, which has all but sworn off a March cut, has months to collect data, and won’t change its view based on one noisy report. If February is similarly hot, that will be a different story. For now, reserve judgment. (Ethan Wu)

Uber: still a taxi company? (Revisited)

Uber will hold an investor update call this morning. Management will discuss strategy and capital allocation plans, and we’ll be listening closely. Unhedged has been mostly sceptical about Uber. Specifically, we’ve taken the view that at maturity, Uber will have the returns of a very large but capital-intensive taxi company, not a big tech company:

[Uber] can’t charge a big premium over what it costs to pay the drivers and cover the wear and tear on the cars. Even where it has a monopoly or duopoly position in ride-hailing, it is not clear that its service has clear cost/speed/comfort/convenience advantages over alternatives such as bicycles, buses, subways and local car services. Profits much above Uber’s cost of capital, on this argument, seem unlikely to ever materialise.

Yes, there has been a lot of talk about how Uber is profitable now, and even generates free cash flow. We’ve been sceptical about this, too. Uber engages in the widespread and legal, but essentially dishonest, practice of not including stock-based compensation expense in adjusted earnings. And heavy stock-based compensation inflates free cash flow, too:

Imagine a company that issues new shares to the public, then uses the cash raised to pay employees. One would not be tempted to exclude that cash expenditure from free cash flow. But in the case where the company cuts out the public, and just gives the shares to employees directly, the same economic value is being given away.

But wait! In 2023, Uber reported positive true free cash flow, operating cash flow after both capital expenses and stock-based comp, of $1.4bn last year:

Meanwhile, Uber’s smaller competitor, Lyft, reported earnings last night, and said they, too, expected positive free cash flow next year (not true free cash flow, of course). The industry looks to be firming up.    

That Uber is profitable in cash terms is a big deal. That does not, however, resolve the question of whether it is just a big taxi company. Yes, it generates cash. But its returns are still below that of traditional transport companies. Uber’s return on capital last year was 3.1 per cent, according to S&P Capital IQ (ROC is basically after-tax profit divided by shareholders’ equity plus debt). JB Hunt, which is a big old capital-intensive diesel-burning trucking company that owns its own trucks, earned 11 per cent (and that was its worst year in more than two decades; trucking is in a slump). That’s a wildly imperfect comparison, but it’s close enough to show that 15 years into its existence, Uber’s profits still look nothing like a technology company’s (Alphabet and Meta’s returns are close to 20 per cent).

The hard question is: now that Uber has cut expenses and raised prices in its core ride-sharing (“Mobility”) business, what is its growth rate? Uber booked almost $70bn in rides last year and returns were low. Presumably, the way to high returns is by getting bigger still. How quickly can that happen? Analysts feel the uncertainty. Here is Morgan Stanley’s Brian Nowak, being diplomatic but using lots of capital letters:

The Market Needs Improved Rides Disclosure to Better Understand What is Informing UBER’s Investment Decisions: We have broken down Uber’s Mobility Gross Bookings multiple ways, including high frequency vs low frequency users, Core UberX vs Non-UberX, rideshare use cases, new geographies . . . all in an attempt to gain increasing confidence in the scale and durability of forward Mobility growth . . . the multiyear path of forward Mobility growth remains the point of greatest uncertainty in our conversations with investors.

Our scepticism about Uber has been thawed a bit by the appearance of nice, warm free cash flow. But we still don’t understand why the business would produce the increasing returns to scale that many tech companies enjoy. What will make the unit cost of incremental sales fall from here? Where is Uber’s exclusive intellectual property? Is urban transport really winner-take-most? Until we see more evidence, we’ll continue to see Uber as a fast growing, moderately profitable transport company. There is nothing wrong with investing in a transport company, of course — so long as you know that is what you are investing in. 

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