Inflation, made in China | Financial Times


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Welcome back. In the few weeks I’ve been writing this newsletter, I’ve spent very little time on the finances of individual companies. But the question of what Soho House (aka Membership Collective Group Inc) might be worth is especially interesting. But before that, Unhedged’s first foray into a tricky topic: China’s influence on world prices.

There will be no newsletter on Thursday. I have other duties to attend to. See you Friday.

Is China an inflationary force now?

The standard explanation for why inflation has been so low for so long in so many places is three words long: “technology and globalisation”. The technology side has a lot to do with Moore’s law. Over time, more of the goods and services we buy are digital, and computing power gets cheaper all the time. The globalisation side has a lot to do with China. Its export machine gives us all cheap stuff and suppresses wages for manufacturing industries worldwide. 

Is the China-as-deflation-exporter story over? Diana Choyleva of Enodo Economics thinks so. She charts the US’s import price index for China against the renminbi/dollar exchange rate:

As the chart makes clear, the exchange rate has a lot to do with whether China exports higher prices to the US. Beijing has allowed the renminbi to strengthen somewhat. But the great majority of China’s trade with the US is still denominated in dollars. So changes in the exchange rate force Chinese exporters to decide whether or not they are willing to absorb the cost of the stronger currency.

Those exporters, Choyleva points out, have seen their profit growth fall in recent years, hurt by both the stronger currency and increasing labour costs. Earnings received only a brief bump from Covid-19, which boosted global demand for electronics and healthcare equipment:

Now the pressure is really on, as reflected in the 9 per cent increase in Chinese producer prices in May. Choyleva argues that passing higher costs on to domestic customers is difficult in China, as evidenced by weak consumer price inflation. Nor is the government likely to provide relief by weakening the renminbi. It is more concerned about things like food price inflation and encouraging capital inflows. So Chinese producers, if they want to protect profits, have little choice but to jack up their export prices in dollars. 

Not everyone agrees with Choyleva, naturally (this is economics). Larry Hu of Macquarie, for example, points out that China’s producer price index is tightly correlated with oil prices — it is, in other words, imported. Oil prices will lap their pandemic trough soon. Furthermore, Hu notes, high Chinese PPI has not historically led to higher export prices (he points in particular to the PPI jump in 2015-17).

The question about inflation that dogs all of us, though, is whether this time is different. The answer will depend, in part, on whether or not Chinese manufacturers are willing and able to pass on higher costs to international customers.

Soho House and mass production of exclusivity

Soho House is an international chain of 28 fancy hotels (“Houses”), operating on a membership model. Members (there are 111,000 of them) pay an initial registration fee and an annual levy (about $3,400 in the US) for access, and then pay on top of that to stay and eat at the houses. 

The company is planning an IPO, and reportedly the owners are looking for a valuation of $3bn. The registration document is a fun read. I think it can be summed up as follows:

  1. Yes, we have about $2bn in debt and lease obligations, and we make losses right now but . . . 

  2. The unit economics of our business are really good and . . . 

  3. The losses are because we are growing the number of units really fast and . . . 

  4. At some point we will not be growing units so fast, and we will be making a lot of money

You will recognise this as the standard pitch of any retail chain. Sometimes it really, really works (look at the Chipotle or Home Depot stock charts, for example).

Here’s the bit about the unit economics, from the filing:

Our unique business model provides compelling House-level economics driven by our ability to grow the member base of each House over long periods of time as operations are refined and frequency of use by existing members normalises. The ability to add members to our Houses over time . . . sets us apart from traditional hospitality companies, which have more fixed occupancy profiles.

That is to say, our members pay fees no matter how often they come to stay. Over time, they come to stay less (“frequency of use . . . normalises”). Then we add more members.

Here is how that cashes out:

For our larger, amenity-rich Houses that anchor our brand in a city, we target stabilised average revenues of $20m to $30m by the fifth year of operation. As [of] fiscal 2019 we achieved or exceeded this target for eight out of our nine large Houses that had been open for at least five years. We target House-Level Contribution Margins of 20% to 30% by the fifth year . . . we target cash-on-cash returns in excess of 50% once membership reaches a level that we consider normalised.

That sounds great! 50 per cent cash returns! How much do they invest in each House? It’s a “capital light” model:

Our landlord[s] agree[] to fund a substantial portion, or all, of the development costs of a House, to our design specifications, leaving us to fund only pre-opening expenses (and art and other unique interior design elements). Virtually all of the Houses that we plan to open over the next three years reflect this asset-light model . . . under our asset-light model we expect our contribution to open new Houses, comprised primarily of pre-opening expenses and art, will fall in the $3m to $6m range.

So, $5m or so invested, returning about half that every year in cash after five years or so. Very good. There are 28 houses now. The plan is to have 46 by the end of 2023. And then who knows what.

What is special about Soho House, what separates it from Chipotle or Home Depot, is the thing that supports those great unit economics — exclusivity:

As a membership founded for the creative industries, we are proud to have championed members who have gone on to shape our cultural landscape as world class writers, artists, performers, directors, founders, designers, and producers — all reflecting the spirit and energy of Soho House . . . The membership of each House is assembled by a select committee of influential creatives and innovators.

Soho House’s success as an investment depends on one question, then. How much expansion is consistent with the whole thing still being cool and insidery? To the company’s credit, it flags this risk explicitly:

If we expand too rapidly we are susceptible to the perceived erosion of the desirability of our brand. In any such event, attrition among existing members may increase markedly, and we may encounter difficulties in attracting new members.

Mass produced exclusivity seems contradictory, but then, is it not the dream of the whole luxury industry? 

One good read

I missed this essay by Stephen Roach when it came out about a month ago. Roach worked at the US Fed under Arthur Burns in the 1970s. Burns tended to dismiss the price increases of the early 1970s as one-offs driven by exogenous factors that would soon subside. They didn’t.

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