2023 Week 2: Good News and Bad News

Space X set to be the leader in the rocket launch industry, Banks' earnings reflect a slowing economy, and bond yields fall following positive inflation news

💡Did you know? Since the 15th century, the tsarist government had a monopoly over vodka sales in Russia, which generated 1/3 of the state’s revenue. It was only until WWI that the regime banned vodka sales to facilitate orderly recruitment for the army.

Market overview:

Space X: Miles Ahead of its Competitors

Starship, Space X’s fully-reusable rocket, is scheduled for a test launch in March this year (Source: Space News).

📝Quick Recap

Following a recording-breaking 61 orbital missions in 2022, SpaceX aims to complete 100 orbital launches this year. The firm also raised $750 million at a $137 billion valuation to expand its Starlink constellation and scale its fully-reusable rocket, Starship.

🧐Analyze like a consultant

As satellite launches become mainstream, how should we, investors and curious readers, think about the industry in general? Hence, in this section, I seek to answer two crucial questions to shed some light on this sector:

1. What are the rocket launch industry’s dynamics?

2. More importantly, which player(s) will emerge as a winner(s) in the long term?

Industry dynamics

It is critical to understand that rocket launch operators have high variable and fixed costs — rocket parts, launch infrastructure, skilled technicians, etc. are expensive! Hence, being a cost leader is crucial in gaining market share in such an industry. Just think about it. If a firm can provide the lowest price per launch while being profitable, it can undercut its competitors to gain market share.

Rocket boosters cost ~$37 million to build, indicating a high cost base rocket launch operators have to work with (Source: Inverse, Space News).

But, how exactly can a player achieve the lowest cost per launch?

Spreading fixed cost across many launches: With any high fixed-cost business, gaining economies of scale is critical to lowering the cost per product. In other words, rocket launch providers must launch satellites into orbit frequently to reduce the average cost per launch. 

Lowering variable costs: This is what all the buzz is about. Firms are inventing innovative methods to lower their variable cost per launch:

1. Reduce rockets’ payload

2. Utilize rockets more efficiently

3. Design a cheaper alternative to rockets altogether — an invention for rocket scientists to ponder upon (e.g., space elevator, electromagnetic launch gun)

Reduce the rocket's payload: The fuel tank is a critical component that increases the rocket's mass (aka payload) — larger rockets need larger fuel tanks to venture into space successfully. A larger fuel tank obviously increases the cost per launch (in terms of fuel and materials required).

Therefore, firms have come up/are coming up with creative ways to reduce their rockets’ payload and, consequently, their cost per launch:

• Virgin Galatic is using airplanes to bring rockets to higher altitudes from where they will subsequently be launched into space, eliminating the need for large fuel tanks and reducing the cost per launch

• Astra is creating small rockets that are 12 meters (38 ft.) long with a payload capacity of 25-150kg, enabling the firm to reduce cost per launch.

  

Utilize rockets more effectively: Rockets are launched in stages, where parts of the rocket (e.g., booster) are discarded after every step — a costly waste! Hence, players, such as Space X, that utilize reusable rockets have a significant cost advantage over competitors that build rockets from scratch after every use. For instance, Falcon 9, Space X’s reusable rocket, saves the firm approximately 30% in cost per launch.

Source: NASA

“If one can figure out how to effectively reuse rockets just like airplanes, the cost of access to space will be reduced by as much as a factor of a hundred”. — Elon Musk

Additionally, firms engage in ridesharing programs to sell excess capacity to satellite operators, enabling the launch operator to reduce cost per launch. Think about it. If your rocket can hold 100 satellites, but you are only sending 50, then you are better off launching a smaller, cheaper rocket. So, you need to utilize your rockets’ capacity more efficiently to lower the cost per kg launched. Space X has scaled its ridesharing program successfully, bringing its Starlink and other operators’ satellites into space and allowing both parties to benefit from cheaper launch costs.

Long-term winners

In any high-cost-based business, scale is vital in reducing the average cost per product — in our case, the average cost per launch. But this is easier said than done.

The current issue with the rocket launch industry is its demand, which is concentrated among a handful of players. Making matters worse, most of these players have long-term contracts with the incumbent rocket launchers. As a result, most rocket launchers, especially upcoming ones, compete for a small piece of the pie, which impedes their ability to achieve scale to compete with incumbents.

Source: Bryce Tech

Space X will be a long-term winner in the sector. The firm not only has scale but also reduces its variable costs actively (via reusable rockets and payload sharing). This way, Space X has emerged as a cost leader. As Space X continues to grab market share with its low prices, the gap between Space X and its players will only widen. Eventually, we will see the firm venture into adjacent industries, potentially operating across the value chain (how Tesla is starting to operate) and becoming a Space services behemoth.

Banks’ Earnings: An indicator of the broader economy

📝Quick Recap:

JP Morgan, Bank of America, Citi Bank, and Wells Fargo reported their Q4’22 earnings last Friday, indicating mixed results. JP Morgan and Bank of America reported a 6% and 2% increase in profits, respectively, while profits declined for CitiBank and Wells Fargo by 21% and 50%, respectively.

Consumer Banking’s Performance:

• Consumer banking revenues, as a whole, have increased across all four banks due to the higher interest rates charged across all loan products. Profits have also increased as these banks did not increase the interest rates provided on customer deposits.

• However, as consumers shied away from purchasing homes in a high-interest rate environment, interest income on mortgage loans declined significantly. For instance, Well Fargo, the third-largest mortgage lender, experienced a 57% decline in mortgage revenue and has decided to step back from the mortgage market.

Mortgage rates are highly sensitive to the fed’s interest rate hikes, and have drastically increased over the past year (Source: FRED).

• Additionally, banks have increased their loan loss provisions due to the deteriorating macroeconomic situation. In other words, banks are predicting their loan default rates to increase as we head into 2023.

Investment Banking’s Performance:

• Revenues from the investment banking division have plummeted across all four banks. The decline in deal flow has been the most significant contributor to this decline, as investors are concerned over a volatile and weak macroeconomic environment. In fact, CitiBank reported a 62% year-on-year drop in investment banking revenue.

🤔What to expect:

Increased layoffs: Unfortunately, as banks struggle to maintain profit margins, they will turn to cut employee expenses, their largest cost component. For instance, Goldman Sachs plans to lay off 3,200 employees globally, and it will not be surprising if other banks follow suit.

Decrease in net interest income:  Banks have yet to raise their interest rates provided on customer deposits, which has contributed to an inflated net interest income (aka interest revenue net of interest expense).

It will only be a matter of time before banks will face competitive pressures to increase deposit rates. In fact, JP Morgan, Bank of America, and Wells Fargo are witnessing a decline in customer deposits by 5-7%. Naturally, we will see banks increasing interest rates on their deposits to prevent fund outflow, further eating into the banks' margins.

Falling Bond Yields

📝Quick Recap

Yields on 10 Years US Treasury Bonds have declined in light of positive inflation news (Source Y Charts)

The Consumer Price Index (CPI), an indicator of inflation, declined by 0.1%, the largest month-on-month decline since April 2020. In light of this positive news, 10 Year US Treasury yield decreased, as investors expect the fed to slow the pace of interest rate hikes as we move into 2023.

Some quick finance knowledge that would explain the direct relationship between inflation and interest rates:

“The higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand a higher yield to compensate for inflation risk”. — Investopedia

Nevertheless, the Fed has clarified that it will continue to monitor the inflation rate and base its decision to hike/ease interest rates on future inflation figures.

🗒Weekly Headline Summary

Asia-Specific

• India's December wholesale inflation eases to nearly a 2-year low|RT

• China's December home prices decline for fifth month in a row| NA

• Singapore Home Sales Slump to 14-Year Low on Supply Crunch|BB

• Bangchak to buy ExxonMobil's Esso Thailand stake for about $603 mln|RT

• South Koreans are the world’s biggest spenders on luxury goods|CNBC

• China trounces U.S. in AI research output and quality|NA

Beyond Asia

• Twitter Offers Free Ads as It Seeks to Woo Brands Back to Its Platform|WSJ

• London suffers IPO ‘drought’ as fund raising plunges by 90% this year|CNBC

• Rare-Earth Find in Sweden Lifts Hope for Shift Toward Clean Energy|WSJ

• US Dollar Shorts Become Favorite Trade as Fed Seen Slowing Hikes|BB

🤓What am I reading:

• AI in 2023: The Application Layer Has Arrived|Digital Native

• 2022 in Review: Our top learnings in Web3, market volatility, and industry insights|Fintech Blueprint