Thursday, August 30, 2012

Investing in the Seven Deadly Sins

was struck by something new I learnt in researching an article on medical device company Covidien.  One of the key surgical procedures for its products turns out to be Bariatric or weight loss surgery. It strikes me that many of these procedures will come as a result of the unfortunate life-style choices of some of its patients.

I was initially startled, but then I realised that I do actually live in the real world and my sense of surprise was really a self delusionary device created to shield my sensitivities from the truth. The inconsequential and light-hearted drivel that follows is as a consequence of this pointless discovery.
I think the reality is that many companies and industries proved to be good or bad investments based on behaviour which could be classified as immoral. Of course, in times of uncertainty (and during sex) many people turn to religion, so as a good Catholic boy I think it’s time to look at the Seven Deadly Sins in investment.


As Einstein used to say (probably) it’s all relative isn’t it? As a Brit, the moral fault line between the UK and the US over medical research has always struck me as fascinating. There are fewer issues that arise more wrath in the States than embryonic stem cell research and the US does not allow Federal funding of programs in which human embryos are subjected to risk of injury or death. Meanwhile, genetically modified food research receives little much less resistance.

It is a completely different situation in the UK where the creation of embryonic stem cell lines is permitted but if you dare try to modify a mushroom –as if humans haven’t been modifying food for thousands of years- or turbo charge, Prince Charles and others are likely to set qualifying times for the Olympics in coming after you. 

I would tend to avoid stem cell companies in the US and avoid crop science companies in the UK.


It is hard to know where to start here and even harder to know when to stop!  There is good greed and bad greed. Bad greed is the kind of behaviour exhibited by some of the banks in recent years. Leveraging up on risk for their own personal gain whilst racking up risk for the shareholder who then has to bail out the banks in order to give them a platform to do it all over again, is not how free markets are supposed to work. What is supposed to happen is that the banks go bust and the greedy incompetents that led these firms are supposed to join the ranks of the unemployed. The largest hate figure of the malcontents with this issue is, of course Goldman Sachs (NYSE: GS).

On a more positive note, it is thanks to the greed of Gilead Sciences Inc (NASDAQ: GILD) that AIDS has not prevented huge numbers of people from continuing to live a normalised life. In addition, the next step is prevention and Gilead is increasing moving towards that.  An FDA Advisory committee has already recommended Truvada for approval as a pill to prevent AIDS and Gilead is awaiting a formal FDA decision.


The market is full of stories of how pride and hubris destroyed seemingly unassailable market conditions. Nokia was once the globally dominant phone manufacturer and Research in Motion’s (NASDAQ: RIMM) fall from grace is obvious for all to see. Blackberry was once the ‘must-have’ device for young people looking for a smart phone, particularly as it had such a strong position in the corporate market. Unfortunately if you rest on your laurels and do not innovate and build on your position, your competitors will.

On the other hand, if it wasn’t for Steve Jobs’s pride in his genius, there would be no IPod. No IPhone. No huge returns to Apple (NASDAQ: AAPL) shareholders. The question is whether Apple will continue to innovate and develop without its guiding light?


Sloth and eating processed food, urban sedentary life styles and just good old fashioned laziness.  All are causes of a lack of exercise and dietary concern. Ultimately this causes weight gain and the conditions that diseases like diabetes will thrive in. Unfortunately this is proving to be a very successful export to emerging markets. I have a more detailed article on the subject linked here.  Suffice to mention here that the trend doesn’t appear to be going away anytime soon.


Let’s not mince words here. If there was no porn, internet infrastructure would not have developed as quickly as it did. Streaming video, E-commerce, Security, broadband capacity, the list goes on. It is fair to say that a company like Juniper Networks (NYSE: JNPR) would not be the company it is today without pornful lust.

On a more negative note, if someone could guide me towards a listed company investing in massage parlours in the Punjab I would be most grateful. The prevalence of self-selective abortions of girls in some parts of the world is truly frightening. If the feminists are looking for a ‘War on Women’ they will find it in many places in Asia.


Every time I hear another upstart politician or commentator in Europe jump on a soapbox and advocate Eurobonds or any such notion that involves exposing taxpayers in countries like Germany, Austria, the Netherlands and Finland to others debt, I am reminded of the root cause of it. It is envy. The PIGS could reform. They could engage in the kind of painstaking measures that West Germany did in order to integrate East Germany. They could even read history and see how Germany was formed out of the Zollverein (customs union) of previously disparate States. They could do these measures and hope to reach Germany’s low rates of unemployment and growth. The markets would like it and it would be a confirmation of the solidity of the Euro.

No. It is so much easier to undertake the politics of envy and try and coerce and game the Germans into taking on responsibility for others failures.  Where the envy would be better directed would be if certain countries in Europe decided to follow Germany or Finland’s example are starting spending in line with their revenue generation.


Hands up if you thought I was going to go for McDonalds? Nope. There is nothing wrong with a burger and McDonalds gets an unfair rap much of the time. I’ve never seen people force fed at gun point in a fast food joint.

Moreover, Gluttony doesn’t just encompass food. I’m fascinated by the fact that diamonds cannot be easily distinguished from artificially produced moissanite. Whilst ‘moissanite is a girl’s best friend’ will not be a hit single any time soon, I can’t help thinking so much misery in certain parts of the world could be alleviated by not buying diamonds or that human kind could direct its intelligence to better causes than finding ostentatious baubles in the dirt.

An Undervalued Health Care Stock

Investors have been keen to bid up defensive sectors recently but one stock seems to have been left behind in the rush. Tyco spinoff Covidien (NYSE: COV) appears to be unloved by the market, yet its mix of stable single digit revenue growth plus double digit earnings growth and high cash flow generation is quite compelling.

Moreover, the future spinoff of its low growth pharmaceuticals division will allow the management to fully focus on medical devices. Reductions in headcount and facilities over the last few years have generated operational efficiencies that have led to margin improvement. This company is well run, it trades at a discount to its peers and I think it's well worth a look for risk adverse investors.

Covidien Offers a Mixed Growth Opportunity

In this article I am going to focus on medical devices. A graphic depiction of Covidien’s offerings by product line reveals the mixed performance over the last few years.

Whilst Soft Tissue Repair and Airway & Ventilation growth has been hard to come by, Vascular and in particular Energy growth has been strong.  Oximetry & Monitoring and Endomechanical growth has slowed this year.  The company is currently tracking ahead of its internal 2-5% overall growth for medical devices but it has been clear in articulating that headwinds would get stronger in the second half. In addition there is one less trading week this year.

Endomechanical and Energy Products are Driving Growth

Together these product lines make up 46.8% of medical device sales, and Energy has consistently generated double digit revenue returns in recent years. Endomechanical and Energy devices in surgical procedures are increasingly being used in a drive to shift surgical procedures from open toward minimally invasive surgery (MIS). The big advantage of MIS is that it tends to lead to better patient outcomes, which in turn creates shorter hospital stays and less post-surgery complications. Both of which reduce hospital costs.

Growth has been impressive over the last few years.

Growth in endomechanical can be seen as tracking a combination of hospital admissions and elective surgical procedures. Both of which are seen as slowly improving in line with the economy. Provided the economy keeps growing, Covidien can expect similar growth in the second half.

As noted earlier, Energy revenues will increase as a function of increasing penetration rates of MIS –especially in regions such as emerging markets- and new product launches. For example, Covidien i particularly excited about the new launch of Sonicision (a cordless ultrasonic dissection device) which will allow surgeons more flexibility in the theatre.

However what about the threat from robotic based surgery?

Intuitive Surgical?

Perhaps one reason that Covidien doesn’t have a higher rating is that investors are looking at the spectacular growth rates at Intuitive Surgical (NASDAQ: ISRG) and concluding that robotics will encroach on its market share or at least moderate Covidien’s growth potential.

It is a powerful case and Intuitive is a strong company in its own right, however its systems require a significant capital outlay and they are seen as being of more immediate benefit to ‘one-off’ type of procedures where the surgeon may not have been trained in MIS procedures, for example things like prostatectomy.

Surgeries adding Intuitive’s robotics can see their revenues jump as a consequence of being able to offer more procedures; however, a MIS trained general surgeon can and will do a whole host of operations in his work. He doesn’t necessarily need to buy a robotics solution in order perform new procedures.

In other words, both markets can grow without Intuitive being able to cannibalize Covidien’s growth prospects.  Although cautious investors will want to keep an eye on Intuitive and in particular its success at expanding the procedures that surgeons use its machinery for, particularly as Johnson & Johnson (NYSE: JNJ) is believed to be seeing slowing growth in endomechanical due to the encroachment of Intuitive Surgical.

Other Divisions Mixed

Covidien also competes with Johnson & Johnson in soft tissue repair and this sector has seen significant competition. Its aim here is to protect market share rather than invest in biologics. It will be hard pushed to achieve this without investment so I would expect further pressure ahead.  It’s a different story with Vascular where Covidien has actively been investing in order to drive growth. Vascular now makes up more than 20% of revenues so if we combine the divisions that are doing well (Endomechanical, Energy and Vascular) it makes up 67.2% of revenues. Covidien is in good shape.

Fundamentals and Future?

The market warmly welcomed Abbott Labs (NYSE: ABT) proposed split and its puzzling to see why it has not accorded Covidien the same kind love. Abbott’s deal makes perfect sense-at least I hope so because I hold a long position- and so does Covidien’s. Indeed, the preparation for the split has seen an increased focus on medical devices being applied.

Hospital admissions and elective surgeries can be expected to provide a favorable market environment in the future and Covidien is growing its largest medical device offerings. The weakness is in the smaller product lines. Turning to valuation matters, it trades on 13.5x its earnings and on an EV/Ebitda ratio of 8.6, both of which are attractive for a company forecasting double digit earnings growth in future. Covidien is forecasting $1.9bn in free cash flow (equivalent to 6.7% of its EV) which will give it the leeway to make acquisitions, invest in R&D or pay off debt.

The next set of results will be in a couple of weeks and it is a stock well worth monitoring for investors looking for exposure to the healthcare sector.

Weakness in Industrial Cyclicals

The Industrial sector has been sold off aggressively in recent months as investors begin to price in a cyclical slowdown and Cummins Inc (NYSE: CMI) recent update is only likely to make sentiment even more negative. The truck engine and power generation company lowered its full year revenue guidance to flat from being up 10%. If that wasn’t bad enough, it also mentioned a softening in order trends in North America as well as the failure of the BRIC economies to rebound.

Continuation of a Trend

The BRIC news can hardly be unexpected. Growth forecasts have been reduced in Brazil, India and China and electricity consumption figures in China have seen a significant moderation. With regards to China, in the last quarter Cummins reduced its overall domestic revenue forecast to -5% from previously being flat. India was previously forecast to be up 7%. I think it’s safe to assume that both countries estimates will be lower now.

The Heavy Truck market started to turn down in November last year and as the housing market has weakened, so the demand for commodities has caused a slowdown in the transportation market. Running in parallel is the overall demand for power. Fixed asset investment makes up a huge portion of China’s GDP so any signs of a slowdown will leave the industrials like Cummins, Eaton Corp (NYSE: ETN) or Caterpillar (NYSE: CAT) heavily exposed. If you rely on China for your marginal growth then you have to be prepared for disappointment when it slows down.

The key point is that Cummins was previously expecting a rebound in the second half in China. When companies usually see customers inventories run down within a market place that was previously growing consistently, it is tempting to assume that future quarters will see a snap back in growth. Throw in the argument that China can always stimulate infrastructural spending by throwing its vast reserves towards it and you have a strong bullish case. It hasn't worked out like that.

It appears that China’s fixed asset investment slowdown is for real this time around and there are significant questions to be raised over the ability of the central Government in China to effectively stimulate the economy. The latter is discussed in more length in an article linked here so.
It's time to look at another bellwether.

What Say You Alcoa

Having confirmed a slowdown is in place and touched upon the reasons why, perhaps it is time to try and find a decent forward indicator?

I think that Alcoa (NYSE: AA) is very useful. I’ve broken down the series of outlooks that it gave by geography for the demand outlook for the Heavy Truck & Trailer segment.

Alcoa lowered its full year 2011 China outlook in Q3 of 2011 and since then the outlook for 2012 has been lowered in each quarter. The US outlook has undulated, but interestingly the European outlook is getting relatively stable. As for Alcoa there is a more detailed discussion in an article linked here.

Long Term Prospects?

The bullish investment thesis for Cummins and for that matter its chief rival Navistar (NYSE: NAV) is that a combination of tighter emissions standards, a historical aging US truck fleet, plus a long term bull market in commodities will drive end demand higher. It is a powerful case but both companies are going to have to deal with the uncertainties inherent in relying on communist countries ability to stimulate its economy. The resolution of this question is likely to dictate mid-term growth rates for Cummins.

In conclusion, I think investors can take two complementary approaches to the investment question. On the one hand, it makes sense to apply a significant margin of safety to Cummins’s valuation in terms of current metrics in order to try and factor the risk. On the other hand, monitoring forward indicators (for example as illustrated with Alcoa’s segmental outlook above) will give a good approximation of when things are going to start trending better.

A balanced approach will be to quantitatively reduce/increase your margin of safety factor by an ongoing assessment of a range of forward indicators are saying. Right now, there is a lot of uncertainty about China and I would urge some caution here. There is plenty of time to buy into the industrial cyclicals.

Tuesday, August 28, 2012

Fastenal Equity Research

Fastenal (NASDAQ: FAST) cheered the market with a decent set of numbers which were in line with analyst estimates. The company represents a decent litmus test of the industrial and construction sectors in the US alongside something like Grainger (NYSE: GWW) or MSC Industrial (NYSE: MSM). In this article I want to provide a brief overview of current conditions and put them in the context of Fastenal’s long term strategy.

Fastenal specializes in selling kinds of fasteners and hardware equipment that are used in construction and industrial applications. As such it is often seen as a proxy for building and manufacturing activity in the US. The best way to gauge any underlying trend is to look at the sales figures for stores that have been open for more than five years. These stores tend to be more cyclical in their revenues because they are more mature in their market share within their local markets. Here are the numbers for revenue growth.


It's not hard to see that construction and housing peaked in 2006 or that growth slowed in 2012. Nevertheless these results were pretty good. Revenues increased by 15% with 53 new stores opened in the first half, however gross margins fell to 51.6% in a sign that conditions are about to get tougher.
Now it's time to turn to look at how Fastenal is achieving its long term objectives.

Fastenal ‘Pathway to Profit’

This is a set of strategic end points that was originally laid out in 2007, but it has seen adjustment due to the effects of the recession.
  1. to continue growing our business at a similar rate with the new outside sales investment model
  2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012
  3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow, and
  4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
  5. to generate 85% of earnings in operating cash flow
As a consequence of the recession, Fastenal reduced the growth of new store openings and headcount additions. Furthermore in 2010, Fastenal pushed out the $125k a store target until 2014, but announced that it was possible to hit the profit objectives (23% operating margin) anyway, thanks to cost cutting.

So how are its plans going?

Scorecard on the Pathway to Profit

Firstly, I want to outline how Fastenal is now increasing the share of sales force outside the store.
Store Selling Personnel7,3098.5709,290
Non-Store Selling Personnel6048931,071
Percentage Non-Store7.69.410.3
In addition it has been expanding sales from its vending machines, which now make up 20.8% of net sales from 10.5% last year. All of which is helping operating margins in line with the first objective in the strategic plan. These sort of initiativs are helping Fastenal deal with increasing competition from the likes of Home Depot (NYSE: HD) who are trying to encroach on its marketplace.

Turning to the second aim, Fastenal has adjusted its objectives. Due to the recession the average store size has had to be reduced so the new aim is to reach an average store sales of $100-110k a month instead of $125k.

Thirdly, the development of leveraging up on sales has been held back by the recession, but Fastenal is back on track now. I want to highlight the percentage of sales generated by stores with sales of over $100k a month.

Stores Selling over $100k per month for Q2201020112012
Percentage of Total Stores12.213.815.9
These numbers are impressive especially given that Fastenal has been pursuing an aggressive store opening policy over the last few years.

Fourthly, lets look at how working capital as a percentage of sales has developed.

Accounts Receivable244,940214,169270,133338,594
Working Capital809,187722,574827,502984,746
WC/Sales %34.637.436.535.6
Again, Fastenal has been doing well even if operating cash flow in 2011 was only 75% of net earnings.

Fastenal End Demand is a Combination of Industrial and Residential Construction

In recent years, Fastenal has benefited most strongly from a cyclical recovery in industrial production and less so from ongoing demand from maintenance. However, commercial residential construction customers (which usually represent 20-25% of their business) are still in a funk, despite the recorded growth. I would guess that this growth is coming of a very low base and, until the US housing market recovers, it will not come back in a meaningful way.

Nevertheless, we do appear to be reaching a bottom in the housing market and the company can look forward to some contributions from more housing starts in future. Arguably, this makes Fastenal more attractive than MSC Industrial or Grainger, both of which are more focused on niche markets in the industrial sector.

Evaluation is Key

Fastenal is a well run company which is executing its long term plans very well. The shift in the composition of sales should enable more efficient cash flow generation in the future and the company is managing its inventory much better.

However, it is facing a moderation in growth in the industrial sector even if demand from the residential housing sector will be better going forward. In addition, the valuation is hardly generous. A current PE ratio of 33 and an EV/Ebitda of 18.8x leaves little room for error and given the macro uncertainty, it would take a good amount of confidence over a quick turnaround in order to buy this stock aggressively.

In this regard a stock like Home Depot would be interesting. Although it does not offer the same potential for operational leverage or cyclical exposure, it is more aligned to the housing sector and as yet, its management are not baking in any upside from a return to growth in the housing market. This suggests that there is upside here. In addition the valuation and cash flow metrics look much better than Fastenal right now

Monday, August 27, 2012

H & R Block, Great Yield But Where is the Growth?

H & R Block (NYSE: HRB) offers a classic value proposition for value investors. The company generates large amounts of cash flow and is actively engaging in restructuring efforts, all of which will continue to enable the distribution of cash returns to investors. Ultimately if looked at as a company capable of generating GDP type returns, it looks attractive compared to say a US Treasury.
However, the real question is what level of confidence investors can have growth prospects and the sustainability of its market positioning?

Intuit’s Strength Has Forced Change at H & R Block

The tax preparation market has been evolving in recent years and Intuit (NASDAQ: INTU) has been aggressive in migrating its software offering into a cloud based solution. In fact the company is the poster child of businesses that have successfully leveraged into the cloud.

The consequences for H & R Block have been significant. It has been forced into expanding in its own digital business and found itself having to scale back store expansion plans. Ongoing rationalization plans have reduced the cost base and the shedding of non-core business has increased focus on the most profitable parts of the company. The cost savings alone are forecast to add $85-100m to pre tax earnings in 2013. Whilst asset sales (mainly tax stores) have brought one-off benefits, they are set to slow in future as the larger part of sales have already taken place.

In addition, it has stepped up marketing and promotional activity in an effort to defend its market share. Marketing spend went up 15% last year in order to defend its competitive position and promote its online and digital offerings.  Promotional activity was focussed on the free offering of Refund Anticipation Checks (RAC) which led to a $49m decline in revenues.  The plan is to discontinue this promotion in the coming year, but given the ‘new frugality’ in consumer behaviour I suspect this will be met with a significant amount of consumer resistance.

So H & R Block is doing the right things but what is happening to its core business?

Core Revenues Challenged

The core tax services revenue division reported a 1.7% decline but this was largely due to a drop in financial product revenues. In contrast, tax preparation revenues increased but only marrginally. Meanwhile, its digital revenues increased 11% which is ahead of the 8% that it forecast the overall digital market increased by.  However, as previously noted H & R Block increased marketing expenses by 15% so this growth did not come without a cost.

The extra marketing expense clearly worked because management claimed it had expanded market share online and in its software offering. Moreover, it feels that digital growth is moderating and Intuit has been reporting weaker than expected growth in its TurboTax product.

The big hope for H & R Block is that with Intuit trying to secure growth by offering more advice to the client, the market conditions appear to be evolving in its favour. I’m not sure that this is necessarily the case for the long term. Employment gains have been weaker than most expected this year, so growth moderation in digital tax preparation is to be expected and it’s not surprising to see the likes of Intuit trying to offer more value added advise. However, the trend towards digital appears to be an inexorable one and it’s hard to have much confidence that H & R Block’s previous model will come back into style.

Indeed, future threats could emerge from companies like the UK’s Sage or Microsoft (NASDAQ: MSFT) could start bundling tax preparation software with other software in order to create a suite of products to the SMB and consumer sectors. Analysts have expected this sort of thing from Microsoft for years but perhaps this is the right time?

Emerging Market Growth?

One area where H & R Block can offer growth is in international expansion and in particular India is being cited as an expansion opportunity. Thus far it is a small part of revenues with only 3.2m tax preparation returns – of the 25.6m total- coming from international markets. With a lot of those returns coming from mature markets like Australia and Canada, it is hard to see international revenues having a meaningful impact in the near future.

Talk of Indian expansion is exciting enough, and there may well be huge numbers of taxpayers there, but the company has only opened three offices in India. Revenues and profitability were described as being ‘not material’ and management see it as a 10-20 year play. Frankly, I wouldn’t get too excited about emerging markets as being a near term profit driver for H & R Block.

Where Next For H & R Block?

The core business is surely challenged on a structural basis but restructuring and international expansion offer hope of future profits growth. In addition, asset sales and distributions to shareholders (not least via a 5% dividend yield) offer some underlying support to shareholders. The stock won’t be attractive to more growth orientated investors as it’s hard to see where it can generate significant top-line revenue growth. International expansion is more of a long term story and local challenges remain. For yield chasers only.

How Alcoa's Results Read Across the Market

The symbolic start to the earnings season kicked off as usual with Alcoa (NYSE: AA) giving results. Investors will be pouring over the numbers and outlook in order to discern where the economy is headed. Whilst it’s easy to pour scorn on the idea that one company can set the tone for a whole economy, Alcoa does give very useful and detailed commentary on its end markets. In addition Aluminum is widely used across a range of industries and markets. It’s time to look into what Alcoa said.

Alcoa’s End Market Guidance

These days what Alcoa doesn’t say is almost as important as what it does. The market has been fretting about China’s growth prospects for some time and, since it is the key driver of hard commodities demand, what Alcoa has to say matters. I’ve summarized the latest outlook below with reference to previous reports.

SegmentQ2 2011 vs. 2010Q3 2011 vs. 2010Q4 2011 vs. 2010Q1 2012 vs 2011Q2 2012 vs 2011Trend
Aerospace76 to 710 to 1113 to 1413 to 14Stable
Automotive4 to 83 to 53 to 83 to 74 to 8Slightly Stronger
Heavy Truck & Trailer7 to 120 to 22 to 51 to 5-3 to 1Weaker
Beverage Can Packaging2 to 32 to 32 to 32 to 32 to 3Stable
Comm Building & Construction1 to 31 to 34 to 52.5 to 3.52.5 to 3.5Stable
Industrial Gas Turbine5 to 105 to 1001 to 23 to 5Stronger

Before breaking down the outlook by industry segment I will focus on where the changes were on a geographic basis.

Geographic Summary of Alcoa’s Results

North America saw a stronger Automotive outlook and this ties in with the extra production shifts planned at Ford (NYSE: F) and others. Heavy Truck & Trailer was weaker but this is coming of some strong numbers and the average age of a US truck is approaching historic highs. Beverage Can Packaging was weaker and this is pretty much in line with what Coca-Cola (NYSE: KO) and Pepsi are reporting in soft drinks and what some of the food companies are saying about canned food. Conditions remain weak in commercial building & Construction but interestingly, there was no change from last quarter.

Somewhat surprisingly there was no change in the European outlook. Although this just means conditions remain negative (apart from in Beverage Can Packaging which has 5-7% growth forecast in Europe) it does imply that things haven’t quite fallen off a cliff in Europe in the way that some technology companies are trying to argue.

Turning to China, the only downgrade to expectations came in the Heavy Truck & Trailer segment where growth is seen as turning negative by 3-8%

Aerospace and Automotive

The aerospace was seen as being particularly strong and, as ever with proponents of the industry, the back log of order at Boeing (NYSE: BA) and Airbus were cited as ensuring strong growth for years ahead but I would urge a note of caution here. Aerospace may well be a long cycle industry but it is still cyclical and when the going gets tough airlines will suffer. They go bust, they cut back on routes, and then ultimately airplane orders get cancelled or delayed.

Alcoa were quick to talk about commercial aerospace (particularly business jets) picking up the slack from the decline on the military aircraft side. However, business jets are the most cyclical of all orders and a large part of the growth in aircraft demand at Boeing has come from European budget operators and emerging market airlines. If the BRICS are slowing then their airlines are likely to see lower passenger miles growth.

The main bright spot was in automotive where there are real signs that North America car sales are expanding. The US car manufacturers are seeing increased orders and provided the US recover remains on track (albeit a slow recovery) Alcoa should see good demand. The average age of the US car has been rising with the economic weakness and is now at a level that suggests that consumers should start to purchase again.

Heavy Truck & Trailer  and Beverage Can Packaging

Heavy Truck & Trailer was seen as weaker in both China and North America. The former has now turned negative whilst the latter is moderating from very strong growth. Alcoa think that China stimulus spending may well increase demand in the second half but again I would urge a note of caution. China is still a communist country and its local Governments have a reputation for corruption and spending for the sake of hitting central Government targets without particular concern for efficiency. In other words, China may find it hard to get stimulus spending filtered down into the real economy. Europe is seen as weak.

I found the Beverage Can Packaging to be the most interesting segment from these results. North America was seen as weaker but Europe and China remain on track. Indeed, I notice that Ball Corporation (NYSE: BLL) was up the day after the results in an otherwise down market. Can packaging is a relatively recession proof industry and perhaps Ball, Crown, Rexam and others are set for margin expansion as Aluminium prices abate but end demand remains stable. The problem I have with the likes of Ball is that the evaluation does not look cheap. These businesses require a lot of ongoing capital expenditures and keeping capacity utilization high is paramount. In other words, they are strategically tied to their customers with little ability to cut costs in any downturn.

Commercial Construction and Industrial Gas Turbines

Rather surprisingly, there was no change to the Commercial Building & Construction markets. This is despite some signs of recovery in North America and weakness in China. Architectural Billings have been weaker in recent months but they were expansionary for a while in the US and construction hiring was strong in the US. I suspect the US will get stronger so perhaps the forecast 5% decline is the low point? As for China the forecast 7-8% growth is probably the tail end of existing fixed asset investment. There are real signs of a slowdown in new developments in China. Need I mention that Europe was weak?

And finally, industrial gas turbines saw its growth prospects pick up. There is secular growth from the increase in market share taken by gas in terms of producing energy. It is interesting that this is causing growth prospects to accelerate and investors should look at some of the parts manufacturers as being potential beneficiaries.

Sunday, August 26, 2012

Can China's Stimulus Spending be Relied on?

Most investor focus has been on the European sovereign debt crisis in recent months but China is demonstrably slowing too. The bearish case on China should be well known by now, but I think the real moot point for China’s future growth is too little discussed. The Bullish thesis has it that China can always stimulate its economy via utilising its foreign currency reserves and vast budget surplus. It is a strong argument –at least I hope so because I’ve held it in the past- but I’m not so sure now.

The issue is a significant one for investors. Companies like Caterpillar (NYSE: CAT) or Joy Global (NYSE: JOY) are largely dependent on future growth for what happens in China’s construction and mining industries. These sort of companies are the obvious beneficiaries but someone like LED manufacturer Cree (NASDAQ: CREE) is also expecting a pick-up in LED street lighting investment from China.

Similarly, telecoms equipment suppliers like Cisco or Juniper (NYSE: JNPR) will be hoping that China picks up the slack from weaker North American service provider spending in the second half.  The key point is that so much of marginal global growth has been coming from China and if it s going to disappoint then there is no way that the globally exposed companies can be immune. Someone like GE (NYSE: GE) is exposed across a range of its long cycle capital infrastructural industries.

Western Political Democracy and Economic Liberalism Hasn’t Triumphed

The essence of the problem is that China may not be the kind of economy that we all perceive it to be. Those of us old enough to remember Francis Fukuyama’s epoch defining book ‘The End of History and the Last Man’ will recall how the relevance of the debate of the book’s conclusions are still apparent today.

Fukuyama did nothing less than pro-claim the final victory of Western political democracy and economic liberalism. Events proved otherwise, and I can’t help note that so many of the erroneous underlying assumptions made then are being made now when discussing China.

Culture matters. It is how we interact with people and organise our affairs. Moreover, culture has a symbiotic relationship with economic policy. For example the Anglo-Saxon countries seem to have a penchant for societies characterised by significant disparities between the wealthy and the poor. Meanwhile, places like Japan, Germany and the Scandinavian countries have a much more egalitarian income distribution and a much more communitarian sensibility.

With this in mind we are entitled to ask that if there is no conformity within Westernised democracies over the structure of their society and polity along the lines that Fukuyama argues, how on earth can we expect this homogenised ideal to apply to China?

China is Not a Capitalist Country

China is still a communist country and despite no end of efforts to convince unsuspecting investors to the contrary, this fact makes it fundamentally different. Essentially its recent history is a story of the wonderful release of energy and productivity that occurs when economic liberalization takes place. Of course we have seen this before. In China! Or rather in the bit of China that calls itself Hong Kong.

It is also a story of a closed capital system where RMB are printed and issued in order to keep the currency weak against exporting currencies. Ultimately, this capital has to end up somewhere and increasingly it looks like a good old property bubble is bursting in China. In addition, and in the absence of developed capital markets Chinese investors have sought the safe haven of Gold.

The Chinese Government is now faced with a difficult set of circumstances. The property market is slowing, its export led economy is facing challenges as Global growth remains weak and significant social unrest is possible if the economy turns sour on the masses of recently urbanized workers see their aspirations threatened.

The solution is well discussed in investment circles and by the Government itself. China needs to stimulate its economy and it needs to shift towards domestic consumption.

The Solution is Well Known but is it Feasible?

The issue here is that China’s political structure may make it extremely difficult to successfully stimulate the economy via stimulus spending. China is a communist country. Its local governments are inefficient and by most accounts, riddled with corruption. Meeting central government targets is one thing for an ambitious official aiming for promotion, but ensuring that capital is allocated appropriately and with the aim of generating return is something that we should expect that administrator to achieve.

In other words, China might find it hard to get efficacious spending into the areas of the country where it matters. Chou En Lai and Mao Tse Tung didn’t exactly have much success when they engaged in their long term planning efforts. Why are some so keen to assume that the current Chinese Government will be any better?

Of course, the difference between then and now is that a significant part of the decision making in China is now made by the private sector.  However, we are discussing a scenario whereby public investment replenishes a country’s growth prospects when its private sector is experiencing a weaker environment.

Capital Allocation Still Matters

Culture and economic policy are not necessarily universal but the principle that there is a benefit in allocating capital more efficiently is. This is a point frequently lost by China Bulls who tend to point out that it doesn’t matter so much that capital is actually thrown at the economy. The problem with this argument is that once capital starts to be mis-allocated, it then creates pricing signals which then leads to more capital being allocated towards increasingly unproductive ends. In other words a classic investment bubble ensues. China is no different to any other country in this regard.

Where Next for China?

China has been slow to release stimulus spending and the reasons expressed above are largely the cause. It is not so easy for the central Government to insure that investment is efficaciously filtered down into the economy and anyone investing in companies on this basis could be due a rude surprise. China is still a communist country and I find it hard to rewrite the history of how inefficiently capital has been allocated by similar systems –not least in China- over the years.

Where Next for Informatica?

Informatica (NASDAQ: INFA) became the latest technology company to warn and this was no gentle reduction in guidance. It announced preliminary second quarter results and shocked the market with a forecast of Q2 revenues of $188-190 million where analyst estimates had been at $217 million. If this wasn’t bad enough, the conference call that followed the announcement was so largely devoid of company-specific "color" as to raise more questions than the management attempted to answer.

The key take-away from the conference call was that management believed it could generate year-on-year revenue growth in Q3 and Q4 and that it would "at least maintain" EPS numbers. Putting these statements together indicates a full year non-GAAP EPS figure of at least 143c which is flat on last year. However, it was way below the recent analyst forecast of 161c.

This is a significant miss, but why did it happen?

 Informatica Not Giving Information

It is rather ironic that a company engaged in selling Master Data Management (MDM) solutions couldn’t be more specific on the reasons for the miss. When questioned, management claimed this was a broad-based phenomenon that wasn’t specific to any industry vertical. Problems appear to have accelerated in June and were largely a consequence of European weakness and the collateral effects of Europe on North American customers. In almost rote like fashion, analysts were informed that customers were delaying orders, requiring further sign-offs and lowering threshold approval levels.

These are the classic early signs of what CEOs do when they want to raise the drawbridge on spending in the face of a slowdown. They are also excuses that customers give when they do not want to buy your product. The reasons for the latter could be coming from a multitude of sources and investors should realize that Informatica is a small company competing against some of the largest companies in tech.

Informatica in the MDM Marketplace

Oracle (NASDAQ: ORCL) and its mortal rival, SAP (NYSE: SAP), compete aggressively in the MDM space as does another tech behemoth, IBM (NYSE: IBM). Oracle offers a number of differentiated solutions to the MDM market with which it tries to generate sales from different sorts of customers. Whilst its Siebel UCM product is currently its largest single MDM product, in the future, it will try and establish Oracle Fusion MDM as its lead MDM solution.
Meanwhile IBM has integrated its three MDM products into a unified offering with which it hopes to offer greater functionality to its customers. This is essential because competitors like SAP or Oracle can offer an integrated solution that carries across myriad business applications from those two companies.
So there is a case for Informatica being squeezed out by some very high powered competition. However, I want to focus on another company in a related space, namely Tibco Software (NASDAQ: TIBX).

Tibco Tells a Different Story

This company gave results at the end of June that were largely in line with analyst expectations. Tibco is relevant because – although its MDM product revenues are very small -- its solutions encompass the kind of business optimization and real time intelligence markets that Informatica’s solutions also tailored too. In other words, I simply don’t believe that Informatica’s solutions would be subject to order delays and greater sign-off approval (as Informatica claimed) whilst Tibco’s would be immune from such a process.

The curious thing is that did Tibco did quite well in Europe and, in fact, it was execution issues in North America that the company cited as causing missed opportunities. Indeed, the company changed its Americas leadership and role of its Senior VP Americas for core infrastructure sales in an effort to better capitalize on opportunities.

With regards to the specific part of its business that relates to Informatica, Tibco stated that business optimization was only marginally up, but was a key factor in most of its larger deals. After a string of growth quarters and a very good  Q1, Spotfire showed less growth in Q2, but continued to show strong pipeline growth and is up over 43% year-to-date. Business Events was down on the quarter, but this belied its central role in enabling many of Tibco’s infrastructure applications.

Put another way, Tibco was saying that business optimization growth moderated but what it didn’t say was that orders were falling off a cliff thanks to Europe. In fact, when asked about it, management said that it had not seen any change in European conditions from a quarter ago. Again, Tibco said this at the end of June, which was a month into the period where Informatica had said the weakness began. Interesting.

Where Next For Informatica?

Clearly investors need to see that this is a macro-issue and not largely a company-specific one. It is indisputable that European concerns will weigh over CEO decision-making and it would be no surprise if it did cause a slowdown. However, these issues have been there for a while and most companies have adjusted. In addition, if companies can turn the tap off quickly, then they can also switch them back on swiftly too.

There are too many imponderables here and I think investors should be cautious before reading sector-wide weakness just because life got tougher for Informatica.

A Look Back At Acme Packet's Results

Acme Packet $APKT delivered the kind of warning that many tech investors are worried about in the forthcoming earnings season. Make no mistake, this was a significant reduction in guidance and it sent the rest of the sector scrambling to sell stock in sympathy. As ever, investors need to ask themselves whether this is a clear sign of a rapidly deteriorating environment or a company-specific issue?  In summary, I think it is more a function of the latter and there is a case for saying that the management was guilty of somewhat wishful thinking with its previous guidance.

What does Acme Packet Do?

Essentially, Acme is a play on the convergence of voice and data networking into just data or rather Voice over Internet Protocol (VoIP) provision.  Whilst this appears to be a inexorable trend, the rate of adoption is subject to question. In addition, it operates in very competitive markets with the likes of Cisco Systems $CSCO and Sonus Networks $SONS The former has already articulated its belief in a broad-based spending slowdown whilst the latter has talked of strong growth in its markets and made a recent acquisition (Network Equipment Technologies), which is seen as strengthening its competitive position. Indeed, this may turn out to be a competitive issue.
The key customers for Acme are the telecommunications service providers and, for example, Verizon (NYSE: VZ) accounted for 16% of total revenues in the last quarter.  So what went wrong?

Service Providers are Still Not SpendingThe market has known that the telcos were holding back on spending for some time now but unfortunately this is not something that Acme’s management has successfully factored into their guidance. Until now that is!

Indeed if we look back at what some of the largest players like AT&T $T and Verizon are saying, there has actually been a downgrading of capital expenditure plans as the year goes on.  In addition, other telecommunications equipment suppliers have been reporting weakness. These aspects were covered in an earlier article linked here.

It is therefore quite puzzling to look into Acme’s previous guidance and read optimism over a second half pick-up, particularly when there appeared to be no confirmatory sign in hard orders or revenues that the market was recovering. It appears to be a classic case of management’s listening to the sales force and then failing to adjust for their (the sales force) exuberance by tempering guidance.

Guidance Too Optimistic?The basis of Acme management’s argument for retaining its 10% top-line guidance for the full year was that the revenues for the first and second half would follow the usual 42/58 split. Unfortunately, this forecast contains little account for the current reluctance of the service providers to commit to spending. And that reluctance has now forced Acme to lower guidance.
And it is a whooping downgrade.

With the explanation being given as
“We are disappointed with our preliminary results for the second quarter.... Our top line results were principally impacted by continued weakness in the North American service provider market. We are completing a full review of our operations and will provide a further update on July 26th."
Investors should note that the usual bugbear of Europe was not mentioned, nor was the government vertical highlighted as being weak.

We should always be careful not to conclude too much from such a simple statement, but frankly putting the pieces of this puzzle together creates a picture of a company that has been too exuberant in its assumptions and guidance, in particular with its expectations for growth in capital expenditures from North American service providers.

Another issue clouding the situation is that Acme's core market of Session Border Controllers (SBC) may well be challenged by other vendors selling end-to-end integrated solutions to network management. SBCs control signaling between service providers and when service providers purchase end-to-end or peer-to-peer solutions, they can be seen as competing for network spending dollars. Moreover, according to many other companies in the telco sector, wireline spending is moderating more than wireless.

When Highly Rated Companies Fail to Hit Guidance

The consequences of a company trading on a high PE coming out with disappointing guidance are plain for all to see. Even after the mid teen percentage fall, Acme still trades on a PE of 33, not to mention a EV/Ebitda ratio of 13x. This stock is not cheap on conventional methods and the growth rate and adoption of VoIP is likely to be moderated in analyst forecasts.

The end markets for Acme will surely improve in time, but for the foreseeable future the company is going to have to demonstrate that it is really an industry issue and not a company-specific concern. Potential investors should listen carefully to what Sonus Networks says and look for signs of a stabilization in telco spending.

In addition, Acme’s management is going to have to rebuild confidence in the stock and in their predictive outlook before cautious investors will be tempted back in.

Acuity Brands Equity Research

The doom and gloom merchants have certainly got hold of the market in certain sectors and few more so than the commercial property sector. Unfortunately for the bears when a shorted stock reports results that more or less confirm its current outlook than the result can be a brutal swing to the upside. This was the case with Acuity Brands (NYSE: AYI) recent results and there is a lesson that can be learned from the 16% rise that followed. Incidentally, the stock slumped after the last results and there is an article on it linked here.

Simply put, the market has seen the recent declines in economic data and aggressively sold off certain sectors on any sign of industry weakness or negative commentary from a bellwether.  In the case of lighting company Acuity Brands, investors saw the weakness in construction hiring in the payrolls numbers and the downturn in the Architecture Billing Index and then concluded that Acuity was headed for a big miss. They were wrong.

Regarding the Billing index, having been above 50 (indicating expansion) since November, it fell into negative territory in April and then accelerated the decline in May. Acuity stock has been weak ever since. Even the takeover speculation in the sector following the bid for its rival Cooper Industries (NYSE: CBE) wasn’t enough to dispel the gloom.  So given the softness in non-residential construction spending, how has Acuity managed to increase sales and unit volumes by 6.4% and 5% respectively?

LED Lighting Plays

It has been a long time coming but it seems that energy efficient LED based lighting is starting to grab market share from traditional lighting. It is not only Acuity that is seeing this. In April, its competitor Hubbell (NYSE: HUB-A) reported a 10% rise in sales and talked of strength in the industrial and utility markets. Interestingly, it argued that non-residential construction activity was soft but was offset by renovation and relighting projects of which LED lighting is a component.

Acuity confirmed this trend in its latest results. Essentially the company is diversifying away from its reliance on new non-residential construction and towards offering innovative renovation, lighting control and LED based solutions. It’s working.

LED based lighting now accounts for 10% of sales from 7% previously and Acuity is a market leader in digital lighting. Whilst LED solutions have profit margins similar to traditional lighting so no margin uplift here, it is the increase in demand which is allowing Acuity to drive sales higher irrespective of slow construction markets. Moreover, the North American renovation and relighting market is seen by market forecasters as growing in excess of the growth rate in new construction.

Another key driver is the convergence of lighting with controls. LED based lighting allows users to create a significant amount of customization and the increase in demand for LED’s will create a concomitant rise in controls demand. In addition, the two are converging.  All of which is creating increased interest in Acuity’s products.

Acuity Brands Analysis

Acuity hasn’t been slow in reacting to softer construction markets over the last few years. It closed a plant in the US recently and downsized operations in Spain. Moreover its strategy of using agents gives it more flexibility to manage fluctuations with end demand. It also allows the company to expand geographic locations with more ease. Going forward, LED costs can be expected to abate but elements like higher rare earth costs mean that overall costs are likely to go up. Indeed, if we focus on what LED manufacturer Cree (NASDAQ: CREE) i saying that it is lighting that will lead demand for LEDs in future. This is important because it encourages companies like Cree to invest in developing new technologies for Acuity’s lighting solutions.

One potential source of worry for the sector is the continued moderation in public sector spending, however Acuity has limited exposure. Gross margin expanded in the quarter and the balance sheet is strong enough for acquisitions (a key part of strategy) and for buybacks.  In other words, the management is wringing every bit of performance that it can from the company.

Where Next For Acuity Stock?

I think the risk/reward proposition is favorable for Acuity. Construction markets remain weak but it managed to achieve 5% unit volume growth in this quarter, so there is ample scope for more growth if and when US construction activity picks up.

Moreover, the company has just generated $157m worth of free cash flow in the last year. This equates to over 6% of the current Enterprise Value (EV) and this is in soft end markets. Analysts have 20% EPS growth pencilled in for the next two years and if Acuity hits these numbers the evaluation will likely be higher.  I think the trend towards LED lighting and control is an exciting secular one and, it is reasonable to expect it to continue as technology improvements and market awareness add to its competitive advantage.

Friday, August 24, 2012

ConAgra Offers High Yield and Defensive Growth

Investors looking for a safe haven yield play should take a look at ConAgra Foods Inc (NYSE: CAG). It is not the sexiest growth story out there but the company generates large amounts of cash flow which amply support a near 4% yield. In addition, it has a some value and private label brands which benefit from a sluggish economy. The consumer focus is probably a good thing (people eating out less) and with commodity costs looking like they are set to moderate, it could see some margin expansion.

Food Companies Riding the StormIt's been a tricky time for the food companies. As companies like General Mills (NYSE: GIS) have noted commodity costs have been rising at the same time as consumers are retrenched in a value conscious behavior. Some companies like Kellogg (NYSE: K) have tried to pass through costs in the form of higher pricing but have been met with a raft of resistance. Price sensitivity appears to have increased for as long as the economy has remained weak.

As a consequence, shoppers are more inclined to buy groceries from the dollar stores and trading down has been a necessity not an option. In addition, the type of buying has changed. Companies like Heinz (NYSE: HNZ) have seen shoppers looking for smaller portion sizes and it has had to adjust its offerings accordingly. Shoppers are more price sensitive but this doesn't mean that quality can be sacrificed. For example, Campbell Soup (NYSE: CPB) has seen a number of changes to its product line up with a view to innovating and cutting costs. None of which seem to be particularly successful.

Putting these issues together suggests that the food companies may not quite be the kind of defensive play that they would have been in the past. They find themselves squeezed on both sides. ConAgra has not been immune and it has seen volumes falling in certain brands as a result of price increases.
However things are changing and, I think ConAgra has some reasons for optimism.

Better Times Ahead for ConAgra?
Commodity prices are falling for ConAgra. In fact, in the first three quarters of the year it reported an 11% increase whilst the fourth quarter saw only a 6% increase. Meanwhile, prices have been pushed through at the largest volume business in the consumer foods segment, namely Banquet. This did cause an inevitable fall in volumes, but overall the consumer foods segment (63% of sales) saw a 6% rise in sales with a 7% rise in adjusted operating profits.

Of particular interest in the consumer foods segment is the strength of its private label brands business which specializes in nutrition and snack bars for store-owned brands. This enables it to leverage a value orientated offering into the sales mix. I was encouraged by the management talking about the expansion opportunities here.
Furthermore, ConAgra has a few key brands in some attractive categories. Healthy Choice, Libby's, Marie Callender and Lightlife all saw sales growth in the quarter. Meanwhile other consumer brands, like Banquet, saw volume declines (organic volume sales were down 5% in the segment) but sales increases due to pricing.

It was a similar story with the commercial foods segment (37% of sales) which reported a 6.8% increase in sales with a 7.5% increase in operating profits despite having to deal with higher commodity costs. Of particular note is the Lamb Weston brand, of which, management is claiming good sales momentum particularly within emerging markets. It strikes me that potatoes are a pretty recession resistant food and as a consequence sales growth has been consistent in this segment. Management seems very confident that growth will remain strong for Lamb Weston.

Is ConAgra Worth Buying?
Investors looking for yield and stability will like ConAgra. It only offers single digit growth prospects but the underlying free cash flow suggests that there is room to grow the already-healthy dividend.

ConAgra ($m)May 2009May 2010May 2011May 2012
Free Cash Flow (FCF)557960886713
Dividend (D)348347375389
Despite increased pension contributions (which are made to fund future requirements) of $326m in 2012, ConAgra generated good free cash flow again and given continued growth in the business, there is ample scope for dividend increases. In addition, the company has been active in making acquisitions which have tended to be in the faster growing snacks and alternative breakfast areas of the food industry. There is plenty of room for more of the same, or perhaps a timely expansion of its private-label offering.

I think ConAgra offers a good mix of steady growth and yield particularly for risk adverse investors fearing an uncertain economy.

Greece Still Matters

With the Greek elections over and the resulting relief rally having soothed fears, investors are entitled to ask whether Greece should matter to them anymore. Unfortunately, I think the answer is yes.  Even if in the short term the markets will like the election result, there is a case for the resulting political set up to be making things worse.
The markets got what they wanted which was the a New Democracy/PASOK coalition Government being formed. The hard line left wing Syriza received a strong showing but not enough to stop a broad based coalition from ‘reasonably’ renegotiating aspects of the EU-IMF bailout program whilst receiving the bailout funds in order to keep Greece solvent. Problem solved?

Not a chance.

US Not Immune
US investors may think that US companies are immune but, this is not the case. A hard default by Greece would cause issues for the European banking sector and the economy, and then ultimately the US.

For example, McDonald’s (NYSE: MCD) generates more than 40% of its revenues from Europe. Any slowdown with European consumer sentiment will hit its top and bottom lines significantly. For Apple (NASDAQ: AAPL), it's 24%, but Europe generated 46% revenue growth for the company on a yearly basis. Again, a slowdown in Europe will hurt the company's growth plans.

Europe is obviously a key area for General Electric (NYSE: GE) and it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. Not only will its long cycle infrastructure industries be hit by a slowdown in Government spending, but GE Financial woud also be exposed in the event of a financial crisis.

As for Coca Cola (NYSE: KO), in the last quarter, it generated more profits from its Europe segment than it did from North America! Coke is seen as a defensive, but consumers can easily shift to a cheaper alternative. In addition, consumer staples are subject to slowdowns. A good proof of this can be seen in Danone's recent disappointments in Spain.

Merck (NYSE: MRK) generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics. The key point is that this problem is wide and pervasive that the traditional defensive safe havens will not work.
Greece Matters!

Deep Structural Problems, Not Short Term Fixes

If the problems are structural then the solutions must be too. Unfortunately, this refrain from leading German figures has hardly been heeded by Greece. Whereas Portugal and Ireland have won plaudits for their willingness and commitment to make reforms, Greece has proved reluctant or unable to implement them.
Moreover, the kind of reforms that Greece needs are deep and structural. Privatizations, asset sales and piecemeal liberalizations are useful for raising liquidity and dealing with short term funding issues, but they need to be accompanied by significant structural reforms of the public sector, fiscal policy, and political system. The bad news is that Greece is not satisfactorily doing the former, let alone contemplating the latter.

All of which leads to a curious clash of perception. Whilst the idea of the EU-IMF is that the bailout program is intended to buy time for Greece to reform and get back to a sustainable debt path, the Greek politicians seem to have other ideas. They seem to be playing a game of extracting as much lending as they can from the EU whilst not making the reforms, partly because they do not believe in them. Even if they did, it would arguably be impossible for them to make them in the face of an increasingly belligerent population.

The Curious Twisting of LogicWe can even see this reluctance to reform in the way that the lexicography of the sovereign debt crisis has evolved. Fiscal conservatism and sound governance has led Germany to historically low unemployment rates and good growth. Meanwhile high debt and public spending has scuppered prospects for so many across Europe. Moreover, under Baroness Thatcher, the UK managed to reduce debt and generate growth via an ongoing program of liberalizing reforms and fiscal conservatism.

However in France, Hollande was elected on a program of borrowing, government spending and opposition to reforms, all wrapped up under the slogan of ‘anti-austerity.’ In other words, if you argue against all the things that have demonstrably resulted in positive things for European economies, you are now to be labelled as ‘pro-austerity.’
The ‘anti-austerity’ light brigade are on the march in Europe, even though everything they advocate will make things worse. It is easy to promise the universal panacea of racking up debt for future generations in order to generate a short term high. Just ask a crack dealer. However, it is not a solution that will amount to anything other than more problems and debt for future generations. This is what got Europe into this mess in the first place.

Alas, politicians like Hollande are only encouraging Greece to carry on a concerted effort at refusing to make reforms. Indeed, with breathtaking audacity, many Greek politicians are advocating cutting taxes (which the Government has a hard time collecting anyway),while using EU money to invest in wide-scale public spending and not engaging in any more ‘austerity’ measures.

When will this madness end?

But the EU-IMF Have a Deal Right?

A deal is only as good as the intent of the parties to enact it. Unfortunately, the situation in Greece is that the parties being rewarded are those that have been explicitly against the reform program. Syriza’s position is well known, but what is little discussed is how vehemently the leading party in the forthcoming Government has been against the reforms.

The reality is that Samaras has continually garnered support by voting against reforms and generally causing problems for the existing Government. He even voted against the first bailout in May 2010 whilst expelling Dora Bakoyannis (a former foreign minister) for voting in favor it. He is arguably the most divisive and culpable figure in Greece’s failure to implement reforms.
And now the idea is that he is going to make the reforms while holding a coalition Government together with a slim majority, in a Parliament riddled with strong representation from Syriza’s collection of Marxists and hard left protagonists. Not to mention the neo-nazis, independents and communists in the Parliament.

To paraphrase Jim Carrey in 'Dumb and Dumber,' so you are saying there is a chance!

So What Next for Greece?

I think it is more of the same. The bailout will buy some time but it is unlikely that meaningful reforms will be made. The support for the ‘anti-austerity’ movement is likely to grow and Greece will revisit insolvency again. Meanwhile, the groups like Syriza who think they can ‘game’ Europe by threatening a hard default will become more emboldened.

The only route out of this cycle will be if Greece defaults (hard or soft) or, if a wide scale European solution (usually a euphemism for exposing the German taxpayer to other peoples debt) is enacted. I think the latter invites a huge amount of moral hazard that will inevitably condemn Europe to a low growth/high debt economy. The former is dangerous if done unilaterally, but probably manageable if carried out by the EU in a coordinated manner. A Syriza victory might have accelerated the process, but the New Democracy/PASOK coalition will likely keep the game going a bit more.

For investors, this means that the underlying risks are still there even if they are being swept under the carpet for now. Buyer Beware.

Adobe Systems Equity Research

Adobe Systems (NASDAQ: ADBE) became the latest technology company to lower guidance as a result of European difficulties and the market immediately marked the stock down. As ever, rational investors will reflect on the results in the context of the long term picture rather than reacting in a knee jerk fashion. So is there a case to be made for Adobe?
I happen to think there is.

Adobe's Results

Whilst Q2 results beat estimates, the company guided lower than market had estimated for Q3 and it also lowered guidance for full year revenue growth to 6-7% from 6-8%. There were two main reasons for this.

Firstly, Europe was seen as having some softness and management were being 'prudent' in guiding lower. Frankly, I would expect nothing else from a company reporting at this time. There is no doubt that the uncertainty over the Greek elections has given sufficient cause for European corporations to delay spending decisions where they could. However, with the election result seen as being favorable (at least in the short-mid term) there is good reason to believe that this pent-up spending could be released.

Secondly, Adobe expects lower sales in its digital media division (72.8% of sales) due to the launch of a cloud based subscription based model for its flagship creative suite product. I choose my words carefully because, Adobe will still offer the perpetual box solution on the shelf. However, expanding sales via the subscription model will result in lower upfront revenues. Indeed, Adobe stated that it was 'overachieving' with regard to signing companies up to the new model.

Some analysts pointed out that it would take up to four years for Adobe to generate the same level of revenue as compared to a perpetual license sale. This may well be true, but Adobe believe they can sign up at least 10% more clients this way. In addition, let's recall that a SaaS based model tends to imply lower churn rates, lower marketing spend, higher cash flows and ultimately a higher life time value for a client.

The subscription issue is actually what Adobe are trying to do with the company so it would be rather churlish to criticize the company for achieving its aims!

Adobe's End Market Drivers

What makes Adobe attractive is that, unlike competitor Autodesk (NASDAQ: ADSK), its sales growth will largely be dictated by company specific issues as well as secular demand drivers. Autodesk has large element of cyclical demand from the construction and manufacturing sectors, whereas Adobe is a lot more about the secular shift to online and digital based marketing and media.

Adobe's ultimate aim is to be to marketing what Salesforce is to sales. As companies expand their digital presence, they will need to analyze and manage large amounts of data that are produced via this activity. The key advantage being that companies can demonstrate and monitor the return on investment (ROI) for their marketing spend in ever increasing detail.

 As these details become clearer and easier to manage, so marketing departments can become more analytical in how they target marketing spend. Adobe's solutions give corporations the ability to do this. In addition to monitoring ROI in marketing, it also allows companies to engage in predictive analysis of the market reaction to their campaigns. This is especially useful because digital marketing is increasingly distributed over various devices such as mobile, tablet and PC. When companies engage in marketing activity on a social networking site like Facebook (NASDAQ: FB) they will need to engage in brand building analytics in order to understand the interaction of potential customers.

One of the big advantages of Facebook is that it creates a huge amount of profiling data that can be used by Adobe's data analytics and marketing solutions. However, the area is not without competition. For example, Google (NASDAQ: GOOG) offers free and paid-for analytics and IBM (NYSE: IBM) offers its core metrics solution. In addition there are a host of other smaller competitors that offer smaller parts of what Adobe offers as part of a big suite.

Google's free solutions are unlikely to be used as a key part of a large campaign and, customers may feel that the independence Google's paid-for solutions might be compromised by a conflicts of interest. IBM is competitive but Adobe is the clear leader.

So What Next For Adobe?

Clearly the transition to a subscription based model in its flagship product will cause some variability in results in the near term. However, longer term, it is a good move and will make earnings more predictable and with probably higher margins too.

 I like the secular trend towards digital media and marketing and the stock is not expensive. In terms of free cash flow, Adobe has averaged $1.09bn in the last three years. In other words, it's around 7.2% of its enterprise value. That looks attractive for a business with high single digit earnings growth forecast for the next few years and I think there is upside potential to these numbers given the rapid expansion in on-line and digital spending.

Weak Auto Sales, What Next for the Car Retailers?

CarMax (NYSE: KMX) gave results recently and disappointed the market with its numbers and outlook. However, perhaps the most surprising thing was that the market was surprised! Industry data has suggested that vehicle sales were a bit weaker in May and other economic data has indicated some softness with the consumer. It is hard to conclude that this is the start of the reversal of a strong trend in car sales but with the non-farm payroll numbers being weak in recent months, it is understandable that investors should be taking a cautious view.

Industry Car Data

As mentioned earlier, industry data for vehicle sales was a bit weaker in May. This can be shown in data from the National Automobile Dealers Association (NADA) and specifically the Seasonally Adjusted Annual Rate (SAAR) of vehicle sales.

SAAR (m)OctoberNovemberDecemberJanuaryFebruaryMarchAprilMay
Vehicle sales13.213.513.514.515.114.314.413.8
Note the downturn in May following some strong numbers in the previous six months.
In truth, car dealers have little visibility of future sales and their prospects are subject to the drift of macro-economic trends.  CarMax is the largest used car dealer in the US. Store traffic numbers were down, which suggests that customers are still very price conscious in an ongoing weak environment. Competition is strong from the likes of AutoNation (NYSE: AN), but I doubt the weakness at CarMax is anything other than an industry wide issue.

However, what is more concerning from the economic perspective is the relative weakness in new car sales. This has been a key part of the bullish case on the US economy this year and any sustained weakness will lead to downgrades to GDP growth expectations. CarMax reported a 5.7% gain in used car sales but a 10.4% decline in new car sales. Equally worrying was the 2.1% decline in wholesale vehicle sales.

Moreover, since CarMax is overwhelmingly a used car sales dealer, its results cannot be explained away in terms of weakness with specific models. For example, other dealers like Penske Automotive Group (NYSE: PAG) or Group 1 Automotive (NYSE: GPI) are more focused on specific car models and their sales results can vary depending on model release dates and popularity.

If there is a specific aspect to CarMax’s results it lies in the availability and pricing of used car models. Analysts grilled the management over this issue and specifically whether it was demand or supply that was the issue behind the weak performance in the quarter. The answer was that it was a bit of both.

Used Car Prices Rising

CarMax’s core sales are traditionally 1-3 year old cars and prices have been rising as fewer vehicles are available in the market. Unfortunately, the economy is such that consumers are now price resistant across the board. This could squeeze CarMax in future as it will need to purchase inventory for the new store openings whilst consumers are resisting price rises. Now does not appear to be the best time to be opening new stores.

Against this trend is the fact that third party lenders appear more willing to extend credit to CarMax's customers. Indeed, credit companies appear to be loosening in their lending standards and whilst employment gains have been weaker than most would hope for, they have still been positive. In other words, the conditions are ripe for an increase in demand, but the high price of supply may take some time before it overcomes purchasers' resistance.

So What Next For CarMax?

From a investment perspective it is always tempting to look at a negative quarter and try and write it off as a blip in an otherwise strong trend. However, in this case I think the confluence of forces that are merging toward CarMax's bottom line are suggesting a bit of caution here. Indeed, management was quite specific on the underlying issues.
"I think some consumers look at pricing and just decide to not get out there and buy right now. And I think until we see some movement in the supply and the SAAR gets back up to historical levels, then we're probably going to be looking at this for a little while."
Given that the SAAR was weaker in May and other economic indicators have been weak of late, there is sufficient cause for a bit of caution here or at least until confirmation of a return to acceleration in car sales. The greatest advantage a private investor has is patience.

Wednesday, August 22, 2012

Procter & Gamble Equity Research

Another day, another lowering of guidance from the under performing Procter & Gamble (NYSE: PG).

The stock price is now below what it was five years ago and the company seems to have been hit with one issue after another. Most commentary focuses on management's inability or unwillingness to take decisive action, but I think the problem is a more subtle one. Every cycle is different and I think the last few years have significantly challenged the way PG traditionally runs its business.

My thesis is that the company has tended to hold its prices in a downturn in order to retain the value of its classic consumer brands and then tried to regain market share when the economy recovers. The problem is that this recovery has been a lot slower than in previous cycles. Consequently, PG now finds itself with prices that are too high, causing market share erosion. The obvious solution is to offer innovation, but this is proving thin on the ground.

Before developing this point further, I want to summarize the change to the guidance issued in the latest presentation.

April to June QuarterPrevious GuidanceCurrent Guidance
Organic Sales Growth      4 to 5%       2 to 3%
Net Sales Growth      1 to 2%      -1 to -2%
Core EPS    79 to 85c     75 to 79c
All in EPS  121 to 123c   117 to 126c
And for fiscal 2013.
Fiscal 2013Guidance
Organic Sales Growth 2 to 4%
Core EPSflat to mid single digits
Core EPS Growth Ex FXflat to mid-high single digits
The market did not like the lowering of guidance and it is seen as confirmation on tough ongoing conditions. It has been one thing after another for PG. Commodity cost increases have trimmed margins, the weakness in developed markets has held back revenue growth and now the slowdown in the emerging world is challenging its growth strategy.

Weaker Developed Markets Recovery and Now Emerging Markets Faltering

As discussed above, the weak recovery in developed markets has changed the way that consumers shop. Consumers are much more inclined to visit Dollar stores and purchase private label, value or discounted brands. Indeed, competitors like Church & Dwight (NYSE: CHD) have been grabbing market share in certain categories. Church & Dwight has 40% of its revenues in 'value' brands and is able to benefit from a weak mass consumer environment. The same cannot be said for PG's brands nor its strategy.

It isn't the only company experiencing these problems. I note that Johnson & Johnson (NYSE: JNJ) gave weak results on its consumer division in the last quarter. The difference is that JNJ's problems partly stem from some production issues whilst PG's are more fundamental. It is losing out to a company like Colgate Palmolive (NYSE: CL), which is more focused on soap and oral care. Colgate is able to innovate and defend market share much better than PG. In addition, its innovation is better because of a tighter focus on research and development.

The longer term plan for PG is to shift revenues toward the emerging markets and since 2000 emerging markets have grown from 20% of total sales to 37% today. This is a worthy idea and considering the populations and growth prospects in the emerging world, it is a no-brainer. However, it does bring about challenges. For example, a company like Yum Brands has seen its focus on generating emerging market growth lead to its dropping the ball in its existing marketplace. Fast moving consumer goods (FMCG) are so-called for a good reason. If you fail to retain brand value, are too highly priced or lack innovative ideas then consumers will punish you. And quickly.

Throw in the slowing emerging market growth and the perfect storm seems to be gathering for PG's business model.

What is the Latest Plan?

The plan outlined recently was not so much a fundamental overhaul as more a series of piecemeal adjustments wrapped up in management talk of a more focused and balanced approach. As such, PG spent a lot of time discussing what it was not going to do! There will be no buybacks, no exiting of existing investments, no pulling out of markets already entered and no stopping country/product expansions.

Instead, there will be an increased focus on its top brands and in its 10 most important emerging markets. Pricing will also be cut in certain brands. it all makes perfect sense but I get the impression that analysts and investors need more than this.

Will it Work?

Frankly, it smacks of a bit of tactical adjustment to tide the company over until the macro-economy hopefully improves. In a sense, this is all investors can really expect PG to do because its brands are not going to morph into value brands overnight. The company is structured for a different kind of economic cycle and its management is finding execution to be extremely difficult. That said, there is a huge amount of cash on the balance sheet and I think that it's time for PG to start thinking about purchasing some value brands to complement its existing portfolio. It could also buy some brands in faster growing segments of the consumer space like skin or eye care.

Dividend investors will value the chance to pick up he stock with a higher yield but growth investors will probably take a pass here. It is hard to see a quick turnaround. PG just wasn't made for this type of economy and restructuring a behemoth is not going to happen overnight.