Tuesday, June 26, 2012

Riverbed Buying Opportunity?

In a previous article linked here, I discussed the uncertainty inherent in the upcoming Riverbed $RVBD results and mooted the possibility that a decent entry point might be created out of them. Well, the results are in and, it looks like short term carnage for the stock price. However, is this time to be looking at buying and what should investors be looking for from the network gear maker?
A quick summary of the results
  • Revenues of $183m vs. estimates of $186.3m
  • Non-GAAP EPS of 20c vs. estimates of 20c
  • Q2 Revenue guidance of $193-197m vs. estimates of $202m
  • Q2 EPS guidance of 21-22c vs. estimates of 24c
At the last results, Riverbed predicted that revenues would be sequentially down 8-10% and, they 'delivered' by coming in at the low end of a 9.8% decline! Moreover, Riverbed previously confirmed full year guidance, but now, they are guiding toward a 15% rise in 2012 revenue. Market estimates were for an 18% increase. Gross margins were predicted to be flat in Q2, but profitability and margins were predicted to then rise through 2012.

Not only did Riverbed miss, but guidance was lowered for the full year. However, and this is a key point, the full year guidance implies that the second half will track what Riverbed previously predicted. Investors have the right to be skeptical about this.


What Went Wrong?

There are four issues, listed in terms of what I think their importance is. Firstly, signs of slowing government spending. Secondly, weakness in European enterprise spending. Thirdly, competitive encroachment. And finally, the sales disruption caused by new product launches and upgrades.

Government spending was 13% of revenue in quarter, which is seasonally usual. However, the big marginal shift in Riverbed’s government revenues occurs in Q3. The current management narrative is ‘upbeat’ over interest and conditions are seen as ‘normal’. In terms of US Federal spending, this seems entirely plausible for this year, as any efforts to reduce public expenditure are likely to start in 2013.

Current European market conditions were described as ‘mixed’ and, in fact, Europe is doing well. A breakdown of regional contributions and, yearly growth here:

RegionShare of RevenueYearly Growth
Rest of World19%4%

Its notable how weak growth was in the Rest of World segment and, Riverbed is upfront about the need to make progression here. Nevertheless, there wasn’t particular weakness in Europe, so, it was hard to attribute the earnings miss to this factor.

Turning, to market share, there is a shift in that Cisco $CSCO is now Riverbed’s most dangerous competitor. Traditionally, it was Blue Coat, but that company has been weak over the last year or so and, Riverbed confirmed that competitiveness with Blue Coat had softened. With a market share more than twice that of Cisco, it is fair to assume that Riverbed is the bellwether rather than Cisco.
In any case, investors can see what some of Riverbed’s key distributors are saying in order to gauge the industry. For example, Arrow Electronics $ARW was responsible for 17% of revenue with Avnet coming in at 10%. Arrow gives results on May 1 with Avnet reporting on April 26.


If it Ain’t Broke then Don’t Fix it

I think the key culprit is the disruption to sales patterns caused by the new product launches and the upgrades to the core Steelhead offering. Such things are common occurrences in technology, whereby customers prefer to run existing technology until they can receive anecdotal or professional information on how the new offerings are working.

Similarly, resistance to undergoing the expense of an upgrade cycle is natural among customers who are happy with the existing technology. These things take time and, from an operational perspective, it will require a realignment of the sales force’s priorities.

New products include Granite, of which orders have already been received. A Steelhead cloud acceleration product was launched with Akamai $AKAM and although sales are not seen as material in the short term, it is a product with potential because it can be sold to existing customers in order to improve their SaaS offering. Akamai is the right partner for Riverbed because of its established customer base within content delivery.

New products, new challenges, but this isn’t just about products. When a company shifts from selling a core offering toward being a multiple seller of different products to different buyers, it needs a refocusing of sales initiatives and approach. In addition, much of Riverbed’s challenge is to educate customers over the advantages and return on investment (ROI) generated by WAN optimization. All told, you have a complex confluence of challenges to overcome. Sales cycles will inevitably be extended.

Realigning the sales structure and marketing effort is, as one analyst pointed out, not something that is typically sorted out in one quarter. This observation calls into question the management’s implication that guidance for the second half should be unchanged. In short, Riverbed is saying that Q1 was weak, Q2 has been lowered but, that the second half will be the same as previously thought. I’m not sure how the market will react to this.

Riverbed a Stock to Buy?

In a sense, investors are worried about another ‘Blue Coat like’ scenario, whereby a serious of excuses are given for gradually reducing sales growth and management undertakes umpteen restructurings and partnership agreements in order to turn things around. In Blue Coat’s case, nothing seemed to work. However, I suspect the key issue there was with product, not with operational concerns. Blue Coat had difficulties even though its competitors in the WAN optimization market were doing well.

For Riverbed, if the new products and upgrades are capable of generating ROI then there is no reason why the existing sales force – who were responsible for the previous excellent sales performance -- can't begin to accelerate sales of the right products to the right customers. I don’t believe good sales people suddenly become bad ones. However, they can become frustrated and de-motivated if their product line is not working. I think the real problem for investors is to discern whether the launches and upgrades have the appropriate traction in the marketplace and, unfortunately, the optics are being obscured by the transition.

Time will tell and Riverbed may well have to lower full year guidance in the next quarter. However, with the recent price declines the upside potential looks a little better and, provided this turns out to be a transitory issue for a few quarters, I think this could be a decent entry point.

F5 Networks Being Unfairly Marked Down?

F5 Network $FFIV gave results and cheered the market. The Nasdaq needed this after the recent sell-offs in tech bellwethers $IBM, Intel $INTC and Qualcomm.

For those not acquainted with F5, it is one of those sexy stocks associated with cloud computing growth and the inexorable rise of bandwidth usage. In short, F5 ensures that the delivery of applications is not degraded when they are moved from one server to another.

Clearly, the need for faster connectivity to access information in the cloud has led to significant growth in bandwidth demand. Similarly, the proliferation of bandwidth-rich video and increasing penetration of smart phones are creating bandwidth demand.

The market was apprehensive coming into these results and, for good reason. However, F5 ‘beat’ on revenue and generated strong earnings. F5’s cautious management did no more than guide their midpoint slightly below market estimates.

F5 Networks Stock Earnings Beat

First off, a pretty good set of Q2 results and guidance for Q3
  • Revenue of $339.6m vs. estimates of $335.3m
  • EPS of $1.12 vs. estimates of $1.07
  • EPS Q3 guidance of $1.12-1.14 vs. estimates of $1.14
  • Q3 Revenue guidance of $350-355m vs. estimates of $355
The book to bill was affirmed at higher than one and, management has some exciting things to say about growth in data center firewalls. This is not an area that F5 are traditionally associated with but positive noises were made about competing with Juniper $JNPR in particular but, also Cisco $CSCO and Check Point.

Indeed, Juniper appears to be assailed from all directions at the moment, not least from Cisco within core internet networking solutions. As for F5 and data center firewalls, it is already seen as a ‘meaningful revenue generator’, and management sounded bullish about the expanding opportunity.

Perhaps what was surprising about the results was the broad-based strength. Americas revenue was up 21%, with EMEA not far behind, coming in at a 19% increase. APAC increased 24%. When asked by analysts, the management affirmed that Europe was doing consistently well and broad based in its growth too. Moreover, Government did well with US Federal (about half total Government numbers) spending showing a slight improvement. Otherwise, worldwide Government revenue was flat.

No matter, F5 tends to be quite diversified in its industry verticals. For example, here is a breakdown of Q2’s major verticals:

VerticalPercentage of Q2 Revenues

Telco was unusually strong this quarter. In the next quarter, financials are expected to be up and, Telco down from these percentages. From a historical perspective, these numbers are quite low for financials but, I got the impression that management felt this was just due to natural lumpiness in ordering. Going forward, F5 expects North American enterprise spending to improve whilst Technology is seen as tracking a bit lower.

One interesting piece of ‘color’ was that two distributors now account for over 10% of revenue generation. Namely, Avnet $AVT with 16.6% and, Ingram Micro $IM. This implies that Avnet and Ingram are very useful barometers for how F5 Networks are doing in the quarter. I would suggest listening in on their conference calls and presentations in order to get an early ‘read’ on how F5 might do.

F5 Growth Prospects and Evaluation

This report is going to confirm that F5 are firing on all cylinders and, with the management talking of sequential revenue growth through 2012, there is little not to like about the stock. As ever, with technology darlings, the stock price can run away from the fundamentals when it is fuelled by momentum and investor sentiment. So is F5 overpriced?

The short answer is no and here is why
Firstly, the drivers for the company are largely secular in nature and are being promulgated by technology shifts. Secondly, F5 is a company that has always been highly cash generative and has demonstrated that it can both grow gross margins and, free cash flow as it expands revenues. Thirdly, there is upside from data center firewall security. And finally, I think that the current evaluation can cope with any disappointments from European enterprise or worldwide Government.

Here is a graph of how F5 is tracking in terms of sequential revenue growth.

Note how the estimated numbers for 2012 are forecast to track last years. Who said equities analysts don’t work hard!

Looking back at the last few years, F5 tends to turn around 33% of its revenues, into free cash flow. So, a simplistic assumption of hitting analyst forecasts of $1.39bn and $1.65bn to Sep 2012 and 2013 respectively would see free cash flow (FCF) of around $459 and, $545m. Interpolating, gives $507m estimated for the next four quarters out.

I like to value companies in terms of Enterprise Value (EV). Now, if you, conservatively, want to pay a forward FCF/EV of around 5% for a company that is generating high teens revenue growth, than this would give you a target of $10.14bn in EV which is around $135. A typically looser estimate of 4.5% would give you a target price of $149.

I would be inclined to be a bit looser with F5 in terms of valuation but, a bit tighter with regards to risk.

Frankly, I don’t think that the pressures in Government spending are going to abate. In fact, in the US they could strengthen because the US hasn’t really done anything about cutting its debt or deficit levels. However, I am aware that F5’s solutions are mission critical and they are largely secular.

Therefore, I wouldn’t be surprised to see some downgrading of forecasts for certain verticals within F5’s markets. This wouldn’t be a disaster, because recall that we are talking about marginal movements in revenues. In addition, most forecasters are certainly not foreseeing a recession, but the potential for disappointment remains.

I would conservatively reduce revenue forecasts by 5% and, based on the assumptions above, this would still give a range of $128-141 as a target price, pending on which stance you want to take on the stock. And, more importantly, how you might tolerate the stock price reaction to any future short term negative news.

Wednesday, June 20, 2012

Cree and the LED Market

LED manufacturer Cree $CREE gave results recently, and disappointed the market by not only missing estimates but also issuing guidance which was below market estimates. Essentially, Cree is in a high growth industry but it has failed to hit market estimates for the last four quarters in a row. There can be a certain amount of sympathy for the management because this is an industry with short lead times and low visibility. However, Cree has been up against some easier comparables and the recent results plus guidance were not great.

Investors can be excused for being puzzled by the investment proposition here. On the one hand, Cree’s long term end market drivers are excellent. LEDs are approaching cost parity with traditional lighting, offer greater long term economy, require less maintenance and therefore offer increased payback. They are the future. And, everyone knows it.

On the other hand, the company is seeing consistent short term weakness due to heavy competition and low inventory levels at customers. Of course, customers do not want to carry inventory when their end markets are weak.

All of which leads to the classic conundrum of what to do with a long term growth stock that is stumbling in the short to mid term?

Cree’s Stock

Turning to the numbers
  • Q3 Revenues of $284.5m vs. estimates of $300m
  • Q3 EPS of 20c vs. estimates of 21c
  • Q4 Revenue guidance of $295-315m vs. estimates of $322m
  • Q4 EPS guidance of 20-26c vs. 28c estimates
It’s not hard to see why the stock fell after results. Moreover, in order to see how revenues are trending, here is a graph of sequential revenue growth.

Note that if Cree hits the midpoint of its internal guidance for Q4, it will be a sequential increase of 7.2% which looks low given that last years numbers were relatively weak. Let’s put it this way, $305m for Q4 would mean a seemingly impressive increase of 25.6% on the year. However, it would only be 15.2% ahead of 2010.

See what I mean about a conundrum?

Cree and the LED Market

Cree argued that whilst the LED, Power and RF results were in line with internal guidance, the revenue weakness was due to lighting. Moreover, it was ‘almost exclusively’ due to the shifting of agents caused by the integration of the Ruud acquisition last year.

Around 80% of Cree’s agents were shifted in terms of the product they were selling. All of which, caused a short term disruption in sales for BetaLED and Cree product lines in lighting. Indeed, Cree’s management went onto claim that they ‘do not believe that the decrease in lighting sales was due to lower end demand’.

This sounds entirely plausible, but if so, why is the guidance weaker than anticipated? As you can see from the graph above, there should be a sharp snapback in revenue following a theoretically short term sequential disruption. Analysts were quick to enquire why.The guidance implied that they would only do similar metrics in Q4 to what they should have done in the current quarter.

In reality, I suspect a number of forces have to come to play here. Cree is not alone in issuing weak guidance. Across the board companies like its rival SemiLEDS $LEDS and LED capital equipment manufacturers like Veeco $VECO and Aixtron $AIXG have also previously given weak guidance. However, that should be in the price, the key is weather an inflection point has been passed or not. Aixtron and Veeco could give advance notice of this, but SemiLEDS is increasingly looking like a small player in the marketplace.

Cree Potential

I think that gross margin trends are usually a good way to see if pricing power is coming back. With that in mind here are Cree’s.

Interestingly, this was the first quarter in the last eight where gross margins improved. This is a good sign, but frankly, I wouldn’t get too excited here. However, if the commentary from other companies in the sector gets better (and some are talking of a pick up) then we could see a return to the good times for the industry.

In particular, Cree is geared up to be able to satiate growth in end demand, and technology in the industry has moved on in the last year. Cree predicted margins would improve in the next quarter and that utilization would be flat. Cree has the capacity to deal with growth.

Thinking strategically, creating the appropriate ‘buzz’ in order to convince customers to forget their inertia and adopt LED based solutions, will take time. It also takes sound demonstrations of cost efficiency. All of which Cree is doing aggressively with things like new developments in street lighting technology.

Investing in Cree?

Investors following Warren Buffet’s famous fearful/greedy dictum would not have been a stock holder going into these results. Even with the initial sell off, Cree is still up over 30% in 2012. Investors were definitely not fearful. But they might be now. Which is why, Cree is starting to look interesting for the ‘nouveau greedy’.

Improving gross margins are a good sign as is the reduced expectations. Throw in some snapback in sales due to Cree’s lighting agents being settled within their new roles and there is upside potential here. However, risk averse investors may want to wait for a bit more of a sell off and monitor what Veeco and Aixtron say in the reporting season. Any positive guidance will benefit Cree. As a result, Cree is becoming attractive.

Johnson & Johnson Stock, A Good Defensive Play

Johnson & Johnson $JNJ gave results recently and underperformed the broader market on what was a strong up day. There wasn't anything inherently wrong in the numbers, but there wasn't anything sexy about them either. Revenues were slightly down, with a negative currency effect of 1.2% not helping matters. However, top line growth is not the key for JNJ.

JNJ’s attraction is of the kind that sends accountants hearts racing. Its prospects are all about execution, execution, execution.

First, consider the integration of the largest acquisition in JNJ’s history (Synthes) which brought the company 50% market share of the skeletal fixation products market. Second, consider the successful resolution of the manufacturing problems which have dogged the company in recent years and kept some highly popular OTC consumer products off the market. For example, Tylenol and Simply Sleep are not yet back in production. Third, consider the ever-present issue of dealing with generic challenges and launching new drugs. Lastly, JNJ probably still needs to restructure the huge portfolio of products.

Johnson & Johnson Delivers a Mixed Prognosis

Operations in the US saw revenues down 5.1% as JNJ suffered from generic competition to Levaquin (anti-bacterial) which saw a US sales decline of 96%. Similarly, Concerta which treats attention deficit hyperactivity disorder (ADHD) also saw generic competition that caused US sales to fall 22%. This reads across well for Watson Pharma $WPI which has successfully launched a generic version of Concerta, as well as a generic version of Pfizer’s $PFE cholesterol fighting blockbuster Lipitor. In fact, Watson has been busy applying for FDA approval for a generic version of Bystolic (hypertension) of which, Janssen- a JNJ subsidiary- sold its rights to Forest Labs.

By way of contrast, international operations saw a 6.4% rise in constant currency sales but much of this came from the pharmaceutical segment. In fact, it was the only segment to report more than 1% growth in the quarter.

Weak Consumer Segment Results

As mentioned earlier, JNJ has had production problems which led them promise to overhaul operations at three plants, and kept key products off the market. That said, these results were still weak. Reported sales declined, both in the US and internationally, with women’s health, nutritionals and baby care looking particularly poor.

The market wasted no time in marking down rival baby nutrition company Mead Johnson  $MJN) in sympathy. Moreover, market rumours hit that Pfizer is close to divesting its nutrition unit to Nestle. If true, this could create future problems for both JNJ and Mead Johnson, as I would expect Nestle to start using its financial muscle to aggressively compete with them in the future.

Pfizer is keen to divest its nutrional and animal health divisions as part of its ongoing restructuring plans.

The two bright spots in the consumer division were in skin care and wound care in the US. Skin care is a hot sector right now and JNJ has always been very strong in wound care. Internationally, every part of the consumer segment, bar a 1.8% increase for oral care, was in decline.

International Pharma Growth Strong but US Challenged by Generics

JNJ splits its pharma segment into immunology, infectious diseases, neuroscience and oncology. The star was immunology with a 20% reported increase in global sales, followed by oncology with a 36% increase. JNJ saw strength across the board in immunology, whilst oncology saw strong gains from the international release of Velcade (multiple myeloma). Internationally, infectious diseases did well but couldn’t counteract the $404m lost in US sales from Levaquin going generic. Perhaps the most interesting part of JNJ’s pharma division is in Neuroscience.

Invega Sustenna (schizophrenia) appears to be cannibalizing sales from Invega, but I note that the total global sales of $282m are not more than declining Risperdal Consta (schizophrenia) which chalked up $361m in sales. The latter is an older drug which is seen as being inferior to Invega and/or Invega Sustenna. However, if you add the three drugs together, sales rose over 9% to $643m. Now, given that Concerta (ADHD) is facing generic competition its sales will decline, but the gains from the Invega franchise could counteract Concerta losses for the Neuroscience segment in future.
Oncology should see a pick up as Doxil/Caelyx (ovarian cancer) hopefully comes back into production in late 2012 after manufacturing problems. In addition, JNJ has new drug launches so prospects are looking brighter for its pharma business.

Medical Devices and Diagnostics

Global sales were basically flat, but US Diabetes care saw strong results. Diabetes is a strong ailment to be focused on and, there is a detailed article on it linked here. However, it was not enough to offset global weakness in cardiovascular and, flat results in general surgery.
Furthermore, US diagnostics and orthopaedics gave negative results. These results are somewhat puzzling as with an improving economy, visits to the doctor and, elective surgeries should be on the increase.

We will get more colour on the diagnostics space when the likes of Gen-Probe $GPRO and Alere, give results. Similarly, with surgeries I would look to Covidien to provide more background information on the underlying conditions. Gen-Probe, in particular, is a good barometer of conditions in the diagnostics and surgical industries in the US.

The Investment Case for Johnson & Johnson?

In conclusion, this is a mixed bag of results, but this is to be expected from such a large company. JNJ generates huge bundles of cash and, it has a stable- if not growing- collection of businesses. In other words, JNJ can invest, acquire and restructure in order to generate growth.

Going forward, the key driver will be execution. JNJ needs to sort out its manufacturing issues and, compete better within consumer health. New drug launches will help pharma and, an improving economy should help the discretionary element of medical devices and diagnostics.

In short, it is a value play orientated at dividend seeking investors. JNJ also offers upside potential from resolution of issues that are primarily outside of the economy. On that basis, it will attract risk adverse investors who would rather hold JNJ yielding 3.6% than a ten year note yielding 2%.

Wednesday, June 13, 2012

Why Europe Matters To Your Portfolio

With markets being moved around by Europe, I thought it would be helpful to give a brief summation of what investors should expect from Europe in the coming weeks. One key date is the Greek election on June 17. At this point, I suspect many US investors will be scratching their heads and wondering why a country with such a tiny portion of global GDP has such an effect? The answer is that Greece affects Europe and Europe affects the world.

Companies like General Electric $GE, Apple $AAPL and McDonald’ $MCD are all multinationals with significant European exposure, but the risk doesn’t stop there. Even if US companies do not have large direct exposure, the knock-on effects of a financial crisis in the European banking sector will be felt by the US banking sector. The traditional safe havens of healthcare and consumer stables are unlikely to work well either. Buying Coca Cola $KO or Merck $MRK may give the appearance of safety, but hard pressed consumers cut back on soft drinks and snacks in a recession, and indebted Governments will do anything they can to cut health care spending.

For example, McDonald’s generates more than 40% of its revenues from Europe. The same figure is 24% for Apple, but Europe generated 46% revenue growth for the company on a yearly basis. Europe is obviously a key area for GE and, it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. As for Coca Cola, in the last quarter, it generated more profits from its Europe segment than it did from North America! Merck 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.

What is the Problem?

I have a more detailed analysis of the debt problems in an article linked here. However, a simplistic graphical depiction summarizes the issue quite well.

These projections are from the IMF, with the Greek number coming from an OECD estimate. The problem countries are the so-called ‘PIIGS’. Spain may seem ok, but it has a major problem with its collapsing housing market putting pressure on its banking system. Spain’s debt load will inevitably increase as it takes on loans in order to recapitalize its banks.
We can see what the market thinks, by way of looking at the yields on 10 year Government Debt.

For now, we need to understand that Greece, Portugal and Ireland are not financing themselves in the open market.

How are Greece, Ireland and Portugal Surviving?

The EU-IMF are giving loans in order to buy time for them to make the structural reforms necessary so they can get back to a sustainable debt path. The problems are structural so the solution must be structural. As such, the EU-IMF monitors performance on an ongoing basis and releases bailout installments on a conditional basis. It is hurting.

There is simply no way around the fact that cutting public sector wages and employment, whilst attacking entrenched self interests is going to cause a significant amount of social tension. Especially in such an anemic growth environment.

The report card on these countries will probably see a positive rating for Ireland, a cautious thumbs-up for Portugal and, then there is Greece. The Irish made their adjustments swiftly and in a disciplined manner, including a large scale recapitalization of its banks at the cost of racking up more debt. No matter, they are following the program. As for Portugal, they passed a recent mission review and the EU-IMF summarized position thus

“The program remains on track amidst continued challenges. The authorities are implementing the reform policies broadly as planned and external adjustment is proceeding faster than expected... ...the authorities are determined to stay the course of adjustment and reform. Broad-based political support and social consensus is a key contribution to a successful adjustment.”
So whilst Portugal’s situation is precarious and, somewhat dependent on economic developments, the country is making the required structural reforms.

What About Greece?

Greece is not achieving what Ireland or Portugal has been able to do. The reasons for this are myriad but mainly relate to the political structure of Greece. Despite having voluntary debt write downs organized for them and ongoing support, nothing has worked. Whatever the underlying reasons for this, the conclusions are still the same.Greece has not been able, or willing, to make sufficient structural reforms. Nor has it adequately responded to the continual requests from the IMF that it find a way to collect taxes from its wealthy.

When asked about the risks to the EU-IMF program, the mission head Poul Thomsen, identified structural reform.

“to get the recovery going we need to get a strong impulse from productivity-boosting reforms and failure to launch such reforms could indeed mean that we will not get to this sort of inflection point where it starts going up any time soon, but that the economy will continue to trend down for longer than expected.”
He then specified reform of the public sector.

“if there is failure to undertake strong structural reforms inside the public sector, I cannot see how the deficit can go down without structural reforms. There are no more, as I’ve said before, low-hanging fruit, no more easy adjustment. Fiscal adjustment needs to be underpinned by fiscal structural reform.”
And this is where it gets tricky.
It is hard to implement significant public sector reforms when the economy is doing well, but when it is in freefall, it becomes nigh on impossible. Again, I don’t seek to apportion blame. I’m just telling it how it is. There is significant resistance to reform in Greece.

It's All About Greece, For Now

In conclusion, having isolated the immediate problem to Greece (although Spain too has significant issues) it is now time to look specifically at what is going on there and, potential outcomes in the upcoming elections on June 17th. I will do this, shortly,  in a forthcoming article.

The Best US Luxury Stock

The luxury goods sector is a great way to play some of the inequalities inherent in the current recovery. I take no pride in articulating that the rich have got richer, however, the focus here is with investment opportunities. It strikes me that there is somewhat of a bifurcation of prospects for retailers due to an uneven recovery.

At the lower end, we are seeing off-price clothing retailers like TJX companies, prospering as consumers retain cost saving behavior learned during the recession. Moreover, the lack of growth in average incomes is also playing to the lower end retailers. Any behavioral psychologist will tell you that it is much easier to sell a price differential as a discount rather than a surcharge. So, once consumers get used to lower prices, they want them to stay. Aside from the macro-economic metrics, current consumer psychology favors retailers like TJX too!

However, I want to focus on the high end.

Luxury Goods Retailers

The luxury goods sector pitch is well worn. It usually runs along the lines of emerging market growth creating a mass of new high income customers for Western luxury goods. It is a strong argument. At least, I hope so, because I happen to hold it.

However, I also happen to hold the view that China’s real estate market is slowing and, I reserve the right to be cautious on the growth prospects implied by the valuations of the China luxury plays such as Richemont, Tiffany’s $TIF LVMH, Coach $COH and Burberry.

Coach is a great company and, its management is excellent at managing costs (which includes shifting some production away from China) and, the brand has strong appeal in the Far East. However, any slowdown in the Far East, and Coach will suffer. In addition, companies like Tiffany, Coach and Burberry’s do a decent part of their business in Europe & the US from Asian shoppers on vacation. Its not something to worry about for now, but risk averse investors may shy away.

Running adjacent to the emerging market story is that of the ‘plutonomy’ economies of the Anglo-Saxon world. In other words, the US, UK and Canada are strikingly different in terms of wealth distribution than say, Japan and continental Europe. When growth and, ultimately wealth returns to these economies, the evidence is that it returns quicker and stronger. And to the already wealthy. 

Putting these two arguments together, suggests that US focused high end plays are the best option for a growth at reasonable price (GARP) investor. I will focus on Nordstrom $JWN but investors could just as easily look at Saks $SKS or Macy’s $M who have also been reporting strong sales growth recently.

Nordstrom’s End Markets

A quick look at the macro picture. These figures are taken from the Federal Reserve and are in $bn.

Although not clear in the graph, consumer credit is now on an upward trend. I've included real estate assets to demonstrate how they have been falling but, at the same time,US net household wealth (NHW) has increased. In my opinion, it is overall growth in NHW that is key to discretionary retail sales growth in the US. It took a dip in Q3 with the stock market, but the recent market move up (along with employment gains) should see better numbers ahead.

To demonstrate Nordstrom’s reliance on NHW.

Note how Nordstrom’s gross profits move closely with changes in US NHW. Also, note how well the company has done with expanding profits more than revenues in recent years.

Nordstrom in More Detail

This analysis is fine, but we need to look closer at Nordstrom and make sure the company is in place to benefit. I’ve made a few bullet points of what I think are the salient challenges and opportunities in future.
  • Expanding the roll out of Rack stores, Nordstrom’s reduced price stores
  • Expanding online presence, including integrating the Hautelook acquisition and, expanding on the Bonobos partnership
  • Taking advantage of increasing credit quality via Nordstrom Bank and its customer cards
Firstly, Nordstrom is not a company standing still. While the high end consumer has made a comeback, Nordstrom has been busy rolling out its chain of reduced price stores named ‘Nordstrom Rack’. In fact, 18 new Rack stores were opened in 2011 and, another 15 are planned for 2012.  The Rack business now accounts for over generated 21% total sales growth and generated $2bn of Nordstrom’s $10.9bn revenues. Management talked of same store sales expanding throughout 2011 for the Rack, indicating strong customer adoption.  Moreover, plans are afoot for significant investment in technology in these stores. For example, mobile point-of-sales devices will be added.

Secondly, alongside capital expenditures on the Rack, Nordstrom intends to expand its Web presence by building its IT infrastructure to enable increased e-commerce sales. In fact, the plan is to spend $140m on e-commerce capital expenditures, or 30% of the total for 2012.  All of which, will be integrated with tools to enable inventory management. A key issue when a company is aggressively expanding online sales.  The Hautelook (a flash sale retailer of luxury clothing) acquisition was a clear signal that Nordstrom are keen to grow online sales. Moreover, the Bonobos (a leading online clothing brand) partnership is similar sign of how important, management view Nordstrom’s online presence.

Thirdly, I think another area of growth for Nordstrom will come from the improving credit quality of US households. At the last results, Nordstrom reported bad debt reserves as a percentage of receivables at 5.5% from 6.9% last year. This boosts profits, but it also means that they environment is favorable for Nordstrom Bank to extend credit. 

You Can’t Please All of the People All of the Time

However, not all analysts are happy. Whilst expanding revenues via investing in direct sales growth is one thing, management also pointed out that high dollar growth in sales and EBIT would come as opposed to EBIT margin. Moreover, the increased capital expenditures are helping reduce 2012 forecast free cash flow to $400m from $432m in 2011. Consequently, they see a business with slowing EBIT margin growth and the execution risk of increased investment in e-commerce.

Frankly, I don’t share this attitude. I like the way that Nordstrom is exposed to favorable macro trends but, is also investing for growth in areas of the economy that retail is trending towards. Not enough companies have been investing for growth in this environment, so it is easy for analysts to see ‘risk’ after years of viewing companies generate growth via cost cuts. One key thing to look out for is that, this year, Nordstrom will be giving results with a breakdown of full-line, Rack and direct sales so investors will get a chance to see how the business is evolving. In conclusion, Nordstrom would be my pick of the luxury goods sector.

Tuesday, June 12, 2012

What the Greek Elections Mean to You

In an earlier article linked here I looked at the European situation and, why it mattered to investors. In this article I will focus on Greece and the forthcoming elections.
US investors may think that US companes are immune but, unfortunately, this is not the case. Europe is significant and, the events in the forthcoming Greek elections will affect Europe. A hard default by Greece would cause significant issues for the European banking sector and the economy, and then ultimately the US.

So What is Happening in Greece and Who is Syriza?

The party (Syriza) that is growing in strength ahead of the election is a collection of disparate left wing entities that advocates such half-baked policies as halting privitizations, nationalising the banks, implementing a gradual increase in corporate taxes to 45%, not a single public sector worker is intended to be sacked and, the bailout packages are to be renegotiated after the election.
Syriza does not want to implement reforms, on the contrary it wants to roll back pension and wage cuts, and it wants to stimulate growth inGreecevia infrastructural investment. Oh and, one more thing. It wants the funding to come from the EU!

Most polls have New Democracy (ND) at 23-26% with Syriza at 20-23% and the formerly ruling PASOK at 12-14% with the rest being an assortment of Communists, Greens, the Far Right and Greek Independency candidates.

I think there are two key takeaways from this.
  1. Greece will vote to stay in the Euro (all three leading parties want to stay in) and it will vote to renegotiate the bailout package. The flexibility from the EU-IMF is probably there in order to agree some negotiation.
  2. The new Government -whether it includes Syriza or not- will be under heavy pressure not to agree to certain structural reforms in the package and even if it does, these reforms will come up against fierce resistance when the time comes to implement them.
It is worth noting that the head of the ND party, Antonis Samaras, has been a thorn in the side of PASOK’s attempts to implement reforms. He fought every single austerity package. He quarrelled with the EU over supporting the implementation of the current package. And this is the guy that the EU are hoping is going to implement the future reforms! In addition, he is supposed to do it in the face of Syriza in parliament and, against significant and increasingly violent, social unrest. A tall order.

Why Does Greece Matter?

Greece matters because if it defaults on its debt in a disorderly way, the knock on effects on the European banking system are significant. It could cause a collapse in confidence in the EuroZone. In fact, the Greek politicians know this and, it has been their main negotiating tool in extracting loans and political concessions from the EU.  A disorderly default would hurt everybody so whilst this threat hangs over Europe, there will be uncertainty. Unfortunately, markets and CEOs do not like uncertainty and, growth is being impaired inEuropeas a consequence.

The threat of a disorderly default comes from a political move by Greece after the election (not likely now), or a future move caused by an economic collapse from a bank run (possible), or significant social unrest and political instability caused by recession and ongoing friction with the EU (possible).


Note the US potential exposure and, the direct exposure of French banks. Ever wondered why the new French President was so keen on trying to get Eurobonds implemented?

What Happens After the Elections?

I have four scenarios.

History suggests the following sequence of events. A bailout package will be renegotiated. Markets might like this and go back to ‘risk-on’ for a while. Meanwhile, the structural reforms will not be implemented, because Greece’s polity neither believes in the reform program nor feels it was elected to enact it.  There will be more social upheaval and unrest in Greece. The possibility of a major bank run will ensue (Greece already has a strange kind of slow motion bank run in place) and, the odds of a hard default will increase.

Alternatively, the EuroZone could decide that the risk of keeping Greece in outweighs the risk of removing them from the Euro. It could ‘force ’Greece into an orderly default, then write down the debt and recapitalise the ECB from the losses on its balance sheet caused by Greece. Then it might engage in liquidity measures so it can recapitalise its banks and, reiterate support for Portugal and Ireland. Such a bold and aggressive move could remove uncertainty over a Greek disorderly default, improve sentiment and, jump start business confidence in Europe. Moreover, the voluntary private sector haircuts have already reduced some of the impact of a Greek default so the EuroZone may feel that now is the right time to do this.

The third outcome is a messy process of an indecisive election, followed by continual upheaval and uncertainty. This could hasten the application of my second scenario or it could exacerbate the problems inherent in pursuing the first.

The fourth scenario involves an extension of the terms, a successful implementation of the reform program, a period of political stability followed by a resumption of growth and a return of market confidence. I have little faith in this outcome!

Frankly, I would prefer the second option to be enacted but consider the first more likely. It is time for bold action and, it also time for the Greek people to have a viable option in front of them rather than be promised unrealistic outcomes by deluded politicians

What Riverbed's Results Will Reveal

This is likely to be a high profile week for network technology players in the cloud.  Riverbed Technology $RVBD reports on Thursday and investors look like they are in for the usual wild ride. Interestingly, fellow cloud technology player F5 Networks $FFIV reports on the day before, so Riverbed holders will want to see beforehand what F5 is saying about enterprise technology spending.
Riverbed is the market leader in Wide Area Network (WAN) optimization controllers, secure web gateway and application performance monitoring. Simply put, Riverbed's solutions optimize delivery of data by compressing, prioritizing and manipulating it. These areas set to be high growth areas in future, thanks to the explosion in bandwidth usage and the mission critical nature of the Internet with cloud computing.

In addition, WAN optimization provides a relatively quick return on investment and can generate growth even in slower economic times. Bandwidth isn't the only issue as the usage of business applications over the WAN isn't linear. In other words, WAN resources might be needed at unexpected times because bandwidth demand spikes can appear at random.

Blue Coat Systems is the main rival to Riverbed. In addition, the likes of Cisco $CSCO, Citrix Systems $CTXS and F5 Networks all play in this market, but they tend to offer specific or expensive large enterprise or data center solutions

Riverbed Technology appears to offer a superior solution to Blue Coat in terms of WAN optimization. However, Blue Coat's solutions offer an integrated approach which can incorporate security and performance measurement in 'one box'. If a customer wants an integrated approach, he will favor Blue Coat. For pure WAN optimization, he is likely to turn to Riverbed. It is incontestable that Riverbed has outperformed Blue Coat over the last few years and, the latter’s operational difficulties and poor performance has led to it being taken private.

What Should Riverbed Investors Look for in the Results?

 A few bullet points, of which, I will discuss in more detail below
  • How revenues and guidance are progressing with the launch of the new Steelhead platform and the new Granite hardware?
  • Weakness in the European outlook?
  • Potential competitive threats to their market position?
  • How Government spending is holding up?

New Hardware Releases and Upgrades to Steelhead

Steelhead is Riverbed’s core offering and, the company will be launching an option on a new platform as well as an adjacent hardware product called Granite. Consequently, at the last results Riverbed confirmed full year guidance but implied that Q1 revenues would be down 8-10% sequentially, which is a much greater decline than usual for Q1. The stock took a fearful hit after this announcement. Of course, this kind of guidance implies that the next three quarters will have very strong growth. Not only that, Riverbed predicted rising gross margins throughout the year. We shall see.

The truth is that there is always a lot of uncertainty about the timing of product sales acceleration with new launches and upgrades. Existing customers may decide to keep running the old system, or they may have been holding back the budget previously in order to buy the new system. Ultimately, who knows?   Riverbed management has done the job of downplaying expectations but the uncertainty remains.

Nevertheless, investors should listen closely to what management says in the conference call and, analysts will be sure to probe them on this issue.

Weakness in Europe?

Whilst the profit drivers of Riverbed are in strong secular growth trends, the company is not immune from slowdowns. In fact, the stock suffered last year when, in the Summer, it announced -in common with Fortinet and F5 Networks – that Europe was weak.

Riverbed described European sales as being ‘weaker than expected’ and, pointed the finger at its execution rather than product lineup. Strangely, they had cited Germany as being weak. However, all of this may have been due to the reshuffling of the company's European leadership in the quarter.
Nevertheless, I don’t believe in coincidences. Around the same time, F5 Networks talked of ‘weakness in some of the more macro affected economies in EMEA’ and, Fortinet mentioned ‘softness in EMEA from a macro perspective as well as timing of some of our larger transactions resulted in lower billings growth for the region’.

All three recovered but, then again, so did sentiment over the European sovereign debt crisis. Therefore, I think that growth for these companies is somewhat contingent upon confidence in European IT spending. Another thing to keep an eye on.

Potential Threats?

Riverbed is the leader in its field, but Blue Coat may make a comeback now that it has been bought out. Furthermore, Citrix and Cisco may also decide to compete more aggressively with Riverbed’s product range. They both have a WAN optimization product portfolio. Furthermore, F5 Networks may decide to take advantage of its position in application delivery to expand upon its WAN optimization offering.

This is perhaps, not something to worry about in the short term, but if Riverbed gives weak numbers –due to other factors- than it could look like they are losing market share. I doubt this would be good for the stock price.

How Government Spending is Faring?

Government sales make up one of the largest portions of Riverbed’s revenue generation. Indeed, in Q3 last year the company reported very strong growth due to this vertical. It is tempting to conclude that Riverbed is relatively immune from cutbacks because this is such a mission critical area of IT spending. However, cutbacks are cutbacks and because Government is such a strong vertical, it will only take a small marginal shift in Government spending in order to affect Riverbed.

What to Expect?

In conclusion, I think Riverbed is attractively priced right now but there is uncertainty connected to these results. This is a volatile stock and the slightest disappointment tends to send it tumbling. However, I suspect that the management has done a good job in downplaying expectations. Any significant earnings beat will send the stock rocketing.

For longer term investors, if they are prepared for how to interpret the upcoming results- and I hope this article is helpful- they might find a decent entry point into a company with excellent long term prospects.

Sunday, June 10, 2012

Who Will Win the Smart Phone Wars?

Nokia $NOK gave disappointing results recently and, it is hard to see where the company can go from here. In less than a decade, smartphones have captured over 50% of the US market and, Nokia has been nowhere near competitive enough in this market. In terms of US smartphone handsets, the clear leaders are Samsung, LG, Apple $AAPL and the declining RIM $RIMM.  So Nokia is challenged at the high-end, but it is also challenged at the low-end where local Asian manufactuers are issuing cheap non-smartphone models.

The investment thesis behind Nokia is usually the opportunity for it to establish itself as the handset (smartphone & non-smartphone) of choice to the emerging markets. Nokia certainly, has the brand name and positioning in emerging markets and, the current situation looks favorable for this idea.
Countries like China are still a couple of years away from a 4G network, and according to official figures, their mobile penetration rate is still at an internationally relatively low figure of 74%. Moreover, 3G penetration in China is still at a very low 14%. This suggests that Nokia can see growth via increasing Chinese mobile penetration with non smartphone models.

However, this is the current situation. It is not the future. Frankly, I see no reason why future growth in China will not be focused on smartphones and Nokia’s positioning looks weak.

In the update, Lumia smartphone sales were lower than forecast and, the launch of the Lumia 900 did not go well. Nokia has been hoping Lumia could create and, then expand upon, a niche with its Microsoft $MSFT Windows operating system. The weak opening does not bode well.
In addition, The previous Nokia system, Symbian, is being phased out and Microsoft is an also-ran in the mobile OS space. Their appears to be little clamor for Windows mobile operating systems and, even if Nokia decided to use Google’s $GOOG Android, it could take years before a handset is produced. It looks like Nokia is stuck with Windows for now.

Who are the Winners in the US Mobile Market?

I’ve adopted some figures from Comscore in putting together this table for US mobile subscribers and Operating Software (OS) share. 

Share of Mobile SubscribersSmartphone OS Market Share

(All data is for the US as of Feb 2012)

Samsung, LG and Apple are doing well. As for Motorola, even with a currently declining market share, the company will have the opportunity to flourish given that Google’s ownership looks ready to spur investment. Turning to operating software, Google gives Android away free but, as yet, has not found a way to meaningfully monetize it. Android is multi-channel and is used by Samsung, LG, Sony Ericsson, Motorola, HTC and many others.

Going forward, the key issue will be the ecosystem created by the operating system and, developers simply do not create applications to run on platforms with little market share. Scale means everything for a developer and, right now, Google and Apple are the runaway leaders. Indeed, Facebook even mentioned the possibility that Google might try to exclude Facebook apps from its Android system, as a potential risk to the business.

Google Winning?

Longer term, Google looks like a winner, because it knows how to monetize search and display in mobile. Facebook does not make meaningful revenues from mobile and, I think is more structurally challenged by mobile than Google is.  Also, Android is only part of Google’s cross product offering and it can be subsidized in order to create revenue from search based ad revenue.

RIM’s Blackberry is losing market share and, is threatening to become a footnote product in the history of technology. The Blackberry seemed to hit a cultural sweetspot as a smartphone option before the Iphone and Android based systems gathered steam.

Apple is a smartphone leader and, the company is about much more than just the Iphone. Nevertheless, a failure to keep innovating in hardware design in future could hurt market share for Apple’s iOS. By way of comparison, Android runs across a range of handset manufactures so, in a sense, it is hedged. However, what Google plans to do with Motorola is still not clear. One thing that is certain, is that Google is actively dealing with the shift towards internet usage on mobile. I’m not sure the same could be said of Facebook!

Another Way to Play the Theme?

While the usual analysis of the sector involves trying to pick a winner from companies competing to capture the current within strong structural trends (smartphones, apps, mobile internet etc), investors can also try and buy stocks exposed to these themes in other ways. I think it is an inexorable fact that increased smartphone penetration will demand enhanced bandwidth and increased data speeds. That said, I like the Internet Protocol (IP) and network testing solution providers. The leaders in this field are the Ixia $XXIA and the UK’s Spirent.

Both are exposed to long term trends in spending on upgrading networks that are seeing increasing demand put upon them. The more that is spent on networks, the more testing that needs to be done. Whilst most of the excitement centers around the next generation 4G/LTE networks, both companies can see upside from the continued roll out of 3G networks in countries upgrading their mobile networks.

Ixxia is a company well worth watching. It tends to be volatile over results because the market reacts to short term guidance over carriers spending plans, but longer term this is an exciting industry to be invested in.

Is the US Housing Market in Recovery and What Stocks to Buy?

Wells Fargo $WFC and JPMorgan $JPM gave results on Friday and, although they both beat estimates, the market immediately greeted them with a 3%+ markdown. The key interest for long term market investors is to discern from these numbers, how the US economic recovery is faring.
In particular, Wells Fargo is a key barometer of US household finances and, the housing market. As the largest mortgage originator in the US, Wells Fargo is effectively geared to the housing market. Therefore, the scope of this article will be to look at the US housing market in the context of finding an investment thesis that will benefit from the trends articulated.

With Citigroup and Bank of America $BAC reporting soon, it is important for investors to understand the underlying trends behind future earnings numbers. In particular, Bank of America appears to be a high beta play on a US recovery. So this kind of analysis is essential.

Wells Fargo & JPMorgan Bullish on Housing

JPMorgan reported that mortgage applications were up 33% on last year and Wells Fargo reported an 84% increase. Both made bullish predictions on the housing. Quoting from Wells Fargo’s conference call, CEO John Stumpf said,
‘But when you have the dynamics of higher rental rates and lower home values at great financing rates, there's a point in time where the market's going to clear and you're going to see improvement. I think we're getting very close to that tipping point, and we've seen it in some of the markets.’
 Similarly, JPMorgan’s CEO, Jamie Dimon, was quoted as saying that housing was ‘very close to the bottom’.
These statements will be music to the ears of Warren Buffet, who is a significant holder of Wells Fargo stock. Here are some quotes from his last annual letter to Berkshire Hathaway shareholders.
‘Every day we are creating more households than housing units… …At our current pace of 600,000 housing starts –considerably less than the number of new households being formed- buyers and renters are sopping up what’s left of oversupply… …Fortunately,  demographics and our market system will restore the needed balance- probably before long. ‘
There can be little doubt that Buffet is invested in Wells Fargo as a consequence of his confidence in housing. Essentially, banking stocks are geared to the economy. When unemployment is falling, credit quality improves, bad debt provisions tend to fall and, banks start lending again.
All of which, leads me to wonder what exactly is the point of managements handing out shareholders cash to employees bonuses when bank earnings are actually guided by the economy?  However, that is another issue. It's timeto go back to housing.

Housing Market Outlook

Returning to what Warren Buffett said, new housing starts have been below 600,000 since the fall of 2008. To put this into context, they rose from 1.2m to 1.8m at the height of the housing bubble in 2006. However, whilst new household formulation in the US tends to add about 1.3m new households every year, homeowner vacancy rates still haven’t fallen back to traditional averages yet. These figures are from the Census Bureau.

Whilst the trend is clearly getting better, the data is still indicating that a strong recovery is not imminent. Moreover, the shadow inventory in the housing market is holding back the housing market. However, the best way to gauge a demand/supply imbalance is through prices!
House prices are still weak, but the trend does appear to be improving. Here is the monthly change in the Case-Shiller Home Price Index.
Another useful indicator is the NAHB/Wells Fargo Housing Opportunity Index, which is a measurement of housing affordability. It is at an all time high and, reflects ongoing low interest rates and falling home prices.

Throw in falling unemployment and increasing credit quality and a positive prognosis for the housing markets ills could be easily created. For example, credit quality data from the FDIC suggest that bad debt provisions at the banks remain on a positive trend.
  How to Play the Sector?

Of the banks, I prefer Wells Fargo because of its exposure to the US mortgage market. It is also a US centric play which should alleviate it from potential problems with deteriorating European sovereign debt issues. However, housing is such a broad sector that there are plenty of ways to get exposure.
One of my favourites is Home Depot $HD although Lowes $LOW is also an option for similar reasons. These two home improvement stores are behemoths in terms of market position and, any uplift in housing prospects is likely to drop straight into their bottom line.

 Home Depot is attractively valued because it continues to generate huge cash flows and, last year, only paid 30% of its free cash flow in dividends. There is ample scope for more buybacks and dividend increases. It is a similar situation with Lowes which paid out 25.6% of its free cash flow in dividend, but Lowes starts with a lower yield. In addition, I prefer Home Depot because the company has been executing better than Lowes in recent years.

Another option, which is little discussed, is credit information provider Equifax $EFX. This company is heavily exposed to the increasing issuance of credit in the US economy. Therefore, if banks and corporations are extending credit again, Equifax will be an obvious beneficiary. Analysts are forecasting double digit growth for the next few years and, I think there could be upside to those estimates. Equifax has gross margins over 60% and, I like the way this sort of business is leveraged to cyclical growth in theUSand secular growth in emerging markets such as Brazil.

In conclusion, there are positive signs for housing and credit in the US. Granted, investors have heard this before over the last two years. Yet, I am going to issue some famous last words and state that ‘this time it’s different’.

Saturday, June 9, 2012

An Emerging Market Healthcare Play

Healthcare is a sector that creates many contradictory investment ideas which sometimes make it difficult to see the big picture. For example, there are no shortages of healthcare enthusiasts that remind investors that populations are aging, so volume demand for healthcare will increase.  However, there are also plenty of commentators who point out that bloated Government debt plus the need to restructure health care will create a lot of political pressure on healthcare pricing.

Somehow with pressures on volumes and pricing moving in different directions, an investor is supposed to pick his way through! One solution to this sort of conundrum is to focus on a disease that is disproportionally going to affect emerging markets and is set for growth.

I’m confident that diabetes is such a disease. Emerging markets are attractive from a healthcare perspective, because in many of these countries, healthcare spending per capita is far lower than in developed economies. Moreover, as these countries grow, the need to generate domestic demand via spending on social infrastructure is going to increase. Finally, diabetes is a disease that is set to increase significantly in the emerging world. Here is a table from the International Diabetes Federation.
So why is diabetes set to increase?

Diabetes on the Rise in Emerging Markets

The most oft cited reasons are due to shifts in incomes, life style, and diets. Simply put, increasing urbanization is causing a shift from active lifestyles with low calorie vegetable diets, towards a sedentary lifestyle rich in meat, dairy, and processed (particularly sugar enriched) foods.
Of the two main types of diabetes, Type 1 (around 5-10% of total) is caused when the body starts destroying the pancreatic cells that creates insulin. This leads to high blood sugar levels which severely threaten health. Type 2 (90-95%) is when the body produces insulin, but its cells do not react to it. Clearly, the far more prevalent, Type 2, is accelerating in emerging markets due to the reasons outlined above.

So, how to play this theme? I think there are two main ways; The first is through kidney dialysis and, the second through insulin treatments.

Kidney Dialysis

Diabetes is a major cause of Kidney disease. High blood sugar levels will, in time, severely damage a kidney and cause the need for kidney dialysis, if not, replacement. The two major players in dialysis are DaVita $DVA and Fresenius $FMSBoth run dialysis centers and provide related services in hospitals. On a standalone basis, both companies are extremely attractively priced, and offer good recurring cash flows to investors from within growing end markets.

However, both are exposed to a significant amount of uncertainty.  The threat of reimbursement cuts hangs like the sword of Damocles over these two companies. Moreover, the economics of running these centers is not as simple as it may appear.

For example, with DaVita in the US, the majority of patients (85-90%) are funded by the Government, and private patient minority (10-15%) tends to produce 40% of the revenue with 110-115% of the profits!  In other words, DaVita loses money on 85-90% of its patients. Whether private reimbursement will continue to carry the costs in this way is another story.

Furthermore, whilst, it is fair to expect DaVita to be a profit maximizing organization, it should also be understood that this does not mean they are free from Government influence or pressure. In other words, DaVita can’t just cherry pick where to run centers.

In addition, another potential threat exists from home dialysis. The most common type of home dialysis is peritoneal. This contrasts with in-center hemodialysis, which is how DaVita and Fresenius tend to make revenue. Peritoneal has a far smaller market share but many people appreciate the opportunity to carry out dialysis at home, as opposed to at a treatment center. There are pros and cons to both treatments, and this is far from an exhaustive analysis. My point here is that Fresenius and DaVita are not immune from margin erosion due to a potential pick up in home dialysis.

Another company, with a large kidney disease segment, is Baxter $BAX which has a number of products and services targeted at treating kidney disease. In fact, Baxter offers solutions to both the in-center and home dialysis markets, although the stock is definitely not a pure diabetes (or even renal) play. Although, for investors holding Baxter, the strength of this division should be noted.

Insulin based treatments

For Type 1 diabetes sufferers, insulin is a way of life. They will be taking it for the rest of their lives. With Type 2 diabetes, around 40% of sufferers will end up requiring insulin as part of their diabetes management regimen. The two major players here are Sanofi  $SNY which has the market leading product Lantus and, Novo Nordisk $NVO which has the broadest portfolio of diabetes products within healthcare.

Sanofi is a very interesting company in its own right. It is a high dividend stock that offers growth from a number of sources. It is strong in emerging markets, has good growth prospects from rare inherited disorders (via the Genzyme acquisition) and relatively little reimbursement issues from its consumer and animal health divisions. However, it does have a number of major selling drugs going off-patent in the next two years, and the pipeline looks a little thin. Indeed, by 2015, Sanofi expects that Genzyme and growth products (which include diabetes, emerging markets, consumer health, vaccines, animal health and innovative products) will make up 80% of sales. Clearly, defending Lantus (insulin glargine) which goes off patent in 2014, is very important to Sanofi.

Novo Nordisk might just have a product ready and approved by then, in order to grab market share. Novo already has a fast growing injectable, Victoza (not an insulin) which can be used to help raise blood sugar levels in Type 2 patients. Novo is already the market leader in this segment of diabetes treatments.

However, with its long acting insulin Degludec, Novo is seriously threatening to compete with Sanofi’s Lantus. Indeed, Novo claim that in trials, Degludec is non-inferior to Lantus and has a lower risk of nocturnal hypoglycaemia. The latter is the experience of low blood sugar levels at night. In addition, Novo claim that it also has a statistically significantly lower risk of severe hypoglycaemia than Lantus.
Degludec may also have a longer action profile which will give Type 2 patients much more flexibility and comfort. Whether, this is enough to justify a higher price point to Lantus, is a moot point. However, I suspect that for Type 2 patients who are being introduced to the idea of taking insulin (remember only 40% of them will) having a better safety profile might be something they are willing to pay extra for.

According to Novo, Degludec is on track in the regulatory approval process in both the US and in Europe, where they are currently under ongoing review. This could be a very exciting year for Novo Nordisk and, longer term, the outlook looks very good.


Fresenius and DaVita both offer a value proposition but carry the risk of reimbursement pressures within their core Western markets.

Novo Nordisk is definitely priced at a premium to the sector, but it deserves it for its growth profile.  As a pure play on diabetes, I think it is the best option. It currently has a PE ratio of 27 and, despite forecasts for double digit EBITDA and free cash flow growth over the next few years, it is hardly cheap. However, it has upside potential from possible Degludec approval. Furthermore, Novo claims to have 62% market share within the key China market for diabetes care, and if investors believe there is upside potential from emerging markets then Novo could be a key beneficiary.

On the other hand, Sanofi is cheap on current metrics, and I think it offers good value for income seeking investors. However, it is not a pure diabetes play and Lantus may be under threat from Degludec in future. Both stocks have strong emerging market potential, but before buying Sanofi, I would suggest looking closer at the rest of their product portfolio.

Friday, June 8, 2012

Gold and Emerging Markets

A friend of mine asked me for some views on gold the other day and I had to confess that it’s not something I have a definitive trading view on. In summary, I think it is an investment bubble, predicated on prices rising higher so that it can be sold onto the next man.

However, calling a bubble too early has been the ruin of many investors and risk averse investors should, in my humble opinion, shy away from taking a substantial position either way. Yes, I think it's a bubble, but I also think it is underpinned by some very powerful structural drivers from the Emerging Markets.

Obviously the key stocks affected would be the largest gold ETF, namely the SPDR Gold ETF $GLD or even an ETF of gold miners such as the Market Vectors Gold Miners Trust $GDX. Alternatively, investors can get gold price exposure by buying gold miners like Goldcorp $GG, Kinross Gold Corp $KGC, or Barrick Gold Corp $ABX. Ultimately, the underlying driver for all of these stocks’ price movements will be the price of gold, even if the miners have been underperforming gold prices of late.

What’s Driving Gold Demand, Speculators?

It’s usually a good idea to start with the hard facts, so here they are.  All figures are from the World Gold Council (WGC).

The interesting thing is that the demand for bar & coin really picks up after 2008, and I suspect this is largely a consequence of its relative attraction as an asset class. I think that asset classes tend to move in cycles of popularity. So for example, at the end of the '90s equities were the "must-have" asset class and prices reached extremely high historical multiples.

Then the 2000 crash came along, interest rates were lowered, nobody wanted equities anymore, so housing (particularly in countries like the US, Ireland and Spain, where housing gets built) became the new investment vehicle of choice. Despite good performance from equities from 2003-2007, they never reached the kind of multiples that the market had been on previously, when interest rates were so low. Everybody wanted housing and everybody wanted housing derivatives.

They also wanted gold.

Gold prices doubled to $600 from 2000-2006. Then when the US housing bubble started bursting in 2006, people wanted more gold. Prices then tripled to $1,800 in 2011.  ETF issuers weren’t slow to get in on the act and suddenly a plethora of ETFs were created, which helped prices go even higher. Fortunately, the largest gold ETF of them all, GLD, has a policy of actually buying the underlying gold, so we were somewhat spared from the exposure to the usual inadequacies of the financial services industry and their structured derivative products.

I have initially focused on bar & coin, because this is where the big increase in market demand has come from. This is illustrated here.

But that is only part of the story.

What is Driving Demand, Emerging Markets?

Obviously, emerging market demand is going to make up a fair portion of the total and with the strong growth rates in China and India over the past few years, their contribution to global demand has been on the increase. Aside from the cultural predilection for gold that the Indians and Chinese undoubtedly possess, there is also the issue of the availability of domestic asset classes for them to invest in.

Whilst the Indian wedding season remains the biggest single driver of jewelery demand, investors should not forget that China’s demand for gold jewelery is now almost equivalent. In addition, as long as China keeps buying US Dollars and selling RMB – in order to keep its currency weak -- it will carry on flooding its markets with capital. China doesn’t have significantly developed equity markets, so we have seen domestic RMB flowing into the China housing market and to alternative assets like gold.
I want to demonstrate this by showing a remarkable chart.


The rise since 2008 has been startling and contributed much to the rise in gold prices. However, there is a key point here. Aside from the Total figure, every one of these percentages fell in 2011. Granted, this does not mean they fell in demand terms, but rather they didn’t grow as much as in other markets. Consequently, as gold prices started falling from mid-2011, China and India’s growth started to slow and GDP forecasts in both countries have been lowered this year.  I do not think this is a coincidence.

So What Next for Gold?

In my view, the risk is on the downside for both China and India growth this year. China’s property bubble has burst and history tells us that it takes a while for property-related bubbles to correct themselves. In fact, the US property bubble burst in 2006!  So, I would expect demand growth from China and India for a discretionary element like jewelery to slow.

That said, if China’s property markets do continue to trend downwards, will this create a second wind for gold as their investors start piling into gold as a safe haven asset class?

I don’t have a strong view on this yet and I think that it is difficult for anyone to know confidently. This is why gold is such a tricky asset class to play with. Following the US property bubble, US investors have been favoring bonds, but I’m not sure if Chinese investors will react in the same way.
As for the global ETF demand, I think that this will be price dependent. In classic bubble fashion, investors tend to pile into the asset class as it is going up, but once a period of underperformance comes, the speculative money will file out.  We can see this in the reduction in ETF demand. Similarly, if prices keep falling then investors (wherever they are) will be induced to sell out of their positions.

Perhaps the safest conclusion to draw from this analysis would be that the key to future gold price movements is likely to be China and India demand. The latest WGC figures to Q1 show India jewelery, bar & coin demand down 13% year on year in dollar terms, but China demand up 33%. So, there is no sign of Chinese demand slowing yet and it may prove a safe haven from falling property and equity markets for them. However, let’s recall that this appeal tends to last as long as gold prices are rising. The longer gold stays in this trading range, the shorter will be the patience of speculators and with Indian demand falling, the downward pressure is building up.

Alcoa's Results Give Mixed Signals

Alcoa $AA kicked off the main body of the earnings season and, investors poured over its results to try and garner an indication of where the economy is headed.

With regards to the earnings, the revenue numbers were surprisingly strong given that aluminum pricing has been weak recently. Management sounded bullish on the conference call, even though others in the industry have been making more cautious statements recently.

Alcoa has had to deal with falling aluminum prices and has cut capacity as a consequence. Ultimately, its profitability will be guided by the demand/supply balance in its industry. For this quarter, Alcoa did well as pricing pressures eased, but the key will be how end demand trends in future.

These are industry-specific questions, but Alcoa’s end demand has plenty of drivers in common with many market sectors. Consequently, Alcoa’s stock performance is not always a useful bellwether, however, the company’s end market commentary is interesting for the wider markets.

Stocks Correlated with Alcoa

For example, looking at the stocks that Alcoa has the highest correlation to, the usual mining and aluminum suspects are apparent. Interestingly, the typical plays on global growth such as DuPont and Caterpillar $CAT are also there.

CompanyCorrelation %
BHP Billiton87.5
Century Aluminum87
Rio Tinto86.1
Du Pont85.5

Investors should understand that correlation is not the same thing as co-integration. Correlation measure  the direction of the movements together, rather than the magnitude. Two stocks can be highly correlated but also exhibit vastly different price movements.

Nevertheless, investors do care about directional movements. With this in mind, I want to break down Alcoa’s end market guidance and, see which companies might be affected by the commentary that Alcoa gave.

Alcoa’s End Markets

Here is a table of how Alcoa has been adjusting guidance over the last four quarters including the latest commentary. The last column is my own interpretation.

The first thing to note is that I am only describing automotive and commercial transportation as being ‘slightly weaker’, because Alcoa lowered the high end and low end of their respective guidance. Secondly, Alcoa raised guidance for the long cycle industries of aerospace and industrial gas turbines, by way of contrast the weaker outlook was in the shorter cycle businesses.

Aerospace & Industrial Gas Turbines Stronger Growth Forecast 

The raise in guidance will be well received by an aerospace industry which is set for good growth in the next few years. Airbus and Boeing order books are both full for years to come. Moreover, with the growth of aircraft such as the popular A320 and Boeing 737, which have a large aluminum component, Alcoa has the opportunity to grow faster than industry growth.

Ultimately, the aerospace industry is cyclical. High fuel prices and economic recessions will ultimately effect growth. Indeed, according to the International Air Traffic Association (IATA) the outlook remains ‘fragile’.  Nonetheless, longer term aerospace growth is being driven by low cost carriers and emerging market passenger growth. The BRICs are all huge countries, whose intercity transportation is likely to have air travel as an integral part.

One company I like in the sector is BE Aerospace $BEAV which provides seating to airlines. It is attractive because it is a pure commercial aerospace play and looks set to benefit from a long cycle of growth in new build and retrofit. Typically, airlines order planes then they buy the seating and cabin interiors separately from the likes of BE Aerospace. However, BE Aerospace now working directrly with the aircraft manufacturers. The company recently announced a contract with Boeing to manufacture modular lavatory systems for the 737. This is exciting because it may presage a new area of growth for the company, particularly as its solution allows for airlines to gain a few seats on the plane.

Another, obvious beneficiary is General Electric $GE which is the leading player in the market. It is also the leader in commercial aircraft engines and would be an obvious beneficiary of Alcoa’s rosy economic outlook.

Beverage Can Packaging

Although the headline guidance stayed the same, it was noticeable that forecasts were raised in Europe. This is an interesting industry because there is rapid growth in emerging markets for can usage. However, in the US, plastic is increasingly replacing aluminum in the key beverage packaging sector. Therefore, companies like Rexam or Ball Corporation $BLL are increasingly shifting production towards emerging markets like Brazil. Ball Corp is worth a closer look, because its end demand remains positive and stable, whilst one of its key input costs (aluminum) is falling. The key for Ball will be in managing the consolidated decline in the US, whilst accelerating growth elsewhere.

The Weaker Segments Reveal Regional Differences

Within Commercial Building, all regions (US, Europe and China) were predicted weaker, although Europe was noticeably so. Frankly, I think there is good potential for China to disappoint in future quarters and, Europe’s economic growth will be weak this year.  Automotive was very enlightening. Europe was seen as notably weaker whilst China was weaker. The latter is not surprising, given the recent relative weakness in car sales in China. However, the US was noticeably stronger. This suggests that the way to play US auto sales strength could be via the US auto dealers rather than global production.

It was a very similar story with the Heavy Truck & Trailer segment. Alcoa sees the US trending higher and growth from China being weaker. One company that could benefit is Eaton Corporation which has good exposure to the aerospace and commercial transportation markets.

Alcoa Results

In conclusion, Alcoa’s guidance was mixed. The clear message is that China’s growth appears to be slowing but, the US is accelerating. I think this signal is a useful one for investors to digest and, an increased focus on domestic US inclined companies is called for. Perhaps the much talked about, but rarely seen, decoupling affect does actually exist?

Monday, June 4, 2012

Pfizer's Upside Potential

Everybody knows that the major pharmaceuticals companies have faced myriad challenges over the last few years. The industry has had to deal with patent cliffs, fears over reimbursement adjustments, the FDA becoming more stringent over approvals, the increasing cost of research and development (R & D) and many other issues.

The patent cliff issue is immediately noticeable in the slowing revenue growth rates in this period and, this year in particular, is seen as the annus horribilis for big pharma. Pfizer $PFE is no stranger to these problems, and generic competition to cholestorel lowering blockbuster Lipitor is going to hurt inevitably Pfizer.

That said I thought it would be interesting to look at how Pfizer is dealing with the challenges and appraise some of its upside potential for 2012.

Pfizer Acquires and Restructures

The first part of Pfizer’s approach to dealing with its strategic challenges was to arrange a merger with Wyeth. It was a deal which gave Pfizer new expertise in large molecules, vaccines, and biologics. It has also generated significant cost savings.

The second part is to significantly restructure and refocus the business.  The management would like to sell the animal and nutritional health business, and continue the extensive buyback policy. As a consequence, R & D expenditure has been cut to about 12-13%

This is a relatively low number, but what will it do the all-important pipeline?

What is interesting in Pfizer's Pipeline?

Looking longer term, the pipeline focus has shifted towards oncology and pain disorder treatments. For example in 2012, Pfizer has phase III trials with Dacomitinib (non small cell lung cancer) and Intuzumab (lymphoma) but, the big kickers could come from Bapineuzumab and Tafocitinib. I want to focus on these two drugs in particular.

Bapineuzumab Makes a Comeback?

Bapineuzumab is a humanized monoclonal antibody that attacks amyloid-beta plaques that form in the brain of Alzheimer’s patients. Phase III results for North America are due mid year. Alzheimer's is the most common form of dementia and, an indication which has seen few treatment advances in recent times. As such, any successful drug is likely to be well received, especially in an ageing population.
The amyloid-beta theory (which this antibody relies on) has been challenged by high profile failures with Myriad Genetics Flurizan and even with Bapineuzumab previously.  In addition, Phenserine (amyloid beta modulator) failed in a previous phase III trial as did Tamiprosate which tried to inhibit amyloid beta plaque formation.

Amyloid-beta optimists will also want to keep an eye on Eli Lilly’s $LLY solanezumab and Morphosys’ gantenerumab which will both give results this year.  Gantenerumab, like Pfizer’s antibody, is an anti-amyloid-beta treatment (in early stage trials) and, based on previous drug class failures, I would cast doubt on its chances of success.

Solanezumab is a humanized monoclonal antibody which binds to soluble amyloid beta. It was taken to phase III on the back of safety data, rather than having achieved efficacy in Phase II. Solanezumab is believed to be similar to bapineuzumab but with less toxicity issues. The latter was found to cause brain inflammation in its highest dose in Phase II. Eli Lilly investors will be hoping to hit a home run with this antibody and, are results due this year.

What all of this drugs have in common is a reliance upon the theory that reducing amyloid beta plaques in Alzheimers patients will work to reduce the onset of dementia.

I think that the clinical evidence doesn’t bode well and, I would be surprised to hear good news on Bapineuzumab.  However, with three drugs giving results,  it is going to be a big year for the amyloid-beta theory!

Tofacitinib could be Pfizer’s next Blockbuster

On a more positive note, Pfizer’s Tofacitinib is the leading small molecule in a new class of drugs called Janus Kinase (JAK) inhibitors. A number of companies have been successful with JAK inhibitors in clinical trials, so there is ample clinical evidence to suggest that they work. Pfizer’s plan is for it to be initially approved for Rheumatoid Arthritis (RA) and then expand its indication to Ulcerative Colitis, Psoriasis, and Crohn’s disease.

In particular, JAK inhibitors are a class of drug being targeted for inflammatory diseases. Many of which, such as Ulcerative Colitis, are potentially fatal. Rheumatoid arthritis is chronic inflammatory disorder which tends to affect the joints and. disproportionally so in the elderly. The current treatments are some of the best selling drugs in the world.

Within RA, Pfizer has already filed and been accepted for review in the US and in Europe. In addition, a file has been submitted in Japan. What makes JAK inhibitors so attractive is that they tend to be taken orally via a pill.  This compares favourably with the previous class of RA treatments, namely TNF blockers. For example, TNF blocker biologic Humira is injected on alternate weeks, Enbrel is injected once a week, and Remicade is given intravenously every month or so.

The three afore mentioned TNF blockers are responsive in 70% of patients, including some who do not respond to the first line treatment of methotrexate. They are all expensive and have significant side effects.
I would expect Tofacitinib, if approved, to be immediately marketed to TNF non-responders and, then start to encroach on TNF-blockers market share. After which, Pfizer can create a market ‘buzz’ around its applicability for other indications. In short, this drug could be a huge blockbuster for Pfizer.

Potential Competition for Tofacitinib?

As mentioned above, Pfizer isn't alone in developing JAK inhibitors. Vertex Pharmaceuticals $VRTX showed significant results in a phase II in RA with its JAK3 inhibitor VX-509. A further phase II trial is planned. Similarly, Rigel Pharmaceuticals has entered into a Phase III with is RA treatment Fostamatinib.

Speaking of Vertex, it has long been touted as a takeover target due to its exciting pipeline and I wouldn't be surprised if a major pharmaceutical company stepped in and acquired the company.
Furthermore, Incyte $INCY in partnership with Eli Lilly, has two JAK inhibitors in development. INCB28050 is in a phase II for RA. Meanwhile, Jakafi (ruxolitinib) is already on the market for myelofibrosis and, Incyte has it in development for psoriasis and polycythemia vera as well.
Myelofibrosis is a disorder of the bone marrow, which tends to cause inflammation of the spleen.  Jakafi works to reduce spleen inflammation. The indications are that Jakafi sales are doing very well. This must surely resonate with the FDA in terms of their confidence with approving JAK inhibitors.
Both Vertex and Incyte will offer stiff competition to Pfizer.

Pfizer in 2012?

In conclusion, Pfizer investors can look forward to more restructuring in 2012. but there could be a lot of excitement around Tafocitinib being potentially approved. Incyte has already got a JAK inhibitor approved and, so far, the indications are that Jakafi is doing well. Bapineuzumab has probably been written off by most investors and, is unlikely to disappoint many. A failure is probably 'in the price'. Therefore, for long term income investors looking for some dividend with some upside potential, Pfizer offers a compelling mix.