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All investors, in common with fisherman, have a tale to tell of ‘the
one that got away’. Of course, I know you expected me to include Katy
Perry in that list following her hit single of the name but bear in mind
that she (in the video) took solace by making a wealthy man’s life a
misery as a consequence. Maybe he was wealthy because he may not
have made the mistake that I made in selling out early in my holding of Roper Industries(NYSE: ROP). Frankly, I think this is one of the best run companies in the US and here is why.
Hindsight Asset Management
Of course, backwards investing is one of the easiest things in the
world to do and it’s easy to kid yourself by only looking at the winners.
Incidentally, that’s what makes writing about stocks so useful. Once it
is written down there is no room to delude yourself. That said I want
to look back at the reasons why I thought Roper was a great company a
couple of years ago and then sold at $68 and see if they apply now. Bear
in mind the stock now trades at $104!
Roper is a diversified engineering company with the following characteristics
A focus on Investment in Machinery & Equipment in its cyclical
businesses. This sector was due an aggressive snapback in growth
following the savage cutbacks it took in the recession.
Roper has a history of great cash flow generation. Its business tends to be asset light and so require relatively less capex.
Strong Ebitda margin growth and a strong track record of using cash to make earnings generative acquisitions.
It is a leader in a series of niche markets whereby it can better retain its competitive positioning.
Each of its business segments has good long term secular drivers and actually has some good defensive growth characteristics.
I want to develop the last point in particular. Here is a breakdown of 2011 sales.
Not only are revenues pretty evenly split but Ebitda is too. Ebitda
margins across the segments range tightly from 29% (Energy) to 31%
(Industrial) and Roper is a leading player in niche markets with these
segments.
Roper Industries Industry Segments
Consider RF Technology. This is an area where technological advances
and increased industry adoption (freight, road tolling, retail and
utility performance measurement) are driving sales growth. Moving on to
Roper’s Industrial operations, this segment largely services the
utilities (and in particular water) with leak testing, flow measurement,
automatic metering and performance monitoring equipment. Again, this is
an attractive long term industry because the need to use technology to
improve utilities performance will only increase in the future. Utility
demand is growing and the days of cheap energy and water are gone.
The third largest segment is Medical and Scientific Imagery. Here
again, Roper is positioned in strongly growing markets. Imaging for
Radiation Oncology is a strong growth area. In addition, it supplies
diagnostic and therapeutic products for one of the fastest growing
sectors in medical devices, namely minimally invasive surgery (MIS).
Looking at Covidien’s(NYSE: COV)
results over the last year shows very strong growth in MIS and whenever
I speak to surgeons they mention this as their key growth area. There
is a temptation to conclude that MIS' prospects are highly correlated
with hospital admissions and elective surgical procedures but thanks to
its cost reduction properties Covidien is generating strong secular
growth. After the forthcoming stock split I would expect investors to
re-rate Covidien as MIS will become more prominent in the medical device
company. Of more concern would be scientific imagery which –despite its
growth in applications- is still largely dictated by Government and
academic budgeting.
The last segment is Energy Systems and Controls whose prospects are
reliant upon large engineered projects in the energy industry and in
particular in hazardous industries. These are the kinds of solutions
that its customers can afford to take risks with and Roper has a history
of performance. Moreover if we look at what the likes of industry bell
weathers like Alcoa(NYSE: AA) are saying, energy spending is holding up well. In fact, Alcoa has been raising
its estimates for Industrial Gas Turbine growth throughout the year.
This is relevant because it's the strongest industry segment for Alcoa
and the company has seen expectations downgraded elsewhere.
Look Ma No Financial Services and Not so Much China Either
Another reason to love Roper isn’t that it isn’t GE(NYSE: GE).
In other words, this is an engineering company that does, err,
engineering. It's not a metal basher with a financial services arm (in
this case GE capital) generating a significant portion of its earnings.
I think this makes it a more representative stock of the Engineering
renaissance in the US (led by cheaper gas) than GE. I also believe that
GE may face some difficulties going forward. Aerospace is a cyclical
industry and is somewhat reliant on emerging market growth. In addition,
GE has been disappointing wth its defensive segments like healthcare.
In addition Roper is far less exposed to China’s growth moderation than a company like Eaton Corp(NYSE: ETN) or Caterpillar.
Throw in Eaton’s reliance on cyclical industries like heavy trucking
and Roper comes out on top again. Eaton has seen some downgrades
recently with analysts citing weaker China hydraulics and NAFTA truck
prospects. Eaton generates about 24% of its sales from emerging markets
and most of it is in highly cyclical industries that are slowing.
But this isn’t just about end-market exposure. Roper is a very well run company internally.
This chart tells you a lot. Note how free cash flow has increased
over the last five years and -crucially- how as a percentage of sales it
has held up in a recession and in the subsequent growth period
afterwards. This a sign that management and the business can see working
capital reductions in tough years (leading to higher cash flows) but
then they can be operationally geared to go for growth but not at the
expense of margins.
A very well run company.
Where Next for Roper?
Unlike most in its sector, Roper has seen estimates rising this year
and with mid teens growth forecast for the next couple of years the
company is a strong GARP candidate. As ever, its cash generation is very
impressive with trailing free cash flow of $578 million comprising 5.3%
of its Enterprise Value. This looks reasonable and I think there is
every reason that Roper can ‘do its earnings’ and generate mid teens
returns for investors.
Perhaps my ‘one that got away’ is about to be get a make-up call?
Filtration company Pall Corp(NYSE: PLL)
gave full year results recently and confirmed why it appears to be the
kind of stock that long term investors should favor. Its long term
revenue drivers are guided by regulatory and environmental quality
concerns and it combines a cyclical division (industrial) with a more
defensive division (life sciences). This gives it the opportunity to
grow across the economic cycle.
Pall operates the kind of razor-blade model that ensures long term
consumables revenue growth provided it can get its systems sold into to
its end markets. It is an attractive company and the market knows it.
The question is do its prospects justify its valuation?
Pall Corp’s Results
Management described its fourth quarter as being ‘solid’. While this
word implies stability, the underlying picture was actually quite varied
on a regional and industry basis. For example the Americas saw strong
growth while Europe and Asia were flat. On an industry basis
biopharmaceuticals, aerospace and machinery & equipment all did well
while industrial markets in Europe saw notable weakness.
As discussed above, when the economy is weak we can expect system
sales to slow, but consumables should carry on generating growth and
cash flow. Indeed, consumables now make up 85% of total revenue and
aside from industrials in Europe (consumables orders fell 7%) there was
strength all round.
The breakdown of divisional systems and consumable sales were as follows.
I want to look into more detail within the divisions.
Life Sciences
Life science consumables sales rose 13.7% while system sales declined
30.5%. Before anyone panics over the latter number, let’s recall that
Pall made a conscious decision to cut back on unprofitable life science
system sales. In particular it rationalized system sales in its Food
& Beverage segment in the parts of the business where it doesn’t
have the razor-blade model.
In addition part of its restructuring program involved selling its blood transfusion filtration operations to Haemonetics(NYSE: HAE).
This deal makes sense for both parties. Pall gets to refocus on life
sciences companies and away from selling to blood centers while
Haemonetics will be able to further increase its penetration of the
whole blood collection market.
Delving deeper into the numbers shows that biopharmaceuticals sales
increased 19.8%, food and beverage increased 4.5% and medical was up
1.6%. As alluded to earlier, this division is relatively defensive and
gives Pall good long term visibility of earnings and cash flows.
Going forward margins can be expected to improve as lower
profitability sales are being rationalized and ongoing strength in
biotech industry investment should ensure decent growth going forward
for life sciences.
Industrial
In Q4 consumables sales rose by 4.6% and system sales went up 7.3%.
This rather impressive headline performance masks some dramatic
differences in performance. Aerospace sales went up 21.6% while process
technologies declined -.2% and microelectronics went up a paltry 2.2%.
The differences within the components of the industrial segment
correlate nicely with what is happening in the global economy.
Microelectronics can be expected to be weak going forward because the
semiconductor cycle simple hasn’t picked up again as most commentators
had hoped it would. Indeed, the Semiconductor Industry Association has
been lowering chip sales forecast throughout the year and the recent
trading statement from Intel(NASDAQ: INTC) revealed weakness in pretty much all areas of its business.
Incidentally, I think a company like Pall can provide very good
forward indications of Intel’s future growth and I would encourage
investors to look out for its commentary on the issue. Intel’s recent
reduction in sales forecast is not good news.
As for aerospace, we only have to look at Boeing’s (NYSE: BA)
order book to see how strong commercial is at the moment. However, I
confess I have some concerns going forward. A lot of aerospace demand is
coming from emerging markets and in a slowdown orders will get canceled
or delayed. Airlines go bust and passenger miles see growth slowing.
Boeing’s order book may not be as secure as many think.
Where Next For Pall Corp?
While being an attractive business, investors should remember that
they are always buying the price of the business rather than making a
value judgement based on how much they like it. Pall doesn’t look
especially cheap right now. Its life science business will probably do
well next year but I have some concerns about the more cyclical
industrial division. Semiconductors will be weak at the start of the
year and I have concerns over aerospace.
In terms of evaluation, the stock does deserve a premium. Consumables
sales are growing strongly and they tend to be more cash generative
which means that a discounted cash flow analysis should see free cash
flow generation increasing in the future.
The argument could be made that it will be a beneficiary if any
cyclical upturn occurs but a quick look across at a comparable company
like 3M (NYSE: MMM)
(which also competes with Pall) shows it on a current PE of 15 and a
forward forecast of 13.3x for 2013. Both companies have similar end
market drivers in the industrial space but 3M is far cheaper and boasts a
2.6% yield.
For next year Pall is guiding towards 9-16% EPS growth which, if
achieved, would leave the stock on no more than a fair valuation in my
opinion. I’m uncomfortable buying a stock on a forward PE of 20 when I
have some concerns over its ability to even hit that elevated ratio.
There is little margin of safety here.
nvestors can glean a lot of useful information from earnings reports
and the associated commentary. Naturally, it’s unreasonable to expect
the average private investor to spend all hours God sends researching
and looking for anecdotal evidence but that’s where the Motley Fool can
come in and help. In this regard, I want to highlight one sector of tech
that is doing very well at the moment.
Data Centers Demand
Despite the current weakness in the global economy and a number of
tech companies lowering their guidance, data center investment shows no
signs of abating. The fundamental drivers of it are secular in origin.
With every other business seeking to expand cloud based service
offerings, the strain on data center provision will only increase.
Furthermore, smart phone and tablet penetration is increasing the
number of hours spent online while content is becoming ever more media
rich. Another –often overlooked-driver of data center demand is the
financial services sector. Their fixation with using technology to
gamble against each other with products (whose risk they don’t really
understand) is only increasing. If they want to do it then so be it,
don't give them your money but invest in areas where they will spend
theirs.
Data Centers
The most obvious place to start would be the data center providers like Equinix(NASDAQ: EQIX), Digital Realty Trust, Interxion or Telecity. In
contrast to much of the tech sector, these stocks have soared. All of
them have been ramping up capital expenditure plans in a bid to capture
future growth. They are attractive businesses because their customers
are sticky and much of the growth in demand is coming from them. This
gives them good visibility over future revenues.
The question is when will industry capacity exceed demand? I always
think the key to this question is gross margins, so let’s look at
Equinix.
There is no apparent decline so it appears that the capacity ramp up
is justified for now and this is the key to ongoing growth. I think
investors should stay with the capex plays while the data centers are
spending.
Data Center Capex Benefiting Suppliers
Increased spending on data center infrastructure is good news for the
equipment suppliers. Indeed it has been noticeable that two of the
biggest tech names out there have seen their strongest prospects come
within data center spending. Intel recently gave a
trading system and basically said its whole business was weaker with the
exception of data center spending. Moreover, Cisco Systems(NASDAQ: CSCO) has reported stellar growth in data center revenues.
This isn’t a coincidence. Data center spending is strong.
Unfortunately, Intel and Cisco are not the best way to invest in the
sector and I think investors need to look at more focused companies.
Stocks With Data Center Exposure
Finisar(NASDAQ: FNSR)
recently gave results and whilst there was continued weakness in its
telecom sales, its Datacom division (primarily sells to data centers)
has been operating well. Telecom made up 36.7% of revenues in Finisar’s
last quarter and you can’t ignore this in your investment decision, but
it’s possible we have seen the worst here and management is talking
about it picking up in the next quarter. As for Datacom, don’t be fooled
by its decline in the last quarter. There were two fewer shipping days
and the result was also a snapback from strong growth in the previous
quarter. It's worth a look.
Another angle on data centers would be to look at companies that have
exposure to data center needs and the industry trends that are creating
the underlying demand. An example of this would be security. Cisco and Juniper service this market but if you are looking for a specialist play in the area I think Check Point Software (NASDAQ: CHKP)
is worth looking at. It specializes in the type of high-end
sophisticated security solutions that large corporations and data center
providers need.
Another interesting entrant into the data center security marketplace is F5 Networks.
In addition its core market of application delivery controllers is
heavily exposed to the increased demand to accurately control the
quality of applications sent over the internet. In this regard, I also
like Riverbed Technology(NASDAQ: RVBD).
It is the market leader in wide area network optimization. In other
words if you need bandwidth heavy data sent quickly over the internet,
then Riverbed is your port of call.
Verint Systems $VRNT followed its rival Nice Systems $NICE
and lowered full year guidance. I don’t think Verint did quite the same
kind of ‘sandbagging’ job that Nice appeared to do but nonetheless the
stock declined. Both stocks are interesting, not least because they
offer a back door way into ‘big data’ analytics demand, but without the
hefty valuations and expectations that the usual big data plays have.
What Happened?
Essentially, revenues and EPS came in ahead of market estimates but
full year guidance was lowered with management signaling weakness in
European Governmental spending as being the major problem. Furthermore,
full year guidance was lowered
Full year revenue guidance of $850-870m vs. $860-880m previously
Full year EPS guidance of $2.50-2.75 vs. $2.55-2.70 previously
Verint only lowered revenue guidance (at the mid-point) by 1.1% which
is far less than Nice did when it lowered its number by 4.2% recently.
The familiar refrain of weaker European revenues was cited as the main
cause. That said there is also a currency effect here. Indeed, Verint
pointed out that on as constant currency basis Q2 European revenues
actually went up $1m rather than the $3m reported decline.
No matter the outlook is weaker. In common with Nice, Verint thinks
that Q3 will be weaker but Q4 will turn in stronger numbers. I’m not
sure what to make of this argument. My initial thought was that both
managements are seeing current order delays and then thinking that they
will be pushed in to Q4?
Then I remembered that Nice categorically argued that its full year
guidance assumptions were based on current run rates. Verint were so
clear about this and my suspicion is that this is why Nice took down
guidance more than Verint did. If my hunch is correct that Nice may
offer more upside if conditions improve.
Back Door Big Data Analytics Play?
Ok let’s not delude ourselves here. These stocks are workforce
optimization plays. They help enterprises and Governments manage and
monitor interactions and optimize workflow. Strictly speaking this is
not ‘big data analytics’, however as an integrated solution provider it
is seeing growing revenues from its data analytics products because its
customers require increasingly sophisticated ways to make sense of the
mass of unstructured data being captured. Naturally, they prefer to buy
this from a single vendor.
Of course the bullish case here is that once they both start
reporting analytics as a product line, this part of the business will be
valued in line with the rest of the big data sector and ‘hey presto’
Verint sees a multiple expansion to put it in line with something like Informatica $INFA or what the market might be pricing in for Adobe Systems, Google $GOOG or IBM’s $IBM analytics solutions.
Speaking of which, the market has spent the summer downgrading
expectations for data analytics. Informatica has had a torrid time of it
recently and is a smaller company competing against some very big
players, nevertheless it trades on 35x earnings. In comparison, Verint
trades on 11x forward estimates. Its management spent a lot of time
blaming macro factors for the recent poor results but I am not so
sure. Other competitors are not reporting anything like as weak numbers
and it maty well be that the competition has stepped up the game.
Google offers a lot of analytics for free mainly because it is a
support for its revenue generating platforms. It's offering isn't as
sophisticated as the kind of solution that Adobe or IBM offer but it
could step its offerings because its operations generate huge amounts of
data to be analyzed.
Perhaps the most interesting company in the space is IBM. It offers
an integrated solution of business intelligence (BI) as well as
possessing the data warehousing solution. So not only can they store
data but they can also provide the analytics to make sense of a mass of
unstructured data held within the data warehouse. Many companies mat
appreciate the opportunity to buy from one vendor.
The 'big data' pitch is a beautiful idea but I don’t think Verint
even needs this sort of thing. The stock is hardly expensive as it is.
Long Term Drivers
The longer term drivers are pretty good and the current weakness for
Verint and Nice may prove to be a temporary reaction to growth fears in
Europe. In the end the kind of regulatory and compliance driven
solutions that Verint offers won’t lose their importance. For example
Governments can’t simply switch off the need to analyze terror and
security threats just because they need to cutback spending growth.
Corporations can’t just ignore surveillance and monitoring
requirements nor are they likely to stop needing to capture and analyze
customer interactions. Considering the latter, this is a need with a
demonstrable return on investment which means that even in bad times
Verint’s solutions are attractive. Instead of, say investing a new
plant, a customer could invest in workflow optimization in order to
reduce operating costs or increase revenues from data (video, emails,
phone calls, website interaction etc.) generated by existing customers.
This is where Verint comes in.
Where Next for Verint?
Investors need to look out for as few things. Its enterprise revenues
are expected to increase sequentially in Q3 and Q4 while the more lumpy
revenues at security (large projects) are expected to decline in Q3
then pick up in Q4. We shall see.
I happen to buy the long term story here and picked up some Nice
Systems stock after it warned. I think on a risk/reward basis the stock
looks cheap because it does appear to have assumed the worst in its
guidance. Verint hasn’t quite down that but if you believe that this is a
temporary blip then both stocks look good value.
Unfortunately few awards are issued to companies outperforming within a difficult environment. If there were, I think Kroger $KR is worthy of a place on the short list.
The grocer finds itself challenged with reluctant consumer behavior
and its markets are being encroached on by the big box retailers at the
low end and an assortment of niche players at the higher end. Its
management is doing all the right things in response, but is it enough
to make it an attractive investment opportunity?
What Happened With Kroger?
As usual the immediate reaction of the media is to look at the
falling share price and then quickly conclude that the market doesn’t
like the results because net earnings fell slightly. I would like to
think that investors are a little more discerning than that!
In fact pre-tax earnings were up 9.7% to $429 million. It was an
increased tax rate that caused the net income decline but diluted EPS
actually rose 10.8%. My view is that it is more to do with the continued
fall in gross margin and the sluggish sales growth.
Sales growth excluding fuel was 3.8%, which is not great considering
inflation in the food sector over the last year or so. Interestingly
Kroger claims it is gaining market share in food but the market doesn’t
seem to want to listen.
Challenging Markets
The thesis with Kroger is that its margins are falling thanks to
increased competition. The structural changes happening with online
merchants grabbing sales from traditional retailers are forcing them to
expand into other categories, and one of them is food. Kroger finds
itself challenged by Wal-Mart $WMT and its efforts to expand food and pharmacy sales, particularly via its increasing number of smaller box outlets.
As Kroger’s management points out, they have been doing a good job so
far in countering Wal-Mart by reducing operating costs and initiatives
designed to create loyalty by creating good customer influences. Like I
said, if anyone deserves an award…
Kroger also faces competition from discount retailers who are seeing
an increasing amount of customers doing more marginal grocery shopping
in their outlets. Moreover the likes of Family Dollar, Dollar General $DG and Dollar Tree $DLTR are all aggressively rolling out new stores. If the experience from Germany (where discount retailers like Aldi and Lidl
began to expand aggressively after they went through an austerity
period after reunification) this kind of shift in consumer habits can
stay a long time.
Another challenge comes from specialty retailers like Whole Foods Market $WFM,
which is managing to create enough differentiation in their product
offerings to grab footfall from traditional Kroger customers, many of
which are likely to be higher margin purchasers for Kroger. It is a
challenging environment and lower end Kroger competitors like Supervalu(NYSE: SVU) are having to close underperforming stores in order to reduce costs.
Other Challenges and Opportunities
As if the increasing competitive challenges weren’t enough, rising
food costs have eaten in to margins and higher gasoline prices always
reduce lower income groups' discretionary spending. Putting all these
aspects together demonstrates how well Kroger has been doing to keep
profits rising over the last few years.
The company has also seen some benefits within its pharmacy sales from the Express Scripts/Walgreen dispute.
Now that that dispute is resolved (they will start working together
again next week) there are some concerns that Kroger has seen some kind
of artificial boost, which will drop out in future quarters. We shall
see.
Where Next for Kroger?
The company is very well run but as good as its management
undoubtedly are, there is only so much they can do to fight a tough
working environment. I think it is hard to argue that the stock is cheap
on 21x earnings. Granted it deserves a premium to its sector (who will
all be fighting the same conditions) but at this level?
I think cautious investors should wait for a more favorable
macro-environment before chasing the stock higher. Moreover, if you
share my view that the stock won't turn until gross margins do then why
fight the trend? Better to wait until they start turning up or Kroger
generates some stronger revenue growth.
The award for the season’s most widely anticipated bit of guidance lowering goes to Intel Corp $INTC.
The semiconductor company duly obliged and I thought it would be
interesting to look at the meaning of it and how it reads across the
tech sector in general.
Intel Lowers Guidance
Intel lowered Q3 revenue expectations to $12.9-13.5 billion from a
previous forecast of $13.8-14.8 billion. It works out to a 7.8% decline
at the mid-point. Ordinarily we might have expected the market to give
Intel a sharper markdown than the couple of points that it is down as I
write. I discussed the potential for near term weakness in a previous article linked here.
Supply Chain Weakness
Furthermore, the color in the commentary was very revealing.
Customers are reducing supply chain inventory rather than increasing it
as they traditionally do in the quarter. Given Intel’s strength in the
PC market, I think we can take it that the PC manufacturers are not
ramping up production. This is a worrying sign for Microsoft $MSFT,
which has been hoping that the release of Windows 8 would lead to its
usual sales pickup. In my opinion, Windows upgrades will gradually
become less important in the future. If you asked an individual or a
corporation whether they preferred to spend money on the Windows upgrade
cycle or on a higher specification smartphone or tablet, I think I know
what the answer would be.
Softness in the Enterprise PC Market
Intel also referred to weakness in the enterprise PC market. Dell $DELL and Hewlett-Packard $HPQ
both reported desktop PC sales down 9%, with HP also reporting that
notebook sales were down 10%. Naturally, both companies put a positive
spin on the outlook for Windows 8 to spur future sales, but according to
Intel the industry isn’t ramping up production in anticipation of
gang-buster sales. Dell and HP’s rising inventory build-up is to be
taken at face value. Falling sales are the problem, not a ramp up in
production to meet demand. Given this scenario, I would expect some
pricing weakness going forward as the PC manufacturers try to reduce
inventory.
Slowing Emerging Market Demand
Intel also referred to slowing emerging market (EM) demand. This is
something that investors need to factor in. It doesn’t mean that EM
demand is ‘weak’ but what it does mean is that a lot of the assumptions
baked in for EM end demand are likely to come in weaker than expected. A
lot of companies have been chasing EM growth as a panacea for sluggish
growth in domestic markets and I suspect that some of those that have
been gearing up on EM will suffer disproportionately. China is slowing,
and as it does so will Brazil and Russia with it due to lower
expectations for commodity demand. Similarly, India has seen growth
forecasts lowered throughout the year.
Capital Spending at the Low End of Range
Capital spending plans were also predicted to be at the low end of
the forecasted $12.1-12.9 billion range; gross margins were expected to
continue their decline.
The soft capex spending is not good news for the semiconductor capital machinery suppliers like Applied Materials or KLA-Tencor.
Data Centers Still Hot
The one bright spot was that the data center business is meeting
expectations. When you look at the surging stock price of data center
providers like Equinix $EQIX ot Telecity, it
is not hard to see why. It seems that all of the leading data center
providers have been ramping up capacity this year in light of strong
demand for broadband. The increasing usage of smartphones, tablets and
other internet enabled mobile devices is leading to a surge in media
rich traffic, which is dropping nicely into the top line of the data
centers.
Intel isn’t alone because Cisco Systems $CSCO
has also reported strong data center growth, with revenues rising from
$259 million in Q1 to $415 million in Q4. Unfortunately, it only makes
up 3.6% of total revenue for Cisco so it is not a game changer; but it
does indicate continued strength in data center spending.
Where Next for Intel?
This statement is pretty much par for the course right now, but the
semiconductor industry and investors need to be aware of the near term
risks. Nevertheless, for long term investors a current PE of just over
10x and an EV/EBITDA ratio of around 5x doesn’t look expensive. The
industry is cyclical, but that doesn’t mean the stock will never be a
good value play. For more cautious investors I would suggest thinking
about buying when we start to see some stability in gross margins. It
usually is the key metric that guides the cyclical fortunes of the
semiconductor industry.
Sometimes successful investment themes seem to creep up unnoticed to
most investors and only after the event do we realize that they were
staring us in the face all along. One such idea is the specialty
pharmaceutical sector. By this I mean generics, over the counter (OTC)
manufacturers and generally those companies outside of the mainstream
pharma and biotech sector. This sector has done very well this year and
this article will briefly mention some names for investors to do more
research.
Why this Theme is Working this Year
Everyone loves the demographics behind the healthcare sector but does
everyone enjoy the pressures on big pharma? If it isn’t the patent
cliff, it is increased reimbursement pressures or general Government
austerity measures putting pressure on pricing. The FDA is getting
increasingly tough on approvals and marketing costs are going up. So
what is an investor to do?
I think the solution is to focus on health care companies whose
offering provides demonstrable cost savings and/or is actually part of
the drive to reduce expenditures. I’m talking about things like generics
where, for example, the Europeans are trying to reach the kind of
penetration levels that the US has. I also refer to companies that
manufacture private label and OTC drugs or who have revenues largely
unexposed to reimbursement issues. In addition, in an uncertain
environment these types of stocks will get bid up as investors gradually
wake up to the story.
Keep Smiling
The first idea I like is dentistry. More older people in general are a
good thing for dentistry. More older people with more surviving teeth
per mouth are even better! The sector is largely devoid of reimbursement
issues and offers good long term growth. I’ve written extensively about
Sirona Dental Systems in an article linked here
and I think its world leading proprietary system for carrying same day
restorations (CEREC) has great long term potential. I’m genuinely
baffled by how little interest there seems to be in this company but who
cares? Discerning investors would have enjoyed a 21% gain this year.
It’s a similar story with something like Align Technology
and its Invisalign invisible brace which is up 49% this year. Growth
and technology investing doesn’t always have to be in cyclical sectors
like semiconductors or telecommunications.
Drug Dealers
Everybody wants more drugs but wants to pay less for them. One
solution is for the pharmacies and drug retailers to increase their in
store private label OTC sales. This would have the benefit of lowering
costs to the consumer and since these products tend to come with higher
margin to the retailer (compared to brand drugs) it’s easy to see why
they are keen to expand them. I like CVS $CVS in this space and have covered them in an article linked here. I prefer CVS to Walgreen for
three reasons. Firstly, I like the plan to increase its private label
sales. Secondly, I think it can play catch-up to Walgreen in terms of
operational metrics. And lastly, I think investors may be
underestimating the amount of customers it can keep from those it took
during the Walgreens/Express Scripts denouement.
Generics
While everyone is crying over lost Government spending revenues, the
generics are gearing up for increased growth. That said I think
investors need to be a bit discerning here because the sector is a mixed
bag. The four big names always quoted are Teva Pharmaceutical, Mylan Inc $MYL , Watson Pharma $WPI and Sandoz (Novartis).
I’ve held Watson and Mylan this year. I sold out of both because they
hit my price targets but I think Watson deserves a closer look now that
earnings have been exceeding expectations. It is a huge cash flow
generator. As for Mylan, my opinion is that it is a good company but it
warrants a decent margin of safety. The management is excited about its
opportunities to get a generic version of Advair (Asthma) onto the
market and is baking in some assumptions into its earnings targets.
I’m not so sure. I hold a position in a cash rich, program heavy, small cap UK pulmonary drug delivery company called Vectura
which is widely believed to be developing a generic version of Advair
in its VR315 program. Vectura are developing VR315 with Sandoz in Europe
and analysts see it being in the European market in 2013-14. However,
in the US, Sandoz returned the rights to Vectura in 2010 and, this
should be seen as a warning that the regulatory and competitive
environment is likely to be tough in the US. Vectura has subsequently
agreed another partnership with a US pharma co for VR315 in the States
but Sandoz really was the ideal partner. Analysts expect a 2015-16
launch but I’ve seen estimations for probability for this as low as 19%.
The fact that Sandoz walked away from VR315 in the US suggests it
wasn’t that confident about getting approval.
Investors willing to look at European small caps might also look at Germany company Morphosys which is cash rich, has a strong partnered program and offers growth prospects through helping pharma reduce development costs..
Specialty Pharma and an Acquisition Target
Within specialty pharma I like Valeant Pharmaceuticals $VRX and Endo Heath Solutions $ENDO The
market loved the proposed takeover of Medicis because it increased its
exposure to dermatology and aesthetics, two segments of health care that
are not exposed to public sector cutbacks. In fact, Valeant’s product
portfolio mainly involves neurology, dermatology and ophthalmic along
with a whole host of consumer and generic brands. The usual criticism of
Valeant is that it is mainly acquisition led growth which tends to
unravel at some point and the company is building up debt. However, what
else should a company be doing with low interest rates? Furthermore,
the company is forecasting $1.4bn in adjusted operating cash flow for
this year. With a current market cap of around $18bn, the acquisitions
are not stretching the balance sheet in my opinion.
The last stock worthy of a mention is Vertex Pharmaceuticals $VRTX.
The unique thing about this company is its pipeline and its market cap
of $11bn places it firmly in the camp of mid-cap names that would give a
big pharma company immediate growth. Moreover its strength in cystic
fibrosis and Hepatitis C will allow a large company to add a product to
its own stable of treatments with these indications.
Campbell Soup Company $CPB
is one of those stocks that is trying very hard to dispel the idea that
revenue and earnings growth are what drives stock prices. In essence,
the company is not doing very well operationally but it is doing very
well in the ugly sisters’ beauty contest of stably high yielding stocks.
This is what the market wants right now and who am I to argue? That
said I do happen to believe that earnings are really what matters and it
was another mixed quarter for the company.
Earnings Up or Down?
Net earnings rose 29% to 40c in the quarter but adjusted net earnings
fell 5%. Moreover, gross margins slipped again this quarter and the
familiar explanation of higher cost inflation and promotional activity
was cited. So while Campbell has declared that fiscal 2012 was a year of
investment, investors should not conclude that this was purely going
for growth strategy. The company needed to halt declines in certain
areas and revamp product lines.
A look at segmental sales.
Only US Simple Meals and US Beverages recorded year on year sales
increases. Negative currency effects did take growth away from Global
Baking and International Simple Meals but the organic sales growth in
these segments was only 2% and 1% respectively.
The standout performer was US Simple Meals within which soup sales
finally got back to sales growth with a respectable 9% increase.
Condensed soup sales rose 14% while ready-to-serve increased 1%.
However, even this comes with caveats. Firstly the company outlined
that much of this came from movements in retailers’ inventory. Soup has
been strangely volatile category over the last year, so it wouldn’t be
surprising if some retailers had had jump changes in inventory levels.
This just seems like a quarter where Campbell benefited. Secondly,
product revamping, promotions and introducing new flavors in order drive
sales comes at a price.
Here are the segmental movements in earnings for the quarter.
It’s not a pretty picture.
Industry Challenges and Opportunities
Campbell is operating in a tough environment right now. Footfall is
down at traditional groceries and consumers are spending less per trip.
Even worse, customers continue to increase their grocery shopping at
discount retailers. Even a company like private label manufacturer Treehouse $THS is suffering because its traditional customers are seeing their
in-store brands challenged by the rise of sales in the ‘alternate’
channels. In response Treehouse is shifting its company more towards
these channels.
H.J. Heinz $HNZ
recently reported some average looking results but it has the growth
kicker of emerging market growth. Moreover, it is hard to tell how much
of Heinz’s growth is coming from its nutrition segment. A sector that
Campbell doesn’t participate in.
I would put Campbell in a category of stocks like General Mills $GIS and Conagra $CAG.
In other words, they are facing similar problems but they all generate
good cash flow, pay relatively high dividends but have low single digit
growth prospects. I hold some Conagra purely because I like the yield
and it has some value brands that I think can see good prospects in the
age of austerity. General Mills is facing some competitive issues in
breakfast cereal and it is generating little growth elsewhere.
Where Next For Campbell Soup Company?
Frankly I don’t think it is going to get any easier, anytime soon.
The guidance is for 10-12% revenue growth. This sounds great but around
9.5% of that is likely to be due to the Bolthouse acquisition. The
underlying organic growth of 1-2% coupled with declining margins is
hardly anything to get excited about and I think Campbell may have
problems with soup when it cuts back its promotional activity.
That said, investors buy stocks for all different kinds of reasons
and there is no doubt that stable companies with high dividends are
sought after in the current climate. GARP based investors like me may
baulk at buying Campbell but as part of a high yield portfolio the stock
may have a place.
VeriFone $PAY
disappointed investors recently with weak results and guidance, but is
this a blip in an industry with strong prospects or is the company set
to disappoint again with its strategy of seeking growth in a weak global
economy?
Who is VeriFone?
VeriFone is the global leader in secure electronic payment solutions.
The long term structural story here is that there is an ongoing shift
towards using electronic payments instead of cash and checks to pay for
Point of Sale (PoS) purchases. For example, VeriFone makes the
Electronic Point of Sales (EPOS) terminals that you might be asked to
pay with in the shops or restaurants.
As such, its fortunes are largely tied to the
cyclicality of the economy but I think it is capable of generating
growth in excess of GDP as its terminals expand market share. In
addition, there is a replacement cycle with the terminals, which should
generate secure cash flows as the business grows.
Long Term Growth Prospects
The business is cyclical but it also has some very strong secular growth prospects which will come from two main sources.
First is the adoption of EPOS solutions within the emerging markets.
Most countries in the world are nowhere near the US in terms of adoption
of EPOS, and as card issuance increases in these countries we can
expect strong future growth.
The second is the emergence of mobile payment systems in which VeriFone is partnering with Google $GOOG and Paypal.
Prospects for wide scale adoption look a lot better now that a Mobile
Payments Committee has been formed. Its members read like a roll call of
the key players that anyone might want involved. Google, VeriFone, Verizon $VZ, AT & T, Mastercard $MA and Visa $V all are signed up and this sort of thing can only encourage industry adoption.
For the telecom carriers like Verizon it represents a great
opportunity to generate new sources of revenue as its traditional wire
line market declines. It has teamed up with AT & T, Sprint and
VeriFone to create the Isis platform, which should be launched in
September. Isis is intended to compete with Google’s mobile payment
offering but the good news is that VeriFone will benefit either way. It
is a similar story with the transaction processors Visa and Mastercard,
and, with these heavyweights on board, it is a good sign that things are
about to take off.
Sounds Good but What Went Wrong?
Essentially two things went wrong in the quarter.
The first was that a fire in Brazil destroyed VeriFone’s staging and
repair center. VeriFone is strong in Latin America and this event
damaged earnings and cost them some market share. However, it does seem
like the sort of one-off event that investors punish the stock price
over, only to regret it as buyers come in later.
The second issue was some weakness in Europe. This should not be
unexpected, but I think there is another angle here. VeriFone’s biggest
competitor is Ingenico, and the French company is particularly strong in
markets like Spain and Portugal. As the consumer is suffering in these
economies, it would be no surprise if Ingenico stepped up competitive
pressure in order to try to compensate in the stronger parts of Europe.
A combination of these factors caused Q4 guidance to be lighter than
analyst estimates. VeriFone forecast revenues of $495-500 million versus
analyst consensus of $519 million, and the stock took a summary beating
Some investors will no doubt rush to conclude that Square is
potentially threatening VeriFone’s end markets, but I think the plug-in
device could be about as popular as antenna used to be on mobile
phones. In other words, it’s necessary when the technology isn’t around
to do away with it.
Where Next for VeriFone?
I think the long term story is largely intact here and this could be a
decent opportunity to gain an entry point. It’s easy for the critics to
complain about the timing of the Hypercom acquisition but growth
companies should, err, grow. The long term potential for VeriFone is
still in place and these sorts of bumps in the road are part of the
journey. The company has heavyweight partners who are committing to
create new channels for VeriFone to generate profits, and mid-teens
revenue growth is not something to be dismissed lightly in this
marketplace.
Mead Johnson $MJN
is the sort of stock that should be working in this marketplace. Its
mix of infant and children’s nutritional food implies relatively stable
end markets in the developed world and there is the long term story of
the emergence of the middle classes in the emerging world. I decided to
take a closer look at the stock and the sector to see if there might be a
buying opportunity here.
The Competition and What it is Saying
The long term growth story is a combination of demographics and
economics. China and India are believed to account for a third of all
global birth. In addition, they are both seeing the creation of the
kinds of middle class that buy nutritional foods for their infants and
children. And everybody knows it.
For example, Pfizer $
announced that it wanted to sell its infant nutrition business and it
had no trouble finding a buyer in Nestle who paid 20x EBITDA to buy it. I
think this was a great bit of business from Pfizer and allows it to
continue its drive towards refocusing the company on its core
competencies. It is also an indication of how keen multinationals like
Nestle are in establishing a presence in this category within emerging
markets (EM). The other key players are Danone(NASDAQOTH: DANOY.PK), Heinz(NYSE: HNZ) and Abbott Labs(NYSE: ABT) also has a nutrition division.
Infant nutrition is only a small part of Abbott Labs total sales so
it is hard to look at it as a nutrition play however I think Heinz could
be worth a look. Unfortunately, it doesn’t break out the nutrition
sales by geographic region but it is safe to assume that increased
nutrition sales in EM are partly behind the 19.3% organic sales growth
recorded in EM last quarter. It only makes up around 10% of total sales
but other parts of Heinz’s business (Ketchup/Sauces) are quite stable so
nutrition could act as a growth kicker for the stock.
China Slipping?
The category is highly competitive and with Danone, Nestle and Heinz
all making aggressive recent moves to chase growth in EM to counteract
weaker prospects in their domestic markets it would not be surprising if
Mead Johnson’s market share come under pressure. Indeed, it lost market
share in the last quarter. Is it anything to worry about?
The answer is yes and no.
Yes, there is no doubt that China is going through a de-acceleration
of growth right now and the company noted that the more discretionary
parts of the business (children as opposed to infant food) were more
affected in the last quarter. As for the market share loss, this was
attributed to the timing of price increases and promotions. I’m not so
sure. Danone has significant company sales in geographies like France
and Spain and with weakness in these markets it is natural that it
should want to increase sales elsewhere. A quick look at its numbers for
baby nutrition reveals that the 13.6% rise was made up of 7% volume
growth and 6.6% value. In other words, this wasn’t about pricing. Danone
just got better.
On a more positive note, Mead Johnson tends to run its business a bit
differently in China. It tries to hold pricing high by keeping customer
inventories relatively low. This has a tendency to reduce sales growth
but keep margins up. It also means that when pricing is increased there
will be pressure on volumes. Another issue that Mead Johnson had to deal
with is the error made by a Chinese University which accused it of
selling baby formula with unsafe ingredients in it. Despite the
allegations being proven to be false, these stories do have an effect.
The Chinese still remember the Chinese milk scandal in 2008 where local
producers adding melamine to milk led to six babies dying and hundreds
of others being hospitalized.
The frustrating thing for Mead Johnson is that this hit the
non-discretionary part of its sales (infant) while the more
discretionary element (children) sector saw some category slowness due
to a weaker economy.
In summary, the competitive environment is tough but there are mitigating circumstances for the market share loss.
Worth Buying?
Frankly I wouldn’t get too worried about a quarter or two of lost
market share in China. It is the biggest market for the category but
there are other geographies (Indonesia, India etc.) which also have
great growth prospects. The long term story is still intact, even if it
is going to suffer some marginal and minor peaks and troughs along the
way. The company is describing the last couple of quarters as a ‘bump’
and I think it makes a good case. China’s growth maybe slowing but the
middle class is still growing and having children.
My concern with Mead Johnson is not with the company but with the
stock price. Recall that Nestle bought Pfizer’s nutrition arm for 20x
EBITDA and it is believed to have paid that price because Danone might
have been interested too. Now consider that Mead Johnson trades on over
16.2x the same multiple. That is hardly cheap compared to the takeover
price paid in a competitive marketplace for a significantly positioned
asset. A PE ratio of nearly 27x and a free cash flow yield of around
3.5% doesn’t make the stock look cheap either.
Long term prospects do look great but investors have to ask
themselves what kind of evaluation premium they really want to pay for
double digit EPS growth for a company in competing with some industry
heavyweights. I can’t help thinking that 27x earnings is not the answer.
Nonetheless, a great stock to monitor.
The market didn’t take too kindly to the latest results from Ciena $CIEN
but in a funny sort of way they were quite positive. I don’t think
anyone can be excused for not knowing that global telecommunications
companies have been lowering their capital expenditure plans this year
so the weak guidance should have come as no surprise. However, the
company did make a lot of positive noises about things improving in the
second half in its last results commentary. As ever, analysts had priced
this in only to be disappointed when reality hit home this quarter.
What Happened With Ciena’s Results?
Revenues of $474 million actually beat the mid-point of internal
guidance of $455-485 million although the EPS loss was a tad more than
estimated. No matter, it was the guidance for Q4 which caused the
problems. The market had been looking for Q4 revenues of $499 million
but Ciena guided towards $455-480 million. The mid-point of which
represents a sequential decline. Moreover, the commentary around these
results was saturated with the usual talk of macroeconomic issues and
weakness in Europe. Network roll-outs are slowing and this is starting
to hurt Ciena.
Non-GAAP Gross Margins disappointed again at 39.6% but the good news
was that the higher margin parts of Ciena’s revenues saw a nice
sequential gain. As such, management forecast that gross margins would
get back to their targeted 40% in the next quarter. A look at revenues
by product and service lines:
Software & Services and Switching are the higher margin business for Ciena and they seem to be on the upswing.
Another positive was that Ciena affirmed that there was ‘no backing
off’ from the perspective of 100G deployment although the timing is
obviously subject to questioning. This is good news for Ciena as it’s
the leader in the 100G optical transmission gear market.
What is the Industry Saying?
I’ve covered this subject in more detail in an article linked here. Essentially, Verizon $VZ
is determined to reduce capital spending as a portion of revenues and
since it has already spent a lot of money on its 4G-LTE network, the
pressure on capital spending growth is downwards. Verizon has been
reducing its spending plans progressively through 2012. As for AT & T $T
it has largely stuck with its spending plans and is expected to be
increasing it in the second half. I think there should be question marks
placed on this now. With 90% of its data traffic on enhanced backhaul
already it is natural to think that expenditures might be reduced in the
face of a slower economy.
In the conference call, Ciena argued that the major US operators
hadn’t backed away from plans to update networks but this is not being
seen in other companies that have reported. For example, Cisco Systems $CSCO
reported flat revenues in switching in the last quarter and while the
market warmed to its moves towards returning cash to shareholders there
was little in the way of optimism on telco spending. Finisar $FNSR
also gave disappointing results and talked of ‘sluggish carrier capital
expenditure levels.’ Product sales for telecom applications decreased
by 14.1% sequentially.
With all of this going on, it is puzzling why the market took Ciena’s downgrade so badly.
My only explanation is that the exposure to 100G and next generation
networking gave the market some undue optimism that Ciena could avoid
the woes of the sector. Some criticism could also be levied against the
management for sounding so upbeat at the last set of results. The second
half pickup doesn’t look like it’s coming in telco capex.
Where Next For Ciena?
The results had some more positive features to them than many may
have supposed and the news that the telco’s are slowing spending is
hardly surprising, so I think these results are not quite the disaster
that the market move tells you they were. Longer term prospects look
good for Ciena but the problem is that, as it has to wait for network
roll-outs and next-generation telco spending to kick in, there is always
the risk that competitors could play catch up. In addition, loss making
telco stocks are hardly in fashion right now and the immediate outlook
for telco capex is cloudy at best.
On a more positive note, the company is cash flow positive now and
gross margins look set to improve. It’s the sort of stock that you want
to be in when the carriers and service providers are reporting better
prospects because it has the capacity to offer super industry growth.
However, that time is not now and I think investors might want to be
cautious here.
Earnings reports come and go and with this season it’s largely been
the same story from global retailers, with the US doing ok, emerging
markets strong and Europe weaker. Customers are being cautious, orders
are taking longer, etc. And then along comes PVH $PVH
telling us that it generated same store sales growth of 15% in its
strongest brand (Tommy Hilfiger) in Europe and guidance was raised.
However revenues were flat overall but non-GAAP EPS was up 17%. So what
is going on here and what can investors expect in the future from PVH?
Q2 Results
The key to these results is to recognize that earnings are largely
dictated by Calvin Klein (CK) and Tommy Hilfiger (TH). In fact, they
made up over 87% of earnings before interest and taxation.
TH earnings were up a whopping 29% as the company continues to
generate operational efficiencies from the 2010 acquisition. Hilfiger
revenues rose 4.1% overall and on a constant currency basis they were up
10%. As noted above, retail comparable same store sales grew 15% in
Europe. However, I wouldn’t get too excited. Let’s recall that 70-75% of
its business is in Northern Europe and the TH brand is very strong in
Germany.
It was a more conventional story at Calvin Klein. Total revenues were
up 4.7% but the strength was in North American retail. Asian sales grew
6% but Europe declined 10%. Management pointed to the weak performance
at European apparel and underwear, which is run by Warnaco $WRC
and licensing did well everywhere bar Europe. It’s easy to criticize
Warnaco but remember that, for example, 70% of the CK jeans business in
Europe is in Spain and Italy.
It’s not just Warnaco/PVH because VF Corp $VFC
has also reported weaker results with its Wrangler and Lee brands in
Europe. Similarly anecdotal evidence is suggesting that the Italian
retail environment is following Spain over the cliff. That said, it’s a
relatively small part of the business and management assured investors
that trading in August for CK and TH was running at 8-9% versus the
planned mid single digits.
The problem area is with the heritage brands. Overall sales were down
9.5% and EBIT margins are currently running at a paltry 6.4%. A major
turnaround plan is in process here and PVH has exited some businesses
(IZOD women’s and Timberland licensing) but it is going to take some
time. Nor was the cause much helped by J.C. Penney $JCP reporting weak performance in the second quarter. J.C. Penney, Kohl’s and Macy’s $M
are all key outlets for Heritage sales and investors should watch their
numbers for a clue as to where PVH’s Heritage business is headed.
Going forward J.C. Penney is opening a substantial number of IZOD
stores in order to turnaround disappointing performance and this augers
well for PVH. Similarly, Macy’s is a key license partner and gives PVH
good shop exposure as well as raising the brands cache. The idea is to
get margins back up to the historical 10%, but this may take some time.
It's nice when your channel partners are pulling in the same direction.
Where Next For PVH?
Aside from the turnaround planned at Heritage, PVH is also undergoing
some major changes in 2013. It is bringing its TH European men’s
tailored apparel and CK European apparel and accessories in house in
2013. Naturally, the management is feeling bullish about this but I
would suggest a note of caution here. I’ve previously seen fashion
licensees try to extract the last mile out of a relationship by taking a
‘by any means necessary’ approach to driving sales growth. This does
not always work out for the best for the license holder because some
near term damage can be done to the brand in this process. It’s hard to
say if Warnaco will do this or not but its something worth keeping an
eye out for especially as the company is possibly a takeover target of
PVH.
On that note, I would also expect some acquisition activity going
forward. PVH is not shy about talking about its acquisitive nature and
the TH purchase now seems to have been integrated. Moreover, debt has
been repaid quicker than hoped after the TH deal and management is
taking a ‘hard look’ at the acquisition landscape. Whether that means
Warnaco or not is another story but many expect some activity from Q4
onwards.
PVH Worth Buying?
The stock has had a great run and it’s hard to argue that it is cheap
right now. Its operating margins are lower than its peers but they
could improve with a turnaround at Heritage. However, this is far from a
done deal. Moreover fashion is fickle and the increasing reliance on TH
is a concern. It is a brand that has had its issues in the past. For
now the ‘affordable premium’ proposition that it offers is working well
in the new age of austerity but, as Coach found out recently, when a
competitor steps into your niche (in this case Michael Kors) things can get tougher. TH may aspire to be a brand like Hugo Boss but there is nothing to stop companies like the latter introducing cheaper product lines in order to react.
In a sense, I’m arguing that you need a margin of safety in an
industry like this and I think there are cheaper options (VFC &
Nordstrom) out there. I’m not sure that a forward PE of 15 or a low
single digit free cash flow yield is enough to argue that the stock is
cheap.
In a previous article linked here
I discussed some of the stocks that worked for my portfolio in the last
quarter. Now I want to review some stocks and articles that I have been
negative on. I’m aware that some people cannot tolerate any slight
perceived criticism over the stocks that they hold, but the mark of a
good investor is that of someone who has the discipline to always stay
objective when he (or she) is investing his hard earned money. So let’s
use the Fool community to try to help each other become better
investors.
Visions of China
The situation in China is concerning and I think the market is still
too complacent about the risks here. Forgive me but I am a (partially
reconstructed) free marketer. So while I can look at China and applaud
the productivity improvements generated by shifting resources towards
the the free market from collective control, I am also aware that it is
still a communist country whose rulers are more interested in staying in
power than anything else.
It is a country that weakens its exchange rate by printing its own
currency and buying US Dollars. This can create local asset price
bubbles. Let me put it this way, if you are flooding your markets with
your own currency (in order to weaken it) and your populace doesn’t have
a range of asset classes available to buy then is it any wonder that
this money will end up local housing speculation?
Joy Global $JOY is in a difficult position right now and
is being hit by a double whammy of US natural gas taking market share
from coal in electricity generation and moderating growth in China’s
fixed asset investment causing coal production to slow. In my opinion
these are structural problems and won’t be resolved in the near term. Caterpillar is
also exposed to heavy construction and its prospects will partly be
determined by how China manages to stimulate fixed asset investment in
future.
As for Vale and Rio Tinto $RIO,
both these stocks are classic mining plays on global growth and
emerging markets in particular. A lot of people miss the point that much
of Brazil’s (and Russia’s for that matter) growth is dependent on
supply China’s resource needs, so in a sense, Brazil is a play on
China’s growth. Rio Tinto has probably outperformed the others thanks to
its gold and silver operations but it’s not enough to cope with
declines elsewhere.
An Ugly Quarter for Technology
Many tech names got beat up over the summer and I was no stranger to
this with a couple of my stocks faring badly. Here are a few of the
stocks I’ve written about and made negative conclusions over:
The standout is Rackspace $RAX, which has performed well,
in line with the rest of the cloud computing sector. However, I still
have doubts. Top line growth may well be very impressive but for the
reasons articulated in the article I am cautious over the underlying
cash flow. I’m not convinced that this business is scalable. Moreover
the principle of outlaying substantive capital expenditures on gear with
high depreciation rates for customers whose demand can wane in the
short term is one that I am not comfortable with.
Facebook $FB
has had a troubled start as a public company. There is a difference
between liking a company or its service and liking it as an investment.
Frankly, I ‘unlike’ analysts dropping estimates in the middle of an IPO.
I unlike its prospects in dealing with the migration to mobile or that
it went public without really outlining a clear pathway to generating
revenues from mobile. And above all, I unlike the fact that Zuckerberg
seems to want carte blanche usage of users’ data and information and yet
comes across as one of the most guarded CEO’s I have ever heard on a
conference call. Of course if you don’t like it, there is a solution:
Don’t buy the stock.
On a more consensual note, I think most people would agree that Hewlett-Packard $HPQ
is facing some very difficult issues in its core markets of printing,
pc’s and notebooks. It is also not a dominant player in storage and the
Autonomy acquisition has disappointed and threatens to use up even more
of the management resources. This is going to be a very tough turnaround
for Meg Whitman to pull off. There is a huge amount of debt on the
balance sheet and free cash flow declined in the last quarter. Its end
markets are hugely competitive and it’s difficult to see what
divestitures it could make that would attract healthy prices.
Nokia$NOK
is another former tech champion fallen on hard times, but I confess I
think the outcome could be happier here. It has a very strong balance
sheet and a strong brand name in key emerging market economies. The
challenge is to find a way to reduce operating income declines. Nokia’s
balance sheet does give it some time on its side in order to
restructure. For those who think that a takeover bid for the company is
unlikely because a deal doesn’t make sense, I would point out that not
all cash-flush IT CEO’s make sensible deals! I would also observe that
it would fit very well with a Chinese company looking to buy market
share and strip down the cost structure.
Value Outs Itself
One thing I’ve observed is that value based defensives seem to have
done well in the markets despite little positive earnings news flow.
Kellogg $K
looks challenged by a weakening cereal category and from some poor
execution issues. It is very hard for food companies to take pricing in
developed markets in this environment; throw in rising prices for food
stocks like corn and you have a perfect margin squeeze. Kellogg’s last
quarter wasn’t particularly good and it guided lower than analyst
estimates. However, the outlook appeared to get a bit clearer and the
stock went higher. Right now, the market is rewarding good yielding
stocks with perceivably stable earnings even if they are not performing
particularly well.
It is a similar story with Campbell Soup Company $CPB, or even in technology with Cisco $CSCO,which is trying to morph into a value proposition.
There is a lesson to be learned here. Investors are very keen on
yield in this environment, even if the companies paying it are not
performing particularly well. Whether this will work going forward is
open to question but an investor looking to diversify his portfolio and
his investment style will take heed. Value will out itself.
I’ve been writing for the Fool for a few months now and I thought it
would be interesting to make a review of articles and performance. Now I
know what you want to know, but my overall portfolio return is a bit
meaningless to most because I follow a leveraged and hedged (short
indices not stocks) strategy. For the record I’m up 38% on the year but
the last quarter has been slightly negative. I’m going to talk about the
long side of the portfolio and specifically stocks that I have written
about before the end of May. I very much enjoy writing these articles as
they help me to clarify thoughts and I (hope) become a better investor
while sharing some ideas. I write them as a kind of investing journal.
In summary it has been a bit of a frustrating quarter. On the
positive side I’ve been slightly overweight housing and avoided the
slump in mining, commodities and anything else China related. The
defensives have held up well and my overweight on health care has paid
off. On the negative, a few tech stocks have fallen sharply without
actually delivering anything traumatic in their results. For example Check Point Software $CHKP
hasn’t seen estimates lowered at all recently and I think the market is
overly focusing on its declining product sales growth while ignoring
the fact that its software blade sells and doing very well.
F5 Networks $FFIV grew product revenues over 15% in the
last quarter and is generating bundles of cash. No matter the market
just seems to think that technology should be sold off in a broad brush
when growth starts to weaken. It doesn’t matter that the primary growth
drivers for both these companies are secular. Namely, criminals trying
to penetrate IT systems and the growth of smart phone usage and
bandwidth demand.
With that said, in the rest of this article I will focus on the
stocks that I’ve been pleased with. I will follow up with another
article on the negatives avoided in the quarter, the mistakes, the
stocks that got away and some opportunities out there
The Good
These are the stocks that I am happy with. As a rule and for
disclosure purposes, the stocks in these tables in bold are the ones I
hold now. The stocks in bold italics are those that I have held recently
but no longer hold.
Sirona Dental Systems $SIRO is a little known and
discussed stock. For the life of me I don’t know why! It offers good
exposure to ageing demographics and is in a sector of health care
without significant reimbursement issues. Its CEREC Cad/Cam technology
is game-changing and still operates with low penetration rates. Long
term growth looks assured.
I’ve written a lot about Nordstrom $JWN
and I think the company is extremely well run. We all know that the US
mass-market consumer is being more frugal and moving towards shopping
online. Nordstrom’s response? Well, the company is investing
aggressively in its online presence and in its lower priced Rack stores.
Meanwhile it continues to execute well in its legacy stores. It all
makes sense and I like the way the company is adjusting to the new
retail reality. I am looking for a re-entry point.
I continue to hold IT security company Fortinet $FTNT.
This is a play on the rise of cyber crime but it is also a ‘trading
down’ play in my opinion. Its unified threat management (UTM) solutions
are typical sold to the SMB and mid-market customer. In this environment
I think the mid-market may well be moving down to Fortinet’s options as
the company is increasingly demonstrating it can service them too. The
other thing to like about Fortinet is that it maybe a takeover target.
It’s highly cash generative, sells to a core market that many large IT
companies don’t service and it has the kind of growth rates that the
likes of IBM $IBM and Cisco $CSCO can only dream of.
No One Ever Lost Money Taking a Profit
Two stocks that I no longer hold are Equinix $EQIX and Cal-Maine $CALM.
These two couldn’t be more different. Equinix is a data center company
with very strong underlying cash flow and very high client retention
ratios. The sector has been on fire this year and I’ve also benefitted
from holding Telecity in the UK. My reasons for selling
both are purely that on a risk/reward basis they are both fully valued
right now. Every data center company that I look at (including Equinix)
is aggressively ramping up capacity and at some point I can’t help
thinking that over-capacity could ensue. I don’t know when or if this
will happen, so all I can do is set a price target with a margin of
safety. Equinix’s price is way above that now. Was I too conservative?
Well, no one ever lost money by taking a profit.
Turning to Cal-Maine, this company is the largest US producer of
shell eggs. I like this company a lot but am a bit concerned by the
threat of corn price hikes following inclement weather. In the long run,
higher corn prices might be a good thing for Cal-Maine but markets might not see it like that in the near term.
Housing Overweight Pays Off
The last three are all US housing related stocks. I’m happy to be overweight this sector and think there is more to come. Wells Fargo $WFC offers
exposure to housing because it has been gradually increasing its US
mortgage exposure over the last few years. In addition, US households
have tidied up their balance sheets significantly and many measures of
credit quality are running at multi-year lows. As a financial it will
also offer upside if sentiment changes of the Sovereign Debt issues in
Europe.
I’ve written a lot about Home Depot $HD
and think the stock remains good value. It’s only recently that the
company started talking about a recovery in housing and the scene looks
set for Home Depot to start decoupling its top-line growth from GDP type
growth. In addition, it has a very strong market position and is
undergoing initiatives like increasing its own brand sales in store. I'm
also a fan of lighting company Acuity Brands $AYI. It
offers a combination of upside exposure to US residential and commercial
construction and there is the long term kicker of growing LED adoption
spurring sales growth.
Usually when companies give results and the stock price gains a few
percentage points there is a good reason. However, I’m struggling to see
what was so exciting about H.J.Heinz $HNZ
last earnings. In summary, outside of emerging markets the growth
numbers were pretty anemic. Heinz operates in some difficult markets and
on closer inspection there are some surprising things in this report
which need to be considered before investing in this yield play.
Headline EPS Good but Why?
The headline EPS growth number of 10% is superficially impressive but
it is made up of some beneficial movements in taxes and a $40m
productivity charge taken last year made the comparable easier. In
reality, gross profits only rose 1.9%. Headline sales growth decreased
by 1.5% but organic sales growth was up 4.8%. Of course, the reason for
the discrepancy is down to currency effects and specifically the fact
that emerging markets growth grew 19.3% on an organic basis and now
represents 26% of company sales.
On a brighter note, gross margins increased with productivity
improvements and pricing increases overcoming commodity inflation.
Management talked about margins building significantly throughout the
year. Whilst I can buy this argument with the regards the softening of
certain soft commodities, I am not so sure about consumers taking
pricing. US shoppers in particular are becoming very price conscious and
companies have found it very difficult to make prices stick.
Moreover, the US and Europe (another region becoming increasingly
price conscious) only make up 55% of sales but crucially they contribute
78% of operating income.
So let’s not get too excited about the idea of relying on emerging market growth.
North American Challenges
Putting aside emerging markets for a moment, let’s consider what is
going on in the US food industry. It seems to be a kind of revolving
door game with mass market consumer products. A company increases
pricing, it then loses market share but gains a bit on margins. Then it
decides to spend some of that margin gain on promotions and discounts,
it gains market share back but then loses margins. And back we go to
square one. Frankly, I don’t think Heinz is immune from this cycle and I
note the ramp in marketing spend due in Q2.
Furthermore, the commentary from rivals has not been particularly positive. I have a more detailed information on Campbell Soup $CPB in an article linked here.
Not only is top line growth hard to come by but its earnings growth is
challenged too. Much of this is to do with soup being a weak category
right now and I note that Treehouse Foods $THS reported weak numbers and is closing some soup operations.
Soup may be out of fashion but all these companies have to deal with
another damaging trend. US consumers are increasingly doing more of
their grocery shopping in discount and ‘dollar stores’ and this marginal
shift is hurting food companies with traditional strength in the
conventional groceries. Even Treehouse –traditionally seen as a
‘trading down’ play due to its private label focus- is suffering as it
has to shift to alternate retail channels. Moreover, customers are being
more frugal and want smaller size portions.
Readers will be as surprised to see that North American Consumer Product organic growth of .9% was less than
the 2% organic growth recorded in austerity laden Europe! These numbers
might be skewed with the inclusion of a BRIC (Russia) in the European
numbers and the ongoing and genetic obsessive compulsive disorder that
the British have with Heinz baked beans, but it still tells you a lot
about how difficult conditions are in the US consumer food sector.
Again, I think a certain amount of skepticism need be applied to the plan to increase US pricing.
Pockets of Growth
Heinz’s management drew attention to its ‘trio of growth engines’
namely global ketchup, the top 15 brands and emerging markets. I think
this emphasis says a lot about the direction of the company.
Ketchup and Sauces now make up 47.3% of total revenues and with
divestitures elsewhere (frozen desserts) plus slowing sales growth in
other categories, the management is focusing on growing this powerful
brand. This is a good as in slow economic times you probably want your
companies to focus on their core products rather than chase category
expansion.
While conditions are tough in Europe and the US, emerging market
growth looks assured. It strikes me that the emerging middle classes in
the BRICS are going to seek out aspirational everyday brands like Heinz
in a similar way to how they are willing to Yum! Brands $YUM)
has been able to aggressively grow sales in China. Traffic and same
store sales growth are both doing well in China. Speaking of YUM, it was
able to buy the extremely popular Little Sheep Group. I had some
dealings with investors in this company and I can affirm that it is
phenomenally popular in China. In the same way, Heinz bought Chinese
company Foodstar (Soy Sauce) in 2010 and investors might expect more
acquisitions as Heinz needs to chase growth.
The food sector could be one of the best ways to play emerging
markets going forward as the slowdown appears to be focused on the
industrial side. Worker’s wages continue to rise and so does the
expansion of the middle class. That said McDonald’s Corp $MCD
recently reported weak sales trends in China. While reasons for this
are difficult to discern, other fast food companies are reporting good
growth. Nevertheless, potential investors in Heinz should watch
McDonald’s commentary very closely, particularly with regards emerging
markets.
So,Where Next For Heinz?
In conclusion, Heinz is a well-run company with good prospects in the
BRICs but near to mid-term challenges in developed markets. Going
forward the company is forecasting 4% organic sales growth, EPS growth
of 5-8% in constant currency and operating cash flow of $1bn for 2013.
Frankly, it’s hard to put these numbers together and reconcile that
Heinz is cheap. The yield of 3.6% is certainly attractive but, when was
paying nearly 20x current earnings for single digit earnings growth an
example of a cheap company? Moreover, forward FCF/EV is around 4.6% and I
don’t think that is cheap for a low growth food company, especially as I
am a bit skeptical about any company looking to take pricing to the US
consumer right now.
That said yield chasers will like the stock and the relative
stability of its earnings and this type of stock is in fashion. The
stock does deserve a premium due to its excellent management and it
wouldn’t surprise me to see it go higher but as a GARP based investor, I
am going to take a pass
As a financial blogger it’s always useful to keep a watch list of
stocks for readers to keep an eye out for. I love reading others' lists
and seeing if there is anything interesting I hadn’t thought of on it. I
tend to favor growth at reasonable price (GARP) investing so the
majority of the stocks in this article will be GARP candidates.
With this in mind I decided to do a mini-review of some of the stocks
I’ve been writing about. You can find the stocks that did well linked here and the bullets I dodged linked here.
In this article I want to focus on the ones that got away, my
regrets/opportunities and the stocks that I liked but thought were too
expensive.
The Ones That Got Away
These are stocks that I have written positively about and liked but
for some reason haven’t got around to buying. They have actually done
quite well. I have no excuses here. This is purely down to either
indolence or me trying to be ‘smart’ by waiting for a dip. The lesson
learned here is that if you like a stock and its valuation then just go
ahead and buy it. Leave market timing to the gamblers.
I like Google $GOOG
and think the company is managing the transition to mobile internet
usage very well. Its dominant position in mobile search plus its
integrated services across many platforms will enable it to continue to
generate strong growth and huge cash flows for years to come. I think
the trend towards e-commerce is inexorable and crosses national and
cultural factors.
Maybe it’s because I use Adsense in my blog that I can see that North
American ad revenue per user tends to be higher than anywhere else.
However, there is no reason why other countries can’t and won’t increase
these metrics to close to what North America does. All of which spells
huge growth potential for Google, and I think long term prospects are
excellent.
Church & Dwight $CHD
is a stock I’ve held and sold out of when it hit my price target. It
dipped recently on a relatively poor set of results but I think its
‘recession proof’ story remains compelling. The poor performance was
actually limited to one product line (Orajel) and the company believes
it has rectified the situation through product innovation. Management
did not lower internal forecasts. Such conditions usually create buying
opportunities but alas I wasn’t quick enough to catch it.
With regards Discover Financial Services $DFS I was
hoping to catch a dip and for some reason it slipped off the radar for
the few early days in June when it did. I missed it and it has surged
ever since. V.F.Corp $VFC is different tale but emanates
from the same desire to be too smart. I like the company a lot but I
tried to guess some weakness in an upcoming report which might then have
created a good buying opportunity. They raised guidance. Enough said.
It’s been a tough summer for technology, and holding Check Point Software $CHKP and F5 Networks $FFIVhasn’t
been my finest hour. However, I happen to believe that both are
undervalued and took the opportunity to buy some more. At some point
sentiment will change. We all know that tech faces some economic
headwinds but I simply don’t believe that holding a stock (Check Point)
that generated 9% of its current enterprise value (EV) in 2011 and has
double digit growth prospects is a bad idea. Similarly, despite some
caution from its customers, F5 Networks is still set for high teens
earnings growth. Sticking to the cash flow theme, by my calculations it
has just generated 6.1% of its EV in free cash flow. Does it really
deserve the trashing the market has given it?
The story at CVS $CVS is one that I believe demonstrates how short term the market can think sometimes. Somehow the fact that Walgreen $WAG and Express Scripts have
resolved their difference has created a catalyst whereby every money
manager shifts out of CVS and into Walgreens because that is the ‘hot
money’ trade. Frankly, I think they are wrong. Don’t underestimate
customer inertia; once a customer shifts to CVS I think they will do
everything they can to keep him/her. The company is indicating 50%
retention of the customers that shifted over but my hunch is that there
will be some upside to this number. Moreover, the stock is well placed
to increase margins via higher sales of generics and private label
products.
Interestingly, Allergan has had a pullback and it could be time to take a close look again. TJX Companies $TJX is
a super company and a great way to play the ‘trading down’ trend within
clothing and home ware. The company is executing on all fronts but it
does look fully priced in for now. The sector isn’t without competition
and, when stocks have this kind of run, any disappointment will hit them
hard.
Perrigo$PRGO
is another story that has really captured investors’ attention. Private
label OTC health care and nutritional products (as mentioned above with
CVS) are categories that will experience strong growth for years to
come. Unfortunately, I think it is more than fully priced into Perrigo’s
share price. I see no reason to pay an EV/EBITDA multiple of 15 for
this stock, despite how attractive it is.
