Wednesday, October 31, 2012

Roper Industries, The Best Run Company in America?

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?

Pall Corp Earnings Analysis

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.


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.

Data Center Spending Stocks

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.

Tuesday, October 30, 2012

Is Verint the Next Big Data Play?

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.

Monday, October 29, 2012

Kroger Is Facing Challenges

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.

Intel Lowers Guidance

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.

Wednesday, October 24, 2012

Hot Health Care Stocls

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.


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 Delivers Weak Results

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.

Monday, October 22, 2012

VeriFone Offers Growth but a Bumpy Ride

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's Prospects

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.

Mead Johnson is the only pure play. Danone’s baby nutrition sales make up about 20% of its total sales even though they increased 13.6% on a like for like basis in the last quarter. Volumes were up 7% and I suspect it took market share from Mead Johnson. Danone’s Dumex is a brand leader in China in infant formula and the company is historically strong in EM. This is even better news when you consider that baby food in Asian markets tends to have higher margin than in developed markets. NestlĂ©’s deal with Pfizer gives it an immediate high single digit share in China and as Pfizer’s former infant nutrition business had over 80% of its sales in EM it has also given it strength there.

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.

Ciena Equity Analysis

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.

Wednesday, October 17, 2012

Can PVH Continue to Outperform?

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.

Stocks Worth Avoiding?

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?

I’ve been negative on the China related plays.

Stock Link Return Since Article
Joy Global JOY Link -28.8%
Caterpillar CAT Link -16.1%
Vale VALE Link -26.8%
Rio Tinto RIO Link -17.8%

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:

Stock Link Return Since Article
Facebook FB Link -35.5%
Hewlett-Packard HPQ Link -25.6%
Rackspace RAX Link  12.3%
Nokia NOK Link -27.4%

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.

Stock Link Return Since Article
Kellogg K Link 1.7%
Campbell Soup Company CPB Link 8.7%

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.

Monday, October 15, 2012

Portfolio Review

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.

Stock Link To Original Article Performance Since Article
Sirona Dental Systems Sirona Link 5.3%
Nordstrom Nordstrom Link 4.2%
Fortinet Fortinet Link 12%
Equinix Equinix Link 23.6%
Cal-Maine Foods Cal-Maine Link 12.5%
Home Depot Home Depot Link 9.6%
Wells Fargo Well Fargo Link 3.8%
Acuity Brands Acuity Brands Link 10.8%

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.

Heinz Equity Research and Analysis

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

Sunday, October 14, 2012

A GARP Portfolio Review

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.

Stock   Link  Return Since Article
 Google  GOOG Link  17.3%
 Discover Financial Services  DFS Link  13.5%
 Church & Dwight  CHD Link  4.3%
 V.F. Corp  VFC Link  10.3%

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.

Regrets & Opportunities

Stock Stock Link Return Since Article
Check Point Software CHKP Link -23.2%
F5 Networks FFIV Link -27.2%
Equifax EFX Link      .1%
CVS CVS Link     -.2%
Riverbed RVBD Link      .2%

It’s been a tough summer for technology, and holding Check Point Software $CHKP and F5 Networks $FFIV hasn’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.

Good But Weren’t Cheap

Stock Stock Link Return Since Article
Allergan AGN Link -7.6%
TJX Companies TJX Link 9.8%
Estee Lauder EL Link 1%
Perrigo PRGO Link 6.4%
Novo Nordisk NVO Link 7.2%
Cree CREE Link -6.5%

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.