Monday, December 30, 2013

Cooper Companies Offers Great Long Term Prospects

In a world where investors make knee-jerk reactions to the latest quarterly earnings reports, it's sometimes difficult to focus on the long term. In the case of the soft contact lens industry, Foolish investors are faced with an industry with pretty secure long-term growth prospects. The only significant players are Johnson & Johnson and Novartis'  Ciba unit, with Cooper Companies  coming in third. Meanwhile, Valeant's  2013 acquisition of Bausch & Lomb puts it in fourth place. Cooper is the closest to a pure eye-care play among them, and it presents an interesting proposition for long-term buy-and-hold investors.

Cooper Companies' long-term growth
According to independent analysis, the soft contact lens industry is intended to grow at a rate of nearly 6% from 2012-2016. Indeed, Cooper companies reported that worldwide industry growth was at 5% this year. However, its CooperVision unit (around 80% of revenue, with CooperSurgical making up the rest) reported soft contact lens sales up at a more impressive 10% this year.

Essentially, CooperVision has the opportunity to grow faster than the market for four key reasons.

First, Cooper's silicone hydrogel (more comfortable, longer-lasting) lens sales grew at 19% (constant currency) in the fourth quarter, and are set to grow faster than the market. Moreover, since silicone hydrogel lenses make up 45% of its CooperVision's total revenue, Cooper can grow ahead of the market. In particular, its Biofinity (monthly, silicone hydrogel) lens has a growth opportunity in the US from customers trading up.

Second, industry wide single-use lens sales grew at 10% over the last 12 months, and CooperVision's single-use lens sales increased by 18% (constant currency) over the last year. They made up 21% of CooperVision sales in the fourth quarter. Going forward, Cooper is gearing up for an aggressive expansion of its MyDay (daily, silicone hydrogel) lens in Europe. Customers trading up to its single-day lens generate four to six times more revenue and three to five times more profit. In other words, Cooper has a revenue and margin expansion opportunity with MyDay, but it will take a few years to come to fruition.

Third, Cooper's specialty lenses (toric and multifocal) grew at 8% and 19% respectively in the fourth quarter, and now contribute nearly 40% of CooperVision revenue.

Finally, CooperVision's Asia sales grew at 11% (constant currency), and Cooper's management claims to have good growth opportunities with its Biofinity lens.

All told, it's not hard to see why analysts have the company growing revenue at more than 7% for the next few years.

Johnson & Johnson, Novartis and Valeant report
With a 43% share of the market, Johnson & Johnson is the No. 1 player, but its growth in the third quarter was a far more pedestrian 3.9% (constant currency). Moreover, its U.S. sales only grew 1.9%. Johnson & Johnson has a dominant market position in the two-week modality in the US and this may prove difficult to defend in future, as single-usage lenses gains popularity. 

Novartis operates Ciba Vision (25% of total market) out of its Alcon division, and its contact lens revenue was up 6% (constant currency) in the third quarter with growth driven, unsurprisingly, by its daily lenses and silicone hydrogel lens called AirOptix. Meanwhile, Valeant's Bausch & Lomb (9% market share) launched a one-day lens this year, but the parent company's main focus is on integrating the eye-care company and cutting costs. Indeed, Valeant is expected to reduce Bausch & Lomb's workforce by up to 15% going forward, while it seeks to expand internationally.

In a sense, Cooper's growth prospects (single-use, silicone hydrogel and international expansion) are nicely mirrored in what its rivals are saying too.

Cooper's bumpy growth
While Cooper's prospects look assured, the growth ahead won't be in a straight line. For example, management was very clear on the conference call that it was willing to invest in building out capacity for the growth of MyDay. According to CEO Robert Weiss:

 it is unlikely we will be making profits on MyDay in the next several years with the intent of continuing to develop that franchise, continuing to drive down cost of goods... ...capacity increases behind the product once we come to the U.S. and then... ...other markets around the world

Ultimately, it's not clear how this will affect profitability over the next few years. Moreover, international expansion comes at a cost, and Cooper predicts capital expenditures at a historical high of $200 million (nearly 12% of projected revenue) for next year.

A look at its historical performance demonstrates that Cooper can grow revenue in a recession (note its 2008-2010 performance) and its adjusted free-cash flow (calculated by assuming capital expenditure is equivalent to depreciation) is quite strong.

Sources: Company presentations, author's estimates.

Time to buy Cooper Companies?
Cooper's aim is to hit 25% operating margins by 2018. Assuming it does so, and revenue grows at 7%, then operating income is likely to be $560 million or 71% higher than it is now. In other words, operating income looks set to grow in excess of 11% a year compounded.

That's not astonishingly cheap for a company generating around 4.4% of its enterprise value in adjusted free-cash flow. However, Cooper is a relatively recession-resistant company, and Foolish investors should be willing to pay a premium for this quality. It's a good stock for long-term investors, but don't expect the ride to be plain sailing all the way.

Thursday, December 26, 2013

Cisco Sneezes, So Will Ciena Catch A Cold?

Cisco  reported a weak set of results recently and gave even poorer guidance, so telco investors must have had a certain amount of trepidation over Ciena's  earnings. In the end, Ciena's recent fourth-quarter revenue topped analysts' expectations, but missed on earnings.  In addition, the guidance was slightly weaker than analysts expected. The market immediately sold the stock off. Does this mean the telco industry is set for another year of AT&T  and Verizon  trying to ruthlessly cut back on expenditures? And is Ciena's status as the "go-to" play in telco under threat?

Ciena misses, but not by much
The "Cisco effect" was always going to hang over Ciena, but the market looks to have been a little harsh in marking Ciena down nearly 7% after the results. While revenue of $583.4 million was ahead of estimates, non-GAAP earnings per share of $0.16 was below analyst estimates of $0.24. Moreover, the midpoint of its first quarter revenue guidance of $515 million to $545 million was below analyst's consensus of $537.7 million. Time to get nervous?

It's not time to panic with Ciena
First, telco spending is notoriously lumpy, and in any case, the midpoint of first quarter guidance is only 0.7% lower than analyst estimates!

Second, Ciena beat revenue estimates in the fourth quarter, because of "expected deployments on one of the large international network builds that we referred to last quarter," according to its management. While this will obviously help revenue, it possibly hurt margins due to the razor/razor blade model that Ciena's management referred to on the conference call. This kind of model tends to generate lower margins upfront, but larger ones as customers start buying more "razors."

And finally, don't read too much into the Cisco-Ciena analogy. Cisco saw specific weakness in emerging market spending, and has a far greater exposure to older technology spending than Ciena does. In fact, Ciena's great strength is its exposure to next-gen networking technologies like 40G and 100G Ethernet networking and Optical Transport Networks. So while Cisco is exposed to overall telco capital expenditures, Ciena can prosper as long as telcos are spending in the areas where Ciena is strongest. Indeed, this is why Ciena outperformed much of the sector in 2013.

AT&T, Verizon, and international carriers
The Cisco-Ciena analogy also breaks down when looking at the geographic mix of revenue. Starting with domestic revenue, analysts spent a fair amount of time on the conference call questioning Ciena's management over the outlook for North America. Clearly, AT&T and Verizon will loom large in the picture.Ciena's management declared that it felt "very positive around what's happening in North America", and of the major carriers "said simply, we will do more business with them in 2014 than we did with them in 2013."

Again, investors need to appreciate that telco spending is always lumpy. For example, Verizon's $130 billion deal to buy Vodafone out of its wireless business in the US could cause Verizon to temporarily pause some spending in the near term, but it will also enable Verizon to invest more in its wireless networks without having to share profits with Vodafone.

Moreover, Vodafone will get a lump of cash with which it can invest on upgrading its network. Indeed, Ciena has signed a "global supply partnership" with Vodafone, and also expects " that they will become increasingly a larger customer for Ciena." In other words, it could be a short-term negative but long-term positive outcome for Ciena.

In addition, AT&T's spending is also somewhat contingent on how quickly its project VIP (a plan to 4G/LTE to 300 million points of presence, or POPs, by 2015) will progress. At the time of its recent results in October, AT&T looked to be well ahead of plan with 250 million POPs already achieved. It's reasonable to expect spending to be tempered in accordance with where it is in the plan, but AT&T also announced that it was " strengthening our financial structure and our balance sheet to give us the ability to invest and maintain financial flexibility". Companies don't do such things when they are inclined to slow long-term spending.

And finally, while Cisco is seeing weakness in emerging markets, recall that Ciena is more exposed to newer technologies. Indeed, there is a "greenfield" opportunity in many emerging markets to roll out next generation networking rather than spend on maintaining existing networks. In contrast to Cisco, Ciena's management declared itself "encouraged by markets like Brazil, and India, and Russia, and the Middle East."

Where next for Ciena?
In conclusion, Ciena has good prospects going forward, but don't expect its revenue and earnings not to be lumpy from quarter to quarter. Then again, you shouldn't be buying medium-sized technology companies if you can't handle volatility. As long as the global economy remains in growth mode, then Ciena has good prospects next year.

Tuesday, December 24, 2013

Verint and NICE Systems, a Cheap Way to Buy Big Data Stocks

Investors in Verint Systems  and its rival NICE Systems  have gotten used to some pretty solid performances in 2013. The two companies specialize in systems that capture and analyze customer and employee interactions. With the growth in data analytics that companies like NICE's partner IBM is seeing, you can expect both Verint and NICE to find it a lot easier to sell analytics as part of their packaged solutions (which is exactly what is happening.) Moreover, the shift toward analytics looks likely to favorably adjust their long term growth rates.

Verint Systems beats and raises
The recent third quarter results from Verint saw the company beat estimates and raise guidance.

  • The full-year revenue growth forecast was increased to 6.5%-7.5%, up from 6%-7% previously.

  • Full-year EPS guidance was raised to $2.75-$2.80. 

  • 2015 revenue and diluted EPS guidance were projected at of 7%-9% growth.

Verint differs from NICE by focusing more on security and government work, while NICE's strength lies in the enterprise (particularly in the financial sector) and call center markets. As such, the two Israeli companies will inevitably be discussed as merger candidates. The differences also mean that they report some contrasting results at times. Looking at Verint's quarter in detail, the standout performer was Verint's communications intelligence segment which recorded 30.6% revenue growth.

Source: Company presentations

If there was a disappointment, it was with the 3.3% rise in enterprise intelligence revenue. Verint's management argued that this was a consequence of weakness in Europe, because its Americas enterprise business was up "mid to high single digits."

NICE and Verint grow data analytics
Both companies are seeing growing analytics sales. The two already have an installed base of clients with their hardware solutions, so it's relatively easier for them to sell larger deals with analytics incorporated into the deal. Indeed, this is part of the reason why IBM has a deal with NICE, that involves incorporating its big data analytics within NICE's solutions.

The big advantages enjoyed by these companies is that their customers get to buy analytics and customer interaction capture systems (voice, video, online, and similar options) from one vendor. However, Foolish investors should note that the shift is changing some of the operating metrics.

  • Verint confirmed that it is seeing stronger average selling prices as its solutions are increasingly being sold with analytics.

  • Sales cycles appear to be getting longer as deal size and complexity increases.

  • Solutions that include analytics software are likely to see a trade-off between short-term revenue generation and longer-term service and support revenue.

  • Margins and cash flow should improve going forward as software tends to be higher margin.

Many of these factors are already playing out in Verint's results. During its conference call, Verint's management outlined that its operating cash flow would be around $160 million for the full year, and "we expect that cash flow to grow kind of commensurate with the earnings growth that we outlined in our guidance."  Assuming capital expenditures of around 1.8% of revenue (a conservative estimate) suggests that free cash flow generation will be around $144 million and $154 million for the next two years. These are impressive figures, especially given that its enterprise value (market cap plus debt) is only $2.28 billion.

Eagle-eyed readers will note that Verint's guidance implies no increase in margins next year, despite it selling more software analytics solutions. When pushed on the issue on the conference call, CEO Dan Bodner replied:

Our guidance is 7% to 9%... ...we are aiming at double-digit growth. So the trade-off here is between leverage that obviously exists in the software business and investing more organically to accelerate growth. And at this point, this is our initial guidance.

In other words, don't be surprised if Verint trades off its margin expansion in the near-term to generate stronger growth in future.

The bottom line
In conclusion, this was a pretty strong report from Verint. Along with NICE Systems, it represents a relatively cheap way to play the big data trend. These companies aren't over-researched glamor stocks, and I think this makes them even more interesting for Fools to look at. With a P/E ratio of 13.4 times 2014 estimates, Verint remains a good value.

Monday, December 23, 2013

Why Ackman and Icahn could both be right about Herbalife

The Carl Icahn vs. Bill Ackman spat over Herbalife    was probably the most entertaining public feud in 2013. It's very rare that two high profile investors go head-to-head in this manner. Moreover, in doing so, they put their reputations at risk in a very public manner. It's difficult not to conclude that Icahn has come out the winner in 2013. Herbalife's stock is up over 130% this year, and Ackman's short position has hurt his fund. However, is it possible that both investors are right?

What matters to direct-sales companies
Herbalife belongs within a class of companies that use a direct-sales model. In other words, they rely on local representatives to generate their sales revenue. There is nothing new about this model. In fact, Tupperware Brands parties and rictus-grinned Avon Products  ladies knocking on the door have become part of most Americans' vocabulary. In addition, Nu Skin Enterprises a stock up more than 250% this year) and Herbalife are rapidly acquiring household awareness.

All these companies critically rely on their representatives to generate sales. Nu Skin can talk all it likes about the science behind its skin-care products and Herbalife can wax lyrical about the benefits of its nutritional products, but if their sales distributors aren't motivated then their businesses will fail. Keeping representatives happy isn't easy. For example, Avon has been forced to fundamentally restructure its sales organization after some disappointing performance.

The bottom line is that these businesses don't solely rely on the intrinsic value of their products. The good news is that having products targeted at growth industries such as skin care (Nu Skin) and nutrition (Herbalife) is obviously going to inspire distributors and their customers. In addition, Tupperware has gone to great lengths to expand into emerging markets, therefore tapping into a new distributor base to offset its slow growth in North America.

Enter George Soros
Ackman's short arguments on Herbalife center around the lack of intrinsic value of its products (he cited poor price comparisons for Herbalife products on eBay),  and his belief that the company is structured to sell products to its distributors. He may well turn out to be right!

However, the entry of George Soros as an investor in Herbalife goes a long way to help explain why -- even if you are sympathetic to Ackman -- it's dangerous to short in this sort of situation.

Soros is best known for his theory of reflexivity, and how it causes investment bubbles. The basic idea is that pricing movements generate feedback loops into earnings, which then encourage higher pricing. A bubble is formed, which then collapses when a tipping point is reached.

The key point to understand here is that the positive effect on earnings from the feedback loop makes the stock look fundamentally cheap. In other words, this isn't about a stock reaching a sky high valuation! In fact, the stock will look a great value. Confused? I will try and explain what could happen with these direct sales companies and their distributors.

How the bubble might burst, but not when you are shortSay, for example, a listed direct sales company launches a new product that captures distributors imagination. It could be anything. Perfume, laundry powder, skin cream, nutritional tablets or whatever.

Sales start slowly and hit a $1 million a year, the company trades on ten times earnings or $10 million, and has had steady 5% growth for a while. So its P/E ratio is 10, and its PEG (PE divided by growth rate) ratio is 2.

Suddenly, the product starts to accelerate sales, a buzz forms around the product and more distributors are recruited. Sales go up 20% for the company, as does its earnings. A sober and conservative analyst produces a report stating that its growth rate is now 20%, with projected earnings of $1.2 million.

He goes on to argue that if it trades on its previous PEG ratio of 2, and its growth is 20%, then the 'correct' P/E valuation should now be 40 times earnings. So, now its valuation should be $48 million instead of $10 million. Remember what I said above about the fundamentals looking cheap?

After a while, the product's popularity starts to peter out. New distributors find it tough to become profitable. Sales start to slow again, then suddenly everyone is looking at their stock holding in a company on a valuation of current 48 times earnings with a 5% growth rate again. The stock crashes. It could even be on 20 times earnings and still be very expensive at this point.

Again, the key point is that Herbalife, Nu Skin and the others all have a critical reliance on their ability to recruit and maintain distributors. The problem is that no one rings a bell when the crash is about to come, and you could find yourself shorting a stock that just moved from a valuation of 10 times earnings to 48 times.

Why Ackman and Icahn may both be right
If this is the sort of scenario (and I stress "if") that awaits Nu Skin and Herbalife, then investors need to consider what stage these companies are at in this process. Are you buying/selling it in the middle of the bubble-like euphoria? Do you really want to short a stock during this strong momentum phase?

Ackman and Icahn may both turn out to be right. Icahn may end up being lauded for riding the stock higher and getting out early. Ackman could be feted for sticking to his guns while he waits for the inevitable collapse. If this scenario is correct, then the only ones not winning any prizes will be the long-term investors who are stuck in their positions after the possible collapse.

Friday, December 20, 2013

Time to Get Bullish on Toro?

The logic is simple: if you buy the housing recovery, then you should buy a recovery in spending on landscaping and gardening. In other words, companies that make landscaping equipment like Deere   or Briggs & Stratton  should be on your radar screen. If you also like the demographics behind golf, then a stock like Toro   will loom large in your thinking. It's time to take a closer look at all three.

Bullish on Toro
A quick look at its revenue by geography shows that 70% of Toro's revenue comes from the US, with Europe providing 12% and Asia 4%. In other words, Toro is still very much a North American play. Furthermore, a breakdown of its segment revenue demonstrates that golf landscaping, residential gardening, and professional landscaping are its key end markets.

Essentially, Toro is a cyclical stock but there are good reasons why it can outperform in the current environment.
First, its residential lawn and garden segment is obviously tied to the housing market. Since this sector of the economy was at the epicenter of the crash, it's reasonable to expect it to behave in a super-cyclical fashion in the recovery.
Indeed, Home Depot and Lowe's have both reported stronger sales of garden equipment this year. Meanwhile, in October, Briggs & Stratton reported quarterly retail lawn and garden sales growth of approximately 50%. Although much of this is due to an easy comparison with last year's drought conditions, it's still a hefty increase.
Second, Toro's professional landscape and grounds business should see a lift in the future from new home construction. As new communities get built, the demand for amenities and infrastructure will go up as well. Indeed, Toro's management made some bullish noise on this segment in its recent conference call:
Toro continues to be added to many states and local government contracts. This helped increase our professional grounds business sales in 2013 and should bode well for business in 2014.
Deere may well have agreed to sell a 40% equity interest in its landscape business, but this is because the company is refocusing on its core agricultural business rather than a negative statement on the landscaping market.
Toro's profit-drive down the fairway
The third major revenue center is probably its most interesting. Golf is traditionally seen as a higher-income earner's pastime. While it's discretionary in nature, it's also affected by the weather. For example, there was a 5.7% increase in US golf rounds reported from 2011 to 2012 (in-line with an improving economy).  
However, in its recent results, Toro's management outlined that US rounds played for the year only declined 5%, even as there were 6.7% less days open for play due to poor weather. This implies that golfers are playing more rounds, and should weather improve next year, Toro could see some favorable comparisons.
Overall, it's fair to say that Toro's prospects -- and particularly those of golf -- are tied to movements in mean household income. For example, here is a chart of Toro's revenue versus US household income for the highest one-fifth. Note that the income numbers are in current dollars (what was recorded at the time), when in 2012 the dollars equivalent figure is actually down 4.1%. This is done because Toro's sales figures will be in current figures too.

Source: US Census of the Bureau, Toro presentations
It's a pretty strong correlation, although Toro probably saw some stronger years in 2003-2006 thanks to the housing boom. It also saw a far more severe downturn in 2009 as the world looked set to implode.
Revenue for 2013 came in with a 4.2% increase after 4% in 2012. Moreover, Toro is forecasting 4%-5% revenue growth for next year; all of which suggests that Toro is a business whose top-line growth equates closely to nominal GDP and income growth, albeit with more downside exposure should the economy fall back.
The bottom line
Toro's forecast revenue growth appears uninspiring, but it has some upside potential if the housing market strengthens. In addition, a cold winter snap will -- in common with Briggs & Stratton -- provide some upside for its snow blowers.
However, while both stocks look to be decent plays on economic growth in 2014, it's harder to make a case that either is a good value pick.
BGG PE Ratio (Forward) Chart
On a forward P/E ratio basis, Briggs & Stratton looks to be a better value. However, on a risk/reward basis, it's hard to make a case for Toro right now. Waiting for any kind of pullback seems to be a sensible strategy.

Wednesday, December 18, 2013

Sirona Dental Systems Equity Research

One of the hardest puzzles in investing is to know what to do when a long-term growth story experiences a slower year. This is exactly the issue facing investors in dental CAD/CAM equipment maker Sirona Dental Systems. After three years of reporting constant currency growth of 16.4%, 12.6% and 11.7% respectively, Sirona's forecast of 4%-6% constant currency growth to Oct. 2014 looks disappointing. It's time to look more closely at the factors influencing its growth.

Four key questions for Sirona Dental
A quick look at its segmental gross profits illustrates that its CAD/CAM systems and imaging instruments are its core profit centers.

Source: Company presentations.

In particular, its CEREC CAD/CAM systems are the key to growth. The systems are distributed exclusively by Patterson Companies  in the U.S., and by Henry Schein  in Europe. Essentially, the systems gives dentists the opportunity to offer same day teeth restorations. Focusing on CEREC, there are three key questions that investors need to ask themselves.

Sirona Dental's gross margin
The first question is what will happen to Sirona's gross margins in 2014?

Sirona faces some challenges and opportunities with margins. Management indicated that next year's gross margins would be flat, but its CAD/CAM segment gross margins could decline by 50 to 100 basis points. One key issue is that its customers continue to trade up to Omnicam CEREC from its older CEREC Bluecam system. The main differences in performance are outlined in this video. Omnicam has a higher ticket price so it generates higher revenue, but its gross margin is lower. Ultimately, both products generate similar gross profits, so investors should expect lower margins as trade up occurs. Indeed, in the fourth quarter CAD/CAM gross margins fell to 64.5% from 68.9% last year, even as revenue grew 35.2%.

The other margin issue to look out for is that, Sirona's management nudged the market toward expecting emerging markets to contribute more growth next year.

Our geographic diversification continues to be an asset for Sirona. Our non-European international markets accounts for 35% of sales. We expect them to be a key driver of growth in fiscal 2014.

If you assume that emerging markets will tend to want to buy lower-priced products than this could imply a lowering of margins in 2014.

Sirona's CEREC penetration rates
The second question is can Sirona increase its penetration rates with its CEREC system?

This is the key to its long-term growth. The CEREC chair-side milling system is now in 15% of dental offices in Germany and 14% in the U.S. Penetration rates are significantly lower outside of these markets. These figures imply that long-term growth can take place in these core markets, and help -- at least in the U.S. -- could come from an unlikely source. Henry Schein has recently agreed a deal to distribute E4D Technologies CAD CAM system in the U.S. Although this is a rival system, Henry Schein's distribution of this product in the U.S. will surely increase awareness of the need for CAD/CAM systems. In other words, it could spur "me too" purchases of Sirona's systems.

Sirona's geographical growth
What will Sirona's geographical growth look like?

Germany and the U.S. make up 50% of Sirona's sales, and they grew 20% in 2013. The U.S. benefited from some pull-forward in sales due to the medical device tax, and from Omnicam trade ups. Germany was described as being "very difficult to grow" in 2014. In other words, growth is going to be a lot tougher in its core markets.

One issue is that Bluecam was only launched in 2009 , and many dentists may feel reticent to upgrade a system only purchased a few years ago.

Another issue that could possibly impact Sirona was mentioned on its U.S. distributor, Patterson Companies, conference call.

one of the issues we did run into in the quarter was the process of installing... ...Omnicams to our Bluecam customers. That process took longer than we had anticipated... ...our salespeople ended up taking more time in terms of the change management process.

Obviously, this is more of an issue for Patterson Companies, but if it causes an inventory build up, then Patterson may decide to slow the growth of orders from Sirona.

And finally, the cost of a CEREC system to its non-core emerging markets may prove prohibitive.

Where next for Sirona?
All told, it's likely to be a year of slower growth for the company, but not all growth stories are linear. The stock may well sell off in response to some disappointing guidance, but Foolish investors should watch closely and look out for an entry point of it does so.

Monday, December 16, 2013

Which Stocks to Buy IF China bounces

China remains one of the great imponderables in the investing world. Is it about to roll of a cliff or return to 10%-plus growth rates in the next few years? It's hard to answer these questions, but we do know that the Chinese government is determined to generate more growth in 2014. It's time to look at which sectors might benefit.

China to bounce back in 2014
By now, everyone will have realized that China's growth is slowing. Indeed, the 7.6% GDP growth target that economists have penciled in for 2013 represents the slowest growth in more than 14 years. Interestingly, the OECD predicts that China's growth will improve to 8.2% in 2014 thanks to a "small fiscal stimulus." Essentially, China has responded to slowing growth by initiating a round of stimulus spending, alongside measures to add liquidity into its system.

This time it's different
Old habits die hard, so whenever there's talk of China and spending, many investors simply go back to the mining and energy-based plays that worked so well in the last decade. However, it's different this time. Following its huge stimulus plan in 2008, China now has overcapacity in many heavy industries, including shipbuilding, solar energy, and cement and steel production. In addition, the government is trying to shift the Chinese economy away from its reliance on housing investment and exports (which are slowing anyway due to the current austerity in the West) and toward domestic consumption.

All told, these trends mean that the sectors likely to bounce in 2014 are not the ones we've seen skyrocket before. Indeed, the old commodity plays like Caterpillar and mining-equipment company Joy Global  have been under pressure this year. China's demand for base metals isn't what had been expected. In its latest quarterly earnings, released back in August, Joy Global reported orders down 28% on a constant-currency basis, with aftermarket bookings down 7%. Furthermore, increasing use of gas in the U.S. is holding back Joy Global's core coal market.

Aerospace and autos
However, there are areas of the industrial sector that are benefiting from this economic shift. For example, China's plans involve building 70 new airports in the next few years and expanding 100 existing airports. And if airports are built, routes usually follow. Indeed, a quick look at Boeing's  order book reveals that net orders of 1,054 (to the start of December) represents one of its strongest results in recent years. There is little doubt that Asia has been a major driver of order growth for Boeing. For example, according to the IATA, the Asia-Pacific region will generate 6.6% passenger traffic growth in 2014, compared to 5% in Europe and only 2.5% in North America.

In addition, Chinese car sales have bounced nicely in the second half of this year.

Source: China Association of Automobile Manufacturers.

All of this suggests that aerospace and automobiles will continue to benefit from China in 2014. In this regard, paintings and coatings company PPG Industries  is worth a look. PPG is heavily exposed to the automotive and aerospace sectors, and this year's acquisiton of the U.S. household paints division of Akzo Nobel is well-timed for the ongoing housing recovery.

A word of warning
All told, China looks capable of bouncing back in 2014, but investors need to focus on the long term. There is no guarantee that any stimulus measures or fiscal loosening will lead to tangible return on investment.

It may turn out that China's economy bounces slightly and then slips back again as these investments turn sour. The 2008 investment in industries like steel and shipbuilding could end up simply being mirrored with airports, roads, and transport infrastructure in 2014. Pause for thought.

Friday, December 13, 2013

Home Depot and Housing Have Further to Run

Despite delivering two strong earnings reports, and raising  guidance in each of them, shares of Home Depot   have oscillated between $75 and $80 since June. As such, investors must be starting to wonder what exactly it's going to take for the stock to break out of its range.  

Moreover, if the naysayers are right, buying Home Depot or other housing-related stocks like Whirlpool , Masco, Williams-Sonoma  or Lowe's  could prove a costly error made at the peak of optimism over the housing market. 

The bear case
A pessimistic outlook sees the housing market as stalling at the altar of higher interest rates. In this scenario, the positive news that Home Depot and Lowe's have been reporting is merely a lagging indicator poised to follow the housing market lower in due course.

As this graph shows, both companies have been reporting much stronger same-store-sales growth this year.

Source: company presentations

Against this backdrop, there is no doubt that the housing market has endured a slowdown as a consequence of higher rates. For example, existing home sales have noticeably weakened since interest rates started rising.

Source: National Association of Realtors

If sales continue to weaken and drag home prices down with them, then the housing recovery could easily be snuffed out.

Housing trap being set?
If this scenario is correct, then stocks tied to the US housing market like Home Depot, Lowe's, Whirlpool, Masco, and Williams-Sonoma are almost perfect traps for growth investors. The trap will be sprung if they report strong results in the fourth quarter, as their demand tends to lag the housing market. Investors would then be induced to buy in, only to see their dreams crushed as housing turns downward in 2014.

Indeed, home-furnishings company Williams-Sonoma recently beat estimates and raised fourth-quarter guidance. Moreover, its growth platforms of Pottery Barn, West Elm, and PBteen recorded comparable-brand revenue growth of 8.4%, 22.2%, and 16.7%, respectively. These numbers are a clear indication of discretionary spending returning, but it doesn't stop there.

Building-products company Masco reported that its North American sales were up 12%, with faucet and toilet sales up "in the mid-teens." Masco's plumbing products are a good indicator of spending in the new-home-sales market, and in general, Masco is more geared toward new residential construction.

And finally, appliance-maker Whirlpool has progressively raised its expectations for full-year industry demand as the year has progressed.

Full Year Industry Demand Assumption  First Quarter  Second Quarter  Third Quarter
North America 2% to 3% 6% to 8% 9%
Europe  flat  flat to (2%)  flat
Latin America  3% to 5%  1% to 3%  1%
Asia  3% to 5%  flat  (2%)

Source: company presentations

All of these companies are reporting strong conditions, but is it all just a bear trap that's about to be sprung?

Rates are only part of the picture
Frankly, it would be a mistake just to look at interest rates in isolation. Moreover, the economy tends to behave like a supertanker--it has its own momentum and takes a while to turn around. Right now, employment remains in a steady growth mode, and usually when that happens consumers tend to feel more comfortable about spending.

In turn, financial institutions start seeing better conditions and lending opportunities, so they start to loosen lending criteria. A credit expansion follows, which then drives the economy onward. In usual recoveries, this is accompanied by rising interest rates because there is more demand for capital.

Indeed, Home Depot's management touched on the issue during its conference call when CFO Carol Tome said, "We've regressed ourselves both against 10-year Treasuries and 30-year mortgages, to see if there is any sort of correlation and we can't see it."  

In other words, the housing market isn't just dependent on interest rates. However, Tome did go on to say Home Depot monitored housing turnover (the rate at which houses are sold) and prices. She continued, " If home prices were to decline, then we might have a different point of view on the housing recovery".

The good news is that despite slowing existing home sales, US home prices are rising.

Source: S & P Case-Shiller

The outlook remains positive for housing.

The bottom line
While all of the companies discussed above have their own internal dynamics, the underlying question is the same: is the housing market about to stall or not? If you share the opinion that it won't, then Home Depot is probably the best pure play.

Lowe's is similar, but it also needs to deliver with its plan to reset its product sales. Masco gives you heavy exposure to new home construction. Whirlpool has significant overseas exposure and heavy competition in appliances, while Williams-Sonoma competes in some highly competitive markets too.

Tuesday, December 10, 2013

Performance Update

A quick update on performance to the start of December. I've been lazy in doing this, and it hasn't helped that I've been writing with a fractured wrist for the last two months. With that said, here is the portfolio performance vs. the S & P 500.

I'm hedged and leveraged. It's an absolute return strategy which shouldn't really be benchmarked against an index, but here you go anyway. Blue line is me, red line the S & P 500.

And for those who know, or care, about absolute returns.

An R^2 of .09 pretty much implies that the index doesn't really have much to do with my returns, but hey, this strategy hasn't been tested out in a bear market yet. I strongly suspect that stock correlations jump in a bear market, so you need to be careful not to be underexposed on the short side.

I'm pleased with the performance overall, although 2013 has been a frustrating year with a couple of horror months in it. However, I can't complain.

I'm highly cognizant of the stress levels I am under. After all, going and living in foreign countries on my own, constantly writing, researching, investing in a leveraged strategies, and finding time to cad my way around, isn't easy. There are times when I wonder how much longer can I do this?

On the other hand, I know I must. There is no other choice. Stability never presented itself as an option for me, and to paraphrase Hyman Roth, this is the business I have chosen. I've spent time in eight different countries this year, had adventures, and made some money. I feel I'm making progress on life, and feeling happier. That's the important thing.


Two Thematic Tech Trends

Asking a group of IT investors to outline which technology is going to be the next big thing is unlikely to reach any kind of consensus. However, most investors are likely to agree to on two things: technology cycles are getting shorter, and IT is becoming ever more specialized. If you agree with these statement, it's time to examine which sectors and stocks are likely to benefit from these shifts. 

Adam Smith Revisited
The great Scottish moral philosophers David Hume and Adam Smith pointed out that increasing division of labor would lead to greater productivity. The difference between their time and now is that workers' skills are becoming increasingly more refined. In addition, the intellectual quotient of a good's value (think of smartphones versus last decade's phones) is increasing. Moreover, according to an article in the Harvard Business Review: "Today, thanks to the rise of knowledge work and communications technology, this subdivision of labor has advanced to a point where the next difference in degree will constitute a difference in kind. We are entering an era of hyperspecialization."

Three investment themes benefit from hyperspecialization and shorter tech cycles.

Technology staffing companies
First, companies will be more inclined to hire temporary workers with highly defined skills, rather than spend large amounts to train in-house employees, or hire a project consulting firm. Indeed, that is exactly what technology-focused staffing firms like, Kforce or On Assignment  are seeing. Quoting from its recent conference call, where On Assignment's CEO, Peter Dameris, said: "We're not saying that we're beating Accenture at project consulting. We're saying that the customer is deciding more often than not now that maybe they should do this on an IT staff aug basis, versus a project consulting basis."

Furthermore, when questioned on the opportunity for bill rates to increase (something likely to significantly improve On Assignment's profitability), Dameris replied that the skill sets it provides are becoming "more and more scarce." The facts back him up. For example, according to government figures, despite the number of college degrees issued in the U.S. increasing by 51% from 1992-2011, the increase in engineering degrees issued only went up 20%.   That's a growth rate of less than 1% per annum, significantly below long-term GDP growth.

Information services
Shorter tech cycles also imply that companies need to remain current on business trends, and this is where the information services companies come into play. They allow companies to "outsource knowledge." With regard to IT trends, the best known name is Gartner  . Indeed, Gartner has grown revenue by 6.8% and earnings per share by 14% per annum since 2008. This is an extremely impressive performance, given that 2009 was a recessionary year and Gartner operates in the highly cyclical IT sector. In addition, according to its management, the company has genuine pricing power and has "consistently increased our prices by 3%-6% per year on an annual basis since 2005."

Another company worth examining is Nielsen, a leader in provider insights into consumer behavior. Technology is significantly changing retail and media channels, and this is putting pressure on Nielsen's customers to monitor and analyze information across many different platforms. Think about social media, mobile, Internet TV, and video-on-demand. Plus, advances in communication are creating global opportunities for marketers, yet media continues to fragment. All of these factors are likely to provide good growth opportunities for Nielsen.

Moving to the cloud
The third key beneficiaries are likely to be cloud-based solution providers. If technology cycles are getting shorter and more specialized, it's likely that companies will want to buy solutions on a subscription basis. After all, why buy an expensive software solution if it's going to be outdated in a few years?

Adobe, Autodesk  and Intuit are three leading names in this regard. Intuit is arguably the early mover with its TurboTax software, while Adobe has been transitioning is digital media and marketing software toward the cloud in 2013. However, AutoCad company Autodesk is probably the most interesting stock right now. Autodesk is shifting software sales from stand-alone products to software-as-a-service-based suites of bundled software. It appears to be working, as Autodesk reported 21% growth in sales in the third quarter. Autodesk believes in can generate 20% more value with its subscription customers.

The bottom lineIT trends are changing at an ever-faster pace, and the companies above have opportunities to profit. Frankly, they are all cyclical companies, but if you are a Foolish investor looking for a cyclical stock that can outgrow its markets, then these stocks are well worth a look.

Monday, December 9, 2013

Estee Lauder Still Isn't Cheap Enough

In theory, there is a lot to like about the beauty, fragrance, and skin care sector. Estee Lauder's    focus on premium products plays to the return of high-end spending, while Elizabeth Arden's   fragrances have been working well this year. Meanwhile, a weak employment market should ensure that Avon Products can find representatives, and Revlon's   mass market consumer must surely be better positioned in 2014.

Moreover, an aging demographic coupled with declining marriage rates in developed markets should ensure strong demand from developed markets in the future. Meanwhile, a growing middle class in the emerging world is likely to spur prospects for years to come. On the other hand, the sector has much of this already priced into its valuation. Is there still value in the sector?

Bifurcated consumers, Elizabeth Arden and Revlon
While demographics and social trends are favoring the sector, it is not immune from economic realities. The big story in retail over the last few years has been how markets have become increasingly bifurcated. In other words, luxury goods are doing fine, and the low end has been outperforming in relative terms due to consumers trading down. However, mass market consumer products are finding life very tough.

These themes have also played out in the beauty companies. For example, Elizabeth Arden recently reported that its prestige channel sales grew 5% in its last quarter, while its mass retail sales were down mid-single digits in-line with the category. All told, its reported sales fell in the quarter.

It was a similar story with mass-market focused beauty companies like Revlon, who reported a sales decrease of 2.2% in its third quarter. Indeed, Revlon has sought to diversify its end market exposure with its $655 million acquisition of The Colomer Group, a company that sells professional beauty products to salons.

Get the Avon lady smiling again
Avon Products
differs from the others in that it has a direct selling distribution model. Theoretically this makes it an attractive company in a weak employment market, because it shouldn't have difficulty in recruiting distributors. However, it hasn't quite worked out like that recently. Its core US market "continues to decline" according to its management on its recent conference call.

It gets worse. Avon has a served model transformation, or SMT, initiative with which it intends to make internal improvements to its business. Unfortunately, the pilot program in Canada led to a "steep drop in the active representative count". This is not a good sign for a company that intends to turn around its sales organization.

Estee Lauder's  focus on the premium end of the market probably makes it the most attractive company in the sector, but is it a buy?

Estee Lauder's puts and takes
As you would expect, Estee Lauder's operating performance has many things in common with its peers. 

First, the industry has had to innovate in order to stand still. Revlon's innovation has, by its own admission, had "mixed results" with its Nearly Naked face creams underperforming expectations. Similarly, Elizabeth Arden's fragrance sales suffered a slight decline in its last quarter, because these products came up against a high volume of fragrance launches last year. The lesson is that beauty companies need to keep innovating.

Unfortunately for the company, many of Estee Lauder's innovative new products for the holiday season are coming from its fragrance category. Fragrance is one of its smallest categories, and it has the lowest operating margin (10% compared to the company average of 16.8%). One concern is that Estee Lauder is investing in lower margin businesses to generate growth.

Source: company presentations

Second, the overriding lesson of retail this year has been that if you don't offer promotions you will lose market share. Indeed, Estee Lauder highlighted that the environment was "very promotional" from July to September, but its "focus was on innovation." Quoting from its recent conference call, Estee Lauder's management said:

Now we believe that our promotion, our competitiveness, during the holiday season will be dramatically improved. Our programs are much stronger, in this sense, however, we do not plan to increase promotions for the long term.

This looks like a response to tough conditions over Christmas, but will Estee Lauder be forced to promote after Christmas as well?

Finally, like Avon, Estee Lauder is undergoing a major initiative in order to improve its operational performance. Estee Lauder's strategic management initiative, or SMI, is essentially a SAP roll-out intended to improve inventory turns from two times to three times in the future. In plain English, this means it will hold less inventory in order to sell the same amount of goods.  

To be fair, the SMI is still being rolled out and it's causing disruptions to Estee Lauder's sales patterns, as retailers tend to buy in ahead of implementation. However, the plan to get the magic three multiple seems a long way away considering current trends.

Source: company presentations, author's analysis

Estee Lauder attractive but at what price?
In conclusion, theory is a wonderful thing, but reality is another. The facts are that the beauty sector is a tough market to be in right now. Avon has internal issues to deal with, Revlon is trying to diversify away from its core mass consumer market, and Elizabeth Arden is forced to innovate in order to generate growth.

Estee Lauder appears the most attractive, but it too faces concerns. Furthermore, with a P/E ratio of nearly 26 times forward earnings to June 2014, the stock is hardly a good value.

Thursday, December 5, 2013

Intuit is more than just TurboTax

There are three main ways to invest in the cloud. One way is to invest in the infrastructural plays that help to create it. Another is to buy companies whose internal operations are benefiting from utilizing the cloud. The third option is to invest in software companies that are shifting into selling software as a service, or SaaS. The poster boy of the last option is Intuit. It's time to take a close look.

Intuit's two key growth drivers
Intuit's stock is peculiar because it has its very own trading dynamic. Most of its profit is made during the all-important tax season. Subsequently, investors are mainly focused on its tax software's fortunes during the spring quarter.

Source:company accounts.

After the tax season quarter, the attention turns toward its small business group (SBG) offerings. Attention shifts back once the tax season comes around again. Intuit isn't just about taxes, though.

In fact, in its last fiscal year, consumer tax only contributed 45% of full-year revenues. Furthermore, its guidance for 2014 implies that Consumer tax (consumer group) and pro tax will only make up 49% of revenue. Moreover its tax operations are only growing in low single-digits while, the SBG's growth is in the more impressive low-teens range.

2014 Guidance
Consumer Group
ProTAx Group

 Source: Company presentations.

Moving into 2014, Foolish investors should be focused on two things with Intuit. First of all, they should look at its plans to ensure a solid tax return season. Secondly, they should watch the ongoing development of an ecosystem within its SBG.

Intuit's disappointing 2012 tax season
Unfortunately, Intuit's last tax season was somewhat disappointing for a number of reasons:

  • Overall tax returns were lower than its internal expectations due to a difficult tax season

  • The software category overall only took a 1% share from manual, when Intuit had expected 2%

  •  Intuit didn't grow its online market share as expected, and smaller competitors took market share

Intuit's rival, H&R Block, also confirmed that the tax season was uniquely difficult this year:

"We expected...  ...the season would normalize to historical growth rates of 1% to 2%...  ...we had little reason to believe that growth levels this year would be different than average historical levels.
Instead, at season's end, IRS returns were down approximately 1%, a result no one was expecting."

In addition, investors in Intuit and H&R Block have some cause for concern in 2014. According to Intuit's management, the IRS is talking about "some delays to the start of tax season again this year." While this is likely to be a timing issue, there is a danger that it could indicate a more complex tax season.

Intuit is making some changes to its tax strategy this year. The company is trying to move away from heavy advertising during the tax season, and more toward simplifying its products and ensuring customer retention. This sort of strategy is very much in line with the advantages of SaaS. In other words, SaaS solutions help to reduce customer churn because they tend to involve more of an ongoing interaction than a one-off software sale does.

Intuit develops an ecosystem
Its second major strategic focus is to develop an ecosystem around its various offerings in its SBG segment. The idea is use the cloud in order to cross-sell its financial management, payment, and employee management solutions (which make up the SBG and account for 37% of segment profits.) Furthermore, its tax refund customers can plan how to utilize their refunds by using the lower end of Intuit's accounting and financial planning software, QuickBooks.

QuickBooks is also undergoing a refresh which is being rolled out to existing QuickBooks online and desktop publishers. Again, a big part of the plan is to encourage its desktop customers to convert to its online offering. Intuit outlined that it now had over 500,000 QuickBooks online subscribers, up by 29% from the previous quarter. This provides more power to Intuit's ecosystem.

A competitive market
One downside to all of this is that Intuit's markets are getting ever more competitive. Paychex has recently launched an online accountancy offering targeted at small business. While this a relatively late move, it still represents the principle of moving to the cloud in order to cross-fertilize its payroll and HR services. Automatic Data Processing's  also competes with both companies in online payroll, and its Vantage product is a cloud-based suite designed to integrate ADP's human resources, payroll services, and benefits administration in one package.

The bottom lineIntuit is facing stiffer competition, but it's an early mover in offering SaaS-based solutions. It's also being aggressive about developing its ecosystem, and it remains a prodigious generator of cash flows for investors. For example, Intuit generated $1.24 billion in free-cash flow last year, representing around 5.8% of its market cap. With analysts forecasting 11% EPS growth for the next couple of years, Intuit looks like a good value.

Wednesday, December 4, 2013

Palo Alto Networks is Starting to Look Good Value

Analyzing the network security sector sometimes gives you the feeling that you are researching the only one company, just at different stages in its development. Most companies tend to evolve in a similar fashion, from high-growth start up to mature GDP growth type cash cow.  Check Point   and Cisco's    security division would definitely represent the later stage of this hypothetical company's development. Palo Alto Networks    is at the high-growth end of the spectrum and Fortinet   lies somewhere in the middle.The question is which company has the best risk/reward profile?

Network security rebounds
It's been a varied year for the sector. After a weak first quarter, where companies like Fortinet, Palo Alto and F5 Networks disappointed with results, the last two quarters have been relatively good.

It's hard to pinpoint exactly what happened back then, but sequestration appears to have had an effect on confidence. Furthermore, some unexpected weakness in telco provider spending also hit the market. No matter, the sector has reported some pretty good results since then.

The mature companies
Check Point finally managed to get product sales growing positively again. In addition, its new low-end product range is making inroads in the small and medium size business market. Meanwhile, it continues to generate huge amounts of free-cash flow. By my calculations free-cash flow was $925 million over the last year, representing around 8.6% of its current enterprise value. However, it's only forecast to grow earnings in the mid-single digit range for next few years.  It's attractive if you favor low growth value plays.

Meanwhile, Cisco Systems has revamped its security offering with its acquisition of Sourcefire. Although, Cisco is not a pure-play security company, the way that is able to buy growth by an acquisition is typical of a mature late stage company. Cisco's main strength is the ability to bundle solutions to the other equipment that it sells to Governments and enterprises. Indeed, listening to Palo Alto's management on its conference call, the Sourcefire acquisition actually created a positive opportunity:

We've also seen confusion in the market from the Sourcefire customers about what that deal means... ...We've been able to develop hundreds and hundreds of leads from dissatisfied or confused Sourcefire customers... ... it's been a positive

Fortinet matures, unusually
Fortinet also beat estimates in its last quarter. Revenue came in at $154.7 million, beating the high-end of its guidance range by 1.6%. In common, with Check Point, Fortinet's guidance for the fourth quarter looks a bit conservative. Check Point has averaged 13.7% in fourth quarter sequential revenue growth over the last five years, while this year's guidance implies sequential growth of just 10.4% Meanwhile,despite beating estimates in its third quarter, Fortinet kept its full year revenue and EPS guidance constant. Here is how its full-year guidance has changed this year.

Source: Company presentations

Eagle-eyed readers will note that its free-cash forecasts have been progressively lowered throughout the year. Frankly, this is a cause for concern in an otherwise attractively valued company. Fortinet has had to lower its inventory turns, and therefore use up more cash in holding inventory on its books. It's not a major issue, provided it stabilizes as expected. However, it's something for Foolish investors to look out for. Companies usually start converting more income into cash flow when they mature, not the other way around.

Why Palo Alto Networks is the pick
It seems odd to talk about Palo Alto as the best value in the sector, but on a risk/reward basis the argument stacks up for three reasons.

First, Palo Alto's revenue for the full year is forecast to be around $559 million , a figure noticeably smaller than Check Point's estimate of around $1.4 billion or Cisco's trailing year security revenue of a similar amount. In other words, even if all four of these companies share the market equally, Palo Alto will see the most growth.

Second, Palo Alto is doing a pretty good job of converting revenue into free-cash flow.

source: Company accounts, author's analysis

If Palo Alto converts 22% of its forecast revenues of $559 million and $734 million then investors can expect around $123 million and $161 million in free cash flow in the next two years. That's not bad for a company that has a current enterprise value of $2.83 billion. 

Third, Palo Alto has a favorable geographic mix of revenue. The most recent quarter saw 67% of the company's revenue coming from the Americas, with only 19% from Europe and 14% coming from the Middle East & Africa and Asia-Pacific.  With companies like Cisco and IBM recently warning that emerging market spending was weakening, it's good for Palo Alto to be focused on the Americas.

All told, Palo Alto may not be the cheapest-looking stock in the sector right now, but it looks a good value based on its stage of development. Pure value orientated investors may prefer Check Point, or even a mix of the two.

Tuesday, December 3, 2013

TJX Remains a Buy

Investors in off-price retailer The TJX Companies  will be very pleased with the company's latest results. Not only were earnings ahead of estimates, but management also guided investors toward some significant developments that should drive the company's long-term growth. There has always been a lot to like about TJX, and now there is even more.

TJX beats estimates, again
TJX previously guided toward diluted earnings per share in the range of $0.69-$0.72 and comparable-store-sales growth of 2% to 3%, but it delivered $0.75 and 5%, respectively, in its third quarter.

The company has a history of giving conservative guidance, and it arguably did so again this time around. Despite the impressive third-quarter numbers, management reiterated its fourth-quarter forecast of only 1%-2% comparable-store-sales growth, and diluted EPS of $0.77-$0.80. Don't be surprised if it beats projections.

A note of cautionA note of caution came from the outlook provided by a rival off-price retailer Ross Stores. In giving its outlook for the all-important fourth quarter, Ross' management argued that the upcoming holiday season "will be the most intensely competitive and promotional holiday selling period in recent years."

One issue that faces the entire retail industry is the six fewer shopping days between Thanksgiving and Christmas this year. In other words, in-store shopping is likely to be more intense, and retailers will fight hard for foot traffic by offering promotions. This is likely to create some confusing signals from the sector.

However, to be fair, Ross and TJX offered up the same guidance of 1%-2% comparable-store growth in the fourth quarter. The difference was that TJX beat EPS estimates in the third quarter, while Ross was only inline.

It was a similar story with Dollar Tree Stores. The dollar store missed analyst estimates for the second straight quarter, and its management spoke of "weak consumer confidence" and inevitably the short shopping season this year. Furthermore, EPS guidance for the fourth quarter of $1.01-$1.07 was weaker than the analyst consensus of $1.10.

However, Foolish investors should note that Dollar Tree's non-consumable categories (which tend to be more discretionary items) grew at a similar rate to consumable; that's a good sign that consumers do have a bit more discretionary income. It could be that Dollar Tree's management is just being cautious.

TJX's long-term growth prospects
Turning back to TJX, each of its divisions achieved good sales growth in the quarter.

Note that TJX's home goods (10% of total segment profits year-to-date) sales grew much faster than the company average, while according to management Ross' home business "ran at the same rate as the company" in the third quarter. Furthermore, TJX gave some positive updates on its long-term growth plans in three ways.

First, the company's management now believes it can increase its number of stores by 60% to 5,100 stores, with Marmaxx's (73% of segment profits and around 1,966 stores  currently) potential raised to 3,000 locations, some 400 more than it previously estimated.

Second, management declared itself "excited" by its e-commerce plans, and more investment will follow in due course.

Finally, its European segmental margins (6% of year-to-date segment profits) grew to 10.4% versus 9.1% last year, and TJX raised its long-term target to "10%-plus." Considering that Marmaxx has margins better than 15%, it's reasonable to expect that TJX can continue to increase European margins in the future.

Where next for TJX?
It's going to be a tricky season for retailers. The spending environment isn't fantastic, and the shortened selling season will cause great potential for retailers to report mixed signals as the holiday season progresses.

Nevertheless, TJX has consistently demonstrated an ability to appeal to off-price shoppers, irrespective of market conditions. Meanwhile, its long-term growth prospects are getting stronger, and investors should focus on these aspects of its potential rather than the short-term noise created by a shorter selling season.

Monday, December 2, 2013

Which Stocks to Buy if Interest Rates go up

Equity investors can be guilty of ignoring the repercussions of bond-market movements, but Foolish investors might not want to be so complacent. Year to date, 10-year Treasury rates have gone up significantly, and even though it's a less than 1% move, it represents a near 50% increase in the rate. The economic impact has already been felt in some ways, and it's time to look at which stocks could benefit if rates rise further.

Rates on the move
Here's how the benchmark 10-year U.S. Treasury yield has moved this year:

Source: Yahoo! Finance.

Clearly, rates have moved up recently. In addition, its noticeable how low they still are when compared to previous years. So, which stocks can outperform if they move up?

Rates up + economy up = time to buy financials
Financials will benefit in this scenario because an improving economy will bring increased loan demand, while rising rates should increase net interest margins for the financials.

For example, although Wells Fargo  recently reported record quarterly net income, its net interest margin has been declining for more than a year now.

Source: Company presentations.

An improving housing market, however, will aid its mortgage loan origination business, and increased interest rates should help it issue loans and mortgages at higher rates than it has in the last year or so.

A similar dynamic applies to a lender like Capital One Financial . Wells Fargo and Capital One have been challenged over the last few years because of weak loan demand. In addition, it has been trying to replace loans issued at previously higher rates. The result is that income has come under pressure. However, there are some positive signs. Capital One is known for being a conservative lender, so it's a good sign when its management says this on a conference call:

New originations are growing, and we're seeing more opportunity to increase credit lines for existing customers, which should improve the trajectory of both the loan growth and purchase volume growth over time.

Capital One expects its domestic card-loan growth to turn positive "sometime around the second half of next year."

Rival lender Discover Financial Services   is a somewhat more aggressive lender, and it managed to grow its credit card loans by 4% in its third quarter even while its credit card charge-off rate hit a record low of 2%.

Moreover, its management described the market as being a "very benign credit environment. We don't see any situation where there is any type of a meaningful deterioration in credit in the near-term horizon at all."

Although not a financial, Automatic Data Processing , or ADP, holds large amounts of its payroll clients' funds on its books, from which it earns interest income.

ADP is interesting because its employer services and professional employer organization, or PEO, services are obviously geared to the economy. In addition, the company is achieving margin expansion as its revenue grows. In fact, in its third quarter, employer services (69% of revenue) grew earnings by 15%, and PEO (18% of revenue) did so by 12%. The main reason its total pre-tax earnings only grew around 7% was because lower interest rates took its interest income down by $17.6 million, to $89.2 million. Given higher rates and an improving economy, ADP has plenty of upside.

In a similar vein, payroll specialist Paychex  (NASDAQ: PAYX  )  also holds significant amounts of customers cash on its books. You can see how the cycle works in the following graph.

Source: Company presentations.

As the economy improves, more small business want use Paychex's payroll services. Consequently, the amount of funds held goes up. Meanwhile, interest rates tend to go up, so the amount earned from customer funds goes up. In fact, it went up to around 8% of total revenue in 2007. If the same thing happens over the next few years, Paychex could see a revenue boost from this effect.

The bottom line
Foolish investors need not fear rising rates because they're usually a sign of a stronger economy. With a relatively benign inflation environment, the stocks discussed above have upside. The financial media often frets about higher rates, but Foolish investors can prepare for them and invest accordingly.

Thursday, November 28, 2013

Despite The Sell Off, Lowe's Looks Good Value

Investors in Lowe's  must have felt they were living in some kind of parallel universe after the company's excellent set of results were greeted by a 6.2% markdown on the day. As ever, the usual knee-jerk response from journalists was to seek out any possible negative in the company's report or commentary. Lowe's results were a lot better than many made them out to be.

What really happened?
Perhaps the most relevant news on Lowe's results was the old news! The stock had such a major run up before the results that almost anything it said could somehow have been construed as a disappointment.

Not only had Lowe's share price increased by more than 50% in the last year, but it was also outperforming its main rival Home Depot .

HD Chart

While it's true that economic commentators have been becoming a little more cautious on the housing market due to higher interest rates, you certainly wouldn't have noticed it from Lowe's stock performance prior to the results.

Frankly, the sell-off after the results looked like a correction of an overbought move and possibly some hedged pairs trading going on with Lowe's versus Home Depot. In other words, traders might have favored buying Home Depot and shorting Lowe's. 

In reality, there were a number of positives from this report.

First, full-year earnings-per-share guidance was raised for the second time this year and now stands at $2.15.

Second, Lowe's management gave a positive industry outlook. Management forecast that growth would persist in the fourth quarter and went on to state "we expect further acceleration of industry growth next year."

Third, it confirmed that its program of product resets achieved around 100 basis points in gross-margin improvement once the product lines "reached stabilization."The reset program is a project to adjust the products the company sells in order to normalize inventories across categories. Stabilization just refers to when it has cleared out the old inventory.

Clearly, the project is working and Lowe's said that only 66% of its business was stabilized by the end of the quarter. Investors can look forward to margin improvements from the remaining 34% in the future, as well as from the 20% of its business that hasn't even been subject to resets yet.

Finally, the makeup of its sales is suggesting industry strength. Lowe's declared that its Pro sales "continue to outpace our [do-it-yourself] consumer." Indeed, only a day earlier, Home Depot said a similar statement when its management declared "the recovery of our pro business continues in the third quarter, our pro business grew at a slightly faster pace than our consumer business." Both companies see this as a sign of cyclical strength in housing.

In addition, Lowe's performed well with its large product categories such as flooring, kitchens, and appliances. This is in line with what appliance makers like Whirlpool  are saying about the marketplace, and customers' willingness to replace appliances that they bought 10 years ago at the height of the housing bubble. It also confirms the positive outlook in the remodeling market index by the National Association of Home Builders.

Weak spots?The report was generally positive, but there were some points of caution. While appliance sales were strong, the level of promotions was significant enough to reduce the gross margin by 10 basis points. Such developments will obviously concern Whirlpool investors, especially as LG has now been added to Lowe's appliance offerings.

In addition, Lowe's has Samsung and LG appliances highlighted on its floors. This is especially relevant given that Whirlpool won an anti-dumping ruling against LG and Samsung earlier this year.

The second possible sore point was that its forecast of 5% full-year comparable- sales growth implies 4th quarter comps growth of around 4%. As the graph shows, this is somewhat lower than the last two quarters.

Source: company presentations

On the other hand, last year's fourth quarter was positively affected by sales due to Hurricane Sandy. Furthermore, the full-year forecast of 5% is an upgrade from the second quarter guidance of 4.5% and first-quarter guidance of 3.5%. It's hardly bad news.

The bottom line
In conclusion, this wasn't a bad report at all. It's just that the stock had run up too much and investor expectations were probably too high Provided the housing market stays on track, the stock looks to be a good value on a P/E ratio of 17.8 times forward earnings as I write. 

Wednesday, November 27, 2013

Time To Buy Patterson Companies

Sometimes investing is about buying go-go growth stocks that are lovingly discussed by the general public, and sometimes it's about buying boring medical supply stocks like Patterson Companies  . Patterson's end markets of dental, veterinary, and medical rehabilitation aren't growing very fast, but the company has taken a number of initiatives to generate growth. Moreover, the underlying business is highly cash generative. It's worth taking a Foolish look.

Patterson beefs up its veterinary supply business
The company reports in three segments, with dental being its largest revenue generator.

Source: Company presentations.

In each of these segments, Patterson has been taking measures in order to generate earnings long-term earnings growth.

Eagle-eyed readers will note that the veterinary division has seen a jump in revenue this year, which is largely due to the $117.7 million contribution from the acquisition of U.K.-based veterinary distributor NVS, from its former parent Dechra Pharmaceuticals. The deal is particularly interesting because unlike its rival Henry Schein    Patterson didn't have substantive international veterinary operations before the acquisition took place.

In recent years, NVS has tended to be a low-growth but highly cash generative business. Dechra's focus has been on expanding sales of its growing veterinary pharma business, and its 87.5 million pound sale of NVS looks like a good deal for both companies. Dechra reduced its debt with the cash while renewing its focus on pharma. Meanwhile, Patterson bought the leading player in the U.K. vet supply market for just 10.4 times its underlying profit. That's an attractive valuation considering that Patterson currently trades on a P/E of 19.3 times forward earnings.

NVS generated 333.2 million pounds (around $539 million) in revenue in its year to June 2013 with 5.5% revenue growth, but has wafer-thin operating margins of 3.3%. It's entirely possible that Patterson can use its distribution expertise and scale in order to generate some margin improvement in the future. Indeed, Patterson is expecting the acquisition to be earnings accretive by $0.03-$0.04 in 2014 alone. More to follow?

Patterson's mixed earnings from dental
In theory, the dental market should provide strong long-term growth for Patterson. An aging U.S. demographic and better dental care (which implies more teeth per mouth to service) should mean increased demand in the future. Unfortunately, dentists don't see it that way at the moment and are reluctant to spend on core equipment. According to Patterson's management on its conference call:

While dental consumable sales were up year-over-year, consumable growth remained sluggish... ...On a macro level, since the economic downturn, dentists have remained cautious about expanding and upgrading their basic practice infrastructure, which includes chairs, units and cabinetry. 

Patterson's dental supply sales were up just 2.5% in the third quarter, with consumables only up 1.7%.  Equipment and software sales were up a more impressive 4.3%, and this is where the immediate growth prospects lie.

Indeed, Patterson has taken measures to accelerate dental growth by expanding its relationship with dental dental CAD/CAM company Sirona Dental Systems . Sirona's CEREC system allows for same-day teeth restorations, and the technology looks set to benefit from strong growth in future years. Indeed, Sirona just gave its full-year results and reported 18% revenue growth with its CAD/CAM and imaging solutions. Its growth is always likely to be lumpy (it's somewhat contingent on the timing of new product releases), but Sirona (and Patterson) should receive a boost from an unlikely source.

Henry Schein recently signed a deal with Sirona's rival E4D Technologies in order to roll out E4D's CAD/CAM technology to various dental practices in the U.S. This could be good news for Patterson and Sirona, because Henry Schein's move (it already distributes Sirona's products in Europe) will help create awareness of the benefits of this class of technology. Ultimately, this could spur adoption of Sirona's CEREC system.

Medical disposals and IT investment
Patterson's medical rehabilitation business is in a tough market as austerity measures impinge on its growth opportunities. Its sales declined 5% in the third quarter, but this is partly due to measures taken to drive long-term earnings growth. In response, Patterson has been disposing of some of its non-core medical assets in a bid to cut costs. Management forecasts that savings equivalent to $0.01 in EPS will be generated by these measures starting in 2015.

And finally, Patterson is investing between $55 million and $65 million in IT over the next five years in order to ensure future productivity gains.

Where next for Patterson?
After excluding the $0.12 restructuring charge taken for its medical business, its internal guidance is for $2.13-$2.24 in EPS for the year to April 2014. This puts the stock on a P/E ratio of 19 times forward earnings. This may seem expensive but recall that Patterson has generated an average of $264 million in free-cash flow over the last three years. This equates to around 5.8% of its enterprise value as I write.

In conclusion, Patterson has been busy engaging in "blocking and tackling" initiatives to improve its productivity in medical. Veterinary has seen the acquisition of NVS, and its dental segment has expanded its relationship with Sirona. All three measures are set to increase its long-term potential, and Foolish investors should look favorably on the stock.