Thursday, January 31, 2013

The Best Stocks in the Telco Sector for 2013

With AT&T (NYSE: T) and Verizon (NYSE: VZ) having reported results it’s time to take a look at what they said about spending and the trends within their businesses. Tier 1 carriers make up the bulk of telco spending, and investors can garner a lot of insight from what they say. In summary I would argue that there has been an acceleration of the trend towards smartphones and corporations spending on mobility based solution in the last quarter, and this will continue in 2013. The overall trend is positive, but the macro-environment is causing the carriers to be cautious on spending.

AT&T Just Loves Efficiency

I previously wrote about this theme in an article linked here, and AT&T managed to repeat the trick it did in the last quarter! Then it talked about capital spending for 2012 hitting the lower part of the $19-20 billion range it had previously given. In the end CapEx came in stronger at $19.7 billion. Granted some of this was due to Sandy, but it also demonstrates the variability in spending plans. Indeed it is this uncertainty that makes telco such a volatile market.

Turning to the guidance for 2013 given in November (at their analyst day meeting) the company discussed spending up to $22 billion this year, and the market got excited by the potential for a ramp up in telco spending. Unfortunately with these earnings AT&T nudged the market lower with forecasts for $21 billion. The reasons given for this were:
  • LTE roll out was ahead of plans so AT&T didn’t feel the need to ramp up spending as aggressively as it had intimated earlier.
  • It found efficiencies with overlaps in wireless and wireline projects.
Frankly this just sounds a bit like the usual story of corporations holding back on spending while they wait for the economy to get better.

The areas where we do know AT& T will be spending are in its LTE network with its ‘Project VIP,’ a scheme to ensure LTE coverage for 300 million people by the end of 2014. In addition its key growth drivers are wireless, wireline data and the expansion of smartphone penetration. Indeed as smartphones expand (89% of postpaid sales in the quarter) the increase in bandwidth demand will expand significantly placing more stress on the network.

The other big driver is corporate spending on mobility solutions and this did very well in the quarter.

Verizon Holds its Cards Close

In recent times Verizon has made a virtue of keeping its spending in check after having been the first major US carrier to aggressively roll out LTE. Its general plan seems to be to continue to reduce CapEx as a share of revenues by keeping spending flat for this year while increasing utilization of its existing LTE network.

Verizon’s capital spending came in slightly higher than forecast this year but that was mainly due to some Sandy related spending and buying some spectrum. Its management declared itself ‘very confident’ that CapEx would be flat in 2013.

My take on what is going on here is that Verizon is seeing its customer spending trends working in its favor. In other words adoption of smartphones and its 4G LTE network is gathering apace and feels that in an uncertain macro environment the correct thing to do is to try to expand margins from its existing LTE network. It has clearlyy stated that it is not adding capacity to its 3G network.
Indeed, its smartphone sales accelerated nicely in Q4 with 65% of smartphones activated in Q4 being on 4G LTE. Overall penetration increased to 58% from 44% last year.

Key Conclusions and Three Ideas

While both companies downplayed or reduced capital spending expectations I think the results and commentary were a net positive. Telco spending isn’t just about Tier 1 spending, and with the acceleration in smartphone adoption and 4G LTE becoming commonplace there will be significant pressure on other carriers to increase spending.

I want to discuss a few ideas that focus on the trends ascertained here. On the theme of corporate mobility I think Bring Your Own Device (BYOD) is a key idea. I last discussed Aruba Networks (NASDAQ: ARUN) in an article linked here, and looking at the mix of Android and iPhone sales in these results as well as the trend towards corporate mobility it is a clear sign that Aruba is doing well. Earnings estimates have been trending higher accordingly. The question with Aruba is when will BYOD growth start to plateau? I’m not sure of the answer but it is certainly not in the next few quarters.

Another idea I like is F5 Networks (NASDAQ: FFIV), which reported results recently and saw a pick-up in its telco related spending revenues. Its application delivery controllers help ensure applications get moved around the Internet efficiently and with both carriers reporting strong growth in smartphone adoption I think this means bandwidth rich application demand is going to concomitantly increase, and F5 should be a key beneficiary. In addition both networks spoke of strong cloud adoption so data center spending should increase as well.

My last idea is Acme Packet (NASDAQ: APKT). I’ve discussed it more in an article linked here. It is a play on the adoption of Voice over LTE (VoLTE) spending by carriers, and the indicators are that this will kick in by the end of 2013 or early 2014. If this idea is correct then APKT should start to see the benefits by mid year. It’s not the cheapest stock out there but it has a strong balance sheet with $370 million in net cash and liquid assets. In addition it generates cash and if and when VoLTE spending ramps up you can bet that the market will bid it higher with the earnings momentum. Well worth a look

The Key Earnings This Week

It's another huge week for earnings and while two weeks ago it was all about banking and one week ago it was mainly technology, this week it’s a broad based reporting week. As ever I will try and pick out some highlights or stocks that are emblematic of industry trends or investment themes. I will try to cover some of these companies so if readers have any favorites they want written up then message me in the comments section or through Google+.


One of my favorite stocks in the industrial sector Roper Industries gave results and readers can read a review of the company linked here.  Investors will be looking to see if its compelling mix of niche industries continues its growth path.

The pick of the day’s results was Caterpillar (NYSE: CAT) but I don’t know why! If Caterpillar’s prospects are guided by China’s growth prospects and the latter is critical to how the global economy fares then Caterpillar should be an important bellwether right? Well, yes and no. Yes because the argument does hold with regard assessing the current situation in China (which is unlikely to be great in mining) and no because I don’t find CAT’s guidance to be particularly useful. The company did say some positive things about China, but overall I felt the underlying trends are not great here. No matter the market is in bullish mood.


Harley Davidson is interesting to see how its international expansion plans are going. EMC Corp is a value play in technology. Pfizer's results were pretty good and Xeljanz (rheumatoid arthritis) could turn into a blockbuster especially as it is being trialled in other indications.

Robert Half (NYSE: RHI) was my pick of the day. You would be surprised to see how closely its metrics correlate with employment data elsewhere and I will try and cover the earnings in more detail shortly. A quick look at the American Staffing Association Index confirms that this is the strongest start to a year since 2007 and I think RHI could have some good things to say. Granted it may well already be in the price but this is such an important component of the US economy that it can’t be ignored.  The company's message was a positive one for the US, but Europe appears to be lagging.


Keeping up the theme of the US economy, Fair Isaac’s commentary may give some color on the potential for increased lending in 2013. Boeing will naturally attract a lot of attention following the dreamliner battery debacle. Core Labs has long been one of the best ways to play oil and investors will be keen to see what it has to say about US rig counts and how the majors are spending on reservoir management. It’s also an important day for technology with IT security company Fortinet reporting results. The sector is doing okay, but there appears to be some disruption from the likes of Palo Alto Networks so there could be some volatility in the mix. I think Fortinet could do well from the type of trading down that has negatively affected others.

However my tech highlight has to be Facebook (NASDAQ: FB). The company produced some excellent results when it integrated advertising into its mobile activities via sponsored stories, but the question is how long can this growth last? It’s easy to project out growth but it’s far harder to predict user behavior and whether it will start to react to having advertisements interspersed within finding out what their friends are up to. I think this is a key issue and I also question how the shift to mobile and tablet is changing the content of what people put on line.


Thursday sees my favorite stock in the aerospace sector BE Aerospace give results and another company with aviation exposure Ball Corp will also report. Sherwin-Williams has been on a great run and investors bullish on housing will want to take a closer look at it. Another stock with heavy US housing exposure is Whirlpool. I like the stock and its prospects and will watch the results closely. My only concern here is with its exposure to Brazil. There appeared to be a slowdown there in the second half, but anecdotal evidence suggests things are getting better of late.

My two highlights are in the personal care sector. Colgate-Palmolive (NYSE: CL) is a superbly run company that has been executing very well over the last few years. It seems to have taken share from Johnson & Johnson with oral care in the US and is aiming for 8-9% growth from emerging markets. I think the latter could prove tough. Yum Brands and others have seen some slowing growth in China and while the Government may be able to spend money Chinese consumers may not be so willing if the export factory that they work at is seeing slowing growth.

It is a similar story with Mead Johnson (NYSE: MJN). The company has been losing market share in China as conditions there have got tougher. Danone is aggressive in the market and when Mead Johnson tried to increase prices earlier in the year and it then promptly lost market share.  Bad timing.  In response Meade embarked on promotional activity and increased trade execution. Such measures can only go so far and it is far from clear what the company will report.


Friday’s are usually pretty quiet but health care plays Merck and Perrigo will create some interest. I love Perrigo’s end markets of generic pharmaceuticals and OTC nutritionals. The problem is I think its guidance may prove hard to hit. The picture will become clearer after these results and it will be good to see the company return to form after two disappointing quarters

Wednesday, January 30, 2013

Check Point Software Disappoints Again

I’ve long been fascinated at how different investment perspectives can produce dramatically different conclusions over stocks. The only sure conclusion I’ve drawn with any certainty over the issue is that investors should stick with the investment approaches that they advocate. With this in mind I decided to sell my position in Check Point Software (NASDAQ: CHKP) not because I don’t think it is a ‘buy,’ but because it has now become much more of a value play rather than the kind of GARP stock that I buy/hold.

Check Point Software Earnings Analysis

Check Point revenues came in below analyst forecasts and slightly below the midpoint of the wide guidance it gave at the last set of results, although non-GAAP EPS came in at the top of internal guidance at 91c. Moreover, the guidance was weaker than expected:
  • Q1 revenue guidance of $320-332 million vs. consensus of $334 million
  • Q1 non-GAAP guidance of 74-80c vs. consensus of 80c
  • Full year revenue guidance of $1.4-1.45bn vs. consensus of $1.45bn
  • Full year non-GAAP EPS guidance of $3.30-3.50 vs. consensus of $3.48
In general the top end of guidance is holding on to the analysts’ consensus. On a more positive note, Check Point does tend to be conservative in its guidance, and the global economy has been weaker in the second half of 2012. Nonetheless there are a few worrying signs here.

Firstly, I want to outline how product sales growth has now turned negative.

This is not a problem in itself because recall that Check Point bundles software blades with its hardware platform, so pricing of software/hardware can change within the bundle. In addition, Check Point has been managing a transition to a new product appliance line and dealing with a weaker global economy (Europe is traditionally around 40% of its sales). Both of which have turned product & license sales growth negative in the quarter. Meanwhile software blade growth has remained impressive.

Deferred Revenues Growth Weaker at Check Point Software

Focusing purely on product and license sales can give a misleading picture. In order to calculate how Check Point is performing I like to add together total revenues plus the change in deferred revenue. This metric has also been in decline.

Indeed the company is aware that investors look at deferred revenues because it outlined the key reasons why growth was lower here.
  1. A tough comparison with Q4 2011 which saw a strong rise in early long term bookings made
  2. Software blades deferred revenues rose less than last year.
  3. Product sales growth slowed (due to the transition) so associated services bookings were lower too.
Furthermore, the product transition also seems to have encouraged some trading down. Check Point argue that the new portfolio of appliances have three times the performance. This has had the unfortunate affect of encouraging customers to pay less in order to retain the performance they had before, and average selling prices (ASP) have been dragged down accordingly.  In other words, customers are taking the opportunity to save money rather than upgrade. Frankly I wouldn’t expect anything less in this environment.

When questioned on the issue of the assumptions made for ASPs in the guidance, management replied that they had forecast them to be ‘stable’ and noted that although they had declined in 2012 there was an ‘improvement in the trend’ in Q3 & Q4. It sounds good, but I’m not sure if this means a de-acceleration in a downtrend or that a trough as been passed in ASPs. Such considerations are important when viewing Check Point’s guidance.

What the IT Security Industry is Saying

Whenever independent analysts like Gartner report on the industry, Check Point is consistently seen as the leading player in terms of sophistication but not necessarily offering the most cost effective solution. Indeed, nascent rivals like Palo Alto (NYSE: PANW) appear to be taking some share from the incumbent firewall players like Check Point, Juniper and Cisco Systems (NASDAQ: CSCO). At the last set of results Palo Alto confirmed the market was still growing and talked of major firewall wins against CHKP and a number of data center security wins vs. CSCO.

Furthermore, it mentioned some aggressive pricing competition in the quarter. Ever since then analysts have been looking to downgrade estimates for the leading firewall players, and investors have to ask whether the decline in CHKP’s ASP is really a pure function of customers trading down because of better ‘bang for buck’ performance or whether there is an attempt by CHKP to kick start unit sales via aggressively pricing hardware/software bundles.  Perhaps the most interesting company right now is Fortinet, whose Unified Threat Management (UTM) solutions are better tailored to smaller companies. It may be a beneficiary of ‘trading down’ as customers look to choose more cost effective solutions over technological sophistication.

Elsewhere Cisco reported good-but-slowing growth in security, and there is a feeling that it needs to make an acquisition here to refresh its approach to the sector. All eyes naturally turn to Palo Alto, which is why I would look away. As a rule I don’t think it’s a good idea to chase richly rated stocks when there is a feeling that speculators are buying the stock and hoping for a bid.

Where Next for Check Point?

This stock is a strong value proposition, but with every value investment there must be a clear pathway to an ‘outer.’ In the case of Check Point ignore the 17x PE and focus on the fact that it is a prodigious free cash flow generator. It just generated 9.5% of its enterprise value in free cash flow and even with only high single digit earnings forecast for this year, the stock looks cheap.

On the other hand, there has to be a clear value outer. To its credit, CHKP is engaging in stock buybacks, but I think it is long since time that the company paid a dividend. The evidence is that when companies like Cisco get with the reality and start becoming an option for income investors then they will get a re-rating

On the conference call the management made it clear that it would not make acquisitions unless they added to the strategy of the company. This seems to be to try to maximize cash flow out of its installed base and from the shift to software blade sales while retaining technological leadership. This is fine but it does indicate a maturing company that is hoarding cash on its balance sheet while its rivals are snapping at its heels. In addition, declining ASPs are never a good sign, especially when accompanied by weak product sales growth.  The hope is that marketplace demand grows into the type of solutions where CHKP is cost effective, but this could take time.

F5 Networks Research and Analysis

While most investors were focusing on the carnage at Apple, some of us were looking at a stock that is benefiting from many of the drivers created by the iPhone. In fact, F5 Networks (NASDAQ: FFIV) benefits from any kind of smartphone, tablet device or anything else that increases the necessity for corporations to move bandwidth rich applications around the Internet. F5 reported a good set of results and there are plenty of profit drivers for 2013. I like the stock and continue to hold; here is why.

F5 Networks Earnings

The numbers were in line with the internal guidance given in the last quarter.
  • Q1 Revenues of $365.5 million vs. guidance of $363-370 million
  • Q1 Non-GAAP EPS of $1.14 vs. guidance of $1.14-1.16
  • Q2 Revenue Guidance of $370-380 million vs. analyst consensus of $378 million
  • Q2 Non-GAAP EPS Guidance of $1.21-1.24 vs. analyst consensus of $1.20
In summary, the results were at the lower end of previous guidance, but going forward the internal forecast was stronger than the market had anticipated. I confess I thought that F5 would give a decent set of numbers when I bought some more of the stock at the last results. As outlined in a previous article there were a few upside catalysts for F5 and it seemed to execute well with them in this quarter. The good news is that they can contribute even more in 2013.

F5 Networks Stock Analysis

On the conference call management reiterated the forecast that the second half of fiscal 2013 would see better relative results than the first and, with the good guidance for Q2, the market took heart that F5 was headed for a strong year. Growth remains in double digit territory despite a challenging tech environment.

Things look good for F5 due to the following points.
  • New hardware and software (which started shipping at the end of the quarter) will create a product refresh cycle.
  • Cisco Systems (NASDAQ: CSCO) pulled out of the application delivery controller (ADC) market and F5 has plenty of potential to replace Cisco.
  • Telco is a key vertical and carrier spending appears to be making a comeback.
  • US Government and Japan were weaker than expected in the quarter, and there is potential for resumption of growth in 2013.
Starting with the industry verticals, Telco was stronger this quarter and snapped a declining streak while Government was declared to be behind internal forecast even if this is traditionally a weak quarter for Federal revenues.

Telco was impressive this quarter, and F5 referenced a lot of interest in its products coming from mobile. This makes sense because if the carriers do ramp up spending it will surely be more on the wireless side. Federal spending is likely to come back a bit after the fiscal cliff issues are resolved.

With the Technology segment, management stated that the weakness was due to a couple major customers who were building IT architecture that required F5 to invest in producing solutions that integrated its functionality within their applications. The hope is that these revenues can come back in a few quarters.

Lastly the Financial vertical remains strong, and if you have seen how some floors of investment banks are becoming data centers thanks to the amount of quant based trading going on, then you would understand too.

Cisco pulling out of investing in the ADC market was fortuitous timing for F5, especially as it has a major product refresh this year. In addition F5 has a small but growing data center security solution, which is competing with Cisco and Juniper Networks (NYSE: JNPR). Juniper recently reported declining revenues in its security solutions and even though F5 doesn’t compete across the whole security product range, it will offer Cisco and Juniper strong competition in areas like mobile or the data center. It already sells into these customers with ADCs.

Finally on the issue of the product refresh, F5 took a positive approach even though these things can sometimes work against technology companies. History is littered with companies that had a quarter or two of weakness based on its sales force or channel partners not getting up to speed on the new products or managing sales leads accordingly. Moreover customers may just decide to buy the cheaper options and take a ‘wait and see’ approach. It's something to look out for.

Time to Buy F5 Networks Stock?

In conclusion I think the stock remains attractively priced and has potential for upside from the factors listed above as well as some cyclical help. The company generates a lot of cash flow which belies its lofty PE ratio, and the median analyst target of $110 should be well within reach provided it hits consensus estimates. There is some uncertainty with the product refresh but the new products are already being shipped. The management should have some early data on how the cycle will work for them, and the noises are positive.

This is a stock well worth looking at for the cyclical end of your portfolio, and I am happy to hold for now.

Tuesday, January 29, 2013

Quest Diagnostics Investment Research and Analysis

Diagnostic testing company Quest Diagnostics (NYSE: DGX) caught my eye recently. It’s always nice to balance a portfolio by deliberately buying stocks whose prospects are not cyclically aligned, and Quest seems to fit the bill. In summary, the stock price driver is likely to be a combination of its internal reorganization plans plus the top line effect of reimbursement issues. It does have some cyclical upside from an improving economy leading to more doctor visits but the key drivers will be the first two points.

Quest Diagnostics

The investment thesis with Quest is that it operates in a marketplace that has historically grown at 4% and (it expects) will do so in the future. The problem with Quest is that hitherto it hasn't grown at these rates, and the opportunity exists for them to do so in the future through a mix of initiatives. As such, Quest offers the kind of growth via execution that I referred to earlier.
I’m going to list these initiatives in order to refer to them later in the year and comment on their progress and viability.
  • The first platform is the refocusing towards Diagnostic Information Services and an ongoing review of the existing businesses. Indeed investors immediately saw some evidence of this in the plan to sell HemoCue (point of care tests). This sort of thing is emblematic of the restructuring challenge ahead. HemoCue was bought as recently as 2007 for $420 million in cash, and from the conference call its clear that it doesn’t expect anything like that amount from the sale. Another area under review is the poorly performing pathology services unit. Anatomic pathology revenues have declined 13.8% since two years ago.
  • The second is described as ‘operational excellence,’ which just seems to be a nicer way of saying cost cuts plus some procurement efficiencies. The good news here is that it affirmed it was on track to hit run rate savings of $600 million by 2014. To put this in context, this year’s revenues were $7.4 billion and these savings are a large part of why it feels it can achieve double digit growth in 2014.
  • The third platform is a range of measures intended to restore growth. This includes internal measures like consolidating the sales force and investing in higher growth areas like esoteric testing. Longer term things like companion diagnostics and international expansion are on the table. With the new unified sales team in place, this will be the first year of this restructuring activity.
  • The fourth is an administrative measure that reduces management layers, which will simplify how the company is run.
  • The fifth measure relates to better capital deployment and a commitment to try to return the majority of free cash flow to shareholders. Debt is being reduced and given that Quest generates huge cash flows there is room for acquisitions. Indeed it forecast $750 million in free cash flow for 2013 (although high, this is lower than normal due to increased CapEx), which equates to around 6% of its current enterprise value. There is scope for greater shareholder return here.
Quest Downgrades Expectations

These plans are fine but Quest has to deal with ongoing challenges from pricing pressures emanating from reimbursement issues. Indeed full year revenue expectations were cut to 0-1% growth and EPS guidance came in at $4.35-4.55, way below analysts’ consensus of $4.81.

Reimbursement issues are expected to cause a 1-2% decline through to 2015 but with a 3% impact in 2013. The key word is ‘expect’ because ultimately political issues come with the usual caveats. In 2013 the biggest negative impact will come from Medicare and pathology.

Here are the last three years of revenues by payer:

It’s not hard to see that it is a difficult marketplace.
Interestingly the hospital and reference lab marketplace has been growing for Quest even though many see this as a challenged area. Going forward, I suspect Quest will try to leverage up its esoteric testing because this is where it can offer the greatest opportunity cost benefit to the hospital.

Where Next for the Market?

Together with Laboratory Corp. of America (NYSE: LH) Quest makes up less than half the market in the US so it is still a fragmented marketplace that could benefit from consolidation. A quick look comparison of LH’s vs. Quest revenues displays that the opportunity for Quest to play catch up is real.

DGX Revenue TTM data by YCharts

Both companies are hoping for growth in the future from the Affordable Care Act (ACA) on the basis that it will bring more people into the mix but the real question is whether the long term growth rate is still at 4% for the industry.

I think there is reason to doubt this because Quest described current market conditions as remaining sluggish, and if it is relying on the ACA to spur growth in 2014 to 4% then the underlying trend must be weaker. Throw in the reimbursement pressures and does 4% per annum really look achievable long term?

Where Next for Quest?

The stock is attractive and worth watching closely. From a value investor's perspective this sort of situation is attractive and Quest does have upside from successful execution. I like the idea here and will monitor with a view to seeing how the diagnostics market develops. If Quest can hit its targets and start returning cash to shareholders, it will surely be higher in a year’s time. However there is plenty of time for this to play out, and reimbursement issues are not going away anytime soon.
One for the monitor list.

Johnson & Johnson Still Offers Good Upside in 2013

The investment thesis for Johnson & Johnson (NYSE: JNJ) has long been that of a cheaply rated company whose medium term prospects are mainly about execution. This is attractive because it gives a nice balance of secular growth to a portfolio while paying a nice yield. Okay, its growth prospects are no higher than single digits but in an environment of miserly bond yields JNJ offers bond-like security with GDP+ growth prospects. A compelling proposition and the recent results did little to dispel this idea. Indeed, the restructuring plans are exactly what the stock needs to take it higher.
As ever with a diversified company of this size, not everything will be firing on all cylinders at the same time. These results were no different.

Consumer Products (21% of Sales)

Yet again the consumer products division gave disappointing numbers with declining US sales being offset by international sales growth in order to reach a paltry .9% rise on an operational basis.
With that said there was some positive underlying news in these results and investors shouldn’t be too disheartened.
  • Baby care sales appear to have stabilized in the US and operational growth in the key international markets was a healthy 3.5%.
  • Oral care growth in international markets was an impressive 6.6% and even though the US was down 4.6% investors need to recall that Colgate-Palmolive (NYSE: CL) has really expanded into mouthwash in the US this year. It’s natural for JNJ to lose some share against such a formidable and focused competitor but JNJ’s international performance with the new Listerine products was good.  CL stockholders need to consider this because EM is really what is driving growth at their company. Is JNJ taking back market share?
  • Skin care remains a problematic category and JNJ is subject to intense competition while women’s health recorded weak performance in the US offset by strong international growth.
The real ongoing story is with OTC/Nutritionals, which make up 32% of consumer product sales and 6.6% of the total company sales. US sales declined 3.8% while international sales rose 5.7%.  JNJ has suffered over the last few years with product recalls and manufacturing issues and it is here that it will likely see some upside in 2013. Management intends to get ‘75% of the brands’ back to the market over the course of 2013. The exact timing is subject to the usual caveats but nevertheless it does represent a growth opportunity for JNJ and brands like Tylenol have strong market resonance.

Pharmaceuticals (37% of sales)

This is the real turnaround story at JNJ and a combination of new drug launches plus clinical success has seen strong performance this year. Worldwide operational sales were up 8.5% in the quarter. Some highlights include:
  • Remicade (rheumatoid arthritis) represents 23% of total pharma sales and was up another 5.5% in the quarter. It belongs to a class of TNF Blocker drugs that represent the fastest growing segment of RA treatment. Sales are likely to carry on expanding strongly but there is a possible longer term concern here. Pfizer (NYSE: PFE) has had a JAK Kinase inhibitor (tafocitinib) recently approved and some rheumatologists believe that if it can demonstrate efficacy, safety and cost effectiveness then this class of drugs (and there are plenty of them in development) could replace TNF blockers like Remicade as a second line treatment.
  • Elsewhere in immunology Stelara (psoriasis) was up 30% worldwide and Simponi grew nearly 55% on an operational basis.
  • Neuroscience results were better than the headline figures suggest. Concerta (attention deficit disorder) is facing generic competition but I note that combined sales of Invega and Invega Sustenna  (schizophrenia) are now above the declining sales of its older antipsychotic Risperdal. So while neuroscience looks tough for JNJ in 2013 the underlying trends are not as bad.
  • The real star was oncology with Velcade (multiple myeloma) and Zytiga (prostate cancer) combined seeing sales rise 51%. Together they were responsible for all the growth in the oncology segment.
In a sense JNJ is demonstrating its real strength as a big pharma company with plenty of marketing muscle. New product sales have been very impressive and it looks likely to continue this trend into 2013 even if Concerta is going to be hit with increased generic competition.

Medical Devices & Diagnostics (42% of Sales)

There are four interesting stories here:
  • Successful integration of Synthes and ongoing growth in orthopaedics
  • JNJ announced it is evaluating options for its Diagnostics division.
  • International specialty surgical sales were up 9.5%, and this is a good sign for a company like Covidien, which is focused on growing surgical revenues in emerging markets. Indeed, JNJ’s results are a welcome positive because others in the sector have been a bit weaker lately.
  • Worldwide vision care operational sales were up 6.4%, and this is ahead of the kind of industry growth rates that Cooper Companies (NYSE: COO) talked about recently. Cooper is better placed in the faster growing segments of the vision care market so if JNJ can report this kind of extra-industry growth then Cooper may surprise on the upside
The Bottom Line

Although the full year EPS guidance ($5.35-5.45) was a bit lighter than the consensus at $5.49, JNJ usually tends to be a bit conservative. Moreover, no one really can say for sure how quickly the McNeil consumer products will get back on the market or if the diagnostics division will be divested. The good news is that these positive drivers look to be in place so it looks like a matter of when, not if.

As an investment proposition JNJ still represents a stock generating 6%+ free cash flow yield with solid high single digit earnings prospects and some upside from successful execution. Throw in the 3.3% dividend yield and it really is a better proposition than a long dated government bond. It is well worth balancing the risk end of your portfolio by holding it.

Monday, January 28, 2013

IBM's Growth Prospects

Johnson & Johnson reported decent results recently and confirmed its status as a high cash flow generative company with growth prospects from organizational upside, then IBM (NYSE: IBM) reported the next day and basically did the same thing. In summary, the results suggested IBM is on track with its refocusing efforts on higher margin business at the expense of pure revenue growth and its outlook provided good news for the IT industry in general.

A Better Quarter

IBM spooked the market at the time of its previous results with talk of a weak September and the technology market wasn’t slow to price this in. There is no doubt that a combination of fiscal cliff issues and the election did cause a reluctance amongst IT purchasing managers in the quarter, but when a bellwether like IBM states it so explicitly, the whole market listens.

In the end, IBM declared the current quarter was ‘fairly constant month to month.’ So nothing to worry about there and nor was there anything unusual about the geographic mix. EMEA revenues were down 3% and the BRICs were up an impressive 14%. US revenue was down 1%, but I suspect this is largely due to the refocus on higher margin work. In fact, gross margins expanded 190 basis points in the quarter while pre-tax margins were similarly up 200 basis points to 26.7%. Pre-tax profits went up 7.7% even as reported revenues declined .6%.

IBM’s Three Key Takeaways from the Quarter

There were some very notable aspects to this quarter:
  • IBM is committed to increasing profitability (possibly at the expense of revenue growth) by shifting to higher margin revenue streams. In a sense this is a given with the increase in software and services revenues relative to hardware, but even within Global Technology Services there has been an emphasis on improving the profitability of low margin contracts
  • The second key point is that software and middleware strength is counteracting any move away from hardware. Indeed IBM reported acceleration in middleware growth from the rate achieved in the previous quarter.

Middleware is expected to contribute mid-single digit growth in 2013.
  • The third key takeaway is that IBM managed to achieve a rebound in its System Z mainframe revenues so total systems revenues were actually up 4% excluding numbers from Retail Store Solutions (RSS). Indeed, IBM talked of double digit growth being driven in the first half by the strength of hardware sales of System Z. Impressive stuff.
How This Relates to the IT Industry

Essentially I think it is pretty good news for the likes of Oracle, which is a key competitor in the middleware market, and I think Informatica can take a positive from the ongoing strength in big data analytics and master data management. The re-acceleration of growth in these initiatives in Q4 added to the affirmation of decent growth in overall software spending suggests that both will have good quarters.

However, for companies that are predominantly hardware based like Dell (NASDAQ: DELL) or Hewlett-Packard (NYSE: HPQ) it was not such a positive report. Although IBM has long exited the PC business, the trend in hardware sales is not good and arguably IBM only reported good results here because of the new System Z mainframe sales. Storage hardware saw a 5% decline and HP and DELL are both key competitors here. In addition, IBM saw power sales down 19%, but claimed that it won significant business from both Oracle and HP. If you put these things together with what Intel said recently about PC sales then it suggests HP and Dell are set for some tough quarters ahead.

Dell's non-software and services revenues (about 68% of the total) declined over 12% in the last quarter and small business surveys have indicated an ongoing willingness for companies to spend on things like smart phones and software over PCs and hardware. Funny enough HP also generates 68% of its revenues from non-software and services and the decline in these revenues was closer to 13% in the last quarter. Worrying times for both companies.

Where Next For IBM?

Full year non-GAAP EPS guidance is for $16.70, which would put IBM on a forward PE of just 11.7x, and the company has just generated 7.5% of its enterprise value in free cash flow. These are impressive numbers for a business that looks set for margin expansion even if top line growth is derisory.
The shift toward more software and services plus the constant pruning is not only changing the performance metrics (higher margins and cash flow), but also de-risking the company from exposure to unfavorable hardware trends. For those interested on compiling a blue-of-blue chip portfolio IBM fits the bill. It’s not expensive and with near double digit EPS growth forecast for the next couple of years I think it will do okay.

Fastenal Still Looks Expensive

Fastenal (NASDAQ: FAST) investors would have looked at the upcoming results with a sense of trepidation following MSC Industrial’s (NYSE: MSM) recent report. The good news is that they weren’t as bad as some had feared and the stock rallied. However, the underlying trends aren’t so positive for the industrial sector in general and much of the growth was related to expanding sales via its vending machines. In summary, this is good execution from Fastenal and augers well for MSM (which is also expanding roll-out of vending machines) and given a second half recovery in the US the company has upside.

Fastenal’s Pathway to Profit

As ever with Fastenal, investors need to keep their eyes on the long term objectives of the company. The so called ‘pathway to profit’ is a series of objectives and metrics with which Fastenal’s performance is benchmarked. I stress this mainly because I am struggling to find a reason why the evaluation of the company is so high. Perhaps the market is merely pricing all of these metrics as a given? I don't know, but whatever the reason Fastenal has done something to win investors over.
A summation of the pathway to profit objectives:
  1. to continue growing our business at a similar rate with the new outside sales investment model
  2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012 (this has subsequently been pushed out to 2014)
  3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow
  4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
  5. to generate 85% of earnings in operating cash flow
We need to understand these objectives in order to put the recent results in the proper context.

Vending Growth Masks an Underlying Slowdown

In the conference call Fastenal discussed the drop-off in demand in its core fastener business and naturally attributed it to a slowing macro-environment. It is perfectly feasible to expect end demand to correlate to its OEM customer production and therefore with industrial demand trends. Indeed, Fastenal reported slowing growth in the key metric that I like to follow.

Specifically, here are the growth rate figures for stores open more than five years. It looks like a clear slowdown to me.

This is confirmed when looking at how the sales numbers this year have been compared to normal sequential movements at the company.

Indeed fastener sales growth slowed to 2.5% in the final quarter from 15% in the first. So the economy did slow end market demand.

On a more positive note Fastenal managed to take initiatives to grow revenues in the non-fastener area. Indeed, a combination of these initiatives in government, metalworking and the previously mentioned vending operations mean that Fastenal can find ways to generate secular growth. In a similar sense a company like Grainger is looking to expand its online activities while MSC is doing both. Another underestimated competitor in the future could be Home Depot. While it is not an obvious rival in specialized lines of business, it obviously has the scale to be able to leverage up its e-commerce offering in the sector, particularly if this will entail selling its in-store brands through online channels.

Essentially these companies have these opportunities because the marketplace is so fragmented and characterized by lots of small local suppliers. This gives Fastenal the opportunity to consolidate the market and build on economies of scale.

As for how vending sales are expanding:

The growth here is wonderful for cash flow generation and helps Fastenal capture economies of scale in line with its plans outlined above. Indeed the plan is to ramp up capital spending this year in order to drive secular growth from vending.

Where Next for Fastenal?

A quick look at analyst estimates sees high double digit earnings growth forecast for the next couple of years. It also indicates a forward PE ratio of nearly 30x which looks a bit rich to me. Granted this ratio will come down with any kind of pick-up in industrial activity in the US, but I still think it is too expensive a proposition. Moreover at some point, growth from vending machine based revenues will slow. For now the company isn’t worried, and vending machines represent a great way to increase margins and cash flow conversion.

An attractive company, but every investment comes at a price and an enterprise value of more than 19x EBITDA simply isn’t cheap enough.

Saturday, January 26, 2013

Capital One Financial's Results Weren't That Bad

We have all heard all we can possibly take on the subject of banks, loan quality, off balance sheet accounting and such matters over the last few years. I won’t attempt to add anything new to the discussion other than to make one key observation concerning Capital One Financial’s (NYSE: COF) recent results. Before I get to that I will summarize that I thought the recent results were okay and the stock still represents a good way to play a belief in a long awaited cyclical upturn in the credit cycle in the US.

Why the Market Hated the Results and I Didn’t

A quick look at the price chart will reveal that not everyone shares my rosy view! Indeed, the reason why the market hated them was a combination of three things.
  1. Some unexpected seasonality creeping into the results
  2. Normalization of revenue suppression (I will explain in plain English)
  3. The outlook for a decline in average loan volumes in 2013 as runoff is forecast to offset underlying loan growth
First, the unexpected seasonality appears to be more of an optical problem. COF’s business is always seasonal--more so than its rivals American Express (NYSE: AXP) and Discover Financial Services (NYSE: DFS)--however, it has been masked over the last few years by unusual cyclicality in the economy. This seemed to catch analysts cold, and COF’s management even mentioned the need to educate the analyst community over this issue.

Second, revenues decreased from the third quarter mainly due to a return to normal levels of revenue suppression, principally in the domestic card segment with loans acquired from HSBC (NYSE: HBC). Finance companies earn income fees and charges from credit card loans in line with contractual arrangements. Since not all of these monies will be paid (and more so when the economy is bad) the company has to reduce the level of expected income, and this reduction is called the suppression amount.

Now let’s say that a company acquires a lot of loans with a high suppression amount and then the economy gets better and concomitantly credit quality does too. This will result in a benefit when that suppression amount is reduced. Indeed COF saw a $70 million benefit in Q3, however, in Q4 that benefit reduced to $10 million. This helped reduce earnings from Q3 to Q4, but it is just a return to normalization. No need to panic. Indeed COF stated that there was no change in its long term estimates of recoverability.

The third issue is more problematic because this issue will face the credit industry in 2013. Essentially we are in a lower lending environment than pre-recession and runoff will challenge the ability of banks to replace those previous loans with new ones. It was a similar story to what many deduced with Wells Fargo's (NYSE: WFC) recent set of results. In WFC’s case it was about investors unfavorably comparing declining refinancing activity with the growth in the mortgage book.  You can read more on that here.

My point is the same for WFC and COF. Ultimately lending will follow the general economy. When the economy is on the up, everyone will want to lend. With regards to WFC the growth in deposits (which hurt the net interest margin) is actually a good thing because it could mean more lending in the future.

One Key Observation

Remember the great financial crisis? Remember how everyone hated the banks for their failure to manage risk? Well they were incompetent but investors need to remember one thing. When the economy is doing well asset quality tends to improve and banks want to lend. Movements in banks' balance sheets are as much about the pricing direction of the underlying assets as they are about credit risk. Investors wanted the banks to lend then because assets (housing etc) were doing well.

Now consider the current situation. If credit quality is improving, unemployment reducing, housing recovering and the economy is gradually improving than its time for the banks to start lending again and it is these notions that will ultimately decide the direction of the banking sector in 2013. Just as prior to 2008 we want the banks to lend but we don’t want off balance sheets leverage.

Where Next for Capital One?

On the negative side the outlook wasn’t great and no one likes to see earnings miss estimates, but on the positive side the reasons for the miss are as much about analyst expectations as they are about the underlying business.

On the positive side, if you share my bullish view on US credit expansion in 2013 and you look at the evaluations of the sector you can see that COF looks cheap on a historical basis. I know this is a busy chart but note how COF is lowly rated because it has a low RoE and vice versa for the other stocks.

data by YCharts

On a relative evaluation basis it rather suggests that DFS is the value in the sector, and AXP looks a little rich in relation to by stint of generating similar return on assets to DFS but having a higher price/book ratio.

Going forward, COF looks set to increase its dividend and provided you want exposure to the credit cycle this dip could be creating a decent entry point.

Varian Medical Systems Research and Analysis

Varian Medical Systems (NYSE: VAR) offers an attractive long term picture but it also contains some execution risk. In fact, its mix of profit drivers and stock specific risk are so rich and diverse that probably the best way to start looking at it would be via a SWOT analysis. In summary, there are many reasons to like the stock but there are also risks. I think this stock will be great for a large diversified portfolio but less attractive for the kind of focused (20-30 stock) GARP based portfolio that I run. Nevertheless I may take a half position here.

  • Along with Elekta it dominates the radiation oncology market (77% of recent orders). It also has an attractive X-Ray division (16%), of which it has 20-25% market share that can grow over time, and a solid security division (7%), which is involved with things like cargo screening.
  • Current book to bill is 1.1x indicating strong demand even in a slow economy.
  • It is developing a game changing proton therapy treatment which will take a few years to come to fruition.
  • It recently received 510k clearance for its ‘Edge’ radiosurgery suite and will be aggressively marketing it in 2013. This threatens to take share from Accuray Incorporated’s (NASDAQ: ARAY) CyberKnife system, and market awareness of this product may be the reason for Accuray’s poor performance lately. Accuray recently gave a nasty downgrade to sales estimates and it it will face increased competition from VAR's edge in the future. Moreover, if emerging markets are the growth opportunity then it will have to demonstrate a cost effectiveness that small companies are rarely able to achieve with low volume production
  • It is exposed to a sector of the economy least likely to be affected by a slowdown in the BRICs.
  • It has already lost share to surgery in prostate cancer as robotic based surgery becomes more fashionable. Meanwhile the likes of Intuitive Surgical (NASDAQ: ISRG) are aggressively trying to expand the procedures that its systems are popularly used in. Intuitive has achieved a strong position in prostatectomies and growth in colon surgery and hysterectomies but its challenge remains the same. These types of procedures tend to be without significant variance and clinics will find it cost effective to increase volumes by using the da Vinci system. However it is not clear that general surgeons (who perform a much wider range of procedures) will encourage clinics to buy the system.
  • Continual need for innovation creates execution risk, R&D risk and costs EPS.
  • The developed and lucrative US market represents a replacement cycle market for VAR unless it can release a new breakthrough product
  • Emerging markets (where the growth will primarily come from) tends to be lower margin
  • The long term development of proton therapy offers exciting technological  advantages (better targeting, less invasive) and opens up new categories for treatment
  • VAR want to expand radiation therapy in lung cancer and this represents a huge future opportunity in emerging markets. According to VAR, palliative care (with radiation oncology) makes up 80% of lung cancer treatment and only 20% is for curable intent. VAR want to get those figures to 50/50.
  • It has strong emerging market prospects, with notable under provision of linear accelerators (Linacs) in the BRICs. For example the company quotes 2,234 linacs currently in the BRICs but sees the potential for 4,100.
  • Growing software and services sales offer the prospect of margin expansion in future.
  • VAR replaced its partnership with General Electric by signing a partnership with Siemens (NYSE: SI). Siemens is pulling out of radiation oncology but has a 2000 strong installed base with which VAR can now target for replacement. It can also sell its information systems into that installed base as they are now compatible with the Siemens legacy systems. 
  • Austerity measures threaten more severe reimbursement issues for the company, and a large part of its sales are to government bodies
  • Will proton therapy ever be commercially viable? VAR is aiming for solutions in the $25-50 million range but even if they get there, will other less expensive treatments take spending dollars away?
  • Will the loss of the GE deal hurt VAR?
  • Will robotic surgery steal its thunder?
  • Advancements in cancer treatments elsewhere may reduce demand for iits products
The VaR at VAR?

Okay not a technically correct subheading, but you know what I am getting at! There are a lot of opportunities here and I also liked the look of the recent healthcare numbers from GE so don’t be surprised if VAR has some near term upside from clinics being more willing to undergo capital outlays.
On the other hand there are significant risks too. The biggest one probably relates to its plans for proton therapy. Committing huge amounts of investment and giving up EPS is one thing, but VAR is making a bet on being able to make this treatment commercially viable and that it will become a gold standard of cancer treatment. Furthermore, the specter of reimbursement issues always hangs over companies selling expensive capital machinery in the US and longer term threats from the robotic surgery companies like Intuitive also present potential competition.

On balance I think the stock is attractive for long term investors who want a health care stock for the risk end of their portfolio.

Thursday, January 24, 2013

Intel is Becoming Interesting

Intel (NASDAQ: INTC) came under pressure after its recent set of results but I think the stock is well worth taking a close look at. There are some interesting underlying things happening here. In summary, Intel is making the right strategic decisions now and if you believe that global GDP will be higher in the second half and you buy Intel’s guidance, then the stock is compelling.

Intel’s Tough Year

There are two reasons why Intel had a bad year leading into these results.
The first is that guidance was progressively lowered over the year, partly because global GDP forecasts were reduced. To be fair to Intel there isn’t much it can do about that and it’s certainly not alone in having hoped for a better second half to 2012.

The second reason is that there is a structural shift towards tablets and smartphones and away from PCs. Throw in the corporate drive towards desktop virtualization and it’s no surprise that PC sales are so weak. These changes are causing significant problems for Intel’s key customers Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ). Naturally, both of them were hoping for a lift from the release of Microsoft’s (NASDAQ: MSFT) Windows 8.

Again, it is hard to blame any of these companies for having such high hopes; after all, this has been how previous Windows cycles have gone. However, Windows 8 is not going to be as big a spur as initially hoped, and HPQ and Dell are going to have to realign their sales efforts. This is also a significant challenge for Microsoft, and pressure will be building on it to start to use its cash pile to make acquisitions. It needs more than Windows.

The combination of these factors has left Intel facing falling gross margins, rising inventories (which threaten average inventory selling prices because it needs to be reduced in a hurry) and the strategic challenge of realigning its business in order to get to the ‘processing market’ via tablets and smartphones.

Intel Responds

To its credit Intel has responded.
  • Inventories were reduced by $600 million as Intel took swift action, although this helped cause gross margins to decline to 58%
  • Capital Expenditures are being ramped up to $13 billion next year in order to keep technological leadership and prepare for tablet and data center growth
  • Intel is becoming more active in ultrabooks, tablets and smartphones
  • Gross Margins are forecast to be flat in Q2 and then get back to 60%+ in the second half
  • Intel is trying to become a selective foundry manufacturer
  • Data Center growth is expected to return to double digits going forward
Some commentators questioned the CapEx ramp up at a time when Intel’s sales growth is forecast to be in low single digits. Moreover it has seen costs and CapEx rise more than the top line recently. All of which is worrying, but what else can Intel do? It needs to invest in factories in order to service future growth, not least growth coming from shifting sales to new forms of computing like tablets, ultrabooks etc. This is what investors should want them to do. The real question is whether it will get it right. Will the future of computing be the kind of convertible PC/tablet that Intel would be ideally placed to service?

As for inventories and gross margins, I discussed how pivotal they are to Intel in an article linked here. Intel is doing the right things, although I would note that its positive gross margin guidance is somewhat dependent on a positive view of global growth in the second half of 2013. If Intel does what it forecasts then I’m sure the stock will be higher. History shows that you should buy Intel when its gross margins trough.

With regards to becoming a selective foundry manufacturer, it will never be a Taiwan Semiconductor (NYSE: TSM) but it doesn't need to be. Such activities will help utilize capacity and keep margins up for Intel. The likes of Taiwan Semi will always have scale on their side, but Intel is investing relatively more on their plants so there should be the opportunity to use these factories to their full potential via this sort of initiative.

Where Next for Intel?

The stock remains cheap but then challenged businesses usually are. The good news is that the company is making the right changes and it is churlish for analysts to jump up and criticize the affect on short term profitability or cash flows when companies do these things. What is more circumspect is Intel’s view that computing will take the direction of PC/tablet convertibles and the tardiness of its development of LTE solutions. If you share Intel’s view (and the fact that they take this view will be significant to future marketplace options) then it looks like a very attractive investment.  On top of it all you will be paid a 4% yield while you wait.

Investors can make their own mind up about the macro-environment, and this too is a crucial consideration before buying Intel. Naturally all of these things together will play out in the numbers so if Intel does what it says it will, then I expect the stock to be higher.

GE Surprises on the Upside

It’s hard to ignore General Electric’s (NYSE: GE) results so I am not going to! Without doubt this is the most impressive set of results that the company has delivered in a while, and a number of positives can be drawn for GE stockholders and for investors at large. A company of this size and diversification is never going to have all its divisions firing on all cylinders at the same time, but GE gave it a really good go in this quarter.

Earnings were up in every segment and overall orders increased 7% ex wind and foreign exchange, leaving the end of year book-to-bill ratio at 1.2x, an impressive quarter by any measure. In particular GE surprised the market with some strength in its orders towards the end of the year.

GE Delivers Growth

The industrial sector has been somewhat difficult in recent months as global growth did not turn out as expected in the second half. The script for 2013 now reads for some stabilization in Europe, modest growth in the US and a lot of hope for the new regime in China to stimulate growth back up to above 7.5%. Indeed if we look at Alcoa’s (NYSE: AA) recent results it is clear (from the chart in the link) that most of its forecast growth is dependent on China. This is not a general rule over industrials and China--different companies sell to different end markets--but I think the argument does apply to GE.
Firstly here is how GE makes its money and an idea of the importance of its end markets.

Keen eyed investors will note that this is the first quarter that the previous Energy segment is now split into power & water, oil & gas and energy management.

There are some good things in GE’s results even for those of us who are somewhat skeptical on China in 2013. For example, while the indications are that the stimulus program will be different to 2008-09 and will focus on developing domestic demand. In addition, certain areas like healthcare, transportation and energy are likely to be invested in and GE is strong in these areas.
What is more puzzling in these results was that China was described as ‘shrinking’ late in the quarter yet GE saw international strength in December. So if it wasn’t China, who was it?

GE’s Order Growth

I’ve summarized order growth in the quarter here.

Power & water had a tougher year with deliveries and orders down on the previous year. Indeed, GE is forecasting around 100 gas turbines this year, which would be down from the 108 ordered in 2012 and 134 in 2011. Thermal orders subsided in line with Government cutbacks in spending on renewable energy.

The most impressive performance came with the return to growth in oil & gas and healthcare orders. As discussed previously healthcare has been an underperforming segment for GE and this looks like a return to form. Moreover the big swing in December’s performance seemed to come from healthcare. My hunch is that orders that were delayed through 2012 got signed at the end of the year. A good read across for the healthcare industry? Similarly oil & gas remains strong, although how long that will last if oil prices slip is another question.

Aviation equipment orders were strong but, here again, China is a large part of that. Indeed Boeing’s (NYSE: BA) order book is largely made up of airlines servicing emerging markets or leasing companies with activities in the Far East. Any sign of a cyclical slowdown and these orders could get delayed. Furthermore it is not an area of spending that the Chinese Government will support strategically unlike, say, health care or transportation. GE did see some aviation orders pushed out again, so look out for some lumpiness in the next quarter.

The ongoing star of GE’s segments in transportation and strong order growth coupled with segment profit growth of 36% for the full year suggest that this sector of the economy will do well in 2013. My favorite play in the sector is Wabtec (NYSE: WAB), which also benefits from US regulatory legislation on positive train control (PTC) adoption. GE’s results and order book indicate a lot more growth in the industry and China’s need to invest in railway infrastructure in the center of the country is well noted.

Key Conclusions from GE’s Results

The positive surprise was in healthcare so investors should look for capital machinery companies in the sector to report some decent orders in the quarter. Elsewhere transportation, oil & gas and aviation remained strong. I’m wondering out loud whether Honeywell (NYSE: HON) is going to confirm much of this next week. The company was cautionary on China in the last quarter but it shares a lot of end markets with GE and what it says may confirm or cast doubt on a nascent theory over a China recovery. We shall see.

GE is still a global growth play but its execution appears to be better now and I think it can be looked at as a good option for income seeking investors looking for some cyclical risk. For me, it’s time to try to find some healthcare and transportation names.

Wednesday, January 23, 2013

Why a Deal Between Verint and Nice Systems Makes Sense

According to a Reuters article, Israeli data and security company Nice Systems (NASDAQ: NICE) is in talks to buy its smaller rival and compatriot Verint Systems (NASDAQ: VRNT). As ever with these sorts of situations, Nice declined to comment on the initial speculation. However, the market seems convinced and suitably marked both stocks up in sympathy. So where next for the two stocks, and would a combined entity be a good deal?

Old Questions, Old Answers

A fitting subheading, because I did what I always do in these situations. For the record I closed a long position in Nice Systems on the day because of a long standing position of always closing positions during this sort of speculative activity. It’s a rule of mine created to avoid possibly trading against people better informed than I am on corporate situations.

That said, I happen to think that –if true- the deal is an obvious one and makes perfect sense. I like both companies and think they are undervalued. Naturally this means that I think Verint would come at a good price for Nice, provided the premium isn’t too excessive.  I last discussed Nice Systems in this article and Verint in this article. Essentially their kinds of work flow optimization solutions are a kind of back door way to play the big data story, but without the sky high evaluations or seeing the big data idea lost within a small part of a much larger companies operations.

The idea is that if multi-platform customer interactions are only going to increase in time than customer interaction monitoring and management are going to grow alongside them. Moreover as companies have more interactions and a greater awareness is created of the return on investment generated by big data analytics than more companies will opt to invest in them.

Why a Deal Would Make Sense

Nice’s strength is in the corporate sector, where it has a strong presence within verticals such as financials and call centers whereas Verint has more Government exposure. Indeed Verint has a larger share of business coming from security issues like monitoring and fighting cyber crime both internally and externally. Whereas Nice’s analytics deal with IBM (NYSE: IBM) indicates that the analytics of the data that its hardware generates are going to be a key driver for the company. The recent extension of this deal will allow Nice to fully leverage its customer base and aid IBM’s intention to dominate the big data analytics space. I’ve always felt that IBM is a potential acquirer of Nice, but if the Verint deal is on then this might have to wait a while.

Security revenues tend to be a bit lumpy with Nice, so merging with Verint would smooth out earnings, particularly as Nice is stronger in analytics. Throw in the potential synergies generated by two companies from the same country merging, and it all works well. It also makes sense from a valuation perspective with Verint trading on an EV/EBITDA multiple of 11.3x, while Nice is on 13.9x. In addition Nice has $422 million in cash on its balance sheet and Verint has (on a trailing basis) generated $111 million in free cash flow. So for the current enterprise value of $1.66 billion Nice gets around, say, $100 million (6%) back in free cash flow in a year plus associated cost savings. It also gets complimentary end markets and the opportunity to sell each others’ solutions to their respective customer bases.

In fact the only major negative could be some competitive concerns and the worry that it could be overpaying for a company that is about to disappoint the market.

Where Next For Verint & Nice?

Both companies have had to downgrade their summer expectations and then have seen things stabilize in the autumn. Although their end market drivers are driven by things like regulatory compliance requirements, they are also exposed to capital spending requirements of their customers. If clients are adopting a ‘wait and see’ approach to investing in customer interaction monitoring due to political considerations, then it will feed through into their results.

A potential deal would make sense to me and I would be attracted back in if it happens. In the long run one of these companies will attract a potential buyer, and perhaps even more so if they are combined. If a software company wants to sell big data analytics it makes sense to own the hardware companies that already have an installed base amongst much of the potential client base.

MSC Industrial Offers Come Back Potential

It’s early in earnings season, but I think that one trend is already appearing in the industrial sector. Acuity Brands said earlier that its lighting customers had adopted a ‘wait and see’ approach to purchasing in the previous quarter (you can read about here). Its argument was that a combination of election and ‘fiscal cliff’ considerations caused customers to delay purchasing. It was a similar story with MSC Industrial Direct’s (NYSE: MSM) results. So is it time to give up on industrials, or is this a buying opportunity?

MSC Industrial Disappoints but is there Upside?

IMSC’s results were disappointing and guidance was weak. Any company that comes out and guides Q2 revenues to $563-$575 million and EPS of $0.86-$0.90, when the market is expecting $592 million and $0.98 deserves to be looked at with a significant amount of circumspection. At the last set of results MSC talked of its end markets being in a ‘holding pattern’ which continued over the last quarter and then turned into ‘paralysis’ in December.

Naturally this is not the sort of environment with which MSC can push through any price increases, so there will be no margin relief there either. Indeed the usual Q2 price increase (undertaken to soften the impact of seasonal weakness in the quarter) is unlikely to take place this year. Not good.

However, I think there are reasons to be optimistic

  • The new CEO may be setting low guidance deliberately
  • Guidance is based on December trends, with little data on January so far to go on
  • The ISM data has been stronger than the sectors results and this looks like temporary bit of weakness
  • MSC’s visibility is always low which implies its purchasers have short lead times, things can turn around quickly
  • E-commerce and vending initiatives offer strong long term growth prospects
  • Its industry is fragmented and MSC can be a consolidator in any protracted downturn
  • Expansion of own label sales

I’ll try and deal with these points in turn.

MSC Industrial’s Near Term Upside

Call me a skeptic, but I think that when a new CEO takes over there is usual a kind of settling in period where the investment community wants to size up the new guy. This can cause a tendency for companies to be a little conservative with guidance in order to start off on a good footing and this may be a part of the cause for such weak guidance. Furthermore on the conference call the management stated that the guidance was based on its limited visibility and current trading. In other words, it’s based on end markets in pseudo ‘paralysis’. Two good reasons to suspect guidance is conservative.

I also think that it is hard for MSC to rely on current trading conditions at any time. It’s the same situation with other industrial supply companies like Fastenal (NASDAQ: FAST) or W.W. Grainger (NYSE: GWW). Their visibility is always limited, but that’s why they are such short term barometers of the US industrial economy. You can’t buy any of these stocks and expect very accurate guidance, nor should you pile in when everything is going great and guidance is strong because the market will usually price them in fully and the risk will be on the downside.

Moreover, the overriding ISM data has actually been a lot stronger than the sector’s recent results would suggest. I’ll articulate graphically; all data is interpolated from the ISM. Inventories refers to manufacturing companies' inventory positions, so when times look tough they get reduced in line with projected sales.

I’ve highlighted some points to demonstrate how inventory movements nearly always lag the top line purchasing managers index (PMI) data. I’ve also highlighted to recent data points, which coincide with a heightened period of political risk around budgetary stand offs. In both cases inventories declined while the headline ISM data was okay. Anything above 50 on the PMI indicates an economy in expansion. So why the sudden drop off in inventories?

It’s hard not to conclude that this mainly due to some form of temporary political effect that may well cause a snapback in confidence in the coming quarters. The graph indicates some unsual activity, and until I see another reason for it (such as a major drop off in other industrial indicators) I am prepared to run with the idea that it is unusual.

MSC Longer Term Drivers

Thinking longer term, Fastenal provides a good model for MSC to follow in terms of expanding its vending sales, and Grainger might be looked at as a model for its online activities. Fastenal has managed to increase margins and cash flow conversion via expanding the share of sales made through vending machines, and this is clearly on MSC’s mind as it spends more money on rolling them out. As one of the few bright spots in this report signings for vending solutions were declared to be ahead of internal estimates. In addition, investment in e-commerce is going to ramp up this year in line with plans.

Investment in e-commerce and other initiatives is forecast to take capital expenditures up to an unusually high figure of around $100 million. MSC needs to do this, not least because Amazon (NASDAQ: AMZN) is expanding in the space. Amazon is highly unlikely to develop into a focused player in this industry, but given that the national market is so fragmented, if MSC is going to consolidate via acquisitions then it will be helpful to have e-commerce facility already in place. Otherwise, MSC might find it hard to expand in regions where Amazon is already establishing a strong presence.

Where Next For MSC Industrial?

This stock now offers a compelling and curious mix of near term upside from -what I think- conservative guidance and long term potential from industry consolidation, vending expansion. and e-commerce development. It also offers a US focused industrial growth proposition. It is an attractive mix of the tactical and strategic. I like the stock. but would prefer it a little cheaper than it is now in order to price in the execution risk. I also think that I might be able to find a stock that has more pure exposure to the theme of a snapback in industrial demand. After all, investments in vending and e-commerce initiatives do entail some element of risk.

Nonetheless, others might like the tactical opportunity here.

Tuesday, January 22, 2013

Cooper Companies Offers Defensive Growth

The JP Morgan Healthcare conference is the most important event in the industries calendar and helps set the tone for the rest of the investing year. Typically the pharma/biotech companies outline the key pipeline events of the year or how they plan to expand existing product sales while the medical technology and services companies discuss their prospects for the coming year. I thought I’d help investors compress their research of the event and the sector by providing a brief overview of some of the presentations. In this article I want to flesh out some discussion on the growth drivers at Cooper Companies (NYSE: COO).

Cooper Companies

I last discussed this company in an article linked here and would suggest using that as a primer for this article. There is a guidance update in that the mid-point of this year’s EPS guidance has now been moved to $6, which puts COO on a forward PE of 16.3x, so it’s hardly cheap. On the other hand, investors should be willing to pay an evaluation premium for the quality of its earnings and its recession resistant qualities.

COO generates 80% of its revenues from Coppervision where it competes with Bausch & Lomb, Johnson & Johnson (NYSE: JNJ) and Novartis’ (NYSE: NVS) Alcon division with the provision of soft contact lenses. Although it is a recession resistant market Cooper argue that growth with fluctuate from 3-5% in a recession to 5-7% when trend-like GDP returns. In addition, it is well placed in specialty lenses where it sees itself as being ‘close to number one.’ Since these lenses (multifocal and toric) are faster growing than the general market then COO has been able to grow in excess of the industry.

In a similar vein, a stock like Allergan (NYSE: AGN) is able to generate super industry growth in its ophthalmic products. As contact lenses increase in popularity this should create more trips to opticians who can then diagnose any unobserved conditions that clients may already have. This is good news for Allergan and Cooper who are strong on specialized treatments.

Growth Prospects?

Aside from the growth prospects inherent in its product portfolio, I think there are a few other key catalysts which could provide upside.
  • Lifestyle changes may be responsible for increased incidences of myopia
  • Geographical expansion creates growth opportunities in places like China and Eastern Europe
  • Trading up to more comfortable silicone hydrogel lenses (where COO is investing)
  • Convincing consumers to shift to more profitable once-a-day usage
Now before I get an avalanche of complaints here, let me point out that I do not have a definitive scientific view on the causes of the incredible increased incidences of myopia in certain places of the world, such as Singapore or Hong Kong. Nor do you. However if we look at the research from one of the most widely cited papers in the subject, it claims that, because it is a relatively recent event, the environmental causes are likely to be related to lifestyle changes in the Chinese community. Whatever the causes, myopia does appear to be on the increase and it is occurring in markets like China where Cooper does have growth prospects.

Trading up to once-a-day usage from two weeks or monthly also offers substantive growth opportunities. Cooper claims to generate 4-6x more revenue and 3-5x more in earnings when a customer decides to make the shift to the more frequent lens usage. According to Cooper’s figures only 38% of users are on once-a-day lenses (and a lower percentage in the US) so there is still ample scope for revenue and margin increases from trading up. Furthermore, it is not just Cooper that benefits from trading up. If Johnson & Johnson and Novartis also aggressively push the once-a-day regimen then market awareness will increase for everyone.

Cooper Companies Evaluation

All of this is fine but how does the evaluation stack up?

Firstly, its management made a compelling case for its operating margins to expand from 20% to 25% over the next five years. COO currently pays an 8% royalty on its silicone hydrogel lenses (about 250bp of margin) and there is 100bp of amortization from an acquisition to drop out in future years. This might make investors more comfortable with the evaluation.

Moreover, Cooper is aiming to generate around $1.3 billion in free cash flow. This amounts to roughly 5% of its enterprise value annually. I’d argue that this makes it fairly valued, but I guess an investment decision in Cooper depends on how much of a premium you want to pay for the quality of its earnings. I prefer to monitor closely and wait for a dip.

PPG Industries an Attractive Play on China

Earnings season is just getting started but we are already seeing some patterns emerging in the industrial sector. Paint and coatings company PPG Industries (NYSE: PPG) gave results that defied the recent gloom over an industrial slowdown in the last quarter expressed by others. The stock has had a stellar run and any technical analysts out there would no doubt be in love with it right now. However, it’s time to ask where next for PPG and whether its earnings are reflective of the industrial sector at large.

PPG’s Results

PPG’s story over the last year has been a mix of execution with a restructuring program, favorable movements in input prices and some beneficial end markets. Not all companies have the same end markets and while all industries are cyclical to an extent, PPG has benefitted from some favorable movements in automotive and commercial aerospace. Indeed if we go back to what Alcoa (NYSE: AA) recently reported and look at the commentary on it, it’s clear that it is a mixed outlook this year. Alcoa is a good marker for PPG because one makes the aluminum and the other makes coatings.

Alcoa noted that it had been a good year for the aerospace sector, and automotive has been okay too, thanks to strong sales in the US. However I would urge a note of caution here. Alcoa’s outlook is very much reliant on growth in China and PPG (admittedly to a much lesser extent) is also hoping that China will get back to growth rates above 7.5%. Since this is not a bet I have a lot of faith in I would suggest investors be a little cautious here.

Other markets like packaging were given a mixed outlook by Alcoa, and a company like Ball Corp (NYSE: BLL) is worth following in this context. With Ball and the other packaging companies the challenge is always to get its fixed asset investment right. They need to be near their customers in order to service contracts, but if there are shifts in geographic production they will suffer disproportionately. You can’t just transport a beverage can manufacturing plant to the other side of the world because Coca-Cola wants to produce relatively more in Brazil than in, say, China!

I’d imagine PPG is faced with similar questions.

PPG’s Internal Execution

The story isn’t just about end markets. PPG has executed a very successful restructuring program which has seen an appreciable hike in margins even while top line growth was only 2.1% for the year. For example, industrial and performance coatings (which together make up around 60% of sales and income) margins saw a notable increase throughout the year.

Don’t forget to compare margins on a year on year basis in this chart.

It wasn’t just about restructuring. PPG also saw some moderation in raw material costs and declared that it expected more ‘balanced’ costs going into 2013. PPG’s management seem to feel that coatings margins can improve again in 2013.

Moreover, the acquisition of Akzo Nobel’s US household paints division is going to give greater exposure to some favorable trends in US housing. I would argue that the pick-up in housing activity is largely the reason for Sherwin-Williams (NYSE: SHW) super run. If you want to see an even better looking chart than PPG, I suggest you look at SHW. Housing looks like a good market to be in and PPG will surely generate synergies from the Akzo acquisition. As for SHW, its EV/EBITDA multiple of 15.3x suggests the evaluation is at least up with events.

Where Next for PPG?

In SHW’s case I am much more certain about its end market prospects (far great exposure to housing) but I am not so sure about PPG. Looking at the recent results from an industrial bellwether like MSC Industrial (NYSE: MSM), it does look like there was a bit of a slowdown in the calendar Q4 in the US. This might not have fed through into PPG’s numbers just yet so look out for some possible earnings volatility in future months. For the reasons expressed in the MSC article I think the US difficulties will be overcome, but then again MSC’s stock price has reacted to the negative news flow already. If PPG comes out and says things slowed in the US in future quarters (even if it is temporary) then the stock will surely drop.

Furthermore, PPG’s international exposure asks questions. For example PPG expects the global automotive market to grow in 2013 and the stimulus in China to feed through into the economy. This is far from a certainty, and even though its internal execution has been superb of late, there is a limit to how much margin expansion PPG can generate.

There is a lot to like about this stock, and investors who are positive on China will be greatly tempted by it, but for me it’s in the ‘wait and see on China’ list. I may regret this!