Wednesday, February 27, 2013

Intuit Still Looking Good Value

Despite the mini fall in the markets recently I’m still finding it hard to find stocks with the golden combination of free cash flow yields in excess of 5% and reliable mid teens earnings prospects. The good news is that one of my long term holdings Intuit (NASDAQ: INTU) is offering those metrics and more. In summary, I like the recent results. The company confirmed the full year guidance so the upcoming tax season looks okay, and its small business group solutions continue to grow in the mid teens. It’s not too late to pick some up.

Intuit Deserves a Re-rating

I think so and not only because of the favorable employment picture dropping into the bottom line of its DIY consumer tax offerings. The other big stories are the gradual acceleration in its small business group solutions (Employee Management, Financial Management and Payment Solutions) and its opportunity to grow margins with the shift to Software as a Service (SaaS) based revenues. I know the company well, and there is a useful primer post on the company linked here from which readers can get more background information.

Going back to the current results I want to demonstrate how they signal continued diversification by breaking down 2012 operating income here. The small business group solutions are broken out in the second circle. The group made up 35% of revenues in 2012, and this will increase in 2013.

The point is that Intuit is diversifying its earnings away from the cyclicality of Consumer Tax. Moreover, the small business group is consistently growing revenues at a strong clip.

Furthermore, the shift towards online based solutions continues apace. To give an idea of what can be expected, Intuit explained that the tax software five year CAGR was 7% as compared to tax stores being down 1% and pro’s being up 1%. In that time period Intuit has trounced H&R Block (NYSE: HRB) both as a company and as an investment. Within its US Federal TurboTax business, Intuit reported 72% share from web based units and only 23% from desktop. This changed from 69% and 25% respectively in 2011. So it is all about the web for TurboTax.

Similarly, it is managing a shift in its Financial Management Solutions (Quickbooks) towards a subscription based model and away from desktop units. Online subscribers increased 28%, and desktop subscribers were up 25% too with desktop units down 18%.

Intuit’s Secular Growth Drivers

A key part of growth in the future will be Intuit’s market leading mobile applications. Its share with mobile is higher than with other channels but it remains a small part of the business. Nevertheless, when a company declares that it is achieving 3x the number of mobile downloads this year then it is clear that the long term opportunities are significant.

As for the shift to SaaS based revenues, this isn’t just about expanding the top line. Cloud based solutions encourage margin expansion because companies can cross sell their solutions to subscribers and therefore make marketing more efficient while consolidating technology costs. For example, a company like Adobe Systems (NASDAQ: ADBE) is engineering this shift because it increases the lifetime value of a customer. It also encourages certain users to sign up for the product when they may have been using it illegally. Adobe is seeing a fall in upfront revenues as this transition takes place, but interestingly Intuit has been relatively unscathed with this issue. I think both companies will succeed.

H&R Block is trying to fight back, but so far it doesn’t appear to have taken any market share away, and with Intuit declaring that its own tax advice support operations were working well now, HRB has lost a small window of opportunity to take share.

Where Next for Intuit?

The next quarter is where Intuit usually makes 88% of its income so it is too early to definitively say how the year will go. However, the early indications for the tax season are positive. Employment is up, and online monitoring suggests that Intuit is at least holding market share on consumer tax. Looking longer term, it estimates that there are 40 million tax filers who could potentially use its service because their tax returns are simple enough to use software.

In addition, I like the strong growth in the small business group and the ongoing cash flow generation, I will continue to hold with a $71 price target.

Henry Schein Equity Research

I have had a difficult time investing over the last few weeks. It seems that all the defensive sectors like consumer staples and health care have been bid up inordinately while all the value seems to be congregating in the technology sector. This is a problem for me, as I like to balance the long side of my portfolio and can’t afford the risk of being overweight any one sector. With that in mind I decided to look around for a relatively stable defensive stock, with double digit growth prospects and sound fundamentals. If you share my desire for this then Henry Schein (NASDAQ: HSIC) could fit the bill for you too.

What Henry Schein Has to Offer

Okay I know what you are thinking, a boring dental and animal health distributor with GDP+ type growth etc. However that’s exactly the sort of thing that I want. The long term idea here is simple. An aging demographic in the Western world is leading to more dental care and companion pets per population. I also think that certain social trends like increases in divorce rates and marriage declines will cause more demand for pets and spending on them.

With that said, these industries are still somewhat cyclical. People tend to take their pets to the vet on fewer occasions and get their teeth looked at with less frequency when the economy is tough. This is something that investors will need to think about because HSIC does have ample exposure to some European markets (within International) that are struggling at the moment.

A breakdown of its sales shown here:

North America makes up 64% of sales and International makes up the rest.

Henry Schein Reports Confusing Numbers

Superficially its results were somewhat concerning. Indeed, when any company I look at reports that sales in its core global dental operations were down 2.4% I would immediately lose interest. However, there are mitigating circumstances here. Firstly, last year contained an extra sales week. Second, currency effects negatively impacted international sales and third, the huge IDS trade show in Europe in 2013 is likely to have held back European (particularly German) sales.

In order to adequately express the underlying trends I will display the ‘Local Internal Sales Growth’ figures as given by the company. This will account for the currency and extra week effects.

The underlying picture looks okay, and International Dental sales should do better after Q1 with the IDS trade show in March.  On a more negative note, HSIC did suggest that some US dental sales had been pulled forward into Q4 thanks to speculation around the loss of a tax benefit. In the end the benefit wasn’t lost (in fact it was increased), but the pull forward effect was likely to have had an effect nonetheless.

The exact impact of this pull forward is somewhat open to question though. I note that Patterson Companies (NASDAQ: PDCO) was also asked about this issue on its conference call but it didn’t seem to think it was a big issue. Perhaps the sales guys at HSIC were pitching on this and are convinced that it helped close deals while Patterson thought it was business as usual? Patterson largely blamed the economy for the weak trend of growth in its dental equipment sales, although it too did well in Animal Health.

Turning back to HSIC, analysts have mid single digit revenue growth forecasts penciled in for the next two years, and this is in line with the 5.1% consolidated local internal sales growth reported for 2012. As for Q1 analysts have 7.7% revenue growth penciled in but I think they will need to lower this target because of the issues discussed above. No matter, it is not a material effect on the long term growth prospects, and the company is set to grow earnings in double digits over the next two years.

More Confusing Numbers!

The animal health division recorded strong growth, but much of this was due to an accounting switch related to Novartis. Adjusting for this, HSIC argued that internal growth was closer to 6.5% and going forward it is seen as growing in the mid single digit range. By way of comparison MWI Veterinary Supply (NASDAQ: MWIV) is forecast to grow revenues averaging double digits over the next two years.  However, you will have to pay over 16x its EV/EBITDA multiple to get hold of this kind of growth. MWIV is just one of those stocks that gets hot and everyone wants to own it. I do too, but I won’t overpay for it, and something like HSIC or PDCO looks like a better way to get exposure to animal health.

Another area that needs explaining with HSIC’s latest numbers is the cash flow situation. The company is traditionally a good converter of income into cash flow but eagle eyed readers will note that 2012 saw a ‘disappointment.’

The simple reason for this is that HSIC brought forward around $150 million in inventory purchases in relation to potential pricing increases thanks to the medical device tax which came into effect in January this year. Adjusting for this would give an underlying free cash flow figure of $507 million or around 6.1% of its current enterprise value.

Where Next for Henry Schein?

Based on the calculations above, I think the stock is good value up to around $102 and presents one of the few value propositions in medical sector at the moment. I like the stock and evaluation and picked some up. It provides a good balance to the portfolio, and I’m confident it can outperform in any market correction. It’s not the sexiest stock around but these things serve a purpose. Revenue growth of around 5-6% is fine, and I think this stock can go higher from here.

Monday, February 25, 2013

The Key Earnings of The Week

Another key week of earnings kicks off in March. There are some interesting technology and retail companies this week. It’s also the week where the market will deal with the aftermath of the Italian election. Allow me a short digression on the subject, because it does matter.

I know most readers have had enough of hearing about European debt, and are happy that the financial markets are awarding the US with incredibly low yields, but it’s still worth taking the time to look at this chart of IMF World Economic Outlook projections:

Italy Government Debt data by YCharts

The US situation does not look good. Yes, it is ‘okay’ for now because the market is being generous, but what if another financial crisis comes?  Bankers’ incompetence may have caused the recession, but it was taxpayers’ money that saved them and the economy from depression.  If another crisis comes along, how will the US Government be able to deal with it? And what if the market demands higher yields from the US in future?

I’ll leave investors to ponder those issues and get back to earnings.


Anyone looking for a defensive stock could do a lot worse than check out Aqua America’s results, although I’ve no doubt that the most widely covered stock on Monday will be Lowe’s Companies. I like the company and last discussed it here. The key thing to look out for is how successful its management initiatives (mainly to simplify the product ranges) are working across its categories.

My highlight of the day is Autodesk (NASDAQ: ADSK). This is an interesting stock with many moving parts to it. There is an article here, and I will try and cover the upcoming earnings. Essentially Autodesk is dealing with resolving some execution issues (restructuring of the sales force,) the transition to a cloud and mobile based offering, with solutions being pushed from standalone flagship products towards being bundled in suites, and the challenging macro-economic environment. The stock looks cheap but it won’t if earnings disappoint again.


Autozone has been doing well recently and I’m not sure why! I can only think that it has been dragged up with the market. However, new car sales have been good and comparable same store sales growth across the industry has been slowing. These are not good signs for the company.

Verisk Analytics is well worth a look due to its pre-eminent position in detecting insurance fraud. I believe Warren Buffett holds a position, and he knows a thing or two about the insurance business.

Today’s highlight has to be Home Depot (NYSE: HD). I thought the stock had further to run in the winter, and I still think so now. One thing to look out for will be if Superstorm Sandy really did add up to around $360 million in sales. Last time around I got the impression that there was some linearity in its trading, and November was described as being ‘strong,’ which points to a good quarter for Home Depot, and in my opinion people often underestimate the length of housing cycles.  Look out to see if its more discretionary based items are selling well too. A good indicator for the economy.


Joy Global will give good color on China. The stock is being buoyed by takeover prospects right now but if you want to focus on the fundamentals the key things to look for are US natural gas prices and Chinese fixed asset investment. More analysis linked here.  Limited Brands is an interesting global retail play, and Target is always worth following closely to see how the US consumer is faring.

My two picks for today are in the retail sector. The dollar stores have been attractive companies for a while now but everybody knew it and when Dollar Tree (NASDAQ: DLTR) disappointed with its same store sales growth in the autumn, the market wasn’t slow to punish the sector. The dollar stores face an uncertain outlook this year. Yes, they have good upside from the ongoing trend of the mass consumer ‘trading down,’ but they are also all aggressively rolling out new stores. I think it is time to see them scaling back expansion plans. Dollar Tree has a lot of restructuring to do.

I also want to highlight TJX Companies (NYSE: TJX). Most people would avoid investing in a company actively looking to expand in Europe, but as discussed here,TJX is an off-price retailer. It should be expanding in new territories, and the economic malaise in Europe should not trouble TJX unduly. In addition, I like its expanding home ware division. Some worry that ‘off-price retailing’ doesn’t exactly have a large moat, but I suggest that the doubters try running a clothing outlet. It requires a lot of experience and TJX has that.


Deckers Outdoor owns the trademark for UGG boots, of which I am reliably informed are typically worn as slippers in Australia. How they became a winter boot is one of the great mysteries of fashion. It’s a pretty big day for technology today with giving numbers. Sonus Networks has seen Oracle buy its rival Acme Packet, so perhaps it’s time someone looked at it?

Today’s pick is Palo Alto Networks (NYSE: PANW). The last set of numbers were pretty good, and it appears to be taking market share from some of its rivals. Check Point is going through the cycle of a new product line which seems to be encouraging its customer to get the same performance with less money. Meanwhile, Cisco’s latest security numbers suggested that the only growth it was seeing (and anemic at that) was in data center security.  Last time around Palo Alto talked of some aggressive pricing competition in the quarter, but none of the other major security companies appeared to report this. I think the evaluation is rich and I’ve no interest in paying 127 times July 2014 forecast earnings for the stock, especially when there is a fair bit of takeover speculation around it.

Saturday, February 23, 2013

McCormick Equity Research

I confess to becoming increasingly perplexed with the markets these days. While whole swathes of the technology sector look like good value it is increasingly hard to find stocks in more defensive sectors like food and health care with which to balance a portfolio. Such thoughts came to mind when looking at McCormick’s (NYSE: MKC) latest set of results. They were disappointing, and the stock sold off only to see the value investors buying back in. Is it time to follow them in?

McCormick’s Disappointing Quarter

I previously discussed McCormick in an article linked here and made reference to some of the questions over its underlying trends. Most notably, McCormick’s underlying consumer segment revenue (which makes up nearly 79% of income) growth was only around 4% for the previous two quarters (excluding acquisitions), and industrial growth slowed to 2.8% in the last quarter. Furthermore, analysts had 4.8% revenue growth penciled in for 2013, a number I found hard to have a lot of confidence in thanks to the Q3 results.

Roll on to Q4, and company guidance is for 3-5% sales growth in 2013 with a disappointing set of earnings reported. The problem in the quarter was that US consumer performance (a high margin business) was weaker than anticipated, and a number of reasons were cited. Sandy affected some supplies, but the key issues seem to be the following:

  • Retailers lowered inventory from last year.
  • McCormick had to issue coupons and price promotions because customers were still adjusting to pricing.
  • Industrial demand in China was weak thanks to lower levels of promotions at restaurants like Yum! Brands (NYSE: YUM).

The weakness in China was somewhat presaged by slowing same store sales growth at the fast food outlets in China, in particular at YUM, and it’s not just about the recent chicken debacle. In fact, as discussed in this article, things were slowing down over the course of the year. McDonald’s too has seen slowing growth. While this is disappointing, it is the weakness in the US consumer segment that has really had an effect.

To demonstrate this, here are revenues ($millions) and operating income margins:

With regards to the Americas region, consumer pricing rose 2.6% but was offset by a 2.2% decline in volume/product mix, and there was also some negative impact from US industrial as its clients didn’t launch as many new products as usual in the quarter.

By way of comparison EMEA constant currency revenues were up 10% with particular strength on the industrial side.

A look at sales growth by segment:

What Makes McCormick Tick

McCormick is a highly rated stock, and for good reason. It’s been a key beneficiary of some favorable trends in the economy. The recovery hasn’t been kind to the mass consumer, and many food companies like Heinz or Campbell Soup Co. have found it tough going to get consumers to take pricing. There seems to be an ongoing cycle of food companies raising prices only to be met with volume declines. The main way out of this cycle is to innovate with flavoring, and this has obvious benefits for McCormick.

Moreover, more stay at home eating means increased demand for McCormick’s flavorings and fast food restaurants, which usually do okay in tough times. I also think that increasing multi-ethnicity in Western economies is encouraging consumers to adopt new flavoring as they try new food and ethnic populations increase. Putting all these things together suggests that McCormick is well placed to benefit from an ongoing weak economy.

The question is, will these conditions continue to be the same in 2013?

Where Next for McCormick?

I suspect the flavorings trend will continue, but if the economy improves (and it is slowly) then any shift in marginal behavior by consumers could have an effect. The good news is that margins are set to increase following commodity cost moderation, and McCormick must be hoping that it can ease up on couponing and promotions within the Americas in 2013 so the full benefits of margin improvements can kick in.

Frankly, I think that whenever companies engage in this sort of promotional activity, investors have a duty to question whether it is a temporary issue or the start of some end market weakness. I think it's too soon to tell.

If it is temporary then the margin improvements will drop into the bottom line, but even if this occurs McCormick is only guiding towards 4-6% EPS growth this year. On a forward PE ratio of over 20x this stock is certainly not cheap for the uncertainty. I’ll take a pass.

Friday, February 22, 2013

VF Corp Offers Mixed Results

V.F. Corp (NYSE: VFC) presents a familiar investing conundrum for which I don’t have a definitive answer. The said problem is whether to buy a stock if you like its long term prospects but think it is facing near term risks. In summary, the company has some great brands that are benefiting from favorable trends in clothing fashion, but there are short term concerns with some of its end markets, and given the evaluation it’s hard to argue that there is a margin of safety for any disappointments in 2013.

V.F. Corp: A Company You Know but Don’t Know

In order to accelerate learning I will link to a previous article on V.F. Corp. Its most famous brands are The North Face, Timberland and Vans, all of which operate within the Outdoor & Action Sports segment. Its second largest segment is Jeanswear, which contains some iconic brands like Wrangler and Lee.

A breakdown of yearly profits is below. In terms of geography North America makes up 63% of sales, Europe 22% and Asia 8% and 7% for the RoW.

It was a mixed bag of performances in the largest segment. The North Face saw 11% constant currency growth in Q4. This is a good result considering that this year saw another mild winter. I suspect VFC learned a lot from last year, and it seems that it is not going to have the same inventory overhang issues as it did then.

However, it was a different story at Timberland.  The warm weather has certainly had an effect with Timberland, but I think the real key to its weak performance (revenues down 4% in the quarter) was more to do with its legacy strength in some weak Southern European markets. Europe is Timberland’s largest sales center, and Southern Europe is its largest market within the region. The guidance is for mid-single digit declines in Europe for Timberland, and this could prove problematic as VFC is integrating Timberland into its European operations this year.

The last of the major outdoor/sports brands is Vans, and it can seemingly do no wrong. Vans achieved 22% constant currency growth and a superb 60% growth rate in Europe alone for Q4. I think the divergence between the performance of Vans and Timberland in Europe is not only a consequence of the weather, but also due to the existing penetration rates. Vans simply has more room to grow, and its brand appeals to a demographic in tune with e-commerce.

What all three have in common is that VFC is expanding its direct-to-consumer (DTC) and online sales. It’s a good way to try ad sales in a difficult marketplace. In fact, DTC revenues now make up 21% of revenues with the number forecast to rise to 23% next year.

Blue Jeans

It was a mixed story with Jeanswear too. Revenues were only up 4% in constant currency for Q4, but profits rose 53% in the quarter and over 13% in the year. Much of this is due to relatively cheaper cotton prices, and investors should be wary of expecting the same improvements this year.

A good way to think about this is to compare VFC’s Jeanswear division with Jones Group (NYSE: JNY). The latter’s gross margins are materially moved around by cotton prices, and we can see the inverse relationship in the following chart.

Cotlook A-Index Cotton Price data by YCharts

The underlying picture was mixed in the quarter with Wrangler revenues up 5% but Lee flat. The latter is facing pricing and top-line pressures from its distribution channels in North America (many of which are troubled mid-market dept stores), while in Asia the moderation in growth has produced an inventory build-up.

Asian Growth?

As recently as September VFC was talking about a 5-year CAGR of 17% for overall Asian sales, but I note it is forecasting low-teens growth for 2013. I’ve discussed the issues at Lee; The North Face, however, has some challenging targets to hit in 2013. Management expects global North Face revenues to grow at high single digits in 2013 but in the mid-teens for international with 30% growth penciled in from Asia. It’s hard for me to question a management as gifted as VFC has, but opening 200 stores and achieving the larger part of that 30% growth in China (which has seen growth moderate) seems a big ask.

Companies like Yum! Brands have been reporting weaker growth in China, and their share prices have suffered as a consequence. Yum’s problems are not just about the chicken scare, its same store sales growth has been slowing for some time, and the company has made China the focal point of its growth drive.

Things to Look Out for in 2013

While the Chinese growth plans are something to ponder in 2013, the Asian region still only makes up 8% of current sales. In other words, it might not matter that much if they miss. Europe’s difficulties are more important, and it’s here that the downside surprise could occur. The clement weather of the 2012/13 winter has caused some operational issues at The North Face and Timberland, but I would argue that this is largely in the price right now. If you buy the stock now you are more worried about what next winter will bring.

Adjusted EPS is forecast to rise 11% in 2013 to hit $10.7 with revenues up 6%. The margin story is better too with gross and operating margins forecast to grow 100bp. All of which leads into free cash flow of around $1.1 billion. That’s not bad for a company on an enterprise value of $18.7 billion and a share price of $158; if it seamlessly hits its guidance I think it could trade closer to $180. Moreover, this company does have a tradition of exceeding internal guidance.

My caveat here is that I’m sure its share price will go lower if it comes out and says something like ‘the mild winter plus Europe caused greater than expected pricing pressure in the first half but we are maintaining our full year guidance.’  Then I would be a buyer because at this price it looks close to fair value for the risk.

Thursday, February 21, 2013

Perrigo is Still Not Good Value

Perrigo (NASDAQ: PRGO) is a company exposed to some very favorable trends in health care, and I would expect its strong performance to continue. In summary, while I have little doubts over its end markets or its growth, the evaluation looks stretched, and there are some near term risks here. Unfortunately, the defensive growth sector (if such a thing exists) has been bid up by the market, and I think investors should stay disciplined and not overpay. However, if you like a long term growth story than Perrigo could fit the bill.

Will Perrigo Hit its Guidance?

I originally discussed the company in an article linked here; I would advise reading that article for a primer on the company. The key questions remain the same after the latest Q2 numbers.

  • Can it really hit the 12-16% guidance range for 2013 when it has just reported top line growth in H1 at 5.7%? 
  • How much longer can Rx Pharmaceuticals (generic prescription drugs) go on expanding margins when it is such a competitive industry? Gross margins hit 58.1% in Q2 alone.
  • Nutritionals growth and margins guidance was downgraded thanks to retailers being a bit slower in phasing out metal cans in anticipation of the launch of Perrigo’s infant formula. Indeed, this is the second quarter in a row where this has disappointed, yet much optimism is still placed on the product for 2013.

I don’t want to appear overly negative on the stock. On the contrary, I think it is exposed to some great end market themes, and its acquisition strategy into animal health makes perfect sense to me. The Velcera acquisition follows on from Segeant in the autumn and establishes Perrigo as a player in animal health; the idea is to expand sales via the retail channel rather than just the vets. In a sense, this sort of activity apes the other key growth drivers at Perrigo. The company is very good at latching onto trends take advantage of changing health care sales channels.

Perrigo’s Growth Trends

For example, the trend towards store brands (from national brands) continues to accelerate. Indeed, companies like CVS (NYSE: CVS), Walgreen (NYSE: WAG) and Wal-Mart are all keen to expand their store brands.  They make more margin (and profits) from their store brands, although revenues take a hit because the products are cheaper. Both companies see this as a great way to expand profits and engender customer loyalty.

Another key trend is the growing shift from prescription pharmaceuticals to Over The Counter (OTC). Again, the key drivers are the desire of both authorities and consumers to reduce costs and in particular in indications like diabetes. Based on Perrigo’s figures, industry store brand sales were up 9.7% while national brands were down 2.1% in the last 52 weeks.

In addition, alongside all of these trends is a general increase in consumer health care spending, a trend driven by lifestyle changes and an aging demographic. Throw in international expansion and the future looks very bright for Perrigo.

Possible Challenges

I want to go back to the questions I asked earlier and put them in the context of the Q2 numbers and discuss some challenges this year.

The consumer health care sector is firing on all cylinders with sales up 23% in Q2 (if normalized with sales days last year) and operating margins expanded 40bp to 18.3%. Perrigo has been favorably helped by the strong flu season and the production problems for Johnson & Johnson’s (NYSE: JNJ) Tylenol have encouraged Perrigo to try and expand Mucinex sales. Indeed, a full scale OTC launch is planned for March. JNJ has had a number of production issues but plans to get 75% of its brands affected back to the market by the end of 2013. Tylenol is one of them, and the timing of this will affect Perrigo.

Nutritionals sales were down 5% in the quarter, and full year guidance was reduced to 1-5% growth. The story here is all about the infant formula, which is intended to resemble some well known national brands. Wal-Mart and Costco were reported to already be positioning the product next to these brands. A lot is being pinned on this product, but I would be cautious here. People don’t take risks with infant formula, and this is a fiercely competitive segment in the US.

Rx Pharmaceuticals sales (which made up 28% of adjusted gross profits in the quarter) were flat on an adjusted basis, and the company is seeing increased competition in this sector, however operating margins expanded to 45.6% and Perrigo maintained its full year 15-19% growth forecast based on a large product pipeline.

Where Next for Perrigo?

Frankly I think there is better value out there, and if you really want to play some of the growth trends discussed above then Walgreen or CVS arguably offer better value. Perrigo has great long term drivers, but it also has near term questions that still appear challenging. The market liked the Q2 results because revenues came in ahead of expectations, but the stock now trades on 24x earnings and a forward free cash flow yield of 4%.

It’s not cheap, and the market seems to want to give it the benefit of the doubt thanks to its long term potential. Investors could wait until it grows into its evaluation but I’d rather try to pick this up cheaper.

Wednesday, February 20, 2013

Nice Systems Results Were Better Than the Market Thinks

It’s worth taking the time to look closely at Nice Systems' (NASDAQ: NICE) latest results because I think the market made an erroneous knee jerk reaction in marking the stock down. The results were pretty good, and the business is doing well with compliance regulation driving sales growth. Meanwhile, its data analytics of customer interactions and cloud based solutions offers good long term growth prospects. In summary, I think the growth story is intact, but the shift in the structure of its sales is making revenue growth look weaker than the underlying bookings and creating less visibility over earnings. No need to worry though, things look like they are on track.

Nice Systems Stock Research

A brief summary of the results and guidance:

  • Q4 Revenues of $240 million vs. consensus of $246 million
  • Q4 Non-GAAP EPS of 70c vs. consensus of 66c
  • Q1 Revenue Guidance of $220-230 million vs. consensus of $234 million
  • Q1 EPS Guidance of 57-62c vs. consensus of 62c
  • Full Year Revenue Guidance of $940-970 million and EPS of $2.55-2.65

I’ve previously discussed Nice in an article linked here, and readers can see from that link just how unusually strong the Q4 was on a sequential basis. Indeed, I had some doubts that the internal guidance would be hit. No matter, the numbers were good (albeit EPS was boosted by a tax gain), and bookings were strong with double digit growth recorded. The current book to bill ratio is greater than 1 and Nice announced ‘strong booking’ in advanced applications for 2012. Advanced applications made up more than 50% of new bookings in the quarter; this is a sign that it’s able to expand into the analytics space easily.

So if it has all these good things going on, then why is the guidance only for full year revenue growth of 7% at the midpoint?

The answer lies in the changing structure of its sales.

Nice Systems Equity Analysis

The first reason given to explain this conundrum is that its sales are becoming more back-end loaded. In other words, we can expect stronger second halves to the year going forward. This is what happened in 2012, and it’s understandable if Nice finds it difficult to confidently predict what will happen in the second half of 2013.

The second explanation relates to how its advanced applications are rising as a share of the sales mix. Its cloud based solutions are growing along with is analytics sales. This means that while bookings are growing double digits, it is likely to take longer for bookings to be added to recognized revenues. Again, this is consistent with companies that are increasing services revenues over product sales.

Of course this won’t go on forever. At some point the bookings will drop into revenues, and they should increase at a similar run rate going forward (when bookings growth naturally slows). The trend of increasing analytics sales will carry on not least because Nice signed a deal with IBM (NYSE: IBM) in order to incorporate its analytics solutions within its service applications. This is a great way for IBM to get a channel into Nice’s strong presence within the Financial vertical. Indeed, Nice booked a major customer interaction deal in Q4 and signed a follow up deal with a large US bank with a compliance based solution.

Nice Systems Earnings Drivers

If, as I do, you think that financials are being increasingly regulated and fined over compliance and customer interaction issues then Nice is set for a strong period of growth. As customer interactions increase across multi-platforms and the threat of fraud (external and internal) rises, there is an increasing need for solutions that log and monitor these interactions.

Moreover, the structuring of this mass of data is what the industry calls ‘big data’ analytics. I think that as corporations increase spending and awareness of the ROI of structuring this data then they will increasingly see the need to capture it--which is where Nice comes in.

Another positive would come if Nice underwent the merger/takeover that some parts of the press think it will do with its rival Israeli firm Verint Systems (NASDAQ: VRNT). I think this deal would make good sense for both companies and discussed the subject here. Verint is stronger in fraud prevention and security while Nice is strong in compliance and analytics. In a timely reminder of this Nice saw its notoriously lumpy security revenues come in a bit lower than expected thanks to a couple of deals slipping into the next quarter. In addition, the key verticals that they sell to are complimentary. A deal makes sense.

Is Nice Systems a Stock to Buy?

I think the stock is attractive, and the announced intent to pay a 64c dividend is a good way to start returning some of its strong cash flows to investors. I think a forward PE of around 15x is decent value, and that gives a target price of around $40 with some upside because I think the management is being conservative with guidance.

Tuesday, February 19, 2013

This Week's Key Earnings

A very interesting collection of companies will be reporting this week (the week of Feb. 18). Sometimes, constructing a portfolio ends up in actually creating a de-facto an ETF that apes the market or a sector in terms of performance and risk. On the other hand, if you take a sniper-like approach to finding a collection of companies, each with their own profit driver, you can achieve good diversified returns. There are quite a few of these sorts of companies giving earnings this week, so keep an eye out.


Express Scripts gives numbers, and investors in CVS and Walgreen will have an obvious interest in its commentary.


There is no doubt that the Herbalife (NYSE: HLF) conference call will attract the most media attention today. By now, everyone will have seen the infamous Ackman/Icahn public dust up. I found it somewhat irritating that the CNBC journalists insisted on desperately trying to turn it into a Icahn/Long vs. Ackman/Short event. Yes it is great television (and Icahn has subsequently disclosed that he has taken a large position,) but there is  danger that private investors can find themselves seduced into getting involved in a bitter game of poker between these two investors. A game in which you would be betting but you can't even see the cards. Make no mistake, these guys go on television in order to influence you to play.

From my point of view, Herbalife has questions to answer over its distributor model, but Ackman is taking a significant amount of risk (as Icahn correctly pointed out) with this position. I happen to think there is a lot of merit in what Ackman says about Herbalife, but I wouldn’t invest a cent in any manager willing to take a "conviction" position like this.

It now looks like Icahn is testing the resolve of Ackman (or rather his investors,) and what happens next will be fascinating. The key point here is the relationship between Ackman and his investors and Icahn must surely know this.  If they start threatening redemptions than a short squeeze could ensue and Icahn makes a lot of money. In my humble opinon, private investors should stay well clear of all of this. There are thousands of other instruments to invest in rather than getting involved in this game.

If there is one good thing about this episode it is this: Call your money manager or broker or whatever, and ask him his opinion on Herbalife. If he tells you to take a position either long/short in tones that suggest it's the one thing he's been thinking about all week, hang up the phone and start looking for a new manager.

When the Herbalife fun and games are over, I would suggest taking a look at the earnings from Genuine Parts Co. and Wabtec. The latter has strong growth prospects and is a rare way to play the growth in rail infrastructural spending. A SWOT analysis can be found here. A couple of health care stocks, Medtronic and Bruker, will also give results.


On Wednesday, I want to highlight three highly diverse companies that are "recovery" plays for vastly different reasons:  Curtiss-Wright has had its exposure to military hardware spending hanging over it, while Crocs is a stock that suffered from ridiculous over-evaluation in previous years as investors bought into the fad even though the barriers to entry for others producing these type of "shoes" is non-existent. Nevertheless, the stock does look cheap now.  Sodastream will also report numbers


This will be a busy day for me.  Nordstrom (NYSE: JWN) has been one of the best run retail companies in the US, and I think it is a nice way to play higher end retail spending, while avoiding the exposure to China that you get with, say Burberry's, Coach or LVMH. Nordstrom has been reporting good sales growth at the Rack, and investors should look out for how it is integrating the acquired online businesses, as well as its own online activities. There are a lot of moving parts to Nordstrom (not least its credit facility,) and most of them are going in the right direction. There is some concern that its online and Rack stores may erode the value of its core stores, but there is no sign of this yet.

Hewlett-Packard will try and convince investors that a turnaround is in the prospects, but I’m not expecting anything here. Treehouse Foods is an exasperating stock.  Theoretically it should be a great play on ‘trading down’ but in reality it has faced many structural challenges this year as its sales channels have changed.

The three really interesting companies reporting today are Aruba Networks (NASDAQ: ARUN), Intuit (NASDAQ: INTU) and Patterson Companies (NASDAQ: PDCO).

Aruba is a play on the growth of Wi-Fi networking and Bring Your Own Device, or BYOD, in the workplace.  Its main rival is Cisco, who just reported strong growth in this segment while other anecdotal evidence also suggests that the BYOD market is in good health. I covered Aruba in an article linked here. The key questions for Aruba are related to encroaching competition within its key verticals: government, health care and education.

I think Intuit is an undervalued cloud play. While its DIY consumer tax offering, Turbotax, is well known and capable of achieving single digit growth rates, I also like the prospects at its small business group. Its employee management, financial management and payment solutions business are all growing in the mid teens, and the opportunity to cross sell these solutions is significant. Indeed, Intuit knows how to scale up synergy benefits from growing SaaS solutions, because it has already done it with Consumer Tax. Moreover, the increasing diversification should lead to a re-rating for this highly cash generative company.

Patterson Companies is attractively evaluated, but it has reported disappointing results in its dental equipment sales for a few quarters now. I originally covered the stock in an article linked here. However, I really like the expansion of its distribution activities with Sirona Dental Systems, and provided it can sort out the core dental equipment business then it has good prospects.

Patterson also has a fast growing veterinary supplies business, and with companies like MWI Veterinary Supply reporting strong numbers recently, I would expect good numbers here. Patterson is one of the few defensive plays that is still at a cheap valuation, and I plan to take a closer look.


A couple of aerospace companies give numbers on Friday. Barnes Group and Heico are relatively unknown companies, but I like their prospects. In particular Heico has some good secular growth prospects as airlines continue to try and cut costs via outsourcing services and buying replacement parts from sources other than the OEM.

Sunday, February 17, 2013

Cisco Earnings Review

The market didn’t like Cisco's (NASDAQ: CSCO) recent results much, but then again the stock is coming off a very strong run. In summary, I thought these results were bullish overall for US corporate IT spending but less so for Cisco. The company has heavy public exposure and it is going to have to weather pressure on the public purse in the US. Meanwhile, the global picture is somewhat mixed and investors need to think carefully about the takeaways from this report.

Cisco Results

For ease of reference there is a preview of the results linked here. Revenues came in better than expected at nearly $12.1 billion, and the guidance was in line with previous estimates.

Starting with the core businesses of Switching, Routing and Services (which make up 69% of total revenues) the numbers came in a bit better than expected, but this was mainly due to good Switching numbers. Growth slowed a bit in Services (reflecting Cisco’s lower growth profile in recent years) and Routing was a bit worse than its usual Q2 decline.

Yearly growth rates here:

Overall the core grew 2.9%, which is incidentally below global GDP. Furthermore, I wouldn’t get too excited with Switching because Cisco guided towards revenues being flat for the next couple of quarters. Even with that forecast the picture is mixed. Switching revenues from the Government are pressured while the corporate sector is doing well. However, since Cisco has heavy government exposure its ability to grow the top line is impaired. Moreover, European enterprise orders in Switching were described as being down double digits. In other words, higher US corporate spending is not enough to bring growth going forward.

The decline in Routing was more than expected, and according to the management reflected the timing of some larger deals and challenges within Europe and China. Again, note how US Enterprise spending is not enough to generate growth here.

Collaboration and SP Video

Collaboration revenues fell a disappointing 11% while Service Provider Video rose 20% but most of this was due to the NDS acquisition. The challenges in Collaboration are coming from TelePresence with its US Federal business cited as a particular area of weakness. Elsewhere, its conferencing revenues were up 11%. I suspect that TelePresence’s weakness is also a function of renewed competition from Polycom (NASDAQ: PLCM), which saw revenues rise five percent sequentially in its last set of results. Polycom has invested in revamping its product portfolio, and the plan was squarely aimed at taking market share from Cisco. It seems to be working.

I think these two divisions highlight a reoccurring theme. Cisco is finding it tough to focus in competition within its peripheral markets and is faced with a lot of macro challenges in its core. However, it has the cash flow and cash pile to make acquisitions in order to generate growth.

Wireless, Security and Data Center

Wireless and Data Center are the strong points of Cisco right now but Security was disappointing. Yearly growth figures here:

Security growth has now crawled to around 1%, and listening to what Fortinet (NASDAQ: FTNT), Palo Alto and Check Point Software are saying, Cisco is not coming back anytime soon. Fortinet and Palo Alto both cited a number of firewall wins over Cisco. Check Point is going through a platform refresh which may be slowing growth while its new products seem to be giving its customers the opportunity to trade down. My hunch is that Fortinet’s solutions (traditionally more focused at the SMB market) are starting to gain significant traction with larger enterprises. Indeed, Fortinet stated that the number of deals above $500k rose to 27 from 15 last year as discussed here.

Data Center is one of the bright spots for Cisco. Yes, the market is surging with companies like Equinix (NASDAQ: EQIX) expanding revenues rapidly but Cisco also deserves credit for being aggressive and taking an overall architectural approach with its unified data center strategy. I previously argued that Equinix’s spending plans would be a decent proxy for the industry, and although Equinix kept its capital spending plans unchanged for 2013 at $550-650 million, there will surely be upside pressure on this if growth continues at the current 20% rate.

Wireless is another strong area with particular strength seen in Service Provider WiFi which managed to double revenues on a yearly basis. I note that telecoms testing and monitoring company Ixia (NASDAQ: XXIA) also beat estimates recently amidst strong growth numbers, and the increasing proliferation of wifi enabled devices is going to have a symbiotic effect on wifi network spending. Ixia will benefit as large corporations will need to monitor how their networks are performing, and Cisco will benefit from network rollouts.

The Bottom Line

The key takeaways here are that Cisco is still facing challenges from Government spending so investors should look out for that with other companies. Furthermore, some of its peripheral markets are being challenged and I would expect some acquisition activity here. The good news is that US enterprise spending was up 9% and it’s time for investors to start focusing on tech names with exposure here rather than relying on emerging markets or global Government spending.

As for Cisco it remains a value proposition. If you are willing to take a long term view and believe in the acquisition ability of its management than you can do a lot worse than buy the stock.

Why I Bought Telco Play Ixia

It’s been a while coming but I’ve finally found a telco stock. I’ve been watching what the Tier 1 carriers have been saying about their capital spending plans and some key trends have been emerging of late. I initially set my heart on taking a closer look at Acme Packet but Oracle scuppered that idea by buying the company! As ever the challenge is to find the next play, and I think Ixia (NASDAQ: XXIA) fits the bill.

Ixia’s Exposed to Favorable End Markets

The idea here is that there are pressures building up on carrier networks from increasing smartphone and tablet penetration. According to what AT&T (NYSE: T) and Verizon (NYSE: VZ) said recently, not only are smartphone subscriptions increasing more than expected, the shift in spending from consumers towards wireless, LTE and next generation networking is gathering apace. At the same time the anemic growth in the economy has caused a lot of caution amongst their spending programs. In other words, the carriers are doing everything they can to avoid spending while at the same time seeing pressures build up. They have to start spending again sometime sand 2013 could be that year.

All of which leads me to network and data center testing solution provider Ixia. If telcos, data centers, device manufacturers and even enterprises are expanding their networks, they may also require monitoring ad visibility over the performance of the network. This is where Ixia comes in.

Customers Spending?

This year’s growth will primarily come from LTE roll-outs and the expansion of wifi networks. Ixia estimates that 50% of its business in 2013 will come from service providers and enterprises with half of its revenue being driven by application testing, security and visibility. Within that the major drivers are Testing, Assessing and Monitoring (TAM) for mobility and network visibility.

Its major customers are the likes of Cisco Systems (NASDAQ: CSCO), Ericsson, Alcatel, AT&T and Verizon. Cisco has long been a major customer, and its wireless solutions revenues have been growing at 20-30% annually for the last four quarters. Ixia described demand from Cisco to be ‘strong’ and suggested it would make up around 10% of its revenues for 2013. Cisco based revenues grew 30% in 2012. Indeed its latest results confirm strong growth.

AT&T is expected to contribute around 12% of total revenues, and I think there is potential for more in the future. It is behind Verizon in rolling out its LTE network. As for Verizon, it’s been a while since it contributed a large amount of sales for Ixia, but since it has now extensively rolled out an LTE network, it is seen as buying more LTE testing solutions from Ixia in 2013.

On a geographic basis Japan and North America are leading the way in terms of LTE adoption but they are still in the mid/early stages so there is plenty of growth to come. Similarly other parts of the world will surely follow so shareholders can expect successive waves of demand in future years.

Acquisitions Spurring Growth

In truth most of the current growth at Ixia is coming from its acquisitions (Breaking Point and Anue), and investors need to appreciate that as carriers invest in new networks they will hold off upgrading older technologies like 3G. This ultimately reduces demand for legacy testing solutions. Indeed, I note that its key rival Spirent reported numbers in November and disclosed that its customers were being cautious over spending. In fact its revenues were actually down 3%.

In turn it would be easy to look at Ixia and argue that the acquisitions caused the growth while the core revenues are flat. Indeed, the combined revenues from the acquisitions totaled $30.3 million in Q4 and $54.9 million in 2012 on the whole.

But the fact is that both companies are being integrated into the total Ixia offering, and if I am right about the ramp up in demand for Ixia’s solutions then the company has upside in 2013 from its existing product range as well.

I’ve discussed its core markets above, but there is a growing market for device and product testing as more and more of them are wifi enabled. In addition Ixia cited an order from IT security company Fortinet (NASDAQ: FTNT) as an example of how companies have a need to demonstrate the efficacy of its products. I hold Fortinet, and I noted that amidst its strong results it was particularly upbeat about mobility based revenues. Of course, Fortinet wants to use Ixia’s equipment in order to convince new clients that its solutions work well across a customer’s network, and this is a sign that other companies will also use Ixia in this way.

Moreover, any large enterprise that has large data center needs will need to monitor and asses its applications as they move around its network. I can only see this demand increasing in the future, and it presents a large expansion opportunity for the company to exploit.

Where Next for Ixia?

I think the stock is a good value and picked some up. It’s on a forward PE of 21 but, according to analyst estimates, it is set to grow earnings by 55% over the next two years. I think there is upside potential to those numbers with better than expected development of wifi enabled devices and LTE networking spending.

Saturday, February 16, 2013

Rackspace Share Price is Still Too High

Investors in Rackspace Hosting (NYSE: RAX) weren’t seeing much ‘fanatical support’ in the share price after the latest set of results. As ever, the ensuing commentary and analyst opinion will adjust to the share price move. Excuse my cynicism but, in my opinion, that’s how it tends to work in these situations.

I prefer to take a step back and look at the bigger picture. In summary, I think this stock is still overpriced but there is nothing wrong with the cloud computing market. My problem lies with the ongoing capital expenditure requirements at the business and the overly optimistic assumptions the market has baked into the stock.

Rackspace Analysis

Revenues of $352.9 million came in a little lighter than analyst consensus of $355.4m but this hardly a big deal.  In reality Rackspace is managing the aftermath of the launch of its OpenStack public cloud. The idea is that enterprises will appreciate the opportunity to have more flexibility over how they use and position their applications rather than be locked into working with a sole vendor. This is a key distinction between what Amazon (NASDAQ: AMZN) is offering in the public cloud and what VMware (NYSE: VMW) is doing in the private cloud.

Rackspace’s argument is that Amazon and VMware are offering a legacy model approach and trying to lock customers into their service. This may well be true but there are also security fears around cloud adoption, and with larger enterprises the operational risks are significant. In other words, they may well appreciate the legacy model or, at least, they may take their time over shifting to Rackspace’s open cloud model. Furthermore, Rackspace is going into unchartered territory here, and VMware also disappointed the market with its results. Meanwhile, Amazon can't appear to do anything wrong at the moment.

It wasn’t just revenues that got the market worried. Rackspace described the slower than expected installed base growth to be a function of its execution rather than anything structural in the industry.

With all this understood, it was only a revenue miss by a couple of million. No big deal. Revenue growth remains strong, and it is understandable if there is some lumpiness as RAX engages and educates enterprises with its open cloud offering.

Rackspace and Cash Flow

So if the revenue miss isn’t a big deal then is the stock good value now?

Frankly I don’t think it is. My concern with Rackspace was previously outlined in an article linked here. I would advise reading that article for a more in depth look. In summary, my worry is that in order to offer its ‘fanatical support’ to customers RAX is locked into buying large amounts of customer gear. I use the term ‘large’ because thus far there hasn’t been a clear sign that RAX has achieved the kind of scalability that it will need to justify the evaluation.

Granted this year has seen some improvement as indicated in this chart. Note how CapEx as a share of revenue fell in 2012 vs. 2011.

However, in these results RAX announced that CapEx for 2013 would be $375-445 million with customer gear expenditures of $235-275 million. Considering that the consensus revenue forecast for 2013 revenues is $1,640 the mid-point of these figures is 25% and 15.6% respectively. It’s an improvement but not by much, and it's possible that RAX will struggle to beat this year’s free cash flow figure of $119 million.

Where Next for Rackspace?

And herein lies the problem. As I write, the stock price is around $60, which gives a market cap of $8.3 billion and enterprise value of 10.2 billion. In other words, it is only generating 1.1% of its enterprise value in free cash flow, and the forward PE ratio is around 41x.

The challenge for RAX is to successfully migrate customers onto its open cloud architecture and grow its installed base by convincing customers of its benefits. However, the real test of whether the company can grow into its evaluation will be when it convincingly demonstrates that it has the requisite scalability. The jury is still out.

Friday, February 15, 2013

Cognex is a Play on Increased Automation

Machine vision company Cognex (NASDAQ: CGNX) reported better than expected results and the market rewarded the company with an initial markup. I could stop the commentary right here but I think investors should look deeper into these numbers because there are a lot of things going on here. In summary I think the slowdown in the consumer electronics industry in 2012 has hit Cognex disproportionately hard, and if you consider that is about to turn up then the company is well worth a closer look.

Cognex’s Mixed Q4

For the sake of brevity I am not going to introduce the company to readers but sufficed to say there is a good primer article on CGNX linked here. Revenues and earnings declined in the quarter and superficially the company appears stuck in a downtrend as earnings fell for the full year to $1.56 from $1.63 last year. Before delving into further details, a quick look at the revenue split by marketplace in 2012.

Breaking out revenues by marketplace shows that Factory Automation revenues actually grew 4% for the year and 1% in the quarter. Surface Inspection revenues grew 5% for the full year and 22% on the quarter, but don’t get too excited because revenues tend to be very lumpy in this division. The real story of 2012 is that Semiconductor and Electronics Capital Equipment sales declined 24% for the year and 20% for Q4.  Note that this market made up 12% of revenues last year but only 9% in 2012.

Similarly the weakness in the Factory Automation numbers came from the consumer electronics industry which is highly correlated to the semiconductor industry anyway. Moreover, Cognex’s relative exposure is not doing it any favors either. Japan is a key geographic region; its Factory Automation revenues declined 17% in the quarter, and for Asia overall it was a 21% decline.

Consumer Electronics Trough?

Much of what Cognex reported on consumer electronics could have been predicted by looking at Semiconductor Industry Association reports (SIA) and you will find a graph of changes in 2012 in the link. In order to demonstrate the geographic relevance and highlight the tentative signs of a trough being passed I’ve tabulated some numbers from it.

Clearly Cognex’s Japanese exposure has hurt it and much of its current sales to China are related to consumer electronics. Management stated that around 11% of its Factory Automation revenues came from China in 2012. Going forward, the challenge is to diversify its end markets for factory automation, particularly within China. For example it has opportunities to do so within automotive, food and beverages.

Regarding semiconductors I view the latest industry numbers as a positive, and Intel (NASDAQ: INTC) forecast that its gross margins would be flat next quarter. I discussed these issues in an article linked here. The best indicator of a bottoming out process in consumer electronics is what happens with Intel’s gross margins and its inventory to sales ratio. As such, Intel reported a significant reduction in inventory in the last quarter, and the gross margins appear to be stabilizing. Coupled with the SIA numbers, this tentatively implies a trough in the industry.

Other Key Revenue Drivers for Cognex

ID products represent a significant area of expansion for CGNX and it expects 20%+ growth in 2013. ID product revenues were $19.7 million or 24% of total revenues in the quarter so this growth is relevant. In addition, there are hopes that CGNX can expand take-up and utilization of its ID products within the logistics industry. The ID and associated RFID industry does tend to have lumpy orders as evidenced by Roper Industries (NYSE: ROP) divisional numbers, which can be looked at here. RFID development takes time because customers tend to want to try the system, analyze the efficacy and then roll it out incrementally. It’s a similar process for CGNX’s ID solutions so it’s understandable if the logistics companies take their time over adoption. Although, with Roper it can expand margins via increased software sales.

Automotive is a key vertical for CGNX and the management declared itself to be cautiously optimistic over conditions in North America amidst predicting mid to high single digit growth. Looking at what Alcoa (NYSE: AA) reported recently, the strength in automotive production will come from China in 2013 so CGNX will hope to expand sales in this market too. Furthermore, while Alcoa sees European revenues to be down 1-4%, it is a story of bifurcation between a weaker Southern Europe and a stronger Northern Europe and Central Europe. Recall that the German automakers all have some production plants in Central and Eastern Europe.

Is Cognex a Stock to Buy?

The bullish case for CGNX is that a trough has been passed in the semiconductor and consumer electronics industry and that global manufacturing will hold up in 2013. It sees CGNX expanding ID product sales as intended and the potential for increased end market diversification within its Factory Automation sales.

The bear case contains the usual worries over global growth and concern over CGNX’s exposure to highly cyclical industries.

I happen to be weighted more on the bullish side here. For example, China is under-automated by international standards and the potential to expand end markets is a real one. It is hard to predict what the semiconductor industry will do but I think the evidence is building for at least some stability in 2013. Analysts have CGNX on forward earnings of $1.73 and I would pencil in an assumption of $2 in free cash flow. Assuming the stock should trade on a forward rate of say 5% of enterprise value gives a target of around $47. I would be looking for entry point around $40 for this stock.

Beacon Roofing Supply Has Hidden Upside

Beacon Roofing Supply (NASDAQ: BECN) gave results recently and served notice that its near term upside drivers from a housing market recovery are in place for 2013. Meanwhile, its long term objective of consolidating the roofing supply industry in the US continues apace. In summary, I like the company and the stock, but it doesn't look cheap. If you are aggressively seeking exposure to US housing then the stock is compelling. However, if you are like me and don’t like buying stocks without a margin of safety then you might want to try to get a better entry point.

Beacon Roofing’s Exposure to New House Building?

Firstly I want to clarify a key point. Traditionally BECN’s exposure to new housing is only 20%, but in recent years (with the slowdown in construction) that has fallen to around 10-15%. So why is BECN a play on new housing construction?

The answer to this is twofold. First the marginal contribution from an increase in new build will have its affect on the bottom line. Second, if new build comes back then the demand pull is likely to drag up pricing for the whole roofing industry.

Lumpiness in Revenues

With that said, this isn’t a linear process. BECN’s top line is always subject to a certain amount of lumpiness thanks to weather uncertainty. Indeed, last year was a classic example with a lot of activity in the sector being pulled forwards at the start of the year thanks to seasonally clement weather.

This is amply demonstrated in the Architectural Billings Index from the American Institute of Architects.

Both Home Depot (NYSE: HD) and Lowes Companies (NYSE: LOW) reported the pull forward effect in their results, and some investors were disappointed when their mid year results didn’t match expectations, which were artificially high thanks to this effect. No matter, things got better from the autumn onwards as the underlying strength in housing started to kick in. It is particularly noticeable that Home Depot is talking about strength in categories that are more discretionary in nature. In addition, Lowes is achieving a lot of success in its program to restructure and simplify its product lines. I don’t believe in coincidences and I suspect Lowes is able to do this because it now has favorable end markets.

All About Pricing

In common with the home goods stores BECN is seeing signs of strength in some of the more discretionary elements of sales. For example Complimentary Building Products pricing was up 3-4% in the quarter and this helped sales in existing markets to be up 2.9% in this segment. It’s a good early indicator of some cyclical strength.

However, Complimentary only makes up 14.6% of sales at present with Residential Roofing providing 47.2% and Commercial Roofing at 38.2%. Commercial Roofing saw pricing flat and I think it’s fair to argue that its growth tends to lag residential growth. The main driver to upside in 2013 will be from the residential market. As such, it was easy to be disappointed by the 3% decline in Residential pricing in the quarter. Throw in the 5.4% fall in existing market sales and disappointment might start turning into despondency.

If so, it would be a mistake! Pricing and sales may be down on a yearly basis but they are up against some very tough comparisons (remember the pull forward effect and the re-roofing activity created by Katrina?) last year.  BECN’s management argued that sequential pricing was up sequentially, and by my reckoning that is three quarters in a row. Another good sign.

Where Next for Beacon Roofing Supply?

Analyst estimates are for $1.81 in earnings, and management declared that they were comfortable with these numbers. The game changer will be if BECN manages to get the planned price rises in Residential to stick. Indeed, the company spent significant sums on inventory in order to take advantage before industry prices rise. BECN reported that January was a good month with its order backlog growing, and there is a real sense that any weakness in the winter was temporary.

With a current stock price of $37, the forward PE is over 20.4, which looks a bit pricey to me. It isn’t ‘pricey’ if you start baking in some increased pricing in Residential Roofing pricing. I’m willing to do this but not without some margin of safety. Another one for the monitor list.

Thursday, February 14, 2013

How Much Upside is Left in Colgate-Palmolive?

Colgate-Palmolive (NYSE: CL) reported another solid set of results recently, with organic sales growing 4%. It’s the sort of stock that investors should be looking at right now because the market has come a long way in a short space of time. As a consequence, it might be a good idea to start looking at some consumer staples in case we see a mini-correction in the main indices. With that said, I think CL is very attractive, but I’m going to take a pass here. It looks fully valued and it has been performing so well (within intensively competitive markets) that investors are entitled to wonder if it can continue.

Colgate Carries on Innovating

The story over the last few years has been how well Colgate has innovated and introduced new brands into new markets. It’s a strong performance because it has squeezed growth in a difficult market; whereas a key rival like Procter & Gamble (NYSE: PG) has failed to exploit the full power of its brands, Colgate has been able to drive growth via new mouthwash, toothpaste and toothbrush products. My take on PG’s difficulties is that its traditional approach to slowdowns (hold pricing, protect the brands but lose a little market share and then reap the rewards of leverage when the economy recovers) has been thwarted thanks to the anemic nature of the recovery in the mass consumer market. However, PG has been changing of late amidst renewed efforts to take back market share.

While the economy has challenged PG, it has played into the hands of Church & Dwight (NYSE: CHD) and its mix of value and recession resistant brands. In fact, CHD has been (alongside CL) the company most capable of generating double digit EPS growth in this environment. If a slow economy has been beneficial to CHD, it is not done much for CL. Its growth has come from internally generated performance and a strengthening presence within emerging markets.

Colgate’s Growth Prospects

A few bullet points on what to expect in the mid to long term future and then some commentary on them:

  • A global restructuring program (costing $1,100-1,250 million in charges) intended to generate $365-435 million annually within four years
  • 1-2% growth in developed markets, 8-9% in emerging markets
  • 6-7% revenue growth for 2013 and 10-11% EPS growth
  • Continued innovation in developed markets
  • Significant new product launches with Hill’s Pet Nutrition (13% of current revenues) will bring back volume growth and contribute positively to margins.

The efficiency program is already in progress, and CL expects $30-40 million in savings this year with charges of $185-220 million. The program reflects a realization of the fact that the developed world is seeing slower growth. The good news is that CL actually increased market share in many key categories in Europe and increased quarterly operating profits by 14% in Europe/South Pacific. Moreover, CL recorded 4% organic growth in North America with some impressive market share gains in such a competitive market place. It’s impressive stuff.

Turning to emerging markets, in Q3 CL recorded 5% organic growth and now 6% in Q4. To be fair, it has been up against some tough quarterly comparisons, but investors need to keep an eye on this metric because it is tracking below the 8-9% that CL would rather have. Furthermore, there are some concerns that the likes of PG are going to be more aggressive within emerging markets and in particular in Brazil. Considering that CL has over 71% market share with toothpaste, there is a lot for rivals to aim at. Similarly, its market share in China was cited as 34%.

Probably the most exciting developments at CL are the new products at Hills which should lead to improved performance going forward. It is a great sector of the economy to be exposed to and offers strong long term growth prospects.

Where Next for Colgate?

The stock certainly isn’t cheap now, and I would argue it is fairly valued for its revenue and earnings growth prospects outlined above. The question is whether it will hit them or not. If so then I think the potential is for Colgate’s share price to ‘do its earnings.’

It will require success with the ongoing product innovation within developed markets and skillful negotiation of the increasing competitive pressures within emerging markets. Alongside this, the guidance contains some assumptions over the restructuring program and success with Hills. The recent history of CL suggests it will achieve these things, but there is little margin for error here and the evaluation doesn’t look compelling.

Regal Beloit is a Hidden Housing Play

The market has been in bullish mood recently, and much to the chagrin of those of us with a contrarian persuasion it’s becoming ever harder to find anything that doesn’t have optimism already priced in. With that said, there are always stocks with some evaluation upside, and I think Regal Beloit (NYSE: RBC) is worth a look. In summary it is a highly cash generative company with a history of accretive acquisitions operating in markets that are set to do well in 2013 provided the global economy holds up.

Introducing Regal Beloit

With further ado (it is not a well known company) RBC is a manufacturer of electrical and mechanical equipment with a heavy focus on Heating, Ventilation and Air Conditioning (HVAC) solutions. As such, it describes its end markets as being 39% residential, 34% industrial and 27% commercial with around 66% of sales occurring in the US in the last quarter.

I’m going to list a few key takeaways and markers to help understand the company better:

  • Free cash flow conversion for the full year 2012 was around 130% of net income. RBC has averaged nearly 140% in this metric since 2007.
  • Highly acquisitive and uses cash flow to grow via acquisition
  • Expanding production in China with two new factories
  • Creation of synergies via acquisitions such as consolidating North American warehousing
  • Increasing energy efficiency standards will raise demand for new HVAC products.

As ever, a lot of investor interest will focus on China, but the country still only represents around 8% of sales. I think RBC should be viewed as more of a US focused stock with exposure to construction markets in line with the percentages outlined above. The good news is that it looks like RBC is being primed for growth in 2013. I'll explain.

Setting up for a Good Year?

Across its geographies there is a good case for a some upside surprise with RBC in 2013. In the US it was doing well in 2012 until some weakness hit in the third quarter, which fed into the fourth, but there was some strengthening towards the end of the quarter. Even then it was a mixed story with residential, commercial HVAC, refrigeration and its food and beverage operations but weakness in industrial equipment and energy.

In my book this looks like the more cyclically based industries in the US reacted to fears over the fiscal cliff and the election (in line with what so many others have said) in the winter, but the underlying economy is still growing okay. If I’m right about this then there is upside as its US based customers should return to making orders this year. Companies can't stay 'worried' forever and do tend to get used to these things.

In addition, Europe (not a major market for RBC) was described as stabilizing and RBC outlined some signs of a return to growth in China. The latter would be welcome as it has experienced weaker conditions in China since the winter of 2011.

What the Industry Is Saying

RBC competes with some smaller divisions of some huge companies. Cummins (NYSE: CMI) has an electrical motors division and its commentary on oil and gas construction (a key vertical for RBC) was pretty much in line with what RBC said. It described construction activity as being ‘flat’ with little sign of a pick-up in North America. As for China, it was described as disappointing overall, and oil and gas was not spared.

Emerson Electric (NYSE: EMR) also gave results recently. The key comparator here is its climate technologies business. EMR had some positive things to say and cited strong growth in residential AC markets in China and more favorable conditions in the US residential.  It expects a continued recovery in residential end markets in Asia and China. Emerson also stated that its climate technology orders were ‘above the line’ in Q4, and January is expected to be the same. This bodes well for RBC.

Where Next for Regal Beloit?

Putting these things together builds as picture of a well run company that has some upside potential this year. My biggest concern would be with China, but it is not a major part of RBC’s sales. On the other hand the US makes up 2/3 of sales, and with an improving residential construction market I think RBC is set to outperform the wider engineering sector.

RBC tradeson a forward PE ratio of 15.3 and if you assume it will generate 140% of its net income ($5.18 of EPS) in free cash flow for 2013 you are looking at a stock set to produce 8% of its Enterprise Value in 2013 and with some possible upside. It's attractive.

Wednesday, February 13, 2013

Cisco Earnings Analysis

In general it’s been a better than expected earnings season for technology. Sure there have been some disappointments with cautious enterprise spending and Government cutbacks, but we haven't seen any major IT stock say that the macro conditions are noticeably getting worse. All of which leads us into Cisco System’s (NASDAQ: CSCO) results for Q2. I want to preview them so investors can quickly know what to expect.

Cisco Earnings Analysis

It’s fascinating to look at Cisco because its constituent parts cover so many areas of technology investing. Not only is the stock worth looking at in itself (although primarily as a value play), but what it says about the tech market is important too.
My take on the backdrop:
  • There is evidence to suggest that Telco spending will be stronger in 2013, and Cisco could be a key beneficiary.
  • Enterprise spending remains cautious, but most companies have reported stabilization.
  • Anecdotal evidence from the earnings of some of Cisco’s rivals in certain segments suggests that Cisco is losing market share in areas like security, collaboration and wireless.
With these points in mind I’m biased to expect some relatively better numbers in Cisco’s core activities of switching and routing but not such good news from its more peripheral activities. It probably needs to have a think about making some acquisitions in the periphery, but it is presented with difficulties in many of these markets because of anti-competitive issues.

Previewing Cisco’s Earnings

A quick look at Cisco’s revenue split in the last quarter demonstrates that the core activities of Services, Switching and Routing make up around 70% of revenues and are what really guides the company.

Continuing the theme of stability in Cisco’s core activities I want to look at the core in isolation first.

Services, Switching and Routers

There is no doubt that the second half of last year proved to be tougher in terms of IT spending than many had hoped it would have been going into 2012. Moreover Tier 1 carrier spending slowed down as the year went on but there are real signs of a pick -in spending from the likes of Sprint Nextel and AT & T. This should start feeding through into Cisco’s switching and routing revenues while its services revenues tend to be pretty consistent.

Switching and Routing revenues tend to decline sequentially going into Q2, and I expect the same again for 2013. Moreover, it is up against some tough comparisons last year.  Therefore combining these three elements together I would expect yearly declines in routing and switching (low single digit declines) plus an 11-12% gain in services. As a rough ball park figure this would make around $8.1bn for Cisco’s core activities.

Collaboration and SP Video

Collaboration is an area where Cisco has had some difficulties over the last year. Frankly it’s been a tricky market, as things like telepresence, call center and unified communications are activities tailored towards corporate expansionary spending. In other words when companies cut back it is precisely in these areas that the first cuts will be made.

On the other hand, Cisco’s key rival in collaboration Polycom (NASDAQ: PLCM) has reported better numbers of late, with a 5% sequential increase in revenues in the last results. Cisco’s collaboration earnings tend to mimic its rival. However, the question is whether Polycom’s efforts to release new products and differentiate itself from Cisco has worked or, whether its results are just a function of an improving market? We are about to find out.

Yearly revenue growth for Collaboration and SP Video.

Before anyone gets too excited about SP Video, I should note that Cisco got a $200 million contribution from the acquisition of NDS in the last quarter. Putting these two divisions together I would expect combined revenue of around $2.3bn with a positive comparison for collaboration.

Wireless, Security and Data Center

Investors in Aruba Networks (NASDAQ: ARUN) should keep a close eye on what Cisco says about its wireless revenues and particularly Bring Your Own Device (BYOD) spending. Thus far, all the evidence is pointing to a very strong set of results. Companies as diverse as Fortinet (NASDAQ: FTNT) and F5 Networks have been reporting strong interest in mobility and BYOD solutions. On a related note, I don’t think the Blackberry 10 is going to bring back the heyday of the company and mark a shift away from the necessity of BYOD. In fact it may increase BYOD demand. I expect Aruba to report good numbers.

Within security, most of the leading players have reported. Check Point is going through its application platform refresh and seems to be playing a waiting game before demand catches up with its new technology. Fortinet’s results were excellent, but the company did cite a number of wins from Cisco (particularly in firewalls) in its conference call, and there is a sense that its solutions are becoming viable to larger enterprises. I think Cisco is falling behind in security and wouldn’t be surprised to see it make an acquisition in the sector. Fortinet?

Lastly with Data Center, I am going to stick my neck out and offer a note of caution. Yes the results will signify very strong growth but it might not be quite as strong as the market thinks in future.  Data Center companies like Equinix (NASDAQ: EQIX), Telecity, and Digital Realty have all been aggressively increasing capacity over the last couple of years and any company selling data center infrastructure has seen the fruits of this. However I note that Equinix is planning to reduce CapEx in 2013 and I suspect the industry could see a shift in the mix towards relatively higher maintenance spending. Look out for the guidance on data center spending.

My back of envelope calculations suggest $1.3-1.4 billion in combined revenues for these segments and don’t be surprised to see security growth slip to mid single digits.

Is Cisco A Stock to Buy?

Putting these numbers together and including $200 million in ‘other’ revenues gives a ball park figure of around $12 million in revenues. The exact number doesn’t matter so much as what Cisco reports and says within its individual segments. For the company as a whole the key marginals will be the switching and routing divisions so keep an eye on those.