Sunday, March 31, 2013

Is Williams-Sonoma Fairly Valued Now?

There are a few precious themes working in the retail market right now and investors would be well advised to stick with them. Housing and autos are doing okay. High end, specialty stores and discount stores are doing fine and, e-commerce continues to grab market share from retail. The interesting thing about Williams-Sonoma $WSM is that it is exposed to more than a few of these positive themes and its rising stock price demonstrates that amply.The question is where is it going to be in future?

Williams Sonoma’s Growth Drivers

I’m going to get into the details of WSM quickly, so for those who are not at least familiar with the company I have a primer article on it linked here. As discussed previously there are a few initiatives that the company is pursuing in order to drive growth

  • International expansion with an immediate focus on Australia and the Middle East
  • Expanding its growth brands like West Elm and Pottery Barn
  • Launching new business and brands in order to offer a differentiate range of product
  • Ongoing expansion of Direct to Consumer (DtC) and its online offering
  • Investment in the supply chain and technological infrastructure in order drive multi-channel sales

As you can see from these growth drivers WSM is a direct beneficiary of a cyclical recovery in the housing market as well the secular theme of the expansion of online sales. Indeed DtC sales now represent 46% of total revenues and its fast growing e-commerce sales should help improve margins in future.

The longer term question relates to increasing competition in the online space. Home furnishing is a competitive market and when markets grow they become attractive for new entrants. Now when that ‘new entrant’ is Amazon $AMZN, there should be cause for concern. Not only is AMZN increasing its own product range of home furnishings but it also bought Quidsi last year. The latter having launched (home goods). Indeed Quidsi is believed to be considering expanding its number of physical stores in order to support its sales expansion. Incidentally this is a strategy that WSM is also following but rather it is supporting its online sales via investing in in-store technology so customer orders can be made online from the stores.

In a salutary reminder of the competitiveness in the industry I would refer to Bed Bath and Beyond $BBBY. It’s been a difficult year for its shareholders. For large parts of the year it managed to report weakening sales trends while seeing margins squeezed by cost prices rising. The ongoing restructuring seems to be taking forever and all this is going on in a sector where everyone else is doing well. It’s hard not to conclude that BBBY is the victim of online competition from the likes of Amazon, WSM and even Pier 1 Imports. Is WSM immune?

The strategic key to WSM’s future is going to lie in differentiating its products (its differentiated products and new launches have tended to outperform) in order not to offer a commoditized products that can be undercut on price from online competitors. Moreover it is aiming to release the potential in its brands via online expansion.

Williams Sonoma’s Potential

In order to see the relative importance of its brands I’ve broken full year net revenue share by brand below.

Naturally Pottery Barn has experienced the benefit of the nascent recovery in the housing market but it has been tougher going at the core Williams-Sonoma brand where comparable brand revenue growth actually decreased 1.1% for the full year. However within that WSM managed to increase the core brands DtC sales and e-commerce revenues in particular.

Time to look at the last two years growth rates.

The decline at the core brand is an obvious concern but the largest brand (Pottery Barn) is doing well. I also think that the international expansion of Pottery Barn Kids is a good idea. The stores in the Middle East are doing well and this is largely a consequence of oil rich disposable income colliding with a youthful demographic. It is no coincidence that the Pbteen franchise store in the region is also doing well. I’m not the sure that Australia shares the same demographic advantages but it certainly offers a relatively strong housing market.

The real story with geographic expansion in 2013 centers on the West Elm stores. WSM rolled out 12 West Elm stores this year as opposed to the initial plan for nine. In addition there are another nine stores planned for this year. As West Elm is a more modern brand it is reasonable to expect WSM’s investments in in-store technology and customer analytics to bear more fruit in this brand.

Where Next For Williams-Sonoma?

WSM is certainly bullish about its future. Management forecasts mid to high single digit growth in revenues accompanied by EPS growth in low to mid teens, for the next three years. This implies significant margin expansion but it’s worth noting that gross margins were flat on the year (although they increased throughout the year) and operating income margins declined 60 basis points to 15%. Moreover the expansion plans will mean increased capital expenditures of $200-220m for the next three years. By way of comparison they were only $130m in 2011. Clearly WSM is in an expansion phase.

As ever there are risks and opportunities with a growth strategy. To buy/hold the stock I think you have to be positive that e-commerce and international expansion will create margin expansion. Meanwhile you should also believe that the management can continue to generate differentiated products in order to avoid potential margin compression. I like the sector and the company but I’m not sure that on a current PE of 20 that it is good value for the risk

FedEx Offers Catch Up Potential

By now, you've probably had your fill of FedEx’s $FDX latest earnings reports. The company reduced guidance, which immediately gave grounds for the bears to come out and point to weakening growth. In reality, it was a mixed report that actually said more about FedEx and its relation to patterns in the global economy. Investors are often criticized for believing that "this time it's different" but in this case I'm going to stick my neck out and say that, with FedEx, it really is different this time.

FedEx Equity Research

What I’m talking about is that the global economy has changed in many ways since 2008. U.S. consumers have de-leveraged while European growth has been weak overall and varied across its regions. Allow me to briefly remark that this is because Europe is at least making some effort to deal with its debt burden while the U.S. seems to be content on making piecemeal changes while the markets reward it with low interest rates. Meanwhile, China continues to be an export-oriented economy and has seen export growth slow as a response to weaker consumer demand from other regions.

These issues matter a lot to FedEx. Indeed, it can be excused for structuring its business to deal with the kinds of economic conditions that were around in 2007, but could it have foreseen what was going to happen in 2008 and after? Furthermore, consider the nature of its business and the difficulties inherent in adjusting its fleet and distribution network to the new economic realities. The result is a business that has had to make ongoing adjustments over the last five years. And it’s not done yet.

FedEx’s ongoing challenges

I’ve discussed FedEx previously and readers who want to see how FedEx and UPS $UPS are both ultimately correlated with global GDP growth can read the article linked here. In addition to see the start of the trend away from express services readers can click here.

For now, I want to summarize the key issues in bullet-point form:

  • Consumers continue to shift to cheaper and slower delivery options and away from express. Express revenues were $100m lower than previously forecast by FedEx
  • Domestic express services were fine with the problem being in international express
  • Ground revenues continue to benefit burgeoning e-commerce deliveries and with the declines in express and low margins with freight, the ground segment contributed 79.2% of operating income in the quarter vs. 57% last year
  • Freight operating margins remain low at 4.4% for the first nine months, versus 17% for ground

The issues with international express are a function of how international trade’s correlation with global GDP has gone down for the reasons discussed earlier. Moreover, FedEx has had issues with network efficiency thanks to uneven trade flows throughout the world. Global trade was cited on the conference call as being lower than in 2008. In addition, a constrained Western consumer has slowed the growth of China’s exports. However, the imbalance in traffic to and from China remains in place. All of these factors lead to logistics problems in terms of fleet management.

These issues are exacerbated somewhat at FedEx, which chose to expand its express service only to walk into the global slowdown. Indeed, the problems have got worse over recent quarters. The company's response is to accelerate the plan to retire older planes and manage the network more efficiently by adjusting routes accordingly. Matters could not have been helped much by UPS’ January launch of a new express air service aimed at high-value international heavyweight shipments.

FedEx Competing With UPS

In fact it’s useful to compare the two because gross margins have diverged in recent years.

FDX Gross Profit Margin TTM data by YCharts

And while UPS share price is higher than it was in 2007, FedEx’s is noticeably lower. Like I said, this recovery was different.

FDX data by YCharts

Which Stock to Buy UPS or FedEx?

The problems at FedEx don’t seem to be going away any time soon, but the company is taking the right action for the long term. In addition, ground services now represent a large part of profits and the company is doing fine with long term growth assured from e-commerce growth. The lowering of EPS guidance is never a welcome sign, though. Neither is the threat of more impairment charges as the restructuring continues.

That said, I think value investors might prefer FedEx to UPS on the basis of a lower evaluation and the potential for it to catch up with its rival after restructuring and hopefully increasing margins.

Saturday, March 30, 2013

Why I Bought Ross Stores

While reviewing Ross Stores' $ROST recent results I had an eerie sense of déjà vu. It’s not just that it operates in the same sector as its chief rival TJX Companies $TJX, but it seems to have the same approach to understating company guidance. Ross has underperformed its rival, but I think this is potentially a good buying opportunity in a sector set to do well in 2013.

Ross Stores Gives Good Results

Rather like its rival, Ross reported a good Christmas and gave its usual conservative guidance In addition it is (like TJX) doing away with giving monthly sales results. Both companies are investing for growth, but TJX is making more of a play on expanding in Europe; in fact I’ve discussed this issue at more length in this article.

Meanwhile Ross is focused on expanding stores in existing markets and building out two new distribution centers in the next two years while relocating its corporate headquarters. In addition, there are 60 new Ross stores planned for 2013. As such, its capital expenditures are forecast to rise $670 million in 2013 from $424 last year. A busy year!

The chartists among you will note that Ross has underperformed TJX over the last six months, and this is partly a consequence of worse than expected performance in its home goods lines. TJX has been performing well in this category, and other home goods stores have been strong so I think this is probably an issue of Ross’ execution.

Elsewhere Ross was not burdened with the need to aggressively discount or promote during the Christmas season. This is a sure sign that the sector has pricing power because overall consumer spending has been tepid.

Why the Off-Price Retailers Can Continue to Win Out

The retail market is competitive at the best of times, and with an ongoing anemic recovery the sector has seen some vicious changes in market share. The bifurcation in retail, with the high end and bottom end doing relatively well while the mid-market suffers, is now firmly established in the marketplace.

The victims have been the likes of the department store J.C. Penney $JCP, whose habit of missing estimates and downgrading guidance seems to perfectly represent the difficulties in the mid-market. Moreover, its restructuring plan involves focusing on areas like footwear. In other words it can’t offer a ‘trading down’ option without eroding its values.

We can see echoes of this conundrum in the plans of stores like Nordstrom $JWN or brands like Coach $COH. Nordstrom’s plan to deal with the changing environment is to expand its reduced priced Rack stores and invest heavily in e-commerce and mobile technologies. It fully intends to significantly increase revenues from these areas rather than focusing on its full priced stores.

As for Coach, its plan is to diversify its revenue streams by expanding (you guessed it) its footwear ranges and also men’s accessories. Essentially its strong position within the affordable luxury market is leaving it vulnerable to market share erosion from companies like Michael Kors, and with a cautious consumer it will find it hard to react.

My point in mentioning the strategy of these companies is to note that they cannot afford to heavily discount or coupon their way to growth because it will erode the value of their brands. In effect, they are forced to open up new categories, store concepts or sales channels. This is a situation that the off-price retailers do not find themselves in.

Indeed, gross margins and same store sales are holding up just fine for Ross Stores.

Is Ross Stores a Stock to Buy?

In common with TJX, the company has a habit of being conservative with guidance, and the analyst community seems to know this by now. Ross is forecasting 1-2% same store sales growth for the next quarter, and full year overall sales were guided towards 4-5%. However, analysts have the latter number at 6%.

In order to see how conservative Ross tends to be, I have broken out the previous quarter’s guidance and then what it actually achieved.

Can we expect 4-5% same store sales growth for the next quarter instead of the 1-2% guided to? We shall see.

In any case, I believe the stock is good value. Analysts have double digit earnings growth forecast for the next few years. Its underlying cash flow is strong, and an EV/EBITDA evaluation of 8.7x is not expensive at all. I will look to pick some up.

Wednesday, March 27, 2013

Oracle Set to Bounce Back?

One of tech’s bellwethers missed estimates and saw hefty declines in its hardware business. On top of this Oracle $ORCL reported negative growth for new software licenses and cloud software subscriptions; so is that it for technology? Are Oracle’s earnings about to presage a period of deteriorating earnings for the Nasdaq? And where next for Oracle?

Oracle’s Earnings

In short the results were disappointing. Oracle’s overall revenues declined 1% and it missed its own revenue guidance of 1-5% growth for the quarter. If this wasn’t bad enough, new software licenses declined 2% and software revenues overall were only up 4%. This growth wasn’t enough to offset hardware revenues, which declined 16%, and services, which fell 8%.

Turning to the guidance for Q4, Oracle forecast 1-4% overall revenue growth with new software license and cloud subscription growth bouncing back to 1-11% and hardware product growth continuing its decline by 12-22%.

What Went Wrong?

I’ve summarized the key points and why Oracle’s management is optimistic over Q4:

  • The sequester fell on the last day of the quarter so some deals were delayed or will fall in to Q4 as a consequence.
  • The adding of thousands of new sales executives caused some disruption over execution.
  • The pipeline was described as being up significantly, and there was little doubt on the conference call that this was an execution and timing issue rather than macro or product related.
  • The turnaround in execution is forecast to be ‘quick’ rather than running over a few quarters, and Oracle was described as a company whose revenues are moving into Q4 anyway.
  • Oracle’s win rate was declared to be up.

The last point implies that it isn’t losing market share and affirms that this is not about product. Putting these arguments together it’s not hard to conclude that this is a temporary issue which will be resolved in a quarter. Indeed, this may prove a great buying opportunity in the long term. Unfortunately the market simply doesn’t see it this way in the short term and the immediate reaction was an aggressive markdown. My concern isn't so much with the sales execution issue as with longer term matters.

Oracle Challenges and Opportunities

In reality there are other developments giving investors cause for concern. The main one is that Oracle’s cloud strategy is working, but it isn't a big enough part of its overall sales to deal with any demand lost from corporations who want to replace their existing IT systems with cloud based services. If this movement is accelerating quicker than expected then it is likely that Oracle’s revenues will suffer disproportionately. The good news is that Oracle has been aggressively preparing a cloud strategy, and it certainly has the cash pile to make more acquisitions in the space. It may need to.

As for hardware, the weakness was expected. Oracle is clearly going through a period of product transition. This isn’t unusual; indeed its key rival IBM $IBM went through a similar thing with its System Z mainframe. This product’s revenues have been up strongly in recent quarters, and IBM is forecasting double digit growth for System Z in the first half. This is a good example of what Oracle is talking about when it talks of generating growth next year with its hardware sales. However, for now it appears that the point of inflection with its hardware has been pushed out by another quarter.

In addition, it’s hard not conclude that IBM is doing well against Oracle in middleware because it reported accelerating growth within this segment. IBM’s recent results suggest that the IT spending environment is doing fine.

Is Oracle a Stock to Buy?

I think there is a good case to see the glass half full for Q4. The rest of the industry has been making positive noises, and Oracle is a company prone to a bit of variance in its results. Whether this is due to Larry Ellison’s ebullient nature or not is anyone’s guess. However, I recall a gloomy Q2 2011 set of earnings which was promptly followed by a recovery. In addition, this year’s Q2 was particularly strong so perhaps some deals were pulled forward, and Q3 suffered accordingly.

Thinking longer term Oracle probably needs to demonstrate that its expansion of cloud based sales is accelerating and perhaps make an acquisition or two. Furthermore, it needs to convince the market that it can keep on track with its launch of new hardware. This could take time.

The stock certainly isn’t expensive on an EV/EBITDA of less than 9 and carries the prospect of a reward for shareholders with a bounce back in Q4. However, even if there is a bounce-back following better sales execution the stock will still be guided by how Oracle deals with the cloud transition and its new hardware releases. Lots to think about here.

Tuesday, March 26, 2013

FactSet Research Looks Fair Value

The ghost of the financial crisis lingers on, and no more so than in the banking sector. It’s not only that financial services firms are reluctant to invest, having barely survived the crisis, but they are also faced with regulatory threats. In this kind of environment it is no wonder that information providers like FactSet Research Systems $FDS are not seeing the kind of pickup in demand that they might expect at this stage in the cycle. So is this a long term problem or is now the time to buy?

FactSet Gives Disappointing Numbers

The recent Q2 results were a bit disappointing. A brief summary here:

  • Q2 revenues of $213.1 million vs. guidance of $212-215 million
  • Q2 adjusted EPS of $1.14 vs. guidance of $1.11-1.13
  • Q3 revenue guidance of $213-216 million vs. analyst estimates of $217.1 million
  • Q3 EPS guidance of $1.14-1.16 vs. analyst estimates of $1.13

The revenues are a little light, but EPS is ahead of estimates. Essentially the story here is of an industry that is reliant on its customers to make hires and in turn that depends on them expanding their assets under management (AUM). These drivers usually make the industry a great way to play recovering financial markets. Indeed, with equities doing well over the last year and FactSet’s heavy exposure to this asset class, it is reasonable to expect it to likewise be doing well. Unfortunately this is not really the case, and we can see this in the underlying fundamentals.

FactSet’s Annual Subscription Value (ASV) is a strong indicator of future revenues, and it appears to be slowing even as client growth continues to expand:

Analysts have revenue of $860 million forecast for the year through August. Since this number is around the current ASV of $863 million it implies that growth will slow in the next two quarters. Furthermore, this is borne out when breaking out the growth rates for ASV and client growth. Both numbers are for YoY growth.

So with equity markets doing well and the Federal Reserve throwing the kitchen sink at you in order to get you to buy risk assets, why isn’t growth stronger for the industry?

Who Does What in the Industry

The answer to this question rests in an appreciation of the various asset class exposures of the leading firms. FactSet’s principle competitors are Bloomberg, Thomson Reuters $TRI and Standard & Poors. Thomson’s share price has been doing well recently, but this is largely a function of the market’s belief in its restructuring plan and investors’ fixation with high yield stocks.

In reality earnings estimates have fallen over the last three months, and sales growth of negative 1.2% for 2013 and positive 2.6% for next year is hardly encouraging for the industry. Thomson has wide exposure across asset classes; its problem has been dealing with weaker growth in areas like Europe.

A more specific view can be garnered by comparing Bankrate $RATE and Morningstar $MORN. The former is heavily exposed to fixed income markets and sells primarily to banking and insurance companies. Meanwhile Morningstar tends to distribute information on mutual funds to investment and wealth managers.

With authorities determined to keep rates low and everyone wondering whether the mother of all fixed income bubbles is going burst, it's understandable that Bankrate has had difficulties while wealth management is doing fine for Morningstar. It is growing revenues in high single digit figures. In a sense FactSet is aware of this because it is trying to expand its wealth management solutions.

MSCI $MSCI is also a major player in the industry, and its trends are illuminating. Growth is coming from its index and environmental, social and governance segment (ESG), which was up 17% in the last quarter. Risk management is doing okay with a 7% rise, but portfolio management analytics declined 5% with increasing competition cited. This may well be due to FactSet, which reported good growth in portfolio analytics. MSCI's varied performance highlights how much the industry has changed since 2008.

One of the key developments has been the demise of supply side research, and FDS has consistently reported weakening numbers here. Indeed, they currently only make up 18% of revenues with the buy side contributing the rest.

Where Next for FactSet?

With the company forecasting continued weakness on the sell side and underwhelming guidance for Q3 it’s clear that the industry is not forecasting any major pick up soon. The bulls will be hoping that equity markets continue to do well and that investment banks and asset managers will start to increase hiring this year. In addition, FactSet must be hoping M&A activity comes back this year to help out its supply side sales.

In conclusion, FactSet must lie in the pile of stocks considered as cyclically exposed. Moreover, the banking industry remains conservative and affected by the financial crisis. Given its EV/EBITDA multiple of 13.4x I think the stock is still no more than fair value for the risk.

Monday, March 25, 2013

Adobe Keeps on Delivering

Adobe Systems $ADBE continues to seamlessly climb the wall of worry surrounding the stock. It may seem bizarre for me to argue this case if you look at how well the stock has done over the last year, but I happen to think there is still plenty of upside in the company. Its transition to cloud based sales is working and has further to run. In addition its performance confirms the attraction of the software as a service (SaaS) model, and I think investors should approach this investment theme with confidence.

How to Judge Adobe

Naturally when any company makes a transition in its business model the inherent risk and change in operational metrics will attract naysayers. Of course if you are a yea-sayer than you will get a built-in buying opportunity. Such is the case with Adobe. I’m going to try to cover the salient points here as I’ve discussed the development of the company in articles linked here and here.

Essentially what investors need to understand is that shifting from a perpetual model to cloud based subscription will have a negative short term effect on the top line but should generate larger lifetime values (LTV) for the company. In addition it should encourage more people to sign up with Adobe and lead to lower customer acquisition costs.

The key factor in generating higher LTV is to keep the retention ratio high. Indeed, Adobe was asked about this issue on the recent conference call. No number was given, but I believe its management had previously cited a figure of around 80%.

To put this crudely one perpetual customer generates $780 in one year. Now turning to the subscription model, he will generate $480 in year one of a subscription, and assuming an 80% retention rate this turns into .8*480=$384 in year two. In other words the subscription model generates $864 over two years, but the perpetual generates only $780. The problem is that in the first year the revenue generated is a lot less, hence all the fears over declining revenues.

Indeed, Adobe is facing a trough year in terms of revenues. No matter, the key is the ongoing shift to subscribers and long term retention.

What to Expect From Adobe in 2013

In order to track how the key metrics are developing here is a chart of creative cloud subscribers and something that Adobe calls its creative Annualized Recurring Revenue (ARR):

The ARR is simply the number of current and team subscribers multiplied by average revenue per subscription (annualized) and then including Enterprise Term License Agreements (ETLA).

This may sound complicated but it’s not really. The subscriber numbers just represent how well Adobe is shifting people to the cloud model, and the ARR is a way of reflecting future revenues generated by the model. For 2013 Adobe is aiming to finish on 1.25 million subscribers and an ARR of $685 million. To put this into context total digital media revenues for 2012 were $3.1 billion.

Adobe managed to increase the ARR to $233 million (ahead if its $215 million expectations), and the indications are that cloud adoption is working very well. If there is a small cause for concern it is that the average selling price was flat on the new subscribers.

Adobe’s aim is to try to get average revenue per user (ARPU) up to around $50 per month from the figure of around $41 that I estimate it is on now. Similarly there is some uncertainty as to whether Adobe will get back to the kinds of margins that it generated in the past, although this is not necessarily a problem if it can increase total end users by 10%.

The Cloud Franchise?

The poster boy of the ‘franchise’ is Intuit $INTU, and the evidence is that the model works. Intuit was an early mover into the cloud, and it has managed to increase revenues, margins and cash flow conversion. I’ve discussed the company in more detail here. Its core payroll business is growing in high single digits, while its small business group solutions are growing in the mid teens; the opportunity to cross-sell its solutions is enhanced by being in the cloud.

Autodesk (NASDAQ: ADSK) is also moving to the cloud, although its model has some differences. It is bundling its solutions into suites rather than selling them in standalone flagship solutions. In addition, it is not moving towards the subscription based model just yet, so this is more about a pure shift to the cloud than perpetual to subscription. Autodesk is very interesting (I covered it here), and on evaluation grounds the stock looks cheap, but you will have to factor in extra cyclical risk and emerging market risk. The shift to the cloud may be a secular growth story. Autodesk, however, is not the sort of stock to hold if global manufacturing turns down.

Where Next for Adobe?

The company is achieving its aims and managing the transition to the cloud very well. Despite the caution on the management’s side in terms of guidance, I think it is entirely possible that it can get back to the kind of operational metrics that it had before the switch.

In other words, Adobe converted 30% of its revenue into free cash flow from 2009-11, and if it does so again in future then the stock still looks cheap to me. With revenues of $4.1 billion and $4.5 billion forecast for the next two years, this could mean around $1.2 billion and $1.35 billion in underlying free cash flow over the next two years. That is not bad for a business on an enterprise value of around $18.6 billion as I write. I will hold with a $48 target pending that it keeps hitting its targets and the economy holds up.

Saturday, March 23, 2013

Whirlpool Equity Research and Analysis

The key to successful investing is to quickly get to the salient points of why a stock’s value will appreciate. In the case of Whirlpool $WHR it is not as easily apparent as it may seem. Yes the stock is exposed to the housing market, but it would be a mistake just to determine that it is a play on a recovery in North American housing. In reality it has quite a few profit drivers which I thought investors might like to look into in more depth.

Whirlpool’s Earnings Drivers

I’m going to summarize some key issues with bullet points and then flesh them out a bit later.

  • New Home Build does drive demand, but housing starts are still relatively low and demand won't kick in until 6-9 months after starts pick up.
  • The replacement cycle will drive demand as the 10 year anniversary of the housing boom takes place.
  • US discretionary demand remains weak.
  • Brazil remains the key to emerging market prospects for Whirlpool.
  • Europe remains a challenge.
  • The policy of trying to expand its higher margin sales
  • Margin expansion thanks to productivity improvements is being offset by higher input costs.

The last five years have been emblematic of the economic recovery for Whirlpool and its chief rival in the home goods appliance market, General Electric $GE. A struggling North American consumer coupled with housing being at the epicenter of the crisis hit the industry hard. Government attempts to stimulate spending had an affect in 2010, but this proved all too temporary and the industry fell back into a more normalized demand path. Throw in the obvious difficulties in Europe and it has been a tough period, last discussed in an article linked here.

The good news is that there does appear to be a sustainable recovery in US housing and efforts to diversify by expanding sales in emerging markets like Brazil. The story going forward will be over the strength of demand spurred by the replacement cycle in the US and the potential for ongoing growth in emerging markets. Meanwhile Europe is in a holding pattern, and the attempt to shift sales to higher margin products will carry the concomitant risk of losing market share in a competitive market. New home sales will add some growth kicker, but ultimately discretionary demand in the US for large ticket white goods remains weak.

What This Means in Charts

A breakdown of the last four years' revenues and margins gives a pretty accurate picture of what has been going on. There was a nice pick up in 2010, but since then revenue growth has slowed. Incidentally, top line growth was negative in 2012, but this is largely due to foreign currency effects and lower tax credits. Stripping these effects out, sales rose 3%. On the plus side, productivity improvements helped margins rise in 2012.

As for the optimism over the replacement cycle this is largely due to the timing of the post 2000 housing boom. In order to demonstrate this I’ve taken some data from the Association of Home Appliance Manufacturers. In this case I’m looking at automatic washers, but the trends are the same across most categories.

While the evidence is compelling, it is one thing to draw up a balance sheet, assume a depreciation rate of 10% and assume that goods should and will get replaced over 10 years; it is another thing for it to actually happen. For example many commentators have been amazed by how the average life of a car in the US has gone up and up, far exceeding historical norms. Will this be the case for household appliances? It’s possible, but one thing that is sure is that in this environment consumers will be reluctant to make discretionary spending decisions over large ticket appliances.

As for the kicker from new housing starts the indicators are that this will indeed kick in for Whirlpool in late 2013. Here is the latest Architectural Billings Index and within this index the residential indicator is the highest.

Broadly speaking the industry has been reporting positive news lately. Home Depot $HD has recently reported broad based strength across its categories and, importantly, its more discretionary based items are seeing sequential strength. It’s worth noting that Whirlpool distributes products at both Home Depot and Lowe’s, and if they are seeing strength then so will Whirlpool. Furthermore, much of the background data in this article equally applies to their end demand too.

As for its chief rival in the US, General Electric recently reported a solid set of results and expressed positive commentary on North America. Its home and business based profits don’t make up more than 13% of GE’s total, though, so it's less exposed to the sector than Whirlpool or Electrolux. Of course this means it can cross-subsidize its home goods sales and engage in the kinds of pricing promotions and discounts that hit the industry in 2010-11. On the other hand with conditions improving in the US there may be some opportunity for price gains across the industry.

And finally the segmental breakdown of profits reveals the importance of Latin America (mainly Brazil) to the company’ profitability:

Indeed, for 2013 the company is forecasting 3-5% growth in Latin America and Asia with 2-3% in North America and EMEA as flat.

Where Next for Whirlpool?

A quick review of the guidance for 2013 shows WHR predicting $600-650 in free cash flow with $950-1 billion in ‘ongoing business cash flow.’ The latter is adjusted for tax credits, pension contributions and restructurings. Even taking the lower number’s midpoint of $625 million, it is still forecast to generate around 6% if its enterprise value in free cash flow this year. Moreover, its earnings guidance of $9.25-9.75 of ongoing diluted EPS implies a forward PE of 12.1 at the midpoint.

In conclusion, the stock doesn’t look expensive, and provided the US housing market is doing okay I think it is worth picking up. As for Brazil, a large part of its prospects depend on servicing China with raw materials, so this makes Whirlpool the kind of stock to avoid should China disappoint with growth. For now things look okay.

Friday, March 22, 2013

Polycom is Facing Challenges

It’s tough to know what to make of the telepresence and videoconferencing market. While the earnings slowdown with its leading listed protagonists Polycom (NASDAQ: PLCM) and Cisco Systems (NASDAQ: CSCO) is easy to spot, the reasons for it are less obvious. Is it a structural decline or is it just due to some pressures on discretionary IT spending at this stage in the cycle?

Structural Decline?

It seems that one of the very few decisions that Hewlett-Packard (NYSE: HPQ) has gotten right in the last few years was the sale of its visual collaboration unit to Polycom in 2011. Many commentators didn’t think it was a good move at the time, especially as Cisco bought Tandberg Television in 2010. Microsoft (NASDAQ: MSFT) wasn’t left out of the party, and its 2011 purchase of Skype made it a player at the low end of the market. Essentially the market was geared up for a battle between Polycom and Cisco at the high end while Microsoft was set to use its positioning to expand Skype at the lower end. Whichever the outcome, video conferencing telepresence was supposed to be here to stay.

The result turned out to be very different. The Tandberg acquisition has proved problematic for Cisco, and few observers think it was a great deal now. Similarly, Skype hasn’t pulled up any trees under Microsoft, and Polycom has been forced into investing in order to generate growth by differentiating its offerings from Cisco. HP may well be faced with structural declines in its PC and printer markets but it acted adroitly in selling this unit to Polycom.

In order to see how badly the industry has fared; here are the revenues for Cisco’s collaboration segment alongside Polycom’s total revenues. The x-axis is based on Cisco’s reporting with Polycom’s numbers adjusted to the most relevant quarter.

Describing the last two years as being challenged would be an understatement, but is it structural?

The argument in favor is that the trend in IT spending is towards software and outsourcing of IT requirements rather than the purchases of in house hardware. Moreover, traditional videoconferencing solutions have tied the purchaser to the solution and requires system-wide integration. It is not in the zeitgeist of open platforms across IT, and as mobility demands ever more corporate IT spending, is a system that requires its users to be in a dedicated room really going to be the future?

Another key trend in IT over the last few years has been virtualization and outsourcing IT into the cloud. Why not do this with videoconferencing? Instead of installing a system that will inevitably require a dedicated room (in each location or node) and then some servicing, why not just buy the service from a cloud based provider and also be able to connect from mobile devices?

Putting these arguments together would conclude that the decline is structural, but it does suggest that solutions like Microsoft’s Skype do have the potential to increase penetration.

Or Is it Just a Cyclical Issue?

The idea here is that this sort of technology is not necessarily about a demonstrable return on investment and cost cutting but more about expansionary investment spending. In this view the slowdown is merely a function of constrained expansionary IT capital expenditures, which will inevitably come back when the economy recovers.

Of course this is a tempting argument because it implies some pent up demand for these technologies. Now throw in the lowly evaluation of Polycom, and the stock starts to look attractive. Indeed, it has been investing in upgrading its solutions to try to pull ahead of Cisco and anticipate rising demand in the future.

The Bottom Line

My view is that it is a combination of these issues in the near term, but the longer term structural concerns are significant. Over the last year the trends in IT spending have been towards mobile solutions, cloud based computing and solutions that encourage flexibility and cross platform usage. The idea of spending on expensive hardware in order to have service and upgrade a tied solution within a fixed location is simply not where IT is trending.

Thursday, March 21, 2013

Donaldson Equity Research and Analysis

In theory, filtration companies have a lot going for them. Growing regulatory requirements promulgated by environmental concerns should ensure GDP growth in the future. Moreover, the promise of long term growth from industrialization and increasing numbers of transport vehicles in emerging markets offers plenty of upside. On the other hand, they are still cyclical plays that are dependent on specific end markets. In this article I want to focus on Donaldson (NYSE: DCI) and discuss some of the reads across to other companies from its recent results.

Donaldson Earnings

The market didn’t like the recent results, and they served as a salutary reminder that the industrial market still faces challenges this year. Sales were up 3%, but operating income declined 5%. In order to demonstrate the particulars with this company I’ve broken out some numbers below. The orange segments represent Industrial Products revenues, while the blue shows Engine Products revenues.

It’s not hard to see that its key end markets are construction and agricultural (aftermarket and off road) machinery, heavy trucks (on road), industrial filtration and gas turbine filters.

Here is how the relative segments have been trending in terms of quarterly revenues.

What the Industry is Saying

In order to assess its end markets it’s a good idea to go back to Alcoa’s (NYSE: AA) recent results. There is a detailed outline of them here. The key thing to note here is that Alcoa’s predictions for its Heavy Truck and Trailer segment got progressively worse in 2012, and Europe and North America are set for declines in 2013. All growth prospects in the segment are expected to come from China.

Turning to gas turbines, Alcoa forecast 3%-5% growth for its industrial turbine sales, and it remains an area of strength. Gas Turbine revenues have been strong for Donaldson (up 79% in the quarter) on account of low gas prices causing electricity generators to run the turbines more. However, it is not all good news for Donaldson. For example, Joy Global (NYSE: JOY) is seeing ongoing weakness in its mining operations because low gas prices have reduced the demand for coal for electricity generation. Of course this is happening because gas prices have been low in the US and because growth has slowed in China. As such, Joy Global is facing ongoing challenges, and Donaldson is talking about mining not picking up until later in 2013. Construction, mining and heavy trucking remain problematic sectors for Donaldson.

Caterpillar (NYSE: CAT) is a major customer of Donaldson and is exposed to many of the same end markets. The fact that its EPS forecasts have been lowered over the last few months should have presaged the negative commentary from Donaldson on construction and mining. Much of CAT’s future growth depends on China, and Donaldson remarking that CAT was still reducing inventory in China (primarily because of weakness in construction) is not a great sign, even as others are predicting better days in China.

Indeed, just as Alcoa predicted, demand from construction and mining OEM manufacturers has weakened in Asia and the Americas. This is a consequence of lower end demand, and it will take time for this to filter through.

Donaldson a Stock to Buy?

The bullish case for Donaldson is dependent on conditions getting better in China and specifically within mining, construction and the heavy trucking industries. The market has been keen on this idea, but I think the information discussed above gives enough clues as to what to look for. If China’s construction industry is picking up you will see this in Caterpillar and Joy Global’s numbers before you see it with Donaldson. Similarly, Alcoa gives key guidance over many of its end markets, and my sense is this there isn’t enough hard evidence to get too excited yet.

Granted, China has the financial muscle to buy 7%-8% growth this year, but it is far from clear whether it will go towards the same kind of stimulus spending that it undertook in 2008. For now Donaldson is talking of reduced visibility and lowering its full year outlook. It’s probably not the time to pile in, but rather monitor what its peer group is saying first.

More Bad News For Coach

Sometimes companies can be a made the victims of their own success. This looks to be the case with Coach (NYSE: COH) at the moment. Having established itself as the leading US player within its affordable luxury niche, the company finds itself beset with encroaching competition from the likes of Michael Kors (NYSE: KORS) even while the mid-market consumer remains constrained. The market has wasted no time in pricing all of this in, so is now the time to buy the stock?

Coach’s Prospects in Bullet Points

As ever, it is worth pointing out that we are looking at the price of the company more than the company itself. With that said I don’t think just buying value is a correct strategy. We buy value because we think it gives us upside skew if the underlying earnings improve. So what about Coach’s earnings prospects?

For a primer on the previous trends within Coach there is an article linked here. For now I’m going to run through the issues with bullet points:

  • Coach claims 30% market share within its marketplace and this position leaves it vulnerable to competitors aiming for its customers. Its margins are notably higher than Kors, which implies future susceptibility to pricing competition and margin erosion.
  • A weak mid-market North American consumer is seeing footfall declines at Coach. Interestingly Coach argues this was across the board and that it didn’t promote its way to growth. However, I note that the previous quarter’s growth was largely due to factory store comparisons that benefited from promotional activity.
  • Sales in China grew 40% in the quarter, and international sales were up 12%. International prospects remain strong but they only represent around 27% of current sales. North America remains the key, and the region's comparable same store sales declined 2.2% in the quarter.
  • Coach is focusing on non-core categories in order to drive growth in the future--in particular footwear, men’s accessories (a category growing at 25%) and apparel. The plan is to leverage its core brand in order to sell more lifestyle products.
  • Competitors stepped up pricing competition within the critical December period, as Christmas turned out to be weaker than many had expected and Coach admitted to losing market share in its core handbag category.

What Does All of This Mean?

Putting these points together creates a mixed picture for Coach. It is achieving strong growth in categories like men’s accessories, online sales and its international operations, but this is needed to offset an increasingly competitive core North American handbags market.

Moreover, its affordable luxury niche doesn’t offer the competitive moat of high quality in the way that, say, Louis Vuitton does. Similarly competitors like KORS or Ralph Lauren (NYSE: RL) are capturing market share within handbags and accessories. Moreover, RL has vastly more experience with men’s retailing and less of a brand reputation to protect. In other words, it can afford to be aggressive on pricing.

The expansion of its footwear activities is nothing new in the marketplace. Indeed, J.C. Penney (NYSE: JCP) is making the category a key part of its turnaround success. In a sense the troubles at JCP and other department stores are reflective of the weakness in the mid-market, and the response of many of these companies is to jump on the footwear and accessories bandwagon.The difficulties at JCP also imply that there is more significant market disruption to come as the department stores adjust strategies and sales channels in order to fight for share within a weakening market.

In summary, I think that Coach is looking to expand in categories in which it is not an established leader, while facing increasing competition and potential margin erosion in its core market. On the other hand, a glass half full assessment of the same facts would argue that Coach is leveraging the power of its existing brand in order to generate profits within higher growth categories.

Where Next for Coach?

My hunch is that investors follow the trends in the retail market, and KORS has the hot hand right now. Moreover, the weaker traffic reported at Coach’s stores also means weaker traffic for its growth categories. Coach finds itself in a tricky situation. Does it increase promotions in order to drive traffic but possibly lower the brands perceived value, or does it hold pricing and try to drive growth through other categories?. At the moment it seems to be arguing for the latter. This could prove a risky strategy if the mid-market consumer doesn't come back.

We may well see strong growth from areas like footwear and men’s accessories, but the core, handbags and women’s accessories, remains the key to its future growth. My hunch is that the challenges in its core market could go on longer than many people think and the company will need a stronger overall retail market in order to start growing its core North American market again. The key metric to follow is traffic, and until that comes back I will keep Coach on the monitor list.

Wednesday, March 20, 2013

Costco Performing Well but Where is the Value?

There have been a lot of mixed messages coming from the mass market US consumer recently. On the one hand employment is up and certain key areas like housing and auto related spending have seen some strength; on the other, retail sales ex-gasoline remain tepid, and a host of issues are ganging up to constrain the US consumer. Where does Costco (NASDAQ: COST) stand in all of this?

A Bifurcated Retail Sector

In the good old days the big box retailers like Wal-Mart (NYSE: WMT), Costco and Target (NYSE: TGT) might be seen as trading down plays and therefore strategic beneficiaries from a weak economic recovery. However, even that argument has fallen foul of the new economic reality as consumers are increasingly buying consumables from the dollar stores. Moreover, items like clothing and home goods are being increasingly bought from off-price retailers. They are the winners out of the recovery and everyone knows it.

Of course the key to investing is not necessarily to find the best companies, it is more about finding the best priced companies. Frankly, for large parts of last year the dollar stores looked like they were overvalued despite the ongoing same store sales. Indeed, all it took was for some slowing in their sales growth (an inevitable consequence of their significant expansion plans in my view) and they all corrected pretty significantly.

However, it isn’t just about trading down. I would argue that the high end consumer has seen an asymmetric improvement in his or her fortunes, and luxury and specialty retailers are doing fine. In common with the dollar stores--and this is all they have in common--the high end names have been doing well, but what of the mid market?

Costco Doing Okay, Relatively

The big box retailers are somewhat stuck in the middle of all of these trends. They are not reliant enough on the high end, and they can’t rely on trading down. But the reality is that Costco is doing pretty well, and this chart helps explain why.

Essentially, its prospects have gotten better over the last year largely as a consequence of moderating inflation and decent same store sales growth. There is also the sense that its wholesale membership club offering has enabled it to grow same store sales even while Wal-Mart continues to refer to a weak consumer. Costco’s business renewals rate is running at 93.9%, and it is this attention to service that has given it the chance to expand sales where others cannot.

Wal-Mart’s larger presence and mix of superstores and Sam’s Wholesale Club means that it is more reliant on mass spending. Throw in the potential for consumption to be constrained via payroll tax changes, the effects of the Sequester and higher gasoline prices and it is not going to be a great environment for the big box retailers.

Target’s story is more of a company that has been successfully remodeling its stores. Indeed, its strength has been in growing comparable same store sales growth within what it describes as its ‘less discretionary frequency businesses.’ In other words, the staples are doing well, but discretionary spending remains weak. I think it is fair to read into this that, with Target, it is a case of execution with core consumables rather than hitting the ball out of the park by sourcing and selling new discretionary spending items.

Where Next for Costco?

It looks like more of the same. Inflation is moderating, and this will continue to help gross margins while improvements in housing will help out some of COST’s lines. For example, I don’t think it is a coincidence that its strongest lines in the quarter were in hardware, patio, lawn & garden and tires. Consumers may well be resuming spending in housing and automobile related sectors (after a significant hiatus) but elsewhere things aren’t as good. In addition, the stock is looking like fair value on a historic basis.

COST Price / Sales Ratio TTM data by YCharts

Putting all these things together it is hard to see the stock appreciating significantly from here despite the strengthening economy.

Nevertheless a fairly valued stock can always ‘do its earnings’ in returns, and with analysts penciling in earnings growth in the teens for the next couple of years the stock looks attractive for those looking for some cyclical exposure.

Tuesday, March 19, 2013

Patterson Companies is a Safe Haven

One of things that all financial bloggers learn quite quickly is that all stocks are equal, but some stocks are more equal than others. In other words certain stocks and certain industries attract a huge amount of attention and others do not. For example, the world and his wife has an opinion on Apple’s stock price and prospects but very few would be attracted to investing in, say, the dental or veterinary supply industry. So guess what this article is going to be about?

Patterson Companies: Let Me Count the Ways

Okay a little bit over the top, but I’ve got a lot more buying interest in stocks like Patterson Companies (NASDAQ: PDCO) and Henry Schein (NASDAQ: HSIC) than I do in hot stocks that are being bid up just because they are in industries that the media likes to endlessly cover. In order to try to redress this imbalance, I’m going to make a few bullet points on why Patterson is attractive:

  • Dental and veterinary products distribution is highly fragmented in the US and there is the need and potential for consolidation, which could improve margins down the line.
  • Demographics (an aging population) favor increased dental provision and expansion in the numbers of companion animals.
  • Social trends (singles, single parent families) increase the attractiveness of companion animals.
  • Technological advancements from companies like Sirona Dental Systems (NASDAQ: SIRO) and Idexx Labs (NASDAQ: IDXX) will drive growth in spending. Both are key partners of Patterson.
  • End demand is slightly cyclical but holds up well in downturns.
  • Highly cash generative: Patterson has generated over 25% of its current enterprise value in free cash flow over the last five (recession affected) years.
  • GDP+ type growth

Patterson has many of the qualities that investors might look for in order to provide balance to a portfolio. The downside appears to be relatively limited, but it appears to have some upside drivers coming from structural and strategic developments.

With that said, investors need to appreciate that end demand is somewhat dependent upon cyclical factors. A breakdown of its constituent segments demonstrates its resilience but also its partial reliance on the economy.

The impressive performance of its veterinary operations (formerly Webster but now branded as Patterson) is in line with the industry. I can't help but think there are some M&A opportunities here. Henry Schein also has a substantive veterinary operations, and MWI Veterinary Supply has been generating double digit revenue growth in the last few years; more of the same is expected in the future. Moreover, Idexx Labs (a partner of both HSIC and PDCO) is expected to accelerate consumables sales in the future. I’ve discussed Idexx in more length in an article linked here. The key point to understand here is that Idexx is in a phase of pushing system sales in order to increase consumables sales in the future. This will benefit Idexx and its distributors.

As for the dental side, it has expanded its key relationship with Sirona following some product unavailability in the last quarter. I discussed this matter in a previous article on PDCO. The good news is that this issue has been rectified, and PDCO's management affirmed that there is strong pent up demand for Sirona’s proprietary technology. This is good news at a time of ongoing sluggishness in core equipment sales to dentists. The consumables market may be stable for Patterson, but demand for things like chairs, lighting, cabinets etc remains weak. I think part of this is due to macroeconomic concerns (dentists reluctant to spend) and a tendency for them to want to allocate spending dollars to solutions like Sirona’s CAD/CAM system. More discussion on Sirona linked here.

One interesting aspect about Patterson’s commentary was that it did not see any ‘pull-forward’ effect from customers in Q4 due to fears over possible tax incentive changes to section 179. Henry Schein noted this and suggested there would be some backwash in the next quarter as a consequence. I guess we will find out who is right in a couple of months.

Where Next for Patterson Companies?

On a current EV/EBITDA evaluation of 10x I wouldn’t argue that the stock is particularly cheap. Since the economic recovery began in 2009 the stock has traded within a price band of 1-1.25x revenues. Based on April 2013 revenue estimates of $3.65 billion, this equates to a current share price of between $34 and $40, where the current price is around the mid-point of $37.

Analysts have GDP type top line growth penciled in for the next few years and double digit earnings growth for next year. There is upside potential to this given a stronger economy, and for the reasons articulated above I think longer term prospects are good with the potential for some kicker from M&A activity. It’s not the sexiest of stocks, but these stocks serve a purpose and I think it’s worth a look.

Monday, March 18, 2013

Ciena Looks Well Placed for Increased Telco Spending

Is telco the new housing? While no one outside the investing world would get particularly excited by that question, it is a subject of real relevance to us. I make the parallel because housing related stocks did very well in 2012 as they quietly priced in better conditions while climbing a wall of worry over the industry. I think telco could do the same this year. The early signs are good and looking at Ciena’s (NASDAQ: CIEN) numbers and other recent earnings in the industry, it appears that conditions are getting better.

What the Industry is Saying

Just as with housing last year, I am determined to prove an obsessive compulsive. Plenty of commentators have been looking for better signs from telco spending and the obvious place to start would be with the Tier 1 carriers. To be fair, a quick appraisal of their spending plans would not reveal any significant hike with their overall spending patterns. But the devil is in the details, there are clear that signs that areas like 4G/LTE, wireless, high speed Ethernet, Voice over LTE (VoLTE), network convergence and next generation networking will be strong from the Tier 1 market.

Initiatives like AT&T’s (NYSE: T) Project VIP are intended to expand LTE coverage to hundreds of millions of people by 2014. AT&T currently feels that it doesn’t need to ramp up LTE spending us much as it had previously intended but with its smart phone sales expanding rapidly there will be no option but to increase network spending. It is a slightly different story with Verizon (NYSE: VZ), which has already aggressively rolled out its LTE network. Indeed, it sees spending as flat without any addition to its 3G network. However, it too is seeing much better than expected smart phone sales. The pressure to spend is building up.

Indeed, Cisco Systems (NASDAQ: CSCO) recent results were testimony to improving trends, at least within the corporate side. It saw US enterprise spending up strongly and investors should appreciate that Cisco has a large part of its revenues within the Government sector. Indeed, it is forecasting switching revenues to be flat for the next two quarters. I suspect this is a combination of weak Government revenues and its exposure to legacy technologies.

Looking outside the Tier 1 North American carriers there is a lot of evidence to suggest that 2012 was a weak spending environment in legacy technologies for global carriers. My sense of what is going on is that a number of carriers have reacted to uncertain macro-conditions by slowing capital expenditures, but that consumer trends will force them to start spending on next generation technologies.

Ciena is Well Placed

All of which leads me back to Ciena. The company is well placed in 100G networking and network convergence, so if the theory is correct than it should be seeing some early signs of a pick-up in demand.

For once the theory does appear to be correct!

Indeed, Ciena now does 60% of its optical transport revenues from 40 and 100G. This is a good sign that carriers are jumping to higher speed Ethernet networking. In fact, Ciena talked of good demand for 100G technologies. With North America it is a story of its design wins starting to be deployed in line with some of the capital spending plans outlined above and Ciena’s management spoke in optimistic tones about the upcoming year. Moreover, its switching revenues tend to be higher margin than transport so gross margins are expected to expand this year as the former becomes a larger part of the sales mix.

As for the order book, I think investors have cause for optimism. Ciena’s order book was back end loaded in Q1 (traditionally a weaker quarter for orders) which suggests that Q2 orders are in good shape. Indeed, its Q4 orders were at record levels and the positive tone around the results suggests that Ciena is set for a good year.

Where Next For Ciena?

Ciena certainly isn’t a value stock but then I think we all know what happens with this sort of stock. The market seems to have a consistent tendency to buy growth stocks as long as the sector commentary is positive but then violently lose patience at the slightest sign of weakness. On a forward PE of 21x for 2014 the stock is hardly cheap and buying it requires a positive view of the macro outlook. On the other hand Ciena is exposed to the growth areas of telco spending.

On balance I think there are cheaper ways to play rising telco spending but if you want an aggressive play than Ciena is well worth a look.

Stanley Black and Decker's Growth Prospects

Buying the US housing recovery has been one of the most profitable trades over the last year, but what of Stanley Black & Decker (NYSE: SWK)? With 54% of its revenues coming from North America, it is obviously a play on a resumption of residential and commercial construction spending in the region, but is it that simple?

As you may have guessed by now, my rhetorical questions are leading to the point that there are a lot more moving parts to assessing this company. It’s a mix of strategic growth initiatives, exposure to construction and an aggressive emerging market initiative which is intended to transform the company over the next five years and get it on track to deliver its 4-6% top line growth target. Will it work?

Introducing Stanley, and Black & Decker too

It’s been three years since the merger of these iconic brands and the company remains on track to deliver more synergies from the deal this year. It’s been a difficult five years for the company with its end markets obviously affected by weak end markets. However, going forward the key issue is the execution of its strategic growth initiative.

A look at its revenue by geographic region.

Of the major markets, Europe declined 2% organically last year and expectations are muted going forward. Europe was weak across all product ranges with Southern Europe the main culprit. As for the US it only recorded 1% organic growth last year but this number masks significant variance within the product range. Construction & Do It Yourself (CDIY) organic growth was up 7% in North America but was offset by weakness in Security and Industrial revenues. Emerging markets recorded an impressive 11% growth last year.

I’ve broken out segmental profits below.

Now considering that CDIY makes up over 50% of profits and North America represents 60% of CDIY revenues, it’s not hard to see that currently North American CDIY is its most important sales segment.

Indeed if you look at Home Depot and Lowe's Companies recent results then all is well. Both companies reported strength across a broad range of product categories and the DIY market (traditionally more exposed to discretionary spending) is showing good growth in line with an improving economy. This bodes well for the sector. Consumer spending may be weak and the likes of Wal-Mart are feeling the pinch but the housing sector seems to be a kind of 'sweet-spot' in the economy. Indeed Home Depot is on record as believing this and that it can generate growth that isn't necessarily correlated with GDP.

Strategic Growth Initiative

Having discussed the current situation, it’s time to look at its growth program. Essentially the idea is get to generate an extra $850m in run rate within three years through an initiative of investments in developing geographically and into new industry verticals.

The impressive thing about this plan is that it doesn’t appear to require much investment. Management forecasts $100m in operating expenses ($65m of it this year) and $50m of one time capital expenditures. With the company having generated $1bn in free cash flow in each of the last two years, it is hardly going to make a significant impact on its balance sheet.

The emerging market initiative revolves around low level investment in plants within emerging markets in order to capture future growth within these markets. This is fine but there are a few questions here. The plan involves changing its addressable markets with these regions. Previously its products were targeted at the top 10-20% of the market but management spoke about expanding this to 70% of the market by competing more with more moderately priced products. Naturally this involves a change of product range and brand recognition within these markets and this could prove a challenge. Moreover it relies on ongoing growth in emerging markets. A far from certain prospect.

The healthcare and security initiatives involve utilizing recent acquisitions and leveraging up by hiring sales executives in order to penetrate these verticals. Again it all makes sense but it does require execution within some difficult end markets. The smart tools and storage initiative includes exciting areas like MRO vending. The evidence from Fastenal (NASDAQ: FAST) and MSC Industrial Direct is that MRO vending initiatives are working very well. Indeed both companies have this type of initiative as a center piece of their expansion plans.

Focusing on Fastenal for the moment, it has grown its share of sales from vending machines from less than 5% at the start of 2010 to more than 25% in the last quarter. Not only is this generating new growth but it also comes with higher margins and cash flow generation. It is a key part of the plan to increase working capital efficiency. In addition as Fastenal and MSC Industrial increase these kinds of activities it will lead to greater awareness and acceptance in the marketplace and therefore help out Stanley Black and Decker too.

As for the US Government and Oil & Gas plans, the idea is to penetrate markets that are relatively under represented for the company. Again this plan is fine in principle but it involves moving into one market that will (or rather should) face significant spending challenges over the next decade and another (oil & gas) that is subject to the vagaries of energy pricing.

Where Next For Stanley Black & Decker?

I’ve tried to give a balanced view point here because I actually find this stock compelling. I like the US construction exposure and even with the front end loading of its growth plan, its management is forecasting another $1bn in free cash flow for 2013. Company guidance is for $5.45-5.65 in earnings for this year. These metrics put it on a forward FCF/EV of around 6.5% and PE of 14.4x for 2013.

The evaluation is cheap if you believe in the long term program and can handle the caveats concerning them. Provided the economy holds up I think Stanley can hit its objectives for this year and I would expect the stock to appreciate in line with the economy this year. Moreover the downside (of it not hitting its objectives) is mitigated because the growth program is not particularly expensive and the evaluation is attractive. Well worth a look.

Saturday, March 16, 2013

Cooper Companies Equity Analysis and Research

Anyone looking for a defensive growth stock for their portfolio should at least add Cooper Companies (NYSE: COO) to their monitor list. If you are underwhelmed by my intro then I have had the desired effect! This is a great company and it has lots of upside drivers to its earnings forecasts but it’s hard to argue that the stock is a great value. Nevertheless if you are willing to be a bit more generous than me with valuation and pay a premium for its high visibility (pun intended) and quality of earnings, then COO could be the stock for you.

Copper Companies Analysis

In case anyone is not up to speed on Cooper I would recommend reading this article as a brief primer because I want to get straight into the detail.

The recent earnings were a bit ahead of estimates but as ever, the key is the guidance.

Eagle eyed followers of the company will note that a few things have changed since the previous guidance. I’ll deal with each point in turn.

  • The lower-end of Coopervision (and total) revenue has been raised $10 million
  • Gross and operating margins expectations have been hiked 50 basis points
  • The mid-point of capital expenditures has been raised by $90 million but free cash flow guidance was only lowered by $35 million

I’m reading the revenue guidance hike as a reflection of expectations following the pull forward of capital expenditure plans. Essentially Cooper is accelerating investment in rolling out its silicone hydrogel one day lenses. The thinking behind this is that its competitors are believed to have also increased investment and Cooper is already behind the market in terms of trading up its customers to silicone hydrogel. It simply cannot afford to be tardy on doing this and investors should welcome the plans. By way of reference only 40% of its Coopervision revenue comes from silicone hydrogel so there is an opportunity for margin expansion in future.

Its chief competitor is Johnson & Johnson (NYSE: JNJ), which has been more focused in growth in Japan for its growth in one day lenses. The Japanese are known to be fastidious in cleanliness and one-day lenses are ideally targeted at their preferences. Incidentally the cultural differences don’t stop there. The US has a major market for two week lenses (where Europe tends to have one day or one month) and Cooper is taking more aggressive steps in this market, which is currently dominated by JNJ. Cooper needs to play catch up because JNJ recently reported 6.4% growth in worldwide vision care sales. This is ahead of industry growth and is partly a consequence of JNJ being able to successfully shift customers to shorter modalities.

Moreover there was no adjustment to its forecast of $1.3 billion in free cash flow over the next five years. Analysts on the conference call seemed to miss the point that the free cash flow forecast was not lowered by the same amount as capital expenditures were raised. This implies that underlying cash flow conversion is doing better than previously expected.

As for the hike in margins unfortunately the position is somewhat distorted because COO renegotiated its royalty agreement with Novartis’ (NYSE: NVO) Alcon unit. For reasons of commercial confidentiality the nature of the change wasn’t outlined so it is hard the reasons for the change in the quantum of margins. Alcon is also a key competitor of Cooper and its growth seems to be in line with the industry. Alcon represents around 18% of total revenue for Novartis and the company and it made two small acquisition in 2012 in order to support this growth platform. However they were on the surgical side and Novartis is also very strong on the ophthalmic pharmaceuticals side. In other words, vision care is not primary focus.

Cooper Companies Equity Analysis

Here's a brief summary of what investors should be thinking about the long term:

  • Growing penetration of its higher margin silicone hydrogel lenses by convincing customers to trade up
  • Margin expansion from shifting customers to a one day modality (which generate 4-6 times revenue and 3-5 times more profit)
  • Taking market share in the two week modality in the US
  • Territorial expansion with silicone hydrogel
  • Expansion in key markets like China and Eastern Europe

Putting these together it’s not hard to see a bright future for COO and investors should be willing to pay a premium for a company whose end markets only tend to drop a percentage point or two in a recession.

Is Cooper Companies a Stock To Buy?

This ultimately boils down to what you are willing to pay for this sort of stock. As attractive as it is I’m not sure I am ready to pay an EV/Ebitda multiple of over 14 for this company. Moreover the free cash flow forecast of $1.3 billion over the next five years implies that it will generate around 4.5% of its enterprise value annually over the next five years. I would argue that this makes the stock pretty fairly valued at this price, but I’d hope to be the first into this stock if it dipped meaningfully from here.

Friday, March 15, 2013

What to Expect From Tibco's Earnings

The only thing we know for certain about Tibco Software’s (NASDAQ: TIBX) upcoming results is that they are likely to cause a lot of volatility in its stock price. It is an intriguing proposition. On the one hand the industry has been reporting better results in this earnings season. On the other, Tibco reported a nasty quarter last time around, articulating that many of its problems were self generated. So will Tibco release sterling numbers aided by better industry spending, or is it set to inform the market that its internal problems are continuing?

Tibco’s Bad Quarter

In order to accelerate understanding of the major issues, I would recommend looking at the article linked here. In summary, Tibco reported a poor quarter last time around, with particular weakness in its US operations. Tibco’s management was forthright in claiming that this wasn’t about end market conditions and more about its US sales leadership failing to adequately execute. The panacea of changing the key personnel and a renewed focus on ‘blocking and tackling’ type measures topped off with a dollop of micro-management was swiftly proscribed.

Obviously if you are inclined to take the company’s guidance as gospel- to be fair, Tibco does have an enviable track record of beating internal guidance-then this would be a decent buying opportunity. In order to put the last quarter’s results and the guidance for Q1 ($243 million in revenues, $86 million in licenses at the mid-point and $0.17-$0.18 in EPS) in perspective, I have created this graph.

Furthermore, the big data industry has been reporting better news recently.

What the Industry is Saying

Tibco’s key competitors are IBM (NYSE: IBM), Oracle (NASDAQ: ORCL) and SAP. In addition, companies like Informatica, Teradata (NYSE: TDC), and Qlik Technologies (NASDAQ: QLIK) are also in the big data game, and are worth looking at in order to better gauge the industry.

Starting with IBM, there is a write up of its recent results linked here, and the key takeaway is that its middleware revenues actually accelerated from the previous quarter. They were up to 6% from 3% previously, and IBM forecast mid-single digit growth for 2013. IBM reported strong growth within areas like websphere and master data management, which implies that corporations are willing to spend on business process solutions and big data analytics.

Oracle last reported back in mid-December, but even then there were signs of a resumption of corporate spending. Its database and middleware solutions (the most relevant to Tibco) were up double digits in the quarter, and its management talked of a budget flush taking place in November and December without any negative impact on pricing. In summary, both of Tibco’s key commentators are reporting that the strength in their businesses is in the parts of those businesses that directly compete with Tibco.

It gets better. Qlik is focused on data analytics, specifically with data discovery and visualization. Its recent results were better than expected, and left analysts no option but to upgrade estimates. It reported more large deals amidst 41% growth in the Americas, and even Europe was up 19%. This is a clear sign that companies view data analytics as a critical part of their spending.

In fact, of the companies mentioned only Teradata reported weak results. This company is more of a data warehousing play and a partner of Tibco. Its chief competitors are Oracle and IBM. Teradata’s recent commentary wasn’t great. It cited macroeconomic headwinds causing customers in the Americas to tighten belts and reduce expenditures. Its number of large deals declined significantly in Q1. Oracle has been vocal about targeting some of Teradata’s markets, so perhaps this is a case of increased competition?

What Will the Results Bring?

On balance I think the industry backdrop is positive, and if things had been firing on all cylinders in the previous quarter for Tibco then the stock would surely be much higher. However, the truth is that it left a lot of uncertainty with its last set of results. It gave no full year guidance for either revenue or margins, and the Q1 guidance that it gave implied a noticeable decline in margins. Whether is a low ball estimate intended to be easily beaten or rather a realistic appraisal of prospects going forward is anyone’s guess.

Last time around Tibco’s senior management was pretty adamant that this was an internal issue, and if it has been sorted out by now then there is good cause to believe that the upcoming results could be better than expected. Tibco has some ground to recover with regards credibility. I suspect this is why it hasn’t participated as much in the recent rally as its peers. Nevertheless, if it beats estimates this time around I suspect it will soar.

Tuesday, March 12, 2013

Kroger Sets The Standards in the Grocery Sector

The markets have been in bullish mode recently and seem determined to price in a glass half full scenario in response to most companies' results, a fact that I felt was particularly pertinent when looking at Kroger’s (NYSE: KR) results. There was nothing wrong with them, but then again I’m not sure what has changed that the company is evaluated 20% more than it was a month or so ago. In summary, the company is extremely well run, and its management has reacted very well to a difficult environment in the last few years. However, it remains a play on general macro conditions.

Kroger’s Good Christmas

I last discussed the company in an article written before Christmas and speculated that it was headed for a decent quarter. In a triumph of randomness over experience my prediction turned out to be correct. Kroger’s numbers were pretty good, and I think many of the positives will roll over to 2013. Inflation is moderating, and the economy is gradually improving with employment gains now coming through in line with a normal type of economic recovery.

Against this positive view comes pressure from the potential for disappointments in consumer spending coming from ongoing political uncertainty, tax changes and volatility in gas prices. Indeed, Kroger mentioned variability in sales patterns on a week by week basis, a sure sign that consumers remain stretched. The mass market retail sector remains categorized by volumes (or tonnage) being driven by promotions and discounts.

In the end its identical sales ex fuel came in with a 3% gain. This is okay but it is at the low end of the 3-3.5% guidance that I discussed in the article before Christmas. This is superficially disappointing, but investors need to understand it in the context of a mix of tonnage and pricing issues. Inflation moderated as the year went on, and this encouraged greater tonnage and some alleviation of gross margin pressure in Q4.

Furthermore, the dramatic increase in generic drug releases this year comes coupled with the Walgreen / Express Scripts debacle. Kroger expressed its confidence in keeping Walgreen customers, but it certainly wouldn’t be alone in this. From Wal-Mart (NYSE: WMT) to CVS, it seems that everyone is confident in retaining these customers. From a Walgreen investor's perspective I wouldn’t worry too much because the stock remains good value. Moreover, with Kroger the generics releases are arguably more important. Generics tend to be lower priced but generate higher margins for the retailer.

Kroger’s Good Year

Furthermore, Kroger’s performance last year is a story of inflation moderating as the year went on, leading to increased tonnage as a consequence. Kroger’s management described itself as being surprised by how quickly tonnage came back, but I think this is a lesson that the retail market has learned this year. The consumer has become incredibly sensitive to pricing. We can see aspects of this in the reaction to Kroger rolling out corporate brands (the Simple Truth range among them). Consumers want trading down options, and Kroger has the footfall in order to be able to offer them.

Initiatives like expanding corporate brands have helped Kroger compete better in the value segment while its initiative on healthy artificial ingredient free foods is a timely measure to capture much of the market that Whole Foods Market (NASDAQ: WFM) plays in. It’s easy to get worried about competition in this space, but I think the overall pie is getting bigger here, and there is room for all these players to grow. Indeed, as Whole Foods expands it will create a greater awareness of healthy eating and should allow Kroger to expand sales of its own product range to consumers. In other words it is not a zero sum game.

On the other hand, Kroger is competing with Wal-Mart, Safeway and other grocers for market share. The Neilsen data quota in the conference call was pretty balanced with Kroger increasing market share in 9 of the 17 categories where it competes with Wal-Mart. The impression I got was that tonnage and price competitiveness increased as the year went on thanks to an abating of inflationary measures and internal execution.

Where Next for Kroger?

Analyst estimates are for double digit EPS growth for the next couple of years, and internal guidance is for 2.5-3.5% identical sales growth excluding fuel. With a forward PE ratio of around 10, this doesn’t look like a demanding evaluation. On the other hand Kroger’s earnings are largely a function of macroeconomic considerations, and my gut feel is that this stock will move around with sentiment over the economy. In a sense this is a positive because in terms of company execution there aren't many managements that are doing a better job right now than Kroger's.