Tuesday, April 30, 2013

McDonald's Facing Challenges

The market gets what the market wants and, for the first quarter of 2013, the market has wanted relatively (as compared to treasuries) high yield ‘defensives.’ I use inverted commas because when looking at a stock like McDonald’s (NYSE: MCD) I’m not convinced it is as attractive as the market thinks it is. Furthermore, if you buy a stock because it is fashionable then you better be prepared for any disappointment should fashion change.

McDonald’s Disappoints

It’s been a tough year for the fast food sector, and McDonald’s delivered another quarter of disappointing same store sales growth. Moreover, it described the informal eating out industry as being flat or declining in many parts of the world. So where did it all go wrong? Wasn’t this supposed to be the great defensive stock that proved itself so well in the last recession?

My take on this is that the 2008-09 recession certainly resulted in a significant amount of global unemployment and income insecurity, which fed through into consumers trading down and adjusting their behavior by dining out in cheaper outlets. Such conditions played perfectly into the hands of companies like McDonald’s and Yum! Brands (NYSE: YUM). In addition they had growth opportunities in expansion into China.

Fast forward into 2012 and the trading down has run its course and suddenly comparables are getting a lot harder. The easy growth has gone and the challenges are building. Sales growth from China is slowing, and McDonald’s is having problems adjusting its menu to deal with the slowdown in Europe. I discussed some of these issues at the start of the year.

 A look at its global comparable sales growth for the last few years.

Spot the slowdown?

Market Share Gains

While recognizing that the US market is tough, McDonald’s spent a lot of time trying to convince investors that it was gaining market share in the US. The idea is that the key to its long term growth would be the retention of market share and not necessarily margin or cash flow growth. It’s hard not to think that this is going to have an effect on Yum and Burger King (NYSE: BKW) in the US.

But this isn’t just about the US. The optics in China are becoming cloudy thanks to a combination of the chicken supply problem at Yum’s subsidiary, KFC, and a later outbreak of Avian flu. All of which has caused issues for the rest of the fast food outlets in China. While this is causing some to believe that there is an inbuilt opportunity to bounce back in the second half of 2013, I’m not so sure. If you look at the chart above, McDonald’s APMEA growth was slowing well before these issues kicked in. Indeed, it was a similar story with Yum, so this isn’t just a story of some temporary weakness.

So even while China’s performance is uncertain, there is no let up in investment with McDonald’s planning to open hundreds of restaurants in China in 2013. Similarly Burger King wants to open 1,000 stores in China within the next seven years, and the country is the focal point of Yum’s growth plans. Obviously these companies wont adjust their long term strategic plans based on some temporary weakness, but might it prove a longer term issue?

As for Europe, despite previous efforts to take action in France and Germany conditions remain weak in Europe, and macro challenges in Southern Europe mean that growth will be hard to come by. Only the UK and Russia are performing in a manner that McDonald’s can be happy with.

Where Next for McDonald’s?

I think this is going to be a tough year for the company. Commodity costs are only forecast to go up 1.5-2.5%, but the real driver of earnings growth will be sales growth. Given that the stated strategy is to preserve or gain market share, it is hard to see any significant margin expansion this year. There is a lot of uncertainty with China, Europe remains in difficulty, and the US is becoming increasingly competitive. In conclusion it is hard to make the case that McDonald’s is the kind of defensive play that investors should be chasing, and if the market loses its fixation with yield then it might not be so well supported.

Monday, April 29, 2013

What Verizon Said About the Telco Industry

We are still early in earnings season but already there are signs that corporations have been affected by a sense of caution in the quarter. Of course these things are part and parcel of an uncertain political environment, and long term investors usually see them as decent buying opportunities. The problem with this approach is that when companies start reporting disappointments it will look similar to what they might say going into a protracted slowdown. So what to make of Verizon's (NYSE: VZ) latest results?

Irrational Melancholy

Investors had a right to be cautious going into these numbers. After all two leading tech companies had already warned of slowing spending by their telco customers. 

Firstly, Fortinet (NASDAQ: FTNT) warned that telco service providers were being cautious over closing deals in the quarter and, in particular over larger deals. On a more positive note, it argued that some customers were switching from a 'CapEx to OpEx’ spending mentality (so revenues might be more spread out in the future for Fortinet) and that the problems were not due to competitive losses. I also think there could have been an element of ‘pull forward’ in the previous quarter because Fortinet reported a very strong number of larger deals in the previous quarter.

Secondly, F5 Networks (NASDAQ: FFIV) also warned of a weak telco vertical. What is puzzling is that both companies reported decent enterprise spending. In the case of F5’s core application delivery controllers (a market that Fortinet has also recently entered by buying Coyote) telco carrier spending was far less than expected. Indeed, if you look at the details F5 reported strong numbers from telco customers in the previous quarter however, they did not follow through as planned in the last quarter.

Putting these things together, there are two scenarios that investors need to consider.

  • Is it the (bullish) case that there was a pull forward in telco spending at the year-end due to a budget flush effect, and all we are seeing now is a natural reaction to that which will get smoothed out in future quarters?

  • Alternatively, are the bears right and there is something unduly negative going on in the telco market causing a change of sentiment?

It’s time to look at what Verizon said.

Verizon Delivers a Mixed Prognosis

It is hard to give a definitive answer to the questions above. If it was easy then it would already be priced in!

On the bullish side the transition to newer technologies and services continues to accelerate at Verizon. The company started investing in 4G/LTE networks over five years ago and rolled out its network far quicker than AT&T (NYSE: T). It obviously has less need to invest now, and as the following graph demonstrates Verizon did its heavy lifting in next generation networks a few years ago while AT&T is playing catch-up.

Moreover, Verizon is seeing increasing penetration from smartphones (up to 61% from 58% at the end of the year), and given that 38% of the customers upgrading to a smartphone in the quarter were first-time users, the potential for rapidly increasing bandwidth utilization should be obvious. Verizon wants to do this. 4G/LTE smartphones already represent 40% of the smartphone total and 54% of its data is being carried on the 4G/LTE network.  As more customers upgrade it will drive growth at other carriers, and the pressure on the industry to spend on telco infrastructure must increase as a consequence.

On the bearish side Verizon spoke of ongoing caution among its enterprise customers. They still don’t appear keen on committing to capital spending, and the environment continues to be one of cost cutting first rather than investing for growth. Some sequester-related weakness in government spending was expected and it didn’t disappoint, but the ongoing caution among enterprises was a bit surprising.

Indeed, hopes of an upside to telco spending in 2013 still largely rest on Tier 1 carriers like AT&T investing in new networks as well as emerging market telcos starting to invest too. In my view the outlook for legacy telco spending has gotten a bit weaker recently with companies like Spirent disappointing with their legacy systems sales and noting that customers seemed minded to jump to higher bandwidth solutions.

The Bottom Line

In conclusion, the underlying trend of smartphone adoption and the proliferation of bandwidth-rich devices and applications continues apace. On the other hand, Verizon’s commentary continues to exercise a note of caution over enterprise spending and until it and AT&T talk of some sort of improvement there it would be churlish to conclude that happy days are here again for telco spending.

Those of us that think, and are invested in the telco spending theme, are left to sulk in the corner and wait for AT&T (which is expected to spend more this year) and others to report better things before going overweight on the idea.  It’s more jam tomorrow I’m afraid.

Saturday, April 27, 2013

Why I Bought More IBM

t’s rare that I recommend watching a movie in order to try to understand investing, but in this case I strongly suggest finding the time to look at the late great Akira Kurosawa's masterpiece ‘Rashomon.’ The film is about the relativity of truth and depicts how three different people recall (in contrasting fashion) what is broadly the same event. Tech investors will have an inkling of what I ‘m talking about already because IBM (NYSE: IBM) became the latest company to disappoint with earnings. The problem is that the reasons for these misses are becoming ever more varied.

Time Heals Everything

IBM’s great rival Oracle (NASDAQ: ORCL) also gave weak results recently and insisted they were largely due to sales execution. Fast forward a few weeks and Fortinet (IT security) and F5 Networks (application delivery controllers) both argued that their telco verticals were weak in the quarter.  Red Hat missed estimates and Verizon discussed an ongoing cautious spending environment amongst enterprise customers. TIBCO Software (NASDAQ: TIBX) missed and guided lower and gave its--now all too familiar-- refrain that its sales execution wasn’t up to scratch but that it would all be sorted out soon enough. Although frankly I think it would be just as interesting to now hear what the sales guys said about the management. 

Just as with Rashomon, all we do know now is that we have dead body on the scene even if the exact story isn’t entirely clear.The good news is that we can get a bit more detail from the crime scene.

Let’s put it this way: if it truly is a question of a bit of excess caution being caused by political uncertainty over the sequester (Oracle’s quarter end fell on the deadline) then as companies report through the ongoing earnings season we might expect to get a bit more color on any pick-up in demand. Indeed, I think IBM may well have just done that. Oracle’s numbers ran to the end of February while IBM’s ran to the end of March. A lot can happen in a month.

Who Said What

In essence Oracle said that it expected to bounce back in its Q4 and that the pipeline was up significantly. Its miss was largely a result of sales execution and timing issues rather than competitive losses or businesses walking away from future deals or even trying to reduce the size of them. TIBCO said a similar thing.

Fast forward to IBM, and in the latest report we hear about issues relating to sales execution, the timing of Easter, the sequester, $400 million of software and mainframe revenues rolling in to the next quarter, the weather and even the change in the Chinese Government.

The conclusions of which led to some disappointing revenue growth numbers for IBM in the quarter.

Superficially it is worrying, but unless you believe that all these tech firms (TIBCO, IBM and Oracle) have suddenly seen their sales managements lose the ability to sell, then the real cause of this slowdown in tech spending (and I think it’s time to call it that) is probably due to some caution around the sequester. IBM reported in September that orders had fallen over a cliff only to see a nice rebound in the next quarter.

Furthermore, none of these companies are blaming the macro environment or seeing their pipelines diminish, so if you are bullish on the economy then there is every reason to expect that this order weakness will prove temporary.

The Bottom Line

I think my line of argument applies to all three companies, but they differ in their attractiveness. Frankly, TIBCO really needs to report a couple of good quarters and regain investor confidence.  It appears to have more issues than just sales execution. Oracle is attractive in this viewpoint, but longer term it faces risk as it refreshes its hardware. It also has to demonstrate that it can continue to be as dominant in the cloud based era as it is with on-premise

For IBM, the response to the weak quarter is to take some workforce rebalancing in Q2, and if recent reports are true it is prepared to sell some low margin hardware businesses.  All of which is in line with its long term objectives to go for margin improvements by divesting and reducing lower margin sales. Even in this bad quarter IBM managed to increase gross and operating profit margins.

Moreover, despite the weaker numbers this quarter it didn’t lower its full year earnings guidance. The company is still forecast to deliver double digit earnings growth in the next couple of years while generating huge amounts of cash flow. I think the sell-off is a decent buying opportunity so I bought some more.

Friday, April 26, 2013

General Electric Reports Mixed Results

Anyone who has watched the classic sales movie Glengarry Glen Ross or worked in sales will know that the acronym ‘ABC’ stands for ‘always be closing.’ However anyone who hasn’t and instead has solely listened to US blue chip conference calls over the last few years will probably conclude that it actually stands for ‘always be cost-cutting.’ In other words, investing for growth is still on the back-burner in favor of pruning and consolidating measures made in light of uncertain end demand. Such considerations came to mind when considering General Electric’s $GE latest results.

A mixed Industrial Environment

The earliest indication of how the industrial sector was faring was outlined by Alcoa $AA recently, and it was pretty positive in my view. Other than a slight weakening of its European automotive outlook, Alcoa kept its end markets prognosis constant. However, on closer inspection it is clear that Alcoa’s growth prospects in 2013 are highly reliant upon China. In addition it is exposed to a few industries that are doing relatively better.

As this article demonstrates, global aerospace is doing well with airlines surprising on the upside and passenger growth numbers growing at a decent clip. This is obviously good news for General Electric and its aviation segment. In addition, Alcoa’s North American outlooks for its automotive and commercial building & construction segments respectively were for 0-4% and 1-2% with China growing up to 10% in both. Europe is expected to decline in both of these segments. So while China is doing well and some global industrial sectors are doing okay, it is far from a universal situation.

More evidence of this divergence in the industrial sector can be gleaned from looking at what the industrial suppliers like Fastenal and MSC Industrial are saying. Aerospace and auto are fine but elsewhere there was weakness in Q1.

What GE Said

Fast forward to GE’s latest results and the company reported that its industrial segment profits were $200 million lighter than had been expected largely due to Europe being weaker than forecast. The power & water segment was particularly affected while elsewhere GE reported some reluctance to close orders in a few of its shorter cycle industries. Again, the latter statement correlates with what the industrial suppliers (who are as about as short cycle as you can get) indicated.

In order to see the relevance of the power & water segment here is a breakdown of GE’s segmental profitability in the quarter.

As the chart indicates the industrial segments that increased profitability were aviation, healthcare and transportation. GE capital profits improved in line with its rationalization strategy. Overall segment profits were down 4%, but net earnings rose 16% thanks to lower charges and eliminations.

See what I mean about ABC? Indeed, the immediate response to the weakness in the quarter was to announce more cost cutting measures. Plus ca change and all that.

What the Results Mean to The Market

Another area of interest was US healthcare, which GE said was a bit weaker than expected. Investors got an early read on this when Johnson & Johnson gave results and noted (within its medical devices and diagnostics segment) that US hospital procedures were weaker than the hospitals had forecast going into 2013. In addition hospital spending wasn’t as strong. It’s nothing dramatic for Johnson & Johnson because it has plenty of other profit drivers within pharma and consumer products, but for a company like Varian Medical Systems $VAR it is a cause for concern.

I like Varian, and based on a SWOT analysis think it has some very impressive long term growth prospects with its proton therapy solutions. In the near term it can expand its radiation therapy into indications like lung cancer, particularly within emerging markets. In addition its new deal (GE was its former partner) with Siemens (which is pulling out of radiation oncology) gives it a large installed base on which to target. On the other hand its systems require significant outlays, and with Johnson & Johnson and GE reporting some weaker conditions, can we really expect immediate upside from Varian?

On a more positive note GE forecast that its oil & gas and home & business segments are going to be ‘pretty solid’ for the year. Within the latter segment one of its key rivals is Whirlpool $WHR I think Whirlpool has good growth prospects in 2013. The US housing market is recovering, and Whirlpool is starting to anniversary the housing boom of 10 years ago. In other words, the white goods purchased back then should have depreciated by now and a replacement cycle should kick in. Furthermore, GE reported good results in emerging markets so we have reason to believe that Whirlpool will do okay in its key Brazilian market.

Where Next for GE?

Cost cutting isn’t sexy, but it does represent a key bottom line opportunity for GE this year. Europe was weaker than expected but China’s strength was a welcome positive note. As noted above GE’s end markets will be variable this year with areas like aviation, transportation and health care (especially in emerging markets) likely to remain strong and counteract areas more exposed to austerity measures like US military spending and European infrastructural spending.

Investors looking for a more focused exposure to their favorite end markets will not buy GE because of its diversification, but those looking for a 3.5% yielding global GDP type play will view this mini sell-off as a buying opportunity.

Thursday, April 25, 2013

Intel Can Fight Back

Investing in Intel is a bit like betting on an old and slightly out of shape, but hard hitting fighter. Mr. Market keeps landing quick jabs and slows his opponent down. The odd cheeky hook to the body gets slipped in, and your fighter starts to slow and look out of place. He is way down on points by the middle rounds, so, he starts throwing haymakers, and commentators scoff about the superior mobility of the other guy.

The quicker opponent comes out confidently in the eighth round, throws a few jabs, and then gets caught square on the chin by an overhand right from your guy. Ten seconds and a medic later, the ringside journalists start re-writing their reports to reflect how ‘clever’ Intel was with its strategy.

Intel fights on

Frankly, the company has had its fair share of jabs in the last year and I looked at some of them recently.

  • Weakening PC demand has hit its core market and negatively impacted capacity utilization and inventory. Ultimately, gross margins have taken a hit too.

  •  Intel found itself behind the curve in adjusting to the shift towards tablets, ultrabooks, and smartphones.

  • A slowing consumer electronics market, plus weaker than expected demand pull from the release of Windows 8 affected its growth expectations

The end result is falling margins, as inventory gets cleared and Intel shifts investment to newer technologies and end markets. Indeed, Intel had to lower revenue forecasts throughout 2012.

It’s easy to make after-the-event criticisms of a management when these sorts of transitions occur, but it’s also hard not to feel a certain amount of sympathy. Those that can predict industry trends (let alone macro) can throw the first stone. Indeed, the market clearly ‘gets’ that Intel has had difficulties because the stock has been marked down accordingly. The question now is whether its adjustment plans will work?

Reasons to be cheerful

Before considering the investment case for Intel, it’s worth reflecting on a couple of issues that will govern the investment decision. The first is that irrespective of the secular shift to tablets etc., the semiconductor market is highly cyclical. Indeed, Intel’s forecast of a better second half is based on an economic improvement. 

The second is that in the long-term, there is the threat of ARM Holdings' core processors winning out over Intel. Intel confirmed that it wouldn’t take on any competitor-based business within its growing foundry business. In other words, buying Intel tends to imply a positive outlook on global growth and confidence in its long-term future against ARM. Intel’s problem is that ARM-based architecture dominates the mobile phone market.

Turning back to the secular issues, Intel will launch its Haswell processors, which will enable it to benefit from growth in tablet, ultrabooks, and convertibles. This is all part of Intel’s drive to be more relevant in a declining PC world. There was more good news with the announcement that it was now making LTE-based phone shipments, while its tablet and smartphone bases sales are growing well. The problem is that it has a significant amount of PC-based sales to replace.

In addition, the negative surprise with PC sales has caused overcapacity issues. Gross margins have been falling…

INTC Gross Profit Margin Quarterly data by YCharts

…and they came in at a lower than expected 56% for the current quarter.

So again, it is a question of jam tomorrow with Intel, but at least it is not lowering revenue forecasts as it did last year. On the contrary, with the new Haswell processors and data center revenue (already around 20% of total company sales) growing in double digits, prospects look better for the second half. I also suspect the Windows 8 disappointment is already fully understood by the market, and Intel looks better positioned from a product portfolio perspective than it did last year.

Another area of growth is likely to come from increasing foundry activity. The Altera deal highlights the potential for Intel to generate some value from its older production technology. It is also good news for Altera, because it secures its chip production from a world class manufacturer that is looking to generate long-term relationships with value-based solutions.

However, this developing aspect of Intel’s activities is not good news for Taiwan Semiconductor The leading semiconductor foundry has seen its gross margin decline over the last few years, and the last thing it needs is Intel muscling in on the market. Altera is a long-term client of Taiwan Semiconductor, and the Intel deal cant have been good news for it. It's margins (at less than 50%) have never been as high as Intel's.

The bottom line

In conclusion, I think there is a lot to like about Intel. Its valuation is now levels not seen since the recession…

INTC Price / Sales Ratio TTM data by YCharts

…and a 4%+ dividend yield is a fine income to enjoy while you wait for a turnaround.

Macro matters are always a concern with such a cyclical stock, and ARM’s strength in mobile does overshadow Intel. But, if you are sanguine on these issues, then I think Intel has good prospects. It’s a heavyweight and still packs a punch, and at some point it is going to remind the market of it.

Wednesday, April 24, 2013

The Key Earnings of the Week

It’s another huge week for earnings. In this article I've suggested some of those companies that I find interesting and provide some ideas for further research. It’s also a good time to try and check the underlying trends in the economy versus what individual companies are saying about them.


BE Aerospace and Hexcel are two of the most interesting stocks in the aerospace sector. The latter is set to benefit from the increasing use of composites in aircraft, while BE Aerospace is one of the very few ways to get pure exposure to commercial aerospace.  Incidentally, its French rival Zodiac Aerospace reports on Wednesday.

However, my highlight of the day has to be Check Point Software (NASDAQ: CHKP). The Israeli IT security company disappointed in recent quarters with its negative products and license sales growth. This is obviously a bit of an issue because it operates a razor/blade model, even though it has been bundling its software and hardware together recently. No matter--the fact is that the company’s product growth is stalling, and I think it needs to do something about it.

Despite being highly cash generative, tech investors will not reward Check Point unless it gets back to growth. The good news is that given easier comparisons coming up and its potential to better market its leading technology, it may well start to do that in this quarter.


All eyes will be on Apple’s results. However, I am much more interested in what AT&T says about its spending plans. Tech is well represented today with Juniper Networks, Broadcom, Cree, Polycom and VMware all giving results. I like Idexx Labs as a company, but must confess that I can’t get anywhere near its evaluation. Discover Financial is one of the few lenders that has seen its loan book growing, but is it chasing business or responding to market demand?  Affordable luxury play Coach gives numbers as well, and it badly needs to demonstrate that it can execute on its growth plans.

The highlight of the day is actually Yum! Brands (NYSE: YUM). The company is very interesting because it is focusing its efforts on growth in China, so what it says about current consumer trends in that country will be fascinating. Moreover, it is trying to recover from chicken supply issues in China with KFC.  Don’t be fooled, though--its sales growth was slowing before the chicken issue. And finally, it is trying to fight for market share within a difficult market in the US. The stock offers some upside drivers, but it is hard to predict what it will report. China bulls need to follow it carefully.


A huge day for earnings.  Aerospace bellwether Boeing will give numbers and Procter & Gamble will try and demonstrate that it is back on track with its growth initiatives.  Whirlpool is a genuine play on housing, and I like its exposure to Brazil as well as its evaluation. Cigarette company Lorillard is a favorite stock to the bears who like its defensive characteristics. In similar vein, rail car part manufacturer Wabtec has long offered one of the few ways to get exposure to the rail industry.

Data center company Equinix gives results, and while F5 Networks has already pre-announced poor numbers, its investors will want to follow the commentary around the results very closely. The key question is what is happening to its telco customers? EMC and Coherent also give numbers, but my highlight is Citrix Systems (NASDAQ: CTXS). 

After two tough quarters Citrix got back on track in the last quarter. Citrix isn’t just about desktop virtualization anymore--it is a genuine play on the corporate need for mobility and for IT to be integrated across multi-platform devices. It also has two powerful partners in Microsoft (virtualization) and Cisco Systems (application delivery controllers) who are both actively helping it develop these relative markets. The problems at Fortinet and F5 Networks were largely a consequence of weakness with telco, but they reported decent numbers with enterprise customers--a good sign for Citrix.


Tech continues reporting, with Informatica giving results. Look out for what Ametek says about aerospace, and 3M usually gives good color on the state of the economy. Within consumer products Colgate-Palmolive needs to keep demonstrating that it can innovate and stay ahead of the competition, and, like Mead Johnson, its growth prospects rely on emerging market growth.

Stanley Black & Decker (NYSE: SWK) is one of the most interesting housing and construction plays in the market. Not only does it have upside exposure to a stronger US housing market, but the company is engaging in a strategic growth initiative intended to ramp up revenues and take full advantage of the synergies from the merger. It involves expanding its emerging market operations and targeting new verticals. The company is highly cash generative, and the growth programs do not appear to be expensive. If it hits its targets then I think the stock will head higher because it looks like it has good value.  


Fridays are usually a bit quieter, but there are some interesting health care results with Abbvie (the Abbott Labs spinoff) giving numbers. Weyerhauser will update on end demand from housing.

My highlight is V.F. Corp (NYSE: VFC).  There are a lot of interesting things going on here. The weather got noticeably worse since the last set of results, and I think this may have caused an increase in demand for North Face and Timberland products. On the other hand Europe is its biggest sales center (and Southern Europe its biggest region within that), and the news hasn’t been great from the continent. Moreover, VF Corp is investing in China even while its last results in Asia were a bit disappointing. It is a mixed picture but the upcoming results might help to set some trends for potential investors to look into.

Monday, April 22, 2013

Johnson & Johnson Remains Good Value

Earnings season is in full swing now and Johnson & Johnson $JNJ was the first of the major health care and consumer products companies to give results. In summary, the numbers were pretty good, but the commentary contained some negatives about the health care industry with regards the medical devices and the volume of surgical procedures. On the whole, it was a net positive for the company and despite the great run, I think there is still a bit of upside left in the stock.

The story of 2013 is really about integrating the Synthes acquisition with the medical devices segment, developing sales for some of its new pharmaceuticals, and getting most of the key brands (affected by production difficulties) back on the market.

Consumer products making a comeback? (21% of sales) 

Within consumer products, management confirmed that 75% of the brands (if not necessarily the volumes) of those affected should be back on the market by the end of 2013. Indeed, a build up of these sales is expected throughout 2013.

On the whole, I thought it was one of the most positive earnings reports I’ve seen in a while for this segment. Okay, overall sales up 3.3% (operationally) doesn’t sound great, but the underlying trends are positive and investors can expect better things going forward.

Its two biggest categories are OTC/Nutritionals and Skin Care, which together make up over 56% of the segment's sales. Sales in both categories have been weak in recent quarters, but the former is benefiting from having products back on the market (analgesics were particularly strong) while the latter appears to be stabilizing in the face of strong competition. The good news didn’t stop there as baby care sales grew 7% operationally, with oral care also doing well with a 5.1% increase.

Colgate-Palmolive $CL shareholders should note that Listerine mouthwash was cited as a notable positive in these results. Frankly, I think that Colgate has had it a bit easy in the past, with being able to aggressively launch new mouthwash products in the U.S.

It is obviously not a core activity for Johnson & Johnson (indeed it has divested some toothbrush products), but it has learnt from Colgate’s execution and the new Listerine products appear to be working well. I see no reason why this can’t continue, so investors need to think about the assumptions they are making over Colgate’s valuation and earnings.Moreover, Colgate already has a strong position within emerging markets and it will have to defend it against competitors.

Pharmaceuticals still going strong (39% of sales) 

This segment has seen the most impressive improvement in performance over the last year and it looks set to continue this year. Overall, sales grew 11.4% operationally and many of the drugs that contributed to this growth are still in the early innings of their sales progression. Meanwhile, its biggest treatment is still Remicade (rheumatoid arthritis), which represents nearly 24% of total pharma sales and it is still growing nicely with 5.5% operational growth in the quarter.  

Other highlights from the segment included

  • Immunology (including Remicade) grew 16.7% operationally, with Stelara (psoriasis) and Simponi growing sales by 72% on a combined basis. As they are both relatively new drugs, it is reasonable to expect strong growth to continue within this category

  • Neuroscience revenue grew 7.7% operationally, with Invega and Invega Sustenna sales now totaling $416 million and managing to replace declining sales of its older schizophrenia drug Risperdal Consta, which contributed $335 million, albeit after a 6% decline.

  • Oncology represents less than 12% of pharma sales, but it contributed over 31% of the growth in the quarter. Zytiga (castration resistant prostate cancer) sales grew over 72% and the intent is to try and get its usage extended for other indications. 

  • Xarelto (anti coagulant) and Incivo (hepatitis C) contributed $158 million and $162 million in the quarter, and both are likely to grow strongly in the future.

In summary, new drug sales are expanding rapidly and it’s hard not to see continued strength here.

Medical devices and diagnostics (40% of sales)

This proved to be the most interesting segment as the company outlined how within the U.S., hospitals had been commenting that procedures were running at levels below what they had previously predicted for 2013. Moreover, within general surgery and orthopedics, it declared that the acceleration that it had seen in Q4 did not carry on into Q1, and suggested that this was a sign of seasonality creeping into these elements' performance.

All of this would appear to be disappointing news for a company like Covidien $COV. Covidien’s surgical activities rely on growing procedures, but elsewhere, I thought there were some good takeaways for Covidien.

For example Johnson & Johnson’s cardiovascular results were good, with endovascular cited as generating double-digit growth. Meanwhile, its international energy results were strong outside the U.S. This bodes well for Covidien, because expanding in energy and vascular within emerging markets is one of its key growth drivers for the next few years.

So, it appears that Covidien will report good results from its existing growth businesses, but there could be some pressure elsewhere. We shall see soon enough when it reports on April 26.

There was no new news on the future of the diagnostics unit after it had been put under review at the time of the last set of results.

The bottom line

This was probably a better set of results for the company than it was for the health care market on the whole. The more negative outlook with regards surgical procedures is likely to cause some concerns among the higher rated companies within this sector of health care.

However, for Johnson & Johnson, its pharma sales are expanding well and look set to continue. There is still upside from a return of the affected brands within consumer products and its plans remain on track.

The stock remains the sort of high cash generating, decent yielding defensive type that the market is in love with at the moment, and I wouldn’t be surprised to see the stock appreciate in the future.

Sunday, April 21, 2013

What You Need to Know About Bed Bath & Beyond

Investing in stocks is a bit like a visit to an auction. Some people enjoy paying a premium for what is in fashion so they can sell it on to someone more excitable than themselves, others enjoy buying a quality item at a reasonable price, and there are those that enjoy buying anything because it’s cheap.

And then there are those who kind of think something is fashionable, the item is cheap, and they can overlook some flaws in the product while hoping that others will do too. This article is about the last group and why they might love a stock like Bed Bath & Beyond $BBY.

Bed Bath & Beyond ticks some boxes

Yes, it is a housing-related play and yes, on a forward PE of 12, the stock is cheap. On the other hand, this company has exhibited rather less than stellar performance over the last year, as margins have fallen while comparable same-store growth is in low single digits at best.

Only last quarter, the company was forecasting same-store sales growth to be in the 2%-4% range, but they came in at 2.5% for Q4. Moreover, it is relying on growth from a couple of acquisitions which have actually reduced margins. My sense is that there are better stocks in the ‘housing franchise’, but as one of those people above who only want to buy quality, this isn’t the sort of stock I can fall in love with anyway.

Whether you buy value or growth, I think it’s fair to say that the prospects of this company depend more over its execution than a continuation of its immediate past. The company has been subject to increasing competition in the sector, and is seen as the primary loser due to Amazon.com's $AMZN move into the home goods space.

Not only does Amazon retail home goods through its core sites, but it also owns the parent company of casa.com, and the latter appears to be taking direct aim at Bed Bath & Beyond’s market. Amazon has the scale to be able to hurt its rivals.

Here is a look at Bed Bath & Beyond’s margins and possibly at how Amazon has effected it.

I’ve included a bar chart of the year on year movement in operating margins in order to better illustrate the situation. It doesn’t make pretty reading, and there is a sense that the company needed to make the World Market and Linen Holdings acquisitions in order to deal with encroaching competition.

The industry fights back

The threat from Amazon has certainly spurred the incumbent players to respond. And frankly, not an earnings report goes by without one of them announcing a step up in capital expenditures in order to expand e-commerce offerings.

For example, Pier 1 Imports $PIR recently announced that it would be rolling out a point of sales (POS) system and fully integrate it with its e-commerce facility.  Pier 1’s plan is to continue to offer in-store pick up for its online customers, while trying to differentiate its offering from the competition.Will it continue to do this successfully in the future and/or does it run the risk of cannibalizing its retail sales? That remains to be seen.

Similarly Williams-Sonoma $WSM has a three pronged strategy of expanding its e-commerce facility, international expansion, and rolling out new stores in its growth brands. Again, it is trying to achieve a certain amount of differentiation with its offerings and experimenting with its new stores.

I think that it will do well with its teens and baby furnishings because this is more of a ‘conceptual sell’. In other words, shoppers will appreciate going to the store in order to feel the impact of its furnishings. Furthermore, its range is somewhat more high-end than Bed Bath & Beyond, and relatively less susceptible to Amazon’s onslaught.

Where next for Bed Bath & Beyond?

In common with the industry, it is moving to a multi-channel offering and is launching some new websites this year, while aiming to generate margins in order to try and turn around performance. Thus far, the acquisitions have eaten into margins (at a time when some of existing stores were reporting poor performance), and the plan to improve prospects will see a ramp up in capital expenditures to $350 million next year from $315 million this year.  

Much of the capex is dedicated to store refurbishments and integrating the World Market and Linen Holdings acquisitions. In addition, the shift to lower margin products in the sales mix as well as increases in coupon redemptions will continue to pressure margins going forward. It's tough out there.

Putting all these things together means that an investment in the company depends upon a certain level of confidence in its plans to turn things around in 2013. Its not the kind of situation I enjoy investing in, so I will take a pass. It’s also not the sort of company you buy as a pure play on housing, but you might if you are hunting for a bargain than could suit your purpose. You just have to expect that it will come (as do all value plays) with some faults.

Saturday, April 20, 2013

Pier 1 Imports Still Looking Good

Pier 1 Imports (NYSE: PIR) delivered yet another strong quarter of results that highlighted its status as one of the ‘go to’ plays for a housing recovery in the States. It is not that the US mass consumer is in particularly good shape right now, but there are a few sweet spots (housing and autos) seeing relative strength. In addition they tend to be coming off a low base so the opportunity for upside leverage is considerable. Where next for the sector?

Housing Thesis Still Intact?

It’s been an interesting few days for the housing market thesis. I’ll return to Pier 1 in a moment but first a few words on Wells Fargo’s (NYSE: WFC) latest results. The bank’s importance to the US mortgage market is significant, and there wasn’t a lot of great news on that front in the latest report. Within its consumer lending group, originations, applications and the application pipeline for home loans all declined sequentially by $16 billion, $12 billion and $7 billion respectively. However there was better news for auto originations, which rose 10% year on year.

This is hardly great news for the current housing market and suggests that it will take a while yet for the recovery to fully kick in. I suspect we are seeing a sustainable recovery, but it is gathering traction at the higher end first. Ultimately, these things feed down into the wider market, and as long as employment gains continue to grow apace I suspect this will happen. There is no doubt that it is taking longer to happen than normal at this stage of a recovery, but that is the way it is and investors need to factor this in.

For Wells Fargo investors this means patience will be required, and they will need to take a sanguine view over yield compression. This graph demonstrates the essence of the challenge facing the bank in 2013:

Net interest income and margins are getting weaker because the bank has seen large rises in deposits while the bank deals with the maturing of previous loans at favorable rates.

With that said, the net interest income after provision for credit losses actually rose 4.3% thanks to a lowering of provisions. The bulls' hope is that a point of inflection will come whereby increasing credit quality and an improving economy will graduate into a better lending environment. I happen to think this will happen, but Wells Fargo could clearly do with diversifying its revenue generation while waiting.

Pier 1’s Plans

Of course this is music to the ears of Pier 1 investors, because the company has thus far benefited from the nascent housing recovery and there should be upside to come if it continues.  I had previously thought that its same store sales guidance for 2012 was conservative, and indeed the Q4 numbers came in at a healthy 7.5%.

On the basis of any metric the company is seeing strong performance, and its plans for 2013 and beyond are being made within a decent end market backdrop. I think there is a good chance that Pier 1’s plans to aggressively increase its e-commerce activities and its point of sales (POS) in-store systems (the two will be fully integrated in the future) will work to expand revenue generation in the near to mid-term.

The idea of a multi-channel retail experience is also in fashion at Nordstrom (NYSE: JWN). The latter is trying to differentiate its offerings but offering more of its lower price point stores (Rack) while increasing its e-commerce activities (organically and via acquisitions) offering--you guessed it--point of sales systems in its stores that are intended to integrate with the e-commerce offering. My concern with Nordstrom relates to the sheer expense and sophistication of its program.

Some Concerns

So Pier 1 is not alone here, and there is evidence that its e-commerce sales tend to attract sales of higher ticket price items. All of which sounds great, but I confess I have my longer term concerns.

If e-commerce is the future then investors have to recognize that the likes of Amazon (NASDAQ: AMZN) are also stepping up their own home goods offerings. Not only does Amazon have its own operations, but it also owns the parent company that runs casa.com. Moreover, Amazon’s strength is in its scale offering of commodity type products. Consumers are happy to buy such items online because they do not have to make the kind of decisions that they do with a more individual product. Ultimately an expansion in overall e-commerce home goods sales could cause a situation where copycat offerings are commonplace, and Pier 1 could lose its distinctive identity or ability to generate sales via the in-store retail experience. The result is an ongoing race to the lowest price. Not good for margins.

The Bottom Line

In conclusion I think the housing market recovery will eventually broaden, and Pier 1 is a legitimate way for investors to play this theme. Its initiatives make sense, and the stock does not look expensively priced at the moment. Longer term, there are concerns, and the fears I’ve discussed above need to be monitored closely. It’s not a stock I’d want to hold for the next five years but for now things look okay.

Thursday, April 18, 2013

Is the Market Being Harsh on Ixia?

I'm a bit bemused by the events at Ixia $XXIA. Recently, the stock took a massive battering after announcing accounting errors that reduced 2012 income, and will hit revenue in Q1 2013. It sounds grim enough, but in reality, no contracts have been lost, cash flows haven't disappeared, and -- at least for now -- the only major impact appears to be over the timing of how it reports revenue. Let's find out what is going on.

Ixia reports accounting errors

On March 19, Ixia filed a notification to the SEC that it would be late in filing its 10-K as a consequence of having identified an accounting practice error related to how it recognizes revenue from its warranty and software maintenance contracts.

This was followed by an 8-K filing on April 3, which identified a separate implied arrangement error related to how it dealt with revenue recognition after extended warranty and software maintenance contracts have been signed. Ixia finally filed its form 10-K on the April 4.

Now I know what you are thinking and you would be right. This does sound like tortuous accounting and legal jargon, and I'm not impressed by the accounting errors either. I wasn’t expecting this when I bought the stock, but are these errors really a big deal?

Accounting practice error

I’ll start with the accounting practice error and quote directly from the 8-K form  regarding its historical practice which…

was to begin recognizing revenues relating to the Company's warranty and software maintenance contracts commencing on the first day of the calendar month following the effective date of the contract, as though the warranty period commenced on the first day of such month and extended for its full duration thereafter”

In plain English, this means that if a contract was effective on April 15, then the company previously recognized revenue on May 1, rather than on the effective date. It will now have to report them from the effective date instead. Frankly, I don’t think there is anything dubious or sinister going on here. It was probably easier for the accounts people to aggregate revenue in this way, and the practice had the effect of reducing near-term revenue and income. Not something you would do to massage numbers.

Implied arrangement error

The second error was defined thus

“The Company has determined that it was required to cease to defer revenues related to the implied warranty and software maintenance arrangement upon the receipt from the customer of the first substantive contract for extended warranty and software maintenance services, and will recognize the applicable previously deferred revenues balance related to the implied arrangement, provided all other revenue recognition criteria have been met.”

This is more a serious issue as Ixia was deferring revenue recognition while it waited to establish that it could enforce its warranty and software maintenance contracts. The good news is that it only relates to one contract. In any case, here are the material effects expected for 2013 for both errors.

  • Ixia doesn’t believe the accounting practice error will have a material effect on Q1 2013 or the full year

  • The implied arrangement error will move $4.15 million of the previously expected $4.9 million in revenue from Q1 to previous years' results. No impact is predicted for the rest of 2013.

So it looks like just an issue over revenue recognition timing.

Previous years?

I think the market has been fretting over the loss of revenue and income for this year, rather than looking at the implied increase in revenue and income for previous years. Indeed, the 10-K outlined that net income would be going up around $360,000, $3 million, $1.6 million, and $2.9 million in the years from 2008 to 2011, respectively.

Meanwhile, 2012’s net income was reduced by nearly $1.8 million and the ‘loss’ of $4.15 million from Q1 will likely reduce net income accordingly. It’s not good, but is that the only way to judge a company?

And this leads us to the crucial point. This is an issue of the timing of recognizing revenue, and whether it is recognized as revenue or deferred revenue at any particular time. From a free cash flow (FCF) perspective, there isn’t much difference. For example, in the years outlined above (where Ixia is now recognizing more revenue and income) there isn’t a change to its FCF generation.

A company is best judged on its cash flow generating abilities, and I think it’s being treated a bit harshly here. In fact, it generated $62.4 million in FCF last year and that’s not a bad evaluation for a company with a $1.34 billion market cap and high growth prospects.  

Where next for Ixia?

Of course, none of this includes any analysis of what to expect in the upcoming results. For that, you will have to look at its major customers like Cisco $CSCO (13.5% of revenue in 2012), Alcatel-Lucent, Juniper Networks $JNPR, and the major telco carriers. Its competitors include companies like Spirent, JDS Uniphase, Gigamon, and Danaher.

Cisco is obviously the first port of call, and its wireless solution revenue has been growing at 20%-30% for the last four quarters. Indeed, Ixia confirmed that revenue from Cisco grew 30% last year. With AT&T and Verizon both stressing that wireless is an investment priority in 2013, Cisco should report good numbers in this segment.

Moreover, Juniper has been reporting better results of late as it continues to beat estimates. Although wireless isn't a core part of its revenue, it is one of its fastest growing segments. Analysts have been gently raising forecasts over the last few months, but the key news is that Juniper is seeing strength (in a weak environment) in areas like mobility, high performance networking, wireless, and the cloud.

These are all good drivers for Ixia’s testing equipment.

As for JDS Uniphase, it reported CommTest revenue at the high end of the guidance, and spoke of a return to spending by Tier 1 carriers in 2013, although its customers are expected to start releasing their budgets in March.

In conclusion, accounting errors are never a good thing, but I don’t see the reason for the stock to get beaten up so badly. In addition, the company recently announced that it expected revenue to come in line (excluding the $4.15 million reduction discussed above), so the underlying trends seem okay. The accounting errors aren't expected to affect future quarters and this looks like a timing issue to me. It also looks like a buying opportunity, so I topped up.

Wednesday, April 17, 2013

Fortinet Starting to Look Interesting

We are very early into earnings season but already two leading tech companies have reported weaker earnings thanks to a reluctance among telco service providers to close deals. F5 Networks $FFIV previously disappointed and now it’s the turn of Fortinet $FTNT to warn over missing estimates.

Fortinet Warns in Q1

The preliminary announcement of results brought with it some disappointing expectations.

  • Total billings expected to be $147-149 million vs. internal guidance of $158-162 million

  • Total revenue expected to be $134-136 million vs. internal guidance of $138-141 million

The billings miss of $12 million (at the mid-points) was blamed on three factors. In the commentary around the results the managements claimed that $6-9 million was due to the service provider segement, Latin America missed by $4-6 million, and there was an inventory shortage due to a product transition, which caused a $2-4 million miss.

The Good News First

Firstly, the inventory shortage issue was forecast to be rectified within a quarter so we can expect some of those billings to come back. Secondly, the geographic performance was mixed. Latin American weakness was put down to some local macroeconomic issues, although there is a new sales management in place there expected to improve performance going forward. Europe was cited as being weaker, but not by much, and a large deal is expected to close soon. Fortinet had has some issues with China previously, but that region was declared ‘back on track,’ and Asia was strong in general with Japan surprisingly good.

Thirdly, the really good bit of news was that US enterprise based spending did well in the quarter. This nicely mirrors what F5 Networks said over this segment of its sales too. This is heartening because it implies that this is not really a US macro issue. I’m glad that Fortinet confirmed this, because the view from F5 is somewhat obscured by the fact that it is undergoing a product refresh right now.

And Now the Bad News

The bad news is that, just as F5 Networks did, Fortinet argued that the telco service providers were determined to prove themselves villains in the quarter. Almost word for word, Fortinet repeated the mantra that F5 had earlier argued. My interpretation of the commentary runs a bit like this: yes there are large deals out there, no they weren’t closed with others due to competition, yes we think we can close them in the future, but no we can’t be sure when the telcos will do this… and I doubt they are both lying!

In the case of F5 it is a bit more obscure because of the product refresh and its dominant market position (50-60%) in its core application delivery controller (ADC) market. Moreover, Cisco Systems $CSCO has pulled out of investing in its ADC, so it is reasonable to expect F5 to be winning some new business there. Similarly, with Fortinet there is the fear that its weakness is being caused by Cisco bundling security solutions with its core networking equipment to the telcos and undercutting other players. However, there was no indication of this from F5 or from Fortinet.

Instead, there appears to be a shift in service provider spending towards more cautious piecemeal spending. Indeed, Fortinet spoke of one large customer that changed from a ‘capex to an opex’ based approach and decided to shift the purchasing over multiple quarters rather than buy with one large deal.

All of this resulted in a nasty sequential drop in Fortinet’s revenues:

And there can be few guarantees that this will recover in time.

Where Next for Fortinet?

It’s a nasty miss, but I think there is some cause for optimism here. Firstly, if we go back to what Fortinet reported last time we can see that it was a strong quarter that involved a significant amount of larger deals being won.

And since the telco deals that missed in Q1 tended to be larger deals, perhaps the Q4 performance is a sign that there was a budget flush in that quarter? Similarly, I note F5 reported a strong quarter from telco in its Q1 only to disappoint in Q2. A royal budget flush? I’m wondering out loud what this might mean for Cisco’s forthcoming results.

If this turns out to be the case then the weakness within the service provider segment may be incrementally graduated into forecasts over the full year as both companies get over the effects of the change in purchasing patterns by the telcos. Furthermore, if US enterprises are still spending then the economy can’t be in that bad shape.

As I write, Fortinet is trading on a current FCF/EV yield of just over 5% and is on track (in a bad quarter) to generate 8% year on year billings growth with revenue up 15% for Q1. That is not bad at all, although cautious investors (like me) will want to listen to what the Tier 1 service providers say about their spending plans in the forthcoming results. Provided their outlooks are okay, I think Fortinet is worth a close look down here.

Is Family Dollar a Buy?

It’s been an unusual year for the dollar stores. For much of the first half of 2012 they looked overvalued, even as they continued to generate impressive earnings growth. They were seen as the great trading down play, and for good reason. The problem is that when everyone sees it that way, it becomes hard to get a decent entry point. Roll on the second half of 2012 and things became a bit more uncertain as its end markets got tougher. Again the stocks looked attractive, but there was no obvious entry point. Roll on 2013 and their outlooks definitively worsened--and so did their stock prices, but are they good value now?

The Outlook For the Dollar Stores

The underlying story within the narrative above is that there has been a gradual shift in the sales mix for the dollar stores.  In the initial post recession years it became clear that the mass consumer was trading down to the dollar stores and creating new demand. Now that that easy pickings from that big move are over the challenge is to keep generating growth while the established grocers like Kroger $KR take action to gain back market share.

In particular, Kroger has been gaining share in the value segment by offering its own corporate brands. It is doing very well with them and Kroger has the footfall to be able to recapture some sales lost to consumers trading down at the dollar stores.

As for the dollar stores, there are three things that I think they can and have been doing:

  • Expand category sales and try to move into higher margin areas

  • Expand stores and capture new geographies

  • Drive footfall  via tactical expansion into categories like consumables

I’ll come back to these points and give my assessment, but first a few words on their end market prospects.

The Dollar Store Marketplace

It is very easy to fall into the trap of analyzing the retail market in terms of an amorphous mass that moves in the direction of the economy. But a retailer like Family Dollar $FDO shouldn’t be looked at in that way because it tends to sell to lower income customers. To give some perspective, here is a breakdown of the share of net worth in the US sourced from the Bureau of the Census. It is sorted by income holders.

I think it’s fair to say that the dollar stores’ customers will largely come from the bottom 60-80% of the populace. As you can see they don’t have that much purchasing power! In addition, their prospects are more affected by unemployment and job insecurity. So even as the economy recovers moderately, conditions will still be tough for its customers.

Family Dollar Analysis

I'm going to run through the three objectives discussed above in focusing on Family Dollar.

Firstly, it tried to increase higher margin home and apparel based sales but ran into merchandising difficulties. I suspect that this is partly a consequence of not having particular experience in apparel and also due to the fact that its customers shop on necessity and want consumables. Family Dollar may well have seen TJX Companies $TJX and Ross Stores $ROST doing very well in apparel and home goods, but it is another thing to be able to match them.

TJX’s management has vast experience in clothing, and its business model is predicated on ‘off-price’ retailing rather than the kind of discount clothing that the dollar stores may offer. Moreover, TJX’s customer base is largely discretionary, its footfall is generated by people coming to buy clothing and home goods. Whereas Family Dollar shoppers are trying to buy a cheap bottle of ketchup, will they stop and buy the apparel that has been placed at the front of the store?

Second, Dollar Tree $DLTR and Dollar General $DG have also been rapidly expanding stores even while same store sales growth is slowing. Indeed, Dollar General has spoke of aggressive price competition and is (like Family Dollar) taking a more cautious approach to its guidance. Its response to competition is to reduce pricing in certain categories, but this comes at the cost of margins. Similarly, Dollar Tree has seen same store sales slow to low single digits. Falling margins, slowing sales growth and tough competition. Is this the time to be expanding stores?

The third point is that as Family Dollar generates footfall by selling more essential consumables (which now make up nearly 70%) it is likely to suffer gross margin pressure. We can see that in the following chart:

Note how gross margins are falling.

Is Family Dollar a Buy?

In conclusion, there are challenges facing Family Dollar and as attractive as they undoubtedly are I don’t think it’s time to buy in. Family Dollar is increasing capital expenditures and its inventory levels have been rising more than sales as it sells more consumables. 

Analysts have it on a forward PE ratio of around 15, and I don’t think this is adequate recompense for the risk in its expansion program. I would like to see the dollar stores scale back these plans and concentrate on their core competency.

Tuesday, April 16, 2013

Fastenal and MSC Industrial Report Weak Numbers

Just when you thought it was safe to go back into industrial stocks, Fastenal $FAST and MSC Industrial Direct $MSM delivered results that raised more questions than answers. Both companies were downbeat and went to lengths to describe how their businesses weren’t performing in line with the headline manufacturing ISM numbers. So what is going on, and what is the read across from these earnings?

ISM Not Relevant Anymore to Fastenal?

Traditionally the manufacturing ISM numbers have guided the industry’s performance, and even more so when it comes to the industrial suppliers. Indeed, the theory (at least mine) was that the stronger numbers in the first quarter would lead to a resumption of growth in the industry. Well, according to Fastenal and MSC, that was not the case!

Here are the headline PMI and New Orders numbers from the ISM.

Starting with Fastenal, it declared that its sales growth was a ‘struggle’ in the quarter and conditions continued to slow down. This sort of commentary is not congruent with the ISM numbers, and its management even suggested that its performance wasn’t as correlated with the index as previously thought.

The bad news didn’t stop there, as its vending machine signings were lower than expected. In addition it had planned for 65-80 new stores for 2013 but announced that it expected to be at the lower end of the range in 2013. Although the company declared that it would still invest, even in a slowdown, it wouldn’t surprise me if it reined in some expansion plans if slow growth continues.  

To put Fastenal’s report in the context of its longer term plans I would recommend going over this article. In terms of its long term 'pathway to profit,' it is obvious that all the objectives are somewhat reliant on sales growth. Unfortunately this is something that has been slowing for Fastenal in recent quarters.

The problem appears to be in its fastener sales, and this is usually an indication of broad based weakness.The one bright spot was its metalwork products, which grew at above the company rate. I’ll come back to this point later.

MSC Weak Too

It was a difficult quarter for MSC too. Having previously announced that its end markets were in a holding pattern, which had descended into ‘paralysis’ in December, it was reasonable to expect better things this quarter. However, the company declared that the latest weak ISM number for March were more in line with what it was seeing in its current trading conditions. Indeed, it reiterated what Fastenal said about sequential weakness in the quarter with January being relatively strong leading into a weaker February and March.

Interestingly it highlighted the metalworking sector as a particular area of weakness. This is contrary to what Fastenal said, but my guess is that the latter has more exposure to aerospace and aviation. If we look at Alcoa’s $AA recent results there was ongoing strength predicted for the aerospace industry, while the US automotive sector is forecast to grow at 0-4% this year. However, Alcoa did not raise its forecast for its US commercial building & construction despite more optimistic indications from new house builds and the Architectural Billings Index. Jam tomorrow?

What Is Going On?

It is hardly a clear picture, but what we do know is that the areas of relative strength in the economy are in things like autos, housing and aerospace. This is probably a function of how weak the first two industries have been in recent years.  In other words, comparisons are easier in these industries. Furthermore they are due to grow thanks to net household formulation and the age of the US care fleet. Aerospace’s strength is due to its global exposure and the recovery in profitability of the airlines.

Allegheny Technologies $ATI is the sort of stock that will give good color on these themes. It recently outlined strong numbers from aerospace builds but weaker demand from the nuclear industry. In addition oil & gas demand was forecast to be lower thanks to inventory management actions by its customers. The story from Allegheny is one of a mixed industrial outlook and it mirrors what Alcoa said recently.

Where Next?

Fastenal and MSC are companies with limited visibility so things can turn around pretty quickly for them. Furthermore, my hunch is that there is a willingness among industrial customers to hold off purchases whenever they see political uncertainty. Obviously long cycle industries like aerospace can’t really adjust demand levels in the short term. In other words, conditions can improve, and I suspect they will.

However my issue with buying either stock is that they are not cheap enough. Falling sales growth is never a good sign, and when I buy stocks like this I would expect to buy them with some excess negativity priced in. As I write, they trade on 34x and 19x current earnings respectively. I think that’s too much to pay for a cyclically aligned sector with little visibility and falling sales growth.

Monday, April 15, 2013

This Weeks Key Earnings

After a quiet opening week to earnings season, this week brings a torrent of earnings reports from Dow components and industry bellwethers.


Monday starts with Citigroup reporting, and it’s going to kick off a big week for financials.


The banking theme continues on Tuesday with Comerica and Goldman Sachs reporting numbers. We also have three bellwethers reporting.

In healthcare, Johnson & Johnson (NYSE: JNJ) will update investors on how its revival in pharmaceuticals is going. Within pharma, I would look for ongoing strength with Remicade (rheumatoid arthritis) and growing Stelara (psoriasis) sales. However, the real question will be over its consumer products division.

A brief look at the previous results reveals that it is still under performing, and it needs to get the brands affected by quality problems back into production. Similarly, OTC/Nutritionals and skin care have been weak in recent quarters. The third major division is medical devices & diagnostics. The company is ‘evaluating options’ with its diagnostics operations, and continues to integrate Synthes in to its orthopedics offerings. In summary, the focus in these results should be on execution with its consumer products.

The key things to look out for in Intel’s (NASDAQ: INTC) results will be its gross margin outlook and inventory situation. Historically, the stock has tended to trade in the direction of its gross margins, and the declines last year have mirrored poor stock performance. While these issues will govern the short to mid-term performance, investors should also focus on the development of its longer-term plans to invest in solutions for ultrabooks and tablets. Intel is somewhat late to the party with some of these things, but it has the scale and financial firepower to get back on track.

The Coca-Cola Company is the third major bellwether to give results today. In addition, industrial play W.W. Grainger will give more color on current conditions.


This day will see numbers coming out from Abbott Labs, American Express, Bank of America, Core Labs, Crown Holdings, Sandisk, and Textron. Alcoa recently talked of better conditions for business jet orders, so it will be interesting to hear what Textron has to say because it too gave a good forecast late last year.

I’m also looking out for Dover’s results. It has had some difficulty with its sound solutions division, and it will be interesting to hear what it says about is smartphone-based sales because Nokia is a major customer.

In rather obscure fashion, I am going to focus on Quest Diagnostics (NYSE: DGX). This is not the sexiest stock nor is it in the most fashionable industry, but, I think there is an interesting value case here. It generates a lot of cash and is a dominant player within an industry in need of consolidation.

Moreover there are a number of management initiatives in place in order to try get to the kind of growth rates that its rival Lab Corp (which reports on Friday) has been able to achieve. It’s a boring stock, but it's cheap and if a turnaround can be achieved, it will surely appreciate.


There are some interesting health care plays reporting today with results from Baxter, Cepheid, and Intuitive Surgical. Banking is represented by Morgan Stanley.  Industrial giant Danaher reports, as does Tier 1 telco carrier Verizon. PepsiCo is a company with a strategy that lacks coherence in my humble opinion. It is also a decent yielding stock in a hot category right now. The market has been very keen to bid up food stocks lately.  

There are also some interesting housing and construction plays reporting. I’m not convinced by Restoration Hardware’s valuation justifies the uncertainty over its growth strategy. As for PPG and Sherwin-Williams, the former has significant exposure to China and the latter is attractive thanks to its U.S. housing exposure, but the stock is hardly cheap.

Google (NASDAQ: GOOG), IBM (NYSE: IBM), and Microsoft also give numbers. As ever, the market will focus on the relationship between cost per click and paid clicks growth at Google.

Google doesn’t give guidance, so its results always cause a lot of volatility and this time won’t be any different. I think Google is managing the transition to tablet and mobile internet usage very well, and investors often underestimate its international growth prospects.

There is no reason why it can’t reach the kind of metrics generated in the U.S. with its international operations. Moreover, we are in the early infancy of the big data revolution and its search facility is something actively used by people. Long-term growth is inevitable.

IBM’s chief rival Oracle gave disappointing results recently, so there are some concerns over what IBM will report. Oracle insisted that this was more of a sales execution issue rather than macro weakness. In addition, I think Oracle is going through some product transition issues as well, as it's relatively underexposed to cloud-based offerings.

IBM investors should expect good System Z hardware sales, and I suspect we are about to find out whether it is taking share from Tibco Software in middleware and analytics after that company reported a horrible set of results recently.


The big news on Friday will come from General Electric. Its last results were strong and contained some upside surprise from health care in emerging markets, plus some impressive order growth overall. Baker Hughes, Honeywell, and Rockwell Collins also have activities that cross over with parts of GE. 

Last but not least, Kimberly Clark and McDonald’s will update us on the mass consumer market.

Alcoa's Outlook Remains Positive

One of Sherlock Holmes’ greatest pieces of detective work was detecting the importance of the dog that didn’t bark in the ‘Hound of the Baskervilles’ and I think investors should follow his lead over Alcoa’s $AA latest results. In other words, the earnings were more important for what they didn’t say about the economy and end markets then what they did.

Alcoa Earnings Analysis

At the last set of results Alcoa gave a relatively bullish prognosis for the global economy and highlighted how much it is reliant upon China for its earnings prospects. Investors could be forgiven for being skeptical given the uncertainty surrounding political events in the US, the state of the European sovereign debt situation and China’s growth outlook in 2013. Of these three macro concerns the fears over the fiscal situation in the US seem to have subsided somewhat (even if the deficit reduction plans are unsatisfactory to many) and Europe appears to be stabilizing as everyone gets used to dealing with a succession of mini disasters.

The biggest question mark is over China, and longer term there are concerns, but if Alcoa’s guidance and commentary is accurate then the Chinese economy is on track.

In fact there weren’t any major changes in its end market outlook.

There was a slight weakening of the outlook for the European automotive industry and a trimming of the high end of guidance for Chinese heavy truck and trailer but otherwise nothing changed. Moreover, the color and commentary given around the results was positive.

Aerospace and Industrial Gas Turbines

It’s a mixed story for aerospace right now with commercial aerospace doing well but the defense sector remaining subject to a lot of uncertainty over spending. The interesting thing was that it saw a strong rebound in regional and business jets. The latter is one of the most cyclical industry segments in the economy and its strength is a good sign.

This outlook is also a good sign for a company like General Electric $GE, which has aviation as a major profit center. Its aviation equipment orders rose 13% in Q4, and some orders were pushed out so we can expect continued growth this year. Similarly industrial gas turbines are a common end market for both companies. Alcoa is seeing 3-5% growth, and as long as gas remains relatively cheap compared to other hydrocarbon fuels, then gas turbines will be run, thus creating end demand. GE will surely benefit too.

Automotive and Heavy Truck & Trailer

It was surprising not to see Alcoa raise forecasts for the US, but the weakness in European auto shouldn’t have caught anyone unaware. Automotive sales continue to be strong in the US, and the increasing willingness of credit providers to give loans should drive further growth. The ultimate arbiter of these factors is employment; this continues to grow in the US. Again the commentary on the Chinese automotive market was positive.

Furthermore Alcoa remains bullish on the heavy truck & trailer market in China. Meanwhile, Europe and the US remain in decline as manufacturers run down inventories. On a more positive note Alcoa described the fundamentals as ‘looking good’ with orders on the rebound.  It’s interesting to compare this outlook with what Cummins $CMI reported last time around. It is expecting the Chinese heavy and medium duty truck market in 2013 to be similar to 2012. It said that truck demand stabilized in Q4, but overall its tone was notably more negative than Alcoa’s. They can't both be right.

Beverage Can Packaging and Commercial Building & Construction

Rather like autos in the US it was surprising not to see forecasts raised for US construction. Alcoa is still predicting 1-2%, but other indicators such as the Architectural Billing Index are displaying strength. History shows us that the residential market tends to lead a recovery in commercial and industrial construction, and a good example of a company with global exposure to this theme would be Stanley Black & Decker (NYSE: SWK). The stock offers a compelling mix of heavy exposure to US construction spending, emerging market growth and company specific strategic growth initiatives. As long as Alcoa keeps reporting better conditions in this segment, then end markets look likely to be favorable for the tool maker and its growth program.

Last but not least, Alcoa reported a consistent outlook for its beverage can packaging end market and referred to the positive trend in China to convert steel cans into aluminum. This is good news for Ball Corp. The risk with the can manufacturers is that they will commit to capital expenditures on plants in order to service nearby customers only to see demand tail off as the economy slows. Therefore as long as markets are holding up well we can expect positive leverage from their investment programs.

The Bottom Line

In conclusion, while this report was nothing spectacular it was consistent and, given that Alcoa had been relatively bullish previously, I think investors can take heart from it. Overall it is a net positive and if it continues like this the economy will be in good shape in 2013.