Wednesday, July 31, 2013

Johnson & Johnson Looks Fairly Valued

Investors in health-care giant Johnson & Johnson (NYSE: JNJ) have been rewarded with a 30% share price rise in the last year. The health-care giant remains a go-to choice for investors seeking a relatively recession-proof stock with a decent dividend. However, investors need to ask themselves a few questions about its recent results: Can this share price run continue?  Does Johnson & Johnson still provide compelling value?  And what are the key takeaways for the healthcare industry from these results?

Johnson & Johnson delivers

The argument for buying Johnson & Johnson is based on the fact that its three big near-term factors depend on how its management performs, rather than purely on the economy. This means that the stock can appreciate even in a weak economy.

First, Johnson & Johnson has been trying reintroduce a number of over-the-counter (OTC) products that were taken off the U.S. market due to production issues. Second, its pharmaceutical division has several new drugs with which it can develop sales. Finally, the successful integration of orthopedic company Synthes in its medical devices and diagnostics division will create earnings growth in a weak medical spending environment.

A checklist of these three factors would conclude that the company is well on track.

The company's plan to reintroduce 75% of those lost consumer brands by the end of 2013 was confirmed in its recent second-quarter results.  U.S. OTC sales were up 17.4% in the quarter, and although they only currently compose 7.9% of total consumer sales, the marginal increases in sales and profits will make an impact in future quarters.

Furthermore, its pharmaceutical division has delivered strong performance, with a 12.9% rise in constant-currency sales in the quarter. The standout performers within pharmaceuticals included newer drugs like Stelara (psoriasis), Incivo (hepatitis C), Xarelto (anti-coagulant), Invega Sustenna (anti-psychotic) and Zytiga (castration-resistant prostate cancer), all of which recorded sales growth at around 50% or more in the quarter.  In addition, its biggest drug, Remicade (rheumatoid arthritis), which contributes nearly 24% of its pharmaceutical sales, saw sales rise an impressive 10.3% in the quarter.

Lastly, the Synthes acquisition is working well. Indeed, J&J's overall growth in the medical devices and diagnostics sector was 12% in constant currency, largely thanks to Synthes.  Excluding the acquisition, the division would have reported sales growth of just 0.5%. It’s clear that the acquisition is helping Johnson & Johnson generate growth within a difficult part of the health-care industry.

It’s all in the price

The problem for investors wanting to buy in is that the market now seems to have priced these three factors into the share price. Compare Johnson & Johnson's price-to-cash flow multiple with its price chart:

JNJ Price to Cash Flow TTM data by YCharts

The stock hasn’t traded on a price-to-cash flow multiple of around 20 since 2005-2007. A cursory glance at the chart would reveal that the share price struggled to appreciate in that period. On the basis that it currently trades on that valuation, I would argue that much of the good news is already priced into the stock. Furthermore, analysts have earnings growing in only the mid-single digits for the next two years, and I’m not sure I’m keen to pay 24.5 times earnings for that kind of growth profile.

Winners and losers from Johnson & Johnson’s results

It’s always fascinating to read between the lines of Johnson & Johnson’s results and pick out indicators for other companies’ prospects. On the positive side, investors in eye-care specialist Cooper (NYSE: COO) will be interested to hear that Johnson & Johnson recorded 5.4% operational growth in its worldwide vision care business, and specifically cited daily lenses as an area of growth.

This indicates strength within the eye-care market, and should be good news for Cooper Companies, since one of its key aims in 2013 is to increase its one-day modality sales. Cooper’s one-day lenses generate three to five times more profit than its monthly lenses. Moreover, it is more of a pure-play on the increasing popularity in one-day lenses, because it doesn't sell lens-care solutions.

On the other hand, two losers from this report could be medical device company Covidien (NYSE: COV) and radiation oncology specialist Varian Medical Systems (NYSE: VAR).

Covidien has generated much of its growth in recent years from surgical device appliances within its energy and endo-mechanical divisions. Indeed, it’s a leader in the minimally invasive surgery market. Covidien’s supporters (and I’m one of them) will always point out that its solutions are relatively low-ticket, and they demonstrate a tangible way for hospitals to reduce costs via achieving better patient outcomes.

On the other hand, Covidien is still exposed to the volume of surgical procedures in medical centers, and in its conference call, Johnson & Johnson outlined that hospital and surgical procedures are flat to negative.

Turning to Varian Medical Systems, this company definitely is a high-ticket solution provider, and could suffer disproportionately if there is a buyer’s strike in the hospital and medical center market. There is a SWOT analysis of the company in an article linked here which outlines its prospects for 2013. Johnson & Johnson talked of the negative impact of macroeconomic conditions on its medical device sales, and robotic surgery appliance manufacturer Intuitive Surgical (another high-ticket solution provider) has already disappointed in this earnings season.

Moreover, in its conference call, Johnson & Johnson described the hospital capital expenditures market as being in recession for 10 to 12 consecutive quarters. All of these events are signs that Varian may find its customers more reluctant to spend in 2013.

The bottom line

Johnson & Johnson has pretty much priced in most of the good news, and it’s hard to see how the stock can appreciate much from here. The stock has had a great run, but now it’s time to wait for a pullback.

Tuesday, July 30, 2013

What IBM's Results Mean to the Market

One of the great IT bellwethers, IBM (NYSE: IBM), issued mixed results in mid-July. It’s hard to be too critical of a company that has just raised estimates despite increased currency headwinds, but a deeper analysis of the company's results reveals some underlying weakness.  It’s been a difficult year for technology, and IBM’s earnings did little to raise investors' spirits.

IBM reports

The two key positives in the report came from the growth in services backlog (7% at constant currency) and the strength in higher-margin software sales. In order to demonstrate their impact, here is a chart of IBM’s segmental growth. All data is sourced from company accounts.

Growth in the second quarter was better than in the first. Moreover, IBM’s reported revenue decline of 3% was made to look worse due to currency headwinds of 2%. Based on its backlog, IBM forecasted that third-quarter revenues in its global business services segment would be up by mid-single digits, with global technology services increasing in the low single digits.

The software segment's bounce back toward growth looked robust, and management pointed out that its 4% reported revenue increase (5% in constant currency) was the strongest recorded since the first quarter of 2012. IBM spoke of a very good software pipeline, and referenced good growth in some important niches like branded middleware (up 10%) and business analytics (11%).

To put this data into context, here is a graph (sourced from company accounts) of the segmental revenue share and normalized pre-tax income share.

Clearly, software is its highest-margin business, and its relative strength in the quarter helped IBM raise gross margins to 49.7% from 48.3% last year.

With the services backlog up 7%, and higher-margin software returning to growth in Q2, why aren’t these results as hot as they look?

Four reasons it's still tough out there

First, although software returned to growth in Q2, this was partly due to the weakness in the previous quarter.  In fact, growth in the first half was only 1.9%, which compares unfavorably to 2.6% and 11.5% in the two previous years. Indeed, a glance at the first chart above demonstrates that IBM is starting to lap some weaker quarters in 2012.

Second, going back to what IBM said last time around, $400 million in software and mainframe deals were rolling in to Q2 anyway. When asked about these deals on the current conference call, management stated that less than half closed in Q2, and, more importantly, rollovers in higher-margin software are actually larger going into the Q3. This all sounds good, but there is no guarantee that rollover deals will get closed. In addition, its main rival Oracle (NYSE: ORCL) also reported some weakness in the quarter.

The third reason is that IBM’s  forecast for services revenue growth in Q3 needs to be put into context. Penciling in growth of 5% and 2% for business services and technology services, respectively, would give a total services revenue figure for Q3 of around $14.9 billion. This compares favorably with the $14.4 billion recorded last year, but rather less so against the $15.3 billion in 2011.

Finally, the macro commentary wasn’t great. America’s revenues disappointingly declined 3%. However, the real surprise was within its growth markets. Revenues in Brazil, India, Russia, and China, were flat (up 1% in constant currency). In common with Oracle, IBM cited specific weakness in Russia and China, and it expressed a cautious outlook for its growth markets for the second half.

Key takeaways for the industry

While the tech market remains weak in 2013, there are pockets of strength. IBM stated that its cloud revenues were up 70%; Oracle also reported cloud-based strength. This shows a clear shift in corporate IT spending towards the cloud and away from legacy on-license/on-premise software.

Furthermore, the relative strength in IBM's middleware and business analytics numbers suggests that middleware and data analytics company TIBCO Software (NASDAQ: TIBX) and interactions management provider NICE Systems (NASDAQ: NICE) could do well.

TIBCO finally seems to be sorting out its problems with its sales force in North America. In addition, its increased focus on big data analytics solutions, and offering its customers its service both on-premise and via the cloud, is in line with trends in IT spending.  Corporations may be holding back on discretionary IT spending in general, but they are still keen to invest in niche areas like social media and customer engagement. Indeed, TIBCO cited specific strength in sectors such as financial services and retail.

As for NICE, it has a deal with IBM  to integrate the latter’s analytics within its services. Unlike many areas of tech spending this year, NICE has been reporting earnings that are in line with expectations. Moreover, it is seeing strength within sales of its advanced applications, which allow customers to analyze the data that its systems capture. Again, this is a sign that in a slow global economy, corporations are willing to spend on analyzing customer interactions in order to better manage how they sell into their existing customers.

The bottom line

In conclusion, IBM and Oracle have both reported earnings, and neither had particularly good news for the IT spending environment. Conditions appear to be stabilizing, but the broad-based bounceback in demand hasn’t really happened yet.

With regards to IBM itself, the company’s story is about its ongoing paring of lower-margin businesses, and how well it manages its shift toward more software sales. For longer-term investors, I think the stock will do fine. If it hits the raised adjusted diluted guidance of $16.90 in EPS for 2013, then it will trade on a forward earnings multiple of 11.4 times, as I write. This is attractive enough, but investors need to be prepared for potential near-term volatility, because tech spending remains weak.

Monday, July 29, 2013

Yum! Brands' Challenges Are Bigger Than You Think

It’s been a frustrating year for Yum! Brands’ (NYSE: YUM) investors, as the fast-food giant has faced some significant challenges in China. The country is at the forefront of Yum!'s efforts to shift toward becoming the emerging-market fast food company du jour. Will the company's problems prove temporary, or are there underlying macro-economic reasons for the weakness in the Chinese fast food sector?

Finger-licking buying opportunity?

The investment thesis behind buying Yum! is that its difficulties in China will be swiftly resolved, and the company’s sales and margins will come back strongly in the second half of the year.  If you buy this argument then you must look into the causes of its problems.

Yum!'s issues in China started with a scare over the quality of its chicken supply, and then moved on to consumers being reluctant to eat poultry due to an outbreak of avian flu. The positive case sees these problems as being short term in nature, and the current valuation as being attractive relative to its long term prospects.

A quick look at its trailing P/E ratio:

Superficially, the above suggests the stock is currently expensive. In addition, if you assume it hits its estimate of “mid-single-digit percentage decline” for 2013, then the stock is priced at roughly 23 times forward earnings as I write.

However,  Yum! forecasts its Chinese sales growth to turn positive in the fourth quarter, with 2014 turning into a year of stellar growth because comparables will be a lot easier. If Yum! hits analysts’ estimates of $3.79 in EPS for 2014, then the stock would be trading on a forward valuation of 18.8x earnings.  This makes it look historically cheap, so should you pile in?

KFC disappoints in China 

In its latest results, Yum! reported that its same-store sales for KFC in China were down 20% for the second quarter in a row. However, in its recent conference call, Yum!’s management outlined – in no uncertain terms – that its EPS forecasts were dependent on Chinese sales coming back swiftly for its KFC operations. It also served up a few indicators as to why it feels confident:

  • KFC same-store sales in China were down 13% in June, compared to 26% for the second quarter, indicating that the worst may be over.

  • KFC made low-teens sequential improvements in same-store sales in China from April to May, and then May to June.

  • Yum!’s second major restaurant chain, Pizza Hut, recorded 7% same-store sales growth in China for the quarter, suggesting that KFC’s problems are company-specific, not due to a weakening Chinese consumer market.

  • Overall emerging-market-same store sales grew 5% in the quarter 

In order to demonstrate the importance of China to Yum!, here is a chart comparing its quarterly operating profit and the percentage of Yum!'s total operating profit that comes from the country:

Source: Yum! Brands financial statements.

In summary, all of these points suggest that Yum! can turn around performance in its key profit center. But what is the rest of its industry saying?

A twist in the tale

Unfortunately, Yum! isn’t alone in seeing weaker results in China. In fact, its biggest rival, McDonald’s (NYSE: MCD), also started to see its same-store sales growth slowing at the end of 2011. The main difference appears to be that Yum!’s performance notably deteriorated after the chicken supply scare had its effect. However, the downtrend was already in place by then, and it should be noted that McDonald’s Asia-Pacific Middle East Africa (APMEA) sales haven’t been strong this year, either. All the data in the chart is sourced from company accounts.

It’s all very well for Pizza Hut to be generating growth in China, but KFC makes up more than  74% of Yum!’s restaurants in the country.

Moreover, Burger King (NYSE: BKW) also reported some disappointing numbers in its first-quarter results to the end of March. For example, its global comparable same store sales growth fell 1.4%. In addition, its results in Asia-Pacific (APAC) weren’t much better with a paltry 2.7% systemwide comparable sales growth recorded in the region. Furthermore, Burger King argued that the rise in APAC was due to positive performances in Korea and Australia, thanks to a combination of value promotions and programs.

In summary, neither Burger King nor McDonald’s are reporting anything particularly positive on the global sales environment, let alone for the Far East.

The bottom line

Yum!’s peers are seeing difficult conditions in China, so this looks like it is more than a company-specific issue. Yum! is a compelling proposition, but cautious investors will want to take a pass. The company probably will engineer a recovery in China, but it may not be of the magnitude needed to take the stock materially higher.

Sunday, July 28, 2013

Wells Fargo is Still Good Value Despite Rising Rates

Earnings season is in full flow now, and it’s the turn of banking heavyweights such as Wells Fargo (NYSE: WFC) and JPMorgan Chase (NYSE: JPM) to give their numbers and commentary on the economy. As ever, investors will focus on the housing market’s effect on banking stocks' prospects, and what it means to the wider economy. Frankly, I think the housing market is the key to future movements in their share prices. Moreover, as long as the banks are saying good things about housing, investors can feel confident about the U.S. economy.

Don’t get fooled by randomness

It’s important not to get caught up in the minute detail of looking at the banks. In truth they are still cyclical businesses. The banks make money when the economy is trading in the direction of the core assets (mortgages, loans, etc) on their loan book.

Therefore, if you want to buy banking stocks, you will need to focus on how the economy affects the quality of their loan books. If housing and the economy are doing well, then their credit quality (loan delinquencies, charge off rates) will get better, loan loss provisions will reduce, and demand for loans will go up. Ultimately higher rates should be a positive to their earnings in the long term. In turn, all of these metrics affect the valuation of the company.

My point here is that it's the direction of the core assets, rather than looking at a snapshot of their earnings right now, that counts in terms of making a decision to buy the stocks.

The big question over the banks…

The key issue is how the banks might deal with a rising rate environment. The markets have been keen to price in higher rates ever since Ben Bernanke implied that the Federal Reserve would begin tapering bond-market purchases. So where does this leave the banks? Will rising rates choke off loan demand, or will the housing market continue to recover despite them?  Naturally, if the latter occurs, the banks will see increased loan demand and banking profitability.

The issue can be seen by looking at Wells Fargo’s net income and its net interest margin (NIM). Interest income (roughly half of income) is more important to follow than non-interest income, because it is more variable.

The market has been fretting over this issue in 2013 as economic growth (therefore loan demand growth) has been moderate, while interest rates remain low (reduced interest rate income) and deposit growth has grown strongly (consumers continuing to deleverage).

Meanwhile, financial services companies such as Capital One Financial (NYSE: COF) have been experiencing run-off. This is where existing loans are paid off and not replaced by new loans due to weak demand. Indeed, Capital One expects run-off to be $12 billion in 2013 and a further $8.5 billion in 2014.

Furthermore, JPMorgan’s CEO, Jamie Dimon, discussed the possibility for a “dramatic reduction” in the bank’s mortgage profits if rising rates slowed demand for home loans. The issue is highly relevant because Wells Fargo and JPMorgan are the two biggest mortgage lenders in the U.S. Moreover, as the housing market is a key determinant for the ‘wealth effect’, the banks can expect demand for other forms of credit (auto loans, credit card, etc) to be indirectly tied to it.

The two reasons why the banks will do well

The first cause for optimism is that the increase in deposit growth created by consumer de-leveraging is building a powerful asset base from which the banks can lend. For example, here is how Wells Fargo’s average core deposits have increased recently:

In addition, its tier 1 capital ratio (a common measure of a bank’s capital adequacy) has been rising. This indicates an increased capacity to lend.

The second reason is that the wealth effect from housing is real. Here is a graph of data from the Federal Reserve that demonstrates how U.S. households and nonprofit organizations have seen real restate wealth and their net worth improve in recent years:

Furthermore, gains in employment and slow-but-steady economic growth are creating a favorable environment for growth in loan demand. If these conditions persist, then the banks should be able to deal with a rising rate environment. Indeed, historically speaking, a rising rate environment means that banks will make more money.

The bottom line

In conclusion, investors should stay positive on the financial services sector as long as the underlying fundamentals are moving in a favorable direction. The debate about the effects of rising rates on the economy will go on and on. There will be tomes of spilled ink discussing the NIM, run-off, Basel III and other esoteric concepts that ordinary investors find hard to grasp.

However, Bernanke has made it clear that tapering the purchases of bonds –therefore lowering interest rates– is contingent upon a stronger economy. Either the Federal Reserve will try to lower rates in the future (given a slowing economy), or the economy will get better (implying more loan demand). In any case, the banks are being supported in their activities and, unless the economy is heading towards another recession, investors should look to hold some banking stocks in their portfolio.

Tuesday, July 23, 2013

Fastenal Reports on the Industrial Sector

It’s always interesting to use earnings season as a way to formulate a view on the economy. Unfortunately, anyone looking for some positive news on the industrial sector would have been disappointed by the recent results from industrial supply companies Fastenal (NASDAQ: FAST) and MSC Industrial Direct(NYSE: MSM). What did these companies say, and what does it all mean for the industrial sector?

Mixed growth in the industrial sector

In short, outside of areas like aerospace and aviation, the industrial sector remains weak. Earlier in the week, aluminum supplier Alcoa (NYSE: AA) came out with a positive report that gave cause for optimism.

The company always gives good color on its industrial end markets, and the fact that it failed to reduce guidance for China has to be taken as a positive. The good news on China was somewhat surprising because companies like FedEx, Pall, and Oracle have all come out and stated specific weakness in China. Nonetheless, we should take what Alcoa said at face value.

Similarly, Alcoa’s global aerospace, automotive, and industrial gas turbine segments remain set for good growth in 2013, even if Europe is a little weaker. Since Alcoa is saying good things, surely the industrial supply companies would, too?  They are always useful as a bellwether because their sales cycle is relatively short. This means that any change in conditions will immediately be seen in their sales figures.

Fastenal adjusts its strategy

Unfortunately, Fastenal and MSC Industrial both had negative outlooks on the industrial sector.

Fastenal spoke of a slow economic condition causing its fastener sales (a cyclical product) to remain weak. In a sense, this apes the overlying Institute for Supply Management (ISM) manufacturing numbers, which have been softer in 2013. The ISM surveys private manufacturing companies in order to produce its Purchasing Managers Index (PMI), which is the leading manufacturing indicator in the U.S.

Note how the strength in new orders (which usually precede a pick-up in the headline PMI numbers) quickly dissipated in February, while the headline PMI number has averaged 49.7 this year. A number below 50 indicates negative growth.

In fairness, Fastenal did point out in the previous conference call that its sales were not represented by the stronger ISM data in the first quarter (ISM new orders had averaged 54.2 in the first three months). However, this historical relationship came back into line in the second quarter as both the ISM and Fastenal’s sales growth was weaker.

The company’s response is to try to drive sales by making significant new hires (mainly sales support staff) in its stores. The idea is to hire 600-900 new in-store staff by the end of the year. The plan would enable its existing managers to have more free time to visit more customers, increasing sales accordingly.

It’s an interesting approach, because previously Fastenal’s main focus was on expanding the installations and sales of its vending machines.  However, with competitors like MSC Industrial also building out its vending machines and Amazon increasingly moving in on the industrial supply market, Fastenal may feel that a balanced approach to growth is a better way to deal with a slow industrial market.

MSC Industrial also weak

The theme of adjusting to macro weakness was shared by MSC Industrial. The company decided against implementing its mid-year pricing increase in a concession to a softer demand environment. It’s tough to get customers to accept price increases at the best of times, let alone when end demand is weak. The good news for MSC Industrial is that it has non-cyclical ways to increase profitability:

  • The acquisition of Barnes Distribution North America will increase revenues, margins and create opportunities.

  • Its e-commerce revenues are growing at north of 40%.

  • It has the potential to increase vending machine installations.

Obviously, these three aims are easier to achieve given a stronger demand environment, and if you buy the "second-half industrial recovery" story, then MSC and Fastenal are interesting propositions. On the other hand, until the headline ISM manufacturing indices improve, investors should brace themselves for more disappointments and negative sentiment around the sector.

In comparing the two companies, MSC Industrial comes out on top in terms of valuation and potential to grow earnings despite the economic cycle.

FAST EV / EBITDA TTM data by YCharts

The bottom line

In conclusion, these results told similar story to the first quarter's about MSC and Fastenal and their end markets. It appears that Alcoa’s optimism is more related to the strength of some of its particular industry segments, such as aerospace and automotive. Investors in Fastenal and MSC would do well to ignore Alcoa and focus more on the ISM numbers in order to see where prospects for the two companies are headed.

Alternatively, there is a strong case for simply staying invested within the areas of strength in the industrial sector. It’s too early to proclaim a general second half pick-up.

Monday, July 22, 2013

Family Dollar's Results Weren't That Good!

Investors can be forgiven for thinking that all is well with the outlook for the dollar stores after Family Dollar (NYSE: FDO) rose sharply in post-earnings trading. However, in reality, there were some warning signs for the economy in the report.  Moreover, the underlying story in these earnings is of how well the company is adjusting to weak market conditions. Dollar General (NYSE: DG) and Dollar Tree(NASDAQ: DLTR) were marked up in sympathy, but it would be a mistake to assume that they will report in a similar manner to Family Dollar.

More margin pressure

In common with Dollar General, Family Dollar is seeing margin pressure as its sales mix shifts towards lower-margin consumables and away from higher-margin discretionary items. In fact, the share of consumables rose to 72.5% of total sales, compared to 68.9% last year. In contrast, Dollar Tree managed to benefit from margin expansion by growing its sales mix in the other direction. However, this appears to be an isolated case amongst the mass market retailers.

Family Dollar actually highlighted industry data that suggested that its typical consumer was spending less in the marketplace, but more at its stores. This is not a great sign for the economy. This data also implies that if there is growth to be generated, it will come at the expense of its competition. Family Dollar is likely taking share from the supermarkets within the grocery category. Unfortunately, consumables like tobacco and groceries are not really high-margin items. So even as Family Dollar expands sales in these areas, it will not see gross margin expansion.

These trends are nicely illustrated with a look at the company’s sales and margin trends over the last few years. Note the company’s forecast for the next quarter is for an anemic-looking 2% same store sales growth. This is a bit disappointing, because even though the first quarter was weak for most retailers due to a number of issues (payroll tax increases, tough weather comps, tax refund delays and the sequester), the second quarter was supposed to be a more favorable environment.

On the other hand, the positive news is that gross margins were forecast to be almost flat in the next quarter, much to the liking of the markets.

Why the market likes these results

The real takeaway of these results is how Family Dollar is adjusting to a slower sales environment. Gross margins were predicted to be almost flat in the fourth quarter, and in the conference call, the management discussed the possibility for them to be flat in 2014 as well. There are a number of reasons for a more positive outlook for both gross and operating margins:

  • The company has adjusted to the slower sales environment and is now highly focused on reducing things like freight, distribution center, and advertising costs.

  • It is starting to lap the unfavorable mix shift movements from last year, so comparisons will get easier.

  • Management spoke of some recent improvements in its core discretionary businesses and spoke of the beginnings of stabilization.

The last point is the key, because Dollar Tree has already managed to do this in 2013, while Dollar General was punished by the market in early June when it lowered guidance thanks to weakness in its discretionary sales.  In addition, Family Dollar is somewhat playing catch-up because its discretionary merchandising decisions were below par in 2012. In short, Family Dollar tried to increase sales with discretionary items like clothing, but found it a tough sell to its customers.

Why you shouldn’t get too excited

In putting these points together, it’s hard not to be puzzled as to why the market dragged the other two dollar stores up in sympathy.  Family Dollar didn’t have many good things to say about the economy. In addition, if it really is winning market share, then the other dollar stores could be missing out.

 Also, the dollar stores have tended to report similar trends in same store sales (as shown in the graph below), but they have tended to differ in how they deal with sales mix issues and getting their discretionary sales right.

In conclusion, if these results were all about Family Dollar adjusting to a slower sales environment, then there isn’t a strong reason to think that Dollar Tree and Dollar General are about to shoot the lights out in their next reports. Don’t get too excited.

Sunday, July 21, 2013

Paychex Earnings Analysis

It’s always interesting to look at Paychex's (NASDAQ: PAYX) results, because the small business service provider usually gives good color on the economy. What do its latest results say about the small business environment, Paychex's own prospects, and can the company grow its relatively large dividend?

Paychex gives mixed commentary

Anyone hoping that Paychex would deliver an upbeat depiction of the economy would have been disappointed with the recent fourth-quarter results. The key metric to follow, in terms of analyzing the health of the small business sector, is its 'checks per payroll’. Unfortunately, it only rose 0.9% in the quarter, and analysts spent much of the conference call trying to find out why it was so weak. The commentary wasn’t good, with the management describing it as moderating in the quarter and then suggesting that the trend was downward.

In addition, this doesn’t even appear to be a Paychex-specific issue because its client retention was at an all-time high at above 81%. The payroll services market is competitive, with the likes of Automatic Data Processing (NASDAQ: ADP) and Intuit (NASDAQ: INTU) also active, but Paychex is holding its own for now. Indeed, it made bullish noises by predicting its client growth would come in at 1%-3% going forward.

Paychex seems to be competing quite well, and it's helped by strength in the housing sector. I note that in May, ADP kept its forecast for pays per control (within its employer services division) at 2%-3% growth. In light of what Paychex just said, will it have to reduce this figure?

In summary I think Paychex’s commentary -- it also highlighted weaker-than-expected new business formulation -- confirms the mild nature of the recovery, and you can see this in the National Federation of Independent Business (NFIB) data. I’ve broken out the current job openings data below.

The trend is favorable, but growth remains tepid, and Paychex’s results did little to assuage fears.

Paychex’s recent results

Paychex’s overall results were okay. In the last quarter, it had forecast full year growth of 1%-2% in payroll services, with human resource services forecast to grow at 9%-11% and net income up 5%-7%. In the end, these full year numbers came in at 2%, 10% and 6% respectively.

In its guidance for 2014, the company predicts:

  •  Payroll services revenue growth of 3%-4%

  • Human resource services growth of 9%-10%

  • Total service revenue growth of 5%-6%

  • Net income growth of 8%-9%

The forecast for the acceleration in payroll service growth is based on revenue per check rising for Paychex. This is thanks to price increases made to customers, rather than an improvement in the amount of checks per payroll. At this point, anyone would be inclined to ask whether it is worth paying 24 times current earnings for a business that is forecast to grow income by only 8%-9%.

One reason to make your answer "yes" is if you see some upside prospects to these forecasts. Paychex obviously has the potential to benefit if the economy does better. Furthermore, its management was keen to highlight the potential for its healthcare services to do well as companies grapple with regulatory changes. However, I think its most interesting upside driver could come from its technological investments.

Technology to the rescue?

In common with others in its industry, Paychex is making ongoing investments in software as a service (SaaS) offerings. The idea is to create an integrated management tool that allows its customers to use its human resource, employee management, and payroll services through one application. In fact, it’s such a good idea that ADP and Intuit have already been doing similarly.

I’ve discussed Intuit in more detail in an article linked here. Its recent results were disappointing, but that was mainly due to its core tax return business having a poor season. In fact, its small business group (which now makes up 35% of revenues) saw growth come in at 17% in the quarter. Its employment management services came in with 11% growth. Intuit is the poster boy for businesses shifting their offerings towards SaaS, and clearly, Paychex needs to embrace these industry changes.

With regards to Intuit, it will be a while before tax return season comes into investors' minds again. Provided it can keep up good growth in its small business group, I think Intuit's stock is well worth looking at.

ADP claims to be the "leading provider in the cloud" and is pushing its ADP Vantage HCM product. This product will integrate things like ADP’s human resource management, payroll services, and benefits administration. ADP described the products sales as "tracking very well against our expectations" in its latest conference call. Unfortunately Vantage is still a relatively small part of its sales, so investors can't expect too much of a contribution in the near term. ADP expects its employer services to grow at 7% this year, but is seeing its growth prospects held back due to its European exposure and ongoing low interest rates holding back investment income.

The bottom line

I think the main attraction of Paychex remains its dividend yield which currently stands at around 3.5%. By my calculations, it paid out nearly 83% of its free cash flow in dividends last year. Therefore, there isn’t much scope to aggressively grow dividends outside of bottom line growth, and, with income forecast to grow at 8%-9%, you shouldn’t expect too much of a dividend increase in future.

In conclusion, Paychex's commentary on the economy wasn’t great, but it is performing well in very competitive markets and has some upside drivers. On the other hand, there are others increasing investments in its core area of payroll services. On balance, it’s not a stock for me, because I don't chase dividends. But those looking for yield could do a lot worse than picking some up.

Wednesday, July 17, 2013

The Winners and Losers From Alcoa's Recent Earnings

Investors always like to look at Alcoa’s (NYSE: AA) earnings and use them as a guide to the rest of earnings season. In the latest second-quarter results, there were some surprising elements which deserve to be looked at in more detail. In this article, I want to examine Alcoa’s end market commentary and discuss the implications for some companies which you might be looking at.

Alcoa changes guidance, but not for China

I’ve tabulated the updated full-year guidance below. The green segments are where numbers were upgraded, and red is for the downgrades.

Probably the most surprising aspect of these results was that Alcoa didn’t reduce guidance in any of its end markets within China.  A number of companies have reported recently and cited specific weakness in the country. For example, FedEx recently spoke of global trade growing slower than global growth, Oracle cited weakness in China, and filtration company Pall (NYSE: PLL) delivered some disappointing numbers in its industrial filtration results.

Pall’s Chinese industrial sales were down 11% in the quarter. The company spoke of the ongoing changes in the Chinese economy and how they are forcing Pall to adjust its sales focus. In general, China is trying to shift towards more domestic consumption and reduce its dependency on export-led manufacturing.  This is presenting challenges to Pall, and given that nearly 60% of its industrial sales are in process technologies and 20% in microelectronics, it is likely to face some difficulties.

Aside from what companies are saying, China’s own economic data has been weaker recently, with the official Purchasing Managers’ Index registering 50.1 in June. A reading above 50 indicates growth, so clearly China’s manufacturing industry is not growing by much.  However, this is not the way that Alcoa sees it! Indeed, it actually cited Chinese demand for aluminum as remaining strong and kept its 11% demand growth forecast. 

The reason why Alcoa may be seeing relatively better conditions is because aerospace and automotives have been the standout performers within the industrial sector this year. Furthermore, beverage can packaging is relatively non-cyclical, and China’s heavy truck & trailer industry is benefiting this year from some regulatory changes. It looks like a case of good news for Alcoa, but not necessarily for the wider economy.

Winners and losers from Alcoa’s report

Aerospace and automotive have been strong this year for similar reasons. The U.S. consumer is starting to benefit from employment increases, and lenders are more willing to expand credit in the form of car loans. North American auto sales have been improving, while China’s remain strong.

Aerospace has been very solid, and the industry has the potential to outperform in a cyclical recovery because its dynamics have changed.  The need for austerity has forced governments to stop subsidizing national loss-making champions, and airlines are getting much better at dealing with high oil prices and outsourcing unnecessary work. The result is increased airline profitability driven by Asian passenger traffic.

This commentary will interest shareholders in a diversified industrial company like General Electric (NYSE: GE) or Ametek (NYSE: AME). Aviation is GE’s largest industrial profit generator, and it needs strength in aviation, transportation, and health care in order to offset some weaker performance in Europe (particularly within its power & water segment). Alcoa spoke of a 40% rebound in growth in its regional jet business and 12% for its business jet segment.  This is great news for GE, but, on a more worrying front, Alcoa also said that it anticipated a weaker demand from Europe for industrial gas turbines. It looks like GE’s weakness in power & water is set to continue, so this is a mixed report for GE.

However, it was a good report for Ametek shareholders. The company has heavy exposure to aerospace, particularly the business jet sector (Textron is a major customer). Ametek also has customers in the North American heavy truck & trailer market. Indeed, in its most recent results, Ametek had cited some softness in its power & industrial business, thanks to softness in the heavy truck market. My point here is that if Alcoa is talking about order rates being up, then this will surely feed through into Ametek in future quarters.

Other stocks worth considering for the aerospace theme are B/E Aerospace, Heico, and Precision Castparts. Finally, the heavy truck & trailer market seems stronger, so stocks like Cummins could see better prospects.

The bottom line

In conclusion, this was a pretty good report from an end-market-demand perspective. There were no downgrades to expectations over China, and if anything, the news on the aerospace and automotive sectors was a little better. There was even some positive news for the heavy truck & trailer market. Overall, it was a favorable report, but investors still need to remain selective about where they invest in the industrial sector, because the sub-sectors within it are reporting some varied performance.

Tuesday, July 16, 2013

ConAgra Foods Earnings Analysis

ConAgra Foods(NYSE: CAG) stands out as a winner in the food industry over the last few years. Its mix of value brands in the consumer division, expanding private label business and, a commercial foods division (which has been expanding profits strongly over the last few years) has stood it in good stead to deal with a challenging environment.

In summary, I think the company is well-positioned to do well, but a lot of its prospects depend on believing the management can execute successfully.

How ConAgra makes its money

I’ve broken out the recent fourth-quarter numbers, because private-label manufacturer Ralcorp hasn’t been part of ConAgra for a full year yet.

In order to properly reflect its performance ConAgra will change the way it reports by splitting the commercial foods division into a private-label segment (to reflect the addition of Ralcorp to its existing private-label business) and, a food service segment which will contain its Lamb Weston potato operations.

The three things its management needs to execute

The first question is it can continue to generate volume growth in its consumer foods division. ConAgra increased prices last year; in common with so many other companies in this slow economy, it then saw volume decreases. Consequently, it’s taken a while for ConAgra to get back to organic volume growth. Indeed, it only did so in the recent fourth-quarter results with a 3% gain. Overall, consumer foods sales were up 7%, with acquisitions contributing 5%.

ConAgra sees the organic sales growth as a turning point, but it has come at the expense of increasing advertising and promotion expenditure by 15%. Margins were up slightly thanks to strong cost savings which may not be repeated this year. This is fine but,note that the company has had to increase marketing costs in order to get volume growth. It is also spending more on supporting the launch of some new products in areas like desserts and frozen breakfasts. It is not a given that the new products will work and/or that operating margins won’t suffer next year thanks to increased marketing spending.

The second question relates to the Ralcorp acquisition. The good news was that It raised its synergy projections to $300 million by 2017, as opposed to the initial target of $225 million. Moreover Ralcorp’s profits were in line with expectations, but its sales performance was softer than ConAgra expects to see in the future. The subsequent restructuring activity was described as short term and fixable in the conference call.This is fine, but it still needs to be done.

Looking at the wider question of private label manufacturing I would issue caution. As investors in TreeHouse Foods (NYSE: THS) will tell you, manufacturing private-label foods can be a volatile business. Industry trends may be favorable right now, but Treehouse has had to deal with difficult conditions in recent years. Its customers' sales channels have changed along with the trend towards trading down.

Private-label companies are subject to the sales patterns of their customers, and while Treehouse is currently doing well with things like single-serve coffee and refrigerated dressings, it has also suffered before with categories like soup and pickles. It’s a business that requires a constant adjustment to the end market conditions of customers. Don’t be surprised if Ralcorp faces similar issues in future. Treehouse is on a forward PE of over 20 and is hardly cheap for such an uncertain business.

The third issue is that its commercial foods segment saw its potato operations (Lamb Weston) lose a major long-term customer. This will reduce EPS by $0.10 next year.The contract loss will also hit margins, but ConAgra expressed confidence that it would make up for it. Again, the management needs to deliver.

In addition, ConAgra talked of "short term challenges in Asia," which caused profits to decline for its potato operations for the quarter. Frankly, I don’t believe in coincidences, and anyone looking at McCormick’s (NYSE: MKC) latest results would note that it reported weakness from its quick service restaurant customers in both China and the Americas. Yum! Brands is a major customer of McCormick and much of its problems are company specific but the truth is that it’s Chinese same store sales growth has been falling since the first quarter of 2012.

In addition McCormick’s industrial growth has been negative for the last two quarters. Is this a short term issue or is it a deeper one relating to slowing quick-service restaurant sales growth? These types of restaurants are major customers of ConAgra's potato operations.

The bottom line

In conclusion, I think these three concerns require you to express a fair amount of confidence in the management to execute over the next year. This might be okay if the stock traded on a more attractive valuation. A forward PE of around 13 may look attractive, but recall that the company has to pay off significant amounts of debt.

Looking at these companies' current enterprise values (EV) in relation to their earnings before interest, depreciation and amortization (EBITDA) reveals that none of them are cheap. The measure helps to account for debt levels in evaluating a stock.

CAG EV / EBITDA TTM data by YCharts

ConAgra is the most expensive of the three companies above, and it's not cheap enough to compensate for the execution risk. It's a stock for the monitor list. The market may be in love with food stocks, but there is no excuse for not sticking to your valuation principles.

McCormick's Evaluation is Looking a bit Rich

There is a lot to like about the long-term prospects for spice and seasoning company McCormick (NYSE: MKC)Consumers are demanding ever more flavor in their cooking, and food companies are being forced to innovate by using flavorings in order to compete in difficult end markets. With these positive trends in place, the company is doing well. But what of its near-term prospects? Moreover, is the stock good value right now?

McCormick delivers mixed results

It was an underwhelming set of second-quarter (Q2) results for McCormick, as reported sales rose a paltry 2%. Its top line growth has been slowing in recent quarters as it laps some difficult comparables. In addition, Yum! Brands (NYSE: YUM), is one of its major clients and it's having some well documented difficulties in China with its KFC stores. First it was a scare over its chicken suppliers, and now it has to deal with fears over bird flu. The issue is hurting Yum!, and McCormick's industrial sales are being hit because it supplies spices and seasonings to KFC.

I’ve broken out the progression of McCormick's divisional sales growth below.

The problems in the industrial division aren’t just about quick-service restaurants in China, because McCormick's industrial sales in the Americas declined 1%. McCormick cited strength in its snack seasonings and food flavorings, but it wasn’t enough to offset declines in demand from quick service restaurants in the Americas. The eating out category has faced some weaker growth and, the areas that are growing within it are not favoring McCormick.

All of which is not to be too negative on the stock because it’s the consumer side that makes the majority of profits. And it is still doing quite well.

A breakout of Q2 operating income here.

Consumer segment sales grew 5% in constant currency. Within developed markets, McCormick is benefiting from a increased willingness among consumers to eat at home and, to utilize more flavors in their cooking. The latter trend is also being driven by an increasingly ethnically diverse population in many developed countries.

Within emerging markets, McCormick is seeing good results via a mix of organic and acquisition-led growth. For example, in India its acquisition of spice company Kohinoor is giving McCormick long-term opportunities in an important growth market. India makes up less that 5% of sales, so there is plenty of scale for this figure to increase in future years. Similarly, the WAPC acquisition in China is believed to bring its Chinese sales up to 7% of the company total.

Two concerns

The first relates to the disappointing performance within China and the Americas on the industrial side. The hope with Yum! is that it will be able to recover from its company specific issues but I think there might be some macro factors at play here too. Yum! Brands' same-store sales in China were getting weaker even before the media scare stories and bird flu worries hit.

It was a similar story with McDonald’s (NYSE: MCD).

The outlook for the quick service restaurant sector is important to McCormick, since much of its industrial demand goes to this industry. The signs are that it is not just a Yum! issue. McDonalds’s could be facing a tough year this year, and Yum! investors need to take note.

McDonald’s management was very clear on its last earnings call that it intends to retain and even grow market share. This as a sign that it will be willing to sacrifice margins and cash flow in order to secure long term positioning. McDonald's and Yum! are likely to increase competitive efforts in North America in order to try and make up weakness elsewhere. McCormick investors will be hoping that Yum! wins out.

The second concern is that even though the consumer division is doing well, its growth is still slowing. The company announced it was increasing incremental marketing on its consumer brands to $15 million but, it did not raise revenue expectations. The weakness on the industrial side is increasing the pressure on the consumer side.Is this marketing increase a sign that it is having to work harder to hit its numbers?

The bottom line

I don’t want to appear too negative here, because this company has plenty of good long-term drivers, and its acquisition strategy makes perfect sense. However, if you are going to add this stock to your portfolio, you will need to assess it on a risk/reward basis. This is a stock that trades at 22 times its November 2013 earnings, which looks pricey when compared to International Flavors & Fragrances' forward PE of nearly 18, and German rival Symrise at 20 estimated 2013 earnings.

McCormick is hardly cheap, and its underlying growth is slowing while its end-market customers (on the industrial side) are facing some difficult market conditions. This stock is worth monitoring for a long-term buy, but an entry point might only come should it miss estimates this year.

Sunday, July 14, 2013

Bed, Bath & Beyond and Beyond

With the housing market seemingly at the start of a multi-year recovery, the market has been keen to bid up any stock related to the sector. Usually this is for good reason, because the earnings outlook is improving for these companies. However, in the case of homeware retailer Bed Bath & Beyond (NASDAQ: BBBY), I think the market is giving it the benefit of the doubt over the prospects for its restructuring, acquisition and expansion strategy. The stock is already up 26% this year. How much further can it run without definitive evidence of success?

A special situations play

Going into this year, BB&B was challenged to adequately integrate its World Markets and Linen Holdings acquisitions, restore same-store sales growth and margins, and successfully continue is store expansion plans.

It needs to do these things because It has been suffering from margin contraction as its sales mix has been shifting towards lower margin item sales. Meanwhile, its acquisitions have increased selling, general, and administration (SG&A) costs.

Here's a graphical representation of how its margins have moved in the last few years:

Source: Company financial statements.

Readers will note that there wasn’t much improvement in the recent quarter.

Latest scorecard from the Q1 results

The bad news in the quarter was that the acquisitions continued to increase SG&A costs by 100 basis points, while gross margins declined thanks to increases in couponing and redemptions. Meanwhile, sales have continued to drift toward lower-margin categories.

The good news was that same-store sales increased by a healthier 3.4%. This was put down to an increase in transactions and transaction amounts. While this is a good sign – and Q1 was a difficult retail environment -- I can’t help but remark that it should be able to sell more items if it is offering more coupons. Unfortunately, the drive to increase sales is coming at the expense of margins. Furthermore, its guidance of 2%-4% same-store-sales growth for Q2 and the full year was nothing to write home about.

So the acquisition integration appears to be holding back margins, but the company hasn't slowed down its expansion plans. In fact, store space (including acquisitions) increased by 16% for the year, and capital expenditures for 2013 are forecast to increase to $350 million in 2013 from $315 million last year.

The company plans the number of new stores opened in 2013 to be in the "mid thirties," although the management gave notice that it would update investors in the final figure as the year progresses.  And finally, a significant amount of investment is being made to upgrade Bed Bath & Beyond's websites and e-commerce facilities in order to drive multichannel sales. Will it all work?

The benefit of the doubt?

Are investors being too keen to cut the company slack over its performance and prospects?  It’s not hard to see why they would, because so much has being going right for this subsector of retail in 2013.

On the other hand, each company must be judged on its own merits. For example companies like Williams-Sonoma (NYSE: WSM) and Pier 1 Imports (NYSE: PIR) have done very well by increasing their multichannel sales efforts. But they are way ahead of where Bed Bath & Beyond is right now.

Williams-Sonoma is trying to increase its Direct to Consumer (Dtc) revenues (things like catalogue and online sales) because they tend to fetch higher margins than selling through retail and wholesale channels. Indeed, its DtC-based revenues rose to 22.9% of total revenues from 20.8% last year. This helped its operating margins rise by 60 basis points in the last quarter. Similarly, Williams-Sonoma is engaging in a program of opening new stores and expanding existing ones -- albeit mostly abroad. It's also increasing capital expenditure plans this year to $200 million-$220 million, this year, compared to $205 million last year.

The difference is that Williams-Sonoma is firing on all cylinders. It is expanding margins and demonstrating success with its expansion plans, and it generated 7.2% overall growth in its comparable brand revenue.  This is a far cry from Bed Bath & Beyond’s 3.4% same-store sales growth.

As for Pier 1 Imports, it recently reported comparable store sales growth of 5.9% and has just reached the anniversary of its e-commerce enabled site. It has seen its e-commerce contributions to total revenue make ‘progressive increases’ since their launch (even though investors will have to wait until Q1 2015 for a breakout of its comparable-sales calculation for DtC sales), and it is investing heavily in that effort as an integral part of its plans.

Pier 1’s strategy is to arrange for in-store pick up capability (customers seem to use this extensively), and it's rolling out an in store point of sales system (90% of its stores are already operating it). Pier 1 grew its overall sales by 9.3% in the quarter. Again, this company is executing very well within a favorable end market. Furthermore, note that Pier 1 is well ahead of Bed, Bath & Beyond with its online plans.

Where next for Bed Bath & Beyond?

Of course, what BB&B does have going for it is its valuation. On these grounds it compares quite favorably with the two other companies mentioned in this article.

BBBY PE Ratio TTM data by YCharts

Moreover, if it hits analyst estimates for $5.02 in EPS it will trade on a forward PE ratio of around 14.4 as I write.

Ultimately, an investment decision here is going to depend on your level of belief in the successful execution of the plans outlined above and an ongoing belief in the housing market recovery. The company will see better end market conditions thanks to an improving market, but I don't think that is enough of a reason to buy the stock.

Moreover, If the the housing market stalls, then this stock’s prospects will be called into question. There are always risks with expansion plans, not least from a company that has been seeing margins falling and lackluster same-store sales growth. Sentiment will likely take the stock higher, but I think the company needs to demonstrate better underlying performance before justifying buying in at this level.

Saturday, July 13, 2013

Acuity Brands Looks Fully Valued

North America's leading lighting company, Acuity Brands (NYSE: AYI), delivered another good set of results for its recent third quarter, and spoke about its markets picking up.The stock offers a ‘back door’ way to play the increasing usage of LEDs in lighting solutions.If you like the construction industry and energy-efficient lighting, then Acuity could be a stock for you. Its prospects look positive, but is that enough to justify its lofty valuation?

Acuity Brands' secular growth drivers

The decreasing cost (per lumen) of LEDs means that Acuity can generate growth from LED lighting replacing conventional lighting. Margins on LED lighting are similar to conventional bulbs, but Acuity argues that it sells controls with virtually all its LED lights. Lighting controls are an essential part of the value proposition because, they help to increase the efficiency of lighting solutions.

The good news is that this is driving sales growth. Its net sales were up 11% in the third quarter, as opposed to the ‘low single digit growth rates’ that it claims its markets are growing at. The ‘bad’ news is that volumes grew by 14%. The discrepancy is due to lower prices of LED components and an unfavorable product mix. Essentially, Acuity is providing relatively more solutions to lower margin renovation work because large scale new construction hasn’t kicked in yet thanks to the slow economy.

Acuity's LED-based revenue is now at 20% of its total, from 15% and 13% in the previous two quarters. This is a powerful trend.

For example, a company like Cree (NASDAQ: CREE) is more of a pure LED play than Acuity. It offers a vertically integrated way to play growth in LEDs. Lighting looks set to be the primary driver of the next upswing in the LED cycle. Cree’s own lighting division managed to increase sales by 6% in the last quarter, even with unseasonal weather negatively affecting outdoor lighting sales.

Cree’s lighting products gross margins are at 30.6%, while Acuity’s numbers are at a more impressive 40.8%. Acuity has a more mature sales operation, while Cree uses sales agents. Nevertheless, Cree appears to have the opportunity to improve its lighting products margins going forward. Cree’s lighting product revenues currently represent nearly 38% of its total, so the opportunity is significant.

Cyclical growth drivers

Acuity can see cyclical growth in two ways. The first is from a general pickup in construction activity, and the second is through margin expansion, as more profitable activity like large-scale new construction takes place. Historically speaking, the former usually entails the latter.

In addition, investors need to appreciate that lighting is one of last phases of construction, so a natural time lag exists between general activity and orders coming in for lighting.

All eyes will be fixed on construction indicators such as the Architectural Billings Index (ABI) from the American Institute of Architects. It has been unusually volatile lately.

One explanation for this is the late spring this year, plus delays over worries with issues like the sequester and payroll taxes.

Moreover there are some peculiar recent dynamics which can be seen in the ABI data.

The recent weakness in the commercial/industrial (C & I) sector is concerning because it’s Acuity’s strongest end market. The hope is that new residential construction will feed into new C & I construction as infrastructure is built up around the new housing.Unfortunately, it hasn't happened yet.

Other companies have talked of weakness. Regal Beloit (NYSE: RBC) revealed a shocker of an earnings announcement at the end of April. The company makes the kinds of motors used in heating, ventilation and air conditioning systems.

Regal lost a major contract when a customer decided to source components from a third party (rather than buy from Regal Beloit and manufacture themselves) and, overall its commentary on its C & I markets was poor. Guidance was lowered and, the strength that it had seen in January fell away through the quarter. The ABI data has weakened since then so it's anybody’s guess what it will say in its next set of results. On the other hand, it's cheap on a cash flow basis and, this could be a decent entry point.

The bottom line

In conclusion, you need to believe in both these drivers to want to buy Acuity at this level. While secular growth looks assured, it is far from clear that the cyclical growth is. On a trailing PE ratio of nearly 32, compared to its smaller rival Hubbell at 20, the stock is not cheap. I share some of the optimism over this company, but a strong and sustained recovery in the C & I market is not a "done deal."  That makes Acuity one for the monitor list.

Tuesday, July 9, 2013

Ametek Offers Aerospace Upside

It’s been a mixed earnings season for industrial-based stocks and Ametek’s (NYSE: AME) last set of results provided a pretty good microcosm of what has been going on. In short, companies with heavy exposure to industries like automotive and aerospace have done well, while almost everything else has found things difficult. So what makes Ametek interesting and what can we read across for other companies?

Ametek generates growth across the cycle

The company is attractive for a few reasons. Firstly although it is not a pure-play aerospace company, it has heavy exposure and as the industry is looking set for good long-cycle growth, it has good prospects. Secondly, Ametek has long been a company categorized by its management’s ability to make earnings-enhancing acquisitions without damaging its return on invested capital (ROIC).

As the chart indicates, Ametek has done a pretty good job of consistently generating ROIC even when market conditions are not great. An acquisition-led growth strategy does have its advantages and disadvantages. On the plus side, the company can carry on generating growth by getting companies cheaper in the downswing (and benefiting from the hopeful upswing in the economy); but on the downside its management will be under pressure to make the right acquisitions. And making the wrong decision can occur irrespective of where the economy is positioned.

Recent results

The good news is that Ametek’s management has a strong track record in this regard and acquisitions are a key part of the focus for 2013 as well. Even in the latest Q1 results we saw organic sales decline 2% but acquisitions contribute 9% and –even in a weaker environment for aerospace- its sales were up 7%.

As ever with this type of company, cost management and lean manufacturing will be a strong focus. Indeed cost reductions were made in the quarter, without which, EPS would have been up 18%. There was good news on the cost-cutting front with estimates for total full-year savings rising to $95 million from $85 million previously. Operating cash flow rose 11% and full-year EPS guidance was raised at the low end to imply 11% to 13% growth. Moreover the commentary on linearity was positive with April cited as looking ‘good’. Like many in the industrial sector it saw some weakness in March.

Industry background

As usual with earnings season, Alcoa (NYSE: AA) tends to set the tone for the industrials. A brief look at the conclusions from its earnings reveals that areas like aerospace and automotive remain relatively positive. Europe remains weak on the whole and the heavy truck and trailer market is experiencing a sharp slowdown. Moreover much of Alcoa’s growth is predicated on stronger conditions in China. The surprising thing was that Alcoa did not alter its full-year end-demand outlook by much even though the consensus is that Q1 did get weaker overall for industrials.

Alcoa’s trends were confirmed by Ametek when it discussed some softness in its power and industrial business created by the North American heavy truck market, so no surprises there. Furthermore within its process business segment the strongest performer was oil and gas while metals analysis revenue was relatively weaker.

The key strength in the business was from aerospace. Its electronic instruments group (EIG) saw aerospace (commercial, business and regional jets) revenue rise by low double digits and growth is expected to remain solid for the rest of the year inline with build-out rates at Boeing and Airbus. Overall EIG sales were up 3%.

It was a similar story in the other segment. The electromechanical group (EMG) saw its differentiated business sales up in the mid-teens with particular strength cited in its aerospace maintenance, repair and overhaul (MRO) operations.  However, overall sales for EMG only rose 3% thanks to a 14% contribution from acquisitions.

Which stocks read across well?

Frankly I think investors should try and stick to the themes that are working well and try and find value in them. If aerospace and automotives are doing well and companies like Alcoa and Ametek are confirming this, then why not stick to the idea? Three names that I like are Heico (NYSE: HEI), Precision Castparts (NYSE: PCP) and PPG Industries (NYSE: PPG).

Heico recently reported strong results and the business clearly has good long term prospects from helping airlines to try and reduce costs by outsourcing flight support activities. Even though Heico argued that its success in the quarter (its flight support group saw sales and income rise 10% and 14%, respectively) was largely a consequence of internal execution rather than industry growth, I think that there are enough positive signs within its performance to suggest further growth this year.

Its space-related sales may well be variable and its defense sales will be subject to sequestration effects so now may not be the best time to buy into the stock. But if you can tolerate these fears, the stock is attractive.

Precision Castparts is attractive because of its heavy exposure to commercial aerospace (75% of its market) and its opportunities to generate synergies from its acquisitions. In addition, it is ramping up production in order to meet demand from Boeing on the 737 and 787.

My one concern with this company is the cyclicality of its cash flows. The aerospace industry is cyclical but there is evidence to suggest that it is likely to experience better conditions in this cycle. However companies like Precision Castparts always need to make significant capital expenditures in order to service demand.

This is great when demand is good but it leaves them exposed should demand start to weaken. You can make the argument for making an evaluation based on assessing its long-term earnings or cash flow performance but in reality I think the market just trades these stocks based on momentum.

My favored play on this theme would be PPG Industries. The company has good exposure to aerospace and automotive and its purchase of Akzo Nobel’s US household paints operation is timely. Costs appear to be moderating and it has some cost synergies coming from the acquisition. Margins are expanding thanks to its restructuring efforts (such as selling some of its commodity-based businesses) and its cash flow generation remains very strong.

Meanwhile the recent court order over the Pittsburgh Corning (a joint venture with Corning) has somewhat de-risked the stock from uncertainty over future asbestos claims. Earnings growth is being held back this year thanks to some of the issues discussed above but, this is a business which has generated an average $1.1 billion in free cash flow over the last three years and trades on an EV/Ebitda multiple of 9.5x. Looks like good value to me.

Where next for Ametek?

This is an impressive company and a real ‘go to’ option for a pick in the industrial sector. Unfortunately its trailing PE of around 22x plus its EV/Ebitda multiple of 13.1x suggest it is largely pricing in the good news. It’s well worth monitoring and hoping for a dip because $42 looks like a fair price for the stock. Given any kind of market retraction it's worth a close look. 

Monday, July 8, 2013

The Pressure is Bulding on Nike

Nike (NYSE: NKE) is one of those companies whose results will interest the whole of the retail industry as well as its own shareholders.  And given its recent results there are many things to consider. It’s a story of strong execution in North America and with footwear in particular. However, its European markets remain weak and China is displaying the kind of softness that others are seeing.

In summary, Nike's prospects are reliant upon continued success within its North American operations and the belief that it will turn around its performance in China. If either of these things fail then the stock's evaluation will start to look a little stretched. The stock may have some good near-term upside drivers, but I think it also has downside risk and this article will explain why.

Nike triumphs in North America

In order to illustrate the importance of the performance of its North American operations I’ve broken out its quarterly earnings before interest and taxes (EBIT) below.

Indeed over the course of this graph, its North American segment has increased its contribution to overall segmental EBIT from 44.3% to 48.6%. Meanwhile China (traditionally its highest margin market) has disappointed and the only other regions to be at a high watermark are emerging markets and the CEE.

Moreover in terms of categories, footwear contributes two thirds of its North American revenues and the growth outside North America is largely coming from footwear.

Clearly the strong performance over the last years is thanks to North America and footwear globally. Part of this is – no doubt- due to the success of sponsorship deals with established stars in sports like basketball and running. Another favorable aspect is the trend towards casual footwear.

The last point is an industry trend that shouldn’t be underestimated. For example a company like V.F. Corp (NYSE: VFC) has some strong outdoor activity brands such as The North Face, Vans and Timberland. All three of these brands contain a strong superficial appeal to consumers but, not necessarily from those that do actually undertake mountaineering, hiking or skate boarding! People will buy the products just to be associated with these sports (and the lifestyle) even if they don't do them so -almost bizarrely- marketing efforts must focus on promoting these activities.

Growth opportunities

Aside from ongoing execution in North America, there are three main near-term growth opportunities.

Firstly, not only is Nike getting its marketing right but its multi-channel efforts are bearing fruit too. Direct to consumer (DtC) sales in North America increased 20% to $2.5 billion for the year while e-commerce sales up were up 30%. Again this sort of growth is in line with industry trends. For example, V.F. Corp is also investing in its DtC facilities in order to increase its share of revenues from 21% in 2012 to 23% in 2013. Overall Nike’s DtC revenues grew 24% (at constant currency) and now make up nearly 19% of total revenues. In a sluggish global economy I would expect more emphasis to be placed on this secular trend.

The second near-term catalyst will come from next year’s soccer World Cup in Brazil. Soccer gear only makes up 9.2% of total revenues but it is a strong category in emerging markets (which grew 19% last year) and a World Cup in Brazil (Nike sponsors the Brazilian team) will obviously have added allure. Nike should be able to generate revenue growth in strategically important markets.

The third catalyst could be a pick-up in performance in China. As ever investors will consider whether this is a macro or company-specific issue. On the macro side, even though Nike said that conditions hadn’t changed over the last quarter I note that V.F.Corp and others have been performing relatively weaker in China. Elsewhere there are signs that China is experiencing less rapid growth in its business sector then many may have hoped. Is this feeding through into the consumer?  On the company specific side, Nike has been undertaking concerted efforts to increase sales efficiency in China for a few quarters now.

The company is taking a long-term view over China, but for the very near term it expects Chinese revenues in the first half of its 2014 to be lower than last year and its future orders are flat on last year too. Any weakening in the Chinese economy will hurt Nike as the country currently provides nearly 22% of segment EBIT.

Where next for Nike?

Nike’s future orders indicate growth of 12% for North America and emerging markets, respectively, while Western Europe and China future growth is at 0%.This pretty much defines where the near-term growth will come from.

Analysts have low teens earnings growth penciled in for the next two years. I would argue that the stock is close to 'fair value'  as it is currently generating 4.7% of its enterprise value in free cash flow.This suggests that the best its stock price can do is to return its earnings growth over the next few years. There is nothing wrong with this because low teens stock returns are fine for most people. On the other hand these earnings prospects will rely on the issues discussed above. An increasing reliance on North America and footwear could place pressure on its performance whereas a stock like V.F. Corp has a wider and more diverse range of brands.

By way of comparison V.F. Corp registered mid-single digit declines with Timberland in Europe (its strongest market) but was able to offset this by generating an incredible 30% increase in Vans sales in the region. Moreover it increased its global DtC revenues for The North Face and Vans by 25% and 20% respectively. Clearly the company has more opportunity to shift emphasis onto brands/geographies that are working and it also trades on an evaluation discount to Nike. V.F.Corp trades on 18x this years earnings while Nike trades at nearly 21 times earnings to next May.

In addition from a historical perspective Nike isn’t particularly cheap.

NKE Price to Earnings Less Cash TTM data by YCharts

In conclusion, the stock isn’t really a value prospect but more of a growth at reasonable price proposition. Ultimately an investment decision will be based on how you view its ongoing growth prospects. So with a degree of uncertainty over China at the moment I think cautious investors would do well to wait for confirmation of better conditions there before buying in here. Its evaluation leaves little room for error.

Friday, July 5, 2013

Oracle's Results Reveal Tech Weakness

The last thing the tech market needed right now was a disappointing set of earnings from Oracle (NASDAQ: ORCL), but unfortunately that is exactly what it got. It would be an understatement to say that it has been a difficult 2013 so far for the tech industry and these numbers will do little to assuage many fears. But what do they mean for Oracle and how do they relate to the rest of the tech world?

Oracle disappoints, again

Looking back at an analysis of the previous quarter’s earnings Oracle missed its own guidance and this quarter saw some key numbers coming in at the low end. For example Oracle had forecast 1-4% overall revenue growth (they came in at 2% in constant currency), new software license and cloud subscription growth was forecast to come in with 1-11% growth (the result was 2% growth). The one ‘bright’ spot was that hardware systems product growth was forecast to be negative 12-22% and came in at the high end with a negative 12%.

Clearly the numbers came in towards the bottom of the guidance ranges. All of which is somewhat disappointing given that many investors have been hoping for a second quarter (2Q)  bounce back. Last time around Oracle blamed some sales execution issues and the timing of the sequester. However it calmed investors by describing its pipeline as being up and, claimed that the issue was really about the timing and execution of deal closure.

Well it was a different story this time around with sales execution quoted as improving ‘significantly’ and economic weakness cited in a few areas like Brazil, China and Australia. Moreover, transaction sizes were described as being smaller (a sign of economic pressure).

The good news from a geographic perspective was that its US and EMEA performance were as expected with 4% and 5% new license growth respectively. The problem was with Asia-Pacific down 7%. This is a worrying sign for the industry because many technology companies are relying on Asia for growth.

What the industry is saying

As a bellwether Oracle’s results will be closely watched and those of us hoping for some sort of confirmation of a return to better days would have been disappointed. In a sense it is a mere continuation of what we have been seeing elsewhere. For example, Palo Alto Networks (NYSE: PANW) recently reported results. It missed estimates and guided lower than the market consensus for the next quarter. Although Palo Alto is in a different area (IT security), I found its results interesting because other companies in the sector had previously reported weakness in April. Unfortunately Palo Alto came out and confirmed that conditions in May were only ‘in line’ with the reduced expectations created by a weak April. Another indication of weakness and it appears to be linear.

One interesting aspect of Palo Alto is that its telco service provider revenues do not make up a significant part of its revenues. This is in contrast with other tech companies like say F5 Networks and Fortinet. These companies missed estimates and disappointed with guidance. Both cited weakness in their service provider verticals and this may well continue into the current quarter. On the other hand Palo Alto's results are more indicative of the wider tech spending environment and investors will need to hear some more positive noises from bellwethers like IBM and Oracle before feeling very confident with Palo Alto.

Moreover Oracle is facing some operational challenges as it shifts revenues towards cloud-based solutions. It described its SaaS (software as a service) based revenues as having a $1 billion run rate. This is fine but to put it into context its full year revenues are closer to $37 billion. In addition some cloud-based companies like Rackspace Hosting (NYSE: RAX) have reported some weakness as enterprises still seem keen to use any excuse to withhold IT spending. In fact in its last quarter it declared that its revenue per server declined to $1,308 from $1,310 last year. This is not a good sign for a company supposed to be in a high growth phase. In Rackspace’s case it was partly due to customers delaying purchases of legacy systems while they appraised its new OpenStack public cloud offering. Rackspace also has increasing competition from the likes of Amazon Web Services (who has been cutting prices) and I take this to be another sign that conditions have weakened in technology in 2013.

With regards to Oracle’s direct competitors like IBM (NYSE: IBM) and SAP (NYSE: SAP), these results are obviously not great news and they got marked down in sympathy. Moreover Larry Ellison was quite candid on his view that SAP’s Hana database was ‘virtually never’ seen in the market and even referenced some large German industrial companies that had bought Oracle’s rival Exadata database machine in order to run SAP’s applications. He also suggested that Hana could never successfully compete with Exadata. Frankly there is no love lost between SAP and Oracle, even when it comes to yachting, and this sort of comment has been heard before. Moreover I think SAP’s investors can take some heart from the fact that EMEA (its core market) was a bit stronger than expected for Oracle.

As for IBM, Oracle’s report was a bit worrying. It pretty much reported a similar story to Oracle last time around by blaming things like sales execution, the sequester, the weather and even the change in the Chinese Government. Will it do the same this time? It’s hard to tell but IBM didn’t lower its full-year forecast last time around and announced it would take some workflow rebalancing in Q2. All of which will put some pressure on it to deliver in the current quarter. As for the issue with the Chinese Government, did we see signs of this in the weak results that Oracle just reported?

Where next for Oracle?

The positives in this report were that the transition to new hardware product systems is going a bit better than expected and the US and Europe are doing okay. In a sense it is another story of current macro weakness amidst ongoing change in Oracle’s business as it shifts to cloud based solutions and new hardware products.

In the last quarter it made sense to pick up some Oracle stock after disappointing results and I wouldn’t be surprised if the same applies this time too. The stock trades on an enterprise value to EBITDA multiple of just 7.4 and generates huge amounts of cash flow that currently represent over 10% of its enterprise value. On a value basis the stock looks cheap and I wouldn't be surprised to see Oracle increasing its returns to shareholders in future. It looks a good long term hold but be prepared for volatility as the tech spending environment still looks a little weak this year.