Thursday, October 31, 2013

IBM Needs to Deliver

There are two key conclusions to be drawn from International Business Machines' (NYSE: IBM  ) recent results. First, for the third quarter running, they were disappointing, and second, the stock is still cheap. Growth-oriented investors probably won't be turned on by such considerations, but value-based speculators may see IBM as too good to pass up.

IBM disappoints, but reaffirms targets
To put these results in context, here is a graph of its major business segments.

Source: company accounts.

Clearly, the last six quarters have been difficult for revenue growth. However, it is understandable because IBM's focus has been on exiting lower-margin businesses and focusing on reshaping the business toward higher-margin software and services sales. Moreover, its stated aim is to hit $16.90 in non-GAAP adjusted EPS for 2013, and ultimately hit $20 in EPS by 2015. Eagle-eyed readers will note that these earnings would put IBM on P/E of 10.2 and 8.8 times its 2013 and 2015 forecasts, respectively. Since management reinstated these targets, should investors just ignore the falling revenue and buy a cheap stock?

Believing the numbers
Ultimately, your decision will boil down to how much you believe in the numbers. The latest evidence suggests that the underlying picture is getting murky.

  • Diluted EPS rose 10.5% in the quarter, but pre-tax income actually fell 5.2%. The difference is due to a large reduction in the tax rate.

  • Buybacks played a part, too. If you assume that the tax rate and share count remained constant, IBM's EPS actually fell 5.2% for the quarter.

  • Last quarter, IBM predicted low single-digit growth for its global technology services, or GTS, but they came in at -1% on constant currency basis.

  • Last quarter's weakness in the BRICs continued, with Chinese sales down 22% (with hardware sales falling 40%) and they are not expected to grow again until the first quarter of 2014.

  • The weakness in software continues, with sales up just 2% in constant currency. Indeed, last quarter's strength was arguably due to rollover deals that were delayed from the first quarter.

In fact, the only segment that really performed well was its global business services segment, or GBS, which delivered constant currency sales growth of 5%. This was in-line with IBM's forecast of mid single-digit growth.

All told, this was a weak quarter for IBM. In common with its major rival, Oracle (NYSE: ORCL  ) , IBM reported good growth in business analytics (up 8% year-to-date) and proudly trumpeted that it delivered $1 billion of cloud revenue in the quarter.However, cloud revenue only represents 4.2% of total sales, and the strength in business analytics highlights the fact that there is growth in IT spending, just not in the areas where IBM gets most of its revenue.Trends in software spending clearly favor software as a service companies like (NYSE: CRM  ) .

Comparing IBM with Oracle
The analogy with Oracle is a strong one. Both are highly cash-generative tech giants with cheap valuations. Both are facing some structural challenges to their hardware offerings due to an increasing willingness among firms to outsource technology infrastructure to the cloud. As usage of software as a service, or SaaS, increases, hardware margins could come under pressure for IBM and Oracle because corporations will not need to buy hardware systems to run their on-premise on-license software. In their defense, IBM and Oracle are trying to migrate toward cloud-based solutions, but it's going to take time to work through the pressures on their existing sales.

However, there is one key difference between the two companies. IBM has set its stall out to achieve the $20 EPS target in 2015, while Oracle has much more flexibility to adjust to changing market conditions. It's good for IBM to laud the $8 billion it used to make buybacks (and there is still $5.6 billion remaining in buyback authorization), but investors surely wouldn't want the company to rack up debt just to hit the $20 EPS target. Moreover, IBM may be using resources that it could instead use to make strategic investments in growth opportunities.

How the deal demonstrates Oracle's flexibility
IBM's net debt stands at nearly $27 billion (14.3% of its market cap),  while Oracle has $15.2 billion (10.1% of its market cap) in net cash and liquid instruments.  Simply put, Oracle is in a better financial position to make the kind of game-changing acquisitions that can help accelerate SaaS-based growth.

Moreover, with its recent strategic partnership with, Oracle is demonstrating its willingness to work with a former rival. With Oracle now integrating into its infrastructure, its mutual customers should benefit from being able to use Oracle infrastructure to run's CRM applications, while also using Oracle's financial and HR applications. The deal should provide synergy for both companies.

The bottom line
Cost-cutting, buybacks, and foregoing revenue growth at the expense of profit growth are noteworthy. However, IBM is going to need a couple of solid quarters in order to convince the market that its long-term earnings objectives aren't affecting the way it reacts to changing market conditions. This is the third quarter in a row in which IBM has given disappointing results, and the company is running out of excuses.

Wednesday, October 30, 2013

Check Point Software Pounds Out Yardage

IT security company Check Point Software's (NASDAQ: CHKP  ) latest results confirmed a return to form, thanks to its product sales growth finally turning positive after three quarters of declines. However, they also highlighted how competitive its end markets are. With its revenue growth having slowed to low-single digits, this company is now firmly in the mature cash-cow phase of its evolution. Is there a case to be made for buying the stock?

Check Point maturing in a tough market

The IT security market has unquestionably gotten tougher over the last few years. As the incumbent leader in the market, Check Point has had to deal with encroaching competition from the likes of Palo Alto Networks (NYSE: PANW  ) and Fortinet (NASDAQ: FTNT  ) . Palo Alto, a company founded by an ex-Check Point employee, has stepped up competition with Check Point in the high-end firewall market. Meanwhile, Fortinet, a company whose traditional strength lies in the small and medium-sized business market, has been successful in increasing its deal size as it becomes increasingly relevant to larger corporations.

Consequently, Check Point has been squeezed at both ends, and its growth has slowed accordingly. The latest third-quarter results saw revenue growth at just 3.5% and the guidance for fourth-quarter revenues of $365 million to $395 million implies growth of just 3.1% at the mid-point.

Source: company accounts

5 reasons to be optimistic

A tech stock with low revenue growth isn't usually seen as an attractive proposition by the market. However, in Check Point's case there are four key positives from its third-quarter report.

First, product growth finally turned positive again.

Source: company accounts

Even though Check Point tends to bundle its software blades with its hardware products (so the hardware/software split is somewhat inexact), the return to product sales growth is still a good indicator because it suggests the installed base is increasing. In other words, Check Point should be able to sell add-on software blades in future to its new hardware customers.

Second, the company has successfully opened up new markets. Its new low-end 600 and 1100 series (aimed at the SMB market where Fortinet is strong) saw sales grow 40%. In addition, its high-end data center based sales (the 13500 and 21000 series) performed extremely well this quarter with healthy growth.

Third, its underlying metrics have improved. When Check Point takes a customer on board it books revenues for the products, and also bills for the full service contract. The service revenues are then recognized incrementally as the work is done. Therefore, investors should look at revenues and the change in deferred revenues to better gauge how it is performing.

For the first time in a year this metric turned positive.

Source: company accounts, and author's analysis

The final point is that its guidance of $365 million to $395 million looks a little conservative. At the mid-point it represents just 10.4% sequential growth when the last five years have averaged 13.7% sequential growth.

Where next for Check Point Software?

Palo Alto Networks gave results in September and they also confirmed that the security market remained healthy by predicting that next quarter's growth would be 37% to 42% on a yearly basis. Meanwhile, analysts have Check Point on low to mid-single digit revenue growth rates for the next few years, with EPS growing around 7.3% next year.

By my calculations Check Point has just generated $925 million in free cash flow (representing around 9% of its enterprise value) and this holds the key to its future. With over $1.2 billion in net cash , it has plenty of options in terms of initiating return cash to shareholders (dividends or more buybacks) or making growth enhancing acquisitions or investments. I suspect that with any of these initiatives in place, the stock will be rerated. However, it's one thing to hope something will happen, and it's another to see it.

In conclusion, Check Point looks undervalued and its underlying trading performance has improved, but you get the feeling its management could do more.

Monday, October 28, 2013

PPG Industries is One of the Best Positioned Stocks in the Industrial Sector

It's easy to think that industrial stocks slavishly follow GDP growth or some general measure of industrial output. In many cases, that assumption proves correct. However, sometimes there are companies whose specific end markets are hitting all the sweet spots within the economy. One recent case in point: coatings and paintings products company PPG Industries (NYSE: PPG  ) .

PPG Industries' favorable positioning

Investors tend to closely follow results from aluminum producer Alcoa (NYSE: AA  )  because they give great color on industrial trends in the global economy. Here's Alcoa's current end market outlook; the cells in green represent where Alcoa upgraded expectations, and those in red are for downgrades.

Source: company accounts

Note that many of its end markets are in good areas of the global economy. And for PPG, that story looks even better.

Promising prospects? Good!

PPG Industries is seeing solid growth in the aerospace sector, with its performance coating segment reporting net sales growth of 10% in the third quarter. That figure's in line with what Alcoa and others are saying about a strong aerospace market.

In addition, it has managed to outperform an already strong automotive sector. PPG's industrial coatings segment increased volumes to its automotive original equipment manufacturers (OEMs) by 10% in the last quarter. Surprisingly, it noted that its automotive coatings growth saw "each major region delivering growth on a comparable scale."

Essentially, PPG finds itself well-positioned with specific European automakers that are generating growth, and it's seeing a pickup in demand from Japanese manufacturers shifting production outside Japan. Moreover, since it doesn't sell to Japanese OEMs in Japan, it isn't suffering any loss of business as a consequence of this shift.

Well-placed internationally, too

Furthermore, PPG is well-positioned geographically, with its specific end markets looking strong within their own regions of the globe. For example, the Chinese economy is shifting toward domestic consumption, and away from fixed-asset investment in areas like housing and commercial construction. PPG is strong in the Chinese automotive, aerospace and packaging sectors, but according to the company, it doesn't have as significant a presence in the architectural market.

Europe remains a challenge, but PPG reported signs of stabilization there. Moreover, partly thanks to cost-cutting measures, the company managed to increase overall European pre-tax segment earnings by 13%. Similarly, its architectural coatings-EMEA segment grew earnings by 30% to $73 million.

source: company accounts.

North American construction

PPG's performance coatings segment probably represents its greatest growth catalyst going into 2014. Unfortunately, the commercial construction market hasn't kicked in quite as strong as many had hoped so far this year. Indeed, on the conference call PPG described itself as being "more bullish on commercial construction coming into the year" than its actuall first-half performance could support.

Rival paint company Sherwin-Williams (NYSE: SHW  ) told a similar story in its most recent set of results. Sherwin-Williams noted that its comparable-store growth was outpacing the US paint market by growing 7%. But while it described the US residential market as "very strong," it said the non-residential market was lagging behind. Incidentally, in common with PPG, it cited the marine market as being weak.

Going forward, both PPG and Sherwin-Williams can expect the US non-residential market to improve; historically, the commercial construction market has tended to lag residential building. Moreover, PPG's acquisition of the U.S. household paints division of Akzo Nobel appears well-timed. It added $400 million to PPG's performance coatings segment sales, and PPG has already achieved 50% of the planned $200 million in synergy benefits. There are more savings to come in 2014.

Where next for PPG Industries?

The indications from Alcoa and others are that PPG is placed in many of the right sectors of the global economy, and its momentum looks set to continue into 2014. Moreover, the stock remains at a discount to its peers.


PPG EV / EBITDA TTM data by YCharts

Analysts forecast PPG's EPS growth to come in at over 15% next year . Given a stronger US commercial construction market, it's not unreasonable to think that this stock could reach $200 in the not-too-distant future.

Saturday, October 26, 2013

Johnson & Johnson Now Relying on Pharma

Health care giant Johnson & Johnson (NYSE: JNJ  ) recently delivered a mixed set of quarterly results that produced more questions than answers. It's hard to be too critical of a company that beats estimates and raises full-year guidance, but there are a few considerations to ponder.

Yet again, the stand-out performer in the quarter was its pharmaceutical division. However, the underlying performance in its consumer and medical devices and diagnostics divisions contained some warning signs. Moreover, whenever pharmaceutical stocks are analyzed the usual approach is to estimate the future value of its pipeline, rather than focus on current earnings. The market should do the same here.

Pharma (40.1% of sales) stands out

While it's pleasing to see an increase in revenues of $523 million (3.1%), the pharma division contributed $634 million of that figure. Ultimately, pharma offset a reduction of $141 million in medical devices and diagnostics revenues and a paltry $30 million gain from consumer products. In other words, the non-pharma divisions (60.5% of revenues) saw their revenues fall by $111 million on a combined basis.

The pharma division is rapidly expanding sales of some of its newer drugs like Stelara (psoriasis), Xarelto (anti-coagulant), Zytiga (castration-resistant prostate cancer), and Invega Sustenna (anti-psychotic). In fact, these drugs contributed $572 million of the $634 million in increased sales in the pharma segment.

Going forward, Johnson & Johnson has high hopes of developing sales of Invokana (type 2 diabetes) although it may face competition in future for its leading treatment Remicade (rheumatoid arthritis). Naturally, it will vigorously defend its Remicade patents, especially given that the therapy represents 24% of its pharma sales.

Consumer products (20.5% of sales)

Operational sales actually rose 2% (and 4% excluding divestitures), but currency effects reduced reported growth to just 0.8%. In addition, this is the year that Johnson & Johnson planned to reintroduce 75% of the consumer brands that were affected by product quality issues. Indeed, two of the affected brands, Tylenol and Motrin (painkillers), were cited as "positive contributors" in the quarter. While their contribution is an obvious plus, it suggests that the underlying performance within consumer products is weak.

There was even some discussion of consumers trading down to store brands. Frankly, this wouldn't be a surprise because the likes of CVS and Walgreen (NYSE: CVS  ) have been aggressively expanding their in-store brand sales. Moreover, the drug stores are likely to keep pushing generic versions of pharma companies' over-the-counter (OTC) and prescription drugs.

Ultimately, growth in the consumer segment will rely on emerging markets, as the U.S. mass market consumer remains challenged by a weak economy.

Medical devices & diagnostics (39.4% of sales)

Orthopedics make up a third of the division's revenues, and unfortunately they only grew 1.1% operationally in the quarter. Despite the long-term growth prospects coming from aging population, there is a note of caution going forward. On the conference call, the management cited pricing competition primarily in the trauma segment in the U.S. In addition, pricing in U.S. orthopedics remains an issue as pricing declines of 3%, 1.5% and 4% were declared for hips, knees and spine solutions, respectively.

Incidentally, this is pretty much in line with what Zimmer (NYSE: ZMH  ) said in its last results. Zimmer saw pricing down 1.3% in the second quarter. Knee pricing declined 1.4% with hip pricing down 2.1%. In a foretaste of what Johnson & Johnson would say, Zimmer had outlined on its conference call: "Competitive pressures, most notably in the United States, slowed our Trauma growth for the quarter, but were mitigated by the company's consistently strong performance in overseas markets."

The worry is that more intensive price competition will extend beyond the trauma market and increase pricing headwinds in the U.S. orthopedics market for all the leading players.

Elsewhere, its eye-care numbers were somewhat disappointing with US growth of only 1.9%, and international operational growth at 4.9%. Contact lens specialist Cooper Companies (NYSE: COO  ) sees the global lens market growing at 4%-6% this year, but for the second quarter running it recorded only 4% growth. Given that Johnson & Johnson' s overall operational growth was only 3.9%, it's reasonable to worry that Cooper's growth might continue at the low end of its targeted range.

The bottom line

The pharma division is firing on all cylinders, and looks set to continue in future quarters. However, there are some warning signs in the other divisions. It's unreasonable to expect all its divisions to be performing well at the same time, but the trend of pharma outperforming has been here for nearly a year now.Much depends on the future pipeline.

All told, the stock looks close to fair value. A forward P/E of around 16.6 times earnings isn't especially cheap for a stock forecast to grow earnings at 6%-7% rate over the next few years. The current dividend yield of 2.9% will attract income seekers, but otherwise the stock looks pretty fairly valued at $91.

Thursday, October 24, 2013

Intel Offers Compelling Upside

In a sense, the initial market reaction to Intel's (NASDAQ: INTC  ) latest results tells you what you need to know about the stock. In short, the semiconductor manufacturer gave lower than expected revenue guidance, declared that its customers were cautiously keeping their inventories lean, and delayed production of a new chip due to technical issues. Yet, the stock still went up.

Intel disappoints
Intel's third-quarter revenues of $13.5 billion were in line with company guidance and its gross margins were higher, but this was far from being a positive report. Essentially, the chipmaker is trying to transition its products toward ultra-mobile PCs and mobile devices. Meanwhile, it has to deal with the usual uncertainty of its end demand that bedevils the highly cyclical semiconductor sector. There are four key takeaways from the results, and each of them highlighted Intel's current difficulties in achieving its aims.

First, the midpoint of Intel's revenue guidance for the fourth quarter implies that full-year revenue will come in at around $52.6 billion. This represents a year-on-year decline of 1.4%, when it had previously forecast they would be flat.

Source: Company accounts.
The main reasons appear to be that its customers are reluctant to build up inventory due to uncertain consumer demand. Indeed, only a day later Taiwan Semiconductor (NYSE: TSM  ) said its fourth quarter revenue could fall by 11%, due to "softer demand for certain high-end smartphones and inventory correction." This is a worrying comment given that the fourth quarter is traditionally the strongest for the industry.

Second, Intel argued that its mature markets in the US and Europe were stabilizing, while Asia and particularly China remained volatile.

The third takeaway is that production of its 14 nanometer chip Broadwell will now begin at the start of 2014, one quarter later than planned. On the conference call, management claimed that this was "a small blip in the schedule" due to a technical issue which has now been resolved.

Fourth, Intel announced that its Bay Trail processor (aimed at the entry point ultra-mobile device market) had over 50 design wins, and eight to ten of these products will be available by Thanksgiving.

What it all means: FedEx, International Business Machines, and Intel

 From a macro perspective the color given on its customers' behavior was disappointing, but it's in-line with what other bellwethers have been saying. For example, FedEx has sequentially lowered its global 2013 GDP forecast throughout the year. In addition, International Business Machines (NYSE: IBM  ) recently reported weakness in China. IBM's sales were down 22% in China, with its hardware sales down a whopping 40%. IBM blamed a combination of its own execution problems, and delays in public spending caused by the wait for the mid-November release of an economic reform plan. Moreover, IBM doesn't expect Chinese demand to improve until early next year. A warning sign for Intel's fourth quarter?

With regard to its internal execution, Intel's scorecard is mixed. The technical issues with Broadwell appear to be resolved, but the delay now means that products incorporating the chip won't be available until after April. In addition, the design wins with Bay Trail are impressive, but investors could have hoped for more products to be available during the critical shopping season.
All told, it's not hard to see why the full year guidance was lowered.

But does it really matter?

 The fact is that none of these developments represent significant long-term headwinds for Intel. The technical issues with 14 nanometer chip production only serve to highlight that next generation chip production requires huge resources, and very few companies have Intel's financial firepower. Furthermore, Intel is now demonstrating its commitment to penetrating the ultra-mobile device market.

Despite the fall in earnings this year, the stock still trades on a P/E ratio of 12.7 times earnings for 2013, and a dividend yield of nearly 4%. In other words, the valuation is so cheap that Intel can afford to make the odd hiccup from quarter to quarter. Moreover its near 60% gross margins and substantive free cash flow generation (approaching $9 billion on a trailing basis) mean that it can buy its way into the new device market. The company may not be firing on all cylinders, but the valuation provides for plenty of upside if/when it starts achieving its aims.

What You Need to Know About Yum Brands in China

Another set of earnings from Yum! Brands (NYSE: YUM  ) , and another setback for its plans to recover KFC sales growth in China. Yum! continues to struggle to recover from adverse publicity due to chicken quality supply issues in China. With the share price now flat on the year, is now the time to be picking up some shares? 

What's going wrong?

There were two main disappointments in the last quarter.  First, KFC's Chinese sales were lower than expected, and the new product launched at KFC in September (a beef burger) failed to generate sales in line with expectations.  Consequently, Yum! no longer expects positive same-store sales in the fourth quarter. Listening to the conference call, it's clear that management feels this is mainly a question of reestablishing credibility in China:
"our overall trust and reliability and safety measures are below what they were the previous year. And we think we really need to get those back at least level."

The question is whether the decline in same-store sales is totally due to the chicken quality/avian flu double whammy, or whether it is a function of hyper-competition in China, or even a macro issue. Indeed, Yum!'s major quick service restaurant (QSR) rival McDonalds (NYSE: MCD  ) has also seen declining same-store sales growth in its Asia-Pacific, Middle East and Africa (APMEA) markets.

source: company presentations

In fact, last quarter's comparable sales were negative in McDonald's big three APMEA markets of China (-6.1%), Australia and Japan. By way of comparison, KFC same-store sales declined 14% in China. Both companies blamed a bout of avian flu in China during the spring, but same-store sales growth has been declining since the end of 2011.  In other words, the trend was in place before KFC's chicken quality issues, and the avian flu issue.

The second disappointment was the $258 million impairment charge taken on Little Sheep (a hot pot restaurant chain acquired in China), and Yum! declared itself 'deeply disappointed' with the results achieved from Little Sheep so far. While the impairment charge is a non-cash item, the ongoing performance at Little Sheep is a concern.

What's going right

There are three good things going for Yum!. First, Yum!'s casual dining outlets are performing relatively better, and Yum! has growth opportunities thanks to innovation. Yum!'s overall US same-store sales were flat, but Taco Bell contributes 60% of US profits and its same-store sales were up 2%. In comparison, Pizza Hut's US number was down 1%. In a confirmation that the quick serve restaurant category is tough globally, KFC's US same-store sales were down 4%. For the immediate future, the good news is that Yum!'s efforts in the US will focus on advertising Wing Street (a chicken wing QSR co-located with Pizza Hut), and developing its breakfast menu at Taco Bell.

Incidentally, many of these trends in the US are confirmed by the National Restaurant Association Restaurant Performance Index (it declined for the third consecutive month to August), or in what QSR suppliers like spice and seasonings company McCormick (NYSE: MKC  ) are saying about the market. In particular, McCormick's QSR-based sales in the US are likely to remain weak, especially because the company is not particularly strong in the breakfast market.

The second positive point is that despite the double-digit decline in Yum!'s China division's same-store sales, restaurant margins only declined 1.9% in the quarter (and by less than 1.5% if you exclude Little Sheep). Hopefully, if and when sales growth turns positive again next year, these underlying productivity improvements should feed into substantial profit improvements for Yum! in China.

Positive indications from sales trends

The third positive indicator may appear esoteric, but bear with me! With regard to third quarter sales trends in China, Yum! said this on the conference call "No real meaningful variances across the city tiers by day part, or any other occasion. Pretty consistent, pretty balanced across the market."

Thinking laterally, different cities will have different levels of competition. Some variance in performance might be expected if the weakness was due to excess competitivenessIn other words, its probably a combination of macro and KFC-specific weakness.

Yum! also stated that the second quarter saw some disparity in performance by city; Shanghai was weaker thanks to its greater concentration of avian flu cases. However, this didn't feed through into the third quarter, which indicates that avian flu fears are receding.

What to do with Yum! Brands?

A bullish case sees a much brighter outlook in 2014. China's sales will turn positive, underlying margin improvements will lead to a massive increase in profitability, and US performance will remain solid on the back of innovation at Taco Bell and Pizza Hut.

On the other hand, the US QSR category remains weak, and so far Yum! has underestimated how long it will take to recover its reputation in China.

In conclusion, a piecemeal approach probably works best here. Investors can monitor three interesting inputs. First, you can look at McDonald's third quarter results (due on Oct. 21, 2013) in order to see if its Chinese sales are turning around. Second, keep an eye out for what McCormick is saying about the QSR environment. Third, Yum! has promised to provide the market with monthly updates on China same-store sales, with the next report due on Nov. 12, 2013.

Wednesday, October 23, 2013

Covidien is the Pick of the Medical Device Sector

It may be tempting to revise the idea that investing in the medical device sector is a defensive strategy. However, don't be too quick to fall out of love with Covidien (NYSE: COV  ) . The company represents one of the more compelling long-term growth prospects within its sector, and has several ways to generate long-term growth.

Covidien, an emerging market play
Prospects for emerging markets to increase medical spending look strong. Not only are they growing their GDP at a faster rate, but countries like China are under increasing pressure to spend their foreign currency reserves on stimulating domestic demand via infrastructural investment.

Moreover, at its latest investor day, Covidien argued that emerging markets had only 6% of their GDP in health care, compared to 18% for the U.S. and 10% in the European Union. The potential for growth is significant, and Covidien hasn't been slow in investing in technology and innovation centers in places like Istanbul, Shanghai, Mumbai, and Sao Paulo.

Although the company currently generates less than 20% of its sales from emerging markets, its growth rates from these regions is little short of spectacular. For example, the BRIC (Brazil, Russia, India and China) countries make up 40% of its emerging market sales, and they are currently growing at around 25%. Meanwhile, the non-BRIC countries are growing at a very respectable 10%. Covidien's growth looks set to focus on the BRIC countries as it forecasts that 60% of its emerging market revenues will come from them by 2018.

Covidien's four sweet spots
First, unlike rivals like Johnson & Johnson (NYSE: JNJ  ) or General Electric's (NYSE: GE  ) health care division, Covidien doesn't have many large-ticket capital machinery type items. Instead, its solutions tend to come at more accessible price points -- a key plus point when trying to expand EM sales. Moreover, Covidien claims that its emerging market margins are higher than the company average, so there is a margin expansion opportunity as well. Furthermore, with no product (or class of product) contributing more that 5% of total sales, it isn't reliant on any one item for its sales growth.

Second, its solutions tend to be relatively non-cyclical, because its strength is in non-elective surgical procedures.  Johnson & Johnson is struggling to generate growth in its surgical device markets, and has talked about a hospital capital spending market in a recession. In fact, in its latest results Johnson & Johnson's surgical care results declined 1.1% on an operational basis. Meanwhile, Covidien's endomechanical and energy growth remains strong.

Source: Company filings.

Third, its endomechanical and energy products -- particularly those relating to minimally invasive surgery, or MIS, solutions -- tend to reduce hospital costs because they produce better patient outcomes. Going forward, Covidien has a growth opportunity by convincing hospitals (particularly in emerging markets) to use MIS procedures to reduce hospital costs. Moreover, if authorities are convinced of the efficiency benefits of MIS, they may start reimbursing this type of procedure in future.

Covidien's fourth sweet spot is that its strengths (endomechanical and energy products) are relatively under-penetrated areas in emerging markets. And there is more opportunity to come, because at its recent investor day the company argued that "10 of 12 pipeline products that we have in the pipeline are going to come from classes of trade where we expect 70% of our growth, Endomechanical, Energy and Vascular."

Where next for Covidien?
Its defensive characteristics and emerging markets prospects will help to offset sluggish spending in its core developed markets, but its forecast for overall revenue growth in 2014 is only between 2% and 5%. Analysts have revenue growth at 3.6% for 2014, and EPS growing just 7.2% to $3.98. While this may seem paltry, consider that GE's medical division revenues were flat in the last quarter despite recording 10% growth from its emergin markets operations.

Moreover, Covidien's forecasts assume a 4% headwind due to foreign exchange and the medical device tax. In other words, Covidien's underlying forecast for 2014 is in-line with its long-term aim of mid-single digit revenue growth and double-digit EPS growth. On a forward P/E ratio of 15.3 times earnings, and with upside from increasing adoption of MIS in emerging markets, the stock is attractive.

Tuesday, October 22, 2013

Walgreen is Transforming Itself, Investors Should too

Superficially, a drugstore chain like Walgreen (NYSE: WAG  ) is a simple business to run. It opens up a store, sells a large volume of drugs and health products, and makes a small profit margin for itself in the process.  While this is a perfectly adequate way looking at the company, it doesn't go anywhere near assessing the growth opportunities that Walgreen has thanks to the initiatives it has taken over the last couple of years. The recent results confirmed that it's on track with many of them, and despite the strong rise this year, the stock remains attractive.

Walgreen working smarter

There are three main ways in which Walgreen is transforming itself in order to drive the business forward. First, it is using data management (of its customer base) in order to be able to better manage its sales.

For example, early in the year it had reported disappointing front-end comparable store sales of only 0.4%. Walgreen responded by initiating a renewed focus on pricing and promotions in mid-May in order to regenerate traffic and sales. It worked.

Source: Company presentations.

This nicely illustrates how Walgreen can use information garnered from its balanced reward card scheme to help better target pricing and promotional activity. In addition, with a stronger understanding of the treatments that its customer base requires, Walgreen is able to expand its specialty drug support. This includes drugs for long-term conditions like rheumatoid arthritis and diabetes, both of which will help Walgreen's aim to establish itself as a pharmacy in the community. 

Transforming the business

The second driver of growth is coming from the way that Walgreen is aggressively transforming its business through deal making. The 10-year deal with pharmaceutical distributor AmerisourceBergen (NYSE: ABC  ) went live on Sept. 1 . It started with the distribution of Walgreen's branded pharmaceuticals, and AmerisourceBergen has plans to move onto distributing Walgreen's generics within the next 12 months as well.

One big plus for the distributor is that the deal also includes Walgreen's partner Alliance Boots. Walgreen will now get daily delivery to its stores, and this means that it should be able to improve inventory management and benefit from economies of scale, particularly in purchasing drugs.

Moreover, the deal will allow Walgreen to generate even more synergies out of its partnership with Alliance Boots. Indeed. Walgreen achieved $154 million in net synergies this year, compared with its earlier estimate of $125 million to $150 million.

Leverage opportunities in its own stores

The third key growth opportunity relates to the potential to leverage sales in its own stores. Fortunately, it can do this in many ways. One way is to expand sales of its private-brand products. Indeed, private-brand sales increased their penetration of Walgreen's front-end sales by nearly 0.9% to 22.3% in the last quarter. Similarly, it has now launched Alliance Boots'  Boots No. 7 product line in stores across the U.S.

Furthermore, in the long term Walgreen should be able to increase margins thanks to increased generics sales. Generics tend to be higher gross margin (but lower revenue) products for retailers, and in the long term they are likely to increase due to pressures on medical costs.

And finally, Walgreen recently announced a long-term partnership with lab-testing company Theranos in order to provide less invasive lab testing services to Walgreen's customers. The big advantage is that customers -- particularly those who require frequent blood testing -- will be able to get test results quickly and easily. In turn, this sort of initiative will help keep customers loyal to Walgreen.

Where next for Walgreen?There is plenty going on at Walgreen, and the company deserves credit for aggressively transforming its business in order to deal with changes in health care needs. The partnership with Alliance Boots is working ahead of expectations, and there are more synergies to come. Expanding generics and private brand sales offer margin expansion opportunities in future, the Theranos deal promises to engender customer loyalty to customers who are likely to be frequent purchasers of Walgreen's products. 

Key Earnings This Week

It's the heart of earning the earning season, and results are coming fast and furious. It's impossible to cover all the stocks, so I am going to pick out some of the more interesting companies that are expected to report. 

Affordable luxury company Coach's outlook on emerging-market spending will be closely followed, as it will attempt to regain market share from Michael Kors. LED manufacturer Cree will hope to report high growth in LED lighting sales, just as Acuity Brands did a few weeks ago.

Whirlpool will give an update on the market for appliances, as well as its margin-expansion plans. Tool maker Stanley Black and & Decker gave weak results, but it seems to be mainly a problem with a European acquisition in the security market. In other words, it shouldn't spell bad news for Whirlpool.

Numbers from human resource consulting firm Robert Half will be fascinating. The company's earnings have historically correlated with U.S. employment prospects, and conditions are getting steadily better in America. But what will it report on Europe?

WednesdayIt is a big day for aerospace, with Boeing and B/E Aerospace giving earnings. Other bellwethers giving numbers include AT&T and Caterpillar. However, the day belongs to the technology sector.

Citrix Systems (NASDAQ: CTXS  ) has already disappointed the market by pre-announcing third-quarter earnings significantly below its previous guidance. Revenue was light by $24 million, and investors will be keen to find out more when the full release is given. It will probably be less worrying if it came from its application delivery controller NetScaler. Citrix competes with ADC market leader F5 Networks (which also gives results on Wednesday), and some lumpiness NetScaler's growth will probably be forgiven.

However, if the shortfall came from Citrix's core desktop virtualization offering, then it could spell deeper underlying trouble. The key metric to follow is its product and license sales growth, particularly within mobile and desktop. Previously, Citrix management had been calling for an acceleration in mobile and desktop license sales, but are those plans still on track?

Data center provider Equinix's (NASDAQ: EQIX  ) share price has been weak amid fears of slowing growth. Previously, it reduced its forecast for growth in the second half, mentioned some softness in Germany, and admitted to longer sales cycles within its enterprise markets. All of the data center providers have been aggressively expanding capacity, and it's possible that they're starting to lose pricing power due to overcapacity.

The three key metrics to follow are its gross margins, client retention ratio, and its "adjusted discretionary free cash flow." The first two numbers are indicators of its pricing power and competitive positioning, and investors will not want to see them falling. The cited cash-flow measure helps gauge the underlying cash-flow generation in the company and is probably the best way to evaluate a company in a rapid expansionary phase.

The third featured tech stock is Fortinet (NASDAQ: FTNT  ) . It's hard to know what Fortinet will report, and the stock tends to be highly volatile over earnings. However, its guidance for the third quarter looks a bit cautious.

Source: Company accounts; author's estimates.

It is a competitive market, and rivals such as Check Point (which reported expectation beating results this morning) have new products out, while fast-growing newcomer Palo Alto Networks will be determined to expand its installed base. One thing to look out for will be how many larger deals ($500,000 or more) it reports in the quarter. This is a good indication of its ability to further expand outside of its core (small and medium-sized) business market.

ThursdayColgate-Palmolive and nutrition company Mead Johnson will update the market on the state of the emerging consumer. Other closely followed companies will include Microsoft and energy services company Flowserve. Investors in Zimmer will be cautiously awaiting results after Johnson & Johnson gave a disappointing outlook on pricing in its orthopedic solutions.

FridayFridays are relatively quiet, but the big earnings of the day will come from Procter & Gamble. In addition, Sherwin-Williams will update the market on the state of the painting and coating industry.

Monday, October 21, 2013

Alcoa's Earnings and What they Mean to the Industrial Sector

While the market frets over the Government shutdown, aluminum producer Alcoa (NYSE: AA  ) quietly delivered a solid set of earnings. More importantly, its end-market outlook was surprisingly strong. In particular, its commentary on industrial conditions in China suggested some strengthening, when only a day previously, the World Bank had cut its forecast for Chinese growth this year to 7.5% from 8.3% in April.   Given this conflicting evidence, what does Alcoa's guidance really mean?

Alcoa can only report what it seesThe company will always be a good bellwether for certain key industries like automotive and aerospace, but it may not necessarily represent the global economy or the broader industrial sector. And this is especially true for China. Alcoa's outlook was good for China, but this might be due to some changes in the composition of China's GDP growth.

Indeed, the World Bank report noted that Chinese consumption is now contributing more to growth than investment compared to previous years. And if Chinese consumption is stronger, you can bet the automotive sales will benefit. Subsequently, Alcoa raised its forecast for automotive demand in China. All told, Alcoa raised its aluminum demand forecast from China to 12% from 11% previously, while keeping its global demand estimate at 7%.

To put all of this into context, here is Alcoa's updated 2014 end-demand guidance. The numbers in red and green are where it has downgraded and upgraded respectively.

source: company presentations
However, a word of caution needs to be issued here. Chinese car production and sales are both rising nicely, but note that production has outpaced car sales for the last eight months. So the likelihood is that either sales will accelerate in the future or else production growth will slow.

source:chinese association of automobile manufacturers

Interestingly, Alcoa argued the reverse could be true for North America. It stated that car manufacturers were running with 60 days inventory (the amount of cars in inventory totaled sales for 60 days) in April, but only 55 days today. This implies a pick-up in production is due provided sales growth holds up.

Alcoa's other segmentsThe second area of industrial strength in 2013 has been aerospace, and the long-term fundamentals on the eight year production backlog at Boeing and Airbus-look solid. Alcoa kept its outlook unchanged and referenced industry demand for newer, more fuel efficient airplanes. All of this is good news for General Electric (NYSE: GE  ) , because its second most profitable industrial segment is aviation.

But there was some less positive news for GE with Alcoa's industrial gas turbine outlook. The market was described as weakening, even though the forecast was kept constant. This is due to Alcoa's strength in supplying aluminum for spare part demand, but it implies a tougher outlook for GE, because its focus is on supplying the turbines.

Elsewhere, there was some good news for a company like Cummins (NYSE: CMI  ) that sells into the heavy truck market. Alcoa raised forecasts for Europe and China, with the main catalyst being the implementation of tighter emission standards in the respective regions. This outlook mirrors Cummins' raising of its full year sales guidance to five percent from flat previously. In fact, last time around, Cummins reported a 35% increase in the medium and heavy truck market in China. 

Another company that can take heart from this report is industrial machine vision company Cognex (NASDAQ: CGNX  ) . Cognex currently generates 78% from its factory automation segment. China is very important to Cognex, because as global manufacturing shifts eastwards, it will need to open up new markets in the Far East. At present, Chinese sales only contributes around 15% of Cognex's factory automation sales, but they grew 41% in the last quarter. In other words, good industrial conditions in China are very important to Cognex's growth.

Where next?Alcoa's report indicated a strengthening Chinese economy, but this needs to be put in the context of the industry sectors that Alcoa is selling into. Aerospace and automotive are doing fine, while conditions are better in the heavy truck market; but this doesn't mean that overall growth in the global economy is strengthening. The key conclusion that investors should take away from this report is to stick with the industrial sectors that are working.

Sunday, October 20, 2013

Acuity Brands Lights Up The Markets

North America's leading lighting company, Acuity Brands (NYSE: AYI  ) , released its quarterly results recently, cheering the market with its positive outlook. The company offers good long-term growth prospects from both the increase in demand for LED lighting and a recovery in commercial and industrial construction. The market seems to have fully woken up to this story, however, and the company needs to deliver in order to justify the current evaluation. Is now the time to be chasing the stock?

An LED playThe growing acceptance of LED lighting is good for Acuity for two main reasons. First, it is seeing replacement demand coming from customers wanting to use LED lighting. Second, this type of lighting usually comes with control systems, so Acuity can generate add-on sales for the systems. Moreover, these demand sources don't rely on the economy or overall construction activity. In reality, it's more of an opportunity to grow sales (rather than margins), because its LED lighting solutions tend to have similar margins to conventional lighting.

Unfortunately, management didn't disclose the exact share of revenues coming from LEDs, but they outlined that it was at least above 21%. Consider that the last three quarters' numbers have been 13%, 15%, and 20%, respectively, which represents very good growth.

More than an LED playAcuity also offers earnings upside from an improving economy, and this time there are margin growth opportunities as well. Construction activity appears to be picking up, as seen in the Architectural Billings Index from the American Institute of Architects:

Source: American Institute of Architects.

The hope is that growing residential activity will ultimately translate into commercial and industrial construction. Increased housing construction implies the build-out of commercial buildings around the new communities. In addition, a resurgent housing market tends to grow household net worth, which in turn leads to increased consumer spending. Ultimately, this feeds into commercial and industrial construction investments in line with an improving economy.  

All of this positively affects Acuity in two ways. First, its strongest market has traditionally been the commercial and industrial sector, and any increase in activity will aid its top line. Second, new construction work is likely to create a higher margin mix than Acuity has now. For the second quarter in a row, Acuity saw its volumes rise 14%, though net sales increased by only 11% last quarter and 13% this time around. On the conference call, Acuity explained the discrepancy as being primarily due to changes in the channel mix, as well as the mix of products sold, and, to a lesser degree, lower pricing on like-kind LED luminaires.

Acuity's renovation work tends to be lower-margin activity, as does its sales through the home improvement stores like Home Depot and Lowe's. Clearly Acuity has a margin expansion opportunity provided that the new construction market improves next year.

Wal-Mart lights up the wayOne catalyst for growth could come from Wal-Mart (NYSE: WMT  ) , as it recently launched an LED light bulb selling for under $10. Analysts are mixed over the potential outcomes, with some seeing future margin pressure to come for Home Depot's LED bulbs (an important retailer for Acuity), and downward pressure on Cree's LED lighting margins. 

On the other hand, Wal-Mart's move is highly likely to spark wide-scale interest in LED lighting. This could turn out to be a net positive for the industry. Cree is also a large scale LED manufacturer, and an increase in end demand should help it to lower its prices. Meanwhile, Cree and Acuity could find it easier to convince customers to buy their lighting solutions if Wal-Mart's move creates mass awareness of the benefits of LEDs.

The bottom lineThere is a lot to like about Acuity, but at a price of $92.80 per share as I write, the company's stock is at 23 times its earnings forecast to August 2014, and around 20 times to August 2015. It looks priced for perfection, and any hiccup with short-term pricing due to Wal-Mart's move will hurt the stock. If you think the commercial construction market is going come back strongly next year, Acuity Brands stands to reap the benefits, but there are probably cheaper ways to play the idea.

Friday, October 18, 2013

Paychex is a Good Dividend Play, but is there More to it?

Earnings from small business service provider Paychex (NASDAQ: PAYX  ) are usually closely followed for three reasons.

First, it's a payroll services segment is a good barometer of current conditions in the small and medium size business market. Second, its results provide good color on the increasingly competitive market for payroll and HR services. Third, and I suspect this is what most of you will be interested in, it's one of the go-to dividend stocks for income seekers.

Paychex gives small businesses some reliefThe company typically generates two-thirds of its services revenue from payroll services, and one-third from its faster growing HR services segment. In general, the first-quarter recent results were positive and tracked quite well against Paychex's full-year guidance.

  Full-Year Guidance Q1 Results
Payroll Services Growth  3% to 4% 2.4%
HR Services Growth 9% to 10% 11.3%
Total Services Growth 5% to 6% 5.2%
Net Income Growth 8% to 9% 6.3%

Revenue growth matters a lot, because its operating income margins are close to 42%. Superficially, the payroll numbers were weak compared to what Paychex is expecting for the full year, but relatively speaking, they were good.

Going back to its last set of results, Paychex had stated that its key checks per payroll metric only grew 0.9% in the quarter. Furthermore, management had noted that the the number had moderated in the quarter, and the trend was downward. With this in mind, investors would have been right to be fearful of what Paychex would report for Q1.

In the end, checks per payroll grew 1.6% in the quarter, and the weakness in the fourth quarter was put down to a "timing issue." The overall payroll services growth rate was only 2.4%, but Q1 was affected by one less trading day than last year.

In a sense, this is a sigh of relief for commentators watching the small business sector, especially as it mirrors Automatic Data Processing's (NASDAQ: ADP  ) unchanged forecast for its "pays per control" to grow at 2% to 3% this year. Small businesses aren't growing as strong as they have in previous recoveries, but conditions aren't as bad as Paychex's Q4 numbers had previously intimated.

Are conditions getting tougher for Paychex?On the other hand, in Q4, Paychex argued that its full-year outlook for 3% to 4% payroll services growth was mainly predicated on revenue per check rising (rather than checks per payroll) thanks to price increases passed onto customers. However, on the Q1 conference call, Paychex stated:

Revenue per check grew modestly as a result of price increases partially offset by discounting.

To be fair, its revenue per client did increase, so any discounting did not totally takeaway any gains from price increases. However, the modest nature of the net increase, and the need to discount, could be a sign that competition is increasing payroll services.

ADP's forecast (reiterated in August) of 2% to 3% growth in pays per control is higher than employment gains in the overall economy, and ADP argues that its clients have been hiring faster than the national trend. So is Paychex's lower growth rate related to its client base?

Moreover, the payroll services space is getting crowded. ADP, Paychex, and Intuit (NASDAQ: INTU  ) are all trying to develop their software as a service-based offerings. Paychex claims that its SaaS-based SurePayroll solution is growing in the double-digits, and ADP is accelerating sales of its Vantage product, which will integrate HR management, payroll services, and benefits administration.

Meanwhile, Intuit can generate growth for its online payment solution by cross-selling it within its small business group solutions. In fact, Intuit continues to generate mid-teens growth with its payment solutions. In addition, Insperity has launched a SaaS-based payroll solution.

Is the dividend enough to buy the stock?The answer to this question partially lies with your desire for the near-3.5% dividend yield that Paychex currently generates for you. It's certainly a lot higher than the current 2.65% yield on a 10-year U.S. Treasury bill, but is it as safe over the next 10 years? The payroll services market is getting crowded, and it's not clear who will be the long-term winner out of the move to SaaS.

Moreover, Paychex paid out around 83% of its free cash flow in dividends last year, so it's difficult to see much scope for strong dividend increases in the near term.

In conclusion, the stock will continue to attract dividend seekers in a low interest rate environment. However, for long-term investors, paying 25 times earnings for a highly cyclical stock within increasingly competitive markets might appear a bit rich.

Thursday, October 17, 2013

Nike Keeps Doing It, But For How Much Longer?

A few years ago, one of the main attractions of Western consumer goods stocks was their potential to aggressively grow sales in emerging markets. That story is still in place, but somehow Nike (NYSE: NKE  ) has managed to flip the script in recent years by generating more of its growth from mature markets.

This trend continued with the latest first-quarter results, with Nike announcing double-digit growth in North American and Western European orders. The stock hit an all-time high in response, but is it time to take profits? Moreover, can it continue to rely on mature markets for growth?

Nike flips the script

There are three key takeaways from the recent results, and each of them serves as a marker for what Nike needs to do going forward.

First, its mature markets are out-performing. A look at segmental earnings before interest and taxes (EBIT) reveals that growth this year has come from North America and Western Europe.

Source: Company Accounts

Western Europe is now generating more profits than Greater China or the emerging markets segments. Furthermore, Nike reported future orders of 11% and 12%, respectively, for North America and Western Europe. Meanwhile, Greater China and emerging markets futures grew at a less impressive 2% and 7%, respectively.

The second takeaway is the ongoing out-performance of footwear versus its other categories in regions outside of North America. The one key exception in the quarter was China (the only area where apparel notably outgrew footwear), and I'll come back to this important point later. For now, focus on how much better footwear is doing.

Source: Company Accounts

This trend is probably going to reverse somewhat because Nike will come up against some easier comparisons with apparel in the upcoming quarters.

With regards to North America, apparel grew at the same 9% rate as footwear, and management declared itself "super excited" by the performance in its women's business. This is something that might concern yoga-gear maker Lululemon Athletica  (NASDAQ: LULU  ) . After suffering quality issues with its black yoga gear, Lululemon was susceptible to losing some market share. This sort of issue is critical for Lululemon, because it's positioned as a premium seller in the marketplace.

The third takeaway was the return to growth in Western Europe. The 8% revenue growth rate (at constant currency) is pretty impressive considering it came up strong growth generated last year by football (soccer) sales inspired by the European football championships. Outside of the World Cup, the European competition is the largest in the World, and features all of the top players outside of South America.

What does it mean for Nike?

Clearly, Nike needs to improve its performance outside of North America. With this in mind, the return to form in Western Europe is a good indicator for Nike's plans in China. Nike is undertaking a similar kind of strategy reset in China to what it successfully did in Western Europe.

It would be churlish to doubt that Nike can improve its performance in China through simple 'blocking and tackling' management initiatives. For example, things like merchandising, improved product selection, and improving logistics were all discussed on the conference call. On the other hand, there are a couple of short-term concerns.

First, Nike's strong performance in North America relates to its successful sponsorship of high profile American athletes in sports like basketball or American football. It's highly unlikely that LeBron James or Kobe Bryant are going to resonate as well with Chinese consumers. Second, when questioned about the future footwear/apparel mix in China on the conference call, Nike's management replied:
So we'll have the more targeted mix of products, but the ratio of footwear and apparel -- we're not seeing a dramatic shift in that ratio. That said, we see tremendous upside in the apparel business in China for Nike to move forward and frankly around the world.
It doesn't look like Nike will specifically address why apparel is outperforming footwear in China, and this may make its strategic reset a bit harder to execute.

Where next for Nike?

Nike's stock price is at an all-time high, and even when compared to a company like outdoor-clothing company VF (NYSE: VFC  ) , Nike's valuation looks a bit rich.
NKE Price to Normalized Earnings Less Cash (TTM) Chart
VF is arguably more attractive than Nike because it has a wider and more diverse range of brands. When market conditions are difficult for one brand, it can focus on another in order to drive growth. Whereas with Nike right now, it really is all about footwear, and its more mature geographies in particular. VF has a mix of powerful outdoor brands (such as Timberland, Vans, and The North Face) and jeanswear with which it can generate growth across the cycle.

What Nike needs to just do

If Nike is going to continue to justify this valuation it is going to have to execute better in China and emerging markets. Fortunately, the World Cup takes place in an emerging market, and Nike is well placed as the sponsor of the powerful Brazilian host team. However, the market is likely to have priced this in by now.
Therefore the 'swing' factor in deciding to buy the stock must be your confidence over the company's ability to turn things around in China. Furthermore, Nike will need to continue to grow at a rapid clip in its mature markets. If you think Nike can just do it, then the stock probably has further to run. For cautious investors, however, now might be a good time to take a little profit off the table.

Wednesday, October 16, 2013

Time to Invest in Tech Value Plays?

If you favor a value-based, long-term, buy-and-hold investing strategy, then you must have noticed how cheap some blue-chip tech stocks are right now. The easy move is to put a bunch of them in your portfolio and forget about them for 10 years. Unfortunately, tech investing is rarely that easy. So what do you need to know before making a decision?

Tech titans
First up, let's look at a chart of these tech titans. I've included a mature blue-chip stock, Johnson & Johnson by way of comparison. Enterprise value over earnings before interest, tax, depreciation, and amortization, or EBITDA, is used, because EV -- market cap plus net debt -- is a better measure to compare companies. Moreover, EBITDA is a good proxy for underlying cash flow.


All these companies look relatively cheap. Moreover, on a historical basis they are all a good value. In fact, Intel (NASDAQ: INTC  ) , Oracle (NYSE: ORCL  ) , and Cisco (NASDAQ: CSCO  ) are all trading at substantial discounts to their pre-recession valuations. Why is IBM (NYSE: IBM  ) the odd man out?

Adjusting early to structural shifts
IBM adopted a different strategy to the rest. It acted early to adjust to structural changes in the economy. The sale of its PC division to Lenovo in 2004 was a key part of its transition into primarily a software and services company.

Source: Company accounts

Consider how well Oracle's stock performed compared to Intel and Cisco over the last 10 years.

IBM Chart

The charts demonstrate that over the last decade, goods, products, and services have commanded higher prices based on how "smart" they are. For example, think of the advanced electronics systems being fitted into cars, or smartphones versus landlines. The shift is mirrored in the outperformance of the one software and services company on the list: Oracle. IBM also did very well, precisely because it made the transition to selling more software and services.

Going forward, IBM's strategy is to sell its lower-margin businesses, and increase margin expansion at the expense of revenue growth.

So while its revenues are forecast to be flat from 2012-2014, its EPS is expected to rise 20%.

Oracle now facing challenges
The previous 10 years have been very good for Oracle shareholders. However, there is no guarantee that the next 10 will be the same. The company remains a very good value play, but it also faces its own structural challenge with its traditional on-premise, on-license sales being threatened by cloud-based software providers. Moreover, as cloud-based sales increase, Oracle will find it harder to bundle its hardware solutions with its software.

Accordingly, analysts have Oracle on low-single-digit revenue growth for the next couple of years, with only high-single-digit earnings growth forecast. Oracle is seen as being late to the cloud party, and its future growth depends on making the adjustment.

Intel adjust its business, Cisco tinkers
Intel is the worst performer of the four, and it's also facing some structural challenges. It wasn't the only company caught out by the acceleration in mobile computing at the expense of PCs. Subsequently, Intel has found its core PC processor market to be challenged as PC sales repeatedly disappoint, and ARM core processor designs have won out in the mobile market. Simply put, Intel's refusal to license ARM's architecture in a meaningful way, has hurt the company.

The good news is that Intel has invested in new processors (Bay Trail and Haswell) that should start to penetrate the ultra-mobile market as of this year. Intel will need to do this in order to hit guidance this year.

Cisco's challenges and opportunities are of a different sort. It's switching and routing divisions still generate low-single-digit growth, but it's not enough to get excited about the company. Moreover, its services revenues growth -- services make up around 21% of total revenues -- is really a function of how well it can sell its products into the marketplace. The real question is how well Cisco will invest its cash in growing its peripheral sales.

You can see the point illustrated in the following chart.


Source: Company accounts

What you need to look for
Intel will become very attractive if it can establish a strong foothold in the mobile market. You'll want to monitor developments later this year.

Oracle needs to halt declines in its hardware sales and demonstrate that it can shift more revenues to the cloud while retaining margins with its traditional software. However, the stock is very cheap right now, and even stabilizing the company to GDP-type growth should see some good price appreciation.

IBM's story is one of ongoing margin improvements and the execution of its plan. Look for margin expansion. Cisco is intriguing because its sits on more than $34 billion in net cash and investments, while its market cap is $123 billion as I write. In other words, it has the capability to invest wisely and generate growth. Keep an eye on its acquisition strategy.

Each of the four has its own risks and rewards, but a portfolio that contains all four isn't a bad idea for a value investor.

Tuesday, October 15, 2013

FedEx May Seem Boring But These Stocks Make You Money

You could be forgiven for thinking that there was something odd about FedEx's (NYSE: FDX  ) latest results. The transportation company is usually seen as a play on global growth, but it simultaneously lowered its GDP forecasts and saw its stock price surge through an all-time high. What's going on?

Fedex lowers GDP estimates

First, here's how FedEx has lowered its forecasts over the year to date:

Estimates for 2013 Start of the year Last Quarter Current Quarter
U.S. GDP growth 1.9% 2% 1.6%
Global GDP growth 2.5% 2.3% 2%

Source: Company presentations.

FedEx and its rival UPS (NYSE: UPS  ) are typically seen as cyclical plays. In other words, their share prices tend to follow the direction of the economy. This is why investors usually respect its views on the economy, and why its lowering of GDP estimates should be bad news. However, a number of elements have come together to give it some upside potential which isn't just about the economy.  

FedEx's structural challenge and its response

Our economy has changed since the financial crisis, and demand for FedEx's services has changed with it. Companies are now a lot more willing to use lower-cost delivery options, even if they ultimately receive their deliveries a day or two later. In response, FedEx's lower-cost ground segment is now its key earnings generator, while the contribution from its pricier express service has fallen.

Source: Company financial statements.

This shift wasn't great news for FedEx; it had invested in expanding its express capacity in anticipation of stronger demand. Ultimately, this led FedEx to spend the last few years losing margins in express while also restructuring the division.

Even as FedEx's customers have grown more frugal, its fuel costs have risen in line with oil prices. International trade has also been growing more slowly than global GDP, mainly because Western consumers' spending on exports from the Far East has slowed post-recession. All of this has led FedEx's express-shipping margins to decrease.

Source: Company accounts.

The company's response to these pressures is to increase its investment in ground shipping, and to work on efficiency gains in express, including retiring planes and modernizing the fleet. All of these things will help to increase its margins in future.

Productivity improvements, e-commerce and its rivals

FedEx aims to realize $1.6 billion in cost savings by 2016 -- which is a large part of the reason why analysts have EPS growing by 39% over the next two years, while revenues are only forecast to grow by 9%. During its recent conference call, management outlined that it was ahead on plans to cut costs, and reiterated its $1.6 billion savings target, despite seeing weaker-than-expected end demand thanks to a slower economy.

Moreover, FedEx's ground segment has strong secular growth prospects from burgeoning e-commerce demand. Speaking of its ground services during the conference call, the company declared that it would put as much money as it could into it. FexEx claimed that ground's margins would remain at 17% to 19%. Ground's volume growth was being "driven by e-commerce."

FedEx's aim must be to increase the amount of free cash it converts from its revenues, because compared to the 9%-plus that UPS has delivered in the last two years, FedEx's conversion looks small. Ultimately, free cash flow is what counts to an investor, because it fuels a company's dividends and buybacks.

Source: Company accounts.

The good news is that FedEx has the opportunity to increase cash flow, while UPS seems more reliant on global GDP growth. UPS lowered its full-year EPS guidance to $4.65 to $4.85 in July as a result of weaker global growth.

Although FedEx's other key rival, Deutsche Post (NASDAQOTH: DPSGY  ) , raised its guidance in June, this was solely due to a one-time item. In fact, Deutsche Post's half-year revenues were flat year-over-year. Increasing this growth will be difficult, because 63% of its revenues come from Europe.

Where next for FedEx?

FedEx should see margin expansion in the next few years as productivity improvements, and the shift in its earnings toward the ground segment, kick in. Indeed, analysts give FedEx a forward P/E ratio of 13.4 for May 2015 -- a discount to UPS's projected 16.7 for December 2014.

Moreover, UPS is slightly more exposed to the global economy then FedEx, and the latter seems to be executing its productivity plans well. FedEx should be converting revenues into cash flow much better in the coming years, and it looks to be a relatively decent value, provided the global economy holds up.