Friday, January 31, 2014

Johnson & Johnson in 2014

The recent earnings results from Johnson & Johnson  $JNJ were met with a near 2% sell-off on the day. As ever, a lot of journalists and commentators immediately searched for a negative in the results or guidance in order to justify the drop. There was nothing significantly wrong with the results. However, the company's stock looks fairly valued and it probably needs to surprise the investment community on the upside in order to move significantly higher in 2014.

The running story with its divisions in 2013 was one of strong pharmaceutical sales, weakening medical device & diagnostics, and moderately growing consumer products. The fourth quarter results stuck to the script, and it's hard to see how things will change much in 2014.

Pharmaceuticals (39.4% of 2013 sales)
Johnson & Johnson's pharmaceutical performance stood out because it had a number of new drugs in early marketing stages, while continuing to generate strong growth with its Remicade (rheumatoid arthritis) treatment.

Remicade sales grew by nearly 14% in the fourth quarter, and generated more than 23% of pharmaceutical sales and over 9% of total company sales in the quarter. Meanwhile, some of its newer drugs achieved very strong growth:

Drug Treatment Fourth Quarter Sales ($m) Fourth Quarter Growth
Stelara psoriais 417 55%
Simponi rheumatoid arthritis 254 40%
Invega Sustenna anti-psychotic 350 54%
Xarelto anti-coagulant 271 n/a
Zytiga castration-resistant prostate cancer 495 87.5%

Source: Company Presentations

Together, these fast-growing drugs generated 24.4% of total pharmaceutical sales in the fourth quarter. Growth should continue at a strong pace in 2014 as the company's sales reach is expanded.

However, one potential problem could be Hospira's (NYSE: HSP  )  biosimilar for Remicade, called Inflectra. Hospira's drug was approved by the European Commission in late 2013, and has proved to be comparable to Remicade in a large-scale trial.   Johnson & Johnson's patent protection for Remicade will run out in most countries in Europe in February 2015, and in February 2018 in the United States. Given the importance of Remicade, Hospira's Inflectra could turn out to be a challenge to Johnson & Johnson in future.

Medical Device & Diagnostics (40% of 2013 sales)
Pharmaceuticals did well, but the medical device & diagnostics division is facing another difficult year. The whole indusrtry has found it tough. Medical device sales are not often seen as economically sensitive, but when the economy is slow patients tend to make fewer visits to the physician. Ultimately, this results in fewer surgical procedures. Throw in a climate of austerity in hospital spending, and the outlook for medical devices looks moderate in mature markets. Indeed, Johnson & Johnson's management outlined on the conference call that surgical lab procedures were "flat over the last 12 months" in the United States.

Consumer Products (20.6% of 2013 sales)The 2.8% increase in consumer products sales for the fourth quarter was disappointing to some, but Foolish investors should note four things about the division.

First, the consumer products division is probably the most visible of its operations, though it's actually the least important in terms of sales. Second, it's also the division with the largest reliance on international markets, and currency effects reduced sales by a significant amount. In fact, on a constant currency basis, consumer products sales were up 4.4% in the fourth quarter.  Third, the company achieved its aim of getting 75% of its over-the-counter brands (previously affected by production problems) back onto the shelves. Indeed, its U.S. OTC sales rose 21.6% in the fourth quarter. Finally, if you exclude the effects of the sales of the manual toothbrush (oral care) and women's sanitary protection (women's health) businesses then U.S. sales were actually up 10%, with global operational sales growth up 6%. 

Johnson & Johnson in 2014
Looking into 2014, investors should focus on three things:

  • Acceleration in the economic recovery so medical device sales can pick up inline with an increase in surgical procedures.

  • Ongoing development of pharmaceutical sales, and activity to protect future market share for Remicade in Europe.

  • An improvement in its international consumer products sales, as they only grew 3.1% operationally in 2013.

Achieving two of the three things should provide for some upside surprise, and Johnson & Johnson needs it. On current analyst estimates, it trades on a valuation of 16 times forward earnings. The company also has only 6% and 7.4% earnings-per-share growth estimated in the next two years. This makes it look like a fairly valued stock.

Thursday, January 30, 2014

Wells Fargo: Still a Well Positioned Directional Play on the Economy

Analyzing the prospects for banking stocks like Wells Fargo  $WFC  isn't really as hard as many people think.

The fortunes of the banking sector tend to follow the direction of its underlying assets, which, in turn, tend to follow the economy. If you are bullish on America, then you should be bullish on Wells Fargo.

Wells Fargo reports results
The bank's fourth-quarter diluted earnings per share increased 10%, but as always with banking stocks, the devil is in the detail. Essentially, Wells Fargo has done very well growing its net interest income over the course of the year, despite its net interest margin, or NIM, falling. The NIM is the difference between its interest income and what it pays out to its lenders, all over interest-earnings assets.

Source: Company presentations.

This was no small feat considering that core deposits (including retail deposits) have gone up significantly more than it managed to increase its loan book.

Source: Company presentations.

It's somewhat of an anomaly to view a rising deposit base as a problem, because raising deposits is what banks are supposed to do! Indeed, in traditional recoveries, deposit growth is highly sought-after because it gives banks greater ability to extend their loan books. However, this recovery has been relatively anemic, and loan demand has been slow to take off. In short, Wells Fargo needs a more positive environment for loan demand, but the good news is, it has the deposit base to benefit should this happen.

So, how has Wells Fargo been generating income growth?
Given the dramatic decline in the NIM, Foolish readers might be wondering just how the bank has increased its overall net income? The answer is that credit quality has improved so much that its provisions for credit loss have declined massively.

In other words, Wells Fargo set aside nearly $1.5 billion less in the most recent quarter compared to a year ago.

Not all good newsThe mortgage refinancing market had been very strong leading into 2013, and Wells Fargo had previously positioned itself to benefit. However, with rates rising this year, the refinancing market has slowed, and Wells Fargo has been inordinately hit. In the words of its CFO, Tim Sloan, on the recent conference call:

Our market share, over the last couple of years was disproportionately high, primarily because the biggest driver for origination volume until the last couple of quarters was refinances, and the reason for that, again to remind everybody, is that we are the largest servicer and the quality of our servicing book was the highest in the industry. 

Indeed, Foolish investors can see the effect of the refinancing slowdown when looking at Wells Fargo's non-interest income. Note how the reduction in mortgage banking income has reduced non-interest income.

Source: Company presentations.

Putting the pieces together for Wells Fargo
In a typical economic recovery, an increase in credit quality is usually followed by an increase in loan demand, and then the NIM starts expanding while interest rates rise at the same time. However, this has been anything but a normal recovery.

In short, Wells Fargo needs to see a pick-up in loan growth in 2014. History suggests this will happen, and given its exposure to housing, and its growing deposit base, Wells Fargo is ideally placed to benefit.

On the other hand, should the economy stagnate, it can't really boost its net income via reduction in credit loss provisions. Moreover, a slow economy implies sluggish loan demand growth. The NIM would probably decline even further in this scenario.

The bottom line
In a sense, the stock remains a key barometer of where you think the economy is headed. Moreover, Wells Fargo gives you specific exposure to the U.S. and to housing, two of the more positive aspects of the global economy.

All told, investors everywhere can discuss this stock to death, but it still remains a cyclical play on the economy. If you think the U.S. housing market will continue to recover and increase loan demand with it, then Wells Fargo is ideally placed to benefit, and the metrics discussed above will all get better.

Wednesday, January 29, 2014

Why FactSet Fell Behind The Market

The logic of buying a stock often appears easy. If "X happens, and I think it will, then Y will benefit." In the case of financial services information provider FactSet Research  $FDS , it's usually a case of "if equity markets do well and the economy is recovering, then FactSet will benefit."

Unfortunately, that didn't entirely work out like that for FactSet in 2013, but what about its prospects in 2014?

FactSet Research disappoints
Equities aren't the only game in town, and FactSet sells a range of information including fixed income, fund, and wealth management information. However, there is no doubt that most financial firms' fortunes are tied to how equity markets perform. For example, wealth management firms find it a lot easier to raise assets during a bull market, and it's a lot easier to sell equity research when stocks are going up.

These sorts of drivers should lead to more bums on seats at financial services firms, something that should be good news for FactSet and industry peers like Thomson Reuters  $TRI  and Morningstar  $MORN

However, a quick look at FactSet's growth in annual subscription value, or ASV, and client numbers reveals that its growth has slowed despite strong equity markets. ASV is the key metric to follow for FactSet, because it's a useful proxy for its future organic revenue growth.

Source: Company presentations.

Organic ASV growth was only 5% in the last quarter, and analysts have the company on 6.2% and 6.8% overall revenue growth for the next two years. Meanwhile, earnings per share is expected to grow at 8% and 11% in the same period. It's fair to say that investors could have expected more given that the S&P 500 went up so much last year.

What's going wrong?
There are four, sometimes related, issues to consider with FactSet.

First, financial firms appear to have been affected by the financial crisis and seem to be a lot more reticent to expand and hire people. Moreover, they operate under an uncertain regulatory environment. In fact, on its first-quarter conference call, FactSet's management described its middle-market banking customers' hiring plans as being "fairly steady," while bulge bracket hiring was best described as "choppy." 

In addition, FactSet saw two large clients renew contracts in the last quarter, but with a reduced number of users on their contracts. According to FactSet, one had overbought in 2009, and the other had shut down its investment banking division in 2010. In a sense, FactSet is still suffering the lagged effect of the financial crisis.

Second, according to FactSet's Executive Vice President Michael Frankenfield, the financial information services industry is consolidating. On a conference call, he outlined:

The days where users had multiple platforms on their desks are behind us, and it's common for firms to reduce the number of platforms that each user has.

This brings good and bad news for FactSet. It's good as it helps FactSet retain clients, because it's a larger player and can offer a wider range of products than a small firm can. Indeed, its client retention ratio was greater than 95% of ASV in the last quarter.  

However, it's bad news because it makes it harder to sell products into other firms customers. In fact, Thomson Reuters shut down a product recently, and according to FactSet's management, when Thomson's product platform "went away, that workflow went to other products that were on their desk" without a new product replacing it.

Third, FactSet may well be suffering the effects of increased competition. As noted above, the days of analysts and brokers cherry-picking various platforms appear to be over, and this implies a smaller pie for Thomson Reuters, FactSet, Bloomberg, and Standard & Poor's to fight over. In addition, Thomson Reuter's scale (it's more than eight times the size of FactSet) means it can afford to bundle its research solutions to customers.

Financial environmental changes affecting FactSet and Morningstar
The fourth issue relates to the industry backdrop. At the start of the year, FactSet generated 19% of its revenue from sell-side research, but that has now fallen to 17.8%. The sell side (primarily mergers & acquisitions and advisory and sell-side equity research) is somewhat affected by takeover activity and the ability for sell-side firms to sell the research. If this turns out to be a structural rather than a cyclical issue, then prospects for the sell-side look dim.

On a more positive note, FactSet is seeing good growth from its wealth management solutions, and especially with portfolio analytics. This is somewhat expected given a strong equity market, and Morningstar is benefiting, too. Morningstar's solutions are more weighted toward investment and wealth managers, and it saw its investment management revenue increase 11.4% in the last quarter.

The bottom line
Frankly, it's become hard to tell whether FactSet is going to be a major beneficiary of another good year in equity markets. This makes investing in the stock somewhat problematic. If markets turn down, then FactSet will surely suffer, too, but if equity markets have a good year, there's no guarantee FactSet will inordinately benefit. On a forward P/E ratio of nearly 22 times earnings to August 2014, the stock is hardly a great value for this kind of proposition. 

Monday, January 27, 2014

Family Dollar Has Much To Do In 2014

Family Dollar Stores $FDO shares have been sliding recently, with the stock down 6.5% in the last three months. Moreover, the latest news wasn't good. Recent results saw the company lower full-year earnings estimates, and the departure of president and COO Michael Bloom isn't exactly what investors needed to hear right now.

In addition, Family Dollar continues to underperform its rivals Dollar General  $DG  and Dollar Tree Stores  $DLTR , while end-market conditions for the dollar stores remain challenging, as lower-income groups in the US are not proportionately benefiting in the recovery. Can Family Dollar turn things around? And is it now the value play in the sector?

Family Dollar disappoints
Key points from the first-quarter earnings report:

  • Comparable same store decrease of 2.8% vs. guidance for a low-single digit decline

  • Earnings per share of $0.68 vs. guidance for $0.65-$0.75

While the results were not particularly bad, there were some significant downgrades in its full-year guidance to August 2014.

Full Year 2014 Guidance At Q4 2013 At Q1 2014
Net Sales mid-single digit increase low-to-mid single digit increase
Comparable-Same-Store Sales
low-single-digit increase
low-single-digit decline
Net Store Openings 445 445
Gross Margin expansion flat
Capital Expenditures $550 million to $600 million $450 million to $500 million
Share Repurchases $100 million $250 million
Earnings Per Share $3.80-$4.15 $3.25-$3.55

Source: Company Presentations

Guidance for net sales, comparable-same-store sales, and gross margin was lowered, but store expansion plans were kept consistent. In addition, don't assume that the lower capital expenditures guidance was an adjustment to the company's weakening performance. Rather, it's more reflective of a change in how its new stores are being financed. In the words of CFO Mary Winston, more 'build-to-suit' financing structures are being used compared to 'fee-development' financing.

This implies reduced capex but increased leasing activity. Eagle-eyed readers will note that share-repurchase plans have gone up by $150 million. All told, Family Dollar's outlook worsened, and it seems to be rewarding investors with share repurchases partly funded by reducing capex. Meanwhile, it's likely to be increasing leasing debt in order to continue to fund a store expansion program.

Whether this is a wise strategy or not will be determined by the success of its readjustment plans for 2014, which involve things like:

  • A renewed focus on everyday low pricing

  • A pallet-delivery program to increase supply chain efficiency

  •  Store layout refreshes

  • Adjusting marketing strategy to increase traffic to the stores

  • Continuing to invest in the new store program

What went wrong?
To understand the reasons behind the plans, it's best to look at what has been going wrong. In discussing the departure of Bloom, Family Dollar's CEO Howard Levine declared that:

"[W]e weren't happy with our financial results. Ultimately, Mike and I were not aligned on our merchandising strategy and we decided to make a change."

Family Dollar's merchandising strategy has undergone some changes in recent years. For example, in the summer of 2012, the company underwent a significant program of adding 1,000 new items, including tobacco, and making store-layout changes. According to Levine, the changes had positive effects on traffic and spending but also resulted in "significant margin pressure, higher store manager turnover, increased shrink and lower inventory productivity."

Some of these effects can be seen in the following graph:

Source: company presentations.

In response to these issues, the company limited changes in consumable categories and store layouts in 2013. The end result is that the first significant changes in its consumable categories took place in the recent quarter; 18 months after the changes in 2012.

Dollar Tree and Dollar General doing better
Essentially, the dollar stores generate traffic via consumables sales and then hope to increase margins by selling discretionary items. As a consequence, the delay in changing its consumable categories has hurt Family Dollar while the retailer has also struggled to generate growth in its discretionary sales. In fact, Family Dollar's traffic slowed "particularly in November and December[,]" while its non-consumable sales (25% of total sales) only rose 1% in the last quarter.

This is in contrast to rival Dollar Tree, which managed to generate positive comparable sales for every month in the last quarter. On its conference call, Dollar Tree's management stated, "So what you saw beginning in [the second quarter of] this year was a little bit of a shift, with the non-consumables growing a bit faster than the consumables."

Moreover, in contrast to Family Dollar, Dollar Tree grew comparable-same-store sales by 3.1% in the last quarter "driven by increased consumer traffic."

Meanwhile, in its last quarter, Dollar General managed to generate "strong customer traffic growth throughout the quarter[,]" partly thanks to the addition of tobacco. Dollar General also grew its non-consumable sales for the second quarter running and reported positive results in its seasonal and home categories.

The bottom line
Family Dollar's performance in 2013 wasn't great, but there is a case for the stock to be a good value proposition. Dollar stores aren't going away anytime soon, and if the company gets its merchandising and layouts right, then there is no reason why consumers won't come back. It's not rocket science.

However, the commitment to rolling out new stores at the same pace is somewhat concerning, considering that the management has enough on its plate in reenergizing the business. Foolish investors might want to be a little patient before piling in. It's one for the monitor list. 

Saturday, January 25, 2014

Is Fastenal Good Value?

Last year was a difficult one for investors in industrial supply company Fastenal  $FAST . The stock ended the year flat, and managed to underperform sector peers such as Grainger $GWW  and MSC Industrial  $MSM. Furthermore, the Institute for Supply Management, or ISM, manufacturing data got a lot stronger in the second half, but Fastenal's performance did not. What's going on? Can the market expect more from the company this year?

Fastenal disappoints, again
Having warned investors that it would miss quarterly earnings per share estimates of $0.36  in its update in December, Fastenal then managed to miss its upgraded estimate of "growth in net earnings per share" by reporting flat earnings growth of $0.33 for its fourth quarter.

Superficially, this is surprising given the strength of the ISM manufacturing data:

Source: Institute for Supply Management

In addition, MSC Industrial's management reported on its January conference call that feedback from its manufacturing customers "confirms the current theme of stabilization and gives us some cause for greater optimism about 2014."

So why did Fastenal miss esimates?

Fastenal adjusts its sales operations, gets heavy too
In the December update, Fastenal outlined the three reasons for the earnings miss.

First, despite the strong ISM numbers, Fastenal is having some issues with its particular end markets. The company generates 50% of its sales from manufacturing, 25% from non-residential construction and the rest from a diverse set of business. Within its manufacturing sales, heavy manufacturing makes up 80% of sales with heavy equipment making up half in turn. Be sure to distinguish between Fastenal's heavy manufacturing and its heavy equipment sales, the latter is a subset of the former.

All told, heavy equipment makes up 20% of total company sales and this segment was weak in 2013. In fact, Fastenal disclosed that heavy equipment sales (agriculture, mining, construction, defense, etc.) grew less than 2% in the third quarter, and only 1.5% in the fourth, even as heavy manufacturing sales were up "between 6% and 7%". The good news is that heavy manufacturing sales appear to be recovering (in line with the ISM) with a 7.2% in the fourth quarter following a 5% gain in the third.

Indeed, the theme was confirmed by MSC Industrial's management on its recent conference call: "Overall, we continue to see that our core customer segments in heavy metalworking are still lagging the broader industrial economy." Grainger also reported that its light manufacturing sales grew in "the high-single digits" in the third quarter, but its heavy, commercial and natural resources sales were only up "mid-single digits". 

In addition, Fastenal's sales to non-residential customers have been weaker in 2013, as poor weather plus sequestration issues hit the commercial and industrial construction markets.

Source: company presentations.

Second, gross margins ran below expectations. According to Fastenal's  December update, this was due to "lower utilization of our trucking network and lower supplier incentives", and "the final components relate to product mix (fasteners carry our highest gross margin and have had a weak 2013) and a very competitive marketplace".

In fact, fastener sales started 2013 by comprising 42.9% of total sales, but only made up 40.6% at the end of it.  However, on the recent conference call, Fastenal's management outlined that gross margin is expected to get back to its historical 51%-52% range in the first quarter, recovering from a disappointing 50.6% in the fourth quarter of 2013.

The third factor was due to the expansion in store headcount made in the second half. Earlier in the year, Fastenal had outlined a plan to hire 600-900 more in-store staff in order to enable existing managers to increase their sales visits. In addition, there was a change of approach whereby the company went for quality over quantity with the expansion of its vending machines; a policy set to be reversed in 2014. It appears that the sales changes caused some initial problems, and Fastenal's management was quite upfront on the failure to execute in the second half.

Where next for Fastenal?
It's a mixed outlook for Fastenal.

On the positive side, 2014 it could be a better year for commercial construction, and the new orders component of the ISM manufacturing index (see above) indicates that manufacturing growth will be strong in the coming months. Furthermore, its gross margin looks set to bounce back, while its sales execution has the potential to improve.

On the downside, the stock remain expensive related to its peers:


Moreover, Grainger and MSC Industrial have the potential to grow their e-commerce revenues and vending machine sales, while sales to customers with vending machines already  make up 36.6% of Fastenal's  net sales.

In conclusion, the U.S. industrial sector looks like it will be healthy in 2014, and Fastenal is likely to bounce back, but there are cheaper ways to buy into the sector than this. The valuation is still not compelling.

Wednesday, January 22, 2014

Introducing Watts Water, a Strong Commercial Construction Play for 2014

The water sector has long been favored by long-term investors who like thematic trends. The critical necessity of water in industrial and commercial applications, and the need for potable water supply for a growing global population means that the sector has strong long-term prospects. However, while the trend maybe upward, the water industry is notably exposed to demand from new housing and commercial construction project, and that hasn't been a great place to be in recent years in the West. However, with these end-markets looking set to pick up in 2014, companies like water products manufacturers Pentair $PNR and Watts Water  $WTS look  well placed.

Watts Water and Pentair look set for growth
Foolish readers know why commercial construction is a good sector to be in next year. Simply put, the commercial construction sector tends to follow the residential sector, and with the housing market in good shape going into 2014, investors in the commercial construction sector should be feeling optimistic about the coming year.

Indeed, a quick look at what analysts have penciled in for Watts and Pentair reveals a positive consensus for the next few years.

Forecast EPS Growth Rates 2013 2014 2015 2016 2012-2016 CAGR
Watts Water Technologies 4.5% 25.4% 21.0% 13.3% 15.8%
Pentair 33.8% 23.8% 22.5% 9.5% 22.1%


Pentair is attractive in its own right, but its forecast revenue mix for 2013 demonstrates that residential and commercial activity only represents 25% of its end market.

Source: Company presentations

Pentair's diversified exposure is fine if you want an industrial play, but for those investors looking specifically for a residential and commercial play then Watts Water is better placed. Pentair's diversification would normally be seen as a major plus point, but not if you want to focus on commercial construction.

Watts transforms itselfWatts stands out for its cash flow generation. For example, Watts has converted around 150% of net income into free-cash flow, or FCF, over the last three years. 

Assuming that  Watts converts 130% of net income into FCF in future, and using these rates and analysts' earnings-per-share forecasts from the table above, can give an idea of FCF per share. For the sake of simplicity, assume that EV is equivalent to current values.

Source:, author's estimates

Watts Water looks like a good value. The impressive thing about Watts is that although its trailing-12-month revenue of $1,452 million is marginally above its 2008 level of $1,432 million, the company has increased gross margins from 33.7% to 36.1% over the period.  In other words, should revenues start to increase in the future, Watts has a good opportunity to generate higher profits thanks to better margins. Moreover Watts generates 50% of its revenue from commercial operations, so it's heavily exposed to a pick up in commercial construction.

On a more negative note, Watts generated only 52% of its sales from the U.S. in 2012 with 40% coming from Europe, the Middle East and Africa, or EMEA. In fact, its guidance for 2013 assumes that EMEA will decline by 4%-5% with North American core business sales estimated to grow 3%-5%. While Europe is likely to remain soft, Watts will come up against some easier comparisons in 2014. In addition, in its latest investor presentation, management outlined that "overall market confidence appears to be improving" in EMEA, while is North American commercial market is "starting to see signs of a pick-up".  Both statements are good signs.

The bottom line
If you are looking for an overall industrial play then Pentair is worth a closer look, but for a developed market play on a resumption in residential and commercial construction spending then Watts is better placed. The company has internally transformed itself over the last few years in order to improve cash flow generation and its return on invested capital. As long as the U.S. housing market remains in recovery mode, it's a good bet that commercial construction will follow, and Watts is well placed to outperform.

Monday, January 20, 2014

Alcoa's Earnings and What They Mean to the Market

The symbolic start to the earnings season kicked off with a disappointing set of earnings from aluminum and alumina producer Alcoa (NYSE: AA  ) . The company always provides useful end market guidance for the industrial sector, and this time around it produced a mix of good and bad news.

Alcoa gives its market outlook
The first notable aspect of its outlook is that Alcoa is relatively less dependent on China this year. This is a due to a combination of three factors. First, China's industrial growth appears to be moderating. Second, North American growth is picking up. And third, European growth is somewhat stabilizing as the region starts to come up against some weak comparables from previous years.

Source: Company Presentations.

Aerospace and automotive
These two sectors were the powerhouse of the industrial sector last year. According to Alcoa's management, growth will remain strong this year as well. The International Air Traffic Association (IATA) recently gave its aerospace industry outlook for 2014, and the forecast is for a strong increase in North American airline profitability. This is good news for Boeing (NYSE: BA  ) and Airbus. Moreover, along with the IATA, Alcoa made some bullish noises about future regional and business jet demand. This is a good sign for the global economy, because demand for these types of jets tends to be more cyclical. With passenger load factors (airplane capacity utilization) forecast to grow, Airbus and Boeing can expect orders to remain strong in 2014.

Unlike 2013, automotive growth is expected to be positive in each region for 2014 (though there are some warning signs in North America). On the recent conference call, Alcoa's CEO Klaus Klienfeld outlined that U.S. automotive production levels were now at almost pre-recession levels, but car inventories were 14% higher than last year. Consequently, automakers have pushed up incentives by 8%. This is a slightly worrying indicator, but with ongoing gains in employment in the U.S. and greater availability of credit it's unlikely to prove a lasting effect.

Meanwhile, growth in the automobile sector in China remains strong.

Two companies set to do well, and one that could disappoint
Paintings and coatings company PPG Industries (NYSE: PPG  ) and seeing machines company Cognex (NASDAQ: CGNX  ) both look set to do well, if Alcoa's report is a useful guide. PPG's industrial coatings business has heavy exposure to the aerospace and automotive sectors, and the company looks set to continue to benefit from favorable end markets in 2014. In fact, PPG even did well with European automotive manufacturers in 2013, because its management believes its clients were those doing relatively well in a down market. Given that European car production is expected to be better overall this year, PPG should do well. In addition, Alcoa expects the North American commercial building and construction market to improve by 3% to 4%, and this is good news for PPG's paintings division.  

One of Cognex's aims for 2014 is to expand its sales outside its core automotive sector and into areas such as pharmaceuticals, consumer products, and the food and beverage industry. The company specializes in seeing machine systems that monitor automated processes. Given that China's automotive sector is expected to remain strong and areas like beverage can packaging are forecast to grow at 8% to 12%, opportunities for Cognex to expand its industry reach should remain significant in 2014.

There was disappointing news for General Electric (NYSE: GE  ) shareholders in Allcoa's report, however. Allcoa's management forecast a 8% to 12% decline in industrial gas turbines. Quoting from the conference call, Alcoa's management said:

In Europe, gas fired power generation is squeezed between low priced coal and subsidized renewals. In the U.S., gas prices have increased and this has allowed coal to claw back some of the share gains. Gas now stands in terms of energy production share here in the U.S. at 27.8 versus 30.4 in 2012

Indeed, GE reported that it only took 27 heavy duty gas turbine orders in its third quarter versus a year ago, while delivering 22 versus 35 last year. In addition, if gas turbines are being utilized relatively less, then GE's service orders to the industry should also decrease. Gas turbine revenue is a large part of GE's power & water division, which has generated nearly 29% of GE's industrial profits so far in 2013.

The bottom line
In conclusion, it was a mixed outlook with the main disappointment coming from the industrial gas turbine outlook. However, Europe looks set to improve, and North American industrial growth prospects look solid. China is subject to uncertainty this year, but Alcoa continues to give a positive reading on the country. Aerospace and automotive demand remains strong, and prospects look good for U.S. commercial construction.

Friday, January 17, 2014

Lennox International Equity Research

While the pickup in the housing market has become a widely accepted investment theme, Foolish investors might favor taking a look at investing in the commercial construction market. One area of interest is the heating, ventilation, and air conditioning, or HVAC, market. The pick of the sector is Lennox International  $LII , with A.O. Smith $AOS also deserving of an honorable mention.

Lennox and A.O. Smith look set to grow earningsWhy is commercial construction considered next year's hot sector? The key argument is that the commercial sector tends to follow the residential sector, so stocks exposed to the former are likely to produce more upside in 2014.

You can think of the commercial construction sector as experiencing a rough five to six years where it grew lower than GDP growth, but is now set to grow faster than GDP, as the economy recovers. Indeed, it certainly seems that way if you look at consensus earnings-per-share growth forecasts for Lennox and A.O. Smith. Both companies are forecast to have high compound annual growth rates, or CAGRs, over the next four years.

Company 2013 2014 2015 2016 CAGR
A.O. Smith 34.9% 12.3% 12.7% 12.8% 17.8%
Lennox 35.8% 21.5% 16.6% 9.4% 20.5%


In the case of HVAC specialist Lennox, the market has clearly priced in a recovery due to its residential market exposure. However, it also has upside potential from a future recovery in commercial construction.

Lennox's management estimates that its 2013 revenue split will likely include residential HVAC contributing 49%, commercial HVAC 27%, and refrigeration 24%. Given the strengthening housing market, it's no surprise that 75% of the increase in overall segment profits came from the company's residential markets. Furthermore, Lennox generates around 85% of its business in North America, so it's very much a U.S. market play. Where it gets interesting is in the fact that Lennox's commercial operations tend to have a higher profit margin.

Source: company presentations

Essentially, if Lennox's commercial HVAC sales come in better than expected then there is an opportunity for a positive shift in the overall margin mix. Moreover, Lennox's management recently gave its 2014 forecast and outlined the key assumptions behind its 3%-7% revenue growth forecast. Management is estimating that North American residential units will be up "mid-single digits" from 10% in 2013. Meanwhile, its commercial units are forecast to rise in "low-single digits" from a paltry 2% in 2013. Frankly, Lennox's commercial forecast looks a little bit conservative, so you should see some additional upside.

Lennox's cash flow advantage
Lennox stands out for its cash flow generation. For example, A.O. Smith's management recently forecast $100 million in free cash flow, or FCF, for 2013, but this is not particularly impressive when compared to its enterprise value, (market cap plus debt minus cash) of around $4.6 billion.

In contrast, Lennox has converted 110% of net income into FCF over the last four years, and is forecasting 90% conversion in 2014. However, A.O. Smith has converted around 60% of adjusted net income into FCF over the last three years. 

For illustrative purposes, lets assume Lennox converts 100% of income into FCF and A.O Smith converts 60%. Using these rates and analysts' EPS forecasts we get an idea of future FCF per share. For the sake of simplicity, assume that enterprise value is equivalent to current values.

Source:, author's estimates.

Lennox looks to be fairly valued, but as discussed above, it offers upside potential if you are bullish on commercial construction. Meanwhile, A.O Smith doesn't look like as a good value, but it's likely to outperform if the sector picks up.

The bottom line
A.O. Smith and Lennox are not cheap stocks, but they both have good earnings leverage should the commercial construction market improve next year. Lennox is probably the choice pick, but don't be surprised if A.O. Smith starts increasing margins and cash-flow generation if its end markets pick up. HVAC is an indispensable part of a commercial construction project, and bulls on the sector should take a closer look at both stocks.

Thursday, January 16, 2014

Commercial Aerospace Looking Good For 2014

Last year was a bumper year for equities, but it wasn't a great one for the economy. However, the commercial aerospace sector stood out, because according to the International Air Transport Association, or IATA, end market conditions progressively improved through 2013. Moreover, the IATA is forecasting an even better year in 2014, so prospects for commercial aerospace plays like Boeing (NYSE: BA  ) , cabin manufacturer BE Aerospace (NASDAQ: BEAV  ) ,aviation services company AAR Corp (NYSE: AIR  ) and airframe product manufacturer Precision Castparts (NYSE: PCP  ) are looking good, too.

IATA Industry Forecasts
The following graph demonstrates how the IATA's expectations for commercial airline profitability in 2013 progressively got better through the year. Meanwhile, its forecast for world economic growth actually declined over the period. In September of 2012, the IATA forecasted world economic growth in 2013 to be 2.5%, while the latest forecast from December of this year was just 2%.

Source: IATA.

Moreover, its latest forecast for 2014 sees global net profits expanding to $19.7 billion from 2013, an increase of 52%. Among these improvements, there is a remarkable turnaround taking place in terms of regional prospects.

Back in 2010, Asia-Pacific airlines generated $11.1 billion in profit, while North American airlines only made $4.2 billion. However, the IATA is forecasting North American airline commercial airline profits to increase to $8.3 billion in 2014 from $5.8 billion this year. Meanwhile, Asia-Pacific commercial airline profits are forecast to be only $4.1 billion in 2014.

The obvious answer would be that passenger traffic growth must have gone up, but according to the IATA, North American growth isn't going up by much, and is still noticeably less than in the Asia-Pacific region.

Source: IATA.

So how and why have North American (and to a lesser extent European) airlines suddenly become more profitable, and how can Foolish investors take advantage?

More pricing power, more efficiency
There are two primary reasons for this increased profitability. First, North American airlines are seeing greater pricing power thanks to a slowly improved economy. Second, they are taking substantive productivity measures to increase profitability. These two factors will combine to drive growth in the future.

You can see the pricing power in the fact that the IATA forecasts that global net profit per departing passenger in 2014 will be at $5.94 in 2014 -- a level not seen since the peak of 2007. Western airlines' willingness to improve productivity includes buying more modern and efficient planes from Boeing and Airbus. It's significant that the airlines placing the largest orders for Boeing planes as of mid-December this year were American Airlines and European budget carrier Ryanair, with 143 and 175, respectively, out of Boeing's total of 1074. Furthermore, Boeing can look forward to a strong order book in 2014 because the IATA predicts that overall passenger load factors (a measure of airplane capacity utilization) will rise to 81.3% in 2014. In other words, capacity pressures are likely to encourage more investment in new airplanes.


BE Aerospace, Precision Castparts, and AAR Corp BE Aerospace is also a key beneficiary of the upswing in commercial aerospace. Not only does it offer newbuild cabins, but its retrofit orders should also increase as airlines become more profitable. In addition, at its last results, BE Aerospace announced the first delivery of its modular lavatory system on a Boeing plane delivered to Delta Airlines.

Precision Castparts has invested heavily in preparation for the upswing, and appears to be ready to realize the fruits of its investment. Precision bought longtime Boeing supplier TIMET for $2.9 billion in 2013. .  Furthermore, Precision has been investing in ramping up production capacity for the Boeing 737 and 787 Dreamliner. Given that these two airplanes have received 74% and 17% of Boeing's total net orders for the year to Dec 2013, it looks like a smart move.

AAR Corp helps airlines improve productivity by allowing airlines to outsource logistics and spare parts provision. AAR is clearly looking to expand its supply chain activities. According to CEO, David Storch on its recent conference call:

So as we think about the supply chain piece itself, one of the things we'd like to do is build out, and we've talked about this before, geographic expansion. And we are looking at a fairly sizable deal that would expand our presence

However, AAR makes less than two-thirds of its sales to commercial customers  with the rest going to defense and government customers. It's not really a pure-play commercial aerospace company, but it is nicely exposed to airlines seeking to cut costs.

The bottom line
Prospects look good for the commercial aerospace industry in 2014, and provided the global economy holds up, the sector has the opportunity to outperform. North American airline profitability is leading the way, and Foolish investors would we will advised to look at companies servicing demand from them. The commercial aerospace upswing isn't over yet.

Monday, January 13, 2014

FedEx's Long Term Prospects

FedEx and its main rival UPS  are well-regarded in the marketplace for their exposure to long-term growth from e-commerce related deliveries.However, it's less well-known that FedEx is also undergoing a major productivity enhancement program which should enable it to catch up to UPS in terms of margins and cash flow generation. These two factors make FedEx one of the most interesting stocks in the transportation sector, and it's worth taking a closer look to see if FedEx's growth prospects can justify the stock moving higher in 2014.  

FedEx upgrades guidance
While e-commerce and its internal productivity improvements are the key to its medium term growth, FedEx will always be a correlated play on global trade. Indeed, its GDP forecasts are some of the most keenly watched data sets in the marketplace.

FedEx issues GDP forecasts because its revenues tend to correlate with global growth, and in particular global trade growth. Naturally, this means that the company has a pretty good handle on macro trends.  Consequently, the upgrades to its earnings and GDP forecasts were good news for FedEx and for the global economy.

Earnings per share are now expected to come in 8% to 14% ahead of last year, versus its previous guidance of 7% to 13%. As for its GDP forecast, the upgrade to U.S. and World expectations suggests a strengthening of growth in the fourth quarter.

Estimates for Full-Year 2013 Start of the Year Next Quarter Previous Quarter Current Quarter
U.S. GDP Growth 1.9% 2% 1.6% 1.7%
World Growth 2.5% 2.3% 2% 2.1%

Source: company presentations 

For 2014, FedEx is predicting stronger growth of 2.4% in the US and 2.8% globally.

E-commerce driving growth in ground servicesThough FedEx originally took its name from its express delivery services, the bulk of its profits now come from its ground segment.

Source: Company Presentations

The driving force behind this shift in segment fortunes is that e-commerce revenues are growing in importance. In addition, the recession and the subsequent 'age of austerity' has created an environment where customers are trading off quicker delivery with express for the cheaper, but slower, option of ground.

UPS is seeing a similar dynamic. For example, its US domestic package segment grew revenue by 5% in the third quarter with its business to consumer business up 5%. Meanwhile, its international segment suffered a 2.5% revenue decrease with management noting on the conference call that  "the segment continued to be affected by shifting customer preference for deferred products."

In other words, UPS's customers are now more willing to accept slower delivery in exchange for a cheaper price.

FedEx's productivity improvementsFedEx is only two quarters into its plan to produce $1.6 billion in productivity improvements by the end of 2016. To put this figure into context, its trailing-year revenue currently stands at $44.8 billion, so FedEx's margins could see a few percentage points' improvement in the coming years.

Moreover, any margin improvement usually implies better free cash flow generation. Indeed, as the following chart points out, UPS has tended to sweat its assets better than FedEx has in recent years.

UPS FCF to Assets (TTM) Chart

No matter, FedEx should have plenty of opportunity to increase free-cash flow conversion in future years. To put the following chart into perspective, note that UPS converted around 9.3% of its revenue into free-cash flow in 2012.

Source: company presentations

Moreover, FedEx's management declared in its recent conference call that it was "on track to be where we need to be" by the end of 2016.

Is FedEx still a buy?
Clearly, FedEx has an opportunity to catch up with UPS in terms of cash flow generation due to its profit improvement program. Furthermore, the productivity measures are the key to why analysts have FedEx earnings per share rising by 12.7%, 27.5%, and 20.2% in May 2014, 2015, and 2016 respectively.   If those predictions hold up, free-cash flow should grow strongly, too.

The analyst consensus would put FedEx on a P/E ratio of just 13 times its 2016 earnings. As an investor, you've got to decide whether you believe this is good value for the execution risk, and whether you think the global economy will let the company down.

Sunday, January 12, 2014

Walgreen Looks Good For 2014

Investors in Walgreen  have watched their stock rise more than 50% in 2013, but is there more to come in 2014? The key to answering this question lies the development of its strategic partnerships with pharmaceutical distributor AmerisourceBergen  and European pharmacist Alliance Boots.  Furthermore, its deal with Theranos offers a disruptive threat to part of Quest Diagnostics'  and LabCorp's   operations. There is a lot going on at Walgreen as it strives to reach its long-term strategic objectives.

Walgreen's long-term plan
The plan is based on five key financial targets for the fiscal year 2016. Revenue (including its share of a fully purchased Alliance Boots and joint ventures) is expected to reach $130 billion, with adjusted operating income of $9.0 billion to $9.5 billion. Meanwhile, the operating cash flow target is $8 billion with net debt expected at $11 billion. Finally, synergies from its partnerships are expected to reach $1 billion.

It's time to put these targets into context by playing with some assumptions. Walgreen currently has 949 million shares in issue, and expects to issue around 228 million shares in order to acquire the remaining 55% of Alliance Boots. This means that Walgreen could have around 1,177 million shares in issue.

The company's trailing 12 month operating income is $4,159 million, and its enterprise value (market cap plus debt) is $58.8 billion, or around 14.1 times operating income. Assuming that Walgreen hits $9 billion in operating income in 2016, and taking the current 14.1 times ratio as a benchmark, that means its enterprise value could be around $126 billion in 2016. Stripping out the $11 billion in debt leaves a market cap of around $115.9 billion, and if there are 1,177 million shares in issue, this implies a share price of $98.

Furthermore, even from a cash flow perspective, Walgreen looks attractive if it can hit its targets. Its current enterprise value is 13.7 times last year's operating cash flow. Assuming the $8 billion operating cash flow target for 2016, means that Walgreen could trade on an enterprise value of $109 billion. Stripping out the forecast $11 billion in debt gives you a share price target of $83.

All of which is wonderful, as these two targets represent a 70% and 45% premium to the current share price, but will Walgreen hit its targets?

Walgreen, AmerisourceBergen and Alliance Boots
On its recent conference call, Walgreen's management discussed the 2016 operating income target, and declared that its performance to date "is currently tracking a bit below the CAGR required to meet this goal." However, CEO, Greg Wasson went on to say:

...we think that we have got ways to achieve those goals. The CAGR on the operating adjusted income is a little bit soft but we think the change in the mix of the business will allow us to get it.

Future macroeconomic conditions will obviously play a part, and there is little that Walgreen can do about that. However, there are three reasons why Foolish investors should feel optimistic.

First, operating synergies between Alliance Boots and Walgreen are already tracking ahead of plan. Walgreen is targeting $350 million to $400 million in synergies for 2014, but has already reported $107 million in the first quarter alone. And this comes after Walgreen delivered net synergies of $154 million in 2013 versus its initial target of $125 million to $150 million.

Second, the AmerisourceBergen deal was done after the original targets were set. The deal involves AmerisourceBergen distributing Walgreen's pharmaceuticals, and enables the latter to receive daily delivery to its stores. In addition, it includes Alliance Boots, so Walgreen should be able to generate even more synergies from it.

Third, Walgreen has a host of initiatives to drive growth. Plans involve expanding its balance rewards scheme, selling Boots beauty products in Walgreens, expanding its own-label products, and expanding its local community reach via offering more vaccinations and ongoing treatment facilities.

However, the tie-up with Theranos is the most eye-catching. In September, Walgreen and Theranos inked a deal to bring the latter's lab testing service to Walgreen's stores on a national level. Theranos owns a medical device that can detect diseases in the blood from a minute sample within a short space of time. While this sort of solution is perfect for Walgreen's aim of transforming "the role of the community pharmacy" toward ongoing care, it does pose questions for testing labs like Quest Diagnostics and LabCorp. These two companies essentially run a duopoly on central lab testing of blood, and if individuals can now do these tests at Walgreen/Theranos then what will happen to end demand for blood testing at Quest Diagnostics and LabCorp?

Where next for Walgreen?
All told, the potential upside for Walgreen is significant, and the integration plan appears to be working well so far. On the other hand, it's still early days and investing in the health care sector comes with the usual caveat of political risk. Nevertheless, based on current valuations, the stock looks attractively priced provided the 2016 targets are hit.

Performance Review 2013

A pretty good year overall with a return on 17.3%. Remember folks that I am leveraged and hedged. Don't try this at home, and remind yourself that an absolute return strategy shouldn't be benchmarked against the main indices (even though I'm going to do that below), because I should be able to generate these numbers even if the market is negative. Well that's the theory anyway.

Interested readers can see exactly what I am holding via my Motley Fool profile. I update it regularly.

As usual the graph of total return since inception in November 2009. The blue line is me, the red line is the S & P 500.  The NAV starts at a 100 so I am up 187% while the S & P 500 is up 79%.


I'm pleased with this performance. It works out to around 30% per annum, and that's not bad for a hedged portfolio in a bull market. Needless to say, I have lost a small fortune in shorting the index, but I have put myself in a psychological framework to make a smaller fortune on the long side by doing so. And I believe I am preparing myself for the possibility of a bear market and how to make money in it. Theoretically at least!

It's bizarre. I have a good set of academic and professional qualifications, an IQ of 147, a genuine hunger for achievement, a love and passion for investing, and-at the very least- some demonstrable ability at it. However, I find myself bereft of any social support or backing, and in truth, it has always been thus. I'd like to say that this has more to do with the investment industry than it does with me, but who knows? Maybe, I was just born as a maverick.

I no longer care to argue the toss, my path is set. I'm lucky enough to get to travel in Eastern Europe, meeting interesting people, having adventures and catching up on so much of the life I missed out on while I was desperately trying to break into the financial services industry in London. I failed in London. Or maybe, London failed me. No matter, the end result is the same.

However, I do care to dispute the notion that the financial services industry is populated by people who are being tested, and toughened up, by having skin in the game. It is not. And it is definitely not the survival of the fittest, because I'm still standing and earning money while toughing it out. Meanwhile the halfwits without skin in the game, and who demonstrably do not know anything about managing risk or generating returns, are earning millions.

And trust me, I tough it out. I operate alone. Me, foreign countries, a netbook, a coffee shop, and that's it. No social support network, no research team, no big fat salary at the end of the month. Nothing.

I digress.

The greatest piece of investment advice that anyone receive is to enquire of a potential investment manager, how much he has invested in what he is peddling? This will wheedle out the charlatans soon enough. You wouldn't hire a plumber if you go to his house, and find pipes leaking everywhere. So why should you give money to a collection of kids-in-suits just because they operate out of an impressive building?

Apologies for the stream of consciousness. Sometimes it's nice to let this stuff out.

For those that know and care....


Friday, January 10, 2014

Prospects for Nike in 2014

Investors in Nike have watched their stock more than "just do it" in 2013, as the stock has risen nearly 50% as I write. Moreover, retailers like Foot Locker and Dick's Sporting Goods  have recently confirmed many of the strong trends that Nike is seeing in North America. Looking into 2014, the soccer World Cup will provide an obvious upside kicker to Nike's prospects, but is all the good news already priced in?  

Nike reports a strong second quarter
The sporting giant is unusual in the consumer goods sector because its growth in recent years has been coming from developed markets (principally the US), while its emerging market performance has been disappointing.

Don't be alarmed by the sequential drop in earnings before interest and taxes, or EBIT, for North America and Western Europe. In actuality, EBIT rose 14.9% and 11.8%, respectively, for these regions in the second quarter.

Source: company presentations.

As such, the rise in Western Europe (revenue grew 18% and futures orders were up 26%) demonstrates Nike's ability to turn around performance with a strategic reset. This is precisely what the company intends to do in China as well.

North America (and to a lesser extent footwear) remains the powerhouse of Nike's operations. While investors have a right to be skeptical as to how long Nike can continue to rely on North America for growth, signs from the industry continue to indicate strength. For example, Dick's Sporting Goods reported same-store sales growth of 3.3% in its last quarter, significantly above its expectation of flat to minus 1%. Furthermore, on the conference call management outlined that "third quarter comparable store sales growth" was "led by strength in athletic footwear and apparel and team sports." 

Foot Locker also saw strength in the US, with its Foot Locker division up by mid-single digits. Interestingly, Foot Locker argued that its sales increase was "driven by average selling prices, which were up low- to mid-single digits depending on category."  Meanwhile, Foot Locker's footwear units were up, but its apparel and accessories were down as the company made a conscious decision to shift to more "premium assortments, away from more basic product." 

Nike's results nicely mirrored what Foot Locker and Dick's Sporting Goods said, in that average selling prices are going up amid ongoing strength in footwear.

However, the good news doesn't stop there because Nike is set for a strong year in 2014.

Nike's growth catalysts
The coming year promises to be a strong one for a variety of reasons:

  • The World Cup in Brazil will generate strong interest in Nike's football products, especially with Nike's sponsorship of the host nation

  • The consistent pattern of average selling prices rising due to a shift in product mix looks set to continue

  • E-commerce revenue grew 35% in the third quarter, and Nike is in the process of launching new country sites and expanding merchandising in others

  • Nike brand futures orders rose 13% (10% units and 3% average selling prices), indicating growth remains strong going into the new year

However, the most important long-term consideration is likely to be Nike's strategic reset in China. The early indications are positive, with revenue from China rising 5% in the quarter. On the other hand, anyone who thinks the battle is won should note the guidance provided on the recent conference call:

...our futures and revenue growth for China won't necessarily show sequential improvement every quarter as we move through this transition.
...we continue to expect overall FY14 revenue to be roughly in line with the prior year with single digit revenue growth in Q3 and flat to down revenue in Q4.

Where to next for Nike?
As ever, the key thing for investors is to try and take a snapshot of what Nike will look like in the future. Its 2014 fiscal year (ending in May) looks to be ending on a strong note, and positive sentiment is likely to remain for the World Cup in the summer. Furthermore, analysts expect Nike to grow revenue and earnings per share by 8.8% and 17%, respectively, for the year to May 2015.

While it all looks rosy, Foolish investors should note that this implies that the stock is trading for more than 22 times its expected earnings to 2015. A lot of good news is baked into the stock price, and any slowdown in Nike's performance in North America or a failure to execute the strategic reset in China could leave the stock exposed. After the World Cup, the market will start asking "where next?" and the focus will shift onto Nike's emerging market performance.

Thursday, January 9, 2014

Telco Spending Outlook for 2014

Last year was difficult for companies exposed to telco spending, but will 2014 bring better conditions? There are countless questions regarding this issue, but for the sake of brevity, this article will focus on demand trends coming from Tier 1 service providers like AT&T  and Verizon  and touch on prospects from emerging markets. The type of solutions being bought by AT&T and Verizon will dictate selling opportunities for companies like Cisco  and Ciena  as well as many others in the telco space.

AT&T and Verizon
The issue facing service providers in the developed world is that average revenue per user is falling because technological advancements have reduced the importance of fixed and mobile voice usage. As a consequence, carriers like AT&T and Verizon are trying to reduce capital expenditures as a share of revenue, even while revenue growth is slowing. Verizon's capital expenditure of $16.1 billion in 2012 is approximately $930 million less than it spent in 2006. Conversely, AT&T's have been rising, but this is largely due to the roll out of its 4G/LTE network later than Verizon.

Source: company presentations.

In addition, both companies have given lackluster capital spending forecasts. AT&T's management stated, "we would expect the CapEx for this year to be in $21 billion range and for '14 and '15 to be in the $20 billion range."These figures are below what AT&T has spent in previous years. Meanwhile, Verizon argued that "As far as CapEx goes, I have been pretty consistent here. You should consider us improving our CapEx-to-revenue ratio going forward."

Smartphone penetration driving growth
However, the reality is that service providers will still have to invest, just in different ways. The trend carrying over from 2013 is that Verizon and AT&T have been surprised by the strength in the increase of smartphone penetration, while seeing disappointments at the lower end. On AT&T's recent conference call, management outlined:

We now have 75% of our postpaid phone base on smartphones. We expect that percentage to keep growing. These are the premium subscribers in our business. They have twice the ARPU of non-smartphone subscribers and much lower churn.

Meanwhile, the company saw "some pressure" with its "subscribers on low-end 2G feature phones." Verizon told a similar tale of increasing smartphone penetration to 67%. Verizon is also seeing strong growth in 4G take-up, with 38% of its retail postpaid customers on 4G, versus 33% in the previous quarter and only 17% last year.

These trends are likely to make carriers in the developed world focus on purchasing higher-end networking solutions, rather than investing in maintaining older networks. This might hurt a company like Cisco, but it will benefit Ciena with its next-generation technology. Ciena is particularly strong in 40G and 100G ethernet networking and optical transport networks. As for Cisco, service providers make up around 31% of its revenue. They matter a lot to the company, but Cisco is only expecting 0%-1% growth in switching and routing over the next 3-5 years.

Emerging market opportunities for Cisco and Ciena
The great imponderable for 2014 will be emerging market telco spending. Cisco's outlook for emerging markets was extremely weak, and if taken at face value, it's hard not to be cautious. On the other hand, if emerging markets follow developed market trends, expect smart phone penetration and data usage to increase strongly in 2014.

Moreover, many emerging market countries have the opportunity to jump to next-generation technologies like 4G/LTE, rather than invest in 3G or maintaining legacy infrastructure. Again, this might play to the strengths of Ciena rather than Cisco. However, Cisco has set the bar so low with regard its emerging market prospects that any upside surprise is likely to be well-received.

The bottom line
It's hard to get too excited by overall North American spending because AT&T and Verizon have made it clear that they are not planning a major ramp up in spending. However, the type of spending taking place means there will be winners and losers in the process. As for emerging markets, much will depend on the macro-economic climate. However, with most forecasters predicting stronger economic growth this year, it's reasonable to expect a better year overall. But, the investment focus should still be on niche players like Ciena, rather than larger all-purpose telco suppliers.

Wednesday, January 8, 2014

How Oracle is Making the Right Changes

The market's valuation of Oracle continues to suggest doubt over its future direction. It's traditional on-premise on-license sales are being threatened by pure-play software as a service, or SaaS, companies like Workday and Meanwhile, analysts are also questioning its future margins, given that management declared an intent to be "price competitive" with Amazon Web Services and Microsoft's Azure. Are the skeptics right about Oracle, or is the stock a good value?

Oracle reports a good second quarter
After disappointments from IBM and Cisco, investors have approached Oracle's recent results with caution, despite the fact that the numbers came in slightly better than expected.

  • New software licenses and cloud software subscriptions (26% of revenue) grew 1% constant currency growth vs. internal guidance of -4%-6% growth.

  • Hardware systems product sales declined 2% in constant currency vs. internal guidance of  -9%-1% growth.

  • Non-GAAP earnings were $0.69 vs. internal guidance of $0.65-$0.69.

Although new software licenses and cloud subscription growth appears weak, Foolish investors should note that the company came up against some very strong numbers from last year's second quarter.

Source: company presentations.

Oracle's management articulated that its mix of software sales had a larger share of renewals and annuity deals versus new license deals. This kind of shift usually involves trading off some upfront revenue for an income stream over time. Indeed, Oracle's management argued, "you would think it would take you a couple to three years to get to that full productivity of the equivalent of a recurring stream of revenue to what you would have typically seen in license."

In other words, Oracle's revenue is likely to be negatively affected in the short term with this shift toward subscription-based sales.

The geographical breakdown confirmed Oracle's strength in the Americas, with sales up 5%, along with "good growth" in China. However, the real talking point is how aggressively Oracle is seeking to expand its cloud infrastructure services.

Oracle takes on Microsoft, Amazon, and Rackspace
As you would expect from a megacap tech company, Oracle's cloud offerings include SaaS, applications, and infrastructure. However, on its recent conference call, Oracle's CEO, Larry Ellison, explained that his company's plans involve being "price competitive" with Amazon, Microsoft's Azure, and Rackspace. Ellison also plans to make Oracle "highly differentiated at both the platform level and the application level."

The plan can easily be criticized for potentially sacrificing infrastructure margins at the expense of chasing future revenue. The market is competitive enough already, as Microsoft has already promised to match Amazon on pricing and features.

Oracle needs to address the threat that pure-play SaaS companies like Salesforce and Workday will grab market share within their respective niches of customer relation management and human capital management. Therefore, a strategy like this will help efforts to retain leadership with long-term recurring revenue from cloud applications.

Similarly, Microsoft and Amazon have their own services that will benefit from selling cloud infrastructure at less-than-optimal prices. The important strategic issue for Oracle is to remain relevant as SaaS solutions become more important.

Oracle's financial firepower and marginsOracle has the financial firepower to make these moves. It's trailing twelve month free cash flow generation of $14.6 billion represents approximately 9.6% of its enterprise value. Furthermore, Oracle is investing in dedicated sales teams to compete for business against Workday and Salesforce. Sales and marketing expenses increased 12% in constant currency during the quarter, as Oracle built out sales capacity to win future business in the cloud.

All told, these initiatives may trim margins, but Oracle has a lot of financial leeway, and so does its valuation. Despite a 20% rise in the last six months, the stock still trades on just 12.5 times forward earnings to May 2014. Operating income margins fell to 36% in the first half, versus 37% last year, but 80% of the increase in operating expenses came from investments in sales and marketing.

The bottom line
Investors can be quick to criticize management for failing to adjust to structural changes, but Oracle is making significant efforts to manage the transition of software into the cloud. Investments in sales capacity, infrastructure services, cloud-based acquisitions, and efforts to respond directly to the threat posed by Salesforce and Workday are all demonstrations of intent.

Oracle is responding to structural changes in its marketplace, and it will take time to come to fruition. However, the stock's valuation suggests it can withstand some margin erosion along the way.

Monday, January 6, 2014

Cisco Upgrades Guidance For 2015-2017

Cisco's recent financial analyst conference wasn't taken well by the market, but many commentators missed the fact that Cisco's guidance implied an upgrading of expectations for 2015-2017. It's time to look at what its management actually said about future earnings growth, and decide whether you believe Cisco can hit its targets.

Cisco upgrades guidance for 2015-2017
Cisco's management previously outlined its expectations for 5%-7% revenue growth on a compound annual growth rate, or CAGR, for the next three to five years. Fast-forward to the recent analyst conference, and management seemed to downgrade expectations by lowering projections for three-to-five-year growth to 3%-6%.

It sounds bad, but actually it's a hike in expectations post-2014. Playing with these assumptions and the updated analyst forecast for a disappointing 2014 gives the following table. The mid-point of Cisco's guidance is taken as the base scenario.

Revenue ($bn) 2011 2012 2013 2014 2015 2016 2017 CAGR from 2013-2017
 Old guidance  43.2  46.1  48.6  51.5  54.6  57.9  61.4  6%
 Growth (%)  7.9  6.7  5.4  6.0  6.0  6.0  6.0  
 Old adjusted  43.2  46.1  48.6  46.4  49.2  52.1  55.3  3.3%
 Growth (%)  7.9  6.7  5.4  -4.5  6.0  6.0  6.0  
 New guidance  43.2  46.1  48.6  46.4  50.0  53.8  58  4.5%
 Growth (%)  7.9  6.7  5.4  -4.5  7.7  7.7  7.7  

Source: Google Finance, company presentations, author's analysis

"Old guidance" refers to what Cisco would have achieved had it hit the 6% CAGR target from 2011. "Old adjusted" is what Cisco would have achieved if management had said something like, "2014 is a bad year, but after that we are sticking to our 5%-7% long-term growth target."

In fact, the new guidance is for revenue growth of 3%-6% CAGR from 2013. When CFO Frank Calderoni was questioned on this matter, he categorically replied, "Yes, it's certainly 2013 as a base year."  

Foolish investors will note that the "new guidance" implies higher revenue in 2015-2017 than if Cisco had left its post-2014 targets at 5%-7% revenue growth.

Do you believe in Cisco's numbers?
No one is obliged to believe that Cisco will hit this guidance, but if it does, then the stock certainly looks cheap. Cisco has approximately $5.45 billion in net cash, and stripping it out of the market cap means the stock trades on just 7.7 times forward earnings estimates of $1.99.

Cisco's guidance relies on a two-track process of slow growth in its core business (switching and routing), and faster growth in non-core areas like cloud, mobility and wireless, and security. Services growth is contingent upon hardware sales, so it can't be considered in isolation.

Growth Driver  3-5 year CAGR
 Core  0% to 1%
 Data Center  20% to 25%
 Mobility & Wireless  9% to 13%
 Security  10% to 15%
 Services  7% to 10%
 Total  3% to 6%

Source: Company presentations

Why the market is skepticalIts valuation suggests that the market is skeptical. One reason is possibly because investors are tired of seeing management's failure to generate significant shareholder value.

Cisco's management hasn't covered itself in glory with its acquisition policy in recent years. For example, Cisco bought Pure Digital Technologies in 2009 for $590 million, only to close its Flip video camera business two years later as smartphones started integrating video cameras. Moreover, Tandberg (video conferencing) was bought in 2010 for $3.3 billion. Below is the segment's revenue since Tandberg was integrated. Although the former Tandberg operations are not broken out, the numbers don't suggest it's been a success. In addition, its videoconferencing rival, Polycom, has struggled, too. In other words, it wasn't a great industry for investors.

Source: company presentations.

Another example is the $6.6 billion acquisition of set-top box manufacturer Scientific-Atlanta in 2006. Cisco is now facing problems with its set top boxes. Service provider revenue fell 13% in the first quarter, with 6% due to the 20% decline in set top box sales.  Essentially, Cisco is transitioning its traditional set-top boxes toward cloud-enabled ones. The result was a delay in the purchasing of new products by customers while Cisco decided to keep margins up by rejecting low profit deals on the older technology. This sort of transitional problem is typical in technology and usually tends to be sorted out in a quarter or two. Nevertheless, some analysts are calling for Cisco to exit the business altogether. Again, it doesn't suggest the acquisition was a particularly strong move by Cisco.

Where next for Cisco?Cisco is definitely facing some structural growth issues, and management has struggled to generate shareholder value for some time now. On the other hand, the stock is so hated by Wall Street that its valuation has become compelling.

Cisco just implied better growth from 2015-2017, and the market seems to have (initially, at least) chosen not to believe it. The market has cause to be skeptical, but provided Cisco hits its revenue projections, the stock is a good value on a risk/reward basis.