Standard Chartered and the Property Market in China

Standard Chartered $STAN gave a bullish trading statement today and the market received it warmly, however the share price move looks to be a blip in a pronounced downtrend

I suspect the main reason for this is that investors have been pricing in a slowdown in Asian growth following tightening measures by China. In addition, the knock on effect of a temporary slowdown in industrial production following the disaster in Japan has scared investors. So is Standard Chartered a stock worth buying?

Is Standard Chartered Worth Buying?

I think not. Turning to the Standard Chartered statement, it seems quite positive...

“Standard Chartered is on course to deliver another strong first half.  We anticipate delivering cost growth broadly in line with income growth for the first six months of 2011. The credit environment remains benign across Asia. We are advantaged by a very strong balance sheet which remains highly liquid, very well capitalised, diverse and conservative; and are capturing increasing levels of business from our markets across Asia, Africa and the Middle East. "

...however, if we look into Standard Chartered said about regional performance, there is a red flag waving here...

“Sources of income growth remain well diversified, both by product and geography. Whilst income in India is lower than in the first half of 2010 and growth in Africa has been muted, this has been more than offset by very strong performances in Hong Kong, Singapore, Malaysia, MESA, China and Indonesia.”

...and the continued strength of Asian credit expansion is supported by other evidence. In normal circumstances, this would not be a matter for concern however China has been consistently raising reserve requirements in order to tame domestic demand and commodity price inflation.  The good news is that commodity price pressure is abating...

..but it is not clear if this is the start of a gently managed moderation or the beginning of a prolonged crash. The former would be good news for Standard Chartered but the latter would be damaging.

Anthony Bolton on China

It was interesting to read what top fund manager Anthony Bolton of Fidelity China Special Situations said recently concerning inflation and property prices in China. For example on inflation...

“I would not want to say that inflation is not a problem but I do not think it will stop the bull market unless it gets completely out of control. The authorities must tread a delicate path between slowing the economy to alleviate inflationary pressures and suppressing growth too much but I believe they will strike the right balance. I am expecting growth to fall back to 7-8% compared with last year's 10%, but that is still a very attractive level relative to the developed world.”

On the property market in China, Bolton cites the reports of empty cities and the speculation over 65million empty apartments. However, he concludes that the mortgage debt held against the properties is not high so he feels the long term picture is ‘very favourable’.

I’m not so sure and I think a cautious approach should be taken here. The good news is that the Chinese Government has the reserves to stimulate the economy if there is a sustained slowdown in housing. However, if there is a crash, China related equity investors-particularly with the US housing crash in their minds- won’t be slow to price this in negatively.

FedEx Bullish Conference Call and Growth Forecasts

FedEx gave $FDX gave Q4 results and the stock markets cheered them by sending FedEx stock 2.6% higher. Essentialy, FedEx is a cyclical company and rather like its rival UPS $UPS it should be seen as a play on global growth. Indeed, this issue was articulated in more detail in this linked article which should search as a good reference point.

In summary, both FedEx and UPS are not investments I would make right now. This is not a negative call on global growth, rather, an expression of my view that there are better value plays which will give directional exposure to global growth. In addition, I believe there are better growth plays which can generate superior returns to buying either of these stocks. Neither have the 'outer' of a takeover, nor great cash flow yields with which to pay high dividends. UPS is currently yielding around 3% but that it is not particularly attractive.

More interesting, is to compare what FedEx where saying about the global economy and compare it with Ben Bernanke's statement today. I'll come back to this point later.

Growth Prospects?

For both FedEx and UPS, there appear to be some upside prospects, at least if FedEx's conference call is to be believed. I will summarize some of the key 'take-aways' from the conference call below.

• Near term ecoomic weakness caused by previously high energy costs and the disaster in Japan
• A stronger second half as consumption picks up and energy costs fall
• Growth to be continued to be led by industrial expansion
• Growth in Asia/Pacific and China seen as showing continuing strength and the current environment described as being 'very positive'
• Currently low Inventory/Sales ratio in the supply chain are seen as boding well for future growth

Both companies should see the benefit from lower energy costs in their margins and also in their revenue numbers as high energy and food costs act as a kind of 'tax' on discretionary spending.


Comparing FedEx with the Fed?

No not Roger Federer, but Ben Bernanke. In the conference call, FedEx gave some specific US GDP growth forecasts which will be interesting to compare with the recent downward revisions to GDP  forecasts by the Federal Reserve.

US GDP Forecast	Q2 2011	Q3 2011	Q4 2011	2011	2012
Federal Reserve January				3.4-3.9%
Federal Reserve April				3-1-3.3%	3.5-4.2%
Federal Reserve Revised				2.7-2.9%	3.3-3.7%
FedEx Forecast	1.9%	3.5%	3.4%	2.5%	3.0%

Interestingly, the FedEx forecasts are somewhat weaker than the Federal Reserve forecasts, even with the lowering of the numbers by the latter. However, they are both indicating stronger growth in the second half and in particular with consumption spending coming back. I consider these strong indicators for stock pickers to take advantage of.

Cognex Offers Growth but Lacks Visibility

Cognex $CGNX is a world leading company in the field of machine vision systems. As such, this makes this stock a direct play on growth in Global Investment in Machinery and Equipment (IME). Cognex sells machines that ‘see’ and help measure and quantify factory automation processes. Whilst, Cognex is a play on this kind of capital spending, it does have a few key industry verticals which can cause performance to be lumpy.

Cognex splits its company into three separate divisions

• Factory Automation-(70% of sales) of which Auto production is a key vertical, Solar is a strong growth area
• Semiconductor and Electronics Capital Equipment (SEMI) (17% of sales)
• Surface Inspection (13% of sales)

By far the most important is Factory Automation which is also the fastest growing and with the highest gross margins of around 80% The other two divisions have gross margins of around 50% and due to these factors and, according to the conference call, Cognex appear to believe that they can continue to achieve overall gross margins of 72-75%

Cognex End Markets

Frankly, Cognex has had very favourable tailwinds over the last two years which has made growth look artificially strong. The last recession was characterised by a severe cutback in IME and Cognex suffered accordingly. However, with the recovery investment has flowed back and the low base effects have created very strong looking growth for Cognex. Some details here on trading history here...

$1000s	2006	2007	2008	2009	2010	2011	2012
Revenue	238,318	225,683	242,680	175,727	290,691	319,450	360,510
growth		-5.3%	7.5%	-27.6%	65.4%	9.9%	12.9%
Gross Profit	173,480	161,333	174,253	119,340	213,130	234,796	264,975
gross margin	73%	71%	72%	68%	73%	74%	74%
Op Profit	44,473	28,136	25,104	-12,668	75,173	76,668	86,522
margin	18.7%	12.5%	10.3%	-7.2%	25.9%	24.0%	24.0%

The slowdown from 2008-09 is demonstrative of the cyclical nature of Cognex’s end markets. However it is worth reflecting on the weakness in 2007. This was largely a consequence of a combination of factors including weakness in the semiconductor industry; an over reliance on the weakening North American auto production; low penetration within factory automation in Japan and some administrative difficulties within the North American sales operation.

Cognex addressed these problems buy increasing diversification in end markets and by shifting the sales focus to the types of countries (China/India/Korea ec) that are expanding automated production. As for the semiconductor industry, around ten years ago 66% of Cognex revenue was generated by this industry but now it is less than a third. Cognex mainly sells into the semiconductor equipment manufacturers that integrate Cognex solutions into their products. The US sales operation was restructured and finally, Cognex formed a partnership with Mitsubishi in order to generate accelerate longer term sales in Japan.

Future Prospects

Cognex’s revenues will be largely tied to global IME, their success in introducing the new Dataman product (they aim for a run rate of $10m by the end of year, but are ahead of expectations) and in increasing the number of customers that utilise vision machine solutions. For example, Cognex is targeting the Life Sciences industry for long term growth. This sort of growth will take time as Cognex integrates with OEM with this type of solution.

Thinking shorter term, Japan automotive comprises less than 1% of Cognex sales, and it is hard to see too much disruption from Japan factory automation beyond a quarter or two. Longer term the Mitsubishi partnership should help Cognex in Japan and also in China, where Mitsubishi has a strong sales infradtructure. In the recent results Cognex claimed that the key factory automation market was actually getting stronger. Surface inspection revenues tend to be lumpy from quarter to quarter, and semiconductor revenues were exceeding expectations.

Cognex Evaluation

Cognex has a strong balance sheet with $316.4m in cash and investments on the balance sheet. At a current price of $33.22 the market cap is $1.36bn and the Enterprise Value is therefore $1.17bn. It is a conservatively run company that has consistently generated strong cash flows.

$1000s	2006	2007	2008	2009	2010
Free Cash Flow	44,255	43,838	52,295	6,817	70,491
%Revenues	18.6%	19.4%	21.5%	3.9%	24.2%

On the other hand, revenues can be lumpy and earnings visibility is not great. The stock fell 10% after a disappointing forecast at the Q4 2010 results, yet they exceeded them in Q1 2011 and the Cognex share price soared. Buying Cognex is a tad tricky because we are in a period where manufacturing growth is moderating, so expectations need to be not unduly optimistic.

Nevertheless, on balance, I think Cognex has good long term prospects and analyst forecasts have it on an EPS of $1.49 and $1.77 for 2011 and 2012 respectively.  Whilst this seems expensive on a PE ratio basis, Cognex generates strong cash flows and has 23% of its market cap in cash and investments. I think it is better priced at $37 which gives 10% upside from the current price of $33.22. I picked some up.

Equinix and Telecity Offer Growth and Cash Flows

Equinix $EQIX and Telecity $TCY are two fast growing data center stocks that I believe are cheaply priced relative to their prospects. I hold both stocks but, in this article will focus on Equinix. However, investors can make similar analysis with Telecity as they are very similar.

In summary, data center providers are capable of generating very high Ebitda margins and are set for high growth in revenues. On an ongoing basis, both businesses (Equinix and Telecity) are already generating large amounts of cash flow and provided that operating margins remain the same and the expected growth materialises then these stocks are very good GARP candidates.

Growth Drivers

Data Centers allow business to store their information in a secure and scalable manner. In other words, they let companies focus on running their own business as opposed to setting up their own onsite mini ‘data centers’. Scalability is a key consideration, because I suspect many businesses will have been caught out by the massive increase in capacity necessary to handle increased mobile, video and global IP traffic. In addition, increasing usage of cloud based solutions will only add to data center usage. Industries such as financial services are generating an exponential increase in demand as the search for ever more complex trading systems continues apace.

In addition, the existing infrastructure of centralized provision supply business over great lengths (globally) is likely to run into quality difficulties as ever growing local growth in bandwidth applies strains upon it. All of which, should benefit companies like Equinix and Telecity, who provide local centers and seek to integrate data flow between corporations and the major hubs.

On a more negative note, data centers can be visualised as giant refrigerators so Telecity and Equinix are both exposed to rising energy costs.

Equinix’s Trading Numbers

In the following discussion I will utilise a recent presentation made by Equinix which is referred to in the source section below. The first thing to look at will be how Gross Margins are evolving over time.

Equinix	2008	2009	2010	Q2 2010	Q3 2010	Q4 2010	Q1 2011	Rolling
Revenue	704,680	882,509	1,220,334	296,094	330,347	345,244	363,029	1,334,714
Gross Profit	290,021	399,089	545,667	133,512	144,871	151,685	168,453	598,521
Gross Margin	41.2%	45.2%	44.7%	45.1%	43.9%	43.9%	46.4%	44.8%

It’s not hard to see that margins are holding steady, in spite of rising energy costs. In addition, Equinix is keen to point out that gross cash margins (excluding non cash items such as stock options) are actually closer to the long term target of 65%  We can see this effect in the cash flow conversion.

 

Equinix	2008	2009	2010	Q2 2010	Q3 2010	Q4 2010	Q1 2011	Rolling
Revenue	704,680	882,509	1,220,334	296,094	330,347	345,244	363,029	1,334,714
OP Cash Flow	267,558	355,492	392,872	56,906	113,263	122,891	117,770	410,830
% revs	38.0%	40.3%	32.2%	19.2%	34.3%	35.6%	32.4%	30.8%
Capex	471,128	369,542	579,397	148,705	143,941	143,351	190,066	626,063
Free Cash Flow	-203,570	-14,050	-186,525	-91,799	-30,678	-20,460	-72,296	-215,233

Whilst conversion to operating cash flow is very good, it is clear that Equinix are not generating free cash flow. This is a concern because with a share price of $100 the current market cap is $4.71bn and net debt is $1.67bn. In other words the Enterprise Value is $6.38bn and on a rolling year basis they have just had a cash outflow of $215m

However, the key thing to understand with Equinix is that they are currently in a high growth phase and are undergoing significant expansionary capital expenditures in order to develop revenue growth. With this sort of business it is useful to try and breakdown maintenance from expansionary capital expenditures. Rather conveniently, Equinix do this in page 13 of the linked presentation. Tabulating from their results gives...

Frankly, I think this means that the underlying cash flow is actually very good here. It would be remiss to assume that, going forward, margins and revenue growth will be strong enough to justify this level of expansionary capital expenditure. However, for the reasons articulated above, I think that with decent GDP growth that Equinix can go on to achieve strong revenue growth.

Longer term Equinix feels that maintenance Capital expenditures will come to around 5% of revenues. So, it is not inconceivable that when Equinix’s growth starts to moderate we could see them generating 20-25% of revenues in free cash flow in future.

Analysts have Equinix on 2011 and 2012 revenues of $1.54bn and $1.74bn respectively. This implies 26% and 15.6% revenue growth in the next two years.

In conclusion, I think a forward FCF/EV of around 5% is fair for this business which would give a price target of around $120. Equinix is a good GARP candidate. I hold.

Telecity

I believe Telecity to also be attractively priced. By way of comparison, Telecity with a share price of 548p has a market cap of £1088m and net debt of £56.8m so the EV is £1144m. Turning to the operational metrics from the last results sees Telecity generating adjusted Ebitda margins of 42.4% and ‘operating free cash flow’ margins of 37.9%. This is very high and demonstrates the underlying cash flow generation. Last year Telecity spent £13.3m or 6.7% of revenues on operational capital expenditure and this figures compares well with Equinix’s long term target of 5%

If we use the underlying operational free cash flow of £74.4m as a benchmark then the underlying FCF/EV is 74.4/1144=6.5% For a business forecast to grow revenue at 18% next year, that is too cheap.

Source:

Equinix Q1 2011 Conference Call Presentations

Equinix	2008	2009	2010	Rolling	Forecast 2011
Discretionary FCF	200100	292000	278000	330000	400,000
DFCF/EV	3.2%	4.6%	4.4%	5.2%	6.3%