Why Europe Matters To Your Portfolio

With markets being moved around by Europe, I thought it would be helpful to give a brief summation of what investors should expect from Europe in the coming weeks. One key date is the Greek election on June 17. At this point, I suspect many US investors will be scratching their heads and wondering why a country with such a tiny portion of global GDP has such an effect? The answer is that Greece affects Europe and Europe affects the world.

Companies like General Electric $GE, Apple $AAPL and McDonald’ $MCD are all multinationals with significant European exposure, but the risk doesn’t stop there. Even if US companies do not have large direct exposure, the knock-on effects of a financial crisis in the European banking sector will be felt by the US banking sector. The traditional safe havens of healthcare and consumer stables are unlikely to work well either. Buying Coca Cola $KO or Merck $MRK may give the appearance of safety, but hard pressed consumers cut back on soft drinks and snacks in a recession, and indebted Governments will do anything they can to cut health care spending.

For example, McDonald’s generates more than 40% of its revenues from Europe. The same figure is 24% for Apple, but Europe generated 46% revenue growth for the company on a yearly basis. Europe is obviously a key area for GE and, it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. As for Coca Cola, in the last quarter, it generated more profits from its Europe segment than it did from North America! Merck generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics.

What is the Problem?

I have a more detailed analysis of the debt problems in an article linked here. However, a simplistic graphical depiction summarizes the issue quite well.



These projections are from the IMF, with the Greek number coming from an OECD estimate. The problem countries are the so-called ‘PIIGS’. Spain may seem ok, but it has a major problem with its collapsing housing market putting pressure on its banking system. Spain’s debt load will inevitably increase as it takes on loans in order to recapitalize its banks.
We can see what the market thinks, by way of looking at the yields on 10 year Government Debt.



For now, we need to understand that Greece, Portugal and Ireland are not financing themselves in the open market.

How are Greece, Ireland and Portugal Surviving?

The EU-IMF are giving loans in order to buy time for them to make the structural reforms necessary so they can get back to a sustainable debt path. The problems are structural so the solution must be structural. As such, the EU-IMF monitors performance on an ongoing basis and releases bailout installments on a conditional basis. It is hurting.

There is simply no way around the fact that cutting public sector wages and employment, whilst attacking entrenched self interests is going to cause a significant amount of social tension. Especially in such an anemic growth environment.

The report card on these countries will probably see a positive rating for Ireland, a cautious thumbs-up for Portugal and, then there is Greece. The Irish made their adjustments swiftly and in a disciplined manner, including a large scale recapitalization of its banks at the cost of racking up more debt. No matter, they are following the program. As for Portugal, they passed a recent mission review and the EU-IMF summarized position thus

“The program remains on track amidst continued challenges. The authorities are implementing the reform policies broadly as planned and external adjustment is proceeding faster than expected... ...the authorities are determined to stay the course of adjustment and reform. Broad-based political support and social consensus is a key contribution to a successful adjustment.”

So whilst Portugal’s situation is precarious and, somewhat dependent on economic developments, the country is making the required structural reforms.

What About Greece?

Greece is not achieving what Ireland or Portugal has been able to do. The reasons for this are myriad but mainly relate to the political structure of Greece. Despite having voluntary debt write downs organized for them and ongoing support, nothing has worked. Whatever the underlying reasons for this, the conclusions are still the same.Greece has not been able, or willing, to make sufficient structural reforms. Nor has it adequately responded to the continual requests from the IMF that it find a way to collect taxes from its wealthy.

When asked about the risks to the EU-IMF program, the mission head Poul Thomsen, identified structural reform.

“to get the recovery going we need to get a strong impulse from productivity-boosting reforms and failure to launch such reforms could indeed mean that we will not get to this sort of inflection point where it starts going up any time soon, but that the economy will continue to trend down for longer than expected.”

He then specified reform of the public sector.

“if there is failure to undertake strong structural reforms inside the public sector, I cannot see how the deficit can go down without structural reforms. There are no more, as I’ve said before, low-hanging fruit, no more easy adjustment. Fiscal adjustment needs to be underpinned by fiscal structural reform.”

And this is where it gets tricky.
It is hard to implement significant public sector reforms when the economy is doing well, but when it is in freefall, it becomes nigh on impossible. Again, I don’t seek to apportion blame. I’m just telling it how it is. There is significant resistance to reform in Greece.

It's All About Greece, For Now

In conclusion, having isolated the immediate problem to Greece (although Spain too has significant issues) it is now time to look specifically at what is going on there and, potential outcomes in the upcoming elections on June 17th. I will do this, shortly,  in a forthcoming article.

The Best US Luxury Stock

The luxury goods sector is a great way to play some of the inequalities inherent in the current recovery. I take no pride in articulating that the rich have got richer, however, the focus here is with investment opportunities. It strikes me that there is somewhat of a bifurcation of prospects for retailers due to an uneven recovery.

At the lower end, we are seeing off-price clothing retailers like TJX companies, prospering as consumers retain cost saving behavior learned during the recession. Moreover, the lack of growth in average incomes is also playing to the lower end retailers. Any behavioral psychologist will tell you that it is much easier to sell a price differential as a discount rather than a surcharge. So, once consumers get used to lower prices, they want them to stay. Aside from the macro-economic metrics, current consumer psychology favors retailers like TJX too!

However, I want to focus on the high end.

Luxury Goods Retailers

The luxury goods sector pitch is well worn. It usually runs along the lines of emerging market growth creating a mass of new high income customers for Western luxury goods. It is a strong argument. At least, I hope so, because I happen to hold it.

However, I also happen to hold the view that China’s real estate market is slowing and, I reserve the right to be cautious on the growth prospects implied by the valuations of the China luxury plays such as Richemont, Tiffany’s $TIF LVMH, Coach $COH and Burberry.

Coach is a great company and, its management is excellent at managing costs (which includes shifting some production away from China) and, the brand has strong appeal in the Far East. However, any slowdown in the Far East, and Coach will suffer. In addition, companies like Tiffany, Coach and Burberry’s do a decent part of their business in Europe & the US from Asian shoppers on vacation. Its not something to worry about for now, but risk averse investors may shy away.

Running adjacent to the emerging market story is that of the ‘plutonomy’ economies of the Anglo-Saxon world. In other words, the US, UK and Canada are strikingly different in terms of wealth distribution than say, Japan and continental Europe. When growth and, ultimately wealth returns to these economies, the evidence is that it returns quicker and stronger. And to the already wealthy. 

Putting these two arguments together, suggests that US focused high end plays are the best option for a growth at reasonable price (GARP) investor. I will focus on Nordstrom $JWN but investors could just as easily look at Saks $SKS or Macy’s $M who have also been reporting strong sales growth recently.

Nordstrom’s End Markets

A quick look at the macro picture. These figures are taken from the Federal Reserve and are in $bn.



Although not clear in the graph, consumer credit is now on an upward trend. I've included real estate assets to demonstrate how they have been falling but, at the same time,US net household wealth (NHW) has increased. In my opinion, it is overall growth in NHW that is key to discretionary retail sales growth in the US. It took a dip in Q3 with the stock market, but the recent market move up (along with employment gains) should see better numbers ahead.

To demonstrate Nordstrom’s reliance on NHW.



Note how Nordstrom’s gross profits move closely with changes in US NHW. Also, note how well the company has done with expanding profits more than revenues in recent years.

Nordstrom in More Detail

This analysis is fine, but we need to look closer at Nordstrom and make sure the company is in place to benefit. I’ve made a few bullet points of what I think are the salient challenges and opportunities in future.

• Expanding the roll out of Rack stores, Nordstrom’s reduced price stores
• Expanding online presence, including integrating the Hautelook acquisition and, expanding on the Bonobos partnership
• Taking advantage of increasing credit quality via Nordstrom Bank and its customer cards

Firstly, Nordstrom is not a company standing still. While the high end consumer has made a comeback, Nordstrom has been busy rolling out its chain of reduced price stores named ‘Nordstrom Rack’. In fact, 18 new Rack stores were opened in 2011 and, another 15 are planned for 2012.  The Rack business now accounts for over generated 21% total sales growth and generated $2bn of Nordstrom’s $10.9bn revenues. Management talked of same store sales expanding throughout 2011 for the Rack, indicating strong customer adoption.  Moreover, plans are afoot for significant investment in technology in these stores. For example, mobile point-of-sales devices will be added.

Secondly, alongside capital expenditures on the Rack, Nordstrom intends to expand its Web presence by building its IT infrastructure to enable increased e-commerce sales. In fact, the plan is to spend $140m on e-commerce capital expenditures, or 30% of the total for 2012.  All of which, will be integrated with tools to enable inventory management. A key issue when a company is aggressively expanding online sales.  The Hautelook (a flash sale retailer of luxury clothing) acquisition was a clear signal that Nordstrom are keen to grow online sales. Moreover, the Bonobos (a leading online clothing brand) partnership is similar sign of how important, management view Nordstrom’s online presence.

Thirdly, I think another area of growth for Nordstrom will come from the improving credit quality of US households. At the last results, Nordstrom reported bad debt reserves as a percentage of receivables at 5.5% from 6.9% last year. This boosts profits, but it also means that they environment is favorable for Nordstrom Bank to extend credit. 

You Can’t Please All of the People All of the Time

However, not all analysts are happy. Whilst expanding revenues via investing in direct sales growth is one thing, management also pointed out that high dollar growth in sales and EBIT would come as opposed to EBIT margin. Moreover, the increased capital expenditures are helping reduce 2012 forecast free cash flow to $400m from $432m in 2011. Consequently, they see a business with slowing EBIT margin growth and the execution risk of increased investment in e-commerce.

Frankly, I don’t share this attitude. I like the way that Nordstrom is exposed to favorable macro trends but, is also investing for growth in areas of the economy that retail is trending towards. Not enough companies have been investing for growth in this environment, so it is easy for analysts to see ‘risk’ after years of viewing companies generate growth via cost cuts. One key thing to look out for is that, this year, Nordstrom will be giving results with a breakdown of full-line, Rack and direct sales so investors will get a chance to see how the business is evolving. In conclusion, Nordstrom would be my pick of the luxury goods sector.

What the Greek Elections Mean to You

In an earlier article linked here I looked at the European situation and, why it mattered to investors. In this article I will focus on Greece and the forthcoming elections.
US investors may think that US companes are immune but, unfortunately, this is not the case. Europe is significant and, the events in the forthcoming Greek elections will affect Europe. A hard default by Greece would cause significant issues for the European banking sector and the economy, and then ultimately the US.


So What is Happening in Greece and Who is Syriza?

The party (Syriza) that is growing in strength ahead of the election is a collection of disparate left wing entities that advocates such half-baked policies as halting privitizations, nationalising the banks, implementing a gradual increase in corporate taxes to 45%, not a single public sector worker is intended to be sacked and, the bailout packages are to be renegotiated after the election.
Syriza does not want to implement reforms, on the contrary it wants to roll back pension and wage cuts, and it wants to stimulate growth inGreecevia infrastructural investment. Oh and, one more thing. It wants the funding to come from the EU!

Most polls have New Democracy (ND) at 23-26% with Syriza at 20-23% and the formerly ruling PASOK at 12-14% with the rest being an assortment of Communists, Greens, the Far Right and Greek Independency candidates.

I think there are two key takeaways from this.

1. Greece will vote to stay in the Euro (all three leading parties want to stay in) and it will vote to renegotiate the bailout package. The flexibility from the EU-IMF is probably there in order to agree some negotiation.
2. The new Government -whether it includes Syriza or not- will be under heavy pressure not to agree to certain structural reforms in the package and even if it does, these reforms will come up against fierce resistance when the time comes to implement them.

It is worth noting that the head of the ND party, Antonis Samaras, has been a thorn in the side of PASOK’s attempts to implement reforms. He fought every single austerity package. He quarrelled with the EU over supporting the implementation of the current package. And this is the guy that the EU are hoping is going to implement the future reforms! In addition, he is supposed to do it in the face of Syriza in parliament and, against significant and increasingly violent, social unrest. A tall order.


Why Does Greece Matter?

Greece matters because if it defaults on its debt in a disorderly way, the knock on effects on the European banking system are significant. It could cause a collapse in confidence in the EuroZone. In fact, the Greek politicians know this and, it has been their main negotiating tool in extracting loans and political concessions from the EU.  A disorderly default would hurt everybody so whilst this threat hangs over Europe, there will be uncertainty. Unfortunately, markets and CEOs do not like uncertainty and, growth is being impaired inEuropeas a consequence.

The threat of a disorderly default comes from a political move by Greece after the election (not likely now), or a future move caused by an economic collapse from a bank run (possible), or significant social unrest and political instability caused by recession and ongoing friction with the EU (possible).

 

Note the US potential exposure and, the direct exposure of French banks. Ever wondered why the new French President was so keen on trying to get Eurobonds implemented?


What Happens After the Elections?

I have four scenarios.

History suggests the following sequence of events. A bailout package will be renegotiated. Markets might like this and go back to ‘risk-on’ for a while. Meanwhile, the structural reforms will not be implemented, because Greece’s polity neither believes in the reform program nor feels it was elected to enact it.  There will be more social upheaval and unrest in Greece. The possibility of a major bank run will ensue (Greece already has a strange kind of slow motion bank run in place) and, the odds of a hard default will increase.

Alternatively, the EuroZone could decide that the risk of keeping Greece in outweighs the risk of removing them from the Euro. It could ‘force ’Greece into an orderly default, then write down the debt and recapitalise the ECB from the losses on its balance sheet caused by Greece. Then it might engage in liquidity measures so it can recapitalise its banks and, reiterate support for Portugal and Ireland. Such a bold and aggressive move could remove uncertainty over a Greek disorderly default, improve sentiment and, jump start business confidence in Europe. Moreover, the voluntary private sector haircuts have already reduced some of the impact of a Greek default so the EuroZone may feel that now is the right time to do this.

The third outcome is a messy process of an indecisive election, followed by continual upheaval and uncertainty. This could hasten the application of my second scenario or it could exacerbate the problems inherent in pursuing the first.

The fourth scenario involves an extension of the terms, a successful implementation of the reform program, a period of political stability followed by a resumption of growth and a return of market confidence. I have little faith in this outcome!

Frankly, I would prefer the second option to be enacted but consider the first more likely. It is time for bold action and, it also time for the Greek people to have a viable option in front of them rather than be promised unrealistic outcomes by deluded politicians

What Riverbed's Results Will Reveal

This is likely to be a high profile week for network technology players in the cloud.  Riverbed Technology $RVBD reports on Thursday and investors look like they are in for the usual wild ride. Interestingly, fellow cloud technology player F5 Networks $FFIV reports on the day before, so Riverbed holders will want to see beforehand what F5 is saying about enterprise technology spending.
Riverbed is the market leader in Wide Area Network (WAN) optimization controllers, secure web gateway and application performance monitoring. Simply put, Riverbed's solutions optimize delivery of data by compressing, prioritizing and manipulating it. These areas set to be high growth areas in future, thanks to the explosion in bandwidth usage and the mission critical nature of the Internet with cloud computing.

In addition, WAN optimization provides a relatively quick return on investment and can generate growth even in slower economic times. Bandwidth isn't the only issue as the usage of business applications over the WAN isn't linear. In other words, WAN resources might be needed at unexpected times because bandwidth demand spikes can appear at random.

Blue Coat Systems is the main rival to Riverbed. In addition, the likes of Cisco $CSCO, Citrix Systems $CTXS and F5 Networks all play in this market, but they tend to offer specific or expensive large enterprise or data center solutions

Riverbed Technology appears to offer a superior solution to Blue Coat in terms of WAN optimization. However, Blue Coat's solutions offer an integrated approach which can incorporate security and performance measurement in 'one box'. If a customer wants an integrated approach, he will favor Blue Coat. For pure WAN optimization, he is likely to turn to Riverbed. It is incontestable that Riverbed has outperformed Blue Coat over the last few years and, the latter’s operational difficulties and poor performance has led to it being taken private.


What Should Riverbed Investors Look for in the Results?

 A few bullet points, of which, I will discuss in more detail below

• How revenues and guidance are progressing with the launch of the new Steelhead platform and the new Granite hardware?
• Weakness in the European outlook?
• Potential competitive threats to their market position?
• How Government spending is holding up?

New Hardware Releases and Upgrades to Steelhead

Steelhead is Riverbed’s core offering and, the company will be launching an option on a new platform as well as an adjacent hardware product called Granite. Consequently, at the last results Riverbed confirmed full year guidance but implied that Q1 revenues would be down 8-10% sequentially, which is a much greater decline than usual for Q1. The stock took a fearful hit after this announcement. Of course, this kind of guidance implies that the next three quarters will have very strong growth. Not only that, Riverbed predicted rising gross margins throughout the year. We shall see.

The truth is that there is always a lot of uncertainty about the timing of product sales acceleration with new launches and upgrades. Existing customers may decide to keep running the old system, or they may have been holding back the budget previously in order to buy the new system. Ultimately, who knows?   Riverbed management has done the job of downplaying expectations but the uncertainty remains.

Nevertheless, investors should listen closely to what management says in the conference call and, analysts will be sure to probe them on this issue.


Weakness in Europe?

Whilst the profit drivers of Riverbed are in strong secular growth trends, the company is not immune from slowdowns. In fact, the stock suffered last year when, in the Summer, it announced -in common with Fortinet and F5 Networks – that Europe was weak.

Riverbed described European sales as being ‘weaker than expected’ and, pointed the finger at its execution rather than product lineup. Strangely, they had cited Germany as being weak. However, all of this may have been due to the reshuffling of the company's European leadership in the quarter.
Nevertheless, I don’t believe in coincidences. Around the same time, F5 Networks talked of ‘weakness in some of the more macro affected economies in EMEA’ and, Fortinet mentioned ‘softness in EMEA from a macro perspective as well as timing of some of our larger transactions resulted in lower billings growth for the region’.

All three recovered but, then again, so did sentiment over the European sovereign debt crisis. Therefore, I think that growth for these companies is somewhat contingent upon confidence in European IT spending. Another thing to keep an eye on.


Potential Threats?

Riverbed is the leader in its field, but Blue Coat may make a comeback now that it has been bought out. Furthermore, Citrix and Cisco may also decide to compete more aggressively with Riverbed’s product range. They both have a WAN optimization product portfolio. Furthermore, F5 Networks may decide to take advantage of its position in application delivery to expand upon its WAN optimization offering.

This is perhaps, not something to worry about in the short term, but if Riverbed gives weak numbers –due to other factors- than it could look like they are losing market share. I doubt this would be good for the stock price.


How Government Spending is Faring?

Government sales make up one of the largest portions of Riverbed’s revenue generation. Indeed, in Q3 last year the company reported very strong growth due to this vertical. It is tempting to conclude that Riverbed is relatively immune from cutbacks because this is such a mission critical area of IT spending. However, cutbacks are cutbacks and because Government is such a strong vertical, it will only take a small marginal shift in Government spending in order to affect Riverbed.


What to Expect?

In conclusion, I think Riverbed is attractively priced right now but there is uncertainty connected to these results. This is a volatile stock and the slightest disappointment tends to send it tumbling. However, I suspect that the management has done a good job in downplaying expectations. Any significant earnings beat will send the stock rocketing.

For longer term investors, if they are prepared for how to interpret the upcoming results- and I hope this article is helpful- they might find a decent entry point into a company with excellent long term prospects.

Who Will Win the Smart Phone Wars?

Nokia $NOK gave disappointing results recently and, it is hard to see where the company can go from here. In less than a decade, smartphones have captured over 50% of the US market and, Nokia has been nowhere near competitive enough in this market. In terms of US smartphone handsets, the clear leaders are Samsung, LG, Apple $AAPL and the declining RIM $RIMM.  So Nokia is challenged at the high-end, but it is also challenged at the low-end where local Asian manufactuers are issuing cheap non-smartphone models.

The investment thesis behind Nokia is usually the opportunity for it to establish itself as the handset (smartphone & non-smartphone) of choice to the emerging markets. Nokia certainly, has the brand name and positioning in emerging markets and, the current situation looks favorable for this idea.
Countries like China are still a couple of years away from a 4G network, and according to official figures, their mobile penetration rate is still at an internationally relatively low figure of 74%. Moreover, 3G penetration in China is still at a very low 14%. This suggests that Nokia can see growth via increasing Chinese mobile penetration with non smartphone models.

However, this is the current situation. It is not the future. Frankly, I see no reason why future growth in China will not be focused on smartphones and Nokia’s positioning looks weak.

In the update, Lumia smartphone sales were lower than forecast and, the launch of the Lumia 900 did not go well. Nokia has been hoping Lumia could create and, then expand upon, a niche with its Microsoft $MSFT Windows operating system. The weak opening does not bode well.
In addition, The previous Nokia system, Symbian, is being phased out and Microsoft is an also-ran in the mobile OS space. Their appears to be little clamor for Windows mobile operating systems and, even if Nokia decided to use Google’s $GOOG Android, it could take years before a handset is produced. It looks like Nokia is stuck with Windows for now.


Who are the Winners in the US Mobile Market?

I’ve adopted some figures from Comscore in putting together this table for US mobile subscribers and Operating Software (OS) share. 

	Share of Mobile Subscribers		Smartphone OS Market Share
Samsung	25.6%	Google	50.1%
LG	19.4%	Apple	30.2%
Apple	13.5%	RIM	13.4%
Motorola	12.8%	Microsoft	3.9%
HTC	6.3%	Symbian	1.5%

(All data is for the US as of Feb 2012)

Samsung, LG and Apple are doing well. As for Motorola, even with a currently declining market share, the company will have the opportunity to flourish given that Google’s ownership looks ready to spur investment. Turning to operating software, Google gives Android away free but, as yet, has not found a way to meaningfully monetize it. Android is multi-channel and is used by Samsung, LG, Sony Ericsson, Motorola, HTC and many others.

Going forward, the key issue will be the ecosystem created by the operating system and, developers simply do not create applications to run on platforms with little market share. Scale means everything for a developer and, right now, Google and Apple are the runaway leaders. Indeed, Facebook even mentioned the possibility that Google might try to exclude Facebook apps from its Android system, as a potential risk to the business.


Google Winning?

Longer term, Google looks like a winner, because it knows how to monetize search and display in mobile. Facebook does not make meaningful revenues from mobile and, I think is more structurally challenged by mobile than Google is.  Also, Android is only part of Google’s cross product offering and it can be subsidized in order to create revenue from search based ad revenue.

RIM’s Blackberry is losing market share and, is threatening to become a footnote product in the history of technology. The Blackberry seemed to hit a cultural sweetspot as a smartphone option before the Iphone and Android based systems gathered steam.

Apple is a smartphone leader and, the company is about much more than just the Iphone. Nevertheless, a failure to keep innovating in hardware design in future could hurt market share for Apple’s iOS. By way of comparison, Android runs across a range of handset manufactures so, in a sense, it is hedged. However, what Google plans to do with Motorola is still not clear. One thing that is certain, is that Google is actively dealing with the shift towards internet usage on mobile. I’m not sure the same could be said of Facebook!


Another Way to Play the Theme?

While the usual analysis of the sector involves trying to pick a winner from companies competing to capture the current within strong structural trends (smartphones, apps, mobile internet etc), investors can also try and buy stocks exposed to these themes in other ways. I think it is an inexorable fact that increased smartphone penetration will demand enhanced bandwidth and increased data speeds. That said, I like the Internet Protocol (IP) and network testing solution providers. The leaders in this field are the Ixia $XXIA and the UK’s Spirent.

Both are exposed to long term trends in spending on upgrading networks that are seeing increasing demand put upon them. The more that is spent on networks, the more testing that needs to be done. Whilst most of the excitement centers around the next generation 4G/LTE networks, both companies can see upside from the continued roll out of 3G networks in countries upgrading their mobile networks.

Ixxia is a company well worth watching. It tends to be volatile over results because the market reacts to short term guidance over carriers spending plans, but longer term this is an exciting industry to be invested in.

Is the US Housing Market in Recovery and What Stocks to Buy?

Wells Fargo $WFC and JPMorgan $JPM gave results on Friday and, although they both beat estimates, the market immediately greeted them with a 3%+ markdown. The key interest for long term market investors is to discern from these numbers, how the US economic recovery is faring.
In particular, Wells Fargo is a key barometer of US household finances and, the housing market. As the largest mortgage originator in the US, Wells Fargo is effectively geared to the housing market. Therefore, the scope of this article will be to look at the US housing market in the context of finding an investment thesis that will benefit from the trends articulated.

With Citigroup and Bank of America $BAC reporting soon, it is important for investors to understand the underlying trends behind future earnings numbers. In particular, Bank of America appears to be a high beta play on a US recovery. So this kind of analysis is essential.


Wells Fargo & JPMorgan Bullish on Housing

JPMorgan reported that mortgage applications were up 33% on last year and Wells Fargo reported an 84% increase. Both made bullish predictions on the housing. Quoting from Wells Fargo’s conference call, CEO John Stumpf said,

‘But when you have the dynamics of higher rental rates and lower home values at great financing rates, there's a point in time where the market's going to clear and you're going to see improvement. I think we're getting very close to that tipping point, and we've seen it in some of the markets.’

 Similarly, JPMorgan’s CEO, Jamie Dimon, was quoted as saying that housing was ‘very close to the bottom’.
These statements will be music to the ears of Warren Buffet, who is a significant holder of Wells Fargo stock. Here are some quotes from his last annual letter to Berkshire Hathaway shareholders.

‘Every day we are creating more households than housing units… …At our current pace of 600,000 housing starts –considerably less than the number of new households being formed- buyers and renters are sopping up what’s left of oversupply… …Fortunately,  demographics and our market system will restore the needed balance- probably before long. ‘

There can be little doubt that Buffet is invested in Wells Fargo as a consequence of his confidence in housing. Essentially, banking stocks are geared to the economy. When unemployment is falling, credit quality improves, bad debt provisions tend to fall and, banks start lending again.
All of which, leads me to wonder what exactly is the point of managements handing out shareholders cash to employees bonuses when bank earnings are actually guided by the economy?  However, that is another issue. It's timeto go back to housing.


Housing Market Outlook

Returning to what Warren Buffett said, new housing starts have been below 600,000 since the fall of 2008. To put this into context, they rose from 1.2m to 1.8m at the height of the housing bubble in 2006. However, whilst new household formulation in the US tends to add about 1.3m new households every year, homeowner vacancy rates still haven’t fallen back to traditional averages yet. These figures are from the Census Bureau.


Whilst the trend is clearly getting better, the data is still indicating that a strong recovery is not imminent. Moreover, the shadow inventory in the housing market is holding back the housing market. However, the best way to gauge a demand/supply imbalance is through prices!
House prices are still weak, but the trend does appear to be improving. Here is the monthly change in the Case-Shiller Home Price Index.
 
Another useful indicator is the NAHB/Wells Fargo Housing Opportunity Index, which is a measurement of housing affordability. It is at an all time high and, reflects ongoing low interest rates and falling home prices.

Throw in falling unemployment and increasing credit quality and a positive prognosis for the housing markets ills could be easily created. For example, credit quality data from the FDIC suggest that bad debt provisions at the banks remain on a positive trend.
  How to Play the Sector?

Of the banks, I prefer Wells Fargo because of its exposure to the US mortgage market. It is also a US centric play which should alleviate it from potential problems with deteriorating European sovereign debt issues. However, housing is such a broad sector that there are plenty of ways to get exposure.
One of my favourites is Home Depot $HD although Lowes $LOW is also an option for similar reasons. These two home improvement stores are behemoths in terms of market position and, any uplift in housing prospects is likely to drop straight into their bottom line.

 Home Depot is attractively valued because it continues to generate huge cash flows and, last year, only paid 30% of its free cash flow in dividends. There is ample scope for more buybacks and dividend increases. It is a similar situation with Lowes which paid out 25.6% of its free cash flow in dividend, but Lowes starts with a lower yield. In addition, I prefer Home Depot because the company has been executing better than Lowes in recent years.

Another option, which is little discussed, is credit information provider Equifax $EFX. This company is heavily exposed to the increasing issuance of credit in the US economy. Therefore, if banks and corporations are extending credit again, Equifax will be an obvious beneficiary. Analysts are forecasting double digit growth for the next few years and, I think there could be upside to those estimates. Equifax has gross margins over 60% and, I like the way this sort of business is leveraged to cyclical growth in theUSand secular growth in emerging markets such as Brazil.

In conclusion, there are positive signs for housing and credit in the US. Granted, investors have heard this before over the last two years. Yet, I am going to issue some famous last words and state that ‘this time it’s different’.

An Emerging Market Healthcare Play

Healthcare is a sector that creates many contradictory investment ideas which sometimes make it difficult to see the big picture. For example, there are no shortages of healthcare enthusiasts that remind investors that populations are aging, so volume demand for healthcare will increase.  However, there are also plenty of commentators who point out that bloated Government debt plus the need to restructure health care will create a lot of political pressure on healthcare pricing.

Somehow with pressures on volumes and pricing moving in different directions, an investor is supposed to pick his way through! One solution to this sort of conundrum is to focus on a disease that is disproportionally going to affect emerging markets and is set for growth.

I’m confident that diabetes is such a disease. Emerging markets are attractive from a healthcare perspective, because in many of these countries, healthcare spending per capita is far lower than in developed economies. Moreover, as these countries grow, the need to generate domestic demand via spending on social infrastructure is going to increase. Finally, diabetes is a disease that is set to increase significantly in the emerging world. Here is a table from the International Diabetes Federation.
 
So why is diabetes set to increase?


Diabetes on the Rise in Emerging Markets

The most oft cited reasons are due to shifts in incomes, life style, and diets. Simply put, increasing urbanization is causing a shift from active lifestyles with low calorie vegetable diets, towards a sedentary lifestyle rich in meat, dairy, and processed (particularly sugar enriched) foods.
Of the two main types of diabetes, Type 1 (around 5-10% of total) is caused when the body starts destroying the pancreatic cells that creates insulin. This leads to high blood sugar levels which severely threaten health. Type 2 (90-95%) is when the body produces insulin, but its cells do not react to it. Clearly, the far more prevalent, Type 2, is accelerating in emerging markets due to the reasons outlined above.

So, how to play this theme? I think there are two main ways; The first is through kidney dialysis and, the second through insulin treatments.


Kidney Dialysis

Diabetes is a major cause of Kidney disease. High blood sugar levels will, in time, severely damage a kidney and cause the need for kidney dialysis, if not, replacement. The two major players in dialysis are DaVita $DVA and Fresenius $FMSBoth run dialysis centers and provide related services in hospitals. On a standalone basis, both companies are extremely attractively priced, and offer good recurring cash flows to investors from within growing end markets.

However, both are exposed to a significant amount of uncertainty.  The threat of reimbursement cuts hangs like the sword of Damocles over these two companies. Moreover, the economics of running these centers is not as simple as it may appear.

For example, with DaVita in the US, the majority of patients (85-90%) are funded by the Government, and private patient minority (10-15%) tends to produce 40% of the revenue with 110-115% of the profits!  In other words, DaVita loses money on 85-90% of its patients. Whether private reimbursement will continue to carry the costs in this way is another story.

Furthermore, whilst, it is fair to expect DaVita to be a profit maximizing organization, it should also be understood that this does not mean they are free from Government influence or pressure. In other words, DaVita can’t just cherry pick where to run centers.

In addition, another potential threat exists from home dialysis. The most common type of home dialysis is peritoneal. This contrasts with in-center hemodialysis, which is how DaVita and Fresenius tend to make revenue. Peritoneal has a far smaller market share but many people appreciate the opportunity to carry out dialysis at home, as opposed to at a treatment center. There are pros and cons to both treatments, and this is far from an exhaustive analysis. My point here is that Fresenius and DaVita are not immune from margin erosion due to a potential pick up in home dialysis.

Another company, with a large kidney disease segment, is Baxter $BAX which has a number of products and services targeted at treating kidney disease. In fact, Baxter offers solutions to both the in-center and home dialysis markets, although the stock is definitely not a pure diabetes (or even renal) play. Although, for investors holding Baxter, the strength of this division should be noted.


Insulin based treatments

For Type 1 diabetes sufferers, insulin is a way of life. They will be taking it for the rest of their lives. With Type 2 diabetes, around 40% of sufferers will end up requiring insulin as part of their diabetes management regimen. The two major players here are Sanofi  $SNY which has the market leading product Lantus and, Novo Nordisk $NVO which has the broadest portfolio of diabetes products within healthcare.

Sanofi is a very interesting company in its own right. It is a high dividend stock that offers growth from a number of sources. It is strong in emerging markets, has good growth prospects from rare inherited disorders (via the Genzyme acquisition) and relatively little reimbursement issues from its consumer and animal health divisions. However, it does have a number of major selling drugs going off-patent in the next two years, and the pipeline looks a little thin. Indeed, by 2015, Sanofi expects that Genzyme and growth products (which include diabetes, emerging markets, consumer health, vaccines, animal health and innovative products) will make up 80% of sales. Clearly, defending Lantus (insulin glargine) which goes off patent in 2014, is very important to Sanofi.

Novo Nordisk might just have a product ready and approved by then, in order to grab market share. Novo already has a fast growing injectable, Victoza (not an insulin) which can be used to help raise blood sugar levels in Type 2 patients. Novo is already the market leader in this segment of diabetes treatments.

However, with its long acting insulin Degludec, Novo is seriously threatening to compete with Sanofi’s Lantus. Indeed, Novo claim that in trials, Degludec is non-inferior to Lantus and has a lower risk of nocturnal hypoglycaemia. The latter is the experience of low blood sugar levels at night. In addition, Novo claim that it also has a statistically significantly lower risk of severe hypoglycaemia than Lantus.
Degludec may also have a longer action profile which will give Type 2 patients much more flexibility and comfort. Whether, this is enough to justify a higher price point to Lantus, is a moot point. However, I suspect that for Type 2 patients who are being introduced to the idea of taking insulin (remember only 40% of them will) having a better safety profile might be something they are willing to pay extra for.

According to Novo, Degludec is on track in the regulatory approval process in both the US and in Europe, where they are currently under ongoing review. This could be a very exciting year for Novo Nordisk and, longer term, the outlook looks very good.


Conclusion

Fresenius and DaVita both offer a value proposition but carry the risk of reimbursement pressures within their core Western markets.

Novo Nordisk is definitely priced at a premium to the sector, but it deserves it for its growth profile.  As a pure play on diabetes, I think it is the best option. It currently has a PE ratio of 27 and, despite forecasts for double digit EBITDA and free cash flow growth over the next few years, it is hardly cheap. However, it has upside potential from possible Degludec approval. Furthermore, Novo claims to have 62% market share within the key China market for diabetes care, and if investors believe there is upside potential from emerging markets then Novo could be a key beneficiary.

On the other hand, Sanofi is cheap on current metrics, and I think it offers good value for income seeking investors. However, it is not a pure diabetes play and Lantus may be under threat from Degludec in future. Both stocks have strong emerging market potential, but before buying Sanofi, I would suggest looking closer at the rest of their product portfolio.

Gold and Emerging Markets

A friend of mine asked me for some views on gold the other day and I had to confess that it’s not something I have a definitive trading view on. In summary, I think it is an investment bubble, predicated on prices rising higher so that it can be sold onto the next man.

However, calling a bubble too early has been the ruin of many investors and risk averse investors should, in my humble opinion, shy away from taking a substantial position either way. Yes, I think it's a bubble, but I also think it is underpinned by some very powerful structural drivers from the Emerging Markets.

Obviously the key stocks affected would be the largest gold ETF, namely the SPDR Gold ETF $GLD or even an ETF of gold miners such as the Market Vectors Gold Miners Trust $GDX. Alternatively, investors can get gold price exposure by buying gold miners like Goldcorp $GG, Kinross Gold Corp $KGC, or Barrick Gold Corp $ABX. Ultimately, the underlying driver for all of these stocks’ price movements will be the price of gold, even if the miners have been underperforming gold prices of late.


What’s Driving Gold Demand, Speculators?

It’s usually a good idea to start with the hard facts, so here they are.  All figures are from the World Gold Council (WGC).


The interesting thing is that the demand for bar & coin really picks up after 2008, and I suspect this is largely a consequence of its relative attraction as an asset class. I think that asset classes tend to move in cycles of popularity. So for example, at the end of the '90s equities were the "must-have" asset class and prices reached extremely high historical multiples.

Then the 2000 crash came along, interest rates were lowered, nobody wanted equities anymore, so housing (particularly in countries like the US, Ireland and Spain, where housing gets built) became the new investment vehicle of choice. Despite good performance from equities from 2003-2007, they never reached the kind of multiples that the market had been on previously, when interest rates were so low. Everybody wanted housing and everybody wanted housing derivatives.

They also wanted gold.

Gold prices doubled to $600 from 2000-2006. Then when the US housing bubble started bursting in 2006, people wanted more gold. Prices then tripled to $1,800 in 2011.  ETF issuers weren’t slow to get in on the act and suddenly a plethora of ETFs were created, which helped prices go even higher. Fortunately, the largest gold ETF of them all, GLD, has a policy of actually buying the underlying gold, so we were somewhat spared from the exposure to the usual inadequacies of the financial services industry and their structured derivative products.

I have initially focused on bar & coin, because this is where the big increase in market demand has come from. This is illustrated here.



But that is only part of the story.


What is Driving Demand, Emerging Markets?

Obviously, emerging market demand is going to make up a fair portion of the total and with the strong growth rates in China and India over the past few years, their contribution to global demand has been on the increase. Aside from the cultural predilection for gold that the Indians and Chinese undoubtedly possess, there is also the issue of the availability of domestic asset classes for them to invest in.

Whilst the Indian wedding season remains the biggest single driver of jewelery demand, investors should not forget that China’s demand for gold jewelery is now almost equivalent. In addition, as long as China keeps buying US Dollars and selling RMB – in order to keep its currency weak -- it will carry on flooding its markets with capital. China doesn’t have significantly developed equity markets, so we have seen domestic RMB flowing into the China housing market and to alternative assets like gold.
I want to demonstrate this by showing a remarkable chart.

 

The rise since 2008 has been startling and contributed much to the rise in gold prices. However, there is a key point here. Aside from the Total figure, every one of these percentages fell in 2011. Granted, this does not mean they fell in demand terms, but rather they didn’t grow as much as in other markets. Consequently, as gold prices started falling from mid-2011, China and India’s growth started to slow and GDP forecasts in both countries have been lowered this year.  I do not think this is a coincidence.


So What Next for Gold?

In my view, the risk is on the downside for both China and India growth this year. China’s property bubble has burst and history tells us that it takes a while for property-related bubbles to correct themselves. In fact, the US property bubble burst in 2006!  So, I would expect demand growth from China and India for a discretionary element like jewelery to slow.

That said, if China’s property markets do continue to trend downwards, will this create a second wind for gold as their investors start piling into gold as a safe haven asset class?

I don’t have a strong view on this yet and I think that it is difficult for anyone to know confidently. This is why gold is such a tricky asset class to play with. Following the US property bubble, US investors have been favoring bonds, but I’m not sure if Chinese investors will react in the same way.
As for the global ETF demand, I think that this will be price dependent. In classic bubble fashion, investors tend to pile into the asset class as it is going up, but once a period of underperformance comes, the speculative money will file out.  We can see this in the reduction in ETF demand. Similarly, if prices keep falling then investors (wherever they are) will be induced to sell out of their positions.

Perhaps the safest conclusion to draw from this analysis would be that the key to future gold price movements is likely to be China and India demand. The latest WGC figures to Q1 show India jewelery, bar & coin demand down 13% year on year in dollar terms, but China demand up 33%. So, there is no sign of Chinese demand slowing yet and it may prove a safe haven from falling property and equity markets for them. However, let’s recall that this appeal tends to last as long as gold prices are rising. The longer gold stays in this trading range, the shorter will be the patience of speculators and with Indian demand falling, the downward pressure is building up.

Alcoa's Results Give Mixed Signals

Alcoa $AA kicked off the main body of the earnings season and, investors poured over its results to try and garner an indication of where the economy is headed.

With regards to the earnings, the revenue numbers were surprisingly strong given that aluminum pricing has been weak recently. Management sounded bullish on the conference call, even though others in the industry have been making more cautious statements recently.

Alcoa has had to deal with falling aluminum prices and has cut capacity as a consequence. Ultimately, its profitability will be guided by the demand/supply balance in its industry. For this quarter, Alcoa did well as pricing pressures eased, but the key will be how end demand trends in future.

These are industry-specific questions, but Alcoa’s end demand has plenty of drivers in common with many market sectors. Consequently, Alcoa’s stock performance is not always a useful bellwether, however, the company’s end market commentary is interesting for the wider markets.


Stocks Correlated with Alcoa

For example, looking at the stocks that Alcoa has the highest correlation to, the usual mining and aluminum suspects are apparent. Interestingly, the typical plays on global growth such as DuPont and Caterpillar $CAT are also there.

Company	Correlation %
BHP Billiton	87.5
Century Aluminum	87
Nucor	86.2
Rio Tinto	86.1
Du Pont	85.5
Caterpillar	84.6

Investors should understand that correlation is not the same thing as co-integration. Correlation measure  the direction of the movements together, rather than the magnitude. Two stocks can be highly correlated but also exhibit vastly different price movements.

Nevertheless, investors do care about directional movements. With this in mind, I want to break down Alcoa’s end market guidance and, see which companies might be affected by the commentary that Alcoa gave.


Alcoa’s End Markets

Here is a table of how Alcoa has been adjusting guidance over the last four quarters including the latest commentary. The last column is my own interpretation.



The first thing to note is that I am only describing automotive and commercial transportation as being ‘slightly weaker’, because Alcoa lowered the high end and low end of their respective guidance. Secondly, Alcoa raised guidance for the long cycle industries of aerospace and industrial gas turbines, by way of contrast the weaker outlook was in the shorter cycle businesses.


Aerospace & Industrial Gas Turbines Stronger Growth Forecast 

The raise in guidance will be well received by an aerospace industry which is set for good growth in the next few years. Airbus and Boeing order books are both full for years to come. Moreover, with the growth of aircraft such as the popular A320 and Boeing 737, which have a large aluminum component, Alcoa has the opportunity to grow faster than industry growth.

Ultimately, the aerospace industry is cyclical. High fuel prices and economic recessions will ultimately effect growth. Indeed, according to the International Air Traffic Association (IATA) the outlook remains ‘fragile’.  Nonetheless, longer term aerospace growth is being driven by low cost carriers and emerging market passenger growth. The BRICs are all huge countries, whose intercity transportation is likely to have air travel as an integral part.

One company I like in the sector is BE Aerospace $BEAV which provides seating to airlines. It is attractive because it is a pure commercial aerospace play and looks set to benefit from a long cycle of growth in new build and retrofit. Typically, airlines order planes then they buy the seating and cabin interiors separately from the likes of BE Aerospace. However, BE Aerospace now working directrly with the aircraft manufacturers. The company recently announced a contract with Boeing to manufacture modular lavatory systems for the 737. This is exciting because it may presage a new area of growth for the company, particularly as its solution allows for airlines to gain a few seats on the plane.

Another, obvious beneficiary is General Electric $GE which is the leading player in the market. It is also the leader in commercial aircraft engines and would be an obvious beneficiary of Alcoa’s rosy economic outlook.


Beverage Can Packaging

Although the headline guidance stayed the same, it was noticeable that forecasts were raised in Europe. This is an interesting industry because there is rapid growth in emerging markets for can usage. However, in the US, plastic is increasingly replacing aluminum in the key beverage packaging sector. Therefore, companies like Rexam or Ball Corporation $BLL are increasingly shifting production towards emerging markets like Brazil. Ball Corp is worth a closer look, because its end demand remains positive and stable, whilst one of its key input costs (aluminum) is falling. The key for Ball will be in managing the consolidated decline in the US, whilst accelerating growth elsewhere.


The Weaker Segments Reveal Regional Differences

Within Commercial Building, all regions (US, Europe and China) were predicted weaker, although Europe was noticeably so. Frankly, I think there is good potential for China to disappoint in future quarters and, Europe’s economic growth will be weak this year.  Automotive was very enlightening. Europe was seen as notably weaker whilst China was weaker. The latter is not surprising, given the recent relative weakness in car sales in China. However, the US was noticeably stronger. This suggests that the way to play US auto sales strength could be via the US auto dealers rather than global production.

It was a very similar story with the Heavy Truck & Trailer segment. Alcoa sees the US trending higher and growth from China being weaker. One company that could benefit is Eaton Corporation which has good exposure to the aerospace and commercial transportation markets.


Alcoa Results

In conclusion, Alcoa’s guidance was mixed. The clear message is that China’s growth appears to be slowing but, the US is accelerating. I think this signal is a useful one for investors to digest and, an increased focus on domestic US inclined companies is called for. Perhaps the much talked about, but rarely seen, decoupling affect does actually exist?

Pfizer's Upside Potential

Everybody knows that the major pharmaceuticals companies have faced myriad challenges over the last few years. The industry has had to deal with patent cliffs, fears over reimbursement adjustments, the FDA becoming more stringent over approvals, the increasing cost of research and development (R & D) and many other issues.

The patent cliff issue is immediately noticeable in the slowing revenue growth rates in this period and, this year in particular, is seen as the annus horribilis for big pharma. Pfizer $PFE is no stranger to these problems, and generic competition to cholestorel lowering blockbuster Lipitor is going to hurt inevitably Pfizer.

That said I thought it would be interesting to look at how Pfizer is dealing with the challenges and appraise some of its upside potential for 2012.


Pfizer Acquires and Restructures

The first part of Pfizer’s approach to dealing with its strategic challenges was to arrange a merger with Wyeth. It was a deal which gave Pfizer new expertise in large molecules, vaccines, and biologics. It has also generated significant cost savings.

The second part is to significantly restructure and refocus the business.  The management would like to sell the animal and nutritional health business, and continue the extensive buyback policy. As a consequence, R & D expenditure has been cut to about 12-13%

This is a relatively low number, but what will it do the all-important pipeline?


What is interesting in Pfizer's Pipeline?

Looking longer term, the pipeline focus has shifted towards oncology and pain disorder treatments. For example in 2012, Pfizer has phase III trials with Dacomitinib (non small cell lung cancer) and Intuzumab (lymphoma) but, the big kickers could come from Bapineuzumab and Tafocitinib. I want to focus on these two drugs in particular.


Bapineuzumab Makes a Comeback?

Bapineuzumab is a humanized monoclonal antibody that attacks amyloid-beta plaques that form in the brain of Alzheimer’s patients. Phase III results for North America are due mid year. Alzheimer's is the most common form of dementia and, an indication which has seen few treatment advances in recent times. As such, any successful drug is likely to be well received, especially in an ageing population.
The amyloid-beta theory (which this antibody relies on) has been challenged by high profile failures with Myriad Genetics Flurizan and even with Bapineuzumab previously.  In addition, Phenserine (amyloid beta modulator) failed in a previous phase III trial as did Tamiprosate which tried to inhibit amyloid beta plaque formation.

Amyloid-beta optimists will also want to keep an eye on Eli Lilly’s $LLY solanezumab and Morphosys’ gantenerumab which will both give results this year.  Gantenerumab, like Pfizer’s antibody, is an anti-amyloid-beta treatment (in early stage trials) and, based on previous drug class failures, I would cast doubt on its chances of success.

Solanezumab is a humanized monoclonal antibody which binds to soluble amyloid beta. It was taken to phase III on the back of safety data, rather than having achieved efficacy in Phase II. Solanezumab is believed to be similar to bapineuzumab but with less toxicity issues. The latter was found to cause brain inflammation in its highest dose in Phase II. Eli Lilly investors will be hoping to hit a home run with this antibody and, are results due this year.

What all of this drugs have in common is a reliance upon the theory that reducing amyloid beta plaques in Alzheimers patients will work to reduce the onset of dementia.

I think that the clinical evidence doesn’t bode well and, I would be surprised to hear good news on Bapineuzumab.  However, with three drugs giving results,  it is going to be a big year for the amyloid-beta theory!


Tofacitinib could be Pfizer’s next Blockbuster

On a more positive note, Pfizer’s Tofacitinib is the leading small molecule in a new class of drugs called Janus Kinase (JAK) inhibitors. A number of companies have been successful with JAK inhibitors in clinical trials, so there is ample clinical evidence to suggest that they work. Pfizer’s plan is for it to be initially approved for Rheumatoid Arthritis (RA) and then expand its indication to Ulcerative Colitis, Psoriasis, and Crohn’s disease.

In particular, JAK inhibitors are a class of drug being targeted for inflammatory diseases. Many of which, such as Ulcerative Colitis, are potentially fatal. Rheumatoid arthritis is chronic inflammatory disorder which tends to affect the joints and. disproportionally so in the elderly. The current treatments are some of the best selling drugs in the world.

Within RA, Pfizer has already filed and been accepted for review in the US and in Europe. In addition, a file has been submitted in Japan. What makes JAK inhibitors so attractive is that they tend to be taken orally via a pill.  This compares favourably with the previous class of RA treatments, namely TNF blockers. For example, TNF blocker biologic Humira is injected on alternate weeks, Enbrel is injected once a week, and Remicade is given intravenously every month or so.

The three afore mentioned TNF blockers are responsive in 70% of patients, including some who do not respond to the first line treatment of methotrexate. They are all expensive and have significant side effects.
I would expect Tofacitinib, if approved, to be immediately marketed to TNF non-responders and, then start to encroach on TNF-blockers market share. After which, Pfizer can create a market ‘buzz’ around its applicability for other indications. In short, this drug could be a huge blockbuster for Pfizer.


Potential Competition for Tofacitinib?

As mentioned above, Pfizer isn't alone in developing JAK inhibitors. Vertex Pharmaceuticals $VRTX showed significant results in a phase II in RA with its JAK3 inhibitor VX-509. A further phase II trial is planned. Similarly, Rigel Pharmaceuticals has entered into a Phase III with is RA treatment Fostamatinib.

Speaking of Vertex, it has long been touted as a takeover target due to its exciting pipeline and I wouldn't be surprised if a major pharmaceutical company stepped in and acquired the company.
Furthermore, Incyte $INCY in partnership with Eli Lilly, has two JAK inhibitors in development. INCB28050 is in a phase II for RA. Meanwhile, Jakafi (ruxolitinib) is already on the market for myelofibrosis and, Incyte has it in development for psoriasis and polycythemia vera as well.
Myelofibrosis is a disorder of the bone marrow, which tends to cause inflammation of the spleen.  Jakafi works to reduce spleen inflammation. The indications are that Jakafi sales are doing very well. This must surely resonate with the FDA in terms of their confidence with approving JAK inhibitors.
Both Vertex and Incyte will offer stiff competition to Pfizer.


Pfizer in 2012?

In conclusion, Pfizer investors can look forward to more restructuring in 2012. but there could be a lot of excitement around Tafocitinib being potentially approved. Incyte has already got a JAK inhibitor approved and, so far, the indications are that Jakafi is doing well. Bapineuzumab has probably been written off by most investors and, is unlikely to disappoint many. A failure is probably 'in the price'. Therefore, for long term income investors looking for some dividend with some upside potential, Pfizer offers a compelling mix.

A Hard Landing For China?

Probably the two most worrying macro events of 2012 will be, if and when, China and Spain come out of their respective property slumps.

Before focusing on China, a few words on Spain. Its problems are quite deeply embedded with its economy. Following an extended property boom, Spain’s GDP growth and its public finances, became reliant upon the housing market. Indeed, prior to the recession, Spain’s public debt situation was looked on favorably. Not anymore!

Spanish banks hold a lot of distressed properties on their books, and their bank's bad debt ratios (unlike the US banks) are getting worse with the ongoing decline in house prices. Equally worrying, Spanish banks hold significant amounts of Portuguese Government debt. So, we have a scenario of declining underlying asset prices, leading to declining capital/asset ratios, leading to the necessity for increased bank funding. Ultimately, this calls for Government aid which leads to an even bigger stress on public finances. And so it goes on. Does it sound familiar?

Well if it does, then why aren’t similar questions being asked of China?


China’s Growth is Slowing

Frankly, I don’t think there is any doubt that China’s growth is slowing and, I would be wary of chasing the commodity story higher. The world and his wife, knows that the increase in marginal demand for hard commodities has being driven by China. Indeed, the major commodity metals stocks such as Southern Copper Company $SCCO Vale $VALE and Rio Tinto $RIO have all been used as proxies for growth in China’s fixed asset investment.

Raw materials like copper are widely used in the construction industry and the price of the metal is intrinsically linked with fixed asset investment. Similarly, the main demand for iron ore comes from the steel industry and, China is the swing player in steel consumption. Indeed, the negotiation of iron ore contracts with China is a key event in Rio and Vale's revenue outlook.

If China's fixed asset investment is set to slow, then hard commodities only have one way to go. Moreover, the companies that service such growth such as Joy Global $JOY or Caterpillar $CAT could also suffer disproportionately. Joy Global's mining equipment is extensively used in China and Caterpillar is a name synonymous with construction. Both are aggressive players in China.

Before being too quick to conclude a slump, let’s look at some of the data. For example, let's consult a few charts from the official China National Bureau of Statistics.

Firstly, fixed asset investment growth is slowing.

 
This isn't a surprise because China's commercial floor space sales growth is now negative.

 
The China optimists argument is that the Government has successfully engineered a slowdown in the housing market so we should now see demand catch up with supply. The bulls point out that the slowing of real estate land purchased will ultimately result in a deficit of supply.

 

However, I should note that housing starts in the US started declining as long ago as 2006!  Restructuring from a housing slowdown takes time. I see no reason why China will be any different.


The Great PMI Debate

Recently, the official Chinese Purchasing Managers Index (PMI) for March hit its best level for a year whilst, the HSBC/Markit PMI number came in below 50. Moreover, the latter data represents the fifth monthly decline. Which number is more accurate?

Frankly, I find the official number puzzling because it does not tally with the direction of other official data. Nor does it correlate with the other sources of China data. For example, I’ve tabulated 3 month average automobile sales from the China Association of Automobile Manufacturers. Here are the year-on-year growth rates for recent months.
 
It’s hard not to conclude that China’s growth is not slowing. Indeed, BHP Billiton recently stated that Chinese iron ore demand is ‘flattening’.


Can China Grow out of a Slowdown?

Despite the gloom, there is cause for optimism. China has huge gold and foreign currency reserves in relation to its GDP. Naturally, this is a consequence of years of surpluses that have been the pride of China’s economy. No doubt this will be used to counter the effects of a slowdown. Therefore, I think that even the Chinabulls would argue that we are likely to see a change in the composition of growth.
Of course, China remains a Communist country and, is a nation that requires concerted attention to preserve social cohesion. This costs money. Consequently, I would expect a shift in emphasis towards domestic consumption and also, increased investment in social infrastructure such as hospitals. Much of which will require hard commodities, so the position is not entirely negative for commodities.

In conclusion, the composition of growth in China is going to change and, accepting this viewpoint will require a shift in thinking on which stocks will be the ways to play China. That is a subject for future debate, but for now ,I would be careful with hard commodities.

SemiLEDS Disappoints Again

Beleaguered investors in SemiLEDS $LEDS must have felt they were due a break with the latest set of results, but true to form, SemiLEDS disappointed and guided the next quarter below the market consensus. This is the latest development in an industry that has been suffering with overcapacity and uncertainty relating to the timing and/or viability of Chinese LED subsidies. This is definitely an industry wide issue and SemiLEDS should not be looked at in isolation.


Earnings Forecasts are being Reduced

In fact, across the board, there have been significant reductions in earnings forecasts over the last year or so. This is usually an early sign that a cyclical industry is about to enter into a downturn. For example, SemiLEDS competitor Cree $CREE has also seen its earnings guided lower after a series of misses. In the following table, I’ve included two of the capital equipment manufacturers, namely Veeco $VECO and Germany’s Aixtron $AIXG They are useful because they give an early indication of how their LED customers are feeling.

Year EPS Estimates	SemiLEDS  to Aug 12	Cree to Jun 12	Veeco to Dec 12	Aixtron to Dec 12
Current	-.91	.98	1.10	.35
7 Days Ago	-.9	.98	1.10	.35
30 Days Ago	-.87	.97	1.16	.51
60 Days Ago	-.87	.99	1.72	.62
90 Days Ago	-.83	1.18	1.83	.64

Clearly the industry is suffering.
Earlier in 2011, Veeco had blamed poor results on longer order-to-revenue cycle times primarily coming from China and there can be little doubt that this where the weakness lies. The industry had geared up capacity for expansive Chinese expenditure on street lighting. Unfortunately, it hasn’t arrived yet.  This has left the industry dealing with the usual concomitant problems of overcapacity. In other words, inventory corrections, pricing wars, margin erosion and ultimately unhappy investors!
However, it is not only about China. Cree also complained about lower than expected growth in LED bulb applications.


So What Went Wrong with LEDs?

The short answer is... ...Nothing!
LEDs still represent a strong long-term growth area. They are more energy efficient, higher quality than conventional lighting, cheaper in the long term, and more "intelligent" than other forms of lighting. The long-term prospects look good for growing applications within commercial and industrial lighting. Moreover, wide scale adoption in the automotive and street lighting industries is a given. However, all industries suffer growth pangs and, right now, there is overcapacity.

Theoretically, a bit of overcapacity in an industry (due to some random shortfall) shouldn't worry long-term investors because they are in the stock for its long-term growth prospects. The idea is that end demand returns to normal after the blip, inventory's correct in time and, the industry goes back to its long-term growth path.

Unfortunately, the reality is that most investors don't see it this way. I think they tend to overreact to short and mid-term events. That said, it's hardly surprising that the market has discounted the sector over the last year or so.


So What’s in Store for the Industry?

The answer to this question probably lies in your viewpoint on what China will do with subsidies. Moreover, with property prices falling in China and growth in fixed asset investment slowing, private sector demand isn’t likely to strengthen. On the other hand, China works by its own rules and the central government certainly has the resources to spend heavily on supporting energy efficient industries.

Western observers frequently underestimate China’s determination to be energy efficient. So, you could make a good case either way. My concern would be that even if China steps up subsidies, will it be directed in a way to support their own industries and, ultimately employment?  Is it really so unfeasible to expect a Communist government to (ahem) try its hand at Communism?

If you share this skepticism then the only game left to play would be to try and analyze when an inflexion point will be reached in the industry. I always think that the key is to look at when gross margins stabilize. This is usually a sign that the glut is disappearing and pricing power is coming back.
The bad news is that with Cree and SemiLEDS, the gross margin declined in the last quarter’s results.  Similarly, investors could look at capital equipment suppliers Aixtron and Veeco to see if they are talking about any pick up in ordering patterns. So far, so bad.  I think there will be plenty of time to pick these names up, should we get more clarity on what China will do with LED subsidies. In particular, Cree is an exciting stock, but timing is everything and risk averse investors might want to be a little patient here.

Two Overlooked Stocks in Big Data and Security

Nice Systems $NICE and its competitor, Verint Systems $VRNT are stocks that benefit from increasing security and regulatory compliance within financial services. They make the kind of surveillance and monitoring systems that banks like UBS would have needed to make sure that rogue trader Kewku Adoboli might have been picked up early on in his activities. As such, their primary profit drivers are increasing regulation and, the growth of ever more complex needs to gather information from multiple sources, both internally and externally.


Nice and Verint set for Growth

With the implementation of Dodd-Frank and the increasing needs for firms to manage security and work flow optimization, these firms look set to grow strongly. They help companies to extract insight from interactions, transactions, and surveillance. The information is gathered from a wide range of different sources, from emails and phone calls to video surveillance.
Nice and Verint should see good growth as financial firms start to spend again in order to support expansion and deal with mounting compliance and regulatory issues. Furthermore, financial firms and Governments are under increasing pressure to protect themselves and the company from internal and external security threats as well as ensure that work flow is being properly managed. These words sound abstract, but consider criminals like Nick Leeson and Jerome Kerviel, both of whom benefitted from lax monitoring and compliance controls.


Nice Systems and Verint Systems Recession Proof?

The odd thing about these two stocks is that they both increased net income and cash flow through the recession. This is to be understood, as their revenue drivers are relatively secular. However, with Nice Systems, there was a drop in revenues of 6.5% from 08-09 and gross profit fell by 10%. However, Nice managed to only lose 7% in EBIT due to reduced SG&A  expenses.
This suggests that they are relatively recession proof but the problem is that a large amount of the company’s revenue comes from the financial services vertical. Unfortunately, if there is a Sovereign Debt Crisis induced slowdown then it is this sector and its suppliers, that will get hit the hardest. Nice Systems will not be immune from any negative sentiment.


Focussing on Nice Systems

I want to focus on Nice as I view it as the stronger of the two.
Essentially, Nice Systems is positioned at the high end of the Work Flow Optimization (WFO) market. As such, Nice tends to offer relatively expensive large scale solutions to the enterprise market. This leaves them exposed to cheaper competitors chasing Nice's installed base when they come to upgrade or renew. However, it also ensures that Nice offers a comprehensive best in class solution.

One area of possible concern is public sector end demand, but it is probable that this is an area of spending that Governments will be highly reticent to cut. Security is not the sort of area they should be cutting back on. Work Flow Optimization gives a tangible return on investment and much of Nice's end demand is regulatory and compliance led. Another cause of worry could be an increase in the demand from organizations for their WFO solutions to be sold by their contact center infrastructure provider. Although, Nice is focused on the high end so this trend is unlikely to have a great affect.


Nice Systems Q4 Results

In the previous quarter a number of questions were raised by analysts regarding current growth prospects. I’ve summarized them here.

• Slower customer bookings in the third quarter, some of which were closed in the ongoing fourth quarter
• Book to bill forecast to be much higher in the fourth quarter
• Weakness in Q3 not seen in any product line or geography
• Management explained that the book to bill also had a pattern of being weaker in the third quarter in previous years, and that this was partly due to the increase in maintenance revenues and the way that business was conducted

Fortunately, when Nice gave its Q4 numbers, all of these issues were resolved in the manner that the company suggested. The book to bill went over one, Nice reported record revenues and the pipeline was strong. There is nothing to suggest that current orders for Nice (and Verint) are not in good shape. The market reacted by marking the stock up. Verint reported later and confirmed that the industry is in good shape.


Should you buy Nice and Verint?

I prefer Nice because it generates more free cash flow and has better growth prospects than Verint. In fact Nice has generated over $380m in free cash flow over the last three years. That is not bad for a company with an Enterprise Value (EV) of $2.21bn. Furthermore, earnings estimates are for mid teens growth in earnings and revenues, for the next two years.
In summary, Nice Systems is currently generating over 6% of its EV in free cash, has strong growth prospects, and is in a favorable long term industry with plenty of upside given increasing corporate awareness of security issues and workflow optimization.

Acuity Brands Stock Research

Acuity Brands $AYI is a manufacturer of indoor and outdoor lighting and as such, is the sort of stock that has been bid up as the market prices in a recovery in the North American real estate market. Alongside its rival Cooper Industries $CBE and other real estate darlings such as Masco $MAS these stocks have been surging this year.

A quick look at a recent price chart, reveals that Acuity has been up as high as 80% above the October lows. When Warren Buffet is talking about a recovery in his annual letter, than investors can feel heartened, even after this strong rise. Longer term, the trends do look good, and Acuity has growth prospects via the increasing use of energy efficient LED lighting.

Acuity is geared to the commercial real estate market and is the market leader in commercial indoor and outdoor lighting. It is also the leader in industrial lighting as well as a major player in the residential market too.

So what happened after the Q2 results? Why the big sell off?


Acuity Q2 Results

Firstly, Acuity managed to beat revenue guidance but they missed on adjusted diluted EPS estimates.

• Revenues at $457.7m vs. $455.4m estimates
• Adjusted diluted EPS at 57c vs. 62c estimates

The market loves to punish companies for an earnings miss and with the recent market weakness, it is not surprising to see Acuity sold off after a very strong run. There are, however, a few extenuating factors here.

Firstly, the tax rate in the quarter was a 35.4% which is higher than last year’s rate of 31.4% thanks to the non-extension of a research and development tax credit. This cost Acuity 3 cents of EPS in the quarter, although management stated that the full year tax rate was likely to be 34%.

Secondly, Acuity reported a loss of $1.3m in Spain in the quarter. This is equivalent to 3 cents of diluted EPS and frankly, I’m not surprised. Spain’s commercial real estate market is in a consolidated decline and there are few signs of a quick turn around. However, the company is taking the right steps and downsizing operations in Spain. Moreover, Spain now represents less than one per cent of sales.

Thirdly, the company took a special charge of 11c relating to a reduction in the sales force in Spain and the closure of a plant in Cochran, Georgia. These streamlining efforts will allow Acuity to benefit from cost savings which should improve margins in the future.

In conclusion, the earnings miss is not really of sign of any underlying problems that Acuity can’t address, if the company is not doing so already.


A Commercial Property Recovery in Site?

As ever, an investment decision will have to be based on a sense of recovery for the US commercial property market. Whilst, Acuity described the five per cent increase in unit volumes as being ‘broad-based’ across products and sales channels, the market will want to see more evidence before taking Acuity higher. On the conference call, management referred to low to mid single digit growth for the North American lighting market for the remainder of 2012. This figure tallies with Acuity’s reported volume growth in the quarter, so it is reasonable to expect that Acuity can achieve single digit growth rates throughout 2012.

Analysts have 7.8% revenue growth pencilled in for 2012, and Acuity is likely to achieve this, provided the trend towards a more favorable pricing mix continues. Management acted quickly in 2011 and increased prices in selected lines, in order to counteract a less favorable sales mix. So, we know they are on the ball.

Moreover, the streamlining efforts will aid margin growth in time and the current glut of LEDs (thanks to over capacity in China) could result in some abating of pricing pressures. Companies, like Cree $CREE and SemiLEDS $LEDS have had pricing problems due to industry overcapacity over the last year. Similarly, if there is going to be a sharp slowdown in China’s real estate market then this too, will alleviate input pricing pressure.


Time to Buy Acuity?

I rather like the trends being discussed and, believe that with the positive trends in US employment, the outlook for property in the US is better than it has been for years. The banks are starting to loosen up on Commercial and Industrial lending, and the US banks bad debt ratios are still falling. Its time for them to start lending.

The signs do look positive and Acuity will possibly be a winner if there is a sharp slowdown in Chinese fixed asset investment. This is definitely a stock worth monitoring and I think it might be worth picking some up around if the sell off continues to the $55 mark. Sometimes the market over reacts.

A Recession Proof Small Cap

Church & Dwight $CHD  a great stock for a balanced portfolio because it is recession resistant. It trades on a good evaluation and offers the prospect of some upside from a fall in commodity input costs.

Furthermore, the company is a small player in a market dominated by large acquisitive companies like Colgate  $CL Procter & Gamble $PG and, London listed Reckitt Benckiser. In fact, Reckitt took over another British company SSL whose Durex condom brand competes with Church and Dwight’s Trojan.

Church and Dwight competes successfully with the likes of Procter & Gamble because it aggressively defends its niche markets from competition. As such, it is able to defend its positions and generate growth in a way that Procter & Gamble's management has failed to do. Furthermore, Church & Dwight offers value brands which already compete on price. A company like Procter & Gamble tends to be reticent to cut prices because consumers tends to want them to stick.

A classic example of this, would be with  the company's Arm & Hammer toothpaste with Colgate's. Arm & Hammer is the value brand and moreover, Church & Dwight's management are nimble enough to leverage the brand by releasing products such as electrical toothbrushes.

The company is little discussed but has an excellent track record of generating earnings through the cycle. I think they can generate at least double digit returns for a stock investor from here and, are a genuine takeover target.


 Church & Dwight Brands

The company’s brands can be categorized as a diversified collection of personal and homecare goods. Much of it’s brands are value propositions which offer upside in a stagnant economy, as consumers trade down to cheaper options. In terms of profits and sales, 80% of them come from the eight leading ‘power’ brands…

• Arm & Hammer (toothpaste, baking soda, detergent, cat litter)
• Trojan Condoms and Vibrators
• OxiClean Laundry Additive
• Spinbrush Battery Powered Toothbrush
• First Response Pregnancy Kit
• Nair Hair Removal
• Orajel Pain Relief
• Xtra Extreme Value Laundry Detergent

The list reads like a roll call of US value brands commonly found in the home. However, Church & Dwight is far smaller than its major competitors and, its business model is tailored towards grabbing leadership in niche markets.  This means that it can protect its market share without resorting to margin erosion via price cuts.

What makes this company really special is the quality of its execution.


Church & Dwight Earnings

The management has demonstrated a tremendous ability to grow earnings and revenues over the years, even in the face of rising commodity costs and, the great recession.  This can easily be summarized below

($m)	2006	2007	2008	2009	2010	2011
Revenue	1,955	2,221	2,422	2,520	2,589	2,749
Gross Profit	761	877	972	1,101	1,157	1,215
Adjusted EPS ($)	1.04	1.23	1.43	1.74	1.98	2.21
EPS Growth (%)		18.3	16.3	21.6	13.8	12

At the final results in February, management guided towards 3-4% revenue growth in 2012 with EPS growth of 14-15% .

All of which paints a picture of a recession proof company. However, 2011 has proved challenging. End demand was lower than initially expected and, rising commodity costs put pressure on margin expansion. No matter, the outlook for 2012 presents upside potential as the US economy generates employment gains and, commodity costs may abate with slowing emerging market growth.

It is also worth noting that gross margins jumped in 2009 with the fall in commodity prices and, Church & Dwight has managed to hold onto them despite rising costs. Similarly, with such a well run business, working capital management is excellent and, the company always generates large amounts of free cash flow.


Church & Dwight Target Price

The stock currently trades at a price of $49.59 with a market cap of $7.09bn. There is $251m in cash on the balance sheet with $249m in outstanding debt. Free cash flow has grown from $200m to $365m from 2007-2011 with a compound annual growth rate of 16%.

Obviously, on a current PE ratio of 22.4, it looks expensive but investors should focus on free cash flow. Church and Dwight trades on a current free cash flow yield of 5.1% and, that is attractive for a recession resistant company which is growing earnings in the teens. In addition, management states that they expect to generate $1.1bn in free cash flow over the next three years. This represents over 15% of the current market cap. Having increased the dividend by 41% at the last earnings, I think we should take them seriously!

 For a relatively secure double digit growth over the next couple of years, this stock could trade on an evaluation closer to $55. There is upside potential from reducing commodity costs and, a potential value outer from an acquisition bid for the company.  A $55 target represents 11% upside with plenty of room to grow, should a slowing Chinese economy reduce commodity input costs. Similarly, a strong return to US consumer spending will see upside to revenue growth at all the leading consumer goods companies.

Church & Dwight is a nice recession resistant stock which is good for balancing any portfolio.  

Sirona Dental Systems Research

Sirona Dental Systems (NASDAQ: SIRO) is a dental healthcare stock which is exposed to favorable demographic tailwinds and the expansion of the rollout of its global leading technology.  The evaluation and prospects look compelling and, there is upside potential to the stock price.

Sirona's Profit Drivers

Sirona has two key earnings drivers.

First, consider the ageing demographic. As people get older they require more teeth maintenance. Furthermore, as people tend to have more teeth decay as they are older, dentists can expect more restoration work. Ultimately, Sirona should see more demand for its products. 
Secondly, its proprietary technology currently has low market share and, provides dentists with many cost and quality advantages.

Whilst the demographic argument is well worn in healthcare plays, it should carry more weight with Sirona because of a relative lack of insurance reimbursement issues with dentistry products and solutions. Indeed, the industry is shifting towards private from public pay and, much of what Sirona does is aimed at the high end market.

The company is very well run and a global technology leader. Sirona spends around six to seven percent on research and development every year and is investing $15m in setting up a major new innovation centre in Bensheim, Germany. The balance sheet is solid, having seen the company engage in deleveraging the business over the last few years. Sirona is now in a position to make some acquisitions and, I would expect some activity on this front. Sirona has its origins as a spin off from German industrial giant Siemens (NYSE: SI)

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