Is the LED Market Turning?

There are a number of interesting and, at times, conflicting trends running through the LED marketplace at the moment. Increasingly, a consensus amongst market participants is being created towards the idea that a point of inflection has been passed. However, longer term, there seems to be significant variance in the outlook from both a geographic and industry perspective. Investors really need to be discerning about the best way to play the sector.

A good example can be seen in LED equipment manufacturer Veeco Instruments Inc $VECO recent results. Earnings and orders, fell off a cliff on a yearly basis, yet sequentially, they were both up significantly. Moreover, Veeco gave better than expected guidance which pleased the market. Similarly, the World’s leading provider of MOCVD equipment, Germany’s Aixtron $AIXG, recently reported a 90% fall in gross profit with gross margins now down to 25% from 51% last year. But investors were cheered by a more positive outlook and, the announcement that, key customer Osram, will build new capacity in China.


I Started Something I Couldn’t Finish

Essentially, what we are seeing here is an industry that is on a long term uptrend, but is also experiencing severe peaks and troughs within that uptrend. Interestingly, the spikes are being driven by technological changes and rapidly accelerating consumer adoption. For example, prior to the great recession of 2008, LED demand was driven by backlighting for notebooks. Following the severe recession, it was picked up by a surge in demand for LED tv’s and smart phones by the likes of Samsung.

Indeed, it is noticeable how much quicker, consumers are adopting new technologies. For example, it took the US less than ten years for smart phones to achieve 50% penetration. Similarly, LED tv sales have accelerated quickly. For companies like Aixtron and Veeco, this quicker rate of adoption, is creating a new market dynamic. It creates less earnings visibility and, encourages more unpredictable and variable capital investment. Investors need to be prepared for a wild ride.

And there is no greater uncertainty than that created by politicians!

In fact, the last spike in investment in the trend, was created by China making strategic investments in order to support and grow their own LED industry. To see how this is affecting the LED market, here is what Aixtron said recently.

“step forward to 2010, national and regional subsidies and strategic investments in China, supported by a Government five year strategic plan to create a sustainable Chinese LED industry, extended the backlighting investment cycle for another year and a half, peaking, for us at a record order intake level of €222 million in Q2, 2011, about 30% higher still than that high Q2, 2010 figure.”

Similarly, the uncertainty over the timing of China’s subsidies for street lighting investment goes on. It's something that Veeco blamed poor performance on last year.

For backlighting, Aixtron believes that the vast majority of LED capacity has already been installed.  And, investors cannot really rely on Solar to save the day either. Solar power is a heavily subsidized industry and, countries like Spain and Germany have notably scaled back investment in this sector, in response to dealing with their debt problems. In a sense, this is good news because it will encourage investment into making solar a truly economically viable option, rather than as an attempt to capture public subsidy. However, it will create short term headwinds for the LED industry.
So where is the growth going to come from?


Remain in Light

Both Aixtron and Veeco are pinning their hopes on future lighting demand and, for good reason. The industry does look set for growth. I discussed Cree’s $CREE recent results in an article linked here. Cree’s gross margins look like they have bottomed and ,any weakness in the lighting end market was seen as being the result of agent realignments rather than a tailing off of end demand.

There is definitely a market ‘buzz’ around LED lighting. Leading US lighting producer Acuity Brands gave positive pronouncements on the future of LED lighting and, companies like Philips, GE and Osram are aggressively expanding their offerings.

LED lamps and lights are now available at more reasonable prices in places like Home Depot and Lowes. Everyone knows they are more cost effective in the long run, but the problem was always that the initial extra outlay created customer inertia. Especially, when you consider that for a commercial application, a user will want uniformity in his lighting and, be committed to replacing with like-for-like in future.

Those issues are being addressed now and, it was interesting to hear Cree talking about LED light pricing starting to approach incumbent lighting. As for the adoption issue, let’s recall that many commercial builders already use LED lights!  Previously, the major demand for LED lighting in commercial and Governmental demand was for uses in lighting fixtures which were difficult to reach, because LED lights last longer and are brighter, so they don’t require as much cleaning or maintenance. The commercial building industry knows the product and, I believe, is waiting for the correct pricing environment before adopting it.

In this regard, investors can look to GE to take leadership. CEO Jeffrey Inmelt has always been keen to push GE’s environmental agenda and, the company has the kind of marketing and political clout to create awareness and support, for LED lamps and street lighting.


How to Invest?

In terms of investing, I think Acuity could be the best way forward. LED lighting sales are still a small part of its overall sales, but new adoption will be spur growth. Acuity is also heavily focused on North America and less exposed to the vagaries of China’s state expenditure plans. In fact, if LED demand in other areas is curtailed in other areas, than lighting companies could benefit from cost savings in the supply chain.  Furthermore, I think the outlook for US commercial and residential investment is, on a relative basis, looking brighter than it is in China.

As for, Veeco and Aixtron, they are exposed to a whole range of end demand drivers, none of which are giving great visibility right now. Furthermore, there are still over capacity issues which need to be resolved. Both companies are seeing a better outlook for 2013, principally being driven by lighting demand.

In conclusion, we are seeing an inflection point and things are starting to look better, but the end market focus is critical and, investors need to be circumspect.

Cal-Maine Foods, A Great Stock to Play Rising Protein Prices

One of the market's favored investment themes is the long term uptrend in soft commodity prices. The central thesis being that, as the numbers of the middle class expand within emerging markets, they will tend to eat more protein. In general, it takes 7-8 times as much feed (wheat/soya/corn/barley etc) in order to produce a protein meal, as it would to give the same meal made out of the feed ingredients.

Such long term considerations are seen as putting upward pressure on food prices. So what is the best way to play the sector?

I want to focus on an overlooked company that I think could give good exposure to corn prices.

Cal-Maine Food $CALM is the largest single US producer and distributor of eggs (about 18% of domestic US consumption) and the only listed company. It also claims to be the lowest cost producer in the industry.  Eggs are a cheap and rich form of protein and demand is relatively inelastic. It actually tends to improve in downturns. So how does this fit in with the commodity thesis?
It would be easy to look at rising feed costs and immediately conclude that margins are about to get crushed, but it is a lot more subtle than that. High feed costs can be good news for Cal-Maine! Essentially, what happens is that as feed prices rise, smaller producers cut back on production because they have relatively higher costs than Cal Maine. So, as production is scaled back, egg prices rise. Egg demand is relatively price inelastic because as protein prices rise elsewhere, eggs will still be relatively cheaper.

A similar argument could be applied to Smithfield Foods $SFD which offers exposure to the attraction of pork as a cheap protein. However, pork meat is likely to be far more price elastic than eggs would be. And, Smithfield is also exposed to the vagaries of Chinese pork production whilst Cal-Maine is much more of a US focused play.

Another option is Sanderson Farms $SAFM with poultry. Sanderson has significant exports and also has large exposure to the more cyclical food service sector. This is reflected in its earnings over the years. It is a similar situation with the traditional crop plays Syngenta $SYT and Monsanto $MON whose products stem across a whole range of crops. In a sense, this makes them attractive because corn and soybean are subsititue crops so, as long as prices stay high for one of the two, then land will be cultivated. However, if prices are low across the board, then Syngenta and Monsanto will be exposed. Arguably, they are more cyclica than Cal-Maine.


So What Drives the Cal Maine Foods Share Price?

Listed in bullet form below.

• Egg pricing is highly sensitive to small shifts in production and demand as it is a price inelastic good
• High Food Prices do not necessarily mean Cal Maine’s margins will fall, on the contrary, they can lead to expansion
• Production is cyclical and follows end demand and feed prices
• Demand can be guided by dietary fads and health concerns, but the marginal demand is guided by the economy (people eating out etc)
• Cal Maine pays a third of its net income in dividends within the quarter
• Speciality egg sales (health/ethical) are less cyclical, higher margin and are growing quickly as a portion of total sales
• Cal Maine tends to be highly cash generative
• It is a consolidator in the industry
• Typical with all foods, Eggs are susceptible to recalls and health scares

I’ll deal with some of these points in turn, but first, I want to hone in on my earlier claim about Cal Maine’s ability to raise margins even given high feed costs.



Note that in 2008, Cal Maine’s margins and profitability soared. This is probably because feed prices did too and, smaller producers would have had difficulty gaining funding in the midst of the financial crisis. However, as feed prices rise, this time around, we haven’t seen the same effect.
 At least not yet, but there is some evidence that high corn feed costs are starting to hurt the industry. Here is the latest data from the USDA regarding egg-type chicks hatched.



Note, how the number of egg-type chicks hatched starts to track weaker at the end of 2011. Indeed, the cumulative numbers finished up weaker than in 2010. Similarly, we appear to be tracking lower in 2012, as well. If this trend continues then, it is reasonable to believe that Cal-Maine’s margins could expand in the future as industry production is scaled back.
Moreover, the company is seen as a consolidator in the industry so the chance to make acquisitions will surely not be lost.


Specialty Eggs: Egg-Land’s Best, Farmhouse and 4-Grain

Cal-Maine producers and markets a range of specialty eggs and the recent news highlights the attraction of this division. Egg-Land’s Best are believed not to increase serum cholesterol levels, whilst Farmhouse layers are non-caged and fed solely on natural grains. 4-Grain eggs range includes natural, cage-free, vegetarian and omega-3 options.

Specialty eggs tend to be higher margin and less cyclical, therefore their percentage contribution to total sales (dollar) will go up in bad times. Furthermore, their volume percentage contribution is also going up because of their strong growth. This is very positive for Cal-Maine and, will reduce cyclicality in future.



It is not hard to see the attractions of the deal with Eggland’s Best and, Land O’Lakes. Specialty eggs are a key growth area that should reduce cyclical risk to Cal-Maine’s stock.


Cal-Maine Free Cash Flow Generation

As you would expect, this follows the cyclicality of its earnings. In particular, working capital requirements fluctuate with higher feed costs. Capital expenditure requirements are relatively light, and the business is highly cash generative.



To put this into perspective, at the current price of $36.44, the stock trades on an Enterprise Value of $713.5m.  In other words, over the last nine years it has generated 74% of its EV in free cash flow. Despite the cyclicality, this stock does not look expensive.


What Next for Cal-Maine?

In the short term, I think the acreage planted this year for worldwide corn may well cause corn prices to go down. Counter intuitively this may not necessarily be good news for Cal-Maine; because it looks like industry wide production is currently being slowed by today’s corn price. And lower production by less cost efficient producers, usually means higher margins for Cal-Maine.

No matter, looking longer term, I do think the price pressure on the ‘softs’ will be for higher prices. This is an environment that the company can thrive in. In addition, the growing portion of revenues in specialty eggs is reducing cyclical exposure, which should mean that the stock attracts a higher rating. Egg demand remains price inelastic. Protein demand isn’t going away anytime soon.

The obvious concern is that margins and profits have been falling in recent years and a long term investor will need to be convinced that this is not part of a structural trend. I don’t think it is an inexorable trend and, if corn prices continue to move higher in the longer term, it is possible that industry production will be curtailed, with Cal-Maine being a key beneficiary.

Credit Services Companies Set For Growth

Once upon a time, credit services companies were seen as defensive stocks. The thesis used to be that loans expanded when the economy was doing well, which led to increased profits. Then when it faltered, the policy response of interest rate cuts, tended to increase net interest income as rate differentials got wider. Of course, when the economy did slow, worsening credit quality leads to increased loan loss provisions which would then eat into profits. But a well managed firm would seek to manage the downside through prudent lending in the upswing.

How quaint that idea seems now!

However, despite the negativity around the sector following the trauma of the financial crisis, there is a case to be made for a long cycle of profit growth. The three major plays in this area are Discover Financial Services $DFS, Capital One Financial $COF and American Express $AXP. All three have performed very well this year and have improved credit quality. A brief summary of their current credit conditions.



Of the three, I like Discover for its growth potential and exposure to the US.


The Financial Crisis was not caused by the Credit Card Companies

There is a sort of moral admonishment against credit issuance because the roots of the financial crisis lay in over leverage by the banks and willfully negligent issuance of mortgage capital. However, let’s not be too quick to blame consumer credit. The facts state otherwise.

Here is data from the Federal Reserve. The debt service ratio (DSR) is the ratio of debt payments to income. FOR is the financial obligations ratio.



Ok, this is a busy chart but bear with me. Note how the rise in the DSR occurred in the period after Greenspan cut rates in response to the ‘dot-com’ bust. However, in that time, Renter FOR was below long term averages. Moreover, Consumer FOR for Homeowners did not rise by much.

Consumer credit was not the problem. It was the massive expansion in mortgage leverage and the hopelessly inadequate risk management regimen of the investment banks.

Of course, this does not mean that credit card companies are immune. Far from it. A worsening economy means higher net charge offs (a declaration that a creditor will not be paid) which leads to losses from loan loss provisions. We can see how Discover Financials metrics played out here



Note how the current charge off rate is actually lower than it has been for ten years.

So, putting these two charts together (at least for Discover Financial) creates an understanding of an environment of low charge offs compounded with a relatively low DSR and consumer FOR. Given increasing employment gains, I think the conditions are ripe for a continued expansion in credit.


What about the Housing Market?

Housing is still a substantive portion of US net household wealth (NHW), and the argument that consumers have been using their house as an ATM is well known. However, the share of NHW made up by housing has been falling in recent years and, there is evidence that the market is at least bottoming.

Moreover, I’m a great believer in behavioral finance. Economic agents do change behavior when they are emotionally affected by an event. We can see that with corporations, who are stuffed with cash and run historically conservative balance sheets. They were affected by the aftermath of the over-investment boom in the late 90’s. As such, ‘cost-cutting’ became the new ‘dot-com’.
Similarly, consumers have been affected by the housing bust. They are busy deleveraging and refinancing as austerity becomes the new norm.

However, whilst I don’t expect a boom in housing, that doesn’t mean that consumer credit can’t expand as the economy recovers. On the contrary, if the US is set for a slow sustainable housing recovery with the Federal Reserve being accommodative, then the environment is ripe for consumer credit do to well. If you get a job, your credit quality improves and you start spending money.


What about Financial Services Regulation?

I would argue that this is good for the credit card companies. If it stops the banks from self imploding (or rather their employees blowing shareholders cash) then it could lead to a sustainable long term recovery.

Moreover, if you force everyone to increase capital-asset ratios then when a downturn comes, even if one bank is in trouble, the others can step in because their financial position will start from a stronger base. The regulatory focus is on ending ‘Too Big To Fail’ and, reigning in the excesses of the investment banking sector.

Whilst the investment banks maybe muzzled from racking up risk (no doubt in order to shuffle it off to the taxpayer in the future) and this will reduce their potential profitability, this should be of benefit to the consumer credit card companies. The political aim is to increase the velocity of money and to get credit flowing in the economy. This is what Discover, Captal and Amex do!
Given the prognosis of a slow but stable economic recovery, I think the combination of low charge off-rates, low interest rates and a historically favorable DSR suggests a bright outlook for the credit card companies.


Clouds on the Horizon?

Analysts believe that charge offs may increase next year and the possibility of markets pricing in an interest rate hike is also a threat. Indeed, we have been hearing these dangers for over a year now. Here is how analysts have been forced to change their views.



The real question is what is the ‘new norm’ for charge off rates? For DFS, management is talking about the 4-5% rate and it is safe to assume it will go up in teh future. But, I’m arguing that this reversion (if it occurs to that level) may take a while due to the factors discussed above.

Turning to the payment processors Visa $V and MasterCard $MA, they have also been sterling performers this year. Not only are they seen as a safe place to ‘hide’ within the financial sector but they appear to have successfully negotiated the threat imposed by the Durbin amendment. The purpose of which was to break their duopoly in processing small merchant’s debit card transactions.

Visa responded by announcing a network participation fee (NPF) and, MasterCard is believed to have raised fees for small retailers.  Throw in the recovery in credit issuance and the environment is set for these stocks to continue to do well. More credit equals more transactions which turn translates into increased revenues for Visa and MasterCard.

In summary, whilst any global slowdown will hurt US growth and, consequently, the prospects for the credit card companies. The current outlook seems favorable and the potential for upside remains.

Kellogg Faces Many Headwinds

Kellogg  $K is one of the classic ‘mom and pop’ stocks that has been bid up as a kind of replacement for seemingly overvalued US treasuries. For dividend hunters the recent pullback may well be an opportunity to catch some yield. For anyone else, I think there have been more questions than answers in Kellogg’s recent performance.

Aside from some supply chain logistics and execution problems that need ironing out, the company’s core cereal market appears to be challenged by rising input costs and by some possible structural issues with end demand. Moreover, competition in the snacks market is heating up with the likes of Kraft $KFT refocusing in the sector. The Pringles acquisition also creates some integration risk. Many challenges ahead.


What Went Wrong?

In the recent results, Kellogg downgraded full year revenue growth expectations to 2-3% and significantly reduced full year EPS guidance to $3.18-3.30. A quick summary here.



There are two main problems here. Firstly, the core cereal market seems to be in continued decline. At the back end of last year a private label food company, Treehouse $THS, had warned of weakening conditions in the US. Notably, the company talked of customers trading down to buy groceries from so called dollar stores.

In addition, rival General Mills $GIS also gave disappointing numbers this year. Listening to Kellogg’s explanation, it is clear that cereal volumes are under pressure and Kellogg is fighting hard to retain share in a falling marketplace. Things aren't getting much better for this marketplace.


USA Cereal Market

No doubt, rising commodity costs have played their part and hard stretched consumers are demonstrating more price elasticity than management had hoped they would. There is little that Kellogg can do here, as hedging out these costs is always problematic and, to say the least, expensive.
Kellogg hedge out input costs for no longer than a year, so even with costs falling now, the company is not seeing the benefit dropping into the bottom line because last year's hedges were profitable. The good news is that, on current trends for corn, I would expect some upside next year from the prices they have been hedging at this year.

That said, I think there maybe a structural problem here. I’m intrigued by General Mills’ acquisition of interest in Yoplait and the continued encroachment of Danone’s (NASDAQOTH: DANOY.PK) yogurts in the US. As they both extol the virtues of a healthier dairy based breakfast, it will help to create a market buzz around the product in general. Indeed, both are expanding sales in the US and I can’t help feeling that the high price of corn is helping tip the balance of many consumers away from breakfast cereal.

I think that with issues of obesity and healthy eating being high in the public eye, it is natural that the US should increase its per capita consumption of yogurt vs. high carb breakfast cereal. It gets worse. Within breakfast foods, Kraft’s Belvita and General Mills’ Nature Valley were cited on the conference call as new entrants. I think there is a good case to be made for a structural decline in breakfast cereals.

With regards to snacks, the Pringles acquisition is a clear attempt to expand sales in that direction. It is a bold move, but will not come without execution risk. And execution, by Kellogg’s own admission, is not something being done well right now. Kellogg is planning some supply chain investment and that too will contain risk. Moreover, Kraft is refocusing toward snacks and Kellogg can expect to feel the heat of competition. In summary, things are hard in Kellogg’s core market.


European Difficulties

I’m not sure where to start here. Management talked of significant weakness in cereal in Europe with price elasticity causing part of the sales drop off. I write ‘part’ because Kellogg was keen to point out that a lot of the European issues were ‘company specific.’ In other words, they can be turned around.
And there is a lot to turnaround. European brand building exercises were curtailed due to lack of success and there have been senior management changes at the European operations. Kellogg is planning to respond further by reducing overhead in order to deal with falling sales. All of which smacks of a tough market place.

Frankly, even though the European economy is going through a very difficult patch, I think there is more to the story here. There does appear to be a structural decline in demand for breakfast cereal and, as a way to boost sales, I would question the long term reliance on this product.


What does Kellogg need to do?

For the stock to become attractive - at least to me - the company needs to integrate Pringles well and come up with an acquisition or two in order to find or create a brand that it can grow sales with. Simply relying on some piecemeal restructuring efforts may well not be enough to turn things around.

Lower commodity costs will help in future and the management restructuring will surely have its effect. So clearly, there is some upside here. A decent dividend will attract some investors. However, it is not enough and until Kellogg executes and/or makes some strategic decisions about how to deal with conditions in its core product market, I’m merely inclined to monitor the stock.

If you like the sector then General Mills is worth a look. Danone is attractive but has heavy exposure to both France and Spain. Kraft appears to be positioning itself better than Kellogg. Nevertheless, none of this group is immune from headwinds this year.

Perhaps food stocks are not as defensive as everyone thought they might be.

Equifax Stock Analysis

Essentially, the recovery theory goes like this. Interest rates are cut, which encourages consumption, that leads to growth, and creates demand for loans, then the banks start lending again as they see employment gains and better credit quality ensues. Then we have the icing on the cake of a recovery.
All said, if you believe in the ongoing recovery, then the primary credit bureaus should be set for significant upside. The three major players are Equifax $EFX, privately held TransUnion and UK listed Experian. Fair Isaac $FICO also has a division that sells consumer data but the previous three are the main protagonists.

Moreover, Equifax is also good to look at from a bottom-up perspective on the strength of the recovery.


Equifax Beats and Raises Guidance

A summary of results and guidance

• Q1 Revenues of $522.7m vs. estimates of $500m
• Q1 EPS of 70c vs. estimates of 65c
• Q2 Revenue guidance of $545-555m vs. estimates of $522m
• Q2 EPS guidance of 70-73c vs. estimates of 68c

The key to these results was the unexpected strength from the mortgage sector within the core US Consumer Information Solutions (USCIS) division.  Overall, mortgages typically make up 14-22% of revenue and, currently, this is running in the high teens. 

This looks like a positive for the housing markets, but management was keen to dispel too much optimism by stating that they felt mortgage growth would slow after Q2. I suspect they are being cautious in order not to bake too much upside into analyst forecasts. We shall see.

One interesting aspect of the commentary was the circumspection poured over the accuracy of the MBA Mortgage Application Survey, of which, management does not think is a definitive measure of market activity. This is an interesting 'tell' because the survey is widely seen as the best indicator of mortgage demand. In addition, on the conference call, Equifax stated that underwriting standards at banks were ‘loosening’ especially at the lower end. Again, this is very interesting for the broader economy.

With regards to the importance of the core USCIS division, we can see that in a breakdown of quarterly profits here.



The cyclicality of total earnings is largely dependent on what USCIS does.


Equifax Reported Segments

The core USCIS division was up 20% in revenues and margins increased to 36.5% from 34.1% last year. Despite tougher comps, this division is seen as growing in double digits for the year with strength being broad based.

Equifax divested its Brazilian operations in Q2 of 2011, so over the years it has become an ever stronger play on US credit cycles. That said, international revenues (excluding Brazil) were up 15% in constant currency.  Equifax is forecasting double digit growth on the year, and declared that current trading in the UK is strong! This is perplexing, given the weakness in those two economies. The UK has just slipped into a recession and Spain’s housing prices are falling off a cliff. Go figure!

The next biggest division is TALX Workforce Solutions which competes with the likes of Automatic Data Processing $ADP and Paychex $PAYX.  Given that Equifax reported revenues up 14% and, expanded margins from 21.9% to 23%, this reads across well for these three companies. In addition, Equifax sees revenues up in upper single digits for the year. There has been some concern over competition in this industry possibly affecting pricing, but if Equifax can expand margins, then why can’t ADP or Paychex?

Turning to ADP's earning in January, the company raised revenue estimates for the key part of the business that overlaps with Equifax's TALX.

"Employer Services and PEO Services new business sales – we anticipate about 12% growth compared to $1.1 billion sold in fiscal 2011; this is up from our prior forecast of 8% to 10% growth"

As for Paychex, things do not seem so bullish. Revenues did increase 8% to the last quarter but management declared that "we believe that checks per payroll growth will moderate in the remainder of the year". However, Paychex said this, despite that metric improving for the last eight quarters in a row. We shall see if the guidance is too conservative.
Returning to Equifax, of the last two divisions, North America Personal Solutions revenue was up 11% although margins slipped a bit. The only disappointment was North America Commercial Solutions which saw only a 1% increase in revenues but a significant fall in margins to 16.8% from 24.9% last year. However, management is forecasting upper single digit revenue gains for the year.


Conclusion

I’m a great believer that you can read across many things from one company’s results to another’s. In this case, I think there is cause for optimism for Paychex, Fair Isaac and ADP. However, the striking improvement is in the performance of the mortgage division. Recently, banks like Wells Fargo WFC and JPMorgan have been making positive noises over the housing market passing a point of inflection. I’ve gone into more detail on this subject in a post linked here.
From these results, I think it is fair to assume that with its large and growing share of US mortgage issuance, Wells Fargo is a likely beneficiary. Throw in, improving credit quality conditions and, it is even more attractive. If you are looking for a ‘bread and butter’ bank with which to play the improving US economy than Wells Fargo is worth closer inspection.

I previously mentioned Fair Isaac, and the company recently gave results which saw its Scores revenues increase 8%. The Scores division currently acounts for around 28% of revenues and,  all three credit reporting agencies (Equifax, Experian and TransUnion) use Fair Isaac software to produce their FICO scores. Therefore, the company is a useful barometer for the industry and, an option as a way to get exposure.

As for Equifax, the evaluation looks attractive. I’m not so sure about international conditions remaining the same, but on the other hand, it is not a large part of profitability. I think Equifax offers upside from here, principally from its US operations, and pending continued growth in the US economy, it looks attractive.

The Best Stocks in the Aerospace Sector

Boeing $BA gave results recently and highlighted the current strength of the civil aviation market. The backlog rose to a record and the first quarter included $42bn in new orders. It’s pretty much a similar situation for EADS with Airbus. It’s fair to assume that the aviation market is currently firing on all cylinders and, with order books full for years to come, it looks like a good industry to be positioned in.

So what is the best way to invest in it and what are the risks?
To answer these questions, an investor needs to take a view on some key long term trends.

• Economic growth, the civil aviation industry is highly correlated with the global GDP
• Oil prices, which cause huge movements in airline profitability
• Airbus’ large planes to regional hub view vs. Boeing’s mid-size planes to more smaller size airports
• Emerging market prospects and infrastructure, will the BRICs travel inter-city by plane, train or automobile?
• Industry growth, low cost carriers vs. premium passengers

I’ll cover these points and conclude with some related stocks ideas.


Economic Growth and Oil

Despite Boeing and Airbus reporting long back logs and companies like Alcoa $AA talking about positive long term industry trends, the fact remains that the aviation industry is highly cyclical. If you look at a snapshot of 2007, many of the market conditions would have been similar to now. Strong backlogs are one thing, but in a downturn orders get cancelled, delayed, or the purchaser might not even be able to pay. The idea that there is some sort of super-cycle in aviation which is insulated from the wider economy is a myth.

Furthermore, high oil prices reduce airline profitability. Here is a table with data from the International Air Traffic Association (IATA) for global commercial airlines, which adjusts forecasts for oil prices.



The ‘oil price spike’ scenario is assuming a move towards $150 Oil with an average of $135 throughout 2012. So, if oil prices spike, airlines become unprofitable and, when this happens orders get cancelled.

One way to actually benefit from high oil prices is to focus on companies that help aircraft reduce costs and, in particular, reduce the weight of the aircraft. One such company is Hexcel $HXL which provides light weight composites for use in planes.

This is an exciting growth area, but my concern with Hexcel is that the business requires heavy capital expenditure. Ultimately, this eats into cash flows. In a sense this is positive, because Hexcel needs to ramp up capacity in order to meet strong end demand. But when end demand slackens, Hexcel will be left with overcapacity. I like the stock, but it has never been close to the kind of valuation that I would pay for a company with such a business cycle.


Trends within Aerospace

Passenger growth is being driven by emerging markets as well as the necessity for them to build international and inter city transportation hubs. The BRICs are all huge countries, so travel between nodes within these countries is an object in itself, let along considering international routes.

As such, aircraft orders are largely being driven by emerging market travel but also by low cost carriers around the world. Clearly, this affects the type of aircraft coming into demand.  As for business jet demand, this is driven by highly cyclical factors and business confidence.

In fact, there is no getting away from cyclicality in the aerospace industry, but if you are looking for ‘aerospace plus’ type growth than the business jet segment is worth a look, as would be a particular company tied to a favorable trend.

For an example of the latter, Alcoa has heavy exposure to Boeing’s 737 and Airbus A320 which, are both midsize airplanes with a significant aluminium component. These planes are very popular with low cost carriers who tend to do short haul flights. Alcoa has recently increased its guidance for aerospace growth this year, and I would expect favorable trends to continue within this division.
For Business jets, Textron $TXT has its popular Cessna range, and I would suggest taking a look at a supplier like Ametek $AME, which has good exposure to the business jet market.


Avoid the Military

Of course, whenever you look at aerospace stocks it is almost impossible to avoid significant exposure to military expenditure. This is wonderful in the boom years, but when the Pentagon unveils a plan for $487bn in cutbacks over the next ten years –with more cutbacks likely to come- it suggests that investors should be cautious. One stock that has little exposure to the military is cabin interior manufacturer BE Aerospace $BEAV or even its European competitor Zodiac Aerospace of France.

BE Aerospace benefits from retrofit and new build of aircraft, and looks set for strong growth. I also like the developments with their new modular lavatory system which is designed in a way that creates more seating on a plane. BE signed a large deal with Boeing for the next generation 737s, which is a good sign. The management team is being relatively cautious about talking up retrofit opportunities here, so I would suspect it is not baked into analyst forecasts.  In addition, if planes are moving towards more wide-bodied aircraft with larger interior cabins, this will benefit BE and Zodiac, because it implies a bigger relative spend on cabins.


A Couple of Little Heard Names

If you are positive in general on passenger growth and civil aviation, I would suggest looking at something like a supplier or logistical firm. The usual suspects are well known, but something like Barnes Group $B or Heico $HEI are worth a look.

Barnes is a components manufacturer which has over a third of its revenues coming from aerospace and its transportation division is exposed to similar end market drivers. It is little discussed, but I find stocks that are found off the beaten-path to invariably be more attractive.

In turn, Heico is a provider of aerospace replacement parts and repair services. It is a good way to get exposure to traffic miles rather than new build of aircraft. What I like, is that its aircraft parts are highly regulated by the FAA and they also do not depreciate much. Furthermore, airlines are increasingly looking to cut costs by switching to cheaper replacement suppliers, or outsourcing services. Both of which should benefit Heico.

In conclusion, there are risks here, especially with slowing emerging market growth and rising oil prices, but there are also plenty of ways to navigate the horizon.

How to Estimate a Drug's Chance of Success in a Clinical Trial

If you share my penchant for investing in biotech and pharma, then you will have, no doubt, come across the standard analyst practice of evaluating the NPV of a pipeline. This is critical but, how is it done? Moreover, does the potential blockbuster in your pharma co's pipeline really have as strong a chance of succeeding as you think it does?

The usual method is to evaluate the pipeline in terms of the potential end market of the indication, market share, and then the probability of the success rate of each individual program. I want to focus on the last factor in this calculation, even though the whole process is fraught with uncertainty. Specifically, I want to discuss probabilities of success in clinical trials. I also want to highlight how varied these rates can be and why?


Big Pharma vs. Small Pharma

The usual approach taken by analysts is to assume a set of probabilities of success for each stage of the trial. How many times have you come across an analysis of a late stage drug, whereby the analyst has penciled in a 50% chance of success for the trial? I’ve seen this umpteen times, but rarely are these analyses accurate.

I suspect this is because the rates are taken from industry averages, which do not explain many factors which go toward their creation. An example of a typical probability analysis, for a listed pharma company, is shown in the top line of this table.



So, for example, you might see a drug in Phase II and the analyst has penciled in (.57*.57*.8) a probability of success of 25% or, a Phase III drug might be given a (.57*.8) 46% chance of being marketed.

The first thing to note is that big pharma is much better in Phase III. The chances are 55% vs. small pharma chances of 43%. I think the reasons for this are that late stage trials are large and expensive. They require resources and, they require experience. In addition, many small pharma companies partner with big pharma for later stage trials and, for good reason.

Takeaway: Favour big pharma over small in late stage and always ask yourself why your small pharma company hasn’t signed a partnership deal.

As an example, YM Biosciences (AMEX: YMI) is a good example with its lead compound CYT387. This is a Janus Kinease (JAK) inhibitor which is being developed to treat myelofibrosis (a bone marrow disorder). In early stage trials, it has demonstrated the ability to reduce spleen size and –unlike Incyte’s (NASDAQ: INCY) Jakafi- has also demonstrated that it could reduce anemia.
However, despite rumors of discussions, it hasn’t been partnered with big pharma yet. All of which, leaves a small company trying to get through Phase III on its own. I would suggest to adjust the probability of success lower as a result.


Molecule Type Matters

Borrowing from a separate analysis, I want to look at how molecule type plays a part.

New Molecular Entity (NME) just means that the molecule contains no active ingredient that has been approved by the FDA for any other application. It is clear that novel drugs and/or modes of action have far less success rates.
Moreover, non-NMEs have quite high rates. It is no wonder that the pharma companies are criticized for releasing ‘me-too’ drugs. They do it for a reason. The drugs work. Also, note that lead indications are typically 3-5x more likely to succeed than secondary indications.
As for biologics, they tend to treat rarer diseases so their primary endpoints can be less stringent and they may have less competition. Therefore establishing efficacy over an existing drug is not so much of an issue.

Takeaways: ‘Me-too’ drugs within an established class and mode of action, have far higher chances of success than novel drugs do. If a molecule’s lead indication data is weak, don’t hold out for hope going for a secondary indication.

Examples: Vertex (NASDAQ: VRTX) had a protease inhibitor (Incivek) approved for Hepatitis C treatment by the FDA. On the same day, Merck also got a protease inhibitor (Victrelis) approved for the same indication. Moreover, Bristol Myers, Gilead(NASDAQ: GILD), Boehringer Ingelheim and others, also have protease inhibitors in development. I would suggest that the chances of getting these drugs approved, are relatively high.

In addition, I’ve written about JAK inhibitors in a detailed article linked here. Incyte’s Jakafi (myelofibrosis) was the first approved in this class, but now Pfizer (NYSE: PFE) has a potential blockbuster with tafocitinib set for approval. Similarly, Vertex has VX509 in development for Rheumatoid Arthritis as does Incyte with INCB28050. In particular, Incyte and Vertex seem to have a number of drugs in development that suggest their chances of success are relatively high.


The Type of Disease Matters, It Matters a Lot

Tabulating rates for some selected diseases.



It is apparent that the chances of getting a drug marketed does, superficially at least, appear to vary depending on the target indication.

However, what this data doesn't do is breakdown the proportion of NMEs to non-NMEs within it. In addition, it doesn’t analyze the value of the programs. It stands to reason that drugs with higher market potential will receive higher research and trial funding. Moreover, an indication like AIDS maybe granted accelerated approval process or less stringent criteria, due to its necessity. In addition, The FDA does factor in the availability of other drugs when giving feedback over the planning of late stage trials.

That said, there are some striking differences here. In particular, note the lack of success with Alzheimer's.

Takeaways: Understand the nature of the target disease and think about why molecules have failed. Try to look into the clinical need for drug, as it does influence the end point, safety and efficacy selection.

Examples: I’ve previously written about a class of drugs which rely on the amyloid-beta theory to treat Alzheimer’s in an article linked here and, given their lack of previous clinical success I think it is safe to assume a relatively lower probability.

Alzheimer’s is a condition which has seen relatively meager breakthroughs in medical understanding in the last decade and, I would not give Pfizer’s bapineuzumab or Eli Lilly’s solanezumab a high chance of success. However, it may not matter, because the value of a new treatment in this indication will be very high. So drugs companies will pursue treatments even with a low chance of success.

On another note, consider AIDs/HIV medications, where Gilead is the clear leader. Its franchise was built on one initial antiviral called Viread, which goes off patent in 2017. The later drugs in the franchise (Truvada, Atripla, Quad) are all combination drugs which have Viread as a base. I think it is fair to argue, that the high degree of success with AIDS drugs is partly due to the submission of non-NMEs that expand the franchise and because existing treatments were lacking.


Oncology a Special Case?

I want to look closer at cancer because within this disease, there are vastly different success rates. The following data is from the Biotechnology Industry Organization and includes many small and private company data, so don’t worry if it looks incongruent with the data above. The key is the relative success rates.





Conclusion

In putting all these elements together, I will share an anecdote over a UK pharma company, namely Antisoma.

A few years ago, I looked at it. It had a pipeline of oncology products. Analysts were very bullish about its prospects with its lead compound, an NME in a class of oncology drugs called vascular disrupting agents. It had given excellent results in a Phase II trial in NSCLC but not so sterling results in ovarian or prostate cancer. I was initially enthusiastic. I read analyst reports which talked of a potential blockbuster and the chances of approval ranged from 30-40%!

So, in summary, we have..

• A small company (although in partnership with Novartis) developing a drug in Phase III
• An NME
• A difficult disease target (cancer)
• A lead compound with good results in a very tough indication (NSCLC) within oncology, but not so good in an easy indication

All the 'bad boxes' were ticked. I shied away from a purchase, which was a good thing, because it used to trade at around 30p.

It now trades at 1.7p

Investors should take the practice of analysts mechanically penciling in probabilities of success, with a pinch of salt. In reality, there are many factors which will give a better 'guesstimate' to these numbers, than just merely assuming a drug has a 50% ‘pop’ at passing phase III.
I don’t pretend to possess the answer to calibrating these numbers, but I hope this article is useful in shedding light on the problem!

Source:
Rosa M.Abrantes-Metz, Christopher P. Adams, Albert Metz "Pharmaceutical Development Phases: A Duration Analysis" Federal Trade Commission Bureau of Economics, 2004

Are Western Union and Moneygram Value Traps?

Western Union $WU and, its rival Moneygram $MGI will give results this week. Near term, there maybe some positive profit drivers but thinking further out, I suspect these businesses have the makings of a value trap. This article will focus on Western Union, but much of the issues discussed are equally applicable to MoneyGram or Green Dot $GDOT.

The essence of my argument is that the core business is being challenged by technological changes. Western Union stock is, on a superficial basis, very attractive for a portfolio, yet it contains structural dangers which may see its core business of cash to cash (c2c), cannibalized in the future or at least suffer protracted margin declines.


Western Union Profit Drivers

The stock actually has a number of things going for it.

• Good exposure to the expected rise in employment this year
• Very favourable demographic trends of globalization and migrant workers
• Increasing utilization of technology to capitalize on the potential of pre-paid cards and mobile money transfer
• An expanding network of 80,000 agents and 16,000 corridors and a global leading position in money transfers
• Highly cash generative business model

It's not hard to see why many would conclude that Western Union is a great stock to buy. As employment picks up in the developed economies, the kind of low level service personnel that uses Western Union's services will see an increase in income.

Furthermore, increasing growth encourages more migration and this helps Western Union in its remittance business. For example, around 9% of Western Union's business involves remittances from USA to Mexico and, 85% of revenues are c2c. Putting all of these things together and it is likely that Western Union will see potential upside in the future. Looked at it as purely a play on Globalization, Western Union does seem attractive.

To understand why I'm worried, its better to look at the business in more detail.


Growth Strategies

Essentially, Western Union flourishes in environments whereby its customers do not have access to existing banking facilities. This is why cash based international remittances of lowly paid workers are the core business for the company. Whilst this end market is guided by macro economic considerations (as discussed above) it is also being affected by technological changes. In response, Western Union is seeking to stay ahead of the technology curve by expanding sales of pre-paid cards and establishing a long term position in mobile money transfer.

This is laudable but, I think, will prove challenging for Western Union. The world is full of companies of who, in recent history, suffered as their business models became obsolete as a consequence of technological change. What is always surprising is how quickly these companies can succumb to these pressures. Similarly, Western Union and MoneyGram are facing significant challenges.


The Future of Money Transfers?

Here are the six main challenges facing c2c transactions.

1. Email transfer banking and internet based transfers
2. Micro Finance companies (many which are non-profit) expanding activities/lending in emerging markets
3. Mobile phone based transfer payments
4. The Federal Reserve may force them to fully disclose fees and exchange rate charges, in line with the Dodd-Frank laws
5. Financial services firms in recipient countries may offer cash transfer services themselves
6. Increasing banking penetration in emerging markets, for example, Latin American banks servicing workers with branches in US

Every one of these factors is a long term threat to Western Union. Pricing is a key issue here and, investors would be advised to listen carefully to what management is saying on pricing in the conference calls. Western Union's management is arguing that this is part of a strategy to win market share via promotions. And pricing has been coming down over the last few years. Volume growth is compensating for it, but what if the pricing reductions are due to trends that will eventually catch up and take away the c2c business?

I have my doubt about the efficacy of price reductions. I think the company is trying to stem back the advance of inevitable technological change. History does not look too kindly on companies that have tried to do this. The problem is that the disruptive technology (internet, mobile based payments) that enables them to cut costs short term, could also eventually cannibalize their core markets.

Similarly, in terms of bank penetration, I think it is fair to say that some of the poorer countries in Africa are not going to see dramatic increases in banking penetration any time soon. However, countries with growing financial infrastructure such as China, India, Turkey and Mexico may be far better positioned.

For example, Spain's Banco Bilbao Vizcaya Argentaria is a huge bank that claims to be the largest financial institution in Mexico. What is to stop them chasiing growth by going after the Mexican migrant worker in the US? A similar opportunity might exist on a global scale with an Indian bank like ICICI Bank or HDFC Bank.

In addition, it is a price competitive industry where customers are likely to have a high degree of price elasticity. In other words, if you are a migrant worker currently using Western Union and sending home $200 a month, you will gladly switch to another reputable firm even if it is only a dollar or two cheaper.


A Value Trap?

In value terms, the stock is very cheap and immediate growth prospects look good. In addition, these companies may report good results next week. The stock price may well recover simply because of the valuation metrics and the appearance of improving prospects.

However, for longer term investors, it is the potential structural challenges that threaten the core market of c2c transfers which will be of concern. Before investing, I would suggest evaluating the sector in the context of these concerns and what the companies are doing to address them.

Check Point Software Earnings Review

Sometimes investors will do the funniest things. Israeli IT security company Check Point Software $CHKP gave pretty steady results and the market greeted them by selling the stock down to as low as 10% on the day. Go figure!

In a sense, I suspect this sort of thing runs in line with current market jitters. Technology companies like Riverbed and Cree have given results and been summarily massacred when they missed guidance or guided lower. The difference here is that Check Point beat on revenues and estimates and gave guidance that is pretty much consistent.

To understand these results better, it's worth starting by saying that Check Point usually does beat guidance and that management are usually conservative in outlook. A quick summary of the results here:

• Q1 Revenues of $313.1m vs. estimates of $312.8m
• Q1 Non-GAAP EPS of 74c vs. estimates of 72c
• Q2 Revenue guidance of $324-336m vs. estimates of $333.7m
• Q2 Non-GAAP EPS guidance of 74-77c vs. estimates of 76c

It's a beat on revenues and EPS. However, the guidance is a little light. I had hoped for a bit more but remember, Check Point are conservative in guidance.


Check Point Guides Lower?

To graphically explain what I think the market is worrying about:



Note that the mid-point of Check Point’s guidance (shown in the graph) is below previous years. However, the top of the guidance range is above and Check Point tends to guide low.
In addition, if I take the average of the last three years' sequential movements and extrapolate out, the company will surpass the analyst consensus forecast of $1.38 billion in year end revenues. So, it hardly looks worrying, but what about the underlying market conditions?


Key Conclusions from the Results

For those that don’t know Check Point Software, its business model (despite the name) is to sell its hardware into a client and then sell them a series of add-on software blades. Its principal rivals are Cisco $CSCO and Juniper Networks $JNPR, although, it doesn't seem that Check Point is losing market share to them.

Cisco has a broad suite of internet security products and was previously the leader in this segment. However, the company is undertaking significant restructuring amidst refocusing on its core network business. It's not clear whether it is ready to take back the top spot from Check Point.

As for Juniper, according to Gartner, its strength lies in the upper-end midsize business (500-999) but it has "limited channel support for the midmarket." This makes Juniper competitive with Check Point but only at the higher end.

Another interesting new potential rival is F5 Networks $FFIV, which gave impressive results recently and made bullish noises about their expansion into the high-end security market. F5's core competency is in application delivery networking, which suggest it should be able to cross sell its emerging security solutions. It is a potentially dangerous rival.

Fortinet $FTNT will give results soon and, although they are more focused on the small and mid size business market, its results will also be seen as a gauge for how the market is doing. It offers Unified Threat Management (UTM) products, which are intended to be an all-encompassing security solution. In the future, as companies grow their internet infrastructure, their security needs may become more complex, so it is possible that Fortinet's core market may migrate upwards toward Check Point's strength at the upper end.

In Check Point’s case, the argument could be made that things are improving. Interpolating from the conference call, I've made the following key points.

• Management announced that due to Israeli tax reforms, the reported tax rate will be reduced next year to around 18-20%
• Margins are expanding due to software sales growing faster than products
• Renewal rates on blades are higher than management had forecast
• The company is launching new software blades
• The competition appears to be ‘weakening’ and not more ‘threatening’

An interesting new solution is ThreatCloud, a collaborative network that is intended to help fight cyber crime. It’s basically a network to report attacks, which can then be responded to quicker, by anyone in the network. It is already being integrated into the latest software releases.
In fact, it is this type of software upgrade that is driving sales at the moment. And since, software tends to have higher margins than products, Check Point reported operating margins of 55.2% as opposed to 50.2% last year.

Analysts did, however, question one aspect of growth. Specifically, that whilst software sales were up 15.2%, the increase in products was a miserly 4.7%. Surely, a sign of slowing underlying growth?
Perhaps not. Check Point is a company that manages profits and revenues rather than margins. In any case, software and hardware are not initially sold separately. So, as more software is sold in the initial deals, it is natural for the company to move more of the sale into the software revenue line, rather than the product line.

In fact, management noted that over 10% of initial sales are coming from the software part now, when the figure would have been much lower a few years ago. The underlying run rate was described as "healthy."


What about the Share Price?

We’ve just seen this company generate nearly $800 million in free cash over the last four quarters, in other words 6.7% of its Enterprise Value. It has affirmed full-year guidance of 10% EPS growth. Margins are expanding due to increased software sales. The future tax rate appears to have been lowered and its competitive positioning seems to be strengthening.

Longer term, network and gateway security issues are on the rise and Check Point is a clear market leader in its segment. I think it there is every reason to expect upside from here.

Ixia Still Growing?

In a somewhat mixed week for technology companies Ixia $XXIA beat estimates and raised guidance. I liked what management said about current prospects, and there was some potentially good news coming for Cisco $CSCO stock holders. Its main rival is the UK’s Spirent although, Agilent also has exposure to this sector through its communications testing division.

Ixia and its main rival Spirent, represent the two best 'pure plays' to benefit from the roll out of next generation wireless technologies. These companies primary activities are to stress test the load bearing capacity of telecommunications network equipment manufacturers and large service providers.

In particular, both stocks are exposed to the upgrade cycle in 4G ad LTE spending, which should see them both expanding margins and cash flow as their customers appear to be in the early stages of a sustained capital expenditure cycle. I previously mentioned Ixia in a post on smart phones linked here, and, I will focus on the US company.

The case for Ixia is relatively simple. From the consumer side, there is an explosion in bandwidth demand which is being driven by social applications (facebook, twitter etc) and a concomitant technological revolution in smart phones and internet based devices.

On the business side, there is a huge increase in demand for ‘anytime, anywhere’ internet access utilizing increasing usage of data. Furthermore, the service providers are moving beyond purely providing bandwidth, by increasingly selling cloud services and helping large enterprises to outsource their IT. All of which, is placing increasing demands on Ixia’s end customers, and it is inevitable that an upgrade cycle will follow.

In addition, as internet traffic grows more complex, there is an increasing demand for large enterprises (financials etc) to invest in stress testing equipment. Financials are seen as a key growth market because their end demand is mission critical and, quite frequently, involves dealing with unusual patterns in network usage.


Ixia Q1 Results

A quick look at the earnings and guidance show an earnings beat plus a hike in guidance

• Q1 Revenues of $85.6m vs. estimates of $83.5m
• Q1 Non-GAAP EPS of 15c vs. estimates of 14c
• Q2 Revenue guidance of $86-89m vs. estimates of $87.09m
• Q2 Non-GAAP EPS guidance of 15-17c vs. estimates of 15c

Cisco is Ixia’s biggest single customer and its orders managed to contribute 17% to revenues after having dipped below 10% last year. Cisco is obviously doing something right, as orders came in above Ixia’s expectations. Cisco spoke of weakness in Government orders last year, but now Ixia is reporting that they are seeing more orders from the US Federal Government and elsewhere in the world. In addition, support revenue from Cisco is now due in Q2 instead of being in its traditional place in the Q1 numbers. It all augers well for Cisco's core networking market.

The other top non-distributors are NTT, Dell, Juniper, and Fujitsu. Details on Juniper's orders were not given, but it is reasonable to assume they were solid.

Turning to the breakdown of customers by type.

Customer Type	Percentage of Revenue
Network Operators	58%
Service Providers	20%
Distributors	14%
Enterprise/University/Government	8%

From a geographical perspective, Japan was the star of the quarter. LTE and Wi-Fi orders being cited as particularly strong. However, Ixia guided gross margins sequentially lower (78-90%) in Q2 because, Q1 saw high margins due to Japanese revenues containing a larger part of software in the sales mix in Q1.

In a sense, much of this was presaged by Spirent’s preliminary results given on the 1^st of March and, also by Agilent who said this in a recent analyst day

“But again, the good news, as we stand here, is that the February orders were solid for the start of our Q2. In the area of Communications, we believe the Communications growth in the quarter year-over-year will grow”

The whole industry looks strong.


Ixia’s Growth Drivers

Wireless orders were at a record, with strong new 3G purchases coming from Asia. Whilst wireless attracts most attention due to its greater growth rates, it should be emphasized that this produces a backload which is then dealt with by wire line. In other words, both these markets will see sustained growth as a consequence.

Ixia also offers the prospect of strong growth in Ethernet based infrastructure. Within data centers, the increases in bandwidth and data demand, have dramatically increased the speeds that the centers need to work with. Ixia stated that some data centers are investing in 100G speeds, with 40G seen as the preferred speed. Wheras, so long ago, 10G infrastructure was seen as the gold standard.
Summarizing the key market drivers and trends.

• Smart Phone penetration growth rates
• Mobile broadband growth
• Network traffic growth
• 4G/LTE growth plus 3G roll out in less advanced countries
• Mobile subscribers growth in the BRICs

All of which are attractive, as is Ixia’s ‘growth at reasonable price’ proposition.

Even assuming a more ‘normalized’ tax rate of, say 30%, would put the stock on a near 5% free cash flow yield. Throw in analyst's forecasts of mid teens annualized growth in revenues and earnings, for the next couple of years and, Ixia’s evaluation of 13.6x EV/EBITDA does not look expensive.

Riverbed Buying Opportunity?

In a previous article linked here, I discussed the uncertainty inherent in the upcoming Riverbed $RVBD results and mooted the possibility that a decent entry point might be created out of them. Well, the results are in and, it looks like short term carnage for the stock price. However, is this time to be looking at buying and what should investors be looking for from the network gear maker?
A quick summary of the results

• Revenues of $183m vs. estimates of $186.3m
• Non-GAAP EPS of 20c vs. estimates of 20c
• Q2 Revenue guidance of $193-197m vs. estimates of $202m
• Q2 EPS guidance of 21-22c vs. estimates of 24c

At the last results, Riverbed predicted that revenues would be sequentially down 8-10% and, they 'delivered' by coming in at the low end of a 9.8% decline! Moreover, Riverbed previously confirmed full year guidance, but now, they are guiding toward a 15% rise in 2012 revenue. Market estimates were for an 18% increase. Gross margins were predicted to be flat in Q2, but profitability and margins were predicted to then rise through 2012.

Not only did Riverbed miss, but guidance was lowered for the full year. However, and this is a key point, the full year guidance implies that the second half will track what Riverbed previously predicted. Investors have the right to be skeptical about this.

 

What Went Wrong?

There are four issues, listed in terms of what I think their importance is. Firstly, signs of slowing government spending. Secondly, weakness in European enterprise spending. Thirdly, competitive encroachment. And finally, the sales disruption caused by new product launches and upgrades.

Government spending was 13% of revenue in quarter, which is seasonally usual. However, the big marginal shift in Riverbed’s government revenues occurs in Q3. The current management narrative is ‘upbeat’ over interest and conditions are seen as ‘normal’. In terms of US Federal spending, this seems entirely plausible for this year, as any efforts to reduce public expenditure are likely to start in 2013.

Current European market conditions were described as ‘mixed’ and, in fact, Europe is doing well. A breakdown of regional contributions and, yearly growth here:

Region	Share of Revenue	Yearly Growth
US	53%	7%
EMEA	28%	31%
Rest of World	19%	4%

Its notable how weak growth was in the Rest of World segment and, Riverbed is upfront about the need to make progression here. Nevertheless, there wasn’t particular weakness in Europe, so, it was hard to attribute the earnings miss to this factor.

Turning, to market share, there is a shift in that Cisco $CSCO is now Riverbed’s most dangerous competitor. Traditionally, it was Blue Coat, but that company has been weak over the last year or so and, Riverbed confirmed that competitiveness with Blue Coat had softened. With a market share more than twice that of Cisco, it is fair to assume that Riverbed is the bellwether rather than Cisco.
In any case, investors can see what some of Riverbed’s key distributors are saying in order to gauge the industry. For example, Arrow Electronics $ARW was responsible for 17% of revenue with Avnet coming in at 10%. Arrow gives results on May 1 with Avnet reporting on April 26.

 

If it Ain’t Broke then Don’t Fix it

I think the key culprit is the disruption to sales patterns caused by the new product launches and the upgrades to the core Steelhead offering. Such things are common occurrences in technology, whereby customers prefer to run existing technology until they can receive anecdotal or professional information on how the new offerings are working.

Similarly, resistance to undergoing the expense of an upgrade cycle is natural among customers who are happy with the existing technology. These things take time and, from an operational perspective, it will require a realignment of the sales force’s priorities.

New products include Granite, of which orders have already been received. A Steelhead cloud acceleration product was launched with Akamai $AKAM and although sales are not seen as material in the short term, it is a product with potential because it can be sold to existing customers in order to improve their SaaS offering. Akamai is the right partner for Riverbed because of its established customer base within content delivery.

New products, new challenges, but this isn’t just about products. When a company shifts from selling a core offering toward being a multiple seller of different products to different buyers, it needs a refocusing of sales initiatives and approach. In addition, much of Riverbed’s challenge is to educate customers over the advantages and return on investment (ROI) generated by WAN optimization. All told, you have a complex confluence of challenges to overcome. Sales cycles will inevitably be extended.

Realigning the sales structure and marketing effort is, as one analyst pointed out, not something that is typically sorted out in one quarter. This observation calls into question the management’s implication that guidance for the second half should be unchanged. In short, Riverbed is saying that Q1 was weak, Q2 has been lowered but, that the second half will be the same as previously thought. I’m not sure how the market will react to this.

Riverbed a Stock to Buy?

In a sense, investors are worried about another ‘Blue Coat like’ scenario, whereby a serious of excuses are given for gradually reducing sales growth and management undertakes umpteen restructurings and partnership agreements in order to turn things around. In Blue Coat’s case, nothing seemed to work. However, I suspect the key issue there was with product, not with operational concerns. Blue Coat had difficulties even though its competitors in the WAN optimization market were doing well.

For Riverbed, if the new products and upgrades are capable of generating ROI then there is no reason why the existing sales force – who were responsible for the previous excellent sales performance -- can't begin to accelerate sales of the right products to the right customers. I don’t believe good sales people suddenly become bad ones. However, they can become frustrated and de-motivated if their product line is not working. I think the real problem for investors is to discern whether the launches and upgrades have the appropriate traction in the marketplace and, unfortunately, the optics are being obscured by the transition.

Time will tell and Riverbed may well have to lower full year guidance in the next quarter. However, with the recent price declines the upside potential looks a little better and, provided this turns out to be a transitory issue for a few quarters, I think this could be a decent entry point.

F5 Networks Being Unfairly Marked Down?

F5 Network $FFIV gave results and cheered the market. The Nasdaq needed this after the recent sell-offs in tech bellwethers $IBM, Intel $INTC and Qualcomm.

For those not acquainted with F5, it is one of those sexy stocks associated with cloud computing growth and the inexorable rise of bandwidth usage. In short, F5 ensures that the delivery of applications is not degraded when they are moved from one server to another.

Clearly, the need for faster connectivity to access information in the cloud has led to significant growth in bandwidth demand. Similarly, the proliferation of bandwidth-rich video and increasing penetration of smart phones are creating bandwidth demand.

The market was apprehensive coming into these results and, for good reason. However, F5 ‘beat’ on revenue and generated strong earnings. F5’s cautious management did no more than guide their midpoint slightly below market estimates.

F5 Networks Stock Earnings Beat

First off, a pretty good set of Q2 results and guidance for Q3

• Revenue of $339.6m vs. estimates of $335.3m
• EPS of $1.12 vs. estimates of $1.07
• EPS Q3 guidance of $1.12-1.14 vs. estimates of $1.14
• Q3 Revenue guidance of $350-355m vs. estimates of $355

The book to bill was affirmed at higher than one and, management has some exciting things to say about growth in data center firewalls. This is not an area that F5 are traditionally associated with but positive noises were made about competing with Juniper $JNPR in particular but, also Cisco $CSCO and Check Point.

Indeed, Juniper appears to be assailed from all directions at the moment, not least from Cisco within core internet networking solutions. As for F5 and data center firewalls, it is already seen as a ‘meaningful revenue generator’, and management sounded bullish about the expanding opportunity.

Perhaps what was surprising about the results was the broad-based strength. Americas revenue was up 21%, with EMEA not far behind, coming in at a 19% increase. APAC increased 24%. When asked by analysts, the management affirmed that Europe was doing consistently well and broad based in its growth too. Moreover, Government did well with US Federal (about half total Government numbers) spending showing a slight improvement. Otherwise, worldwide Government revenue was flat.

No matter, F5 tends to be quite diversified in its industry verticals. For example, here is a breakdown of Q2’s major verticals:

Vertical	Percentage of Q2 Revenues
Telco	27%
Financial	16%
Technology	19%
Government	12%

Telco was unusually strong this quarter. In the next quarter, financials are expected to be up and, Telco down from these percentages. From a historical perspective, these numbers are quite low for financials but, I got the impression that management felt this was just due to natural lumpiness in ordering. Going forward, F5 expects North American enterprise spending to improve whilst Technology is seen as tracking a bit lower.

One interesting piece of ‘color’ was that two distributors now account for over 10% of revenue generation. Namely, Avnet $AVT with 16.6% and, Ingram Micro $IM. This implies that Avnet and Ingram are very useful barometers for how F5 Networks are doing in the quarter. I would suggest listening in on their conference calls and presentations in order to get an early ‘read’ on how F5 might do.

F5 Growth Prospects and Evaluation

This report is going to confirm that F5 are firing on all cylinders and, with the management talking of sequential revenue growth through 2012, there is little not to like about the stock. As ever, with technology darlings, the stock price can run away from the fundamentals when it is fuelled by momentum and investor sentiment. So is F5 overpriced?

The short answer is no and here is why
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Firstly, the drivers for the company are largely secular in nature and are being promulgated by technology shifts. Secondly, F5 is a company that has always been highly cash generative and has demonstrated that it can both grow gross margins and, free cash flow as it expands revenues. Thirdly, there is upside from data center firewall security. And finally, I think that the current evaluation can cope with any disappointments from European enterprise or worldwide Government.

Here is a graph of how F5 is tracking in terms of sequential revenue growth.



Note how the estimated numbers for 2012 are forecast to track last years. Who said equities analysts don’t work hard!

Looking back at the last few years, F5 tends to turn around 33% of its revenues, into free cash flow. So, a simplistic assumption of hitting analyst forecasts of $1.39bn and $1.65bn to Sep 2012 and 2013 respectively would see free cash flow (FCF) of around $459 and, $545m. Interpolating, gives $507m estimated for the next four quarters out.

I like to value companies in terms of Enterprise Value (EV). Now, if you, conservatively, want to pay a forward FCF/EV of around 5% for a company that is generating high teens revenue growth, than this would give you a target of $10.14bn in EV which is around $135. A typically looser estimate of 4.5% would give you a target price of $149.

I would be inclined to be a bit looser with F5 in terms of valuation but, a bit tighter with regards to risk.

Frankly, I don’t think that the pressures in Government spending are going to abate. In fact, in the US they could strengthen because the US hasn’t really done anything about cutting its debt or deficit levels. However, I am aware that F5’s solutions are mission critical and they are largely secular.

Therefore, I wouldn’t be surprised to see some downgrading of forecasts for certain verticals within F5’s markets. This wouldn’t be a disaster, because recall that we are talking about marginal movements in revenues. In addition, most forecasters are certainly not foreseeing a recession, but the potential for disappointment remains.

I would conservatively reduce revenue forecasts by 5% and, based on the assumptions above, this would still give a range of $128-141 as a target price, pending on which stance you want to take on the stock. And, more importantly, how you might tolerate the stock price reaction to any future short term negative news.

Cree and the LED Market

LED manufacturer Cree $CREE gave results recently, and disappointed the market by not only missing estimates but also issuing guidance which was below market estimates. Essentially, Cree is in a high growth industry but it has failed to hit market estimates for the last four quarters in a row. There can be a certain amount of sympathy for the management because this is an industry with short lead times and low visibility. However, Cree has been up against some easier comparables and the recent results plus guidance were not great.

Investors can be excused for being puzzled by the investment proposition here. On the one hand, Cree’s long term end market drivers are excellent. LEDs are approaching cost parity with traditional lighting, offer greater long term economy, require less maintenance and therefore offer increased payback. They are the future. And, everyone knows it.

On the other hand, the company is seeing consistent short term weakness due to heavy competition and low inventory levels at customers. Of course, customers do not want to carry inventory when their end markets are weak.

All of which leads to the classic conundrum of what to do with a long term growth stock that is stumbling in the short to mid term?

Cree’s Stock

Turning to the numbers

• Q3 Revenues of $284.5m vs. estimates of $300m
• Q3 EPS of 20c vs. estimates of 21c
• Q4 Revenue guidance of $295-315m vs. estimates of $322m
• Q4 EPS guidance of 20-26c vs. 28c estimates

It’s not hard to see why the stock fell after results. Moreover, in order to see how revenues are trending, here is a graph of sequential revenue growth.



Note that if Cree hits the midpoint of its internal guidance for Q4, it will be a sequential increase of 7.2% which looks low given that last years numbers were relatively weak. Let’s put it this way, $305m for Q4 would mean a seemingly impressive increase of 25.6% on the year. However, it would only be 15.2% ahead of 2010.

See what I mean about a conundrum?

Cree and the LED Market

Cree argued that whilst the LED, Power and RF results were in line with internal guidance, the revenue weakness was due to lighting. Moreover, it was ‘almost exclusively’ due to the shifting of agents caused by the integration of the Ruud acquisition last year.

Around 80% of Cree’s agents were shifted in terms of the product they were selling. All of which, caused a short term disruption in sales for BetaLED and Cree product lines in lighting. Indeed, Cree’s management went onto claim that they ‘do not believe that the decrease in lighting sales was due to lower end demand’.

This sounds entirely plausible, but if so, why is the guidance weaker than anticipated? As you can see from the graph above, there should be a sharp snapback in revenue following a theoretically short term sequential disruption. Analysts were quick to enquire why.The guidance implied that they would only do similar metrics in Q4 to what they should have done in the current quarter.

In reality, I suspect a number of forces have to come to play here. Cree is not alone in issuing weak guidance. Across the board companies like its rival SemiLEDS $LEDS and LED capital equipment manufacturers like Veeco $VECO and Aixtron $AIXG have also previously given weak guidance. However, that should be in the price, the key is weather an inflection point has been passed or not. Aixtron and Veeco could give advance notice of this, but SemiLEDS is increasingly looking like a small player in the marketplace.

Cree Potential

I think that gross margin trends are usually a good way to see if pricing power is coming back. With that in mind here are Cree’s.


Interestingly, this was the first quarter in the last eight where gross margins improved. This is a good sign, but frankly, I wouldn’t get too excited here. However, if the commentary from other companies in the sector gets better (and some are talking of a pick up) then we could see a return to the good times for the industry.

In particular, Cree is geared up to be able to satiate growth in end demand, and technology in the industry has moved on in the last year. Cree predicted margins would improve in the next quarter and that utilization would be flat. Cree has the capacity to deal with growth.

Thinking strategically, creating the appropriate ‘buzz’ in order to convince customers to forget their inertia and adopt LED based solutions, will take time. It also takes sound demonstrations of cost efficiency. All of which Cree is doing aggressively with things like new developments in street lighting technology.

Investing in Cree?

Investors following Warren Buffet’s famous fearful/greedy dictum would not have been a stock holder going into these results. Even with the initial sell off, Cree is still up over 30% in 2012. Investors were definitely not fearful. But they might be now. Which is why, Cree is starting to look interesting for the ‘nouveau greedy’.

Improving gross margins are a good sign as is the reduced expectations. Throw in some snapback in sales due to Cree’s lighting agents being settled within their new roles and there is upside potential here. However, risk averse investors may want to wait for a bit more of a sell off and monitor what Veeco and Aixtron say in the reporting season. Any positive guidance will benefit Cree. As a result, Cree is becoming attractive.

Johnson & Johnson Stock, A Good Defensive Play

Johnson & Johnson $JNJ gave results recently and underperformed the broader market on what was a strong up day. There wasn't anything inherently wrong in the numbers, but there wasn't anything sexy about them either. Revenues were slightly down, with a negative currency effect of 1.2% not helping matters. However, top line growth is not the key for JNJ.

JNJ’s attraction is of the kind that sends accountants hearts racing. Its prospects are all about execution, execution, execution.

First, consider the integration of the largest acquisition in JNJ’s history (Synthes) which brought the company 50% market share of the skeletal fixation products market. Second, consider the successful resolution of the manufacturing problems which have dogged the company in recent years and kept some highly popular OTC consumer products off the market. For example, Tylenol and Simply Sleep are not yet back in production. Third, consider the ever-present issue of dealing with generic challenges and launching new drugs. Lastly, JNJ probably still needs to restructure the huge portfolio of products.


Johnson & Johnson Delivers a Mixed Prognosis

Operations in the US saw revenues down 5.1% as JNJ suffered from generic competition to Levaquin (anti-bacterial) which saw a US sales decline of 96%. Similarly, Concerta which treats attention deficit hyperactivity disorder (ADHD) also saw generic competition that caused US sales to fall 22%. This reads across well for Watson Pharma $WPI which has successfully launched a generic version of Concerta, as well as a generic version of Pfizer’s $PFE cholesterol fighting blockbuster Lipitor. In fact, Watson has been busy applying for FDA approval for a generic version of Bystolic (hypertension) of which, Janssen- a JNJ subsidiary- sold its rights to Forest Labs.

By way of contrast, international operations saw a 6.4% rise in constant currency sales but much of this came from the pharmaceutical segment. In fact, it was the only segment to report more than 1% growth in the quarter.


Weak Consumer Segment Results

As mentioned earlier, JNJ has had production problems which led them promise to overhaul operations at three plants, and kept key products off the market. That said, these results were still weak. Reported sales declined, both in the US and internationally, with women’s health, nutritionals and baby care looking particularly poor.

The market wasted no time in marking down rival baby nutrition company Mead Johnson  $MJN) in sympathy. Moreover, market rumours hit that Pfizer is close to divesting its nutrition unit to Nestle. If true, this could create future problems for both JNJ and Mead Johnson, as I would expect Nestle to start using its financial muscle to aggressively compete with them in the future.

Pfizer is keen to divest its nutrional and animal health divisions as part of its ongoing restructuring plans.

The two bright spots in the consumer division were in skin care and wound care in the US. Skin care is a hot sector right now and JNJ has always been very strong in wound care. Internationally, every part of the consumer segment, bar a 1.8% increase for oral care, was in decline.


International Pharma Growth Strong but US Challenged by Generics

JNJ splits its pharma segment into immunology, infectious diseases, neuroscience and oncology. The star was immunology with a 20% reported increase in global sales, followed by oncology with a 36% increase. JNJ saw strength across the board in immunology, whilst oncology saw strong gains from the international release of Velcade (multiple myeloma). Internationally, infectious diseases did well but couldn’t counteract the $404m lost in US sales from Levaquin going generic. Perhaps the most interesting part of JNJ’s pharma division is in Neuroscience.

Invega Sustenna (schizophrenia) appears to be cannibalizing sales from Invega, but I note that the total global sales of $282m are not more than declining Risperdal Consta (schizophrenia) which chalked up $361m in sales. The latter is an older drug which is seen as being inferior to Invega and/or Invega Sustenna. However, if you add the three drugs together, sales rose over 9% to $643m. Now, given that Concerta (ADHD) is facing generic competition its sales will decline, but the gains from the Invega franchise could counteract Concerta losses for the Neuroscience segment in future.
Oncology should see a pick up as Doxil/Caelyx (ovarian cancer) hopefully comes back into production in late 2012 after manufacturing problems. In addition, JNJ has new drug launches so prospects are looking brighter for its pharma business.


Medical Devices and Diagnostics

Global sales were basically flat, but US Diabetes care saw strong results. Diabetes is a strong ailment to be focused on and, there is a detailed article on it linked here. However, it was not enough to offset global weakness in cardiovascular and, flat results in general surgery.
Furthermore, US diagnostics and orthopaedics gave negative results. These results are somewhat puzzling as with an improving economy, visits to the doctor and, elective surgeries should be on the increase.

We will get more colour on the diagnostics space when the likes of Gen-Probe $GPRO and Alere, give results. Similarly, with surgeries I would look to Covidien to provide more background information on the underlying conditions. Gen-Probe, in particular, is a good barometer of conditions in the diagnostics and surgical industries in the US.


The Investment Case for Johnson & Johnson?

In conclusion, this is a mixed bag of results, but this is to be expected from such a large company. JNJ generates huge bundles of cash and, it has a stable- if not growing- collection of businesses. In other words, JNJ can invest, acquire and restructure in order to generate growth.

Going forward, the key driver will be execution. JNJ needs to sort out its manufacturing issues and, compete better within consumer health. New drug launches will help pharma and, an improving economy should help the discretionary element of medical devices and diagnostics.

In short, it is a value play orientated at dividend seeking investors. JNJ also offers upside potential from resolution of issues that are primarily outside of the economy. On that basis, it will attract risk adverse investors who would rather hold JNJ yielding 3.6% than a ten year note yielding 2%.