Keep Smiling with Shares in Colgate Palmolive

The only problem with Colgate-Palmolive $CL is that there isn’t a problem with Colgate-Palmolive. The company has defensive growth prospects and is extremely well run. Its management has successfully innovated and are expanding strongly within the growth markets in the emerging world. It has strong market positioning in most of the leading markets and is leveraging its brand in order to maximise value for its shareholders. Alas, I suspect most of this is already in the price and who likes buying a stock that is fairly priced?



Why Colgate is Outperforming the Sector

Unlike its struggling rival Procter & Gamble $PG Colgate has managed to weather the slowdown quite well. Whilst the former is traditionally understood to try and hold pricing in a downturn and then leverage its powerful brands in the upswing, Colgate has managed to be innovative enough in order to drive sales growth. A better comparison would be with a much smaller rival like Church & Dwight $CHD.

Colgate and Church & Dwight have outperformed thanks to innovation, new product development and a staunch defense of their brands. The difference is that the latter is really a strong player in niche markets and is small enough to be able to shift easily. Colgate is much larger and I think its achievements are even more notable.

The innovation comes in the form of products like Colgate Optic White toothpaste and mouthwash. Having read about this product I was astonished to see it widely available in Hungary recently and I think a visit to a personal care store would help an understanding of why Colgate is doing so well. Simply put, the brand is very strong and seeing a selection of Colgate toothpaste, toothbrushes and mouthwash all displayed together in store brings an immediate appreciation of what the company is doing to leverage its brand strength.



Not Just Good at Oral

It’s not just about Colgate. The other major brand Palmolive is being leveraged through the creation of new fragrances in personal care and dish liquids. I recall looking at McCormick & Company recently and was surprised at how its industrial flavors division was doing. This is largely because food companies are being forced to innovate and introduce new flavors. I think it is the same principle with personal care and the company is continually doing this with Palmolive.



The Numbers?

The latest numbers were excellent. In this environment generating 8% organic growth within personal care products categories is little short of sensational. In addition 4.5% came from volumes whilst pricing accounted for 3.5%. Gross Margins increased 50bp but were actually held back by currency effects. No matter, the company forecast sequential increases in gross margin for the third and fourth quarters. Earnings only increased by 6%, but were up double digits on a currency neutral basis.

What is interesting about the sector is that soft commodity costs do appear to be abating, which means that margins should be able to expand. Of course, this is only part of the story. Companies still need to hold or even expand market share.



Growth Prospects

Geographically there was the usual problem of softness in Europe, but emerging market growth remains strong. The recently acquired Sanex brand is heavily exposed to Europe and Colgate will have its work cut out to generate growth above the flat to low single digit growth that these categories are growing in Europe right now.

A much better prospect will be expanding new products into emerging markets like Latin America and the Far East. For example in toothpaste, Colgate has 72% and 83% market share in Mexico and Brazil respectively. This kind of brand strength should create opportunities for increasing sales of mouth wash and other oral products. Emerging markets contribute about 53% of revenues and a similar amount in earnings for Colgate.

That said, Colgate operates in highly competitive markets with all its product lines and if its competitors have failed to innovate, then discounting and increased promotions will be the name of the game. US growth is slowing and there appeared to be a negative reaction in the US with the pricing increases in the last quarter. Growth prospects are focused around the launch of mouth wash in the US. If there is one thing that we know from this earnings reporting season it is that US consumers are not taking well to price increases in personal care or household products.



The Bottom Line

Colgate is a fine and worthy business, but is it a good investment? Frankly, I would love to own this stock and I did until recently, but I find it difficult to justify paying 21x earnings for a stock expected to generate single digit growth in the next couple of years. It may be relatively stable and secure but no company is without risk and Colgate operates in highly competitive markets. Nor is the yield anything to write home about.

In conclusion, Colgate is an excellent company, but all of this seems to be priced into the shares already. Now if it had a meaningful dip from here...

Investing in Protein Stocks

My favorite type of modern music is minimalism. You know that sort of insistently repetitive series of ambient noises that guys like Brian Eno or Steve Reich specialize in. In response to its seemingly infinite army of detractors I always point out that although the music does sound the same, it is in fact subtly changing so the end result is significantly different.  Ok, so what does this pretentious twaddle have to do with Cal-Maine Foods? $CALM. I think that in a similar way this company’s results and prospects need to be appreciated as subtly changing but seemingly the same.

Superficially, these results were not that great and it appears to be the same old story of slowly growing egg sales accompanied by an increase in feed costs, which ate into gross margins. However, just as with minimalism there are some interesting things slowly developing here.


What Happened with these Results?

Eggs sold went up nearly 11% whilst prices rose 2.4% to $1.152 per dozen. This led to a 13.6% rise in revenues but unfortunately feed costs rose 7.4% so gross margins declined by 200 basis points. The result was that gross profits were flat for the quarter. This is part of a declining gross margin trend that is largely being caused by rising feed costs and easier financing terms for Cal-Maine’s competitors.

Frankly, I would usually avoid business with declining gross margins but I think there are some interesting underlying developments here.


Specialty Egg Sales Rising

Firstly the share of revenues coming from specialty eggs appears to be rising. Cal-Maine produces 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 also explains why it went into a joint venture recently with Eggland’s Best Inc., and Land O’Lakes in order to expand sales of specialty eggs.

Feed Costs Rising

Feed costs are rising again. I confess that earlier in the year I had thought that the high levels of corn acreage planted this year would cause an oversupply and feed prices would start to drop. Alas the weather had other ideas and the company warned that feed costs are likely to rise in the near term.

This is a significant concern because – although egg demand is relatively price inelastic -- the egg market is competitive.

This is a significant benefit because – although egg demand is relatively price inelastic -- the egg market is competitive.

See what I mean about me and minimalism?

There is a serious point to this journalistic self-indulgence. In the near term high feed costs will hurt margins at Cal-Maine, but in the long term, high feed costs will cause the weaker players to drop out or create acquisition opportunities for Cal-Maine. This is good news because ultimately egg prices are very sensitive to shifts in production. The latter scenario happened in 2008 and Cal-Maine actually came out of that year in pretty good shape.

Rising feed costs are not necessarily a problem for the company. On the contrary they could be a good thing. Aside from the opportunity to acquire and consolidate in the industry, higher protein prices overall will add to the "substitute value" of eggs as being a cheap protein option.


Hedging High Feed Costs and Other Options

Incidentally, a similar argument applies 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. I also quite like Sanderson Farms $SAFM with poultry. Sanderson has significant exports and also has large exposure to the more cyclical food service sector. In addition I think Cal-Maine's competitive positioning and ability to act as a consolidator in its industry make it more attractive.

Investors worried about higher feed costs could do worse than look at 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 substitute crops so as long as prices stay high for one of the two, then land will be cultivated either way and they should benefit. Another alternative is just to go and buy a focused agricultural play like Deere & Co., although Deere comes with a lot more global exposure, which makes it a bit weaker to be used as a hedge for what is going on in the US. In addition Deere, Syngenta and Monsanto are a much more cyclically sensitive then Cal-Maine is.


Where Next for Cal-Maine?

Going forward I would expect further gross margin declines because feed prices are rising. As for the dividend, the company tends to pay a fixed portion of its earnings in dividends so dividend hunters need not get too excited about the dividend if earnings decline. Cal-Maine needs to continue its strategy of expanding specialty egg sales and making acquisitions in order to consolidate the industry. These actions would help reduce the cyclical nature of its earnings and margins. As a long-term holding it makes sense but investors will have to put up with the same story repeating itself as the underlying changes migrate the business toward a less cyclical business.

Nice Systems Equity Research

Another day and another technology company lowers guidance. This time the market seems to have been caught unaware by Nice Systems (NASDAQ: NICE) lowering full year revenue and EPS guidance below its previous guidance and notably lower than the market consensus. In a sense, I’m surprised that the market was surprised. Despite Nice and its rival Verint Systems (NASDAQ: VRNT) reporting upbeat results and guidance in the last quarter, since then a number of technology companies have waned. Moreover, many stocks in the data sector such as Informatica (NASDAQ: INFA) haven’t had many positive things to say recently. That said, the question now is to decide whether Nice is worth investing in right now, so I decided to look at the bull and bear case.

What do Nice Systems do and Why Might it be Relatively Recession Resistant?

Nice and Verint’s end demand is driven by regulatory and compliance drivers, as well as the need for companies to analyze customer interactions. Essentially, they sell enterprise intelligence solutions, which help corporations monitor customer interactions and optimize workflow. Verint is seeing its deal size increase over time, as customers are taking advantage of its increasingly broader product offerings. For example, previously a customer might have bought a data capture solution (video or voice recording), but now they are also buying data analytical solutions as well. Nice is doing well out of offering an integrated range of offerings across financial crime and compliance to customer interaction and analytical applications.

Turning to the financial sector, both benefit from increasing security and regulatory compliance within financial services. They make the kind of surveillance and monitoring systems that banks need to monitor money laundering, cyber crime and illegal trading activity. At that is just within their own staff’s 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.

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. 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.

Furthermore, financial firms and Governments are under increasing pressure to protect themselves and the company from internal and external security threats as well as to  ensure that work flow is being properly managed. These words sound abstract, but consider criminals like Nick Leeson and Jerome Kerviel, both of whom benefited from lax monitoring and compliance controls. It strikes me as being an area of spending that Governments will be highly reticent to cut.

In addition, 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.

What is the Sector Saying?

I mentioned Informatica earlier, but to be fair it did not specify weakness in Government or Financial but rather a broad based spending slowdown. This may be company specific. However, Tibco (NASDAQ: TIBX) said that business optimization growth moderated, but what it didn’t say was that orders were falling off a cliff thanks to Europe. In fact, when asked about it, management said that it had not seen any change in European conditions from a quarter ago. Again, neither Government nor Financials were singled out.

What is clear is that data sector growth is slowing.

Why Weren’t These Results so Nice?

The Q2 results were pretty much in line on EPS but revenue was light by $4.6m from consensus. However, the real problem was the guidance:

• Full Year Revenue Guidance of $890-910m vs. previous guidance (May) of $930-950m and market consensus of $940m
• Full Year Non-GAAP EPS Guidance of $2.28-2.38 vs. previous guidance (May) of $2.32-2.50 and market consensus of $2.44
• Q3 Revenue Guidance of $217-225m vs. consensus of $239m
• Q3 Non-GAAP EPS Guidance of 56-60c vs. consensus of 61c

It’s not hard to see why the stock is getting slammed.

Management made the usual noises about delays in getting deals signed off and customers implementing tighter controls on budgets. This sort of thing is de rigueur for an industry embarking on a protracted slowdown, but it is also symptomatic of what could be a bit of temporary weakness caused by enterprises displaying caution over euro zone difficulties. Investors will need to decide which is which.

Some color was given in the conference call where management was at pains to point out that they didn’t think it was from competitive tensions. Deals were slipping rather than being lost. In particular an ‘extraordinary’ amount of deals were not being completed towards the end of the quarter.

Here is a chart to demonstrate how Nice now forecasts revenues to develop for the rest of the year.

It’s clear that this appears to be a case of the company lowering guidance from previously expected strong growth rather than one of a dramatic fall off in revenues and earnings.

The Bullish Case for Nice Systems

The Bullish case has it that now the temporary slowdown is priced into the stock, and it can appreciate from here. Enterprises’ always act in a cautionary manner when faced with large macroeconomic risks but when they get accustomed to them, they gradually start to spend again. This is particularly relevant with Nice because its solutions are mission critical in many cases. The situation is nowhere near as bad as in 2008 and the company is still growing.

Moreover, the company’s new guidance is based on projecting forward the deal conversion rates that it is seeing now and, this is likely to be the low point. In other words, if deal conversion improves then guidance will have to be raised and the stock will shoot higher. In addition, in Q3 of last year Nice reported a weak quarter but told the market that it felt it would recover in the next quarter. It did. Investors would have been rewarded then as they will be now. The book to bill is still forecast to be above one for the full year. Nice is still growing.

This is a buying opportunity.

And Now the Bear Case

The bear case points out the weakness in the macro environment and points out that it doesn’t appear to be going away anytime soon. Government and Financial are both key sectors, and they are both going to be hit hard by austerity measures and by ongoing uncertainties in Europe. Also, if you look at the guidance for Q4 –despite it being lowered- it is questionable whether Nice can hit these numbers. For example, the Q4 target requires Nice to hit a record quarter and a huge pick up in sequential growth. Even the revised guidance is too optimistic.

The company has little visibility and is ultimately set to disappoint.

Where Next for Nice Systems?

On balance, I would be more positive than negative here. The lowered guidance still represents yearly double digit growth rates in revenues and EPS. In addition, the company generates a lot of cash flow. By my estimates around $129m on a trailing basis, which makes up around 6.8% of its enterprise value. If you believe in the lowered guidance, the stock looks cheap and I like the fact that the management is projecting ahead based on current conversion rates.

Make no mistake, if we are headed towards Armageddon in the euro zone then its end customers will be hit hard and so will Nice Systems. Then again, investing is about balancing risk with reward, and on that basis I think the stock is attractive at these levels.

Covidien Looks Good Value

For long term investors it’s always interesting to find companies that are undergoing structural changes which can unleash inherent value. These situations create opportunities for discerning investors. I think one such company is Covidien $COV and the recent results confirmed the progress that the company is making. The underlying performance of its largest medical device products remains strong and the future spinoff of its pharmaceutical division will create even more opportunity for its strong cash flow generation to be returned to shareholders. In summary, despite the superficially mundane performance, I think the underlying story is a good one.



Covidien Reports Good Results

The company beat adjusted EPS estimates by a cent but declared that the next quarter would be sequentially lower. Now given that the consensus for the next quarter is $1.06 this can be taken as Covidien guiding a bit lower. Don’t get stressed though, this is largely because of adverse currency movements and the fact that this year’s numbers will contain one week’s less trading.

In fact, all medical device product lines recorded positive growth, but currency headwinds reduced growth by 1-5% across the board. In particular the largest product line (Endomechanical) saw operational growth reduced to a reported 1% thanks to currency headwinds of 5%.  No matter, the company is doing OK and notably outperforming the medical technology market. For example Johnson & Johnson SJNJ reported nowhere near this kind of growth in its medical device division. Indeed, I think the Synthes acquisition is evidence that JNJ is focusing away from surgical procedures within its medical device division. This is good news for Covidien.



Largest Product Lines Growing the Fastest

The usual suspects of Energy and Vascular were very strong in this quarter. Endomechanical growth is definitely moderating and management talked of negative results with mechanical fixation devices due to competitors launching new products in the market place. It also has to deal with longer term competition coming from robotic technology companies like Intuitive Surgical $ISRG and Mako Surgical $MAKO. Both of whom are trying to expand the surgical procedures that their products are routinely used in.

Intuitive is seen as being very strong in one-off types of procedures, so a health center will be able to add volume by buying one of their machines. However, a general surgeon can perform all sorts of different operations and he/she will not be so inclined to outlay the expense of buying an Intuitive machine. As for Mako, the company recently cut its sales forecast for the second time in the last few months. Perhaps the march of the robots is not as inevitable as many think it is?

On the other hand, Covidien is doing fine and investors should note that the three biggest product lines within medical devices are Vascular (21.2%), Energy (16.8%) and Endomechanical (30.5%) and –on an operational basis- they grew 15%,13% and 6% respectively.

Here is the revenue breakdown for the medical device division.

In order to demonstrate how well the three largest divisions are doing, here is the separation of Endomechanical, Vascular and Energy from the rest.

It is noticeable how strong the trends in the most important product lines are.



New Product Launches

Covidien launched a number of new product launches in 2012 which lead to supra-industry growth, but is it sustainable? There are two reasons why it may well be. Firstly, medical device sales usually hit their peak a few years after their launch so what is launched in 2012 will feed into growth in future years. Secondly, investment in R&D remains healthy and Covidien can also expand its new products into new markets.

Management affirmed its confidence that Sonicision (a cordless ultrasonic dissection device which will allow surgeons more flexibility in the theatre) was receiving very positive feedback.



Geographic Opportunities Mixed

On a geographic basis, Covidien is seeing no change in the US as conditions remain repressed. This is somewhat surprising as hospital admissions appear to be trending up and its strength is in non-elective procedures. In other words, surgical revenues should be correlated with admissions.  As for Europe, conditions remain challenging with Spain noticeably deteriorating in the quarter. Asia growth remains strong. In a sense, Covidien’s geographic commentary could be scripted in common with for all the other medical device companies right now, but the company is outperforming its peers and the opportunity to expand its products into emerging markets is a good one.



Covidien’s Growth Performance and Growth Prospects

I think Covidien is outperforming thanks to its research and development profile. Ever since the Tyco spin off, management has been able to focus and invest for growth. Product innovation has been notable in Energy which has generated double digit growth for a long time now as minimally invasive surgery (MIS) increasingly demonstrates better patient outcomes and ultimately saves hospitals money.  This kind of investment produces results even in weak end markets.

In a similar way, investors can look forward to more of the same in the run up to the spinoff of the pharmaceutical division. The spinoff is on track and as a mark of confidence Covidien announced that they would be increasing the level of intended cash flow return to investors to 50% from the historical target of 25-40%.



Future growth prospects

Returning cash and spinning off divisions is one thing but the best equity investments are all about growth. The company's aim is to continue to benefit from the increase in penetration of MIS and to expand its products within emerging markets. It also has growth potential from the ramp up in sales in future years from the products launched this year and finally hospital admissions appear to be on the rise in the US and this should start to drop into the top line.

On a more negative note, Covidien does have some poorly performing product lines and it isn’t the sexiest growth story around. European exposure is an obvious worry and it operates in some fiercely competitive markets. It isn't risk free.

On balance I think the company is doing the right things in order to generate growth and returns for its shareholders. Cash generation remains excellent and the underlying performance is good. On a risk/reward basis the stock looks like a good value.

 

Sanofi Aventis Equity Research

The two most obvious things about health care are that Dr. Dre is not actually qualified to give medical advice and that every diversified investor’s portfolio, particularly in this environment, should have a high yielding large cap health care stock. I think Sanofi-Aventis $SNY is a stock that US investors should look closely at. Despite being one the big pharma stocks most affected by a patent cliff, it has successfully restructured and underlying growth is good.  The Genzyme acquisition has added growth and there is upside in the stock following resolution of some production issues. Moreover, it has a specialization on emerging markets and some exciting products in the pipeline. Throw in a 4.2% yield and the story is compelling.

Investors should not underestimate the sector. I spent much of 2008 trying to put some biotech investors together to create a fund in the UK and for good reason. In the UK, the three listed investment trusts recorded mid-teens returns despite the overall carnage.


Sanofi Dealing with its Patent Cliff

A few years ago Sanofi was faced with a significant patent cliff. From 2010-12, Sanofi had nine products going off patent. From an investors perspective this was always going to create a dark cloud that obscured the underlying growth. To put this into context, sales of the key genericized products declined from E2.21 billion  in Q2 2009 to E752 million in 2012. In contrast, sales from its growth platforms increased from E3.34 billion in Q2 2009 to E5.75 billion now. In other words, Sanofi has more than compensated for its losses to generic competition in the last three years.

In addition, there is good and bad news on this front. The bad news (I know you want it first) is that its second biggest product Plavix (blood clot prevention) which currently represents 6% of sales was off patent as of May. Moreover Lovenox (deep vein thrombosis) and Taxotere (chemotherapy) reported declining sales due to generic competition and Eloxatin will face similar completion from August 2012.

The good news is that, from the end of this year, there really isn’t any more bad news!

Sanofi will have largely come out of the patent cliff issue, comparables will get easier and it will start to look like a balanced pharmaceutical company with a diverse set of end markets, an exciting pipeline, and a strategic focus on diabetes and emerging markets.


Sanofi’s Growth Prospects

The company has long had strong emerging market exposure and it is the single biggest geographic segment with 31.8% of sales, moreover sales to emerging markets grew at 9.8% in the quarter. Favorable demographics and an overall increase in health care provision in these countries should drive growth for years to come in these regions and Sanofi is well placed in most of them. Everyone focuses on the BRICs but actually Sanofi sells nearly double to the non BRIC countries in the emerging market world.

Not only is Sanofi diversified geographically but its end markets are, too. The Genzyme acquisition gives it a specialty in rare diseases, while its strong diabetes franchise gives it exposure to one of the strongest growing emerging market indications. Sanofi is also set to record high single digit growth in consumer health and decent growth in animal health and vaccines.

A key aspect to this diversification is that much of these end markets leave the company with relatively little risk exposure (within the pharmaceutical world) to reimbursement issues or susceptibility to Government cutbacks.

It is interesting to contrast this strategy of diversification with that of a company like Pfizer $PFE which has taken the opposite route and decided to divest operations in a bid to return to its core competency. Pfizer is attractive in its own right, but its management have chosen a different way to deal with the patent cliff.

However, Sanofi’s principle near to mid-term risk comes from another source. Whilst it is the world’s leading player in diabetes and Lantus (long-acting insulin) saw sales rising nearly 17% in the quarter. It might come under pressure from competition in future from Novo Nordisk $NVO and Degludec.

I have more detailed information on the issue in an article linked here.  Since that article was written, the FDA has delayed approval of Degludec until after an expert review. Clearly Degludec approval is not a ‘done deal’ and even if it is, it would unlikely be on the market until 2013. Nevertheless Sanofi investors need to appreciate the risk.

Sanofi investors also need to appreciate the reward!


Sanofi’s Exciting Pipeline

Looking at regulatory milestones due in Sanofi’s second half there are decisions due for Aubagio (MS) and Lemtrada (MS) and it has an exciting PCSK9 inhibitor entering into phase III with Regeneron Pharmaceuticals $REGN.  Sanofi claim that in three phase II studies it was able to reduce LDL-Cholesterol by as much as 70% on top of high dose statins. It faces competition from the likes of Roche (NASDAQOTH: RHHBY.PK) but the timeline suggests it could be the first in class to get approved.

Another exciting development is a potential vaccine for dengue fever; a virus for which there is no available treatment. In addition, further upside could come from an increase in sales from the resolution of production problems at Genzyme and supply issues in vaccines.


The Bottom Line

In conclusion, Sanofi looks attractively priced for a company that has a good pipeline plus exposure to some fast growing markets. There is certainly risk with Lantus and the usual caveats over cuts in Government expenditure on health care need apply. However, every stock should be analyzed on a risk/reward basis and I think Sanofi provides good value.

IT Security Stocks Research

The market seems to be moving into an interesting phase. We seem to have moved from a situation whereby everything was indiscriminately sold off in line with its sector as investors started to price in lower global growth. Estimates have been reduced and many companies have adjusted guidance in line with the reality.

The good news (from a stock pickers perspective) is that stock prices are starting to get back to being correlated with individual earnings and stock specific growth prospects. One sector that I think is capable of generating relatively better growth is internet security, and the latest company in the sector to please the market with its results was Fortinet $FTNT.

In absolute terms, the results and guidance were ok, but in the context of what so many other technology companies are reporting they were nothing less than spectacular. Fortinet handily beat estimates and raised guidance for the next quarter and full year. Check Point Software $CHKP also reported favorable growth recently, and I think it is fair to conclude that IT security is demonstrating that it is a sector that can generate growth in excess of the IT sector.


Fortinet Results and Guidance

In order to see how good these Q2 results are, I have put together a historical chart of the sequential movements in revenues from quarter to quarter.

The Q2 results are pretty much on a level with sequential movements in previous years. Moreover, the guidance was ahead of (already lowered) market estimates. Of course, as we can see from the chart, the mid-point of guidance is not particularly strong in relation to previous years. Now do you see my point about how the market is now rewarding companies beating reduced estimates?

Why Did Fortinet Outperform?

Fortinet’s conference calls (both of them) are always entertaining affairs. One Ken (Goldman) always sounds ebullient and answers questions with a sort of semi-religious fervor. The other (Xie) focuses on the technical aspects of Fortinet’s product range in quite dry language. It is a compelling combination and it is certainly working. Both are keen to point out that Fortinet is taking market share from the likes of Juniper Networks $JNPR, Check Point and Cisco Systems $CSCO.  According to industry analysts, Fortinet is now in fourth place behind these far larger companies.

I suspect that Fortinet is taking market share in the mid-range market. Its traditional strength is in the SMB market, where its Unified Threat Management (UTM) solutions give its customers overall protection, whereas at the higher end customers have usually gone for more sophisticated solutions from the other vendors mentioned above.  In an age of slowing discretionary IT spending, it is possible that the mid-market is deciding to trade down into buying Fortinet’s solutions.

Indeed, the company’s commentary somewhat reflects this. For example, the deals over $100k in the quarter numbered 168 this year versus 127 last year, and the deals over $250k numbered 55 versus 37 last year. Deal size does appear to be getting bigger.

Check Point and Cisco have new products coming out and it will be interesting to see if this enables them to reduce ticket price. In Check Point’s case I doubt it (it has a razor/razorblade model), although it would more likely lead to better product sales than it has reported recently.


New Operating System

An interesting development for Fortinet this year will be the launch of its new operating system and a performance enhancing ASIC. Essentially , Fortinet believes the new operating system is necessary to address the changes in the nature of security threats. The new ‘FortiASIC’ will give it more computing power to address security threats from content and applications.

Management was keen not to guide towards some sort of pick up in end demand following the release of some pent-up demand that had been waiting for the new operating system and ASIC. However, I note that sequential growth is forecast to be relatively better in Q4 than Q3, so perhaps there is an element of this baked in?


The Bottom Line

It is hard to argue that the stock is particularly cheap, but it is performing, and in my experience any stock with sustainable mid teens earnings growth prospects for the next few years trading on a decent cash flow yield usually produces very good performance. In the case of Fortinet, management is forecasting $165-170m in free cash flow this year, which implies a FCF/EV evaluation of around 4.7% with a stock price of $25.09.

This looks cheap but it requires confidence in Fortinet to 'do its numbers.' I think with expectations now lowered, it is more likely that it can hit these targets. Investors will have to watch Check Point and Juniper and see if they start to react to Fortinet encroaching on the mid market. Another possible value 'outer' is a bid, and IBM $IBM has long been mooted as a potential acquirer. IBM does seem to have a gap in its product range for the SMB market.

In terms of its end markets, the usual caveats over global growth need apply. That said, Fortinet remains attractive at this price and for its growth prospects. A good GARP candidate.

Why Facebook Will Falter

After all the intensive hype and then disappointment over the IPO, Facebook $FB went through another rite of passage by giving its first set of results as a public company. The market wasted no time in savagely marking the company down. Whilst the numbers hit estimates, I think there is a growing consensus that the company is not really articulating a strategy for how it can generate the kind of earnings growth in order to justify such a high valuation. In summary, I think there are a number of challenges here which are not being accounted for in the market price of this stock.

In a sense, this was an opportunity missed by Facebook. It had the perfect opportunity to outline a clear strategy for mobile and allay market fears over its direction but instead Zuckerberg in particular appeared more interested in promulgating Facebook’s ‘mission’ to connect the world. I suspect most investors are more interested in getting Facebook’s huge user base ‘connected’ with the bottom line of its profit and loss sheet.


Users Create the Value Not Facebook

This sub heading may seem a statement of the obvious but sometimes it’s hard to see something that is staring us in the face. Just as a lot of analysts were behind the curve with the speed of the shift to mobile internet usage, so I think many of them will be missing this key point.

Users create the content that ultimately is the value for the company. It is the content which gets people to use the site and it’s the content which creates the data which allows marketers to be more efficiently targeting and understanding their marketplace. Facebook itself does not create this content; it merely acts as a conduit.

Why is this point so important? I think there are three key reasons.


How Mobile is Changing Content and Value

Well firstly, if Facebook usage is going to shift to mobile then the content created for it (by its users) will start to evolve in a different way. It is wrong just to think of the shift to mobile as being a pc site now being downloaded on a mobile, especially when the content on the site is being created by someone using a mobile phone.  I doubt Tolstoy would have written ‘War and Peace’ on his Android phone but he might have swapped the odd picture of himself holding up a shot of Vodka with Victor Hugo. Of course, if the content changes then the way users engage with it will too and this has implications for mobile can be monetized.

Secondly, Facebook seems to be making a play of the fact that it wants to become the platform of choice for applications developers. Moreover, much is made of the opportunity to share applications activities with your friends. Again, I think Zuckerberg and co are rather over estimating their brand leverage and the fact these apps (usually games) became popular as a consequence of a group of people playing them on pcs. You only have to ask Zynga $ZNGA shareholders about how fortunes can change with this kind of stuff.

Facebook simply doesn’t create content the way that BMW adds value by manufacturing a car. There is no reason for anyone to be ‘loyal’ to Facebook in the way that I am loyal to BMW engineering. No one is obliged to ouse an app just because it’s available on Facebook. I may enjoy learning to speak German or following the Tour de France but I surely don’t feel the need to buy the app via Facebook and encourage my friends to do so.

And finally, if we accept that the content will morph in ne ways due to mobile being a different type of viewing than the value inherent in the data created out of this new online interaction will be different too. I doubt it will be as comprehensive. By definition pc usage is more ‘lean forward’ than mobile and this has a lot of consequences for the kind of data created. It also has repercussions on the type of advertising that can be integrated into the site. If I am discussing wine from Italy, I might appreciate an add from a wine distributor. If I am merely looking at a pic of a friend drinking wine in Italy, it would be a different story.


Mobile is a Game Changer

I think it’s time to reflect on what Facebook is and take Zuckerberg at his missionary word. It is an incredibly successful website that has in a way ‘connected the world’. However, if this is its mission then making money has been more of a by product of its success rather than its aim.

Indeed, even before the market started to realise the seismic shifts being created by mobile, questions were being asked about how Facebook would monetize its user base. Whilst Google $GOOG is leading the way in managing this shift, it comes from a proven background in generating advertising revenue. If anyone knows how to do it, it will be Google. I'm not sure the same can be said for Facebook.


So where does this leave Facebook?

Facebook has a huge user base and has had a genuine and lasting impact on society, yet the challenge remains to manage the migration to mobile whilst generating the earnings growth to justify a very high evaluation. Even with the recent fall, the stock still trades on 47x forecast  earnings for 2012 and its EV/Ebitda multiple of 25.4 would inspire vertigo in a high wire circus act.

The Outlook for Telco Capital Expenditures

We are in the full flow of earnings season, and one sector that has been particularly interesting is telecoms. A slew of equipment manufacturers have warned that telco spending was not currently as strong as they had hoped it would be, even though analysts had rosy forecasts. This is creating a somewhat confusing picture. I decided it would be interesting to look at what the North American telecom carriers and service providers have been saying with regards to spending.


Telco Spending Has Slowed

Aside from the warnings and negative commentary from the likes of Acme Packet $APKT, Cisco $CSCO and Finisar $FNSR it is clear in the numbers from the carriers that spending has slowed.
We can see that if we look at a graph of capital expenditures versus depreciation. Over time, this ratio should approximate to one because, unless a business is in decline or has found a way to ‘super’ sweat its assets, companies should be replacing their depreciating assets. The ratio will swing around as companies invest for future growth with expansionary CapEx or reduce it in line with slowing growth.

Here is the current situation.

The dip in the last data points is causing the consternation right now. Simply put, the telecom equipment manufacturers that sell to the carriers expected this to tick up, not down.
On closer inspection of the situation, a clear difference can be observed. AT&T $T is expecting capital expenditures to trend up in the second half while Verizon $VZ seems determined to carry on reducing spending as a portion of revenues. Indeed, the latter specifically mentions the aim of reducing this ratio until at least 2014.

So what are the trends in telco spending and why the difference between AT&T and Verizon?


Trends in Telco Capital Expenditures

Essentially, in North America, the trend is toward wireless from wireline and for the increased rollout of 4G-LTE networks, but these decisions take time. Telco CapEx spending tends to be long cycle and involves significant financial commitments. This means that if the service providers are seeing slowing growth and a weaker macro-economic environment, they will cut back on expenditures for the foreseeable future. Cisco was adamant that it is seeing a broad weakness in Telco spending, largely as a result of Europe and macro-economic issues, and we are seeing this confirmed in what the carriers are saying.

If we think globally for a second, there is the issue for service providers of committing to a technological platform for its customers. More developed service providers are increasingly being faced with the choice of rolling out a new 4G/LTE network or expanding their existing 3G operations. Whereas in the emerging world, while 3G spending remains active, some service providers face the choice of just jumping to 4G/LTE anyway. These sorts of considerations can delay decision making, because the service providers will have a tendency to wait until economic conditions are ripe in order to decide.

So in summary, for consumers in the developed world it is wireline to wireless and 4G-LTE. In the emerging market world it is wireline to wireless but 3G rollout still has great significance.


AT&T Sticks to Spending Guidance but Pressure is Building

Starting with AT&T, it expects CapEx to pick up in the second half, and the company decided to stick with its CapEx guidance for the year.  It more or less admitted it had been prudent in the first half but with efficiencies now in place the second half is likely to see a sequential tick up.

The spending mix is set to be weighted towards wireless where AT&T spent 60% of its CapEx in the first half. Moreover, the company is engaged in an ongoing and intensive build out of LTE, and management affirmed that 90% of its data traffic is on enhanced backhaul already.

With this kind of build out already in place and wireline growth clearly moderating while the economy is slowing down, it is natural to conclude that AT&T will feel under pressure to reduce its spending plans. However, the company stuck by its CapEx guidance. We shall see.


Verizon Looking to Moderate Spending

It is a different story at Verizon. Its first half capital spending was down 16% year to date with an outlook of flat to down for the full year. In addition, while AT&T was expanding wireless spending, Verizon spent 23% less in the second quarter, although this was largely due to a ramp up last year in order to support its initial launch of the iPhone.

The issue with Verizon is that it has already rolled out an extensive 4G LTE platform, and migrating traffic onto it from 3G has generated significant cost and capital efficiencies. Its argument is that it can continue to try to reduce CapEx as a percentage of revenues because its 4G network is utilizing capacity well enough to enable them to do this. If this is the case then the pressure on AT&T to do the same will be greater in the future as well.


Where to Next?

The overall picture is somewhat puzzling. On the one hand, data usage and smart phone growth suggest that the exponential growth in traffic will force North American carriers to ramp up spending. On the other hand, both major service providers are being cautious about spending and, in Verizon’s case, arguing that operating efficiencies generated by switching to already built networks will ensure that they don’t need to significantly step up spending for a few years. AT&T has a more positive story, but we will need to see how that develops in the second half.

I consider it appropriate to listen to what these companies are saying and not try to guess against them, particularly when the global economic outlook is so uncertain. It is hard to be too positive about telco spending if the carriers are not sharing this opinion.

What Happened With Riverbed Technology?

I suspect a few plastic surgeons will be getting some odd calls in the next few days thanks to Riverbed Technology $RVBD After the shorters have had their faces stitched back on, it might be the right moment for a bit of consideration over what actually happened and what we can expect in future from Riverbed.  I’ve rarely seen a stock so beaten up by the media and the analyst community. It’s time to listen to what the company is saying and reporting.


Previous Results Were a Leaping Salmon to a Bear

Riverbed disappointed at the last set of results but it guided toward a 15% revenue increase ... a number that many didn’t believe. In fact, Riverbed’s insistence that the weakness was due to a new product cycle caused analysts no end of skepticism and they were quick to start downgrading. Ever since then, investors have heard one argument after another whose main purpose seemed to be to justify the falling stock price.

The PE ratio was seen as too high, even though the company remained cheap on the cash flow evaluation that really matters. The WAN optimization market was seen as saturated, even though Riverbed always explained that a large part of their sales are to green field accounts. Cisco $CSCO and Juniper Networks $JNPR (who are now partnering with Riverbed) were supposed to be grabbing market share, even though Riverbed said they didn’t see any step up in competition.  In short, the company was toast.

It didn’t quite work out that way.


Is this a Sales Call?

Going into these results the key moot point was whether the weakness in the previous two quarters was a consequence of a slowing marketplace or hiccups with execution over a new product cycle. Optically they are the same, but for a deeper understanding I think investors need to consider some of the dynamics of how sales guys think.

In my experience, a good sales guy will always try and close the immediate deal in front of him. Continuity and sales discussions are fine but it is only a means to an end. ABC does not stand for Always be in Continuity and coffee really is only for closers.

So consider what happens when an upgrade occurs in a product range that already requires educating the buyer as to the potential return on investment generated by buying it. In addition, the sales force are asked to start selling (in some cases) to slightly different key decision makers because of the change in product.

In my experience this is likely to create some disruption. I doubt many sales guys would be particularly enamored with trying to generate new business by starting from scratch with a new collection of decision makers and explaining the difference in the product upgrade to them. In my humble opinion, they are more likely to chase the "easy" deals. In other words, they would run after existing customers and try and sell the new upgraded products to them or at least focus efforts on converting the "hottest leads" from their lead book.

This is not necessarily the best approach in IT 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. It is no wonder that Riverbed had execution issues.


Execution Issues Fixed?

Riverbed appears to have fixed its previous sales execution issues. Management stated that it took until the end of May in order to get its sales compensation plan realigned in order to realign the sales force to the new product cycle. Riverbed beat on both revenues and earnings and guided above consensus for the next quarter where a "normal run rate" for Q3 is expected. The pipeline of orders is encouraging confidence, even though Riverbed stopped short of confirming the 15% revenue guidance increase.


Juniper Deal Makes Sense

There seems to be a certain amount of cross completion in technology these days. For example F5 Networks $FFIV is developing data center security solutions and competing with Check Point and Juniper. In this case, Riverbed and Juniper are teaming up to challenge F5. Juniper will pay $75 million for Riverbed’s application delivery controller (ADC) technology, while the two companies will collaborate on WAN Optimization controllers. The deal makes sense because Juniper is an also-ran in the WAN Optimization market and the ADC product line only makes up 3% of Riverbed’s revenues.


Where Next for Riverbed?

I think the key take away from these results is that things aren’t as bad as many thought they were. The fact that Riverbed didn’t strongly affirm the previously given 15% revenue increase guidance is probably a sign that the market is weaker than it had thought it would be early in the year. No matter, it is not the kind of Armageddon that so many analysts and commentators were thinking it would be. The WAN Optimization market isn’t saturated and investors can get back to analyzing the company based on the underlying fundamentals rather than paranoia and noise.

General Electric Equity Research Analysis

A stock like General Electric $GE is always going to be seen as a proxy for global GDP growth and I can’t argue with the logic. However, global economies have many moving parts and I think there was good cause to believe that GE was exposed to some of the more favorable trends. The bad news is that while the recent results confirmed some positive end markets, on balance the figures were rather disappointing.


GE’s Favorable Trends

Global energy infrastructural spending remains ok and low prices in gas should be encouraging purchases of gas turbines as utilities switch to using it for power generation. Further, as turbines are used more (to take advantage of low gas prices) GE’s service revenues should be increasing too.  Aviation is a strong sector for GE and so far most of the companies in the sector have reported good results, albeit with a weak outlook for defense spending.

Turning to healthcare, this is clearly a more defensive sector and with low interest rates and increasing credit quality in the US, GE Capital has good opportunities to grow profits. While global growth is definitely slowing, GE looks well placed to weather them so it does look rather positive from an end-market perspective.

The problem is that GE’s positioning and sales mix within this segments looks a bit weaker after these results. Before going into detail on these issues, here is the relative importance of the divisions in terms of segmental profits for this quarter.

Maybe this is the Strongest Point?

Starting with the largest contributor to profits (GE Capital), things are unlikely to be as rosy going forward. The US is doing ok but GE capital has significant European exposure. Europe is a mixed bag but unlike many other companies that might predominantly sell to a particular market, GE has broad-based exposure. Italy was described as a "tough place" and places like Spain will create difficulties too. As we saw in 2008 with GE, it is not just an industrial company and loan losses and write-offs can quickly hurt the bottom line.


Energy infrastructure is doing fine with mid-teens growth in revenues and segmental profits and it confirms what Alcoa $AA said recently about its industrial turbines business. However, I would strike a note of caution. These businesses tend to be long-cycle so any slowdown will not be seen initially in a downturn. The market isn’t silly and will anticipate such events, so investors need to bear this in mind. Within the two components of the division, energy spending remains robust but it was noticeable that oil & gas equipment revenue was flat while service revenue rose 10%. This suggests that oil & gas spending is starting to moderate.

Aviation saw strong revenue growth in line with what companies like Textron $TXT and Alcoa said recently about commercial aviation. GE did see some strong areas here but overall aviation margins were down due to a negative relating to the sales mix, and segmental profits were down 4%.  I noted that AAR Corp $AIR recently affirmed how much of a drop off on military spending there would be in the future and GE is exposed here. The other thing that worries me is that aviation spending is cyclical. Orders will get canceled or delayed and order books that look full now do not so look so good in future when airlines start cutting back.

Probably the biggest disappointment was in healthcare. Revenues were flat and segmental profits went down 2%. Management blamed some "execution issues" in Latin America but the weakness seems global. Moreover companies do not usually take pricing when they are competing well in stable end markets. European revenues were down 8% and the US only recorded a 1% increase. On a brighter note, GE was positive about better performance in Q3.


What About China?

Whilst we know Europe is weak I think China is also a cause for concern, particularly with GE. It has a lot of long-cycle business in China that won’t be turning down initially, given a slowdown. This can create a misleading optic especially when a company’s numbers are being supported by a relatively stronger growing region. In other words, the earnings and order numbers may look great now but they will suffer in future if China’s growth continues to moderate.


Overall Outlook

GE management stated that four or five segments would be positive in the next quarter with energy being a particular strong point. My concern is that aviation and oil and gas are sectors that could disappoint in future. GE is not performing in the healthcare segment and GE Capital has significant European exposure. China is creating some positive optics but that situation could unravel the other way.

In conclusion, GE is a well run company and investors who are bullish on the global outlook would do a lot worse then pick some up. However, it also has challenges and if you are worried about the global situation then there is a strong case to be made for the argument that GE’s revenue base is giving over-exposure to cyclicality whilst its defensive divisions are not performing well enough.

Google vs. Facebook Over Mobile

The market liked the recent results from Google $GOOG and in many ways the company’s strategy is being better understood. It is ironic that it took the Facebook $FB IPO in order to truly focus the market’s attention on the seismic changes that are happening in internet usage. While it is highly debatable whether Facebook has a coherent strategy for mobile, few people can question that Google is not leading the way in adapting to the new mobile reality. Google faces a number of challenges with mobile related issues, and understanding them is critical to any investment appraisal.


Integrating Motorola Mobility

The most apparent issue is the integration of Motorola Mobility. This was the first quarter in which its numbers were included in Google’s reporting. Analysts wasted no time in questioning when it would no longer generate losses, but the answers seemed quite non-committal. Perhaps it’s understandable in that Google’s team has only had a few weeks in charge, but buying a business without a clear pathway to profitability is a sign that this acquisition is seen as a kind of ‘loss leader’ for the core part of Google’s advertising offering.

The challenge here is that –while the Google name is synonymous with mobile technology- it has not had demonstrable success with hardware.  Investors would be right to view the integration with caution. However, I think it is better to view Motorola as part of the integrated way that Google runs it strategy.


Google’s Mobile Strategy

According to most industry statistics Google’s Android has a majority share of smartphone operating systems. In addition, Google has almost all of the mobile market for search. This dominant positioning in mobile is the key to Google’s overall offering.

Advertisers and marketers want their brand management to work and achieve leverage wherever consumer interaction takes place, therefore it is essential that campaigns be integrated and analyzed over a range of platforms. This means that Google has an increasingly strong position with advertisers because it offers a pathway to monetizing mobile. Moreover, Google Analytics gives companies the capability to better generate and monitor return on investment in campaigns via an integrated approach across various sales channels.

Google is well placed in analytics but faces fierce competition in the analytics market from IBM $IBM and Adobe Systems $ADBE Google offers much of its analytics for free, but Adobe has a strong relationship with digital marketing via its publishing software and IBM has an integrated offering for corporations.

Putting these strands together, the Motorola acquisition gives Google a hardware component in which to experiment and secure positioning for Android. In turn, the operating system gives Google future revenue potential and a de-facto monopoly over search. Google Analytics lets companies analyze and integrate Google into their marketing activities across all platforms. All of which lead to revenues in the core activity of advertising.


Google Adjusting to Mobile Realities

In order to demonstrate the changes here I want to share some data graphically.

It is not hard to see what the market is worried about. As internet usage increasingly shifts to mobile and tablet usage, Google has had to adjust the way it does business. Cost per click has seen a dramatic decline, while the increase in paid clicks has been similarly dramatic. Overall revenue growth has been moderating but from extremely high levels. It’s easy to forget that Google is achieving 20%+ revenue growth while generating huge amounts of cash flows.

Frankly, I don’t think this is as much of an issue as a lot of the media makes it out to be. Google explained that currency effects (stronger dollar) had an effect, as well as a conscious shift to increasing paid clicks at the expense of cost-per-click.

An example of this is the increase in site links. These are the individual links to various parts of a website that appear after a search. While they are great for encouraging interaction with a site and therefore increase paid clicks, I suspect they do generate less cost-per-click. This is not a problem as long as overall revenue increases in the mix.

As for the issue of increasing mobile ads, this too, should not be seen as a particular issue. Smartphone internet usage is definitely different but probably involves more focused search (via engines) and re-occurring visits to favorite websites (Facebook, Youtube) than the meandering browsing experience of sitting in front of a pc. There is every reason to expect that Google will be able to continue to generate growth even as internet usage shifts to mobile & tablet from pc.

The key thing is that Google is recognizing the need to adjust to this reality, even if it is putting pressure on cost per click metrics.


Geographic Expansion Opportunities are Underestimated

I think the geographic opportunity is vastly underestimated by many investors. The argument is that penetration in the Anglo-Saxon countries is a precursor to the kind of rates that Google can expect on a worldwide basis.  For example, US revenues make up around 46% of the total and the UK makes up about 20% of international revenues.  For linguistic and cultural reasons, it’s natural to expect these regions to lead the way, but I will be amazed if these ratios stay the same in five years time.

There is no reason why English speaking countries shouldn’t catch up with the Anglo-Saxon world in terms of e-commerce and digital marketing activities. This argument applies to domestic advertisers but, critically, it also applies to the international campaigns of global advertisers.

If you think about it, the huge amounts of data being generated by social networks such as Facebook or Google+ are going to change the way marketers can target consumers. It will lead to more focused campaigns that can be tailored to suit localized consumers in a highly differentiated way. This means that online advertising can be better targeted and that revenues in the less developed markets have huge potential for future growth.


What Next For Google?

Google really needs to carry on executing and experimenting in order to find the perfect way to manage the shift to mobile. Investors often want jam today, but Google is managing to deliver jam while also working on new recipes in mobile. So far, so good, but the Motorola acquisition will remain a question mark and analysts will be watching new handset development very keenly.

I think the long term picture is extremely positive for Google.  Expansion of international revenues is likely to lead to very strong growth in the future and investors should respect that if anyone can monetize mobile successfully it will be Google. The stock offers growth drivers that are a lot less cyclical than so many other companies, and I think it offers good value too.

VF Corp Equity Research Analysis

With weaker US retail sales recently, investors have been fretting over the retail sector in the upcoming earnings season. One company that consistently seems to buck the trend is V.F. Corp $VFC. It reported a super set of results, upgraded guidance and demonstrated that it can find growth drivers within a diverse portfolio of brands. The company had challenges in the quarter but seemed to pass them quite well.

The company is trending strongly this year and it raised EPS guidance to $9.50 following a previous hike in April to $9.45 from $9.30 at the start of the year. In addition forecasts for operating cash flow were raised due to better operational efficiencies. In summary, this is a well run company that has many positive trends in its favor.


VF Corp Stock

The name may be ambiguous but the brands are anything but! In fact, 70% of its revenues are generated by five household brands. In order of importance, they are The North Face, Timberland, Vans, Wrangler and Lee. It could be seen as a mid tier play that competes with the likes of the Gap Inc $GPS for purchasing bucks. Unlike the Gap, I like this company because it offers a diversified product range, whose products all tend to offer utility to its users, as well as being a fashion statement.
VF is attractive because it offers a compelling mix of growth drivers.

• Rugged outdoor clothing, skateboarding fashion and Jeanswear have far less variable demand than much of fashion.
• E-Commerce initiatives with the North Face and Vans will drive new revenue generation
• Key brands are under-penetrated in Europe so the company can drive top-line growth even if the region is weak
• The growing Jeanswear business in China is the most profitable for the group and good growth is forecast going forward
• Geographic expansion opportunities offer the potential for growth. Potential to introduce new brands into China

However, it also faces a significant amount of challenges

• Timberland has a very high portion of sales in Europe and is struggling there
• Commodity prices are no longer so favorable. Cotton prices are not falling so much and other costs are rising. Margin expansion will get tougher.
• European trading remains mixed
• China’s growth is slowing so conditions may get tougher
• Timberland inventory still needs to be run down following low sales due to a mild winter

VF Corp & the North Face

The North Face brand saw sales rise 14% globally with mid-teen growth in Europe and high growth in China. Essentially, this brand has benefited from a favorable secular consumer trend. The type of rugged outdoor clothing offered by the North Face has transcended its traditional outdoor sports market and is being increasingly warn as a kind of fashion statement.

For an analogy, think of how urban drivers seem to love driving off-road vehicles like a Range Rover because they think it gives them some sort of adventurous cache. I doubt many people wearing North Face products really do go mountaineering or trekking in the North Pole although many may think they do whilst strolling to a Starbucks in New York!

Europe is a concern here but the e-commerce initiatives in Italy & Spain plus new sites to be launched in Austria, Germany and the Netherlands (three of the strongest markets in Europe) offer the potential for growth. Eastern European expansion is also planned and although the company talked about Poland the printing presses should be stopped right now. I am currently in Hungary and have seen a boarding up for a North Face store in the top shopping street in the capital. Never say that the Motley Fool doesn’t give you exclusives!


Vans Keep Moving but Jeanswear Looks Tough

In a similar fashion, the Vans brand has been able to crossover from functional leisure gear to fashion wear. The company has high hopes for expansion in future. The plan is to add $1bn in revenues by 2016 from a figure of $1.2bn in 2011. What differentiates Vans from so much of retail at the moment is that it is able to generate strong growth in Europe thanks to its broad based fashion appeal.

In contrast the Jeanswear division is having difficulties in Europe. In the last recession European Jeanswear revenues declined and the company is facing similar challenges now. European denim demand is much more fashion oriented and the Wrangler and Lee brands are simply not as highly regarded as they are in the States. I would expect more challenges here.

On the other hand, these brands are much stronger in China. Unsurprisingly, Lee is a very popular brand in China and VF Corp is pinning its hopes in growth in this area because Lee’s brand appeal appears to be fading in the US, even if Wrangler is still solid.


Timberland Carrying Some Timber

The last of the major brands is Timberland. It is carrying some excess inventory thanks to a mild winter and it is also dealing with weak conditions in Europe. Given that Europe traditionally makes up 50% of its global sales, this is an issue.

The good news is the excess inventory situation was declared as improving in the quarter and management described the impact on sales from the downsizing of distribution as being ‘minimal.’ So far so good, but conditions are weakening so this issue isn’t finished yet.


Where Next For VF Corp?

More of the same please. The company needs to carry on executing with its core strategy of leveraging favorable consumer trends within North Face and Vans. E-commerce initiatives also need to be successfully completed. The biggest concern comes with the inventory at Timberland and the ongoing weakness in Europe with both Timberland and Jeanswear. It’s hard to see how Lee can be turned around quickly (ex-China) but the company can continue to develop the work wear aspect of its Jeanswear in the States. China offers the strongest growth prospects as its brands are under penetrated and growth remains strong.

In conclusion, I think the stock is fairly valued right now. It is very attractive but it also faces challenges and in an uncertain environment. Long term investors might want a cheaper entry point in order to guarantee a bigger margin of safety.

F5 Networks Equity Research

In a final proof that investors really are not willing to hold a stock for more than five minutes these days, F5 Networks $FFIV was sent sharply higher even though it warned of a cautious spending environment and gave guidance below analyst estimates. The market was probably anticipating a whole lot worse and no one seems to have any patience with holding stocks if there is any kind of tangential negativity around them right now. Indeed, stocks catering to proprietary technology spending have been subject to no end of negative sentiment recently.
Perhaps investors can now start to remember that value does actually matter!


Why F5 Networks is Less Vulnerable in a Slowdown

What makes this company attractive is that it has secular growth drivers that give it some insulation from the ravages of a weak technology spending environment. For the uninitiated, 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.

In other words, every time you see a kid holding something electronic whilst surfing or watching a video stream, it's good for F5.

CEOs maybe keen to cut back on certain areas of spending, but investing in mobile apps and taking advantage of mobile traffic growth is not one of them. You only have to look at how Google $GOOG  is restructuring its business in order to monetize mobile through search and ad placement. The shift to mobile internet usage is tangible and companies won’t stop spending in this as it is a secular trend.

The need for corporations to engage with social networks and other virtual environments is also seen as being a secular shift in how companies do business. Similarly, the demand for bandwidth is creating consolidation and security issues at data centers. All of these things play into F5’s strengths.

So What Happened With The Results and Guidance?
After fellow networking play Acme Packet $APKT gave horrible results and guidance, the market was understandably nervous about F5's upcoming results. However, I think there is a strong case to be made for the former being too optimistic in its previous outlook and operating in some difficult end markets. F5's results were nothing like as bad.

The Q3 results were pretty much in-line but the guidance was a little weak relative to analyst expectations and historical trading patterns. Analysts had forecast revenues of $377m and EPS of $1.24 for Q4 but F5 guided towards $360-370m and EPS of $1.16-$1.19. No matter, the stock went higher as investors breathed a sigh of relief. Historically the guidance was a bit weak too.
Here is how F5’s sequential growth rates have moved in the past.

The Q4 guidance is notably lower than it has been in recent years and is only slightly above what the company recorded in Q4 2008. But so what?

Unless you believe that we are heading into another global recession this sort of optic should not scare investors too much. After all, the weakened guidance of $360-370m in revenues still implies a 16% growth.


Weakness Was Macro Based Not Industry

One surprising aspect of these results was that F5's management reported that they saw caution across a broad base of sectors rather than in any specific vertical. This is somewhat surprising given the weakness in telco spending that saw many others.  There was a decline in the telco sector but this was as expected following a very strong quarter previously. I would have expected worse from the Telco sector. Again, this suggests that F5 are relatively less vulnerable.

I’ve broken down the industry verticals for the last two quarters.

Sector	Q2 Revenue Share	Q3 Revenue Share
Telco	27%	22%
Technology	19%	16%
Financial	16%	23%
Government	12%	12%

As for the European exposure, F5 said a similar thing to what Check Point $CHKP talked about recently. Europe is a wide and varied region and different countries have considerably different prospects. Generally speaking the North is doing ok but the South is struggling.  In any case, Europe only makes up 21% of current revenues with the Americas contributing 57%.

Incidentally, Check Point is a good company to reference because it competes with F5’s nascent data center security business. The former recently gave a decent set of results too.


Where Next for F5 Networks?

On a PE basis this stock is obviously very expensive and it is easy to dismiss it on that basis. However, the company generates large amounts of cash flows ($440m in free cash flow on a trailing basis) and earnings are somewhat unrepresentative of the true value because the profit and loss sheet contains significant non-cash items (stock options). In addition, a lot of its sales get booked as deferred revenues and then get recognized in time. Product revenues actually grew 15.4% in this quarter so the underlying picture remains sound.

I think the stock is attractive at this price but be prepared for volatility and lots of it!

Check Point Looks Good Value

Technology investors can be forgiven for thinking that the sky was about to fall on them in the last few months. Granted, some companies have given eye watering warnings and the macro environment has unquestionably weakened, however, a ‘one size fits all’ approach in technology investing has rarely been more ill advised. Not all companies are seeing revenues collapse and because catastrophe is priced in, there is upside even if they only report in line with earnings and give moderate guidance.  Such was the case with IT security company Check Point Software $CHKP


Whisper Numbers Were Just Whispers

I must confess I’m fed up of hearing the phrase ‘whisper number.’ It usually refers to some commentator or other trying to guide consensus in the direction of his trade on the stock. With Check Point, we seemed to hear it all before these results.

According to the whispers, its relatively high European exposure was about to cause a collapse in revenues. Upstart IT security company Palo Alto was supposed to be positioning itself as the ‘Check Point Killer.’ Fortinet $FTNT was achieving its success by grabbing market share from the Israeli competitor. Product and licence sales were in a consolidated decline. The stock got trashed.
Dealing with these points in turn, Europe contributed 39% of revenues in the quarter and growth was described as mixed across the region. I’m writing this from Austria and, I assure you that conditions here do not seem anything like as bad as in, say Spain. Analysts asked about Palo Alto on the conference call and the management stated that it had seen no competitive changes from them. Trading conditions in the US were described as ‘great.’

Similarly, it stated that it thought Juniper $JNPR  and Cisco $CSCO were still losing market share.  Fortinet is a fine company and it does talk about winning business from Check Point, but the fact is that its core market is in its SMB stronghold. Check Point mainly generates its revenues from mid-large size companies who require a more sophisticated solution.
As for product sales, some explanation is needed here.


Why Product and Licence Sales are Weaker

The first thing to acknowledge is that product sales have been trending weaker for a while now. Here is a graph of product & licences and software sales growth.

Clearly product sales growth is weakening but there are mitigating circumstances. Check Point is increasingly bundling its product and software services together and, with more software blades being offered, more of the revenue is being recognized as software.

Essentially, technology companies sell products (hardware and software) but they also sell services which tend to be long term. So when a customer is taken on, the company books revenue for the products and bills for the full service contract. However, the full contract is not recognized as revenue until the service work is incrementally done. No matter, the work is billed. Therefore, investors can’t just look at revenues or product sales in isolation.

Moreover, the mix of sales between services and product will dictate the mix between revenues and current deferred revenues. In order to demonstrate this I want to show a chart of the growth of a selected metric. This chart shows the growth rate of revenues plus the change in deferred revenues. I think it is a good way to see how a technology company is trending.

Growth is moderating but then again the yearly comparables are getting tougher. In conclusion, Check Point’s underlying growth is still good.


Warning Signs?

Despite the positive tone of this article I am not going to conclude by saying that everything is firing on all cylinders. Growth is moderating. If conditions continue to deteriorate then Check Point could disappoint.  The guidance given for the next quarter was very wide (revenues of $316-345m) which indicates an amount of increased caution over current trading.  The company also talked of new customers wanting smaller size deals.

More competition is coming and particular from a company like F5 Networks $FFIV which reported decent results and confirmed that its nascent security offering was gathering traction. F5 has a powerful position in its core application delivery market and can leverage this to grab market share.


The Bottom Line

The company also has an annoying tendency to hoard cash. It is a high cash generator and has nearly 14% of its market cap in cash or cash like instruments. On a trailing basis its free cash flow generation is $784m or 9% of its Enterprise Value.  This makes Check Point a rare breed of stock that appeals to both value and growth investors. Frankly, I think it’s time for it to do more for the former. The $1bn buyback approval is a good move, but I think a dividend would drive the stock price higher and also encourage longer term value investors into the stock.

In conclusion, Check Point looks like good value down here. The evaluation is attractive and security is one of those areas of IT spending that may turn out to be a lot less discretionary than the whisperers would have you believe it.

Johnson & Johnson Powers On

Johnson & Johnson (NYSE: JNJ) in turn demonstrated why investors love and loathe the stock. The results were superficially disappointing and confirmed the company’s weak growth trajectory. Full year guidance was reduced in the face of currency headwinds and there was the usual mix of production problems and generic competition eroding established products. The Synthes acquisition added some growth, but it also demonstrating how difficult it will be to generate top line growth via acquisitions.
On the other hand, the stock barely moved as a consequence. Simply put, Johnson & Johnson represents a relatively high yield play with stable end markets and in this kind if environment that will do fine. Any growth upside comes from execution and new product launches, and that is good news because it offers risk adverse investors some income plus the potential for some non market correlated upside.

Johnson & Johnson reports in three business divisions.


Consumer Products  (22% of Sales)

Investors wouldn’t have had a good night’s sleep with this division’s results in recent quarters, and I am not just talking about the manufacturing problems that have kept Tylenol off the market. On an operational basis US sales fell 1.9% whilst international rose 2% although negative currency effects took them down by 8%. Overall reported sales fell by 4.6%.

Superficially this isn’t great but recall that the loss was due to currency effects and international sales (which are growing organically) are 75% larger than domestic. Essentially JNJ needs to sort out its production problems and continue to expose its products to emerging market growth. Categories like oral and baby care offer good growth prospects internationally. Competitors like Colgate-Palmolive (NYSE: CL) in oral continue to report good numbers and emerging market birth rates remain conducive to longer term growth in baby care. Of a slight concern here would be the wound care division which is seeing very strong competition from the likes of Covidien (NYSE: COV).
Overall it seems that JNJ is halting the decline in this division.


Pharmaceuticals (38.1% of Sales)

Overall sales rose by a paltry .9% but excluding currency effects they were up 5.1% and again, it is a story of strong international growth (organically 15.5%) versus weaker US (down 4.5%); however, I think the underlying picture in the US is quite strong here.

The reduction in sales in the US was almost entirely due to Levaquin (bacterial infections) which lost sales due to generic competition. Of course, this will drop out of future sales comparisons and Levaquin sales are now minimal to results.

On a brighter note, new product launches went well. Zytiga (prostate cancer)sales increased by $183m, moreover JNJ filed with the FDA and EMA to extend the use of Zytiga in patients who haven’t received chemotherapy.

Immunology makes up 30% of pharma sales with Remicade (anti-inflammatory diseases) responsible for 79% of those sales.  Sales grew by 12.7% on a worldwide basis and the potential for international sales growth remains good.

 The second biggest division within pharma is neuroscience which makes up 27.2% of sales. Operational sales were up a meager .5%. I’ll start with the bad news first. Converta which treats attention deficit hyperactivity disorder (ADHD)  saw further generic competition that caused US sales to fall 37.6%. This reads across well for Watson Pharma (NYSE: WPI) which has successfully launched a generic version of Concerta.

More positively I think the underlying picture in schizophrenia (40% of neuroscience) is quite good. Risperdal is an older treatment which is in decline but the improved version of Invega (Sustenna) is more than compensating for any fall.

In summary, the pharma division is now performing well and with new drug marketing applications plus the continued success of Remicade, Invega Sustenna and Zytiga growth looks assured.

Medical Devices & Diagnostics (44.6% of sales)

This division reported a .1% revenue decline but operationally it was up 3.5% and that figure includes contribution from the Snythes acquisition. This is the most cyclically sensitive part of JNJ’s revenues and investors should not expect too much, too soon. Hospital admissions and elective surgeries in North America are coming back but, by most estimates, it is only in line with the kind of revenue growth that JNJ is reporting.

The concern here is that US revenues in cardiovascular (partly due to a decision to exit the drug eluting stent market), diabetes and general surgery all declined. It is reasonable to expect that both Intuitive Surgical (NASDAQ: ISRG) and Covidien (with its energy products) are winning market share in surgery and JNJ’s positioning is a concern.


In Conclusion

Same old same old, I am afraid. A mixed bag of results from a healthcare giant that has low growth and, is a difficult company to jump start growth in. Pharmaceuticals are doing well and have good prospects. Meanwhile consumer products offer some upside from execution and the fixing of production woes and the medical device sector needs some work in its surgery product line.
But so what?
JNJ offers a high yield, huge amounts of cash flow and upside from execution. It offers security and in an insecure market and income where so many other safe havens are very highly priced. It’s worth a look at for any portfolio in this environment.

China's Telecom Spending Weakens, Where Next?

China’s ZTE Corp surprised the market with a grim pre-announcement on Friday and the Hong Kong-listed stock was the latest in the telecom sector to crash on Monday. Whereas other stocks in the sector have disappointed on weakness in North American service provider spending, part of what ZTE is saying is related to China’s spending. The company makes around 50% of its revenues from telecom network equipment and is a leading player in China. What it says matters.


What did ZTE Say?

The company pre-announced results and stated that profits would be down 60-80% on last year. There were three reasons given for this. The first two relate to a stock-specific issue (a drop in investment income from the disposal of shares) and foreign exchange losses blamed on the depreciation of the Euro.

However, it is the third reason that will interest external investors. ZTE’s targeted growth rate fell short because domestic carrier networks postponed some contract tendering. At the same time there was a decline in the overall gross profit margin. The two are likely to be correlated and should be seen as symptomatic of a weaker spending environment. In a slowing environment many companies will be faced with rising inventory or high operating costs (due to being geared to higher expected sales) and this usually presages price cuts in order to keep market share, reduce inventory or keep assets ticking over.

This is not just restricted to China. If Huawei or ZTE are having trouble in their domestic market than I suspect companies like Cisco (NASDAQ: CSCO) will start to feel it in its core developed markets. Chaos theory and butterflies flapping in China and all that.


When Will the Spending come back and why does it Matter?

As ever, some analysts are predicting a bounce back with China’s telecom network spending in the second half. This may turn out to be wishful thinking. 

It seems that the telecom equipment suppliers have spent the most part of 2012 talking about weakening sales but pinning hopes on a rebound in China’s spending. In particular, China recently announced a $58 billion stimulus package to invest in telecom infrastructure so the bulls have a strong case. China certainly has the firepower to support more spending, but investors need to look at the economy on the whole. It has been weakening recently and the full consequences of a housing market slowdown are certainly not felt yet. Will China actually invest in telecom infrastructure if the rest of the economy is slowing?

As ever with China we need to look at fixed asset investment.

It is definitely moderating and it should be noted that this type of investment tends to be long cycle. In other words, the graph is showing us where the economy was with a time lag. The likelihood is that the trend is getting worse.

This isn’t just bad news for the likes of ZTE and its domestic rival Huawei, it also spells trouble for a company like Cisco which has been trying to expand sales in China. Similarly, telecom equipment suppliers like Finisar (NASDAQ: FNSR), Ciena (NASDAQ: CIEN) and JDS Uniphase (NASDAQ: JDSU) have all talked of a stronger second half, but with every profit warning and negative outlook this is increasingly looking like a "jam tomorrow" story.

We know that North American service provider spending has been weak and despite the verbiage from the likes of Verizon and AT&T there are little signs of an imminent recovery. Now China seems to be going in the same direction. Moreover, it is not just weakness in wire line versus wireless; it appears to be broad based.


A Mixed Picture

Whilst the weakness is broad based, the trends in telecom spending are varied and this provides challenges for equipment suppliers. The mature GSM markets tend to be higher margin, but the growth is likely to come from 4G-LTE & wireless spending. This has consequences for the bottom lines of many telecom companies as changes in the sales mix can affect profitability. Indeed, in certain emerging markets the pressure to upgrade directly to 4G is likely to cause some initial rollout delays and a "spending gap" as they delay 2G/3G spending and wait for the timing to invest in 4G-LTE.
It is inevitable that carriers will start investing again but, as ever, it is a question of timing.


So What Next for the Telecom Companies?

Frankly with a declining end market, none of them look safe. Cisco’s story is one of strength in its periphery offerings, but its core routers division put in a weak performance in the last quarter. With ZTE and Huawei already seeing difficulties in their domestic markets, they are likely to step up competition with Cisco in North America. Moreover, it’s hard to see how things could have got better overall for Cisco because its last commentary was mainly about weakness in Europe.

Ciena provides a relatively better outlook because of its strong position in the 100G market. Finisar has had four straight quarters of negative growth in its telecom revenues and has already spoken of the unpredictability of China’s spending plans. Its rival JDS Uniphase is seeing things a bit better, but it too is probably relying on a second half pick up.

In conclusion, I don’t think China’s spending (what they do, not what they say) will be divorced from the trend of its overall economy. In addition, North American service providers remain cautious and Europe is enthralled in its own political and economic difficulties. On a more positive note the demand for bandwidth, mobile and next generation networking is a secular growth trend so the pressure will be building up. It is a question of timing and right now I think investors need to be patient.