Home Depot Equity Research

One of the things that I often find with private investors is a sense of bewilderment at just what is going on with analyst estimates and target prices. This is rarely more prevalent than in businesses whose prospects are ultimately determined by a big macro theme like housing.

Let’s take $HD as an example. I think the US housing market is going to improve and gradually this will get baked into analyst estimates and targets. In summary, investors should not miss the opportunity to try and get ahead of upgrades.

The reason I think this is that analysts don’t make big macro calls. Instead they tend to prefer a linear join-the-dots approach based on a mix of historical precedents and derivations from industry statistics. I’m not knocking this approach -- I use it myself -- but if you do have a macro call to make, you can get ahead of the upgrades. In terms of housing, there is an article linked here that takes you through some of the recent positive data on housing. If you don’t share this view than read no further!

Home Depot Earnings

Full-year guidance was raised to GAAP EPS of $1.95 from $1.90. Superficially the numbers weren’t great but the pull-forward effect of unseasonably warm weather in the winter was always likely to skew the results somewhat. In order to demonstrate this here are the revenue and gross margin numbers by quarter.

The year on year growth comes in at a paltry 1.7%. No matter, by smoothing out the effect of the pull-forward in Q1 we can see that the underlying picture is a lot stronger.  Let's look at numbers by the half-year.

Note in the following chart that H1 2012 is growing at a 3.6% clip, which is pretty good. In addition in the first half of last year Home Depot had strong sales from roofing repairs thanks to hurricane Irene.

Furthermore, the commentary around the results was a lot more confident than it has been for a while. Home Depot, rather like its chief rival $LOW, has been reticent to call a recovery in the housing market amidst pointing out that its prospects were based on GDP type growth and whatever operational efficiencies they could squeeze out of their respective companies. This is a sound approach and it encourages analysts not to pencil in overly optimistic assumptions.

A More Positive Outlook on Housing

I detected a change of tone in the conference call for two main reasons.

Firstly, the company was keen to emphasize that whereas previously it had seen its growth as correlating with overall GDP growth -- which most forecasters have as slowing -- now it is seeing housing as a "bit of a bright spot." Indeed housing is back to being a positive contributor to GDP growth. Moreover, management stated that it saw signs of "stabilization" in the key Florida and California housing markets and gradual improvement overall in housing.

The second reason is that the more discretionary items seem to be doing better.  For example décor, kitchens, baths, flooring and plumbing were called out as outperforming while garden and building materials were down. Moreover the last two categories were down under plausibly mitigating circumstances. The drought has held back gardening sales and building materials were up against tough comparisons following the hurricane last year.

Given the strength in the tools category it was somewhat surprising to see Stanley Black & Decker $SWK negative on the day although the market may not like the European exposure.

Essentially, the core of Home Depot performed well and I think this is confirmed when we look at what Lowe’s reported in its last set of earnings.

I think there is more to come from the home improvement stores.

Where Next for Home Depot?

The company is a cash-generating juggernaut and the stock remains cheap. Trailing free cash flow generation of $5.1 billion is a testimony to the underlying strength of Home Depot and if you buy the story of a housing market recovery it would not be unreasonable to see this stock better priced with a $60 handle.

I think the stock remains attractive. As we have seen from 2006 onwards, housing markets take a long while to finish changing direction and at the moment we seem to be in the early stages of a slow but gradual recovery phase. There is still time to get in before analysts start upgrading.

Which Stocks are Hot in the Food Sector?

Theoretically the private label food manufacturers should be one of the great winners out of the new retail reality. However both the main listed plays Treehouse Foods THS and Ralcorp Holdings $RAH are down substantially this year. Go figure! Unfortunately, there are many moving parts to their business and the food retail industry is in a genuine state of flux right now. So what is going on and what are their prospects going forward?



The New Retail Reality

The US seems to have fallen in love with frugality and deleveraging. Over consumption is definitely off the table. Customers are not only trading down; they are buying food in smaller packages and changing where they shop by moving away from the traditional supermarkets and grocers towards alternative channels, such as the dollar stores, discount stores and, interestingly, specialist shops like Whole Foods.

I make the last point to highlight that this isn’t just about trading down. There is a curious kind of bifurcation going on here. The brands that are doing well are those at the premium end and those offering unrelenting value, particularly those sold through anything containing the word ‘dollar:’ Dollar Tree, Dollar General $DG or Family Dollar $FDO.

As such, private label is also doing well. Not only do they tend to be cheaper, but retailers are increasingly differentiating their product offerings within private label, in order to capture different segments of the marketplace. Again, the premium brands and category leaders are doing fine but it is the second to fourth line brands within a category that are suffering the onslaught of the growth of private label.

In addition, food costs have been rising in recent years and the consumer has been demonstrating that food is, after all, not a price inelastic good. Prices go up, consumers consume less and woe betides the company that tries to hike prices in front of its competition. The golden equation of the new retail reality is prices up=volumes down, and then let’s hope you get lucky on margins.

It’s time to confess. I lied. It's actually not new. We have seen this before: After the reunification of Germany, the economy fell into a period of slower growth as the West accommodated the East. One of the consequences of this was that the German consumer hankered down and started shifting to discount stores and it is no surprise to see that Europe’s leading discount stores emanate from Germany, namely Aldi and Lidl. Before you ask, both are private companies.

Turning back to the US, here is how Treehouse demonstrates industry forecasts for the potential growth in private label food and beverage.

So why aren’t the private label companies doing better?



Changes Turn and Face the Strain

Treehouse recently lowered its full year adjusted EPS guidance to $2.75-2.90 from a previous forecast of $3-3.15 amid plans to shut down a soup plant early in 2013 and then a salad dressing plant later in the year, while Ralcorp recently said it would be consolidating its business. Both stocks are down sharply this year.

The explanation comes if we understand that these businesses are also subject to change and as consumers shift to alternate channels they will need to adjust who they sell to. This is somewhat of a challenge for private label manufacturers because they suddenly realize that the contract they signed with a previous store is not going to be as profitable as they might have hoped.

In a way this highlights one of the difficulties with these companies. They are subject to the strategic and operational considerations of their clients, and if they don’t want to sell or promote a certain food product anymore than Treehouse et al will just have to eat it while they start anticipating taking a hit on the inevitable restructuring that will follow.



Soup Wars

Moreover, as times and prices change so do consumer tastes. One area that is proving particularly tough is soup, and investors in Heinz $HNZ and Campbell Soup Co $CPB need to pay attention to what Treehouse is saying here. The category seems to be in decline, and the closing of its soup plant portends further problems for the product. As ever with tough end markets, the protagonists start fighting ever harder for a larger piece of a smaller pie. As such, price competition is heavy and Treehouse has lost a lot of work with a key private label customer in recent times.

To their credit, Heinz and Campbell are innovating with new flavors and recipes, but it just looks like a difficult category to be in and I note that Heinz has previously remarked over the issue of smaller packaging and the growth of discount retailers taking away traditional traffic for their products.



Where Next for the Industry?

The soup plant restructuring has hit Treehouse’s forecasts for this year and remains a salutary reminder that the industry remains in flux. Last year it was pickles and this year it's soup. As for Ralcorp, investors in ConAgra can thank their lucky stars that the previous bid failed. Conditions look challenging at Heinz and Campbell but they both remain dividend darlings and the market has had time to digest their own going trends.

As for the dollar stores, I wrote about them at more length three months ago in an article linked here arguing that while prospects looked good, the evaluations were a bit rich. Since then, only Dollar General has outperformed the S&P 500 and the other two dollar stores are flat to negative.  I like these stocks, but isn’t the new retail reality about not overpaying for something even if you like it?

The challenge for Treehouse and Ralcorp is get their relative restructurings done in line with the way retail traffic is trending. If they can demonstrate this then I think end markets are favorable although cautious investors will want to see demonstration of this first. The food industry remains in flux as it adjusts to the changes.

CVS Caremark Equity Research Analysis

The market promptly sold off CVS Caremark $CVS even after it delivered a strong set of results. My suspicion is that a gang of investors were simply waiting for a pop on the results in order to try and be ‘smart’ and sell out in order to monetize the appreciation in the share price following the Walgreen $WAG and Express Scripts $ESRX debacle. Now that Walgreen will restart filling prescriptions from September 15 from Express Scripts. The hot money seems to have flowed back into the stock and away from CVS. Here is why I think that viewpoint is a mistake and why CVS is a core holding for any portfolio.



CVS Caremark’s Recent Results

CVS beat estimates with net revenues rising 16.3% with retail same store sales increasing 5.6%. Moreover, the company raised and narrowed EPS guidance whilst confirming strong cash generation at the company.  Movements in guidance this year:

The stock still sold off!

I think the market now believes that momentum will shift back to Walgreen from mid September. CVS discussed the issue and stated that it believed that it would retain the ‘vast majority’ of scripts in the third quarter and at least 50% in the fourth quarter. I think 50% might be too low a figure and here is why.

Inertia. Simply put, the prescription business is very sticky and whenever I have seen the subject of inertia addressed in behavioral finance tomes, there is always an underestimation of how resistant people are to change. However, not everyone is blind to this fact.

Ever wondered why every single candidate to an incumbent politician uses ‘time for a change’ as part of his/her core campaign? It is because they know that overcoming inertia is a large part of their fight. Moreover, if you think that inertia and behavioral finance is mumbo-jumbo then consider the insurance industry. The whole industry is structured around behavioral finance.

Ever wondered why new customers get more favorable rates than existing customers in terms of car insurance? It is because of inertia. Of course customers could en masse just keep switching for the cheaper deals, but human beings are hard wired to pay a premium for the ‘benefit’ of inertia. And the insurance industry is all too happy for you to pay it.

That said, CVS is undertaking a whole series of measures including advertising, promotions and data analyzing the new clients with a view to ensuring they stay. To go back to the car insurance analogy, the whole Walgreen/Express Scripts debacle was like running promotions in order to gain new customers without actually having to pay for it. A very nice scenario. I think CVS could surprise on the upside with customer retention in the second half.

No matter, the stock has a whole host of other mid and long term profit drivers which makes it extremely attractive.



CVS Caremark’s Profit Drivers

 I think CVS shareholders can look forward to a number of positive catalysts for the stock in future years.

• Demographics. An aging population will require more prescriptions and CVS is the leading player in  the Medicare Part D prescription drug program.
• Digital capabilities will allow then to monitor and profile customers better in order to personalize an offering
• Private label penetration is intended to increase from 17% to 20% and these products typically come with higher profit margins
• Margins are likely to increase as the patent cliff causes higher adoption of generics
• Expanding store brands from just being strong in consumer health
• Growth created by offering a ‘one-stop’ service by being a pharmacy benefits manager (PBM), a retail pharmacy and running a retail clinic
• Cash flows set to expand rapidly

CVS writes over 20% of the PBM retail scripts in the US and on the retail side has around 7,300 pharmacy stores. It is the leader in the ‘minute clinic’ sector with over 600 locations in operation. It is the confluence of this triangle of operations that differentiates CVS from the competition, of which there is plenty.

Not only is Walgreen a strong competitor in retail but there is also the struggling Rite-Aid $RAD and the ubiquitous name of Wal-Mart $WMT is in the fray too. The latter is a formidable foe but CVS is differentiated via its overall offering and Wal-Mart would have to invest significant time and resources in aping CVS’ offering or in digitally analyzing the customer base in the way that the specialist operators can. In fact, CVS outlined plans to further differentiate itself by expanding the number of minute clinics from 60 to 1,000 by 2016.

The demographic argument is well understood, but I want to focus on a less discussed issue. Everyone knows that aging demographics will create political and financial pressures on health care. However, CVS is likely to be a beneficiary. Private label or store brands tend to be higher margin and companies that make them such as Perrigo $PRGO are set to benefit. Perrigo is attractive in its own right, but it currently trades on 29x earnings and an EV/Ebitda of nearly 17x  whereas CVS trades on 16x and 7.8x these metrics respectively.

In addition, the increasing use of generics is beneficial to margins. Whilst generics may reduce overall revenues, they tend to be higher margin for the retailer as the pharmaceutical companies take a huge portion of the profits for their patented pharmaceuticals. Therefore it is in the interests of CVS and Walgreens to expand generics sales. Indeed, CVS mentioned that operating profit in the retail segment is now expected to be at the high end of prior guidance.



Where Next For CVS?

In my opinion it pays to ignore the market noise. Forget the ‘smart’ traders who think that investing is all about trading in and out on what the street thinks. The company has just told you that it expects to generate $4.6-4.9 billion in free cash flow this year and $4.7 billion each year from 2011-15. This equates to around 7.2% of its enterprise value. Furthermore, the stock looks like a great value as it is set to defensively grow earnings in the teens.

Granted, there are always political risks with this type of stock, but there are always political rewards too. The public wants more in store and generic drugs in supply and they won’t complain if prices go lower even if CVS is making more margin and profitability out of them. In conclusion, the stock looks undervalued, I like the long term story and think there is more to come from this stock.

5 Great Growth Stocks

Despite some good moves lately I think this market still hates technology stocks. In a sense I can understand why; if we are headed towards a global slowdown then a cyclical sector like enterprise technology will surely get hit disproportionately. Nevertheless, investing is about balancing risk and reward. It is all very well loading up your portfolio with a collection of defensive stocks on high teens PE ratios but a balanced approach should include some growth kickers and right now some of these stocks are looking like good value. I want to discuss a few of them and also highlight a way to avoid a familiar evaluation pitfall.

Quite frequently with technology stocks, investors take a quick look at the PE and conclude that they look expensive so why bother investigate any further? For example, few could avoid wincing when taking a cursory look at the PE ratios on these stocks.

See what I mean?

However, I think that the PE ratio isn’t really the way to best judge these companies and the next time you come across someone who glibly argues to short one of these stocks based on the PE ratio alone you can send them a link to this article. There is more to investing than the PE ratio!

 

Equinix Stock Analysis

I’m going to separate data center service provider Equinix $EQIX from the rest because it has a different business model. What you are looking for here is the underlying cash flow generation at the company. Equinix builds out data centers and then it typically takes around four years to reach full capacity. Customers tend to be very sticky and much of the expansion in capacity utilization at a data center can be expected to come from existing customers.

I’ve discussed this issue at more length in an article linked here. The key metric to understand here is something called ‘discretionary cash flow’ which Equinix defines as ‘cash generated from operating activities less ongoing capex.’ In other words, this is the underlying cash flow generation if Equinix weren’t expanding capacity. For 2012 the company is forecasting $520-540 million, which roughly equates to 6% of its market cap or 5% of its enterprise value. For a company growing sales in the mid teens that is not expensive, however investors will want to keep an eye on gross margins. Any slippage will be an indication of over capacity in the industry and that could be the beginning of a problem

 

Cash Flow is King in Technology Stocks Too

Ever get bored of hearing how great Procter & Gamble $PG or Coca-Cola’s cash flow is? For some reason value investors usually like to focus on these sorts of companies when they discuss this metric, but why not with technology companies too? The usual counter argument is the idea of the factor of safety enhancing moat. However, consider that Riverbed Technology $RVBD has 50% of the market for WAN optimization and Citrix Systems $CTXS has a strong position in the fast growing Cloud computing segment. Check Point Software $CHKP has long been one of the top companies in the high end of IT security while Fortinet $FTNT is the global leader in Unified Threat Management (UTM). They all strike me as having pretty decent moats within their core markets.

Here is how cash flows are developing for these companies.

Frankly, they all look cheap. Fortinet looks a bit pricier but recall it is forecast to grow revenues at nearly 20% for the next two years.

 

Ok they are Cheap but What About Growth?

Here again there is a trap with just looking at earnings. With some tech stocks there are revenues and there are deferred revenues, and investors can only really see the underlying picture if they look at both. So what is the difference?

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 top line revenues.

Moreover, the mix of sales between services and product sales, will dictate the mix between revenues and deferred revenues. For example, a company like Check Point is purposely increasing its software sales as it adds new solutions to its hardware. In order to get a better underlying picture I think investors should look at revenues plus the change in deferred revenues. This should help give a better picture for how the company is performing and what future cash flow growth to expect.

Here is how these companies are performing using this metric.

As you can see, Fortinet had a strong quarter and Riverbed looks like it is sorting out its sales alignment with its new products. Growth remains strong at Citrix and Check Point, even if the latter is reporting slowing product sales growth.

 

Where Next For These Companies?

On current trends, these evaluations look favorable and investors would do well to consider these stocks for the more cyclical parts of their portfolios. There is more to value (or in my case GARP) investing then just looking at the PE ratio.

Acme Packet Has Upside Potential

So why would Acme Packet $APKT be the next Riverbed Technology $RVBD and what exactly does that mean anyway?  Well, what I am referring to is the fact that Acme is faced with the same sort of investment quandary that Riverbed was faced with recently but for different reasons.

Both companies are seeing a weaker operating environment and both stocks had reported weak results. In both cases, some analysts were quick to conclude that there was some structural problem. In Riverbed’s case the WAN Optimization market was supposed to be saturated and growth would therefore slow dramatically. It didn’t turn out to be the case and the stock soared.  With Acme Packet, the core market of session border controllers (SBC) is possibly structurally challenged.  In the light of the recent results from Sonus Networks $SONS I thought it would be interesting to take a closer look.



Session Border Controllers Versus End to End Solutions

SBCs are networking equipment that control real-time session traffic at the signaling and call-control as they cross a packet-to-packet network border between networks or even between different portions of a network. Essentially they are a play on the convergence of voice and data networking, otherwise known as Voice over Internet Protocol (VoIP).  SBCs are necessary because they allow for session traffic to cross network address translation devices or firewall boundaries in real time.

The issue clouding the outlook is that Acme's core market of Session Border Controllers (SBC) may well be challenged by other vendors selling end-to-end integrated solutions to network management.  SBCs control signaling between service providers and when they (service providers) purchase end-to-end solutions, they can be seen as competing for network spending dollars, particularly when the end-to-end solution has SBC capability already built into it. For example a company like Ericsson can come along and offer an integrated solution which obviates the need for an independent SBC from Acme Packet or Sonus Networks.

 

So What Did Sonus Networks Say?

Sonus said two things.

The first is to reiterate what everybody should know by now. It is a weak capital spending environment for the service providers. I have discussed this issue in an article linked here. With regards the big two in North America, AT&T $T i saying they intend to spend more in the second half but this deserves some circumspection whilst Verizon $VZ is intending to reduce capital expenditures as a share of revenues. In fact Verizon has gradually lowered expectations for capital spending throughout 2012. There is a sense that Verizon has already spent significant sums on rolling out a network in previous years. Therefore it was no surprise when Sonus declared that only one customer accounted for more than 10% of revenues and that –of course- was AT&T.

The second thing was far more interesting. Trunking product revenue declines were guided even lower but, in essence, there is nothing wrong with the SBC market! In fact, Sonus claimed to be taking market share and made very confident growth noises. It claimed its SBC revenue was stronger than had been expected and forecast that by year-end SBC would make up 50% of its revenues.

With guidance that management described as being ‘conservative,’ Sonus predicted third quarter SBC revenue of $17-19 million and a significant increase in the fourth quarter to $22-25 million. The full year outlook was consistent with prior expectations. In other words no SBC slow down here.



What This Means to Acme Packet

The obvious inference is that Sonus is taking market share from Acme Packet and this may be the case. However, we mustn’t lose sight of the fact that Sonus was very positive about the overall SBC market. It may well turn out to be a sweet spot within telco spending and the long term story remains valid. The fears over a slowing in SBC growth due to end-to-end solutions grabbing their marketplace seem unfounded.

For Acme Packet this implies that its core end-market may not be as tough as we may have thought it to be. Perhaps the previous earnings miss really was a case of management being too optimistic in its guidance and maybe not factoring in the strong competition from Sonus which was fighting hard to make up for trunking product weakness. If so, Acme has the potential to come back just in the same way that Riverbed did when it announced results.

It is a tempting idea but there is a slight flaw. Riverbed was cheap on a cash flow evaluation basis before it reported while Acme Packet is not cheap by any measure that I care to consider. However, evaluations are, more often that not, subject to the conscience of the individual investor. So for those comfortable with Acme Packet at these levels, there could be a decent case for an entry point here.

Nordstrom Equity Analysis

n the retail sector there are few companies whose management stands out from the rest. In the mid-market, I think V.F. Corp $VFC has outstanding management and at the higher end, Nordstrom Inc. $JWN also has excellent leadership. What these companies have in common is a drive towards adjusting to the retail reality by investing in things like e-commerce initiatives and changing their offerings in order to deal with the new ‘age of austerity.’ Consumers are getting ever more price conscious, and it is essential for retailers to adjust. In this article I want to focus on the latest results from Nordstrom and put them in the context of the ongoing development of the business and the retail landscape.

I previously wrote about the company in an article linked here which gives a good overview of the strategic direction being taken. I like writing these articles because in doing so, I can create good objective benchmarks for analyzing how companies are developing their businesses. I hope readers find them useful too. Going back to the original article, I outlined the correlation between Nordstrom’s revenue and gross profits and the growth in US net household wealth. We can monitor that in line with the overall economy and that profit driver is largely a strategic consideration.

For the detail of how Nordstrom is managing its company operationally, I previously highlighted a few things that I think investors should be looking for with Nordstrom. It’s time to run the check list.

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

Nordstrom Rack Stores

In adjusting to a slower consumer environment, Nordstrom has been busy rolling out its chain of reduced price stores named ‘Nordstrom Rack.’ It opened 18 new Rack stores in 2011 and another 15 are planned for 2012.

In these results, Nordstrom confirmed the rollout for 2012 and outlined a plan to create 24 new Rack stores for 2013. A graphical depiction of the plans is shown here:

The Rack stores are a growing share of Nordstrom’s revenues and management talked of results that ‘exceeded our expectations.’ Moreover, plans are in place for significant investment in technology in these stores. For example, mobile point-of-sales devices are being added in order to improve the customer experience. In addition, management claimed that the extra Rack stores would only cause a minimal increase in capital expenditures and it appears that these stores are scalable.

Naturally, when any retail company increases the number of its reduced price stores, there is the risk of a negative effect on the overall brand. This is something to keep an eye on but, so far, the Rack stores appear to be complementary to the full price stores. Moreover, they should enable better inventory management in the future and they are a reflection of the times.

With initiatives like free shipping for e-commerce, Nordstrom continues to create a feeling of a high quality of service, and this sort of thing resonates with consumers. I’ve heard other retailers refer to free shipping as being effectively a discount, but they aren’t selling discretionary items to a customer base that values service. Nordstrom is.

Regarding the brand, Nordstrom stores are run along classic lines. There is little of the Abercrombie & Fitch $ANF approach about them. It’s not the kind of store that is going to create a fad out of pumping perfume, loud music and young fashion models in order to create the sensory experience and ambiance of a night club for its shoppers. Whilst that may be a good thing for Abercrombie & Fitch, it is not the sort of thing that would keep Nordstrom customers happy. Brand protection is paramount and Nordstrom does it well.

Check: It’s a thumbs up for the Rack plans.



Integration of Acquisitions and Online Presence

The Direct business saw sales increase by 40% in the quarter following a 44% increase in the previous quarter as the investments in e-commerce initiatives are starting to payoff. As for the acquisition integrations HauteLook’s sales increase for this year is forecast to be between 50% and 60%, and according to the management is running at or slightly above plan. It is reasonable to expect synergies to be created in terms of merchandising and infrastructure and investors have cause to be positive here.

Rather like VF Corp, expanding the online presence is important to Nordstrom, but I think they will find it easier. VF Corp is expanding online into new geographic territories while Nordstrom is a US centric company. In addition, cultural differences count for a lot in retail and the US is a far more mature and more e-commerce savvy region than any other. Nordstrom should find things easier.

That said, inventory growth overall was a little high in the quarter and it is expected to run a little faster in the near term--but don’t be alarmed. Although this sounds like a classic case of working capital difficulties caused by management chasing sales in the short term, there are two plausible reasons. First, inventory ran up because the company was preparing for the anniversary sale (which fell in fiscal Q3 this year so is not in the Q2 results) and because of the Rack expansion plans. If you open new stores you have to have something to sell in them!

Check: The acquisitions are bedding well and the e-commerce initiatives are driving strong growth and creating a differentiation from other stores via the free-shipping policy.



Credit Card Revenues and Metrics

Credit card revenues only made up 3% of revenues in the quarter so why am I obsessing about them? The simple reason is that the metrics around these revenues are a good indication for the wider economy and for trends within Nordstrom’s customer base. The news is good.

Annualized net-write offs as a percentage of average credit card receivables decreased to 4.8% from 7.2% last year and 30 day delinquency rates on credit card receivables were as low as 1.9%.

In case you haven’t heard it yet, American households are really cleaning up their balance sheets. While this is creating some severe price resistance within consumer goods, it is also producing an environment of slow but sustainable growth. It is up to the retailers to adjust to it. As we have seen recently with Coach $COH, this aspect is causing competitors to try to grab market share in new territories. I suspect Nordstrom has more flexibility than Coach. The latter is trying to protect its brand offering of ‘affordable luxury’ while Nordstrom can shift its merchandise offering to the new reality of what consumers want, while continuing to offer them a high level of service.

Check: Credit card indicators are suggesting that the consumer is in shape to start to expand discretionary spending and Nordstrom is making the right moves

McDonalds Equity Research

Donald Rumsfeld once memorably outlined his treatise on metaphysics in his known/unknown speech. Alas Wittgenstein was not around to appreciate it, but allow me to plagiarize and describe the recent same store sales numbers from McDonald’s Corp (NYSE: MCD) as being an unkown unknown. All three major regions comparable store sales were down. In the US they were down .1%, Europe declined .6% and the unusually named APMEA (Asia Pacific Middle East) also declined a worrying 1.5%. Analysts were surprised, as were investors, and you can add a third group to the bemused party: McDonald’s management, because on July 23^rd they were telling the investment community that July same store sales would be positive but less than the second quarter. I’m going to try out Rumsfeld’s metaphysical epistemology and see where it takes me. No one else seems to know what is going on here.



Known Knowns & Known Unknowns

Presumably McDonald’s has pretty decent sales monitoring technology in place so we can take it that the prediction of positive comps on the 23^rd of July is accurate. If so, it suggests that there was a significant drop off in the second half of July. I think this is an important point because it suggests linearity. In other words, a trend is continuing its decline.

Management were keen to blame the macro economy and a worsening consumer environment. I’m sure there is truth in this. I research a lot of company statements, and it is clear that, for example, Spain has had a sharp drop off in the last few months, and I’m told Italy is following it. This is understandable but it neither explains the declines across all the regions nor the linearity within them. Moreover, McDonald’s is supposed to be the great defensive stock. A winner in the new age of austerity and trading down.

To graphically illustrate these points, here is a chart of comparable sales for McDonald’s.

Note how well McDonald’s did in the great recession of 2008-09. Sure growth slowed, but it didn’t go negative, and McDonald’s was a stock market darling in the period. It is therefore very difficult to pin the blame solely on macroeconomic conditions.

The last of our known knowns is revealed by looking at what its competitors are saying. In its last results, released on July 19^th, Yum! Brands (NYSE: YUM) reported same store sales growth of 10% in China, 1% in the US and 7% in YRI (Yum Restaurants International) amidst reconfirming full year guidance. This is nothing unusual for Yum because its focus is on aggressive growth in China. A fact which many believe has caused them to drop the ball in the US. So overall it is not painting the kind of macro picture that McDonald’s is.

Nor is its rival that recently returned to the public markets, Burger King (NYSE: BKW), which reported same store sales up 4.4%. With regards to Burger King, I confess I am a bit skeptical in general about businesses sold off by private investment companies (even if they do retain a large share) that rely on franchising to drive growth.

Wendy’s Company (NASDAQ: WEN) reported a more modest system wide same store sales increase of .7% in Q1 for North America and recently reported a 3.2% increase for Q2. Chipotle’s (NYSE: CMG) recent revenue numbers missed estimates amidst talk of slowing traffic in North America. Unsurprisingly, the stock took a significant hit. Chipotle has its own company-specific niche to play in, but the numbers from Wendy’s, Burger King and Yum for North America were are all pretty similar. All of which make McDonald’s numbers so surprising.

So to recap, what are our known knowns?

McDonald’s comparable sales growth figures are trending down in a linear fashion. The economy is a factor but not as much as the company makes out. Competitors are executing better and are not talking so negatively about the macro-environment

As for the known unknowns, they are comprised of questions like: "To what extent the slowing trend is due to operational issues at McDonald’s?" "Did it expand too much too soon, and is now suffering the consequences of trying to wring revenue and earnings growth out of increasingly unproductive stores?"  "Moreover is this a company specific issue which suggests that its product lineup is stale and in need of a revamping?" "Did (now departed) Jim Skinner’s influence and drive start to wane as he prepared to hand over the reins?"



Where’s the Beef?

I think a clear picture is going to take time to come into focus. The evidence of 2008-09 demonstrates that it can generate growth even in a difficult economic environment. However, investors will need to watch the future commentary very closely in order to learn more of the root causes of this sudden decline.  If it is a question of too much expansion too soon then store roll outs might be scaled back. If it is product offering then more revamping is in order.

I can’t speak with the certainty of a Rumsfeld (few can) but I do think the evidence is pointing to a combination of weak end markets and a competition that just got better. My suspicion is that the competition has stepped up and is grabbing market share via promotions, sales and a more focused value offering. If so then, on balance, I think that McDonald’s can recover from here because these issues are largely matters of execution, but it may take at least a quarter or two to turn around.

Church & Dwight Research Analysis

So it turns out that Church & Dwight $CHD are human after all. After quarter after quarter of beating estimates and causing analysts to raise forecasts, the company disappointed. Q2 EPS was slightly ahead of market estimates but revenues were a bit light. In addition, the EPS guidance for Q3 was lower than market estimates at 58c vs. 61c. So is it time to give up on Church & Dwight?


Product Mix in Personal Care

In a sense it was merely more of the same. In the last quarter, management noted that the product mix of revenues in the personal care division was being skewed toward lower-margin goods. This trend continued in this quarter and was the main cause of the disappointment. However, management pointed out that July had begun well for the personal care division and that consumption had outpaced shipments in the last quarter. This is usually an indication of stronger growth to come. In addition, full-year EPS guidance was maintained.

The main problem seems to be Orajel oral care products, which are traditionally higher margin. Action has been taken and management sounds confident of a resolution to the underlying issues. New products are being launched and I would expect Orajel to make a comeback.


Competitive Markets Remain Competitive

Once you have taken in the full impact of the pearl of wisdom in the subheading, it will then be time to look into more detail as to what happened in this quarter.

Frankly, this sort of thing is inevitable in the fast moving consumer goods (FMCG) category. Competition is fierce and the macro environment is not particularly strong for the mass market. Church & Dwight is a relatively small player in the marketplace that outperforms via a relentless focus on growing and defending its brands within niche markets of FMCG. It offers a significant amount of its revenue in ‘value brands,’ which benefit from consumers trading down.

I always like to compare it with its much larger rival, Procter & Gamble $PG. PG owns some classic brands and its long-term strategy is different. It is usually understood to favor retaining pricing during a downturn -- at the expense of some volume loss -- in order to benefit from not devaluing its brands, so when the recovery takes place it will see earnings leverage. It’s a beautiful idea in theory and it usually works in practice, but this time it really is different.

This recovery is a lot slower and more shallow than normal. As such, consumer behavior is changing. US consumers are trading down and they are shopping more at discount stores. Companies that try to take pricing are suffering volume losses. Even an extremely well run and innovative company like Colgate-Palmolive $CL saw volumes decline in North America when it took pricing on certain product lines.

The result is a highly competitive market where promotions and discounting are tactically used in order to generate market share gains and favorable sales mixes. The old strategic ways aren’t working anymore for a company like PG and so it is reacting and stepping up pressure with categories such as laundry detergent.  Church & Dwight felt the pressure in this category in the last quarter and I note that Clorox $CLX also declined on these results in an otherwise strong day for the market. Clorox has had administrative issues to deal with in the past and now looks set to face stronger competition from PG.


Great Companies or Great Investments?

You should always look for both and for the last few years the household and personal care sector has offered both, but investors are entitled to ask how much longer the market will give high teens to low 20s PE multiples for companies growing earnings in single digits.

Church & Dwight has usually commanded a premium over Clorox, PG et al because its cash flow conversion is very strong and its management has a track record of doing what it takes to get growth. The new products in personal care due to be released in the second half, as well as the commentary on current trading, suggests it can do it again.

It’s hard to argue that Church is not fairly valued right now, which means that it is likely to "do its earnings" going forward. No matter, the recent pull back could create a decent buying opportunity because companies with this kind of track record should not be taken lightly and the economy continues to move in Church & Dwight’s favor. Well worth watching closely particularly as the ultimate value creator could be that the company ends up being taken over by one of its much larger competitors.

Housing Recovery Stocks

There are signs that the US housing market is making a slow but steady recovery, and if it continues the sector will be attractive in an uncertain global economy. Investors need to be careful to avoid exposure to the Chinese housing market and continued weakness in Europe; however, there are plenty of US centric opportunities out there. In this article, I want to give a few reasons why I think US housing is coming back and suggest a few names for further research.



Evidence that US Housing is coming back?

I’m not going to go into the theoretical argument in this article, sufficed to show some data which I think supports the case. All the data is sourced from the US Census Bureau.

First, Housing appears to be coming back.

Second, the data suggests that the supply of new single family houses is starting to get to low levels. Incidentally, the dotted line is the average for the period in question.

Note how it starts snaking up in 2006 as the bubble starts to burst. Interestingly, we are getting back to pre bubble rates.  I appreciate that this data doesn’t capture the shadow inventory of foreclosed homes, but the effect of this inventory will be felt on prices. And the latter appears to be recovering.

I’m going to stick my neck out and say that the recent dip in pricing is probably a consequence of the pull-forward effect of the unusually warm winter in the US. In other words, people may have gone house hunting a bit earlier. Moreover, while prices have risen before in the last three years, they weren’t accompanied by the kind of positive trending data we see in the previous two charts. Perhaps it really is different this time?



Stocks to Play a Housing Recovery

The house building stocks go without saying as an option, but I thought it would be interesting to look at some of the more derivative type names. Again, investors need to be discerning here and try to focus on US centric plays.

I’m a bit of a fan of Home Depot $HD. It has seen profits and margins rising even though its management refuses to attribute any of this to a housing market recovery. I think we need to take them at their word, which means that there should be upside potential here. Unfortunately, analysts do not always do that and they love the ‘join the dots’ mentality, which means the unusually warm winter encouraged a bit too much optimism earlier in the year. I have a detailed article on the subject linked here. No matter, the stock remains cheap on a cash flow basis and the dividend is useful too. Naturally, another option is its rival Lowes.

If you like the theme of buying into the home improvement retailers, then why not look at what is being sold in them? Stanley Black & Decker $SWK is a company I intend to look at very closely in future. It has a very large market share in hand and power tools for the DIY market in the US. Unfortunately, it has had to lower estimates recently due to currency headwinds, and it does have international exposure. However, any company in a favorable sector that is telling you that it expects to generate $1.2 billion in free cash flow (10% of its market cap) is worth a look!

Other stocks related to the home improvement retail sector are Fastenal $FAST and Pier 1 Imports $PIR. I’ve detailed both of these stocks at length so potential investors might find the following useful. Here is an article on Fastenal and an article on Pier 1.

For different reasons, I’m a bit concerned about both, but they may attract others. Fastenal has exposure to the industrial sector too, and it never appears to be a cheap stock, although its growth rates have been exceptional. As for Pier 1, this is a truly fantastic turn around story but I wonder how much longer it can go on. In addition, its internet strategy may well end up cannibalizing its own stores. But hey, I wrote that at the time of the original article. It then soared. So what do I know?

Another stock I like is Wells Fargo $WFC. It may not appear to be the most obvious choice, but this bank has been aggressively moving (organically and by acquisition) into the US mortgage market and I think therefore is a good play on housing. In addition to balanced portfolios it offers a good way to get exposure to the financial services industry while avoiding some of those firms whose interests are not necessarily aligned with shareholders. I only invest in companies that represent my interests, not those trying to game me in order to line their own staff's pockets. We own the company, not them. Here endeth the sermon!

Other options in the sector include something like timberland owner Weyerhauser or its rival Plum Creek Timber Co, although the timber companies are also exposed to other cyclical industries such as paper and packaging. Investors with a bit more stomach for risk may also like the look of Masco or Whirlpool, although the latter has extensive international operations.



The Right Time To Get In?

As the data in the charts above indicates, the housing industry has the turning radius of an oil tanker on ice. Note that the housing recession started in 2006, and it took a year or so before it significantly affected the wider economy and two years before it really hit home. These things take time to play out, and all the while you will have people willing to take the other side of the trade. This is the good news, because it should keep good value opportunities available. If you think that the housing recovery is tangible then many of these stocks look like good value, in my humble opinion, and it is not too late to get in.

Coach Losing Out to Michael Kors?

Coach $COH recently delivered results below market estimates and the stock took the equivalent of a violent hand-bagging from a demented harridan. The problem appeared to be limited to North America, where sales rose a paltry amount amidst strong competition and a declining market share. In comparison, international operations did fine. So is this a temporary setback or is there a more fundamental issue?



Coach Occupies an Enviable Niche

I’ve long been interested in this company for a few reasons. I’m fascinated by how it has managed to establish itself as a leading brand in Asia. I’m also struck by the marked cultural difference between US and European fashion brands. In general, US brands don’t seem to be able to exist while being focused on price, whereas European retailers are focused more on quality retention. In the US, if the price is right, the consumer will judge the quality. In Europe, if the quality is right, the consumer will judge the price. In terms of the luxury market, Coach is something of an anomaly and as a consequence has carved out a very profitable niche.

Its handbags are not of the quality of a Louis Vuitton or Richemont brand. Nor is it close to one of the leading Italian brands, or Burberry or even a small independent like Mulberry. However, to be fair, it isn’t trying to be. It operates in the middle ground, which analysts like to describe as "affordable luxury." The beauty of occupying this space is that you can drive margins higher by shifting production into China or Vietnam, etc. Any corresponding loss of quality or cache is fine as long as you compete on price. It is not the same thing for the leading European brands. Alas, only one who dates high maintenance women would really know so much about how these things work.

Speaking as one who dates high maintenance women, I can assure you that Louis Vuitton bags are bought strictly for their quality first and then price second. Coach bags are bought and used as everyday bags. All of which leaves Coach in an enviable position. It can expand margins via cost cutting (without driving customers away) and it can pursue its international expansion into the fast growing Asian market.



And Others Have Noticed

Unfortunately, it appears that others are gunning for this niche, and Coach’s problem is that it can’t really defend its market share on price (already relatively cheap) and innovation, and new product launches will likely trim its margins. In particular US mid-market brands like Michael Kors $KORS and Ralph Lauren $RL appear to be eating away at Coach’s market share. Kors is expanding its handbag sales and both these companies are of a similar standing to Coach in terms of consumer awareness and cache.

In the recent conference call, management cited increased promotional activity by competitors and a decline in traffic at its factory stores, which they believed was primarily responsible for the slowdown in North American sales growth.

Frankly, I think this is an issue and it might not go away unless Coach matches promotional activity. As I have tried to argue above, competing on quality doesn’t tend to trump pricing with the US consumer. That said, Coach has recently introduced the Legacy brand, about which the company seems very excited. However, it appears to be a more leather oriented suite of products. Of course, the margins on leather bags tend to be significantly lower than those of canvas (note how Louis Vuitton innovates with the canvas bags to drive sales) so I would expect some margin compression with the Legacy brand.

It’s not surprising that Coach’s CEO expanding the Legacy brand into non-handbag products such as jewelry, watches and scarves. These items traditionally have huge profit margins, but Coach needs to be very careful it doesn’t denigrate its brand.  With more than two thirds of sales originating from US stores, these challenges are significant.



Putting North America Aside

Otherwise, the earnings report was pretty good. China sales were up a whopping 60% and total company sales increased 13%. Coach is a very strong brand in Japan and sales were up 16% in constant currency. As is usual with luxury companies these days, Asia is the focus and Coach is committed to opening 30 stores a year in China. It also announced it would be buying the domestic retail business in South Korea from its current distributor. Indeed, the forthcoming fiscal year was described as being an ‘investment year.’ Much of which will be focused on Asia, but Coach is also expanding its men’s products sales and investing in e-commerce initiatives.

The e-commerce initiatives are not going to be on the scale of what a company like Nordstrom $JWN is doing, but then again Nordstrom does not have the issue of possibly competing against its own products within distribution channels. In plain English, this means Nordstrom will likely have more control over differentiating what is discounted online, whilst Coach needs to protect its brand overall.

On a more positive note Coach is highly unlikely to suffer the kind of faddish sentiment that seems to be affecting Abercrombie & Fitch $ANF at the moment. Sure you can dream up a marketing gimmick and pump perfume and loud music and customers in order to create a ‘retail experience’ and then sell them a product whose quality can easily be matched elsewhere.  This will work for a while, but as Abercrombie is finding out, you need to change the act if you want to keep bums on seats. No such issues for Coach.



Where to Next for Coach?

The stock is certainly not expensive and its management has a history of delivering. The initiatives all make sense and Coach remains a well regarded brand in some very fast growing international markets. The question is, under the heat of competition, just how strong is its brand in the US?

Moreover, is the age of the US consumer deleveraging and trading down going to erode margins? I suspect we have seen a sign of this in the latest report and cautious investors might want to wait a while before seeing how successfully Coach is reacting to the new competition trying to take its profitable niche away.

Harley Davidson Equity Analysis

It’s hard to find a purer play on consumer discretionary spending then Harley-Davidson $HOG and it’s always useful to look at it as a kind of barometer for spending trends in the global economy. In terms of growth prospects, brand recognition and sheer love, the HOG has few rivals as a brand and it has the opportunity to grow sales internationally.

However, its growth will vary from region to region and I’m not just referring to macro issues. Simply put, energy guzzling recreational vehicles are not the flavor of the month in every country round the world. As for the US, growth prospects are due to a mix of trends in discretionary spending and credit availability.


What Happened with the Latest Results? 

The results were slightly below analyst estimates but I think there are a couple of mitigating factors.

Firstly, estimates may have been too high thanks to other stocks in the discretionary vehicle segment reporting blowout numbers recently. Namely, Polaris Industries (NYSE: PII) and Arctic Cat (NASDAQ: ACAT). Interestingly, the latter recently beat estimates with revenues rising 49% in the quarter. In addition, Polaris is also doing very well with North American retail sales rising 17% in the last quarter. Both these stocks beat estimates so it is not surprising that expectations were high for Harley-Davidson. Perhaps too high?

Secondly, in common with so many other weather-sensitive retail stocks, sales were pulled forward in to Q1 due to the unusually warm weather in the winter. This has likely caused too much optimism to be baked in. No matter, sales were pretty good and management noted that credit losses were at their lowest levels for 10 years. The US consumer continues to deleverage and adjust to more sensible and sustainable lending. Gross margins saw a slight rise but management expects them to fall in the second half, primarily as a consequence of a strengthening US dollar. In order to demonstrate the latest numbers and how they fit into the long-term picture I’ve graphically demonstrated some data here.

Management clearly believe it is a "pull forward" effect, because they didn’t adjust their guidance for global sales of between 245-250k motorcycle shipments. A breakdown of motorcycle related revenues by halves illustrates the underlying strength.

In terms of market share Harley is doing well in the US although it noted pricing competition from Honda in Japan.


Growth Prospects Outside of US Motorcycles

US discretionary spending is not only linked to things like employment gains and GDP growth; it is also a function of credit availability. I doubt anyone wants to go back to mid 2000’s levels of credit issuance, but there is a real case for saying that credit companies are being too conservative right now. As Harley-Davidson pointed out, its loan losses are at historic lows and financial services income is starting to kick in here.

I would expect these improvements to continue. Moreover, Harley has earnings growth potential from productivity improvements and the implementation of its new ERP system. However, the real wild card here is international sales.

Theoretically, this slice of Americana should be ripe for a massive expansion overseas and the company is certainly planning for it. My concern is that it maybe focusing on the wrong areas. It is de rigueur to target China and India but thus far the Chinese have been assiduous in insisting on fuel efficient vehicles and promoting their own electric and solar powered vehicles. Frankly, I don’t see this changing anytime soon. As for India, motorcycles are already part of life there and Harley will face pricing competition from local competitors. The one area that I’m confident Harley will see very strong growth in future is in the Middle East.

It is puzzling why management don’t focus more on this region in their commentary or plans. If there is any region on this earth that is immune to fuel efficiency concerns and has the highways and moneyed populace in order to buy Harleys, it is the Middle East and Gulf. In addition, Americana and the Harley-Davidson brand are extremely popular amongst the educated parts of the population. Unfortunately, it is not the largest region to target but nevertheless the growth potential is very strong.

Where Next for Harley-Davidson?

The underlying indications are rather positive for Harley-Davidson in the short term, however in the long term the question remains over its compatibility in a world of rising oil prices and consumers desiring fuel efficiency. I suspect for these considerations the stock will remain relatively cheap.

In the mid-term investors can look forward to better US credit conditions leading to increased contributions to profitability from the financial services division. In addition, the ERP implementation appears to have been made successfully so working capital and margins should improve going forward. I suspect international sales growth will be mixed with southern Europe a particular concern.

In conclusion, if we look across the sector, US consumer discretionary spending seems to be doing ok. At least it’s a lot better than the headline makers in the media are suggesting.

The Best Stocks to Buy in the Animal Health Sector

I think everyone is familiar with a stock pitch or a research report that mentions ‘favorable demographics’ as a key earnings driver. I certainly am. In fact, I’ve written articles that use the phrase, so I have no axe to grind on the issue. On the other hand, I think it is sometimes used to describe sectors like healthcare that so obviously have favorable demographics that the fact itself starts triggering a political or consumer backlash, which threatens the profit potential of the firms. Think of healthcare and reimbursement issues. In response, perhaps the solution is to find a demographic trend that operates underneath the radar of political action? I think the animal healthcare market is an option, and investors would do well to take a closer look.

I know some readers will be puzzled by why animal health should be demographically favored. The reasons are twofold. On the food side, the creation of a whole new middle class across myriad emerging markets will create an upsurge in the demand for protein, if historical trends are borne out. Inevitably, this will create animal health issues. Secondly, declining birth rates, increasing divorce rates, decreasing marriage rates and increasing numbers of single parent families will encourage the purchase (particularly in the developed world) of a furry friend in order to supplant emotional attachment to a partner or a kindling. Sad but true.

It’s time to look at a few investment options.



VCA Antech Disappoints

VCA Antech $WOOF is an owner and operator of animal hospitals and also runs clinical laboratories (veterinary only) throughout the US.

A quick look at revenues and gross profits:

Clearly the lab division is the highest margin business, but its revenues largely depend on footfall at the animal hospitals. Unfortunately, the story hasn’t been so positive lately here and particularly in the last quarter. Headline revenue growth in animal hospitals was up 17.4%, but most of this was due to acquisitions. The real story is told by same store revenue growth, which was only up a paltry .2%.

In addition, animal hospital adjusted gross margins fell to 15.2% compared to 18.2% last year.  Lab revenues only grew by 2.6%. As such, the company guided full year earnings to the lower end of expectations and the stock got hit hard. So what is going on here?

I think there are a couple of possible issues. The first is that the warm winter encouraged some pull forward in hospital visits as owners were more inclined to take their pets for operations/check ups then they seasonally might have done. Indeed, VCA did see a pickup late last year and then again in Q1. All of which created positive optics, encouraging some false optimism. No matter, weather effects are transient and it could be argued that the fall is a buying opportunity.

The second is that with this type of business, when a leading company gets involved in purchasing lots of smaller independents and consolidates them, the transition is rarely without disruption. For example, VCA is clear that it is not the cheapest animal hospital option so it may have faced resistance from the existing client base. Moreover, a purchaser cannot assume that it will be able to tap into the long running relationship that an animal hospital has with its client base. If the key staff have retired or a change of ownership has taken place, clients may well go elsewhere.

Of course, the company is saying that it believes it is largely to do with the weaker macro-environment and certainly the likes of Home Depot have seen this seasonal ‘pull-forward’ effect in its revenue numbers this year. We shall see.



Idexx Labs and PetSmart

One company that is somewhat backing up what VCA (and Home Depot for that matter) said is Idexx Laboratories $IDXX. It declared that patient visits grew by 4% in the last quarter with practice revenues growing by around 5.5%.  This seems fine, but it is a deceleration from numbers of 5% and 7% respectively in Q1. 

As for Idexx, I have long liked this company and I love the sector. Unfortunately, so does everyone else.

A good salesperson usually pitches the benefit of a product or service before he mentions the price. However, someone on a beer wallet doesn’t walk into a champagne store. In other words, should investors in this environment be paying 30x earnings or an EV/EBITDA ratio of 17.3 for a company forecast to generate low teens growth for the next couple of years? Not to mention one that has just lowered its full year guidance. I suspect the market likes the stock because of its focus on companion animals (83% of sales) and its growing diagnostics business. However, every stock has its price and it’s hard to argue that Idexx is good value.

Another stock that is good value in the sector is PetSmart $PETM. The trailing PE ratio of 24 makes it look expensive, but this company is very good at converting earnings into cash flows. Forecast growth rates look very impressive and the company appears to be able to do no wrong with revenues up 9.4% and gross profits up 12.6% in the first quarter.

I like this business and its prospects, however investors need to factor in a margin of safety, because in reality it doesn’t have a large business moat. Once a company like Wal-Mart $WMT decides to expand its offerings in any one category, the incumbents can expect to feel the pressure. Indeed, there is probably no other organization on earth that has a better handle on demographic changes and its effects on consumer spending than Wal-Mart.

The good news is that (so far) this hasn’t happened and PetSmart continues to perform. Gross margins expanded in the last quarter and the company is ideally placed to capture the top-line drivers discussed earlier. PetSmart will give Q2 results on August 15, and I would urge a bit of caution here. Home Depot, Idexx Labs, VCA Antech and, for that matter, Wal-Mart too have all seen this pull-forward effect due to warm weather, and it wouldn’t surprise me to see PetSmart report the same thing.



What to do With the Sector?

In conclusion, these are great companies operating in favorable long term end markets. VCA Antech is the most attractively priced and has a good balance of upside exposure plus competitive moat. However, it might be worth waiting to see if its issues are purely macro or due to some acquisition turbulence. Idexx is not cheap, but then again it never is.

As for PetSmart, investors would do well to look out for the next set of results. For those investors interested to look further afield, I would suggest taking a look at Dechra Pharmaceuticals in the UK and Virbac in France.

Sirona Dental Systems Equity Research

One of the things that we know we should be doing in equity investing is taking a long term view and, not getting seduced into looking at monthly or quarterly movements. I think this is an argument that should be applied to Sirona Dental Systems $SIRO. In summary, this is an attractive company with a technological edge in markets with very favorable long term demographics. In true Teutonic style –which belies its origins as a spin off from Siemens $SI - the company invests heavily in innovation and R & D because it knows it has a quality advantage that generates tangible return on investment (ROI) for dentists. The stock deserves a wider audience.

Before discussing the recent results, here is a brief primer on the company.

Sirona's Earnings Drivers

Sirona has two key profit drivers.

Firstly, the aging demographic. As people get older they require more dental maintenance. Furthermore, as older people tend to have more frequent tooth decay, dentists can expect more restoration work. Sirona should see more demand for its products due to aging. Secondly, its proprietary technology currently has low market share and, provides dentists with many cost and quality advantages. Whilst the demographic argument is well known in healthcare plays, it should carry more weight with Sirona because of a relative lack of insurance reimbursement issues with dentistry products and solutions. Indeed, the industry is shifting towards private from public pay and, much of what Sirona does is aimed at the high end of the private market.

Just like its former parent Siemens, Sirona doesn't skimp on R & D and spends around six to seven percent on it every year. Recent investments include $15m in setting up a major new innovation center in Germany. The balance sheet is solid, having seen the company engage in deleveraging the business over the last few years and it converts earnings into cash very well.

Who is Sirona Dental Systems?

Sirona is best known for its CAD/CAM system Cerec, which allows dentists to make a tooth restoration in a single client visit in 95% of cases. This is good because the patient gets an immediate treatment as opposed to a seven to ten day wait. The traditional system requiring a restoration created and then fitted in a second visit.

Among Sirona's distributors are companies like Patterson $PDCO  and Henry Schein $HSIC who have helped establish the Cerec system into low double digit penetration in developed markets. Although impressive, it does suggest that there is plenty of room for growth. In fact Sirona recently announced that it was extending its partnership with Patterson in the US to include all of Sirona’s products. Henry Schein remains its most important distributor in Europe. For those worried about moats, it is a proprietary system which is backed up by patents and Sirona's research leadership.

Both Henry Schein and Patterson should be buoyed by these results and I think other companies such as Align Technology $ALGN have demonstrated recently that the dental health care market is relatively recession resistant.

Regarding Cerec’s cost effectiveness in an age of austerity, clearly many dentists will balk at paying the sticker price of $100-120k for the system but it delivers a demonstrable return on investment. Sirona estimates that with 25 restorations a month, the cost savings of using the Cerec system should pay for itself within one year. Nevertheless, it is not hard to see that penetration has begun within the higher end practices. For less active practices, Sirona has Cerec Connect, which gives dentists the option to tap into the Cerec technology but at a lower initial cost. 

The second most important product line is Imaging Systems, and the company continues to see good underlying growth here as dentists shift to 3D from 2D imaging systems. Sirona has 40-45% penetration in this market place. Although this level seems high and therefore prohibitive to future growth, the 'penetration' actually refers to at least one sensor in the practice. Therefore, Sirona should have the opportunity to be able to sell more of them into this established base. Sirona tends to sell a few sensors into a given practice after establishing a presence.

Sirona's treatment centers are focused on the high end and have seen a resumption of growth as the economy recovers. Demand growth was stronger in Asia and Europe (Sirona is very strong in Germany) and I would expect this to continue as dental surgery for cosmetic reasons is something that the wealthy can afford. Another attractive feature of this segment is that it is focused on geographies (Germany, US, Asia) which are doing relatively better in the current economy.

The last (and smallest) product line is Instruments, which is also the lowest margin business. In fact, it only contributed 8% to gross profits in the quarter. This product line is the most challenging due to its not being able to offer any particular technological advantage.

What Happened with the Latest Results?

Sirona reported a strong set of results which were masked by unfavorable currency effects. No matter; the market ‘got it’ and sent the stock up sharply. Here is how currency movements affected results.

The negative contributions from currency mask some strong underlying growth.

In fact, Sirona raised its constant currency revenue guidance to growth of 8-10% from being at the ‘upper end’ of 6-8% previously. We can see just how good these results are with a longer term view of revenues.

Note that in Q3 2011 the company launched a new imaging product and saw outstanding sales at the International Dental Show (IDS). Ultimately, this meant that this quarter came up against a very tough comparable, but if you look at the sequential movement it is way ahead of the movement between Q2-Q3 in 2010.

The Bottom Line

I like the long term prospects here. CAD/CAM Cerec can expand penetration rates in the long term and imaging system sales should follow as the company sells into its installed base and benefits from the move to 3D. Treatment center revenues are favorably positioned in geographic regions and I would expect more growth to come. With this being an investment year, Sirona looks set to expand earnings and cash flow in the next few years. Indeed, analysts have forecasts for high single digit growth in revenues and low teens earnings growth. The company remains highly cash generative and could be set for appreciation once the market appreciates the long term story.

Cisco and Polycom are Competing in Tough Markets

In recent months the markets have been selling off enterprise technology stocks as if we were about to enter a dark age of Luddite supremacy where we end up turning to the Amish for advice in how to live in this brave new world. Fortunately, it doesn’t work like that.

However, in a slowdown corporations will change their IT spending habits. They will focus on maintenance spending or critical IT spending. Also, they will mainly want to buy products that have a demonstrable return on investment (ROI) and/or can be easily shown to generate cost efficiencies.

What they will not do is invest in expansionary or discretionary IT spending, which could be seen as an unnecessary expense. I think that video conferencing and unified collaboration is arguably an example of the latter.


Video Conferencing Marketplace

Now I know what you are thinking, but you would wrong. I’m not about to launch into a diatribe on the pointless nature of this technology. On the contrary, I think it has great potential. Globalization is challenging many companies' administrative ability to keep up with the adoption of new regions for sales and manufacturing activity. Moreover companies can use this technology to generate productivity improvements from their staff and manage things like inventory much more efficiently.

That said, the reality is that companies have spent the last few years generating a good part of their earnings growth from productivity improvements via cost savings and avoiding hiring unless completely necessary. They haven’t been splashing out on aggressive expansion. Unfortunately, video conferencing is not seen as a ‘must-have’ technology as it usually implies expansionary spending and it’s also hard to demonstrate productivity improvements with it. In other words, the CIO might ‘get it’ but will he get sign off from the CFO or CEO?

Another reason why CEOs might be reluctant to countenance such expenditures is that cheaper, albeit less practical, solutions abound with things like Microsoft’s $MSFT Skype. When you see global news networks using Skype, it is hard to get too excited about kitting out your global offices with expensive Cisco $CSCO or Polycom $PLCM hardware. Ironically, Microsoft is a partner of Cisco.

In addition the inexorable rise in usage of mobile internet and corporate smart phones means that expenditure is likely to be shifted in the direction of connecting staff via these devices than linking up via meeting rooms.


How is the Market Faring?

According to industry analysts the biggest single player is Cisco with around 50% market share and then comes Polycom with a bit more than half of that.  Other smaller competitors include Logitech $LOGI. I’m going to focus on the top two players.

Here is how revenues are developing for Polycom and for the segment of Cisco (collaboration) that largely contains videoconferencing (telepresence). Note that the last results for Cisco are actually for Q3 but I have adjusted to a calendar year to ease comparisons.

I have labeled Polycom’s revenues because they recently gave results. The last figure of $379m actually beat estimates handily but the next two quarters guidance was a disappointment. Granted the company is divesting its enterprise wireless solutions business so those numbers will drop out comparisons, but the guidance for Q3 revenues of $325-335m and $355-365m for Q4 looks a light. It’s hard not to conclude that revenues are in decline.

Of course, much of this decline is already in the price of Polycom because it is a pure play on the marketplace. In its defense the company is innovating and hoping to release a collection of new products in the second half, which are intended to take market share from Cisco.

As for Cisco, the failing revenue trend raised questions about the efficacy of its purchase of Tandberg Television. It does seem to have been the wrong strategic move. In a similar way perhaps Logitech is regretting its purchase of Mirial?


Where Next?

Frankly, things look tricky. This isn’t a favorable environment for this type of technology. Polycom is doing the right things. Innovation may help it generate future sales growth via grabbing market share and the company is clear that it is gunning for Cisco. It is also divesting a non-core asset. However, competitive and declining end markets usually spell more trouble down the line.

As for Cisco, we will have to see what John Chambers says on the subject in the next result. This is one of Cisco’s largest segments and it’s hard to envisage the company standing buy and losing market share.

Unified collaboration’s day will come but it will be when corporations feel good about expanding discretionary spending. That time isn’t now. Moreover, structural changes in mobile usage and communication may supersede the core demand for video conferencing in future. Investors will have to ride the downturn before things get better and then who is to say Cisco and Polycom will be the winners?