Time to Buy Mead Johnson?

I write these articles as part of an investment process I make with my own money so unlike most writers, my conclusions are likely to be more towards not buying a stock rather than piling in. I’m not going to apologize because that is the way it is supposed to be. Investors shouldn’t buy every stock they look at immediately and sometimes the process can take months, years, or never. I mention this with regards to Mead Johnson's (NYSE: MJN) latest set of results that were received poorly. I like the stock and the sector and suggested it was worth monitoring in an article linked here. So it’s time to do just that. Is it time to buy in?

When Richly Priced Stocks Fail

The last time I looked at this company I remarked that I didn’t feel like paying an enterprise value that was 16.2x EBITDA when Nestle had paid 20x EBITDA for Pfizer’s (NYSE: PFE) nutrition arm. In any case, Nestle paid a high price but there isn’t enough of a premium – Danone is rumored to have also been interested- to make Mead Jonson look cheap. Moreover, Pfizer’s divestiture was part of an ongoing restructuring program. It wanted to sell. All of which led me to conclude that Mead Johnson was expensive and we all know that richly rated stocks will fall hard if they disappoint.

Unfortunately, Mead Johnson did disappoint, but what was the underlying reason for it?

Was it the Market or Was it Mead Johnson?

With this sort of question you have to appreciate that global market conditions do affect operational decisions at companies. In other words, the market does- despite whatever a deluded management consultant will tell you- shape companies operational and administrative strategies.

In this case, Mead Johnson is faced with some global competitors of which, it is the only pure nutrition play. Nestle, H.J. Heinz (NYSE: HNZ), Danone and Abbott Labs (NYSE: ABT) all compete in the space. They are global companies with the resources to subsidize grabbing market share in key growth markets. Danone is the market leader in infant formulation in China, and is usually viewed as the best positioned within emerging markets.

The story of the last quarter was consolidated decline in the developed world coupled with a slowing of growth in emerging markets like China. The US is slowing primarily because of declining birth rates and a sluggish economy while its European operations are also dealing with reimbursement changes as governments seek to cut expenditures.  Throw in slowing growth in China –caused by a slowing economy and a reduction in consumer confidence- and you have the perfect conditions for a cut throat price war as multi-nationals fight hard for positioning.

Unfortunately, while these forces were taking shape Mead Johnson was increasing prices, a bad move which cost it around 3.5 points of market share and it has been fighting to recover that lost share while dealing with lower than expected sales thanks to its distributors taking longer to run down inventories.

What the Industry is Saying

A quick look at the most recent reports from its rivals reveals much about how competitive the last quarter was. Within baby nutrition Danone managed to record a global 3.6% rise in volume and 7.9% growth in value leading to overall growth of 11.5%. This may seem good, but consider that the previous period saw 7% volume growth with a 6.6% growth in value. In other words, volume growth slowed down in relation to value in the last quarter.  This is what you might expect in a price competitive environment. With regards to China, Danone has an excuse in that it is completely revamped its market leading Dumex range of products.

Turning to Heinz it’s impossible to see exactly what its nutrition sales were to emerging markets (they are not broken out) but it’s fair to assume that the near 20% rise in organic sales to emerging markets contained a large amount of growth from nutritional sales. We know from subsequent presentations that nutrition makes up around 10% of sales.

Another company worth looking at is Johnson & Johnson (NYSE: JNJ) whose baby care products are a kind of proxy for overall spending in the infant sector. Frankly it has been under performing in baby care in the US for a while now and this is in line with the general weakness in the US. However its international baby care sales were negative in the last quarter too. This suggests that the infant sector might not be as recession resistant as many people are hoping it will be.

Last but not least is Abbott Labs which appears to be firing on all cylinders in the category. Its pediatric nutritional sales in the US were up 15.9% and on a constant currency basis its sales were up 7.3%.

Conclusions?

I suspect the likes of Abbott Labs, Heinz and Danone have taken market share from Mead Johnson. The latter chose the wrong time to implement aggressive price increases and its management spoke of ongoing aggressive price discounting in China. The good news is that via increased promotional activity and increased focus on trade execution Mead Johnson is claiming to have recovered two points of the market share loss. The bad news is that its traditional strategy of holding pricing is likely to come under pressure as others continue to discount.

Constant dollar sales guidance has already been lowered from 8-9% toward 6-7% for the full year and the near term trend of the economy in China and socio-economic climate (birth rates in the US & Europe) is not in its favor either.  I suspect things will get worse before they get better for the company and how many times have we seen managements be overly optimistic about timescales for customers running down inventories?

Moreover, on a PE of 23 and weaker prospects, the stock is still far from value. If the market falls out of love with the long-term-emerging-middle-class-in-China growth story than it could get a bit cheaper yet.  I happen to buy the story and think that Mead Johnson will probably get through this difficult patch okay but, I don’t think now is the right time or evaluation to chase the stock.

High Yield Stocks That Have Increased Dividends for 40 Years

Dividend investing is certainly back in vogue these days. With the Federal Reserve committed to keeping interest rates low, there has been an increased focus on good old blue chip dividend-paying stocks. I previously discussed 15 stocks that have raised their dividends over the last twenty years in an article linked here, and those that have raised them over thirty years in this article.  Now it’s time to do the same for those companies that have increased dividends for forty years.

While it’s never advisable to buy stocks just for their dividends, a long term history of paying dividends implies a management focused on delivering shareholder value by running the company in the owner’s (your) interests.

Here are the 15 stocks I have selected. I’ve tabulated the current yield and a column of ‘current D/Forecast E.’ This column is to better gauge the capacity for dividend increases in future. The lower the number the more the potential for dividend increases.

Even though I’m not the biggest fan of dividend investing per se I can appreciate that if you want a long term income then analyzing the reasons why these stocks have increased dividends for so long is very important to you. With that in mind let’s look in more detail at some of these companies.

Go for the KO

No prizes for guessing I am talking about the Coca-Cola Company (NYSE: KO) here. Warren Buffett’s favorite stock holds the quintessential moat of one of the most powerful brands ever. While it is essentially just flavored water it also represents a piece of Americana that is globally recognized and aspired too. These points are critical in a long term yield seeking investment in Coca-Cola. I would look at this stock as a global ‘GDP plus’ type growth play. In other words expect it to increase earnings in line with GDP growth but throw in some extra for increasing penetration rates in underdeveloped markets. There is the issue of increasing health concerns reducing demand for sugar laden beverage, but the brand retains its power and the company is highly innovative in introducing sugar free drinks. Considering how low US long bond yields are I think Coca-Cola is a relatively good purchase.

Here Kid Take Some Mouthwash

I’m still not giving prizes out. Colgate-Palmolive (NYSE: CL) is another iconic American company and I think in a few years time MBA students will be nestling to read case studies of how this company has successfully leveraged the power of its brands in recent years. I’ve discussed the company at length in an article linked here.  It has led the marketplace in innovation in personal care and cleaning fluids by launching new fragrances that create instant rapport and curiosity with customers. Similarly in oral care innovations like optic white toothpaste and whitening mouthwash have long to strong customer acceptance. Just like Coca-Cola, I think its long term growth prospects can be defined as being ‘global GDP plus’. Unlike Coca-Cola it has a lot more competition in its various end markets so perhaps its current valuation is a little high.

A Lowe Blow

No, this isn’t anything to do with Andrew Golota. Lowe’s Companies (NYSE: LOW) is an interesting stock right now. Along with Home Depot it dominates the home improvement market in the US, but unlike its rival it has not been managing its operations to its full potential. Gary Player once said that the harder he practiced the luckier he got, but I think with companies sometimes the luckier they get the easier will be their practicing. In plain English, when end markets are favorable it is a lot easier to adjust operations. More than a few companies have been saying positive things about the housing market recently and it’s time for Lowe’s to take full advantage.

Pack a Powerful Punch

Just as with Lowe’s, an improving housing market means that things should be looking up for power tool manufacturer Stanley Black & Decker (NYSE: SWK). With that said it’s actually been a choppy year for the company. It has a large share of the market for hand and power tools in the US, but it also has significant European exposure and it may face increasing competitive pressure from home improvement stores developing their own tools and crimping margins. Of all the featured stocks I see this as being the one with the hardest visibility. Will it increase its dividend for the next 40 years?

An Explosive Finish

Nope, nothing to do with Finns brandishing Molotov cocktails. Mine Safety Appliance (NYSE: MSA) is -as the name suggests- a world leader in manufacturing and supplying safety products to the hazardous workplace. Theoretically this makes it a correlated play on growth in industrial and commodity output with a kicker from increasing safety regulation requirements. However it is not that simple.

The company had previously built up some non-core businesses of which it has now divested (ballistic vest and North American ballistic helmets) in order to drive growth in its core product range. Moreover, slowing industrial demand and the fall in hard commodity prices this year is challenging growth assumptions here. It is a tricky outlook near term and longer term the shift of industrial production to the Far East could cause issues.

Textron Research Analysis

Textron (NYSE: TXT) delivered a mixed quarter, but increased guidance. The market focused on the former and sent the stock down, but there has been a bit of a recovery since. In summary, Textron remains a play on North American spending and while the media attention usually focuses on its Cessna business, it’s actually the Bell helicopters segment that traditionally produces the bulk of profits. In addition, there are a lot of moving parts to Textron’s prospects, and investors need to be aware of them.

Introducing Textron

It’s easy to get trapped into thinking that Textron is really all about Cessna business plus a bit of military spending. On closer analysis, there is a lot more going on.  For example, here are the segmental profits on the manufacturing side.

See what I mean about Bell’s importance?

Interestingly, with the exception of Industrial, all the segments have over 70% of their sales in the US. This surprised me as Bell helicopter is a commercial and military supplier while Cessna claims to be the world’s leading general aviation company (unit sales) and has global recognition.  One company worth looking out for in this regard is Ametek (NYSE: AME) which has Textron as a major customer within its aviation sales. Interestingly, Ametek is seeing business and regional jet sales to be up low double digits on an organic basis and its outlook appears to match that of Textron's with regard to business jets.

Textron Systems is largely a manufacturer of defense and aviation mission support systems and is largely a play on defense spending in things like unmanned aircraft, weapons, and sensors. If you are looking for a company to compare this segments results with, I would suggest something like Teledyne (NYSE: TDY), which is also heavily exposed to trends in defense spending. In general, the bias is positive-the US does want to focus more on intelligent systems- but cutbacks are cutbacks and demand is also dependent on conflict. A winding down of military operations is not helping much either. Teledyne's weapons and sensors are a key part of the shift towards “smart” warfare rather than a reliance on pure hardware or military manpower.

The Industrial segment is a rather odd fit that manufactures fuel systems, golf/turf care equipment, and powered tools. It also tends to have a high percentage of sales coming from Europe.

In addition, Textron has a Finance arm which cannot be divorced from its overall operations. Essentially, it is a commercial business which provides financing for the purchase of Textron’s equipment. In order to demonstrate its importance, I have compared it to the industrial section for the last few years.

See what I mean about a lot of moving parts? Improving credit quality and an ongoing asset liquidation plan have improved performance here, so that the segment is now a net contributor instead of being a drag.

Textron Q3 Results

Textron outlined some execution difficulties within Systems and they recorded a $14m charge in the quarter. It had over-estimated the potential to transfer existing operating expertise on a DoD contract and ended up having to throw more resources than expected towards it. A hiccup? Perhaps, but these things tend to happen when end market demand is getting weaker.

There was some negative news with Cessna. Business jet orders were weaker in the quarter but management implied that things got better in September and gave a positive outlook for Q4. Cancellations are dropping which will obviously improve the net position, but it needs to increase gross orders. One idea is that 2012 will tend to follow the tendency of 2010 & 2011 in seeing a pick-up in orders in Q4. I’m not comfortable with this idea because in both those periods growth and business sentiment seemed to pick up at the end of the year. That is not the case this year as GDP growth forecasts are being downgraded at the moment.  The long term dream for Cessna was that the concept of the “air taxi” would take off in a big way.  The idea was popular around 2008, but the recession saw the concept fade and it has never really come back since.

Industrial also saw tougher times predicted. As mentioned above, this segment has a high exposure to Europe and the region was forecast to weaken, but there was also weakness emanating from the fallout of a political dust up between China and Japan. It seems that Chinese consumers are holding back on purchases of Japanese goods in response and this is having a knock on effect on Textron’s industrial sales.

The real star in the quarter was Bell where revenues increased 20% to over $1bn. Commercial deliveries were particularly strong at 46 units versus 26 last year. In addition, even the military side was stronger, although overall Bell’s backlog fell on a year-on-year basis by $434m to $6.3bn. Again, this is somewhat puzzling because a company like Honeywell (NYSE: HON) recently downplayed expectations for the defense and aviation markets. Perhaps the reason for the discrepancy is that Honeywell has more international exposure while Bell typically generates over 75% of its revenues from the US? Honeywell is far more aligned towards international sales than Textron is and it is much harder for a company of its size to focus on niche areas of defense with which it can profit while overall spending is declining.

Where Next?

With this stock, it is the direction of its earnings that are more important than quibbling over its value range. Metrics like earnings and cash flow will move around violently here.  I confess I’m not all that positive. The assumption of order growth in Cessna is baking in some optimism, which may not be delivered. In addition, continued performance at Bell seems a bit incongruent with the rest of the industry. Textron is telling you that times are getting tougher in industrial and systems. I think investors should listen and take a cautionary approach here.

Is Whirlpool a Good Way to Play a Housing Recovery

With the US housing market showing signs of picking up, Whirlpool (NYSE: WHR) is a company well worth a look. Not only has it restructured in a drive towards increasing productivity and margins, but cash flow has been improving of late as well. In other words, all its metrics are moving in the right direction and its end markets look favorable. So what does the future hold in store and what does the risk reward proposition look like right now?

Whirlpool Bringing it All Back Home

It’s been a good year for the company as productivity initiatives have resulted in over $200m in cost savings, much of which is reflected in the bottom line. Moreover, another $200m in capacity reductions and cost benefits are expected next year. This is good news for a company with small margins, like Whirlpool. The result has been a nice uptick in operating margins in Q3, as demonstrated.

Indeed, the focus this year has been on margin expansion rather than trying to chase volumes or market share. That said, Whirlpool claims to have taken market share at the higher end. The turnaround in its prospects is most dramatically seen when looking at how operating profits have changed in North America.

In a sense Whirlpool is becoming an Americas focused company and I think that is a good thing. It means its earnings prospects are more dictated by the US housing market, over which, management declared its optimism that the market was trending better.

Housing Market Stocks Reporting Good Growth

The housing market in the US is getting better with a host of companies have been confirming this recently. For example, Home Depot (NYSE: HD) recently talked about housing being a sweet spot in the economy and its margins and revenue growth are demonstrating that pricing power is coming back to housing focused stocks. Indeed, Whirlpool is participating in a pilot program with Home Depot.

As such, Whirlpool has been included in that group of companies that has benefitted from better investor sentiment towards US housing, alongside things like Pier 1 Imports (NYSE: PIR) or Williams-Sonoma (NYSE: WSM). Both companies gave good numbers recently with Pier 1 raising guidance and forecasting mid-digit same store sales growth. Meanwhile, Pier 1 is generating enough cash to be able to invest in its e-commerce initiatives designed to maintain its market share. Similarly, Williams-Sonoma reported comparable brand revenue growth of 7.4% with its e-commerce revenues recording a mid-teens increase. Further growth initiatives include international expansion and new brand launches.

Product innovation is key for both these companies, but the underlying point is that end demand is improving thanks a better housing market. Whirlpool did affirm this, but in case anyone thinks it is just a case of setting up a shop and watching the customers roll in, I would suggest taking  a look at the problems at Bed, Bath and Beyond (NASDAQ: BBBY). This company simply isn’t managing its costs well and margins are being squeezed while same store sales growth has been slowing. Clearly there needs to be some restructuring here, but the company seems more focused on integrating acquisitions.

Where Next For Whirlpool?

I like what the company is doing and the evaluation is attractive. Asia is not a big part of profits, European comparables will get better, and Whirlpool appears set for growth in North America. It trades on EV/EBITDA multiple of 6.4 and with adjustments for the Brazilian collection dispute, free cash flow generation was around $520m on trailing year basis.  In other words, it generated around 5.6% of its enterprise value (EV) in free cash.  With another $200m due in cost savings next year the case for value is compelling.

My first concern would be with Latin America where other companies have been talking about a slowdown in Brazil and my second is the potential loss of market share inherent in shifting the mix of products sold to higher margins. Whirlpool competes in highly competitive markets. If you are jejune about the Brazilian question than this stock could start to look attractive but I confess I’d probably prefer to monitor events for now and hope for a larger margin of safety in the stock before buying.

VF Corp Research Analysis

VF Corp (NYSE: VFC) is starting to become interesting and I think is well worth monitoring. The recent Q3 results were pretty good and full year guidance was raised, although the market sold the stock off. I suspect this is because of some weakness in The North Face brand in Europe. However, this is good news because it may allow investors an entry point into a compelling growth story. The stock is starting to move into range.

VFC’s Growth Drivers

Having raised guidance in July to $9.50 after a previous hike to $9.45 from $9.30 at the start of the year, VFC increased it again to $9.60. I like the company and think it has a number of good growth drivers. The three biggest brands are The North Face, Timberland, and Vans and all of them are benefitting from the fashion trend towards wearing rugged outdoor clothing or skateboarding fashion on a casual basis. Aside from this, VFC has a large jeanswear division that comprises iconic brands like Wrangler and Lee.

On a geographic basis, while every retailer wants to chase growth in China, VFC’s opportunity comes from the fact that it is relatively under represented there at present. So for example, while a business like Coach (NYSE: COH) is going to be volatile over demand from China that is more closely correlated to GDP growth a company like VFC can get growth through territorial expansion alone.  Coach is doing okay in that regard and the recent results were good but it is hard pushed to expand in Europe. Meanwhile VFC –despite the slowdown in Europe with the North Face and jeanswear- is on track to grow European revenues this year and has good opportunities via its e-commerce launches in Europe.

Another thing in VFC’s favor along with a company like Jones Group (NYSE: JNY) is that it has significant exposure to cotton prices and any reduction in prices will leverage its way into higher margins. Indeed, VFC is expecting further margin expansion this year. It will be interesting to see what Jones Group says in its forthcoming results on the issue.

The other thing I like about VFC is that it has a diverse set of brands while a stock like PVH is heavily dependent on Tommy Hilfiger. In other words, PVH is heavily exposed if a competitor comes along and starts grabbing market share from its core brand.

Current Trading

It is a familiar retail story with strong growth in China and weaker European growth particularly with jeanswear and The North Face. However, management is predicting a resumption of growth with the latter on the assumption that wholesalers will now start to stock up after depleting the previous over capacity created by a mild winter last year.  With jeanswear this is exactly the same pattern as was seen in Europe during the 2009 recession and it should come as no surprise, nor is the heavy exposure to Spain and Italy much of a help either.

However, VFC came out with some bullish projections for Europe by stating that it expected 10% revenue growth in Q4 which presumably implies some pretty robust assumptions for a bounce back in growth from The North Face.

Vans also has strong potential to expand in Europe and on a global constant currency basis revenues were up 26%. And it’s no surprise that VFC is planning to increase marketing investment in Vans and The North Face. They both seem capable of generating growth in a weak environment.

It is a weaker story at Timberland, but investors need to recall that excess inventory needed to be sold as a consequence of the mild winter. Throw in the brand's traditionally heavy European exposure and the result is a slight decline in constant dollar revenues.

Where Next For VF Corp?

I think this dip could be the start of a buying opportunity. I still think the stock is hardly cheap on a PE of 18.8 and an EV/EBITDA multiple of 13.3x. Investors will be getting a high quality name with good growth prospects, but there is always a price to pay for those prospects so it’s hard to argue that VFC is attractively priced yet.

That said, if it delivers on its Q4 forecast and then confirms what the analysts are hoping for in 2013, the stock is quite capable of “doing its earnings” and giving investors mid-teens returns. The problem is there are some imponderables here in relation to Timberland and The North Face recovery in Europe, and needs to be seen first rather than talked about. Moreover, no one can be confident knowing what the winter weather season will be like. There is little margin of safety priced in to this stock but the market seems to be slowly moving it into range.

Riverbed Commentary

The market was right to be apprehensive about Riverbed’s (NASDAQ: RVBD) earnings in the light of two recent disappointments from key bellwethers IBM and Intel, but it turned out to be business as usual for the leader in the WAN optimization market. Or rather it was business as would have been usual before the product transition earlier in the year spooked the market so badly. No matter--the company is demonstrating that there are areas of technology that are relatively strong, and investors should seek them out.

Tech Results in General

IBM scared the market with its talk of revenues dropping off in North America and its growth markets in September, but as I’ve tried to argue in a previous article, IBM’s results are really part of a trend in weakness within its operations and the markets it competes in. It is a story of hardware weakness but software strength. Furthermore, with Intel’s ongoing weakness we are seeing a reflection of this shift to spending on software, data centers, cloud computing and mobile devices.  So the key for investors is to find areas of technology that are holding up well.

I chose my words carefully because in general tech spending is slowing. The IT security plays are relatively less exposed to discretionary spending, yet both Fortinet (NASDAQ: FTNT) and Check Point Software (NASDAQ: CHKP) gave weaker outlooks. Fortinet’s revenue guidance reduction was hardly dramatic, but it comes after management (including the much-vaunted but departing CFO Ken Goldman) proved to be overly enthusiastic in their predictions of the last set of results. But so what? The company will still generate lots of cash flow and mid-teens revenue growth this year.

As for Check Point, it hit estimates but lowered guidance and the stock was punished. I think the management may be conservative, so I put my money where my mouth is and bought some more. Even on a conservative estimate this business generates so much cash that it could easily pay a 4-5% dividend yield and still use the $1.5 billion (17% of market cap) in net cash on the balance sheet to buy back stock. No one likes to see flat product revenue growth, but overall revenues were up 8% and deferred revenues were up 11%. Given the conservatism over the balance sheet I think it’s time for investors to ‘get involved’ with the management over returning cash to them or investing it. We don’t hire management to park cash on balance sheets.

Riverbed Delivers

Turning back to Riverbed, what we are seeing here is a continued ‘snapback’ in growth following the product upgrades and new launches made earlier in the year. The company looks like its sales force has been restructured and is back on track.

Not only is it performing well, but management is seeing normal linearity (so no IBM-style drop off in September) and federal and enterprise spending are both strong. As for the new products, Granite’s growth was described as being ‘great.’ Its numbers aren’t material yet, but Riverbed is comparing its initial growth to its Steelhead product.

 It’s worth noting that Riverbed has 50% of the WAN optimization market, so it really is the bellwether here, rather than Cisco, which only owns 22%.  In other words, what Riverbed says is pretty much how it goes for its market. I want to put the last couple of quarters’ results and the Q4 guidance in a historical context.

It’s clear that the guidance is for a sequential gain pretty much similar to last year's. In this environment it’s fair to say that may be setting a high benchmark.

Where Next For Riverbed?

The market will now look to F5 Network's (NASDAQ: FFIV) results this week in order to get a fuller picture. Riverbed also sells application delivery controllers (ADC), which is F5’s core market.  However, the key point is that many of F5’s end market drivers are the same as Riverbed’s. Riverbed’s results suggest that F5 will do okay, but the latter has been reducing guidance this year  and Telco is a key vertical for it. It is anyone’s guess what its results will bring, but Riverbed investors need to watch them closely.

Riverbed remains attractively priced and is a potential takeover target. I like the stock, but the guidance will come into question if the tech market heads downwards from here and things companies F5 and Aruba Networks give poor results. Cautious investors might want to watch developments and wait for a possible dip here.

Tough Times Ahead for General Electric?

I think Jack Welch would have cause for optimism after General Electric (NYSE: GE) gave its latest results. It’s not that they were particularly good, but rather that the management tried their best to make it sound like everything was firing on all cylinders. The market had other ideas and sent the stock down.

My view is that GE has seen the best of its operational performance for the foreseeable future but it may not matter to the stock price performance. In the end its yield is sustainable and the stock will be supported on that basis. However if you are looking for growth then GE is not going to be attractive, and here is why.



GE’s Unfavorable Mix

My thesis with GE is that it is performing well in areas that are longer cycle and about to turn down (Aviation and Energy) but it is not performing well in the less cyclical Healthcare segment. Moreover, GE Capital’s extensive European exposure is not the best place to be right now. GE Transportation is doing great but it’s not big enough to make a substantive difference.

Here is how GE makes its profits:

As the graph shows, Energy and GE Capital make up nearly two thirds of profits. This will be the last quarter that GE reports Energy in the current basis and in the future it will report in three separate businesses as Power & Water, Oil & Gas and Energy Management. The segment is doing fine for now, but Wind orders were down massively and future growth will be challenged if oil prices slip. The good news within Energy is coming from gas. As Alcoa’s (NYSE: AA) recent results confirmed, orders for gas turbines are strong and GE is well positioned in LNG infrastructure. As gas turbines are increasingly being run (thanks to low gas prices) this means that Alcoa and GE can profit from replacement and servicing revenues. As for GE Capital, the company is trying to cut down on non-core assets, and revenues and net income were down single digits accordingly.

Aviation revenues were down slightly but profits were up 7%. New orders declined 8% but GE explained this away as a consequence of backlog lumpiness due to the length of the order cycle. It also explained that $500 million in orders for two customers in Asia were pushed out this quarter. Frankly I’m not buying it, because this is exactly the sort of thing that happens in the aviation cycle. Certain loud mouthed journalists on television make noises about Boeing’ s (NYSE: BA) order book as if they have discovered something the market doesn’t know about. The truth is that if there is a slowdown coming then orders will get canceled, delayed or pushed out. This goes for Boeing and it also applies to GE’s engines. Neither is immune and pointing at a full order book now will not protect you in future when the market prices in these issues. Is it a coincidence that the two ‘push-outs’ are in Asia? Time will tell.

The next biggest segment is healthcare, and GE still isn’t performing here. I’m going to demonstrate revenue movements for all the segments here.

Healthcare is a laggard and has been so for some time and this is unfortunate because this segment is supposed to help support GE when the economy slows.

The star performer in the quarter was Transportation where revenues grew 9.5% and profits were up 35%; despite a slowing economy, orders were up 21%. All of this spells good news for Wabtec (NYSE: WAB) stockholders who will see results given soon. I’m a fan of the company but am hoping for a dip to go back in. GE’s results are suggesting that this is unlikely to happen when Wabtec reports, but we shall see.

 

GE Stock Analysis?

This report is a tale of declining order books and ongoing restructuring with GE Capital.  Healthcare is performing poorly, and Aviation and Energy both saw some worrying order declines. Transportation is doing fine, but it is not enough. As for the general economic environment much will depend on China because that is where the big driver for aviation and energy demand is coming from. Fellow industrial giant Honeywell International (NYSE: HON) also gave results recently and pointed out that it felt China’s growth could dip below 7% in 2013. This is a level significantly below what most forecasters are predicting and given that Honeywell shares many end markets with GE, it is not a forecast to be taken lightly. If it happens, then GE’s exposure will hurt the stock operationally.

The good news is that I’m not sure the market can’t tolerate these issues as long as the dividend is sustainable and at a premium to long bond yields. GE isn’t a stock I fancy very much, but then again dividend investing isn’t my thing. No matter, the market likes the theme at the moment, so don’t be surprised if any weakness is followed by support flowing into the stock.

What IBM's Results Mean to the Tech Sector

When looking at IBM’s (NYSE: IBM) results there are always two concerns. The first is IBM itself and the second is the commentary around all its various sectors and what this means for its competitors. Therefore I’m going to split this article into first discussing IBM's main business segments and then the individual components.

IBM Disappoints

The market didn’t like the results or the associated commentary. Management pointed out that September saw a sharp fall off in demand from North America and what IBM calls its ‘Growth Markets’ (the BRICs and other emerging markets). Of course these regions are supposed to be the stronger areas of the global economy!

On closer inspection the weakness in the BRICs was mainly attributed to Brazil with the other countries growing strongly. Meanwhile Australia and Mexico were also cited as areas of poor performance. As for North America, if it is broad based macro weakness than we will be hearing about it soon enough from other tech companies. It is tempting to get into an in-depth play by play analysis and formulate reasons and excuses that lead to concluding that the quarterback and overall offensive unit playing tag football in the park are actually Dan Marino’s 1984 Dolphins in disguise.  The difference is that Marino’s stats backed up the claim while IBM’s trends do not.

To be fair to IBM, currency effects have affected results. For example, Software and Global Technology Services had positive sales growth on a constant currency basis with numbers of 3% and 1% respectively. Software has more than double the gross margins of the other three major segments. Moreover Software apparently had a ‘handful of deals’ that slipped into the next quarter so the underlying performance is probably better than has been reported.

On a more negative note, Global Business Services has been negative on any basis you like for the last few quarters but the real disappointment was saved for Systems & Technology.  Even adjusting for the divestiture of Retail Store Solutions and currency effects, hardware revenues were still down 9%.

To look at these issues closer I have broken down revenues on a sequential basis.

This helps filter out some of the currency effects. Frankly it’s hard to conclude that technology markets aren’t slowing but are there pockets of resistance or even strengthening growth?



What IBM’s Results Indicate for the Competition

Essentially it is a story of hardware weakness with some strength in areas like business analytics, cloud computing, storage software and database management.

In fact total branded middleware solutions were up 3% on a constant currency basis and this should interest Tibco Software (NASDAQ: TIBX) shareholders after it confounded the naysayers with a set of results and outlook that wasn’t as bad as most had feared. However with the recent weakness in IT and IBM's commentary I’m looking at Tibco’s guidance for Q4 license revenues and wondering if it is now going to hit it.

I would also be concerned about prospects at Master Data Management (MDM) Informatica (NASDAQ: INFA) because this company has been largely blaming Europe for its troubles but IBM said that the drop off was generally in North America. Informatica is a small company (giving results soon) which competes against some behemoths like IBM, Oracle (NASDAQ: ORCL) and SAP and if the tech market is slowing overall, it is not unreasonable to expect these companies to compete that much harder.

Speaking of Oracle it also competes with IBM in data-basing, storage analytics and middleware. The news on the storage was mixed with hardware down 8% but software (reported within Tivoli) was up 14%. It all suggests that Oracle might be better placed to deal with the current markets than most IT companies. Another company who might also have cause for optimism is CA Technologies (NASDAQ: CA) which competes with Tivoli within enterprise management software. Earnings estimates haven’t come down much for CA this year and the stock has performed well. If  Tivoli’s results are anything to go by then perhaps it too can outperform?

Where Next for IT?

The key takeaway from these results is that the results seem to be part of a trend within IBM’s operations (see first graph) therefore it is too early to conclude that there is broad based weakness in North American corporate spending on IT. Moreover, the relative outperformance of software versus hardware suggests that there are opportunities out there for certain companies, but stock pickers are going to have to be very selective and watch the earnings season very closely.

Pepsico's Strategy Lacks Coherence

The food and beverage sector is interesting because its leading players seem to be pursuing different types of strategies in dealing with the same problems. The North American mass consumer remains highly cautious with spending, but the economy is improving; meanwhile, emerging market (EM) growth is moderating and it’s unclear how its consumers will react in terms of spending on food and beverage. The answers to these questions will not only shape their operational strategies but also their structure, and I think this is a critical year for decision making at these corporations.



Pepsico’s Power of One

At Pepsico (NYSE: PEP), it’s not entirely clear whether the ‘power of one’ represents a coherent business plan meant to leverage economies of scale or if it is a reference to Indra Nooyi’s role as Chairman and CEO. Whichever it is, it is unlikely to change the game plan of piecemeal engineering with its powerful brands combined with investments in EM. For Pepsico, the former is much more important than the latter because North Americas still makes up the bulk of its profits.

Essentially Pepsico tied its colors to the North American mast when it split from Yum! Brands (NYSE: YUM), and the latter is a great example of a company that has chosen to chase emerging market growth in China. The difference is that Pepsico has more leeway to adjust its strategy now. Meanwhile, Yum is firmly set on a path of expansion in China while trying to optimize its operations in the US by restructuring. In a sense, Yum’s mind is already made up, but Pepsico could decide to replicate Kraft (NASDAQ: KRFT) by splitting its operations in order to release value and create more management focus in the separate parts. The market liked the Kraft split idea, but should Pepsi be pushed to do the same just because the market thinks so? I happen to think it should.



Pepsi’s Gone Flat?

Politicians are assiduously taught never to say sorry or admit any mistake however minor or trivial it may be. The reason for this is that it is an implication of weakness, and their opponents will endlessly exploit this in campaigning against them. And if Pepsico was running for a election, its opponents would have a field day reeling out old tape of its forays into bottled water, its mistakes with Gatorade and its relative failure to take advantage of the trend towards energy drinks. Indeed, management specifically ruled out any M & A activity directed towards the energy drink sector.

Of course the last two points are interlinked because Pepsi admits it shouldn’t have marketed Gatorade as a general hydration drink when energy drinks were starting their acceleration in popularity. It also shouldn’t have chased volume growth at the expense of profitability, and its management articulated a willingness not to do so in the future. All these issues are being addressed, as is the ongoing difficulty of convincing politicians that sugary carbonated drinks are not the new tobacco.

All of this is wonderful, but investors are entitled to ask what happened to the ‘power of one?’ Chasing volume and category growth is surely an intrinsic part of a strategy devoted to developing a coordinated approach to selling beverages and snacks together. In other words, enacting piecemeal restructuring and cutting back on chasing unprofitable growth is one thing, but developing profitable growth by category expansion is another. It strikes me that Pepsico is trying to do both right now. It reported 5% organic growth, of which 1% was volume growth and the other 4% was pricing. Again, this is a sign of a company maximizing profits rather than looking for scale.



The Other Guy Blinked

As ever, investors will compare Pepsico with its beverage rival Coca-Cola (NYSE: KO), and the contrast in strategy and performance is notable. Both companies had issues with FX, but Coca-Cola seemed to do relatively better in the US. Moreover, it has been taking market share in water (a market that Pepsico has struggled in) and investing in buying bottling operations in emerging markets.

As detailed above, Pepsico is still primarily a North American focused company and performance in the quarter softened with the usual story of sales channels in the US shifting to discount stores. The challenge going forward will be to carry on trimming underperforming assets in the US and hoping that Pepsico’s low ticket items will be immune from any moderation in growth within emerging markets, a particular concern given the investment in the Tingyi alliance in China.



Where Next for Pepsico?

It is a facet of investing that sometimes companies appear attractive for the wrong reasons. It’s hard to see that the company’s core strategy is being applied, so it’s hard to judge it on that.  Pepsico has very strong brands, but the ‘power of one’ hasn’t been working particularly well in maximizing profits or growth. No matter. The stock remains a dividend play, and with the US economy slowly getting better, it’s hard not to think that conditions might not get easier for them.

The investment in China with Tingyi offers growth prospects within emerging markets. Prospects do look better, but the stock doesn’t look cheap, and I’m not a fan of buying companies because you hope the management will change direction. In addition, there is probably better value elsewhere for the macro assumptions you would have to make before buying the stock.

Time to Buy Intel?

Intel (NASDAQ: INTC) did what Intel does and managed to report results above the high end of its recently lowered expectations. However, I doubt this will be enough because anyone looking for an early sign of recovery in the semiconductor market will have been disappointed.

Microsoft (NASDAQ: MSFT) investors should note that PC demand certainly isn’t going to be propelled by Windows 8. In summary, this report was saying that industry conditions are going to get worse short term. What it is not saying is that Intel is necessarily a bad buy at the moment.

Intel Reports and Guides Weaker

Much hope has been placed on Windows 8 driving PC sales but the likes of Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL) are likely to have to downgrade expectations even more after Intel said that the Q4 PC business looked set to grow at half the normal seasonality.  This is not good news at the best of times and certainly not what investors would have been hoping for at the start of the year where most analysts were predicting an upturn in semiconductor demand.

Neither was there any good news for the semiconductor capital machinery as Intel lowered its capital expenditure plans in the light of weaker end demand. This is bad news for companies like Applied Materials or KLA-Tencor (NASDAQ: KLAC). KLA-Tencor previously talked of industry CapEx being down by 10-15% in 2012 but with Intel lowering its spending guidance it is likely that KLA-Tencor and others will have to lower their top line expectations accordingly.

There was even some disappointing commentary on data center spending. At the start of September Intel released a statement and lowered Q3 expectations, but it also said that its data center business was performing in line with its expectations. However Intel is now saying that the corporate server market segment softened during the course of the quarter. In other words, we have a broad-based slowdown on our hands here. While this is not unexpected from a macro perspective the market still seems to be taking hard when companies inevitably lower guidance and I don’t think Intel is any different.

Longer-Term Picture

The key point is to keep matters within a long-tern perspective. The all important metrics with Intel are always gross margins and inventory. What usually happens is that inventories start rising as sales are lower than expected and then gross margins come down as Intel and the rest of the industry struggles to lower inventory levels.

This chart demonstrates it well.

 

INTC Inventories data by YCharts

What the chart is not telling you is that gross margins for Q3 came in at 63% and that Intel guided margins for Q4 to come in at 57%. Inventory grew by $400 million in Q3 and investors can expect average selling prices to be under pressure in Q4.

Of course this type of analysis doesn’t include any discussion of the underlying trends and this is unfortunate because there are some important changes happening. PC demand is maturing (even within emerging markets) and it is hard to imagine that this is not partly due to the growth in usage of smart phones and tablets as internet-enabled devices. As such Intel is under pressure to change its product development in line with end demand and it is doing this, but to argue – as some inevitably will -- that Intel can generate contra cyclical growth as a consequence of engineering this shift in the types of processors it develops is a deluded idea.

The simple fact is that if you are going to invest in Intel you are going to take bet on the semiconductor industry cycle and in turn the macro environment. The companies that are being hit by the shift in the makeup of internet-enabled devices are the likes of Dell and Hewlett-Packard. They are both fundamentally challenged business and this report does not auger well for them. Nor does it say much about Microsoft's prospects with Windows 8.

Where Next for Intel?

It’s not the end of the world. Consumers will still buy PCs, mobiles, tablets and anything else that Intel’s processors get position in. If you believe that the company is correctly readjusting to sales shifts then on a historical basis the stock looks good value.

INTC Price / Sales Ratio TTM data by YCharts

Throw in a 4%+ dividend yield and you can bet that yield chasers will start moving in at some point. Short term, I suspect things are going to get worse and markets surely don’t like downgrades and earnings misses, so any buyer needs to be able to stomach near-term volatility. However in the long term, Intel looks decent value down here. Cautious investors (I'm one of them) might prefer to wait until the inventory situation starts to demonstrably get better but at some point it surely will.

Johnson & Johnson Resarch Analysis

Johnson & Johnson (NYSE: JNJ) reported market pleasing results, but many questions remain unanswered. This quarter’s star was the pharmaceutical division that performed well with particular strength in immunology and oncology. Moreover, underlying conditions in neuroscience are positive. The cause for doubt relates to ongoing disappointing results within consumer products, and if we exclude the contribution of orthopedics (much if which was due to the Synthes acquisition), revenues were actually down in medical devices and diagnostics.  However, the question that remains is that of evaluation. JNJ is not doing much, but it’s enough to see the stock appreciate, given its cheap evaluation.

Consumer Products (21% of Sales)

The US makes up only 34% of divisional sales, and that’s a good thing because operational sales were down .4%, with ongoing production problems having their affect. Operational results from international increased a paltry 1.8%, but this was more than wiped out by negative currency effects, which resulted in reported sales dropping 6.1%.  Overall, sales dropped 4.3%, and there were some particular areas of concern.

OTC/Nutritionals are doing well and are in line with the sector, but there is ongoing weakness in baby and oral care in the US. I suspect the latter is partly due to Colgate Palmolive (NYSE: CL) stepping up competition with mouthwash in the US. As for baby care it was also down internationally where others have reported pretty good growth.  In general, Colgate is generating growth via innovation and JNJ needs to respond or continue to lose market share. The other surprise was the negative result in international skin care. This is another category where rivals have been giving good numbers.

At the last set of results I had thought that the decline in the division was beginning to slow but it seems that there is much more work to do.

Pharmaceuticals (37.5% of Sales)

Pharma outperformed for JNJ in this quarter as a combination of new drugs accelerated sales and a hefty $183m contribution from Remicade helped overall revenues rise 7% to $6.4bn. In fact, Remicade made up nearly 25% of total pharma sales, although the drug is part of a class of drugs (TNF Blockers) for Rheumatoid Arthritis that may face competition in future from Janus Kinase Inhibitors (JAK) . In fact, Pfizer’s (NYSE: PFE) tafocitinib may receive FDA approval quite soon. Long term this may prove to be an issue, but most observers think that JAK inhibitors will initially be marketed to TNF non responders, and (like the TNFs) there are some safety concerns with Pfizer’s drug. We shall see. However, the issue does hang over Remicade. It should also interest Abbott Labs shareholders because after the forthcoming split its TNF-Blocker (Humira) will make up a large part of revenues and profits for Abbvie (the future pharma and biologics part).

Elsewhere reported Neuroscience revenues were down 1%, but I expect Invega and Invega Sustenna will gradually takeover lost revenues from Risperdal and Concerta. The launch of Zytiga (prostate cancer) has gone very well and reported Oncology sales were up 27.1% in the quarter.

In conclusion, it was a strong quarter for Pharma but keep an eye out for developments with RA treatments.

Medical Devices and Diagnostics (41.4% of Sales)

Frankly it was a mixed bag and I want to demonstrate this by splitting orthopedics from the rest of the division.

Much of the orthopedics growth is due to the Synthes acquisition and without it this wasn’t a strong quarter. Diabetes care was weak and diagnostics reported negative sales growth in the US and international, although this may turn around in future with improvements in hospital visits.

Moreover, surgical care was weak with reported sales down 4.4% and it is hard to conclude that JNJ isn’t losing market share to the strongly performing Covidien, whose mix of endomechanical, vascular, and energy devices and is generating close to double digit growth for the company. It will be interesting to hear what Covidien has to say about conditions in surgery because hospital admissions are up but JNJ does not seem to be able to generate growth.

The Bottom Line

In conclusion, it’s the usual mixed bag of results from JNJ.  There is an obvious need for the company to turn around the poorly performing consumer division and there are longer term concerns with Remicade and some parts of medical devices.

On the other hand, the stock remains cheap on every single value metric that you might care to consider. Cash flow generation is substantial and the company has the capacity to increase dividends significantly. Moreover, more acquisitions are possible given the strong cash flow and investors should applaud the successful integration of Synthes.

15 High Yield Stocks That Have Increased Their Dividends For 30 Years

Dividend investing is certainly back in vogue these days. With the Federal Reserve committed to keeping interest rates low, there has been an increased focus on good old blue chip dividend-paying stocks. I previously  discussed 15 stocks that have raised their dividends over the last 20 years in an article linked here, and now it’s time to do the same for those companies that have increased dividends for 30 years.

While it’s never advisable to buy stocks just for their dividends, a long term history of paying dividends implies a management focused on delivering shareholder value by running the company in the owner’s (your) interests.

Here are the 15 stocks I have selected. I’ve tabulated the current yield and a column of ‘current D/Forecast E.’ This column is to better gauge the capacity for dividend increases in future. The lower the number the more the potential for dividend increases.

Dress Nicely

I confess to being a bit of a fan of mid-market clothing company V.F.Corp (NYSE: VFC), and have covered the company at length in a previous article. It has been doing all the right things over the last few years. The North Face and Vans are two brands of the moment and VFC has been a key beneficiary of the change in fashion towards wearing rugged sporting clothing in a casual manner. Its e-commerce initiatives make sense, and China remains a largely virgin territory for most of its brands. The more problematic areas for VF Corp in future will be its Jeanswear operations in Europe and Timberland (a brand with a large amount of sales in Europe).

Drink and Drugs

Another stock I like is Walgreen (NYSE: WAG) which was discussed in this article. The company has its detractors and no one likes to see declining same store sales at a retailer, but the reason for this –the Express Scripts debacle- is over, and investors should focus on the long-term prospects.  The business is highly cash generative and its end market demand is very secure.

I also think that many investors are underestimating the potential for Walgreen to increase its own store product sales and grow margins via generics sales. Simply put, the future will see more old people needing more prescription and OTC drugs and but wanting to pay cheaper prices. Walgreen can benefit from this trend. It is the branded pharmaceuticals companies that suffer the most from pricing and reimbursement pressures.

The third stock to look at from a long-term perspective is PepsiCo (NYSE: PEP). It is far from being the sexiest stock around, and the company has been under pressure to make a split like Kraft did. Unfortunately, this is unlikely to happen while Indra Nooyi is around. but I guess there is some upside available from getting rid of her. Pepsico is interesting because it still generates the bulk of its profits from the US, a fact which is in marked contrast to its spin off Yum! Brands, a China-focused company these days.

Frankly I don’t think Yum! would have been able to achieve what it has if it was still part of PepsiCo, and it’s time for Nooyi to change tack. The ‘power of one’  tagline seems to resonate stronger as a description of her role as Chairman and CEO then as a strategy designed to release the full value in PepsiCo’s hugely powerful brands.

Get a Job and Move in Together

The next company is Automatic Data Processing (NASDAQ: ADP). This stock offers a bit more cyclicality than the others, but as the data in the table suggests the dividend is well covered. In addition, I like the prospects for margin and cash flow expansion given the assumption of an ongoing economic recovery. Its evaluation is attractive, but EPS forecasts look a bit weak. No matter, this stock offers a nice mix of current value proposition plus some upside kicker from a stronger-than-expected economy going forward.

I always like to look at a new stock when I write this type of article, and I’m intrigued by RPM International (NYSE: RPM). Superficially it is another boring materials company; but what is wrong with that? It recently raised full year sales and EPS guidance and gave commentary alluding to ‘gradual improvement in North American commercial construction.’ The company has around 24% of its market cap in debt (Yahoo! Finance), but its strong cash flow generation makes servicing and repaying it hardly a difficult task. While North America is doing fine, European sales were negative year-on-yea--but then again Europe has been weak for a while, and any upturn there will see many companies beat low earnings estimates.

There was a bit of confusion regarding RPM's roofing division at the time of the last results. When pressed by analysts it became clear that the weakness was in its international operations, which is why RPM is now exiting overseas roofing contracting. This should create some operational improvements going forward.

Fastenal Research and Analysis

There are fewer companies that report more details on trading performance than Fastenal (NASDAQ: FAST) and I think its results are a key barometer for how the US construction markets are trending. According to the company, sales typically comprise of 75-80% from residential construction customers and 20-25% from industrial so it is a good gauge of house building prospects.

In summary, there were signs of a slowdown in the Spring, but Fastenal reported a recent and tantalizingly strong uptick which has also been supported by things like the Architectural Billings Index. Will it last or will it be another variable data point in a mixed year?  I happen to think the former.



Fastenal’s Profit Drivers

I like the company because it has a number of good profit drivers. I’m going to discuss four of them here. First, as a leading player in a fragmented market, it has the opportunity to expand its store numbers and consolidate its industry.  Second, this expansion should bring about improvements in working capital and inventory management. Third, it is expanding the percentage of sales from non-store sources (vending machines) and lastly it has upside kicker from an improvement in the residential construction market.

As ever, it is the last point that investors will focus on in the near term. I’ll return to that point later but first I want to focus on the long term drivers, specifically what Fastenal’s objectives are and how it is measuring up.



Fastenal’s Long Term Objectives

I’m going to go back to the plan laid out in 2007 which I originally highlighted in an article linked here

1. to continue growing our business at a similar rate with the new outside sales investment model
2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012 (this has subsequently been pushed out to 2014)
3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow
4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
5. to generate 85% of earnings in operating cash flow

Essentially the objectives are typically the kind of thing you might expect from a business with an opportunity to improve operational performance with an expansion strategy. It’s time to look at the numbers.



Fastenal’s Immediate Prospects

First here are revenue growth numbers for stores open more than five years.

There is an obvious slowdown this year, but very recently there has been some cause for optimism. Fastenal helpfully breaks down monthly sequential sales movements and gives the comparison versus historical movements. I’ve graphed them for 2012 below…

…it’s hard to get too excited about the September number because it has been such a variable year but the Architectural Billings Index has perked up recently too…

... or is this yet another false dawn for the housing market?

Possibly but the longer that the lack of new supply comes and prices keep rising then the more the likelihood that the housing market will see a sustained upturn. Indeed the most recent corporate news on housing is positive. Both Wells Fargo and JPMorgan (NYSE: JPM) are seeing better market conditions. In particular Jamie Dimon, CEO of JPMorgan, said that housing ‘has turned a corner’. One would hope that he means it because he reduced the amount of provisions for loan losses. It's a nice way to improve profits, but it will bite JPMorgan back if housing makes a downturn. No matter it is another positive sign for housing.

Fastenal is more of a housing play than companies like Grainger (NYSE: GWW) or MSC Industrial (NYSE: MSM). Those companies have more of an industrial focus and for investors in those companies, here is the breakdown of revenue growth for industrial customers for Fastenal.

Longer Term Scorecard

Going back to the long term plans, a key aim is to increase sales via vending machines…

Above shows a strategy which is working well. In a sense Fastenal has to do this because competition is coming from the likes of Home Depot (NYSE: HD) who are trying to encroach on its market share in store. In addition, Home Depot is expanding online sales and, bolts and fasteners strike me as exactly the kind of product that can be easily shifted to e-commerce.

What about the plan to increase average sales per store?

Fastenal is increasing the amount sold per store (currently at $88.3k) and (as shown above) the percentage of stores selling above $100k, so increasing the number of stores is not having a detrimental effect on average sales per store. This suggests the company has plenty of room for growth. Will it hit the $125k target by 2014? It’s possible but I suspect Fastenal will need some assistance from the economy.



The Bottom Line

I like Fastenal and I like prospects for the residential construction sector but it’s very difficult to argue that the stock is good value. Fastenal’s proposition of mid teens EPS growth coupled with significant long term operational improvements is a compelling offering, but investors always need to factor in a margin of safety in their assumptions.

I’m bullish about the housing market but not bullish about buying richly priced stocks, especially as it is far from clear how the economy will fare next year. Frankly an evaluation of EV/Ebitda of 18.7x is not cheap and nor is its current free cash flow yield anything to write articles home about.  It’s a good company but there is better value elsewhere.

November Portfolio Review

It's the end of the month so it’s time to assess portfolio performance. I know readers like articles that have a watchlist of stocks for them to research, so I hope this format is useful. Every month I like to review the quarter and provide a kind of compendium for the articles I wrote on specific stocks in the month leading into the quarter. I use these articles as a way to help formulate views and invest in the stocks I write about. Any constructive suggestions on how these posts can be improved will be gratefully received.

It was a good quarter, ending 24.4% up and taking me up to 73.3% YTD and 78.8% on a trailing year basis. It obviously won’t always be like this, but I’m reasonably pleased with my performance* since I switched to investing in the US from predominantly UK small caps. I typically hold 20-30 equity positions. For the record, I’m leveraged and hedged so expect volatility. I short indices, not stocks, which means that the stock research I do is always with a view to buying the stock, and I’ve made a conscious effort to push harder and find more stocks. That said, I don’t buy everything I research.

Here is the stuff I looked at in August. The hyperlinks go back to the original articles.

Company	View + Article Link	Performance Since Article
Sirona Dental Systems	Positive	25%
Home Depot	Positive	23.6%
Cal-Maine Foods	Positive	19.8%
Beacon Roofing Supplies	Positive	11.1%
Sanofi-Aventis	Positive	10.3%
Nice Systems	Positive	6.4%
Covidien	Positive	5.9%
CVS	Positive	4.4%
Intuit	Positive	1.9%
Wells Fargo	Positive	-1.8%
Check Point	Positive	-9%
Fortinet	Positive	-18.1%
Colgate-Palmolive	Evaluation	2.5
Nordstrom	Evaluation	-2.5
Perrigo	Evaluation	-4.6
GameStop	Neutral	42.9%
Acme Packet	Neutral	18.7%
Harley Davidson	Neutral	11.2%
Heico	Neutral	8.7%
Autodesk	Neutral	6.1%
Church & Dwight	Neutral	4.1%
McDonalds	Neutral	.4%
Cisco Systems	Neutral	-.2%
Aruba Networks	Neutral	-1.8%
NetApp	Neutral	-5%
Coach	Caution	5.6%
Joy Global	Negative	10%

The statisticians amongst you will note that the ‘positive’ stocks (all of which I bought and hold until they hit my target prices) returned an average of 6.6%, while the ‘neutral’ stocks (which I looked at to buy but rejected for myriad reasons) returned 8.5%. The ‘evaluation’ stocks (I liked but rejected due to evaluation) returned -1.5%. Meanwhile ‘caution’ and ‘negative’ returned 5% and 10% respectively. Go figure! This is the second month in a row that the stocks I rejected outperformed the ones I bought, although the ‘neutral’ stocks would have returned 4.7% without GameStop.

I can’t explain this away with an argument based on risk. In other words, say that the market soared and took the riskier stocks up disproportionately. In fact, the market is up since the start of August and was pretty flat during August itself.

Incidentally with GameStop, I’m under no illusions here. If forced to be long or short GameStop, I would rather have been short, but since I don’t short stocks it's academic. The problem with shorting stocks is that unless you are a dedicated short seller, it’s very hard to re-frame from a long only mindset.

Buy Unfashionable Stocks

I’m particularly please that four of the big contributors were relatively under-researched and unloved stocks with Sirona, Cal-Maine Foods, Beacon Roofing and Nice Systems providing nice returns. There is more to investing than endlessly discussing Apple! I would encourage investors to be willing to go off the beaten track. We see the views for our articles and believe me, they are not launching when I write about Sirona Dental Systems.

Healthcare and Housing

These sectors have been doing well for differing reasons. Housing has done well because there is a structural recovery going on in the US, and health care is a relatively resilient sector which was very low rated at the start of the year. Health care is also somewhat of a high-yield sector acting as a proxy for bond investors tired of paltry rates. As such, I prefer many of the stocks within it to the food sector. In particular, I look at something like drugstore CVS (NYSE: CVS) and see plenty of opportunity for it to grow its private label sales as well as expand generics sales to an aging demographic.  Elsewhere in the portfolio health care and housing has worked.

Not All Good News

The standout disappoints are Fortinet (NASDAQ: FTNT) and Check Point Software which hurt performance here and in my portfolio. I was fortunate that Fortinet hit my target price so I exited before the disappointing last results but held Check Point over its lowering of guidance. While not my finest hour, I happen to think both are cheap and bought more Check Point. As for Fortinet, I’m waiting to see what Palo Alto Networks says before thinking about going in again.

Evaluation Still Matters

This is perhaps the most frustrating part of investing and why it helps to write stuff down. Sometimes you find a great stock in a good industry and buoyed with enthusiasm you then sit down and work out an evaluation only to discover that everyone else discovered it too. I love Colgate-Palmolive (NYSE: CL) but I have no intention of paying the current market price. All businesses have risk, and I want a margin of safety for everything, including toothpaste and mouthwash. Yum! Brands recently lowered guidance for sales in China; who is to say Colgate might not do the same?

Loosen Up

Actually I’m not going too. The ‘neutral’ stocks did outperform this quarter but I’m going to stick to my guns. I’m not a value or deep value investor so things like Autodesk (NASDAQ: ADSK), Acme Packet and Heico, which appear to have near term risks but good long term value, will be avoided for now. All three are very attractive though, and I’m intrigued by how Autodesk is shifting to a SaaS based sales model. The trouble is, it is doing so at a time when its end markets are deteriorating.

Similarly, I think there are real signs of a moderation in growth in China, and Coach and Joy Global (NYSE: JOY) do have heavy exposure. With that said, perhaps much of it was in the price and they bounced back as a result of hopes for a stimulus package from China? It’s possible, but overall I would still urge caution. The US housing recession unfolded over years, and I see no reason to expect anything different from China’s fixed asset investment.

The Bottom Line

I’m pleased with how things are going, and the general theme of overweight US housing, health care and assorted secular growth stories is working. Avoiding over-exposure to emerging markets and cyclical stocks has worked too. My selective technology buying hasn’t worked well (unless it's where I added after downgrades) and my avoidance of some of the high-yield-but-also-highly-rated food stocks has also seen me give up gains. No matter, I’m sticking to my guns here.

It’s a tricky macro environment, but if us private investors can carry on sticking our heads together we can continue to beat the index-hugging professionals without too much difficulty.

* just over 33% p.a. since end 2009 with an R^2 of .07 and Sharpe ratio of 1.07

Is Costco Worth Buying Now?

I’m a great advocate of ignoring short term price movements in favor of focusing on the underlying value in a stock but in the case of Costco Wholesale (NASDAQ: COST) this week  I am going to break that principle. I think the price action told you all you need to know. In other words, a strong set of results was met with a nice rise and then a negative statement from Dollar Tree (NASDAQ: DLTR) hurt the sector and immediately wiped out the gains. Costco closed lower just before the results. Go figure.

Now I know what you are thinking. Here is going to be another boring article which can be summarized as ‘great stock but fairly valued, no buying opportunity here.’ If so, you would be right, but I’m not going to apologize for this. If you want to read writers that laud jubilant pom-pom praise on a stock because they know it gets attention then you can find that elsewhere. I happen to invest my hard earned money in the things I write about, so forgive me if I express caution on occasion.



Costco Delivers

That said, the important thing is to monitor developments here, and I think it is positive for Costco. If you agree with my general investment thesis of the risk weighted towards US upside/China downside then the big box retailers like Costco, Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) are well worth looking at.

The general idea is that as credit conditions ease in the US and employment gains slowly increase we should see stronger end market demand coupled with some margin increases from deflation caused by a relatively weaker China. If you buy the argument that emerging market (EM) demand growth is behind the marginal increases in certain commodities, then if GDP growth is slowing in the EM world so commodity and raw material costs should moderate too.

For example, I have fleshed out this argument with regards to oil/gasoline in an article linked here. You don’t have to read the whole article, just note the contributions to oil demand growth made by Asia/Pacific in recent years and then think about what could happen if that slows.  Similarly go and look what companies like Cree and Intel are saying about falling demand and prices for things like LEDs and semiconductors and this is partly due to weaker than expected EM demand.

Before I develop this argument I want to demonstrate how things are trending with Costco. Here is a chart of comparable sales growth, revenue growth and gross margin movements.

There appears to have been a trade off between revenue growth and gross margin movement since the start of 2011, but the market got excited by the combination of margin improvement and revenue growth in the last quarter. As the chart demonstrates, this looks to be more about contributions from new stores, because comparable same store growth wasn’t as strong as revenue growth. No matter, these metrics are trending in the right direction.

How the Industry is Performing

Going forward the likely benefit from deflationary input costs is going to come from apparel and electronics. The drought in North America has contributed to soaring feed costs, and protein costs are inevitably rising as a consequence. This is inevitably going to hold back margin expansion but opportunities still exist.

For example Wal-Mart recently pleased the market by lowering its future capital expenditure plans and confirming it is on track to reduce its operating expense margins by 100 basis points from 2013 to 2017. Margins matter, and if gross margins reduce going forward then Wal-Mart will find itself in a favorable position.  Similarly, Target has performed well this year as its strategy of store remodeling has brought about favorable same store sales growth. In common with Wal-Mart and Costco the stock has hit a new 52 week high recently.



The Bottom Line

So if top line growth looks good and margins are likely to expand then why aren’t these stocks raging buys?  As ever, I don’t think you can divorce a stock’s prospects from its evaluation, and it’s hard to conclude that they are cheap. All it took was for Dollar Tree to give a disappointing update, and Costco retracted pretty sharply. Dollar Tree's problems look more company specific (it has trailed rivals sales per store growth for a while) but even this is enough to scare investors. Turning back to Costco, on a PE of around 25 it looks fairly valued to me and fairly valued stocks tend to not tolerate any earnings disappointments. The good news does look like it has already been baked into the price.

With that said, the outlook does appear good here and it fits within an overall investment theme that is working this year. My guess is that any significant dip in the share price will be met by buying, but value orientated investors might want to wait for that dip first.

The Slowdown in China's Fast Food Sales

I’m writing this article in a café in on the corner of a boulevard in Central Eastern Europe. It is a square shape building that has an L-shaped KFC surrounding it. As I write this article on Yum! Brands (NYSE: YUM) the allure of the Zinger Tower is increasingly tempting me. By the end of this I suspect I’ll be partaking in the hospitality of the Colonel’s finest home cooking. I’ll let you know if they have any paprika flavored specials later.*
Okay the pat journalistic intro is over so it’s time to get to the beef of the argument or rather the chicken and pizza of the matter. Yum delivered a pretty solid set of results. I suspect many commentators will look at the sharp rise in the share price and immediately conclude that things are on fire here. It’s certainly hard to be downbeat about a company that just reported EPS growth of 18% and raised full year EPS guidance to 13%, however, our role as investors is to be objective and I think there is some cause for caution here.

Visions of China
The first thing to understand about Yum! is that it now makes the majority of its profits from China.

The company now has 4,952 restaurants in China with another 750 planned for 2013, but I was more impressed with the 6% sales growth recorded in the US then the same amount put up for China. Its US operations have been restructured amidst fierce completion from the likes of Domino’s Pizza (NYSE: DPZ) and others. Despite revenues declining in the last quarter Domino saw same store retail sales increasing 1.7% in the second quarter. This may not sound like much, but it is within its long term 1-3% expectation.
But back to Yum! and China! In listening to the associated commentary around the results it’s clear that China is slowing and we can see that in the evolution of same stores growth in China.

Spot the slow down?
Or is it? Investors need to recall that this year’s growth is coming off some spectacular rates last year. And here is the key question. We all know that China’s growth is moderating and this is having an effect on growth but will it settle down to a level that allows for the kind of profit expansion that is baked into Yum’s valuation? The latest figure of 6% same store sales growth is actually a bit lower than GDP growth and certainly lower than nominal GDP growth. Will it snapback?

Competition Heats Up
I’m a bit cautious on this front. No one likes investing in the tail end of a retail investment boom where suddenly everyone is fighting for a bigger piece of a smaller pie and I find it hard to conclude that this is not what will be happening in China.
This is especially a concern because Yum’s slowing same store sales growth is confirmed with how McDonald's (NYSE: MCD) has been finding things in China (APMEA) this year.

The Big Mac meisters managed to record 5.7% same store sales growth in APMEA in August but it has been tough going this year. It is continuing to expand store growth in China and its rival Burger King (NYSE: BKW) is doing the same. Burger King has signed a joint venture with a ‘proven franchisee’ who has committed to opening 1000 restaurants within the next 5-7 years. Add this to the 750 that Yum! are planning for China next year and it starts to add up to a lot of new fast food outlets. It’s great when the going is good, but not so fine if the economy slows.

Where Next for Yum?
As impressive as the performance was in the US with operating margins expanding over 400 basis points as it cuts back on company ownership levels. As a consequence US profits were up 13%. This is fine but the long term story is really about China. Yum has tied its colors to the China mast and its fortunes will be decided by its performance there.
So far Yum! is doing very well, but its rivals are expanding store growth and the market is slowing. Unless you are a China bull, I would suggest looking for a bit of stability in same store sales growth trends and/or some slowdown in overall industry expansion plans in China before piling in. At some point comparables are going to get very tough to beat and unless China picks up growth there could be overcapacity down the line.


*I couldn't see any paprika specials although I suspect they do something. However, they do seem to be pushing this odd KFC Kebab? thing in the light of the local fixation with kebabs with yogurt.