This blog is devoted to helping investors make informed decisions. It will be regularly updated and provide opinions on earnings results. It is not intended to give investment advice and should not be taken as such. Consult your investment advisor.
Investors looking for a read on the global economy usually take an interest in mining equipment company Joy Global’s(NYSE: JOY)
results and in previous years they have had good reason. The two key
drivers of its prospects in recent years have been Chinese demand for
coal (more or less a proxy for steel demand) and US coal demand. In this
article I want to highlight a few economic indicators with which
investors can monitor prospects for Joy Global. In addition I’m going to
warn that JOY is possibly not going to be as useful an indicator in the
future.
US Coal Demand
Starting with the US, the world knows that the shale gas revolution
in the US has seen gas marginally replacing coal as an energy source for
electricity generation. Indeed JOY pointed out that the share of power
generation coming from coal fell to 33% from 43% by April but has risen
to 38% as natural gas prices rose in the summer.
In addition in the earnings release it pointed out that coal from the
Powder River Basin was competitive at $2.50, then Illinois Basin at
$3.00 and then Central Appalachia at $4.00. So if you want to know about
JOY’s US coal prospects then I would suggest keeping an eye out for
natural gas prices.
Here are spot prices courtesy of the US Energy Information Association (EIA).
The trend has been looking better in recent months but is nowhere
near pre-recession levels. Nor is it anywhere near the 2008 boost where a
lot of hedge funds purchased natural gas in order to use as energy to
produce hot air.
Another great indicator for JOY investors is the US rail carloads of
coal from the American Association or Railroads (AAR) which can be accessed here.
The coal charts are on page 10 and they indicate a tick up in November
but they are still tracking way below the previous years’ numbers. In
addition there doesn’t seem to be any slowdown in the US to try and
expand gas production. I wouldn’t get too excited by coal just yet.
China’s Fixed Asset Investment
The Chinese economy has been categorized by huge increases in the
amounts of investment in housing and construction over the last decade.
The question isn’t whether that was where its economy came from, but
rather where it is going?
For the current picture, investors can look at the official
statistics from the National Bureau of Statistics of China website which
is linked here. The latest numbers show a slowing in the rate of growth and particularly from private investment.
It is not hard to see that private sector investment growth has been
slowing this year amidst a slowdown in China’s rate of economic
expansion.
Now I am going to confess something here. I listen to a lot of
earnings conference calls and read a lot of reports and one familiar
refrain this year has been the idea that China’s stimulus spending was
going to kick in and drive growth in the second half of 2012. Many
companies are holding out for hope in this regard and the latest
catalyst is seen as coming from the regime change in China.
There are two questions here. The first is whether the stimulus will kick in and the second is which companies will benefit?
Frankly I think that anyone thinking that any upcoming stimulus will change
previous plans will be proved wrong. On the contrary the signs are that
China prefers to focus on stimulating domestic demand via private
investment, consumption and domestically orientated industries rather
than in the housing sector or major public infrastructural investments.
Unfortunately there is no certainty with these plans but it doesn’t look
like the kinds of plans undertaken in 2009 to keep the economy growing.
If Not Construction?
If the thesis that China’s increase in spending won’t necessarily
benefit construction and mining then who might benefit? My hunch is that
sectors like technology could be set to benefit. The Chinese may be
reluctant to undergo another construction boom but they don’t show any
signs of wanting to slowdown technological development.
For example, Intel(NASDAQ: INTC)
is hoping that China’s stimulus spending is going to kick in and
stimulate electronics demand which had been getting progressively weaker
as 2012 went on. I discussed the stock in more length here
and I like the long term prognosis and the evaluation but would caution
against buying it until gross margins are forecast to trough.
Another two stocks that I think should be considered are Cognex Corporation(NASDAQ: CGNX) and Cree(NASDAQ: CREE). Cognex is a play on the increased automation of manufacturing
and its potential to grow long term revenue in China is significant.
The near term problem is that when companies cut back on investment it
will affect all programs and Cognex would be inevitably disappointed
with certain programs. As for LED and lighting company Cree I think that
it is starting to look very interesting.
The LED industry looks set for another upswing in growth from lighting
and I think any expectations from significant upside from China street
lighting investment should be sedated by now. In other words, any
increase in China’s street lighting plans that significantly involve
Cree could create a lot of upside surprise.
Any Joy Out There?
Turning back to Joy Global and putting the outlook for US/China coal
markets together leads to the conclusion that end markets might not get
noticeably better for JOY or other mining and construction focused
companies like Caterpillar(NYSE: CAT).
Indeed CAT has actually increased its exposure to mining related
expenditures with its purchase of Bucyrus. The result of this exposure
can be seen in the gradually lowering of estimates for CAT throughout
this year.
In conclusion, if you think that China will stimulate its economy
with fixed asset investment than go ahead and pick up some JOY or CAT. A
second option would be to look at companies more focused on where China
might spend or a third is simply to wait and see. I confess I’m in the
third camp but watching closely in order to move into the second.
It’s always interesting when a company that you monitor gives
disappointing results, because it can create a decent buying
opportunity. In this case it’s time to take a look at financial
information services company FactSet Research Systems whose results were greeted with an immediate markdown. So is it time to buy?
FactSet Research’s Q1 Results
A quick summary of the results and guidance:
Q1 Revenues of $211.1 million vs. estimates of 212.3 million
Q1 Non-GAAP EPS of $1.11 vs. estimates of $1.11
Q2 Revenue Guidance of $212-215 million vs. estimates of $216.3 million
Q2 Non-GAAP EPS Guidance of $1.11-1.13 vs. estimates of $1.13
So it’s a revenue miss, and the guidance is lighter than analyst estimates for both revenues and earnings. Time to get worried?
Yes and no. This was a somewhat confusing set of commentary and
results which left as many questions as answers. For example, the key
metric that FactSet always guides investors to is the Annual
Subscription Value (ASV), which is a snapshot of what its annual
revenues should look like. Of course, as time goes forward FactSet will
lose and gain clients so it usually increases in time. It's only a
snapshot.
The ASV number came in quite healthy, although the number of clients seemed to be slowing in growth.
In order to demonstrate the underlying trend, I have charted the
growth rates below. They reveal that the ASV is actually increasing its
growth rate this quarter. There was some contribution from the
StreetAccount acquisition in June, but nevertheless organic growth was
at a healthy 7% organic growth rate.
Moreover, FactSet disclosed that more than 95% of its ASV was
retained as well as 92% of clients. Furthermore, in the conference call,
investors were encouraged to think of future revenues being more about
the quantum of growth in customers than any significant client churn. So
the ASV looks good.
So Why the Weak Guidance?
It was interesting to hear analysts asking these questions but
FactSet kept a pretty straight bat in answering them. It is
understandable if, for reasons of commercial sensitivity, the company
doesn’t disclose too much granular detail, but as investors we are
entitled to ask. Indeed, one of its rivals Thomson Reuters had reported weaker numbers with its financial information subset
earlier in the reporting season. So perhaps TRI was responsible for
weaker pricing? Or is the market weak overall?
In addition, FactSet sees its chief rivals as being Bloomberg and, McGraw-Hill’s subsidiary
Standard & Poors. Both have been coming out with new products and
innovating so, again, this may be an indicator that FactSet is facing
competitive pricing pressure?
A Novel Answer
In the end I don’t think it was either of these issues. FactSet’s
management declared that there wasn’t any significant change to pricing
in the quarter, so the weaker guidance is probable not due to market
share losses or pricing.
My take on it all is so novel that it is brilliant. Perhaps its
better just to accept what the management said? In short, FactSet placed
a lot of emphasis on headwinds within its sell-side business (around
19% of revenues) with some challenges faced by the industry due to low
transaction volumes and a lack of merger & acquisition advisory
work.
On the other hand, the buy side (81% of revenues) is doing okay with
equity markets given solid returns this year and clients happy to
expand. A nice way to think of this is to compare Bankrate with Morningstar this year.
This is a rough proxy, but Bankrate sells a lot of banking &
insurance information while Morningstar sells information mainly on
mutual funds and investment management. It’s not hard to see who has
been faring better this year.
The Bottom Line
In conclusion, I think what we are seeing here is some weaker
guidance simply because one area of FactSet’s revenue generation is
weak, but these situations don’t last forever, and I think the
environment is favorable for a pick-up in M&A activity. Then again
you’ve heard that one before!
As for competition from Bloomberg , Reuters and S&P I think it is
fair to think of FactSet’s offering as a ‘trading down’ option. It has
the potential to do well even if the economy turns down, because instead
of buying expensive terminals (which as ever I will point out that I
have never seen turn a bad investor into a good one) clients may choose
FactSet’s products. The company might not agree that it is a trading
down option but then again, I’m investing my own money on my own
opinions, and that’s all that matters to me.
With today’s decline, the stock looks close to fair value to me so
it’s still on the monitor list. There is not a lot wrong here, and if
M&A activity does pick up then so will FactSet’s stock price. One to
watch.
By now investors will be getting well into 2013 and looking forward
to planning out the year. It’s a quiet week but we can always use these
periods as a chance to discover and research new stocks. In addition it
is the week of the JPMorgan Healthcare conference and anyone who is
anyone in Biotech and Pharma will be there. It’s a great chance to find
out what’s happening in healthcare.
With regards earnings news, it’s a pretty disparate collection of
stocks but there are a few things here that will give some interesting
industry color with which we can read across.
Tuesday
Acuity Brands (NYSE: AYI) gives results. The lighting company is a favorite of mine and I picked some up after it disappointed last time around.
The Architectural Billings Index has perked up recently and this could
be reflected in Acuity’s results even if the previous quarter to August
was a bit weaker than expected. In addition with most of the LED
lighting companies continuing to report good growth, I would expect an
increase in Acuity’s LED based lighting and controls sales as a portion
of their overall sales. The market has anticipated a decent set of
results so let’s see.
Inevitably, much of the focus will be on Alcoa(NYSE: AA) and more importantly what it says about its end markets. There is a summary of the developing trends linked here.
I’m particularly interested to see what it says about conditions in
North American commercial building and construction as I am expecting an
improvement and perhaps a downgrade to expectations in China.
Similarly, automotive in North America remains strong, but globally the
market for heavy truck and trailer got weaker throughout last year. The
really interesting thing will be to hear what Alcoa says about Europe
because growth has been weak there, so companies will start lapping
easier comparables.
Other companies reporting are Lindsay Corp, Monsanto and Global Payments.
Wednesday
ConstellationBrands and US investors will look forward to hearing if the wine will keep flowing like beer and AZZ Incorporated will give indication of how the power equipment market is shaping up this year.
Thursday
The industrial sector has experienced some tougher conditions recently so any good news out of MSC Industrial Direct (NYSE: MSM)
will be greatly received. The industrial supply company usually gives a
great indication of where the US industrial sector is headed and along
with Fastenal, I think it is the best stock to follow
in this regard. However, MSC does usually have limited visibility so
look out for a lot of variability in its commentary. I would be
surprised if investors got anything more than a ‘cautiously optimistic’
out of the company. It is also useful that Synnex Corp will give results and putting them together can give a good overall picture of the industrial sector.
The mass consumer market in the US was weak in 2012 and Supervalu(NYSE: SVU)
has suffered disproportionately. However it would be churlish to merely
discuss its markets and earnings potential. The real story here is of a
company trying to survive its huge debt and possibly restructure by
disposing of investors. The stock will greatly interest special
situation or deep value investors, but it has little attraction for a
growth focused investor like me.
Friday
The big news on Friday is the results from Wells Fargo(NYSE: WFC).
It might not be the sexiest financial out there, but investors who are
not interested in subsidizing prop traders flighty punting in the sector
will be more attracted to it. The bank has been aggressively increasing
exposure to the US mortgage market and what it says about future credit
issuance is an important indicator for the US economy at large. The
Federal Reserve has been trying to get banks to increase lending and
perhaps 2013 is the year when it will happen. In addition look out for
any commentary on a potential settlement over the foreclosure debacle.
I often think that Wittgenstein was wasted as a philosopher. Of
course he was born of a very wealthy family so he didn’t need to bother
learning how to invest but, if he had, he would have loved the kind of
philosophical puzzles that investors are faced with on a daily basis.
These obscure thoughts came to my mind in considering the latest set of
results from Ciena (NASDAQ: CIEN).
The Ciennese Waltz
Here is a company that misses estimates and guides the next quarter
lower than existing consensus estimates while expressing a healthy
degree of caution over analysts (positive) forecasts for growth in
telecoms spending. Analysts then downgrade estimates and price targets.
The stock goes up. Does all of this make sense?
Well as a matter of fact I think it does.
Essentially Ciena managed to eke out revenue and gross profit growth
in Q4 and for the full year within declining end markets. It did this by
winning market share and increasing diversification by developing sales
within new markets. Ciena isn’t profitable yet but it did generate
around $59 million in free cash flow and reported record orders for Q4.
With orders totaling over $2 billion in 2012 and a current backlog of
$900 million, the current analyst estimates of $2 billion in revenues
for 2013 may prove a little light.
Ciena also claims to be benefiting from the trend towards network
convergence. Indeed, starting from the next quarter it will report
results within new segments that reflect this. Investors need to look
out for this when modeling the company.
In summary, it is a story of execution within difficult end markets.
Aside from convergence, the other big driver for Ciena will be the move
towards 100G networking, within which it is well placed. Indeed, the
company offers a compelling proposition because it does not have
substantive legacy solutions that will drop out of the top line thanks
to technological obsolescence. In other words, it’s a good stock to
consider if you think there is upside to telco spending next year.
This Means Nothing to Me, Oh Ciena
The truth is that irrespective of how well Ciena is executing, if the
telcos don’t pick up spending next year then investors will be
disappointed. I’ve looked at the current situation in an article linked here
and for a variety of reasons the big three have actually cut spending
plans for this year. Of course, this turned out to be a bit of a letdown
because the telco suppliers had been hoping for an increase in spending in the second half.
So why are industry analysts being so optimistic about 2013? And are investors setting themselves up for another disappointment?
The case for higher spending is based on an underlying assumption
that telcos have been cautious on spending because of macro fears.
However, the reality is also that pressure is building up thanks to
increasing strains on capacity caused by things like rising smartphone
penetration using bandwidth-rich applications. I’m sympathetic to this
argument but consider it apposite to listen carefully to what the telco
are saying themselves.
Sprint Nextel seems to be pushing some spending into next year while Verizon is making a virtue of reducing CapEx as a proportion of revenue going forward. The big hope lies with AT&T(NYSE: T),
and it is talking up CapEx plans for the next few years. Happy days are
here again? Perhaps, but at the end of the day it is still largely a
macro call. The way to think of Ciena is as a leveraged play in growth
that has its merits in its own right.
Markets and Competition
Ciena was clear on the conference call that it had been subject to
pricing competition with rivals trying to take market share but, given
that, Ciena actually increased their share. Moreover, when rivals like Inifinera(NASDAQ: INFN)
make more positive noise on the pricing environment it suggests that
conditions might be getting a little better for the industry. Infinera
is predicting 10-20% revenue growth for 2013 with particular strength in
100G.
As for telco spending in general, Cisco Systems(NASDAQ: CSCO)
also referred to better signs from US carriers, and I doubt anyone will
get an earlier, more accurate read than Cisco. With that said, Cisco’s
switching revenues have been very lumpy for the last year or so. They
appear to have alternate good and bad quarters so it is hard to read a
trend into them.
In general, most of the telco focused companies are talking about
Europe remaining weak yet stable, but US conditions appear to be set to
get better. Putting these things together suggests that telco spending
overall can generate supra-GDP growth next year.
Where Next for Ciena?
I think the solution to this philosophical investment puzzle is to put Ciena in a class of telco stock alongside something like Acme Packet(NASDAQ: APKT), a stock discussed here, which
also has technological leadership in an area of telco spending that is
likely to be ramped up if/when telcos upgrade networks. APKT offers
upside from the increased spending on voice over LTE while Ciena is
strong in convergence and 100G networking.
They are probably the pick of the sector, and growth orientated
investors who buy the telco spending recovery story will be well advised
to take a look. However, as a GARP-based investor I would probably like
to see some stronger evidence of increased telco spending first.
If anyone had any lingering doubts over the recovery in housing related spending, then home furnishings retailer Pier 1 Imports' (NYSE: PIR)
latest set of results would have surely dispelled them. The housing
investment theme is doing well and Pier 1 is executing on all fronts
with its nascent e-commerce operations generating good growth. In
summary, I think Pier 1 remains a good play on housing with some near
term upside, particularly as I believe its management is being cautious
with guidance. On the other hand I have some longer term concerns.
Pier 1 Imports' Q3 Numbers
Results exceeded expectations, and PIR reported a 7.9% increase in
comparable same store sales. This is impressive stuff given that a
significant number of its outlets were hit with closures thanks to
Sandy. In addition, this number comes on top of a 6.7% increase in the
last quarter. Putting these two figures together suggests that the
continued guidance of mid-single digit same store sales guidance for the
full year may prove to be conservative.
This was the second quarter in a row where footfall and average
ticket item spend went up, with the company claiming broad based
strength across its product range. It cited particular strength in its
furniture range. In common with the likes of Home Depot(NYSE: HD),
management called out the start of a housing recovery. The interesting
thing about HD’s latest results was that it is the discretionary parts
of spending that are starting to improve (kitchens, baths, flooring
etc), and this is a sure sign that housing is coming back. PIR's sales
are more weighted to the discretionary end, and it should benefit
disproportionately from a recovery.
The improved environment also suggests that PIR will hit some long
term targets a bit earlier than expected. Management is on record as
targeting e-commerce to be 10% of revenues by 2016 and sales per retail
square foot in stores to reach $225 by 2015. Given that e-commerce
revenues are already around 1.5% of total revenues (after just four
months) and sales per retail square foot are currently $194 on a
trailing basis, it is not hard to speculate that PIR is very much on
track.
E-commerce Initiatives
Its e-commerce activities are performing well, but it’s here that I
have some long term concerns. PIR is unique in the sector in that it
offers online customers the option to pick up orders in-store, and it
was surprised by the strength of take-up (35% of online sales) for this
option. This is a good thing because it encourages more footfall and
customer interaction to possibly increase things like impulse purchases.
Apparently online customers are spending twice what in-store customers
are, but it is hard to know whether that is due to the type of customer
shopping online or something intrinsic to purchasing online itself.
My long term concern here would be with online cannibalization of its
retail store sales and the effect that this might have on its gross
margins and customer loyalty. PIR sells a lot of low ticket items that
are, arguably, exactly the kind of products that can be sold online
effectively. The problem is that everyone else can do it too, and there
is no shortage of companies expanding in the space. Amazon’s subsidiary Quidsi has casa.com in the space and Williams-Sonoma saw its online sales expand 17% in the quarter.
Furthermore off-price retailers like TJX Companies (NYSE: TJX) and Ross Stores(NASDAQ: ROST)
are both rapidly expanding their home ware retail outlets and taking
advantage of strong footfall attracted by their off-price clothing.
There is nothing to stop either expanding their online offerings and I
suspect it is only a matter of time before other retailers move into
areas where PIR may be expanding strongly.
On a more positive note, PIR’s in-store pick-up does create
differentiation and investors should look for this to expand. This could
somewhat restrict the opportunity for operating margin expansion with
online sales in the future. I don’t believe PIR’s idea is to become an
online retailer in the long term.
Where Next For Pier 1?
As ever, investors want to know where the stock price is headed from
here. I think the indications and trends are indicating a good Christmas
for the sector, and PIR should see some benefit. Full year non-GAAP EPS
guidance was raised again to $1.17-1.21 from $1.10-1.16 last time
around. I think the management may be a little cautious with guidance in
general, and investors might see some upside ‘surprise.’
My long term concerns are, well, long term, and even if I am right I
don’t think that they will bite into PIR's prospects just yet. My guess
is that PIR will continue to do well, but I prefer other stocks within
the theme.
Investing in stocks is supposed to be easy, but it rarely is. Take a look at Adobe Systems(NASDAQ: ADBE).
There is no end of confusion with this stock, and most of it is
centered on its transition to subscription-based software as a service
(SaaS) sales from a perpetual license model. In other words, Adobe is
deliberately trying to give up immediate upfront license revenues in
favor of longer term revenues.
This creates a disturbing trend whereby revenues, earnings, and cash
flows (everything you normally look at to go up) initially dip but then
should accelerate as the longer term benefits of subscription based
customers kicks in. In fact, Adobe intends to accelerate this process in
order to get to the trough point earlier in 2013. See what I mean about
investing not being easy?
Adobe’s Transition Ahead of Schedule
I appreciate that this is somewhat of a conceptual argument, but if
you are interested in the stock than you must spend the time
understanding it. This chart helps to clarify how Adobe makes its money
and the transition.
Note the yearly decline in digital media revenues. Of course this is
part of the plan. Let me paraphrase one important comment from the
conference call: a customer might pay $780 for a license upfront in the
perpetual model, but he will pay roughly $480 a year in the subscription
model.
In reality it is not quite that simple, because subscription
customers will churn. When asked about the retention ratio (how many
annual subscribers would renew), Adobe’s management disclosed that they
were modeling 80%.
For example purposes, putting this together gives a very crude figure
of $480+ ($480*.8) = $864 over two years instead of $780 over one.
It’s not hard to see how that the immediate transition from $780 to
$480 will hurt initially, but then happiness returns as revenues migrate
into another $384 next year. This is roughly how to think of Adobe in
2013. The company is modeling a trough year in terms of revenues,
earnings, and cash flows, but then forecasts a compound annual growth
rate of 15% for the creative cloud from 2014-2016.
If this translates into overall revenue growth, then the $4.1 billion
forecast last year will turn into $6.24 billion in 2016, and if Adobe
can get back to converting around 30% of its revenues into free cash
flow (as it did in 2009-11) then it could be generating nearly 12% of
its current enterprise value (EV) by then.
If you want to model 30% FCF Conversion as an ‘underlying rate’ for
2013, then the 4.1 billion in forecast revenues translates into
(4.1*.3)/15.9=7.7% of its current EV.
Still think the stock is expensive?
Believing the Numbers
The poster boy of the transition to the cloud is Intuit(NASDAQ: INTU),
and if its example is anything to go by then Adobe will find its
customers enjoying the ease of access to updates and applications that
they otherwise would not have gotten. In addition, Intuit is finding it
easier to market and cross sell to its customers. This is a key point
for Adobe because its mix digital media and marketing has powerful cross
selling opportunities and will help differentiate it from the
competition.
In its own right Adobe’s digital marketing solutions are seeing rapid
growth as marketers seek to generate returns on investment across multi
channel platforms, while using data analytics to work with the huge
amounts of information being generated by things like social media.
The Competition
Yes, Google (NASDAQ: GOOG)
offers some free analytics and a growing premium service, but there is
no sign that it is eating into Adobe’s growth. Google Analytics is seen
as being supportive of Google’s overall revenue generation in Search and
Advertising rather than a focal point. In addition, IBM(NYSE: IBM)
is a growing presence in data analytics, but I believe it is right to
think of Adobe as being to marketing analytics what Salesforce.com is to
sales. In other words, a leader in a fast growing niche whose
constituents are familiar with the product and sales approach. IBM’s
target markets are more horizontal across many industries.
Market, Psychology and Criminals
One big point in Adobe’s favor is that –unlike Autodesk(NASDAQ: ADSK)
- it is faced with very favorable markets while it makes the transition
to SaaS. Digital media and marketing are hot areas right now, while
Autodesk is facing some significant near term challenges in its execution however longer term it is starting to look attractive.
Behavioral psychology also suggests that Adobe will find it easier to
attract new customers. Offering a lower initial pricing point tends to
be more efficient at generating the same revenue because, according to
the theory, people tend to overweight near term losses.
Another little discussed point (for obvious reasons) is that Adobe is
often the victim of intellectual property theft. Offering more
accessible entry points will somewhat encourage those who are currently
stealing from the company and using some incomplete Adobe solutions to
buy the original subscription.
Where Next For Adobe?
For the short sellers it looks like a day of reflection is at hand.
For the longs the progress of the company carries on and ahead of plan.
It is not the easiest company to analyze but prospects appear very good
here, and I think as long as it exceeds its internal targets then the
market will reward the company. There is a reason why so many are keen
on investing in cloud based models: they work.
In a recent article, I suggested that Costco(NASDAQ: COST)
was going to see decent results but the stock was hardly looking cheap.
Judging by the market’s initial muted reaction to the recent Q1
results, it seems that it agrees with me. The numbers were pretty good,
and the read across for the US economy and retail in general is good. It
is part of a slowly evolving, but positive, trend and investors should
not downplay its significance.
Costco’s Q1 Results
A brief summary of the results
Q1 Revenues of $23.72 billion vs. estimates of $23.67 billion
Q1 Diluted EPS of 95c vs. estimates of 93c
It’s an earnings ‘beat’ but it seems this was well anticipated by the
market. No matter, serious investors focus on reading into the long
term trends rather than knee jerk trading over results. With this in
mind, I think there are some interesting things here which this chart
helps to demonstrate.
The key point here is that this is the first quarter in a while where
gross margins (yearly comparison) have improved at the same time
comparable sales growth has accelerated. Whereas previously it was
possible to argue that there was a trade-off between margins and sales
growth, this is no longer the case. I think there is a good case for the
argument that the big box retailers are going to move into a ‘sweet
spot’ where a marginally stronger consumer increases their top lines
while slower growth in emerging markets reduces input costs as commodity
prices fall and demand from China etc slows.
Broad Based Strength
Costco saw broad based sales strength across its categories with
particular good results within ‘hard lines’ sales. Interestingly
management declared that gross margins were flat in hard line sales,
with any significant inflationary effects mainly restricted to fresh
food categories. The latter hasn’t had much effect on sales, but the
former is somewhat surprising. My suspicion is that margins in hard
goods and electronics will start to improve in future quarters.
However, the strength in hard lines was a bit unexpected given that Target(NYSE: TGT)
had cited hard line comparable sales as being slightly down, with
particular weakness in electronics. It is easy to put these things
together with flat gross margins (in hard lines) and conclude that
Costco must have been extra competitive on pricing. If so, it wasn’t
apparent from the conference call.
This is all somewhat distinct from what Wal-Mart(NYSE: WMT)
said in its recent results, in which it announced that comparable same
store sales growth came in lower than it had expected. Wal-Mart cited
movements from inflation (causing more trading down), and deflation in
some categories (that came late in the quarter) reduced sales growth.
Moreover, Wal-Mart had cited macro weakness and a level of uncertainty
amongst its customers that Costco did not.
Turning back to Costco specifically, membership fees increased by
over 14% but were expected to be somewhat higher in some quarters.
Frankly I don’t think this is a particular issue because Costco
increased fees by 10% last year, and although this implies new member
growth has slowed, the key issue is to keep renewal rates up. Longer
term customers tend to spend more in retail so the first priority should
be to keep existing customers.
Where Next for Costco and the Big Box Retailers?
As ever, investing is about trying to find the right price to pay for
the risk/reward profile of a stock. For the reasons articulated above I
think the big box retailers will see an improvement in performance;
however, they also face the same macro risks as the rest of the market.
Therefore, any investment in the sector is de facto a position
on the direction of the economy, especially as Wal-Mart's, Target's and
Costco’s customers and their spending decisions will be governed by how
they feel about their incomes and job security.
Costco is undoubtedly the strongest performing of the three, but its
PE of 25 and EV/EBITDA multiple of nearly 11x means it is hardly cheap,
despite the double digit growth forecasts. Putting these things together
means Costco is going to have to stay on my monitor list for now.
The US housing sector has been one of the best performing themes to
be invested in this year, so the recent IPO of luxury home furnishings
retailer Restoration Hardware(NYSE: RH)
seems to have come at the right time. The stock certainly represents
another way to play the idea, however I think the investment proposition
here is largely about the company’s internal execution. It's not a pure
play on a stronger housing market but it will appeal to growth
orientated investors who want exposure to a high growth company with
favorable end markets.
A Favorable End Market
Most companies have a pretty similar evolution and RH appears to
still be in the fast growth stage. This is somewhat expected of a recent
IPO, but what took me back about this company is how much uncertainty
there is over the quantum and quality of its future growth. RH is
targeting a combination of mid-high teens revenue growth with EBITDA
growth in the twenties and EPS growth of around 20. This is wonderful in
theory, but investors will price the stock on their level of belief in
the company hitting these targets.
So how will RH generate growth and why the uncertainty?
As a high end luxury retailer, it is set to benefit from a gradual
recovery in housing, particularly within this kind of high end led
recovery. It is an indisputable facet of this recovery that income and
wealth outcomes are becoming more polarized. The rich are getting richer
and prospects are looking good for those servicing them. I’m not saying
it’s right, but I’m not denying the fact of it all.
Restoration Hardware’s Growth Plan
As for RH, it is planning to expand locations and introduce new
channels and concepts to the market. With regards to the former, the
company argues that only 25% of its existing offerings are currently
displayed with sharp increases in sales predicted once retail space is
expanded to accommodate more of its offerings.
Similarly, a combination of new distribution centers, increased
automation and utilization of its ‘center of innovation and development’
will ensure increased operating efficiencies as well as reduce the time
to market. Development costs are expected to reduce along with
increases in operational leverage from introducing new sales channels.
Many of these initiatives will be completed in 2013 so investors can
look forward to these growth drivers really kicking in at the start of
2014.
Looking across the industry, Williams-Sonoma(NYSE: WSM) and Pier 1 Imports (NYSE: PIR)
are both benefiting from the increased willingness of customers to
spend on home furnishings. Although these companies' customer base is
closer to the ‘mass’ consumer, the overlying trends are the same as with
RH. In other words, a resurgent housing market at the high end is
trickling down to increased net household wealth in the economy, and
consumers are spending more on housing. RH is at the epicenter of the
ripples that WSM, PIR and the home goods stores like Home Depot(NYSE: HD)
are profiting from. As long as a bellwethers like Home Depot continue
to give increasingly positive guidance on the housing market then
investors have good cause to favor this theme.
It is one thing to want to play the manifestation of a macro theme,
and it is another to invest in a business on the basis of it executing
in some new growth concept stores and categories. While RH's management
has extensive experience and has generated 11 straight quarters of
double digit growth in revenues, the stock price is likely to currently
represent the past. The sector may be doing well, but investors only
need to take a look at the stock price of Bed, Bath and Beyond to see that that execution is also critical. BBBY simply hasn’t been able to get it right despite improving end markets.
Where Next For Restoration Hardware?
The company declined to give Q4 guidance, which usually means that
its actual numbers will exhibit a higher than usual deviation from
market estimates. This is not so much of an issue because RH is still in
a high growth phase and results will bump around from quarter to
quarter. Analysts have it on a forward PE of around 25x as I write. An
interesting stock, but it requires an awful lot of belief in the
management to justify buying it for all but the most ardent growth
investor.
One of the things that I love about investing is coming across a company like Cooper Companies(NYSE: COO).
It is exactly the sort of stock that-if told about it now- would leave
most investors saying ‘of course! But why didn’t I hear about it before
when it was a great value and it made this big move?’
While it would be easy to fall into this negative mindset, I think we
should think positively and do three things. First, realize that this
means that there are probably other great stocks out there that are as
attractively priced as Cooper was a year ago. Second, research Cooper
and keep it on a watch list or future reference. Third, ignore the price
chart and stick to asking yourself if Cooper is a good value now.
Introducing Cooper Companies
Cooper is a health care company with a rough mix of 80% of revenues coming from Coopervision and 20% from Coopersurgical.
Coopervision is a manufacturer of soft contact lenses, an industry
that has truly proved itself to be recession resistant and currently
generating mid-single digit growth globally. Indeed I looked at Allergan(NYSE: AGN) in an article linked here
and it’s easy to see from that article that its forecasts are
relatively predictable. Rather like Cooper, Allergan is generating
super-industry growth. I think its cash flow generation plus potential
upside from the approval of Botox in new indications as well as the
expansion of sales for spasticity and migraines means it should trade at
a premium.
Novartis(NYSE: NVS)
is also active in the space with its Alcon unit, but its growth rates
are currently tracking pretty close to industry averages. Turning back
to Cooper, its growth rates are higher than those of the industry
primarily because of growth in its silicone hydrogel (more oxygen gets
to the eye ensuring more comfort) based lenses Avaira and Biofinity.
Revenue for these silicone hydrogel-based products grew 24% in the
quarter and now make up 39% of Coopervision’s revenues and 31% of total
company revenues, and they also represent the immediate growth
opportunity for the company.
Moreover, another thing in Cooper Companies favor is that it has the
potential to grow geographically, whereas an already global player in
eye care, such as Johnson & Johnson(NYSE: JNJ),
has less growth potential because it has an established global market
share. It also can generate growth through moving into new ranges of
wear, with the two-week range market (currently dominated by JNJ) being
cited as a target.
In summary, Coopervision has good long term growth prospects through a
combination of geographic, demographic, and product mix (most notable
its silicone hydrogel range), which should enable it to generate
above-trend growth in an industry that already has solid single digit
growth prospects. In addition the trade up to silicone hydrogel based
products is likely to increase profitability and margins in future.
With Coopersurgical, it is a story of integrating the Origo
acquisition and utilizing its international sales channels to generate
growth outside of Coopersurgical’s traditional geographies.
Current Trading and Guidance
Having discussed longer term prospects, it’s time to discuss current
trading and guidance. I’ve summarized what Cooper forecast for 2013 in
the table below.
I would recommend that interested parties bookmark this guidance and
come back to it as the year progresses. The current stock price is
$94.53 with a market cap of $4.67 billion and an Enterprise Value (EV)
of $5.03 billion. Capital expenditures are rising (depressing free cash
flow) in an effort to support expansion of silicone hydrogel based
product sales, but the good news is that should lead to margins
expanding throughout 2013.
As for current trading, thanks to Hurricane Sandy earnings were
lowered to the tune of $0.02, with a particular impact on
Coopersurgical. Indeed, earnings growth in the segment was reduced to 2%
when an organic rate of 4%-5% would have otherwise been recorded. In
addition, there was a $0.07 impact from an inventory contraction in the
quarter. Frankly it is always questionable as to whether this is due to
a genuine inventory contraction or a fall off in end demand. In this
case I think the company deserves the benefit of the doubt because it
doesn’t strike me as a marketplace with particularly volatile end
demand.
Where Next For Cooper Companies?
The mid-point of guidance has the stock on a forward PE of 16.2 and
forward FCF/EV of 4.2%, neither of which look particularly cheap.
However, the stock offers a high degree of solidity in its earnings and a
combination of high single digit top line growth with low teens EPS
growth. Margins and underlying cash flow conversion should improve
throughout 2013, so the stock might start to look cheap if it hits its
guidance.
As ever the decision lies with the conscience of the individual stock
picker. For what it’s worth I think Cooper Companies is a great
investment but slightly overvalued now, and would prefer to try and get
it at a discount. Whether it gets there or not is another story.
Nevertheless, this is a strong stock for the watchlist.
Everyone loves the dollar stores as an investment theme. If there is a
sector of the retail market that has better represented the anemic (but
trending) recovery then I haven’t found yet. This recession has been
particularly hard on blue-collar America and the recovery only seems to
have benefited certain segments of the population. The result is to
create an environment where consumers have gotten used to trading down
and increasing their categories of shopping within discount operators
like the dollar stores. So where are we now with the likes of Dollar General (NYSE: DG)?
Buying Value at the Dollar Stores?
I last discussed the sector in an article linked here.
The key thing to look at in that article is the adjusted free cash flow
figure. Even with this assumption the stocks didn’t look like good
value at the time.
I merely assumed the reported depreciation represented the
maintenance capital expenditures, and this produced a free cash flow
over enterprise value figure. None of which looked particularly cheap.
This sort of thing is usually a good approximation, but it should only
be used if you are confident that the expansionary CapEx will generate
the same amount of return on assets as previous investment. This has
appeared to be a ‘no-brainer’ type argument this year, but Dollar
General’s recent Q3 2012 report and guidance are giving pause for
thought.
Here are the key comparable same store sales metrics for DG and the mid-point of guidance for Q4.
It’s not only that the guidance is weaker, but the commentary around the results has spooked investors.
My Three Concerns with Dollar General
Dollar General described an environment in which rivals are
aggressing on price competition. As a consequence, its management
expressed a ‘cautious’ approach to its prospects amidst a sales
environment of extreme fluctuations in weekly sales. My interpretation
of this is that Dollar General feels this is mainly a factor of the
macro environment and few can challenge its knowledge of the ‘pay check
cycle’ in the US. However, I have two concerns/questions.
Might this not be a result of customers becoming extremely price sensitive and holding out for discounts at retailers?
The dollar stores have all been aggressively expanding stores, and
the traditional grocers/retailers are also starting to fight back on
offering value
With a gradually improving economy, is this the time to be aggressively expanding new stores while same store sales are slowing?
In a sense, I'm building a classic argument of an industry undergoing
strong growth and then being subject to increased competitive pressure
and margin pressure as the competition reacts and capacity expands.
Expansion Plans Continuing While Market Is Getting Tougher
Indeed, the expansion plans are continuing. By the end of 2012, 625
new stores are expected to have been opened with another 635 planned for
next year, and DG described its new store pipeline as being ‘full.’
The amount of square footage devoted to sales is expected to increase
by 7% and in line with recent history.
So expansion plans continue, but DG is having to respond to
competition and will reduce pricing in certain categories while engaging
in increases in incremental advertising. The argument cited was that
this was in long term interests and intended to encourage customer
loyalty. Frankly I find this to be a puzzling argument.
By definition, discount store purchasers are shopping for price. They
aren’t shoppers particularly interested in brand loyalty or being
faithful to an outlet as some kind of affirmation of lifestyle. They
just want to buy some cheap macaroni and cheese, and reducing the price
of it is not going to engender any loyalty to the store doing it beyond
the time when someone else offers it cheaper.
The pricing reductions smack of a forced move to deal with a changing marketplace. Indeed, Dollar Tree (NASDAQ: DLTR) recently reported that its same store sales only increased 1.6% from 4.8% last year. Although, Family Dollar (NYSE: FDO)
recently reported a far more respectable 4.7% same store sales
increase. No matter, both stocks have been beaten up in sympathy with
what DG reported.
Where Next for the Sector?
I like to include Ross Stores(NASDAQ: ROST) and TJX Companies(NYSE: TJX)
in this mix of companies, and they are particularly relevant because DG
reported disappointing results in apparel. Indeed, DG was forced to
issue markdowns in order to try to clear inventory. Is that a warning
sign for Ross and TJX?
As for the dollar stores, they are still attractive businesses, but
growth expectations have to be reduced and I think it’s time for
investors to consider the points I raised earlier. Investors are going
to look for some re-acceleration in same store sales growth, and when it
happens the stocks may well have gotten a bit lower. They are
attractive (the discount store story isn’t over yet), but the stocks
still do not look cheap enough.
In a recent article I spilt some cyber ink on the subject of how investors could better achieve their aims.
The central thesis of the post was that investors need to focus on
ascertaining what is the key qualitative or quantitative factor that
will drive share price. Your ability to discern these factors are what
will separate a good investor from a bad one. Now we all rely on certain
favored metrics in order to try and price out stocks, but sometimes it
is the level of confidence in the numbers that governs the investment
decision. In the case of yoga gear manufacturer Lululemon(NASDAQ: LULU) I think it's useful to invoke some insights from legendary investor George Soros.
Flexibility and Reflexivity
For some background on Soros’s theory of reflexivity I would refer readers to this article.
Soros primarily talked of how favorable price movements attract
investment, which then creates the fundamentals which encourage more
investment, and so on. Ultimately these positive feedback loops lead to
an unsustainable bubble which collapses into negative feedback loops on
the way down. Note that this means you can make money for a long time on
the way up and usually a lot of money within a shorter time frame on
the way down.
Now think about this in terms of supplanting ‘price’ with the ‘feel
good factor’ (FGF) of buying Lululemon yoga gear. Yogis invest in the
brand by buying the gear, it then acquires a FGF, this then encourages
more interest in the FGF, which buyers are willing to pay increasingly
more for. This goes on until one day someone walks into a yoga class
with some super cool looking yoga gear from Adidas (NasdaqOTH: ADDYY) , Puma, or Nike(NYSE: NKE).
All three of these companies are chasing this marketplace with their
own gear. And I think we can safely say that these companies know how to
make athletic gear. The rest is investing history. Consumers will then
start to ponder with the premium attached to Lululemon’s products
adequately recompenses them for the FGF. The decline sets in.
Don’t Underestimate the Power of the Brand
With that said I would urge some hesitation before getting too
negative here. I’ve known more than a few women who eulogize over the
brand and they are willing to pay a premium for the product. I also know
that yoga is a fast growing activity whose attraction is only being
magnified by trends in modern life. The Lululemon story undoubtedly has
legs and the company sells the idea of its products being part of a
lifestyle choice. This is savvy stuff when you are trying to get
consumers to part with money to buy your relatively expensive products.
For a flavor of the company’s presentations I would suggest looking
at the 2011 annual review video accessed on the investor relations site
of their website. It refers to developing a culture of personal
development and aiming for brighter futures, which elevate the world
into greatness from mediocrity. Bemusingly, management claims
“to see what problems and what elegant solutions we are going to
have for people that they are not asking for and that they don’t even
know that they want yet”
and they claim the ability to
“look into the future and require no evidence for where we are
going.. … we know what the future looks like, because we are going to be
wearing it”
They make yoga gear.
It’s easy to lampoon this, but again, I would caution against it.
Yoga is a social activity and Lululemon’s strategy of grassroots
involvement ensures it keeps focus on what its clients want. It is
tapping into the whole lifestyle aspect of its customers, so we
shouldn’t be surprised by this kind of approach.
My point is not to criticize this, but rather argue that this means a
significant amount of pressure is going to be placed on its management
to get fashions right on an ongoing basis. And predicting the future is
fraught with uncertainty. The company may feel it is on top of things
right now, but any drop in popularity or its FGF and the forward PE of 32x is going to look very expensive.
What to do With Lululemon?
It certainly has growth prospects. E-commerce sales are expanding
rapidly. It’s significantly under-penetrated globally and its clientèle
doesn’t tend to be short of money. For an insight into the latter,
consider a similar sort of healthy lifestyle play like Whole Foods Market(NASDAQ: WFM),
which recently claimed that the 80/20 rule applies in its sales. In
other words, 20% of its customers can make up 80% of its sales. This may
be normal in, say, industrial companies, but it is astonishing for a
grocery store. I see Lululemon in a similar vein.
My suspicion is that it is not a stock that is going to work well in
terms of evaluating on its metrics alone. I think the market will keep
buying while it stays hot and the short side needs to beware of being
aggressive here. It’s a stock whose dynamics are more governed by
thinking about reflexivity.
For now Lululemon is hot, and if you put a gun to my head I’d rather
be long than short. However, when you put the gun down I’d tell you I
had no interest in a position or any idea with guessing what the future
was going to look like. Although it is highly unlikely to involve me dressing in spandex and making the shape of a tree while a duet of Olivia Netwon-John and Leroy from Fame sings 'Physical' in the background.
One of the most frustrating things about investing is finding a great
stock then pricing it out and discovering that everyone else seems to
have done the same thing! In other words, the stock is not good enough
value. In this scenario many investors just buy it anyway, but the more
disciplined among us will try to keep these things on a monitor list.
Now monitoring a monitor list is about as interesting as getting stuck
in a lift listening to Carrie Bradshaw talking about Kim Kardashian’s
new haircut, but it has to be done. With that in mind, I thought I’d
make a watch list of stocks to monitor based on previous articles.
It’s not only useful for me to come back to my articles, but I hope
readers might get an idea or two out of it. I’ll also try to discuss any
updates.
Outlining Portfolio Performance
I’ve been trying to objectify my investments by writing about them on
here. I would encourage all investors to try writing things down; it
helps you to truly understand what and why you are doing what you do.
With that in mind, here are the portfolio write-ups to the end of August, September, October and November. I want to focus on the stocks that I‘ve looked at previously and thought were attractive but too rich.
5 Recent Stocks to Monitor
There are five stocks that have been looked at relatively recently,
and I don’t want to dwell on them. The linked articles should suffice.
First up, anyone looking for a company in a solid recession resistant
industry with good growth prospects should keep an eye out (sorry) for
soft lens manufacturer Cooper Companies, and in a similar vein I’m a big fan of Sirona Dental Systems.
The latter has an under-penetrated and leading technology enabling same
day tooth restorations. Contrary to rumor and plenty of evidence, I am
not their PR agent!
I’m also a fan of Beacon Roofing Supply,
which has consolidation opportunities within a fragmented industry.
Another small company that I think is benefiting from a form of ‘trading
down’ in the financial services sector is information service companyFactSet Research Systems. And why not? In my experience, a Bloomberg Terminal never made anyone a better investor.
Lastly in this group is Costco(NASDAQ: COST), which is discussed here.
It gives results soon, and I’m expecting some improvement in margins
and revenues here, which may create an entry point. Costco and the other
US based big box retailers are interesting because they will benefit
from an improving US economy on the top line, and input costs should
moderate as emerging market growth slows.
The Defensives
One facet of investing this year has been the willingness of the
market to pile into decent yielding stocks even if their growth
prospects are limited. I suspect a lot of this has to do with
ridiculously low Government bond yields and investors subsequently using
these stocks as substitutes. With that said some ‘defensives’ do have
good growth prospects. I think McCormick
is a compelling mix of defensive end markets in food with some growth
kicker coming from the increasing tendency of food manufacturers to
innovate with flavoring.
Within consumer staples I like Church & Dwight(NYSE: CHD) and Colgate Palmolive(NYSE: CL), and I’ve discussed these stocks here and here.
It is hard to argue that they are attractively priced now even as their
managements prove themselves to be some of the best in the sector. CHD
has benefited from being a smaller, more nimble company which has been
able to adjust to the changing landscape of a more value conscious US
consumer. There are some signs that the likes of Procter and Gamble are now adjusting and fighting back. As for CL, there are signs (McDonald's, Yum! Brands
etc) that emerging market (EM) mass consumer spending may not be
growing as strongly as many expect it too. This could be an issue for a
highly rated stock like CL, which is relying on EM growth and is under
constant pressure to innovate in its home markets.
Finally, while I like the prospects for Perrigo,
I simply can’t get anywhere near the valuation, and there are some
cautionary signs with the stock. It has disappointed the market with its
last two sets of results.
The Cyclicals
Perhaps Google(NASDAQ: GOOG)
doesn’t deserve a place on this list? The company really is a one-off.
Its management refuses to give guidance and this tends to cause stomach
churning volatility over its results. However, it continues to grow
strongly even while generating huge cash flows with which it steadfastly
refuses to pay a dividend. I would argue that the stock would get a
massive re-rating if it changed its policy over these issues alone.
From the retail sector, I think Nordstrom and VF Corpare
two of the best run companies in the sector and are well worth
monitoring for any. Industrial and construction parts supplier Fastenal (NASDAQ: FAST) is a great company with strong prospects;
but is a forward PE of 25 really good value? Despite a host of
improving metrics (cited in the article) no company is immune from
competitive pressures. As such, I think it is going to take significant
earnings disappointment to get Fastenal anywhere near what I would pay
for it.
The Bottom Line
In conclusion, I think all of these stocks are well worth monitoring.
Patience is the strongest weapon of a private investor, and I think
this kind of exercise is valuable. In reality, investors should be
rejecting many more stocks than they buy, and this process helps to
avoid pulling the trigger too early.
In the first article of
this series, I discussed how I was setting up for 2013. I'm going to
get to the process here, but first a recap of the overall portfolio. For
the record, my New Year resolution is to update the portfolio on my blog linked here.
The current holdings are as follows:
Technology
Another interesting area of IT is security. Check Point looks
like a value play, but it needs to convince the market that it can
continue double digit earnings growth even if product growth is slowing.
I picked up some Fortinet(NASDAQ: FTNT) after Palo Alto’s recent
results confirmed that the sector wasn’t any weaker. Fortinet looks
like a good value; the company generates a lot of cash and is more
focused on the SMB market than its rivals. I think a target price of $23
is not excessive for such a strong growth company even if its guidance
proved too exuberant in the summer.
The last stock in the tech holdings is F5 Networks(NASDAQ: FFIV).
It has been a turbulent year for the stock and there are legitimate
fears that it is over-reliant on Government revenues right now.
Nevertheless, F5 generates lots of cash flow and I think telco spending
(a key vertical for F5) could come back next year.
The underlying trend of bandwidth-rich application growth driven by
increased connectivity remains intact, and F5 is a good play on this.
Stay Healthy
Pfizer, Johnson & Johnson (NYSE: JNJ) and Sanofi Aventis
are my ways of playing the market’s demand for high and stable dividend
yield and all have worked well. JNJ is also attractive because its main
profit driver will come from execution rather than macro issues. JNJ
needs to deal with product recalls, the integration of Synthes and
development sales of some of its impressive new pharmaceuticals. It is
slowly working, and I think the value proposition remains compelling.
The other two specific healthcare stocks are the Biotech Holders ETF (just a nice way to get diversified exposure to biotech) and a reduced weight position in a small cap UK pharma play Vectura. The latter has a lot of cash on the balance sheet plus great prospects with some COPD compounds in partnership with Novartis. There
is also upside from the approval of some blockbuster asthma and COPD
drugs. Well worth a look but with the usual caveats attached to small
cap biotech/pharma investing.
The Misfits
This group of stocks can be loosely defined as all having growth drivers that are somewhat non-cyclical. Wabtec offers exposure to railway spending, and I like Roper Industries as a superbly run company with leadership in a diverse set of end markets. I think the market is undervaluing Walgreen (NYSE: WAG) just because it has suffered this year from the Express Scripts debacle, but the evaluation is attractive and it looks like it has passed the worst of it. Getting customers back will be difficult, but it will happen to a certain extent and the stock is cheap anyway.Tesco in
the UK is in a similar situation. The company overstretched itself in
recent years with things like ‘Fresh n Easy’ and expansion into Eastern
Europe (where I live, and I assure you Tesco has nothing to offer over
the local produce), which caused it to lose sight of the ball in the UK.
No matter, it still has huge footfall and a dominant position. I think
it can turns things around.
Nutreco is a Dutch animal and fish feed company and a great way to play increases in long term food pricing. Lighting company Acuity Brands(NYSE: AYI)
is a stock I have been in and out of this year. It is the leading
player in industrial and commercial lighting in the US, and while its
housing exposure is relatively small, I think history shows us that
(with commercial in particular) these types of markets usually follow
housing. Home building takes place and then commercial properties are
developed around them. In addition, there is a quiet revolution building
within LED lighting and controls, which will slowly take share away
from conventional lighting. They don’t appear to be higher margin
products but I would expect increased volumes.
The last of the ‘misfit’ holdings is Allergan, a
company with a nice mix of stable ophthalmic end markets and some
secular growth prospects from the expansion of indications of Botox. The
evaluation may appear rich, but investors should be willing to pay up
for quality and the rate of cash conversion is quite high.
Observations
A cursory look at this portfolio would reveal a bias towards
technology and healthcare, and I have no problem with that. An
overweight position in the latter is a conscious choice, and with the
technology stocks I think there is a nice mix of drivers that do not
just mean I’m holding cyclical ‘beta.’ The one area that I am
surprisingly weak in is food, where stocks like ConAgra and Viscofan were
sold after hitting price targets. Similarly, I have no FMCG exposure
and am probably a little light on the US consumer too. I will look to
add another financial soon. Another area that I haven’t had time to
explore is Europe, and I really need to add more there too.
In conclusion, I will look for a stock in food, retail, financials,
possibly an FMCG (if I can find any on a reasonable evaluation) and
there is probably room for another technology stock.
It’s almost the New Year and it’s time to pause and think about what
we are all doing with our portfolios. In this regard I’ve been trying to
find a way to update my own portfolio. I’m a great believer that people
that write about investment should actually invest and disclose what,
why and how they are doing themselves. For anyone interested, my New
Year resolution is to update developments on my blog. I already disclose positions for stocks written about in posts but I realize it’s better to disclose a whole portfolio.
How I’m Positioned for the New Year
For the record, I am hedged with a long-stocks/short-index strategy
and leverage up on relative outperformance against the market. If I
truly wanted to diversify against macro risk, I would sector weight the
long side against the index. This just means holding the same percentage
of my long side in, say, financials as the index I was shorting. I try
to do this to a certain extent, but I also believe in taking a macro
view if not a market one.
A quick summary of what I am holding now:
Forgive the pitiable attempt at color coding. The idea was to
differentiate these positions in line with the views that they manifest.
For easy reading I’ll bunch these stocks into sub-headings.
US Housing and Credit
I’m sympathetic to the idea that the US is heading for a protracted
recovery in housing and credit issuance, the idea being that the trough
was so bad that any companies with decent evaluations now can expect
upside as the economy improves and their operational leverage kicks in. Home Depot is a pure play on housing and the US consumer. Similarly, home furnishings company Williams-Sonoma (NYSE: WSM) is expanding at the right time in the right sector and offers some growth kicker from international expansion.
The idea behind Wells Fargo is to capture some
exposure to the US housing market via its substantive holdings of US
mortgages. The lesson of 2008 is not that it this just about the value
of an asset but more about where it was trending. Wells Fargo holds a
lot of mortgages. Housing is starting to recover, ergo buy Wells Fargo. Equifax (NYSE: EFX) is kind of related to this idea because it will benefit from increased credit issuance
and that will only come if the housing market is improving. The Federal
Reserve is doing anything it can to pump liquidity into the economy and
one way or another this is going to mean increased credit issuance.
I’m going to loosely include TJX Companies(NYSE: TJX)
on this list. Although the off-price retailer is often seen as a
counter-cyclical play, I think that the trend towards buying from
discounters is firmly entrenched now, and I note that the growth of Aldi
and Lidl in Germany did not let up even as the economy recovered from
the integration of East Germany.
Cloud Plays
The cloud sector has been hot this year but it’s not just about the infrastructural plays. Intuit(NASDAQ: INTU) and Adobe Systems(NASDAQ: ADBE)
are two examples of companies benefiting from a shift to selling
software as a service. There has been a lot of ink spilt by journalists
over Adobe recently, and my eyes glaze over with boredom every time a
wannabe shorter starts talking about the reduction in earnings in 2013
and the high PE ratio without actually mentioning that this is part of
the plan! The idea is to generate more long term revenue and customer
retention, and 2013 is the trough year.
As for Intuit, I've discussed it here.
It is growing its small business group revenues, and this is the key to
ensuring that it can diversify away from being a play on the economy
via its consumer tax revenues. Its cash flow generation is very strong
and the evaluation is attractive. Investors shouldn't underestimate the
opportunity to cross sell solutions from its product portfolio.
I'll get into the rest of the portfolio in the second part of this review.
Investors in the IT security sector had a right to approach the upcoming results of company Palo Alto Networks(NYSE: PANW)
with a certain amount of trepidation. Competitors have been downgrading
expectations and enterprise spending in technology has been weaker as
the year has gone by. However, Palo Alto delivered a solid set of
results and guidance, and despite the market response (which initially
looks to be negative) this should not reflect on the operational
performance of the company. Whether the stock is good value or not is
another question.
Palo Alto Delivers Good Results
Palo Alto’s place within the security market is as a fast growing
company that is accelerating sales growth primarily via displacing
incumbent security providers. As such, we should expect it to have lower
margins and cash flow conversion than the established players but much
faster growth. The company makes a play over its quality differentiation
allowing it to carry a pricing premium. This may well be true, but as
it matures it may well find it harder to sell on this basis. Not all
customers will be focused on quality, and its primary firewall
competitors, like Check Point Software(NASDAQ: CHKP), Juniper Networks(NYSE: JNPR) and Cisco Systems (NASDAQ: CSCO), are highly cash generative and capable of upgrading their offerings in the future.
No matter, Palo Alto is firing on all cylinders at the moment and
none can match its growth prospects. A brief summary of its results.
Q1 Revenues of $85.9 million vs. estimates of $83.8 million
Q1 EPS of 4c vs. estimates of 3c
Q2 Revenue Guidance of $90-94 million vs. estimates of $90.8 million
Q2 EPS Guidance of 4c vs. estimates of 4c
So it’s a ‘beat’ and the guidance looks pretty good relative to
market estimates. This is a key point because its rivals have been
downgrading expectations and new entrants like F5 Networks (NASDAQ: FFIV) have been aggressive about their prospects in data center security.
Moreover the commentary around the results was positive with
management claiming that 50% of its new sales were for primary firewalls
(this tends to increase the lifetime value of a client as it implies
higher recurring revenues and retention ratios). In addition, they
scored a host of major wins against Check Point (with a major telco),
Juniper and Cisco (a leading European broadcaster) and a number of US
data center security solutions from Cisco.
It wasn’t quite a Larry Ellison style alpha male conference call, but
not far from it. Although he would, no doubt, be impressed by the
hiring of F5 Networks' former global head of sales. He will no doubt
bring a plethora of enterprise and data center contacts with him, and
investors should take Palo Alto seriously when its management outlines
that F5’s data center security solutions are not really competing with
the larger part of Palo Alto’s business.
But what of the rest?
What is the Industry Saying?
Essentially Check Point had lowered guidance and analysts saw some
weakness on account of its slowing product sales growth. In reality,
this is partially due to its progress in bundling software sales within
overall sales. Check Point’s overall revenue growth is in the high
single digits but no matter, the market hates slowing product growth
because it implies slowing future software sales.
Alongside this, Cisco had earlier seen its security revenues growing
at a slower pace. In other words, the market was set up for a possible
disappointment with Palo Alto. It didn’t come.
Palo Alto is a much younger company and there are no such growth
problems here, although it did disclose some more aggressive pricing
competition in the quarter. Management also claimed to have high win
rates across all its major competitors (Juniper, Cisco and Check Point)
without being drawn on any specific strength against any particular
incumbent.
Furthermore, deferred revenues are growing faster than top line
revenues (86% vs. 50% year on year), and free cash flow is now at over
20% of revenues.
Where Next for Palo Alto?
In conclusion, this is a pretty good set of results from Palo Alto.
The market’s immediate reaction is probably more about investors who
were lined up to try to take advantage of a market pop and then sell
out. It’s the sort of thing that happens with highly rated stocks.
From my perspective as a growth at reasonable price (GARP) investor, I
am not interested in Palo Alto; but I am interested in the IT security
center and this reads like pretty good news to me. Palo Alto is
affirming that conditions remain good, and I think the sector is well
worth looking at now.
I’ve contributed a few articles recently discussing the nature of investing and what investors should look for
with stocks. In summary I think our success as investors depends upon
the ability to identify the salient factors that move a company’s stock
price. AutoZone(NYSE: AZO)
is a great example to look at in this respect and I will do so with
reference to its latest results. What moves its share price? What are
the factors that will govern it in the future?
Autozone’s Strategic End Markets
Strategic simply refers to the governing macro conditions and
industry trends. This is usually the most important factor and the
starting point. Auto parts retailing has typically been seen as a
counter cyclical sector in the last few years and stocks within it have
been massive out-performers.
AutoZone, Advance Auto Parts(NYSE: AAP) and O’Reilly Automotive (NASDAQ: ORLY)
are seen as beneficiaries of an ageing US car fleet. As cars get older
they are more susceptible to wear and tear and need proportionally more
parts and servicing. Indeed, AutoZone monitors the ratio of cars over
seven years as a key metric and there is no doubt that the recent
recession has helped accelerate the trend towards an ageing fleet.
Moreover even though new car sales haven’t been great in 2008-10
(suggesting that there will be fewer ageing cars in the future) I think
the key metric is actually going to be miles driven overall and the age
of the cars doing them. As such AutoZone argued that on a comparable
basis the year to September saw miles driven up .6%. This is okay
because the fleet continues to age. Indeed it allows AutoZone to pursue
its model of low single digit expansion in square footage with mid
single digit EBITDA growth. Since it typically converts more than its
income into free cash flow it is able to then engage in buybacks which
leads to mid-teens EPS growth.
This is fine but what happens if/when the economy recovers, new car
sales expand and drivers stop maintaining or driving their older cars?
Given the strong US car sales numbers this year I would argue that we
are nearing that point.
Here is a graphical representation of the trend in comparable same store sales.
Spot the slowdown?
The Bear case here is that strong new car sales and drivers not
maintaining their cars in anticipation of buying a new one, have caused
an industry wide slowdown. The Bullish retort is that it is largely
weather related as in a mild winter did not stress cars as much as it
might have done.
Delving Deeper into AutoZone’s Numbers
I confess I lean towards the Bearish camp here. AutoZone breaks out
its product categories into failure, maintenance and discretionary
sales. On the conference call management outlined that maintenance sales
(usually about 40% of the total) are growing weaker than the other two
categories. This could be a consequence of drivers anticipating buying a
new automobile in the future. If it was general macro weakness then
surely discretionary sales would be trending on a similar track?
Moreover there appears to be regional issues with the Northeast,
Midwest and Plains cited as being the primary areas of weakness. Given
that AutoZone has invested in new stores in these regions then this bit
of ‘color’ is somewhat concerning.
Cash or Credit?
Another trend favoring accelerating new car sales is the increasing
willingness of lenders to extend credit. Whenever I look at these things
I monitor the Federal Deposit Insurance Corporation (FDIC) updates on
conditions and they suggest things are getting better. I also like to
look at Equifax(NYSE: EFX) because as a credit bureau it will give a first-hand read on trends in lending. I’ve discussed the company in an article linked here . Similarly as argued hereDiscover Financial Services(NYSE: DFS) saw credit card loans increasing 4.2% from last year and 3.2% sequentially even while charge off rates fell to new lows.
While Equifax and Discover tend to be conservative with guidance, it
is hard not to conclude that conditions are getting better for lending
in the US and this will inevitably feed through into new car financing.
Where Next For the Sector?
Turning back to the questions I posed at the start, I think the key
factor will be the overall economy, the willingness and ability of
vehicle financing. You could make a case that an improving economy will
lead to more miles driven. Moreover if gasoline prices continue to fall,
the sector will be in a win-win situation. Miles driven will go up and
drivers will have more discretionary income to spend.
However, I would suggest caution here. The weakness in maintenance
spending and the strength of new car sales in the US are, I believe, the
key metrics to follow. I think the sector is worth avoiding until it
can at least pick up same store sales growth again.
Communications company Finisar Corp(NASDAQ: FNSR)gave
results and the market appeared to like them. However, I think it looks
a bit more like a relief rally than an affirmation that there was
anything in the results to suggest that the corner had turned on the
Telco spending side. At some point it will -- the demand for bandwidth
and data rich devices shows no sign of abating -- but in summary, I
don’t think you can adduce much from these results.
Finisar’s Q2 Results
As ever, the results need to be put into context of what the market was expecting. A brief summary.
Q2 Revenues of $232 million vs. estimates $231.8 million
Q2 Non-GaaP EPS of 15c vs. estimates of 14c
Q3 Revenue Guidance of $230-245 million vs. analyst estimates of $239.5 million
Q3 Non-GaaP EPS Guidance of 14-18c vs. estimates of 17c
So it’s a revenue and earnings ‘beat’ but the mid-point of guidance
is lower than analyst estimates. What makes Finisar interesting is the
guidance and color it usually gives on its Telco and Datacom verticals.
And investors have been given mixed signals on the issue recently. For
example, Cisco Systems(NASDAQ: CSCO) has spoken of signs of conditions getting better with US carrier spending, but if so we haven’t seen it in the CapEx guidance from the major carriers in the US.
Along with the rest of the sector, Finisar had been looking for a
pick-up in its end markets in the second half from a combination of
increased US carrier spending and Chinese stimulus spending.
In order to see what is going on I have broken out Datacom and Telecom revenues for Finisar.
This is one of those situations where the optics of a graph needs
explaining. Datacom’s growth appears to have slowed to high single
digits and looks flattish sequentially. This could be seen as
disappointing because data center CapEx has been steadily improving this
year. However, Cisco too said that its latest quarter was more of a
natural slowdown in data center spending than any kind of trend change,
and from what I’ve seen of Equinix’s and others' gross margins that appears to be the case. I'm willing to accept this as a one-off quarter.
Telco Spending Still Cautious
The optics also needs explaining with regards Telecom. Although the
sequential up-tick looks good, it is no more than usual. This chart
explains all.
There has been some market chatter with regard to increased spending at AT&T(NYSE: T), and there has certainly been some positive rhetoric on that front. However, we haven’t seen it yet and Verizon(NYSE: VZ)
also lowered its CapEx spending for the full year. In truth I suspect
both will watch the macro-economy and keep their ears tuned to their
customers’ gripes over the fiscal cliff and other sources of economic
uncertainty. Bellwethers aren’t called bellwethers without reason and
that usually is due to their sensitivity to the global economy.
Finisar’s Operational Performance
Having discussed the macro read from Finisar’s results, it’s time to
turn to some operational specifics. As ever, these things are somewhat
guided by the top line. A couple of years ago, Finisar was hoping for
something closer to 36% but they are now coming in nearer 30%. No
matter, the new manufacturing facility in China should help margins in
the future as will as increased spending from customers ramping up to
100G from 40G.
As for the competition, the decent Telco numbers (historically
tracking but let’s recall that the environment has gotten weaker
throughout the year) were seen in some quarters as being the result of
winning market share from others in the industry. Finisar refused to be
drawn into discussing specifics on the conference call, but it did imply
that it had won market share. I suspect we will see that some of it
came as a result of pricing in the next quarter (my reasoning being that
management claimed that the growth in Telcom and Datacom revenues
‘might well be on par’). If so, then any significant margin erosion
(from telcom pricing) would show up by then.
The Bottom Line
Unfortunately there isn’t anything in these results to suggest a
corner has been turned in telco spending, and the slowing in growth in
datacom (although in line with industry peers) may well unsettle some
nerves. At some point in the longer term this will change, because the
rise in bandwidth demand is only going to go up with things like
smartphone and tablet penetration rates and the increase in data rich
applications.
The question is whether Finisar is the way to play this or not.
Moreover, I suspect there will be plenty of time to get in but it would
be nice to see some firm evidence of conditions getting better first.
