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I would rather forget last month. After nine months of gains, I hit a
nasty double digit loss. In truth, this sort of thing was inevitable
and the preceding months were as much a part of the process as last
month was. The previous month’s write-up and links to others can be found here. I do this stuff because I happen to believe that anyone writing about investment should disclose his own performance.
Philosophizing over, I'm going to confess to a certain amount of exasperation at being hit with accounting errors with Ixia, a weaker than expected tax return season at Intuit, the loss of a major customer contract with Regal Beloit, and when even Pfizer disappoints then you know it’s not going to be your month.
The weakness at IBM and Citrix Systems
was a bit more predictable and I topped up on both. I suspected tech
would be weak over earnings and held back buying more before their
earnings.In fact, this approach helped me avoid disasters in companies I like and have held before, such as Fortinet and F5 Networks.
It was definitely a month of dodging bullets! I’ve put some performance
charts at the end of this post for those interested. I will update my
current portfolio on my blog in a few days.
For now, it’s the usual format of reviewing the articles for January
(i.e. three months previously) and picking out some investing ideas that
readers might find useful. The companies in bold are those that I hold
now. Acuity Brands was sold because it hit its price target.F5 Networks was sold because it hit its target and my general tech caution.
Superficially these numbers look good, but let’s recall that the
S&P 500 has put on over 12% in 2013. The ‘buy’ stocks averaged 6.8%,
‘positive’ recorded (0.6)%!, ‘evaluation’ returned 7.7%, and ‘caution’
did 0.4%. The difference between what I bought and didn’t was 6.8% to
1.9%.
Some observations and conclusions
It’s been a relatively tough period for tech stocks like Fortinet, F5 Networks, IBM, and Citrix,and cyclicals like Dover, Fastenal(NASDAQ: FAST) and MSC Industrial.
The defensives are starting to look fully priced with nice gains for Cooper Companies and Perrigo.
Tech ‘value’ ex Intel and Check Point Software(NASDAQ: CHKP) has held up better than the growth tech stocks.
Nothing but nothing seems to stop the market wanting to buy yield with stocks like Johnson & Johnson and McDonald’s.
In conclusion, think it’s time to start thinking about buying some select industrial and/or technology stocks.
Some stocks to consider
With these thoughts in mind, I think Intel(NASDAQ: INTC) and Check Point Software are worth a look.I’ve covered both after their recent results in articles linked here and here.Intel
is a curious beast in the market place. It offers a high yield, good
value, and cyclical exposure to consumer electronics, but it is also
faces long-term challenges from ARM core processors. It also offers a
restructuring story as it adjusts to the shift in computing devices. Gross margin appears to be bottoming and while it hasn’t turned the corner yet ,the potential upside in the stock remains.
As for Check Point, in retrospect, its last results were okay and
there are some signs that its customers are more willing to buy its new
products. Like Intel, it offers a genuine value proposition because of
its high cash conversion and potential to leverage its technology into
expanding its sales. On the other hand, I think the market is tired of
seeing falling product and license growth and a ‘cash harvesting’
approach to its business development.If that should change, I’m sure the stock will go higher.But will it?
The next two stocks are both industrials. I still think Fastenal is
expensive and am concerned with the falling sales growth, but if you are
looking for some short-term upside from the idea that industrials will
come back then, it is a great stock to look at. Its visibility is
limited and it is exposed to short cycle decision making by purchasers,
all of which leaves it susceptible to violent changes in sentiment by
its customers. Bad when it’s bad, good when it’s good.If you like the industrial space and want a near-term play, then Fastenal is worth picking up
Another industrial worth considering is PPG Industries(NYSE: PPG). I like its end market exposure
and its purchase of Akzo Nobel’s U.S. household paints division.
Aerospace and automotive are the two stand out sectors within
industrial, and PPG is well placed in both. Its long-term dividend
record is excellent and it is a very good generator of cash and has the
potential to generate some synergy-based cost savings with the
acquisition.Despite reporting a good quarter -- notably
better than so many other industrials -- the stock has lagged the
overall market and looks decent value. I may pick some up.
The last stock for consideration is Capital One Financial (NYSE: COF).
The stock has underperformed this year and the credit card companies do
face challenges to net interest margins thanks to low interest rates
and the maturing of higher rate loans. Moreover, the weak recovery has
left the yield curve relatively flat and loan demand is not where it
usually is at this stage of an economic recovery. No matter, if you
believe that employment will keep increasing and the recovery is
ongoing, then at some point demand will come back. Meanwhile, asset
quality and delinquency rates carry on improving so Capital One is well
positioned to catch an uptick in end demand.
Additional data
As discussed above, here is how this lousy month affected performance
since inception. The blue line is my portfolio the red line is the
S&P 500.
Earnings season is starting to wind down, but we still have some
interesting companies reporting this week. Since we are nearing the end
of the season a lot of these companies’ peers will have already
reported, so the market will be anticipating the direction of the
results. I’m going to use this approach to preview what investors might
expect from the results this week.
Tuesday
I can think of very few sectors as unglamorous as painting and
coatings, but who cares? Anyone purely focused on making money couldn’t
help but notice that these stocks have been hot over the last year or
so. Valspar (NYSE: VAL) will give numbers, and following the recent solid results from Sherwin-Williams and others we can expect similarly good numbers here. However, it is somewhat a story of a two different markets.
The US consumer market has been strong--in line with an improving
housing market--but industrial coatings have been more varied. The key
thing to look for in these results will be how its mix of geographies
and end markets are holding up. The industrial sector has been mixed so
far this year, with areas like automotive and aerospace strong but
general industrials growing weaker. Indeed, Valspar reported weakness in
food and general line packaging last time around. Given the more
positive news out of China recently we could see a bounce back.
Wednesday
A couple of bellwether’s report on Wednesday, with Deere outlining the state of play in farming and construction machinery, and Macy’s will be discussing high end consumer spending.
Thursday
Thursday is undoubtedly the most interesting day of the week. Bring your own device (BYOD) play Aruba Networks(NASDAQ: ARUN)
has already pre-announced and disappointed by missing estimates and
guiding lower. Frankly if you don’t know that the telco and enterprise
technology sector has been weak in Q1 then you aren’t invested in
technology. Company after company has pretty much repeated the mantra:
customers are reluctant to sign off on big deals but the pipelines
remain in place, etc. It is disappointing, but the correct tactic has
been to buy after the crash. This is why the color around Aruba’s
conference call will be so important. Investors will want to discern
whether this is a company-specific issue or a macro one. If it is the
latter then the stock can recover strongly given a cessation of
sequester/macro fears. Unfortunately at this point it is hard to tell
the difference.
Autodesk(NASDAQ: ADSK) is a company I’ve discussed at length in an article linked here. Frankly it is very hard to predict what it will report.It
is a company with an enviable record of beating its guidance, so when
it misses the stock gets trashed. If you follow the general‘tech
is weak in Q1’ approach then you should be braced for a miss. On the
other hand, certain industrial sectors have been strong in Q1.
The question is does Autodesk have enough exposure to areas like automotive and aerospace?Moreover,
it has long term secular growth prospects from the shift to a software
as a service (SaaS) based company, and this should provide sales
support. The one thing I’m sure of is that the stock will be volatile
over the results. Its internal guidance is for $570-590 million in sales
and Non-GAAP EPS of $0.41-$0.46.
Two vastly different retail names also give results. Wal-Mart is about as mass market as you are going to get, but Nordstrom Inc(NYSE: JWN)
is arguably more of a high end play. It’s a company with a well
regarded management team that it engaging in every initiative it can to
generate future growth in the face of a difficult consumer environment.
There is an outline of its growth strategy in an article linked here.
Nordstrom is expanding its lower priced Rack stores and investing
heavily in its e-commerce facility and in store Point of Sales
offerings. Over the next few years its revenue streams will be
substantially changed. The key questions are whether this will
cannibalize or denigrate its existing brand and if the investment
program will be executed successfully. For the next few years it is all
about investment for Nordstrom, and investors should focus on this (and
its effect on margins) in the upcoming results.
Friday
Friday’s are usuallyquiet days, but I’m interested to look at industrial filtration company Donaldson (NYSE: DCI).
Its prospects are largely dictated by conditions in China. Its exposure
to transportation and industrial products (with a heavy weighting
towards construction machinery) will always mean it is a cyclical play.
Construction, mining and heavy trucking are problematic end markets
right now, and investors have seen the point of an anticipated pick up
being pushed out to the end if 2013 in previous reports. The key thing
in the upcoming results will be the commentary over the recovery in
China and where the country’s stimulus spending will be directed. In
general it has been a weakening environment for its industry
bellwethers, with Caterpillar and Joy Global both struggling to
convince. On the other hand, Alcoa reiterated its guidance for 2013 within China, and since this implies 12%-16% growth in its Chinese heavy truck and trailer division, I think this bodes well.
To be or not to be? To buy or not to buy? That is our question with The Estee Lauder Companies .
Whether it is nobler in the mind to suffer not buying a stock that that
the market loves, or to take arms against a high valuation, revenue
forecasts at the bottom end of guidance, and a management initiative
that thus far isn’t quite going as planned? The good news
is that unlike Shakespeare’s Hamlet not everyone is going to end up
being murdered--but, being the maverick type, I favor raising arms
against Estee Lauder's evaluation.
Estee Lauder’s growth prospects
I can understand why the market loves this stock and why it is
willing to award it an valuation of nearly 24 times earnings to June
2014. The company has a number of attractive growth drivers:
An aging demographic and cultural trends that will ensure the skin care business has good long term growth.
Strong emerging market growth prospects.
On a relative basis Estee Lauder has more focus on prestige brands than mass and is better placed than, say, Revlon or Avon Products to benefit from the two-tier recovery whereby the high-end fares better.
Unlike Procter & Gamble ,
it is a more beauty-focused company and should find it easier to
innovate and react to changing consumer trends. This is incredibly
important as more cultures become a bigger part of its clientele, and
unlike Nu Skin Enterprises it is relying on a traditional sales channels rather than multi-level marketing.
A strategic management
initiative (SMI) is intended to considerably increase inventory
management and therefore cash flow and return on investment. A key part
of this is a SAP deployment.
Putting these things together creates a powerful case for the company.
On the other hand, these drivers have been known for some time. I’m
not convinced that Estee Lauder is a good value or is outperforming to
the extent that the market is rewarding it.
Estee Lauder’s performance could be better
For brevity’s sake I should note that I covered the stock previously in an article linked here for anyone looking for a primer or background. I have three main points to make on why I think it could do better.
First, the SMI was supposed to produce significant cost savings and
improve its operational metrics. This is already happening, but by some
measures we could have hoped for a bit more. In the previous article I
discussed how Estee Lauder was hoping to increase inventory turn to 3x
from 2x. In simple terms this just means it holds relatively less
inventory and can decrease working capital requirements accordingly.
Ultimately this would help increase cash flow.
Its performance over this issue is best expressed in a graph. These are my calculations based on company data.
I realize that I am probably being a bit harsh here – it is early in
the SMI -- but we are still a ways away from the 3x figure. This is a
metric worth following because it will guide cash flow in the future.
Secondly, the SMI has caused some short term customer service
challenges, which led to some delays and products out of stock.
Management claimed that these problems were largely dealt with and were
expected to have been resolved by the end of the quarter, but I note
that the next wave of the SMI roll out has been delayed by six months.
The SMI is not entirely going as planned.
And finally, the full year revenue guidance has now been moved to 6%,
which is at the lower end of the previous guidance of 6%-8%. The reason
cited for this was that the overall market is now predicted to grow 3%
instead of 5%.
What the industry is saying
Revlon is more exposed to the mass market and it is suffering
accordingly. While declining sales in Europe are expected, the slowdown
in its Chinese sales (in line with the economy) is more
disappointing. Its Asia Pacific sales declined 2% mainly due to declines
in its color cosmetics in China. This is not a good sign in a market
that is supposed to provide its long term growth prospects.
Similarly, Procter & Gamble recently announced a net sales
decline of 2% in its beauty segment. Organic volumes and sales were down
1% each. The company cited a heavy competitive and promotional
environment in hair care and skin care, although sales increased in its
salon professional sub-segment. This is further evidence of a
bifurcation between the prestige and mass market. In fact, Procter &
Gamble faces challenges in keeping market share in all of its
categories.
The last two companies are somewhat less reliable indicators. Nu Skin
has been reporting strong growth but I think this company is partly
reliant on keeping its distributors active and motivated. Avon is in the
middle of a restructuring program that will take time. Indeed, sales
are still declining in the US and China. Avon is more of an internal
restructuring story.
It is not a positive industry score card, and near term conditions do not look great for Estee Lauder.
The bottom line
In conclusion, while I think the company has good long term
prospects, it is hard to argue that it is a good value. Moreover its
near term prospects (despite the hike in EPS guidance) appear to have
gotten worse. The market is giving it the benefit of the doubt for now
but, I’m not sure it's time to follow it.
A few weeks ago IT security company Fortinet $FTNT
helped kick off a pretty dismal reporting season for technology by
pre-announcing a weak set of results. Since then a plethora of other
companies have reported and given a myriad set of reasons and excuses
for missing. I think it’s fair to conclude that there was a marked
reluctance among business to sign off on large tech deals in the
quarter. Given that this could be temporary, is it now time to start
buying these names? And with Fortinet, what does its new guidance entail for 2013?
Fortinet Updates the Market
Before going into the color I want to outline the full year guidance changes.
The guidance changes are pretty significant but I think that if they
are hit then Fortinet will be higher by the end of the year. As I write
the Enterprise Value of the stock is around $2.4 billion. I’ve followed
this stock for a while and never seen it trading on a forward free cash
flow over enterprise value (FCF/EV) of around (145/2400)=6%. The reason I
highlight this metric is to compare it with very low Government bond
yields.
It is arguably cheap on this basis alone. Furthermore consider the
new guidance was based on a continuation of the weak trends in Q1
continuing in Q2 and most notably coming from U.S. service providers. So
if you think this weakness will prove temporary then there could be
upside to come. On the other hand my concern is that the guidance
appears to imply some pretty optimistic assumptions for the second half.
Is Fortinet’s Guidance Achievable?
Consider that Q2 revenues were guided towards $143 million at the
mid-point with $135.8 million reported already for Q1. This makes $278.8
million for H1 but the full year guidance is for $600 million. In order
to see what this implies I have included the Q2 guidance plus my
guesstimates for what Q3 and Q4 are implied to be.
I’ve assumed that Q4 will contribute 28.3% of revenues as it has done in the last three years. The Q3 and Q4 numbers are my estimates.
As you can see the implication is for a pretty concerted resumption
to growth in the second half and I’m not entirely clear how this can be
accepted categorically given the weakness in H2.
Furthermore here is how these numbers look on a sequential basis.
From this graph it looks like the Q3 and Q4 assumptions are for ‘same
again’ sequential growth. Fortinet may well do this but given that Q1
& Q2 are notably weaker it does seem to imply a return to better
conditions.
Why Was the Q2 Guidance So Weak?
I must confess I was hoping a bit more from Fortinet than it gave in Q2 guidance. If you go back to the analysis of the Q1 results
there were three reasons given for the billings miss of around $12
million. Fortinet attributed $6-9m to service providers, Latin America
missed by $4-6m and there was an inventory shortage (due to product
refresh) which caused a $2 million-4 million miss. The
last two issues were believed to have been able to rectify in the
short/medium term thanks to new management and better execution, with
the service provider issue being more problematic. However
in the latest statement Fortinet basically said that conditions
remained the same in Q2 as Q1. Rather confusingly Fortinet cited
challenges in Europe even though a few weeks ago it said Europe was only
a bit weaker.
With regards the telco service providers, there can be little doubt that they have been reluctant to spend. F5 Networks $FFIV also reported very weak numbers from its key telco vertical . My suspicion with F5 is that its problems are a combination of weak telco spending, the success of Citrix Systems
with its rival Netscaler product and the difficulties in protecting its
dominant market position within the application delivery controller
market. For F5 and Fortinet the following graph of the latter’s deal
breakdown reveals a lot.
I think there is a case for a ‘budget flush’ in Q4 which caused some
overdue optimism and lets recall that the previous quarter contained
worries over the fiscal cliff while Q1 saw a lot of attention over the
sequester. Telco customers tend to do large deals and it wouldn’t
surprise if this boils down to a few deals that didn’t close in Q1. So
will future quarters bounce back?
The Competitive Environment?
Looking back at the recent results in the quarter I thought Check Point Software(NASDAQ: CHKP)reported a mixed set of results.
While Check Point probably needs to generate some product and license
sales growth to truly convince, in the light of what the rest of the
industry has reported its results are starting to look good. The good
news is that yearly comparisons are likely to get easier going forward
even if the company doesn't seem to ready to shake off its 'cash flow
now but investors wont see any of it' image.
Amongst the discussion of the deal commentary it mentioned winning a
seven figure contract with U.S. wire based carrier and replacing Palo Alto Networks(NYSE: PANW) as a consequence. In addition it won a large U.S. deal with a global retailer and beat out Check Point, Palo Alto, Juniper and Cisco
in the process. These sorts of wins (and other large deals cited in the
commentary) are actually quite impressive because Fortinet is coming
from a position as being known as primarily a SMB focused company.
For Palo Alto this sort of thing must be a concern because as a young
and fast growing company (with an evaluation top match) it is not a
good thing to see others replacing it with security solutions.
It has a lot of expectations built into its evaluation. Moreover its
solutions are not known for offering a value proposition so given any
kind of discounting in the industry it could see its margins cut.
F5 only has security as a very small part of its revenues (and only
really in the data center) but many of its customers are in common with
these companies and if CFO's have decided to 'go slow' then it will get
hit accordingly. My only concern with F5 as a recovery play is that it
is undergoing a product refresh which might take a quarter or two to
fully filter in. We shall see.
Is Fortinet Worth Buying Now?
As the charts indicate the guidance assumes somewhat of a bounce back
in the second half and there are some internal opportunities (Latin
American leadership and inventory shortages) which can be rectified but
the key issue will be with telco spending.
The good news is that we can keep an eye elsewhere at what other
companies are seeing. It has been a miserable reporting season for most
companies selling into them and cautious investors might want to wait
until one or two companies with telco exposure start saying better
things.
V.F. Corp
is one of those infuriating stocks that never seems to be cheap
precisely when you want it to be. The latest set of results kept up its
tradition of raising EPS guidance even if the revenue numbers were far
from stellar. Indeed the key takeaway from these results was the margin
improvements achieved within difficult end markets. This is one of the
best run stocks in the retail sector, but it faces some headwinds in
2013. Is it good value right now?
V.F. Corp Prospects and Challenges
With its key brands of The North Face, Vans, and Timberland the
company has benefited from the trend towards wearing outdoor sports
clothing as a kind of fashion statement. I doubt that most people
wearing mountaineering or hiking clothing have ever been on a climb or a
trail. Moreover wearing Vans and listening to Sonic Youth doesn’t
necessarily qualify you as bona fide skate boarder, but who cares as
long as it adds to the bottom line of the company’s numbers.
In order to explain how Timberland makes money here is a breakdown of
its segmental profits in Q1. The key brands are in the outdoor &
action sports wear division.
Throughout 2013 the company is going to be faced with the following challenges
Timberland’s has significant exposure to Europe and markets like
Italy and Spain are some of its biggest existing markets. Fortunately,
Vans and The North Face were ‘built out’ of Northern Europe.
J.C. Penney is a key retail channel and in
particular with Lee jeans and Vans. The difficulties with the department
store and ongoing restructuring efforts could affect sales generation.
It’s Chinese operations haven’t performing great and it is a key part of its international expansion plans
In general the mid-market consumer is challenged in the current
environment. It offers neither the income secure spending of the high
end or the potential to benefit from trading down by the mass market.
Of course much of this known and the plan to deal with challenging
markets is to expand its direct to consumer (DtC) sales via increasing
the number of stores and investing in e-commerce facilities. Indeed DtC
made up 21% of revenues in 2012 and are expected to rise to 23% in 2013.
What makes V.F. Corp different is that its diverse set of brands,
channels and end-markets allow it to select areas in which to focus to
generate growth through the cycle. Moreover its brands benefit from some
secular fashion trends (as discussed above) whereas a company like The Gap $GPS
is more exposed to general macro trends. Indeed, The Gap has had to
completely restructure its business and separate its three brands (The
Gap, Old Navy and Banana Republic) into three global entities. The idea
being that this will create the ability to focus and innovate in order
to drive growth. Note the difference here, The Gap is trying to innovate
its brands to make the ‘cool’ while V.F. Corp is innovating in its
sales channels. I’d argue that the latter is easier to do.
The J.C. Penney question is an uncertain one. The store has been hit
hard by consumer spending changes and a misguided strategy of promising
lower prices in general instead of the kind of discounting and
promotional activity that the rest of the sector has been using. Whether
the restructuring will work is open to question and it’s something to
consider for V.F. Corp shareholders.
Q1 Performance
We can see how well V.F. Corp is run by looking at the profit margin movements in the quarter.
Margins were the real story this quarter because overall revenue
growth was only up a paltry 2.2% and significantly below the 6% target
for the full year. EPS was ahead of expectations and full year guidance
was raised to $10.75 from $10.70 previously.
The standout performers in the quarter were the North Face and Vans
which increased revenues 6% and 25% respectively. Moreover they achieved
growth in the DtC channels of 25% and 20% respectively. As for the
troubled region of Europe, The North Face recorded ‘modest’ growth while
Vans rose an incredible 30%.
As discussed earlier the problematic brands in 2013 are likely to be
Timberland and Jeanswear. Timberland revenues were up only 2% and flat
in the Americas. Fortunately mid-teens increases in Asia managed to
offset mid-single digit declines in Europe.
Where Next For V.F. Corp?
As I write the stock trades on 16.3x forward earnings. It is
certainly not the cheapest stock out there and it has some headwinds to
meet in 2013. With that said some of its brands are recording very
strong growth and the DtC expansion is very impressive.
The problem with buying the stock up here is that I get the sense
that all the positives are priced into it already and as good as the
management are, the target of 6% growth for 2013 when only 2.2% was
achieved for Q1, raises more questions than answers. Cautious investors
will want to monitor events here and wait for a more favorable
risk/return proposition.
Earnings season is starting to wind down this week and most of the
really big names have already reported. Nevertheless there are still
plenty of interesting companies giving results this week and there is no
excuse for not trying to unearth value when you see an opportunity.
Tuesday
There is a health care theme to today’s results as surgical knife company Accuray gave results. Medical distributor McKesson
also reported but I think the most interesting stock to report today
was health care distributor (medical, dental and veterinary) Henry Schein of which there is anarticle linked here. Infection prevention company Steris also gave numbers.
Wednesday
Today was probably the most interesting day of the week for me. Israeli company Nice Systems(NASDAQ: NICE)
specializes in systems that monitor and analyze customer interactions.
If you buy the whole big data analytics story (I do) then you must also
buy the idea that data capture is going to grow too. The last earnings
were confusing becausebookings growth was stronger than revenues.
This is mainly because its cloud based and analytics solutions grew
faster than product sales. These results confirmed these trends and its
clear that the second half will be stronger. Although the results were
only in line they were pretty good in the context of a weak market for
tech in Q1.
The second tech company reporting was Rackspace Hosting(NYSE: RAX). I confess I’m not the biggest fan of this company’s business model.
Essentially the concern is that by effectively offering its customers
the opportunity to outsource their IT expenditures, it is committing
itself to capital spending on customer gear. This is okay when markets
are trending upwards but it is problematic when they move down because
cash flow generation would take a hit. The relationship is best
represented in this graph.
Unfortunately it missed estimates and the stock is being severely
punished for it. Going forward it needs to demonstrate that it can
generate leverage from its capital expenditures rather than have to keep
spending insync with revenue growth. This is is
obviously harder to do if sales are weakening and it is going to be a
lot harder to ascertain whether it really does have the kind of
scalability to justify its lofty rating.
Thursday
Thursday sees an interesting bunch of companies reporting. You don’t
have to be Charles Murray in order to be aware that Western society is
shifting in terms of family relationships and a child care ad early
education company like Bright Horizons Family Solutions is likely to see increasing demand in future years.
NVIDIA and priceline.com are today’s tech highlights. Precision Castparts (NYSE: PCP)
gives numbers and it will be another chapter in the fascinating story
of the industrial sector this year. So far the real strength in the
sector has come from the automotive and aerospace sectors. The latter
makes up 57% of its customers, with power 22% and general industrials at
21%. Looking forward to the results, investors can be confident of the
aerospace sector but power has been weaker with some companies and there
has been a slowdown outside of the best performing sectors.
Another interesting company to give results will be Treehouse Foods(NYSE: THS). I’ve never held this stock but should imagine it’s a nerve racking experience to hold it over results.Theoretically
the private label food manufacturers should have done very well out of
the weaker consumer spending environment. Indeed ConAgra’s purchase of Ralcorp
is a sign of the sector’s attraction. On the other hand, the changing
environment has also meant that sales channels have changed and this has
sometimes caused problems for Treehouse. It’s customers have seen their
volumes and sales channels changing and this has had effects on
Treehouse in the past.
Friday
Today’s highlight will be Beacon Roofing Supply(NASDAQ: BECN). I like this company and think it has a lot of long term upside drivers.
It can benefit from consolidating a fragmented industry and if the
housing market continues to recover then we can expect some upside from
new build and consequently from commercial and industrial build going
forward. The key thing to look out for in this set of results is the
pricing outlook. Pricing was down at the last set of results but this
was due to some tough comparisons caused by strong demand from Katrina
last year. On a sequential basis, pricing was up at the last results
(for the third quarter in a row) and the key will be to see if it
forecasts further improvements for 2013. We shall see.
The difficult earnings season for technology continues, and Citrix Systems $CTXS didn't disappoint to disappoint. The market is in no mood to take
prisoners right now with any kind of tech company that misses revenue
and earnings forecasts. Consequently, the stock took a battering after
it missed and guided earnings lower for Q2. On the other hand, I think
there are some mitigating circumstances and this drop is a good
opportunity to pick some up. So I did.
Citrix's citric Q1 results
A quick summary of the earnings and guidance relative to analyst forecasts
Q1 Revenue of $672.9 million vs. analyst estimates of $676.9 million
Q1 Non-GAAP EPS of $0. 62 vs. analyst estimates of $0.63
Q2 Revenue guidance of $705 million-$715 million vs. analyst estimates of $711.5 million
Q2 EPS guidance of $0.62-$0.63 vs. analyst estimates of $0.70
Full Year Revenue guidance of $2.95 billion-$2.98 billion vs. analyst estimates of $2.97 billion
Full Year EPS guidance of $3.08-$3.11 vs. analyst estimates of $3.14
So, its Q2 EPS guidance is way below consensus estimates but the full
year revenue guidance is in line with the market and Citrix’s previous
guidance. However the full year EPS forecast is now 1.4% below
estimates. Is that really a reason to panic?
I think the answer to this question is ‘no’, but then again, I can
appreciate how some investors wouldn’t want to spend a summer waiting
for the market to wake up and come around to its point of view. As for
the maintenance of full year revenue guidance and the decent looking
earnings guidance, well, what usually happens is that the market chooses
to ignore them and focus on the near-term trends. They appear to be
negative. Or do they?
Short-term loss aversion
I have a few points to make over these results which should add more color.
Firstly, there was a combination of temporary macro weakness and a new product issue which appears to be rectifying.IBM, Oracle, TIBCO, Fortinet, F5 Networks $FFIV
have all missed estimates this earnings season. There is no doubt in my
mind that corporations are in a ‘cost-cutting’ first mode right now,
and fears over the sequester haven’t helped. In fact, they appear to be
using any excuse to delay purchases, particularly with discretionary
items.
IBM and Oracle saw general weakness (although they blamed sales
execution), but I note that F5 is undergoing some product refreshes
while the story with Citrix was largely over disappointing mobile &
desktop virtualization revenue.
Citrix argued that this was partly due to the Q1 launch of its
enterprise mobility XenMobile solution. In other words, customers may
well have delayed orders. In a cautious spending environment, it’s
reasonable to expect CIOs to ‘prioritize their caution’ towards any
solution that wasn’t mission critical or required consideration. Is this
what also happened with F5’s product refresh?
The good news is that Citrix forecast low double-digit growth in
mobile & desktop license, and that its full year plans were ‘on
track’.
Secondly, the Q2 earnings estimate is disappointing, but this is the
first time that the company has actually given Q2 guidance. I suspect it
did so because management knew the earnings number was coming in way
below market estimates. I think that this is a consequence of the way
analysts were modeling the numbers.
Moreover, the product mix (with Netscaler sales increasing strongly
but virtualization growth weaker) is contributing to lower margins.
Indeed, Citrix did lower full year margin and earnings guidance, but it
was hardly a dramatic downgrade.
Thirdly, Netscaler saw strong growth in the quarter. Interestingly,
this is in contrast with F5 Networks’s recent results. It’s hard not to
conclude that the relationship with Cisco $CSCO
hasn’t helped. After Cisco decided to stop investing in its application
delivery controller (ACE), it shifted to recommending that its
installed base should purchase Citrix’s Netscaler.
While the market was also made open to F5, it appears that Citrix has
taken the opportunity to broaden the number of verticals it sells into.
If there was some good news for F5 investors, it is that Citrix is not
seeing any competitive changes in the sectors where it competes with F5.
As for Cisco, these results are a good sign that its intelligent
networks have real relevance with its customers.
Where next for Citrix?
In conclusion, if Citrix hits its full year guidance then the stock
will be higher from here, although, I doubt many will believe that right
now. In my view, there were enough positives in this report to justify
topping up. Netscaler sales were excellent and XenMobile was cited as
being on track for the full year. The weakness in desktop & mobile
virtualization license sales is understandable in the context of a weak
tech spending environment for Q1, and the launch of XenMobile seems to
have caused some delays.
As ever, investors need to focus on valuation. This stock generated
nearly $700 million in free cash flow and despite the weaker Q1, it is
guiding towards over 14% revenue growth in 2013. If the tech slowdown
proves to be temporary and customers get acquainted with the XenMobile
offering, then the stock could recover nicely from here.I bought some more in anticipation.
It’s been a fascinating –if at times confusing-earnings season for
the industrials. In the good old days all an investor needed to do was
look at the ISM manufacturing index and generally expect his stock to
trade in the direction of its trends. Not anymore. In this disjointed
recovery all industrial sectors are equal, but some are more equal than
others. The question is does your stock have exposure to the flourishers
or the survivors in the sector? Such thoughts came to mind when looking
at Cognex’s(NASDAQ: CGNX) latest results.
Cognex Seeing Better Days
For those who don’t know the company well, I have a primer article on it linked here.
Its long term prospects are attractive. It is inevitable that
manufacturing (particularly within emerging markets) will become
automated and with that the need for monitoring robotic processes will
increase. The future looks bright for Cognex. Moreover it is managing to
diversify its revenues by increasing the amount of its non-cyclical end
markets in areas like food & beverage and packaging.
All of this fine for the long term but what of its near term
prospects? In short I think Cognex is well placed within its end markets
and is starting to see better days in some of its key industry
verticals. It suffered last year as industries like consumer electronics
and semiconductors (they are highly correlated) were affected. Moreover
it has faced some geographic issues with weakness in Europe and the
secular trend of manufacturing moving from Japan (a market where Cognex
is strong) to other Asian countries.
What Happened in Q1 For Cognex and how Does this Relate to Industrials?
A breakdown of revenues in Q1.
Starting with the most cyclical part of its revenues there is some
evidence that semiconductors and consumer electronics (the latter also
accounts for demand within factory automation) have passed a trough.
Cognex noted that semiconductor revenues increased year on year and
sequentially for the first time in two years but were cautious over
pronouncing a recovery because of the relatively small amount of
customers that it has.
Elsewhere Intel’s(NASDAQ: INTC) recent results weren’t great, but the good news is that it seems to have stopped lowering revenue forecasts
and forecast that its gross margins are about to trough. Historically,
its share price has trended in the direction of its gross margins and
while things don’t look great right now (particularly with the PC
market) the industry is highly cyclical and can turn around pretty
quick. While Intel faces challenges from the changes in computing
devices, all Cognex really cares about is being in the production plants
irrespective of what the devices the chips end up in. In summary, 2013
does look like it will a better year for the semiconductor industry
Turning to Cognex’s biggest revenue driver (factory automation) there
were some good signs here too. Unusually it reported a sequential
increase of 2% in revenues from Q4 to Q1, when the norm is for a
decline. It is hard to pin this on any one event but I think we have to
recognize-as discussed above- that industrial sector is growing at
uneven rates. Indeed looking back at Alcoa’s recent
results we can see that the automotive (a key area of strength for
Cognex) and aerospace sectors are doing well while packaging is seeing
solid, if unspectacular, growth. It was a similar story with PPG Industries
recent results too although PPG was also helped by its US residential
housing exposure. If you are selling into the right sectors within
manufacturing you did okay, if not times were tough. PPG is always going
to be a cyclical play buy I think its end market focus means it can
grow faster than the market.
This theme was also repeated in Fastenal (NASDAQ: FAST) and MSC Industrial'srecent results.
Fastenal has more exposure too automotive and aerospace and it reported
relatively better numbers than MSC did within metalwork. My take on
these ideas is that aerospace is a long cycle industry and customers
can’t just halt or slowdown production for customers. Moreover
industries like automotive and residential housing are driven by
consumer demand which is relatively less affected by immediate political
concerns than say corporate inventory building.
Moreover let’s recall that the automotive industry leads the way with
just-in-time production so there is less ‘time’ for manufacturers to
temporarily halt inventory purchases. I think Fastenal and MSC’s end
demand will come back this year but it is subject to short term
pessimism.
Where Next For Cognex?
If you are bullish on the global economy and industrial output then
you should like the look of Cogex for the long term. Not only is
manufacturing becoming more automated but Cognex is trying to expand the
industry verticals that it sells into. For example, it has its products
in trials with logistics companies. The shift in manufacturing from
Japan to China is an issue but I note Chinese factory automation sales
were 23% and it still has a lot to play for with automotive in China.
Moreover it is realizing new products aimed at the high volume lower
priced market place.
It’s easy for investors to take Google (NASDAQ: GOOG)
for granted. The company seems to grow seamlessly while so many others
flounder amid the pressure of constantly having to deal with the
challenges of technological change or even just trying to stay ‘cool’.
In my view Google does these things well, and in this article I want to
discuss the five reasons why the market fears certain things about the
stock.
Google Is Normal Company
The first two reasons relate to the fact that it refuses to play the
game according to the ‘rules’ of the market. Firstly, Google does not
give guidance and secondly, it does not appear to have any plans to pay a
dividend.
In the short term world that we live in, companies that don’t give
guidance are creating ever more variance around their earnings results.In
the cold light of rationality it is quite remarkable that companies can
see their evaluations change by 5-10% overnight just because they
missed a few contracts or booked a few deals early in the quarter. But
that’s how it works folks. The fact that Google doesn’t give guidance
can cause some investment managers or brokers to shy away from the stock
because they do not want to explain short term losses to their
investors. Private investors shouldn’t care because their focus should
be on long term development.
As for the dividend issue, I previously discussed it at length in an article linked here.
There are valid concerns here. After all why buy a stock that cannot
really be taken over and doesn’t offer much prospect of seeing cash
flows--however large--returned to shareholders?My guess is that the company would get a re-rating if it paid a dividend, and I think in time it will do so.
Hard Core Worries
The next two concerns the market has are that Google’s history is as a
software company yet it continues to invest in hardware. The first
point is that investing in hardware requires it to constantly stay
ahead of the completion. The second is that many of these investments
are outside its core activities. I will deal with each point in turn.
Investors only have to look at Apple(NASDAQ: AAPL)
in order to start to get worried. Despite the endless lauding of the
Apple ecosystem, at the end of the day, Apple’s prospects are guided by
its hardware. And fashions change. A year ago Apple was unstoppable and
analysts were competing to see who could come up with the largest
estimates for iPhone 5 sales. Subsequently enthusiasm seems to have
waned as many have realized Android offers comparable functionality and
apps. Furthermore as other manufacturers catch up with Apple, why are
emerging market customers likely to pay a few hundred dollars extra for
an iPhone?
Frankly I don’t think these sorts of concerns are as big for Google.The
Motorola acquisition is intended to support Android and will allow it
integrate technologies with its own Nexus line of phones, but I doubt
they will reach the kind of market share that Apple has now. However
that is not the point. What really matters to Google with mobile is to
continue gaining share with Android, to retain its dominance over mobile
search and generate mobile ad revenues.
It's a similar story with regards to its non-core activities. Things
like Google Glass, Google Fiber and driver-less cars are media attention
grabbers, but there is little evidence that Google is a company not being
run as a profit maximizer. In other words, if Google Fiber isn’t seen
as being profitable then it’s hard to see the company rolling out huge
networks. With regards to Google Glass, its price tag (around $1,500?)
is highly likely to mean that it won’t become a mass market item. Throw
in the inevitable privacy issues and the likelihood of a significant
amount of mugging and it’s hard to see it becoming a blockbuster
product.None of these products are fundamental profit drivers for the
company.
Managing the Mobile Transition
A lot of investors tend to compare Facebook(NASDAQ: FB)
to Google in terms of the shift to mobile, but I think Google is likely
to do much better. Investors need to remember that the pull of using
Facebook is in its user generated content. Will that content and how
people interact with it stay the same with mobile? Or is Facebook
inevitably going to migrate towards being Twitter with pictures? The
content might change to encourage less usage time while concomitantly
Facebook is pressured to introduce ever more intrusive advertising. So
while Facebook is doing fine with mobile now, it faces a lot of
challenges in the future.
Here is how Google is doing:
Part of the move downward in cost per click is due to the migration
towards mobile, but nevertheless revenues grew overall at nearly 23% in
the last quarter and it recorded 20% growth in its relatively more
mature (and highly smartphone penetrated) markets in the US and UK. In
the rest of the World, revenue growth hit 27%. Google is managing the
transition very well, and whether search and advertising is desktop or
mobile based, Google dominates.
The Bottom Line
In conclusion, I think investors are often afraid of Google for the
reasons expressed above, but the key point is that its core revenues
continue to grow strongly, and its strategic development remains on
track. Its non core activities shouldn’t detract from the attractiveness
of the stock.
Its dominance of search and advertising across multiple
formats isn’t going away anytime soon, and given the mid-single digit
free cash flow yield and mid-teens earnings growth prospects I think the
consensus analyst target of $900 looks achievable. I think it will get
there quicker if it starts paying a dividend though.
The market turbulence in April has left many if whether we are headed
for another spring sell off. I have no opinion on this, per se, but
what I do know is that it always makes sense for investors to try and be
diversified. So if you are worried about the economy or just looking to
create a balanced portfolio, the following stocks should be of
interest.
Defensive growth
I’ve previously thrown some thoughts over on how to best achieve diversification in an article linked here.
One of the ideas is to try and have a portion of your portfolio in
stocks whose growth prospects are relatively non-correlated with
economic expansion or even stocks with prospects that are enhanced by
slower growth.
Unfortunately, as the market has moved higher it has fallen ever more
in love with the sectors (food and healthcare) that tend to contain
such stocks. But that doesn’t suggest you can’t monitor them with a view
to buy in should the market drop.
Some healthcare plays
I think Johnson & Johnson still has further to
run provided it can get the consumer brands affected by production
difficulties back onto the market. In fact, there are many names to look
at here, but I would caution against just taking a ‘buy healthcare’
approach. Many of them are exposed to cyclical trends, such as elective
procedures or the ability of governments to fund hospital expenditures
and reimbursements.
Instead of a blanket approach, companies such as Cooper Companies (NYSE: COO) and Allergan(NYSE: AGN) are worth examining. Eye care is about asrecession resistant as it gets, and Cooper is a great way to get exposure.
Around 80% of its revenue will come from Coopervision this year (the
other 20% from its Coopersurgical division). While contact lenses tend
to grow in any economy, I think the company has upside from increased
adoption of its silicone-hydrogel lenses coupled with significant margin
expansion opportunities from persuading customers to move to a one-day
modality.
All of this is fine, and the increase in investment in
silicone hydrogel makes perfect sense, but it's hard to argue that the
stock isn’t trading at fair value right now. Nevertheless, things can
change and this exactly the sort of stock that should be bought in a
sell-off.
Turning to Allergan, its mix of specialty pharma (including Botox and
ophthalmology products) and medical-device products means it can
benefit from an aging population. Other drivers are the expansion of the
usage of Botox geographically and within indications for spasticity,
migraine and bladder treatments.
It does have a dominant position with Botox (Allergan claims a global
market share of over 75%), but is subject to increasing competition
from Xeomin (Merz Pharma) and Dysport (Valeant Pharmaceuticals).
But even if it loses market share, there is enough growth for everyone.
Again, the problem is that its valuation is well up with events and
fashion. Even with the recent dip it still trades on over 30x current
earnings. It's hardly cheap.
Frustrating stock
Another frustrating stock in this regard is Perrigo (NASDAQ: PRGO). Its mix of generic pharmaceuticals, nutritional offerings and over the counter (OTC ) private-label products makes it one of the most attractive defensive growth plays in the market.
There is a clear trend from prescription to OTC drugs and pharmacies
are actively expanding their private-label offerings. In addition,
expanding generic drug sales is one way to cut down on healthcare costs.
In other words, all of its end- market drivers are ways in which to
reduce healthcare expenditures. So if I like the stock so much, why
don’t I hold it?
Frankly, I think it's too expensive and that some of its targets for
this year will not be easy to achieve given what it has reported so far.
Let's put it this way: the top line growth for H1 was only 5.7%, yet
its guidance for the full year remains at 12% to 16%. It will need to do
a lot in H2 to hit this figure. It strikes me that a buying opportunity
in Perrigo will only be created by an overall market fall or a profit
warning.
My last suggestion would be to pick up some speculative biotech.
Investing in a portfolio of stocks is difficult for a layman so I would
suggest looking for a biotech ETF.
The rest
I’m not going to dwell on CVS and Walgreen because I have discussed them at length articles linked here and here.
Both have good growth prospects thanks to demographic changes, the
expansion of their private-label offerings and the necessity of offering
more personalized services to customers with ailments (ex diabetes)
that require monitoring and ongoing treatment.
I think a food stock such as Cal-Maine Foods is worth a look. I covered it recently in this article. If eggs aren’t recession-resistant than I don’t know what is!
The last two stocks to consider are Church & Dwight(NYSE: CHD) and TJX Companies (NYSE: TJX).
The former is a consumer-products company that competes with some
giants within its various collection of niche markets. But therein lies
its strength!It’s a small company and its management has the experience and ability to know how to defend its brands from competition.
It is also flexible enough to react quickly on pricing and
promotions. So if one of its much larger competitors decides to
aggressively price discount or promote within one category, it has the
capability to make up any shortfall by taking action in other
categories.
Moreover, given that around 40% of its brands are value brands, it
has been a key winner in the desire for consumers to trade down or to
buy more products via discount stores.
And finally, TJX Companies offers a very unusual proposition.
Most investors know of its benefit as an off-price retailer in a slow
economy, but what makes TJX interesting is that it's a retailer actively
expanding in Europe. US investors should recall that the most notable
Western shift toward discounters occurred in Germany after the
reunification. In other words investors should embrace the European
expansion plans rather than be afraid of them. I see it as a net
positive.
For example, discount grocers such as Aldi and Lidl
saw rapid growth, and I see no reason why an off-price retailer like
TJX can’t do the same with clothing and home goods in Europe. As for
competitive moats, I think that inventory purchasing with clothing and
home goods requires a different set of skills than pure ‘pile em high
sell em cheap’ approach taken by the discounters.
Many thanks for sticking with a long post, and I hope there are a few useful ideas here!
One of the peculiar aspects of the market move upwards in 2013 is
that the defensives have led the way while the traditionally more
economically sensitive areas like technology have lagged. Indeed, anyone
trying to construct a balanced portfolio is going to have to deal with
the contradiction inherent in only wanting to buy value as well. What
happens when the value is mainly within technology and therefore guiding
you towards being overweight in the sector? What happens to your
diversification dream?
While the market has been somewhat vindicated in the current earnings
season (a lot of tech co’s have warned), I also feel that many medical
companies are at the very least fairly valued. With this in mind I thought I would look at Covidien’s(NYSE: COV) latest results. Is it time to buy in?
What the Industry Is Saying
Don’t get me wrong. I like this company and its prospects and have held and written about it before.
It has many good properties, but the market seems to have factored all
of this--and more--into the share price. Moreover, going into the latest
set of results there were some signs that the medical device market was
a bit weaker.
For example Johnson & Johnson generally gave a positive set of results, but there was a note of caution
in its medical devices division. Apparently hospitals have been
reporting that the levels of surgical procedures in Q1 were tracking
weaker than forecast at the end of 2012. This is problematic because, if
healthcare companies are cyclical at all, it is in areas like demand
from elective procedures and surgery visits.
It is not a major problem for Johnson & Johnson because it has
plenty of other opportunities to grow earnings, and many of them are
about internal execution (getting products back into the market,
integrating Synthes etc) but for Covidien it spells danger.
Similarly, I noted that General Electric
reported that its healthcare division saw its performance a bit weaker
than expected as hospitals were seeing pressures on their budgets. Again
a diversified industrial like GE can cover up any shortfalls elsewhere,
but it’s worth noting that many of its solutions do come with
relatively high ticket prices. So if you are worried about a global
slowdown then GE’s healthcare revenues are likely to give you a place to
hide.
Varian Medical Systems
is another company I like for its emerging market growth prospects.
Indeed, its latest results demonstrated strong growth from the BRICs and
other emerging markets. The problem is that its equipment requires
large capital outlays at a time when clinics in the US and Europe are
under budgetary constraints. It was no surprise to me that its North
American oncology systems net orders were weaker with a 9% decline, and
it isn’t just macro. US hospitals are faced with uncertainty over
reimbursement issues and health care reforms. It is all well and good
lauding the claims of radiotherapy as being a cost effective treatment,
but if clinics are financially constrained they will delay ordering.
Varian is definitely a stock to watch--mainly for its BRIC growth
prospects--but I think buying it depends on timing the moment when the
market is fearful of Western healthcare spending.
What About Covidien?
Covidien is a kind of a mix of these companies. Rather like Johnson
& Johnson’s surgical division, it needs decent growth in hospital
procedures in order to drive revenues at its key endo-mechanical and
energy devices segments. And in common with GE it is seeing pricing
pressure from hospitals. Covidien’s management made it clear that there
wouldn’t be ‘upside to pricing going forward’. In other words, it’s all
about volumes.
There is a silver lining in the sense that Covidien doesn’t really
sell a huge amount of large ticket capital spending items. In other
words many of its revenue streams can fall under the radar of cutbacks
at hospitals. With that said, it was affected in the quarter (at least
within Western markets) by capital spending pressures, and it's time
that the market realizes this.
There was also some uneven performance among its industry segments.
Energy remains a strong point for Covidien as its solutions offer
cost effective ways for surgeons to achieve better outcomes and reduce
hospital costs. Meanwhile endomechanical put in another strong
performance helped by stapling. However in its third key market
(vascular) there were some disappointments. Covidien lost a key
contract, and growth for Q3 is forecast ‘significantly below that of
Q2’. Since Q2’s growth was a lowly 3.6% in vascular, I think investors
should brace themselves for next quarter’s vascular results.
The Bottom Line
Covidien gave notice that Q3 would come up against some difficult
yearly comparisons, and the weakness in vascular is also going to hurt
performance. Moreover, the uncertainty over healthcare regulations and
funding may hit capital spending in energy. In addition its plans for
increased investment spending are likely to trim margins.
With that said Covidien has many good long term drivers. The pharma
spinoff will allow it to focus efforts and possibly invest in some
acquisitions. Longer term I think this stock will do well but growth is
slowing this year and I’m not sure it’s good value just yet. One for the
watch list.
The story with the industrial sector in this earnings season has been
that there has been great variability in performance. It is very much a
sector picker's market, and the broad based industrial plays like GE or Alcoa(NYSE: AA)
have reported this theme. In short, Europe has been weak, but China has
rebounded somewhat, the US is doing okay and the areas of relative
strength overall are in things like housing, autos and aerospace. With
this understood, is there a company with good exposure to these sectors?
PPG to the Rescue
I think PPG Industries(NYSE: PPG) might fit the bill, and based on the share price graph the market seems to think so too. I last discussed the company in an article linked here and
back then concluded that there was some uncertainty over China. Since
then things have picked up a bit in China (at least in the industries
that PPG is focused on), and it has completed a few notable
transactions.
The industrial sector is certainly not firing on all cylinders but by looking at Alcoa’s last results
it is clear that some segments are doing better than others. However,
with a stock like Alcoa, it really is dependent on broad based
industrial output in China.
So what makes PPG different?
I have a list of reasons to like the stock:
Its exposure to automotive, aerospace and packaging has led it to outperform the industrial market this year.
The restructuring program has led to the company expanding margins with productivity improvements.
Some of its raw material costs appear to be moderating in 2013.
Even with weakness in European autos (see Alcoa) PPG managed to do relatively well thanks to its ‘good customer mix’.
The sale of its commodity chemicals business will allow it to focus on its core activities.
The acquisition of Akzo
Nobel’s US household paints division is a good move given the nascent
housing recovery and the $200 million of synergy savings that it thinks
it can generate in the next three years.
Putting these things together leads to an attractive proposition for
2013. In addition, China has been doing better recently in the sectors
that matter to PPG.
How PPG Makes its Money
Having conceptually discussed the positive tailwinds for the company,
it’s time to look at how this translates into earnings. Here is a
breakdown of its segmental earnings:
And now consider that it has more than doubled the size of its US
architectural coatings business with the purchase of Akzo Nobel US
household paints division.
For evidence of how well margins have expanded, I want to focus on the profit margins in its three largest businesses.
Note how well performance coatings and industrial coatings are expanding (don’t forget to look at them on a year on year basis).
There could be more to come with raw material costs moderating. PPG’s
management were relatively cautious over the issue, but if we go back
to Sherwin-Williams'(NYSE: SHW)
last results, it reduced its view on raw material cost inflation for
the year. Indeed, Sherwin-Williams reduced its view to flat from low
single digits previously. Titanium dioxide and propylene prices may see
some pressure as other parts of the industrial sector are not doing so
well, and since these are key inputs into PPG's cost base, I think there
is reason to be optimistic.
The Bottom Line
In conclusion this company has a lot of things going for it. It’s a
mixture of acquisition-led growth plus good exposure to the parts of the
industry that are working right now. In addition, the increases in
margin plus opportunities for synergy-driven cost savings mean that its
(already substantial) cash generation can improve in future years. For
those looking for exposure to an industrial cyclical then PPG looks to
be one of the best options.
It’s another big week for earnings and by now investors will have
formulated a thesis on the first quarter. That thesis will be put to the
test this week. In my view there are some clear signs that there was a
bit of caution over discretionary spending among corporations. Will it
continue?
As the weeks go by, let's recall that companies will get a bit more
data on current trading conditions. If there was some temporary weakness
due to the sequester, then we should start to see that correct itself
in company trading updates.
Monday
It’s rare that a Monday is so interesting. Riverbed Technology will report alongside industrial plays like Eaton and Cognex. I like Cognex’s exposure to the increase in industrial automation and think it has strong long term growth prospects. However,
it is very difficult to know what it will report this time around.
Semiconductors and consumer electronics are major markets for Cognex,
and they were not strong this quarter. Small business services company Insperity will give an update on how that market is faring and crucially will gauge employment conditions. The Herbalife circus will likely continue when it gives results, although, as discussed previously, investors would be better advised by staying away from spending their hard earned money in these types of situations.
My highlight of the day is Masco Corporation (NYSE: MAS).
Its share price reads as a barometer for sentiment on the housing
market. There was a severe crash in 2009 and then a couple of false
dawns leading into two significant dips. But since the start of 2012 it
has been one way traffic. Indeed, analysts have been raising estimates
already in 2013. Masco is interesting because it is more a play on new
house building than many of other housing related plays, as such, you
should expect it to be higher beta.The question for investors will be
similar to that facing Whirlpool recently. The stock has had a great run up, so will it deliver enough to keep the short term momentum going?
Tuesday
The industrial theme continues with Cummins and Regal Beloit
giving numbers. The former competes in some difficult markets right
now, but things are starting to look a little brighter for Regal
Beloit’s construction end markets. A few interesting tech companies will be reporting, with Sonus Networks (whose rival Acme Packet was taken over by Oracle recently) giving numbers. Fortinet has already pre-announced and disappointed, but I think it could come back strong, particularly if it starts to talk of some normalization in orders.
It’s also a big day for pharmaceuticals. Vertex Pharmaceuticals is a company that has had a lot of success in clinical trials over the last few years but the big news today will come with Pfizer’s(NYSE: PFE)
results. The company has continued its long term plan to focus more on
core activities by spinning off its animal health care business Zoetis and restructuring other divisions. The key now is to ramp up sales of its new pipeline of drugs. Xeljanz (tofacitinib)
has been approved for rheumatoid arthritis and threatens to become a
blockbuster (especially if it can get it approved for other
indications), and Pfizer has high hopes for blood thinner Eliquis to
also reach blockbuster status. The market will obviously focus on how
Pfizer’s plans for these drugs are progressing. This sort of thing is
critical to the share price because the restructuring and divestitures
of recent years were intended to drive growth in its more focused
pipeline.
Wednesday
Today is Facebook(NASDAQ: FB)
day. The stock is obviously high profile and will attract a huge amount
of attention. I confess I’m not a fan of either the website or its long
term prospects. Granted it did very well in generating revenues from
mobile, but at what cost to its users?
Moreover, investors need to appreciate that the value in this company
is largely generated by user-created content. As Facebook usage shifts
to mobile, might the content created change to reflect that? I suspect
it will and we will see more memes created (by other entities) whose
sole purpose is to generate data that can then be sold. How long can
people keep calling this fun? The key question for Facebook holders is
to try and ascertain whether its mobile advertising initiatives are
starting to negatively effect the user experience or not.
One company that I think has rather more reliable long term prospects is Allergan(NYSE: AGN).
I like its mix of Botox, specialist eye care products and medical
device solutions. However, I think it is fairly priced right now. While
investors should be willing to pay a premium for a company with high
quality of earnings, in truth there is no stock that doesn’t contain an
element of risk. Allergan may lead the neuromodulator market but Merz Pharma is now re-commercializing Xeomin and Valeant Pharmaceuticals has purchased Medicis partly
in order integrate Dysport (Botox’s chief rival) into its dermatology.
More competition is coming even as Allergan tries to expand Botox sales
in areas like spasticity. Any sign of weakness and the market will start
talking about these issues.
Thursday
Church & Dwight is a great favorite among conservative investors, thanks to its recession-resistant properties. The Estee Lauder Companies stockholders will want to hear how its strategic management initiative is progressing. Healthcare is represented by Beckton Dickinson, Mylan Labs, Inctye Pharma, Sanofi
and the above mentioned Valeant Pharmaceuticals. I’m a former holder of
this company and I like its expanding dermatology franchise while its
branded generics have good growth prospects in emerging markets.
Obviously the market will focus on the integration of Medicis, but it
has elements of a research and development pipeline that could boost its
prospects this year. Efinaconazole (toenail fungal infection) and
Luliconazole (fungal infection) have FDA actions due this year. And
finally, look out for two big food companies reporting when Kraft and Kellogg give numbers.
The Bottom Line
In conclusion, it is quite a big week for all the defensives,
particularly pharmaceuticals and food, that the market has been in love
with recently. Will there be enough in the results to take the market
higher or will any failure to beat estimates be used as an excuse to
take profits? For the patient investor the latter could create some
buying opportunities; hopefully this article has given you some ideas.
It’s very easy to get a bee in your bonnet with investing, and there
are certain issues and metrics that just become the one big thing that
guides the performance of certain stocks. In the case of IT security
play Check Point (NASDAQ: CHKP)
it is its falling (and now negative) product and license sales growth.
In summary, there are mitigating circumstances, and there was some good
news in the latest report, but until it gets this metric back on track,
it is hard to see the stock aggressively re-rating from its undoubtedly
low rating.
Check Point punching below its weight?
As usual, the management was forthcoming in outlining Check Point’s
technological leadership and cited the IDC Worldwide 2012 Security
Appliance Tracker (which claimed it was the leading firewall and UTM
appliance market company) as a reference point. The company is known for
the sophistication of its products but also for their high cost.
Indeed, the latter is part and parcel of this company’s relatively
mature position in the IT security market.Competitors like Fortinet(NASDAQ: FTNT) may have better growth prospects (from a lower installed base), but no one generates margins and cash flow like Check Point.
Unfortunately, I suspect that these characteristics are part of the
reason for the falling product and license sales growth. In other words,
Check Point appears to prefer sticking to its high-margin, high-quality
razor blade model, rather than stepping up marketing or reducing prices
to generate growth.
The results are obvious.
The mitigating argument (I know it because I held it) is that the
company is deliberately bundling hardware and software together and
trying to get the razors (hardware) installed so it can sell more
blades. Moreover, it has increased the number of blades that it can sell
to customers in recent years. Consequently, product sales growth should
look weaker.
The problem with this argument is that software sales have started
getting weaker, too, and the mid-point of revenue guidance for the
second quarter would bring annual revenue growth down to a paltry 1.9%.
Growth is clearly slowing.
Why Check Point’s growth is slowing
One explanation for all of this is that Palo Alto Networks’(NYSE: PANW)
growth is eating into Check Points' pie. Indeed the ‘Check Point
Killer’ (Palo Alto’s founder is an ex-high-level Check Point employee)
is growing rapidly and winning a significant amount of primary firewall
business, even as its solutions are regarded as high ticket. On the
other hand, Fortinet is usually seen as more of a cost-effective UTM
vendor, and in this tough environment it is doing well (albeit with
lower-than-expected results the last time around). Fortinet is starting to look interesting after the warning.
Another reason is that Check Point is in the middle of a new hardware
platform appliance. This transition can cause some existing customers
to hold off purchasing. In addition, in the last quarter the management
noted that some customers were enjoying getting the same performance but
with less cost, thanks to the increased efficacy of the new products.
Of course, in time, their requirements will increase and this pent-up
demand could lead to better numbers down the line.
The immediate problem is that investors have seen with Riverbed Technology(NASDAQ: RVBD)
what can happen with product refreshes in technology. They can take at
least a quarter or two to iron out, and the market takes no prisoners
when companies are faced with such short-term difficulties. It took
awhile for Riverbed to recover, amid speculation over the maturity of
its core WAN optimization market. Indeed, the company has been
diversifying its end markets in a view to avoid over-reliance on one
marketplace.
Incidentally, this is why I am cautious on F5 Networks (NASDAQ: FFIV) right now.As with Fortinet, it reported a severe reluctance among telco carrier clients to sign off on deals in the quarter.
This would be acceptable if it didn’t coincide with a product refresh.
Investors can be understandably concerned that it isn’t a coincidence.
In addition, it doesn't have enough revenue outside of core application
delivery controllers to make up any shortfall.
The good news
However, it wasn’t all bad news. Europe, which at 38% of revenue is a
significant profit generator, saw surprisingly strong performance.
Contrary to what F5 and Fortinet said recently, it saw no specific
weakness in its telco vertical.Some super high-end deals
failed to close, but that can probably be attributed to the same
cautious approach among tech buyers that seemed to hit IBM and Oracle. They could easily bounce back if the political uncertainty lifts.
Probably the most bullish point relates to how deal size improved in
the quarter. Management cited that 67% of transactions were at $50k and
above, opposed to 60% last year, and 43 customers made transactions at
over a £1 million as opposed to 34 last year.The key
reasons are a higher average selling price (ASP) driven by a higher
revenue product mix. Remember what I said about how Check Point prefers
margins and cash flow to revenue growth?
The bottom line
This stock remains a very good value on a price/cash flow basis, and
it clearly has market leading products. The increase in ASP is a sign
that it is getting over its product transition and customers are
starting to buy the new appliances so a bullish case can be easily built
for the stock.
The problem is that the market hasn’t wanted to know anything about
the stock while its revenue and product and license sales growth are
slowing. That may change this year because comparisons are getting
easier, but I think this company is going to have to come out and
declare it is going for growth, and/or report some better growth numbers
before buyers feel confident again.
Sometimes when companies outline their strategic thinking the market chooses
to ignore them and then be surprised when the results come out in line with the
company’s strategy rather than with what the market chose to think. I think
there was a bit of this mentality with Whirlpool's (NYSE: WHR) recent results.
Revenues were a bit less than market estimates but earnings were ahead. The
company told us that its focus was on margin and cost reductions rather than
purely revenues and volumes; why don’t we try taking that at face value?
Staring Into a Whirlpool
This is an activity that can produce confusing optics. The periphery may
swirl around and signal danger but the center is calm. It’s a nice way to think
about these results. Whirlpool declared it was on track to deliver on all its
key metric such as profit margins, EPS and an impressive $600-650 million in
free cash flow for the year. Most notably omitted from these metrics is revenue,
and I suspect the reason is that the company intends on pushing ahead with
margin expansion rather than chasing or holding market share. As a consequence
there was no change to its full year guidance.
However the revenue numbers got the market worried.On an
adjusted basis sales were flat at $4.3 billion but adjusted operating profits
were up 21% to $280 million and free cash flow improved by $139 million to an
outflow of $376 million. So margins and cash flow improved but sales didn’t.
Nobody likes companies that aren’t increasing sales, but there is a rationale
for it. Whirlpool is trying to achieve margin expansion in an industry that is
coming off a historically low base, so the opportunity for leverage is
significant. Operating margins rose to 6.6% in the quarter with the longer term
aim being to get them up to 8%. I think this strategy makes sense in a rising
market but, make no mistake, if the market does turn down again Whirlpool will
suffer inordinately compared to its peers.
The stock is very much a directional play on US and Latin American housing.
EMEA (nearly 16% of sales) is a significant region, but conditions are tough
there and the forecast is for flat revenues in 2013 while Asia is not a
significant region (4.4% of sales). Hopes rest on the US and emerging markets,
particularly Brazil.
Will it Work?
Whirlpool seems to be of the opinion that promotional activity won’t
necessarily increase market share and appear to be jejune to the threat posed by
LG and Samsung selling into Home
Depot(NYSE: HD) and Lowe’s
Companies(NYSE: LOW). Indeed, LG saw some
margin erosion in its last quarter. All of which leads to a classic investment
proposition. Do you favor a company gaining market share with margin erosion or
one like Whirlpool that tends to hold margin but is willing to lose some market
share?
As ever there is no immutable answer to these sorts of questions. My feeling
is that the latter is a better strategy provided its end markets are doing well
and the company invests in innovation in order to keep the perception of value
in the brand.The good news is that Whirlpool is doing this. Furthermore let's
recall that Whirlpool is acting on behalf of its shareholders rather than trying
to establish volume growth for some ulterior motive.
With this in mind it's worth looking at what the industry is saying. I noted
that in General Electric’s(NYSE: GE)recent
outlook it gave a positive prognosis for its home and business division.
While it is not a big part of GE’s operations it is a significant marker for its
view on the consumer market in 2013, particularly the housing related sector.
Moreover, GE is similarly positioned to Whirlpool in the market so there isn’t
strong evidence to suggest LG and Samsung are set to dominate.
Turning to the home goods stores, Home Depot reported that its pro sales were
starting to increase more relative to consumer sales in Q4. This is a sign that
the market is starting to turn up definitively and not just relying on
replacement sales anymore. Furthermore, Home Depot reported that more of its
discretionary elements were starting to outperform and crucially for Whirlpool,
it said that kitchens, bath performed positively. It was a similar
story with Lowe’s Companies. It reported that the outperforming categories in
the quarter were things like cabinets, counter-tops, home fashion, storage and
cleaning. Again this is good news for Whirlpool.
As noted
in a previous article we are approaching the 10 year anniversary of the boom
years in the housing market where consumers were accelerating their purchases of
white goods. Therefore it is reasonable to expect a new replacement cycle to
kick in over the next few years. This should benefit all the companies discussed
above.
Where Next for Whirlpool?
On balance I think Whirlpool’s mix of exposure to a resurgent housing market
plus its margin expansion opportunity makes it an attractive stock to hold. It
is forecasting North American growth to come in at 2-3% with Latin America at
3-5%. If it hits these rates and continues to expand margins and cash flow I
think the stock will be higher at the end of the year.
