Nike Keeps Doing It, But For How Much Longer?

A few years ago, one of the main attractions of Western consumer goods stocks was their potential to aggressively grow sales in emerging markets. That story is still in place, but somehow Nike (NYSE: NKE  ) has managed to flip the script in recent years by generating more of its growth from mature markets.

This trend continued with the latest first-quarter results, with Nike announcing double-digit growth in North American and Western European orders. The stock hit an all-time high in response, but is it time to take profits? Moreover, can it continue to rely on mature markets for growth?

Nike flips the script

There are three key takeaways from the recent results, and each of them serves as a marker for what Nike needs to do going forward.

First, its mature markets are out-performing. A look at segmental earnings before interest and taxes (EBIT) reveals that growth this year has come from North America and Western Europe.

Source: Company Accounts

Western Europe is now generating more profits than Greater China or the emerging markets segments. Furthermore, Nike reported future orders of 11% and 12%, respectively, for North America and Western Europe. Meanwhile, Greater China and emerging markets futures grew at a less impressive 2% and 7%, respectively.

The second takeaway is the ongoing out-performance of footwear versus its other categories in regions outside of North America. The one key exception in the quarter was China (the only area where apparel notably outgrew footwear), and I'll come back to this important point later. For now, focus on how much better footwear is doing.

Source: Company Accounts

This trend is probably going to reverse somewhat because Nike will come up against some easier comparisons with apparel in the upcoming quarters.

With regards to North America, apparel grew at the same 9% rate as footwear, and management declared itself "super excited" by the performance in its women's business. This is something that might concern yoga-gear maker Lululemon Athletica  (NASDAQ: LULU  ) . After suffering quality issues with its black yoga gear, Lululemon was susceptible to losing some market share. This sort of issue is critical for Lululemon, because it's positioned as a premium seller in the marketplace.

The third takeaway was the return to growth in Western Europe. The 8% revenue growth rate (at constant currency) is pretty impressive considering it came up strong growth generated last year by football (soccer) sales inspired by the European football championships. Outside of the World Cup, the European competition is the largest in the World, and features all of the top players outside of South America.

What does it mean for Nike?

Clearly, Nike needs to improve its performance outside of North America. With this in mind, the return to form in Western Europe is a good indicator for Nike's plans in China. Nike is undertaking a similar kind of strategy reset in China to what it successfully did in Western Europe.

It would be churlish to doubt that Nike can improve its performance in China through simple 'blocking and tackling' management initiatives. For example, things like merchandising, improved product selection, and improving logistics were all discussed on the conference call. On the other hand, there are a couple of short-term concerns.

First, Nike's strong performance in North America relates to its successful sponsorship of high profile American athletes in sports like basketball or American football. It's highly unlikely that LeBron James or Kobe Bryant are going to resonate as well with Chinese consumers. Second, when questioned about the future footwear/apparel mix in China on the conference call, Nike's management replied:

So we'll have the more targeted mix of products, but the ratio of footwear and apparel -- we're not seeing a dramatic shift in that ratio. That said, we see tremendous upside in the apparel business in China for Nike to move forward and frankly around the world.

It doesn't look like Nike will specifically address why apparel is outperforming footwear in China, and this may make its strategic reset a bit harder to execute.

Where next for Nike?

Nike's stock price is at an all-time high, and even when compared to a company like outdoor-clothing company VF (NYSE: VFC  ) , Nike's valuation looks a bit rich.

 

Nike price-to-normalized-earnings less cash (trailing-12 months) data by YCharts

 

VF is arguably more attractive than Nike because it has a wider and more diverse range of brands. When market conditions are difficult for one brand, it can focus on another in order to drive growth. Whereas with Nike right now, it really is all about footwear, and its more mature geographies in particular. VF has a mix of powerful outdoor brands (such as Timberland, Vans, and The North Face) and jeanswear with which it can generate growth across the cycle.

What Nike needs to just do

If Nike is going to continue to justify this valuation it is going to have to execute better in China and emerging markets. Fortunately, the World Cup takes place in an emerging market, and Nike is well placed as the sponsor of the powerful Brazilian host team. However, the market is likely to have priced this in by now.

 

Therefore the 'swing' factor in deciding to buy the stock must be your confidence over the company's ability to turn things around in China. Furthermore, Nike will need to continue to grow at a rapid clip in its mature markets. If you think Nike can just do it, then the stock probably has further to run. For cautious investors, however, now might be a good time to take a little profit off the table.

Time to Invest in Tech Value Plays?

If you favor a value-based, long-term, buy-and-hold investing strategy, then you must have noticed how cheap some blue-chip tech stocks are right now. The easy move is to put a bunch of them in your portfolio and forget about them for 10 years. Unfortunately, tech investing is rarely that easy. So what do you need to know before making a decision?

Tech titans
First up, let's look at a chart of these tech titans. I've included a mature blue-chip stock, Johnson & Johnson by way of comparison. Enterprise value over earnings before interest, tax, depreciation, and amortization, or EBITDA, is used, because EV -- market cap plus net debt -- is a better measure to compare companies. Moreover, EBITDA is a good proxy for underlying cash flow.

IBM EV / EBITDA TTM data by YCharts

All these companies look relatively cheap. Moreover, on a historical basis they are all a good value. In fact, Intel (NASDAQ: INTC  ) , Oracle (NYSE: ORCL  ) , and Cisco (NASDAQ: CSCO  ) are all trading at substantial discounts to their pre-recession valuations. Why is IBM (NYSE: IBM  ) the odd man out?

Adjusting early to structural shifts
IBM adopted a different strategy to the rest. It acted early to adjust to structural changes in the economy. The sale of its PC division to Lenovo in 2004 was a key part of its transition into primarily a software and services company.

Source: Company accounts

Consider how well Oracle's stock performed compared to Intel and Cisco over the last 10 years.

Data by YCharts

The charts demonstrate that over the last decade, goods, products, and services have commanded higher prices based on how "smart" they are. For example, think of the advanced electronics systems being fitted into cars, or smartphones versus landlines. The shift is mirrored in the outperformance of the one software and services company on the list: Oracle. IBM also did very well, precisely because it made the transition to selling more software and services.

Going forward, IBM's strategy is to sell its lower-margin businesses, and increase margin expansion at the expense of revenue growth.

So while its revenues are forecast to be flat from 2012-2014, its EPS is expected to rise 20%.

Oracle now facing challenges
The previous 10 years have been very good for Oracle shareholders. However, there is no guarantee that the next 10 will be the same. The company remains a very good value play, but it also faces its own structural challenge with its traditional on-premise, on-license sales being threatened by cloud-based software providers. Moreover, as cloud-based sales increase, Oracle will find it harder to bundle its hardware solutions with its software.

Accordingly, analysts have Oracle on low-single-digit revenue growth for the next couple of years, with only high-single-digit earnings growth forecast. Oracle is seen as being late to the cloud party, and its future growth depends on making the adjustment.

Intel adjust its business, Cisco tinkers
Intel is the worst performer of the four, and it's also facing some structural challenges. It wasn't the only company caught out by the acceleration in mobile computing at the expense of PCs. Subsequently, Intel has found its core PC processor market to be challenged as PC sales repeatedly disappoint, and ARM core processor designs have won out in the mobile market. Simply put, Intel's refusal to license ARM's architecture in a meaningful way, has hurt the company.

The good news is that Intel has invested in new processors (Bay Trail and Haswell) that should start to penetrate the ultra-mobile market as of this year. Intel will need to do this in order to hit guidance this year.

Cisco's challenges and opportunities are of a different sort. It's switching and routing divisions still generate low-single-digit growth, but it's not enough to get excited about the company. Moreover, its services revenues growth -- services make up around 21% of total revenues -- is really a function of how well it can sell its products into the marketplace. The real question is how well Cisco will invest its cash in growing its peripheral sales.

You can see the point illustrated in the following chart.

 

Source: Company accounts

What you need to look for
Intel will become very attractive if it can establish a strong foothold in the mobile market. You'll want to monitor developments later this year.

Oracle needs to halt declines in its hardware sales and demonstrate that it can shift more revenues to the cloud while retaining margins with its traditional software. However, the stock is very cheap right now, and even stabilizing the company to GDP-type growth should see some good price appreciation.

IBM's story is one of ongoing margin improvements and the execution of its plan. Look for margin expansion. Cisco is intriguing because its sits on more than $34 billion in net cash and investments, while its market cap is $123 billion as I write. In other words, it has the capability to invest wisely and generate growth. Keep an eye on its acquisition strategy.

Each of the four has its own risks and rewards, but a portfolio that contains all four isn't a bad idea for a value investor.

FedEx May Seem Boring But These Stocks Make You Money

You could be forgiven for thinking that there was something odd about FedEx's (NYSE: FDX  ) latest results. The transportation company is usually seen as a play on global growth, but it simultaneously lowered its GDP forecasts and saw its stock price surge through an all-time high. What's going on?

Fedex lowers GDP estimates

First, here's how FedEx has lowered its forecasts over the year to date:

Estimates for 2013	Start of the year	Last Quarter	Current Quarter
U.S. GDP growth	1.9%	2%	1.6%
Global GDP growth	2.5%	2.3%	2%

Source: Company presentations.

FedEx and its rival UPS (NYSE: UPS  ) are typically seen as cyclical plays. In other words, their share prices tend to follow the direction of the economy. This is why investors usually respect its views on the economy, and why its lowering of GDP estimates should be bad news. However, a number of elements have come together to give it some upside potential which isn't just about the economy.  

FedEx's structural challenge and its response

Our economy has changed since the financial crisis, and demand for FedEx's services has changed with it. Companies are now a lot more willing to use lower-cost delivery options, even if they ultimately receive their deliveries a day or two later. In response, FedEx's lower-cost ground segment is now its key earnings generator, while the contribution from its pricier express service has fallen.

Source: Company financial statements.

This shift wasn't great news for FedEx; it had invested in expanding its express capacity in anticipation of stronger demand. Ultimately, this led FedEx to spend the last few years losing margins in express while also restructuring the division.

Even as FedEx's customers have grown more frugal, its fuel costs have risen in line with oil prices. International trade has also been growing more slowly than global GDP, mainly because Western consumers' spending on exports from the Far East has slowed post-recession. All of this has led FedEx's express-shipping margins to decrease.

Source: Company accounts.

The company's response to these pressures is to increase its investment in ground shipping, and to work on efficiency gains in express, including retiring planes and modernizing the fleet. All of these things will help to increase its margins in future.

Productivity improvements, e-commerce and its rivals

FedEx aims to realize $1.6 billion in cost savings by 2016 -- which is a large part of the reason why analysts have EPS growing by 39% over the next two years, while revenues are only forecast to grow by 9%. During its recent conference call, management outlined that it was ahead on plans to cut costs, and reiterated its $1.6 billion savings target, despite seeing weaker-than-expected end demand thanks to a slower economy.

Moreover, FedEx's ground segment has strong secular growth prospects from burgeoning e-commerce demand. Speaking of its ground services during the conference call, the company declared that it would put as much money as it could into it. FexEx claimed that ground's margins would remain at 17% to 19%. Ground's volume growth was being "driven by e-commerce."

FedEx's aim must be to increase the amount of free cash it converts from its revenues, because compared to the 9%-plus that UPS has delivered in the last two years, FedEx's conversion looks small. Ultimately, free cash flow is what counts to an investor, because it fuels a company's dividends and buybacks.

Source: Company accounts.

The good news is that FedEx has the opportunity to increase cash flow, while UPS seems more reliant on global GDP growth. UPS lowered its full-year EPS guidance to $4.65 to $4.85 in July as a result of weaker global growth.

Although FedEx's other key rival, Deutsche Post (NASDAQOTH: DPSGY  ) , raised its guidance in June, this was solely due to a one-time item. In fact, Deutsche Post's half-year revenues were flat year-over-year. Increasing this growth will be difficult, because 63% of its revenues come from Europe.

Where next for FedEx?

FedEx should see margin expansion in the next few years as productivity improvements, and the shift in its earnings toward the ground segment, kick in. Indeed, analysts give FedEx a forward P/E ratio of 13.4 for May 2015 -- a discount to UPS's projected 16.7 for December 2014.

Moreover, UPS is slightly more exposed to the global economy then FedEx, and the latter seems to be executing its productivity plans well. FedEx should be converting revenues into cash flow much better in the coming years, and it looks to be a relatively decent value, provided the global economy holds up.

Cooper Companies, Great Prospects, Expensive Stock

When it comes to investing, sometimes it's best to start with the obvious and look for companies that have the potential to slowly grow. Contact lens specialist Cooper Companies  (NYSE: COO  ) is one such stock, and it's definitely worth taking a closer look at it.

Cooper Companies growth prospectsCooper reports numbers in two separate segments. CooperVision is a soft contact lens manufacturer generating 80% of revenues. CooperSurgical generates 20% of revenues, with two-thirds coming from surgical devices, and one-third from its fast growing fertility treatment products.  I'm going to focus on CooperVision.

Cooper's management is on record as expecting the soft contact lens market to grow at a 4%-6% clip this year. The bad news is that, for a second quarter running, the worldwide market only grew at 4%. This suggests that market demand is not as strong as it could be.

The good news is that CooperVision managed to grow its sales by 11% over the last 12 months, and there are a number of reasons why it can continue to grow.

First, its silicone hydrogel lenses (more comfortable, last longer) revenues now make up 43% of CooperVisions total. They grew at 22% (constant currency) in the last quarter, and Cooper can expect to generate more growth in the future from customers "trading up" to these lenses.

Second, Cooper's management never tires of pointing out that a customer trading up to its single-use (or one-day) lenses generates four to six times more revenue and three to five times more profit. In other words, there is ample room for growth in earnings and margin growth from expanding one-day sales. For reference, its single-use sphere revenues only make up 21% of CooperVision revenues (17% of total company), and they grew at 9% in constant currency in the last quarter.

Third, Cooper plans to move in on Johnson & Johnson's (NYSE: JNJ  ) dominant position in the two-week modality in the U.S. by marketing its own two-week lenses.

Fourth, Cooper has just launched its new branded one-day silicone hydrogel based lens called MyDay in Europe. According to the management, MyDay is "not going to be a major influence" next year because sales are building from a small base. It will take Cooper time to build up production capacity, but longer-term Cooper should have good prospects with MyDay. 

And finally, Cooper has plans to geographically expand sales of its leading Biofinity (monthly silicone hydrogel lenses). Moreover, it can cut costs thanks to not paying royalties, because sillicone hydrogel patents will expire in the U.S. in 2014 and globally in 2016.

Threats to growth?While Cooper has been growing, there is no guarantee that it will continue to do so. Indeed, Valeant Pharmaceutical's (NYSE: VRX  ) purchase of Bausch & Lomb suggests that competition will get tougher. For example, Bausch & Lomb recently launched a one-day lens. Moreover, Valeant has worldwide plans to generate synergies between its existing dermatology and eye-care products, and Bausch & Lomb's eye-care solutions. Valeant will surely invest in trying to expand Bausch & Lomb's international sales.

Similarly, Johnson & Johnson managed to accelerate growth in its vision-care segment to 5.4% operationally in the last quarter, and it cited its one-day lenses as one of "the primary contributors to operational growth." Cooper is not alone in recognizing the margin potential of one-day lenses, and Johnson & Johnson has a formidable distribution network in the kinds of emerging markets that Cooper wants to expand into.

A look at the numbersCooper has strong prospects, but it also has a strong valuation. Cooper's own EPS guidance has increased throughout the year.

Source: Company presentations.

However, its valuation has more than kept pace, and it now sits on a forward P/E of over 20 times the mid-point of its full-year EPS guidance. This looks expensive, but recall that Cooper has long-term margin expansion opportunities. Furthermore, a better gauge of its value is to look at its free cash flow potential. I've chosen to adjusted for the increased capital expenditure program it's undertaking right now. Cooper is investing in order to develop production capacity and to accelerate sales of its silicone hydrogel based sales. 

In the following table, I have assumed that capital expenditures equate to depreciation in order to give a better picture of underlying cash flow generation.

Sources: Company releases, author's estimates for 2013 and 2014.

My underlying free cash-flow estimates of $264 million and $290 million for the next two years indicate that Cooper continues to generate plenty of cash. However, these figures represent only around 4% and 4.3% of its current $6.65 billion enterprise value.

Cooper is an attractive company, but its valuation gives little room for error, and it operates in a very competitive market against giants like Johnson & Johnson and Novartis (Alcon). It's a great company, but one to keep on your watchlist for now.

McCormick Not Looking Such Good Value Right Now

Food company McCormick (NYSE: MKC  ) is down over 13% from its high of the year as disappointing sales in some of its markets dragged the stock lower. The spice and seasoning maker has long been attractive thanks to its defensive-growth prospects, demographic appeal and long-term potential within emerging markets. However, its valuation has also looked a bit too spicy for a while. Is the recent weakness a chance to buy in?

What happened?

The recent third quarter results were disappointing, and McCormick indicated that its full-year earnings per share would come in at the lower end of its $3.13 to $3.19 range. Similarly, its full-year adjusted operating income is now forecast to grow 3% to 5% versus a prior forecast of 5% to 7%. What went wrong?

McCormick reported three weak points in the quarter. First, its industrial division saw weak demand from its quick service restaurant customers in the quarter. Essentially, the fast food companies are seeing lower demand, and they are also tailoring their products and promotions toward the kinds of items (breakfast, coffee, etc) that McCormick doesn't sell into. On a more positive note, McCormick argued that China was a bit better than expected.

We had weak demand from quick service restaurants in the U.S. and China, although China was better than we expected as sales begin to recover from consumer concerns about bird flu earlier this year.

Given that Yum! Brands (NYSE: YUM  ) is a key customer of McCormick (it's almost certainly being referred to in the above statement), then this is relatively good news for Yum!'s plans to return to growth in China. Over the last year, Yum! has been hit by food safety scares, and an outbreak of bird flu has kept customers worried. With McCormick indicating that China was relatively positive, it can be seen as a good portent for Yum!'s next results.

source: company accounts

Second, McCormick outlined that its US consumer sales were lower at the start of the quarter. They did come back up toward the end of the quarter, but it wasn't enough to counteract the earlier weakness. Furthermore, there was a pull-forward in consumer sales in the third quarter. This was due to retailers aggressively taking up McCormick's holiday display program (an initiative that McCormick does to encourage early season sales), and this induced customers to buy early for the holiday season.

In fact, if overall consumer sales are adjusted for currency, the pull-forward effect and the sales contribution from its WAPC acquisition mean that its consumer sales actually declined by 2%. It wasn't a strong set of results for McCormick.

source: company accounts

And finally, McCormick's underlying international consumer sales were not strong either. Sales in Europe, the Middle East and Africa, or EMEA, were flat (constant currency) with a year ago. It wasn't much better in Asia-Pacific, or APAC, either. Sales in China were down 5% (constant currency) on a comparable basis, but they rose 54% on the back of a 59% contribution from WAPC. Furthermore, the company's sales in India declined. This must have come as a disappointment, because only two years ago it formed a joint venture with Kohinoor Specialty foods in India.

A reason to be cheerful

The good news is that McCormick guided toward a better outcome in the next quarter, and in particular, from the part of the company's sales that really matters. After the quarter started off weakly in regard to US consumer sales, McCormick saw a stronger trend at the end of the quarter. Its management predicted that the trend would continue into the fourth quarter, and ultimately lead to a 7% sales increase in the quarter.

While industrial sales are likely to remain weak, remember that McCormick generates around 80% of segment income from its consumer sales. Moreover, WAPC will contribute to sales growth in the quarter as well, even if the underlying picture in China isn't that strong.

Going forward, if McCormick can get US consumer sales back on track and make some more acquisitions, then it may be able to ride through this difficult period.

Where next for McCormick?

In conclusion, McCormick's valuation still looks a little stretched for the risks involved. With a current share price of around $64.80 it still trades at a P/E ratio around 21 times its forecast earnings for 2013. The company has good long-term prospects, but it needs to start delivering.

MKC Price to Earnings Less Cash TTM data by YCharts

McCormick's current performance isn't great, and the positive forecast for the next quarter is yet to be delivered. Despite the pull-back in the share price, it still isn't a good value yet.

Is Equinix in a Bubble About to Burst?

Those of you old enough to be investing before the year 2000 will recall that there there was another recession in the last decade or so. Many investors have forgotten about the technology boom and bust that occurred at the start of the last decade. However, in certain sectors like telecommunications and Internet infrastructure, the scars still run deep. Indeed, stock prices of data center providers like Equinix (NASDAQ: EQIX  ) , InterXion (NYSE: INXN  ) , and the U.K.'s Telecity are all down in 2013, largely because of fears of the sort of overcapacity that plagued the economy after the tech bust. Are the concerns justified? Is now a time to buy?

As is always the case in investing, the answer is yes, and also no.

Why it's a "no"

Economics 101 will tell you that most industries follow a pretty familiar path. High profits in an industry tend to encourage new entrants (or in this case, encourage existing providers to invest in new data centers), and capacity increases as everyone enjoys profits. After the initial profit euphoria, history tells us that firms tend to over-invest, only to then see profitability fall as too much supply is on tap. Indeed, all the leading players have been aggressively expanding data center capacity in recent years.

Of course, the problem for investors comes when profitability starts to fall in anticipation of tougher conditions. Analysts start downgrading their price targets, and suddenly the roof caves in on your stock. Everyone then realizes that end-demand was vastly overestimated. All of this happened in 2000 with Internet infrastructure darlings like Cisco Systems (NASDAQ: CSCO  )  and Alcatel-Lucent. The fallout was painful.

CSCO data by YCharts

Fast-forward to today and there are signs that the data-center providers may be facing overcapacity issues. The single best indicator is probably gross margin. Decline is an indication of a drop in pricing power, while an increase represents the contrary.

INXN Gross Profit Margin Quarterly data by YCharts

Gross margins look like they are moderating for InterXion and Equinix. Furthermore, Telecity saw its gross margin decline in the first half from 57.3% last year to 56.9% this year. Telecity's revenue per occupied square meter increased only 2.1%, which suggests that future revenue increases will come from capacity expansion rather than pricing.

Turning to Equinix, it reduced its forecast for second-half revenue growth, partly because it saw softer conditions in Germany, longer sales cycles within its enterprise markets, and its average deal size appears to be getting smaller. All three are signs of slower growth. 

InterXion gave results in August, stating:

Customers continue to have extended decision-making time frames, but demand remains healthy and the pricing environment is consistent with previous quarters, as is the sales pipeline.

Again, when sales cycles get longer, it is usually a sign of a slowing market. If pricing is consistent, it implies the industry players are finding it harder to increase them.

Why it's a "yes"

This isn't the late 90s. It really is different this time around because long-term demand looks much better-placed.

Internet-enabled devices -- smartphones, tablets, etc. -- simply weren't available back then in order to drive demand for all the network capacity that had been built up. It's a different story now. AT&T and Verizon are both seeing strong smartphone subscriber growth, and Intel has had to take substantive action to change its business, thanks to the shift to mobile devices.

It's a similar story with corporate demand for cloud computing, and software as a service (SaaS) applications. All of which is leading to demand for data centers to store information and applications for corporation. Moreover, financial services firms are not displaying any slowdown in their desire to use increasingly complex trading systems.

Data center demand remains high as evidenced by Cisco's revenues.

source: company accounts

Where next for Equinix?

In conclusion, end demand does appear to be slowing, and analysts/investors are starting to downgrade expectations. However, this is arguably reflected in Equinix's  share prices right now. The key valuation metric -- as defined by Equinix -- is the 'adjusted discretionary free cash-flow.' Roughly speaking, this is the free cash flow generated if you strip out the expansionary CapEx. In its last update, Equinix forecast this figure to be around $620 million to $640 million for 2013, which represents around 5.2% of its current enterprise value. 

 

The valuation looks fair, but the stock carries the normal risks inherent in industries that are facing short term risk. If you are a cautiously minded investor, you might wait for a better entry point to compensate for the risk that margins start to fall. Alternatively, you could monitor gross margins, and industry pricing power in order to gauge when the demand has caught up with capacity.

Oracle Faces Challenges, but the Stock is Priced for a Disaster

Oracle (NYSE: ORCL  ) is one of the most tempting cash-rich plays in the market right now. The company has an undoubtedly cheap valuation, but is it a long-term value trap in the way that Dell or Hewlett-Packard (NYSE: HPQ  ) have been over the last five years? Moreover, is its current low-single-digit growth rate signaling the endgame of its relevance as a growth company?

It's the cash-flow, stupid

 

Investing is supposed to be easy. Take a stock like Oracle, which just generated $14.1 billion in free cash flow over the last four quarters--representing more than 10% of its enterprise value.  In other words, if you hold the stock for 10 years, even with no growth, the company will have generated enough cash to buy you another Oracle for free. Furthermore, it can return that cash flow to shareholders by increasing its dividend, buying back stock, or increasing earnings through acquisitions. Sound good?

And that's assuming no growth, when the reality is that Oracle's forecast revenue growth rates for the next few years are pretty close to nominal GDP growth.

Why this isn't a no-brainer
Superficially, this isn't a hard choice to make, but the market seems to be making some harsh conclusions about Oracle:

• The market does not reward tech companies if they cannot generate growth, and you can stay waiting ages for "good value" to be realized

• Corporations are favoring cloud-based software, and Oracle's traditional on-license, on-premise software will lose sales to providers of software as a service, or SaaS, like Salesforce.com (NYSE: CRM  ) . It looks set for a structural decline just like Hewlett-Packard was.

The first concern is an existential one, and older investors would do well to remember how the mentality of the market changed after the dot-com bubble burst. During the bubble, traditional valuations didn't matter, but after the burst suddenly everyone remembered value. It doesn't matter if Oracle makes database solutions or chicken tikka sandwiches; if it can return 10% of its valuation in cash every year then it is good value.  

The second is more problematic. It's easy to look at Salesforce's near 30% growth rates, and conclude that Oracle is being left behind in the shift to the cloud, but the fact is that Oracle does have growing SaaS sales. The problem is that they are not enough to counter slow growth in its traditional software sales. In addition, the increasing use of SaaS solutions is reducing customers' need to buy hardware, and negatively impacting Oracle's aim of selling hardware and software systems to them. Indeed, Oracle's hardware system revenues (around 14% of total sales) have declined for the last two years.

Hardware revenues are forecast to drop next quarter.  Even worse, Oracle predicted that its new software license- and cloud-subscription revenue growth (20% of revenues, and the key to growth) would be -4%-6% in the next quarter. Game over?

It would be a mistake to jump to a negative conclusion. First, Oracle is up against a very strong comparison from last year's second quarter for new license and cloud subscription sales.

Source: Company accounts

In fact, the second quarter was so strong last year that there appears to have been a pull-forward effect on the third quarter.

Second, Hewlett-Packard's problems were that its core profit centers of printers, notebooks and desktops were in decline.  Its challenge was to restructure in the face of a systematic decline in end demand. In comparison, Oracle's customers still want software; it's just that more of them want it from the cloud. The company has the cash pile and cash-flow generation to make significant acquisitions of cloud based companies (such as its purchases of Taleo and RightNow), and it's hard not to see it doing some more in future.

Third, there is an element of geographical effect here. New software license and cloud software subscriptions grew 7% in constant currency for the first quarter, but they were up 14% in the Americas. This indicates that it's not necessarily a structural issue.

Where next for Oracle?

The market looks like it's pricing in some severe problems for Oracle in the future, but if things don't turn out as bad as many fear, then the stock has significant upside potential. The company needs to stabilize its hardware revenues while demonstrating willingness to invest in cloud-based solutions. It could also do with a quarter or two of beating the mid-point of its software sales guidance. These are not necessarily high hurdles to overcome, and the reward of owning the stock could be significant. Moreover, even if Oracle's growth does graduate into a "GDP+" type of range, the stock still represents good value.

Buy ConAgra on the Dip?

It's been a pretty dismal summer for investors in ConAgra Foods (NYSE: CAG  ) , with the stock currently down 18% from its high at the start of August. Essentially, the market got a little bit too excited by the company's purchase of private-label food manufacturer Ralcorp.

 

Furthermore, the stock price reflected a significant amount of optimism over the company's prospects within a difficult economy for food retailers. Unfortunately, ConAgra managed to miss estimates for the first quarter in FY ending 05/2014, and the market punished the stock accordingly. Is now the time to take advantage of this?

 

ConAgra disappoints

First, in order to put the following discussion into context, here's a look at each segment's operating income for the quarter.

 

source: company accounts

In a previous article, I discussed the three big risks with the stock, and it's time to assess them again. In its recently reported first quarter, ConAgra disappointed with the first risk factor by failing to generate organic volume growth in its consumer-foods division.

 

The second risk was also somewhat disappointing. The Ralcorp integration is proceeding as planned, but Ralcorp sales have been below management's expectations for the second quarter in a row. Last time around, ConAgra argued that the problem was short term and fixable, but this time around it blamed the soft retail market.

 

The third issue is that ConAgra still hasn't replaced the revenues given up when it lost a key customer for its Lamb Weston (potato operations) brand earlier in the year.. Aside from declaring that it was "very confident" in making up these sales going forward, there wasn't any significant announcement on the issue. Accordingly, the commercial-food segment saw sales flat, and operating income decline 7%.  

 

Tough markets, tough decisions

Focusing on the issue of organic growth in consumer foods, you shouldn't be surprised to see ConAgra's weak results. The consumer market remains challenged, and particularly so in the food category. Consequently, the leading players have been forced into an ongoing cycle of raising prices only to lose market share, then discounting/marketing/promoting in order to take back share, and then the tough cycling begins all over again.

 

The fact is hard-pressed consumers have become highly sensitive to price. Even a company that has been doing relatively well, like General Mills (NYSE: GIS  ) , is having to invest in order to generate growth. In it's latest quarterly results General Mills outlined how its' advertising spending grew at a higher rate of 7% compared to its operating profit growth of 6%, and its organic sales growth of 3%. Sales growth doesn't come easy in this environment.

 

Unfortunately, it isn't getting any better. In fact, in August -- and one month into the previous quarter -- ConAgra reported that conditions were favorable, but conditions must have significantly deteriorated through the quarter. The company finished the quarter with a 3% organic-volume decline in consumer foods. Having declared that it felt a turning point had been reached thanks to the 3% organic-sales increase in the previous quarter, this result must have been disappointing. However, as noted at the time, ConAgra had increased advertising and marketing spend by 15% in the previous quarter in order to get this growth. See what I mean by a tough cycle?

 

Indeed, it isn't just ConAgra. Kellogg (NYSE: K  ) gave results at the start of August, and promptly stated that "sales growth was lower than expected." A dosage of -- you guessed it -- increased advertising spending was immediately proscribed. Moreover, the only real growth is coming via acquisitions. Kellogg acquired Pringles, General Mills invested in Yoplait, and ConAgra bought Ralcorp.

 

Ultimately, it proved to be a quarter categorized by intensive pricing competition. Going forward, ConAgra's plan is to increase merchandising efforts, with the aim of taking back market share

 

What's Next for ConAgra?

Despite the gloom, there are reasons to be optimistic!

 

First, if the consumer market really is categorized by heightened consumer-price sensitivity, then ConAgra's merchandising efforts should lead to a pick up in volumes again. Second, the Ralcorp acquisition is going largely as planned, and management confirmed that it still expects $300 million in cost savings by 2017. Third, any announcement of a contract win for Lamb Weston's frozen-potato operations will provide some upside to the stock.

 

However, while ConAgra's operational performance can get better, its valuation still looks stretched.  The mid-point of its 2014 earnings-per-share guidance ($2.36) puts it on a forward P/E ratio of around 13 times. This looks good, but its implied free-cash-flow guidance is for around $1 billion this year. In other words, it's around 4.4% of its current enterprise value. 

 

Recall that ConAgra has around $8.6 billion in senior long-term debt, and few people are expecting rates to fall. Moreover, with debt repayment a priority, it's hard to imagine the dividend can increase for a while yet. All told, the recent pullback still hasn't made ConAgra's shares attractive enough on a risk/reward basis.

This Week's Key Earnings

The symbolic start to the new earnings season takes place this week when aluminum producer Alcoa (NYSE: AA  ) gives results. It's going to be a very interesting season of results, and the key stocks this week should give good color on certain sections of the global economy.

Tuesday

Alcoa always gives good guidance on the global economy, and last quarter's report was quite positive. In fact, the surprising thing was that it maintained its outlook for China, even while companies like FedEx have been lowering their global growth forecasts throughout the year.  Furthermore, FedEx recently lowered its U.S. GDP forecasts inline with economists' thinking. All of this suggests that an economically sensitive company like Alcoa could lower some of its end-market forecasts. We shall see. 

Two important things to look out for are its outlook for the Chinese automotive sector, and the U.S. building and construction sector. Here are the growth rates for automotive sales and production in China. 

Source: China Association of Automobile Manufacturers.

Production rates have been strong in the last few months, but production has outpaced sales throughout 2013. So is it time for a moderation in production growth?

Turning to the U.S. construction and building sector, the architectural building index has perked up in recent months. It will be interesting to see if Alcoa upgrades its expectations accordingly.

Source: American Institute of Architects.

The second key report on Tuesday will come from Yum! Brands (NYSE: YUM  ) . All eyes will be on its outlook for KFC same-store sales in China because it has lost a lot of ground thanks to fears over its chicken supply quality in China, and then an outbreak of avian flu in the spring.

Source: company presentations

The good news is there are some signs that the worst is over. First, on its last conference call, Yum! pointed out that its July same-store sales declined 13% versus a 26% decline in the second quarter. Furthermore, McCormick (a spice and seasonings company that is a major supplier to KFC) stated that its sales to quick-service restaurants in China were "better than we had expected." This is a good sign for Yum!'s earnings.

Wednesday

The attention shifts to the U.S. retail scene on Wednesday when big-box retailer Costco Wholesale (NASDAQ: COST  ) and discounter Family Dollar Stores  (NYSE: FDO  ) release earnings.

It's been a tricky year for U.S. retailers as consumers seem highly responsive to pricing and promotions. The pattern appears to be that retailers hike prices only to be met with a drop in volumes; then they are forced to take action to regain market share. Then the cycle is repeated.

However, Costco stands out because it has managed to generate sales growth, as well as margin expansion.

Source: company presentations.

The key things to look out for with Costco are its new membership signups and whether traffic and frequency (the rate that its customers return) remain in growth mode.

Turning to Family Dollar, its forecasts for the upcoming results are that same-store sales growth will come in at 2% and gross margins will be flat. The latter is somewhat of a victory because its margins have been under pressure due to its expansion in sales of lower-margin items such as tobacco and groceries.  

However, the key thing to look out for will be its core discretionary sales. At the last results, Family Dollar spoke of some stabilization in these sales. Discretionary sales at the dollar stores tend to be higher-margin items. Unfortunately, the dollar stores have struggled to deliver consistent discretionary sales growth in a difficult economy. Have they turned the corner?

Industrial-supply company Fastenal (NASDAQ: FAST  ) also reports Wednesday. The company has long been a good barometer for U.S. industrial conditions, and investors would do well to listen carefully to what it says.

The key thing to look out for with Fastenal will be how its plan to recruit 600-900 new in-store staff by year end is transgressing. The idea is that the new support staff should free up time for its managers to make more customer visits and help expand sales. Interestingly, Fastenal reported that its stores open for more than five years had sales growth of 0.6% in July, and then 4.7% in August. This implies that the plan is starting to work, and investors will want to see more improvements in September's numbers as well as some positive news on U.S. industrial conditions.

Verint Systems is an Inexpensive Way to Invest in Big Data

If there is such a thing as a defensive growth stock in the IT sector, then Verint Systems (NASDAQ: VRNT  ) might be it. Along with its rival NICE Systems (NASDAQ: NICE  ) , Verint has put in a very consistent performance this year. Both companies are leaders in customer-interaction and analysis solutions, and both look set for good earnings growth in the future. Verint recently followed NICE in reaffirming its 2013 guidance, and those of you looking for a relatively safe option within tech should consider the stock carefully.

End demand looks good...

 The market reacted well to Verint's strong second-quarter results, even though it kept its full-year guidance unchanged. It was a similar story with NICE's second-quarter results delivered earlier in the reporting season. While the market may appear to be overly rewarding these companies for merely hitting guidance, there are deeper reasons why it is right. Essentially, there are a number of positive trends in the sector that help increase their longer-term earnings potential.

• Customers are demanding more value-added data-analytics solutions.

• Big data is starting to be used across all kinds of data channels, and companies will need to capture and integrate data from things like call centers, websites, social media, video etc.

• Verint and NICE have strong, installed bases with their hardware-capture solutions, and they have an opportunity to sell data analytics into them because customers value buying solutions from one vendor.

• Companies can still generate growth -- even in a weak economy -- by better analyzing their existing customers.

• Solutions to prevent money laundering, fraud, and other crime are seeing secular growth prospects because criminals are also using technology to become more sophisticated.

•  Governments are increasingly pressured to use surveillance and intelligence gathering in order to monitor terrorist threats.

The points above relate to end-market demand, but the type of demand is also likely to positively change their earnings potential.

That demand is likely to help Verint's operating metrics

 First, on its conference call, Verint predicted gross margins to be flat this year. You shouldn't read too much into this, because longer-term, the prospects for margin expansion are significant. Increasing demand for higher-margin analytics solutions implies that gross margins should increase in the future. Quoting from the recent conference call:

So overall, we still have about 50-50 mix between capture products and analytics. But clearly, we are growing our analytics portfolio. Analytics is growing at higher growth rates, which kind of shifts the overall growth rate of the company.

Verint is benefiting from analytics, and NICE has the bonus of a deal with IBM (NYSE: IBM  ) that integrates IBM's analytics solutions within NICE's solutions. This is a particular benefit to call centers and financials, sectors in which NICE is strong. IBM gets the benefit of tapping into NICE's installed base, and the latter gets to offer its customers the kind of analytical solutions that they require in the "big-data" world. It's a win-win scenario.

Second, even though it kept its full-year revenue-growth forecast at 6% to 7% and its EPS target at $2.75, the underlying picture did get better. Verint disclosed that it was seeing larger orders this year compared to last year.

What you need to understand is that these larger orders are likely to take longer to generate revenue, particularly if they contain a large services component. In other words, there won't be an immediate effect, but in the longer term, earnings and cash flow will be enhanced by booking larger orders now.

Where next?

 Long-term prospects look good, and it's reasonable to expect margin expansion going forward. Moreover, if Verint and NICE can continue to grow revenues in the 6% to 7% range, then assuming an earnings growth rate in the double digits seems reasonable. Moreover, both companies are highly cash-generative. For example, Verint has converted more than 250% of its net income into operating cash flow over the last three years. This cash-flow conversion is likely to increase in future years as services and analytics grow as part of the revenue mix.

If NICE can hit free cash flow of around $125 million, and Verint hits its target of $100 million, then both stocks will trade on a free-cash-flow-to-EBITDA ratio of 5.9% and 4.3%. NICE looks cheaper on this basis, although both stocks look attractive for the long-term investor.

Church & Dwight Demonstrates That Managements Matter

Investors in household-goods company Church & Dwight (NYSE: CHD  ) have watched the stock almost double over the last five years. It's tempting for them to think that the outperformance of the stock is solely due to the nature of the company's products. Indeed, 40% of its sales come from the kind of value brands that the consumer has been trading down toward. However, events over the last year have demonstrated that the company's excellent management team is an even larger part of its success.

When the going gets tough...

The recent second-quarter results saw the company delivering good numbers in spite of an ongoing tough consumer market. Indeed, there are three reasons to suggest that conditions are going to remain difficult.

 

Firstly, full-year organic sales growth is now forecast to be just 2% from an earlier estimate of 3%-4%. One-third of the shortfall is due to weaker-than-expected sales within specialty products. The remaining two-thirds is due to plans to increase discounting in the face of price competition. When pressed on the categories facing pricing pressures, the management replied that cat litter and laundry were the main culprits.

Secondly, plans are being made to increase marketing spending in the third quarter in order to support some of its key brands. Again, this is a sign of a more difficult marketplace. Indeed, management outlined that in the conference call:

"In fact, of the 14 categories that Church & Dwight operates in, five incurred lower category dollar sales in the second quarter versus the prior year and five more had category growth of less than 2% versus the prior year."

Thirdly, key rival Procter & Gamble (NYSE: PG  )  recently discussed plans to release a cheaper version of its Tide laundry detergent in 2014. Although the launch is set for next year, Church & Dwight is likely to act in advance to try to protect market share for its XTRA brand. In addition, Germany's Henkel will also be pressured into protecting its Purex detergent brand.

 

....the tough get going

The good news is that its management team has long been acquainted with dealing with difficult conditions, and its excellent execution is a key reason why the company continues to do well. There are three near-term pathways to growth, and all of them are thanks to management's actions.

 

Firstly, full-year gross margins are now expected to increase by 50 basis points to 75 basis points instead of the 25-to-50 basis-point increase previously forecast. The key to this upgrade was better-than-expected cost savings with the integration of its gummy-vitamin manufacturer Avid.

Secondly, sales growth at Avid is "tracking ahead of expectations," and is expected to be a significant contributor to sales growth in the second half. Thirdly, on the conference call, Church & Dwight argued that it had a "great pipeline" of new products to be released next year.

 

What about its peer group?

Essentially, the mass-consumer market remains difficult, but Church & Dwight has already demonstrated that it can outperform the market and its peer group in such an environment.  

 

Procter & Gamble data by YCharts

 

Moreover, the company has a good opportunity to continue its outperformance. Its relatively small size gives it a significant amount of flexibility in responding to changing market conditions. Furthermore, unlike much larger peers Procter & Gamble or Kimberly-Clark (NYSE: KMB  ) , it does not rely on premium brands for its profitability.

 

In previous economic cycles, such companies would have preferred to retain pricing during the downturn in order to benefit when the recovery came. However, this recovery has been so tepid (particularly for the mass market) that many large consumer goods companies are forced into discounting to retain market share.

 

A good example of this is with Procter & Gamble with the previously mentioned plans to release a cheaper version of Tide (rather than just cutting Tide prices), but also with its plans to downsize its Pampers diapers. Similarly, its key rival Kimberly-Clark is also used downsizing with its Kleenex brand. While such measures are innovative ways to try to keep pricing for premium brands, they are also emblematic of a weak consumer market.

Church & Dwight set to carry on outperforming

This sort of macro environment favors Church & Dwight's mix of value and power brands. In addition, its management has demonstrated that it can make earnings-enhancing acquisitions, and generate productivity improvements, even in a weak economy. Furthermore, at some point, a much larger rival may look to buy the company in order to generate some much-needed growth.

 

On a less positive note, Procter & Gamble appears to be stepping up the competitive pressure, and Church & Dwight's valuation of over 23 times current earnings suggests the stock is close to fair value. Consequently, long-term investors can look for the stock to 'do its earnings growth' in future years. Given that this implies double-digit returns, the stock remains attractive, particularly if its management can continue to wring every bit of growth it can from unhelpful market conditions

Mead Johnson not Getting its Own Way

 Perhaps it's a sign of how well the markets have done in the last year that Mead Johnson Nutrition's  (NYSE: MJN  ) stock price is basically flat over the period. It's been a difficult 12 months for the infant and child nutrition company. Not only have its near-term earnings expectations been reduced, but there is a growing amount of uncertainty over its long-term prospects as well.

Mead Johnson's Long-Term Story

The company is attractive to investors because it offers defensive growth within emerging markets. It lumps together its emerging market operations in a segment called Asia/Latin America.

 

source: company accounts

 

The long-term investment thesis is simple. Developed markets will provide relatively stable demand, and the growth kicker will come from higher birth rates in emerging markets. Furthermore, a growing middle class in the developing world will increasingly demand better nutrition for their babies and children.

 

It's a compelling story, and Mead Johnson represents the purest way to play it. Others think so too, because Pfizer had no trouble selling its infant-nutrition business to Nestle (ADR)  (NASDAQOTH: NSRGY  ) for a hefty 20 times earnings before interest, taxes, depreciation, and amortization. The price that Nestle paid highlighted the strategic importance of obtaining market share in emerging markets. For example, it immediately gave Nestle a high single-digit share in China. Moreover, Pfizer's unit generated over 80% of its sales in emerging markets.

 

The benefits outlined above have not been lost on investors, and the stock has traded in a P/E range of 20 to 35 since early 2010. However, there are a couple of warning signs that investors need to consider.

 

Developed Markets, Developing Problems

The first concern can be seen by tracking Mead Johnson's segment revenue and EBIT margins over the last few years. Declining birth rates in the West have led to falling sales and margin pressure. Indeed, its North American/European margins have fallen from above 30% a few years ago to barely 20% now.

 

source: company accounts

In addition, the last few years have been difficult for Western consumers, and the lack of pricing power has been evident across many retailers in the U.S.  On its conference call, Mead Johnson argued that U.S. births were in line with the prior year, and investors hope that this is an inflection point. Indeed, management is continuing to invest in the expectation of better days ahead. According to Peter Leemputte in the company's most recent conference call, "I would point out that we have made a decision consciously to continue to invest in this business for when the recovery comes."

 

The underlying question is whether the declining birth rate in the Western world is a short-term consequence of a slower economy, or part of a longer-term social trend?  If it's the latter, then Mead will be investing in the expectation of growth that will not occur.

 

Emerging Markets, Emerging Problems

Emerging markets generate the majority of the company's profit, and margins and growth rates are significantly higher. Indeed, Mead Johnson and the rest of the infant-formula industry in China enjoyed some favorable market dynamics. For example, the baby formula scandal in 2008  largely affected local producers, thereby creating the ideal environment for foreign producers to be able to charge a premium. The situation led to good growth for the foreign players, but it also led to increased jostling for market share.

 

Consequently, Mead Johnson found itself losing market share in China in 2012, as the likes of Danone (ADR) (NASDAQOTH: DANOY  ) and Nestle fought hard to counteract weak sales in European markets. Mead was therefore forced to reduce shipments to distributors in order to get inventories back to normal levels. The plan worked – Mead claims that its market share has now been stable for the last four months, but this also may be a sign of strong competition.

Another potential problem is political in nature. The premium prices in China did not go unnoticed by the regime, and an antitrust probe was subsequently launched into price fixing in China.   The result was that six infant-formula companies were fined, including Mead Johnson, which had to pay a $33 million penalty.

 

In addition, Mead Johnson reduced its prices in China by 7% to 15% , and Danone and Nestle made similar moves. Mead Johnson's price cuts took place in mid July, and were forecast to reduce annual sales by $55 million to $65 million. On the one hand, these figures only represent around 1.4% of its forecast sales for 2013. On the other, they present a warning over potential political risks in the future.

 

In addition, whenever companies cut prices across an industry, there will be uncertainty over which businesses will end up winning/losing market share. Will Mead Johnson end up losing market share out of this?

 

Where Next for Mead Johnson?

The company faces some fundamental questions over long-term demand from developed markets, and near and long-term risk from emerging markets. For different reasons, margins could come under pressure in both segments in the future.

 

However, with a current P/E ratio of around 25 times, the market doesn't seem to want to stop believing in its prospects. This is understandable because outside of China, the company has been performing well, and it is still forecasting constant-currency revenue growth of 8% for 2013.

However, analysts now predict EPS growth that only approaches double-digits for the next few years, and Mead Johnson's valuation is looking stretched for the risks involved in both of its segments. This is one for the monitor list.

The Key Earnings to Look out for this Week

There are some interesting earnings being released this week that should offer up a few investment ideas and shed some light on which sectors are set to outperform in the fourth quarter. Investors need to be selective, because the market has gone up significantly this year, while global GDP growth forecasts have been reduced. Consequently, valuations are likely to be high at precisely the point when some earnings might disappoint due to slower growth.

Monday

This morning saw shell egg producer Cal-Maine Foods (NASDAQ: CALM  ) deliver quarterly results. The company's earnings of $0.36 per share fell $0.13 short of analyst estimates. However, revenue of $319.5 million was up 17% from the year-ago quarter and well ahead of estimates of $272.9 million. This owed partly to the company's rising sales of cage-free, organic, and nutritionally enhanced eggs, which are growing ever more popular among consumers.

 

Cal-Maine is attractive for long-term investors, because it has the potential to grow irrespective of the economy. In other words, it gives you good diversification in your portfolio. Egg demand tends to be price-inelastic (i.e., demand doesn't change much in response to price movements), so when feed costs, rise Cal-Maine can usually pass on prices, albeit with some loss of margin.

 

Source: Company accounts.

 

However, the key to its prospects is what happens with industry egg supply. Note that its gross margins were extremely high in 2008, thanks to the financial crisis (and high feed costs in the first half of 2008), making it difficult for less efficient egg-producers to obtain credit.

 

Cal-Maine directly benefited because it's the largest independent egg-producer in the U.S. In the longer term, Cal-Maine can profit from consolidating the industry via acquisitions and expanding its higher-margin specialty egg sales.

 

Small-business service-provider Paychex (NASDAQ: PAYX  ) , due to report after today's market close, has long been a favored stock among dividend hunters, but it's also a great barometer of the state of the small and medium-sized business market.The key metric to follow is its checks-per-payroll number. Last quarter, its checks per payroll rose a miserly 0.9%, and it was even suggested that this growth would "moderate" in the quarter.

 

Furthermore, Paychex forecast that payroll services revenue growth would be 3% to 4% this year, but this is mainly due to price increases to customers rather than gains in checks per payroll. Look to see whether the price increases are sticking and the checks-per-payroll metric has improved. In addition, any update on its plans to develop an integrated management tool (so customers can use all of its separate services on one application) would be useful, too.

 

Tuesday

Lighting distributor Acuity Brands (NYSE: AYI  ) is one to watch because it is a direct play on a pick-up in construction activity in the U.S., as well as a backdoor way to play the increasing use of LED lighting solutions. Although management claims that its margins on LED lighting aren't any higher than on conventional lighting, it still has good growth opportunities. LED lighting will drive new demand, and Acuity is also able to sell LED lighting controls as an add-on solution.

 

The stock looks a bit rich going into these results, and Acuity tends to be volatile over earnings, so you need to be on your toes. One thing to look out for is its commentary on the state of the commercial and industrial lighting market. Architectural Billings Index data has perked up a bit lately, so the "favorable trend in June order rates" discussed previously might continue through the quarter for Acuity. We shall see.

 

Source: The American Institute of Architects.

 

Pharmacy giant Walgreen (NYSE: WAG  ) missed earnings last go-round, and the key thing to look out for in the upcoming results is whether its plan to revive store traffic and same-store sales growth is working. Last time, same-store sales came in at just 0.4%, with store traffic down 3.9%. In response, Walgreen initiated a renewed focus on pricing and promotions in mid-May, and since then conditions have improved. For example, comparable-store sales increased 4.8% in August, and its basket size, or average transaction value, increased 3.7%. On a more negative note, customer traffic was down 1.5% in August.

 

Watch to see whether the increased sales came at the expense of margins. Another thing to look out for is Walgreen's commentary on its balanced reward card program. Walgreen is trying to gather data from the cards so it can better target sales promotions.

Polycom Offers Big Risk but also Big Rewards

Unified communications specialist Polycom (NASDAQ: PLCM  ) is one of the most interesting high risk/reward situations in the market place today. It's not a stock for widows and orphans, but if you looking for a speculative investment with a lot of upside then Polycom might fit the bill.

High risk...

 There are three key concerns with Polycom. The first is that it is a small company (around $1.75 billion) competing against a giant in the tech world, namely Cisco Systems (NASDAQ: CSCO  ) . The latter can easily subsidize an aggressive market share grab, so Polycom is likely to be forced into constantly innovating in order to retain its position.

The second is that unified communication systems are seen as part of discretionary IT spending. In other words, corporations tend to invest in these video-conferencing systems when they are in growth mode, rather than in the current cautious spending environment. Indeed, you can see this by looking at the recent growth in Polycom's sales and Cisco's collaboration segment revenue.

source: Company accounts

 

While the first two risks are considerable, they can also be opportunities if Polycom gets product innovation right and if the macro-environment improves. However, the third risk comes with a more significant long-term threat.

Simply put, Polycom and Cisco's collaboration segment may be operating within a market in a structural decline.

• Current trends in IT spending are in favor of outsourcing and virtualizing IT infrastructure into the cloud, rather than purchasing dedicated hardware solutions

• Corporate IT departments are getting used to using open platforms, and the desirability of being tied to one solution provider for video conferencing is questionable

• Mobility has been one of key buzzwords of IT spending this year, and investing in a solution that may require a fixed location is not really in line with this trend

The shift to cloud and mobility based solutions doesn't look like it is slowing anytime soon, and the question for Cisco and Polycom is whether they can continue to attract purchasers to their dedicated video-conferencing systems?

...and high reward

 The arguments above present existentialist dangers to the long-term viability of its business, but investors should not lose sight of the potential reward in buying the share. Arguably the stock is being priced with the assumption of long-term revenue and cash flow declines in mind.

 Indeed, the company has been keen to point out how cheap it is. For example in its second quarter results it highlighted how it ended the quarter with cash and investments equivalent to $4 a share, and generated trailing operating cash flow of $195 million.

In other words, given its current price of ~$11.00, the stock has nearly 39% of its market cap in cash and investments. Similarly, the trailing free cash flow of around $135 million means it has just generated around 11.8% of its enterprise value in free cash flow. This stock is cheap.

Current trading

 In its recent results the company gave forecasts for a "very modest low single-digit growth rate" in the second half of 2013. Moreover the mid-point of its guidance for the third quarter assumes that revenues will be flat for the quarter. This means that it is forecasting a return to growth in the fourth quarter, and analyst forecasts have the company on a 3.8% revenue growth rate in 2014.

This sounds good, but readers should note that it has released a new series of products, which it claims are helping win market share from Cisco. The danger here is that the company is getting trapped into a long-term game of investing in new technologies in order to wring out any bit of growth from a market in decline. If this is the new reality then its free cash flow could start to degenerate in future years.

 On the other hand, if it hits analyst targets for 2014, and a better economy encourages some more discretionary IT spending, the stock is a great value.

Where next for Polycom?

 Ultimately, an investment decision here will boil down to your opinion on the long-term viability of Polycom's solutions. Risk seeking investors may love the proposition here, but for more cautious investors a piece-meal approach probably works best. You could always monitor the next few quarters of Polycom's results in order to see if it is hitting its targets. Meanwhile, it would be useful to see if Cisco can start to report some growth in its collaboration segment.

Polycom is an attractive stock, but it doesn't come without risk. No one said investing was easy!