A Hard Landing For China?

Probably the two most worrying macro events of 2012 will be, if and when, China and Spain come out of their respective property slumps.

Before focusing on China, a few words on Spain. Its problems are quite deeply embedded with its economy. Following an extended property boom, Spain’s GDP growth and its public finances, became reliant upon the housing market. Indeed, prior to the recession, Spain’s public debt situation was looked on favorably. Not anymore!

Spanish banks hold a lot of distressed properties on their books, and their bank's bad debt ratios (unlike the US banks) are getting worse with the ongoing decline in house prices. Equally worrying, Spanish banks hold significant amounts of Portuguese Government debt. So, we have a scenario of declining underlying asset prices, leading to declining capital/asset ratios, leading to the necessity for increased bank funding. Ultimately, this calls for Government aid which leads to an even bigger stress on public finances. And so it goes on. Does it sound familiar?

Well if it does, then why aren’t similar questions being asked of China?


China’s Growth is Slowing

Frankly, I don’t think there is any doubt that China’s growth is slowing and, I would be wary of chasing the commodity story higher. The world and his wife, knows that the increase in marginal demand for hard commodities has being driven by China. Indeed, the major commodity metals stocks such as Southern Copper Company $SCCO Vale $VALE and Rio Tinto $RIO have all been used as proxies for growth in China’s fixed asset investment.

Raw materials like copper are widely used in the construction industry and the price of the metal is intrinsically linked with fixed asset investment. Similarly, the main demand for iron ore comes from the steel industry and, China is the swing player in steel consumption. Indeed, the negotiation of iron ore contracts with China is a key event in Rio and Vale's revenue outlook.

If China's fixed asset investment is set to slow, then hard commodities only have one way to go. Moreover, the companies that service such growth such as Joy Global $JOY or Caterpillar $CAT could also suffer disproportionately. Joy Global's mining equipment is extensively used in China and Caterpillar is a name synonymous with construction. Both are aggressive players in China.

Before being too quick to conclude a slump, let’s look at some of the data. For example, let's consult a few charts from the official China National Bureau of Statistics.

Firstly, fixed asset investment growth is slowing.

 
This isn't a surprise because China's commercial floor space sales growth is now negative.

 
The China optimists argument is that the Government has successfully engineered a slowdown in the housing market so we should now see demand catch up with supply. The bulls point out that the slowing of real estate land purchased will ultimately result in a deficit of supply.

 

However, I should note that housing starts in the US started declining as long ago as 2006!  Restructuring from a housing slowdown takes time. I see no reason why China will be any different.


The Great PMI Debate

Recently, the official Chinese Purchasing Managers Index (PMI) for March hit its best level for a year whilst, the HSBC/Markit PMI number came in below 50. Moreover, the latter data represents the fifth monthly decline. Which number is more accurate?

Frankly, I find the official number puzzling because it does not tally with the direction of other official data. Nor does it correlate with the other sources of China data. For example, I’ve tabulated 3 month average automobile sales from the China Association of Automobile Manufacturers. Here are the year-on-year growth rates for recent months.
 
It’s hard not to conclude that China’s growth is not slowing. Indeed, BHP Billiton recently stated that Chinese iron ore demand is ‘flattening’.


Can China Grow out of a Slowdown?

Despite the gloom, there is cause for optimism. China has huge gold and foreign currency reserves in relation to its GDP. Naturally, this is a consequence of years of surpluses that have been the pride of China’s economy. No doubt this will be used to counter the effects of a slowdown. Therefore, I think that even the Chinabulls would argue that we are likely to see a change in the composition of growth.
Of course, China remains a Communist country and, is a nation that requires concerted attention to preserve social cohesion. This costs money. Consequently, I would expect a shift in emphasis towards domestic consumption and also, increased investment in social infrastructure such as hospitals. Much of which will require hard commodities, so the position is not entirely negative for commodities.

In conclusion, the composition of growth in China is going to change and, accepting this viewpoint will require a shift in thinking on which stocks will be the ways to play China. That is a subject for future debate, but for now ,I would be careful with hard commodities.

SemiLEDS Disappoints Again

Beleaguered investors in SemiLEDS $LEDS must have felt they were due a break with the latest set of results, but true to form, SemiLEDS disappointed and guided the next quarter below the market consensus. This is the latest development in an industry that has been suffering with overcapacity and uncertainty relating to the timing and/or viability of Chinese LED subsidies. This is definitely an industry wide issue and SemiLEDS should not be looked at in isolation.


Earnings Forecasts are being Reduced

In fact, across the board, there have been significant reductions in earnings forecasts over the last year or so. This is usually an early sign that a cyclical industry is about to enter into a downturn. For example, SemiLEDS competitor Cree $CREE has also seen its earnings guided lower after a series of misses. In the following table, I’ve included two of the capital equipment manufacturers, namely Veeco $VECO and Germany’s Aixtron $AIXG They are useful because they give an early indication of how their LED customers are feeling.

Year EPS Estimates	SemiLEDS  to Aug 12	Cree to Jun 12	Veeco to Dec 12	Aixtron to Dec 12
Current	-.91	.98	1.10	.35
7 Days Ago	-.9	.98	1.10	.35
30 Days Ago	-.87	.97	1.16	.51
60 Days Ago	-.87	.99	1.72	.62
90 Days Ago	-.83	1.18	1.83	.64

Clearly the industry is suffering.
Earlier in 2011, Veeco had blamed poor results on longer order-to-revenue cycle times primarily coming from China and there can be little doubt that this where the weakness lies. The industry had geared up capacity for expansive Chinese expenditure on street lighting. Unfortunately, it hasn’t arrived yet.  This has left the industry dealing with the usual concomitant problems of overcapacity. In other words, inventory corrections, pricing wars, margin erosion and ultimately unhappy investors!
However, it is not only about China. Cree also complained about lower than expected growth in LED bulb applications.


So What Went Wrong with LEDs?

The short answer is... ...Nothing!
LEDs still represent a strong long-term growth area. They are more energy efficient, higher quality than conventional lighting, cheaper in the long term, and more "intelligent" than other forms of lighting. The long-term prospects look good for growing applications within commercial and industrial lighting. Moreover, wide scale adoption in the automotive and street lighting industries is a given. However, all industries suffer growth pangs and, right now, there is overcapacity.

Theoretically, a bit of overcapacity in an industry (due to some random shortfall) shouldn't worry long-term investors because they are in the stock for its long-term growth prospects. The idea is that end demand returns to normal after the blip, inventory's correct in time and, the industry goes back to its long-term growth path.

Unfortunately, the reality is that most investors don't see it this way. I think they tend to overreact to short and mid-term events. That said, it's hardly surprising that the market has discounted the sector over the last year or so.


So What’s in Store for the Industry?

The answer to this question probably lies in your viewpoint on what China will do with subsidies. Moreover, with property prices falling in China and growth in fixed asset investment slowing, private sector demand isn’t likely to strengthen. On the other hand, China works by its own rules and the central government certainly has the resources to spend heavily on supporting energy efficient industries.

Western observers frequently underestimate China’s determination to be energy efficient. So, you could make a good case either way. My concern would be that even if China steps up subsidies, will it be directed in a way to support their own industries and, ultimately employment?  Is it really so unfeasible to expect a Communist government to (ahem) try its hand at Communism?

If you share this skepticism then the only game left to play would be to try and analyze when an inflexion point will be reached in the industry. I always think that the key is to look at when gross margins stabilize. This is usually a sign that the glut is disappearing and pricing power is coming back.
The bad news is that with Cree and SemiLEDS, the gross margin declined in the last quarter’s results.  Similarly, investors could look at capital equipment suppliers Aixtron and Veeco to see if they are talking about any pick up in ordering patterns. So far, so bad.  I think there will be plenty of time to pick these names up, should we get more clarity on what China will do with LED subsidies. In particular, Cree is an exciting stock, but timing is everything and risk averse investors might want to be a little patient here.

Two Overlooked Stocks in Big Data and Security

Nice Systems $NICE and its competitor, Verint Systems $VRNT are stocks that benefit from increasing security and regulatory compliance within financial services. They make the kind of surveillance and monitoring systems that banks like UBS would have needed to make sure that rogue trader Kewku Adoboli might have been picked up early on in his activities. As such, their primary profit drivers are increasing regulation and, the growth of ever more complex needs to gather information from multiple sources, both internally and externally.


Nice and Verint set for Growth

With the implementation of Dodd-Frank and the increasing needs for firms to manage security and work flow optimization, these firms look set to grow strongly. They help companies to extract insight from interactions, transactions, and surveillance. The information is gathered from a wide range of different sources, from emails and phone calls to video surveillance.
Nice and Verint should see good growth as financial firms start to spend again in order to support expansion and deal with mounting compliance and regulatory issues. Furthermore, financial firms and Governments are under increasing pressure to protect themselves and the company from internal and external security threats as well as ensure that work flow is being properly managed. These words sound abstract, but consider criminals like Nick Leeson and Jerome Kerviel, both of whom benefitted from lax monitoring and compliance controls.


Nice Systems and Verint Systems Recession Proof?

The odd thing about these two stocks is that they both increased net income and cash flow through the recession. This is to be understood, as their revenue drivers are relatively secular. However, with Nice Systems, there was a drop in revenues of 6.5% from 08-09 and gross profit fell by 10%. However, Nice managed to only lose 7% in EBIT due to reduced SG&A  expenses.
This suggests that they are relatively recession proof but the problem is that a large amount of the company’s revenue comes from the financial services vertical. Unfortunately, if there is a Sovereign Debt Crisis induced slowdown then it is this sector and its suppliers, that will get hit the hardest. Nice Systems will not be immune from any negative sentiment.


Focussing on Nice Systems

I want to focus on Nice as I view it as the stronger of the two.
Essentially, Nice Systems is positioned at the high end of the Work Flow Optimization (WFO) market. As such, Nice tends to offer relatively expensive large scale solutions to the enterprise market. This leaves them exposed to cheaper competitors chasing Nice's installed base when they come to upgrade or renew. However, it also ensures that Nice offers a comprehensive best in class solution.

One area of possible concern is public sector end demand, but it is probable that this is an area of spending that Governments will be highly reticent to cut. Security is not the sort of area they should be cutting back on. Work Flow Optimization gives a tangible return on investment and much of Nice's end demand is regulatory and compliance led. Another cause of worry could be an increase in the demand from organizations for their WFO solutions to be sold by their contact center infrastructure provider. Although, Nice is focused on the high end so this trend is unlikely to have a great affect.


Nice Systems Q4 Results

In the previous quarter a number of questions were raised by analysts regarding current growth prospects. I’ve summarized them here.

• Slower customer bookings in the third quarter, some of which were closed in the ongoing fourth quarter
• Book to bill forecast to be much higher in the fourth quarter
• Weakness in Q3 not seen in any product line or geography
• Management explained that the book to bill also had a pattern of being weaker in the third quarter in previous years, and that this was partly due to the increase in maintenance revenues and the way that business was conducted

Fortunately, when Nice gave its Q4 numbers, all of these issues were resolved in the manner that the company suggested. The book to bill went over one, Nice reported record revenues and the pipeline was strong. There is nothing to suggest that current orders for Nice (and Verint) are not in good shape. The market reacted by marking the stock up. Verint reported later and confirmed that the industry is in good shape.


Should you buy Nice and Verint?

I prefer Nice because it generates more free cash flow and has better growth prospects than Verint. In fact Nice has generated over $380m in free cash flow over the last three years. That is not bad for a company with an Enterprise Value (EV) of $2.21bn. Furthermore, earnings estimates are for mid teens growth in earnings and revenues, for the next two years.
In summary, Nice Systems is currently generating over 6% of its EV in free cash, has strong growth prospects, and is in a favorable long term industry with plenty of upside given increasing corporate awareness of security issues and workflow optimization.

Acuity Brands Stock Research

Acuity Brands $AYI is a manufacturer of indoor and outdoor lighting and as such, is the sort of stock that has been bid up as the market prices in a recovery in the North American real estate market. Alongside its rival Cooper Industries $CBE and other real estate darlings such as Masco $MAS these stocks have been surging this year.

A quick look at a recent price chart, reveals that Acuity has been up as high as 80% above the October lows. When Warren Buffet is talking about a recovery in his annual letter, than investors can feel heartened, even after this strong rise. Longer term, the trends do look good, and Acuity has growth prospects via the increasing use of energy efficient LED lighting.

Acuity is geared to the commercial real estate market and is the market leader in commercial indoor and outdoor lighting. It is also the leader in industrial lighting as well as a major player in the residential market too.

So what happened after the Q2 results? Why the big sell off?


Acuity Q2 Results

Firstly, Acuity managed to beat revenue guidance but they missed on adjusted diluted EPS estimates.

• Revenues at $457.7m vs. $455.4m estimates
• Adjusted diluted EPS at 57c vs. 62c estimates

The market loves to punish companies for an earnings miss and with the recent market weakness, it is not surprising to see Acuity sold off after a very strong run. There are, however, a few extenuating factors here.

Firstly, the tax rate in the quarter was a 35.4% which is higher than last year’s rate of 31.4% thanks to the non-extension of a research and development tax credit. This cost Acuity 3 cents of EPS in the quarter, although management stated that the full year tax rate was likely to be 34%.

Secondly, Acuity reported a loss of $1.3m in Spain in the quarter. This is equivalent to 3 cents of diluted EPS and frankly, I’m not surprised. Spain’s commercial real estate market is in a consolidated decline and there are few signs of a quick turn around. However, the company is taking the right steps and downsizing operations in Spain. Moreover, Spain now represents less than one per cent of sales.

Thirdly, the company took a special charge of 11c relating to a reduction in the sales force in Spain and the closure of a plant in Cochran, Georgia. These streamlining efforts will allow Acuity to benefit from cost savings which should improve margins in the future.

In conclusion, the earnings miss is not really of sign of any underlying problems that Acuity can’t address, if the company is not doing so already.


A Commercial Property Recovery in Site?

As ever, an investment decision will have to be based on a sense of recovery for the US commercial property market. Whilst, Acuity described the five per cent increase in unit volumes as being ‘broad-based’ across products and sales channels, the market will want to see more evidence before taking Acuity higher. On the conference call, management referred to low to mid single digit growth for the North American lighting market for the remainder of 2012. This figure tallies with Acuity’s reported volume growth in the quarter, so it is reasonable to expect that Acuity can achieve single digit growth rates throughout 2012.

Analysts have 7.8% revenue growth pencilled in for 2012, and Acuity is likely to achieve this, provided the trend towards a more favorable pricing mix continues. Management acted quickly in 2011 and increased prices in selected lines, in order to counteract a less favorable sales mix. So, we know they are on the ball.

Moreover, the streamlining efforts will aid margin growth in time and the current glut of LEDs (thanks to over capacity in China) could result in some abating of pricing pressures. Companies, like Cree $CREE and SemiLEDS $LEDS have had pricing problems due to industry overcapacity over the last year. Similarly, if there is going to be a sharp slowdown in China’s real estate market then this too, will alleviate input pricing pressure.


Time to Buy Acuity?

I rather like the trends being discussed and, believe that with the positive trends in US employment, the outlook for property in the US is better than it has been for years. The banks are starting to loosen up on Commercial and Industrial lending, and the US banks bad debt ratios are still falling. Its time for them to start lending.

The signs do look positive and Acuity will possibly be a winner if there is a sharp slowdown in Chinese fixed asset investment. This is definitely a stock worth monitoring and I think it might be worth picking some up around if the sell off continues to the $55 mark. Sometimes the market over reacts.

A Recession Proof Small Cap

Church & Dwight $CHD  a great stock for a balanced portfolio because it is recession resistant. It trades on a good evaluation and offers the prospect of some upside from a fall in commodity input costs.

Furthermore, the company is a small player in a market dominated by large acquisitive companies like Colgate  $CL Procter & Gamble $PG and, London listed Reckitt Benckiser. In fact, Reckitt took over another British company SSL whose Durex condom brand competes with Church and Dwight’s Trojan.

Church and Dwight competes successfully with the likes of Procter & Gamble because it aggressively defends its niche markets from competition. As such, it is able to defend its positions and generate growth in a way that Procter & Gamble's management has failed to do. Furthermore, Church & Dwight offers value brands which already compete on price. A company like Procter & Gamble tends to be reticent to cut prices because consumers tends to want them to stick.

A classic example of this, would be with  the company's Arm & Hammer toothpaste with Colgate's. Arm & Hammer is the value brand and moreover, Church & Dwight's management are nimble enough to leverage the brand by releasing products such as electrical toothbrushes.

The company is little discussed but has an excellent track record of generating earnings through the cycle. I think they can generate at least double digit returns for a stock investor from here and, are a genuine takeover target.


 Church & Dwight Brands

The company’s brands can be categorized as a diversified collection of personal and homecare goods. Much of it’s brands are value propositions which offer upside in a stagnant economy, as consumers trade down to cheaper options. In terms of profits and sales, 80% of them come from the eight leading ‘power’ brands…

• Arm & Hammer (toothpaste, baking soda, detergent, cat litter)
• Trojan Condoms and Vibrators
• OxiClean Laundry Additive
• Spinbrush Battery Powered Toothbrush
• First Response Pregnancy Kit
• Nair Hair Removal
• Orajel Pain Relief
• Xtra Extreme Value Laundry Detergent

The list reads like a roll call of US value brands commonly found in the home. However, Church & Dwight is far smaller than its major competitors and, its business model is tailored towards grabbing leadership in niche markets.  This means that it can protect its market share without resorting to margin erosion via price cuts.

What makes this company really special is the quality of its execution.


Church & Dwight Earnings

The management has demonstrated a tremendous ability to grow earnings and revenues over the years, even in the face of rising commodity costs and, the great recession.  This can easily be summarized below

($m)	2006	2007	2008	2009	2010	2011
Revenue	1,955	2,221	2,422	2,520	2,589	2,749
Gross Profit	761	877	972	1,101	1,157	1,215
Adjusted EPS ($)	1.04	1.23	1.43	1.74	1.98	2.21
EPS Growth (%)		18.3	16.3	21.6	13.8	12

At the final results in February, management guided towards 3-4% revenue growth in 2012 with EPS growth of 14-15% .

All of which paints a picture of a recession proof company. However, 2011 has proved challenging. End demand was lower than initially expected and, rising commodity costs put pressure on margin expansion. No matter, the outlook for 2012 presents upside potential as the US economy generates employment gains and, commodity costs may abate with slowing emerging market growth.

It is also worth noting that gross margins jumped in 2009 with the fall in commodity prices and, Church & Dwight has managed to hold onto them despite rising costs. Similarly, with such a well run business, working capital management is excellent and, the company always generates large amounts of free cash flow.


Church & Dwight Target Price

The stock currently trades at a price of $49.59 with a market cap of $7.09bn. There is $251m in cash on the balance sheet with $249m in outstanding debt. Free cash flow has grown from $200m to $365m from 2007-2011 with a compound annual growth rate of 16%.

Obviously, on a current PE ratio of 22.4, it looks expensive but investors should focus on free cash flow. Church and Dwight trades on a current free cash flow yield of 5.1% and, that is attractive for a recession resistant company which is growing earnings in the teens. In addition, management states that they expect to generate $1.1bn in free cash flow over the next three years. This represents over 15% of the current market cap. Having increased the dividend by 41% at the last earnings, I think we should take them seriously!

 For a relatively secure double digit growth over the next couple of years, this stock could trade on an evaluation closer to $55. There is upside potential from reducing commodity costs and, a potential value outer from an acquisition bid for the company.  A $55 target represents 11% upside with plenty of room to grow, should a slowing Chinese economy reduce commodity input costs. Similarly, a strong return to US consumer spending will see upside to revenue growth at all the leading consumer goods companies.

Church & Dwight is a nice recession resistant stock which is good for balancing any portfolio.  

Sirona Dental Systems Research

Sirona Dental Systems (NASDAQ: SIRO) is a dental healthcare stock which is exposed to favorable demographic tailwinds and the expansion of the rollout of its global leading technology.  The evaluation and prospects look compelling and, there is upside potential to the stock price.

Sirona's Profit Drivers

Sirona has two key earnings drivers.

First, consider the ageing demographic. As people get older they require more teeth maintenance. Furthermore, as people tend to have more teeth decay as they are older, dentists can expect more restoration work. Ultimately, Sirona should see more demand for its products. 
Secondly, its proprietary technology currently has low market share and, provides dentists with many cost and quality advantages.

Whilst the demographic argument is well worn in healthcare plays, it should carry more weight with Sirona because of a relative lack of insurance reimbursement issues with dentistry products and solutions. Indeed, the industry is shifting towards private from public pay and, much of what Sirona does is aimed at the high end market.

The company is very well run and a global technology leader. Sirona spends around six to seven percent on research and development every year and is investing $15m in setting up a major new innovation centre in Bensheim, Germany. The balance sheet is solid, having seen the company engage in deleveraging the business over the last few years. Sirona is now in a position to make some acquisitions and, I would expect some activity on this front. Sirona has its origins as a spin off from German industrial giant Siemens (NYSE: SI)

To read further click on the link here at Motley Fool Blog Network

Mylan Labs Creates Too Much Uncertainty

Mylan at the Nasdaq

I recently exited a position in Mylan Labs $MYL and, I thought it would be interesting to do some equity research analysis on Mylan and the reasons why I sold.

Sometimes, with an investment, you get a nagging sense of some things that you are not quite comfortable with. When it builds so that your spider senses are tingling, I usually find it is time to sell.

 So what is about Mylan that attracted me to buy and, why did I then sell?

Mylan Attractively Positioned in Generics Market

The market for generics is a no-brainer for future growth. The US has to cutback on its burgeoning healthcare spending and indeed, one of the first things Obama did was take steps to introduce a regulatory pathway for biologic generics. Generics are not only cheaper for the consumer, they also tend to generate more profit for the distributor. Companies like CVS $CVS should see margin expansion by selling more generics. Throw in a substantive number of high profile drugs that will be going off patent in the next few years and, the outlook seems good.

Similarly, Europe has a far lower penetration rate of generics than in the US and, there will be a lot of political pressure to increase this rate in future. Moreover, an ageing population should ensure strong volume growth. In addition, whilst pricing is always an issue with generics companies (pricing declines rapidly once other entrants release copies) it should be noted that producing generics is no easy business.

Producing bio-similars is even harder because of the complicated manufacturing processes involved. The likes of Mylan, Teva, Watson and Sandoz (Novartis) do have a kind of moat.

So, why did I sell?

Herb Greenberg and Mylan

In a CNBC article, Greenberg highlighted a few causes of concern. He cited the recent investor day when Mylan outlined a $6 EPS target for 2018.  He then goes onto to point out that Mylan paid $22m to buy the right to develop Pfizer’s generic version of GlaxoSmitKline’s blockbuster Advair for Asthma and COPD.

Mylan are also getting the right to Pfizer’s dry powder inhaler which they can also use for other products. Mylan then put a contingent consideration of $376.1m on the balance sheet, which Greenberg argues gives them latitude to adjust non-cash earnings, because the consideration involves discretionary assumptions over future royalties, milestones and profit sharing.

Frankly, I think Greenberg’s skepticism is worthy but doesn't entirely hit the salient points. Biotech & Pharma investors know that the value of a company lies in its pipeline. If this program is successful, then Mylan pays the consideration. If it isn’t, Mylan doesn’t. However, the estimation of the risk weighting in the pipeline will change with investors’ perceptions and, with clinical trial, market or regulatory evidence. Investors know this and, I doubt that anyone took Mylan’s 2018 EPS target of $6 with anything other than a pinch of salt.

Mylan investors want to pay the consideration and therefore, they do not want to see earnings adjusted upward by the company reducing the liability. Investing in biotech is not for those who don’t like uncertainty!

Key Takeaway: Where I do agree with Greenberg, is with being dubious over companies talking about EPS numbers in six years time!



Vectura's GyroHaler (source Vectura)



Vectura VR315 Generic Advair?

Vectura is a UK listed pulmonary drug delivery company which is widely believed to be developing a generic version of Advair (Seretide). They have an extensive partnership with Novartis and their generic arm Sandoz. Indeed, Vectura are developing VR315 with Sandoz in Europe and analysts see in being on the market there in 2013-14.  However, in the US, Sandoz returned the rights to Vectura in 2010 and, this should be seen as a warning that the regulatory and competitive environment is likely to be tough in the US.

Vectura has subsequently agreed another partnership with a US pharma co for VR315 in the States but Sandoz really was the ideal partner. Analysts expect a 2015-16 launch but I’ve seen estimations for probability for this as low as 19%

Key Takeaway: Sandoz walked away from generic Advair in the US and, Mylan is talking about the generic as a potential ‘game changer’ for the company and baking that into long term forecasts.

Management Keep Selling Stock

If you are going to talk about $6 in 2018 (which would put the stock on 3.8x earnings) then it is not a good idea to promptly start exercising options and selling stock off. The investor day took place on the 21^st February 2012. Following that….

• 22-24 Feb Wendy Cameron exercises a cumulative 106,875 shares worth of options and then sells 106,875.
• 23 Feb-13 Mar  Douglas Leech exercises 33,750, sells 33,750
• 2-15 Mar Robert Coury exercises 231,771 and sells 184,342

Prior to the investor day, 

•  17 Jan-15 Feb Coury exercised 300,000 and then sold 300,000

Incidentally, all numbers are sourced from Yahoo Finance.

Key Takeaway: Management are exercising options and selling stock.

My Mylan Conclusion

Putting all these things together makes me feel uncomfortable. I like the sector, I like Mylan but biotech investing is already full with uncertainty, it doesn’t need more. It doesn’t need management’s making ambitious projections and, then exercising options and selling stock. As for the pipeline, respiratory is competitive and biogenerics are fraught with ‘known unknowns’.

I am also slightly skeptical with some of the language used to promulgate Mylan’s future success. For example, at the investor day, Mylan’s ability to generate cash was championed and, then the CFO announced that Mylan would ‘generate over $1bn annually and beyond in financial flexibility’.

Everyone else talks about free cash flow generation, so what does ‘financial flexibility’ mean?  Apparently, it means free cash flow plus borrowings. Are we supposed to applaud the fact that Mylan can borrow money?

From the investor day presentation, the mid-point of guidance for 2012 adjusted free cash flow is $600m (flat on 2011) and for a business with an Enterprose Value of $14.67bn this does not make the stock cheap at the current price of $22.89

Moreover, Mylan has refused to reinstate a dividend, despite the management’s confidence in the outlook.

Frankly, there are too many questions here and I decided, perhaps wrongly, to close my position.

Software Company Stocks Moving to Cloud Computing



Intuit, Sage and Cloud Computing



Intuit $INTU is a stock that offers investors exposure to the shift towards SaaS (Software as a Service) amongst software providers. This makes Intuit a stock set to benefit from cloud computing growth. It is also attractive as a way to play an economic recovery in the US via its tax offering.

So with Intuit, you have a structural growth story with the shift to cloud, combined with the cyclical growth story of increasing US employment leading to increased tax filing.  I thought it would be interesting to do some equity research analysis on Intuit and compare it with a UK stock called Sage, which competes in some of its end markets.

Intuit Earnings Analysis

Firstly, these set of results beat estimates but what is really important is the outlook for the April quarter, which usually makes up around 85% of earnings for the year.  Intuit confirmed previous guidance and forecast $2.47-2.51 in non-GAAP EPS for April, which is in line with analyst estimates of $2.49.

Similarly, the conference call made some positive noises on the next quarter, although cautioned that there was a lack of data from the IRS this year on tax returns. No matter, payroll data has been strong recently and most of the economic data- as well as commentary from the likes of Robert Half $RHI – has been indicative of decent employment gains.

Moreover, INTU noted in the conference call that (despite it being early in the season) tax returns are up on last year even though the evidence is that there is a trend towards tax returns being filed later and later each year.

Cloud Computing Stocks

However, Intuit isn’t just about a cyclical growth story, there is a real secular shift occurring in their digital business. Intuit was an early investor in the cloud computing and selling SaaS, and a company like Sage needs to take notice. The shift to online is progressing across the whole company and it is leading to increased ROI (return on investment) and lower churn rates. Indeed, as Intuit pointed out with QuickBooks Online, it has a 20% increase in life time value (LTV) as compared with QuickBooks Desktop.

A company like Sage should take note because the possibility to leverage its leading position in the UK (accountancy software) into the cloud is significant. Sage is talking about doing this but is far too slow in adoption and, runs the risks of having its market share eroded and ultimately facing a disruptive shift when it does finally make the move aggressively.

According to Intuit, the company is already generating 62% of its annual revenue from connected services.  I doubt Sage is anywhere near that, but the company should be thinking aiming for it. Let’s look at what Intuit said in the conference call and see how it demonstrates the power of the cloud to steal market share. In this case with QuickBooks…

“3 years ago, we used to get 40% of our new customers outside of QuickBooks Desktop. We're now getting 70% of new customers beyond QuickBooks Desktop. So as we shift to more Connected Services and mobile apps, it's helping us get new customers into the franchise and it's easier for us to identify additional problems that we can introduce them to a product through a simple link and so that drives cross sell and up sell and attach.”

Indeed, Intuit’s Turbotax is the highest grossing iPad app in the Apple store. It is initiatives such as this that have lead to online tax returns growing to 75% of the market versus 25% for retail. Intuit is trouncing the likes of H & R block $HRB.

Sage Future Challenges and How Intuit Shows the Way

Intuit competes with Sage with its QuickBooks accountancy software and, it is worth looking at what Intuit said about growth rates of QuickBooks online and Desktop…

“Well, what we're seeing right now in QuickBooks is year-to-date, the desktop customers, the units are down about 2% in terms of the units sold. With that being said, the online version's up 35%, but you've got to keep that in perspective. We've got 4 million installed QuickBooks customers and we have 326,000 odd or 230,000 odd QuickBooks Online customers. So it's growing off of a smaller base. If we had to take a look at what we think the future will be, you're going to continue to see a faster growth rate in online than desktop. But a lot of customers really want to have their accounting information on the desktop. “

In other words, unless Sage wants to continue along the conservative low single digit revenue growth path, it had better get into the cloud and quickly. There will always be a core demand for desktop but the growth is online.

Not only is the growth online, but the ROI is higher. The LTV is higher and the marketing is more targeted, which results in lower churn rates. Sage has the chance-given its market dominance in the UK- to aggressively make an ‘Intuit’ style shift, but does it have the commitment and are the management being slow to adapt?

Sage is launching several versions of their mid-market offerings in the cloud this year and, if successful, Sage has the potential to generate some upside surprise. Although, potential investors will have to consider that nearly 60% of revenue comes from Europe and notably the SME market. These headwinds create a fair amount of uncertainty for Sage.

Intuit Equity Research

Turning back to Intuit, INTU currently trades at $57.57 which gives it an enterprise value of $17.23bn.  Over the last five years, revenue growth has had a CAGR of 9.6% and EPS growth is forecast to grow this year at 17.9% and then 13.2% for July 2011-12.  These are excellent numbers and, furthermore INTU is very good at converting income growth into free cash flow..

(m)	July 2009	July 2010	July 2011
Non-GAAP Net Income	600	685	798
Operating Cash Flow	812	998	1013
Ocf conversion	135%	145%	127%
Capital Expenditures	131	74	114
Free Cash Flow	681	924	899
Fcf conversion	114%	135%	113%

…so if we take a rough estimate of 120% FCF conversion, and the analyst of non-GAAP EPS of $2.96 we will get FCF of 2.96*1.2= $3.57 for 2012. For the next year, estimates are for $3.35 in earnings which would give around $4 in FCF for 2013.

This equates to FCF/EV of 3.57/57.57= 6.2% and 4/57.57= 7% for the next two years. This is cheap for a business that should be able to generate earnings growth with the shift to online services for many years to come. Compound this with the relatively defensive nature of the company (SME’s tend to have a high failure rate, but they all need tax and accounting software) and this evaluation of $57.57 looks cheap. 

Analysts mean price target is for $64 but I think that is too conservative. Intuit could trade closer to $70 if the economy continues on track. I bought some more after the results.

As for Sage, it has economic headwinds for the first half of 2012 but potential investors should watch events closely. If Sage is committed to the cloud then it could see a re-rating with a lighter than expected recession and he beginnings of traction in the move to the cloud. However, I would like to see hard evidence of the latter first, before piling in.

Telecity Set to Benefit From Cloud Computing Growth

A good set of results from Telecity $TCY which highlight how this stock benefits from the growth in internet traffic and cloud computing. Data centers are a very good ‘picks and shovels’ play and companies like Equinix $EQIX are seeing strong growth in end demand. Inevitably, this is causing increased capital expenditures as the data center providers expand capacity.

The potential downside here is that this ramping of capacity (the likes of Equinix and Telecity are expanding aggressively) will cause a supply glut which will lead to falling margins just as the data centers need cash flow in order to pay back the debt needed to expand capacity. No matter, right now, this doesn’t look like being a problem and investors will see the early signs when Telecity et al, start reporting slipping EBITDA margins. The growth in internet traffic is progressing at an exponential rate and increases in cloud computing will only strengthen the case.

Telecity is a Good Play on Cloud Computing

Turning to the expansion program, Telecity has nine simultaneous locations in development at the moment. Over the course of the last year, they expanded capacity to 68MW from 58MW last year. A further 10MW is expected to come online within the next six months and, longer term plans for a total of 124MW in three to four years are already in place. This is almost a doubling of current capacity, but Telecity has good reason for confidence over these plans.  

For example, 95% of last year’s revenues were recurring and 60% of organic growth came from existing customers, with only mid single digits churn. Clearly, Telecity’s end demand is very sticky and they are seeing strong growth from existing clients who need expansion to meet their mission critical demand.  Ultimately, this provides Telecity with a high visibility of earnings.

Telecity’s Growth Drivers

Moreover, the growth in internet traffic is broad based across sectors and, has proved to be recession resistant. This looks like a structural growth story and, will only increase as cloud computing and data traffic increases. Whilst, superficially, there is no moat in data center provision, it is in fact a mission critical application which requires substantial planning and trust on behalf of the clients.

An example of the broad base of Telecity’s clientele can be seen when looking at the breakdown of new customer wins by application type

• 29% content
• 24% financial
• 16% connectivity
• 16% systems integrator
• 15% cloud computing

Financial simply refers to financial transactions through the centers. The diversification in usage belies the growth potential for Telecity.

Telecity Financials

At a current price of 650p the stock is valued at £1287m. Telecity currently has £164m in net debt, which put together gives an Enterprise Value of £1451m. This stock is obviously not bought for its dividend, even though Telecity is promising to pay 20-25% of its earnings in dividends. For those interested, this would make 6p or 1% yield based on analyst forecasts for 2012. The company expects to commence dividends at the half year in 2012.

The key to Telecity is to think if it as a cash generating ‘annuity’ type stock. It is in the expansion phase now so, superficially, cash generation looks weak but the underlying picture is much stronger. At the full year, Telecity generated £106.5m in operating cash flow from £109.9m in EBITDA and, cash flow conversion has been similarly strong over the years. Telecity spent £109.9m in expansion capex but maintenance capex was only £21.8m. This means that the operating free cash flow was £106.5-21.8m=84.7m or 5.8% of EV.

Telecity Stock Analysis

The underlying cash flow generation is strong and investors should consider that it will, roughly, take four years for a location to reach peak demand. Therefore, the expansion now will generate future revenue growth in the next  few years. Furthermore, the net debt situation of £164m is easily manageable given cash flow generation and a five year £300m debt facility hich was signed in May 2011. There is ample head room for more expansion.

The key thing here is that any investor will need to be confident in the long term growth rates of internet traffic and then try and ‘price’ in this confidence. The correct approach might be to watch gross margins across the industry and see that as a marker for over capacity. However, we are not there yet and Telecity’s stock price is probably at least capable of ‘doing its earnings’ for 2012. On this basis it is better priced at 750p then the current price of 650p.

Source:

Telecity Results Presentation

Google Earnings, Motorola and the Pay Per Click Challenge

Google $GOOG came out with earnings numbers that disappointed the market and received no end of negative commentary from journalists and commentators. The stock declined 10% in after hours trading and the next day closed 8.5% down.

  However, I suspect this is more to do with adjustments to the game of hitting analyst estimates rather than any weakness in the underlying performance of Google. Granted, there are some changes in terms of accelerating paid clicks (up 34%) but declining cost-per-click (down 8%) but I don’t consider them to be a major issue and will discuss this later.

Google Don’t Give Estimates or Guidance

Google don’t give guidance nor do they give estimates. Ever. This makes life that bit tougher for analysts. It also happens to cause significant variance with actual earnings and estimates, because analysts do not have a number from the company from which to ‘anchor’ their estimates. We can see the variance expressed in the stock chart below. Note the high volume big gaps that occur, up and down, every three months after earnings are given

 

Indeed, the standard deviation of the difference between earnings and estimates is nine per cent over the last five earnings! However, this mainly represents the inability of analysts to forecast correctly what the numbers will be, rather than the underlying progress at the company.

Google’s Underlying Performance

The underlying performance was strong, although there are some structural changes taking place at Google. Most notably Google is increasing operating expenses quicker than revenues so earnings are not growing as strongly as the top line.

The strategy is to grow Google advertising in the mobile space and the acquisition of Motorola Mobility is a key part of ensuring the primacy of Google’s Android operating system. According to NPD, Android based smart phones have 53% of the market vs. Apple iOS at 29% and RIM Blackberry at 10%

It is inevitable that screen time will increasingly be taken by smart phones and tablets so it is essential that Google grow in the mobile sector. In fact, some analysts are looking at the eight percent decline in cost-per-click as a sign that mobile will be less profitable than pc advertising. Moreover, the acquisition of Motorola Mobility is seen as a challenge to Google because it is a hardware rather than Software proposition.

 I’ll discuss this below, but firstly let’s look at the numbers…

• Net revenues rose 27.6% to $8.13bn
• Total Costs and Expenses Rose 29.6% to $5.46bn
• Free Cash Flow rose 300% to $2.97bn
• Full Year Free Cash Flow was $11.1bn
• Non-GAAP EPS rose 8.6% to $9.5
• Paid Clicks rose 34%
• Cost-per-click declined 8%

…clearly, there is a need to look closer at some aspects of these numbers.

Why Google Cost Per Click Declined

Frankly, I don’t think this is as much of an issue as much of the media made it out to be. Google explained that currency effects (stronger dollar) had an affect as well as a conscious shift to increasing paid clicks at the expense of cost-per-click.

An example of this is the increase in site links. These are the individual links to various parts of a website that appear after a search. Whilst they are great for encouraging interaction with a site and thus increase paid clicks, I suspect they do generate less cost-per-click. This is not a problem as long as the overall revenue increases in the mix.

As for the issue of increasing mobile ads, this too, should not be seen as a particular issue. Smart phone internet usage is definitely different but probably involves more focused search (via engines) and re-occurring visits to favourite websites (facebook, youtube)  then the meandering browsing experience of sitting in front of a pc.

 There is every reason to expect that Google will be able to continue to generate growth even though internet usage shifts to online.

Google can meet its Challenges

Whilst a lot of negative commentary is directed towards what management will do with Motorola Mobility, I think this is somewhat misguided. Motorola is a hardware company, but increasingly, the value in a handset is actually coming from the operating system, software and mobile applications!  Google knows what it is doing here.

 In addition, the shift to advertising on mobiles involves a change in activities that Google has performed endlessly and iteratively, with pc advertising. It is not a significant strategic shift, Google knows how to generate revenues from links and advertising and has

Google’s Evaluation

In summary, at the current price of $586 we are looking at a business that is growing net revenues at 27.6% and has just generated 11.1/154.5bn=7.2% of its Enterprise Value in free cash flow over the last year.Trading on a PE ratio of 16.3x I think this business is cheap despite the ‘disappointment’ in these results.

There are issues with the management’s attitude to shareholders and refusal to pay a dividend despite having a $35bn on the balance sheet. However, Google’s prospects look bright and fears look overdone. There is more to investing than meeting analysts estimates!