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Discover Financial Services $DFS gave the market some positive news regarding the trend of the US economy. The headline news (pre-tax income being down 6% due to an increase in loan loss provisions) suggests weakness, but the devil is in the detail. In fact, this report was rather bullish. In this article I want to focus on the reasons.
Loan Loss Provisions Higher, But So is Lending
Firstly, with regards to the increase in loan loss provisions from $176m to $232m for the comparable quarters, the reason is that Discover is planning on future growth. An expansion of provisions implies an increase in loans and/or deterioration in credit quality. Frankly, I am finding it hard to believe in latter. For example let’s look at credit card loans and overall net charge-offs prior to this quarter.
Indeed, quarter after quarter, analysts inquire whether the charge-off rate has bottomed. Typically, Discover’s management are cautious about this issue and tend to sympathize with the view that we could be close to a trough in this ratio. And quarter after quarter it goes lower! Perhaps management are being too cautious?
The principal charge-off rate declined to 2.79% in this quarter and, interestingly, total loan receivables were up 9% while credit card loans (81.7% of total) went up 4%. It seems that Discover is lending more but the increase in loan loss provisions seems to imply that it thinks that customers will start to not pay balances on time. My suspicion is that Discover is ready to ramp up lending but is being overly cautious about it in its commentary.
Tier 1 Capital Ratio
Another subtle sign that Discover is seeing better conditions is in its Tier 1 capital ratio. If this ratio declines in the future (while credit quality improves) it will be a sign that Discover is more willing to extend credit.
New Product Launches
Another sign that Discover is reacting to more favorable market conditions comes with the expansion into three new product areas. Mortgages will now be offered via a home loan center platform, a fixed rate student loan product is now available and, Discover is releasing its first major affinity card.
So while credit quality is improving and loans are increasing, Discover is also introducing new product offerings to capture different sources of growth in a low interest rate environment.
Competition Coming?
The market is competitive and in the conference call, management talked of increased competition most notably from Visa $V. However credit card rewards did not increase significantly, so Discover is not having to "buy" growth at the expense of income. With regards to the payment processors Visaand MasterCard $MA they have also been sterling performers this year. Not only are they seen as a safe place to hide within the financial sector but they appear to have successfully negotiated the threat imposed by the Durbin amendment, the purpose of which was to break their duopoly in processing small merchants' debit card transactions.
Visa responded by announcing a network participation fee (NPF) and MasterCard is believed to have raised fees for small retailers. Throw in the recovery in credit issuance and the environment is set for these stocks to continue to do well. More credit equals more transactions, which in turn translates into increased revenues for Visa and MasterCard.
What Next For Discover?
The attractive thing about Discover is that the macro-economic environment looks good for the company. The diagnosis of a slow gradual recovery is a good scenario for Discover. In other words, interest rates will stay low for the foreseeable future whilst slow gains in employment and growth should translate into increased credit quality and the opportunity to expand receivables in a sustainable manner.
The financial services industry has come a long way since 2000 and is, arguably, too conservative right now. No matter, if the recovery continues then lending will come. For the wider US economy, Discover Financial's results are an indication of ongoing strength.
As the market grapples with the consequences of the Greek election, I thought it would be interesting to look at a stock which could give balance to a portfolio. In its own odd way, FactSet Research Systems Inc(NYSE: FDS) has a combination of defensive characteristics and cyclical growth prospects. Unfortunately, given that its main activity is providing financial information, the stock is well known to the investment community, so retail investors won't be discovering an under researched company here. It has had a good run this year, however, the recent fall -caused by moderately weaker guidance- could provide a decent entry point.
The last results were pretty good but the market sent the stock down 13% because next quarter’s revenue was forecast to be $208m vs. analyst consensus of $210.5m. Non-GAAP diluted EPS was forecast to be $1.15-1.17 compared with analyst estimates of $1.21 and, in these turbulent times, those numbers were enough to disappoint investors. The commentary around the results contained the familiar refrain of Europe and the macro economy. So why do I think FactSet is worth a second look?
Facts about FactSet
Firstly, the company offers the opportunity for a ‘trading down’ play. In other words, when the environment gets tough, financial services firms can make incremental cutbacks by expanding their provision of FactSet services rather than, say, buying a license for a Bloomberg terminal or Thomson Reuters Corporation(NYSE: TRI) desktop. FactSet also competes with Standard & Poor’s which operates within McGraw-Hill Companies(NYSE: MHP). Both Thomson Reuters and S&P offer a range of prices based on products and content type. What differentiates FactSet is that it tends to offer a substantial amount of varied content with its offerings.
Secondly, financial firms do suffer when an economy weakens but there are many different asset classes within their operations, some of which are not necessarily tied to the economy. For example, if equities are doing badly, firms could expand their bond, FX trading or absolute return research support. Moreover, while the financial industry is at the epicentre of any shock to the system caused by a potential hard default by Greece, we are nowhere near 2008 conditions, and even then, FactSet managed to report revenue and earnings growth.
Thirdly, given a resumption to the European growth following the forced expulsion of Greece from the Euro, I think that FactSet will offer some decent upside exposure. I suspect financial firms have held off hiring and expansion plans while adopting a ‘wait and see’ approach. Should the uncertainty be resolved, a release of pent-up hiring should see expansion opportunities for FactSet.
Key Metrics Declining?
One of the concerns with the last results is the confirmation that Annual Subscription Value (ASV) growth appears to be moderating. While ASV implies that it is a good indicator of future growth, investors should understand that clients can give FactSet notice and add or delete parts of the service at will. Therefore, ASV should be looked at it in conjunction with client growth and the outlook for financial firms future spending. The tricky part is judging whether the recent moderation in growth is due to the wider environment or due to competitive positioning.
Note from this chart that ASV annual growth didn’t go negative, even at the height of the financial crisis. However, there does appear to be a graduated moderation of growth here even as client growth is doing ok. The industry is very competitive and increasingly firms may be able to source information and analytics from specialized providers or alternative sources. FactSet’s offering covers a wide range of interests so, for example, an equities analyst may use and regard the system in a vastly different way to a wealth manager. Companies like Bankrate(NYSE: RATE) or Morningstar (NASDAQ: MORN) will provide more specialist research in the fields of banking/insurance and mutual finds respectively.
It is noticeable how Morningstar has struggled as equity mutual funds have seen redemptions. In fact, across the industry it is the only one that has seen significant downgrades to estimates this year
All of which, leaves each individual offering from FactSet to be susceptible to competition from a more specialized provider in that field. In view of this I would suggest incorporating a margin-of-safety approach with this stock.
So What Next for FactSet?
Investors will want to follow the stock with a view to deciding whether the moderation in ASV growth is a consequence of the economy or not. It is hard to tell at this stage. However, in future quarters if the macro environment improves but ASV does not accelerate, than I think it is safe to assume that there is some sort of competitive pressure building.
Moreover, the stock is hardly cheap. It trades on a forward PE of around 20 and that is not cheap for a stock exposed to the financial services sector. Free cash flow has averaged around $184m for the last three years and this puts it on a FCF/EV yield of 4.6%. Again, I don’t think this is particularly attractive for a business in a competitive market. I would want a larger buffer built into this stock before buying it.
Nonetheless, it is a stock with a lot of attractive drivers and investors would do well to keep an eye on its developments.
As the market grapples with the consequences of the Greek election, I thought it would be interesting to look at a stock which could give balance to a portfolio. In its own odd way, FactSet Research Systems Inc (NYSE: FDS) has a combination of defensive characteristics and cyclical growth prospects. Unfortunately, given that its main activity is providing financial information, the stock is well known to the investment community, so retail investors won't be discovering an under researched company here. It has had a good run this year, however, the recent fall -caused by moderately weaker guidance- could provide a decent entry point.
The last results were pretty good but the market sent the stock down 13% because next quarter’s revenue was forecast to be $208m vs. analyst consensus of $210.5m. Non-GAAP diluted EPS was forecast to be $1.15-1.17 compared with analyst estimates of $1.21 and, in these turbulent times, those numbers were enough to disappoint investors. The commentary around the results contained the familiar refrain of Europe and the macro economy. So why do I think FactSet is worth a second look?
Facts about FactSet
Firstly, the company offers the opportunity for a ‘trading down’ play. In other words, when the environment gets tough, financial services firms can make incremental cutbacks by expanding their provision of FactSet services rather than, say, buying a license for a Bloomberg terminal or Thomson Reuters Corporation (NYSE: TRI) desktop. FactSet also competes with Standard & Poor’s which operates within McGraw-Hill Companies (NYSE: MHP). Both Thomson Reuters and S&P offer a range of prices based on products and content type. What differentiates FactSet is that it tends to offer a substantial amount of varied content with its offerings.
Secondly, financial firms do suffer when an economy weakens but there are many different asset classes within their operations, some of which are not necessarily tied to the economy. For example, if equities are doing badly, firms could expand their bond, FX trading or absolute return research support. Moreover, while the financial industry is at the epicentre of any shock to the system caused by a potential hard default by Greece, we are nowhere near 2008 conditions, and even then, FactSet managed to report revenue and earnings growth.
Thirdly, given a resumption to the European growth following the forced expulsion of Greece from the Euro, I think that FactSet will offer some decent upside exposure. I suspect financial firms have held off hiring and expansion plans while adopting a ‘wait and see’ approach. Should the uncertainty be resolved, a release of pent-up hiring should see expansion opportunities for FactSet.
Key Metrics Declining?One of the concerns with the last results is the confirmation that Annual Subscription Value (ASV) growth appears to be moderating. While ASV implies that it is a good indicator of future growth, investors should understand that clients can give FactSet notice and add or delete parts of the service at will. Therefore, ASV should be looked at it in conjunction with client growth and the outlook for financial firms future spending. The tricky part is judging whether the recent moderation in growth is due to the wider environment or due to competitive positioning.
Note from this chart that ASV annual growth didn’t go negative, even at the height of the financial crisis. However, there does appear to be a graduated moderation of growth here even as client growth is doing ok. The industry is very competitive and increasingly firms may be able to source information and analytics from specialized providers or alternative sources.
FactSet’s offering covers a wide range of interests so, for example, an equities analyst may use and regard the system in a vastly different way to a wealth manager. Companies like Bankrate (NYSE: RATE)or Morningstar (NASDAQ: MORN) will provide more specialist research in the fields of banking/insurance and mutual finds respectively. It is noticeable how Morningstar has struggled as equity mutual funds have seen redemptions. In fact, across the industry it is the only one that has seen significant downgrades to estimates this year.
All of which, leaves each individual offering from FactSet to be susceptible to competition from a more specialized provider in that field. In view of this I would suggest incorporating a margin-of-safety approach with this stock.
So What Next for FactSet?
Investors will want to follow the stock with a view to deciding whether the moderation in ASV growth is a consequence of the economy or not. It is hard to tell at this stage. However, in future quarters if the macro environment improves but ASV does not accelerate, than I think it is safe to assume that there is some sort of competitive pressure building. Moreover, the stock is hardly cheap. It trades on a forward PE of around 20 and that is not cheap for a stock exposed to the financial services sector. Free cash flow has averaged around $184m for the last three years and this puts it on a FCF/EV yield of 4.6%. Again, I don’t think this is particularly attractive for a business in a competitive market. I would want a larger buffer built into this stock before buying it.
Nonetheless, it is a stock with a lot of attractive drivers and investors would do well to keep an eye on its developments.
Investors looking for signs of a housing market recovery were cheered when Pier 1 Imports Inc(NYSE: PIR) recently gave a good set of results. In summary, I’m not convinced that this is clear evidence of a recovery.
Larger companies like Home Depot (NYSE: HD)and Lowe's Companies (NYSE: LOW) have both said that they are not really seeing any sign of a housing-related pickup in their sales. Indeed, the commentary around results from Pier 1 was pretty neutral. Consumers don’t appear to be accelerating spending on home furnishings just yet, and in any case, I’m not sure that Pier 1 is the best way to play this theme.
The company has certainly achieved an incredible amount in the last few years. Having been on the verge of bankruptcy in 2009, the turnaround has been little short of sensational. Since then, gross margins have seen a sterling improvement from 27% to nearly 40% currently. It is a textbook story of generating operational efficiency and it isn’t over yet. Store relocations and remodeling are an integral part of the ongoing strategy and management is clearly delivering. Moreover, the stock sits on a lowly rating. There are a lot of things to like about Pier 1 ... but there are also challenges.
E-Commerce and Shipping?
The company will undergo a soft launch of its new e-commerce enabled website at the end of July and frankly, this is a necessity rather than an optional add-on. Pier 1 tends to sell a large volume of low-ticket home furnishings and gifts. In other words, it’s exactly the sort of product that is increasingly sold online via the likes of Amazon. In addition, firms like TJX Companies (NYSE: TJX) are expanding their offerings in home ware. Competition is coming and Pier 1 needs to react to it. The question is, how can they expand an online presence without cannibalizing their own store sales or even, de-facto, encouraging people not to go and experience the sensory pleasure of shopping at one of the stores?
The management's expectation is to increase online sales so that they will be at least 10% of sales within five years, but I think this could be a conservative estimate. The trend toward e-commerce is an inexorable one and low ticket items are attractive to purchasers because they can try and save on shipping costs. The problem is that these costs then get passed onto the retailer. Pier 1’s current plan is to offer the customer the option of picking up the goods in-store or paying to have them delivered.
In contrast to a high-end retailer like Nordstrom Inc (NYSE: JWN), Pier 1 regards free shipping as being effectively a ‘markdown’ and won’t be offering it. This may be laudable but consider that it offers a large amount of small ticket items whilst the average Nordstrom customer spend will be higher. Similarly, its costs could be relatively higher because more of its goods are bulky and fragile.
In addition, the idea of internally crediting the stores with the sales that come from the trade areas in the region is a good way to ensure that employees get internal recognition. However, workers require remuneration for their efforts. So would it be sensible to reward staff for sales that are actually coming from another channel?
Moreover, since the plan isn’t to hold the online inventory at the stores, it’s not hard to see the possibility for a dilemma arising over this issue in future. It is particularly concerning because the stores are intended to have pricing parity with the online offering. In other words, if online competition is forcing online sales to be cut then they will have to be reduced in-store as well.
What Next for Pier 1?
A stronger housing market will help sales and I think it is set for a cyclical tailwind to support it. Thinking more long term, I think there maybe better ways to play this theme. Pier 1 is certainly a cheap option but it faces a combination of execution risk in its own internet-based strategy as well increasing competition elsewhere. Investors need to keep an eye out for how the online offering is developing and whether this will have an effect on in-store sales and gross margins. All of which paints a mixed picture but no one said investing as easy!
Given Warren Buffett’s confidence in beating hedge fund returns over time, I thought it would be interesting to take a closer look at the performance of Berkshire Hathaway(NYSE: BRK-A) and discern whether there is an opportunity for investors to try and construct their own mini-hedge fund out of it. The attraction of the question is clear. Buffett is the world’s greatest investor. Surely, if anyone can consistently beat the market, it is him. Moreover, if he can beat the markets (generate alpha) then why doesn’t he just leverage up and hedge Berkshire Hathaway against the index?
Now, I know what you are thinking. Another idiotic financial journalist trying to make a name for himself by peddling another contrived angle on the “Look ma’ I proved Warren Buffett is a lousy investor” theme. And you would be partly right, the idea did tempt me greatly, I confess. However, I think any rational analysis would conclude that Buffett really is that good. He just is.
But I digress, back to the matter at hand.
Buffett vs. the S&P 500
Here is a graph of Berkshire’s per share book value versus the total return on the S&P 500. All data will be based on Berkshire's annual letters. The blue data is Berkshire. The red data is Berkshire’s relative performance against the S&P 500 since 1965. It can be taken as a proxy for the kind of returns that a hedged strategy might have returned.
The first thing to note is that Berkshire has only had two negative years! In comparison, it has failed to beat the index for eight periods within this data. Whilst ultra risk adverse investors would not like the performance of the ‘hedged’ strategy due to the larger amount of drawdowns, others might see the potential upside from greater returns from leverage. It’s time to explore this angle.
Buffett’s Uncorrelated Returns
Hedging using leverage is all well and good, but there is a potentially nasty problem with correlation. Simply put (and it is very easy to put this in difficult language) if you are going to hedge against an index, then you need to be correlated (and co-integrated for that matter) with it. Why?
Because otherwise, we are not actually ‘hedging’ anything! Let’s put it this way -- we are betting on the time difference between Usain Bolt and Tyson Gay in a race. The runner’s times are correlated. They run in the same race. Now consider that we are now betting on the difference in quantum between Usain Bolt’s time and the temperature on an island off Scotland. Two completely different things.
One way to see the relevance of Berkshire’s results relative to the S&P 500 is to perform a regression analysis of the type shown below.
The x-axis represents the yearly return of the S&P 500 whilst the y-axis represents Berkshire’s return for the same year. The key number to note is the R^2 number, which represents how much these returns are correlated. The closer it is to one, the more the correlation. As is evident, Buffett’s numbers are not particularly correlated! This creates a significant problem for a hedged strategy using Berkshire and the index.
What about Leverage?
Having established the problem of correlation, it is time to look at how leverage affects the strategy ... the underlying idea being that hedging is supposed to control volatility. If this is achieved and the strategy has a positive expectation -- with relatively few negative returns -- it could be argued that leverage will allow an investor to maximize returns. With this in mind, here is a range of outcomes for leveraged strategies based on hedging Buffett against the S&P 500.
The graph is quite messy but also very revealing. For example, 4x hedged leverage would have generated the best total return since 1965. However, note the huge drawdowns. I simply do not believe that any investor would not find himself psychologically affected by losing 80% of his money in one year! This is a key point because in order to generate the outperformance that followed, the investor would have to stay with the strategy. I would suggest asking the hedge fund managers that saw huge redemptions in 2008 whether this is a likely occurrence or not!
In addition, there is no late data for 5x because this strategy would have wiped you out in 1999. Furthermore, the ratio of 2.5-3x appears to work, but how on earth is an investor supposed to know this beforehand? The truth is this sort of knowledge is wonderful in hindsight but very difficult to predict at the outset.
Conclusions
The correct conclusion is that Berkshire’s lack of correlation probably makes it impossible to truly hedge with it. The reasons for this quality relate to the specific investment style that Buffett holds. By his own admission, it tends to underperform in strong markets but outperform in weak ones. However, this tendency is not so strongly correlated as to render a hedging strategy to be a foolproof approach.
For the retail investor, Buffett’s performance is an object lesson in what can be achieved with a disciplined long only approach focused on value principles.
This is the second article on some potential technology takeover targets. The first article islinked here).
Weak markets always bring up opportunities and none more so than in the M&A space. Whilst it’s never a good idea to solely buy a stock for its takeover potential, I think that potential acquirers are looking at exactly the same valuations that other investors are. Naturally, their decision is more motivated by strategic concerns, so in this article I’m going to stick to discussing firms on good evaluations and with a key rationale for the acquirer.
To do this properly, we also need to look at who might be doing the acquiring. I’ve identified six names. Their net cash positions and market capitalizations are shown below.
Company
Market Cap ($bn)
Net Cash ($bn)
Microsoft
249
45
Google
189
39.9
Cisco
89.6
32
Oracle
135
14.8
Facebook
57.9
3.1
IBM
225
-18.9
Facebook and Microsoft Go Mobile?
Ever since the Facebook(NASDAQ: FB) IPO took place, analysts have increasingly focused on the question of how Facebook is going to monetize mobile? Google’s acquisition of Motorola Mobility appears to have shown the way, so the press speculation over a similar Facebook move is understandable. All of which, makes Research in Motion(NASDAQ: RIMM) and Nokia(NYSE: NOK) candidates for a bid. I don’t think either company is ideal, but if Zuckerberg is intent on buying a mobile phone company than realistically these are the best options. RIMM would require a significant amount of restructuring and is a brand in decline, but Facebook doesn't strike me as a company with any deficit in belief over its own social appeal.
I think Nokia would be a more interesting buy for Facebook. The Finnish company still has huge appeal in emerging markets and, if Zuckerberg believes he can increase Facebook’s penetration rates by marrying his company with Nokia then a deal could be possible. Another potential buyer for Nokia (or RIMM) is Microsoft(NASDAQ: MSFT). Nokia already runs Windows and, if Nokia continues to suffer, then a Microsoft deal makes sense. Nokia has a lot of cash on the balance sheet so an acquirer maybe convinced it could be restructured by using that cash. Samsung has also been mentioned as a potential acquirer, but they recently issued an official statement saying that the rumours were not true.
Will the Force Always Be With You?
Larry Ellison spooked the tech markets in the winter when Oracle gave weak results and he blamed the macro-environment for the company’s shortfall. Some investors didn’t quite see it like that. I think there is a structural change occurring in the enterprise software market. Cloud based solutions are gaining market share and I would take Oracle’s purchases of RightNow and Taleo as well as SAP’s purchase of SuccessFactors is implicit recognition of this.
Salesforce(NYSE: CRM) has achieved outstanding growth and, given Oracle’s cash and acquisitive nature, it would not stretch the company to buy it. However, Ellison has already responded and set his stall behind the ‘Oracle Cloud.’
Microsoft could also be a potential acquirer, but given that it is a fierce competitor with its Microsoft Dynamics CRM solution, any deal would likely be subject to regulatory scrutiny. Google has even been mentioned but this would be an aggressive foray into business software when Larry Page has enough on his hands with managing the transition to mobile based internet usage.
For now, Salesforce looks safe but should another technology behemoth want to make a move into business software than Salesforce will be the first company it looks at.
Microsoft Gets Sage?
While Salesforce may not be the perfect acquisition for Microsoft, I think another company fits the bill very well. The UK’s Sage is a leading provider of business software to the SMB market. It competes with Intuit and Microsoft in accounting, payroll and tax software. There are two main reasons why I think a deal makes sense.
First, the price is right. Sage generates huge amounts of cash flows (around $440m in free cash flow last year) and with an Enterprise Value (EV) of around $4.82bn and an EV/EBITDA multiple of around 8.5, it is not expensive.
The second reason lies behind the cause of the cheap evaluation. Sage has been left behind by the likes of Intuit in terms of shifting its solutions to the cloud. In fact, Intuit is a wonderful example of what could be achieved by a Sage acquirer. By shifting solutions to SaaS, Intuit has managed to reduce churn rates and lower operating expenses. Margins have got better.
Now why couldn’t Microsoft do this with Sage? I appreciate that Greece was viewed to have had sound finances the first time someone mentioned a Sage/Microsoft deal, but I think this could be the year for this deal. The opportunity to leverage Sage's solutions to the cloud is a big one and they appear to need a hand in doing it.
There are few industries that are less cyclical than the telecom industry. At the top of the pyramid lie the service providers like Verizon(NYSE: VZ) and AT & T(NYSE: T). Their capex plans ultimately drop into the top lines of the equipment providers like Cisco Systems(NASDAQ: CSCO), Alcatel-Lucent or Ciena and then down to the switches and components manufacturers like Finisar(NASDAQ: FNSR) and its chief rival JDS Uniphase (NASDAQ: JDSU).
It was Finisar’s turn on Monday to report numbers and from the results plus commentary, it’s clear that the story is still one of jam tomorrow. So when can we expect the Telcos to start spending and get the cycle going again?
There a few separate answers to this question. Before going into them, it is worth looking at how long this weakness has been persisting. We can see this in Finisar’s Telecom revenues below.
After a strong 2011, it has now been four quarters in a row that Finisar’s telecom revenues are lower on a yearly basis.
What is Happening in Telco Spending?
Telco capex spending tends to be long cycle and involve a significant financial commitment. This means that if the service providers are seeing slowing growth and a weaker macro-economic environment, they will cut back on expenditures for the foreseeable future. Cisco was adamant that it is seeing a broad weakness in Telco spending, largely as a result of Europe and macro-economic issues. Ciena cheered the market, but its stock performance has been more about a relief rally than any definitive evidence of a return to spending.
There is the issue for service providers of committing to a technological platform for its customers. More developed service providers are increasingly being faced with the choice of rolling out a new 4G/LTE network or expanding their existing 3G operations. Whereas in the emerging world while 3G spending remains active, some service providers face the choice of just jumping to 4G/LTE anyway. These sorts of considerations can delay decision making, because the service providers will have a tendency to wait until economic conditions are ripe in order to decide.
Capacity utilization has an obvious effect on spending plans. In terms of their own infrastructure, the carriers are faced with the decision to shift from 10G to 100G and possibly bypass 40G. In addition, when they see that top line growth is slowing there is a tendency to run existing capacity as long as possible before investing. Indeed, the messages have been mixed on this front.
Ciena talked of strength in the 100G market, of which they are particularly well placed, but the news from Finisar was not so positive. Similarly, whilst plenty of surveys and anecdotal evidence are highlighting the strains on load, the equipment manufacturers still haven’t seen a pick up in spending. Service providers seem determined to play ‘wait and see’. But, this can’t last forever.
Lastly, not all Telco spending is determined by corporations. While the key part of US spending is likely to be undertaken by companies like Verizon and AT&T, it is a different story in other parts of the world. Finisar mentioned that China's stimulus spending is hard to predict and I think this stands to reason.
A lot of optimism is being built into the market place in general over China’s ability to spend. However, investors need to consider that China remains a communist country and it is also ridden with corruption. Indeed, the central government is being very cautious over spending because it is not clear how much of it is misallocated or siphoned off by local governments and "fixers."
Whither AT&T and Verizon?
Taking a closer look at what these two companies said in their last outlooks is quite revealing. While companies like Finisar, Ciena and JDS Uniphase are making noise about a stronger second half, there doesn’t appear to be any sign of it yet in what the service providers are saying publicly. In addition, JDS Uniphase may be seeing things a bit better because it was more exposed to Thailand's flooding than Finisar, so its comparables will be easier to beat.
As for the carriers, AT&T guidance is for flat or "slightly more" capex spending this year. Turning to Verizon, here is what was said at the last results presentation:
“Capital expenditures totaled $3.6 billion in the quarter, a decrease of about $800 million compared to last year. Our overall capital efficiency continued to show steady improvement. We expect our annual CapEx-to-revenue ratio to decline for the full year based on improving revenue trends and disciplined capital spending.”
All of which, creates a rather confusing picture. On the one hand, they are being cautious over expenditures because of macro-economic fears, but on the other there are a veritable slew of new devices and applications that are ramping up demand for bandwidth.
Long-term demand for video and photo-rich applications is increasingly strong and, as noted earlier, the strains are starting to show. I happen to take the view that it is a question of when and not if there is a return to spending. These are secular demand trends and as smart phone penetration rates increase, the pressure on existing capacity is only going to build.
Time to Invest?
As ever, timing is critical in investing. It is very hard to pick a bottom in cycles. Anyone who tries should expect turbulence along the way. The key thing is that carrier spending has been sluggish for a while and there are the technological changes that are causing some delays in expenditure. However demand has been increasing and customer churn will only increase if carriers aren’t able to satisfy customer bandwidth requirements.
Given a resolution to the current macro worries over European sovereign debt, the sector could start to see a resumption of spending, but I think a cautious investor would wait until Verizon or AT&T starts confirming an increase in investment in their public statements. The biggest advantage that a private investor has is patience.
Weak markets always bring up opportunities, and none more so than in the M&A space. While it’s never a good idea to buy a stock solely for its takeover potential, I think that potential acquirers are looking at exactly the same valuations that other investors are. Although naturally, their decision is motivated more by strategic concerns, so in this article I’m going to stick to discussing firms on good evaluations and with a key rationale for the acquirer. If you like the stock anyway, then some takeover possibility adds some spice.
To do this properly, we need to look at who might be doing the acquiring. I’ve identified six names. Their net cash positions and market capitalizations are shown below.
Company
Market Cap ($bn)
Net Cash ($bn)
Microsoft
249
45
Google
189
39.9
Cisco
89.6
32
Oracle
135
14.8
Facebook
57.9
3.1
IBM
225
-18.9
This article will focus on Cisco, IBM and Oracle. I will submit a future article concerning the others in due course.
NetApp a Good Net Add?
According to IDC Storage Tracker, NetApp (Nasdaq: NTAP) is the third largest player in the external disk storage market. It has a low-teens market share, compared with mid-teens for IBM (NYSE: IBM) and nearly 30% for EMC. Hewlett Packard and Hitachi are hovering above and below the 10% market share mark, respectively.
The stock is a perennial target for takeover speculation and its troubles over the last year have made the stock cheap on traditional metrics. NetApp trades on an EV/Ebitda multiple of 6.5 and a forward PE of 14.6, but that is half the story. It has a market cap of $11bn and net cash of $4.14bn, so if it generates similar free cash flow to last year –around $1.1bn -- any company buying NetApp would effectively get it for $5.76bn or around half the current market cap. In other words, it would be on a forward PE of 7.6 if you took out the cash. Not bad at all.
The downside is that the company recently gave poor guidance and talked of a lack of visibility. It may well be losing market share to EMC and IBM. With regards to acquirers, I think IBM is the most likely. It would immediately push its market up to close to EMC and it’s in a market place that IBM knows very well. Market consolidation is usually a good thing for margins and a deal would make sense. Cisco Systems(NASDAQ: CSCO) is also a possibility as it’s a longtime partner of NetApp. Oracle(NASDAQ: ORCL) could also be in the hunt because much of NetApp’s business is in storing Oracle’s database data.
A fast Growing Network Play
F5 Networks(NASDAQ: FFIV) has 47% of the market share for Application Delivery Controllers, which are devices in the data center that help corporations optimize the delivery of applications across the network. With the increasing demands on networks coupled with the possibility of huge unexpected spikes in usage, its products are seeing strong demand. Video rich applications require much more bandwidth and no corporation likes to see its website down or its network applications not functioning properly. The company competes with the likes of Citrix Systems and Radware and is doing well so far this year.
Cisco also competes in this marketplace, but it chooses to bundle its Application Control Engine into its data-center and WebEx solutions. These are actually two of Cisco’s fastest growing solutions. The implication is clear. With a market cap $8.1bn a $490m in net cash, F5 is easily affordable for Cisco and it could be an acquisition that immediately generates synergies and strengthens Cisco’s position in a key growth area.
Another potential acquirer could be IBM. It is already a partner of F5 in offering network performance optimization solutions. Moreover, F5 CEO John McAdam formerly worked at IBM after his company was sold to it 1999. Whilst IBM does have debt, it has averaged $16.1bn in free cash flow over the last three years. A deal for F5 would not stretch its balance sheet and buying a company forecast to grow revenues at 20% for the next two years is a good way to get growth at a reasonable price.
Brocade Finally Finding a Buyer?
Next up is Brocade Communications Systems(NASDAQ: BRCD), a network solutions provider that is a constant source of takeover speculation. Dell is believed to have taken a good look at it previously, and Oracle is often mentioned as being a potential acquirer. A deal for Oracle would give Oracle a complementary networking product. However, one problem would be that a lot of Brocade’s switches for data storage solutions are sold through the likes of Hewlett Packard, Oracle and IBM. If any of these companies bought Brocade, they might have an issue selling to a rival company in future. I suspect this means that Cisco could be the most likely acquirer. Other potential acquirers include Hitachi or even Chinese giant Huawei.
Cisco is being increasingly challenged within its core switches and routers divisions by companies such as Huawei. So as part of a drive to restructure and return to its core business, purchasing Brocade would make sense. The company trades on an EV/Ebitda multiple of just 5.3 and it tends to throw off cash. It is also widely believed to be up for sale and the current market weakness has only made the price cheaper. Well worth a look.
In an earlier article linked here I looked at the European situation and, why it mattered to investors. In this article I will focus on Greece and the forthcoming elections.
US investors may think that US companes are immune but, unfortunately, this is not the case. Europe is significant and, the events in the forthcoming Greek elections will affect Europe. A hard default by Greece would cause significant issues for the European banking sector and the economy, and then ultimately the US.
For example, McDonald’s(NYSE: MCD) generates more than 40% of its revenues from Europe. For Apple(NASDAQ: AAPL), it's 24%, but Europe generated 46% revenue growth for the company on a yearly basis. Europe is obviously a key area for General Electric(NYSE: GE) and it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. As for Coca Cola(NYSE: KO), in the last quarter, it generated more profits from its Europe segment than it did fromNorth America! Merck(NYSE: MRK) generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics.
So What is Happening in Greece and Who is Syriza?
The party (Syriza) that is growing in strength ahead of the election is a collection of disparate left wing entities that advocates such half-baked policies as halting privitizations, nationalising the banks, implementing a gradual increase in corporate taxes to 45%, not a single public sector worker is intended to be sacked and, the bailout packages are to be renegotiated after the election.
Syriza does not want to implement reforms, on the contrary it wants to roll back pension and wage cuts, and it wants to stimulate growth inGreecevia infrastructural investment. Oh and, one more thing. It wants the funding to come from the EU!
Most polls have New Democracy (ND) at 23-26% with Syriza at 20-23% and the formerly ruling PASOK at 12-14% with the rest being an assortment of Communists, Greens, the Far Right and Greek Independency candidates.
I think there are two key takeaways from this.
Greece will vote to stay in the Euro (all three leading parties want to stay in) and it will vote to renegotiate the bailout package. The flexibility from the EU-IMF is probably there in order to agree some negotiation.
The new Government -whether it includes Syriza or not- will be under heavy pressure not to agree to certain structural reforms in the package and even if it does, these reforms will come up against fierce resistance when the time comes to implement them.
It is worth noting that the head of the ND party, Antonis Samaras, has been a thorn in the side of PASOK’s attempts to implement reforms. He fought every single austerity package. He quarrelled with the EU over supporting the implementation of the current package. And this is the guy that the EU are hoping is going to implement the future reforms! In addition, he is supposed to do it in the face of Syriza in parliament and, against significant and increasingly violent, social unrest. A tall order.
Why Does Greece Matter?
Greece matters because if it defaults on its debt in a disorderly way, the knock on effects on the European banking system are significant. It could cause a collapse in confidence in the EuroZone. In fact, the Greek politicians know this and, it has been their main negotiating tool in extracting loans and political concessions from the EU. A disorderly default would hurt everybody so whilst this threat hangs over Europe, there will be uncertainty. Unfortunately, markets and CEOs do not like uncertainty and, growth is being impaired inEuropeas a consequence.
The threat of a disorderly default comes from a political move by Greece after the election (not likely now), or a future move caused by an economic collapse from a bank run (possible), or significant social unrest and political instability caused by recession and ongoing friction with the EU (possible).
Note the US potential exposure and, the direct exposure of French banks. Ever wondered why the new French President was so keen on trying to get Eurobonds implemented?
What Happens After the Elections?
I have four scenarios.
History suggests the following sequence of events. A bailout package will be renegotiated. Markets might like this and go back to ‘risk-on’ for a while. Meanwhile, the structural reforms will not be implemented, because Greece’s polity neither believes in the reform program nor feels it was elected to enact it. There will be more social upheaval and unrest in Greece. The possibility of a major bank run will ensue (Greece already has a strange kind of slow motion bank run in place) and, the odds of a hard default will increase.
Alternatively, the EuroZone could decide that the risk of keeping Greece in outweighs the risk of removing them from the Euro. It could ‘force ’Greece into an orderly default, then write down the debt and recapitalise the ECB from the losses on its balance sheet caused by Greece. Then it might engage in liquidity measures so it can recapitalise its banks and, reiterate support for Portugal and Ireland. Such a bold and aggressive move could remove uncertainty over a Greek disorderly default, improve sentiment and, jump start business confidence in Europe. Moreover, the voluntary private sector haircuts have already reduced some of the impact of a Greek default so the EuroZone may feel that now is the right time to do this.
The third outcome is a messy process of an indecisive election, followed by continual upheaval and uncertainty. This could hasten the application of my second scenario or it could exacerbate the problems inherent in pursuing the first.
The fourth scenario involves an extension of the terms, a successful implementation of the reform program, a period of political stability followed by a resumption of growth and a return of market confidence. I have little faith in this outcome!
Frankly, I would prefer the second option to be enacted but consider the first more likely. It is time for bold action and, it also time for the Greek people to have a viable option in front of them rather than be promised unrealistic outcomes by deluded politicians
Verint Systems(NASDAQ: VRNT) gave results recently and demonstrated that tech is not quite dead yet!
The sector has been horribly beaten down by fears over Europe and whilst those fears are real, they haven’t shown up yet in companies like Verint. Everybody knew that this year was going to be tough in Europe, but so far, most companies haven’t reported a significant slowdown. All of which leads me to conclude that if the European problems can be dealt with in a more comprehensive fashion, there is upside in technology stocks like Verint Systems.
Verint Systems Results
Verint beat revenue and EPS estimates. A quick summary.
Non-GAAP revenues of $200m vs. estimates of $196.4m
Non-GAAP EPS of 53c vs. estimates of 49c
Full year revenue guidance unchanged at $860-880m vs. estimates of $871m
Full year EPS guidance of $2.55-2.70 vs. estimates of $2.64
It is a pretty good "beat," but Verint kept full year guidance unchanged and cited concerns over the macro-economic environment as the cause of the reluctance to raise them. Turning to the next quarter, management forecast a "modest sequential increase in revenues." I note that analysts are forecasting a 6.5% sequential rise to $213m and I’m not sure if this tallies with what Verint means by modest. No matter, these are good results and they mirror what rival Nice Systems(NASDAQ: NICE) said in May. Verint’s gross margins declined but this is mainly due to the product mix, which can shift around for these types of companies.
Verint achieved growth in all territories but the particular strength was in the US.
($m)
Q1 2011
Q1 2012
% of Q1 2012 Total
US
88
105
52.5%
Europe
47
50
25%
APAC
42
45
22.5%
Europe’s performance was described as mixed -- a familiar refrain from conference calls -- which highlights that not all companies are seeing the kind of broad-based weakness that Cisco Systems(NASDAQ: CSCO) referred to earlier in the reporting season. Similarly, other companies like NetApp(NASDAQ: NTAP) have been severely sold off after investors reacted to weak guidance and questioned its European growth prospects.
In addition, NetApp -- in common with Verint -- has the financial sector as a key industry vertical. NetApp suggested this vertical could be weak in future. We shall see.
Financials are also a key vertical for F5 Networks(NASDAQ: FFIV), a stock that has also been sold off, despite giving upbeat guidance in the last results! Doubts about F5 Networks stemmed from the loss of a board member and the Executive VP of Worldwide Sales. However, the former probably left because he has cancer and the latter left for a more senior position at another leading US technology company.
With regards to Verint and the financial sector, the results were fine and management did not specify any current weakness. All of this augers well for the companies mentioned above, although management did mention that deals were taking somewhat longer to close.
Reasons to Like Verint
I like the sector that Verint and chief rival Nice Systems are playing in. Their end demand is driven by regulatory and compliance drivers, as well as the need for companies to analyze customer interactions. Essentially, they sell enterprise intelligence solutions, which help corporations monitor customer interactions and optimize workflow. Verint is seeing its deal size increase over time, as customers are taking advantage of its increasingly broader product offerings. For example, previously a customer might have bought a data capture solution (video or voice recording), but now they are also buying data analytical solutions as well.
A breakdown of segmental revenues demonstrates how enterprise (including workflow and analytics) solutions are growing whilst pure video intelligence seems to be stagnating. Communications intelligence is growing strongly too.
Verint’s product applications are varied and cross many industry sectors. In financial services, Verint helps banks monitor branch activity, financial transactions and ATM fraud. Government is also a key vertical, with transportation security being a major issue. Simply put, expenditure on the need to monitor and analyze data in border controls and transit hubs is not something that governments can really cut back on significantly.
Similarly, in the retail sector, even if top line growth is hard to generate, retailers can increase margins by reducing theft and managing customer behavior. Verint helps them do this by capturing and monitoring customer behavior and allowing them to model how shoppers behave in their stores.
What Next for Verint?
I’ve always preferred Nice Systems to Verint because it has been far better at converting profits into cash flow. However, Verint has made great strides to improve this and cash conversion seems to be on the rise. Indeed, management said that cash flow was likely to rise in line with operating earnings in the near future. Longer term, Verint has a nascent cyber security solution, which it hopes will close deals in the second half and then contribute to revenues next year. Revenue and EPS growth are forecast to grow by close to 10% over the next two years.
Whilst the stock is not immune from macro-economic uncertainty, investors will want to take a close look at it because with a forward PE of 11, good cash flow generation and decent growth prospects, it could outperform, given a resolution to the current round of macro fears.
A financial analyst hit the mainstream headlines recently when he declared that Facebook (NASDAQ: FB) could disappear in 5-8 years, in a similar manner to how Yahoo! (NASDAQ: YHOO) has declined. It is a bold claim but is it grounded in reality? I happen to think it is.
Time and time again, we have seen the pace of technological change leave behind companies that were once seen as insurmountably dominant. In addition, Facebook’s challenges are already apparent with its inability to outline a coherent strategy for monetizing the trend to mobile, but I think it is also susceptible to an absolute decline in popularity.
Myspace or Messy Space?
For example look at rival social networking site Myspace. The company was bought in 2005 for $580m by Rupert Murdoch’s News Corp. It still kept on growing and, Murdoch must have thought he was onto a winner. Just six years later, eclipsed by the rise of Facebook, it was sold for $35m.
All the usual arguments about user longevity and loyalty would have been used to defend Myspace in 2005. The truth is that Myspace and Facebook have user generated content and it tends to be very topical. I doubt anyone goes on Facebook in order to see how someone or other, might have replied to a post somebody else put up in 2008. In other words, when users stop generating content, the site quickly loses popularity. In Myspace’s case it was simply due to Facebook having a better interface and, having less freedom to customize the page. Facebook kept things simple.
Facebook should take heed. Myspace had a dominant position but within a few years, it disappeared thanks to a rival doing the same thing, but better.
Friend’s Reunited
Another warning should come from the, once wildly popular, British site Friends Reunited. It was launched in 2000 and, by 2005 had 15m members. It was then sold to British television company ITV for £120m plus earn-outs. Just four years later it was sold on again for just £25m. It’s new owners now value the site at £5.2m.
In many ways Friends Reunited had a key jump on Facebook. It was a site based on reuniting school friends and was able to tap into pre-existing relationships that users had at school. This creates instant familiarity and the site was hugely popular. Unfortunately, its owners were very short sighted. The ability to interact was very limited and, users were forced to pay for usage. This meant that content growth would be limited and, despite the site’s natural advantages, users began to turn away in droves.
The lesson is that the decision to act and monetize a site has to be made with a delicate understanding of the effects of the consequences of this action. Friends Reunited failed because its desire to make money alienated the desire of its users to interact with the site. Facebook needs to be careful not to do the same thing, especially via its privacy issues. Companies like Zynga (NASDAQ: ZNGA) may generate revenues on Facebook, but there is a limit to how much FarmVille can be put in users faces.
Lastminute.com
This was the UK’s ecommerce champion. It essentially morphed into a standard travel site but was initially a kind of ‘concept’ website. The idea being that subscribers would receive daily emails with suggestions for ‘lastminute’ vacation offers. The idea was fatally flawed on the back of the fact that ‘lastminute’ implies a discounted deal. This is fine but when customers are expecting a discount with a few clicks of a mouse they might find a cheaper option so ultimately lastminute purchases will always be viewed as a discount option and nothing else. However, its founders were well connected and it was the dotcom boom. They got backing.
The company floated in 2000 with a value of £571m. Five years later it was sold for a similar amount, but the shareholders who bought in the IPO lost half their money due to the constant acquisitions that led to their equity being diluted. Moreover, the company had never reported a profit until it was taken over. The two founders –unlike so many other ecommerce pioneers- have not gone on to lead any other significant company. This speaks volumes for their abilities.
There was nothing special about lastminute or its tediously PR savvy management. They were just in the right place at the right time, with the right backers. If you throw enough money at setting up a travel site at the right time, it will work. Facebook need to understand this, because trends change and, the good fortune that Zuckerberg has had may not last.
Google+
Whilst still a junior player, Google (NASDAQ: GOOG) has a social network which will prove to be a serious impediment to growth for Facebook. Should Zuckerberg try and excessively monetize Facebook, users may get suitably irritated to shift to Google+. Similarly, the more that user ire is roused via Facebook’s privacy policies, the more Google+ comes into focus. The integration with Youtube and Google search, is seamless and I can see Google+ gathering strength.
There is no reason why users should be intrinsically loyal to Facebook. After all, it is really just a template to get an online presence for free and swap pictures with you friends. As we have seen above, fashions can change quickly and, plenty of others have fallen by the wayside when they haven’t adjusted to changes or they alienated users via attempts to monetize someone else’s social life.
With markets being moved around by Europe, I thought it would be helpful to give a brief summation of what investors should expect from Europe in the coming weeks. One key date is the Greek election on June 17. At this point, I suspect many US investors will be scratching their heads and wondering why a country with such a tiny portion of global GDP has such an effect? The answer is that Greece affects Europe and Europe affects the world.
Companies like General Electric (NYSE: GE), Apple(NASDAQ: AAPL) and McDonald’s(NYSE: MCD) are all multinationals with significant European exposure, but the risk doesn’t stop there. Even if US companies do not have large direct exposure, the knock-on effects of a financial crisis in the European banking sector will be felt by the US banking sector. The traditional safe havens of healthcare and consumer stables are unlikely to work well either. Buying Coca Cola (NYSE: KO)or Merck(NYSE: MRK) may give the appearance of safety, but hard pressed consumers cut back on soft drinks and snacks in a recession, and indebted Governments will do anything they can to cut health care spending.
For example, McDonald’s generates more than 40% of its revenues from Europe. The same figure is 24% for Apple, but Europe generated 46% revenue growth for the company on a yearly basis. Europe is obviously a key area for GE and, it actually cited the ‘European sovereign debt situation’ in its caution regarding forward looking statements. As for Coca Cola, in the last quarter, it generated more profits from its Europe segment than it did from North America! Merck generates 30% of its sales from EMEA, but any slowdown will also hurt margins as medical bodies will not be keen to spend or may accelerate plans to buy generics.
What is the Problem?
I have a more detailed analysis of the debt problems in an article linked here. However, a simplistic graphical depiction summarizes the issue quite well.
These projections are from the IMF, with the Greek number coming from an OECD estimate. The problem countries are the so-called ‘PIIGS’. Spain may seem ok, but it has a major problem with its collapsing housing market putting pressure on its banking system. Spain’s debt load will inevitably increase as it takes on loans in order to recapitalize its banks.
We can see what the market thinks, by way of looking at the yields on 10 year Government Debt.
For now, we need to understand that Greece, Portugal and Ireland are not financing themselves in the open market.
How are Greece, Ireland and Portugal Surviving?
The EU-IMF are giving loans in order to buy time for them to make the structural reforms necessary so they can get back to a sustainable debt path. The problems are structural so the solution must be structural. As such, the EU-IMF monitors performance on an ongoing basis and releases bailout installments on a conditional basis. It is hurting.
There is simply no way around the fact that cutting public sector wages and employment, whilst attacking entrenched self interests is going to cause a significant amount of social tension. Especially in such an anemic growth environment.
The report card on these countries will probably see a positive rating for Ireland, a cautious thumbs-up for Portugal and, then there is Greece. The Irish made their adjustments swiftly and in a disciplined manner, including a large scale recapitalization of its banks at the cost of racking up more debt. No matter, they are following the program. As for Portugal, they passed a recent mission review and the EU-IMF summarized position thus
“The program remains on track amidst continued challenges. The authorities are implementing the reform policies broadly as planned and external adjustment is proceeding faster than expected... ...the authorities are determined to stay the course of adjustment and reform. Broad-based political support and social consensus is a key contribution to a successful adjustment.”
So whilst Portugal’s situation is precarious and, somewhat dependent on economic developments, the country is making the required structural reforms.
What About Greece?
Greece is not achieving what Ireland or Portugal has been able to do. The reasons for this are myriad but mainly relate to the political structure of Greece. Despite having voluntary debt write downs organized for them and ongoing support, nothing has worked. Whatever the underlying reasons for this, the conclusions are still the same.Greece has not been able, or willing, to make sufficient structural reforms. Nor has it adequately responded to the continual requests from the IMF that it find a way to collect taxes from its wealthy.
When asked about the risks to the EU-IMF program, the mission head Poul Thomsen, identified structural reform.
“to get the recovery going we need to get a strong impulse from productivity-boosting reforms and failure to launch such reforms could indeed mean that we will not get to this sort of inflection point where it starts going up any time soon, but that the economy will continue to trend down for longer than expected.”
He then specified reform of the public sector.
“if there is failure to undertake strong structural reforms inside the public sector, I cannot see how the deficit can go down without structural reforms. There are no more, as I’ve said before, low-hanging fruit, no more easy adjustment. Fiscal adjustment needs to be underpinned by fiscal structural reform.”
And this is where it gets tricky.
It is hard to implement significant public sector reforms when the economy is doing well, but when it is in freefall, it becomes nigh on impossible. Again, I don’t seek to apportion blame. I’m just telling it how it is. There is significant resistance to reform in Greece.
It's All About Greece, For Now
In conclusion, having isolated the immediate problem to Greece (although Spain too has significant issues) it is now time to look specifically at what is going on there and, potential outcomes in the upcoming elections on June 17th. I will do this, shortly, in a forthcoming article.
The downgrades to China’s growth expectations have hit commodities hard and I think this is creating potential for some upside surprise to certain sectors in the developed world. The good news is that analysts rarely make big macro calls in their estimates, so I think there is a good possibility that their forecasts will prove too low.
It’s time to have a look at some stocks that could be set to benefit. Ultimately, I’m looking for stocks with substantial commodity input costs but, whose end demand will not be affected by the cyclical factors that are causing commodities to fall.
To put this argument into context, let’s have a look that the US ISM manufacturing prices paid data.
May saw a dramatic drop off but might this be a one-off event -- similar to the data in the fall of 2011? I doubt it. Here is the Thomson/Reuters Jefferies CRB Index.
The decline is clear and both graphs correlate, so which sectors are set to benefit?
Consumer Packaging
Investors like the consumer staples sector for its defensive characteristics, but why not look at the companies that package the goods? For example, Ball Corp(NYSE: BLL) is a major manufacturer of beverage, food and aerosol cans.
What makes this sector attractive is that the likes of Ball and UK rival Rexam tend to build their plants near their customers in order to capture long-term manufacturing contracts. Given that their end customers have relatively stable end demand, this gives the packaging companies a lot of revenue visibility. However, it does leave them exposed to any major slowdown as they would have already committed to capital expenditures. Also, they are exposed to commodity costs, which in this case, is the good news!
Now I know, these companies all argue that they hedge their input costs. They also argue that they are not exposed because they pass on costs in the contracts to the customer. Both of which are worthy arguments. However, I have never seen a company of this type effectively hedge commodity costs. Hedging costs money and as it gets more expensive, the more the commodity goes up. Moreover, when commodity prices rise, even if the input cost is passed on to the client, his customers will cut back on volumes because of raised prices. This is a negative cycle when input costs rise, but a virtuous cycle when they fall.
Since we are hoping for the latter, I think consumer packaging is worth a look. With regards to Ball Corp, investors may want to investigate its emerging market growth prospects. China’s housing market may be in trouble but I doubt the growth in soft drink consumption is going away anytime soon.
Food Companies
Investors should be looking at a traditionally safe haven of food. The sector has been hit with rising prices over the last few years and with changing consumer trends that have seen established brands losing share to private label. Kraft is worth a look because I think the split will create synergies that will allow snacks to generate growth.
For a purer play on this theme, I think General Mills(NYSE: GIS) is attractive. The company reported 10-11% input cost inflation in the last quarter and margins were under pressure. This suggests that when costs fall, it can expand profitability significantly. Whilst the cereal market is difficult, much of this is due to sharply increased corn prices, which are now moderating. In addition, it has made the right move in diversifying with the Yoplait yogurt acquisition. The dividend will attract income seekers and its management has a good track record of execution.
Consumer Goods
This is an obvious port of call for this theme. Not only is this sector exposed to raw material input prices but also to energy prices within production line costs. The usual suspects are well known. Kimberly-Clark, Procter & Gamble, Unilever etc.
I like Colgate-Palmolive(NYSE: CL). It is not the sexiest of stocks, but it has single digit earnings growth forecast and generates very strong cash flows. It offers security given a protracted slowdown in the global economy and has upside potential if commodity prices keep falling. Moreover, Colgate has growth initiatives with products like ‘Optic White’ toothpaste and is increasingly exposed to emerging market consumer demand.
Big Box Retailers and Transportation
The last two sectors are volume based retailers and transportation companies. I don’t want to dwell too long on the big box retailers because they were covered in an earlier article. Suffice to mention that recent sales figures from companies like Wal-Mart and Target(NYSE: TGT) have been at the high end of expected ranges. Target reported strong comparable sales numbers for May. Moreover, as fuel costs decline, more discretionary income will be in the hands of consumers. Revenues should then shift to higher margin sales and, the warehouse retailers should see some margin expansion from lower costs as well as cheaper input prices.
Similarly, with regards to transportation companies like UPS(NYSE: UPS) or FedEx, a major part of their cost base will be in fuel costs. Granted, the slowdown in the economy will create downward pressure on their revenues, but UPS has a growing ecommerce exposure. This is a trend that appears to be accelerating in a tough economic environment as customers value the cost savings in buying online. Also, the dividend is attractive for income seekers that want GDP style growth, but more yield than a Treasury.
Friday saw a very poor non-farm payrolls report and, equity markets had their worst day of the year. Whilst it is hard to argue against a payrolls report that saw the three month average gain go down to an anaemic 96k, it is worth pointing out how incongruent these numbers were with every other employment indicator out there. Unfortunately, the market doesn’t form its view of US employment from a multitude of sources. Instead, it just follows non-farm payrolls. This could be a mistake.
Not only were these numberrs out of line with other economic reports, I think, it is also running contrary to anecdotal evidence of increasing hiring among major firms. For example, US auto sales are very strong at the moment and Ford(NYSE: F) announced that it was going to produce an additional 40,000 cars in the summer by reducing its summer shut down at 6 plants. Chrysler is also planning to increase production.
Turning to technology, cloud computing companies like Equinix(NASDAQ: EQIX) and Rackspace(NYSE: RAX) have also been ramping up capital expenditures and hiring activities. In fact, Rackspace was criticized by some for hiring too much in the last quarter. Amazon(NASDAQ: AMZN) has been aggressively hiring too, and lets recall that online business is more than just a virtual presence. It requires logistics, warehousing and shipping. Hiring appears to be broad based with AT & T(NYSE: T) , Wells Fargo and AIG all making significant hiring plans this year.
So why wasn't this seen in the non farm numbers?
Non-Farm Payrolls, the Best Measure?
The non-farm numbers certainly took the market by surprise and here is why. Firstly, the private component of the non-farm numbers was noticeably weaker than the ADP numbers were a few days earlier
Secondly, whilst the Total non-farm numbers were weak, with a gain of 69k, the household survey recorded an increase of 442k! In fact, according to the Household Survey the US has already added close to the entire number of hires for 2011!
Moreover, it looks like we are in one of those periods where the non farm payrolls numbers do not correlate with what survey’s, like the ISM, are reporting.
Most puzzling of all, the non farm payrolls recorded a 28k drop in construction employment when most evidence suggests that US construction activity was picking up in May. Granted, it was an unusually mild winter in the US so a lot of activity and hiring was brought forward, but it’s hard to see how that accounts for a drop of that magnitude.
In addition, the Conference Board Employment Trend Index improved in April and here is what their Director said:
“We did not expect employment growth in December to February, averaging almost 250,000 a month, to continue. However, the disappointing job gain in April (115,000) is probably below the current trend and should pick up to about 150,000-175,000 jobs a month through the summer.”
It was a similar story from the National Federation of Independent Business (NFIB) where April saw a net 5% increase in small businesses hiring plans for the next three months. And finally, the American Staffing Association (ASA) index reached a year high of 94 which is also the highest rate at this time of year since 2008.
So What Went Wrong?
I suspect the answer is not much. The mild weather probably brought forward hiring plans for the year and has front end loaded certain companies hiring plans. The average non farm payroll number for 2012 is around 164k against 153k for the whole of 2011.
I also suspect that a lot of small business hiring goes under the radar of the official surveys initially and that the Household Survey probably captures more small business hiring than the payrolls data does. In addition, with continued high levels of unemployment, it is likely that firms will find it easier to hire temporary staff rather than commit to full time staff. We are seeing that in the strength of the ASA numbers which indicate robust hiring.
On a more worrying note, it is undoubtedly true that firms will respond to uncertain macro economic events by holding back full time hiring. And we are not short of events to worry about at the moment. The growing realization that China and the other BRICs are facing slowing growth coupled with lingering uncertainty over Greece’s role in the Euro do seem to be creating negative sentiment towards investment in Europe and the US.
It is simply too important to ignore the consequences of these issues, but it is also too soon to write off the idea that the US will continue to generate employment and jobs this year. I suspect these numbers will be revised upwards in due course. The non farm payroll data is a notoriously unreliable indicator of employment and is always subject to substantive revisions.
One of the great imponderables in investing is when to buy a cyclical? The usual advice is to buy when its PE is high or when gross margins have troughed or some other quantitative "rule of thumb" measure. Very rarely is the question asked as to whether the stock is really a cyclical or not. I raise this question in looking at mining equipment supplier Joy Global(NYSE: JOY). The stock is always seen as a classical cyclical, but why should its end demand drivers be necessarily cyclical and why should the cycles be of the same magnitude?
As the reader has probably worked out by now, I think that there is a case against such thinking. Simply put, Joy Global’s principal end market drivers have been the demand for copper and coal. Along with Caterpillar(NYSE: CAT) and Deere & Company(NYSE: DE) it was a darling of the hedge fund industry’s fixation with all things China and commodity related. I recall these stocks notably outperforming the broader markets throughout most of 2008 as commodities surged in the first half of the year, only to then crash as the markets spiraled into chaos in the autumn of 2008. Then as the global economy and the stock market recovered in the spring of 2009, they outperformed again.
However, last year has been a period of marked underperformance.
So is the cyclical about to turn?
Understanding the Commodity Cycle
Markets do have a way of moving prices before earnings movements and they did it again with Joy Global. Although the recent results beat estimates on both the bottom top line, the immediate outlook was not good. Bookings were down a whooping 34% from a year ago and also negative on a sequential basis. New order bookings for surface mining equipment were down 20% and underground mining equipment bookings were down 38%. This led to the legacy backlog being reduced to $2.8bn from $3.3bn in the last quarter.
In addition, the company removed $119m in underground equipment backlog scheduled for the US as it believed that there was a risk of deferral or cancellation. Not good.
Essentially, there are two problems here. The North American coal market and emerging market demand.
US Shale Gas
Shale gas drilling has reduced relative demand for coal as an energy source. This is a structural change in the marketplace and I don’t think that it is going to reverse anytime soon. Indeed, the more applications that are created to take advantage of cheap natural gas prices, the more long term demand there will be for gas.
Furthermore, the US desire for self sufficiency in energy provision is also a key driver, especially when compared with a source like coal, which is perceived as a "dirty" energy source. Joy Global’s hope is that the export industry will drive US production, but this too is questionable. Not only is China’s electricity usage growth slowing as the economy cools down, but steel demand is likely to slow as well.
It is a similar story with Peabody Energy(NYSE: BTU), which recently lowered US production targets in response to lower demand. In order to see the effects of this, I’ve pulled out some data from the Association of American Railroads. This is useful because it provides a good barometer of how US coal production is faring.
The decline appears to have set in, even before this year’s weaker growth and mild winter.
BRIC Demand Slowing?
Interestingly, Joy Global thinks that the risk to demand for copper, coal and iron ore as being on the upside. I’m not so sure. BHP Billiton(NYSE: BHP) has already talked about demand for iron ore flattening out as China’s growth cools down.
The marginal increase in demand for these commodities has been coming from China and the other BRICs. However, there are clear signs that China’s property market (both residential and commercial) is slowing. Prices are negative on a yearly basis and commercial floor space sold is falling in China. All of which suggests that, despite steel production back on tap in China, future demand will slow.
The market feels that, given a slowing economy, China will use its huge foreign currency reserves to start launching infrastructural projects in order to stimulate demand and job growth. This may well be true -- why should it be in areas that already have over capacity? After all, the solution to the economic problems in the US was not to build more housing!
Joy Global Not so Cyclical After All?
All of which suggests that investors should not look at Joy Global as just being a cyclical that they can pile into as a contrarian play. All cycles are different and I think there are some challenges here that might cause a longer, flatter pattern of recovery. Also, it is far from clear that we are anywhere near a trough in terms of orders or demand for its particular demand drivers.
There is plenty of time to get into the stock. Joy Global’s cycle will turn again at some point but, right now, there are plenty of unknowns and potential investors might want to see how China’s stimulus spending is going to be allocated before getting too excited.
A decent set of results from Ciena (NASDAQ: CIEN) sent the stock racing higher amidst another down day for the market. In fact, what was really surprising about these results was that they were surprising. Well, at least to the market!
Ever since Cisco Systems (NASDAQ: CSCO) reported a weak set of results and guidance, the short sellers have been out in force with regards to many technology stocks. However, all Ciena had to do was generate a decent beat (which is not unusual for a company with such lumpy revenues) and give guidance of which the mid-point implies flat sequential revenue, and the stock was up 14%.
I think we have a rather odd situation in the marketplace right now. Cisco’s conference call murdered sentiment toward the technology sector. At the same time, we see the odd fund manager talking about a stock like Danone being a safe haven. Of course, Danone has heavy exposure to Spain. So, would you rather buy a food company exposed to an economy in recession or a technology company (with minimal southern European sales) exposed to secular growth trends like, mobile, bandwidth usage or cloud computing? Go figure.
Ciena Dancing through the Gloom
A lot of short sellers got burnt in Ciena's post earnings reaction and this could be a sign of things to come. Current expectations are so low for technology that the risk is on the upside. Taking Ciena as an example, some analysts were talking about lowering their full-year estimates after these results. Gross margins came in lower than expected at 39.6% when the company is aiming to hit a number in the 40s. Moreover, there were some concerns about declining switching revenues. Essentially, the two issues are linked because switching products tend to have higher margin than transport.
No matter. These results were good enough.
Ciena spoke confidently about an overall pickup in the second half and made reference to service providers’ willingness to migrate to 100G networks. This confirms what telecom testing equipment provider Ixia (NASDAQ: XXIA) said earlier this year, so both sets of investors should be feeling better about the outlook now. It’s a particularly good trend for Ciena because it is believed to hold an 85% share of the 100G optical transmission gear market. Cisco actually gave good numbers for switching in the last quarter but perhaps its weak guidance is a consequence of a relatively weaker positioning in the 100G marketplace?
With regards to Ciena’s guidance, the company guided Q3 revenues to be $455-485 million. The mid-point of this is close to the analyst consensus of $470 million. Like I said, these results were nothing spectacular.
Macro-Environment
Investors should be looking for a second half pickup in switching with Ciena. As for the macro-environment, management talked of emerging market opportunities and strength in North America counteracting softness in Europe. Quoting from the conference call…
“While not significantly better or worse than we've seen in recent quarters… ...increasing opportunities in Latin America, Asia Pacific, the Middle East and especially North America… …helping offset the lingering softness in Europe… …the macro climate may be affecting overall CapEx spend, we continue to see, as we've said in previous quarters, that customers are shifting a greater percentage of their CapEx towards next-gen solutions”
Unfortunately, today’s Euro Zone PMI data did nothing to dispel fears that Europe is heading for a protracted contraction and the ongoing crisis in Greece continues to damage business sentiment. Investors should be mindful of the risk in these events but they should also be aware of the rewards!
A successful resolution to Greece -- which could involve a Euro Zone exit -- is likely to see a release of pent up investment demand in Europe. If so, Ciena could see some upside from its current targets.
Ciena’s Stock Sharply Higher
In conclusion, Ciena gave a decent set of results but nothing spectacular. Sure, they beat estimates but then telecommunications capital expenditures are usually lumpy and this always shows up in Ciena’s results. The next quarter’s guidance was basically in line, but gross margins were disappointing. However, the stock closed sharply higher.
I think this is recognition of the fact that many stocks have been bombed out on fears of a severe global contraction that is not likely to happen. The demand for bandwidth and necessity for service providers and telcos, to upgrade their networks to next generation technology isn’t going away any time soon.
