FactSet Research Systems Equity Analysis

FactSet Research Systems (NYSE: FDS) gave earnings which were met with an immediate markdown. For some reason the stock seems to usually invoke great drama after it gives results, but the latest numbers and guidance were pretty much in line. I like the company and think it has some attractive defensive properties which make it a good stock to hold in a balanced portfolio.



FactSet Results

At the previous set of results FactSet had guided towards $208 million in revenues and Non-GAAP diluted EPS of $1.15-117c. In the end it recorded $207 million in revenues and $1.18c, both numbers were pretty much in line. Moreover the guidance for Q1 2013 of $210-213 million and $1.10-1.12 in EPS was in line with analyst estimates. So why the initial sell off?

Who knows? But what we do know is that these results were pretty good. Prior to them I had mentioned that the key metrics to look out for are the Annual Subscription Value (ASV) and the client count. The former represents the forward looking yearly revenue for the firm, although I would caution investors from reading too much into it. Clients can give FactSet notice and get rid of parts of the service that they don’t want anymore. In reality they are unlikely to do so in meaningful amounts as long as the financial services industry is doing okay.

A quick look at how these two key metrics have been trending.

The recovery since 2008 is clear but, interestingly, note that ASV held up quite nicely even in the turmoil. I’ll come to the reasons why in a moment.

First I want to look at the underlying trends in more detail.

Client growth improved in the last quarter even though the pace of growth in ASV appears to be slowing. Superficially this looks worrying and could be a sign that FactSet is now pushing for less lucrative customers however lets recall that new customers don’t tend to be the most profitable so when client numbers are accelerating, it’s natural to see some slowing in ASV.

Moreover the StreetAccount acquisition should create some good cross selling opportunities as well as a boost to ASV.



FactSet’s Defensive Qualities

The company did okay in 2009 for two main reasons.

 First, it has a range of product offerings which tend to offset each other across market conditions. For example if equity departments are being cut back then bonds, alternative asset classes or foreign exchange might be doing better.  It is a diversified offering which compares favorably with a company like Bankrate (NYSE: RATE) or Morningstar (NASDAQ: MORN). Bankrate offers a lot of specialist research and information to the banking and insurance industries and its products are closer tied to their prospects. Meanwhile, Morningstar is more of a play on mutual fund research. It is trying to expand its equity coverage but financial firms are notoriously particular when it comes to information.

The second reason is that FactSet’s offerings are not the most sophisticated and are often seen as a ‘trading down’ option. The company is unlikely to take this line of argument but I think many people would agree with me. Its solutions are certainly not as expensive as a Bloomberg terminal or a Reuters desktop from Thomson Reuters Corporation and as FactSet adds more information it can increasingly encroach on these companies share.

Others may disagree with me and forgive my cynicism, but I simply don’t believe that owning a Bloomberg terminal or Reuters desktop makes any equity investment professional any better. They look good though and it’s a key status symbol and the financial services industry is not short of people willing to waste other people’s money on status symbols. My point is that financial firms may well wake up to the fact that their staff are no less effective by using a cheaper FactSet solution.



Where Next For FactSet?

The results look pretty good and the StreetAccount acquisition makes sense. I would hope to see an increase in ASV going forward as the acceleration in new accounts over the last year or so should bring some added revenue opportunities.

I also like the defensive qualities of the firm. It will suffer a lot less if there is some kind of severe financial slowdown. The realist in me tells me that the story of the last few years is that no expense will be spared to save the financial services industry and I don’t think that will change anytime soon. In other words, FactSet’s customers will still be around in the future. However the risk of short term disruption caused by the EuroZone cannot be discounted.

Furthermore, it's hard to argue that the stock is cheap right now and I wouldn’t be in a hurry to pay 24x earnings for a company in this environment.  This is one for the monitor list

Stocks Exposed to Favorable Small Business Trends

I want to take a check on what is happening with the environment for small businesses in the US and see if there are any identifiable trends worth investing in. I’ll start with the most recent company in the sector to give results and that is Paychex Inc (NASDAQ: PAYX).  Then I will compare some industry surveys with what companies are reporting.

In summary, the results and guidance were slightly ahead and there were no major surprises here. However, there are a few trends that can give clues as to other stocks and sectors that might prove attractive. With regards Paychex itself, the stock’s dividend will interest income seekers but its single digit earnings prospects won’t turn on growth junkies.  Each to his own!

Paychex Results

The results were slightly ahead in terms of revenues and the company reaffirmed full year guidance so nothing new here. As for the specifics, payroll services (67% of revenue) increased by 1% and human resource services (32%) increased by 7%.  The key takeaway here is that checks per payroll continue to increase albeit at a slower pace with 2% growth this year versus. 2.4% growth last year.

 This is consistent with a slowing economy and anyone looking for upside surprise would have been disappointed. It pretty much confirms what the key industry surveys have been saying. Moreover, Paychex predicted that checks per payroll would experience lower growth going forward while revenue per check would see a modest increase. Again this is confirmation of a slowing economy that doesn’t have much traction.

It is a ‘steady as she goes’ type of earnings report. Yield chasers will love the stability of the dividend and this is true attraction of the stock. Of course in an environment where growth is a lot weaker than it traditionally is in recoveries we can expect increased competitive pressure as companies fight for a piece of a smaller cake. Indeed, the likes of Automatic Data Processing (NASDAQ: ADP) offer stiff competition. ADP is doing a bit better than Paychex in terms of generating growth. Its employer services division recorded 5% organic growth in the last quarter and the company forecasts 6-7% revenue growth along with some margin expansion. It is predicting a modest 2-3% growth in pays per control which tallies closely with what Paychex is seeing too.

Industry Surveys?

While according to what Paychex and ADP are reporting, small business conditions appear sluggish at best, is this what the industry surveys are saying?

I think the answer is yes.

The National Federation of Independent Business (NFIB) surveys have tended to be a bit on the weak side this year but August saw a slight uptick. With regards employment here is the NFIB small business job openings data. This measures the percentage with positions not able to fill right now.

So a slight tick up in August but it has been a very sluggish recovery and the numbers are still far from pre-recession levels. Nonetheless the trend remains positive.

It is a similar story with NFIB capital expenditure plans. This measures the percentage planning a capital expenditure in the next three to six months.

So we seem to be having a decent August following a tough couple of months and it’s amazing how the market seems to be pricing this in.

Opportunities in the Small Business Market?

Aside from Paychex, ADP and the other obvious beneficiaries of a pickup in small business sentiment there are other companies that could benefit. I want to focus on what Wells Fargo said in July with its Wells Fargo/Gallup small business index.  In line with the NFIB data (for June/July) it was predicting weaker capital spending plans but as August has rebounded with the NFIB it is fair to assume that the capital spending trends identified in the Wells Fargo index will strengthen in August.

Interestingly new technology is very high on the capital spending agenda of small businesses. Here are the movements in purchase rates for technology over the last year.

Smart phones and tablets are replacing traditional cell phones and desktop computers in importance and if the mini recovery in August is sustained then companies exposed to these themes will do well.

Stock Ideas

There will be winners and losers in this kind of shift in spending and the clearest losers are Dell and Hewlett-Packard (NYSE: HPQ). Both are seeing pc sales collapse and mobility revenues challenged. Moreover Hewlett Packard’s printing division has been under pressure for a long time now and the company’s debt puts it in a tricky position. It’s hard to see an easy turnaround for either of these companies but HP looks in particular difficulty.

On a more positive note Aruba Networks (NASDAQ: ARUN) looks like a beneficiary of this shift.  Incidentally, there is a more detailed article linked here on Aruba. The company is a good play on companies rolling out smart phones and mobile devices across their workforce. It is also exposed to the trend of bring your own device (BYOD) in corporate mobile. A trend that is increasing as Blackberry continues to lose market share as the device of choice for corporations. Aruba did make some positive noises in the last report but I am a bit concerned with the evaluation. Nonetheless, it is a great stock to monitor.

Another SMB focused business that will do well out of new technology spending is Fortinet (NASDAQ: FTNT). I am a bit of a fan of this IT security company and think it is performing very well this year. Its unified threat management (UTM) solutions provide SMBs with their IT overall security needs and the company is also winning business from mid-market firms that are increasingly moving to its solutions. Whether this is ‘trading down’ or not doesn’t really matter, it still ends up in its bottom line.

The Bottom Line

In conclusion, small businesses are doing ok. The recovery is slow and not offering great upside to the traditional plays but there are trends within small business spending that can be capitalized on and I hope this article has created some ideas for you.

How Will Slower Growth in China Affect Your Investments

t’s time to look at China again. In a sense considerations over the country’s growth prospects are a bit like an itch that will not go away. You can try and ignore it for a while but deep down you know you need to do something about it. It’s all very well feeling good by listening to your favorite CEO eulogizing over his company’s Asian growth numbers and prospects in China but if growth is weaker than expected, those estimates will have to be taken down.  I thought it would be interesting to look at what sectors could be threatened by this and which might have an opportunity.

Is China Slowing?

It takes two to make a market and you will not get a definitive argument either way on this subject. My view is that it is and I’m skeptical over the argument that stimulus packages will save the day. Forgive me but I am an unreconstructed free marketer and I’m not willing to conveniently forget everything I’ve learnt in my lifetime. Communist Governments (or any other kind for that matter) aren’t very good at stimulating economies and the real story of China is about the increase in productivity created by foreign investment and allowing the free market greater leeway.

However, free markets can create economic bubbles. They do so especially when they are being fuelled by Governments issuing capital in order to weaken their own currency because they want to keep their exports cheap and keep social cohesion high with full employment. This game tends to end up in a local asset class bubble and Jim Chanos and others are arguing that that is what is happening in China.  A plausible argument but is there evidence for it?

I think there is.

First, let’s look at how automotive sales are weakening this year.

And other evidence is pointing to a slowdown in things like electricity demand, export growth, property prices and fixed asset investment. These sorts of things usually manifest themselves in consumer expectations.

It’s not just consumers who are getting less optimistic. Here are the new orders indices from China’s official PMI data.

Let’s recall that the official PMI data is not widely accepted as being as accurate as other private surveys which are showing worse conditions. Furthermore, the manufacturing numbers (unlike the US) are more important in China.



Stimulus Efforts?

I don’t want to dwell to long on this issue because I have outlined some thoughts on the issue in an article linked here.  Simply put, I think it will be a lot harder for the Government to do this than many people think it is. If you share my views than the next step will be to try and incorporate this into your investing by looking at which companies are heavily relying on China and which companies might actually benefit.



Early Warnings

There are early signs of a slowdown everywhere. For example FedEx (NYSE: FDX) recently gave notice that global trade is slowing faster than global GDP growth. It particularly mentioned issues with China’s export trade for a couple of reasons. First, protectionism is rearing its ugly head and Governments are implementing policies which are slowing trade. Second, consumer demand in Europe is causing Chinese export growth to slow disproportionately. Putting these factors together led to FedEx lowering its own earnings guidance as well as its estimates for GDP growth.

Similarly, we have seen Asian focused luxury goods maker Burberry warn that conditions were weakening. I think the luxury goods sector could be at risk and Coach (NYSE: COH) might be a stock worth being cautious with. It relies on China and Japan for much of its growth and with more intensive domestic competition coming from Michael Kors and others it is going to be even more reliant on the Asian consumer.

Other signs of a slowdown have been seen in the commodity sector where China has been the driver of marginal demand for the last decade. We can see this in how earnings estimates are falling for a diversified mining company like Rio Tinto (NYSE: RIO)

Another area that might get affected is technology and telecommunications. For example China’s ZTE gave a grim warning this year over domestic spending. I’ve discussed this in an article linked here and I think Cisco (NASDAQ: CSCO) could be affected in a couple of ways. First, its own sales to China are likely to be directly affected and second if Huawei and ZTE are facing difficult conditions at home they are more likely to get price aggressive in other markets and that means challenging Cisco in its core routers and switching market in the West.



Who Might Benefit?

If commodities have been driven up by China’s demand then a slowing should see prices falling even more and this is good news for the input costs of many manufacturers. It is also good news for Western consumers who have been forced to pay higher costs for soft commodities and food stocks. Indeed, if we focus on recent statement from the food producers like General Mills and others, the good news is that cost inflation is set to slow significantly.

I also think that the big box retailers could benefit too. Not only will input cost prices slow for the likes of Wal-Mart but lower energy prices will see gasoline costs reduce. This is good news for US consumers discretionary spending and mass market retail should see a boost as a consequence.

In conclusion, there are winners and losers from a potential slowdown in China. Whether it is inevitably going to happen is debatable and investors should watch stimulus plans and see if they have the desired effect. For now I think it makes more sense to take a cautious approach because the data is trending in a weak fashion.

Aerospace Industry Analysis

Sometimes you have to wonder how much more short term the market can be? AAR Corp (NYSE: AIR) had already pre-announced results at the start of the month but when they formally released them the stock was met with a 6% decline and then a 3% rise the next day; this is after raising guidance as well. The results were actually fairly strong, but there was a lot in the details that revealed the underlying trends in the aerospace industry.



Private Sector Good, Public Sector Bad

No, not a eulogy to free market enterprise but a statement of what is currently trending in aerospace. Cuts in public spending and military hardware are reducing end demand on one side. Fortunately commercial aerospace is flying high at the moment and companies with heavier exposure to this side of the industry are benefiting accordingly.

A quick look at Boeing’s (NYSE: BA) order book reveals that it is filled for years to come. Even more interesting is where the orders are coming from. Here are the airlines that have made more than 20 orders in 2012 from Boeing.

Aside from the large order from United, all of these orders are being driven by budget airlines and emerging markets. In addition, a large part of the leasing company's orders are for operations in the Far East, and arguably Virgin Australia is an Asian carrier. Essentially the marginal growth in passenger miles flown is being driven by emerging markets. Indeed, the fact that commercial aerospace is actually an emerging market play has been one of the best kept investing secrets of recent years.



AAR’s Profit Shift

Turning back to AAR corp we can see these trends play out in its gross profits movements over recent years.

Commercial aerospace is heavier weighted in Aviation Services than it is in Technology Products, and there is a clear shift in revenues and profitability here. Commercial revenues now make up 57% of the total and they are currently rising at 25%, although there was a 12% contribution from acquisitions. By way of comparison, defense spending only rose 1%. The company is making the right strategic decisions by acquiring commercially focused companies.

However, the market is clearly concerned with the outlook for military spending, and ever since the Pentagon outlined plans to cut nearly $500 billion in military spending over the next 10 years, the market has been stressing over which programs would get cut.

The result has been to shift investor sentiment on the sector in a fascinating way. Previously investors would favor companies with a balanced mix of revenues between defense and commercial (the argument being that the cyclical commercial side would be balanced with stable defense spending when the economy slowed). However, this year investors have been forced to move away from that idea and focus more on commercial aerospace orientated names.



Commercial Aerospace Companies

My favorite stock in the industry is cabin interior manufacturer B/E Aerospace (NASDAQ: BEAV).  The company profits from new and retro fit aircraft cabins. Traditionally, airlines would buy aircraft from Boeing or EADS (Airbus) and then a cabin fitter like B/E Aerospace or its French rival Zodiac Aerospace would kit out the interior. As for the retro fits, this is a market largely determined by passenger miles flown and the financial condition of the airlines. In other words it is cyclical but BE is adding products in order to offer some secular growth prospects. I particularly like the new lavatory system offering which actually adds some more seats to the aircraft. Moreover this activity would see the company working directly at the aircraft manufacturers.

I also like Heico (NYSE: HEI) because of its exposure to some favorable trends within aerospace. Just as the car industry has undergone a revolution in just-in-time manufacturing and outsourcing processes over the years, I think the time is ripe for a similar sort of thing to happen in aviation. Outsourcing servicing and the increasing use of non-OEM spare parts are ways that airlines can cut costs, and Heico offers both these solutions.

Another option would be to look at how strong AAR’s structures and systems revenues have been and conclude that Spirit AeroSystems' (NYSE: SPR) growth will continue in line with OEM order books. Spirit is more aligned to Boeing but also sells to Airbus.  Not only are its revenues correlated to the general order cycle but it also has exposure to the 787. Another key driver is the need for airlines to improve operational performance and profitability by replacing less fuel efficient aircraft with more modern models (although I confess I am not particularly sold by this argument). The truth is that if the airlines' end markets are turning down, they just stop spending.

 

Where Next for AAR?

My picks for the sector would be BE Aerospace, Heico and AAR, but frankly we need greater visibility over long term growth in the industry and in particular a pickup in growth in emerging markets. As Boeing’s order book demonstrates, relying on US passenger growth is not enough, and right now growth estimates in the emerging world are being downgraded.

It’s definitely a sector to watch should China et al manage to stimulate their economies back to growth, but for now a cautious approach works best.

Tibco Equity Research

It has been a tricky summer for technology as growth forecasts have been cut and the sector has seen some hefty mark downs as a consequence. The interesting thing now is that some tech companies are reporting results below analyst expectations but still seeing price rises. Such was the case with the recent results at Tibco Software (NASDAQ: TIBX). The market was clearly baking in an earnings Armageddon when all it got was a minor downgrade.

Tibco Results and Guidance

I like this stock and its big data driven end markets and I think it is relatively immune from a tech slowdown. Before doing this I will make one thing clear. There is a slowdown in tech and Tibco but it’s not as disastrous as some people think.

We can see the slowdown in how revenues and license growth is being affected at Tibco.

Note how relatively weak the guidance for Q4 is compared to what Tibco normally does in Q4. Moreover it was below analyst estimates.

• Q4 Revenue Guidance $310-318m vs. analyst estimates of $326m
• Q4 EPS Guidance of 42-44c vs. analyst estimates of 47c

No illusions here. Tech growth is slowing.  The geographic commentary featured a familiar refrain. Revenues in the Americas were up 19% with Asia Pacific/Japan rising 11% and EMEA flat on a constant currency basis. What was unusual is that management feels its execution could be better in the Americas and declared it had a ‘laser-like focus’ on improving it. There seems to be a desire to recruit some senior level personnel for the America because leadership was categorically referenced in the conference call.

So, yes there is a slowdown but we are still looking at mid-teens growth in license revenues and I think there are good prospects for Tibco.

Tibco and Big Data

Everyone talks about big data but what does it actually mean and what are its drivers?

I like to think of it like this. Massive decreases in the cost of storing data plus the proliferation of social networking and mobile computing are creating an explosion of data and more importantly unstructured data created by consumers. Unfortunately, making sense of this data requires substantive analytics and data mining.

Where Tibco’s middleware expertise comes in is with the real time structuring of this data in order to facilitate integrated action. It’s more than just CRM, it is about connecting with back office functions and processing transactions. It’s middleware by another name. Only more of it. Much more. The amount of unstructured data being produced by social networks like Facebook is truly staggering.

Facebook’s problem is in finding a way to successfully monetize this data without doing anything to stop consumers creating it. I think this will be an issue for the company particularly with mobile. Zuckerberg may well be right that Facebook will earn more money via mobile but the question is how much more and does it really justify an IPO price that valued every Facebook user at around $100? It’s nice to see the company getting towards a sensible evaluation but I still don’t think we are there yet.

No matter, the big data revolution is real and I think provides an excellent secular growth story for marketing spend. Let’s put it this way. Even if a company’s top-line growth is receding thanks to a global recession it will still invest in big data solutions if it helps it to better allocate marketing spend and therefore increase margins.

Industry Gearing For Growth

It isn’t just Tibco that believes in this. Oracle (NASDAQ: ORCL), Microsoft, IBM (NYSE: IBM) and SAP (NYSE: SAP) have all been investing in data centers and buying business intelligence companies in order to increase their big data capabilities. SAP, IBM and Oracle all offer data warehousing solutions along with analytics and business intelligence capability.

IBM and Oracle compete with Tibco in middleware solutions but they also sell a host of infrastructure, database and server solutions that are being driven by big data accumulation. Indeed in Oracle’s recent results presentations, Larry Ellison declared that he believed Oracle was winning market share from IBM and Microsoft in database.

Oracle’s rivalry with SAP is the stuff of technology legend and its German competitor is challenging it within its core competency of database. It launched a new data analysis software product (HANA) which gives corporations the capability to analyze and process data at high speeds. Ellison famously responded to the announcement of this product by speculating that SAP must be ‘on drugs’. With sales forecast at $420m for 2012 alone it looks like the ‘drugs’ must be working.

What unites all these companies is that they investing heavily in big data because they know it will drive growth in future. I doubt they are all wrong. For Tibco this should mean that corporations will be ever more willing to buy its solutions.

Where Next For Tibco?

Putting these arguments together creates a powerful case for Tibco. Growth is slowing but at the same time Europe has been weak for a while now. This means the European comparables will start to get easier next year. Meanwhile, the long term drivers for Tibco are strong. If there has been upside surprise in tech this year it’s been in the data center and the ongoing proliferation of mobile internet.

With regards evaluation Tibco is very good at cash conversion and because of its large ongoing service revenues the headline earnings number gives a misleading picture of the company’s future generate cash generation. With around $226m (or 4.8% of its enterprise value) in trailing free cash flow and mid-teens growth in revenue and earnings forecast for the next couple of years, I would argue that Tibco can ‘do its earnings’ in terms of share price movement. The median analyst target of $35 looks achievable.

Earnings to Look Out For This Week

It's another big week for earnings this week so I’ll pick out some of the interesting things happening and discuss what key indicators investors should be looking for in the results. So far this earnings season has been very mixed with some weakness in technology being offset by strength in US housing and retail stocks. The more cyclical side of emerging market spending has disappointed somewhat.

As for Europe most of the US companies I have been looking at have been reporting stable conditions in their sales to the region. Admittedly this translates as ‘still weak’ but the comparatives are getting easier while they are getting tougher for China et al. Moreover allow me to point out that Europe ex Greece (which will hopefully be finessed out of the Euro soon) is genuinely trying to make structural reforms and reduce deficits.

Hopefully elsewhere people will start to look and learn fiscal discipline from the ‘Herring Economies’ (you heard it first) in other words Germany, Austria, Denmark, Sweden, Finland, Norway and the Netherlands. Countries that eat herring extensively seem to know how to pay their debts. Even Iceland is doing better these days.

But enough waffle!

Monday

I’m going to pick out house builders Beazer Homes and DR Horton as the stocks to watch today. Most of the others have reported good numbers this season but these two are bellwethers so their commentary will be interesting. In particular commentary on any improvements in Florida and California.

Tuesday

Cisco Systems (NASDAQ: CSCO) usually moves the markets and I suspect it will do so. I’ve previewed its earnings here and am not expecting any great things. Cisco played its ‘we are now a value proposition’ wild card last quarter. As for this quarter I would keep an eye on enterprise spending. It has been a bit up and down for Cisco this year and we will see if last quarter's better results were due to some pull forward or not.

It’s also a big day for retail with Home Depot (NYSE: HD), TJX Companies and Saks all giving numbers.  In a way the house builders on Monday will guide towards what Home Depot may say. I’m interested to see if its management continues to see its earnings decoupling from overall GDP growth as housing enters a ‘sweet spot’ in the economy. Look out for how the more discretionary aspects of its sales are increasing. TJX has been a bit weak recently despite reporting good same store sales growth. I’ve discussed the stock in an article linked here.

Wednesday

More retail on Wednesday as Abercrombie & Fitch gives numbers alongside PetSmart and Williams-Sonoma. I’ve discussed PetSmart  in an article linked here and the key thing to look out for is whether increasing competition from the likes of Amazon and Wal-Mart is pressuring same store sales growth or margins. Similarly Williams-Sonoma is another business that has been reporting good growth, but is threatened with increasing competition. Look out for its geographical expansion plans.

Thursday

This promises to be one of the most interesting days of the earnings season for me. There are three themes here comprising retail, technology and the ‘horror shows’. Dollar Tree gave a disappointing update recently so any color on what is going on with store sales will be interesting. The company typically generates less per sq. ft. than its rivals. Wal-Mart (NYSE: WMT), Target and Limited Brands will also give results. I like the mix of business at Limited Brands and its commentary on European operations will be useful.  As for Wal-Mart and Target you can either analyze US consumer spending data to death or model what Wal-Mart, Costco and Target are saying. I’m expecting better things from them. After all consumer spending tends to be late cycle and employment is increasing (albeit slowly) in the US.

Now it’s time to turn to the proper horror shows. I like Autodesk (NASDAQ: ADSK) as a company and covered it an article linked here which should give a good background on what to look for in the upcoming earnings. A combination of emerging market weakness and customer resistance to its new sales model maybe causing problems.  Such issues make its prospects over earnings very volatile. I’m monitoring for an opportunity.  The second horror show is Gamestop (NYSE: GME) which I’ve discussed here. The stock has done very well recently, but I don’t think any of the structural issues have gone away and I would keep an eye out for how used game sales are progressing. However everyone knows about these issues and the stock is full of nervy longs and shorts. Expect volatility and over reaction.

The last two horror shows are Dell and Applied Materials. Dell is another structural challenged business discussed in more length here. The key thing to look out for here is how the acquired businesses are growing and whether it is going to be enough to counteract slowing sales elsewhere. As for Applied Materials the whole semi-conductor sector has been weaker recently and solar company revenues and earnings have fallen off a cliff.

In a side note Intuit also gives results. More details on the company linked here. This is one of the quieter quarters for the company but investors can look out for details of operational improvements with improving conversion rates from stores.

Friday

My highlight for Friday is earnings from Sirona Dental Systems. The company is a bit of favorite of mine and I think well worth watching closely. The market seems to have woken up to it recently and I’m out for evaluation reasons but will be watching closely to take advantage of any developments. The company’s long term prospects are excellent.

Is Adobe the Next Big Cloud Play?

Behavioral finance enthusiasts are fond of giving examples of how investors act irrationally when faced with a position that involves a short term loss in order to obtain a larger long term gain. They have a point. Nobody really likes the potential for short term losses but if investors can avoid the myopia then Adobe Systems (NASDAQ: ADBE) could present an opportunity to profit while others irrationally avoid it. I like the company's prospects and think there is good potential here.

Adobe’s Profit Drivers

The first principle driver for future growth is its movement into the cloud and the second is everybody else’s movement into the cloud!

In plain English, Adobe is shifting its digital media solutions from a perpetual license model to a cloud based subscription service. Furthermore as more companies shift into the cloud and integrating multi-platform marketing efforts Adobe’s digital marketing suites will become increasingly important as content needs to be created across platforms.

Similarly the huge growth in data generated by engaging in marketing activity on a social networking site like Facebook means that companies need to buy brand building analytics in order to understand the interaction of potential customers. Facebook generates huge amounts of profiling data which can be mined and made sense of by data analytics. While Facebook isn’t necessarily good at using it to make money (or at least commensurate with its market evaluation) it doesn’t mean that marketers can’t do it.

Short Term Pain Long Term Gain

When any company shifts from a perpetual license to a monthly subscription model there will be an inevitable drop off in revenues. Indeed, Adobe predicted that digital media revenues would be down in 2013 but then start to grow strongly in 2014.

Here is how revenues are trending by segment.

Clearly the shift is starting to hurt headline revenues in digital media. In fact Adobe is exceeding its expectations with regards to signing up subscription customers and this means that guidance for the next quarter is going to be adjusted downwards.

Here is what Adobe guided versus market expectations

•          Q4 Revenues guidance of $1.075-1.1 billion vs. market estimates of $1.21 billion
•          Q4 Non-GAAP EPS guidance of 53-58c vs. market estimates of 67c

See what I mean about staying calm over the short term?

The key metric that Adobe is nudging analysts towards within Creative Cloud subscriptions (digital media) is something it calls the annualized recurring run rate (ARR). This is the number of current subscribers times the (annualized) monthly revenue per user (ARPU). Here are the numbers plus Q4 guidance. Please note that the first row is my approximation based on company statements.

Subscription growth has been greater than expected and Adobe’s guidance implies that it will accelerate further in Q4. This is good news –because investors should want adobe to shift its sales towards subscription- but perversely it also means that headline revenue numbers will be worse thanks to loss of upfront perpetual license sales.

Long term the key issue is Adobe should be generating more profits from this model and the plan is to increase monthly pricing to closer to $50. Obviously this move will increase churn so I would expect Adobe to try and gradually finesse the increase while keeping an eye on the affect on churn rates.

How Will Adobe Make Money by the Shift?

I confess I was a bit puzzled by some of the things that Adobe said and I think management are being overly cautious and downplaying expectations. For example, when asked about operating margin differences between perpetual sales and subscription they responded by saying there wasn’t going to be any ‘great’ difference. Similarly, cash flow was predicted to be similar with the change in sales.

While this narrative is great for keeping analyst’s modeling expectations in check it is not the sort of experience that a company like Intuit (NASDAQ: INTU) has had when it shifted to the cloud. I’ve discussed Intuit at length in an article linked here. Intuit has managed to increase operating margins, cash flow conversion, reduce churn, and reduce marketing costs as a consequence of shifting to the cloud. It is the benchmark for software companies shifting to the cloud and I don’t see why Adobe can’t do the same. The interactivity and ongoing service provided by Intuit is a similar sort of model to what Adobe will bring.

So far the main advantage that I have heard from Adobe is that it feels it can get 10% more customers by offering services in this way but overall I think management are being too conservative.

Adobe Digital Marketing and Analytics

While most attention was focused on digital media investors should not forget the fast growing digital marketing segment. Adobe’s stated ambition is to be to marketing what Salesforce.com (NYSE: CRM) is to sales. This is a poignant aim because Salesforce has entered the marketing analytics arena itself! As Oracle (NASDAQ: ORCL) has found out in the CRM space it is a strong competitor but I think Adobe has a strong position within marketing and the integrated offering of media, publishing, and marketing analytics will resonate stronger than Salesforce’s offering.

As for Oracle and IBM, they both offer a complete solution of data warehousing plus analytics and Oracle is included as a leader in Gartner’s Magic Quadrant of Web Content Management solution providers but this is for its Oracle real time decisions or RTD product which is an overall Business Intelligence application. It is not focused on marketing analytics in the way that Adobe is and with increasing data from social media, marketers will require analytics devoted to that space.

I like what Adobe is doing here and if Intuit is a useful guide then the company can achieve more than it is promising right now. We only have to look at how Intuit took market share from H&R Block and how Salesforce has taken market share from Oracle to see the potential for Adobe. Furthermore, the evidence is that moving to software as a service based models generates lasting improvements in operational metrics. There is a reason why Oracle is responding to Salesforce by moving towards the cloud.

The Bottom Line

In conclusion, the potential to improve its operational metrics and its customer numbers is significant and provides upside potential from what analysts are being guided to model now. Adobe's transformation is not an easy one to contemplate immediately, so thanks to readers who have stuck by reading this post. I think if investors can look beyond the short term revenue disruption the long term potential is there for Adobe to transform itself into a pure cloud play.

Bed,Bath and Beyond Competition Coming?

With the housing sector perking up Bed, Bath and Beyond (NASDAQ: BBBY) is the sort of stock that investors should be looking at. It is supposed to be a simple play on an improving housing maket. Unfortunately investing is rarely that simple and the company delivered a set of results that sent the stock down nearly 10%. Moreover it created more questions than answers. So I thought I would try and make sense of it all and suggest some other ways to play the housing theme.

With the housing sector perking up Bed, Bath and Beyond (NASDAQ: BBBY) is the sort of stock that investors should be looking at. It is supposed to be a simple play on an improving housing market. Unfortunately, investing is rarely that simple and the company delivered a set of results that sent the stock down nearly 10%. Moreover, it created more questions than answers. So I thought I would try and make sense of it all and suggest some other ways to play the housing theme.

Bed, Bath and Beyond’s Results

Net sales increased 12.1% but same store sales growth declined to a 3.5% increase from 5.6% last year. However, the real story here was about margins. The company was hit with a double whammy of increased cost of sales margins and higher selling, general and administrative (SG&A) costs. The result was a 200bp reduction in operating income margins which actually took operating profit down 1.7%. Not good.

A quick look at how these margins have been moving.

Costs have been going up this year while same store sales growth has been slowing. Furthermore, acquisitions have been made in 2012 which suggest that it is trying to buy growth to compensate for slowing organic growth.

Turning to the specifics with cost of sales, the increase was attributed to three factors. First, an increase in coupons coming from redemptions going up and average coupon amount increasing. Second, the mix of product sales resulted in an increase in lower margin sales. And third, the inclusion of costs from the acquired (World Markets) business.

With regards SG&A the management put it down to higher payroll, occupancy, and advertising costs. In addition all of these costs included contributions from the acquired business which has higher costs ordinarily.

In a nutshell, BBBY is paying for top line growth at the expense of margins and earnings. This is fine if it is just a transitional issue before the revenue contributions from the acquired businesses start to anniversary but the slowing same store sales growth is a concern.

A look at how the acquired businesses contributed to sales growth.

To be fair BBBY is in process of rolling out new stores so we can expect new stores contributions to increase in future. Nevertheless, slowing same store sales growth is an issue particularly when considering how well competitor Pier 1 Imports (NYSE: PIR) is doing right now.

What the Industry is Saying?

Pier 1 recently reported in line results but raised full year guidance and forecast same store sales growth in mid-single digits. Interestingly, it is accelerating its e-commerce activities and I take this as a sure sign that online competition is coming to the industry. I have concerns about Pier 1’s online activities affecting its margins but then again businesses are obliged to respond to competitive threats.

BBBY would be advanced to take note because companies like Amazon are expanding their product offerings.  Amazon’s subsidiary Quidsi launched casa.com this year. A website whose rasion d’etre is arguably to grab market share from BBBY and Williams-Sonoma (NYSE: WSM). While Quidsi seems to operate with relative autonomy from Amazon it is hard to imagine that Amazon couldn’t drive significant traffic flows to its websites if it wanted too.

As for Williams-Sonoma, it recently reported revenue growth of 7% with comparable brand revenue growth improving to 7.4%. In a sign that e-commerce support is now essential in the industry it saw online revenues go up 14%. Williams Sonoma has driven top line growth through a mixture of innovation in its core brands, new brand launches and international expansion. All of which requires a lot of management focus and execution.  So far, so good for Williams-Sonoma.

The home goods space is becoming crowded and when you consider that off-price retailers like Ross Stores (NASDAQ: ROST) are aggressively expanding their store roll outs and home goods are a big part of the expansion. Ross describes its traffic as being more robust than it has been in a long while. And footfall is the holy metric of retail. It’s hard not to imagine that the off-price retailers are grabbing market share although that sectors operational performance is not as closely tied to housing and consumer spending.

In summary, the industry is becoming more competitive and BBBY is underperforming.

Where Next For Bed, Bath and Beyond?

The company needs to do a few things going forward to make it a more attractive investment proposition. First, it needs to get same store sales growth back in line with its peers. I would guess around mid-single digits would do. Second, it needs to successfully integrate the acquisitions and demonstrate it can reduce SG&A costs accordingly. Third, it needs to make hard decisions over whether it wants to chase/protect top line growth or expand margins.

I expect a lot more competition in the sector going forward and its combatants need to prepare for an online onslaught. I prefer companies that are in shape to deal with challenges rather than struggling to keep up with its peers. BBBY can turn this around because end demand is looking good for the sector but cautious investors will wait to see some evidence first.

General Mills Equity Research

Conditions are tough in the US food sector. Everyone knows that. But when the going gets tough, the tough get ordered around by the General. In this battle General Mills (NYSE: GIS) appears to be executing its plans very effectively and its latest results are the latest demonstration of its management’s ability to fit all terrains.

The last time I looked at General Mills I concluded that it needed to consolidate its core US markets by focusing on snacks and look for growth in its international segment. Before analyzing how this plan is working, it’s a good idea to see how it compares with the rest of the sector.



What the Food Industry is Saying

The market has loved Kraft (NASDAQ: KRFT) this year because of its upcoming split and its focus on the faster growth snacking category. The company is executing well and the market is giving it the benefit of any doubt by chasing its yield. Meanwhile, Kellogg (NYSE: K) has had struggles with pricing as its commodity input costs have risen sharply and it has had to deal with the tricky issue of shoppers trading down to discounted private label brands. When Kellogg tried to raise prices in certain lines the price sensitive consumer responded by sending its volumes down. Its challenge is to demonstrate it can get the mix right.

Turning to H.J.Heinz Company (NYSE: HNZ), this company has found it difficult in the US and has shifted strategy by focusing on its core ketchup and sauces brands as well as emerging market growth. Its last results were no more than ok with gross profits rising only 1.9% with organic sales growth up 4.8%. Unfortunately, Heinz doesn’t break out numbers from its nutrition division so it is difficult to see how much it was responsible for its international growth.

In summary, Kraft is going for growth in snacking. Kellogg is hoping for an improvement in US volumes and cost inflation while Heinz is focusing on its core brands, divesting non-core operations and going for emerging market growth.

I would argue that General Mills is doing all these things in one!



General Mills Strategy and Latest Results

The strategy is to go for growth via buying business exposed to emerging market growth while consolidating its domestic position with a renewed focus on snacking and higher growth categories like yogurt, Haagen-Dazs, and healthy snacks. Meanwhile it's controlling costs and looks set to benefit from a more benign cost inflation environment.

A breakdown of segmental operating profits in the quarter.

Much of the international profit growth was thanks to the contribution of the acquired Yoplait operations. Moreover, the company bought a Latin American focused food company (Yoki) whose numbers will start to be integrated in the next quarter. Europe is proving relatively better for General Mills than most in the sector are reporting and I think this has much to do with the highly popular and growing Yogurt category in Europe.

Turning to the US, segment profits were down 2% and sales fell 1% with volume down 2%. While this does not appear impressive the underlying picture is actually a bit better. Having dealt with 10% cost inflation last year, its forecast for this year is 2-3%.

It also appears to be a bit closer to an inflexion point with US yogurt and cereals. Both declined in the last quarter but with cereals, management argued that it is largely an issue of timing merchandising. Unit volume growth is predicted for the rest of the year and moderating cost inflation will help a lot here. As for yogurt, there have been a number of recent product launches and marketing initiatives in order to turn the sales decline around. We shall see.



Where Next for General Mills?

I think more of the same. Investors are in love with dividends now and see them as a proxy for very low US treasury yields. If a company can demonstrate the ability to generate stable cash flows and a commitment to paying a high dividend than investors will reward them.

In General Mills case, there is some upside from its execution and the moderation in commodity costs. It is doing the right thing by buying emerging market businesses and expanding operations there. Meanwhile its snacking brands continue to grow strongly. Going forward much will depend on how successful the new product launches in yogurt will be in the US.

There is nothing particularly sexy about the business or its ‘17x PE ratio for mid-single digit growth’ proposition but if investors want a stable 3.4% yield then this is a good way to get it

Cognex Research Anaysis Part II

Anyone left with any residual doubt that the industrial sector is slowing would only need to look at Cognex’s (NASDAQ: CGNX) latest set of results in order to have their worst fears confirmed. Overall revenue was flat and sales in its factory automation segment were only up 4% and were flat on a sequential basis. However, don’t be too put off by this intro. This stock has some great long term growth drivers and is well worth a look for those willing to take a long term view.

Introducing Cognex

Cognex is the global leader in ‘seeing machines’ that monitor automated processes in factories. Of course its products will see their earliest adoption in industries that are heavy users of robotics, so it is no surprise to see that automotive is its biggest industry vertical. In fact, the early adopters tend to be in the highly cyclical industries and this means the company is exposed to movements in global industrial output.  I’ve written a primer post on the company in an article linked here, and I would encourage those who don’t know the company to read it first.

There is not much that Cognex can do to reduce the cyclicality of its end market customers, but it is trying to diversify and sell into other industries that are only starting to use advanced automation. In addition, it can expand into new geographies that are adopting vision machines as part of their manufacturing processes. Longer term investors can expect more focus on end markets like medical devices and logistics, but for now it is the automotive and consumer electronics that guide its revenue movements.

A quick look at the revenue split demonstrates the reliance on industrial production.

Turning to the actual results, the story is on one of weakness in areas like semiconductors and solar (which declined by $10 million alone) with some stronger sectors like automotive, logistics and medical.

Cognex Q3 Results

Looking in more granular detail shows 4% growth in factory automation offset by weaker results from the electronics industry, while the semiconductor segment revenues were down 5%. With regards to semiconductors, Intel (NASDAQ: INTC) recently lowered expectations for full year revenues, and there is no sign of the anticipated recovery in the electronics market in 2012. Going by Intel’s guidance for gross margins, things are going to get worse before they get better for the industry.

There is better news if we look at Cognex’s biggest industry vertical, which is automotive. I always think it is interesting to look at what Alcoa (NYSE: AA) is saying about their end markets. In fact, a quick look at Alcoa’s recent results reveals that the automotive sector is the only one that it has raised guidance for in 2012. In fact, Cognex’s overall factory automation closely mirrors what Alcoa is reporting by geography.

Going forward, the great imponderable will be China. There are signs of the economy slowing but Cognex can still generate growth thanks to the relative under penetration of its type of machines within factory automation in the country. Factory automation revenues grew 42% on the year and 12% sequentially while Japan declined 13% and 11% sequentially. The latter is a concern because there are some political differences that are causing a boycott of Japanese electronic goods by Chinese consumers. As for China, Cognex’s management was clear that there is a lot of short term uncertainty here.

Moreover, part of the growth this year has come from the launch of four new products and the acceleration of growth in less mature industry verticals like ID products in logistics. I think this is a key area of growth, and if you look at something like Roper Industries (NYSE: ROP), you can see that RF devices and ‘smart’ technologies are increasingly being adopted by this traditionally conservative industry. I‘ve discussed Roper here, and while its latest results demonstrated revenues in the RF segment down 1%, operating profits increased 10% with strong growth traffic and freight matching software.

Indeed, as e-commerce revenues are likely to grow as a percentage of overall retail sales then the pressure for the likes of Fedex (NYSE: FDX) and UPS to introduce such technologies will only increase. In addition, as both logistics companies are seeing slower growth in light of weaker global trade, they should be looking to introduce measures that generate long term operational improvements.

Where Next For Cognex?

Cognex looks set for strong growth in the years to come. Secular demand trends from increased factory automation and robotics should ensure good growth. Moreover, it should start to diversify its revenue streams so as to find a way to reduce cyclicality. The long term China growth story is intact but the concerns here are with the short term.

Frankly, I haven’t heard anything positive coming out of the semiconductor and solar industries in quite a while, and it is safe to conclude that the near term risk is on the downside here. As for China, I think a cautious approach needs to be taken here and, to be fair, Cognex is downplaying expectations. All of which leads to a classic investment conundrum. Do you want to buy a stock whose long term prospects you like but which you also consider to have near term downside risk?  Cautious investors may want to wait and watch events in China.

Cognex Research Analysis Part I

Cognex (NASDAQ: CGNX) is one of those stocks that you really want to like. Its long term growth prospects are very good and its management always ‘tell it like it is’ regarding the company’s prospects. Throw in the humor with its highly entertaining results presentations and it’s hard not to feel engaged by this company. I strongly recommend looking at its annual reports in order to see how investing information can be fun and factual at the same time.

Now I know you are expecting the ‘but’ bit right now and you wouldn’t be wrong. The simple fact is that any company that makes capital machinery is going to be tied to investment cycles in manufacturing and to the industries it serves. Moreover globalization has resulted in the almost seamless ability of manufacturers and OEMs to shift production to different countries or suppliers. This means a company like Cognex is dependent on its customers production patterns. That said this is an attractive long term story and investors willing to take a long term view may find a great investment here.



Who is Cognex and what is the Long Term Story?

Cognex is the global leader in seeing machines. In other words vision systems that monitor production processes at automated manufacturers. As production becomes increasingly robotized and items get ever smaller, the need for quick and accurate quality control and monitoring is getting more important and Cognex provides the solution.  Good ole human eyesight simply cannot compete with its vision machines.

In addition technological advances with Cognex’s product range mean that it can offer its products to a wider range of industries and in the future this will help reduce the cyclical nature of its earnings. Things like surface inspection solutions for the packaging industry would help but, for now, Factory Automation and Semiconductors remain the key end markets.

And with 85% of its revenues in highly cyclical industries, it’s not hard to see why earnings and revenues have proved so cyclical over the last few years.

Cognex got hit badly in the last recession but the long term trend is positive. Due to its fixed cost base when end demand falls there is little Cognex can do to keep margins and cash flow up. However, the company’s free cash flow generation is improving and if you average out the last seven years the company converts 18.6% of revenue into free cash flow. Furthermore the compound annual growth rate (CAGR) of revenues in this period works out to around 6.8%.

It’s not difficult to play around with these numbers in a DCF calculation and conclude that Cognex is attractively priced right now, but I don’t think investing is that simple.

Cognex’s Near Tern Challenges

I have a few near to mid-term concerns here.

First, on a geographical basis Cognex has challenges. The world and his wife know that European manufacturing is going through a tough time, but investors shoudn’t forget that the BRICs are slowing too. Listening to FedEx (NYSE: FDX) the other day, it is clear that global trade is slowing more than global GDP.  FedEx discussed this as being partly due to Governments policies affecting export industries but also due to a slowdown in European/US consumption trends causing Asian exports to slow. Given that Asia’s strength is in export led manufacturing this is a significant issue for FedEx and it is also a problem for Cognex. Cognex has positioned itself as the leading machine vision company in China and if its customers slow investment it too will suffer.

Second, on an industry specific basis the end market mix does not look favorable. Cognex has heavy exposure to the semiconductor, solar and consumer electronics industries and they are weak right now.  Applied Materials (NASDAQ: AMAT) is a good company to look at because it has exposure to semiconductors and solar cell capital spending cycles. Its recent results and outlook were not good.  The semiconductor industry is suffering from weaker than expected end demand and the solar industry has overcapacity compounded with a growing reluctance amongst Governments to subsidize it. Applied Materials forecast net sales to decline by 25-40% in Q4 and its operating margins continued their decline.

With regards to general factory automation I think Danaher Corp (NYSE: DHR) is a useful bellwether. Across its line of business the weakest recently has been Industrial Technology (the area most relevant to Cognex). In its last quarter Danaher argued that its second half might play out weaker than expected. Everyone , from telco to luxury goods, is hoping for a rebound in growth from China but everyone seems to be reporting that it hasn’t happened yet and Danaher is no exception. Danaher discussed taking cost actions in order to protect margins should current trends continue.



Where Next for Cognex?

To be fair Cognex did express a significant amount of caution in its guidance for the rest of the year. However, my opinion is that the risk over China is skewed more towards the downside. I think that plays out negatively for Cognex.

On the other hand, its long term drivers are excellent and provided you can put up with the potential for near term disappointment this looks like the kind of small cap that many investors will look back at in 10 years time and wonder ‘why the hell didn’t I buy it back then?’

If you think the global economy will rebound and China with it then the stock looks like a very good value. For those of us who are a bit more cautious this is a great stock for the watch list.

High Yield Food Companies

I must confess that while listening to ConAgra (NYSE: CAG) on its conference call I got an eerie sense of deja vu. I couldn’t quite put my finger on it, but then it hit me. It's management had mentioned the ability to hike the dividend thanks to its high cash flow generation and I knew that I had heard this argument somewhere before.  Frankly I think chasing high dividend food staples is a useful tactic that is being rewarded this year so I decided to find some more names for investors to consider.

Before doing that I want to discuss ConAgra’s latest results.



ConAgra Results

ConAgra delivered a good set of results, increased the dividend and raised EPS guidance to $2.03-2.06 which equates to 10-12% growth.

Within Consumer Foods (62% of sales) acquisitions contributed 8% of sales growth but organic sales were flat. Organic volumes declined 4% and there was a 1% currency hit while favorable pricing/mix contributed 5% growth. In other words, all the growth came from acquisitions which the company was able to finance out of its strong cash flow. After hearing this I got another of my -now famous- feelings of deja vu.

General Mills (NYSE: GIS) said pretty much the same thing in its results recently too! This is no coincidence. The simple fact is that the US food sector is very tough at the moment and standing still organically is an achievement in itself. In General Mills case, it has gone for growth via internationally focused acquisitions while ConAgra has made strategic acquisitions in food categories offering growth such as snacks and alternative breakfast bars. What both have in common is that commodity input costs are abating and they can look forward to some easing of margin pressure.

Turning to the Commercial Foods (38% of sales) segment it seems that ConAgra served up a hot potato. Literally. Its Lamb Weston potato operations reported sales up 5% with good volume growth and a whopping 37% profit increase on a comparable basis. It seems to have hit a sweet spot in terms of servicing demand for away from home eating and fries are hardly the most economically sensitive of foods.

In conclusion, ConAgra continues to leverage its mix of value brands and health brands in order to counteract weakness in other consumer categories such as frozen foods. The company is distinguished by having a private label business which specializes in nutrition and snack bars for store-owned brands. Management has discussed expansion opportunities for private label in the past and don’t be surprised if they make an acquisition in this space.



Where Next in the Food Sector?

Investors could analyze the risks and opportunities in the food sector until kingdom come. They could knock up discounted cash flows until the beans got fed up of being counted and decided to start sprouting. They could quote Benjamin Graham until they are blue in the face.

By now, you get the picture. There really is only one thing supporting these companies right now and that is the dividend. With this in mind it’s interesting to repeat the ‘ConAgra trick’ and see who has the free cash to support higher dividends in the food sector.

The lower the Dividend/Free Cash Flow ratio, the greater the chance it could be increased.

I was surprised to see Campbell Soup Co (NYSE: CPB) make this list. I’m not the biggest fan of the company principally because I think the underlying growth is not strong and its product and category mix looks more challenged than the other companies. Organic revenue and earnings growth has been hard to come by for Campbell and I think it's set to continue.

Then again who cares?

Investors are rewarding stocks for paying high and stable dividends and Campbell has the room to increase them. It certainly looks a better bet than Kellogg (NYSE: K). This company appears to have little room to aggressively raise its dividend and appears more troubled than most with issues over a weak cereal market and stagnating European sales. In addition it's had issues with getting its pricing right this year.

B&G Foods (NYSE: BGS) is also worth a brief mention because it too is seeing its sales growth being largely generated via acquisitions. In common with the rest of the food industry it has had to adjust its distribution in order to shift sales to where the consumer is increasingly buying its groceries from, namely, dollar stores and mass merchants. These are common themes in the industry, but the difference with B&G is that it has a lot of net debt in relation to its market cap and servicing it will constrain dividend increases.



The Bottom Line

I’m going to leave the last word to my first word and in doing so invoke some deja vu in you. ConAgra remains the pick of the high yield food sector. It generates a lot of cash flow and has relatively good prospects in a challenged environment. If you want yield and stability in your portfolio then ConAgra looks the best of the bunch to me.

Stock Resarch on the Auto Parts Companies

The auto parts sector has been one of the strongest performers in the market over the last few years. The investment thesis behind it is that as the slow economy causes drivers to keep their cars on the road longer the average is going up. This is great news for the cash registers of AutoZone (NYSE: AZO) and O’Reilly Automotive (NASDAQ: ORLY) because older cars require more servicing and therefore more parts. The thesis has been working, but will it continue to do so?



Auto Parts Sector Dynamics

There are a few moving parts to the answer to the question I posed above.

First, there is the question of industry capacity. Obviously capacity is related to ongoing end demand but I want to focus the fact that all the auto parts companies have been expanding store roll outs in order to chase volumes.  If we look across the industry at AutoZone, O’Reilly and Advance Auto Parts (NYSE: AAP) we can see that same stores sales growth is slowing.  Incidentally, I’ve adjusted the others results to the comparable period for AutoZone.

The de-acceleration is noticeable and let’s recall that there was some pull forward in activity in the previous quarter. It looks like we are reaching the stage where industry growth is starting to be constrained.

The second factor is the age of an old car in the US. The latest data (Jan 2012) suggests that this metric remains very favorable to the auto parts retailers.

However US new car sales have been very strong this year. According to Kelley Blue Book new car sales in August jumped 18.7% from last year. I think that a combination of an improved economy plus the need for car replacement is going to start taking down the average age of the US car.

Ford Motor Company (NYSE: F) stock may be performing badly this year, but that has more to do with European car sales hitting historic lows.  In the US, Ford’s auto sales were up 13% in August alone. Ford’s problem is that it is heavily exposed to Europe and its sales there were reported as being down 29% in August alone. Ouch! Unfortunately, Ford isn't a good way to play booming US car sales.

The third factor is car miles driven. This is a function of the overall economy and gasoline prices. Many think it is price inelastic, but the truth is that this metric has reached a plateau in recent years and this suggests that driver behavior has adjusted to higher gasoline prices. If it continues then this is a net negative for the car parts retailers.

Putting these three factors together rather suggests the sector has had its heyday and could be set for some moderation in growth going forward.



AutoZone’s Latest Results

The key point take way from AutoZone’s results was the weak same store sales growth, but this was pretty much anticipated by the market. In addition the company admitted it had hoped for more out of the quarter. The big imponderable here is how much of this is weather related? The mild winter in the US meant that many cars were not as stressed as they might have been and AutoZone argued that this could be the case for the industry wide slowing in same store sales growth.

I would normally give management the benefit of the doubt, but in this case I am skeptical. It is too much of a coincidence for me that new car sales are surging this year and suddenly the auto parts retailers metrics start to look less strong. For example, if new sales are being driven by a replenishment cycle then it is precisely the sort of high maintenance jalopies which are being taken out of service first. Those jalopies are AutoZone’s bread and butter sales generators.

Where Next for the Auto Parts Companies?

The sector hasn’t really done much in recent months as the market anticipated the weaker numbers, but the question is how will things look going forward? I think the outlook is not as strong as it's been for a while here and I wouldn’t get too excited about buying into the sector.

With that said, a key point needs to be outlined. These stocks offer counter cyclical growth prospects and investors looking for true diversification should be interested in holding such stocks in their portfolio. If we do move into a double dip scenario, these stocks will relatively outperform.

A Look At FedEx's Prospects

I wear a single handed watch. No second hand, no digital display and only five minute intervals between notches on the face. The German manufacturer wastes no time in pointing out that it seems to cause time to slow down for the wearer. They are right and it doesn’t trouble me at all if I am a little late for some things. What does this have to do with FedEx Corporation's (NYSE: FDX) latest set of results?

Well, actually, everything!



Life in the Slow Lane

The underlying story of FedEx's results is that with a global economy that is clearly moderating, its customers are electing to shift to slower delivery services (Ground) rather than FedEx Express. This is not a huge problem for FedEx per se, because the Ground segment actually has higher operating margins. However, it is a problem when the company is geared for stronger growth at Express.

Here is a chart of how FedEx generated income in the last quarter ($millions).

Indeed it has already taken a $134 million impairment charge this year and retired 24 planes in order to closer align with ongoing volumes in the US.  Furthermore its international Express operations have disappointed this year and it has taken measures to scale back network expansion. Further measures to reduce costs in Express have been promised.

Similarly, the slowdown in Asia caught FedEx by surprise and a lot will depend on certain technology companies' (Apple’s iPhone5, Windows 8 computers, etc) shipments in the future but it’s clear that these shipments won’t counteract weaker end markets.



FedEx Downgrades GDP and Earnings Forecasts

The company is such a reliable bellwether that its GDP forecasts are generally more accurate than the Federal Reserve’s. When FedEx speaks, the market listens.

Here is how they updated the market on GDP

• 2012 US GDP growth forecast unchanged at 2.2%
• 2013 US GDP growth forecast at 1.9% vs. 2.4% previously
• 2012 Global GDP growth at 2.3%
• 2013 Global GDP at 2.7% vs. 3% previously

So 2013 growth forecasts have been downgraded but the bad news is that FedEx appears to have downgraded its earnings forecasts relatively more than GDP. There are three reasons for this.

Firstly, declining US domestic package volumes will hurt margins and growth even if International Express expands volumes; it is lower margin anyway. Secondly, political considerations have encouraged weaker export growth as Governments undergo protectionist trade policies in the face of a slowdown. And thirdly, weaker consumption growth in the US and Europe caused China’s export growth to slow.

Guidance was reduced substantially:

• 2013 EPS Guidance of $6.20-6.60 vs. $6.90-7.40

FedEx has issues with realigning its business to the new growth, but its rival UPS (NYSE: UPS) will not be immune either. Here is how UPS’ growth usually correlates with global growth.

Frankly, UPS and FedEx remain the kind of correlated plays on global growth that they have essentially always been.



Another Way to Profit?

Even if an economy is weak there are always opportunities or eddy currents within economies from which investors can profit. In this case I think we should look carefully at what FedEx is saying about Express vs. Ground and air vs. rail. The Express segment saw revenues rise 1% but Ground revenues went up 8%.

If customers are shifting to slower rail based delivery then we should follow them. FedEx isn’t predicting a 2008-2009 type recession, it is just saying that growth will weaken and one consequence is that customers will want to use cheaper delivery options.

I think the key takeaway here is to buy railroad stocks. Companies like CSX (NYSE: CSX) or Norfolk Southern (NYSE: NSC) and Union Pacific (NYSE: UNP) look set to be benefit from a slow but steadily growing US economy.  The railroad sector has had to deal with the headwind of a weakening coal car loads thanks to the replacement of coal by gas in terms of electricity generation.

Another long term factor in their favor is that rail cars have become much more fuel efficient. This means that their value proposition is even more attractive as the world learns to live with high energy costs.  As a consequence, these stocks have all continued to do well even as the economy slows. Since they are traditionally regarded as cyclical stocks, this is a sign that the market has woken up to the fact that rail’s prospects are not just GDP correlated.

Equifax is a Stock to Benefit From QE3

Here we go again. Another round of QE and another pop at stimulating the economy by pumping liquidity into it and keeping interest rates low. I’m not saying it’s right, I’m not saying it’s wrong but what I am saying is that it is usually a good idea not to fight the Fed and try to invest in line with what they are doing. With that in mind I think shares in Equifax (NYSE: EFX) are well worth a look.

The investing thesis runs like this. If the Fed is going to keep rates low and try to get the banks to lend then consumption will inevitably pick up. This leads to growth and then loan demand. Given that most credit quality ratios are indicating US households have significantly tied up their balance sheets and employment gains are up then it is surely time for the banks to start lending. And when the banks lend, the primary credit bureaus start making money.



Equifax’s Prospects

The three major private credit bureaus are Equifax, privately held TransUnion and UK listed Experian. Fair Isaac (NYSE: FICO) also has a division that sells consumer data but the previous three are the main protagonists. All three credit reporting agencies (Equifax, Experian and TransUnion) use Fair Isaac to produce their FICO scores. Therefore, the company is a useful indicator and a good way to get exposure to the credit bureaus prospects.

A quick look at Equifax’s divisional revenues ($m) in the last quarter.

The core US Consumer Information Services (USCIS) division is the key to its earnings as it is largely responsible for the marginal movements in Equifax’s income. In the last quarter, this division reported a 19% increase in revenue. Within which online consumer information went up 20% to $153.4 million and mortgage solutions rose a whopping 51% to $40.6 million. Consumer Financial Marketing fell 9% to $36.1 million.

It’s understandable if investors awaited the international results with trepidation but somehow Equifax managed to get revenues up 9% on a local currency basis (excluding the divested Brazil operations). The UK was cited as an area of strength in the conference call and that doesn’t surprise me. The country can’t seem to lose its addiction to debt.

Workforce solutions had a strong quarter with a 20% increase in revenue accompanied by a 180bp improvement in operating margins to 23.4%. The mortgage market made a good contribution to the Workforce numbers. This division competes with companies like Automatic Data Processing (NASDAQ: ADP) and Paychex (NASDAQ: PAYX) There are concerns over competition in this industry possibly affecting pricing, but the fact that Equifax keeps expanding margins is a sign that competition is not as tough as people think.

Turning to the last two divisions, North America Personal Solutions rose 12% while Commercial Solutions displayed ongoing weakness by falling 2%.

In summary, the last results were quite strong and confirm on ongoing recovery in US credit issuance and in particular strong growth in mortgages.

What is the Industry Saying?

With regards the workforce division, its competitor ADP confirmed its full year guidance for 12% growth in its employer services and PEO services businesses (the bit that competes with workforce). I think this is a pretty strong performance although investors interested in ADP should note that a low interest rate environment hurts ADP because of lower yields on its client fund portfolio.

Turning to Paychex, the company recently reported its highest service revenue in its history and the key checks per payroll metric has improved for the last nine quarters in a row. So far there is no sign of the moderation in this growth that its management had suggested would happen previously.  The stock yields 3.7% and is well worth a look as a play on an ongoing US recovery.

On a less positive note, Fair Isaac’s last results saw flat scores revenues. Although interestingly its B2B scores growth was much better than its B2C numbers. Note that this contrasts with what Equifax reported for North America personal and commercial solutions.

As for commentary on what the mortgage market is doing, look no further than Wells Fargo with its large and growing share of US mortgage issuance. The bank has been making progressively bullish noises throughout the year on the mortgage environment and housing in general. I think it remains one of the best ways to play the theme. There has been some recent chatter about net-interest margin compression due to low rates, but there is a reason why interest rates are this low. It is to stimulate the economy so the banks can issue more credit. After all, that is how they make money!



Where Next for Equifax?

Revenues were predicted to rise 9-11% in Q3. I wouldn’t expect any upside in the near term from QE3. However, the authorities are determined to pump liquidity into the system and that will only mean that lending and Equifax’s prospects are being supported by the Fed’s actions. I think Equifax was attractive even before QE3 was announced but it is even more so now.

Management have returned nearly 50% of cash from operations over the last two years which is a sign that they are aligned with shareholder interests. Now given that the stock is on a current FCF/EV valuation of 6.1% with low teens earnings growth forecast for the next two years I think the stock is cheap. Throw in the upside from QE3 and it is very attractive.

Agilent Earnings Analysis

It’s always useful to get an industry read across from a company that services many different end markets. In this article I will focus on Agilent Technologies Inc (NYSE: A). It is a cyclical stock and has suffered over the summer as global growth has turned out weaker than expected. However within its end markets there are some varied trends of which investors can either avoid or take advantage.



Agilent Technologies

Agilent is a test and measurement company so when global growth is good and companies are engaging in capital expenditures we can expect Agilent to benefit. Obviously this makes its earnings highly cyclical. A quick look at its revenue share by business segment.

Clearly Agilent’s prospects are largely dependent upon the key Electronic Measurement Segment and I will get into more granular detail in a moment. For now let’s look at how future prospects are looking.

Here is a chart of orders by business segment.

The electronic measurement business is doing ok and the life sciences segment is holding up well but we are seeing declines in new orders in chemical analysis. It’s time to look in more detail into the underlying trends.

Electronic Measurement

The key end markets here are communications (21% of total revenues), aerospace & defense (8%) and the industrial, computers and semiconductors division (20%).

Despite the headline data looking stable, the underlying picture is mixed. Somewhat surprisingly in the last quarter aerospace and defense revenue was down 11% and I can only conclude that this division is heavily skewed towards defense spending. While US Government spending was described as stable, defense contractor spending was described as weak.

Turning to the industrials/computers/semiconductors division I have some concerns here. Results were down 4% but semiconductor and computer revenue growth was described as ‘solid’ while industrial demand was cited as dropping. This is worrying because Intel (NASDAQ: INTC) recently updated the market and downgraded its full year revenue expectations. More importantly it guided towards the lower end of capital expenditures for the year and this sort of slowdown will show up in Agilent’s numbers going forward. Intel is relying on the Windows 8 upgrade cycle but few computer manufacturers are reporting good news here.

I’ve saved the best news for last. Communications revenues were up 7% amidst strong demand for wireless manufacturing and testing driven by smart phone adoption. This is secular growth trend and looking at what AT&T and Verizon are saying about spending there is a clear shift towards wireless spending from wire line.

One company worth looking at in this regard is Ixia (NASDAQ: XXIA) which is a leader in communications testing. Ixia’s prospects are determined by carrier spending but they are skewed towards test measurement in 3G/4G/LTE spending. So whether its data center spending (very strong this year) wireless or even less developed countries rolling out 3G, the company has good prospects. I think its long term prospects are excellent but I would urge some caution here as its fierce UK rival Spirent issued notice that its end markets are slowing. Ixia’s share price is extremely volatile and it is doing very well now so I would look out for the next news flow before chasing the stock higher.

Chemical Analysis Group

This is the hardest hit segment and Agilent is quite clear that it is a macro issue rather than a competitive one. Chemical & Energy (13%) was described as flat and it is being affected by lower replacement business in the private sector. A clear sign of a cyclical slowdown. Emerging markets are helping growth via long term infrastructure projects but it is not enough to make orders positive overall. One concern is how weak Environmental & Forensics (10%) are at the moment. I take this as an indication that Governmental spending on the environment is not as protected as many think it is. The one bright spot was Food (5%) which rose 3% largely driven by emerging markets.

These results don’t read across well for key competitors in this segment Thermo Fisher (NYSE: TMO) and PerkinElmer. A quick look at TMO’s recent outlook shows that it nicely mirrors what Agilent is saying. Its management talked of academic and government spending being down low single digits, but there is ongoing strength in pharma and biotech spending. Meanwhile healthcare and diagnostics spending remains strong while TMO is somehow managing to wring growth out of its industrial and applied end markets.

The difference between TMO and Agilent is that the former has a lot more of its revenues in the faster growing sectors of its end markets. It is a much more cyclical company.

Life Sciences (including Diagnostics and Genomics)

The last segment to look at also has mixed results. Pharma & Biotech (13%) remains strong and was up 4% driven by technological changes which are spurring secular growth. The downside comes from Academic & Government (7%) which was down 6% largely as a consequence of reduced public spending. Meanwhile diagnostics (3%) growth was primarily generated by Dako.

Pharma & Biotech is an obvious source of strength and investors should look for more portfolio exposure here.

Turning to academic spending, this sort of weakness might worry investors in a company like Bruker Corporation (NASDAQ: BRKR). That said Bruker reported a very respectable 10.4% organic revenue growth in the last quarter although it mentioned some weakness towards the end of the quarter. Moreover whenever a company talks about having been ‘somewhat immune’ to the European situation over the last year I start to worry that the reported weakness from the end of May could in fact accelerate. Throw in Bruker’s exposure to industrial & applied markets as well as semiconductors and the outlook seems pretty similar to Agilent’s.