Agilent Has Too Many Negative End Markets Right Now

I think that Agilent (NYSE: A) is a great barometer of a cyclical companies willingness to undergo capital expenditures. If companies are expanding CapEx then they will need to invest in test and measurement instrumentation. With this in mind Agilent’s recent results and commentary were not exactly encouraging. I want to break them down and see the areas of relative strengths/weaknesses with reference to Agilent’s and other companies’ prospects.

It’s Tough Out There

When a cyclically exposed company comes out and forecasts next year’s growth to be flat with EPS down 5% (at the mid-point) then you know times are hard. Recall that these numbers are nominal so they imply falling real growth. Perhaps Agilent is being too pessimistic here but, in my experience, companies with this type of broad based industry exposure are rarely behind the curve when it comes to the economy.

In fact I have rarely heard a company be so focused on the macro conditions on a conference call. If it isn’t the fiscal cliff, its European difficulties or delays in Chinese stimulus spending that are causing its customers to be canceling or delaying spending plans. The guidance wasn’t good, but it also included some discussion of a muddling economy in the first half followed by stronger conditions in the second half.  In response to a tougher environment Agilent is doing the right things and focusing on generating cost efficiencies by closing sites and selectively choosing areas of investment.

Which End Markets are Working?

Firstly, here is how its main segments are performing in revenue terms.

It doesn’t look good, but within this broad weakness there are some pockets of strength. Within EMG, communication markets were described as being down high-single digits within aerospace and defense was down low single digits. Industrial, Comps and Semiconductors were as weak as can be expected with the ongoing downgrades to growth being made by Intel (NASDAQ: INTC) and others.  Of course, the reason Intel is guiding lower is because its end market customers (mainly consumer electronics companies) are finding it harder to shift inventory and this should feed through into general market weakness for a company like Agilent which relies on these companies investment plans.

The one bright spot in EMG was wireless spending which was a bit soft in the quarter, but this is seen as being due to a natural pause from previously strongly growing quarters rather than any kind of problem with carriers’ wireless spending. I think there is cause of optimism here because these comments mirror what Cisco (NASDAQ: CSCO) said recently about wireless spending. I’ve discussed Cisco’s results in an article linked here. However Cisco also mentioned that it saw some signs of improvement with overall US service provider spending. This was not confirmed by Agilent.

Going forward the concern with wireless is that competitors like Teradyne (NYSE: TER) are chasing its obvious growth prospects. Indeed Teradyne recently agreed to buy private held LitePoint which is a leading player in the wireless testing market. It’s hard not to envisage that competition from Teradyne and others won’t start pressuring margins in future.

Chemical analysis orders were flat with revenues down 3% with softness all round except for drug testing. Food maybe doing okay, but it only makes up 5% of end revenues with chemical & energy makes up 13%. Agilent is a very cyclically exposed company.

It is a tale of two end drivers within the Life Science Group. Austerity measures are causing a slowdown in funding for academic research but pharmaceuticals appear to be continuing to spend. The strength in the latter is a point that I think a lot of investors miss. Forget about the fiscal cliff, big pharma has been battling the patent cliff in recent years. Either it invests in R&D for a healthy pipeline or it faces steadily declining revenues.

I like to compare what Agilent reports within this segment to a company like Bruker Corp (NASDAQ: BRKR). Bruker has displayed some surprising strength this year most notably because it has exposure to academic spending in its end markets. No matter it has outperformed thanks to product innovation and timely releases compounded with strength in optical imaging.

Where Next for Agilent?

As ever with cyclical companies, price movements will largely be dictated by a kind of moving weighing machine over prospects for the global economy. The good news is the management doesn't appear to be baking in overly positive assumptions.  This probably leaves the company exposed to the upside if the economy does create some positive surprise going in 2013.

As to its own execution I don’t think that wireless and pharma spending is enough to justify an investment here. Agilent has too many end markets exposed to areas of the economy that are notably weak right now and the near term outlook is getting worse. 

Earnings To Look Out For This Week

Moving into the third week of December, most professional investors' thoughts will turn to protecting gains and dressing up portfolio holdings in order to hang on to assets under management or maybe poach some from competitors. As private investors, we have no need to get involved in this game. I think it’s time to stay tight, focused and surgically alert to picking up great stocks so we can hit the ground running in the New Year.

There are a surprising number of very interesting companies reporting this week, and it's not a time to rest on your laurels. Keep working.

Tuesday

The action kicks off with Oracle (NASDAQ: ORCL). It’s a been mixed season for the tech bellwethers with IBM reporting weakness in enterprise spending and diverging trends, with decent software numbers but weaker hardware numbers. IBM also cited a notable drop in enterprise spending in September, which spooked the market. Cisco Systems then reported a set of results that were pretty much in line, and the market loved them. However, conditions don’t appear to have gotten any better and Oracle, as it proved this time last year, can be a bit of a wild card. Given that Oracle competes with IBM in many markets, these results will be a kind of litmus test for IBM's assertion that September heralded weakness in tech.

Oracle needs to demonstrate that its cloud based acquisitions are working on track and, as ever, articulate its current competitive positioning viz a vis SAP, IBM and others across middleware,servers,data analytics and storage. IBM reported low single digit growth in middleware overall so Oracle is likely to set the tone for this segment of IT for the next quarter. It's something to look out for with Tibco reporting on Thursday too.

The other three I want to highlight are AAR Corp, which I’ve written about here in the context of the aviation industry and on a similar theme Heico is one of the best plays in the sector. Both should give good color on the state of aviation and airline spending. Another stock I like is FactSet Research Systems which is discussed here, it is a good ‘trading down’ stock (in my view) within the business information sector. It just doesn’t look cheap enough.

Wednesday

Wednesday sees five diverse companies reporting. Bed, Bath and Beyond will demonstrate if it has improved its competitive positioning  and global bellwether’s FedEx’s forecasts and commentary are always interesting. It’s forecasting is better than the Federal Reserve’s! I'm intrigued to see if the move towards slower rail frieght based delivery has accelerated.

Another company that will give good perspective on the US economy is Paychex which is looking set to benefit from an improvement in small business prospects.  The market will be fascinated by what Jabil Circuit (NYSE: JBL) says about the IT contracting and in particular its exposure to Apple’s iPhone.  Apple is believed to be responsible for around 10% of Jabil’s sales. Jabil has invested heavily in capital expenditures in order to prepare for huge sales via manufacturing casings for the iPhone. It is usually quite tight lipped about this relationship but its hard to imagine the market wont draw its own conclusions. Another good read from Jabil will come in the form of its reporting on the solar cell industry where beleagured investors will hope to see some faint sign of a trough. Perhaps some decent commentary from Jabil will put some strength back into Apple?

And lastly, General Mills (NYSE: GIS) which is not a stock I am in love with but then again who cares what I think? The market loves yield and GIS gives you that but frankly  I think the whole ‘stable high yield and who cares about growth’ attitude is going to unwind at some point. GIS is using its cash flows to buy growth in the form of acquisitions but this is building up debt. The challenge here will be to see some turnaround in its core business in the US. GIS cant rely on acquisition led growth forever.

Thursday

Speaking of the food sector I’ve long believed that ConAgra (NYSE: CAG) is the pick of the high yield food sector and has a good mix of value brands on the consumer side and a strongly performing commercial sector (Weston Lamb) with exposure to potatoes and fries. In other words, ConAgra can do well in a weak environment. I just wish I had shared the market’s enthusiasm because I got out too early here. Investors should look for continued growth in the commercial plus some stabilization on the consumer side and listen carefully to what the management says about its sales channels. One of the key issues for the food companies this year has been the shifting of sales to alternate channels (dollar, discount or even specialty food stores) and how this has affected their rout to market. ConAgra has the product range to be able to manage these shifts but it needs to keep executing.

Another stock I regret (I didn’t even buy this one) is Discover Financial Services which remains a good way to play a resumption of credit issuance in the US. And finally Tibco Software (NASDAQ: TIBX)  will report some eagerly anticipated results. The company has already pre-reported but the commentary and color will be fascinating and most probably cause some volatility. Investors should look out for more information on its performance and degree of confidence in the administrative changes in its US operations. Tibco's challenge will be to reestablish investor confidence in its outlook after it previously guided far too high. Moreover investors will be looking to learn about why the company is under-performing in the US. Look out for analysts questions on the issue. If the management can make a convincing case for a successful restructuring than sentiment could turn around very quickly with Tibco

Where Next For Autodesk?

It’s the third quarter in a row of disappointing results from Autodesk (NASDAQ: ADSK), but by now investors appear to have become relatively immune. Autodesk tends to be a business operating in cyclical markets without a great amount of visibility for future revenues. This quarter confirmed a slowdown in its end markets, but the stock is looking cheap now and operational improvements with its move to software as a service (SaaS) based suite sales offer potential upside to margins. I decided to take a closer look.

Autodesk’s Earnings

I discussed the company in depth in an article linked here and I would encourage investors to read it in conjunction with this article.

Turning to a summary of the Q3 numbers.

• Revenues of $548 million vs. internal estimates of $550-570 million, analyst consensus at $559 million
• Non-GAAP EPS of 47 cents vs. internal estimates of $40-45 cents, analyst consensus 43 cents
• Q4 Revenue Guidance of $570-600 million vs. analyst consensus of $604 million
• Q4 Non-GAAP EPS Guidance of 43-51 cents vs. analyst consensus of 54 cents

So in earnings parlance it’s a “miss” and it’s also a lowering of full year guidance. Last quarter Autodesk had guided towards full year revenues of $2.3-2.35 billion but this has now been lowered to $2.275-2.305 billion or by $35 million at the mid-point.

While the lowering of guidance and the linearity of it is a concern, I think there are reasons to look positively on Autodesk’s prospects.

Reasons to be Cheerful

First, it’s a slowdown, but it’s not 2008! A reduction of $35 million in full year guidance over the last two reports is disappointing, but it is hardly a catastrophe. Gross basics were basically flat and nine month cash flow is ahead of last year. Management described the slowdown as broad based.

Second, in the last quarter’s results management indicated that the weakness was due to the realignment of its sales force rather than macro difficulties. Apparently, it was the other way around in this set of results. This implies that the shift to SaaS is not an intrinsic part of the company’s current weakness. This is a key point because if Autodesk can accelerate this shift it might be able migrate to the kind of-previously discussed- 30%+ operating margins even while its end markets get tougher. We shall see.

Third, this is a small consolation, but if you add back the $2-3 million that Autodesk estimates it lost due to Sandy then it actually came in above the low end of its revenue change.

All About the Macro?

Autodesk was cautious in the outlook and understandably so. It has significant exposure to the kind of emerging market industrial sectors that are noticeably slowing right now. Execution improved in Central Europe and Brazil, but in general markets were weaker.  In fact these results were in concert with another company with similar end markets Dassault Systemes (NASDAQOTH: DASTY) which discussed a weaker macro environment and a lengthening in sales cycles recently.

In common with Dassault, Parametric Technology (NASDAQ: PMTC) reported that the Americas and Far East were doing well, but saw weakness in the more developed markets of Europe and Japan. I think that this is more of a function of where these companies are positioned to sell too as the US seems to be doing relatively well right now.

As I outlined in the previous article, Autodesk tends to be cautious with its guidance so when it starts missing it is a cause for concern. Going forward I think your near term view of this stock is going to be colored by a macro opinion on the global economy. This is usually the case with such a cyclical stock.

On the other hand, investors don’t always invest with such a myopic focus. In the long term its end markets will get back to growth and there is an important secular growth story here with the shift to Saas.

Analysts have questioned the viability of this move in terms of the inevitable shortfall in revenues that it will create when you shift a permanent license buyer to a subscription based customer. However, I think it makes sense. If a company like Intuit (NASDAQ: INTU) is a useful guide, operational efficiencies should ensue as customer acquisition costs decline when marketing becomes easier. In addition, Autodesk is a company whose top percentages of customers create the bulk of revenues.

The key is to get customers (existing or new) to buy new licenses. It is not just about signing up new customers. I would look for future customers or if the top customers are buying more licenses under SaaS. Of course, the problem with this optic is that it will be clouded by the weakness in the economy.

Where Next for Autodesk?

It is the classic investment puzzle. The stock is attractive long term, but has near term risk so what is an investor to do? Frankly I wouldn’t buy in here without a long term perspective and an expectation of some volatility.

That said, the company has a rock solid balance sheet and continues to generate significant amounts of cash. If it can demonstrate success in its SaaS operational shift then it may well get as re-rating. Until then it remains a position on the global economy with an emphasis on emerging markets.

Sirona Dental Systems Stock Research

Sirona Dental Systems (NASDAQ: SIRO) delivered another set of results that got investors smiling. I’m a fan of this company and its long term prospects and am somewhat puzzled as to why it doesn’t get more media attention. Its long term growth drivers are an attractive mix of favorable demographics (more old people plus more teeth per person means more restorations) and secular growth from proprietary technological change with is CEREC CAD/CAM system which ensures same day restorations. Plenty more growth to come here.

Sirona’s Q4 Results

Investors can be forgiven for thinking that management is too cautious with guidance. Going into the start of its reporting year it had mentioned that it saw some weakness in its end markets. This caused constant currency revenue guidance to be indicated at 6-8% for the full year. This was then indicated towards the upper end of that range and then, as I wrote in an article in August, it was then raised to 8-10%. In the end it came in at 12.6%, so it seems things got progressively better as the year went on.

I have three observations to make on the surprise growth in Q4.

First, Q4 benefitted from the extension of its exclusive distributor relationship with Patterson Companies (NASDAQ: PDCO) in the US. I’ve discussed Patterson in an article linked here amidst noting how bullish it was about prospects for selling Sirona’s hardware.  Patterson gives earnings soon and they will be worth looking out for to see if it has managed to increase sales in its higher margin products.  My point is that it looks like there could have been some pull forward in revenues as non-Patterson clients might have accelerated orders in the quarter.

Incidentally, while Patterson handles the US, Henry Schein (NASDAQ: HSIC) is its main European distributor. The latter caused some concerns when it gave less than stellar results in its dental business recently but Sirona doesn’t seem to have been affected.

Second, none of this growth includes significant contributions from the new Omnicam or the intraoral sensor Schick 33. Hopefully the interest shown in the products will result in strong adoption and sales in the coming quarters. I get the sense that this could provide some upside to guidance.

Third, there is an interesting dichotomy here. Sales in the CAD/CAM segment for the year (up 13.9% in constant currency) were described as strong globally but particularly good in the US while the strongest growth for the year was reported in Treatment Centers (up 15.1% in constant currency) driven by non-European international markets and Germany.  Imaging Systems growth was less strong at 11.5% in constant currency but this is largely due to tough comparisons against strong growth in Germany the previous year.

Growth Prospects?

I want to develop some points from my third observation above.  I think the CEREC CAD/CAM system will see its strongest growth in developed markets and investors shouldn’t expect too much too soon internationally. The basis of the argument for a dentist to buy a CEREC is that -although the ticket price is $100-120k for a system- it should generate good return on investment provided X amount of restorations at a price of Y are made. However the ‘X’ and ‘Y’ numbers are highly likely to be much higher in the US/Germany than they are in other parts of the world. Investors shouldn’t assume equal rates of adoption.

However growth will surely come from an increase in penetration rates in the US where Patterson argued that the CEREC system only has 10% penetration in the US and this figure will be in low single digits worldwide for Sirona. In other words multi-year growth looks likely. I would have appreciated some more color in the commentary of growth via CEREC connect (a system that allows less active practices to tap into the system for a lower initial cost) because I think this will be a key driver in non-developed markets.

Imaging systems too look set for good growth. Sirona’s model involves selling an imaging system into a practice and then in time expanding sales of other sensors into the installed customer base. This year saw some tough comparisons with product launches (the XG-3D product) last year but going forward Sirona expects good growth.

As for Treatment Centers, investors should understand that revenues here are largely immune from reimbursement issues and tend to be tailored towards the high end patient. In other words, they are less economically and politically sensitive than most other parts of healthcare.

Putting these points together makes an interesting comparison with another company in the sector such as Align Technology (NASDAQ: ALGN) whose Invisalign braces are seen as largely offering a cosmetic benefit. Sirona’s benefits are tangible from a cost perspective and also involve a clear technological edge. Therefore I think its solutions offer the safest and most secular growth prospects in the industry. Its revenues are likely to be much less exposed to cyclical movements in discretionary spending than Align’s would.

Where Next For Sirona?

For 2013 Sirona is guiding towards 9-11% revenue growth in constant currency and 10-13% growth in non-GAAP adjusted EPS. All of which is fine but does leave the evaluation looking a bit stretched on a current EV/EBITDA of 14.2x. I’m a great believer that article writers should disclose positions and performance and I won’t hesitate to say that Sirona hit my price target before these results came out.

On that basis it is hard for me to argue that the stock looks cheap. I think it will have to carry on beating estimates to see a significant re-rating. Nevertheless it is a great company and investors will be well advised to keep it on the monitor list and watch developments closely. I know I will.

Make Money From Feminism

It isn’t often that investing articles touch on social trends, but if you want to invest in equities, you need to keep an eye on these things. In this article I’m going to focus on what I think is an increase in hypergamy caused by various factors. Hypergamy is defined as the desire to marry above your perceived class or social status. It is most commonly exhibited by women and it is increasing. If you disagree with the last two statements then I will save you some time. Don’t read any further because this article isn’t for you nor will you want to invest in the stocks I suggest on this basis.

Nothing New

Frankly I’m not arguing anything new here. Hypergamy has always been with us. I’m not going into the evolutionary psychology or the arguments why it exists. What interests me is why it appears to be on the increase. Now I know you all like a chart or two so here is my effort. I’m going to keep this simple.

Here is what might be called the ‘normal’ state of affairs. In reality there is no norm but for arguments sake let’s say this might be 1950’s USA.

There has always been a desire for hypergamy in women which creates a kid of ‘hypergamy gap’ that means women are looking to marry someone above their status. Here we can see the gap. The areas I’ve labeled are those of men and women theoretically left without a partner thanks to hypergamy.

Of course in this period there would have been a lot more social pressure for a woman to find a ‘good man’ and for a man to shape up because Olivia Newton John et al needs a man. In other words there was more cultural pressure on these gaps to close.

You Go Girl

My argument here is that for myriad reasons there has been an increase in the perception of value (I’m choosing my definition carefully) that women have. I’ll get onto the possible reasons why in a moment.  First I want to schematically depict what I think is happening now

If I'm right the gap has got bigger because the perception of value in women has increased. Note I am not talking about actual value I’m taking about perceptions. In addition social pressures are actually encouraging women away from marriage.

I need not articulate how divorces, single parenthood and the numbers of single people are on the increase in the West. This is common knowledge.

What Has Changed?

I think it is self-evidently true that there have been significant changes in society over the last few decades or so. Some of them are part of a political agenda and others are inexorable changes in the structure of the economy.

  A few view points on the situation in the West.

• Feminism
• Social welfare
• Law
• Social networks
• Government Policy (quotas etc)
• Structural Economic Shifts (manufacturing to services)

I believe that the true test of feminism’s advance (from which many good things have been achieved) will be when women look to marry men of perceived lower value.  As unpalatable as it sounds to some, there is no harm in it. I think this is what the body of feminist literature should be aiming it right now because otherwise the women in the right hand side of the curve may not find a partner. Unless of course if the feminist agenda is to ensure that some women remain barren and men childless just to prove an academic point.

In addition the expansion of social welfare has created a scenario where some people are actually incentivized not to get married or work because they will lose benefits. It gets worse. In some cases the incentive is to have kids out of wedlock because it brings more benefits. In my opinion things like child and housing benefit -as well as housing policy itself- have significantly affected matters in the UK.

Neither are trends in law helping matters much. Consider this high profile case where a famous footballer was obliged to pay a large portion of his future earnings to his wife. I know more than a few men in the UK who have been financially ruined by divorce. I don’t know any women in the same situation.

Perhaps the most interesting point here is that of social networking through things like Facebook (NASDAQ: FB) or Twitter. To explain what is happening consider here consider the famous jam consumer experiment. Consumers buy more when faced with fewer options but they always want more of them. In other words, they follow behavior which is not optimal in terms of making a decision.

Now consider what happens when women spend time on Facebook ‘networking’ or tapping away on a smart phone. Their perception of their chances with- their very own high value George Clooney- go up just because they are ‘connected’ with him. Their perception of value goes up just because 50 people ‘like’ their new hairstyle. Lots more jam out there but nobody is buying anymore. The nice guy they met at the gym last week doesn’t get his text answered just because some guy they like has changed his FB status to single. Social networking is creating the illusion of choice. A similar argument could be applied to men and an increase in their perceptions of an abundance of choice. No matter, the conclusion is the same.

All of these things add up to increase the social pressure on women to increase the hypergamy gap. The simple thought that it could be reduced by women marrying ‘lower value’ men seems to escape the mainstream media. It is never discussed. There seems to be a tacit assumption that women should always marry above themselves and men below. Why?

How to Make Money Out of All This?

If I’m right about these trends continuing than you can bet that single people will have more pets as an emotional replacement so expect PetSmart (NASDAQ: PETM) to do well on a long term basis. Indeed pet ownership does seem to be on the increase.

Another angle would be to assume that increasing numbers of wealthier and older single women will mean more cosmetic surgery so Botox manufacturer Allergan (NYSE: AGN) or the maker of rival treatment Dysport, Valeant Pharmaceuticals (NYSE: VRX) will be beneficiaries. If there are more older women who are incentivized to undergo plastic surgery in order to keep looking for a partner than companies offering aesthetic treatments will surely benefit. You can see my view in the disclosure section at the bottom.

It will also mean that more childless women of a certain age will have more discretionary income so things like Louis Vuitton, Richemont or Coach (NYSE: COH) might expect favorable long term trends as a consequence. If a large part of the populace is shifting its income spending from raising children then it is safe to assume that that income will go towards luxury items that are traditionally bought by women.

In conclusion, if these trends continue -and you don't have to agree with me over the causes- then there will be some fundamental changes in spending patterns. It is an investor's role to spot them at invest in them. It is not an investor's role to ignore them because he/she wishes they were not true

Intuit is An Undervalued Cloud Play

Intuit (NASDAQ: INTU) delivered results in line with estimates and affirmed full year guidance, but its next quarter was seen as ‘weaker’ than expected. I use inverted commas because the reason for this is that revenues in its core tax division tend to move around based on the timing of tax legislation. This year it has caused revenues to move more into the third quarter. This is not really an issue for me, but you never know how the market will react to this sort of thing. In summary, I think the stock remains a compelling mix of growth and value that should attract any GARP based investor.

Intuit’s investment Case

The case for Intuit is fourfold and offers a nice mix of cyclicality and secular growth. I’ve put the main points in bullet form.

• Cyclically growth in its core tax revenues as the economy improves
• Secular and cyclical growth in its small business group as it increasingly cross sells its solutions and transitions clients to the cloud
• International expansion
• Improving operational metrics overall as a result of increasing software as a service (SaaS) revenues

Frankly I think the numbers speak for themselves with Intuit. You can think of it as a business growing its tax revenues in the mid-single digit range with some growth kickers from any economic improvements and mid-teens growth in is small business group leading to overall growth in the low teens. Throw in its high free cash flow conversion, which is forecast to grow in line with operating income this year, and the stock has good upside potential.

A look at how the individual segments of the Small Business Group are growing.

Growth is pretty strong here, and the company continues to diversify its revenue and income streams from do-it-yourself consumer tax revenues. We can see this in the breakdown of revenues and income for the full year.

Consumer Tax remains the most profitable income generator and the highest margin business, but employee management margins are now pretty similar. Going forward, if Intuit can continue the mix of mid teens growth in the small business group and single digits in consumer tax, then the opportunity of diversification (and therefore a re-rating based on risk reduction) is obvious.

Get Into the Cloud with Intuit and Others

The key to Intuit’s growth strategy is going to be further integration of its solutions across new platforms such as mobile and tablet. As such, it is a continuation of how the company has been transformed in recent years. It has delivered a sound competitive thrashing to H & R Block (NYSE: HRB) in the tax preparation market. As he is wont to do, Warren Buffett does sometimes invest in value stocks that are about to be overtaken by a technological erosion of their business moats. Such was the case with his position in H & R Block.

Intuit is the poster child for companies moving to the cloud, and you can see others like Adobe Systems (NASDAQ: ADBE) and Autodesk (NASDAQ: ADSK) trying to follow in its footsteps.

These two haven’t exactly found it easy going. Autodesk has been battling with a cyclical slowdown in manufacturing, and a shift in its model seems to have been met with some customer resistance as many of them were buying individual solutions rather than packages.

As for Adobe, the switch to SaaS has caused a short term reduction in growth as initial revenues are less for services. I’m bullish about Adobe’s prospects, because I think the shift will generate more lifetime value and, in common with Autodesk, there will be many enticed to pay the smaller initial upfront fee rather than continue to illegally download/copy software.

Where Next for Intuit?

Longer term there is a question mark over where Intuit will be, but short to mid-term its prospects look excellent. The shift to the cloud has improved its cash flow generation and ability to generate more bang for its marketing buck. On the basis that free cash flow generation will match operating income growth next year, Intuit could generate around $1.25 billion, and this comprises around 7.4% of its enterprise value. Not bad for a company growing earnings in double digits.

Headwinds are coming in taxes and other areas, but the stock seems to have enough margin of safety to justify buying. At last I think so, because I happen to hold it!

Time to Buy Cisco Systems?

Cisco Systems (NASDAQ: CSCO) allayed the worst fears of the market and the stock got a nice boost. There was nothing really unexpected in these results, but the commentary on enterprise spending was welcome after other tech heavyweights had taken a far more cautionary tone. In summary, Cisco remains a value play and I think the key to its future performance will lie in how it uses its cash flows and balance sheet cash to make acquisitions.

It is an interesting stock, but tech investors usually want growth and value investors usually shy away from tech. I suspect either the market is going to have to change its prejudices or Cisco is going to start getting acquisitions right again before the stock goes meaningfully higher.

Cisco’s Earnings: Macro

It would be disingenuous of me not to mention that I previewed these earnings in an article linked here and earnings came in pretty much as expected. On a top line basis I was looking for around $11.7bn and they came in at $11.9bn but with around $200m contribution from the NDS acquisition within the collaboration segment.

However, the key surprise was in the commentary on the strength of US enterprise spending which grew 9% whilst European enterprise spending was down in the “mid-teens.” This is incongruent with what IBM said a few weeks ago about enterprise conditions weakening in September. Unless the idea is that overall conditions worsened in September only to improve in the US in October?

Cisco is a company known to be relatively exposed to public and developed market spending and has been vocal about warning over a slowdown here so any strength in enterprise will be well received by the company and others. It’s likely to give a fillip to other tech companies. In addition its talk of signs of improvement with US service provider spending is going to set Telco investor’s hearts racing.

Cisco Earnings by Segment

Turning to a segmental view, the core divisions of switching and routing displayed their usual “good cop-bad cop” double act. This time around switching was stronger than expected and routing was weaker, which is a reversal from previous quarters. Routers saw some weakness from Europe with operators switching to faster networks causing a decline in Cisco’s optical networking revenues.

Yearly growth shown here.

The good news here is that the management sounded a lot more upbeat about how it is responding to the competitive threat from Huawei, Juniper Networks, Avaya, and others. These segments are Cisco’s core revenue generators and while its acquisitions in recent years have been questionable and it loses market share in non-core markets it is essential that it continues to perform well here. There are perceived security issues for companies using Chinese hardware and Cisco seems to be benefitting from these fears. While mentioning Juniper it should be noted that a lot of the segments were it competes with Cisco showed strength and I would expect the stock to go up in sympathy.

Service Provider Video results were actually pretty good. The NDS acquisition contributed significantly by underlying revenues were still good. This sort of result will interest those with a position in something like Riverbed or F5 Networks (NASDAQ: FFIV) who both partly depend on service providers spending on application delivery and network optimization solutions. Indeed as outlined here I think F5 maybe being a bit cautious in its outlook. The financial vertical is likely to be cautious until some sort of resolution over Greece and/or the fiscal cliff issue is resolved but AT&T recently affirmed its CapEx guidance and Cisco did say positive things about enterprise spending.

In addition collaboration revenues weren’t as weak as some had expected but with TelePresence described as being down in the mid-teens then this hardly bodes well for its competitor Polycom (NASDAQ: PLCM). The latter has been innovating with new products so it could be grabbing share but overall this just looks like a solution looking for a problem right now. Corporations do not invest in expansionary technology when they see a slow economy.

The last three segments of wireless, security and data center all delivered results pretty much in line with expectations. Data Center spending remains very strong and I think is subject to strong secular growth trends as smart phones, tablets and bandwidth rich internet applications grow exponentially.

Security growth has slowed and this is pretty much in line with a lowering of estimates from companies like Check Point and Fortinet.

Wireless is an ongoing area of strength with bring your own device (BYOD) cited as a key driver. This is good news for Aruba Networks (NASDAQ: ARUN) and with the ongoing diversification of mobile device choices away from the traditional corporate Blackberry solution and towards Iphones and Android based smart phones the outlook does look good here.

Where Next For Cisco?

These results are not a game changer and Cisco still looks to be the low to mid single digit grower that it has been in recent years. It is hardly a growth investors dream. Now I know what you are thinking now and you would be right. I am setting this conclusion up to argue that Cisco is a value play. It generates billions in cash every year and according to Yahoo data it trades on an EV/EBITDA ratio of 4.4 and has nearly $38bn in net cash/instruments on its balance sheet.

Its recent acquisition history hasn’t been glorious but Cisco is a company that was built on timely acquisitions. Given its huge financial firepower it could buy some growth but the market doesn’t seem willing to give it the benefit of the doubt until it demonstrates a return to winning ways. For long term value investors Cisco remains attractive.

TJX Companies Looks Good Value

It’s not often these days that you hear a retail company emphasize its growth opportunities in Europe, but TJX Companies (NYSE: TJX) is no ordinary company. The off-price retailer has been a clear winner in the new retail reality in the US, but investors can be forgiven for wondering if it is likely to continue in future and if relying on European retail is a wise policy. I happen to think the answer to both questions is yes, and here is why.

Growth Drivers at TJX Companies

The company outlined three key areas where it plans to improve prospects.

First, it is seeking to increase its attraction to a broader demographic by appealing to them with marketing initiatives. Second, it is aiming for supply chain efficiencies, and third it intends to increase store count. In addition, I think the potential in the Home Goods stores is significant. It is a good space to be in right now, as housing is showing signs of recovery. Moreover, once consumers get accustomed to off-price purchases in one format (clothing), they will surely do so in another.

Pivotal to all of this is the opportunity to expand in Europe, and I think TJX has good potential to capitalize on this. It’s easy to point at European macro conditions and conclude that a US retailer would be insane to look to expand there. However, if the company was able to aggressively increase sales and margins in the US during a weak period then why not in Europe too? I think there are three reasons why it can do so.

First, an off-price retailer is essentially a ‘trading-down’ play, and I’d argue that European consumers are more brand aware than US consumers are. In my opinion, the latter tend to be more price aware. In other words, expanding stores in Europe is likely to be even more successful conceptually than in the US for TJX.

Second, I doubt TJX will have any problems getting inventory in Europe. As noted above, European brands compete more on quality, and its leading brands will not want to discount in their main branches and normal priced stores. Therefore TJX should be able to obtain good quality inventory and have the opportunity to extract better margins from it than currently reported.

Third, I am a great believer in the idea that when certain behavior becomes socially acceptable then it is likely that individuals will accelerate their adoption of it. This is another way of saying that as more and more consumers adapt to buying off-price clothing, it will become more acceptable for an individual to shop there.  Mainstream journalists start writing about the shops, a few tv features appear, and suddenly everyone is talking about it.

Sales Growth Remains Strong

Comparable same store sales growth grew 7% in the quarter, and the company raised its full year guidance for same store sales growth from 4-5% to 5-6%. This implies the all important Q4 same store sales growth will be 0-2%, and I think this looks a little cautious. It will be interesting to see what its off-price competitor Ross Stores (NASDAQ: ROST) says in its guidance this week. Although I suspect it too will be cautious given some impact from Sandy. Ross is a competitor, but it also helps to market the category and TJX stores are often positioned near them.

Both Ross and TJX have been a bit weak recently as the market frets over competition for its spending dollars from developments at the likes of Nordstrom (NYSE: JWN) with its discounted Rack stores. Nordstrom is aggressively expanding roll out here and investing in e-commerce initiatives in order to drive growth. Similarly, the department stores are beginning to start offering discounted pricing, and a company like J.C. Penney (NYSE: JCP) surely needs to respond to its operational difficulties. The likelihood is that JCP will continue to offer coupons in order to encourage footfall, and even Coach (NYSE: COH) has had to step up couponing at some of its stores in order to get traffic back. In essence what the developments at JCP and Coach demonstrate is that the US consumer is getting very savvy about pricing and promotions by retailers.

Turning back to TJX, I’ve broken out segment sales growth in order to demonstrate how well TJX is doing in Europe this year.

In fact, Europe is growing faster than the company average and management sees full year comparable same store sales coming in at 8-9% on a constant currency basis. Segment margins grew in Europe from 5.7% in Q3 last year to 9.1% this year.

Where Next For TJX Companies?

I think investors should focus on the long term story here and not get too worried about quarter by quarter movements. I don’t think that Europe’s troubles are going away any time soon (even if weak comparables will be lapped by many businesses), so the market opportunities for a proven off-price retailer like TJX are significant. Moreover, the US recovery shows every sign of being slow and drawn out for the mass market consumer, and off-price retailers are becoming increasingly popular in the US.

Competition is coming, but TJX is a pure-play off-price retailer. It is one thing for department stores to want to muscle in on the act, but another thing when they see their discounting hurting margins elsewhere. In short, the market dynamics remain favorable and TJX is the leading player in the category, with plenty of potential for geographic expansion.

Its Not Too Late to Buy Home Depot

Home Depot (NYSE: HD) cheered a market seemingly worried over a Roadrunner like rush over the fiscal cliff. I think it was a timely set of results which served to remind the market that conditions in the US are –albeit slowly and unevenly- getting better. It’s not my intention to make any social comment, but rather try and contribute some information which might help investors make better decisions. In this piece I want to articulate why Home Depot is still a buy in my book and look at the color in these results and see what conclusions can be reached for other stocks.

Home Depot Raises Beats and Raises Guidance

On a reported basis it was a miss but there was an 11c charge for closing stores in China where its idea of establishing big box stores has been deemed a failure. No matter on an adjusted basis it is a pretty handy beat on earnings as well as revenues. Indeed Home Depot raised full year sales growth. I’ll get back to earnings in a moment but for now, here is how it has been adjusting guidance upwards this year. Note the contrast to previous years.

There is an obvious and pleasing progression this year but this is partly an optical illusion. In reality there was a pull forward in sales in Q4 2011 and Q1 2012 which was partly a consequence of the un-seasonally warm weather encouraging more construction activity in those quarters as well as an increase in demand coming from housing repair work created by Irene.

In fact these points are the key to understanding why the market is so excited by Home Depot’s results. In spite of raising guidance, its management was cautious about baking in any assumptions for Q4 from Sandy.  The reason is that much of Irene’s repair work was brought forward by the warm weather and no one has strong idea of what the weather the will be in Q4 this year. However, the repair work due to Sandy is believed to be adding at least what Irene did (around $360m in sales) so analysts will have to start raising assumptions for Q4 and Q1 and this is on top of favorable developments in its end markets due to a nascent recovery in the housing market.

Home Depot Sales Signaling Strength

Looking at the results in more granular detail I think there are two really interesting points.

The first is that Q3 came up against a tough comparable last year and Q4 will do the same. No matter guidance was pretty good for Q4 and this is without any assumptions from Sandy. In addition the start to November was described as being strong. This implies that there is some linearity in its performance. Indeed I have outlined what is happening in the housing market in a recent article linked here. Read if you are looking for pictorial representation of macro data for the housing markets.

Here is how comparable same store sales growth is trending this year.

The second point is that it is starting to see strength in the more discretionary areas of spending. Things like décor, kitchens, indoor paint, gardening, bathrooms, and appliances were cited as having particular strength. In other words it is not just about repair work, the consumer is starting to open up on housing related expenditure. Moreover 33 of its top 40 markets were cited as being in positive territory with the only weakness being in the North East. This is somewhat understandable given tougher comparisons caused by Irene last year. However that weakness is likely to turn into strength soon.

What This Means to the Sector

The only major negative was in tough roofing conditions relating to the comparison with Irene. In contrast with Irene-which had more wind- the damage caused by Sandy is believed to be mainly caused by water. This suggests that Beacon Roofing Supply (NASDAQ: BECN) might not find as much upside as many think following Sandy. I like the stock but am out of it now on evaluation grounds. It will be interesting to see if it can take its intended pricing this year.

On a more positive note if higher ticket white goods are doing well than surely Whirlpool (NYSE: WHR) can expect better things going forward in the US? Europe has now decreased so much in profitability that the US and Latin America are the key to its prospects.  It’s a similar story of strength with a stock like Sherwin-Williams Company (NYSE: SHW) which makes the kind of indoor paints that Home Depot is outperforming in. The stock has had a great run this year but with its heavy weighting towards the US construction market its prospects are likely to get better.

Another two companies worth highlighting are Williams-Sonoma (NYSE: WSM) and Pier 1 Imports Both were up in sympathy with these results and it’s a good call by the market because they depend on relatively lower ticket item discretionary spending in the housing sector. Home Depot outlined that the worst geographic areas of the housing market were now seeing sequential improvements and this broad based strength will surely feed into WSM’s and Pier 1’s top line numbers.

Where Next For Home Depot?

I think the stock goes in the mid and longer term. Analysts will have to raise estimates after these results and given an ongoing recovery in housing there is upside potential to prospects. On current earnings it looks fairly valued so I think it is likely to at least ‘return its earnings’ in the next year or so. This translates to a target price in the low 70’s with upside potential given acceleration in end market conditions. I like this kind of investment.

Allergan Has Good Growth Prospects

Allergan (NYSE: AGN) should interest investors looking for a healthcare stock for their portfolio. Its long term growth drivers are largely driven by demographics and increasing adoption of its market leading Botox product into other indications than aesthetics. Moreover, it has a strongly growing portfolio of eye care products that give it earnings stability and an aggressive R & D plan to develop future products. On the down side, it faces some headwinds from austerity measures and a competitor re-commercializing a rival product in January. In summary, I think the risk/reward balance is now in favor of the stock, and I picked some up.

Allergan Gives Good Visibility

Forgive the atrocious pun in the sub-heading but it happens to be true. I’ve tracked how Allergan forecasts end-of-year guidance throughout the reporting year.

There are some downgrades with things like Lumigan (high eye pressure) and upgrades with Restasis (chronic dry eye) and Alphagan (intraocular pressure), but in general there is a comforting consistency in guidance. This is somewhat surprising because there are actually quite a few moving parts to Allergan’s prospects.

Allergan’s Growth Dynamics

According to company statements, Allergan’s best selling product is its neuromodulator Botox, for which it has 84% market share within the largest markets. Globally, this market is growing in low double digits, and Allergan claims to be holding market share. This is likely to change in January as Merz is allowed to start to re-commercialize its rival Xeomin product for aesthetics.

Indeed, Allergan estimates it gained share in therapeutics but lost some in aesthetics. Going forward, Botox sales are likely to expand further into other indications, such as chronic migraine, spasticity and bladder treatments. These are key examples of how Allergan is expanding Botox sales, although there were some issues in Europe with austerity measures eating into profitability. On a more positive note, it does take a while before reimbursement is approved in certain countries in Europe so Allergan can look forward to some growth from Botox for migraine, spasticity and bladder indications in the old continent.  Going into 2013 the company hopes for approvals for Botox in idiopathic overactive bladder.

Competition is expected to emerge from Valeant Pharmaceuticals' (NYSE: VRX) purchase of Medicis (manufacturer of Botox competitor Dysport), as it is expected to step up investment and marketing know-how in order to expand sales in dermatology. Another competitor is Johnson & Johnson (NYSE: JNJ), which has anti-wrinkle products as part of its acquisition of Metnor. JNJ hasn’t been doing great in its consumer products division and reported only a .2% rise in worldwide skin care sales in the last quarter. No matter, with the industry growth in double digits there is enough opportunity for everyone.

However, it’s not just about Botox, Allergan has an attractive product portfolio in eye care. Sales increased 12.5% on a constant currency basis in the quarter and are up 10% year to date. Allergan has 15% of the global ophthalmic market, which has been growing in the mid single-digits this year. Competitors include companies like Novartis (NYSE: NVS), whose Alcon unit competes across many of Allergan’s product lines.  A quick look at Alcon’s latest results reveals its net sales expanded 5% on a constant currency basis for the first nine months this year. This is slightly below overall industry growth, but not enough to suggest any significant market share shifts.

The Bottom Line

I think the risk/reward calculus is favorable right now and bought some stock. Allergan faces some headwinds from competition for Botox, but it also has plenty of growth potential. Austerity measures also will create pricing pressure, but Botox sales are being expanded in other indications, and I like the long term growth prospects. Eye care should also see good long term growth as it benefits from an aging demographic.

The stock trades on 27x earnings, but its cash flow generation is pretty good, and R & D expenditures should see a bigger pipeline developing in the future. The stock looks fairly valued right now and is possibly only capable of ‘doing its earnings’ in the coming year. In other words, mid-teens returns. That’s fine with me.

The US Housing Market and the Stocks to Buy

An overweight position has helped me outperform this year, and I see no reason to reduce it right now. In fact, the fundamentals look like they are getting better. A host of anecdotal evidence and commentary from housing related stocks has been suggesting better days ahead. In this article, I want to focus on the fundamental data. Investors should be discerning and not afraid to research things thoroughly. After all, it’s your hard earned money that you are investing.

Housing Data Looking Better

The first exhibit is the Architectural Billings Index from the American Institute of Architects...

…which has perked up lately. This is usually a pretty accurate barometer of future housing market conditions, but the picture has been distorted this year with the pull forward of activity in housing due to the unseasonably warm winter in the US. So is this another optical trick with housing?

I happen to think it isn’t.

Firstly, homeowner vacancy rates (US Census Bureau) have fallen every consecutive quarter since Q4 2010 and are now not far away from historical levels.

Of course homeowner vacancy rates are one thing, but the key is to see some traction in the demand situation.  I think we are seeing that now. For example, here is how the monthly supply of new single family homes is trending.

Again we are approaching historically favorable conditions. Now the last time I looked at an Economics 101 text book, it told me that Demand>Supply=Pricing^ -- so is this happening now?

It looks like pricing is back too.

In summary, all the data is pointing towards a more meaningful pick up in housing and the supplementary information is supporting what the Architectural Billings Index is suggesting. With that said, it’s time to drill down and look at possible beneficiaries. I want to try to keep this as broad as possible because I realize that investors will have different opinions as to which stocks are attractive.

Which Stocks to Buy in a Housing Recovery?

As ever, you can start with the home builders, and despite the fall after DR Horton’s (NYSE: DHI) and Beazer Homes'  numbers, I think the sector is still doing well. Beazer missed estimates and isn’t the best way to play the sector, while DR Horton’s numbers were a little light relative to upbeat expectations. Nevertheless, its order backlog was up nearly 50% and sales demand remains strong. This is hardly the stuff of a weak housing market. However, I would encourage investors to look elsewhere. The house building sector has had a huge run up in anticipation of a better economy.

I think there is further room to grow at Home Depot and that the stock belongs in the high 60’s, but Lowe’s (NYSE: LOW) will interest those looking for a company trying to make operational adjustments and play catch up. The stock isn’t expensive, but it needs to execute better. The good news is that it’s always easier to do this with favorable end markets, so it’s down to its management to get its merchandising right. From my perspective, I like purer exposure to macro calls and am sticking with Home Depot for now.

Home Spending Stocks

Increased construction activity should help something like Fastenal, and others might find good value here, but it’s a case of ‘love the company but hate the evaluation’ for me. I’ve discussed it in more detail here, and it’s a similar story with Pier 1 Imports in an article here. Just to prove that my misery knows no bounds, I’ve also decided to take a pass on buying into Bed, Bath and Beyond (NASDAQ: BBBY) as discussed here. The company faces competitors encroaching on its core market place and seems to be paying for top line growth at the expense of margins. Meanwhile, it doesn’t appear to be managing its cost base particularly well this year.  Much will depend on performance at the new store rollouts.

Before you conclude that I am a complete pessimist, I should point out a relatively positive discussion of Whirlpool (NYSE: WHR), which I think has managed a restructuring very well. I’m a bit concerned with its exposure to Brazil and think investors should watch what other companies are saying about conditions there. It may even have a bottom in its results in Europe -- more details here.  A company with similar kinds of exposure is Masco (NYSE: MAS), although this stock is higher risk. Its debt levels are significant in relation to its market cap, and it has significant overseas operations. In other words, it is not ideally placed to deal with an unexpected slowdown. Nevertheless, those looking for a bit more risk/return will want to take a closer look.

On a more positive note, I think Acuity Brands is worth holding. Its main exposure is to commercial and industrial lighting solutions, but spending on commercial construction tends to follow residential spending in a cyclical fashion. In addition, there is the longer term secular growth driver of LED lighting to look forward to. Lastly, the timber companies, like Weyerhauser and Plum Creek Timber, are also well worth a look, as they will have good housing exposure.

Conclusions

I think that the macro data is suggesting better times ahead, and this is a sector that investors should be trying to get more exposure to, at least on a relative evaluation basis. It’s been a long time coming, but the US housing market does look like it's back this year.

Colgate Palmolive is Relying on Emerging Market Growth

Colgate-Palmolive (NYSE: CL) did as it does and delivered a solid quarter of 5% organic growth while outlining some market share gains in key markets. This is about as good as it is going to get in the mass market these days, as the US market remains weak and emerging markets are showing signs of a slowdown. That said, Colgate is doing the right thing in launching a four year growth and efficiency program. Its new product launches have helped to drive growth and now is not the time to take the foot off the pedal. The real question, as ever, is whether the evaluation is right for the future prospects.

New Problems, New Programs

I thought there was some peculiar discussion on the conference call, with analysts trying to get at the kind of recurring time-frames for when Colgate takes charges for restructuring programs. The subject came to my mind as I sometimes write these arguments from a café wherever I am in the world. In this case, it’s Eastern Europe, and the last few nights I have not been regaled with the melodious (higher culture) music of Liszt or Bartok, but rather a group of guys discussing discounted cash flow (DCF) analysis on some sort of financial modeling course. All of which is fine and dandy (sort of), and it’s exactly the kind of approach that analysts will take with Colgate. In other words, factor X amount of sales for a restructuring charge every Y amount of years and then nicely insert it into a DCF without actually understanding why.

However, the ‘why’ is the important bit. It is because of a bifurcation of prospects with the mass markets in the western world and large parts of emerging markets. Simply put, the US lost over 8 million jobs (payroll data) in the last recession and hasn’t even recovered 50% of them yet. Everyone knows what is happening in parts of Europe. Meanwhile, polities in places like China are doing everything they can to generate and keep employment for the masses.

The new reality has brought winners and losers. Procter & Gamble (NYSE: PG) has been doing okay recently, but it has notably underperformed companies like Church & Dwight (NYSE: CHD) on a five year view.

PG data by YCharts



The difference is that PG’s traditional strategy in a slowdown is seen as being to hold pricing at the expense of market share and then be leveraged to the upside of an economic recovery. Times have changed, and this recovery is a lot longer and shallower than usual. Not good news for PG.

As a consequence, consumer behavior is changing and adjusting to discounting as retail channels are shifting in the mass market. As such, a company with powerful value brands like Church & Dwight can be nimble enough to gain market share.

Can Colgate Generate Double Digit Growth?

Indeed, Church & Dwight is the only company in the sector that has consistently generated good growth, but Colgate-Palmolive has not been far behind. Colgate’s story is one of impressive new product launches (Colgate optic white etc) and expansion in new categories like mouthwash in the US. The restructuring plan is intended to deal with the new realities, and management affirmed its intent to generate 6-7% organic revenue with a 10-11% increase in reported EPS. Can it achieve this?

On the negative side, investors will look at the slowing economy and increasing competitive pressures in emerging markets (as everyone chases growth there) then point at the 5% organic growth in the last quarter and conclude that this is a big ‘ask.’ Moreover, the strong growth in recent years has been a result of new product & category launches that will be hard to repeat. Indeed, growth slowed in Q3 as Colgate came up against tough comparisons. According to management, it is aiming for near 1% growth in Europe, 1-2% in North America and 8-9% in emerging markets. Much depends on the latter, and given that it has huge market share in places like Brazil and Mexico, it is hard to be completely confident that it will hit these growth targets.

The positive case with Colgate is that the restructuring is timely, and focusing on efficiency gains with things like centralizing costs in Europe makes sense. In addition, a renewed focus on where to invest over the next five to ten years is also an implicit recognition that sticking to the old reality won’t work.  I’ve been skeptical on the issue of China’s mass market continuing to generate growth despite GDP growth slowing, but if you look at Yum! Brands' (NYSE: YUM) latest results, it is actually doing quite well. Growth is slowing but nowhere near as dramatically as in other parts of the economy, and generating this kind of high single digit growth looks achievable in China.

The Bottom Line

Frankly, I think the stock looks a little overvalued right now for the risks going forward. It has had a magnificent run and it remains fund managers’ favorite.  For sector weighting reasons, professional investors will pick out a ‘go to’ stock, and Colgate seems to fit the bill. The end result is that it trades on 20x earnings and an EV/EBITDA ratio of 12.2. This is hardly cheap for a company that depends a lot on macro conditions in the Far East and has been winning thanks to previous product innovation. There is no guarantee that these two factors will remain favorable for Colgate.

It is a high quality company, but I think cautious investors would do better by waiting for a significant dip before buying in here. Private investors do not have to be invested in sectors if they dont want to be. No need to chase this stock higher in my view.

Why I am Not An Investor in Rackspace

Rackspace Hosting (NYSE: RAX) promotes its service offers “fanatical support,” but I think that description rather aptly describes some of its shareholders. With a cursory view the stock looks expensive, but then again proper investors don’t just take initial views at face value. The stock is in very attractive end markets and 20%+ revenue growth rates can turn an expensive looking stock into a value proposition in no time at all. I decided to take a closer look.

What the Industry is Saying

I wouldn’t get too alarmed by the recent results from Rackspace or even the sector. I don’t think there was much wrong with them, but when the overall market slows down it is the outperforming sectors that are going to be sold off aggressively.

RAX data by YCharts

Equinix (NASDAQ: EQIX) is more a pure data center play and I thought its recent results were okay. It was good to see the growth in capital expenditures forecast to slowdown next year. The big worry with data center companies is that they are aggressively rolling out capacity in response to customer demand and at some point this could turn into a capacity glut. So far so good and its gross margins are holding up well. For those interested I have a primer article on Equinix and Rackspace here.

Rackspace’s big initiative this year is to shift to OpenStack, which basically means its customers can have more flexibility with how they utilize and position their applications rather than be tied to one vendor. It’s a bold move and makes sense for Rackspace but it’s a different direction from what VMware (NYSE: VMW) is doing with its leadership position in the private cloud and similarly with Amazon.com (NASDAQ: AMZN) in the public cloud.

No matter the market has loved the cloud story this year and for good reason. Oracle (NASDAQ: ORCL), SAP and nearly every other major on-premise license based software company have been rushing to develop cloud based software as a service (SaaS) solutions. The trend is not turning anytime soon. If someone like Larry Ellison can seemingly be converted to the necessity of cloud based architecture and SaaS, then the whole industry will surely follow, even if it is disruptive to their traditional offering.

Rackspace’s Cash Flow Generation

I’m going to cut to the chase here. The question with Rackspace is not over its growth potential or its shift to its open source architecture. It is also not about its current weighting to private cloud services and/or a debate over private vs. public cloud preferences. No. It is about its cash flow generation. Simply put, as a service company which allows its customers to outsource their IT hosting requirements, it is committed to an ongoing level of expenditures just to support its clients. The fear is that in any slowdown it will be lumbered with high fixed costs. In addition, despite working on a contractual basis there is no obligation from its customers to keep up a level of expenditure commensurate with the top line growth that Rackspace might need to justify its stock evaluation.

With that said, I took a look at how revenues, cash flow, capital expenditures, and customer gear expenditures were developing in recent years. The ideal would be capital expenditures as a percentage of revenues to fall as revenues expand strongly. I’ve included customer gear because I think it is a good idea to try to separate maintenance from expansionary capital expenditures. Rackspace has to spend on customer gear-for the reasons discussed above- but things like spending on data center build out are more expansionary.

All figures are a percentage of revenues and a yearly trailing basis.

Ideally this chart would show rising operating cash flow with falling CapEx and Customer gear percentages and that is exactly what we have seen in the last two quarters. Indeed, Rackspace has been lauding its sudden cash flow generation ability.

Now frankly this chart is going to impress the corporate finance’s guys demigod Aswath Damodaran, but then again I don’t know if any of them (or him for that matter) know how to make money from stocks. The key point here is that Rackspace still hasn’t demonstrated it can lower the key metrics for a sustained period. It may well do in future and the last two quarters have been good but if you are like me then you will not be that keen to pay 84x earnings or an EV/EBITDA ratio of nearly 22, until there is some more evidence.

Interpolating from the graph it is hard to see that Rackspace is on track to generate more than 10% of its revenue into underlying free cash flow.

Rackspace Evaluation

There is nothing wrong the above assumption, but it’s not what the current evaluation needs. Let me put it this way, if you want to buy the stock on a future free cash flow yield of say 5% this requires the stock to trade on 2x revenues.  When the reality is as follows:

RAX Price / Sales Ratio TTM data by YCharts

However, Rackspace is growing revenues very fast. Analysts have forecasts of $1.31bn for this year and $1.65bn and its market cap is currently around $8.22bn. Roughly speaking, if it is still generating 10% of its revenues in free cash flow in future it is going to take over six years of revenue growth at 20% in order to hit that figure of 2x revenue.  It’s  not a bet I feel like taking right now. Don't get me wrong, these key metrics may improve in time and I suspect they will but, I’d like to see more evidence first.

A Mixed Outlook For Covidien

Covidien (NYSE: COV) remains as Covidien was, an undervalued health care stock with a product mix that is experiencing differing growth rates.  The future spin off is likely to release value and increase focus and the company remains share holder friendly as it continues to retain free cash flow to investors via dividends and buybacks. It’s not the sexiest story out there but if you looking for a solid value play in healthcare than this is worth a look.

Covidien’s Earnings Overview

Before I get into the color I want to break out the segmental importance. For the full year revenue split was as follows.

First, it should be noted that the final quarter’s results were affected by an unfavorable comparison to last year due to an extra week in last year’s quarter. It may seem innocuous but management argued that it reduced Q4 sales growth by 7-8% and had a ‘leveraged’ effect on the bottom line.

Second, negative currency effects helped to reduce reported revenue growth in the quarter and Covidien predicts a similar affect in Q1. I’ve adjusted for currency effects here.

There are some pretty dramatic effects here which make the reported results much worse and FX also helped to reduce gross margins.

Third, the product recall with Duet reduced revenues by about $20m or by just above 3.3% within the endo-mechanical segment.

Fourthly, Covidien doesn’t break out earnings by emerging markets but the commentary on the conference call suggested that  ‘momentum has actually increased’ despite the slowing of GDP growth in emerging markets like Brazil and China. Meanwhile conditions remain tough in Europe and the US.

Medical Devices Focus

With the excuses/explanations out of the way it’s time to look in more detail at the medical device division.

Growth is slowing and is expected to moderate overall next year. The strength of Covidien is in that it offers solutions that are not so expensive that they filter themselves out of medical capital expenditure plans and they are not so commoditized that they are subject to heavy pricing pressure from competitors.

In particular Energy and Vascular look sources of good growth in future. Covidien’s Energy solutions are still relatively lowly penetrated in the market place and offer significant cost savings to hospitals through minimally invasive surgical (MIS) procedures. Patient outcomes are better and hospital stays are less.

I think Energy will continue to do well. Granted there is competition for surgery spending budgets coming from robotics companies like Intuitive Surgical (NASDAQ: ISRG) and Mako Surgical (NASDAQ: MAKO) as these two companies are very keen to expand the treatment procedures that their solutions are typically used for.  The difference is that the initial take up of Intuitive and Mako’s solutions has been in focused areas where surgeries can increase the amount of procedures done within a narrow field whilst a general surgeon will use Covidien’s Energy solutions for a much wider range of procedures.

They are also a lot cheaper than the huge capital outlay that it takes to buy, say, Intuitive’s Da Vinci system. For these reasons Covidien can also still expect strong growth in emerging markets but overal the surgery market looks tough. If Johnson & Johnson’s (NYSE: JNJ) recent numbers in General Surgery are anything to go by (a paltry .1% rise in worldwide revenues on a constant currency) then the market is actually getting tougher. Indeed Covidien’s numbers in Soft Tissue Repair have been weak for some time and even the new product initiatives were not forecast to take its growth to anything above the market.

Endo-mechanical has had issues with a product recall but stapling is reported to be doing well and Vascular continues to be as bright spot as further investment is put into clinical trials. Stryker (NYSE: SYK) is moving into the market after its acquisition of Boston Scientifics Neurovascular business in 2011. Stryker’s entry could encourage more hospital investment within this treatment area as it should help raise awareness. In the end the key for any medical device company in this environment is to demonstrate efficacy without and tangible return on capital without being too cost intrusive and Covidien is well placed.

The Bottom Line

Covidien isn’t expensive and if you can ignore the currency effects here the underlying growth is okay. The company is shareholder friendly and if Abbott’s performance this year is anything to go by then the market should like the upcoming split.  The growth areas are in things like Energy, Vascular and certain Endo-mechanical products. Elsewhere Covidien remains challenged by a weak spending environment and pressure on hospital budgets.

In conclusion, it’s a decently valued stock but without tremendous upside. On 12.5x forward earnings it's attractive for those who want a solid medical play with the upside of an improving economy

Is Perrigo Worth Buying Now?

Perrigo (NASDAQ: PRGO) gave results on a tough day for the market and saw itself marked down nearly five percent.  The is the second quarter in a row where its sales have come in a little light and investors have a right to question whether its forecasts for 12-16% revenue growth for 2013 are likely given that it only reported just over 6% in the current quarter. Moreover there appear to be a few assumptions over its growth prospects which are debatable. Don’t get me wrong, I love this company’s prospects, but I question whether it’s at the right price to pay for the risk.

Perrigo is a manufacturer of over the counter (OTC), consumer healthcare and nutritional private label products. I think this is a strong area of growth due to an ageing demographic

Perrigo’s Q1 Results

Before I get into the detail I want to outline how this company’s guidance has moved around. This is a key point to understand because its earnings are variable due to reliance on approvals and customer adoption of its and rivals’ products.

The first thing to note is that revenue and earnings guidance has been raised, but this is largely due to the Sergeant pet care acquisition which is forecast to add 10c to adjusted EPS.  Another point is that CapEx requirements have been raised due to integrating Sergeant and investing in growth initiatives. All of which is fine, but investors need to look at these results in the context of what Perrigo just reported.

 To understand its revenue and profitability mix, I’ve broken down revenues here.

But a more interesting picture is seen when adjusted operating income is broken down too. The key point here is that Rx Pharmaceutical (generic prescription products) has huge margins and makes up nearly 42% of income.

Indeed reported gross margins for the Rx Pharmaceuticals segment are 53% which compares with Teva’s 52% and is in excess of Watson Pharmaceutical's (NYSE: WPI) 42% and Mylan Lab's (NASDAQ: MYL) 44% respectively. These companies are all aggressively trying to expand their generic offerings and it is hard to see why Perrigo should necessarily have higher margins than them.

Moreover, even though the nutritionals segment only made 6.1% of adjusted operating income there was a reduction of about $5.5 million on a yearly basis due to a combination of issues which I will discuss below.

Key Take Aways and Future Challenges

So in summary the key take ways and questions from these results are

• Whether the 6.1% sales growth reported in Q1 is going to translate into the 12-16% predicted for 2013
• Can Perrigo retain such high margins in its Rx segment given increasing competition?
• Will it be able to deal with the issues in its nutritionals segment?

Perrigo’s argument is that the year will be back-end loaded and that initiatives being taken now will drive growth in future. For example, within nutritionals it is introducing plastic packaging which is intended to look similar to national brands. Indeed part of the nutritionals shortfall this quarter was due to disruption caused by this shift. In addition new products are being launched in an aggressive fashion. Nevertheless the last two quarters sales have disappointed the market and without the acquisitions there has been no upgrade to full year sales forecasts.

Perrigo is also facing headwinds within infant nutrition where price competition has been heating up globally. Mead Johnson recently gave results and said a similar thing about intense price competition in the sector. Similarly vitamins, minerals and supplements (VMS) saw tougher conditions amidst increased competition.

Turning to Rx Pharmaceuticals, margins are high and management cited increasing competition in dermatology. The challenge here will be to continue to engage in new product development and hope that the competition doesn’t encroach on their key revenue generators.

I think there are a lot of assumptions being made here so investors need to price in a margin of safety.

Growth Drivers and Headwinds

Going forward Johnson & Johnson (NYSE: JNJ) is expected to get Tylenol back on the market in early 2013 and this will likely have an effect on consumer health sales. Perrigo can expect to keep some sales, but JNJ is a formidable competitor with deep marketing pockets and it is in need of generating some growth again in its consumer products section.

Another area of growth is likely to be the shift of products from prescription to OTC. Pfizer’s (NYSE: PFE) heartburn treatment Nexium is being eyed, but Pfizer is obviously trying to keep exclusivity. In any case Perrigo received FDA tentative approval for another heartburn treatment (omeprazole and sodium bicarbonate) on Oct 16. Sales of store brand omperazole are already expanding nicely for Perrigo.

In the short term the weak economy continues to put pressure on OTC pharmaceutical sales, but Perrigo has exposure to store brands and the drug stores and retailers are keen to expand sales of these higher margin products.

The Bottom Line

In conclusion, Perrigo does have strong long term prospects but mid-term there are questions over its internal execution and future competitive threats. It has disappointed for two quarters in a row with sales and it is relying on ongoing high margins in its generics segment to counteract current weakness in nutritionals.

Frankly I don’t think the current valuation of 24x current earnings and 18x future earnings is attractive enough to warrant the risk/reward proposition here.  Well worth monitoring, but its hardly cheap right now.