Is The Market Being Too Complacent Over ConAgra?

Good investing often lies somewhere between the extremes of rigidly sticking to preset ideas and following the latest investing fashion. Quite often one of these things works against you in order to suddenly make you realize the underlying risk that you actually took on. In the case of ConAgra Foods $CAG I would argue that investors may be buying both ends of the aforementioned extremes at the same time!

The market seems wedded to the idea that food stocks are defensive, and they are also fashionable thanks to Warren Buffett's recent actions.

ConAgra Stock a Buy?

Don’t get me wrong. I like the stock and held it for a long while in 2012. That holding was part of a desire to balance a portfolio with a food stock, and I felt its mix of value brand, private label and evaluation made it a stock with an attractive risk/reward proposition. Indeed, ConAgra has performed very well since then in generating growth with its commercial foods sector and wringing every last piece of performance out of its consumer foods. Its underlying cash flow is very strong and it has been correctly using it to make growth-enhancing acquisitions.

Its consumer foods segment saw sales up 7%, but this was largely driven by acquisitions. Organic volume actually declined 3% with favorable movements in pricing fully offsetting this decline. Going forward, pricing will not be so easy to take because it is lapping previous increases and some of its competitors are reducing marketing efforts in favor of pricing and promotional activities.

Commercial foods revenues grew a paltry 1%, but comparable yearly profits were up an impressive 18%. The big contribution in this quarter came from its milling operations. Indeed, there should be more to come as ConAgra recently announced the creation of a joint venture (to be called Ardent Mills) that will combine its milling operations with Horizon Milling in partnership with Cargill and CHS. The transaction is expected to complete later this year.

ConAgra’s Growth Opportunities

If the ConAgra story in 2012 was about generating operational efficiencies, making acquisitions and competing in tough markets, then 2013 looks like it will be more of the same.

The key operational event will be the integration of the private label business (Ralcorp) that it recently acquired. In theory, private label business should be flourishing in this environment, but as investors in Treehouse Foods (NYSE: THS) will tell you it is a difficult industry even at the best of times. I’ve followed European white label producers before, and the pattern seems to be the same. A company like Treehouse will report some great quarters, investors pile in, only to be disappointed when market conditions change. The truth is that US consumers continue to want to trade down and favor buying if there are promotions and coupons. These shifts in sales channels caused Treehouse a lot of disruption in 2012, and I think it is just a facet of the industry. Will ConAgra run into similar problems with Ralcorp?

All of which leads me to wonder why investors continue to bid up the sector? Obviously the Buffett/Heinz (NYSE: HNZ) deal has sparked a lot of interest, but my reading of that situation is that Heinz clearly has some powerful brands, of which it wasn’t releasing the full value, and the team partnering with Buffett looks set to go about doing it. Their emerging market expertise is going to be very useful in growing revenues in the key markets for the company.

Ever since that deal the market has fallen even more in love with food stocks, and it has taken ConAgra up with it.

Where Next for ConAgra?

This is going to be a busy year for the company. Integrating Ralcorp will obviously demand management resources and its consumer foods markets remain highly competitive. ConAgra’s reaction to tough end markets has been to increase marketing recently; while its competitors seem more interested in discounting and promoting their way to volume growth. It remains a tough market. Moreover, the stock is no longer good value and there is little margin for error in its performance within difficult end markets.

On a risk/reward basis I think the stock is no longer great value, and any company that is seeing increased marketing costs while volume growth is weakening is hardly flourishing. On a more positive note the company has executed well over the last year. The questions are can it continue to do so and what evaluation are you willing to pay in order to bet on it?

RPM International Research and Analysis

By now every investor should know that the current strength in the US economy lies in things like autos and housing. This is not to say the economy is flourishing overall, but it doesn't need to for stocks in the housing sector to do well.The truth is that companies in these sectors have recovered from such a low base that they are seeing significant opportunities for earnings expansion as the housing upturn occurs. And the market has wasted no time in pricing this in. Housing related stocks have done very well in the last year but is there still value in stocks like RPM International $RPM?

RPM International...But Probably Wishes it Wasn’t

Or rather it probably wishes it had less European exposure. The recent results painted a mixed picture of its performance and outlook. On the one hand its consumer business benefited from increased turnover in US housing and contributions from acquisitions. For the nine months of 2013, consumer sales rose 13.4% with EBIT up 32% to $132.1 million. On the other hand its industrial sales rose 6.4%, but segment EBIT fell 53.8% thanks to a combination of issues discussed below.

While industrial sales growth was helped by acquisitions, profitability was significantly affected by weak European conditions and US roofing, which is hurt by weak government spending and tougher comparables from last year’s hurricane affected roofing activity.

Indeed, if we go back to what Beacon Roofing Supply said recently then this trend is confirmed. Beacon reported that commercial roofing pricing was flat but residential pricing has been up sequentially for a few quarters now. After the industry laps Katrina affected comparables then I suspect residential is likely to grow again and commercial construction will lag afterwards. As for RPM the question of roofing relates to its exposure to government work. Unfortunately, it’s not only due to the necessity public spending restraint because RPM is also embroiled in an investigation over some of its previous work on government contracts. A settlement over the issue is expected before the end of May.

Elsewhere its core commercial construction business is doing quite well.

Housing  Industry Making a Comeback

The consumer side looks set to grow nicely for RPM this year; it upgraded its expectation for full year growth (to May 2013) to above the previously guided 8-10%. By way of comparison, industrial growth is now forecast to struggle to hit its 6-10% target.

Housing is making a comeback in the US, and we can see the evidence of this in the paints sector with Sherwin-Williams $SHW, which entered 2012 with EPS of $5.52 being forecast for the full year but ended it with $6.49. The company is probably the pick of the sector thanks to its US housing exposure, but investors should also look at PPG Industries $PPG, which has recently acquired the US household paints division of Akzo Nobel. PPG is more of an industrial play than Sherwin-Williams (aerospace and automotive have been good to it this year), and it is more exposed to conditions in China as a consequence. Both stocks have had great runs over the last year, but going forward I think Sherwin-Williams' evaluation and PPG’s industrial exposure to China are the key things to consider.

Another stock to consider in this context is Valspar $VAL This company is seeing some improvements in its home improvement channel in North America, but it also has exposure to housing in China and construction in China. Frankly I think the latter is worrying in the medium term. The Chinese Government certainly has the firepower to buy its way to 7-8% GDP growth this year, but if domestic demand isn’t stimulated enough by these measures then the Chinese property market may well find itself facing tougher times in the next few years. Moreover, dampening down real estate speculation is actually an aim of the government.

Where Next for RPM International?

Income seekers will love its dividend, and it has a long history of hiking the payments. However, it is hard to argue that the stock is cheap now, and it may well face some severance costs in Europe as it adjusts to a lower volume of business there. Moreover, the settlement issue overhangs the stock to a certain extent.

On a more positive note US housing looks set to continue to do well and I think construction markets will follow. Its US housing based acquisitions are working well, and the Brazilian company it acquired offers the prospect of some international growth, while Europe treads water.

 Analysts are calling for mid-teens earnings growth to May 2014, which puts it on a forward earnings of 14.6x. It’s probably close to fair value. I think there are better ways to play the US housing recovery, but if you are bullish on the global economy then it could fit the bill.

Is it Time to Buy F5 Networks?

F5 Networks $FFIV pre-announced results and delivered the kind of eye watering earnings miss that only small company technology investors can fully appreciate. In truth it was a pretty nasty miss on the top and bottom lines. As ever the market will react with a savage markdown and then start guessing at the causes. Is this an F5 issue or does is it an issue of broader based technology weakness?

F5 Networks Misses Estimates

In order to fully appreciate how bad this miss was it is worthwhile looking at what F5 said last time around. I’m going to highlight a few takeaways from the recent pre-announcement.

• Q2 Revenues expected to be $350.2m vs. internal forecast of $370-380m

• Non-GAAP EPS expected to be $1.06-1.07 vs. internal forecast of $1.21-1.24

• Telco sales down sharply and below company guidance.There was broad based telco weakness and in North America in particular. F5 said the pipeline was there but deals failed to close at the rate it had expected.

• US Federal Sales down significantly

• Enterprise sales were described as being ‘okay’

• Japan and Asia Pacific were ‘in line’

• F5 is undergoing a product refresh

A graphical depiction of the effect on revenue growth.

To make matters worse a rival Application Delivery Controller (ADC) provider Radware $RDWR followed up by announcing that it would miss its own revenue guidance for the quarter by 8% and earnings by over 20%. So is that game over for the ADC market? Furthermore with industry forecasters putting F5’s market share at 50-60%, if the market is saturated then how does this speak to F5’s prospects?

F5’s Prospects

To answer this we have to delve into the detail of what happened and unfortunately it is not clear. Indeed Radware stated that EMEA and China were weaker than expected but described US sales as being ‘strong’. Note that this is almost a mirror image of what F5 said about its regions. I appreciate that F5’s sales are nearly 8x that of Radware’s (always view F5’s as more accurate) but this variance in regional performance does raise questions.

Furthermore as F5 has such a dominant market position it is somewhat susceptible to encroaching competition from Citrix Systems $CTXS and others. Indeed there has been some significant activity on that front. Late last year Cisco Systems $CSCO announced it wouldn’t be making new investments in its Application Control Engine (ACE) products and instead would be recommending and Citrix’s ADC NetScaler to its customers while integrating it into its network technology. It’s an expansion of its overall strategic partnership with Citrix.

Of course it also gives F5 opportunities and the company claimed that its rate of closure on the ACE contracts was better than the rest. This implies that this isn’t really a problem of the new customers and contracts that came up.

As for the ‘market saturation’ argument –and no doubt you will be hearing a lot more about this in the next few weeks- I’m not convinced. There may well be a short term affect as customers try and hold back on investment in technology that they feel they are well covered in (this is normal with all industry cycles) but, the truth is that the rise in bandwidth rich applications and, the need to move them around the net seamlessly and without degradation,  is still rising significantly. Hardly a day goes by without a corporation announcing significantly more investment in its e-commerce or social media strategy. Indeed F5 did say that the pipelines were there but they just couldn’t close them in the quarter.

So if it isn’t macro, new customers, or market saturation, then what is it?

What Went Wrong?

My best guess is this that it’s a combination of factors. To fully appreciate them it’s useful to go back to a breakdown of its key verticals.

• The sequester looks like it had an effect on US Federal spending

• The telco sector snapped back in Q1 from declining previously and has now fallen back again. This could be a case of the sales force bringing deals forward into Q1 and then management assuming a similar rate of deals would close in Q2.

• F5 mentioned that the pipeline deals that didn’t close were with F5 customers and its possible that this is because Citrix and others are pushing for their solutions to be benchmarked against F5’s new products

• In a tough environment customers may feel inclined to try and hold off spending when there are various options in front of them

In addition investors need to recall that product refresh cycles can have an effect. Indeed Riverbed Technology $RVBD had significant problems when it upgraded its product range only to see sales come back nicely. Sometimes product upgrades and refreshes give companies a reason to pause and assess options and Riverbed certainly saw that last year with its WAN optimization solutions. Would it be a surprise if a similar body of customers took the same approach with F5’s product refresh amidst competitors upping their competition? What is more disappointing is that F5 made some pretty positive noises about the new products in its last conference call.

In conclusion, I think this may well be a combination of the product refresh causing telco customers to pause, the sequester and a high market share which is attracting competition. We will get a clearer reading when F5 formally reports its earnings and when Citrix Systems discusses its ADC performance in the quarter. For now I think cautious investors may want to stay clear.

Acuity Brands Offers LED Lighting Growth

Anyone looking at the North American construction sector will be interested in what Acuity Brands $AYI had to say about the current state of markets. As a lighting manufacturer and distributor it is somewhat late cycle in the construction phase, but in general the commentary was positive and its revenues came in better than expected. So is this the green light for the construction sector and Acuity?

Acuity’s Q2 Results

As usual with companies that don’t give specific guidance, the results caused volatility in the share price. However the good news is that for the first quarter in three, the result was a happy one for existing shareholders. I’m a follower of this stock and have previously bought in after the last two ‘disappointing’ results.

If you want to see how Acuity’s previous results turned out (look out for the variance between analyst forecasts and the reported numbers) and get a primer in the trends in the company, there are articles linked here and here.

Fast forward to this quarter:

• Q2 revenues of $486.7 million vs. analyst estimates of $468.5 million
• Adjusted diluted EPS of 62c vs. analyst estimates of 62c

Revenues were way ahead of estimates after being significantly below the last time around. Meanwhile the EPS result implies that margins were below what the market had expected.

Indeed, while net sales were up 6.3%, volumes rose a more impressive 9%. The reason for the difference is that changes in the product mix (more lower margin renovation work) and increased sales of lower priced LED based lighting ensured that volumes rose more than sales.

In a sense the increased renovation work is a spill-over from the previous quarter (an indication that corporations will do anything they can to hold back spending during political uncertainty), and if it cost the company some margin expansion in the quarter then it is not unreasonable to expect margins to grow throughout 2013 as Acuity’s product mix moves back towards a more normal distribution.

The State of the Industry

The commentary around these results was pretty consistent with previous quarters. Last time around Acuity spoke of spending inconsistency and mentioned a ‘lull’ in no-residential construction while commercial and industrial customers were playing a ‘wait and see’ approach. My guess is that this was mainly with the kind of renovation work that bounced back in this quarter.

Furthermore and as noted earlier, lighting is relatively late phase in the construction cycle, and the sales process usually has a long gestation period. In other words if the industry is reporting good news in terms of building permits and billings then it will take at least 6-12 months before much of it even shows up with Acuity.

As ever let’s look at the Architectural Billings Index numbers from the American Institute of Architects, which certainly indicate stronger conditions for the industry...

…and while it’s true that residential is leading the way…

…investors need to understand that residential construction does tend to lead into increased commercial and industrial construction. It is the last two segments that are most important for Acuity, so clearly investors shouldn’t expect too much too soon. On the other hand the long term prognosis is looking good.

In the short term I note that Home Depot and Lowe’s Companies $LOW both reported broad based strength in their category sales. Lowe’s is in the middle of a product reset program ,but so far it is going very well and the company is undoubtedly being aided by favorable end markets. Amid the restructuring it has reported decent comparable same store sales growth in four of the last five quarters. Given that both Home Depot and Lowe’s sell Acuity products I think this bodes well for future performance.

While the home goods stores are good indicators of housing, I think a stock like Regal Beloit $RBC is worth following in conjunction with Acuity. Two thirds of its sales are in the US, and its sales split is roughly 39% residential and 61% commercial and industrial. Regal Beloit specializes in Heating, Ventilation and Air Conditioning (HVAC) machinery. I’ve covered the stock in an article here, and what Acuity investors need to focus on is that HVAC solutions tend to be late cycle (but before lighting) in the construction phase. In other words, if it is reporting good results than Acuity can expect conditions to be improving too. Indeed, it recently reported good results for HVAC in North America with the familiar commentary over some temporary weakness due to fiscal cliff worries.

Where Next for Acuity Brands?

Longer term I think margins will expand with increasing LED based sales (now 15% of total revenues from 13% in the last quarter) but as the management affirmed this will take time. LED lighting isn’t necessarily higher margin, but there is an opportunity to sell controls alongside new LED systems. LED lighting is going to lead to another wave of demand for LEDs and Cree $CREE has high teens revenue growth forecasts penciled in for the next few years. Indeed, Cree’s own lighting sales grew 14% in the quarter. These are clear signs that Acuity is right to carry on investing in LED based lighting.

As for the near to mid-term a recovering construction market and some margin expansion from a more favorable product mix going forward presents upside potential for Acuity. My one issue is that on 18x forward earnings I think the stock is pretty much fairly valued at this level. One for the monitor list.

McCormick is Still in Fashion

If you share my opinion that the market is getting a little too much in love with food stocks right now, then the recent results from McCormick $MKC will have done little to allay any concerns. While they were perfectly okay, they didn’t offer much upside potential to a stock already trading at a lofty evaluation. On a more positive note, I think there are one or two things in here that read across better for other parts of the food industry.

McCormick reports mixed results

For a while now, I have been of the opinion that McCormick was a good company, but the market was overestimating its performance. For example, in a previous article I pointed out that the underlying growth (i.e. excluding acquisitions) in its consumer segment (which contributes nearly 80% of income) for the previous two quarters was only 4%. In addition, growth in the industrial segment has been noticeably slowing this year. Yet, the stock has soared.

Fast forward to the latest set of results, and the good news is that the consumer segment has seen stronger growth, thanks to a mix of brand marketing support and an increased desire among consumers to dine at home. Meanwhile, the industrial segment has suffered a decline.

The negative growth within industrial was due to a combination of tough previous year’s comparisons as well some regionally specific issues. Oddly enough, European performance was described as ‘robust’, while the Americas saw steady sales to food manufacturers but significant declines in food service sales. Meanwhile the Asia Pacific region saw sales decline, mainly due to the problems that Yum! Brands $YUM is having in China.

Putting these things together, I think it is important to appreciate that there is an element of a zero sum game here. If hard pressed consumers are buying more spices because they want to eat at home, then it is reasonable to expect them dining out less in the kind of quick service restaurants that McCormick sells into. In other words you can’t look at these issues in isolation.

Reading across from McCormick’s industrial sales

Any analysis of the U.S. quick service restaurant sector must begin by looking at McDonald’s $MCD, and I wasn’t particularly impressed by its recent results. Its Chinese sales have been weakening for some time, and its anemic looking U.S. growth was achieved partly due to revamping the Dollar menu and making promotions. Meanwhile, McDonald’s is talking about the Informal Eating Out (IEO) category being flat to negative for 2013.

As for Yum!, it has got back on track in the U.S., but that too is a result of promotions and recovering from having dropped the ball previously while focusing on China. The good news in all of this is that fast food companies like Yum! and McDonald’s are recovering volumes by taking action, and ultimately that will work out positively for McCormick. Indeed, the company is forecasting a stronger second half within industrial as these effects take place. Furthermore, Yum! is surely set to recover from the chicken debacle in China.

As for demand from food manufacturers, McCormick suggested that it was seeing them more inclined to invest for growth (rather than last year’s cost cutting efforts), but that there were fewer major launches planned than in previous years.

Companies like Campbell Soup $CPB have been forced to innovate with flavorings in order to generate category growth or hold market share against private label competition. The essence of the problem (pun intended) is that consumers continue to trade down and shop in discount and dollar stores.

This has caused significant disruption for many food companies' traditional distribution channels. As a consequence, over the last few years, Campbell and others have had to differentiate their offerings via offering new flavorful products, while trying to cut costs elsewhere.The shift in emphasis towards growth is a good thing.

In summary, the difficulties for the fast food companies look set to continue. In addition, there is not let up in pressure for food manufacturers.

Where next for McCormick?

The forecast of 2013 growth of 3-5% was reaffirmed with a stronger second half forecast, thanks to the actions taken by its industrial customers to drive volumes in food service. Meanwhile, the higher margin consumer segment continues to do well and long-term trends (more flavorful food plus demographic changes ) look favorable for growth.

The question boils down whether you really want to pay 20 times current earnings for a stock set to grow earnings in single digits for the next couple of years. Frankly, I’m not, but the market might not agree with me. Food stocks are in certainly the fashion right now but, for how much longer?

Is Cal-Maine Still Good Value?

Cal-Maine Foods $CALM gave results recently, and I felt it was time to reassess its prospects. The stock is unusual in that it has a number of profit drivers which can come together positively to give the prospect of generating non market correlated returns. This is interesting in itself, but investors should understand the underlying dynamics before buying. And it is not as simple as it appears.

Cal-Maine A Recession Resistant Stock

As the world demands ever more protein consumption, it stands to reason that cheap protein options like eggs will see demand increase. Moreover, egg demand does tend to be price inelastic because as its input cost prices go up (pushing egg prices up) so will the prices for other proteins. Consumers will then be pushed into buying cheaper options like eggs. The downside is that gross margins will be affected.

Indeed, this was exactly the case with its recent results where revenues and profits went up (partly due to contributions from acquisitions), but gross margins declined thanks to higher feed costs. The longer term picture can be seen here.

The relationship is clear. As feed costs go up, so does the average selling price and gross margins fall. The relationship holds the other way too. So is Cal-Maine just a play on feed costs?

Cal-Maine Equity Research

2008-09 did some funny things to certain industries. Cal-Maine is the largest single egg producer in the US, and when the recession hit it became very hard for its much smaller competitors to get financing, particularly as soft commodity prices were going through the roof. A combination of these issues negatively affected industry hatch numbers, and Cal-Maine found itself in a fortunate position.

The paragraph above hints at what I think is the key to understanding the company. While egg demand is price inelastic, the key factor deciding margins for its normal eggs will be egg supply. As financial conditions are slowly getting better, I wouldn’t expect a ‘2008’ effect any time soon unless corn prices really go through the roof.

Cal-Maine Specialty Eggs

If market dynamics are reducing Cal-Maine into being a kind of black swan play for cautious investors (although there is nothing wrong with that) then what are the other potential upside drivers?

There are two obvious reasons to be optimistic. The first is that its specialty egg sales are rising as a proportion of the total and that it has long term consolidation prospects.

Alas specialty eggs don’t refer to chocolate Easter eggs but rather a range of eggs that offer consumers some added benefits. The range includes eggs that are believed to lower serum cholesterol levels, or hatched from naturally reared layers fed on natural grains or even omega-3 rich eggs. The benefits of expanding specialty egg sales is that they tend to be higher margin and less cyclical. A nice way to de-risk the stock.

The plan appears to be working, but as the first graph demonstrates it hasn’t offset the threat of margin contraction given rising feed costs.

Industry consolidation also offers long term prospects, and the company does tend to be highly cash generative (even after paying a third of net income in dividends), so we should expect more acquisitions going forward. Indeed, rising feed costs could create conditions where smaller producers are more willing to sell up. Cal-Maine’s scale gives it the opportunity to produce at a lower cost and obtain financing easy.

Smithfield, Sanderson Farms and Cal-Maine

I class the company as a protein play. In that vein Smithfield Foods SFD is worth looking at. It is a major pork producer, a relatively cheap meat option which has the attraction of long term demand increases from the emerging Chinese middle class. While this presents good growth prospects, it also exposes it to the variance of internal Chinese pork production. In other words, you will not escape cyclicality with this stock. For example, export demand of pork carcasses was stronger overall this year but substantially weaker in China. This isn't a stock that you buy purely on a macro view.

Sanderson Farms $SAFM offers exposure to the poultry market, however (a bit like Smithfield) it is reliant on export markets. Rather like Cal-Maine it is subject to the vagaries of feed input prices, but unlike the egg producer its poultry is not as price inelastic. Furthermore Sanderson’s heavy exposure to the food service market (which is still weak according to the company) means that it has more need of a return to dining out by consumers.

Where Next for Cal-Maine?

As discussed above, it represents an attractive proposition, especially compared to its peers. The US focus and ability to grow end demand in a weak environment means it should command a premium in its sector. The problem is in calculating what that premium should be and where the cycle is going.

CALM EV / Revenues TTM data by YCharts

If you accept that its earnings and margins are cyclical then price/sales might a better way to look at the company, and on that basis the stock looks like decent value but not special enough to pile in just yet. However, black swan (or should that be black chicken) worriers might want to buy some.

The Key Earnings of The Week

Is it just me or does it seems that earnings season should no longer be called a season but rather an ongoing activity? Alcoa’s $AA results usually mark the beginning of the season and, as they come up next week, I guess it’s time to declare a new season open.

It’s been a good quarter for equities but some recent weakness in the ISM data is causing a bit of a pause for reflection. In my opinion the markets have priced in a recovery in the US but the relative over evaluation of sectors like food (as opposed to say technology) suggests that there still is an element of uncertainty out there. If I am right then –provided the upcoming earnings confirm an ongoing economic recovery- there is still some upside likely in sectors like technology and industrial cyclicals but less so with others like food and high yield consumer staples.

Monday

As mentioned above Alcoa gives results today. I’ve looked at the company at length in a previous article and it was notable to me that the company is really relying on China for its growth this year. It was pretty bullish on China last time around and investors will want to see that tone repeated in these results. Some of the data has been looking a little stronger recently and forecasters have been coming round to the view that 8% growth is achievable in China this year.

Regarding sectors, with the positive commentary from General Electric in its last results the aerospace and industrial gas turbine sectors should be okay. The automotive and construction sectors are more interesting. Autos and housing have been doing well in the US lately and if China’s plans to stimulate domestic demand are working than we could see some improvement in this segment for Alcoa.

Tuesday

PriceSmart is the sort of stock that investors who are bullish on Latin America should be looking it. It’s hard to find this kind of play and I think its worth looking at their results for this reason alone.

Wednesday

Adtran is the first of the telco plays to report and the sector will be looking out for some more positive noises over spending in the industry. In a similar vein-but completely different industry- Family Dollar will give earnings. The discount sector fascinates me. It looked overvalued in the first half of last year and then same store sales started slowing for the sector amidst citations of increased pricing competition. With that said the underlying fundamentals remain positive and the fall in the share prices is starting to bring them into value range.

The stocks I want to highlight today are the industrial supply companies Fastenal (NASDAQ: FAST) and MSC Industrial Direct $MSM. I’ve long been an admirer of Fastenal but not of its evaluation. As can be seen here the company has significant opportunities to grow revenues, margins and cash flows via increasing its number of stores and sales via vending machines. This is all well and good but it won’t achieve these things unless the industrial market holds up and its commentary on industrial fastener sales is a key indicator of current trends.

MSC Industrial talked of ‘paralysis’ in its end markets in December and its guidance for this quarter was based on the weakness at the end of the quarter but since then the manufacturing data has been good. In other words it is not unreasonable to expect that it will beat estimates this time around. As the chart in this link suggests when political fears rise, industrial manufacturers tend to run down inventory only to replenish them when the fears pass. Thinking longer term investors should look out for commentary on its e-commerce and vending machines initiatives.

Thursday

Today’s highlights are two vastly different retailers in Pier 1 Imports  and Rite Aid Corporation . Pier 1 has benefited from a better housing market and its e-commerce initiatives are generating strong growth. I felt its guidance was a bit cautious and while the Christmas season wasn’t great for retail overall, it was relatively better for companies like Williams-Sonoma. With this in mind investors can expect some decent results from Pier 1. It will be interesting to see if there is any acceleration in its e-commerce plans and how it is dealing with its in-store collection policy.

Pier 1’s turnaround story is something that Rite Aid’s investors will be hoping to emulate. The stock is not for the faint hearted and is best advised towards risk seeking investors. The stock bulls will be heartened by the positive trends in the industry. Generics sales have expanded well in the industry and it benefited from the Walgreen/Express Scripts debacle. In addition its same store prescription sales have been growing and there will surely be a short term benefit from a bad (good) flu season this year. Well worth a look.

Portfolio Review For March

Every month, I like to look back at the quarter’s performance and look at the articles I wrote over the month leading into. It’s a useful discipline, and I think writers have a duty to disclose whether they can actually do what they write about.

I had a return to form last month with a 10.2% return, which contributed to an 18.9% return for the quarter and 57.5% over the last year. I've been on a good run which will be hard to sustain. The previous write up can be found here, and I will update the current portfolio on my blog in due course.

This month, I’m going to look back at December’s articles originally published on the Fool.

I hedge and am leveraged, so expect my performance to continue to be market neutral (R^2=.08) and more volatile than the market. I short indices not stocks. Readers should be aware that the S&P 500 has put on around 10.8% since the start of December, so as a hedged investor, I’m looking to at least beat that on the long side.

It’s the usual format with links to articles in the table and a summation of the views taken at the time. The stocks in bold are those that I bought or held.

View	Company+Link	Performance Since Article (%)
Buy	Adobe Systems	13.7
Buy	Walgreen	23.9
Positive	Pier 1 Imports	12.2
Positive	Paychex	11.9
Evaluation	Kroger	19.6
Evaluation	Cooper Companies	11.5
Evaluation	Costco	8.9
Evaluation	General Mills	17.3
Caution	Restoration Hardware	1.4
Caution	Ciena	.8
Caution	FactSet Research	4.6
Caution	Procter & Gamble	11.5
Caution	FedEx	15.1
Caution	Bed Bath & Beyond	14.8
Caution	Patterson Companies	11
Caution	Finisar	-5.9
Caution	AutoZone	9.5
Caution	Lululemon	-19.6
Caution	Tibco Software	-1.8

The ‘buy’ stocks averaged 18.8% with the ‘positive’ (I liked but didn’t buy or hold) stocks returning 12.1%. ‘Evaluation’ (like but not cheap enough) generated 14.3% and the ‘caution’ (liked or disliked with some concerns) stocks came in with 3.8%. These distinctions can be seen as arbitrary, but if you average all the stuff I didn’t buy/hold, it comes to a less-than-market return of 7.2%.

Evaluation and positive stocks

The reason I didn’t buy Pier 1 Imports and Paychex was because I felt they were both pretty good short to mid-term plays, but they are not stocks that I would like to commit to for the long term.

I’m also aware that the ‘evaluation’ stocks outperformed the market, but these things happen in a bull market. Kroger and Costco are both fine and worthy companies and I have updated views on them here and here.

The company that interests me the most in this group is The Cooper Companies. Eye care companies have strong long-term growth prospects from an aging Western demographic and the high incidence of myopia in the Far East. Moreover, Cooper can generate significant revenue and margin expansion by shifting people to a one-day modality, and encouraging customers to trade up to silicone hydrogel lenses.

The good news is that this sort of stock should trade at a premium because it offers relatively recession resistant growth. The bad news is that (from my point of view) it is no longer great value. One to monitor.

With General Mills and Procter & Gamble , I think we have a classic case of the market rewarding fashionable stocks because they suit its mood. Right now, the market wants large cap high yield stocks, because they act as a proxy for very low U.S. Government bond yields.

Procter & Gamble also has the upside prospect of its management getting round to releasing the latent potential of some of its powerful brands. I’m not the biggest fan of the company, and note that it hasn’t been doing that well in China compared to its rivals, although it seems to be stabilizing market share in the U.S. No matter the market wants this sort of stock, so don’t be surprised if it goes up in line with the market.

What’s with the caution?

Actually, investors should research more ‘caution’ than ‘buy’ stocks, because this helps avoid overtrading and creates a more rigorous approach to investing. I’m proud to be a coward.

Delving into the list, we come to Bed Bath & Beyond . The company would release results on the April 10, and investors will get a further update on its plans to restructure and turn around disappointing same-store sales growth. Unfortunately, there are tangible signs that online competitors are eroding market share.

However, the market has decided to give the company the benefit of the doubt. Indeed, the rest of the housing related sector is doing well and the market has been bullish overall. In such circumstances, you can expect stocks like Bed Bath & Beyond to do well, but much of the gains could disappear if the next earnings aren’t good.

The next two highlighted stocks are both telcos. Finisar recently reported its familiar story of strong datacom spending but weak telecom revenue. Many observers believe that this could be a better year for telco spending, but it certainly didn’t show up in Finisar's numbers.

In addition, some analysts think there is a potential longer-term issue with Cisco (currently a key customer) silicon photonics-based solutions that will rival Finisar’s existing products. Finisar claims it is ‘agnostic’ over using the technology itself in future, but that will be small recompense for losing market share to others using it first.

Ciena reported a good quarter. Shareholders were immediately rewarded with a sharp rise, only to see it start falling afterwards. This is inevitably going to be the situation with a stock like Ciena.

The company has good exposure to some of the genuine growth areas of telco spending like network convergence, Voice over LTE, and 100G networking. These are areas that the major carriers are spending money in this year. Indeed, analysts have some pretty spectacular growth rate forecast for the next few years. However, the stock trades 37 times earnings for October 2013. It’s the sort of stock that will be volatile and move around based on sentiment over telco spending prospects.

The bottom line

One conclusion from this quarter's performance is always to remember to not be selective over how you view your risk aversion. It would be easy for me to pick out one or two winners from the 'caution' list and then beat myself up over not buying them, but the same approach led me to avoid the losers too. And as the numbers outline, the stocks I didn't buy were under performers overall.

Verint Systems Guidance Looks Conservative

Verint Systems $VRNT is one of those stocks that you buy because you think it’s good value and then get bored with as the market ignores it for ages. Then one day you look again and realize that suddenly somebody noticed it and it's up sharply. The buzzwords of big data, cyber security, customer relationship management (CRM) and data analytics all seem to trigger market interest, and it looks like the market has finally woken up to this stock. So after the sharp rise, is it still good value?

Verint Reports Solid Results

Verint’s recent results were good and came accompanied with more bullish commentary on current performance, although the usual conservative looking guidance was issued. For those not familiar with the company I have some background on Verint and its chief rival Nice Systems $NICE in an article linked here. Not only is Nice a rival, but it is also potentially an acquirer or merger partner of Verint. A deal between the two makes a lot of sense because they are complementary with their end markets and geographies.

The idea behind investing in these companies is that as companies increasingly see the value in analyzing customer interactions and making actionable decisions from structuring data then they will also invest in monitoring it. Similarly security issues require governments to increasingly engage in intelligence gathering from monitoring and surveillance. Indeed, Verint is more of a government (25% of revenues) and security play, while Nice is more focused on enterprises.

A breakdown of revenues for the full year.

Enterprise intelligence revenues have been growing strongly, and Verint described the pipeline as being stronger than in recent years. Furthermore, this segment contains more software and analytics sales, so as it increases we should expect gross margins to improve. The one weak area has been video intelligence, but that is more about declining hardware sales and the forecast is for this segment to be flat this year.

From Hardware to Software

Investors will note that both Verint and Nice analysts estimate high single digit revenue growth for the next few years, but the bottom line is only forecast to grow at a similar rate. Why is this, especially as gross margins are rising and software and analytics become a larger part of the mix? In addition, is the PE ratio the best way to value this business?

I’m going to answer these questions by looking at Verint, although Nice is seeing the same kind of dynamics.

Firstly, let's look at the relationship between product share of revenues, gross margins and free cash flow generation. Free cash flow and margins go up as product revenue share of total revenues declines.

While generating more free cash flow is a good thing it is partly because Verint (and Nice) are generating more sales from higher margin software/analytics revenues. This can be seen as bad by investors because it can cause earnings to grow slower in the short term.

However, if you think about it software revenues tend to be recognized over time while hardware revenues tend to be booked upfront. The best way to gauge the underlying trend is to look at deferred revenues as well as product sales.

Note how current deferred revenues are growing in the last three years even while product revenue growth is slowing.

I have included product revenue growth as a useful benchmark, but Verint (or Nice for that matter) doesn’t, strictly speaking, have a razor/blade model. An industry company to compare them with is Check Point Software $CHKP This IT security company does have a razor/blade model, and even though it is growing its software revenues, its product and license growth is now negative. This implies that growth going forward will be difficult to come by. I’ve covered Check Point in more detail in this article. The difference between CHKP is that the hardware is the first foot in the door while Verint and Nice sell their solutions as part of an overall mix.

Overall the underlying trend is good for Verint.

Where Next for Verint?

This is a difficult question to answer because its future may well lie in a merger with Nice. In addition, it has simplified its corporate structure with the acquisition of Comverse Technology (which formerly owned a large chunk of Verint) so the extra liquidity will appeal to investors.

There are a few drivers here. A key competitor of both Nice and Verint is Hewlett-Packard’s $HPQ Autonomy. This company is allegedly under investigation by the Serious Fraud Office (SFO) in the UK and the US Department of Justice. Ironically, the SFO is a customer of Autonomy. I think it is reasonable to expect Verint and Nice to be favored in competition with Autonomy as a consequence of the cloud hanging over Autonomy.

In conclusion, Verint is getting close to that 5% free cash flow yield that I find attractive, and in the future it can grow cash flows in excess of its revenue growth. I prefer (and hold Nice), but I don’t think investors will go far wrong with Verint either.

Paychex Offers a Good Dividend But What Else?

One of the most important parts of successful investing is to quickly discern the key drivers of a company’s stock price. Of course, it is easier said than done! It is a bit like deciding how an election is won. Different voters vote for different things. However, in the case of Paychex $PAYX I think I know what the campaign issues are likely to be.

Paychex Pays You Checks

In a low interest rate environment, income seeking investors are virtually being forced by the Federal Reserve into seeking high yielding stocks as a substitute for US Treasuries. Frankly I think PAYX’s near four percent yield is a compelling proposition.

In addition, consider that its earnings prospects are largely contingent upon the economy and the small and medium sized business market picking up hiring and employee payments. In other words, you are getting earnings that correlate with nominal GDP-like growth but with a higher yield and some prospect of growth.

It all sounds good for income investors, but there are a few questions over the company:

• Will small and medium sized business start hiring this year after a few years of tepid growth?
• Will competition in its core payroll service hold back pricing and erode market share so that the company decouples from its position as a GDP play?
• Does PAYX have any other opportunities to generate margin expansion and/or growth?

I will try to shed some light on these questions in light of PAYX's and its competitors' recent results.

Paychex Sees Growth

I thought the recent results were pretty good, and the growth in the key payroll per checks number of 2.3% versus 1.8% last year was a stronger than anticipated number. This is a good sign for the US economy at large.

Indeed, plenty of small business indicators have been gradually improving in the last six months. As I argued last time around political events do have a short term effect on small business hiring plans, although they tend to bounce back provided they are resolved. It is no accident that the National Federation of Independent Business (NFIB) indicators tend to worsen over fiscal cliff worries and then bounce back afterwards. The economy is like a supertanker--it doesn’t just turn around that easily.

With the ongoing headline payroll numbers improving I would expect some improvement in small business formulation. Indeed, PAYX argued that since there hasn’t been the typical surge in small business start ups yet, there should be upside to come in the future. We shall see. On a positive note PAYX talked of strong bookings in its core payroll services division but mentioned that pricing increases would be at the low end of the range.

My view is that the economy is improving, but PAYX has more limited pricing power than in previous recoveries thanks to increasing competition. It is not only coming from its traditional sources like Automatic Data Processing $ADP but also from companies like Intuit $INTU. Both of these companies are strong in the online payroll via their Software as a Service (SaaS) offerings. Intuit is the poster boy of the movement towards SaaS based services to small business, and it has the opportunity to cross-sell its range of products to its existing customer base. Intuit is achieving teens growth in its total small business group, and I see the company as a formidable competitor.

As for ADP, its growth prospects are pinned to its professional employer organization (PEO) services group, which is also growing strongly. However, margin growth has been hard to come by in recent years, and the human capital management market is getting crowded.

All of which leads me to answer the third question with a reference to its plans to invest in its ‘market leading’ SaaS technology, although I have a feeling that it is a bit late to the party here, and ADP and Intuit have stolen a march. Nevertheless PAYX can expand margins if its SaaS sales expand.

Where Next for Paychex?

On balance I think the recent results were a net positive for PAYX. Operating margins increased even though the pricing outlook wasn’t great, and there should be upside to come from an improving economy. The SaaS investments make sense, even if the payroll service market (around 2/3 of revenue) is only forecast to grow 1-2% in the full year to May 2013. Human Resources Services are forecast to grow at 9-11% with net income up 5-7%.

In summary, income investors can probably enjoy some high dividends for a few years to come. On the other hand growth investors should probably look for better ways to play a cyclical economic recovery than PAYX.

TIBCO Has Many Questions to Answer

Another TIBCO Software $TIBX earnings report and it’s another miss, another guidance downgrade and another series of expressions of dissatisfaction with its own salesforce. As such, the stock now appears to be at a crucial juncture whereby its guidance is so low that rectifying the execution problems could lead to a significant earnings beat and a rapid recovery. Alternatively these misses could be representative of a market that is structurally changing against TIBCO. In this article I’m going to outline what the management has been saying over the last year.

Tibco’s Earnings

The story of TIBCO’s performance over the last year is personified in the following chart:

In short it’s been a pretty miserable year for investors, and the failure to beat internal guidance is even worse.

In order to demonstrate this I have compared the midpoint of the previous quarter's guidance with what actually happened.

Now let’s recall that this guidance has been given at a time when the company would have already been through the larger part of a month within the three month period. Of course this is why stocks react so negatively to earnings misses. As Jack Welch famously pointed out, companies should do everything they can to avoid missing them. A company that continues to miss its own guidance will do damage to its market credibility.

TIBCO's Guidance

I’m going to run through a summation of the earnings calls this year and what management said on them.

Q1 2012- CEO & President Vivek Ranadive remarked that TIBCO had never seen ‘such pricing power.’ When asked about competitive pressures from its chief middleware competitors IBM (NYSE: IBM) and Oracle (NASDAQ: ORCL) and specifically if they were bundling middleware in order to undercut TIBCO, Ranadive answered that IBM was its main rival but that he felt ‘very comfortable’ with TIBCO’s competitive position. Later on in the same call SAP and Oracle were described as ‘dinosaurs’ competing with old fashioned technology.

Q2 2012- This quarter saw some relatively better numbers, and TIBCO was described as operating under the ‘best of times’ by Ranadive.

However, the guidance wasn’t great, and the problem of US sales execution was cited. The regional trends for TIBCO can be seen in this graph.

When asked about the timing of a turnaround in US prospects, management replied that what they were seeing right now ’is opportunity’ which needed investing in. Later on Ranadive declared that he was ‘very, very confident’ that TIBCO would get back on track as early as the current quarter. The main adjustment was to have the North American sales people reporting directly into a senior level TIBCO VP Murat Sonmez.

Q3 2012- Roll on Q3 and a disappointing set of numbers, but that didn’t stop TIBCO from guiding towards some pretty good license sales growth in Q4. Indeed, Ranadive told analysts that the company was sitting on a $500 million pipeline. Deals were seen across all geographies and industries. Surely TIBCO would bounce back?

Q4 2012- I recall this conference call very well because I’ve rarely heard such a candid assessment of a company’s performance. Time and time again TIBCO pointed out that the problem wasn’t macro or product. It was execution, specifically with the US. The relatively better performance in Europe was cited to back this view up.

The pipeline previously discussed did not close as expected, and ’10 to 20’ deals slipped. Naturally Ranadive & co were grilled over the issue. He argued that some deals were lost thanks to ‘sloppiness’ and the deals that slipped were not lost but rather delayed. IBM was cited as its biggest competitor, but the problem was ‘absolutely an execution related’ issue in the US.

Raj Verma was appointed to oversee a turnaround in the US; he was supposed to bring an attention to detail and overall scrutiny that might help turn things around for TIBCO.

Q1 2013- Fast forward to the recent results and Europe is now weak, the US problems are ongoing, the guidance is horrible, and now there is a problem with the UK operations! TIBCO has had more execution problems than Robespierre, and I will leave the reader to look at the charts above to see how poor the guidance is for the next quarter.

Where Next for TIBCO?

Who knows? Overall the big data sector has done well this year with the only weakness being seen in something like Teradata. Okay, Oracle reported some weak numbers recently, but then it had had a particularly strong quarter previously. Meanwhile, IBM’s last quarter was good and corporations (particularly US) don’t appear to have made significant cutbacks lately.

So if it isn’t macro then what is it? Everything that management is pointing at indicates that it’s internal execution, but this has been going on for nearly a year now and it seems to be infectious with Europe now catching a cold and the UK catching a fever. It’s hard not to conclude that this isn’t at least partly an erosion of competitive positioning--the suspect will be IBM.

In conclusion TIBCO has much to do to regain investor’s confidence. It is no doubt an attractive recovery proposition right now, but it is certainly not a stock for those of a nervous disposition or for those who only buy stocks where the management has got its guidance accurate in recent quarters. Perhaps TIBCO should use some of its own big data analytics on itself when it sets guidance? Frankly I think the company owes its investors a bit better than this.

The Key Results To Look Out For This Week

Earnings season is winding down now, but there is no excuse for not continuing to work hard to find stocks with upside potential. Paradoxically, the fact that there are so few major companies reporting next week should give investors the opportunity to spend more time looking at stocks that might not ordinarily be on the radar. And there are plenty of interesting stocks to look at next week, particularly if you like the food and construction markets in the U.S.

I’m going to pick out a few that I know well, and give some pointers towards what to expect.

Monday

Cal-Maine Foods (NASDAQ: CALM) is the kind of stock that investors can integrate into their portfolios and not worry too much about market risk. I like such stocks, but they must be attractive in their own right. I've discussed the drivers of this stock's profitability at length in an article linked here.

In summary it is the largest single shell egg producer in the U.S., and has growth opportunities from consolidating the industry and growing its higher margin specialty eggs sales. I also like the stock as a play on rising protein prices. With that said, it is exposed to input prices (particularly corn) which tend to cause significant gross margin volatility. Cal-Maine tends to pay out a third of its income in dividends, so don’t buy this stock if you are looking for consistent and easily predictable dividends.

Longer term, I wouldn’t worry too much about rising feed costs, as they can create consolidation opportunities for Cal-Maine and also put smaller producers out of viable production. This is good news for Cal-Maine because, in reality, higher feed costs also lead to higher meat costs. In other words, eggs become more attractive as a cheap protein option. The upcoming results could present a decent buying opportunity if there is any disappointment with rising input prices and the stock sells off.

Tuesday

The food theme continues with McCormick (NYSE: MKC). This is one of those stocks that will torment investors. I like company and its long-term growth prospects. Food companies are pressured to use flavorings, thanks to increasingly diversified food consumer tastes and the need to innovate in order to retain market share in a weak economy.

Similarly, consumers are purchasing more flavorings as home eating becomes an economic necessity in a slow economy. In the long run, things look good, but over the short-term, McCormick has some headwinds and I think there is some risk here.

I outlined some the issues recently. The last results were disappointing, the stock sold off, and then the McCormick bulls came out and drove the stock higher. Investors need to hear that customers restocked in this quarter.

As much as I like the company, I’m not quite willing to pay nearly 24 times current earnings and an EV/EBITDA multiple of over 15 times for a company with only 5-6% EPS growth forecast for this year, and whose forecasts have been lowered over the last few months.

Wednesday

 More food on Wednesday with ConAgra Foods (NYSE: CAG) and Monsanto releasing results. ConAgra is an old favorite of mine. For much of 2012, it looked like a rare breed in the market -- a high yielding defensive growth stock at a very attractive valuation. Its mix of value brands offered exposure to the ‘trading down’ trend, and it managed its private label business much better than competitors like Treehouse.

The market woke up to the story, and as the valuation rose (and it continued to generate large amounts of cash), it found itself in a position to make the strategic acquisition of private label food company Ralcorp. While the deal makes perfect sense, there are elements of risk.

Private label sales continue to expand, but there have been significant disruptions in sales channels over the year and companies like Treehouse have had to make fundamental changes in their sales channels. Investors need to listen carefully to what ConAgra says about the integration.

Acuity Brands (NYSE: AYI) also releases results. I am somewhat a fan of this company and its long-term opportunity to benefit from an improving construction market in the U.S., alongside secular drivers of more LED lighting and controls sales. There is some discussion about the company’s prospects linked here.

The funny thing about this company is that it has missed estimates in three out of the last four quarters, even though the underlying market dynamics have tangibly improved. My best guess is that analysts are too aggressive in upgrading prospects on the back of better indicators, like the Architectural Billings Index. Lighting is relatively light cycle in a construction project, and sales leads times take time in this industry. No matter its results are worth watching closely for any opportunity.

Thursday

The last really interesting result of the week comes from RPM International (NYSE: RPM). Along with its industry peers, the stock has been a stand out performer over the last year. One area to focus on will be its roofing division, where operational improvements are expected following the exiting of international operations.

Aside from its cyclical exposure to the U.S. housing market, the stock has a decent current dividend yield of 2.8%, and is one of those select group of stocks that have increased dividend for the last 30 years. It’s not screaming value anymore, but the markets are in volatile mood right now and the results are worth following closely.

Nike's Results are Not as Universally Strong as They Look

Retail is one of the sectors that it pays to have an open mind over. In other words don’t let your built-in ideas and prejudices take precedence over the hard facts. Sometimes retail trends develop that we can’t personally foresee or understand. It is worth approaching Nike $NKE with these thoughts in mind. There are three key trends that investors need to appreciate about this company and will guide its performance going forward.

Three Things About Nike

I’ve been looking at Nike over the last year, and the three things that strike me about its performance are:

• Chinese sales have weakened substantially, and since they tend to be relatively high margin this has had a disproportionate effect.
• The strong performance in the last quarter was largely due to footwear sales. Footwear is a hot category in retail right now, and Nike has been doing particularly well with it. Apparel performance (particularly ex-US) hasn’t been as good. This has been somewhat surprising given the strength of other outwear brands.
• Nike’s growth is somewhat contingent upon which sports it is strong in and, of those, which is trending well.

 A Weak Chinese Consumer?

A graphical summary of Nike’s performance in China:

Note how sales start to drop off in the last calendar year and that China’s share EBIT is much larger than its revenue share. In other words China is very important for Nike. It is also a long term strategic play for the company, and management spent a lot of time discussing the plans to reset the merchandise. The main focus of inventory management will be on China, and investors can expect to see some margin erosion in the region as inventory is sold off.

The wider question is whether this is a function of Nike getting its merchandising wrong or if it is a problem of a slowing Chinese consumer. Nike is not alone in seeing a downgrade of expectations. Other companies like McDonald's, Yum Brands! $YUM and V.F. Corp $VFC have all reported weaker sales in China.

For Yum, this trend was in place even before the recent chicken supplier controversy in the country. Of course. this is somewhat problematic for Yum because China is the focal point of its sales efforts. It has no option but to try to ride through the controversy and carry on expanding even while same store sales growth is slowing. McDonald's has also seen some negative numbers in China, and V.F. Corp reported an inventory build-up in jeans wear thanks to slowing sales growth.

It is not entirely clear whether this is a macro issue or a Nike merchandising one.

Best Foot Forward

If I had a dollar for every time I heard a retailer or department store talk about expansion plans with its footwear then I would start saving for my latest pair of Laszlo Vass shoes. As discussed in the intro this is not the sort of insight that I would intrinsically know, but when you hear companies like Coach talking about expanding its footwear range then you know that the consumer is spending on shoes in a way that she is not elsewhere.

It’s clear from this chart that the reason for the decent performance is due to footwear. Indeed, apart from China and Japan, every region reported good growth in footwear, from Central and Eastern Europe (up 8%) to North America (up 15%).

The bounce-back is largely due to successful footwear launches and the on going strength of running and basketball for Nike. I suspect the former’s success is due to the popularity of new product launches kicking in while Nike’s success in basketball shoes is partly a function of its significant investment in sponsoring players that achieved high profiles in the NBA season.

Where Nike Is Strong

Another key point to note is that outside of North America, apparel sales are not doing well at all. I’ve stripped out North America from the chart below to demonstrate this.

I was surprised by this because a company like V.F. Corp has been doing well internationally with the North Face and Vans shoes. The on going onslaught of the shift towards casual attire (you can tell I don’t like it) appears to be gathering pace.

My take on this is that consumers are becoming more specialized in their casual attire. For example, if you want to look like a skateboarder while driving your 4x4, buy Vans. Climbing Mount Everest before a trip to a coffee shop? Buy a North Face jacket. As a consequence Nike could be losing its appeal as an all purpose outwear brand.

Where Nike is not losing its appeal is in sports like basketball. The sports strength in North America goes some way in explaining why it is doing particularly well. In order to grow internationally it will have to connect emotionally with the sports that are popular in various markets and this requires marketing and sponsorship dollars.

Where Next for Nike?

The recent results were ahead of estimates, but Nike still has a lot of work to do in solving its problems in China, and there is a sense that the easy growth is over in the country. Moreover, strength in North America is great, but investors should not assume that this will translate internationally.

Having mentioned revenue growth in the high single-digits with earnings growing in the mid-teens for 2014, Nike will have to confirm this at the next set of results.

Jabil Circuit Equity Research

A cute way to get to know someone is to ask him or her to describe three qualities that people usually attribute to them. Now consider if you met Jabil Circuit $JBL at a cocktail party (us Europeans invented surrealism after all); what three things would you immediately learn? They missed estimates last time around, Apple $AAPL is a major customer, and it’s on a current PE of 10. Is that enough to start a relationship? It's time to take a closer look.

Jabil Circuit's Market Prospects

It’s been a difficult period for the company. The consumer electronics business hasn’t been firing on all cylinders for a while now, and it's natural for this to feed through into the contract manufacturers. Moreover, they (Jabil etc) are more sensitive because they have already committed their cost structure in order to service contracts. If the end demand turns down then they are usually lumbered with ongoing costs that eat into margins. As such, if you want to tell the direction of its earnings you have to first guess how its mix of end market customers will be performing.

I would argue that this means that companies like Jabil should trade on a lowly PE, but the market is not obliged to agree with me! On the contrary, its stock price seems to follow the direction of its earnings and not necessarily its evaluation. The following chart demonstrates the relationship.

JBL Price / Sales Ratio TTM data by YCharts

So if we are agreeing (I won’t personally but that’s another matter) that the key is to guess the earnings direction then what are the key upside drivers and downside risks to the current forecasts?

Jabil’s End Markets

In order to quickly run through some of the issues going into 2013 I have an earlier article linked here. Jabil operates through three segments, and I’ve broken out Q2 revenue share in the following chart.

It’s a familiar story with the Diversified Manufacturing Services (DMS) segment. Specialized services are doing fine and now make up 31% of total revenues, but the problems with health care & instrumentation (6%) and industrial & clean tech (10%) remain unsolved. The problem with the latter is that the solar industry is still suffering from significant overcapacity thanks to government cutbacks. Revenues were up 11%, but margins eroded a bit thanks to the faster than expected integration of the Nypro acquisition. Indeed, Nypro (healthcare, rigid packaging and consumer electronics) is expected to help drive segmental revenue and profitability going forward.

Of course DMS attracts most of the attention because it contains the part of the business that manufactures plastic casings for the iPhone. Naturally analysts rush to upgrade and downgrade DMS’ prospects based on their view of Apple’s sales. Unfortunately, Jabil is pretty tight lipped over its Apple related work, but it's hard not to conclude that at least some of the extra capital expenditures planned for this year are a consequence. On a more positive note the forecast bounce-back in Q4 could be a good indication for iPhone shipments.

Enterprise & Infrastructure and High Velocity Services

Enterprise & Infrastructure has been performing well with a 12% increase in the quarter, but this business has wafer thin margins. The aim is to get them to 3% by the end of the year.

As for High Velocity Services, this segment covers things like set top boxes, mobile handsets, circuit boards and automotive components. Many of these end markets have been struggling thanks to their exposure to consumer electronics. Indeed, revenues declined 15% in the quarter. However, this segment is predicted to experience a sequential uptick in Q3 thanks to the manufacturing ramp with some new handsets. The uptick is also partly due to a seasonal uptick in some products.

I’ve summarized the last quarter’s segmental growth along with company forecasts for the next quarter.

The story with Jabil is one of a company coming through a difficult period with DMS predicted to grow again in Q4 and HVS & EIS getting to their targeted margins by the end of year.

Going back to what I argued earlier about margins, does this mean that earnings are set to improve and that the stock is a buy right now?

Where Next for Jabil Circuit?

Essentially your decision over buying the stock will rest on your cyclical view of the economy. The good news is that the stock is priced to give you good returns should some strength return to the consumer electronics market. Moreover, key contracts such as its Apple work provide the company with upside potential.

One future concern with Jabil lies with the hike in forecast capital expenditures from $500 to $700 million. This was described as broad based expenditure, but I read it as a response to weak end markets and an attempt to support growth in other areas. It's not a great sign. In addition the stock has the risk of the Nypro acquisition being factored in, and then there is always the headline macro risk.

In conclusion I decided to take a pass, but for those looking for exposure to consumer electronics then Jabil may well fit the bill.

Is Williams-Sonoma Fairly Valued Now?

There are a few precious themes working in the retail market right now and investors would be well advised to stick with them. Housing and autos are doing okay. High end, specialty stores and discount stores are doing fine and, e-commerce continues to grab market share from retail. The interesting thing about Williams-Sonoma $WSM is that it is exposed to more than a few of these positive themes and its rising stock price demonstrates that amply.The question is where is it going to be in future?

Williams Sonoma’s Growth Drivers

I’m going to get into the details of WSM quickly, so for those who are not at least familiar with the company I have a primer article on it linked here. As discussed previously there are a few initiatives that the company is pursuing in order to drive growth

• International expansion with an immediate focus on Australia and the Middle East
• Expanding its growth brands like West Elm and Pottery Barn
• Launching new business and brands in order to offer a differentiate range of product
• Ongoing expansion of Direct to Consumer (DtC) and its online offering
• Investment in the supply chain and technological infrastructure in order drive multi-channel sales

As you can see from these growth drivers WSM is a direct beneficiary of a cyclical recovery in the housing market as well the secular theme of the expansion of online sales. Indeed DtC sales now represent 46% of total revenues and its fast growing e-commerce sales should help improve margins in future.

The longer term question relates to increasing competition in the online space. Home furnishing is a competitive market and when markets grow they become attractive for new entrants. Now when that ‘new entrant’ is Amazon $AMZN, there should be cause for concern. Not only is AMZN increasing its own product range of home furnishings but it also bought Quidsi last year. The latter having launched casa.com (home goods). Indeed Quidsi is believed to be considering expanding its number of physical stores in order to support its sales expansion. Incidentally this is a strategy that WSM is also following but rather it is supporting its online sales via investing in in-store technology so customer orders can be made online from the stores.

In a salutary reminder of the competitiveness in the industry I would refer to Bed Bath and Beyond $BBBY. It’s been a difficult year for its shareholders. For large parts of the year it managed to report weakening sales trends while seeing margins squeezed by cost prices rising. The ongoing restructuring seems to be taking forever and all this is going on in a sector where everyone else is doing well. It’s hard not to conclude that BBBY is the victim of online competition from the likes of Amazon, WSM and even Pier 1 Imports. Is WSM immune?

The strategic key to WSM’s future is going to lie in differentiating its products (its differentiated products and new launches have tended to outperform) in order not to offer a commoditized products that can be undercut on price from online competitors. Moreover it is aiming to release the potential in its brands via online expansion.

Williams Sonoma’s Potential

In order to see the relative importance of its brands I’ve broken full year net revenue share by brand below.

Naturally Pottery Barn has experienced the benefit of the nascent recovery in the housing market but it has been tougher going at the core Williams-Sonoma brand where comparable brand revenue growth actually decreased 1.1% for the full year. However within that WSM managed to increase the core brands DtC sales and e-commerce revenues in particular.

Time to look at the last two years growth rates.

The decline at the core brand is an obvious concern but the largest brand (Pottery Barn) is doing well. I also think that the international expansion of Pottery Barn Kids is a good idea. The stores in the Middle East are doing well and this is largely a consequence of oil rich disposable income colliding with a youthful demographic. It is no coincidence that the Pbteen franchise store in the region is also doing well. I’m not the sure that Australia shares the same demographic advantages but it certainly offers a relatively strong housing market.

The real story with geographic expansion in 2013 centers on the West Elm stores. WSM rolled out 12 West Elm stores this year as opposed to the initial plan for nine. In addition there are another nine stores planned for this year. As West Elm is a more modern brand it is reasonable to expect WSM’s investments in in-store technology and customer analytics to bear more fruit in this brand.

Where Next For Williams-Sonoma?

WSM is certainly bullish about its future. Management forecasts mid to high single digit growth in revenues accompanied by EPS growth in low to mid teens, for the next three years. This implies significant margin expansion but it’s worth noting that gross margins were flat on the year (although they increased throughout the year) and operating income margins declined 60 basis points to 15%. Moreover the expansion plans will mean increased capital expenditures of $200-220m for the next three years. By way of comparison they were only $130m in 2011. Clearly WSM is in an expansion phase.

As ever there are risks and opportunities with a growth strategy. To buy/hold the stock I think you have to be positive that e-commerce and international expansion will create margin expansion. Meanwhile you should also believe that the management can continue to generate differentiated products in order to avoid potential margin compression. I like the sector and the company but I’m not sure that on a current PE of 20 that it is good value for the risk

FedEx Offers Catch Up Potential

By now, you've probably had your fill of FedEx’s $FDX latest earnings reports. The company reduced guidance, which immediately gave grounds for the bears to come out and point to weakening growth. In reality, it was a mixed report that actually said more about FedEx and its relation to patterns in the global economy. Investors are often criticized for believing that "this time it's different" but in this case I'm going to stick my neck out and say that, with FedEx, it really is different this time.

FedEx Equity Research

What I’m talking about is that the global economy has changed in many ways since 2008. U.S. consumers have de-leveraged while European growth has been weak overall and varied across its regions. Allow me to briefly remark that this is because Europe is at least making some effort to deal with its debt burden while the U.S. seems to be content on making piecemeal changes while the markets reward it with low interest rates. Meanwhile, China continues to be an export-oriented economy and has seen export growth slow as a response to weaker consumer demand from other regions.

These issues matter a lot to FedEx. Indeed, it can be excused for structuring its business to deal with the kinds of economic conditions that were around in 2007, but could it have foreseen what was going to happen in 2008 and after? Furthermore, consider the nature of its business and the difficulties inherent in adjusting its fleet and distribution network to the new economic realities. The result is a business that has had to make ongoing adjustments over the last five years. And it’s not done yet.

FedEx’s ongoing challenges

I’ve discussed FedEx previously and readers who want to see how FedEx and UPS $UPS are both ultimately correlated with global GDP growth can read the article linked here. In addition to see the start of the trend away from express services readers can click here.

For now, I want to summarize the key issues in bullet-point form:

• Consumers continue to shift to cheaper and slower delivery options and away from express. Express revenues were $100m lower than previously forecast by FedEx
• Domestic express services were fine with the problem being in international express
• Ground revenues continue to benefit burgeoning e-commerce deliveries and with the declines in express and low margins with freight, the ground segment contributed 79.2% of operating income in the quarter vs. 57% last year
• Freight operating margins remain low at 4.4% for the first nine months, versus 17% for ground

The issues with international express are a function of how international trade’s correlation with global GDP has gone down for the reasons discussed earlier. Moreover, FedEx has had issues with network efficiency thanks to uneven trade flows throughout the world. Global trade was cited on the conference call as being lower than in 2008. In addition, a constrained Western consumer has slowed the growth of China’s exports. However, the imbalance in traffic to and from China remains in place. All of these factors lead to logistics problems in terms of fleet management.

These issues are exacerbated somewhat at FedEx, which chose to expand its express service only to walk into the global slowdown. Indeed, the problems have got worse over recent quarters. The company's response is to accelerate the plan to retire older planes and manage the network more efficiently by adjusting routes accordingly. Matters could not have been helped much by UPS’ January launch of a new express air service aimed at high-value international heavyweight shipments.

FedEx Competing With UPS

In fact it’s useful to compare the two because gross margins have diverged in recent years.

FDX Gross Profit Margin TTM data by YCharts

And while UPS share price is higher than it was in 2007, FedEx’s is noticeably lower. Like I said, this recovery was different.

FDX data by YCharts

Which Stock to Buy UPS or FedEx?

The problems at FedEx don’t seem to be going away any time soon, but the company is taking the right action for the long term. In addition, ground services now represent a large part of profits and the company is doing fine with long term growth assured from e-commerce growth. The lowering of EPS guidance is never a welcome sign, though. Neither is the threat of more impairment charges as the restructuring continues.

That said, I think value investors might prefer FedEx to UPS on the basis of a lower evaluation and the potential for it to catch up with its rival after restructuring and hopefully increasing margins.