Does Buying Intuit Make Tactical Sense?

Investing is often about weighing the possibilities of various outcomes and then trying to assign a value to the stock on a balance of probabilities. With Intuit , I think investors are getting a fundamentally cheap company that has disappointed in its core activity this year but is performing very well in its fast-growing non-core businesses. Furthermore the question marks over its core activity (tax returns) won’t be at the forefront of investors’ minds until next year. Time to pick some up?

Intuit explains itself

Having previously been rather positive over its prospects for its core tax-return business this year, the company managed to disappoint the market by announcing that it would only grow 4% this year. This is below the 8-10% analysts had penciled in. For an idea of how important tax returns are to its full year, readers can take a look at the charts in the article linked here.

Naturally, investors will want to focus on why and how its tax-return revenues came in lower than expected. Here are the reasons cited.

• Overall tax returns were 1% lower this year against Intuit’s previous expectations of 1-2% growth. The IRS has not yet come to a clear conclusion as to why this was so, therefore it would be remiss to expect Intuit to have a clear view either at this time. Obviously this is an industry issue which could normalize in future years.

• More worrisome, the software category only took 1% market share from manual when it had expected it to come in at 2%. This could be an indication of a slowing of growth in this secular trend or it could be a reflection of issues with Intuit’s software.

•  Intuit claimed that it didn’t grow its online share as it had expected (although it did well with mobile and retail) and smaller competitors took some share. With 60% of the market Intuit is obviously vulnerable to future erosion. 

In summary, it wasn’t as good as expected. But the reasons for this are a combination of structural and company-specific issues. Nevertheless there were some plus points. Mobile is performing very well and Intuit has clear leadership in developing mobile-app solutions. In addition it is competing well against H & R Block . In addition its main rival reported in its press release that the industry had "experienced unprecedented delays and changes to the timing of taxpayer filings this tax season which created significant challenges."


It then went on to argue that it was essentially flat in terms of overall market share of tax returns. So while H & R Block is pleasing investors because it has managed to fight back against Intuit by developing its own online operations, this is not really a story of Intuit notably losing market share. Moreover if there are some structural reasons why manual tax returns can stabilize their market share then H & R Block is going to be a relative winner out of this.

Intuit's Small Business Group continues to grow

If tax returns disappointed, then there was no such let down with its Small Business Group (SBG) results. This group made up 35% of revenues in 2012 and is growing in the mid-teens. A graphical depiction of its ongoing growth is shown below.

These results have been achieved in an otherwise weak environment for small business and they attest to the cost-effectiveness of their offerings. In addition, Intuit has the capability to cross-sell solutions across its customer base. There is a natural correlation between financial management solutions (QuickBooks, etc.) and HR services

Indeed, this space is getting somewhat more competitive now with Paychex  and Automatic Data Processing chasing growth in order to offset slow growth in their core offerings. I’ve discussed these companies in more detail in an article linked here.  Paychex’s payroll service market is only growing in low single digits but its human resources services operations are growing in double digits. Paychex's key attraction is its dividend yield, and even though it has more limited pricing power than in previous recoveries, it still has upside from the jobs recovery working its way down into small businesses. Meanwhile ADP’s growth prospects come from its professional employer organization services group. The environment is clearly getting more competitive, but for now Intuit is performing well.

Where next for Intuit?

I think investors need to keep things in perspective here. Intuit is a huge cash generator and is on a good cash-flow yield. This hasn’t been a good year for its core tax revenues but it still recorded 4% growth while growing its SBG in the mid teens. If it only replicates this performance next year, then I think the stock is a good value. Indeed, there is some upside potential from some of the structural issues (falling tax returns) being resolved.

By my calculations Intuit has generated over $1.2B in free cash flow on a trailing year basis and as I write. That puts the stock on a free-cash-flow yield of 6.8%. In other words, if you buy the stock now and it keeps generating this kind of cash then in 14 years (and this is conservatively assuming no real growth) it will have generated its evaluation in cash. I think that is attractive for a business that – despite slowing growth in its core activity – is still capable of revenue growth in the high single digits.  In addition, the market's focus is largely going to be on its SBG until the next tax season comes around.

Time to Buy Dollar Tree?

Investing in the dollar stores has been one of the most profitable trades since the 2008 financial crisis. With that said, it has been a bumpy ride along the way with all of the leading players having experienced a difficult second half to 2012 and then a nice recovery in 2013. In the light of Dollar Tree’s (NASDAQ: DLTR) latest results I thought I would shed some light on what has been happening in the sector.

The dollar stores in 2012

The general story with the dollar stores can be explained by a couple of charts. The first is the price performance over the last year:

DG data by YCharts

This indicates that the market was very willing to buy their growth stories up until the middle of 2012. So what went wrong?

The answer is that Dollar General (NYSE: DG) and Dollar Tree started experiencing falling same-store sales growth. Meanwhile, Family Dollar (NYSE: FDO) did experience same-store sales growth in 2012, but this was at the expense of margins. I’ve discussed its issues at more length in an article linked here.

In summary, Family Dollar had tried to expand its sales of higher-margin home and apparel goods but ran itself into procurement difficulties. In a sense, it was guided to make such an attempt because it tends to sell a lot of consumables (which tend to be lower margin) and generates significant traffic by doing so. However, the difficulties that it found in trying to expand in these categories speak volumes about the highly competitive nature of its industry.

As for the general growth slowdown, I think it is a normal consequence of a business development. All three firms have chased growth by engaging in significant capital expenditures to fund expansion. It is natural that at some point same-store sales growth will slow because competitors will be attracted to the industry and start to encroach on their market share. This can come from things like dollar stores opening up near each other or from supermarkets like Kroger or Safeway deciding to compete on price through things like loss-leading discounts or promotions in order to drive traffic.

The industry responds

I’ve discussed Family Dollar’s response above. As for Dollar General, it saw significant competition in the last half of the year and its story is one of expanding sales in consumables. In particular, its move into tobacco has caused some margin contraction. The simple fact is that dollar-store customers remain economically hard-pressed. Any strategy to expand into higher-margin categories has been met with resistance. Meanwhile, end markets are getting more competitive.

Turning to Dollar Tree, I think its recent results were quite good and contained a few notable positives.

•  Discretionary-items sales are growing faster than consumables. This should help margin growth in the future.

• Gross margins improved thanks to merchandise leverage and operating margins improved.

•  E-commerce initiatives are driving growth and opportunities to attract store traffic.

• Store openings continue, with 375 new stores and 75 relocations planned planned for 2013.

•  A wide-scale program to increase the number of stores with freezers and coolers should drive incremental traffic.

• The Deals format stores should allow for growth opportunities with higher-priced ticket items without compromising the core appeal or recognition of its Dollar Tree format.

In summary, Dollar Tree has managed to increase margins while carrying on investing in new stores. It’s guiding towards a 7.3% increase in square footage for 2013 and forecasts low-single-digit same-store sales growth.

Where next for the dollar stores?

With all this said, the sector’s strong run doesn’t really leave any of these companies looking cheap. With companies in their growth phase, it is important to realize that they will not be generating high cash flows when they are investing for growth. With that in mind I decided to adjust their free cash flow figures by taking their depreciation rates as a proxy for capital expenditures.

The figures for Dollar General and Dollar Tree are for the last full year but I’ve calculated the numbers for Family Dollar on a trailing basis because its full year runs to August.

We can see the effect of the poor inventory decisions by Family Dollar in the cash flow numbers.

Frankly none of these stocks looks cheap right now.  Even with adjusting for the extra expenditures implied in their store roll-outs, I don’t think that the underlying metrics make them attractive. Despite their attractive growth prospects, the dollar stores still have competitive conditions, and it probably makes sense to wait a bit for a better entry point and some confirmation that same-store sales growth has stabilized.

Why I'm Still Not in Love with Rackspace

It’s been a difficult year so far for investors in Rackspace Hosting (NYSE: RAX). While it is not alone in having delivered disappointing results in the tech world the latest earnings raise more questions than answers as to how to best evaluate this company.

In summary, an investment decision here requires a certain amount of confidence in the future of its OpenStack public cloud project.It also requires an expectation that it is about to demonstrate the kind of scalability in its cash flow generation that it has hitherto not been seen.  No one said investing is easy! But I’m saying you don’t have to invest when it isn’t.

Just another tech disappointment or is it?

In a sense the results were the usual story of tech weakness in the first quarter. Okay Rackspace had the excuse that it is engaging in managing a product cycle transition to its OpenStack public cloud offering. In this kind of environment enterprises are taking any excuse to delay spending decisions. In this case it seems that its customers are holding off investing in Rackspace’s legacy and hybrid solutions while they assess its OpenStack offerings. It does look like a mix of macro and company specific issues but both create uncertainty.

I discussed its strategic move in more detail in an earlier article linked here.  Essentially Amazon (NASDAQ: AMZN) is offering a public cloud approach and VMware (NYSE: VMW) has a private cloud focus while Rackspace wants to do something different by offering its customers the benefit of not being tied to one customer. The  benefit being that the the customer will not ultimately be locked into one provider. This makes sense for VMware because it is in line with its unique selling point of offering ‘Fanatical Support’ to its customers.

Unfortunately in a weak environment the competition tends to get tougher. Amazon Web Services (AWS) has cut prices in order to attract market share and customer growth. Of course it can take some potential margin loss because it is part of a highly cash generative e-commerce monolith. Google has also lowered its cloud storage costs and even though AWS reported 21% in its international operations this came in below what some may have hoped. AWS claimed to still be in 'investment mode' so we can expect a heightening of competition in the industry.

As for VMware, the market was disappointed with the recent results, but the stock has come back strongly since then as investors appreciate its long-term potential.

So will Rackspace’s share price see a similar bounce back? Frankly I’m not sure and here is why.

Same old Scene

Put quite simply VMware generated $599 million in free cash flow in the quarter while Rackspace generated adjusted free cash flow of ($1 million). If we look at the reported free cash flow (operating cash flow less capital expenditures) it was ($11 million) in the quarter.

Moreover expenditures on customer gear are being ramped up at a time when revenue is disappointing. In fact Rackspace stated, in the conference call, that revenue per server declined to $1.308 from $1,310 in the quarter, although in mitigation it had opened a new data center in Australia replete with investment in new servers.

Nonetheless the question mark over its long term ability to leverage its capital expenditures will get even more relevant after this report. Here is a graphical depiction of what I am talking about.

It is one thing to laud offering ‘fanatical support’ and argue (positively) that capex only increases with future growth, but the fact is that the gap between operating cash flow and capex isn’t expanding much at present. Where is the scalability?

Moreover I note that –despite revenue disappointing- there was no downward adjustment to the full-year capex forecast of $375-445 million. The bulk of which being focused on customer growth. Rackspace is going to continue investing because it believes in its strategy. That is fair enough but to follow it you need to share this belief.

Where next for Rackspace?

Clearly the question marks over its business model are not going to be answered definitively anytime soon so investors will have to live with this uncertainty. In addition investors will have to deal with the general macro uncertainty around tech spending. Naturally this also provides some upside potential as well. If enterprise spending picks up then it could appreciate strongly but I would argue that there are better ways to get exposure to it than by buying Rackspace.

Competition is also an issue here with Amazon and VMware determined not to cede market share meanwhile investors need to appreciate that VMware is generating huge amounts of cash while Amazon Web Servces can be supported. In other words they can deal with some margin erosion from price cutting. Can Rackspace do the same while it has significant outlays planned for capital gear this year?

Throw in the overlying uncertainty over the transition to its OpenStack public cloud model and proposition gets even harder. It’s not a stock for widows, orphans or for me.

Is Buying After a Tech Company Crashes a Good Idea?

It’s been an unusual earnings season so far. The market has kept moving higher even though many tech companies have warned. This can appear counter intuitive because tech is usually seen as a cyclical part of the economy. In other words, if tech is slowing down, then the economy will do too. Surely, if tech companies are warning, the market should be pricing in a slowing of growth rather than moving up in anticipation of stronger growth?

Pricing in a recovery?

One explanation for this is that the first quarter saw a weakness in technology spending which should be rectified in coming quarters. Indeed, I have suggested some reasons why this might be the case in an article linked here. If this argument is correct, then buying after the tech companies warn should be a good tactic. The chances are that expectations will have been lowered and the falls would have created some decent entry points.

In order to avoid the dangers of relying on anecdotal evidence and hearsay, I decided to take a bit of a methodological approach and see if the data supported the idea. 

The companies in this graph are those that warned or gave disappointing results in the current earnings season. They were garnered from the NYSE Arca Tech 100 Index. I have excluded biotech and focused on the IT hardware and software companies.

The blue lines are the stock’s performance since the day after the warning and the green lines are how they have performed against the S&P 500 since they warned. The data is current till April 20.

I think the evidence is pretty clear. Tech companies have tended to outperform the market since they warned. I appreciate that part of this effect might have been investors looking to buy stocks that looked ‘cheap’ in a rising market, but on the other hand, the evidence above is pretty broad based.

If I am right about this, then investors should start to look at potential tech company warnings as buying opportunities.

Who said what?

It’s time to look at a few of these companies to see what the specific issues were. This is useful because it helps us understand what is causing this effect.

I’m going to start with Oracle  and International Business Machines Oracle blamed its disappointing earnings on sales execution failures. This is partly a consequence of adding significant numbers of new salesmen and the inevitable disruption that this causes. In addition, its management argued that the pipeline was still in place, it was just that deals were not completed at the rate that they had expected. Oracle expects these issues to be ironed out ‘quick’ and argued that it wasn’t losing any market share.

Thinking longer term, Oracle does have question marks over some hardware product transitions and dealing with the affects that the shift to the cloud (Oracle still has substantive legacy software sales) will have on its revenue.

IBM delivered a very rare miss and I took it as an opportunity to buy some more. In a familiar refrain, it blamed sales execution but also managed to discuss the sequester, the change of Chinese leadership, the timing of Easter, and even the weather.

The good news is that -- just as Oracle did -- it argued that the pipeline hadn’t been reduced and deals weren’t lost to competition. It’s just that its sales guys just had a hard time closing deals in the quarter. The response was to do as IBM does and make some operational adjustments (workforce re-balancing) in the next quarter.

Citrix Systems also saw revenue and earnings come in lighter than expected. In addition, its Q2 earnings guidance was significantly below estimates. In actuality, it was a mixed quarter for Citrix. Its Netscaler product (an application delivery controller that competes with F5 Networks) saw good growth, but its core virtualization growth was disappointing. The latter has higher margins, so the net effect was to reduce expectations for overall margin growth in future.

It’s always worrying to see a company’s core activity slowing, but Citrix had a feasible excuse. It launched its XenMobile mobility solution in Q1 and it is entirely understandable if some of its customers may have decided to hold off purchases while they assess buying the new product. Again, Citrix outlined that its full year plans were ‘on-track’.

The bottom line

In conclusion, all three companies saw what looks like some temporary weakening caused by hesitation among customers rather than a reduction in overall spending plans. Although they all had their own reasons for disappointing, there was a common theme. All three saw their pipelines intact but customers exhibiting caution in their spending decisions. If this dissipates in future quarters (and it may do so after the media stops talking about the sequester) then buying these names, and others within technology, will prove to be a wise choice.

Why TJX Companies Remains Good Value

The retail sector has been one of the hardest to call in recent years. The bifurcation in prospects between the haves and have-nots in the U.S. has created an atypical situation within the sector. Whereas in previous recoveries, the general drift is upwards across the board, this recovery has seen a strengthening at the high end and a general movement towards ‘trading down’ in the mid range. Within these shifting sands, one island of retail has offered strong prospects.

Specifically, the off-price retailers have demonstrated continued strength and The TJX Companies’  latest results are confirming this trend.

TJX Companies reports sales growth at the high end

Earlier in May TJX Companies had reported same-store sales growth of 2% in the quarter and declared that its same-store sales in April came in at the high end of guidance at 8%. This positive trend appears to be in place as the company declared that its May sales were off to a ‘strong start.’

As ever with TJX Companies, it is worth noting that its guidance tends to be conservative. I discussed this issue at more length in an article linked here. In rote like fashion, its management tends to guide towards 0%-2% in same-store sales growth. However, they came in at 2% for this quarter and the guidance was 2%-3% for Q2. All of this makes it rather surprising that it kept its full year guidance at 1%-2%. Upside to come?

I’ve broken out the revenue trends within its segments.

And in order to see how TJX makes its money, here is a breakdown of its segmental profit for the quarter.

Clearly, it is still largely a story of Marmaxx (T.J. Maxx and Marshalls) and its prospects are largely guided by the retail movement towards trading down. TJX is not alone in this. Indeed, Ross Stores has benefited from exactly the same trends. Furthermore a retailer like Nordstrom is expanding its lower priced Rack stores in order to react to the new retail reality. I’ll come back to these companies in a moment, but for now I want to look at some of the interesting other growth drivers that TJX has going for it.

TJX Companies’ other growth prospects

While the reliance on Marmaxx is well understood, TJX has some interesting growth drivers going forward

• Europe presents significant growth prospects. The competition in the off-price market is a lot less and Europe’s economic difficulties are creating growth opportunities. The U.K. has long been a strong market for TJX, but Germany was cited as doing ‘very well’ with the potential to expand to 350 stores from 50 at present.

• Home goods in the U.S. have the potential to grow in line with the recovery in the housing market. Its segmental margins increased 120 bps in the quarter and the opportunity to cross sell home goods to its clothing customers is significant. It is the right category at the right time.

• TJX also has growth opportunities from expanding its appeal to male and youth customers

• It is launching a large scale e-commerce initiative in the second half of 2013, of which it claims to have made minimal assumptions within its growth projections.

Many of these plans have things in common with other companies in the retail sector. For example Coach  is trying to deal with the problem of rivals like Michael Kors encroaching on its affordable luxury market by focusing on non-core categories for its growth. In particular, its initiatives in footwear, apparel, and men’s categories are a recognition that retail outlets need to be innovative in developing new revenue streams. In common with TJX Companies' plans to target men, Coach is trying to tap into the growing market for male fashion and grooming.

Similarly, Nordstrom’s collection of growth plans center on expanding its e-commerce, in-store mobile point of sale devices, and Rack stores; all of which requires significant capital expenditures (around $3.7 billion) over the next five years. It is an ambitious plan and adjusting to the new retail environment is the right thing to do, but investors need to be confident in its execution.

Where next for TJX Companies?

The stock has had a nice run and I note some profit taking after the results. I like the stock and have a target price in the mid $50’s. Analysts expect double-digit earnings growth for the next couple of years and I like its long-term earnings prospects from the growth drivers discussed above.

A forward PE of around 18x may appear expensive, but it has converted over 140% of its earnings into operating cash flow on average for the last three years. Its business model is cash generative and it has good growth prospects. If it can generate another $2 billion in free cash flow this year, this would put it on a forward free cash flow yield (as I write) of 5.4%. That’s good value for its long-term prospects.

Time to Buy Autodesk?

There have been two major themes to the first quarter reporting season. The first is that tech spending has been weak across the board, and the second is that--outside of pockets like aerospace and automotive--the industrial sector has been weak too. Cue Autodesk’s latest set of results. It’s a software company and its end markets are industrial. The rest is history--the company's results were disappointing and it guided lower. What's next for Autodesk, and what do its latest results say about the industrial sector?

Autodesk’s first quarter results

I have previously covered the stock, and those wanting to assess the migration of its earnings can get some background information on the company there.

 A brief look at Autodesk's first quarter numbers versus its internal guidance:

• first quarter revenue of $570 million vs. internal guidance of $570-590 million

•  first quarter earnings-per-share of $0.42 vs. internal guidance of $0.41 to $0.46

• second quarter revenue guidance of $550 to $570 million vs. analyst estimates of $583 million

• second quarter EPS guidance of $0.39 to $0.44 vs. analyst estimates of $0.45

• Full-year revenue guidance of $2.38 billion vs. analyst estimates of $2.45 billion

The end result is that the company's revenues and earnings for the first quarter came in at the bottom end of guidance, and its future projections were lower than analyst estimates. I appreciate that the lowered guidance may appear to be somewhat easier for the company to hit, but I want to demonstrate how even this might prove tough.

Assuming that the mid-point of the second quarter guidance is hit, the remaining $1.25 billion in revenues that were forecast by Autodesk could be split up in the following manner. I note that the management stated that fourth quarter growth would be stronger than that of the third quarter, so some back-of-the-envelope revenue estimates of $593 million and $658 million for the third and fourth quarters respectively could be implied. I want to graphically demonstrate what this means to the back end of 2014’s revenues.

Looking at it, reaching these goals seems like a fairly big ask. The company was duly forced to spend significant time during its conference call discussing various reasons why targets like these might be feasible.

Can Autodesk hit guidance?

The main reasons that Autodesk gave to indicate that it can hit its (lowered) full year guidance are:

• Its business is becoming more back-end loaded with its major account business. As this was an area of weakness in the first quarter, the numbers are expected to contribute more in the second half.

• Autodesk argued that $24 million of growth for the first half of 2014 was pulled into the fourth quarter 2013, resulting in somewhat distorted seasonality for 2014.

• The comparisons from the second to fourth quarters of last year are a lot easier to beat.

• The ongoing transition in its business model towards selling software as a service (SaaS) suites (bundled software packages) rather than standalone flagship products should drive growth in the second half. This is similar to he way that Adobe Systems  is shifting its customers to SaaS-based solutions instead of standalone software.

• Autodesk sees improved strength in certain sectors of the economy that heavily use its software, such as global commercial construction. The company is also making progress in expanding its automotive accounts.

There are notes of caution against this, of course:

• The company reported that April is weak. With other manufacturing exposed companies like Fastenal and MSC Industrial Direct reporting weak numbers before April, this is not a good sign for the second quarter.

• Despite the second quarter of last year being relatively weak, the guidance for the second quarter of 2014 is not great.

• Emerging markets underperformed in the quarter. These markets are supposed to be a long-term growth driver for the company.

• Suite sales in emerging markets have been a bit disappointing, and piracy remains an issue.

• The transition to SaaS is making the company's revenues harder to predict, and with companies like Adobe shifting sales models towards SaaS and subscription-based sales it is causing some hesitation in the purchasing habits of customers.

Essentially, the manufacturing sector has been weak as both Fastenal and MSC Industrial confirmed in their earnings reports that are discussed here. Both companies have limited visibility and short sales cycles. MSC saw sequential weakness in the quarter to the end of March, and with Autodesk saying that its April got weaker then this is hardly good news for MSC.

It was a similar story with Fastenal, though interestingly it saw stronger results in its metal work operations. I think this is partly due to having more exposure to aerospace and automotive. Investors in the industrial manufacturing sector should watch the statements of these two companies quite closely while also keeping an eye on the ISM numbers.

As for Adobe, its shift looms large in Autodesk’s thinking because the former has started to regenerate growth in its core product range thanks to the shift to SaaS and subscription-based sales. At some point Autodesk may well emulate Adobe’s model of ending perpetual license sales (which will cause some short-term revenue shortfalls as customers shift), but until then we shouldn’t model too much of these effects onto Autodesk’s numbers. Prospects for Adobe look good in the mid-term but will it hit is (raised) expectations this year, bearing in mind how many other tech companies have warned in the first quarter?

Where next for Autodesk?

In conclusion, I think that it makes sense to wait for more evidence of a pick-up in general industrial conditions before buying into Autodesk. I've no doubt that many will be tempted into buying in after the fall as this has been a good tactic this quarter, but cautious investors may want to wait to avoid buying in while the stock still has room to fall.

Is Treehouse Foods Still Good Value?

It has been a difficult couple of years for Treehouse Foods, and the share price is only above what it was back then thanks to the recent strong run. I’m sure that part of this is due to the market’s infatuation with the food sector this year (sparked by Buffett’s move into Heinz), but it is also down to the company successfully reorganizing its activities in line with market shifts.

With some successful acquisitions contributing to revenue growth in the quarter, and more M&A activity to come, its prospects are looking brighter than they have for a while. Is now the time to pick up the stock?

Food for thought

The recent results need to be looked at in depth to ascertain the underlying conditions. On the one hand, revenue was only up 3.1%, and this was largely due to acquisitions. On the other, adjusted EPS rose 17%, and restructuring activities have created a more favorable product mix. Production efficiencies, moderating commodity expenses, and supply chain improvements (transport efficiencies) have helped operating margins.

In a sense, these restructuring efforts were essential because the company has been faced with some difficult conditions in the last few years. Theoretically, a slow consumer environment where trading is down, and promotions and discounting are the key buzzwords, should be ideal for a private label manufacturer like Treehouse.

Unfortunately, it is not that simple. Shifts in consumer spending patterns, and more importantly where they buy certain groceries, has resulted in changing outlooks for some of Treehouse’s customers. Consequently, it has needed to restructure in order to realign its retail channels accordingly. The good news is that some of these changes are now coming to fruition.

There was a $0.14 restructuring charge relating to its soup operations, and if soup is excluded from revenue, then it would have risen a more respectable 7%. The strength comes from growth in its hot beverages (particularly single serve coffee) and from acquisitions in areas like refrigerated dressings and sauces. These are measures initiated to restructure, following some below par performances, with categories like soup and pickles, over the last few years. In addition, the management was pretty clear that more M&A activity is on the cards for 2013.

What to expect this year

Potential investors in Treehouse will have to accept that its prospects are somewhat dependent on the dynamics of the food industry. The industry story of 2013 is likely to be an environment of modest volume growth, aided by moderating commodity input costs. The question is, what will the food companies and grocers do in response? Will they try to hold pricing and take margins, or will they use the opportunity to lower prices and grab volumes or market share?

We got an early taste of these kinds of dynamics with ConAgra’s latest results. Its strategy seems to be to increase marketing activities in the face of weakening volume growth. Of course, this decision is guided by the fact that it tends to have value brands and is already competitive on price. In addition, its acquisition of Ralcorp is a positive indicator for private label manufacturers like ConAgra. In fact, across the retail market, the drive toward private label in-store brands has been a key development in the last few years. ConAgra has a lot on its plate this year, with integrating Ralcorp and dealing with some difficult conditions in the service food industry. Its evaluation of nearly 30 times earnings also suggests there is little room for error in its execution.

Meanwhile, grocers like Kroger have been rolling out corporate brands in order to better compete with lower-priced stores that have been gaining market share. In looking at Kroger’s earnings, I was struck by how tonnage came back strongly when prices abated. This is a sure sign that price sensitivity is still the key determinant of volume growth. The good news for Kroger investors is that margin pressure is finally starting to ease. Commodity prices are moderating for Kroger, and given its sterling efforts to retain market share and footfall with a mix of innovation and pricing, it should now see some margin growth.

A look at Kroger's revenue and margin trends:

Putting these thoughts together, I think it is clear that 2013 will be another year of intense competition categorized by promotions and discounts. As a consequence, the shift to private label brands is unlikely to slow down, and conditions should remain favorable for Treehouse. We are not yet in an environment where customers will take pricing easily.

Where next for Treehouse?

Full year EPS guidance of $3.00-3.10 was maintained, and conditions for Treehouse look better than they have for a few years. The restructuring activities are working, and moderating commodity costs should allow for volume increases, while the trend toward private labels continues. The company appears to have sorted out its retail channel challenges.

The bad news is that, on a forward evaluation of 21 times earnings, the stock is hardly cheap, and I would argue that this sort of company usually needs to be priced at a relative discount to reflect the risk inherent in buying a company whose prospects are largely governed by its customers' trading patterns and decisions.

If you are looking for relative value (in an expensive sector), Treehouse may fit the bill. But, cautious investors may want to wait for a better entry point.

Is Capital One Financial A Buy?

Textbooks will tell you that economies work in concert with some kind of ideal and consistent. Unfortunately, it never quite works out like that. In the financial sector in particular we have seen some unusual developments in recent years.

On a historical basis the sector looks cheap, with many of the leading companies trading at below book value; however, we are living in uncertain times and the credit cycle is not the same as it once was. So do the financial companies present good value right now?

It’s different this time

These are some of the most famous last words in investing. They induce investors into making assumptions that they build into stocks, which then promptly disappoint them. In the case of the financials we are seeing ongoing weak consumer demand for loans; however, I think it would be a mistake to assume that it really is different this time. At some point--as long as the economy keeps improving--consumer demand for loans will increase. History suggests that when employment and incomes increases then loan growth will follow.

With this said it is worth reflecting on how slow the recovery has been. Employment gains have been on a par with previous recoveries, but nothing near enough to recompense for jobs lost in the recession. Moreover, we have come through a few years of consumers deleveraging, and such behavior can become habitual.  Meanwhile, the Federal Reserve is doing anything it can to throw liquidity into the economy. Interest rates are low and financials are facing declining net interest margins as they struggle to replace higher rate loans that are maturing. A veritable mix of pluses and minuses.

How this plays out in the Industry

We can see these issues playing out in the metrics of the lenders. For example, here is Discover Financial Services' (NYSE: DFS) net charge off rate and delinquency rates for its US credit loans.

Clearly asset quality has improved in a rather dramatic way since the last recession, and it is notably lower than before.

While asset quality has improved across the board, low interest rates have created net interest margin (NIM) difficulties. For example, here is a look at Wells Fargo’s NIM numbers.

In the case of Wells Fargo It has seen significant increases in deposits, which created pressure on its NIM while new mortgage origination hasn’t been as strong as many might have hoped. 

In a sense the whole industry is positioned in a similar manner. Asset quality is improving, but consumer demand remains weak and many loans are maturing, leading to significant amounts of runoff and capital appreciation.

Enter Capital One Financial

Within financials the stocks that I like are Wells Fargo (on the basis of its exposure to the US housing market and conservative approach), Goldman Sachs  because it still trades below book value and offers significant upside from exposure to more M&A activity this year, and Capital One Financial .

Here are the price to book numbers for the stocks discussed in this post.

GS Price / Book Value data by YCharts

Discover’s evaluation reflects its more aggressive approach to lending, while Goldman Sachs remains subject to regulatory risk. Nonetheless I think Goldman is good value. I’m not the biggest fan of this company and the way that successive administrations have catered to its interests, but I’m willing to bet that these trends will continue and regulatory fears will ease. As for Discover, investors have to ask themselves if it is chasing too much business.

Good Value?

Evaluations are attractive, but these stocks will not have such good value if lending doesn’t come back. My point is that if the economy continues to improve then at some point loan demand will surely return. However if it doesn’t (or if the same weak environment ensues) then I would rather be invested in a financial with a traditionally conservative approach to lending. In this regard I think Capital One is a good option.

Drilling down into the details of Capital One’s latest numbers it’s clear that it expects run-off to continue this year and the next.  It plans for $12bn in 2013 and then a further $8.5 billion in 2014. So while its credit performance is good, consumer demand is still weak. It would be understandable if its management then decided to chase growth in areas like auto loans (which grew $800 million); however its auto loan originations declined by $500 million in the quarter as they refused to chase low quality loans.

In essence Capital One is a more conservative lender that still gives exposure to the upside of an improving economy. The fact that areas like auto loans have offered growth to lenders hasn’t caused Capital One to create potential areas of weakness in its loan book which could then threaten the company’s ability to lend in future.

Moreover, it is planning to use its capital appreciation to reward investors with buybacks and is already in talks with regulators about this.

The bottom line

Capital One offers a solid way to get exposure to the financial sector without too much risk. I think investors should take this into consideration rather than just looking for broad-based financial exposure.

Its evaluation is not expensive on a price to book basis, and a dividend yield north of 2% plus the prospects of further capital returns to shareholders offers upside prospects if the economy continues to grow.

Precision Castparts Offers Leverage to the Global Economy

Another week and another set of earnings in the industrial space that confirms the curious bifurcation in the sector. Companies selling to the aerospace and automotive sectors had a good quarter, while others found things a lot tougher.  Such thoughts came to mind when looking at Precision Castparts'  latest results. In this article I want to delve into the reasons why, and suggest some other stocks in the aerospace sector.

Precision Castparts lifts off

The bifurcation that I spoke of above was further demonstrated in these results. Fortunately for Precision Castparts’ investors, the company has increased its exposure to aerospace. It now makes up 67% of revenues, vs. 64% last year.  The Timet acquisition has helped while also allowing it to generate operational efficiencies and synergies.

A quick breakdown of revenues demonstrates the positive effects of Timet on the forged products segment:

And a breakdown of operating income in the quarter shows how it makes its money:

Moreover, there is still plenty of growth to come as it ramps up production (notably by getting its 29,000 ton press back to full capacity by the end of the year) for the Boeing 787 this year. It will do similar with the 737 next year.  Fortunately, large commercial aerospace makes up 75% of its market, with military only at 17%. Elsewhere, its other segments saw less than stellar performance, with power falling to 18% of sales from 21% last year, and general industrial remaining flat at 15%.

What the industry is saying

Focusing on the macro aspect of its results, investors need to understand that the commercial aerospace industry is highly cyclical. The good news is that in this cycle the airlines have been surprisingly profitable. I discussed some of the reasons why here.

In summary, I think airline profitability is better this time, due to a combination of factors. Austerity measures have brought about a reduction in the willingness of governments to subsidize loss-making ‘national champions'. At the same time, financing has become harder for new entrants. In addition, the growth in emerging market passengers has created new growth drivers for the industry. And finally, the airlines have had a few years to adjust to high oil prices.  The really interesting point is that –past the short term- profitability does not appear to correlate with oil prices. All said, it is a better operating environment for the airlines.

We got a good early read on the current strength of the industry when Alcoa  reported results.  It was a generally positive set of numbers from its end market perspective. With regards to aviation, Alcoa stuck to its previous bullish guidance of 9-10% global growth this year, with particular strength coming from emerging markets. The issue with Alcoa is not necessarily its end market growth, but rather the state of overcapacity in aluminum production. Its aviation demand remains strong.

Therefore, it is not surprising that Boeing has been beating estimates and looks set to continue. Naturally, the aviation industry will never truly escape being cyclical, but as long as the global economy remains on track, it is a sector that can outperform. This is good news for Boeing, Precision Castparts, and other players like cabin manufacturer BE Aerospace.

The latter is one of the most interesting names in the aerospace sector, and offers a rare way to get pure exposure to commercial aerospace. Its growth prospects rely on a mix of retrofit and new build demand. In addition, it is a key beneficiary of the trend towards wide bodied aircraft, and has a number of new innovations, like its lavatory system for the 737 which allows airlines to gain a few extra seats. However, I think its key plus point relates to the profitability of airlines. If the industry is on a more sustainable path, then airlines will be better positioned financially in order to retrofit planes, rather allow them to depreciate.

Where next?

On a stock specific basis, this means that companies like Precision Castparts can continue to outperform. It offers a combination of upside from a ramp-up in production, plus synergy opportunities. Both activities can increase margins going forward.  Similarly, something like BE Aerospace is going to benefit from more favorable industry financials. Boeing is an obvious momentum play.  If you are bullish on the global economy and particularly emerging markets, then all these stocks represent attractive propositions. 

How Cisco's Results Read Across the Market

Tech investors have seen a slew of warnings over the last few months, so Cisco Systems' (NASDAQ: CSCO) recent ‘beat’ was always likely to be well received. As ever with bellwethers, there is as much interest in what its constituent segments mean to the tech industry as there is in its own prospects. Moreover, as Cisco is reporting late in the quarter, there may be some indication that the tech market is going to recover from a weak calendar Q1.

Cisco cheers the Market

After heavyweights like IBM, Oracle, and basically any company that sells anything to service providers delivered disappointing numbers, investors were entitled to expect Cisco to miss as well. However, the company has always been a little different than others thanks to

• the strength of its government-based business (which made it relatively weaker last year as austerity measures crimped expenditures). This can cause some lumpiness in results.

• a huge cash pile with which it can invest to buy growth. Indeed, acquisitions have always been a major part of the strategy.

• Its ability to bundle solutions together in order to generate growth across all segments.

I think these factors need to be understood before looking at the results. In summary, I think its core business of switching, routing, and services was a little bit disappointing. The good performance was in the non-core activities where acquisitions and the ability to bundle solutions may well have helped out. Nonetheless, this was a positive report overall for the tech sector.

On a geographical basis, the Americas grew 7% with some surprising strength in its U.S. commercial business, which was up 10%, and in a bullish marker for the tech industry, its U.S. enterprise numbers were up 10% with service provider-based revenue up 10%. In fact, this is a continuation of the strength that Cisco saw in the last quarter with regards to U.S. enterprise.The U.S. public sector grew 5% with local and state growth of 13% counteracting a 3% decline in Federal.

EMEA was flat with some signs of ‘bottoming out’ being cited.  Asia-Pacific was somewhat more disappointing with only 1% growth and some Cisco specific issues were cited in China.

Cisco’s core business

You can access a review of Cisco’s previous numbers in an article linked here. Switching was a bit weaker than I had expected because previously, it had said that switching revenue would be flat for this quarter and the next. Routing revenue was flat year on year but saw a nice sequential increase from a disappointing quarter in Q2.

Services revenue growth was only 7%, and this reflects the lower growth profile that the company has had in the last couple of years. It calls into question whether Cisco will hit its 9%-11% CAGR target for services in the next 3-5 years.

A graphical depiction of these segments growth depicted below.

Having looked at what Verizon (NYSE: VZ) said recently over its enterprise customers' spending patterns and their ongoing cost cutting first based approach, it is no surprise to see Cisco’s switching and routing revenue entering a period of weakness. Switching had a stronger quarter in Q2, but in common with the rest of the industry, this quarter delivered a weaker set of numbers. For Verizon investors, Cisco's positive commentary on enterprise spending must be a plus going forward.

Whereas Verizon has rolled out much of its next generation network, AT&T (NYSE: T) is supposed to be playing catch up. However, in its last results, it announced that its capital spending plans would be reduced by 9% for the next two years. This is clearly disappointing because it was one of the service providers that the market was hoping would give a lift.

So, if the core results were a bit disappointing, where was the good news?

Cisco grows its non-core revenue

For a mix of reasons there was better news in its non-core activities. Starting with Service Provider and Collaboration.

While the SP Video results look great, they were largely a consequence of the NDS acquisition. This is no slight on Cisco, because the idea that it can use its cash pile to buy growth is a big plus point, but it does suggest that it should make more acquisitions. Unfortunately, poorly timed acquisitions in the collaboration sector may well have dimmed the market’s confidence in its strategy. Speaking of collaboration, it saw conferencing rise 11% but there was more ‘softness’ within telepresence as it continued to decline.

It is, therefore, somewhat puzzling to see Polycom (NASDAQ: PLCM) rising in sympathy. I think this end market may well face some structural challenges in the next few years. IT spending trends are favoring mobility, open source platforms, and cloud-based solutions rather than hardware that ties purchasers to do things like use a fixed room within a location in order to engage in ‘telepresence’.

Turning to Wireless, Security, and Data Center, it is here that we can see the strength in these results.

Data Center has been a stand out performer for Cisco for some time, and its unified data center strategy is enabling it to offer integrated solutions to its customer base. Moreover, Cisco is executing very well in wireless. Telco budgets are shifting from wireline to wireless and it is essential that Cisco takes advantage of this. In particular, its service provider wi-fi growth was quoted as being ‘extemely strong’ while its wireless local area network group was up 17%.

I read this as a positive for a stock like Ixia (NASDAQ: XXIA). Not only is Cisco a major customer, but the company’s test, assess, and monitor solutions are well placed to take advantage of enterprise spending on wi-fi and LANs. If Cisco is rolling out more networks, then Ixia should be well placed to benefit from spending on making sure those networks function effectively.

The bottom line

Frankly, in the current environment, the market will take a lot of heart from these results and the relief rally is evident. Cisco didn’t beat by much and its EPS guidance of was in line with analyst estimates, but it has been such a tough quarter for tech and Cisco’s commentary (particularly on U.S. enterprise spending) was positive.

In reality, it was a mixed performance with its core businesses demonstrating sluggish growth, but the strength in its non-core activities is pointing the way to the future. In short, Cisco needs to use its cash pile to make acquisitions. The good news is that it can, and consequently, it still presents a decent value proposition.

NICE Guys Coming First

It’s been a disappointing earnings season for technology stocks. A marked reluctance among telcos and enterprises to sign off on big deals has caused company after company to miss earnings and lower guidance. In this environment any company that merely hits guidance is a 'winner.' With these thoughts in mind the market liked the recent results from NICE Systems(NASDAQ: NICE). In fact I got the impression from the tone of the questions on the conference call that the analysts were rather surprised at how well it all went.

NICE guys come first

Nope not a throwback to before the dark ages of feminism but a reference to NICE Systems earnings in the quarter

• Q1 Revenues $225 million vs. internal guidance of $220 million-230 million

• Q1 EPS of $0.61 vs. internal guidance of $0.57-$0.62

• Q2 Revenue guidance of $220 million-230 million vs. analyst consensus of $231.9 million

• Q2 EPS guidance of $0.58-$0.64 vs. analyst consensus of $0.62

•  Full year revenue guidance of $940 million-970 million vs. analyst consensus of $957 million

• Full year EPS guidance of $2.55-$2.65 vs. analyst consensus of $2.61

The results were pretty much in line and the guidance for the full year was left unchanged. This is good in relation to what others have been reporting but it is also encouraging for NICE shareholders because the company is becoming more back end loaded in its results. In other words, earnings are being pushed towards Q3 and particularly Q4. It’s great when they come in as expected but investors will always have concerns when in Q1 & Q2. I discussed some of the reasons why in an article linked here.

NICE Systems earnings drivers

In essence NICE is seeing larger deals coming in (a notable contrast to the rest of the tech world) as it is able to sell on more advanced applications solutions to its customers. While this is obviously good news it also means that bookings may take longer to translate into revenues. In addition the sales cycle will be longer with these types of complex deals. All of which means that earnings and revenues are becoming more back end loaded (a lot of deals will be signed in Q4).

A graphical depiction of what to expect can be seen here.

The company is looking for bookings of above $1 billion in 2013. A quick look at the revenue guidance of $940 million-970 million confirms that the book to bill is expected to be above one this year. Another good sign is that it claimed the growth was coming from its existing customers, which implies that it has good opportunities to sell its advanced applications into its installed base. 

With all this good news going on, investors are entitled to ask how it hit guidance when so many had missed?  For example TIBCO Software (NASDAQ: TIBX) gave a horrible set of results recently and this company has questions to answer over its guidance. Although not strictly speaking a competitor, TIBCO is exposed to enterprise spending on big data analytics.TIBCO needs to demonstrate that it can turn around its poor performance with its US sales execution. In addition it has spent a year blaming this region for its problems but now its European operations are performing poorly too. My guess is that this because its solutions maybe tied to expansionary spending expectations (marketing budgets etc) rather than the sort of efficiency gains that NICE offers.

Moreover IBM also missed estimates (a rare event in itself) amidst discussion of a weaker macro environment. Its analytics results were relatively stronger and there is a suggestion that it is taking market share from TIBCO. However it was hardly a strong statement regarding the overall spending environment. 

Why NICE Systems is doing so well

Some reasons why it did so well are that other than the opportunity to sell its advanced applications to a mature and large installed base I think its solutions are somewhat non-discretionary. Whereas a corporation may hold back on investing in new marketing expenditures (TIBCO) and on upgrading its IT (IBM) if a company is facing increasing security, money laundering or regulatory & compliance requirements it will need to invest. Indeed NICE has a deal with IBM to incorporate its analytics solutions within its services.This gives both companies advantages to sell through services particularly with financials.

Moreover NICE’s new solutions largely involve analyzing customer interaction data that its systems are already capturing. In other words it is a proposition largely based on productivity and efficiency gains rather than purely growth.It also means companies can buy a range of solutions from one supplier.

Longer term there is always going to be speculation over a potential tie up with its rival Verint Systems (NASDAQ: VRNT). The companies are good potential partners thanks to complimentary end markets and customers. NICE is strong with financials and call centers while Verint has more strength with Government business and security solutions. Indeed Verint’s recent results were quite good  and I think its guidance may prove to be conservative. Verint's focus on security should enable to grow as there is no shortage of worries over cyber attacks and in particular with Government agencies. A deal between the companies is a real possibility due to complimentary end markets, a common culture (both are Israeli) and they are likely to share many shareholders in common as a consequence.

 Where next for NICE Systems?

Anyone predicting that he had found a corner of tech that is oblivious to the slowdown in Q1 would have been left with egg on his face, or rather an omelet. So I would be cautious with expecting too much here. 

With that said NICE seems to be on track to hit its full year guidance. In terms of evaluation the current PE may seem high at 33x but its cash flow conversion is excellent. This business has generated an average of nearly $126m in free cash flow over the last few years. Compared to its market cap of $2.18 billion and enterprise value of $1.85 billion this makes the stock good value and I think the analyst consensus target of $40 is achievable.

Restoration Hardware Has Momentum

t’s been a pretty good earnings season for the home furnishings industry, and Restoration Hardware $RH continued the good cheer by upgrading its Q1 guidance only a few weeks after reporting an impressive set of full year results.

The company has a number of positive drivers behind it. It marries a recovering housing market with the spending power of the high-end consumer and a collection of ongoing operational improvements along with new category launches. In summary, it is well worth a look for anyone wanting to get exposure to the sector.

Restoration Hardware upgrades

Before going into details, I want to outline the changes to guidance. Note that these changes were made on May 10, having been previously been issued on April 18.

• Q1 Revenue guidance of  $295 million-300 million versus $280 million-285 million.

• Q1 adjusted diluted EPS guidance of $0.02 to $0.04 versus $(0.02) to break-even.

• Q1 Adjusted net income guidance of $900,000 to $1 million versus $(1) million to break-even.

• The increase in Q1 guidance is expected to be incremental to the full year guidance, so start penciling in upgrades folks.

For the sake of clarity, the existing full year guidance is $1.42 billion -1.45 billion in revenue and $1.29-1.37 in adjusted EPS.

It’s an impressive hike and the company lost no time in announcing on the May 14 that it would launch a follow-on offering of 7.5 million shares to be sold by existing stockholders. The business appears to be firing on all cylinders, so what should investors look out for going forward?

Restoration Hardware’s growth drivers

I’ve previously discussed the stock in an article linked here which should give some good background reading. Regarding its growth drivers for 2013, I have a few bullet points

•  Increasing the number of its full line galleries

• Growth from new business launches such as RH Tableware and RH Objects of Curiosity

• Opening of distribution centers in order to increase capacity and improve service

•  Expanding its baby and child offerings

•  Developing its contemporary art offerings

It’s worth noting that despite the 30% increase in net revenue in Q4, gross margins actually fell 200 bps to 36.5%. This is largely a consequence of the increase in lower margin furniture sales as part of overall revenue. Going forward, investors should look to initiatives like the new business and, in particular, the contemporary art offerings to increase margins as they contribute more as a share of revenue. No matter the revised Q1 guidance implies 35%-38% revenue growth.

With that said, the key to its growth will be the increasing number of full line galleries. I note that previously, the company argued that only 25% of its current assortment was being displayed in retail galleries, but it recently quoted a figure of 20% (and below 15% if baby and child categories were included).

The opportunity is to expand retail space (via full line galleries) and maximize the potential in its overall assortment. Indeed, it declared that the first three full line galleries in LA, Scottsdale and Houston were outperforming expectations, and with new galleries being opened this year, we can expect more of the same.

What the Industry is saying

It is certainly not alone in reporting good numbers, although I note that other companies have differing operational improvements planned in order to benefit from an improving housing market. For example Pier 1 Imports $PIR is following a strategy of expanding its e-commerce activities and in store point of sales systems in order to drive new channel growth. Meanwhile its Q4 same-store sales numbers came in at an impressive 7.5%. My longer term concern here would be that its e-commerce activities might cannibalize its in-store offerings and place extra pressure on it to innovate in order to achieve product differentiation.

Another good indicator for Restoration Hardware is Williams-Sonoma $WSM.  It has seen good growth in its pottery barn kids and teens categories, and in addition to expanding its e-commerce and direct to consumer sales channels (now 46% of total sales), it has an ongoing international expansion plan. However it also needs to keep a focus on achieving product differentiation because online specialists like Amazon are entering the space. Just like Pier 1, the company is targeting mid to high single digit revenue growth. Impressive stuff.

And finally, I think Bed Bath & Beyond $BBBY is worth a mention. I think it has been the business most challenged by online competition and is finding it difficult to hold onto margins. With that said, it too is shifting to offering multi-channel distribution amid launching new websites and integrating acquired business. Rather, like Restoration Hardware, it offers some upside from improvements in operational efficiency, but on the downside, it also has a lot more specific competitive activity (Amazon et al) potentially targeting its revenue base while its growth has been less than stellar in recent times.

The bottom line

In conclusion, I think momentum is with the sector and it is a favorable time to be invested in it. Analysts will likely raise full year estimates so the top end of existing company guidance at $1.37 looks beatable. At least I would hope so, because at the current price, it puts it on a forward evaluation of 37 times earnings.

It’s not the sort of stock or evaluation that I would chase, but we have all seen how some stocks can perform when momentum is behind them and they are raising guidance. Don’t be surprised to see this stock higher by the year end, but be prepared for some significant downside if it misses any numbers and the growth story loses its luster.

Why Tech Can Outperform the Market

t has been a somewhat perplexing reporting season for many companies in cyclical industries. I’ve detected a recurring trend with a number of technology and industrial companies. Simply put, Q4 of last year ended quite strongly, and encouraged a sense of optimism that many companies haven't lived up to in 2013. The result is that many warned and lowered guidance.

Is now the time to take advantage of lowered expectations and cheaper share prices? I want to look at three factors that might help you make your mind up.

IT Staffing Companies are reporting good growth

Following the earnings misses at tech bellwethers like IBM and Oracle(NASDAQ: ORCL) investors in staffing companies must have been fearing the worst over prospects for their tech operations in their upcoming results. However, the reality turned out much better than most could have predicted.

On Assignment (NYSE: ASGN) is a staffing company that generates the majority of its revenues from the IT sector. It reported a strong start to the year and guided towards the high end of its previous full year forecast. Its IT end markets were cited as being particularly strong- with the largest growth coming from healthcare, telecoms & media. Overall revenue was up 13.6% and the stock rose double digits in response. Moreover, the outlook for its tech sector was flat for Q2 vs. Q1; in other words it is not reporting any sequential slowdown, and strong demand will continue.

In addition, Robert Half International (NYSE: RHI) reported good results within technology. Overall its numbers were a bit disappointing, but this is largely due to weaker European results. In comparison the US numbers were in line with expectations, and it declared that this was the first quarter in years in which its tech operations had reported sequential improvement.  Investors will hope it can stabilize its European operations.

My view is that the strength that the staffing companies have seen in tech is a consequence of underlying structural strength. Whereas the weakness reported by the software companies is more of a tactical response to fears over sequestration.

 Business survey’s are indicating strength

If this is a tactical issue –which could be resolved pretty quickly- then business surveys should be showing underlying strength. I find the Duke University Fuqua CFO Business Outlook Survey to be a useful indicator of corporate spending plans.

I’ve broken out the key data that interests us:

It’s clear from the graph that capital and technology spending tends to lag the earnings growth outlook. This is also intuitively true because if revenues are rising then the spending needed to service it should grow too. Note also that employment plans appear to be improving this year.

It sounds good, but we still need to reconcile this sort of survey data with the reality that tech spending was weak in Q1. My view is that, again, this is due to some sensitivity over short term events rather than an underlying malaise.

We’ve seen this before

If this argument holds, then we should have seen elements of it previously. Political and economic uncertainties have been with us for a while, and they are not going away anytime soon. In a sense I think businesses have become hyper-sensitive to them. As I’ve articulated in an article here, corporations and individuals have cleaned up their balance sheets and debt situations. It’s now time for the government to do so. 

The current worries are over the effects of the sequester on the economy and they were around last year too. They hit their zenith in Q3 over ‘fiscal cliff’ worries. I would argue that this is why we saw such a relatively strong Q4 in technology. In other words, firms held off from spending in Q3, which then got released in the next quarter.

For example, IBM talked of US orders falling off a cliff in September and spooked the market, only to report a strong quarter in the next set of results. Guess what? IBM missed estimates this time around as sequester fears kicked in. Oracle also gave a disappointing set of numbers this quarter and blamed it on internal execution. Even smaller companies like F5 Networks (NASDAQ: FFIV), Fortinet, Citrix Systems,TIBCO Software and others have warned over profits.   

Fascinatingly, they have all said a similar thing with regards their pipelines. None have seen them reduce –as they might in a systematic slowdown- but rather that there was a failure to convert them into orders. The reasons for this differ with the individual companies. F5 and Fortinet saw notably weaker performance from telcos, Oracle blamed sales execution, IBM blamed a mix of things, while Citrix Systems said a new solution caused order delays.

Of these companies I think TIBCO may be facing competitive pressures, and F5 Networks' near-term prospects are somewhat made unclear, thanks to its product refresh taking place. These things can take a quarter or two to work themselves through, so anyone looking for a tech stock to play a 'bounce back' may want to be a bit cautious with it for now. In addition, Citrix reported a good quarter with its rival Netscaler product, so it may well be taking market share from F5.

I think that they all experienced some tactical reluctance amongst customers, with many of them adopting the same ‘wait and see’ approach that they did in Q3.

The bottom line

If this thesis is correct, then this is not the time to go underweight in technology, and investors should hold their nerve with some of the disappointing results we have seen in the quarter. If Q2 bounces back in the way that Q4 did, then the sector could outperform in the coming months.

Is Allergan a Buy?

It’s been a varied reporting season with a general uptrend in markets accompanying more than a few profit warnings. If you’ve been holding some of these names before the disappointments then it has been painful. The good news is that these situations can create buying opportunities. I think Allergan (NYSE: AGN) is a case in point, and here is why.

Allergan’s Outlook

It was almost a tale of two reports. On the one hand Allergan's ongoing operations are performing a bit better than expected while on the other, there was some disappointing news with regards clinical trials. The stock promptly sold of aggressively as the market discounted future revenues from the two problematic programs. I will come to the trial issues in a bit, but first here is how Allergan adjusted its full year guidance for product sales.

As the table demonstrates there was a slight increase in the bottom end of the revenue ranges, so obviously the mid-point of guidance has been increased. The only product that saw the top end of guidance hiked was Restasis (therapeutic dry eye). In addition there was quite a bit of positive news on its key neuro modulator Botox. So if the guidance remains upbeat, what happened in the current quarter?

 What Allergan Reported

Despite the positive guidance, sales in the quarter for its ophthalmic products (47% of total product sales) were below long term trends at just 3.2% in local currencies. While Botox sales (32% of total product sales) came in with a much healthier 15.4% increase, ophthalmic sales were affected by a decrease in Lumigan (eye pressure) sales thanks to the discontinuation of a formulation of Lumigan. No matter--sales should recover going forward as the inventory channel gets filled up again.

All of this should interest Novartis (NYSE: NVO) shareholders because it is engaged in a legal battle with Allergan over Lumigan patents. Novartis is believed to be able to get a generic version to the market in the next few years, provided it can avoid infringing any patents.  Restasis sales increased by 11.2% in local currencies amidst an increase in consumer awareness, partly promulgated by Allergan investing in direct-to-consumer marketing.

However, the really good operational news was with Botox. I confess I was somewhat concerned going into these results as two competitors appeared to be shaping up to try and grab some market share from Allergan and Botox. First, Merz Pharma was able to start re-commercializing Xeomin for aesthetics in the quarter. Meanwhile, Valeant Pharmaceuticals' (NYSE: VRX) purchase of Medicis was partly intended to integrate Dysport into its dermatology unit. As it turned out –at least according to Allergan- Xeomin sales only increased slowly in the quarter and its market share was cited as being just 5%. Meanwhile Dysport’s share was reported to have dropped to 13% from 16% last March. Valeant will surely invest in Dysport in time, but for now Botox has the momentum.

Moreover, the overall market is growing at 14% and Botox’s overall market share is believed to be about 78%. It is also able to generate future growth in areas like spasticity, chronic migraine and urology indications. Aesthetic growth remains very strong--despite a weak global economy--as the stretchy face look seems to show no signs of losing popularity.

What Went Wrong?

The stock got hit thanks to delays to its DARPin (macular degeneration) program. The Phase II data suggests product differentiation with the control (Roche’s Lucentis), and this is believed to have put the program back by up to two years. This is great news for Regeneron Pharmaceuticals (NASDAQ: REGN) shareholders because its rival product Eylea will now have more time to entrench its market share. It is difficult to predict whether the DARPin program is a bust or not, and Allergan was understandably tight-lipped over giving an opinion before they release a comprehensive examination of the data. My general view is that delays tend to decrease the chances of success rather than increase. Regeneron should sleep a bit more comfortably over the issue.

In addition the Bimatoprost (scalp hair loss) Phase II trial failed to demonstrate sufficient efficacy in order to proceed to Phase III, but the Phase II trial is now being extended to include a ten times higher concentration. Enrollment with male patients will begin in Q3. All of which leads me to wonder –if safety doesn’t appear to be a issue- why it wasn’t tested in the high concentration anyway?

Where Next For Allergan?

Investors need to recall that neither DARPin nor Bimatoprost were inside the time frame of Allergan’s five year plan. In other words this company can go on generating mid-teens earnings growth for the next few years and at least high mid-single digit revenue growth. In addition its existing long term growth drivers are excellent and, from here, I think any good news with the two clinical programs discussed here will provide upside.

In conclusion you are getting as high quality, highly cash generative name that has been sold off aggressively and I think it’s worth picking Allergan up.

Time to Buy Stanley Black & Decker?

There are three positive earnings drivers to look out for with Stanley Black & Decker( NYSE: SWK), and if they all come together in 2013, then this stock has significant upside potential. It is a nice mix of value and growth.The company offers a nice mix of improving end markets, ongoing cost savings from synergies created via acquisition integration, and it has a strategic growth initiative in place in order to drive revenue growth and return on capital. In this article, I want to look at how these three facets are playing out so far this year.

End market prospects

The recent results were a mixed bag, as estimates were missed but the full year guidance for EPS and free cash flow was maintained at $5.40-$5.65 and $1 billion, respectively. The strength in its mix of business is undoubtedly coming from its construction and do-it-yourself (CDIY) segment and it is set to continue. Meanwhile, its security and industrial segments have more subdued prospects this year.

A breakdown of segmental profits in the quarter.

The results were superficially disappointing. Organic revenue declined 1% overall, and it was only the 4% contribution from acquisitions that caused the top line growth of 3%. Moreover, cash outflows were greater than expected in the quarter and its core CDIY segment saw flat revenue. It gets worse. Security revenue fell 1% on an organic basis as did industrial revenue. So, is this a story of declining organic growth and an over reliance on acquisitions? And where does the confidence to maintain full year guidance come from?

The 2013 guidance is for mid-single digit revenue growth in CDIY, and flat to low single digit growth for security and industrial, respectively. With regards to CDIY, there were three issues of which two look like they will be rectified in due course.

Firstly, there is a late start to the North American outdoor season which was primarily caused by the weather. Secondly, there has been some temporary weakness in Latin America due to a variety of reasons. Interestingly, Whirlpool (NYSE: WHR) said a similar thing about the region, and in particular with Brazil. Both of these companies are arguing that this is a temporary setback and Whirlpool shareholders should take heart from the positive trends expressed for Latin America in these results. Sequentially, things got better in Q1 and this gives confidence that Q2 will be better for both companies.

The third issue is -- you guessed it -- Europe, but investors need to recall that comparisons are likely to get easier going forward. Security’s exposure to Europe is worrying (and there was some temporary weakness in the Nordic regions), but an extra $15 million of cost synergies from the Niscayah acquistion are expected. This should help out margin growth. It’s a similar story with industrial where moderate U.S. growth is hopefully going to offset weaker conditions in Europe.

Another company displaying confidence in the North American outlook is Masco (NYSE: MAS). This is more of a leveraged play on new housing construction, and its margin expansion and operational leverage opportunities will come from new builds, but its repair and remodeling market is also expected to grow moderately. Frankly, I think the latter tends to key off the former, and as long as there is good turnover in housing, then prospects will get brighter for all the companies discussed here.

Acquisitions working well

The scorecard over its acquisition strategy over the last few years is positive. It has been a difficult few years for housing and construction related stocks, but I think it has done the right thing in trying to drive cost synergies with its acquisitions. As discussed above, there is an extra $15 million to come from Niscayah (security) which should bring the total for 2013 to $50 million, and management is currently evaluating the potential for increasing the targets for 2014.

Strategic growth initiative

I’ve haven’t got the room to discuss this in great depth here, but investors wanting more color on this can find it in an article linked here.

A graphical summary of the plan to increase revenue by $850 million and profit by $200 million within three years is shown below.

Its early days, but the plans were declared as being ‘on track’. Indeed there was a bit of extra investment in this program although there was no adjustment to the targeted CapEx/Revenue figure of 2.5%-3.5%.

The bottom line

This is an attractive proposition and if it can hit its $1 billion in free cash flow, then the stock would be generating nearly 6% of its enterprise value (based on the current share price of $77). This is cheap for a company expected to grow revenue in mid-single digits and earnings in the mid teens for the next few years.

Ultimately, investors will have to price in the uncertainty that it will hit these targets. If you are positive on the global economy, then this stock is going to give you some upside potential and I think a target price in the mid $80’s is not unreasonable. A good GARP candidate.