Friday, November 30, 2012

Key Earnings for The First Week of December

When we enter the first week of December everyone will have an idea of how their investing year is going to shape up. Nevertheless, for private investors it is not a time to rest on your laurels or panic if you are behind. For professional investors it is probably time to start dressing up their performance and holdings in line with trying to retain or garner new assets under management in the New Year. They may be tied to this nonsensical game, but for the rest of us it is a great time to stay focused/aggressive and find some great investments. Marvin Hagler never let up on an opponent at the start of the 12th round, so why should we?

I write this type of article in order to bookmark and then work off it as the week goes by, the idea being to research stocks as they give results. If anyone has any requests or suggestions as to how to make them more useful then please leave a message in the comments box or leave a message on a post of mine on Google+.


Conns (NASDAQ: CONN) is an interesting company. In some ways an electrical retailer really shouldn’t be doing this well. However, its combination of heavy exposure to Texas (a region relatively unscathed by the recession) and willingness and ability to provide in-house credit to customers has led it to massively outperform the likes of Best Buy. Similarly, the expansion of its home goods offerings is the right move at the right time. The stock doesn’t look particularly cheap, but it’s worth a good look over results.


I’m picking out three contrasting companies for Tuesday. Firstly, Autozone (NYSE: AZO) will give results. I covered the stock and sector in an article linked here. It is a difficult scenario right now. There is evidence of slowdown in same store sales growth at all the auto parts retailers. This fits with the thesis that a recovering new car sales market in the US will cause a negative marginal effect on sales of parts on older cars. On the other hand, the good winter weather probably created some pull forward of sales and less wear and tear on cars over the winter. This means that the first half numbers were probably a bit weak. Will we see a snapback in sales growth or is this sector set for a slowdown?

The other two companies are Big Lots and Toll Brothers. The former is a curious sort of company within a sector that has been on fire over the last few years but somehow the only sale that this closeout retailer has got right is its stock price. Nevertheless, there might be something for deep value hunters here. Toll Brothers will update on the housing market, and if recent history is right in the sector it will give good results and outlook and then be promptly sold off by profit takers.


Finisar (NASDAQ: FNSR) is a very useful stock to monitor because it reports in two segments. Datacom revenues will give a clue as to the ongoing strength of data center spending, and telecom revenues will do the same in the telco sector. There have been mixed signals from telco related companies recently. Cisco had some positive commentary, but as I outlined here it is not backed up by the CapEx outlook of the major carriers.

SAIC will update the market on prospects for US defense and intelligence spending.


The defense theme will continue when Esterline gives results. H & R Block will update its plans to develop its core tax preparation business in response to the onslaught of competition from Intuit and others. Thursday also sees two hot (but incredibly different) companies reporting.

Lululemon (NASDAQ: LULU) is the kind of stock that you won’t ‘get’ unless you do yoga. It’s the sort of thing (yoga gear) that outsiders will argue can just be replicated by an Adidas or a Nike and suddenly LULU’s revenues and margins start disappearing. On the other hand, if you actually talk to a yoga enthusiast (I suggest you do, they tend to be hot) then you will understand the devotion that its customers have to the brand and the lifestyle it represents.

On the other hand IT Security company Palo Alto Networks (NYSE: PANW) had a great IPO this year, and many investors are convinced it is grabbing share from incumbents like Check Point and Cisco. With some of the sector downgrading expectations recently, it will be interesting to monitor what PANW says about market conditions.

The final three of interest are Cooper Companies, which will update on the eye care market (which from other sources is running at a mid single digit rate), Smithfield (whose commentary on input costs will be useful) and Tuco’s favorite gun maker Smith & Wesson, which will give numbers and some indication on whether the gun market has peaked or not.

What Alcoa is Telling You About Earnings Season

Alcoa (NYSE: AA) gave its latest set of results and as ever it’s time to pour over the numbers and commentary in order to get some clues as to the state of the global economy. In summary, the report was not a good one and confirms that the economy is slowing. The good news is that most people reading this are private investors who do not need to invest in the ‘global economy’. Our focus should be on surgically finding stocks that can outperform in any environment and I think there are some clues as to what stocks might work in this report.

Headlines Not Fundamentals

Alcoa’s CEO described the market as being driven by ’headlines not fundamentals’ and I think he is right. In fact, he is always right! In my opinion markets are usually driven by headlines and they set the tone for the fundamentals. If European CEO’s won’t invest because they are worried about Greece/Spain et al then this will show up in the fundamentals. It’s a similar thing with China’s housing market and its export industries. And neither is political uncertainty over presidential cycle helping things much in the US. Of these three issues I think the most problematic will prove to be China.

In any case we can see echoes of these issues in the progression of Alcoa’s outlook for the year. I’m going to split up its commentary in terms of geography. But first a few words on the end markets that Alcoa does not separate on a regional basis.

Aerospace and Industrial Gas Turbines

The commentary around aerospace was positive and as usual the full order books at Airbus and Boeing (NYSE: BA) were cited as evidence of good long term growth prospects. However, I think this is a line of argument that deserves a lot of circumspection. While it is certainly true that airplane orders are long cycle and Boeing won’t just stop making a plane midway through its construction phase, the truth is that the market doesn’t care.

What the market cares about is the flow of new or canceled/delayed orders and guess what folks?  Commercial aerospace is a highly cyclical industry. Orders do get canceled in a downturn and if Asia is headed for lower growth than that’s where the cancellations/delays will come from because that’s where passenger mile growth has been coming from. Indeed, if you look at Boeing’s order book, most of the orders are coming for Asian routes.

However, if aerospace is more cyclical than many think than the demand for industrial gas turbines might not be.  The sector is experiencing a strong uptick in demand thanks to the emergence of gas as the energy source of choice for electricity generation. In fact Alcoa has raised its yearly forecast for gas turbine demand through the year. This is good news for General Electric (NYSE: GE) who has gas turbines as one of its largest profit centers on the industrial side. If you couple that together with the aerospace commentary it’s easy to conclude that GE will report some decent numbers in the next quarter or so. Longer term the picture is more cloudy.

Alcoa’s Geographic Outlook

A graphical depiction of how Alcoa has been evolving its full year view throughout the year. All points represent the mid-point of guidance. I'm going to intersperse the charts within my remarks.

The progressive weakness in Heavy Truck & Trailer will be a recurring theme in this report. Growth has been significantly downgraded and this is not unexpected. This tends to be more short cycle and if freight and transportation companies are seeing slowing growth they will cut back on orders quickly.  Each region saw a downgrade to expectations.

On a more positive note North American automotive is doing well and strong US car sales are the probable cause. Unfortunately this is not an easy theme to get direct exposure but one interesting-if tangential idea- is CarMax (NYSE: KMX). The idea here is that the car auction company has found it harder to get stock in recent years as US car drivers have kept running older cars for longer. So if ongoing good new US car sales are seeing more second hand vehicles available in the market place than there is room for margin expansion at the dealers. I was slightly surprised to see China a bit stronger as car sales have not been great there recently and this is something to look out for in future.

Another area which looks a bit stronger in North America is beverage can packaging but this area was weaker in the other two regions.  In a sense this might be expected because both Coca-Cola and Pepsico (NYSE: PEP) have found things difficult this year in North America. Perhaps this signifies slightly better conditions for North American beverage? In this regard I would focus on Pepsico. Despite its global pretensions, the company generates over 77% of its operating profit from North America and 31% from Americas beverage.

The last end market is commercial building and construction and there was no change to any geographic outlook although my suspicion is that China will be downgraded in future and North America upgraded.

The Bottom Line

It was a negative report overall and I suspect things will get worse near term. Much hope is being pinned on China’s stimulus plans. We shall see how that works out.  You could buy the argument than Alcoa looks like a good value right now. If you prefer to monitor events for now then I think there are a couple of bright spots in this report. Specifically North American automotive sales look good and beverage can packaging prospects look better too.

Thursday, November 29, 2012

Market Outlook From UK Multinationals

It’s common with many US focused investors to forget about the rest of the World in terms of company and industry updates. Quarterly reporting in the US means that most up to date ‘tells’ come from there but it would be a mistake to ignore what major bellwethers are saying in other markets. In this article I’m going to discuss three recent statements from the UK and how they relate to some US stocks.

Cookson Cooks Up a Mess

Cookson plc gave a recent profit warning and cited weakness in its Engineered Ceramics business as the cause for its full year performance is now expected to come in ‘materially below’ previous expectations. Investors should note that this division is a major supplier of consumables to the steel industry

“trading performance in the third quarter, and in particular over the last month, have been weaker than previous expectations. Assuming a continuation of current end-market conditions, the Engineered Ceramics division's performance in the second half of 2012 is now expected to be substantially below both the first half and previous expectations.”

Note that conditions appear to have accelerated to the downside recently. The US, Europe and Brazil were cited as particular areas of weakness with foundry castings and in particular solar mentioned as experiencing a further slowdown from the second quarter.

Allegheny Technology (NYSE: ATI) should take particular note of this commentary. I know the stock has been weak this year and no one likes contemplating further weakness ahead, but Cookson and Allegheny share many of the same profit drivers. If Cookson’s end customers are seeing weakness then it is highly likely that Allegheny’s metal producing operations are also seeing weakness. Allegheny may have relatively more exposure to aerospace and oil & gas, but I think it’s too large and too diversified not to feel the effects of a general slowdown.

The recent weakness in solar expressed by Cookson is only mirroring what Jabil Circuit said recently regarding this market. Things are getting worse and when you put these statements together with Intel’s recent lowering of guidance it is hard not to conclude that life is getting tougher for Applied Materials (NASDAQ: AMAT). Again, I know conditions have been like this for a while and AMAT has taken a restructuring charge on solar, but these companies are saying that things have got worse from the second quarter. In the long term AMAT may well be a great investment but look out for near term volatility here.

Putting on the Wolseley

Alas I am not talking about the high end tea room that is so popular with North American visitors to London, but rather the British company that supplies much of their plumbing supplies back home. Nearly half of Wolseley’s revenue comes from the US and it is the no 1 player in the US heating and plumbing supply market. Its recent full year results speak much about where growth is in the global economy.

For the full year, revenues in the US were up 8.4% on a like for like basis with the UK down .8% and France down 1.4%. Moreover Wolseley mentioned that Waterworks and Industrial business grew strongly in recent trading but demand weakened in the oil and gas sectors. Interestingly the repairs, maintenance and improvement (RMI) market in the US was described as ‘resilient’ and a ‘modest recovery’ was cited in the new residential market.

The message is clear, stick with your US housing plays. My preferred play is Home Depot (NYSE: HD) as I think it offers the widest exposure to the US housing market and has a cheap valuation. The company is a huge cash generator and as input costs like copper and other metals reduce in price we can expect some margin expansion here. Home Depot’s profit is the difference between two huge numbers and the slightest incremental reduction in costs is going to accelerate profits significantly.

I also like something like Beacon Roofing Supply (NASDAQ: BECN).  Rather like Wolseley it is the leading player in a highly fragmented US marketplace. In other words it can grow by consolidating its industry and it has good recurring revenues from roofing maintenance plus some upside kicker from new builds. I like prospects here. The company is trying to increase pricing and there is a sense that demand was pulled forward this year due to mild weather. Will Beacon’s customers not react negatively to pricing increases? In general I think customers don’t reject pricing as long as their end markets are looking better and the housing indicators are looking better in the US.

Growth Checked at Burberry’s

The last company from over the pond to look at here is Burberry. It gave a nasty profit warning of which I wrote about here. Since then, there hasn’t really been any retail company reporting and saying that things got better in China and Asia in general.  We should listen to what these companies are saying. Conditions aren’t a disaster, but they are not what a stock like Burberry had priced into it and we can see that from the share price reaction.

Subsequently it is hard to like some of the more Asian focused luxury plays out there like Coach or Tiffany (NYSE: TIF). In particular the latter has already lowered its full year sales growth forecast and its EPS target for the full year. It has also failed to hit market estimates for the last three quarters in a row. I have no idea what will happen in the next quarter, but if Burberry is saying that conditions are getting weaker it is difficult for me to be too bullish about Tiffany.

The Bottom Line

I hope you have enjoyed this trip over the pond and found it helpful in making investing decisions. If it’s useful then I’ll be happy to cover any specific industries or themes that readers are interested in, just leave a note in the comments section below.

Wednesday, November 28, 2012

Big Pharma Round Up

As a diversified investor it is not good practice to avoid certain sectors but if there is a sector that I’ve found many private investors hate investing in it is biotech and pharmaceuticals. I suspect this is because overly bullish assumptions and predictions always seem to be baked into these stocks only for investors to get bitterly disappointed when the downside of randomness kicks in. Trials fail, drugs don’t get approved, launches aren’t as successful as expected, rivals have better results and while all this is going on the stocks tend to experience volatility based on nothing more than sentiment and speculation. With this in mind I decided to look back at some of the big events expected for the first half of 2012 and see how they actually panned out.

In this article I will focus on Pfizer (NYSE: PFE) and Bristol Myers Squibb (NYSE: BMY).


Starting with Pfizer there were four major events expected.

Product Indication Class Event Outcome
apixaban(Eliquis) Atrial Fibrillation  anticoagulant  FDA Action/European Review  Complete response letter issued, decision due March 2013. Recommended for approval in Europe.
axitinib (Inlyta) Oncology  small molecule kinase inhibitor  FDA Action Priority Review Approved for treatment of renal cell carcinoma
bapineuzumab Alzheimer's  monoclonal antibody  Phase III Data  Failure
tofacitinib Rheumatoid Arthritis  janus kinase inhibitor  FDA Panel/Action  Extended action decision due November 2012

It had one success (Inlyta), one failure (bapineuzumab) and two delays. As ever with pharma the patience of a Saint is needed. The two biggest drugs (Eliquis and Tofacitinib) saw potential approvals delayed until November and March next year respectively. Both are expected to be blockbusters.

Tofacitinib is also under trial for ulcerative colitis and Pfizer hopes to get it approved for a range of indications in the future, but there are concerns over its safety profile. Therefore getting approved for RA in November is not the only aim. Investors will watch closely to see how it is going to be labeled.

The delay for Eliquis is perhaps not unexpected given the size of the trial and the mass of data collected. No matter, it is widely believed to be more efficacious and safer than its Johnson & Johnson’s (NYSE: JNJ) Xarelto and Boehringer Ingelheim’s Pradaxa. If approved, it will likely see strong sales growth.

The delay will no doubt please JNJ shareholders whose rival drug Xarelto is only just establishing sales. Its partner Bayer has been forecasting peak sales of over Euro 2 billion for Xarelto even after the FDA refused to expand its indications. If these sorts of numbers are baked into JNJ’ forecasts and Eliquis (if approved) starts to grab market share then this will be a blow.

As for bapineuzumab little was expected, little was delivered. I’ve lost count of the hundreds of millions that have been spent on the beta-amyloid theory. Perhaps it just doesn’t work?

Bristol Myers Squibb

Key events here.

Product Indication Class Event Outcome
apixaban (Eliquis)
Atrial Fibrillation
anticoagulant FDA Action/European Review Complete response letter issued, decision due March 2013. Recommended for approval in Europe.
daclatasvir Hepatitis C NS5A inhibitor Phase II data Successful trial
daplagliflozin Diabetes SGLT2 inhibitor FDA Action FDA rejection. European approval recommended

Management can be forgiven for wanting to take their vacations in Europe this year because they have had two recommendations for approval there while the FDA has delayed one (Eliquis) and rejected another (Daplagliflozin). I’ve discussed the former above but the latter was rejected with fears even expressed over the possible increased risk of cancer with it. None of which has stopped Johnson & Johnson and others from developing SGLT2 inhibitors. Indeed JNJ recently reported positive results in Type 2 diabetes patients for its version called canagliflozin. Unfortunately, this drug too has side effects including low blood pressure.

Bristol Myers had better fortunes with daclatasvir in combination with its protease inhibitor asunaprevir. The trial managed to achieve detectable results with 77% of difficult-to-treat hepatitis C patients. Daclatsvir is expected to be filed for approval in Japan next year and Medivir is trialing it in combination with its own protease inhibitor Simeprevir.

Where Next?

Across the six major events forecast for 2012, one of the two trials proved successful while only one of the four FDA approval processes was successful on time.  Two were delayed and another rejected. That is two successful outcomes out of six.

Pfizer shareholders should be looking for the labeling on tofacitinib (if approved) as it will give a marker as to its potential in other indications.  Inlyta has now received European approval but few expect iit to be a blockbuster like tofacitinib or Eliquis. Bristol Myers also has high hopes with Eliquis and with daclatasvir progressing well in development as there are plenty of upside catalysts for both stocks.

Pharmaceutical investors shouldn't get too down when events don’t turn out as planned particularly when prospects remain excellent at both companies. This is all part and parcel of investing in the industry and patience is required. It is not a sector for those with an itchy trigger finger.

Stocks That Can Outperform in a Slow Growth Environment

Another month and another set of payroll numbers. The market likes them and the long slow haul of economic recovery. I want to analyze this recovery in the context of previous recoveries and see which stocks or sectors might do well with the conclusions drawn from the analysis.

A Weak Recovery

The US worker has a right to feel aggrieved because this cycle has followed a path of good recovery in corporate profitability which hasn’t been accompanied by strong employment gains

First let’s look at how bad this recession has been compared to previous ones using non-farm payroll data from the Bureau of Labor Studies.

Note the magnitude of the job losses in the last recession.  Moreover while the recent job growth has matched previous recoveries it is nowhere near strong enough to reclaim the jobs lost.

I want to demonstrate this pictorially.  I confess that when I put this together I wasn't expecting this result! The x-axis represents months since the payroll data turned positive (for two months in a row) after the recession. The y-axis represents the percentage of jobs lost in the recession that have been regained in the recovery.

The table is truly astonishing. The US hasn’t even recovered half the jobs lost in the recession and by this stage in the next worst recovery (2001) the economy had regained over 200% of the jobs lost.

Meanwhile corporate profits have snapped back nicely.

US Corporate Profits After Tax data by YCharts

It is impossible not to conclude that this recovery hasn’t been uneven and ‘unfair’ to those who believe in the concept of social justice.

However lest I stray onto political matters I want to discuss how this affects the types of stocks and sectors that investors should be looking at for this recovery.

Stocks For Sluggish Growth

I’ve always believed that consumer discretionary stocks were late cycle stocks. The idea is once employment gains start to materialize (after the initial growth phase) consumer spending will pick up accordingly.  However, as we have seen above, not all recoveries are equal in terms of job growth!  As a consequence I think something fundamental has happened in retail. US consumers (at least in terms of the mass) are now extremely price sensitive and inclined towards using the discount and dollar stores. I’ve written elsewhere in an article linked here that I think this story is a long term one.  Not only are the dollar stores like Family Dollar, Dollar General, and Dollar Tree (NASDAQ: DLTR) seeing increased footfall but they are also selling more and more products that were usually sold via traditional grocers.  Dollar Tree is my favored stock in the sector because it has the best underlying cash flow yield and the smallest number of stores. This implies it can finance growth in stores while trying to maintain its leadership in sales per store.

However the story isn’t just one of discount stores. The truth is that corporate profits are strong and if you have a job, borrowing rates are at historic lows and the Federal Reserve wants to keep it that way. So now we are seeing a curious bifurcation where the higher end and specialty stores are seeing good sales growth.  So I look at a stock like Whole Foods (NASDAQ: WFM) and think it has further to go. The stock is not cheap by any measure but then the market doesn’t worry about these things as long as growth occurs. I wouldn’t buy the stock right now but it should be on monitor in case it has a growth hiccup (and it will at some point) along the way.

The other aspect that I think investors should be aware of is that certain patterns of behavior seem to accelerate when they become socially and culturally acceptable. I’m a big fan James Q. Wilson and he often articulated this point.  For our purposes when it becomes socially acceptable to shop at an off-price retailer and every housewife is talking about the bargain she got yesterday then this trend will accelerate. I think the off-price retailers like Ross Stores (NASDAQ: ROST) have a great long term story. It is seeing good footfall growth and expanding the categories of products in its stores.  If it is becoming more acceptable for some people to buy clothing there then why not things like table lamps, food, cutlery, etc.

I also like financials. In particular I like something like Wells Fargo (NYSE: WFC) Let’s put it this way, corporate profitability is back and corporations are flush with cash so lending quality should be high. Similarly, US households have cleaned up their act and the credit companies are reporting very low levels of charge offs and delinquencies. Wells Fargo’s growing mortgage book should benefit from rising house prices which help asset quality.  Moreover the sub-prime debacle has led to all manner of regulations and adjustments to lending behavior which help to reduce long term risk. And finally this industry is political protected and everyone knows it.

Almost bizarrely, I also like companies tied to the employment cycle like Automatic Data Processing (NASDAQ: ADP).  Think about it. If we are headed for a long slow period of sluggish job growth than the employment based companies will do well because the cyclical nature of their earnings will be reduced. Moreover the likes of ADP have been operationally calibrated to make money in the current environment. Any uptick will see operational leverage kick in and it will drop into the bottom line pretty quickly. If ADP can generate 6.5% of its enterprise value in a difficult year just think what it could do when things get better?

The Bottom Line

I’d like to thank readers for sticking with this article and hope that they got some interesting ‘tells’ and stock ideas from it. The anemic state of job creation is very sad for many Americans and I’d hope that fact wasn’t forgotten when some of us more fortunate souls make moral judgments on the unemployed. This is a very difficult time.

Monday, November 26, 2012

Family Dollar Looks Good Value

Family Dollar (NYSE: FDO) is the first of the dollar stores to report results this earnings season and if this is what to expect then investors in the sector can look forward to better things to come. In this article I want to explore a few themes and see if future performance is likely to be as good. I'll also look at who might be affected by the changing trends in retail.

America You Are Not Alone

North Americans can be forgiven for thinking the trend towards discount stores is a recent phenomenon, but actually the Germans were there first. Germany experienced a period of austerity during the reunification phase between West and East Germany. This period of belt tightening led to extraordinary growth of privately held retailer Aldi, and its rival Lidl.  It didn’t stop there. Indeed, these two discount stores are now gaining share in the UK as it goes through its own period of austerity. Recent market research figures in the UK have Aldi’s sales growing at 25.6% and Lidl’s at 12.6%, and together they have 6% of the market.

My point is this. The UK consumer is now shopping at discount stores. The German consumer continues to do so even as its economy grows relatively strongly. In other words, while austerity may have started the movement towards discount stores once consumers get used to them they tend to stick with them and this works across cultural boundaries.

The Third Woman         

Analysts like to talk of a two tier shopping environment where the mid-market shopper is trading down and buying more at the low end and then the high end shopper is spending more of her cash at the high end. Allow me to introduce the third woman.

The third woman has realized that she can buy certain items at a cheaper price at a discount store and she has realized that she can take those savings and buy higher priced and higher quality items in high end or specialized stores. She has also realized she can buy high quality goods at cheaper prices in other stores.

Incidentally, it is because of the third woman argument that I like Nordstrom (NYSE: JWN) and TJX Companies (NYSE: TJX). Nordstom offers higher quality clothing and it is doing all the right things in retail. It is expanding its on line offerings and increasing the roll out of its lower priced Rack stores in order to appeal to more price sensitive shoppers. Moreover the flagship store in New York is appealing to tourists. I don’t think age of austerity is bad for retailers, just for those who don’t adjust.

Similarly, TJX Companies offers off-price clothing and home ware to the consumer and it’s an excellent way for her to buy the same quality but more of it. Foot traffic is up at TJX and its rival Ross Stores and I think we are at the start of a long term favorable trend here. The company is attractively priced and generates large amounts of underlying cash flow.

But I digress. Back to Family Dollar!

Family Dollar in Graphs

The numbers were pretty good and are a continuation of the benefits coming from the trends discussed above.

The first thing to highlight is that same store sales are increasing well…

…but gross margins appear to be declining. This is partly because there has been an increase in lower margin consumables sales over the years. For example in the latest results…

 …and it’s this last point that should cause concerns for other parts of retail. The traditional grocers like Safeway and Kroger (NYSE: KR) are being challenged. Kroger has excellent management who has fought hard to retain market share and keep revenues going, but frankly I think it is competing against some very tough forces now. Gross margins are declining and Kroger finds itself pressured from the dollar stores and from big box retailers like Wal-Mart. In this sort of environment and with foot traffic increasing at discount stores; does Kroger deserve a PE of 22x? Moreover, companies like Family Dollar are expanding rapidly.

Here is how selling floor space has been expanded over the years at Family Dollar…

 …In addition Dollar Tree and Dollar General are also aggressively expanding store roll outs. All of this means real challenges for the food industry. Take for example a business like Treehouse Foods which as a private label manufacturer is supposed to be a ‘trading down’ play. However, so many of its customers have faced issues with declining sales via traditional grocers that it has had to realign itself to try and sell more into the ‘alternate’ channels. In other words, the big box retailers and dollar stores.  Treehouse doesn’t think this trend is going to stop anytime soon and I would agree.

Where Next For the Dollar Stores?

My view is more of the same. As the experience of Germany demonstrates consumer expectations are very hard to change when they get used to buying items at lower prices. The question is whether the market is over saturated or not? So far, gross margins are still holding up well and consumables margins actually look set to expand as commodity input costs fall. I think there is more to come here and the discount retailer story still has plenty of room to run.

The Best Stocks That Have Increased Dividends for Over 20 Years

I’ve been reviewing my portfolio performance recently and assessing what is working and what isn’t. There is a constant refrain: The market is in love with yield right now and dividend paying stocks are working. In one sense, it isn’t surprising. As treasury yields sink to ever lower yields, blue chip yields are increasingly in demand. Let’s put it this way. You can get 1.7% yield on US GDP for 10 years or you can get a bunch of stocks (whose revenues actually comprise a large part of US GDP) currently yielding more than 3% with the chance of increases in the next 10 years. Is it any wonder investors are chasing yield?

Dividend Champions

Of course a decent current yield is not enough. Investors would be better advised to look for stocks that have a history of increasing yields. With this in mind, I want to focus on companies that have increased their dividends consistently over the last 20 years.

I chose these fifteen.

Note that they have been sorted in terms of ‘current D/forecast E,’ and this is just an idea to estimate how much leeway these companies have in terms of increasing their dividends. The ideal candidate is a dividend aristocrat with good leeway and a current high yield.

I'm going to feature five of these stocks.

The Five Best Dividend Paying Stocks

By sheer coincidence, the five I am going for are bundled together in the middle of the table.

I’ll start with Johnson & Johnson (NYSE: JNJ). This is a stock I hold and believe has very interesting prospects. It has had execution issues over the last few years –not least with high profile product recalls- and top line growth has been hard to come by, but I think things are looking better. The Synthes acquisition gives it strong market share in a growth area of medical devices and it has a number of new drug launches coming which should drive pharmaceutical growth in future.

As for its consumer products division, it simply needs to execute better; but this is a good thing because it implies that its key profit driver is not something exposed to the economy. I like the stock and think it gives good balance to a portfolio.

Next up is a stock I am not in love with from an operational perspective, but it does offer good prospects for dividend hunters. Procter & Gamble (NYSE: PG) has had it tough over the last few years. Its traditional strategy during downturns (try to hold pricing at the expense of market share and wait for the upturn) has been particularly challenged by the long period of slow growth that we are in. Its stable of classic brands has been under attack from all sides and the company hasn’t performed as well as it could operationally.

The reaction has been to shift gears and try to take pricing while engaging its promotions. It hasn’t really worked that well but investors should feel optimistic about a more benign commodity price environment going forward, and PG does have some fantastic brands.

Kimberly-Clark (NYSE: KMB) is an odd sort of stock. Superficially it appears to be a bog standard company that is as dull as, well, toilet paper and Kleenex. But actually there are a few things to consider here. Is it the sort of company that will get ruthlessly attacked by private label in-store brands? Is it an emerging market growth story as it penetrates new territories with its well known brands?  I confess I am not smart enough to know the answers to these questions, but analysts have the stock on mid single digit growth rates for the next couple of years and if the dividend grows at that rate too then the stock looks like good value.


Abbott Labs (NYSE: ABT) is an interesting case because the company is going to be split up into a medical diagnostics and device company and a pharmaceutical company to be named Abbvie. Both companies are attractive, and most analysts think there will be some acquisition activity from them after the split. My concern with Abbvie would be over its reliance on its blockbuster drug Humira. The challenge is to use cash flows from this drug (primarily from rheumatoid arthritis) in order to invest in new drug development. Humira is a TNF Blocker type of treatment and a whole new class of drugs is coming called Janus Kinase Inhibitors (JAK), which may challenge their position in future.

The last of the featured candidates is a stock that I knew little about before writing this article. It’s great to do these things and discover new avenues of research out of them. Community Bank System (NYSE: CBU) is an upstate New York and Pennsylvania based local bank that claims to be 1st and 2nd in 70% of its markets. EPS has grown at a 9.5% CAGR over the last five years and dividends have grown at 4.7% too. This is hugely impressive given the carnage inflicted on the banking sector in recent years, and in that time it increased dividends every year. The bank’s Tier 1 capital ratio looks okay at 8.98% but it looks great when compared to the asset quality of this bank.

Net charge-offs over average loans are at a paltry .24% and non performing assets/total assets are at .49%. These are very good metrics. At first I was tempted to put this down to some sort of positive local economic factor (in the way that the Texan banks have been doing well) but actually upstate New York is underperforming the rest of the nearby economy in terms of job growth. I think this a well run bank and well worthy of a closer look for investors looking for a high yield financials.


They all look like strong companies that are worthy of a place in a long term high yield portfolio. Raising dividends consistently over 20 years is a sign of a company that is disciplined in its commitment to shareholders. The Federal Reserve's desire to keep rates low is undiminished so I suspect more and more investors will start focusing on yield.

Sunday, November 25, 2012

Is Acuity Brands a Stock Worth Buying?

Lighting company Acuity Brands (NYSE: AYI) announced earnings recently and missed estimates. As usual, the market greeted this sort of news with a knee-jerk reaction sell off—but is this a buying opportunity? I think so, and will look to go back into this stock in due course.

 Acuity’s Core Profit Driver

Let’s not kid ourselves: this stock is primarily a play on the North American property construction market. Acuity has been active in diversifying its profits away from new builds, but its core market remains commercial and industrial lighting. And the market didn't like Acuity’s commentary on the North American market.  Acuity argued that it had “experienced a slowdown in the rate of growth over the past few months.”  Worrying?

Not really. It is pretty much consistent with what the Architectural Billings Index has been reporting.

Acuity’s results were for the end of August, so with most of the quarter being weak and the trend deteriorating since March it is not surprising that the numbers missed estimates. As for the commentary, what else would you expect the company to say?

As you can see above, the recent trend looks like a linear uptick, and this is a cause for optimism. Another positive point is that all three segments within the property constructions sector are improving:

In a sense this is normal, because the mild winter pulled forward some construction activity and the hurricanes last year also created some artificially strong activity. However, these factors have created weaker results for this quarter.  I think the underlying picture is good here and I’m not that concerned.

LED Lights the Way?

With technology improvements and the increasing commoditization of pricing, LED lighting is becoming a truly viable solution for the construction industry. Indeed, I’m intrigued by what key manufacturer Cree (NASDAQ: CREE) is saying. It sees strong growth from its lighting division and is innovating in the development of LED solutions. Of course, the company is better known as an LED manufacturer (Acuity uses them) and with demand weak elsewhere in LED land the cost and quality advantages for Acuity should be getting better.  Indeed, this quarter saw LED-based sales increase to 12% of sales, from 10% previously.

Just as with Cree, I expect Acuity’s LED-based to sales to spur growth, but not only with lighting. I think lighting controls are going to be an ever more important source of revenue. As LEDs offer so much more functionality the need to integrate them with control systems will increase; and these solutions come with a higher value added ticket price. In other words, Acuity & Cree can expand margins.

Housing Driving Growth

Going back to the last chart, it’s clear that the residential construction market is getting stronger. If we listen to Home Depot  (NYSE: HD) and accept its argument that US housing is somewhat of a ‘sweet spot’ in the economy, then housing related spending  is on the up. For Home Depot this means it can start to expect to separate its growth trajectory from US GDP, and I think the same applies to Acuity.

Even though residential only makes up 10% of direct revenues for Acuity, much of construction activity is related to residential growth. You can’t build new housing without building infrastructure around it, and the different parts of construction spending do tend to correlate. I like Home Depot as a housing play and think Acuity is –although somewhat indirectly- also a housing play too.

Incidentally, both Home Depot and Lowe’s (NYSE: LOW) distribute Acuity’s products.  While Lowe’s has been weak recently, it has pushed sales of Osram’s Sylvania LED system. Lowe's may be having execution difficulties, but it is not because of LED sales.  This sort of marketing push is great for the industry because as soon as neighbors see each other buying LED lights, they will surely not want to be left out.  The good news is that Lowe’s is not the only company doing this.

General Electric and Philips Electronics (NYSE: PHG) are also aggressively marketing their LED lighting solutions. Philips sees itself as the number one player in LED lighting and its market share in the segment exceeds its share in conventional lighting. LED lights already make up over 18% of its total lighting sales. With heavyweights like this promoting LED lighting, every company should benefit, as the industry is in its infancy.

Buying Opportunity?

I think so. Acuity is a well-run company that consistently has a high income to cash flow conversion rate. Gross margins and adjusted operating margins are expanding, and I like the long term drivers.  Yes, the commentary on why Acuity missed estimates wasn’t great, but I have tried to demonstrate why there’s still plenty of growth to come for the company. The underlying picture looks positive, and with a “benign” cost environment I expect margins to improve with volumes and LED lighting sales.

Acuity trades on a FCF/EV evaluation of 5.3% and a PE of 22, with EPS growth forecasts of 18% for next year.  With strong financials and a bearish backlash for missed earnings, now looks like a buying opportunity to me.

Are Stocks Set to Start Suffering From Emerging Market Exposure?

One of the investment themes of the decade has been the increase in correlation across geographies and asset classes. It seems that one region only needs to catch a cold before the whole world starts sneezing. European debt issues flare up and US markets take a hit. Is China slowing? Let’s sell off commodities. And it goes on. So how much truth is there in this argument and where are we now?

Before I humbly attempt to answer this question I want to point out that I think there is a lot of truth in this type of analysis. Global capital flows have created strong correlations and economic cycles do appear to be getting larger from peak to trough. With that said I think it’s important to understand that economies don’t always necessarily have to veer into crisis mode. There is room for analysis that involves appreciation of subtle changes in growth trajectories rather than boom and bust.

China Slowing, US Growing Moderately, but Upside for Europe?

This is pretty much how I see it. The argument is that China appears to have significantly over invested in fixed assets like property and could be headed for a slowdown in growth. Throw in skepticism over the efficacy of a communist government stimulating an economy and I find it hard to be optimistic over China in the mid-term.

However, there are more than a few indicators that suggest that the US economy is doing okay. Not great, but okay. A long period of slow steady growth coupled with low interest rates is not a bad environment for equities.

My view on Europe will invite derision but I am holding to it. Europe has been weak for a while so companies will start to “anniversary” easier comparables in their reporting. Moreover, they will have had time to restructure and refocus sales efforts in Europe from the South to the North. Furthermore, Europe is making liberalization measures. It is dealing with its debt burden and countries are adhering to the program.

Before anyone scoffs, I should point out that most countries in Northern Europe are in much better debt situations than the US. For example, Finland never breached the rules over deficit to GDP, not even at the height of the crisis. And with a bit of luck and political will Greece can finally be thrown out of a club that it should never have been let into. Europe has upside potential.

So How Does This View Affect Stocks?

Well to answer this you have to look into the global revenues of the stocks you hold and see where the long term trends have taken them. I want to share a few examples.

Here is a long term look at its trends in terms of geographic share of total revenues for Johnson & Johnson (NYSE: JNJ)

It’s not hard to see that despite the strong growth in APAC/Africa in recent years the overwhelming bulk of JNJ’s revenues still come from the Western world. Moreover, if you think about the kind of consumer health and medical device solutions that JNJ offers, it is not really that cyclically aligned to changes in growth in Asia. Putting together the favorable geographic distribution and end market demand suggests that JNJ can outperform in this environment.

Next up is Intel (NASDAQ: INTC).

This graph perfectly represents the shift in semiconductor and consumer electronics production to the Far East with Taiwan leading the way. Of course, what it doesn’t do is look at the ultimate end market demand but emerging markets do make up a large part of consumer electronics growth. Indeed, if companies in countries like Taiwan and China are seeing slowing growth they will cut back and reduce chip inventories accordingly. That is exactly what we are seeing at Intel now and since the enterprise PC market continues to stall. I would be cautious here.

The third company I want to look at is Pfizer (NYSE: PFE).

Pfizer has been making divestitures which have affected the geographic revenue mix but the trend is clear. It’s become much more of an international play. However, this is partly to do with patent expirations in its core US market. The good news is that the company has a strong pipeline and if Eliquis (blood thinner) and Tafocitinib (Rheumatoid Arthritis) it could kick start a huge change in sentiment over the stock.

Time to turn to a bellwether in General Electric (NYSE: GE).

I was surprised by how large a part of revenues the US still makes for GE. I know much of that is from the financial side but it still indicates that GE is largely a western economy play. The trend in marginal growth is favoring the pacific basin and GE would take a hit from a protracted slowdown in BRIC growth but it’s not disastrous.

However, I do have some concerns with GE. On the industrial side its two largest profit centers are aviation and energy infrastructure, both of which are somewhat reliant on emerging markets for growth. In addition the company hasn’t been executing particularly well in health care.

The Bottom Line

In conclusion if you share my view that emerging markets are going to provide the down side surprise in future than its time to start looking closely at exposures and the geographic mix of the companies that you hold. The good news is that not all companies are relying on emerging markets for growth, and ironically, thanks to China’s trade policies many of them do not have as much exposure there.

As investors our focus is always on whether the stock is the right price and even assuming a continued slowdown in the BRICs, many US companies look good value. In particular sectors like healthcare, food, US domestically focused stocks and some parts of technology look well placed to grow even with a slowdown in emerging markets.

Wednesday, November 21, 2012

Walgreen Looks Good Value

Sometimes as investors we can over-analyze and spend so much time looking at fine details that we miss the bigger picture. I think this is exactly what many are doing with Walgreen (NYSE: WAG). Every investor is trying to analyze how many of the lost customers Walgreen will regain from the Express Scripts (NASDAQ: ESRX) debacle, but does a debate over the marginal amount really matter when the stock is so cheap? I don’t think it does.

Time to Confess

OK, I admit it: I am one of the guilty parties. I hold a position in CVS Caremark (NYSE: CVS), and quite frankly I think Walgreen will find it difficult to win back lost customers from the likes of CVS and Wal-Mart (NYSE: WMT). I even articulated this view in a previous article.

Investors should understand that whole industries are structured around the reason why Walgreen will find it hard to win customers back. Customer inertia is a very powerful force; not for nothing do insurance companies lower premiums on first time buyers in order to increase their hold over them in future years. Customers tend to stick around because they overvalue the hassle of switching. The same principle will be at work here, and CVS and Wal-Mart are both companies that know exactly how to retain customers in their pharmacy businesses.

But Really, Who Cares?

There is a great temptation to get sucked into a Walgreen vs. CVS argument, and then maybe conclude that CVS is better and buy that. But even if you share my view that CVS is the more attractive company, who said you can’t buy both stocks?

Even a cursory look at the valuation shows that Walgreen is hardly stretched. Despite the effect on revenue and profits from the loss of the Express Scripts business, Walgreen is still trading on some very attractive multiples.  A current PE of 14.5x and an EV/EBITDA multiple of 8.2 is not expensive.  It doesn’t stop there; the company just generated $2.9 billion worth of free cash flow, which represents around 7.5% of its enterprise value.

The point I’m making is that the stock is already attractive on a current basis even without arguing over whether it will regain X percentage of customers.  The fact is that Walgreen will recover customers, and I’m convinced that the stock (and the sector) have a lot of positive growth drivers.

Alliance Boots

I like the Alliance Boots deal. Even though it only has a non-controlling 45% share and there is a bit of an issue with transparency –it is a private company- I think this is the right sector in Europe to be investing in. Wall Street analysts might not agree with me for two reasons. First, they hate not having (or rather not having the perception of) transparency and a direct handle on earnings prospects. Second, they tend to have a join-the-dots mentality to macro issues.

In response to the first point I would argue that it doesn’t really matter what analysts think. If they give the stock a negative rating but it delivers earnings then few investors will care. Earnings move share prices in the long term.

With the second issue, few analysts like or are allowed to put their necks on the line by making macro calls so they tend to just go with the macro consensus. It’s usually a fair approach but in this case they might miss the fact that European austerity measures are playing into the hands of pharmacy companies. European generics penetration is lower than the US so as Governments seek to cutback by expanding generics sales this will benefit pharmacies because generics tend to give them higher margins than branded drugs. It is the pharmaceutical companies that suffer a loss of earnings.

Walgreen’s Growth Drivers

Aside from the drivers discussed above, Walgreen is favored by long term demographic trends (older people require more medication), and it has a wonderful opportunity to expand its own private label in-store brands and consumer health products.

Everyone talks favorably about this issue with Wal-Mart and CVS, and if you look at the valuation of Perrigo (NASDAQ: PRGO) it is clear that the market loves the idea too. Perrigo develops and manufactures over the counter (OTC) and generic prescription drugs for the likes of Walgreen, CVS and Wal-Mart. I like the stock a lot, but question whether 27x earnings is the right price for it. As we saw recently, any disappointment will see the stock hit. No matter, the market buys the idea so I think the market should buy the potential for Walgreen and CVS to expand margins by increasing their own brand penetration.

The Bottom Line

I think Walgreen is attractive, even with the near term issue of possibly missing expectations of how many customers it’s able to claw back. Putting together the arguments expressed here paints a picture of a company with some strong near and long-term drivers that is priced on as very reasonable valuation. There is a pretty decent 3% yield, and investors shouldn’t let some near term loss myopia get in the way of a good long term investment.

October Portfolio Review

It’s the end of the month and time to reflect on another investing quarter. I’m a great believer that anyone who writes (or shouts loudly) about investment should always try and disclose how they are doing themselves. For the record I am up 54% YTD. Don’t get too excited I’m leveraged (so expect volatility) and hedge but for those who know or care my Sharpe ratio is close to 1. For the purposes of most readers I write articles discussing investment ideas on the long side of the portfolio. I short indices not stocks.  In this article I’m going to discuss the last quarter and some of the stocks I wrote about in June in order to try and identify some trends.

Article Write Ups

I have tabulated the articles below, they are graded in terms of the optimism expressed at the time. What should be noted is that the S&P has performed very well during this period.  As a rough guide, FactSet and McCormick are a kind of dividing line. They were looked at and rejected on the grounds of valuation whilst those above were viewed favorably. Those below were looked at less favorably.

I’ve held and exited positions in Acuity Brands and ConAgra and recently initiated a position in Adobe Systems (NASDAQ: ADBE).  Acuity hit its price target but I would advise investors to keep an eye out for its forthcoming results. I would argue that ConAgra is the pick of the high yield food stocks.  Turning to Adobe Systems, it has been a difficult summer for technology stocks. Many have underperformed as the market starts pricing in a cyclical slowdown, but I am intrigued by its long term prospects. The company is undergoing a structural shift in how it sells its solutions, moving from a license sale to selling subscription based software as a service (SaaS) solutions. This is resulting in lower initial revenues but the idea is that the (hopefully) increased lifetime value of a client plus new sign-ups will generate more value in the long term. I buy the argument.

Verint Systems Inc (NASDAQ: VRNT) has underperformed largely because it’s management were too optimistic in the last quarter and the stock got hit when it had to downplay expectations recently. I’ve recently initiated a position in its rival Nice Systems.  Verint is a sort of hidden play on big data. It’s really a workforce optimization company but as companies increasingly need to make sense of masses of unstructured information with big data analytics, they will also be driven to better capture and analyze customer interactions. And that’s where Verint comes in.

I also like Discover Financial and have written positively on it recently. I’m afraid I failed to pick some up due to a familiar failing of mine. I tried to time a buy on the dip. Lesson learned but then again I’ve told myself that before!

Evaluation Still Matters

The two stocks that were rejected on evaluation grounds (FactSet and McCormick) have both underperformed the market. I still like both stocks but find their evaluations have a lot of optimism baked in. Funnily enough, they both gave results recently and confirmed that underlying growth remains good. FactSet saw some decent growth in client numbers and McCormick seems to be on an underlying growth path of around 4%.

Another stock that deserves a ‘neutral’ view is Ciena Corp (NASDAQ: CIEN). The stock is exposed to the bits of telecommunications spending that are holding up OK like wireless and 100G optical network spending. However, the company also talked of an expected pickup in carrier spending in the second half. Others have spoken of this but so far none has reported it and, if anything, the commentary around telco spending has got worse not better. I would approach the sector with caution although some point these stocks will be great value

High Yield and Housing

Two areas of the market that have been working well are high yield stocks and US housing related stocks. I’ve been looking at and buying both themes hence the interest in ConAgra, Procter & Gamble (NYSE: PG) and Pier 1 Imports.  I believe PG’s performance demonstrates what the market is favoring at the moment. It is not doing anything wonderful operationally, but it seems that any relatively high yield stock is seeing support come in for it as long as it doesn’t disappoint too badly. PG does have some upside potential from lower commodity input costs, but I am a bit concerned by its reliance on emerging market growth. I’m also concerned that while the US luxury and specialty retail markets are doing well the mass market remains tough.  No matter, the market wants high yield right now to compensate for very low treasury yields.

As for housing related stocks, I hold a few and like the near term prospects at Pier 1 however longer term I think this business could see some powerful competition from rival specialty retailers, big box retailers encroaching on its market and online competition from the likes of Amazon.  That said, the sector has been very good recently and I think there is more to come. It offers a way to hit what Home Depot described as a sweet spot in the economy.  Stick with the housing trade. It’s working.

Avoid China, Avoid Facebook

I’m a China skeptic and think the authorities will find it harder to stimulate the economy than most people think. This viewpoint goes a long way to explain why I’ve been negative on things like Joy Global and Caterpillar in the past. Frankly the more that China’s GDP forecasts get weaker the more you will hear pundits (usually with no skin in the game) telling you to buy the China plays because they are cheap. In my opinion there are plenty of ways to buy in the market rather than betting on a communist country to stimulate growth.

The last stock discussed was Facebook (NASDAQ: FB). I see absolutely no reason why this stock should trade at a premium to Google. In fact it deserves a discount. Google trades on an EV/Ebitda multiple of 13.8x while Facebook is on 35x. Why?

Google has a tried and tested management that has demonstrated it knows how to generate revenue across many platforms and a hugely powerful position in mobile search. Facebook is a business trying to manage a transition to mobile at the risk of alienating the generation of value (user generated content) in the company. The switch to mobile won’t stop people googling around and looking at websites but it might stop Facebook users generating content. Particularly if that content is on a small screen and interrupted with Facebook ads.

Many thanks for sticking with this post and I hope there have been some ideas here which will be interesting for investors.

Monday, November 19, 2012

Stop Relying on Emerging Markets for Growth

Nike (NYSE: NKE) is the last company to report results and disappoint the market with its outlook and commentary on emerging markets and China in particular. I think investors have three choices in this sort of situation. They can either react to the reality of the situation, pretend it doesn’t exist or try and take a long term view based on their prognosis for the Chinese economy.

Corporations Need to Rethink China

In a similar way corporations have to ask themselves these questions too and this will require a change in thinking. For the last few years earnings reports from international companies have been littered with a familiar refrain. It usually involves a variant of the ‘US doing ok, Europe weak, emerging markets going great and we are investing for growth there’. This sort of commentary plus associated earnings numbers usually results in a series of expectations for future growth that rely on a large contribution from markets like the BRICs. It’s time to rethink those earnings assumptions and the valuations put upon the companies that are expected to make them.

Moreover these considerations aren’t just linked to top line growth. If a company is investing heavily in a market that will disappoint in future then it will be saddled with unnecessary fixed costs, inventory and underutilized capacity. Margins would suffer. So don’t listen when someone tells you ‘Oh it’s ok that China’s growth will come in at 7% when 8.5% was expected, it’s still good growth’. If your company is geared for 8.5% then the marginal shift downwards will hurt you.

What Nike Said

A good example of the kind of considerations that investors and corporations need to be making can be illustrated with Nike in this report. Orders for China were weaker and order book growth of 6% was a lot weaker than revenue and inventory growth of 10%. Nike’s commentary on China was ‘involved’ and detailed. I will summarize.

  • Consumer is becoming more discerning
  • Economy is slowing
  • Market ‘evolving’ and maturing quicker than expected
  • Company strategy changing to reflect consumer tastes
  • Retail landscape changing

In other words, Nike is recognizing that the economy is slowing, but believes that it is also about a consumer that is evolving its preferences into more distinctive and expressive ways. You can’t just slap a logo on a pair of trainers and expect to sell them anymore.

It’s an interesting argument to which my only rebuttal is this.

Nike may well be able to innovate and generate sales growth but frankly I’d rather invest in companies with end markets that had the potential to outperform expectations rather than disappoint.

Where Next For China?

I’m not going to apologize for displaying tendencies that border on the early stages of obsessive compulsive disorder with this theme. There is nothing wrong in being cautious on investing hard earned money. I’ve discussed my doubts that China can effectively stimulate growth in an article linked here. Also here is a recent article which outlines some of the recent data on China and which stocks are particularly affected.

Of course it isn’t just about a slowing China, it is also about companies who have been baking in assumptions of the Chinese Government successfully stimulating the economy back to growth. This is particularly pronounced in the area of technology spending where Cree (NASDAQ: CREE) will be hoping that China can and will massively expand its roll out of LED street lighting. The issue has been around for over a year now and China’s plans are still not clear.

 Another industry hoping for second half growth from China is telecommunications. With North American carrier spending weakening and Europe’s ongoing problems the industry was jolted when Chinese company ZTE warned of weakening domestic spending. This is a problematic development because the likes of Cisco, Finisar, JDS Uniphase (NASDAQ: JDSU) and Ciena have all been expecting a better second half. JDS Uniphase is a good example. It’s management is generally cautious on the outlook but when discussing the geographic outlook in its last conference call it affirmed that Asia was a ‘pretty strong environment’ and it was expecting it to remain reasonable.

Caterpillar (NYSE: CAT) recently lowered its outlook based on slowing mining capital machinery spending and even McDonalds (NYSE: MCD) has reported very weak same store sales growth in China recently. It’s tough out there and from Big Macs to Big Mining, China’s demand growth is slowing and putting pressure on once coveted sales growth in the region.  I think Caterpillar’s growth will remain weak as long as fixed asset investment growth slows in China. As for McDonald’s it is dealing with an increasingly aggressive promotional and discounting market in China.

What is an Investor to do?

If you think that the Chinese Government will successfully stimulate the economy then go ahead and pick up some bargain looking stocks. The other option is to bury your head in the sand and pretend it is not happening. I need not discuss the wisdom (or lack of) in this approach.

The third approach is to downgrade your expectations for Asian growth in your stocks and reshape your portfolio towards stocks less exposed to China and emerging markets. I appreciate that this might involve avoiding large swathes of the market (something truly diversified investors will not be comfortable doing) but if you are taking a macro view you should be willing to do something about it. The good news is that there are plenty of stocks out there that are not overly dependent on cyclical growth from emerging markets and perhaps it’s time for them to come back into fashion?

US Financial Stocks Set to Boom?

There is an odd contradiction with Discover Financial Services (NYSE: DFS). Whereas earlier in the week the Consumer Financial Protection Bureau (CFPB) and the Federal Deposit Insurance Corp (FDIC) accused Discover of deceptive marketing by encouraging customers to pay for extra add-ons, its management can be accused of anything but over-egging the company’s prospects. I have always found them to be overly cautious in guidance. Nonetheless the results in the latest earnings report suggest that Discover and the US economy are on the right track.

Key Takeaways from Discover’s Results

The company delivered a strong quarter and a host of metrics suggest that things are getting better in the US economy. I’ve listed the key points below

  • Credit card ending loans increased 4.2% from last year and 3.2% sequentially
  • Credit card net principal charge rate fell to a historic low of 2.43%
  • Total 90 day delinquency rate fell to a historic low of .81%
  • Loan loss provisions increased less in this quarter by $26 million vs. a $56 million increase last quarter
  • Payment services pre-tax income was up 31% in the quarter

Essentially Discover is in a position where credit quality is improving at the same time as consumers’ appetite for lending appears to be increasing. Whereas earlier in the year much of its growth had come from student loan lending, this report signaled a return to more cyclical credit card lending. This is a strong sign for the US economy.

In a sense it was presaged by the increase in loan loss provisions in the previous quarter. At the time I took it as a sign that Discover was going to start increasing lending and -despite the relative cautious commentary at the time- they certainly did so. The good news is that even as lending increased the 90 day delinquency rate kept falling. This is a good sign that future loan losses will be well contained.

There has been some market chatter about low rates causing yield compression amongst lenders. While this is certainly an issue investors should remember one key point. Banks and credit card companies lend money when employment is gaining and the economy is growing and low interest rates usually create economic growth. In other words don’t get suckered into the idea that just because the Federal Reserve wants to keep interest rates low for an extended period that this means yield compression will hurt lenders, on the contrary they want Discover to lend.

The string results from payment services is a good sign for future results from Visa and Mastercard. Transaction volumes were up 13% for Discover. It is particularly good news for the payment processors because not only is one of its –albeit smaller- rivals reporting good transaction volumes but if lending is picking up again it's a sure indication that spending and processing will be too. Both Visa and Mastercard were up on this news.


What Else is Going on in the Industry?

Discover is not alone in seeing favorable conditions. For example American Express Inc (NYSE: AXP) recently reported that its delinquency rate was down to 1.3% from 1.6% last year. Its write off rates were down to 2.2% from 3.1% last year and on a sequential basis as well.

Discover recently signed a deal with eBay Inc (NASDAQ: EBAY) but unfortunately its exact terms are confidential. What we do know about the deal is that PayPal customers will be able to use their accounts to purchase goods at merchants who accept Discover cards. This will surely involve driving more volume into the Discover network. As a consequence eBay will benefit as PayPal customers will be able to expand their purchasing channels.

As for Discover’s problem with the FDIC and CFPB, it is not alone! In July its rival Capital One Financial Corp (NYSE: COF) reached a similar settlement deal. Interestingly, neither development had much impact on the share price of either stock. There is a moral to the story there somewhere, but for the life of me I can’t find it. I note that both Capital One and Discover have seen next year’s estimates rising this year, despite any negative publicity from these actions. Incidentally, neither company admitted any wrongdoing but both made large settlements. Go figure.

The Bottom Line

There are two bottom lines.

The first is Discover is in strong shape and can look forward to future growth despite some pressure from yield compression. The economic recovery and ongoing improvements in loan quality are important and policymakers are committed to working to create economic conditions in Discover’s favor.

The second is that the US recovery is real and there are signs that lending is making a comeback. Investors should not discount the significance of this. The conditions look set for a strong period ahead for US focused lenders.

Sunday, November 18, 2012

McCormick Offers Good Long Term Growth

The same old story. Another good set of results and another new set of admirers for McCormick & Company (NYSE: MKC). You can count me in the list but while I like company, I don’t like the valuation. The market has woken up to the favorable profit drivers here and it is hard to argue that the stock is a value anymore. In addition, I have some concerns about the underlying growth not being what the market may be expecting it to be. That said, I am not the final word on valuation and other investors will find a lot to like in these results.

McCormick’s Growth Trends

McCormick reports in two business segments of which consumer contributes over 75% of income. Consumer margins are typically double those in the industrial segment and the recent acquisitions have been made on this side of the business.

A graphical depiction of margins and revenues below.

Consumer revenues have been growing faster than industrial but this partly has to do with contributions from acquisitions.

In fact if you strip out the contributions from acquisitions, the growth in the consumer segment has been around 4% for the last two quarters. Similarly, industrial growth slowed to just 2.8% in this quarter. However, analysts have 4.8% revenue growth forecast for next year. Based on this quarter’s results it may find it hard to achieve this. Although part of this is due to currency effects so I don’t want to be too harsh on the company.

McCormick’s Favorable Profit Drivers

There are few industry specific trends which are favorable for McCormick.

First, food companies like say Campbell Soup (NYSE: CPB) are being forced into a huge amount of innovation in flavors and taste offerings in order to retain market share in the face of high costs and reluctant consumer spending. Whenever a Campbell or a H.J. Heinz (NYSE: HNZ) tries to increase pricing in the US it is usually greeted with a drop in volumes. Subsequently both these companies have aimed for growth from emerging markets while trying to hold market share domestically. For Campbell the international challenge is to grow categories like snacking but I think overall it has a weak mix of product categories. Prospects look a little brighter at Heinz. It has a fast growing nutrition business and core products with strong emerging market appeal.

Turning back to these companies domestic situation the main way to retain market share (without cutting prices) is to increase marketing or try and innovate on flavoring. The latter is obviously favorable to McCormick’s industrial sales.

Second, as consumers are eating more at home they will tend to carry on buying McCormick’s spices. In this sense the company is actually a beneficiary of the new age of austerity.

Third, its products are low ticket item so passing on higher input costs is relatively easier than it will be for a company like Kellogg (NYSE: K) or General Mills (NYSE: GIS). These companies find themselves locked in a game of rising input costs leading to raised prices, volume and market share losses followed by marketing initiatives and cost cuts which lead to margin decreases. Then the game begins again. It is a very tough environment and consumers are monitoring pricing and promotions very closely. Kellogg has acquired Pringles and I think the commodity price hedges it has put in place this year should benefit the company next year. Nevertheless Europe is a big market for them (and cereal in particular is struggling there) and the US retains its pricing difficulties. Fortunately, McCormick is relatively immune from such tribulations.

Fourth, soft commodity costs are falling and margin expansion should be easier in future. Indeed, General Mills pointed out that cost inflation was falling to low single digits in its last results presentation.

And finally, there is the long term story of emerging market growth to drive future sales. McCormick already generates around 14% of sales from emerging markets and despite evidence that growth is slowing in places like China, the food sector still has good growth prospects.

In summary, it is a compelling long term growth story but is it already in the price?

Is McCormick’s Price Too Spicy?

Without over indulging in the cheap food gags I do think that the evaluation is getting a little hard to swallow right now. If we accept that top line growth will be around 4-5% with some margin expansion leading to high single digit earnings growth than I don’t think that a PE of 21 or an EV/Ebitda multiple of 14.3x is screaming good value.

Throw in the lower revenue growth in the industrial side in the quarter and the vagaries of having to rely on the promotional and sales activities of its food service clients and arguably the stock is expensive on a risk/reward basis.  One for the monitor list.

Tough Environment for Jabil Circuit, Will the Iphone Help?

With a background of global growth slowing and worries over emerging markets, investors could be excused for bracing themselves for the latest results from IT focused contract manufacturer Jabil Circuit Inc (NYSE: JBL) and they certainly didn’t fail to disappoint. Margins are under pressure and end markets are weakening, it’s a tough environment out there. Whether this is already priced into the stock or not is anybody’s guess. I want to dig deeper into the results and see what we can read across from them into other companies and industries.


Jabil Circuit’s Q4 Results

A quick summary of the headline results and guidance

  • Q4 Revenues of $4.3 billion vs. estimates of $4.2 billion
  • Q4 Non-GAAP EPS of 54c vs. estimates of 58c
  • Q1 Revenue guidance of $4.3-4.5 billion vs. estimates of $4.5 billion
  • Q1 Non GAAP EPS guidance of 51-62c vs. estimates of 67c

Revenues came in better than expected but margins are under pressure and the revenue and earnings guidance is weak. The problem is not only a weakening global environment, but also an ongoing structural shift in IT spending from hardware towards software and services.  The value of the intellectual quotient in the average IT good is increasing and hardware spending is losing out as a consequence.

From a geographic perspective a familiar refrain was heard. Asia and Americas revenues were described as stable while Europe was described as ‘very poor’.  In response I would contribute my refrain that Europe has been weak for a while now and as this weakness ‘anniversaries’, growth numbers for the region will look better for some companies. I wouldn’t discount the potential for the Euro Zone debt crisis to flare up again but I think the greatest uncertainty lies with emerging market growth prospects.

Jabil reports in three business segments of which the revenue share is as follows.

The surprise for Jabil came in the diversified manufacturing services (DMS) segment where growth was at 12% when 17% had been expected.Part of the problem here is that it has been ramping up capital expenditures in order to manufacture casings for Apple’s (NASDAQ: AAPL) iPhone. Apple is a very important customer for Jabil and is believed to be responsible for around 10% of its sales. Understandably it is not keen to disclose too many details about its work for Apple but it would come as no surprise if the operational disappointment here was due to meeting Apple’s exacting standards. Great for Apple shareholders and device users, but not so good for Jabil Circuit.

High velocity services (HVS) actually declined less than expected by 10% when 22% had been forecast previously. However I wouldn’t get too excited because HVS sales are expected to decline 24% in the next quarter.

Industry Read Across by Segment

The intriguingly named HVS segment largely comprises of automotive systems, set top boxes, printers, circuit boards and point-of-sale solutions. Automotive appears to be doing well, but there is weakness in the set top boxes and mobile handsets. Rather surprisingly the printers business was described as being ‘strong’.

Turning to the DMS segment it was a mixed picture. Specialized services (24% of total revenue) growth was good with the under performance coming from healthcare & instrumentation (8%) and industrial and clean tech (12%). The problem here is due to three reasons.

First, Governments around the world are cutting back on clean technology and solar investment. They are simply not areas that many countries are willing to subsidize in the way that they have done previously.

The second reason is that the dynamics of the solar industry are changing. It is no longer the nascent high initial capital investment industry it once was and has now matured to a lower investment phase where rampant Chinese price competition has made conditions very hard for global OEMs.

And finally, Government spending on defense and aerospace has been underperforming as austerity driven cutbacks start to bite. In addition, I think there is a long term tendency with defense spending to shift towards intelligent systems from hardware spending.

What This Means to Who

Jabil’s competitor Flextronics (NASDAQ: FLEX) covers many of the same markets and with 26% of its sales in ‘high velocity solutions’  there is cause for concern. The company has forecast mid single digit growth in this segment for the September quarter. In light of what Jabil just reported , investors have the right to question this. However, Flextronics has a large part of its revenues in Integrated Network Solutions (communications, networking, storage) which are areas where Jabil is doing okay.

It is a similar story at a rival contract manufacturer Sanmina-SCI (NASDAQ: SANM) which recently gave notice of some divergence in its end markets. Just like Jabil it is seeing strength in communications, medical and aerospace, but areas like computing and storage are flat. Meanwhile the real weakness is in traditional IT contract manufacturing areas like circuit board printing and mechanical components. Sanmina previously said that defense revenues were good, but I'm wondering if this will be the case following Jabil's commentary.

With regards the specific weakness expressed in solar and capital spending in their industry.  I think investors in Applied Materials (NASDAQ: AMAT) should take note. The company has gone to great lengths to position itself in solar. It's not something that AMAT shareholders don’t know about, new orders in the energy & environmental solutions (EES) division were down to just $35 million in the quarter from $318 million last year. However, Jabil's weal commentary suggests more restructuring costs could be on the way for AMAT. A turnaround in solar doesn't look likely anytime soon.

For Jabil shareholders, the proposition remains the same. It is a geared play on global growth with a growth kicker from potential blockbuster sales of Apple's new iPhone. If you like both then pick some up but don't expect Jabil to do well if the economy carries on slowing.