Saturday, December 29, 2012

Patterson Companies is Starting to Look Healthier

n a recent article I discussed the issue of perspective and investment style and how it affects the decision to buy a stock or not. As a growth at reasonable price (GARP) investor, it’s hard for me to fall in love with  dentistry supply company Patterson Companies (NASDAQ: PDCO). The stock has had execution issues for a while, and revenue growth was anemic in the last quarter. Nevertheless value investors are likely to find a lot of interesting things about the company and I would suggest they take a closer look.

Harvester of Sorrow

The investment thesis is based on its attractive long term end market drivers and the idea that it will sort out its execution issues in time. The dental market is set to benefit from favorable demographics in future years. Higher numbers of older people with more teeth per mouth means more trips to the dentist and spending on dental provision. Long term, things look good, but it is the near to mid-term that looks problematic.

I’ve highlighted a few immediate considerations.

  • The macro-economy is causing weak spending on core equipment in the US
  • Austerity measures in Europe are hurting dental spending
  • The company keeps harvesting sorrow by missing estimates with one segment weak, then another
  • Although technology spending is good, it is hard to tell if this is being compensated with lower core equipment spending

Against these concerns, the company does have many positive points. Free cash flow remains very high and there are plausible reasons for the earnings misses in the last couple of quarters. As discussed at the time, Patterson missed last time thanks to the sales mix contribution from consumables. Last time around dental sales were good but consumables missed with a relative increase in sales from the lower margin consumables.

This time around dental equipment sales missed estimates with the weakness coming from things like core equipment (chairs, light, basic equipment). Meanwhile technology equipment spending did well in the quarter with the company talking of mid-single digit increases in technology spending in the quarter.  As noted above, it is not clear if this is because surgeries are cutting back on spending on basic equipment because they were waiting to spend on technological upgrades.

Furthermore, gross margins were weaker than expected thanks to lower than anticipated Omnicam deliveries from Sirona Dental Systems (NASDAQ: SIRO) plus higher than expected upgrades from Redcam to Bluecam imaging products from Sirona. Upgrading to Redcam carries less margin than Omnicam and the lack of availability hurt the company. No matter, this is a good sign for future Omnicam sales and, although it will take over a quarter to sort out, it augers well for future sales.

Like I said, plausible reasons.

Enter Sandman

In defense of Patterson, it appears to be doing the right things. I’m a big fan of Sirona and discussed it recently here; Patterson’s extension of its exclusive distribution agreement with Sirona (which now covers its complete product line) is surely an attempt by Patterson to expand sales in the higher growth technological segment of dental.

Moreover, it is not just about dental. Patterson also has a strongly performing veterinary supplies business called Webster which recorded 13% internal growth in the quarter. Frankly, I think this is another good long term growth marketplace as companion pet spending has proved very resilient and is subject to favorable long term social trends. You can’t divorce your dog. Patterson is a distributor for Idexx Labs (NASDAQ: IDXX), a stock I like very much but am simply not willing to pay 30x its earnings for.

….And Health Care for All

In fact, if you add up the parts for Patterson, it is arguable that selling Webster (or the higher margin medical rehabilitation segment would realize significant value to shareholders. Indeed, something like MWI Veterinary Supply (NASDAQ: MWIV) is trading at a heady looking 26x earnings compared to Patterson on 15x earnings, even though Patterson’s overall business has double the operating margins.  The difference is that MWI has growth and the market is willing to pay for it. Indeed, with Pfizer planning to spin off its animal health business, the industry is in a state of flux at the moment. With these sorts of developments, don’t be surprised if there is some industry consolidation to follow.

Nothing Else Matters

Patterson is doing the right things, but history suggests that when a company repeatedly disappoints, even for seemingly plausible reasons, it always takes longer to sort out than is expected.  Full year guidance was lowered from $2.10-2.16 to $2-2.06 as a result of the Omnicam issue with Sirona and because management was cautious on the outlook, particularly in Europe.

With that said, it is generating a lot of cash flow with which it is engaging in buybacks, and on a sum-of-the-parts basis it looks relatively cheap to other companies. It is a tempting value play, but don’t be surprised if not all the moving parts work in sync every quarter.

Why You Should Invest In Social Engagement

I recently looked at a retail company in an article linked here and was struck by its expansion plans with a new store concept and how they were tailored towards social engagement and creating a sense of community. It’s an interesting theme which I think has legs. Let’s be clear here. I’m not talking about corporate social responsibility or some PR-laden activities.  I’m interested in how companies can profit by tapping into consumers' desire to engage in social activity. I think there is a clear and growing need for this kind of thing and companies would be well advised to seek to profit from it.

Internet Killed the Video Star

The great paradox is that in a world seeing an exponential rise in technological social networking, it is possibly becoming harder for people to interact with one another on a personal basis. Indeed, these days even human interaction seems to be subjugated to social media. I’ve lost count of the times I see people out and one or the other is tapping away on a mobile device. My suggestion is to cut a date short if anyone does this with you.

Don’t date anyone that can’t hold a conversation or spends his or her days making inane comments on Facebook while waiting to see how many ‘likes’ the latest picture or moronic meme generates. Just because you misquote Gandhi or put an ‘unhappy face’ emoticon up next to a link about an atrocity taking place somewhere (of which you know nothing about) it doesn’t make you an educated or interesting person.

In with the In Crowd

On a more serious note, Charles Murray makes some excellent points on the subject of the increasing bifurcation of American life. He talks about the divergence from a common set of values that has taken place since the 50’s between wealthier and poorer communities in the US. It’s hard for me to comment on these issues as a European and, anyway, my main interest here is how this might affect social interaction.

If Murray is right and there is a trend towards gated communities in the US where the wealthy concentrate, then the consequences are clear. An increase in disparate micro-communities will, in my opinion, tend to break down a common culture and threaten a sense of community.  After all, culture is what is formed when people interact. No interaction, no culture.

Another aspect is the increasingly prevalence of online shopping being driven by the ubiquitous Amazon (NASDAQ: AMZN) and others. I’m not criticizing Amazon for this. On the contrary, it is only doing what its customers want. The challenge for other parts of retail is to adapt to this and start to offer a retail experience that offers the opportunity for the kind of social interaction that online shopping is taking away.

So What Difference Does it Make?

Well my point here is that if these points are tangible and trending then there will be an opportunity for companies to step in and offer a sense of community as part of the unique selling point of their product or service. I’d argue that this is already happening, and it’s a good idea for investors to strongly consider the companies that could benefit.

Coffee in the Community

With this in mind, I’m tired of how many times I’ve seen people discuss Starbucks (NASDAQ: SBUX) in terms of its coffee or products etc. If you want to see how these things are really done then I suggest going to a Central European cafĂ© in perhaps Vienna, Milan or Budapest.  I don’t think this is the way to think of Starbucks at all. The fact is that it offers a focal point for the kind of social interaction that is elsewhere affected by the forces discussed above. It is no accident that the coffee shop featured heavily as a center of interaction in the tv show Friends. Starbucks is getting this right, and I think other companies should follow.

In a similar vein, I think something like Barnes & Noble (NYSE: BKS) could be positioned to benefit. Saying it is a structurally challenged business is something of an understatement. Amazon truly has damaged this business, but I’m not sure if its idea of fighting back in the digital space with things like the Nook device is the right strategy. Why doesn't it push the idea of offering more of a social focal point for its customers?

A New Retail Experience

The pressure to introduce more experience into retail has led to the popularity of outlets like Abercrombie & Fitch (NYSE: ANF). It offers a kind of ‘nightclub-like’ experience to its shoppers, but my problem with this is that I think it is somewhat gimmicky and its appeal may prove transient. It’s all very well being served by a shop assistant that looks like a model, but at some point the people that go there will realize that it isn’t actually a night club and the staff aren’t actually choosing to go there to meet you.

On a more positive note, Wal-Mart (NYSE: WMT) is not a name that immediately springs to mind when discussing local communities. In fact, it is often seen as the antithesis. However, it is actively expanding its neighborhood market stores. In effect this will encourage local interaction with grocery purchasing (by some individuals) to take place in more frequent but less intensive trips. This is hugely different to a 15 minute drive to an out-of-suburb supercenter where an impersonal, mammoth once-a-week trip takes place.

The Bottom Line

I happen to think that this trend in society is one that companies can step in and take advantage of. Social interaction is changing dramatically, and unfortunately many companies are caught up in this trend rather than looking at exploiting the gaps being created. In my opinion creating social engagement doesn’t mean jazzing up your Facebook page or using gimmicky sales tactics. On the contrary, it means offering something that people are missing, which is the human interchange that constitutes culture. I think the companies that do this will be rewarded, and I am looking out for opportunities.

Kroger Set For a Good Christmas?

In a recent article I described the fundamental attribution error in investing. In other words, it’s the tendency of investors to over-weigh performance based on inherent qualities of the management and under-weigh the effects of the macro environment. In the case of Yum! the reality caught up (with its fast food sales in China) in a negative way, but with Kroger (NYSE: KR) it got a whole lot better. The US economy is in a multi-track recovery. It’s tough at the value end, but more positive comparisons are starting to drift down the income spectrum. Throw in a better inflationary environment and things are starting to look favorable.

Kroger’s Keeps on Delivering

It gets better.

As discussed in a previous article, Kroger’s management is delivering superb performance within a challenging environment. The good news in the recent set of results is that, according to Kroger, it gained market share in food and despite the continued fall in gross margin, identical supermarket sales growth (ex fuel and pharmacy) was 3.2% in Q3 against 3.1% in Q1 and Q2 respectively. In a sense this is not surprising because Kroger seems committed to driving gross profits via reducing prices for the customer.

Note the sequential improvement in revenues from Q2 to Q3.

The bad news is that the market has largely priced this in. So the conditionality I suggested in the last article was useless. The market moved too quickly.

Revenue growth appears to be back, but the stock is hardly cheap now having put on a nice rise in recent months. This kind of growth is what happens when good management positions a company in a downturn and then benefits when conditions get better.

In addition, Kroger continues to benefit from having taken customers from Walgreen (NYSE: WAG) following the Express Scripts debacle. With a number of competitors increasingly making bullish noises about retaining ‘the departed,’ Walgreen stockholders must be concerned. Indeed, I’m one of them but my suspicion is that it is all in the price, and some.  Just as with Walgreen, Kroger is seeing some pressure on its top line pharmacy sales thanks to increasing generics sales, but this should be more than offset by increased margin.

A Two Tier Market

The US retail market remains in a curious and unusual recovery mode. It is a duality of growth at the discount end as value with the new ‘retail reality’ and at the same time the high end is doing fine with specialty stores like Whole Foods Market (NASDAQ: WFM) continuing to blaze a trail. Indeed Whole Foods argues that only 20% of its customers account for up to 80% of its business. This is unusual for a large retailer but perhaps typical of US income distributions.

Indeed, KR is in on the ‘healthy’ act too with the launch of brands that are free of artificial ingredients and preservatives. I expect more of this to come from retailers in general. It is their business to service their customer’s needs after all.  More color on the composition of its sales was given when Kroger announced that the share of grocery corporate brands declined in the quarter thanks to aggressive competitive activity from national brands. This sounds like a cause for concern for private label manufacturer Treehouse Foods (NYSE: THS), which has had no end of difficulty this year dealing with changing sales channels and customer realignments.

As for the discount stores, the likes of Dollar General (NYSE: DG) continue to aggressively roll out new stores, and competition remains fierce. KR basically said that the value end remains challenging, and I would read this as an indication that customers are still eager to trade down. Therefore, despite some economic improvements, which KR is seeing with customers purchasing more items on their trips, the environment remains favorable for the dollar stores.

Where Next for Kroger?

A combination of moderating inflation, a gradually improving economy and operational excellence should create nice conditions for Kroger to leverage earnings in future. Full year guidance was raised to $2.44-2.46 from $2.35-2.42 and identical same store growth (ex fuel) for Q4 was forecast at 3-3.5%. Growth appears to be accelerating.

With that said, the shares no longer look particularly cheap. Sometimes it can be interminably frustrating waiting for a reasonable price but that’s the way investing is, although my hunch is that Kroger will probably be pulled up by a decent Christmas season for US retail.

Friday, December 28, 2012

Performance Review

It's the end of the month so it’s time to assess portfolio performance. I know readers like articles that have a watchlist of stocks for them to research, so I hope this format is useful. Every month I like to review the quarter and provide a kind of compendium for the articles I wrote on specific stocks in the month leading into the quarter. I use these articles as a way to help formulate views and invest in the stocks I write about. Any constructive suggestions on how these posts can be improved will be gratefully received.

It was a good quarter, ending 24.4% up and taking me up to 73.3% YTD and 78.8% on a trailing year basis. It obviously won’t always be like this, but I’m reasonably pleased with my performance* since I switched to investing in the US from predominantly UK small caps. I typically hold 20-30 equity positions. For the record, I’m leveraged and hedged so expect volatility. I short indices, not stocks, which means that the stock research I do is always with a view to buying the stock, and I’ve made a conscious effort to push harder and find more stocks. That said, I don’t buy everything I research.

Here is the stuff I looked at in August. The hyperlinks go back to the original articles.

Company View + Article Link Performance Since Article
Sirona Dental Systems Positive 25%
Home Depot Positive 23.6%
Cal-Maine Foods Positive 19.8%
Beacon Roofing Supplies Positive 11.1%
Sanofi-Aventis Positive 10.3%
Nice Systems Positive 6.4%
Covidien Positive 5.9%
CVS Positive 4.4%
Intuit Positive 1.9%
Wells Fargo Positive -1.8%
Check Point Positive -9%
Fortinet Positive -18.1%
Colgate-Palmolive Evaluation 2.5
Nordstrom Evaluation -2.5
Perrigo Evaluation -4.6
GameStop Neutral 42.9%
Acme Packet Neutral 18.7%
Harley Davidson Neutral 11.2%
Heico Neutral 8.7%
Autodesk Neutral 6.1%
Church & Dwight Neutral 4.1%
McDonalds Neutral .4%
Cisco Systems Neutral -.2%
Aruba Networks Neutral -1.8%
NetApp Neutral -5%
Coach Caution 5.6%
Joy Global Negative 10%

The statisticians amongst you will note that the ‘positive’ stocks (all of which I bought and hold until they hit my target prices) returned an average of 6.6%, while the ‘neutral’ stocks (which I looked at to buy but rejected for myriad reasons) returned 8.5%. The ‘evaluation’ stocks (I liked but rejected due to evaluation) returned -1.5%. Meanwhile ‘caution’ and ‘negative’ returned 5% and 10% respectively. Go figure! This is the second month in a row that the stocks I rejected outperformed the ones I bought, although the ‘neutral’ stocks would have returned 4.7% without GameStop.

I can’t explain this away with an argument based on risk. In other words, say that the market soared and took the riskier stocks up disproportionately. In fact, the market is up since the start of August and was pretty flat during August itself.

Incidentally with GameStop, I’m under no illusions here. If forced to be long or short GameStop, I would rather have been short, but since I don’t short stocks it's academic. The problem with shorting stocks is that unless you are a dedicated short seller, it’s very hard to re-frame from a long only mindset.

Buy Unfashionable Stocks

I’m particularly please that four of the big contributors were relatively under-researched and unloved stocks with Sirona, Cal-Maine Foods, Beacon Roofing and Nice Systems providing nice returns. There is more to investing than endlessly discussing Apple! I would encourage investors to be willing to go off the beaten track. We see the views for our articles and believe me, they are not launching when I write about Sirona Dental Systems.

Healthcare and Housing

These sectors have been doing well for differing reasons. Housing has done well because there is a structural recovery going on in the US, and health care is a relatively resilient sector which was very low rated at the start of the year. Health care is also somewhat of a high-yield sector acting as a proxy for bond investors tired of paltry rates. As such, I prefer many of the stocks within it to the food sector. In particular, I look at something like drugstore CVS (NYSE: CVS) and see plenty of opportunity for it to grow its private label sales as well as expand generics sales to an aging demographic.  Elsewhere in the portfolio health care and housing has worked.

Not All Good News

The standout disappoints are Fortinet (NASDAQ: FTNT) and Check Point Software which hurt performance here and in my portfolio. I was fortunate that Fortinet hit my target price so I exited before the disappointing last results but held Check Point over its lowering of guidance. While not my finest hour, I happen to think both are cheap and bought more Check Point. As for Fortinet, I’m waiting to see what Palo Alto Networks says before thinking about going in again.

Evaluation Still Matters

This is perhaps the most frustrating part of investing and why it helps to write stuff down. Sometimes you find a great stock in a good industry and buoyed with enthusiasm you then sit down and work out an evaluation only to discover that everyone else discovered it too. I love Colgate-Palmolive (NYSE: CL) but I have no intention of paying the current market price. All businesses have risk, and I want a margin of safety for everything, including toothpaste and mouthwash. Yum! Brands recently lowered guidance for sales in China; who is to say Colgate might not do the same?

Loosen Up

Actually I’m not going too. The ‘neutral’ stocks did outperform this quarter but I’m going to stick to my guns. I’m not a value or deep value investor so things like Autodesk (NASDAQ: ADSK), Acme Packet and Heico, which appear to have near term risks but good long term value, will be avoided for now. All three are very attractive though, and I’m intrigued by how Autodesk is shifting to a SaaS based sales model. The trouble is, it is doing so at a time when its end markets are deteriorating.

Similarly, I think there are real signs of a moderation in growth in China, and Coach and Joy Global (NYSE: JOY) do have heavy exposure. With that said, perhaps much of it was in the price and they bounced back as a result of hopes for a stimulus package from China? It’s possible, but overall I would still urge caution. The US housing recession unfolded over years, and I see no reason to expect anything different from China’s fixed asset investment.

The Bottom Line

I’m pleased with how things are going, and the general theme of overweight US housing, health care and assorted secular growth stories is working. Avoiding over-exposure to emerging markets and cyclical stocks has worked too. My selective technology buying hasn’t worked well (unless it's where I added after downgrades) and my avoidance of some of the high-yield-but-also-highly-rated food stocks has also seen me give up gains. No matter, I’m sticking to my guns here.

It’s a tricky macro environment, but if us private investors can carry on sticking our heads together we can continue to beat the index-hugging professionals without too much difficulty.

* just over 33% p.a. since end 2009 with an R^2 of .07 and Sharpe ratio of 1.07

Thursday, December 27, 2012

Yum Brands Disappoints With China Sales

One of the most consistent errors in investing is the determination to cling on to what behavioral psychologists call the fundamental attribution error. Now I know what you are thinking: yet another dreary hard-to-read article on a concept that doesn’t conclude with anything tangible even if you could make sense of it? Okay, well there will be some of that too (I promise), but bear with me -- there is a key point here and it relates to how many people view their investing.

Fundamental Attribution Error

Simply put, the fundamental attribution error (FAE) is the tendency to over-value personality based traits and under-value situational influences upon behavior. This sort of thing crops up a lot in investing. For example, you usually see it when a group of companies in a sector or theme start warning and one company reports a half decent set of numbers. The FAE then kicks in and investors start concluding that it’s the management stupid! They are somehow capable of generating growth against an industry downtrend simply because growth is dictated by the ‘personality’ or ability of the management.

Of course, we see this at its best (worst) in the banking sector where star traders and senior management are deemed worthy of huge swathes of shareholders' money. Well it’s funny, but these banks only seem to make money when the overall economy (and taxpayers' money) is in their favor. Moreover, I don’t recall any downgrades to EPS forecasts when Bob Diamond left Barclays. It strikes me that the easy way to raise earnings would be for stockholders to insist that salaries be cut. I doubt it would affect performance much.

Yum! Brands and the FAE

But I digress! I meant to talk about Yum! Brands (NYSE: YUM), which recently delivered something of a ‘shocker’ of a full year forecast statement which contained the prediction of a 4% decline in same store sales in Q4.  I used inverted commas because if you look back at this article linked here you can see that this decline is in line with a trend. It is also in line with McDonald’s (NYSE: MCD) patchy performance in China this year. Indeed, MCD recently announced that same store sales were negative in China in October. Throw in the fact that Yum now makes the majority of its operating profits from China and it’s not surprising that the market is selling it off.

The truth is that a number of companies have been reporting weaker conditions in China, so what makes Yum any different? Granted it is coming up against tough comparables, but it is an industry-wide problem.

Yum's China sales:

And with McDonalds aggressively expanding stores in China and Burger King (NYSE: BKW) also planning to open 1,000 restaurants with a partner in the next 5-7 years, there is no let up in expansion. Indeed, Yum itself is planning another 700 units in China for next year.

Good timing?

Don’t Rely on Emerging Markets

I think there is a good case to be made for being very cautious with China right now. Yes, it will still record GDP growth in excess of anything that the West will produce, but you must remember that a lot of companies have built up their hopes on APAC growth. Meanwhile companies with heavy European exposure are lapping some easier comparables and the US recovery appears to be on track. Investors will do what they have always done and continue to believe in yesterday’s story.

For more detail in the kinds of stocks that could suffer if China continues to disappoint, there are a couple of articles linked here and here. I’m not going to apologize for seeming to have the early onset of Asperger’s syndrome over the issue, because I may well have saved myself some losses as a consequence. Picking out any one company to focus on is perhaps unfair, but businesses like Caterpillar (NYSE: CAT), Rio Tinto, Burberry’s or even Coach do have heavy exposure to China. Caterpillar has the 'double whammy' effect of being exposed to China's fixed asset investment.

Moreover, I think it’s time to focus on those companies that are talking about slowing down expansion growth in China because it is far from clear that China is going to rebound in growth next year. There is plenty of time to get back into the China story, but some prudence is needed now.

Avoiding the FAE

Tying these points together leads to the conclusion that no company is immune from its sector/geographic conditions for too long. Committing the FAE is very tempting because we all like to think we invest in great managements. Indeed, Yum is clearly a very well run company, but it hasn’t managed to avoid conditions in China.

Forget the idea that Yum’s management (or others) can generate growth against a slowdown. My point is that if you buy Yum you are investing in a snapback in growth in China rather than the ability of the management per se. Don't commit the FAE!

Beacon Roofing Supply Has Strong Long Term Prospects

It’s always interesting to chat with young investors, not least because it forces you to go through the discipline of crystallizing thoughts and expressing them in a concise manner. In a recent discourse, an economics student was telling me he had studied a mathematics course designed to help predict the operational performance of a company. Such things are interesting and good to integrate into investing, but I think they are a small part of the picture. My response was that the real key to investing is trying to appreciate the meaning behind the numbers.

In other words, analysts can model companies and knock up discounted cash flow (DCF) models into perpetuity but it won’t necessarily mean they understand why the numbers are what they are, whether they will be that way in future or how to make money out of them. I have two points here.

Firstly, the numbers themselves (return on equity etc.) are only reflective of market conditions in the period within which they were created, and conditions change over time. Secondly, even the numbers don’t decide how/if you make money. Consider a DCF for a tech stock that gives a value X in 1998. A similar one in 2007 also gives a value of X.  In both cases the stock is bought. The first guy generates huge returns, the second loses his shirt. Is one an investing genius and the other an idiot? However you try to hide it, taking a long only position with equities is a manifestation of a macro-economic viewpoint.

What on Earth Does This Have to do With Beacon Roofing Supply?

I’ve covered Beacon Roofing Supply (NASDAQ: BECN) in some detail in an article linked here and I would advise going back and reading it after finishing here.

My point with BECN is that I think it has a few earnings catalysts that are not immediately apparent in the numbers. Moreover, these metrics should be able to improve in the future and investors should be willing to pay more for them.

  • A fragmented marketplace within which it can acquire and grow geographically
  • A niche market sector (roofing) that non-specialists cannot encroach
  • Strong recurring revenues from non-discretionary re-roofing that protect it in a downturn
  • Upside exposure to natural disasters
  • Small but relevant exposure to new build

If you put these arguments together I think you could make a case for BECN to carry a supra-market rating because it does offer stability of earnings plus good long term upside.

Moreover, the ‘growth kicker’ of a recovering new build market (BECN claims to be well positioned in the markets where new build is prominent at the moment) is underrated in my opinion. It’s very easy for investors to point at the housing market stocks and conclude that ‘they have had a good run, it’s time to take profits off the table, the evaluations look stretched etc.’ but before you do that I suggest looking at the current metrics in line with where the market is now and where it could be in a few years. I’m not going to labor the point, sufficed to refer you to this article linked here where you can see graphical evidence of what I’m talking about.

Investing isn’t just about looking at, say, Lowe’s (NYSE: LOW) and concluding that the PE is too high. Maybe its growth prospects and leverage opportunities will make it seem cheap in the future?  I happen to think it will.

But Back to Beacon

I thought the latest BECN numbers were good. They were in line with analyst estimates and I admit I was a bit cautionary ahead of them (having sold out after it hit my price target earlier in the year) because Home Depot (NYSE: HD) and others had mentioned weak results in roofing. In addition, after Sandy took place a host of journalists had been pitching up the stock as a key beneficiary. Frankly this concerned me because, as Home Depot argued, Sandy was more of a water damage event as opposed to the wind effect of Katrina. This may not be an issue for HD, but it could disappoint newbie BECN investors. Moreover, BECN is not particularly strong in the areas where Sandy had the most impact.

No matter, the good news is that BECN hasn’t baked much from Sandy into its guidance. Instead the key catalysts going forward will be growth from acquisitions, favorable gross margin shifts from an increase in higher margin residential roof sales, and some ‘kicker’ from new house building. If you look at what Masco and Whirlpool are saying, there is a real and tangible uptick in spending on larger ticket items within the US Housing markets (and on the discretionary side too).

However, the real imponderable is pricing. Again I was somewhat concerned here because weaker market conditions usually make it harder for corporations to take pricing. BECN is currently lapping strong growth from Katrina, and it built up its inventorie, so pressure on pricing was likely. As it turned out pricing was flat year on year for the quarter and was declared as being sequentially up for the last two quarters.

Where Next for Beacon?

BECN guided towards 5% organic growth (volume based), which gives around $102 million, and acquisition related growth of around $138 million, which totals around $240 million. However, it suggested a figure of around $275 million for revenue growth, which suggests a 1.7% assumption over pricing. This may prove conservative given that pricing was up sequentially and (at least in residential) was described as being up 1-2%. Ultimately it will be guided by the local markets BECN serves, and I think there is cause for optimism.

Moreover, BECN declared itself comfortable with the current analyst consensus of $1.82 for 2013. I argued in the first article that it tends to convert its income into free cash flow very well, so assuming a par conversion would give around $85 million in free cash flow or around a forward FCF/EV yield of around 5%. I’m willing to pay more for the reasons outlined above, but not much more, and it’s hard for me to justify paying more than $33. I’m willing to wait/hope for a handle in the $20’s before buying.

Perhaps that’s something the economic student would agree with me on?

Pall Corp's Prospects

I always like looking at companies with diversified end markets because they tend to give valuable information on their individual verticals. In the case of filtration company Pall Corp (NYSE: PLL), it really is a tale of two cities with some differences within the suburbs too. The Industrial city’s prospects got worse over the quarter while the Life Sciences metropolis is actually doing quite well. No matter; it wasn’t enough to stop sales declining .1% in the quarter, and forecasts for next year were taken down.  I last discussed the company in an article linked here and argued that the stock needed to come off a little bit. It has, so it’s time to ask whether Pall is good value right now.

The Case for Pall Corp

Pall is a nicely balanced business comprised of Life Science and Industrial segments, which complement each other.  It typically operates a razor-blade model comprised of system and consumables sales. The good news is that end demand is partly driven by environmental and regulatory concerns, but the bad news is that consumables demand is driven by activity. Less activity, less sales.

Industrials Suffering

Unfortunately, it’s been a tough time recently for industrial cyclicals. Growth is slowing on a global basis, but interestingly it is the growth in global trade that seems to be bearing the brunt of the slowdown. I first heard this point made on FedEx’s (NYSE: FDX) conference call and in retrospect it was a good read on what was to come in earnings season. FedEx warned that global trade was slowing faster than global GDP growth as a consequence of increasing protectionism and faltering western demand causing a slowdown in Far Eastern exports.

All of which has played out in slowing microelectronics and semiconductor demand, and it shows in Pall’s results. Frankly, I wouldn’t assume a turning point in consumer electronics until a major bellwether like Intel (NASDAQ: INTC) comes out and starts talking about things like gross margins increasing again. As it stands, Intel and everyone else in the industry have been lowering expectations, and it is results like these from Pall that cause more concerns.

A look at sales and orders by segment.

Industrial growth slowed over the quarter with emerging markets being weaker than expected. On the conference call, Pall explained that 2/3 of the slowdown is due to the end market and 1/3 due to customer de-stocking, although frankly these elements are driven by similar factors. Customers de-stock when they feel less confident about the outlook. Municipal water customers are predicted to be weaker in 2013, and I think there will be downside surprise in aerospace.  For example, when a bellwether like General Electric (NYSE: GE) gives disappointing results and sees order books declining in its aviation and energy segments, then the industrial sector is definitely weaker.  GE’s shorter business cycles have been weak, but when this starts to feed through into the longer cycle then it is a sure sign that times are tough.

However, there was some good news. Operational efficiencies actually caused margins to increase and segmental profits rose to $52.8 million from $43.6 million last year. Impressive stuff.

Life Sciences Firm

Paradoxically, segment profits at Life Sciences fell to $69.8 million vs. $79.7 million last year. Go figure!

The reason for this was an unfavorable sales mix, which should hopefully resolve itself in future quarters. Gross margins should rise in the future, particularly as there is good momentum in the biopharma (67.5% of LS sales) business. Bizarrely, Pall reported some decent conditions in life sciences in Europe amidst claiming to be taking market share.

Life sciences remains the big hope for Pall in 2013, and the numbers suggest that the pharmaceutical industry is still investing in order to get over its very own cliff.

Where Next for Pall Corp?

Investors will be hoping for more operational efficiencies in the industrial segment plus the usual canard of Chinese stimulus spending to drive a second half pick up. Moreover, Pall has been stripping out low margin system sales, and there is more room to run here, so margins might continue to improve even as revenues fall.

Guidance is for flat to low single digit growth in overall revenues with EPS growth of 5-13%. This represents a reduction from the 9-16% earnings growth previously forecast. The stock is not particularly cheap on a cash flow or EV/EBITDA basis (12.7x) and is probably only worth considering if you think you are buying it at close to the bottom of the industrial cycle. Frankly, I think the evidence is that conditions will get worse near term, so cautious investors might want to hold fire and monitor events.

Wednesday, December 26, 2012

Williams Sonoma Offers Good Upside From a Housing Recovery

It’s been a good quarter for housing related stocks and Williams-Sonoma’s (NYSE: WSM) results were no different. The company has managed to execute from an operational standpoint and is starting to benefit from favorable end market dynamics as the housing market is in recovery mode. However, profitable investing is so much more than buying a stock at the top of its performance in a hot sector, and history is littered with people who piled in at the peak. Is WSM one of those stocks or is there further to run here?

What the Industry is Saying

Home Depot (NYSE: HD) kicked off the sector’s reporting season with a bullish set of results which I covered in an article here. HD is seeing an increase in spending on discretionary items and good broad based comparable sales growth with some kickers from Sandy to come. In the link provided, you can see how full year sales guidance has been progressively raised throughout the year. All of which is fine, but was it just a case of stealing market share from Lowe’s (NYSE: LOW)?

The answer has to be ‘no’ because Lowe’s reported a pretty good set of results too. I covered them in this article, and I think the key takeaway is that favorable end markets are giving it the breathing room to enact initiatives designed to simplify its product offerings in order to drive product sales. It appears to be working, and the stock is a compelling value proposition.

However, it is not all plain sailing as Bed, Bath and Beyond (NASDAQ: BBBY) continues to struggle to gain sales traction. I discussed its issues in an article here.  The company is being hit with the double whammy of slowing same store sales growth while rising costs are eroding its margins. As a consequence, investors have a right to be skeptical over the aggressive expansion strategy. Do you feel confident with your management rolling out new stores when the existing ones are not doing great even while the competition is doing well?

Special situation investors at the value end of the investing spectrum will be attracted, but for more growth orientated investors it might be worth avoiding.

Williams-Sonoma’s Growth Strategy

BBBY’s problems all lead back to the point that a company’s prospects aren’t just about its end markets. Indeed, Williams-Sonoma has been executing even when conditions were tough. At the heart of its current initiatives is a commitment to

  • growing the existing brands
  • expanding internationally
  • launching new businesses

I would add e-commerce initiatives to this list because I happen to think that, whether the industry likes it or not, online competition is coming. (NASDAQ: AMZN) via its subsidiary Quidsi launched this year with the idea seemingly being to do to BBBY and WSM what it did to Best Buy with consumer electronics.  I view Amazon as a very serious threat in the future because the percentage of spending dollars within a population that has been gleaned from e-commerce is only going to grow in the future. Consumers are used to shopping around, and Amazon knows how to play this game. Furthermore, it is no accident that Pier 1 Imports and WSM (e-commerce revenues jumped 17% in the quarter) are expanding strongly here.

It’s something to keep an eye on for the long term.


In terms of growing existing brands, WSM is seeing the strongest growth in its innovative and exclusive brands. It’s a good way to differentiate its offering, and Q4 prospects look good as it declared that it would be launching a ‘significantly higher’ percentage of exclusive products in the quarter.

It’s not hard to see that growth is being driven by West Elm and Pottery Barn. Interestingly, the West Elm stores are the only ones seeing a significant expansion this year. Clearly WSM is executing well in terms of generating growth at its existing stores.

As for international expansion, new stores have been opened in Kuwait and four retail stores are under construction in Australia. It’s always comforting to expand in a country that speaks the same language, and Australia’s housing market has been showing signs of strength recently.

The launch of West Elm Market, a neighborhood store version of West Elm with an emphasis on a ‘sense of community,’ is a very interesting development which I think many retail companies should look at. Indeed, Wal-Mart is expanding into neighborhood stores, and I think these sorts of things do fill a social need. They are also easier to do when a rampant housing market isn’t increasing rental costs for businesses.

Where Next for Williams Sonoma?

As ever, the current quarter is the key to the full year, and I think investors should be optimistic. The housing recovery seems real enough and WSM is doing all the right things by differentiating its offerings and trying to create an air of exclusivity about its product range. Longer term, I have some concerns about possible margin erosion from the likes of Amazon or other online retailers but this also provides opportunities for WSM to improve inventory management and working capital via its own online sales. Moreover, online competition is not likely to affect matters much in the near term.

In conclusion, the stock is not particularly expensive on a cash flow or EBITDA basis, and I think a good Christmas could see this stock up to a $50 handle. As such, the recent pullback makes it very interesting because I think there is some upside surprise potential here.

Why Investors Look at Stocks Differently

I’ve been meaning to write this article for a while now because I think it’s the sort of subject little discussed in mainstream journalism. Essentially, most investment journalism focuses on buying or selling this stock or other with a forthright opinion expressed either way. I understand why this formula works (not least because readers want this), but there is usually very little discourse over how or where the stock should fit in your portfolio. In addition, there is never any discussion of the investment approach of the author, how it might affect a decision over a stock or even the positioning of that stock within a portfolio.

In terms of portfolio construction, I have discussed the matter in an article linked here. In this piece I want to focus on how different investors might view stocks differently.

Same Stock, Different View

It's important for investors to understand that there is no absolute truth to investing. The key thing is to find a strategy or tactic that works for you and then implement it in a way that works for you. Then try to make sure that it works across market cycles and conditions. For the record, with me, this has always meant a diversified stock picking, growth at reasonable price (GARP) based approach. I tend to buy quality stocks that I think are 15-20% undervalued and in a position in the economy that I think has upside potential.

I’m not saying it is a perfect strategy, but I am saying it works for me. I’m also pointing out that sometimes I might look at a stock from this perspective and reject it because it doesn’t fit the model (Cue howls of derision and contempt in the comments section when a writer dares to mention that he doesn’t fancy a stock for his portfolio). The point is, it might not work for me but other investors who follow, say, a value or special situations based approach, might love the stock.

You have to do what works for you.

Some Examples

I want to give some brief examples of what I mean here.

I’ve written about Cisco Systems (NASDAQ: CSCO) and Intel (NASDAQ: INTC) quite a bit and I think neither stock fits the bill for a GARP based investor. I last covered Cisco here and Intel here. They share similar characteristics. Both are seeing growth slowing but present good long term value. Intel offers a very high dividend, and Cisco is turning itself into a value play by returning cash to shareholders. What both are not is companies that have much upside surprise (in my opinion) over the next six to twelve months. The semiconductor industry continues to downgrade expectations and the telcos remain reluctant to spend. Growth orientated investors like me don’t tend to buy such things, but that doesn’t mean that value players won’t make money from them!

Another example is Autodesk (NASDAQ: ADSK), which I covered in an article linked here. This is a company facing very difficult market conditions and a lot of near term risk combined with the execution risk inherent in its shift towards software as a service based sales.  Again this is not the sort of stock that a GARP based investor would buy, but why should that matter to a special situations investor?  The latter tend to buy a lot of these sorts of stocks and hit a few huge home runs with them while missing with a lot of stocks elsewhere. Just because it doesn’t suit my portfolio profile, it doesn’t mean that it might not fit yours.

The last two examples are of stocks that I like but appreciate won’t fit other styles of investing are Allergan (NYSE: AGN) and Wabtec (NYSE: WAB). I hold both and wrote about them here and here. Now, I can understand why value investors won’t fancy Allergan on nearly 27x current earnings or Wabtec on 17x earnings.  However, both have relatively secure mid and long term growth prospects. Allergan has the opportunity to get Botox indications expanded, and its eye care division is well placed for stable growth amidst favorable demographic changes.

As for Wabtec , it has near term catalysts from positive train control (PTC) revenues and shale gas rail, while longer term there are geographical opportunities for expansion, and rail is seen as an energy efficient and cost effective way to transport goods.

Both stocks convert earnings into cash flow well, and despite the high rating, a GARP investor will be attracted to them while a value investor will simply balk at the evaluation.

The Bottom Line

In conclusion, there is no right or wrong way to invest. The only wrong way is to not stay true to your principles, and the only right way is to try to keep those principles flexible. In the end, the aim is to generate favorable risk adjusted returns over the long term.

Sometimes writers don’t articulate why they favor certain stocks over others. They are afforded that regrettable luxury* because many of them don’t own anything they write about, so getting it wrong or right doesn’t really matter. For private investors, this luxury doesn’t exist, so the next time you read a stock write-up try to consider how the stock fits into your style of investing or your portfolio.

*For the record I do try to self impose a discipline of monthly write-ups and I do invest in stocks I write about

Sunday, December 23, 2012

Dover Corporation, An Interesting Industrial

Dover Corporation (NYSE: DOV) is one of those industrial companies that the market never seems to knowingly overvalue, and everyone is cautious with it as a consequence. It strikes me that industrial cyclicals are always going to be relatively undervalued because investors can’t be sure how a company will be positioned coming out of a slowdown. In Dover’s case, I think its long term history of performance deserves a bit more respect and, provided investors can tolerate some volatility, it is worth a closer look.

Dover over the Cycle

Dover is certainly a company that knows how to execute across the cycle, having generated a 10% compound annual growth rate (CAGR) in revenues over the last 10 years alongside 14% earnings growth. Moreover, free cash flow tends to consistently be around 10% of revenues, and it has increased its dividend for the last 57 years. As such, it belongs in this group of select companies; throw in the share buybacks and this is a pretty shareholder friendly company.  All of which is fine, but how does Dover make its money?

I’ve broken out rolling segmental earnings.

The case for Dover revolves around diversified end markets and how they allow the company to generate growth across the cycle. Thinking longer term, its strategic focus is benefiting from favorable long term trends in Energy, product ID, refrigeration and Energy markets. Essentially it is a typical ‘GDP Plus’ type of growth story.

Growth Slowing

However, because its prospects are correlated to GDP growth it will fluctuate with sentiment over the macro conditions. As such, Dover’s last results stated the familiar refrain of Europe being stable but weak, China slowing and modestly stronger conditions within the US.

We can see some of these factors represented in bookings.

Dover confirmed that growth is slowing in China and in particular within its export led industries. For example, Dover’s electronics end markets saw bookings decrease by 10% to $343 million and did not forecast any ‘near term recovery.’  The best way to see where future growth in consumer electronics is headed is to keep an eye on Intel (NASDAQ: INTC) because its sales reflects inventory decisions by the large electronics firms. As such, Intel keeps reducing guidance and gross margin forecasts.  It will get worse before it gets better. While that is already in the price, there are other warning signs.

Nokia (NYSE: NOK) is Dover’s biggest customer within handsets, and its travails should be well known to investors. Much depends on its product activity, and prospects there must be seen as uncertain at best. Even if the company is eventually taken over, this implies structural changes which may or may not help Dover.  Other risks include the falling US rig count, which has affected the likes of Baker Hughes (NYSE: BHI) this year. Energy is the largest profit center, and a lower rig count is an issue for Dover because its drilling related revenues tend to be high margin.

The other main threat is the failure to execute at Sound Solutions. Granted it has been a difficult environment for handsets and it is an ever changing market, but there is some tardiness in making manufacturing changes in its Beijing operations. The intent to shift to semi-automated production is music to the ears of Cognex (NASDAQ: CGNX) stockholders since it is a huge beneficiary of Chinese production moving towards automated production lines -- an interesting piece of ‘color.’

Where Next for Dover?

Frankly, no one likes buying companies that have just reduced guidance or changed their outlook over the last quarter, but Dover deserves at least a monitoring look. There are plenty of near term risks (macro, Nokia, rig count, Sound Solutions) that would keep me out of a position right now, but if it dips then it would become interesting.

Dover has generated around 10% of its revenues in free cash flow over time and if you figure that a 5% FCF yield is acceptable then valuing the stock at 2x revenues makes sense.

DOV Price / Sales Ratio TTM data by YCharts

As this graph demonstrates, it never really trades up to 2x earnings, but when the economic going is good a ratio of 1.75x seems to be the peak. Of course interest rates are far lower now, so arguably the stock has room to run. The slowing rate of growth in bookings indicates that revenue growth will be no more than low single digits for the next couple of years.

In conclusion, I think Dover is an attractive stock, but it might be worthwhile monitoring now while keeping an eye out for the risks that I mention above. Apologies if this article doesn’t produce the kind of hard resolution that many readers want, but the greatest weapons a private investor has are patience and preparation, and I don’t plan on giving either up just yet.

Campbell Soup Earnings Analysis

What to do with Campbell Soup (NYSE: CPB)?  On the one hand, it’s a company serving up mediocre growth in organic revenue and earnings, but on the other, it is exactly the kind of relatively high yield defensive stock that the market is in love with right now. The bias inherent in the latter argument is likely to stay as long as US Government bond yields remain at depressed levels and money managers construct proxy equity portfolios for ‘safe’ assets.  But how safe is Campbell Soup?

A Crowded Trade

Frankly, I think it is a crowded trade right now and should a stronger US recovery cause bond yields to rise, then this type of stock could suffer. It is a similar sort of argument with food stocks like its rival H.J. Heinz (NYSE: HNZ) or ConAgra Foods (NYSE: CAG). Heinz was featured in an article linked here and, although its recent results were superficially strong, I have some concerns about the long term sustainability of its tax rate and its underlying earnings growth. ConAgra is arguably more attractive because it has a bit more growth and a collection of value brands with which it can benefit from consumers trading down.

With Campbell the question is how can it generate growth within a difficult trading environment?

Soup Kitchens

Okay it’s not quite that bad yet, but there is no doubt that the mass US consumer market is suffering. As a consequence it is changing its purchasing habits in ways which are affecting Campbell’s revenues. I’ve identified the following factors

  • Trading down to cheaper alternatives
  • Shopping at alternate sales channels like discount stores
  • Becoming highly aware and responsive of promotions and price reductions

These issues disrupting how food companies traditionally generate revenues. For example, even a private label manufacturer like Treehouse Foods (NYSE: THS) has had great difficulties this year. Its value offering is the sort of thing that should be flourishing but its traditional sales channels are being eroded in favor of consumers doing more grocery shopping at stores like Dollar General (NYSE: DG), Dollar Tree or Family Dollar. Treehouse has had to deal with a significant realignment in its end markets as its traditional customers lose footfall and sales to the discount stores. As for the dollar stores themselves, there are some signs of slowing growth in these companies but it is not due to a reversal of shopping behavior and more about how they are dealing with the pressures of their aggressive new store rollout plans.

Campbell’s Latest Results?

A quick look at how Campbell performed in its latest set of results.

I haven’t included earnings growth for the Bolthouse acquisition because they were not broken out from the overall ‘Bolthouse and Foodservice’ numbers.

And to put these segment growth numbers into perspective, here is how Campbell generated its earnings in the quarter.

First, the overall sales growth of 8% was largely due to the Bolthouse acquisition whereas organic sales growth was a miserable 1%.

The good news is that the turnaround in the core US simple meals segment appears to be on track. The bad news is that a large part of it appears to be due to movements in retailers’ inventory which will be corrected in the next quarter. Indeed Campbell confirmed that next quarter’s EPS would be likely to be lower than the full year guidance rate. Given that that guidance is only for 3-5% adjusted EPS growth, it suggests a tough quarter coming up.

Moreover, the sales growth in soups (US Simple Meals) has been driven by product innovation; new product launches and associated marketing. These things cost money and they also cost margin.

Gross margins declined in the quarter to 37% from 39.5% last year and, even with adjusting for the margin dilutive Bolthouse numbers, they were still down to 37.9%.

Global Baking & Snacks sales increased 1% but it took a 3% hot from increased promotions spending in order to generate it. This is somewhat of a concern because categories like snacks are showing strength for the likes of Kraft. Organic sales actually increased 2% in International Simple Meals & Beverages and gross margin gains were good. I suspect this is due to higher sales in Asia Pacific relative to Europe. US Beverages remain a challenged business as consumers continue their trading down efforts. Unfortunately for Campbell this means they are moving away from Campbell’s juice products.

Where Next For Campbell Soup?

If you put the moving parts together you have a company driving sales growth by acquisition. Organic sales growth isn’t great and there is going to be a correction in growth in soup following previously favorable customer inventory movements. The other segments are hardly performing well and even with the Bolthouse acquisition adjusted EPS growth is forecast in low single digits.

It isn’t impressive stuff and reducing marketing spending on soup after launching a lot of new products can appear like an attempt to grab some margin for past investments. I’m not sure that in this environment it will work. I’m also not sure that paying 15x earnings for a low growth business with business segments facing severe challenges makes sense right now. In my view there is better value out there.

Saturday, December 22, 2012

The Outlook for Telco Spending in 2013

If any telecom investor wants a good clue as to how his company’s top line numbers will develop, he would be best advised to look at the capital spending plans of the leading carriers. In the case of North America, the bulk of spending is done by the top tier carriers like AT&T (NYSE: T), Verizon (NYSE: VZ) and Sprint Nextel (NYSE: S). I decided to do a roundup of what they are saying with regards to spending.

For the larger networking players, it is the global telecoms market that counts, but I see the US carriers as the ‘swing’ hitters at the moment. Everyone knows (and has priced in) that European spending overall will be weak in the near future. As for Asia/Pacific, there are real signs of slowing with Chinese companies like ZTE warning of a lower spending environment. The vagaries of China’s stimulus spending remain, and few telco companies, at least so far, have seen the second half ramp up from China that they were expecting earlier in the year. However, the US economy seems to be on a better trajectory, and Cisco Systems (NASDAQ: CSCO) recently said that it saw some signs of better trends in North America. Is this confirmed in the recent results and outlook from the leading players?

As for other telco networking related stocks, I noted that revenues declined for the third quarter in a row for F5 Networks. Similarly, something like Acme Packet (NASDAQ: APKT) reported a weak spending environment but believed that things would pick up in a year or so. I happen to think that Acme Packet is a stock well worth taking a look at, because at some point the carriers are surely going to increase investment in Voice over LTE (VoLTE ); but the question is if the stock can outperform when the overall telco market is getting weaker? I doubt it.

AT&T’s Efficiency

AT&T has been the big hope this year because it has been spending relatively more than the others in line with its need to build out its 4G/LTE network. With that said, by the last quarter the majority of its network was already on an enhanced back haul. In other words, there was growing pressure on it to reduce its spending plans going forward.

To the surprise of many, it stuck to its earlier CapEx forecast last quarter but then reduced it this quarter by announcing that they would be at the lower end of $19-20 billion. The good news is that this is largely because it felt it had generated enough efficiency in spending to be able to do this without changing its program. It also declared that it was ahead of its LTE roll-out plans.

This is all good news for AT&T, but the increase in second half spending is going to increase. Furthermore, if AT&T is spending less due to greater ‘efficiency,’ it could be because it is getting better purchasing ability out of a weak telco market.

Verizon Lowers Expectations

Over the last year, Verizon has been making a virtue of reducing capital spending as a percentage of revenue. This is part of a long term plan to get this metric down. In a sense this is implicit recognition that it has already built out a large part of its wireless network, having spent more last year in order to launch the iPhone.

Moreover, smartphone adoption continues to increase (from 50 to 53% over the quarter), as does the migration to 4G/LTE from 3G with 35% of its data traffic on the 4G/LTE network already. These kinds of shifts will inevitably put pressure on Verizon but for now there is no sign that there is a necessity for increased spending.

On the contrary, Verizon’s full year capital spending plans have been reduced over the year. Going back to Q2, Verizon announced that full year capital spending was likely to be flat to down vs. last year’s $16.2 billion. If we fast forward to Q3 the expectation is now for lower spending.

It is a subtle change and might not appear significant, but when telco suppliers have been talking about a second half spending increase, it is a clear disappointment.  Even in wireless Verizon is spending less than last year, so while wireless remains an area of relative strength (Cisco reported good numbers), the trend is not improving, at least for Verizon.

Sprinting Towards LTE

It’s a similar story with Sprint Nextel, which has been aggressively rolling out its 4G/LTE network. Indeed, it is doing it early with the strategic aim of creating awareness as they build out sites. All of which implies that spending should be increasing. However, the story is mixed.

In Q2 Sprint said it was keeping its full year capital expenditure plans unchanged at $6 billion; however, in Q3 it announced that it expected them to be less, partly due to a timing shift of expenditures on towers falling into 2013. There are two points here:

First, an earlier deployment hasn’t caused a pull forward or an increase in spending. Second, it’s funny how many times companies talk of delayed orders moved into the next quarter. The market usually responds to this with disbelief and marks the stock down, so why shouldn’t it have the same skeptical attitude when a company talks about expenditures moved into the next quarter?

In general I try to stay neutral when these things happen and take the company’s word for it unless other indicators are suggesting it is wishful thinking. In this case, I would watch what Sprint says in the in next quarter very closely.

Telco CapEx Spending?

In conclusion, I don’t think there is strong evidence (at least from the carriers plans) that spending plans are trending higher. On the contrary, they have been getting weaker. It’s all very frustrating because increasing smartphone adoption and data traffic should be creating investment ideas for stock pickers. Indeed, I think some niche areas are worth pursuing, but overall things don’t appear to be getting better just ye

Heinz Not Looking That Impressive

H.J.Heinz (NYSE: HNZ) delivered a pretty solid quarter, but I have my doubts. In the short term, its relatively high and stable dividend yield seems to be the main attraction of the stock. The longer term underlying story with Heinz is how emerging market growth and favorable movements in tax revenues are generating the income to enable it to invest in growth elsewhere.

If I’m right in my argument then Heinz’s shareholders must consist of some unusual bedfellows. There are the usual yield chasers looking for the stability of the food sector, and then there are those who believe in the long term story. Considering that investors can get that yield elsewhere, it is more interesting to focus on the growth numbers in the report and how they came about.

Heinz’s Recent Results

The results reflect the good work that its management has been doing in a difficult environment. Strategically, it is not at all dissimilar to what its rival Campbell Soup (NYSE: CPB) is trying to do. Campbell is trying to keep a ‘holding pattern’ in the US while aiming for emerging market growth and trying to squeeze anything it can out of positive growth categories like snacks.

Turning back to Heinz, most analysts liked the results, but I think the results are not good as they may initially seem.

Overall organic growth was a respectable 3.3%, while emerging markets delivered 13.2% organic growth. As ever, the movement in income by segment reveals a lot.

Overall segmental operating income was down $1.5 million, however the reported operating income was up $35.5 million. The difference was largely made up of a $37.3 million charge taken for a productivity initiative last year. In fact, the only positive comparisons came from Asia/Pacific and the US Foodservice segments.

North American Consumer Products income took a hit despite revenues being essentially flat, thanks to marketing expenses being up double digits. There was some positive commentary over marketing investment in the likes of ketchup, snacks and Hispanic advertising, but the results speak for themselves. The strategy seems to be to chase volume growth at the expense of margins. This is fine if the economy improves, and Heinz is able to take pricing in the future on that retained volume; but it's not so good if consumers continue their tendency to want to trade down.

In addition, Heinz faces difficulties because of the type of shopping that consumers are doing these days. While the recent results from discounters like Dollar Tree have indicated a slowing of same store sales growth, I think this is largely a consequence of the amount of competition among discounters (they have all expanded store numbers aggressively) and the traditional retailers reacting to encroachment on their market share. My point is that Heinz is still going to be challenged, because consumers continue to migrate away from its traditional sales channels and/or seek out private label alternatives.

The US Foodservice segment did well and it appears that the productivity initiatives were well spent in getting this segment back on track. In fact, its increase in operating income of $9.3 million wasn’t far away from Asia/Pacific’s $9.7 million (the only two in positive territory). Nevertheless, it is not a large part of profits, and comparisons will get harder going forward.

As for Asia/Pacific, growth looks strong and management seems to be focusing attention on this region, but I have some concerns here too. Much of Heinz’s growth in emerging markets was believed to have come from infant/nutrition, and when a company like Mead Johnson (NYSE: MJN) warns of increasing competition amidst heavy promotions in the Far East and Heinz reports a 5.4% drop in revenues, it’s hard not to conclude things will get tougher.  Indeed, Johnson & Johnson (NYSE: JNJ) reported lackluster results in the US and is subject to increasing competition there too. This is somewhat worrying for Heinz because it implies that Danone and others will chase growth in China very aggressively, and we can expect Mead Johnson to fight back too.

Europe’s consumer difficulties are well known, but fortunately Heinz is relatively insulated thanks to its remarkable popularity in the UK. All of which is fine, but I think the European mass market is a tough place to be in right now. US investors need to understand that it was Germany that led the ‘movement’ towards shopping in discount stores. In other words, don’t expect any respite from the trend towards increasing value awareness.

Where Next for Heinz?

As discussed above, if you add back the $37.3 million charge last year then operating income actually fell by $3.75 million. Moreover, a lower tax charge of $31 million vs. $53 million last year helped attributable net income rise by 22%. Heinz’s management has done very well to get the tax charge lower, and it affirmed that it was confident over the issue for the next six quarters; but frankly, many of these things are decided by political considerations, so it’s hard to rely on this low level in say, a discounted cash flow analysis.

My point is that a few moving parts have created a very positive optic in these results. Some unfavorable tax movements in the future, plus more competition (likely) in infant/nutrition and a continuation of the ongoing ‘mass consumer’ spending malaise, and Heinz could very easily report negative numbers.  In addition, analysts are only forecasting single digit growth for the next couple of years, but the market is asking you to pay 19.4x earnings and an EV/EBITDA multiple of 11+.

On a more positive note, the management is doing a great job in difficult conditions. The turnaround in foodservice is evident, and emerging market growth prospects look good with the lower tax rate giving them time to continue investing in higher growth areas.

I think the rating is too rich, but the market wants yield right now, so don’t be surprised if it goes higher. However, for a GARP based investor like me this stock has few attractions.

Lowe's Is Looking Good Value

Allow me to shamelessly rewrite a famous quote. It’s usually attributed to Gary Player and basically involves claiming that the more he practiced the luckier he got.  However, when investing in companies I think that it’s often a case of the luckier they get, the more chance they get to practice. In other words it’s a lot easier to increase operational performance when they are blessed with favorable end markets. I would argue that this is the story with Lowe’s (NYSE: LOW), and the stock deserves a closer look.

Same Tune, Different Band

A slew of companies have come out recently and reported some tangible signs of a housing recovery. Let’s be clear on this though: It’s not a return to the glory days of 2006, which ultimately proved unsustainable, but more of a slow, sustained recovery that allows corporations to leverage up profitability from a lower cost base. As such, the house builders have had a great year with stocks that have lots and approvals, like DR Horton (NYSE: DHI), doing very well while others that lack them, like Beazer Homes (NYSE: BZH), have struggled. The key point is to have operational leverage at the right time. All of which leads me back to Lowe’s.

Lowe’s is facing better end markets but, by its own admission, has not been executing well enough to take advantage. This leaves the company in classic value proposition territory. In other words, a value investor might compare its metrics with a key rival like Home Depot (NYSE: HD) and then argue the case that it should be able to play catch-up, particularly if end markets are helping it. I quite like this argument, but I confess as more of a GARP based investor I prefer quality rather than value.  Of course there is no right or wrong way to invest. It’s all about doing what works for you. So how is this thesis playing out for Lowe’s?

Coming off the Lowe’s

Lowe’s pretty much confirmed what Home Depot recently outlined. The consumer remains cautious and is struggling, but housing is making a slow comeback. Moreover, there was broad based strength with 12 of its 14 product categories showing positive comparisons. In concert with Home Depot, it reported that it is seeing some strength now in bigger ticket items and items focused on discretionary spending, like cabinets and appliances.

Another area of strength is in paint, and with Home Depot also reporting good signs here this means that Sherwin-Williams (NYSE: SHW) stockholders should look forward to good numbers from the company. It has large exposure to the US housing and construction marketplace.

All of these things are good signs for the sector, whereas previously much of sales growth was driven by general repair work plus the affects of Katrina last year. As for the ‘practicing’ I referred to earlier, Lowe’s is starting to see some traction with its management initiatives. The idea is to simplify the product range in order to generate operational efficiencies. So far so good, and Lowe’s reported good sales growth in the items that it has subjected to closer management scrutiny.

I don’t think the initiatives are anything more than retail ‘blocking and tackling,’ but that is the good news. It shouldn’t be too hard for experienced retail managers to get things like store layouts, purchasing, in-store promotions and inventory management right. This sort of know-how already exists within the management, and Lowe’s has the opportunity to start to close the gap on Home Depot in terms of operating margins and sales per store etc.

Where Next for Lowe’s?

On current metrics, I don’t think the stock is particularly cheap, but if you believe that they will improve via initiatives and end market growth then there is a strong case to be made for buying the stock. If so, then working capital requirements should not be as high next year, so cash flow conversion is likely to be better and the stock will attract more investors. Lowe's is talking about reducing inventory by up to 10% as a long term aim, and so far only up to 20% of its product categories have been 'reset.' There should be plenty more improvement to come.

The key thing going forward will be successful implementation. As ever, investors will make the comparison with Home Depot (I hold the stock), but no one ever said that you can’t buy both stocks. My preference would be to stick with the stock that offers less execution risk and therefore has more thematic exposure to housing (which means Home Depot); but investors looking for more upside via stock specific risk can just as easily buy Lowe’s.

Friday, December 21, 2012

How Much Longer Can Whole Foods Keep Growing?

Whole Foods Market (NASDAQ: WFM) is one of the stocks that is going to give emotional investors sleepless nights. On the one hand it’s starting to look expensive in relation to its growth prospects, particularly with competitors making plans to encroach on its market area. On the other, its growth prospects are starting to make it look cheap on a long term basis. I happen to like both sides of the argument, hence the uncertainty. I don’t buy stocks that I am uncertain of, but I’m sure others will have more concrete views.

I wanted to articulate some of the salient points so investors could make their own minds up.

A Smaller Piece of a Bigger Pie?

The sub-heading is why the proposition is so tricky at Whole Foods. More often than not, any analysis of a company usually involves trying to find its value proposition within a particular point of a cycle that most companies go through.  I’ll try to elucidate. The cycle typically runs a bit like this: high growth nascent industry phase, growth phase as company matures, GDP (plus a bit more) growth phase as maturity sets in and competitors enter, GDP (or less) growth phase as the company matures.

Of course this type of conceptual thinking is usually expressed rationally in a discounted cash flow analysis and the question is always “am I paying the right price for the stock?” The best answer usually lies within a better understanding of where the company is in the cycle. So what does it all mean for Whole Foods?

Well, usually a company is involved in fighting for a bigger piece of a relatively smaller pie in the future. Competitors enter and it gets that much harder to retain or grow market share. However, with Whole Foods I think that its end markets will accelerate in the future so that we will be in an elongated position within the second growth phase of the cycle.  The pie will get bigger and Whole Foods can still generate growth even with a smaller piece.

A quick look at some of the key metrics suggests that quarterly gross margin comparisons are still favorable while same store comparables remain in the 8%+ range.

So far so good, and there are no real signs of slowing growth in the metrics yet.

Bigger Pie

Long term, the trend towards organic, ‘healthy’ or non-GM foods looks assured. I use inverted commas because I’m not someone who views GM foods as being unhealthy, but I am a cynic when it comes to the unfailing ability of the media and celebrities to discuss important subject matters that they know nothing about. Scare stories involving health issues are particularly prevalent and few more so than GM foods.

Another favorable trend will be that of increasing discretionary spending by wealthier career women. I wouldn’t underestimate this trend. Indeed, in the recent conference call Whole Foods outlined that 20% of its customers do about 75-80% of its business. This is a kind of devotion only usually inspired by Scientology or other cults. In addition marketing data suggested that they gained 22% in new customers in the quarter.

In a sense, this is why Wal-Mart (NYSE: WMT) and Costco (NASDAQ: COST) don’t appear to be making inroads yet, despite their expansion into the food category. Shoppers like the Whole Foods retail experience and the feeling of ‘being healthy’ by eating there. They don’t get this at Wal-Mart or Costco, even if the food is exactly the same. Moreover, if Wal-Mart and Costco are expanding their food operations, it will squeeze the traditional mass market grocers who will then try and find other areas of growth, and this could mean trouble for Whole Foods.

A Smaller Piece

With that said, I’m simply not ready to cast aside everything I’ve ever learned about market forces. The big box retailers may not offer the same retail experience to a typical Whole Foods customer, but traditional grocers like Kroger (NYSE: KR) and Safeway (NYSE: SWY) have a footfall of customers who probably also shop at Whole Foods.

Kroger in particular has management that has demonstrated that it is willing to go to every length to wring every sale it possibly can out of its customers. At some point, the sheer weight of footfall will start to tell, and they will both start to grab meaningful market share.

Moreover, while the devoted will still stay, the newly acquired customers may prove fickle amidst the temptation of every food retailer chasing the ‘health’ angle.

Where Next for Whole Foods?

If you strip out the amount spent on new stores the FCF/EV yield is 4.5%, which is a surprisingly high number for such a highly fancied stock. However, I think it does imply that Whole Foods needs to hit its earnings targets over the next few years.

There is little margin for error here, and any slowdown in comparable same store sales growth and this stock will get hit hard. If so, the stock will be worth a look because its end markets look good. However, I would rather buy it when the market is pricing it as I see it, rather than as a bigger piece of a bigger pie.