Wednesday, September 26, 2012

NetApp Looks Good Value

Shares in NetApp $NTAP suddenly became very interesting after a set of results that could be described as stabilizing. I realize my description is not going to excite anyone but what you have to understand is that NetApp’s evaluation is so cheap right now that all it has to do is demonstrate some stability and market share retention and the stock is likely to go higher. Furthermore, it is a small player, with a decent market share in a competitive market. I think it is a strong takeover target.

What’s Special about the Evaluation?

Unusually, I am going to start with the evaluation.

With a current price of $33 the stock trades with a market cap of $12.1bn but has around 40% of it in net cash and cash-like instruments on the balance sheet. This means its enterprise value is only $7.52bn and moreover the business is highly cash generative. For example, in the year to April 2012 the company generated $1.06bn in free cash flow and its target is to average 19-21% of its revenues in free cash flow for 2013-15. A quick look at analyst estimates for revenues gives free cash flow for 2013 & 2014 to average $1.33bn.

Let me put this into the context of a potential bidder.

If a competitor like say IBM $IBM where to come along and bid for NetApp and pay an assumed 30% premium it would pay $15.73bn. Strip out the 4.6bn in net cash and this comes to $11.15bn. Now assume NetApp generates $1.3bn in a year, this means that a year from now IBM would have effectively paid $9.85bn. If NetApp generates another 1.3bn in free cash the next year, the company would stand on an effective free cash flow yield of 13.1%. And none of this assumes any synergy effect of adding their market shares together (both are in the mid to low teens) in order to get to something close to EMC $EMC market share.

Attention will obviously focus on IBM because the other two leading storage players, Hewlett Packard $HPQ and Hitachi, are not exactly in a position to go out making acquisitions right now. However, another potential suitor is Oracle $ORCL  perhaps NetApp’s partner Cisco Systems $CSCO? Oracle $ORCL is interesting because it has the cash, an acquisitive nature and complementary products to storage solutions. Oracle is a long time partner and Larry Ellison is on record as thinking buying NetApp is a possibility.

If all of this sounds too good to be true, then it probably is. There are a lot of questions to be answered about NetApp’s competitive positioning and no one (investor or business acquirer) wants to buy a business in decline.

How Where the Latest Results?

As Einstein pointed out, it’s all relative isn’t it? In the previous results NetApp had given guidance which was horribly below market estimates and the stock got hit hard. It guided towards a midpoint with a 15% sequential decline, when the traditional decline to fiscal Q1 is around 10%. Moreover it declined to give full year guidance either then or at the analyst day in June. Europe, global public spending and a weak financial vertical were all blamed and visibility was seen as low. Now that is how to downgrade expectations! Estimates were slashed.

Of course, when you have downgraded expectations it is that bit easier to beat them. NetApp duly came in with the 15% sequential decline in Q1 but beat market estimates on EPS. Furthermore, I note that IDC Storage Tracker had NetApp taking market share over IBM in the last quarterly report given in June. Indeed, the guidance that NetApp gave for Q2 was for a much more normalized sequential revenue movement. These are all good signs and analysts are generally positive about the launch of ONTAP 8.1 and ramping of growth in other areas.

On a more negative note, product revenues were down 7% and as this is the key to future growth, cautious investors might want to see some stabilization in these numbers before piling in. In stark contrast to NetApp, EMC reported product sales up 4.4% on the year and up 3.6% sequentially. It’s hard not to conclude that EMC aren’t taking market share and it will be interesting to see what HP reports in its storage segment.

Where Next For NetApp?

This is definitely a stock for value investors with a stomach for risk. The reduction in guidance in the last quarter took everyone by surprise but to be fair, NetApp hit the revised guidance so it’s reasonable to expect it to do the same in the next quarter. The evaluation is cheap and if NetApp can demonstrate a bottoming out of product sales then I suspect it will be higher in future. Definitely one to watch.

Cisco Becomes a Value Stock

Tech investors have learned to brace themselves for Cisco $CSCO results, so it was a pleasant surprise to see such a positive reaction. My take on the results is that they read quite well for the technology market but less positive for Cisco itself. However, in terms of Cisco as an investment I think the outlook just got better. The company is doing the right thing in accepting its slowing growth trajectory and now sees itself firmly as a value proposition. It's usually a good thing when investor and management perceptions are aligned.

In summary, I think there are a lot of key takeaways here for other tech investors.

Enterprise Spending Comes Back but Not in Cisco’s Core Markets

The wider tech market got really spooked at the last set of results when Cisco talked of broad based weakness and reported enterprise sales down 1%. This was supposed to be the area of relative strength in the economy so the market reacted badly. However, enterprise spending saw a 6% rise in this set of results with the weakness in service provider revenues (down 1%) coming as no surprise to telco watchers. I don’t think that enterprise spending was anything as weak as implied by Cisco’s previous results and the evidence is now here to support that view.

There is also evidence to suggest that Cisco’s core markets remain challenged while other parts of its revenues are faring much better. To demonstrate this here is a graph of the latest results by product line. Note I have excluded data center growth for the sake of clarity, even though it is the fastest growing division. Also note that the product divisions are arranged in terms of size from left to right.




Clearly we are seeing slowing growth in the core markets of switches and routers and the next two largest divisions are both in negative territory. We can see the relative importance of these divisions in a breakdown of Q4 revenues.






The top four product lines account for 65.4% of revenues and aggregating them produces a 1.4% decline in revenues.

So what is going on?

Cisco Gives a Mixed Outlook

Essentially I think that telecommunications carriers have slowed spending this year. I’ve discussed this at length in an article linked here. AT & T is expecting spending to rise in the second half but Verizon Communications $VZ continues its drive to reduce capex/revenues. There is a sense that Verizon has largely completed its big network rollout and it is gearing itself to utilize its network in the next few years rather than expand it.

In addition, a Chinese rival to Cisco (ZTE) recently downgraded its outlook for China carrier spending. Competitors such as ZTE and Huawei are increasingly threatening to grab market share from Cisco in switches and routers and with their domestic situation worsening, it is reasonable to expect them to get more aggressive in North America. Indeed, Cisco CEO John Chambers was clear in his estimation that Cisco is responding to competition and winning. So far, so good. Nevertheless, the outlook in Cisco’s core divisions doesn’t look great and there is a limit to where cost cutting and price reductions can get you.

Moreover, question marks need to be raised about the collaboration division and in particular the purchase of Tandberg Television. The 7.8% decline in revenues is not a good sign. Even worse, it is in line with what key competitor Polycom $PLCM have been reporting which suggests that the industry is weak. I’ve discussed this industry in an article linked here. Simply put, videoconferencing and ‘telepresence’ are solutions looking for a problem right now. Companies don’t invest in expansionary projects when economic growth is slowing.

On a more positive note the wireless, security and data center spending are all doing fine. Going back to the telcos, there has been a pronounced shift in spending in recent years from wire line to wireless spending and based on the large service providers commentary I would expect this to continue. This is good for the companies like Aruba Networks $ARUN that specialize in mobile technologies.

As for security, I think there is clear evidence to suggest that spending here is holding up and Cisco is confirming this. The recent results from IT security company Fortinet were pretty good and the recent IPO of Palo Alto Networks $PANW has been warmly received by the market. I think the sector has further to run and evaluations don’t look stretched.

Turning to Data centers, spending has also been extremely robust this year and it’s interesting to contrast the capital expenditure plans of data center companies like Equinix with that of the telco carriers mentioned earlier.

Where Next For Cisco?

The dividend hike and the declaration that it wants to return 50% of free cash flow to shareholders in future is a good move. It is an implicit recognition of the fact that growth is slowing and investors want to see the value released by the management. This is fine because it puts the management in tune with how many investors view the stock.

Growth prospects in the core divisions look somewhat difficult in the near to mid-term but the periphery activities are suggesting that other areas of technology are holding up well and the return to growth in enterprise spending is a major plus. We know government and European spending will be weak for a while, so any good news on enterprise spending is warmly received. I think this report is a positive all round but perhaps more for companies in the areas of technology that Cisco is reporting growth in than Cisco itself. From an investment perspective Cisco is now doing the right things in order release value.

Game Over for GameStop?

GameStop $GME rallied after a recent set of results. I think the stock is so heavily shorted that any remotely positive news will see ‘weak shorters’ running for cover. However, on balance I do not see this report as suggesting any kind of fundamental turn around in the long-term prospects for GameStop. The business remains structurally challenged.

In this article I will discuss the reasons and explain the salient point that many journalists and analysts miss. Specifically, used video game software sales contribute over 50% of gross profits. If you want to analyze this company properly then start with this business segment.

Why Used Games Sales Matter

Of course it is much more interesting to talk about new game or console releases. Moreover, when you typically walk into a gaming shop the first you thing you notice is the new hardware and software on display. I doubt you think too much about the bucket or two of used games on sale. Well as an investor you should, because that is where GameStop makes the majority of its profits.




In the latest quarter, GameStop saw sales declines in all three major categories with only the fast growing ‘other’ category reporting growth. ‘Other’ consists of the company’s new digital and mobile channel offerings. The irony is that it is the growth of digital sales across the industry that is the biggest challenge to GameStop.

 A breakdown of sales growth in Q2.




The bullish argument in favor of GameStop is that footfall and sales are decreasing thanks to the late stage of the console cycle, but as the next generation of consoles are due in late 2012 and then throughout 2013-14 the company should see good earnings growth as new hardware and video games are released. I’m not buying this argument for three reasons.                                

Why I Don’t Believe this is Just about the Console Cycle

Firstly, the footfall issue isn’t just about the console cycle. It is about the inexorable shift to online sales in products that can be discretized. GameStop can see this in its own growth with its ‘other’ category. As for hardware, what is to stop it being sold through Amazon $AMZN? 

The second reason is that software manufacturers are shifting to delivering the games online via software as a service (SaaS) type offerings.  It has the added bonus of avoiding many piracy issues and protecting IP for the software makers. Therefore it is wrong to assume that the upcoming console cycle will be the same as previous ones.

The third reason is that – remembering how critical used video games sales are - the late stage of the console cycle appears to be a good thing for used game sales. Here is how sales have played out historically.




Note that as new hardware sales fall (in line with the console cycle) used video game sales go up. This is natural as gamers start selling off their old games due to usage and in anticipation of the next console.

Not Just Threatened by Digital

There are other challenges to GameStop aside from software digital sales.

  • Traditional retailers like Wal-mart $WMT and Best Buy $BBY are attempting to take market share in retail
  • Online merchants like Amazon are grabbing market share from in-store sales in hardware as well as software
  • GameStop is being forced into the 'long tail' of retail (superstores are selling the blockbuster titles), an area that is not its forte
  • Efforts to increase GameStop’s digital sales may reduce footfall and cannibalize its retail sales
  • GameStop’s inventory management with used game sales is unlikely to be as good as an pure online based play

Amazon is continuing to increase competition with GameStop. The advent of bar code reading smart phones means gamers can instantly compare prices and this will pressure margins at ‘bricks and mortar’ type retailers. GameStop could try and increase the sensory retail experience in the stores but hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.

However, the biggest challenge may come from how the gaming companies deliver files. With 4G and other ‘fat bandwidth’ provisions, it is now feasible for games to be sold online. This has a big advantage to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licenses to the original purchaser.

This helps avoid the kind of piracy that is rife in this form of intellectual property but it is also a significant problem for GameStop because it cuts it out of the sales chain.  Games publishers like Activision Blizzard $ATVI are shifting games to online play and the recent partnership with China'a largest ISP Tencent is a good example of this.

Where Next for GameStop?

Frankly, it’s hard to advocate buying a stock on the basis of it shifting sales into a sales channel (digital & mobile) that is in fact the primary challenge to its core business. However, if you buy the console cycle/footfall argument then there is a strong case for the stock being very good value. If like me you don’t, then it is hard to see how GameStop are going to be able to stem the declines.

One interesting aspect of the situation with such a heavily shorted stock is that the bears might end up delivering the stock into the valuation arms of a purchaser. Indeed Best Buy is now subject to a takeover attempt. However, I think the structural challenges at Best Buy are not as strong as with GameStop. GameStop has much to do.

Monday, September 24, 2012

Cree and the LED Industry Outlook

Cree $CREE recently gave a mixed bag of results although the market sent the stock sharply higher. This is probably due to the fact that -- for the first time in five quarters -- Cree beat market estimates and because the stock went into relief rally mode.  In summary, whilst the results were mixed for Cree, I think there is enough "color" in the numbers and in the surrounding commentary to produce some useful takeaways for the industry at large.

The "relief rally" argument carries more weight if you recall that LED demand has low visibility and is subject to short lead times. Throw in the weaker macro economic environment in the quarter and there would have been a high degree of variability in investor expectations for the quarter. No matter. Cree delivered and in doing so it demonstrated that it had largely cleared up the agency issues that dogged lighting sales for the company in the previous quarter.

On the other hand, the guidance for the next quarter was weaker than market estimates, LED prices continue to fall, markets remain extremely competitive, the uncertainty of China’s stimulus spending remains (not to say Cree’s opportunity to benefit from it) and industry capacity remains under utilized. 



Agency Issues, Lighting Sales and Gross margins

Returning to the previous quarter Cree suffered some weakness in lighting revenue due to major changes in agency sales operations. Essentially around 80% of Cree’s agents shifted around the types of products they were selling and this caused disruption. This was a disappointment because lighting appears to have the best prospects within the industry.

LED prices are falling and quality is improving so LED based lighting products are approaching initial cost parity with traditional forms of lighting. This is important because many customers have ignored the fact that LED lights offer higher quality lighting require less maintenance and offer quicker payback in favor of buying traditional lighting because the upfront cost is less. With regards the agency issue, lighting sales came back strongly and it seems that the issues are largely resolved.

Cree stated that it was targeting ‘pretty significant’ growth in lighting and if we look at what competitors (within the lighting segment) Acuity Brands $AYI and Hubbell Inc $HUB-A are reporting, this part of the industry looks set for strong growth. Acuity reported a 6.4% increase in sales in the last quarter and Hubbell reported a 10% increase. In my opinion, Acuity remains the best play in the overall sector. With Acuity you get exposure to the North American residential, commercial and industrial lighting sectors and I like the outlook for construction in the US. Hubbell is also attractive but this company is more cyclically exposed to industry.

One area where Acuity and Hubbell have an edge over Cree is that they have been selling traditional lighting products so shifting customers into LED based solutions will be relatively easier for them. For example, many developers already use LEDs for difficult to reach areas which are expensive to maintain. Now these same developers can look at LED solutions as being cost effective all over a development. And Acuity and Hubbell are there to tell the story.

General Electric $GE is also going to help spur demand and awareness via their LED bulbs which are available in outlets like Home Depot $HD. Indeed, its new LED bulbs are priced at a comparable cost to traditional lighting. This is only a small part of GE’s operations but there is no doubt that with its muscle behind LED adoption, the penetration rates will increase markedly.

Turning to gross margins, I always think this is the key to decoding when an inflection point has passed. Here are the reported numbers for Cree.




It looks like we are bouncing along the bottom, but Cree’s management did spend an inordinate amount of time on the conference call outlining how on an adjusted basis they were improving. That said the stated reason for the adjusted uptick was that it was due to factory cost reductions, new products and process improvements. In other words, it wasn’t really about the kind of supply/demand imbalance which will lead to a sustained increase in the future.

The key to longer term growth will come from a sustained pick up in demand and a new wave of adoption of LED technology in the way that flat screens or solar power drove previous booms. The other imponderable is China and its stimulus spending.



China to Spur Demand?

Cree did have a big street lighting win in the quarter and there is no doubting China’s commitment to utilizing energy efficient technologies like LEDs in a wide range of applications. However, there is also no doubt that the timing and willingness of China to invest is subject to uncertainty. A lot of projects tried to use domestic LEDS and they failed, whilst this implies that Cree –as a higher quality manufacturer- should see great benefits going forward, we need to consider a few things. China is not the US. It is not ruled by a democratic and liberal free market consensus handed down from generation to generation. They are Communists.

It strikes me that maintaining employment, developing export industries and supporting their own companies are the Government’s main focuses. So when it comes to street lighting it is entirely feasible that they will wait until they feel domestic producers can supply them with the quality they want and then the spending will start. Unfortunately, that scenario is not ideal for Cree.

One company that may fair better out of this is Veeco Instruments Inc $VECO which provides capital machinery to manufacturers. In the end, it doesn’t really care where or who is making the LEDS just as long as they are doing it with Veeco’s manufacturing solutions. Veeco’s key end driver is capacity utilization by its end customers and the company recently talked of a gradual order recovery in the second half of 2012.



Where Next For Cree?

A quick look at the sequential movement in revenues suggests that this was a decent quarter for Cree but if we take the midpoint of next quarter guidance for $305-320 million in revenues, it is only a 1.9% increase. This is low by Q1 standards and doesn’t inspire a lot of confidence.




Longer term, the LED industry is very attractive and in particular lighting looks set for strong growth. Cree’s stock is certainly not expensive on a cash flow basis and a strong case could be made for some upside potential but I would exercise a bit of patience before chasing the stock higher.

Home Depot Equity Research



One of the things that I often find with private investors is a sense of bewilderment at just what is going on with analyst estimates and target prices. This is rarely more prevalent than in businesses whose prospects are ultimately determined by a big macro theme like housing.

Let’s take $HD as an example. I think the US housing market is going to improve and gradually this will get baked into analyst estimates and targets. In summary, investors should not miss the opportunity to try and get ahead of upgrades.

The reason I think this is that analysts don’t make big macro calls. Instead they tend to prefer a linear join-the-dots approach based on a mix of historical precedents and derivations from industry statistics. I’m not knocking this approach -- I use it myself -- but if you do have a macro call to make, you can get ahead of the upgrades. In terms of housing, there is an article linked here that takes you through some of the recent positive data on housing. If you don’t share this view than read no further!

Home Depot Earnings

Full-year guidance was raised to GAAP EPS of $1.95 from $1.90. Superficially the numbers weren’t great but the pull-forward effect of unseasonably warm weather in the winter was always likely to skew the results somewhat. In order to demonstrate this here are the revenue and gross margin numbers by quarter.




The year on year growth comes in at a paltry 1.7%. No matter, by smoothing out the effect of the pull-forward in Q1 we can see that the underlying picture is a lot stronger.  Let's look at numbers by the half-year.

Note in the following chart that H1 2012 is growing at a 3.6% clip, which is pretty good. In addition in the first half of last year Home Depot had strong sales from roofing repairs thanks to hurricane Irene.




Furthermore, the commentary around the results was a lot more confident than it has been for a while. Home Depot, rather like its chief rival $LOW, has been reticent to call a recovery in the housing market amidst pointing out that its prospects were based on GDP type growth and whatever operational efficiencies they could squeeze out of their respective companies. This is a sound approach and it encourages analysts not to pencil in overly optimistic assumptions.

A More Positive Outlook on Housing

I detected a change of tone in the conference call for two main reasons.

Firstly, the company was keen to emphasize that whereas previously it had seen its growth as correlating with overall GDP growth -- which most forecasters have as slowing -- now it is seeing housing as a "bit of a bright spot." Indeed housing is back to being a positive contributor to GDP growth. Moreover, management stated that it saw signs of "stabilization" in the key Florida and California housing markets and gradual improvement overall in housing.

The second reason is that the more discretionary items seem to be doing better.  For example d├ęcor, kitchens, baths, flooring and plumbing were called out as outperforming while garden and building materials were down. Moreover the last two categories were down under plausibly mitigating circumstances. The drought has held back gardening sales and building materials were up against tough comparisons following the hurricane last year.

Given the strength in the tools category it was somewhat surprising to see Stanley Black & Decker $SWK negative on the day although the market may not like the European exposure.

Essentially, the core of Home Depot performed well and I think this is confirmed when we look at what Lowe’s reported in its last set of earnings.




I think there is more to come from the home improvement stores.

Where Next for Home Depot?

The company is a cash-generating juggernaut and the stock remains cheap. Trailing free cash flow generation of $5.1 billion is a testimony to the underlying strength of Home Depot and if you buy the story of a housing market recovery it would not be unreasonable to see this stock better priced with a $60 handle.

I think the stock remains attractive. As we have seen from 2006 onwards, housing markets take a long while to finish changing direction and at the moment we seem to be in the early stages of a slow but gradual recovery phase. There is still time to get in before analysts start upgrading.

Sunday, September 23, 2012

Which Stocks are Hot in the Food Sector?

Theoretically the private label food manufacturers should be one of the great winners out of the new retail reality. However both the main listed plays Treehouse Foods THS and Ralcorp Holdings $RAH are down substantially this year. Go figure! Unfortunately, there are many moving parts to their business and the food retail industry is in a genuine state of flux right now. So what is going on and what are their prospects going forward?



The New Retail Reality

The US seems to have fallen in love with frugality and deleveraging. Over consumption is definitely off the table. Customers are not only trading down; they are buying food in smaller packages and changing where they shop by moving away from the traditional supermarkets and grocers towards alternative channels, such as the dollar stores, discount stores and, interestingly, specialist shops like Whole Foods.

I make the last point to highlight that this isn’t just about trading down. There is a curious kind of bifurcation going on here. The brands that are doing well are those at the premium end and those offering unrelenting value, particularly those sold through anything containing the word ‘dollar:’ Dollar Tree, Dollar General $DG or Family Dollar $FDO.

As such, private label is also doing well. Not only do they tend to be cheaper, but retailers are increasingly differentiating their product offerings within private label, in order to capture different segments of the marketplace. Again, the premium brands and category leaders are doing fine but it is the second to fourth line brands within a category that are suffering the onslaught of the growth of private label.

In addition, food costs have been rising in recent years and the consumer has been demonstrating that food is, after all, not a price inelastic good. Prices go up, consumers consume less and woe betides the company that tries to hike prices in front of its competition. The golden equation of the new retail reality is prices up=volumes down, and then let’s hope you get lucky on margins.

It’s time to confess. I lied. It's actually not new. We have seen this before: After the reunification of Germany, the economy fell into a period of slower growth as the West accommodated the East. One of the consequences of this was that the German consumer hankered down and started shifting to discount stores and it is no surprise to see that Europe’s leading discount stores emanate from Germany, namely Aldi and Lidl. Before you ask, both are private companies.

Turning back to the US, here is how Treehouse demonstrates industry forecasts for the potential growth in private label food and beverage.




So why aren’t the private label companies doing better?



Changes Turn and Face the Strain

Treehouse recently lowered its full year adjusted EPS guidance to $2.75-2.90 from a previous forecast of $3-3.15 amid plans to shut down a soup plant early in 2013 and then a salad dressing plant later in the year, while Ralcorp recently said it would be consolidating its business. Both stocks are down sharply this year.

The explanation comes if we understand that these businesses are also subject to change and as consumers shift to alternate channels they will need to adjust who they sell to. This is somewhat of a challenge for private label manufacturers because they suddenly realize that the contract they signed with a previous store is not going to be as profitable as they might have hoped.

In a way this highlights one of the difficulties with these companies. They are subject to the strategic and operational considerations of their clients, and if they don’t want to sell or promote a certain food product anymore than Treehouse et al will just have to eat it while they start anticipating taking a hit on the inevitable restructuring that will follow.



Soup Wars

Moreover, as times and prices change so do consumer tastes. One area that is proving particularly tough is soup, and investors in Heinz $HNZ and Campbell Soup Co $CPB need to pay attention to what Treehouse is saying here. The category seems to be in decline, and the closing of its soup plant portends further problems for the product. As ever with tough end markets, the protagonists start fighting ever harder for a larger piece of a smaller pie. As such, price competition is heavy and Treehouse has lost a lot of work with a key private label customer in recent times.

To their credit, Heinz and Campbell are innovating with new flavors and recipes, but it just looks like a difficult category to be in and I note that Heinz has previously remarked over the issue of smaller packaging and the growth of discount retailers taking away traditional traffic for their products.



Where Next for the Industry?

The soup plant restructuring has hit Treehouse’s forecasts for this year and remains a salutary reminder that the industry remains in flux. Last year it was pickles and this year it's soup. As for Ralcorp, investors in ConAgra can thank their lucky stars that the previous bid failed. Conditions look challenging at Heinz and Campbell but they both remain dividend darlings and the market has had time to digest their own going trends.

As for the dollar stores, I wrote about them at more length three months ago in an article linked here arguing that while prospects looked good, the evaluations were a bit rich. Since then, only Dollar General has outperformed the S&P 500 and the other two dollar stores are flat to negative.  I like these stocks, but isn’t the new retail reality about not overpaying for something even if you like it?

The challenge for Treehouse and Ralcorp is get their relative restructurings done in line with the way retail traffic is trending. If they can demonstrate this then I think end markets are favorable although cautious investors will want to see demonstration of this first. The food industry remains in flux as it adjusts to the changes.

CVS Caremark Equity Research Analysis

The market promptly sold off CVS Caremark $CVS even after it delivered a strong set of results. My suspicion is that a gang of investors were simply waiting for a pop on the results in order to try and be ‘smart’ and sell out in order to monetize the appreciation in the share price following the Walgreen $WAG and Express Scripts $ESRX debacle. Now that Walgreen will restart filling prescriptions from September 15 from Express Scripts. The hot money seems to have flowed back into the stock and away from CVS. Here is why I think that viewpoint is a mistake and why CVS is a core holding for any portfolio.



CVS Caremark’s Recent Results

CVS beat estimates with net revenues rising 16.3% with retail same store sales increasing 5.6%. Moreover, the company raised and narrowed EPS guidance whilst confirming strong cash generation at the company.  Movements in guidance this year:




The stock still sold off!

I think the market now believes that momentum will shift back to Walgreen from mid September. CVS discussed the issue and stated that it believed that it would retain the ‘vast majority’ of scripts in the third quarter and at least 50% in the fourth quarter. I think 50% might be too low a figure and here is why.

Inertia. Simply put, the prescription business is very sticky and whenever I have seen the subject of inertia addressed in behavioral finance tomes, there is always an underestimation of how resistant people are to change. However, not everyone is blind to this fact.

Ever wondered why every single candidate to an incumbent politician uses ‘time for a change’ as part of his/her core campaign? It is because they know that overcoming inertia is a large part of their fight. Moreover, if you think that inertia and behavioral finance is mumbo-jumbo then consider the insurance industry. The whole industry is structured around behavioral finance.

Ever wondered why new customers get more favorable rates than existing customers in terms of car insurance? It is because of inertia. Of course customers could en masse just keep switching for the cheaper deals, but human beings are hard wired to pay a premium for the ‘benefit’ of inertia. And the insurance industry is all too happy for you to pay it.

That said, CVS is undertaking a whole series of measures including advertising, promotions and data analyzing the new clients with a view to ensuring they stay. To go back to the car insurance analogy, the whole Walgreen/Express Scripts debacle was like running promotions in order to gain new customers without actually having to pay for it. A very nice scenario. I think CVS could surprise on the upside with customer retention in the second half.

No matter, the stock has a whole host of other mid and long term profit drivers which makes it extremely attractive.



CVS Caremark’s Profit Drivers

 I think CVS shareholders can look forward to a number of positive catalysts for the stock in future years.

  • Demographics. An aging population will require more prescriptions and CVS is the leading player in  the Medicare Part D prescription drug program.
  • Digital capabilities will allow then to monitor and profile customers better in order to personalize an offering
  • Private label penetration is intended to increase from 17% to 20% and these products typically come with higher profit margins
  • Margins are likely to increase as the patent cliff causes higher adoption of generics
  • Expanding store brands from just being strong in consumer health
  • Growth created by offering a ‘one-stop’ service by being a pharmacy benefits manager (PBM), a retail pharmacy and running a retail clinic
  • Cash flows set to expand rapidly

CVS writes over 20% of the PBM retail scripts in the US and on the retail side has around 7,300 pharmacy stores. It is the leader in the ‘minute clinic’ sector with over 600 locations in operation. It is the confluence of this triangle of operations that differentiates CVS from the competition, of which there is plenty.

Not only is Walgreen a strong competitor in retail but there is also the struggling Rite-Aid $RAD and the ubiquitous name of Wal-Mart $WMT is in the fray too. The latter is a formidable foe but CVS is differentiated via its overall offering and Wal-Mart would have to invest significant time and resources in aping CVS’ offering or in digitally analyzing the customer base in the way that the specialist operators can. In fact, CVS outlined plans to further differentiate itself by expanding the number of minute clinics from 60 to 1,000 by 2016.

The demographic argument is well understood, but I want to focus on a less discussed issue. Everyone knows that aging demographics will create political and financial pressures on health care. However, CVS is likely to be a beneficiary. Private label or store brands tend to be higher margin and companies that make them such as Perrigo $PRGO are set to benefit. Perrigo is attractive in its own right, but it currently trades on 29x earnings and an EV/Ebitda of nearly 17x  whereas CVS trades on 16x and 7.8x these metrics respectively.

In addition, the increasing use of generics is beneficial to margins. Whilst generics may reduce overall revenues, they tend to be higher margin for the retailer as the pharmaceutical companies take a huge portion of the profits for their patented pharmaceuticals. Therefore it is in the interests of CVS and Walgreens to expand generics sales. Indeed, CVS mentioned that operating profit in the retail segment is now expected to be at the high end of prior guidance.



Where Next For CVS?

In my opinion it pays to ignore the market noise. Forget the ‘smart’ traders who think that investing is all about trading in and out on what the street thinks. The company has just told you that it expects to generate $4.6-4.9 billion in free cash flow this year and $4.7 billion each year from 2011-15. This equates to around 7.2% of its enterprise value. Furthermore, the stock looks like a great value as it is set to defensively grow earnings in the teens.

Granted, there are always political risks with this type of stock, but there are always political rewards too. The public wants more in store and generic drugs in supply and they won’t complain if prices go lower even if CVS is making more margin and profitability out of them. In conclusion, the stock looks undervalued, I like the long term story and think there is more to come from this stock.

Saturday, September 22, 2012

5 Great Growth Stocks


Despite some good moves lately I think this market still hates technology stocks. In a sense I can understand why; if we are headed towards a global slowdown then a cyclical sector like enterprise technology will surely get hit disproportionately. Nevertheless, investing is about balancing risk and reward. It is all very well loading up your portfolio with a collection of defensive stocks on high teens PE ratios but a balanced approach should include some growth kickers and right now some of these stocks are looking like good value. I want to discuss a few of them and also highlight a way to avoid a familiar evaluation pitfall.

Quite frequently with technology stocks, investors take a quick look at the PE and conclude that they look expensive so why bother investigate any further? For example, few could avoid wincing when taking a cursory look at the PE ratios on these stocks.


See what I mean?

However, I think that the PE ratio isn’t really the way to best judge these companies and the next time you come across someone who glibly argues to short one of these stocks based on the PE ratio alone you can send them a link to this article. There is more to investing than the PE ratio!

 

Equinix Stock Analysis

I’m going to separate data center service provider Equinix $EQIX from the rest because it has a different business model. What you are looking for here is the underlying cash flow generation at the company. Equinix builds out data centers and then it typically takes around four years to reach full capacity. Customers tend to be very sticky and much of the expansion in capacity utilization at a data center can be expected to come from existing customers.

I’ve discussed this issue at more length in an article linked here. The key metric to understand here is something called ‘discretionary cash flow’ which Equinix defines as ‘cash generated from operating activities less ongoing capex.’ In other words, this is the underlying cash flow generation if Equinix weren’t expanding capacity. For 2012 the company is forecasting $520-540 million, which roughly equates to 6% of its market cap or 5% of its enterprise value. For a company growing sales in the mid teens that is not expensive, however investors will want to keep an eye on gross margins. Any slippage will be an indication of over capacity in the industry and that could be the beginning of a problem

 

Cash Flow is King in Technology Stocks Too

Ever get bored of hearing how great Procter & Gamble $PG or Coca-Cola’s cash flow is? For some reason value investors usually like to focus on these sorts of companies when they discuss this metric, but why not with technology companies too? The usual counter argument is the idea of the factor of safety enhancing moat. However, consider that Riverbed Technology $RVBD has 50% of the market for WAN optimization and Citrix Systems $CTXS has a strong position in the fast growing Cloud computing segment. Check Point Software $CHKP has long been one of the top companies in the high end of IT security while Fortinet $FTNT is the global leader in Unified Threat Management (UTM). They all strike me as having pretty decent moats within their core markets.

Here is how cash flows are developing for these companies.


Frankly, they all look cheap. Fortinet looks a bit pricier but recall it is forecast to grow revenues at nearly 20% for the next two years.

 

Ok they are Cheap but What About Growth?

Here again there is a trap with just looking at earnings. With some tech stocks there are revenues and there are deferred revenues, and investors can only really see the underlying picture if they look at both. So what is the difference?

Essentially, technology companies sell products (hardware and software) but they also sell services which tend to be long term. So when a customer is taken on, the company books revenue for the products and bills for the full service contract. However, the full contract is not recognized as revenue until the service work is incrementally done. No matter, the work is billed. Therefore, investors can’t just look at top line revenues.

Moreover, the mix of sales between services and product sales, will dictate the mix between revenues and deferred revenues. For example, a company like Check Point is purposely increasing its software sales as it adds new solutions to its hardware. In order to get a better underlying picture I think investors should look at revenues plus the change in deferred revenues. This should help give a better picture for how the company is performing and what future cash flow growth to expect.

Here is how these companies are performing using this metric.


As you can see, Fortinet had a strong quarter and Riverbed looks like it is sorting out its sales alignment with its new products. Growth remains strong at Citrix and Check Point, even if the latter is reporting slowing product sales growth.

 

Where Next For These Companies?

On current trends, these evaluations look favorable and investors would do well to consider these stocks for the more cyclical parts of their portfolios. There is more to value (or in my case GARP) investing then just looking at the PE ratio.

Acme Packet Has Upside Potential


So why would Acme Packet $APKT be the next Riverbed Technology $RVBD and what exactly does that mean anyway?  Well, what I am referring to is the fact that Acme is faced with the same sort of investment quandary that Riverbed was faced with recently but for different reasons.

Both companies are seeing a weaker operating environment and both stocks had reported weak results. In both cases, some analysts were quick to conclude that there was some structural problem. In Riverbed’s case the WAN Optimization market was supposed to be saturated and growth would therefore slow dramatically. It didn’t turn out to be the case and the stock soared.  With Acme Packet, the core market of session border controllers (SBC) is possibly structurally challenged.  In the light of the recent results from Sonus Networks $SONS I thought it would be interesting to take a closer look.



Session Border Controllers Versus End to End Solutions

SBCs are networking equipment that control real-time session traffic at the signaling and call-control as they cross a packet-to-packet network border between networks or even between different portions of a network. Essentially they are a play on the convergence of voice and data networking, otherwise known as Voice over Internet Protocol (VoIP).  SBCs are necessary because they allow for session traffic to cross network address translation devices or firewall boundaries in real time.

The issue clouding the outlook is that Acme's core market of Session Border Controllers (SBC) may well be challenged by other vendors selling end-to-end integrated solutions to network management.  SBCs control signaling between service providers and when they (service providers) purchase end-to-end solutions, they can be seen as competing for network spending dollars, particularly when the end-to-end solution has SBC capability already built into it. For example a company like Ericsson can come along and offer an integrated solution which obviates the need for an independent SBC from Acme Packet or Sonus Networks.

 

So What Did Sonus Networks Say?

Sonus said two things.

The first is to reiterate what everybody should know by now. It is a weak capital spending environment for the service providers. I have discussed this issue in an article linked here. With regards the big two in North America, AT&T $T i saying they intend to spend more in the second half but this deserves some circumspection whilst Verizon $VZ is intending to reduce capital expenditures as a share of revenues. In fact Verizon has gradually lowered expectations for capital spending throughout 2012. There is a sense that Verizon has already spent significant sums on rolling out a network in previous years. Therefore it was no surprise when Sonus declared that only one customer accounted for more than 10% of revenues and that –of course- was AT&T.

The second thing was far more interesting. Trunking product revenue declines were guided even lower but, in essence, there is nothing wrong with the SBC market! In fact, Sonus claimed to be taking market share and made very confident growth noises. It claimed its SBC revenue was stronger than had been expected and forecast that by year-end SBC would make up 50% of its revenues.

With guidance that management described as being ‘conservative,’ Sonus predicted third quarter SBC revenue of $17-19 million and a significant increase in the fourth quarter to $22-25 million. The full year outlook was consistent with prior expectations. In other words no SBC slow down here.



What This Means to Acme Packet

The obvious inference is that Sonus is taking market share from Acme Packet and this may be the case. However, we mustn’t lose sight of the fact that Sonus was very positive about the overall SBC market. It may well turn out to be a sweet spot within telco spending and the long term story remains valid. The fears over a slowing in SBC growth due to end-to-end solutions grabbing their marketplace seem unfounded.

For Acme Packet this implies that its core end-market may not be as tough as we may have thought it to be. Perhaps the previous earnings miss really was a case of management being too optimistic in its guidance and maybe not factoring in the strong competition from Sonus which was fighting hard to make up for trunking product weakness. If so, Acme has the potential to come back just in the same way that Riverbed did when it announced results.

It is a tempting idea but there is a slight flaw. Riverbed was cheap on a cash flow evaluation basis before it reported while Acme Packet is not cheap by any measure that I care to consider. However, evaluations are, more often that not, subject to the conscience of the individual investor. So for those comfortable with Acme Packet at these levels, there could be a decent case for an entry point here.

Thursday, September 20, 2012

Nordstrom Equity Analysis




n the retail sector there are few companies whose management stands out from the rest. In the mid-market, I think V.F. Corp $VFC has outstanding management and at the higher end, Nordstrom Inc. $JWN also has excellent leadership. What these companies have in common is a drive towards adjusting to the retail reality by investing in things like e-commerce initiatives and changing their offerings in order to deal with the new ‘age of austerity.’ Consumers are getting ever more price conscious, and it is essential for retailers to adjust. In this article I want to focus on the latest results from Nordstrom and put them in the context of the ongoing development of the business and the retail landscape.

I previously wrote about the company in an article linked here which gives a good overview of the strategic direction being taken. I like writing these articles because in doing so, I can create good objective benchmarks for analyzing how companies are developing their businesses. I hope readers find them useful too. Going back to the original article, I outlined the correlation between Nordstrom’s revenue and gross profits and the growth in US net household wealth. We can monitor that in line with the overall economy and that profit driver is largely a strategic consideration.

For the detail of how Nordstrom is managing its company operationally, I previously highlighted a few things that I think investors should be looking for with Nordstrom. It’s time to run the check list.

  • Expanding the roll out of Rack stores, Nordstrom’s reduced price stores
  • Expanding online presence, including integrating the Hautelook acquisition and, expanding on the Bonobos partnership
  • Taking advantage of increasing credit quality via Nordstrom Bank and its customer cards



Nordstrom Rack Stores

In adjusting to a slower consumer environment, Nordstrom has been busy rolling out its chain of reduced price stores named ‘Nordstrom Rack.’ It opened 18 new Rack stores in 2011 and another 15 are planned for 2012.

In these results, Nordstrom confirmed the rollout for 2012 and outlined a plan to create 24 new Rack stores for 2013. A graphical depiction of the plans is shown here:




The Rack stores are a growing share of Nordstrom’s revenues and management talked of results that ‘exceeded our expectations.’ Moreover, plans are in place for significant investment in technology in these stores. For example, mobile point-of-sales devices are being added in order to improve the customer experience. In addition, management claimed that the extra Rack stores would only cause a minimal increase in capital expenditures and it appears that these stores are scalable.

Naturally, when any retail company increases the number of its reduced price stores, there is the risk of a negative effect on the overall brand. This is something to keep an eye on but, so far, the Rack stores appear to be complementary to the full price stores. Moreover, they should enable better inventory management in the future and they are a reflection of the times.

With initiatives like free shipping for e-commerce, Nordstrom continues to create a feeling of a high quality of service, and this sort of thing resonates with consumers. I’ve heard other retailers refer to free shipping as being effectively a discount, but they aren’t selling discretionary items to a customer base that values service. Nordstrom is.

Regarding the brand, Nordstrom stores are run along classic lines. There is little of the Abercrombie & Fitch $ANF approach about them. It’s not the kind of store that is going to create a fad out of pumping perfume, loud music and young fashion models in order to create the sensory experience and ambiance of a night club for its shoppers. Whilst that may be a good thing for Abercrombie & Fitch, it is not the sort of thing that would keep Nordstrom customers happy. Brand protection is paramount and Nordstrom does it well.

Check: It’s a thumbs up for the Rack plans.



Integration of Acquisitions and Online Presence

The Direct business saw sales increase by 40% in the quarter following a 44% increase in the previous quarter as the investments in e-commerce initiatives are starting to payoff. As for the acquisition integrations HauteLook’s sales increase for this year is forecast to be between 50% and 60%, and according to the management is running at or slightly above plan. It is reasonable to expect synergies to be created in terms of merchandising and infrastructure and investors have cause to be positive here.

Rather like VF Corp, expanding the online presence is important to Nordstrom, but I think they will find it easier. VF Corp is expanding online into new geographic territories while Nordstrom is a US centric company. In addition, cultural differences count for a lot in retail and the US is a far more mature and more e-commerce savvy region than any other. Nordstrom should find things easier.

That said, inventory growth overall was a little high in the quarter and it is expected to run a little faster in the near term--but don’t be alarmed. Although this sounds like a classic case of working capital difficulties caused by management chasing sales in the short term, there are two plausible reasons. First, inventory ran up because the company was preparing for the anniversary sale (which fell in fiscal Q3 this year so is not in the Q2 results) and because of the Rack expansion plans. If you open new stores you have to have something to sell in them!

Check: The acquisitions are bedding well and the e-commerce initiatives are driving strong growth and creating a differentiation from other stores via the free-shipping policy.



Credit Card Revenues and Metrics

Credit card revenues only made up 3% of revenues in the quarter so why am I obsessing about them? The simple reason is that the metrics around these revenues are a good indication for the wider economy and for trends within Nordstrom’s customer base. The news is good.

Annualized net-write offs as a percentage of average credit card receivables decreased to 4.8% from 7.2% last year and 30 day delinquency rates on credit card receivables were as low as 1.9%.

In case you haven’t heard it yet, American households are really cleaning up their balance sheets. While this is creating some severe price resistance within consumer goods, it is also producing an environment of slow but sustainable growth. It is up to the retailers to adjust to it. As we have seen recently with Coach $COH, this aspect is causing competitors to try to grab market share in new territories. I suspect Nordstrom has more flexibility than Coach. The latter is trying to protect its brand offering of ‘affordable luxury’ while Nordstrom can shift its merchandise offering to the new reality of what consumers want, while continuing to offer them a high level of service.

Check: Credit card indicators are suggesting that the consumer is in shape to start to expand discretionary spending and Nordstrom is making the right moves

Monday, September 17, 2012

McDonalds Equity Research

Donald Rumsfeld once memorably outlined his treatise on metaphysics in his known/unknown speech. Alas Wittgenstein was not around to appreciate it, but allow me to plagiarize and describe the recent same store sales numbers from McDonald’s Corp (NYSE: MCD) as being an unkown unknown. All three major regions comparable store sales were down. In the US they were down .1%, Europe declined .6% and the unusually named APMEA (Asia Pacific Middle East) also declined a worrying 1.5%. Analysts were surprised, as were investors, and you can add a third group to the bemused party: McDonald’s management, because on July 23rd they were telling the investment community that July same store sales would be positive but less than the second quarter. I’m going to try out Rumsfeld’s metaphysical epistemology and see where it takes me. No one else seems to know what is going on here.



Known Knowns & Known Unknowns

Presumably McDonald’s has pretty decent sales monitoring technology in place so we can take it that the prediction of positive comps on the 23rd of July is accurate. If so, it suggests that there was a significant drop off in the second half of July. I think this is an important point because it suggests linearity. In other words, a trend is continuing its decline.

Management were keen to blame the macro economy and a worsening consumer environment. I’m sure there is truth in this. I research a lot of company statements, and it is clear that, for example, Spain has had a sharp drop off in the last few months, and I’m told Italy is following it. This is understandable but it neither explains the declines across all the regions nor the linearity within them. Moreover, McDonald’s is supposed to be the great defensive stock. A winner in the new age of austerity and trading down.

To graphically illustrate these points, here is a chart of comparable sales for McDonald’s.




Note how well McDonald’s did in the great recession of 2008-09. Sure growth slowed, but it didn’t go negative, and McDonald’s was a stock market darling in the period. It is therefore very difficult to pin the blame solely on macroeconomic conditions.

The last of our known knowns is revealed by looking at what its competitors are saying. In its last results, released on July 19th, Yum! Brands (NYSE: YUM) reported same store sales growth of 10% in China, 1% in the US and 7% in YRI (Yum Restaurants International) amidst reconfirming full year guidance. This is nothing unusual for Yum because its focus is on aggressive growth in China. A fact which many believe has caused them to drop the ball in the US. So overall it is not painting the kind of macro picture that McDonald’s is.

Nor is its rival that recently returned to the public markets, Burger King (NYSE: BKW), which reported same store sales up 4.4%. With regards to Burger King, I confess I am a bit skeptical in general about businesses sold off by private investment companies (even if they do retain a large share) that rely on franchising to drive growth.

Wendy’s Company (NASDAQ: WEN) reported a more modest system wide same store sales increase of .7% in Q1 for North America and recently reported a 3.2% increase for Q2. Chipotle’s (NYSE: CMG) recent revenue numbers missed estimates amidst talk of slowing traffic in North America. Unsurprisingly, the stock took a significant hit. Chipotle has its own company-specific niche to play in, but the numbers from Wendy’s, Burger King and Yum for North America were are all pretty similar. All of which make McDonald’s numbers so surprising.

So to recap, what are our known knowns?

McDonald’s comparable sales growth figures are trending down in a linear fashion. The economy is a factor but not as much as the company makes out. Competitors are executing better and are not talking so negatively about the macro-environment

As for the known unknowns, they are comprised of questions like: "To what extent the slowing trend is due to operational issues at McDonald’s?" "Did it expand too much too soon, and is now suffering the consequences of trying to wring revenue and earnings growth out of increasingly unproductive stores?"  "Moreover is this a company specific issue which suggests that its product lineup is stale and in need of a revamping?" "Did (now departed) Jim Skinner’s influence and drive start to wane as he prepared to hand over the reins?"



Where’s the Beef?

I think a clear picture is going to take time to come into focus. The evidence of 2008-09 demonstrates that it can generate growth even in a difficult economic environment. However, investors will need to watch the future commentary very closely in order to learn more of the root causes of this sudden decline.  If it is a question of too much expansion too soon then store roll outs might be scaled back. If it is product offering then more revamping is in order.

I can’t speak with the certainty of a Rumsfeld (few can) but I do think the evidence is pointing to a combination of weak end markets and a competition that just got better. My suspicion is that the competition has stepped up and is grabbing market share via promotions, sales and a more focused value offering. If so then, on balance, I think that McDonald’s can recover from here because these issues are largely matters of execution, but it may take at least a quarter or two to turn around.

Church & Dwight Research Analysis

So it turns out that Church & Dwight $CHD are human after all. After quarter after quarter of beating estimates and causing analysts to raise forecasts, the company disappointed. Q2 EPS was slightly ahead of market estimates but revenues were a bit light. In addition, the EPS guidance for Q3 was lower than market estimates at 58c vs. 61c. So is it time to give up on Church & Dwight?


Product Mix in Personal Care

In a sense it was merely more of the same. In the last quarter, management noted that the product mix of revenues in the personal care division was being skewed toward lower-margin goods. This trend continued in this quarter and was the main cause of the disappointment. However, management pointed out that July had begun well for the personal care division and that consumption had outpaced shipments in the last quarter. This is usually an indication of stronger growth to come. In addition, full-year EPS guidance was maintained.

The main problem seems to be Orajel oral care products, which are traditionally higher margin. Action has been taken and management sounds confident of a resolution to the underlying issues. New products are being launched and I would expect Orajel to make a comeback.


Competitive Markets Remain Competitive

Once you have taken in the full impact of the pearl of wisdom in the subheading, it will then be time to look into more detail as to what happened in this quarter.

Frankly, this sort of thing is inevitable in the fast moving consumer goods (FMCG) category. Competition is fierce and the macro environment is not particularly strong for the mass market. Church & Dwight is a relatively small player in the marketplace that outperforms via a relentless focus on growing and defending its brands within niche markets of FMCG. It offers a significant amount of its revenue in ‘value brands,’ which benefit from consumers trading down.

I always like to compare it with its much larger rival, Procter & Gamble $PG. PG owns some classic brands and its long-term strategy is different. It is usually understood to favor retaining pricing during a downturn -- at the expense of some volume loss -- in order to benefit from not devaluing its brands, so when the recovery takes place it will see earnings leverage. It’s a beautiful idea in theory and it usually works in practice, but this time it really is different.

This recovery is a lot slower and more shallow than normal. As such, consumer behavior is changing. US consumers are trading down and they are shopping more at discount stores. Companies that try to take pricing are suffering volume losses. Even an extremely well run and innovative company like Colgate-Palmolive $CL saw volumes decline in North America when it took pricing on certain product lines.

The result is a highly competitive market where promotions and discounting are tactically used in order to generate market share gains and favorable sales mixes. The old strategic ways aren’t working anymore for a company like PG and so it is reacting and stepping up pressure with categories such as laundry detergent.  Church & Dwight felt the pressure in this category in the last quarter and I note that Clorox $CLX also declined on these results in an otherwise strong day for the market. Clorox has had administrative issues to deal with in the past and now looks set to face stronger competition from PG.


Great Companies or Great Investments?

You should always look for both and for the last few years the household and personal care sector has offered both, but investors are entitled to ask how much longer the market will give high teens to low 20s PE multiples for companies growing earnings in single digits.

Church & Dwight has usually commanded a premium over Clorox, PG et al because its cash flow conversion is very strong and its management has a track record of doing what it takes to get growth. The new products in personal care due to be released in the second half, as well as the commentary on current trading, suggests it can do it again.

It’s hard to argue that Church is not fairly valued right now, which means that it is likely to "do its earnings" going forward. No matter, the recent pull back could create a decent buying opportunity because companies with this kind of track record should not be taken lightly and the economy continues to move in Church & Dwight’s favor. Well worth watching closely particularly as the ultimate value creator could be that the company ends up being taken over by one of its much larger competitors.

Sunday, September 16, 2012

Housing Recovery Stocks

There are signs that the US housing market is making a slow but steady recovery, and if it continues the sector will be attractive in an uncertain global economy. Investors need to be careful to avoid exposure to the Chinese housing market and continued weakness in Europe; however, there are plenty of US centric opportunities out there. In this article, I want to give a few reasons why I think US housing is coming back and suggest a few names for further research.



Evidence that US Housing is coming back?

I’m not going to go into the theoretical argument in this article, sufficed to show some data which I think supports the case. All the data is sourced from the US Census Bureau.

First, Housing appears to be coming back.




Second, the data suggests that the supply of new single family houses is starting to get to low levels. Incidentally, the dotted line is the average for the period in question.




Note how it starts snaking up in 2006 as the bubble starts to burst. Interestingly, we are getting back to pre bubble rates.  I appreciate that this data doesn’t capture the shadow inventory of foreclosed homes, but the effect of this inventory will be felt on prices. And the latter appears to be recovering.




I’m going to stick my neck out and say that the recent dip in pricing is probably a consequence of the pull-forward effect of the unusually warm winter in the US. In other words, people may have gone house hunting a bit earlier. Moreover, while prices have risen before in the last three years, they weren’t accompanied by the kind of positive trending data we see in the previous two charts. Perhaps it really is different this time?



Stocks to Play a Housing Recovery

The house building stocks go without saying as an option, but I thought it would be interesting to look at some of the more derivative type names. Again, investors need to be discerning here and try to focus on US centric plays.

I’m a bit of a fan of Home Depot $HD. It has seen profits and margins rising even though its management refuses to attribute any of this to a housing market recovery. I think we need to take them at their word, which means that there should be upside potential here. Unfortunately, analysts do not always do that and they love the ‘join the dots’ mentality, which means the unusually warm winter encouraged a bit too much optimism earlier in the year. I have a detailed article on the subject linked here. No matter, the stock remains cheap on a cash flow basis and the dividend is useful too. Naturally, another option is its rival Lowes.

If you like the theme of buying into the home improvement retailers, then why not look at what is being sold in them? Stanley Black & Decker $SWK is a company I intend to look at very closely in future. It has a very large market share in hand and power tools for the DIY market in the US. Unfortunately, it has had to lower estimates recently due to currency headwinds, and it does have international exposure. However, any company in a favorable sector that is telling you that it expects to generate $1.2 billion in free cash flow (10% of its market cap) is worth a look!

Other stocks related to the home improvement retail sector are Fastenal $FAST and Pier 1 Imports $PIR. I’ve detailed both of these stocks at length so potential investors might find the following useful. Here is an article on Fastenal and an article on Pier 1.

For different reasons, I’m a bit concerned about both, but they may attract others. Fastenal has exposure to the industrial sector too, and it never appears to be a cheap stock, although its growth rates have been exceptional. As for Pier 1, this is a truly fantastic turn around story but I wonder how much longer it can go on. In addition, its internet strategy may well end up cannibalizing its own stores. But hey, I wrote that at the time of the original article. It then soared. So what do I know?

Another stock I like is Wells Fargo $WFC. It may not appear to be the most obvious choice, but this bank has been aggressively moving (organically and by acquisition) into the US mortgage market and I think therefore is a good play on housing. In addition to balanced portfolios it offers a good way to get exposure to the financial services industry while avoiding some of those firms whose interests are not necessarily aligned with shareholders. I only invest in companies that represent my interests, not those trying to game me in order to line their own staff's pockets. We own the company, not them. Here endeth the sermon!

Other options in the sector include something like timberland owner Weyerhauser or its rival Plum Creek Timber Co, although the timber companies are also exposed to other cyclical industries such as paper and packaging. Investors with a bit more stomach for risk may also like the look of Masco or Whirlpool, although the latter has extensive international operations.



The Right Time To Get In?

As the data in the charts above indicates, the housing industry has the turning radius of an oil tanker on ice. Note that the housing recession started in 2006, and it took a year or so before it significantly affected the wider economy and two years before it really hit home. These things take time to play out, and all the while you will have people willing to take the other side of the trade. This is the good news, because it should keep good value opportunities available. If you think that the housing recovery is tangible then many of these stocks look like good value, in my humble opinion, and it is not too late to get in.

Coach Losing Out to Michael Kors?

Coach $COH recently delivered results below market estimates and the stock took the equivalent of a violent hand-bagging from a demented harridan. The problem appeared to be limited to North America, where sales rose a paltry amount amidst strong competition and a declining market share. In comparison, international operations did fine. So is this a temporary setback or is there a more fundamental issue?



Coach Occupies an Enviable Niche

I’ve long been interested in this company for a few reasons. I’m fascinated by how it has managed to establish itself as a leading brand in Asia. I’m also struck by the marked cultural difference between US and European fashion brands. In general, US brands don’t seem to be able to exist while being focused on price, whereas European retailers are focused more on quality retention. In the US, if the price is right, the consumer will judge the quality. In Europe, if the quality is right, the consumer will judge the price. In terms of the luxury market, Coach is something of an anomaly and as a consequence has carved out a very profitable niche.

Its handbags are not of the quality of a Louis Vuitton or Richemont brand. Nor is it close to one of the leading Italian brands, or Burberry or even a small independent like Mulberry. However, to be fair, it isn’t trying to be. It operates in the middle ground, which analysts like to describe as "affordable luxury." The beauty of occupying this space is that you can drive margins higher by shifting production into China or Vietnam, etc. Any corresponding loss of quality or cache is fine as long as you compete on price. It is not the same thing for the leading European brands. Alas, only one who dates high maintenance women would really know so much about how these things work.

Speaking as one who dates high maintenance women, I can assure you that Louis Vuitton bags are bought strictly for their quality first and then price second. Coach bags are bought and used as everyday bags. All of which leaves Coach in an enviable position. It can expand margins via cost cutting (without driving customers away) and it can pursue its international expansion into the fast growing Asian market.



And Others Have Noticed

Unfortunately, it appears that others are gunning for this niche, and Coach’s problem is that it can’t really defend its market share on price (already relatively cheap) and innovation, and new product launches will likely trim its margins. In particular US mid-market brands like Michael Kors $KORS and Ralph Lauren $RL appear to be eating away at Coach’s market share. Kors is expanding its handbag sales and both these companies are of a similar standing to Coach in terms of consumer awareness and cache.

In the recent conference call, management cited increased promotional activity by competitors and a decline in traffic at its factory stores, which they believed was primarily responsible for the slowdown in North American sales growth.

Frankly, I think this is an issue and it might not go away unless Coach matches promotional activity. As I have tried to argue above, competing on quality doesn’t tend to trump pricing with the US consumer. That said, Coach has recently introduced the Legacy brand, about which the company seems very excited. However, it appears to be a more leather oriented suite of products. Of course, the margins on leather bags tend to be significantly lower than those of canvas (note how Louis Vuitton innovates with the canvas bags to drive sales) so I would expect some margin compression with the Legacy brand.

It’s not surprising that Coach’s CEO expanding the Legacy brand into non-handbag products such as jewelry, watches and scarves. These items traditionally have huge profit margins, but Coach needs to be very careful it doesn’t denigrate its brand.  With more than two thirds of sales originating from US stores, these challenges are significant.



Putting North America Aside

Otherwise, the earnings report was pretty good. China sales were up a whopping 60% and total company sales increased 13%. Coach is a very strong brand in Japan and sales were up 16% in constant currency. As is usual with luxury companies these days, Asia is the focus and Coach is committed to opening 30 stores a year in China. It also announced it would be buying the domestic retail business in South Korea from its current distributor. Indeed, the forthcoming fiscal year was described as being an ‘investment year.’ Much of which will be focused on Asia, but Coach is also expanding its men’s products sales and investing in e-commerce initiatives.

The e-commerce initiatives are not going to be on the scale of what a company like Nordstrom $JWN is doing, but then again Nordstrom does not have the issue of possibly competing against its own products within distribution channels. In plain English, this means Nordstrom will likely have more control over differentiating what is discounted online, whilst Coach needs to protect its brand overall.

On a more positive note Coach is highly unlikely to suffer the kind of faddish sentiment that seems to be affecting Abercrombie & Fitch $ANF at the moment. Sure you can dream up a marketing gimmick and pump perfume and loud music and customers in order to create a ‘retail experience’ and then sell them a product whose quality can easily be matched elsewhere.  This will work for a while, but as Abercrombie is finding out, you need to change the act if you want to keep bums on seats. No such issues for Coach.



Where to Next for Coach?

The stock is certainly not expensive and its management has a history of delivering. The initiatives all make sense and Coach remains a well regarded brand in some very fast growing international markets. The question is, under the heat of competition, just how strong is its brand in the US?

Moreover, is the age of the US consumer deleveraging and trading down going to erode margins? I suspect we have seen a sign of this in the latest report and cautious investors might want to wait a while before seeing how successfully Coach is reacting to the new competition trying to take its profitable niche away.