Tuesday, August 20, 2013

Is Beacon Roofing Supply a Buy?

With the housing market recovery ongoing, it’s natural for investors to look for construction-related plays. As its name suggests, Beacon Roofing Supply (NASDAQ: BECN) distributes roofing materials. The stock has had a great run over the last year with a 43% rise, but its latest results were disappointing. Is this dip a good buying opportunity? Let's take a closer look.

Is Beacon a defensive or a cyclical stock?

The answer to this question is “a bit of both.”

Beacon has plenty of recession-proof qualities that make it a genuine defensive-stock candidate for your portfolio. The company’s traditional exposure to new housing build is only around 20% (although it fell to around 10% to 15% after the last housing boom), because its main activity is roofing replacement and repair work. The latter obviously has relatively stable underlying demand (economic boom or bust, leaky roofs aren’t fun), but it’s affected by weather conditions.

Moreover, Beacon can generate long-term growth by consolidating a highly fragmented roofing supply industry. In other words, a lot of its end demand comes from factors outside the overall economy.

However, Beacon does have a cyclical kicker in the form of demand from new residential builds. First, its residential supplies tend to be more profitable, boosting Beacon's margins. Second, an increase in residential new build has historically led to new commercial construction. In other words, as new residential communities appear, the infrastructure around them will also get built. Finally, if residential demand improves, it should lead into increased demand in the industry, and overall pricing should improve as roofing contractors buy more materials.

In other words, Beacon is a stock with good long-term prospects, but also some good cyclical growth kickers in 2013. It’s not hard to see why the market has bid up the stock over the last year. So what went wrong last quarter?

Beacon disappoints with its third-quarter results

In short, Beacon’s luck with weather ran out. The company has had a couple of years of "favorable" weather (tornadoes, hailstorms, Hurricanes Irene and Sandy) to generate strong demand for re-roofing activity. However, weather conditions this year are shaping up to be less extreme than in previous years, at least according to the National Oceanic and Atmospheric Association.

Moreover, hailstorms and wet weather in the quarter significantly held back roofing activity, so contractor demand for materials was a lot weaker than Beacon had expected. A look at the industry confirms that conditions were tough. For example, building supply company, Carlisle (NYSE: CSL), disclosed on its conference call on July 23 that "the quarter did not grow as anticipated, as wet weather continued to impact the number of roofing days."

This was tough for Beacon for two reasons. First, early in the year, Beacon had made significant purchases of inventory in order to get ahead of price rises from its suppliers. It was looking forward to benefitting from increasing volumes and prices. Unfortunately, the 1.2% organic growth recorded in the quarter fell below its expectations, and it proved difficult to pass on any material price increases. In its conference call, Beacon disclosed that it managed to take 1% of pricing in the quarter, when it had expected to take more than 5%.

Second, as expected, its suppliers did raise prices, and consequently, Beacon suffered some input cost increases in the quarter.

Ultimately, a combination of weaker-than-expected demand and cost increases saw Beacon’s gross margins fall to 23.5% from 25.1% last year. Due to the difficulties in the quarter, Beacon lowered its full-year EPS guidance to a range of $1.50 to $1.60, from a previous range of $1.75 to $1.85.

A beacon of hope

While its lowered guidance is disappointing, the company does have some positive signs ahead.

First, according to Carlisle, the weakness in its roofing sales wasn’t because of weak underlying demand: “Our contractors continue to have heavy backlog comprised of both new construction and reroofing projects. Reroofing appears to have been impacted more than new construction.”

If Carlisle is right, then Beacon can look forward to better conditions in future quarters. Indeed, Beacon argued that its July sales were relatively strong.

In addition, one company that supplies roofing products, Owens Corning (NYSE: OC), gave a relatively bullish outlook for its second half roofing sales. It expects:

“... improved full-year margins versus 2012. We continue to expect the full year market shipment to be flat versus last year. Based on first half shipments, we expect higher volumes in the second half ...The U.S. housing market outlook continues to support improvements in new residential construction and modest growth in re-roof."

According to Owens Corning, roofing distributors are going to take higher volumes in the second half and, at the higher prices too. This is a good indication that Beacon will be able to pass on pricing more easily.

The bottom line

In conclusion, there is a good chance that Beacon will see better conditions going forward. Furthermore, investors should not fret too much over the difficulties in the current quarter, because it looks like a weather-related issue. On the other hand, the valuation does not look generous.

The best way to look at a business like Beacon is to accept that its return on assets will be variable (it can’t control the weather), and to try and buy it when its price/book valuation looks historically favorable.




BECN Return on Assets data by YCharts

The chart above indicates that Beacon is not a good value on a book value basis, at least compared to where it has traded at over the last few years. Despite its good long-term prospects, and the chance of some better trading conditions in the near term, investors should hold out for a better entry price.

Monday, August 19, 2013

NICE Systems Still Growing Strong

It’s been a volatile year for the tech sector, but one company's consistency has helped it stand out. Customer interaction company NICE Systems(NASDAQ: NICE) has managed to keep its guidance on an even keel throughout the year. Meanwhile, the company is gradually transforming itself from a hardware specialist into a big data play.

NICE Systems' latest results

Here's a brief summary of the company's latest-second quarter (Q2) results:

  •  Q2 revenue of $225 million, vs. internal guidance of $220 million to $230 million

  • Q2 non-GAAP diluted EPS of $0.61, vs. internal guidance of $0.58 to $0.64

  • Q3 revenue guidance of $225 million to $240 million

  • Q3 non-GAAP diluted EPS guidance of $0.56 to $0.66

  • Full-year guidance maintained, with revenues forecast at $940 million to $970 million, and EPS of $2.55 to $2.65

The Q2 numbers were bang in the middle of internal estimates, while full-year guidance held steady. In a year where so many other tech companies have warned or reduced guidance, this must be seen as a net positive. So why is NICE doing so well?

Reasons to be NICE

There are three key reasons why the company has been outperforming.

First, its solutions do not necessarily need a strongly growing economy. Essentially, NICE enables governments and enterprises to monitor and analyze interactions through call centers, websites, email, or even internal company interactions (for compliance, fraud or regulatory reasons).

Fortunately, these sorts of activities are equally relevant in a slow- or a fast-growing economy. In fact, in today’s cautious spending environment, corporations might be more inclined to maximize the potential within their existing customers, rather than chasing new ones.

Second, big data is only getting bigger. The explosion of data being created by social networking sites such as Facebook is creating a huge amount of awareness of the need for corporations to monitor and analyze customer behavior. This benefits NICE, because it may drive demand for its data-capturing hardware systems,  and also because NICE has the capability to sell data analytics solutions into its installed customer base. NICE calls these solutions “advanced applications,” and they made up a 50% of its new bookings in Q2.

Moreover, the company has been proactive in developing its offerings, thanks to a deal to incorporate IBM's (NYSE: IBM) world-leading analytics solutions within its services. In exchange, IBM gets to tap into NICE’s installed customer base (particularly its key financial customers).

You can see the gradual shift in NICE’s revenues by looking at product sales vs. services sales.




Source: Company accounts.

The third reason is that a lot of NICE’s solutions are not really economically aligned. For example, its financial crime & compliance solutions increased an impressive 7% in Q2, and contributed 15% of revenues. In addition, its security based revenues made up 20% of revenues in Q2.  In other words, 35% of NICE’s revenues are coming from sectors whose end demand is not really cyclical.

In addition, on its conference call, NICE outlined that the Dodd-Frank act will likely increase financial companies' enforcement and regulatory activity. This is good news for NICE, because financials are likely to buy more compliance and monitoring solutions as a consequence.

What the industry is saying

In general, the rest of the data capture and analytics industry has been reporting good market conditions. For example, despite reporting a mixed set of results in July, IBM generated 11% growth from its business analytics solutions. Meanwhile, NICE’s perennial rival and potential merger partner, Verint Systems (NASDAQ: VRNT), maintained its full-year revenue guidance of 6%-7% at its results in June.

Verint is a good potential partner, because its strength is in security and government-based work, while NICE is stronger with enterprises (particularly financial companies) and call-centers. Despite reducing its guidance for its European operations, Verint’s overall view on the first quarter was one of “particularly strong business activity relative to the first quarter in the year.” In addition, Verint reported similar business trends to NICE, with its analytics solutions generating faster growth than its legacy capture systems.

Where next for NICE?

For the reasons outlined above, NICE has good chances to hit its full-year guidance of around $2.60, putting the stock on a forward P/E ratio of around 14.4 times earnings. That looks cheap for a business with good long-term prospects, and relatively defensive growth properties.

NICE has a tradition of good cash flow generation, having generated an average of around $125 million in free cash flow over the last three years. This figure represents around 6.2% of its current enterprise value. In other words, there is plenty of scope to increase its dividend yield of around 1.4%. Furthermore, the shift towards more services revenues is likely to increase cash flow generation in future.

In conclusion, the stock represents a good way to get exposure to big data spending, and is a good value proposition for more cautiously minded tech investors.  It could also see some upside if the market reevaluates it as a big data play.

Sunday, August 18, 2013

CVS is Still a Buy

Sometimes the best thing to do in investing is nothing. In the case of the pharmacy chains CVS (NYSE: CVX) and Walgreen(NYSE: WAG), this policy has been a winning one over the last year.

Their stock prices have risen by 34% and 39.4% respectively in that period, mixed with short downward moves as investors looked to cash in. Meanwhile, both companies continue to generate huge amounts of cash flow, and according to analyst estimates, they're set for double-digit growth in the near future. The "good news" is that the market marked down CVS following its results, and this looks like a good entry point for long-term investors.

CVS’s optical illusion

The stock market apparently lives in a "shoot first, ask questions later" world, since CVS seemed to fall almost at the moment that its management updated guidance.

CVS adjusted its 2013 EPS forecast to a range of $3.90 to $3.96, from the previous $3.89 to $4.00.  Eagle-eyed readers will note the midpoint has been lowered to $3.93 from around $3.95. Before you rush to pull the sell trigger, you should consider a few things.

First, CVS outlined that it has had to delay share purchases this year while it reached a settlement with the SEC over previous actions. In other words, the ‘S’ bit in ‘EPS’ is larger than it was expected to be at this stage in the year. Moreover, CVS outlined that the timing issue could reduce full-year EPS by “as much as $0.04.”  In other words, it could reduce earnings by more than it just lowered its mid-point by. In this sense, CVS just raised guidance.

Secondly, on the conference call, CVS argued that its key target of retaining 60% of the customers gained following the Express Scripts/Walgreen debacle was well on track. Management declared that it was “very confident” that at least 60% would be retained in 2013, and this augers well for the next few quarters.

Thirdly, all of its long-term growth prospects remain in place. The trend towards increasing generic drug sales continues apace, even if last year’s strong growth will make the second half’s comparables a bit tougher for CVS.  CVS and Walgreen are both key beneficiaries of this trend, because generics tend to come with higher margin for the retailer. However, though they slow revenue growth due to being more cheaply priced.

Another positive trend-welcomed by cost conscious consumers is each store's increase in private-label brands. In addition, CVS and Walgreen are both keen to personalize offerings by using the huge amounts of data that they both have on their customers' spending habits. In particular, Walgreen is trying to increase retail traffic by using its balanced reward card program.

Still a good value

Analysts will spill a lot of ink debating the merits of Walgreen vs. CVS, but frankly, both stocks look good value on a historical basis. There is no rule of investing that says you can’t hold both. Both stocks have seen some dramatic increases in cash flow generation as the long-term benefits (discussed above) start to drop into the bottom line.

Readers should note that  during the time period in the following chart, Walgreen lost some of its business because of the Express Scripts impasse.




WAG Free Cash Flow TTM data by YCharts

In addition, don’t let CVS’s trailing free cash flow numbers fool you. In its conference call, management reaffirmed guidance for $4.8 billion to $5.1 billion in free cash flow for 2013. This figure represents around 6% of its current enterprise value, which suggests there is plenty of room to grow its dividend.

The bottom line

In conclusion, the market has somewhat overreacted to these results. Despite its strong rise over the last year, CVS still looks like a good value. Long-term demographic trends favor the drugstore industry, and there was even some noise about CVS following Walgreen’s lead in terms of making substantive international investments. There is plenty of upside potential in the sector, and it represents one of the safer ways to invest in health care right now.

You rarely find stocks with double-digit growth prospects and high free cash flow yields, but when you do, it usually makes sense to pick some up.

Friday, August 16, 2013

Sirona Dental Systems Looking Good

The market decided it didn’t initially like dental equipment maker Sirona Dental Systems(NASDAQ: SIRO) third-quarter results, and subsequently marked the company down by more than 5%. Investors may well have reacted negatively to the margin declines in each of Sirona’s business segments, but that shouldn’t detract you from its positive long-term prospects. In fact, here's why now looks like a good time to pick up the stock.

Sirona generates growth

I’ve described Sirona as a "dental equipment maker," but this shouldn’t make you think of it as a boring low-growth company. On the contrary, it’s actually a proprietary technology company set to generate long-term growth, primarily thanks to its revolutionary CEREC CAD/CAM system. The system allows for same-day teeth restorations, and generates significant cost savings for dentists. It also allows patients to be treated more quickly, and with less intrusive procedures.

While the benefits of the system are obvious, the CEREC system’s up-front costs can be prohibitive to emerging-market customers. Indeed, it is noticeable that much of the strong growth in the third quarter came from Sirona's U.S. and German operations. Constant currency revenue growth was up 15.7% overall with U.S. growth cited as being up a whopping 28.8%.

Furthermore, Sirona stated in its results presentation that international sales were up 10% in constant currency, “led by an exceptionally strong performance in Germany.” Going forward, it will be challenged to continue generating growth in the U.S. and Germany, while finding a way to increase penetration rates in other markets as well.

Sirona’s growth plans

Sirona’s plans to increase market penetration include its ‘CAD/CAM for Everyone’ initiative. The latter involves trying to segment the market by offering a range of products and solutions. In fact, Sirona has 25 new products in its portfolio to sell through to customers. Dentists can buy the solution best tailored to their needs, at a price point that they find comfortable.

A big part of the plan involves training Sirona’s distribution partners, principally Patterson Companies (NASDAQ: PDCO) and Henry Schein (NASDAQ: HSIC).

Patterson is Sirona’s exclusive distribution partner in the U.S., and it’s notably bullish on its prospects to generate growth by distributing high-tech products such as the CEREC system. Patterson needs to focus on these areas, because its core equipment sales to dentists have been slowing. Dentists remain cautious in their spending habits.

Sirona’s chief European distributor, Henry Schein, has similar plans. Low growth in its dental consumables sales is spurring it to focus on selling Sirona’s systems in Europe. In summary, both distributors are a large part of the ‘CAD\CAM for Everyone’ plan, and with their distribution expertise, they should be able to sell the new products on successfully.

Margins declining, product mix responsible

Unfortunately, gross margins declined in every one of Sirona’s segments.




Source: company accounts.

However, it’s not time to panic.

Firstly, CAD/CAM margins were down thanks to increased sales of the new Omnicam camera system. Incidentally, you can learn about the differences between Omnicam and Sirona’s older system, Bluecam, in a video linked here.

Omnicam’s ticket price is higher than Bluecam, but its costs are, too. In its conference call, Sirona outlined that while gross profits are similar for the two products, margins are lower on Omnicam because of those higher costs. In other words, the acceleration in Omnicam purchases is likely to create profit growth at margins' expense. That's not a big deal as long as profits are still growing strong.

Second, margins in imaging usually bounce around for Sirona, so the decline this past quarter shouldn't be worrying. It owed to changes in the product mix. Moreover, despite the decline in Sirona's treatment center margins, they remain above its targeted figure of 40%.

And finally, potential investors need not worry too much about small movements in margins with treatment centers and instruments sales, because they only make up around 20% of gross profits at Sirona.




Source: company accounts.

Where next for Sirona Dental?

In conclusion, the margin declines at Sirona are really not a big deal, and the company's long-term plans make good sense. Sirona’s distributors are keen to push its new products, and with CAD/CAM penetration rates in the low teens in the U.S. and low-single-digits internationally, its long-term growth prospects look favorable. Sirona’s technology presents a rare way to get exposure to a secular growth trend in a stable industry like dentistry.

Sirona now trades at a relatively cheap valuation compared to where it has been over the last few years.




SIRO Price to Cash Flow TTM data by YCharts

The market reaction looks overdone, and this could be a good time to take a position. Analysts have low-teens growth penciled in for the next few years, and the stock looks attractively priced for its long-term prospects. In fact, I found Sirona compelling enough to buy some shares for myself.

Wednesday, August 14, 2013

Covidien Has Upside Potential

It’s been a tricky market for medical device companies in 2013, but you wouldn’t know it from Covidien’s (NYSE: COV) share price performance.

The stock is up nearly 23% this year, even while companies like Johnson & Johnson(NYSE: JNJ) have disclosed lower-than-expected growth in surgical procedures. Moreover, the spinoff of Covidien's pharmaceuticals business (to be called Mallinckrodt) turns it into a pure-play medical device company. Why is Covidien outperforming its sector, and what can investors expect in future from the company?

Covidien offers inexpensive, cost-effective solutions

Firstly, while the overall medical device market is bedeviled with weak spending patterns, Covidien’s solutions tend to come at much lower ticket prices than many of its competitors. This means that a lot of its solutions fall under the radar of items earmarked for cutbacks.

However, other companies in the sector have not fared so well.  For example, on its last conference call Johnson & Johnson described the hospital capital spending market as being in a recession for the last 10 to 12 quarters. Indeed, Johnson & Johnson only recorded 0.5% growth (excluding acquisitions) in its medical device & diagnostics division.

Meanwhile, Covidien managed to grow constant currency revenues by 5% in the last quarter, despite coming up against some difficult comparables in its vascular product sales.

A breakout of its product revenue growth reveals pretty solid growth, and on its conference call, management affirmed its belief that growth would continue “to be slightly above market.”




Source: Company SEC filings.

Second, many of Covidien’s solutions actually enable hospitals to reduce costs. For example, its energy devices division has some of the world’s leading minimally invasive surgical (MIS) equipment.

Covidien’s MIS solutions allow hospitals to create better patient outcomes, and save costs by reducing outpatient days. Such properties mean that hospitals keen on restraining spending will still consider making purchases. Moreover, in previous conference calls, Covidien argued that it could generate growth by increasing MIS use in procedures such as hysterectomies and colorectal surgery.

Emerging markets, obesity, and cost savings

Third, emerging markets present a strong growth opportunity. According to company presentations, Covidien plans to reach $2 billion in emerging market sales within the next couple of years. The current percentage of overall sales from emerging markets is around 15%, and a move to $2 billion would probably take it nearer to 20%. This looks achievable, because in this quarter alone, Covidien recorded “operational sales growth in the mid-teens and double-digit increases in most product lines” within emerging markets.

This compares favorably with what General Electric (NYSE: GE) reported in its health-care division recently. GE outlined that its emerging-market growth was up 10%, while developed-market revenues declined 4%. In the end, GE’s health-care revenues were flat on the last quarter.

The first two reasons discussed above are a big part of Covidien’s appeal to hospitals in emerging markets. Its products are not the kind of high-ticket capital machinery solutions that will make poorer countries balk at up-front purchases. In addition, areas like endomechanical and energy devices (MIS) enjoy significant growth potential because they haven't yet expanded much into those emerging markets.

The fourth reason why Covidien can generate growth relates to the kind of procedures that its equipment serves. Previously, management has outlined that bariatric (weight-loss) procedures are one of its most important profit drivers. Frankly, with more than one-third of U.S. adults obese, the demand for bariatric surgery isn’t going away anytime soon.

Finally, spinning off Mallinckrodt will allow Covidien to focus on investing as a pure medical device company. This is likely to mean more acquisitions, and a heavy focus on emerging markets.  It should also enable the company to cut some corporate costs. Indeed, management outlined programs designed to trim around $400 million from its budget.

Investors should look out for more disclosure in the upcoming investor day event in September. Covidien’s management is very good at this sort of thing. For example, despite a string of acquisitions, it managed to reduce headcount by around 5% over the last four years.

Where next for Covidien?

In conclusion, this was a pretty strong quarter for Covidien. Unlike Johnson & Johnson and GE, it managed to generate some good growth from medical device sales, despite a sluggish hospital spending environment. In the long-term its growth prospects look assured, and the stock is one of the most attractive in its sector. In the near term, it has managed to get over a tricky quarter in its vascular business, and there is likely to be some upside to come from its cost-cutting initiatives.

Analyst estimates call for $4.04 in EPS for 2014, which puts the stock on a forward valuation of around 15.8 times earnings. If you are happy to pay this valuation for a company with solid 4% to 6% revenue growth prospects, and earnings growth forecast in the high-single-digits, go ahead and buy the stock.

In my view, it looks fairly valued for now, but I wouldn’t bet against management’s ability to generate future cost savings and margin expansion. With this in mind, it’s well worth closely following what the management says in its investor day presentation in September.

Tuesday, August 13, 2013

Why VF Corp Deserves to Trade at a Premium

Outdoor clothing company VF (NYSE: VFC) is one of the most compelling growth stories in the retail sector. Its mix of brands gives it the diversity to deal with a slowdown in any one segment, and many of its brands are under-penetrated within key growth markets. Here's why it deserves to trade at a premium to the rest of the retail sector.

VF raises guidance, again

In its latest second-quarter results, the company kept up its tradition of raising guidance, hiking its full-year EPS expectations by $0.10 to $10.85.  Moreover, it declared itself on track to hit its targets for the full year. The company’s aiming for 6% revenue growth, 13% in EPS growth, and marked improvements in margins and cash flow.

While all of this is good news, it's already priced into the stock. The real question: In a weak retail environment, how is VF reporting such good numbers? And can it continue?

Diversity helps VF to outperform

The first factor that distinguishes VF is that it has a range of brands in its portfolio. This gives it significant flexibility to deal with changing retail conditions.

A good comparison would be something like Nike (NYSE: NKE).  Michael Jordan’s favorite sportswear company is doing well at the moment, but this is largely due to outperformance in North America. Moreover, much of its growth is focused on footwear.  However, the other parts of its empire are not performing particularly well, and the pressure is building up on Nike to continue to execute. Nike just doesn’t have the same kind of diversity that VF's mix of outdoor wear, sports clothing, footwear, and jeanswear generates.

You can see how well VF imanages investments in its various segments by looking at margin growth in the last quarter.




Source: company accounts.

Five out of its six segments saw margin increases, and a look at its profits for the first six months illustrates their relative importance.




Source: company accounts.

Within its Outdoor & Action Sports division lie three diverse brands. The North Face gives it exposure to the rugged outdoor hiking and mountaineering market, and equally importantly, people who want to be associated with this lifestyle. Vans generates a similar appeal to people attracted by skating, surfboarding and snowboarding, while Timberland has long been a leading outdoor wear brand. All three are placed in distinct fashion niches.



The big three brands

It isn't all plain sailing for VF. For example, Timberland has had problems due to its heavy exposure to Europe. Timberland’s European revenues were down in double-digits,but it managed to record only a 3% overall decline in revenues. On a more positive note, Timberland’s Asian revenues were up 10% and, it generated low-single-digit-growth in the Americas.

VF reacted to weak conditions in Europe for Timberland, by investing in direct-to-consumer (DtC) initiatives such as e-commerce enabled websites. These actions led to positive DtC comparables in Europe, and high-single-digit growth in the Americas.

Furthermore, its other two key brands (Vans and The North Face) have great potential to grow via international expansion. Both brands tap into the growing trend for consumers to wear outdoor activity clothing as a fashion statement. Indeed, Vans generated 15% growth in the quarter, with international sales up 20%; incredibly, Europe rose 20%. As for the The North Face, it generated 5% growth overall. The North Face’s international sales were up 20% with European sales increasing an impressive 10%.

VF has a good mix of growth opportunities from regional expansion, growing its DtC business, and favorable lifestyle trends .It can selectively invest across its brands and regions in order to counteract any weakness elsewhere.

How VF compares across its industry

Here's a brief look at how the company matches up versus its industry peers.





Frankly, VF doesn't merit its discount to Nike, because of the advantages (as discussed above) that VF holds over its footwear-focused rival. On the other hand, its premium to Columbia Sportswear (NASDAQ: COLM) is well-deserved.

Columbia is forecasting full-year sales to decline by up to 2.5%. Its brands do not have the kind of lifestyle appeal that VF has managed to generate with Vans or The North Face. Columbia's core clothing tends to be for activities like skiing and fishing. Arguably, these are not hobbies whose clothing has the kind of crossover appeal that VF's brands generates.  .

The bottom line

In conclusion, VF’s diversity gives it good growth prospects for the next few years. Its valuation of over 18 times forward EPS estimates may look expensive, but the company has low-teens-growth forecasted for the next couple of years. In addition, it is expecting to generate around $1.4 billion in cash flow for 2013.

Arguably, the stock is fairly valued right now, but if it hits its low-teens EPS growth targets, then it’s reasonable to expect the stock to return at least low-teens returns for investors over the next few years.

Sunday, August 11, 2013

Is Fortinet a Buy?

It’s been a difficult year for investors in IT security company Fortinet (NASDAQ: FTNT). They have been forced to watch the stock fluctuate wildly, and then settle at a price similar to which it began the year. On the one hand, Fortinet's underperformance to the Nasdaq is justified; throughout 2013, the company has been lowering full-year guidance. On the other hand, the key to investing is always to look at the pros and cons of investing in the stock right now. So is Fortinet worth buying now?

The pros

After delivering a nasty warning in the first quarter, Fortinet returned to form in the second. It beat its own revenue expectations by $4.4 million, posting $147.4 million. Earnings were in line with expectations, and it appeared to resolve the larger part of the issues that caused the shortfall in Q1. There are four key takeaways from these results that might lead you to be positive on the stock.

First, in the previous quarter, Fortinet had explained that its billings miss of around $12 million was a combination of weakness in orders from telco service providers ($6 million-$9 million), and the Latin American region ($4 million-$6 million). Moreover, it had an inventory shortfall that created a $2 million-$4 million shortfall. The good news is that telco orders came back in second quarter, and Fortinet successfully rectified the inventory issue. However, Latin America still remains tough

The second takeaway is there were some positive signs from deal sizes reported in the quarter




Source: company presentations.

The larger deals (above $500,000) came back strongly in the quarter, and this is probably due to a return to spending by the telcos. In addition, Fortinet has seen a strong rise in the number of smaller deals signed in the last three quarters. The last point is a sign that it’s capturing the growing market for small and medium size business who want to prioritize cyber security.

The third positive point is that Fortinet’s guidance looks overly cautious.




Source: company accounts.

In fact the second quarter turned out to be consistent –in terms of sequential growth- with the previous years. However, the guidance for the third quarter looks historically conservative.

The final takeaway is that Fortinet made some positive commentary in its conference call. The company expects to take market share, and declared that it wasn’t seeing any pricing pressures at the moment. This suggests that even in a weak spending environment, it can still generate growth.

The cons

There are three reasons to be cautious over the stock.

The first is that competition is going to increase. Cisco Systems(NASDAQ: CSCO) purchase of Sourcefire will surely result in increased investment. Cisco’s security division’s growth turned negative in its last quarter, and the Sourcefire acquisition is an attempt to regain traction in the sector.

This sort of deal is critical to Cisco because its core switching and routing divisions are generating very-low-single-digit-growth, it needs to push growth in its peripheral activities. Moreover, Cisco can bundle security solutions with a whole range of other technology offerings.

In addition, Check Point Software (NASDAQ: CHKP) has released some lower priced products aimed at the small and medium size business market that Fortinet is traditionally strong. Check Point has long been known for its high-end solutions, but this move will bring it into more direct competition with Fortinet. Given that Check Point needs to get product sales growing again, it is reasonable to more competition here.

Similarly, Palo Alto Networks (NYSE: PANW) missed estimates last time around, and it will be under pressure to keep its growth profile intact. Indeed, in its conference call, Fortinet referred to the ‘enormous amount of money’ that Palo Alto spends on marketing.

The second reason for caution is that the correction of Fortinet's inventory shortage came at a price. Fortinet outlined that it would be decreasing expectations for inventory turns to two to three, from above four times. This just means that more working capital will have to be allocated towards inventory, as it will be turned over at a lower rate in future. In other words, long-term cash flow expectations should be reduced.

Indeed, Fortinet lowered full-year free cash flow expectations to $130 million-$135 million, from $140 million-$150 million previously. Note that when it started the year, its free cash flow expectation for 2013 called for $180 million-$190 milllion. That's a worrying downtrend.

The final negative takeaway is that the company expressed some lackluster commentary on the macro environment. Latin America continues to be weak, and Fortinet’s European sales rise of 22% in the current quarter will surely not be repeated anytime soon. Management expressed caution over both these regions. In addition, management spoke of sales cycles lengthening, and customers wanting to buy in smaller deal sizes. Both are classic signs of a slowing end market demand.

Where next for Fortinet?

In conclusion, there are mixed signals from the recent report. While the third quarter guidance looks conservative, the increase in working capital requirements is a concern for the long-term.

As discussed above, the free cash flow guidance for the full year has been reduced by $52.5 million or 28%  throughout the course of the year. Indeed, the $132.5 million midpoint forecast for free cash flow in 2013 now only represents 4.5% of its enterprise value. That looks to be pretty fairly valued in my book, and given the weakness in tech spending, it makes sense to wait for a dip here.

What F5 Networks Needs to do in the Second Half

One of the hardest things to do in investing is to buy a stock that you know is out of fashion. With application delivery controller (ADC) specialist F5 Networks (NASDAQ: FFIV) you have a classic case of a technology company that is attractively valued, but seeing slowing growth.

Typically, the market doesn’t reward such companies, and you can find yourself waiting a long time for the market to come around to your view. On the other hand, if F5 can get back to growth the upside potential is significant.

F5 shifts

The recent third-quarter results were a return to form for F5 Networks:

  • Revenues of $370 million vs. internal guidance of $355 million to $365 million

  • Non-GAAP EPS of $1.12 vs. internal guidance of $1.06 to $1.09

  • Fourth quarter (Q4) revenue guidance of $378 million to $388 million

  • Q4 Non-GAAP EPS guidance of $1.17 to $1.20

The stock appreciated sharply on the back of the revenue and earnings beat, but you need to look at the numbers in the context of long-term trends. 




Source: F5 Networks accounts.

Growth is clearly slowing at F5 Networks, and the guidance for Q4 isn’t particularly positive, either. With that said, Q3 was a significant improvement over F5’s nightmare in Q2. Essentially, its telco service provider revenues made a bit of a comeback.




Source: F5 Networks presentations.

F5 wasn’t the only company to report some weakness with spending from telco service providers in the spring. Other IT companies such as Fortinet reported a similar story. The good news is that some of the deals that slipped over from Q2 were closed in Q3. In addition, its U.S. enterprise revenues were surprisingly strong, particularly in an earnings season where tech bellwethers Oracle and IBM gave disappointing results.

Growth prospects?

The real question for investors: Can F5 get out of its low-single-digit revenue-growth funk?

To do so, it must get product sales positive again. Representing 53% of total revenues, these sales declined 5% on the quarter, and are down 3.7% over the first three quarters. Indeed, on the conference call, F5’s management declared that generating product revenue growth would be its “No. 1 priority.” In the long term, its service revenues growth depends on getting more customers to install its products.

Moreover, there are other concerns with F5 Networks:

  • The company has a dominant market share (over 50% according to most industry sources), so it will find it hard to grow by gaining market share from here.

  • Citrix Systems (NASDAQ: CTXS) is growing its application delivery product NetScaler. Cisco Systems (which has discontinued investing in its ADC product) is recommending that its existing ADC customers integrate Netscaler.

  • The ADC market may be maturing, and thus only capable of supporting low single-digit growth in future.

  • F5 has significant revenues in the Governmental sector (see chart above), which may be challenged by austerity measures.

  • F5 generates very high gross margins of 83%, which may come under threat if competition increases while the market matures.

  • Smaller competitors like Radware (NASDAQ: RDWR) are also seeing weak conditions.

F5 described Citrix as its No. 1 competitor “by a mile”. In contrast to F5, Citrix recorded strong growth of 46% in its networking and cloud revenues in its recent quarter. Moreover, on its conference call, Citrix stated that NetScaler was the “major driver of growth in the quarter” for its networking division.

Not only does Citrix have the advantage of its relationship with Cisco Systems (as discussed above), but it also can bundle NetScaler with its market-leading desktop virtualization solutions. Indeed, it stated that this type of bundling deal was up 20% in the last quarter.

In comparison, Radware reported revenues and gross profits that were flat on the quarter. On its conference call, it stated that the underlying conditions were very good for the industry, but also talked of “some new platform pricing by some of the competitors that have simply brought down the average sale price.”  If Radware’s commentary is accurate, then competition is increasing, and Citrix appears to be the big winner in 2013.

The bottom line

In conclusion, F5 Networks reported a better quarter, and the return of telco spending is a good sign. In addition, its guidance looks a bit conservative. By my calculations, the company has generated more than $467 million in free cash flow over the last four quarters, which puts it on a free cash flow yield of nearly 7% as I write. This is a generous valuation, as it seems that the market is pricing in a significant amount of doubt over its future cash flow growth.

While the stock is undoubtedly cheap, my hunch is that it could remain so until F5 gets back to reporting growth in its product sales, and it’s hard to get too excited about the stock until it does so.

Thursday, August 8, 2013

Whirlpool is Still Good Value

Investors in home appliance manufacturer Whirlpool (NYSE: WHR) have seen a near-90% rise in its share price over the last year, and many of them must feel tempted to take some profits. But the company has a number of positive things happening for it in 2013. And  if it continues to execute in moving towards hitting its long-term targets, Whirlpool could have plenty of upside left.

Whirlpool upgrades guidance

In line with many other companies in the current reporting season, Whirlpool reported that North American conditions were strengthening, while Europe remained weak and Asia weakened somewhat. Indeed, a quick look at its updated expectations for industry demand tells the tale:

Industry Demand Assumptions Previous Outlook Current Outlook
North America 2% to 3% 6% to 8%
Europe flat flat to -2%
Latin America 3% to 5% 1% to 3%
Asia 3% to 5% flat

Source: Company presentations.

Eagle-eyed readers will note that only the forecast for North American was raised, but the good news is that this is the key region for the company. Whirlpool generates nearly 55% of its revenues from North America, and a graph of its regional profits illustrates that its importance:




Source: Company accounts.

With regard to revenue, North America makes up nearly 54.8%, with Latin America contributing 25.3%, EMEA around 15.4%, and Asia with only 5.2%. For those of you worried about a potential slowdown in China’s housing market, the good news is that Whirlpool is not particularly exposed.

For this reason alone, the stock is more attractive than home-improvement toolmaker Stanley Black & Decker (NYSE: SWK). A large part of Stanley Black & Decker’s growth prospects come from its strategic growth initiative. The plan involves aiming to increase revenues by $350 million within emerging markets, and China makes up a big part of its growth intentions. Although Stanley Black & Decker has a similar exposure to Whirlpool in North America, the market won’t waste any time in marking down the former if its growth prospects diminish in China.

The really good news for Whirlpool investors was that its overall guidance was upgraded. Ongoing diluted EPS forecasts were raised to $9.50-$10.00 from $9.25-$9.75 previously. Equally importantly, its forecast for free cash flow was raised to $650 million-$700 million from $600 million-$650 million. Some investors have worried about Whirlpool's lack of cash flow generation in recent years, but given ongoing margin expansion, the company looks set for strong growth in free cash flow.

The three reasons why Whirlpool’s prospects will get better

Firstly, its ongoing productivity improvements and restructuring are seeing genuine improvements in margins. Whirlpool’s long-term target is to get operating margins up to 8%, and on current trends, that looks achievable.




Source: Company accounts.

The second reason is that the U.S. is approaching the 10-year anniversary of the housing market boom. This is important, because the large number of appliances bought at the top of the market will increasingly need replacements.

For example, here is the data on total home laundry product shipments from the Association of Home Appliance Manufacturers:




Source: Association of Home Appliance Manufacturers.

Obviously, home-improvement stores like Home Depot (NYSE: HD) and Lowe’s will also be beneficiaries from these trends. Indeed,  in a  sign that the cycle is turning, Home Depot is starting to see its professional sales outpacing its consumer revenues. Moreover, the segments of its sales that outperformed in the last quarter involved things like kitchens, electrical, d├ęcor, lighting and hardware. These trends are positive for Home Depot because they imply an increased willingness among consumers to spend on discretionary items. Moreover, they are the kinds of goods that Whirlpool sells.

The final reason is that the housing recovery is encouraging new housing construction. This is good news for Whirlpool, because it will spur sales growth 6-9 months down the line as new homeowners start to purchase home appliances. In addition, this trend could boost profits, because the types of appliances bought by new homeowners tend to carry higher margins.

The bottom line

In conclusion, Whirlpool has some very positive trends in its favor. If it hits the targets of expanding operating margins and cash flows, then the stock can appreciate from here. Analysts have it on a consensus forecast EPS of $11.85 for 2014. This puts the stock on a forward valuation of less than 11 times earnings, as I write. That number looks too cheap. Provided the company hits expectations, Whirlpool shares represent a good value  for long-term investors.

Wednesday, August 7, 2013

PPG Industries is a Stock to Buy

Investors in paintings and coatings company PPG Industries (NYSE: PPG) have enjoyed a nearly 45% rise over the last year, but the stock has remained in a tight $150-$160 range over the last few months. Is this a sign that it’s time to take profits on the stock?  Before you rush to hit the sell trigger, you should consider the upside potential in this stock. PPG can move higher in 2013, and here is why.

End market conditions

PPG’s prospects for 2013 will largely be governed by its performance within the industrial and architectural/construction end markets.

With regard to the industrial sector, it’s been a mixed earnings season so far. As a general rule, companies exposed to sub-sectors such as aerospace and automotive have done really well, while the rest of the industrial sector has faltered. For example, aluminum manufacturer Alcoa (NYSE: AA) started this trend in this earnings season by affirming its forecast for 9%-10% growth in its aerospace market, and also upgrading its expectations for the North American automotive market.

However, while Alcoa is seeing strength within some of its key end markets, companies exposed to general industrial trends like supply companies Fastenal (NASDAQ: FAST), and MSC Industrial (NYSE: MSM), are seeing weaker conditions. Both companies cited the softening Institute for Supply Management (ISM) survey data as being indicative of a difficult industrial environment. Fastenal reported disappointing industrial fastener sales (an indication of cyclical weakness), and announced plans to hire new staff in an effort to generate revenue growth. Similarly, MSC Industrial declared that it wouldn’t be pushing through its usual midyear price increase due to softening demand from its customers.

The architectural markets have also seen some mixed performances. A look at the data from the Architectural Billings Index from the American Institute of Architects (AIA) reveals the difference in performance between the residential and commercial markets in 2013.




Source: American Institute of Architects.

The idea is that a recovering residential market will lead to an improvement in commercial/industrial conditions, but it hasn’t happened so far in 2013.

How is PPG faring?

A brief look at its segmental income demonstrates that PPG is generating income growth from a variety of sources.




Source: PPG accounts.

In its recent earnings release, PPG disclosed that its performance coatings saw its automotive and aerospace refinish businesses deliver ”mid-to-high single digit sales increases”. PPG received a major contribution to sales and income growth, from its acquisition of Akzo-Nobel’s US household paints division.  However, its North American architectural coatings sales (excluding acquisitions) actually declined 5%. The decline was partly due to a major customer changing its product mix, but PPG also referenced some cautious purchasing patterns amongst independent dealers.

 Indeed, its rival Sherwin-Williams (NYSE: SHW) referenced similar market dynamics in its conference call on July 18. Sherwin-Williams spoke of the loss of business from a key retailer (in this case Wal-Mart), and outlined that its non-residential sales were lagging residential. In addition, its consumer group sales declined 1% even after a positive 3.2% contribution from an acquisition. 

Industrial coatings sales benefitted from a 12% rise in volumes from its automotive sales, and PPG was keen to highlight that this is partly a result of excellent long-term positioning within the leading car companies. It claims to be the number one player in automotive coatings in North America and China.

Perhaps the most surprising aspect of PPG's results were that its Europe, Middle East and Africa (EMEA) – architectural coatings income increased by $5 million to $69 million, despite sales declining 5%. This increase is a testimony to how well its management is implementing cost savings programs.

Where next for PPG?

The company has a number of good catalysts for growth. Input costs are moderating, the automotive and aerospace sectors are growing strongly, and investors can look forward to some improvement in the commercial/industrial construction market. PPG is a well-run company that has coped admirably with the slowdown in Europe. In addition, it plans for to generate around $200 million in synergies thanks to the Akzo-Nobel acquisition.

With regard to valuation, the stock trades on a discount to its peers:




In conclusion, I think the company is set for good growth going forward, and its valuation makes the stock attractive for the long term investor.

Tuesday, August 6, 2013

Why General Electric is Outperforming

If you think that investing is simple, then just take a look at industrial giant General Electric’s (NYSE: GE) latest results. The industrial sector has been weaker this year, but GE reported a surprisingly good set of results. Furthermore, rivals such as Switzerland’s ABB and Germany’s Siemens, have subsequently given disappointing results and guidance. So what's going on with GE? How has it managed to achieve such good results?

The three reasons why the results were good

GE actually reported a 4% decline in revenues, and its earnings from continuing operations before taxes were down 11%. It may seem peculiar to describe such results as being "good," but here are three reasons why the description fits.

First, the industrial side actually increased segment profits by 2%. The negative contribution came from the financial services side, where GE Capital’s segmental profits declined 9%. The decline at GE Capital was in line with the company's strategy to reduce its portfolio size and focus instead on its core GE business. The days are long gone from when GE was regarded as a financial services company with an industrial division attached to it. In fact, the industrial division now generates double the income of the GE Capital.

Here is a chart (sourced from company accounts) of GE’s segmental income in the quarter:




Five of the six industrial segments increased profits, so the underlying performance is better than it appears at first.

Orders are up

The second reason is that its industrial orders were better in the quarter. Overall orders were up 4%, with U.S. orders up a whopping 20%, and its European orders were up 2%, having been down 17% in the previous quarter. Indeed, industrial bellwether Alcoa (NYSE: AA) highlighted similar dynamics in its latest conference call.  Alcoa implied that North America was strengthening, Europe was weak-but-stabilizing, and its outlook for China remained the same. Meanwhile, GE claimed on the conference call that its emerging-market performance “remained resilient.”

A breakdown of GE’s order growth in the quarter, with all data sourced from company accounts:




Power & water has been the problematic segment this year, particularly within Europe. Indeed, European power & water orders were down 40% in the quarter. Excluding Europe, power & water orders were actually up 6%.

Furthermore, GE claimed that 70% of the segment's shipments would occur in the second half of the year, which should lead to strong margin expansion in the second half. This is good news, because the segment is GE’s biggest industrial profit center.

Relative strength in GE’s key markets

Finally, GE is relatively well-exposed to the growth areas in the industrial sector in 2013. The relative strength in the aerospace and automotive sectors has been a recurring theme of investing in the industrial sector this year.

Indeed, Alcoa noted a similar trend in its recent results. Alcoa investors should note that, on its conference call, GE discussed its gas turbine orders, and said that “the overall market is not going to be quite as strong as we had initially expected.”  In contrast, Alcoa left its forecast for industrial gas turbines unchanged.

GE also has heavy profit exposure to other sectors that are outperforming, such as oil & gas, and transportation. The most surprising result probably came from its health-care segment.

Healthcare giant Johnson & Johnson (NYSE: JNJ) has a large medical device and diagnostics division (40% of sales) that achieved tepid growth of only 0.5% (excluding acquisitions) in the last quarter. Moreover, Johnson & Johnson described the U.S. hospital capital expenditure market as being in a recession for the last 10 to 12 quarters.

GE’s healthcare sales told a similar story. Its strong expansion in growth markets (revenues up 10%) managed to offset weakness in developed markets (where revenue declined 4%), resulting in flat revenue for the quarter.

Where next for General Electric?

In conclusion, revenue growth will be hard to generate in 2013 due to a weak global economy, but GE has enough exposure to the end markets that are doing relatively better. Conditions could hardly get much worse for its European power & water operations, and going forward, GE will start to lap some easier comparables.

The underlying performance on the industrial side is relatively good for the sector, and GE represents one of the better ways to play the industrial sector this year. It's well worth looking at.

Monday, August 5, 2013

Reasons to Buy Check Point Software

Whether rightly or wrongly, the market always seems to want technology companies to deliver growth, or they will be punished with low valuations. Consider the case of low-rated IT security specialist Check Point Software (NASDAQ: CHKP).  The company generates huge cash flows, and holds a significant portion (over 30%) of its market capitalization in cash. On the other hand, it’s estimated to only grow earnings in the 6% to 8% range over the next couple of years. Is now the time to buy the stock?

Great cash flow, low rating

Frankly, the main attraction of Check Point is its cash flow. For example, by my calculations, the company has just generated around $944 million in free cash flow over the last four quarters. In other words, that cash flow represents nearly 8.8% of its current market value.

Putting this into context, if the company only did this for the next 11 years (with no growth) then it would have generated the equivalent of its market cap in cash. However, the company is still growing earnings and cash flows, so why is it so low-rated?

One possible explanation is that the market is concerned about its falling product & license revenues. Check Point has a razor/razorblade business model, which means its hardware products are sold into customers in order to generate future software blade sales. The fear is that falling hardware sales will ultimately lead into falling software sales.

The following chart (sourced from company accounts) demonstrates how its product & license growth has turned negative over the last year.




If this isn’t worrying enough, then investors only need look at how competitors like Fortinet (NASDAQ: FTNT) and Palo Alto Networks (NYSE: PANW) have lowered guidance this year due to a weakening environment. Fortinet gave a weak set of results for the first quarter, and reduced its full year revenue guidance by about 5% from its previous forecast. Moreover, its guidance for the second quarter looked weak, and implied that conditions weren’t improving.  A month or so later, Palo Alto disappointed the market by claiming that its end-market conditions remained weak going in to June. 

So if Check Point’s hardware sales are falling, and its competitors are warning, can investors feel comfortable with the company’s prospects?

Six reasons why Check Point investors can feel secure

Firstly, Check Point’s average selling price (ASP) has been increasing in recent quarters, and its management stated that the ASP was back to its level of two years ago. The improvement is partly due to selling a higher proportion of larger deals.

For example, Check Point disclosed that 68% of its deals were at $50,000 or above, versus 66% last year. This is clearly part of a positive trend, because in the last quarter’s results, the same percentage went up to 67% from 60%.

Second, on previous conference calls, Check Point had spoken of a trading-down effect due to its product refresh. Essentially, its customers were holding off purchasing its new higher-end solutions in favor of buying the new lower-end solutions. The customers’ rationale was that they were getting the same performance as before, but at a lower price. However, the rise in the ASP in the current report suggests that the trading-down effect has come to an end.

Third, the company has long been regarded as offering relatively expensive solutions that hinder its opportunity to sell into the small- and medium-size business market. The good news is that Check Point now has a lower-priced ($400 to $1200) entry-level product with its new 600 series. This is a market segment that Fortinet has traditionally been strong in, so look out for increased competition here.

Fourth, potential investors always need to remember that Check Point uses bundling as part of its sales strategy. In other words, it tends to try and accelerate software sales by bundling them with hardware sales. As the company is increasing the amount of software solutions that work on its hardware, it is reasonable to expect that hardware sales will fall as a percentage of the total bundled amount. Don’t panic too much over falling hardware sales.

Fifth, the guidance looks conservative. Based on company accounts and the guidance given on the conference call, I have graphed revenues and implied assumptions for revenue growth in the next two quarters. It doesn’t look like an aggressive forecast, and Check Point has a history of being conservative with guidance.




Finally, Cisco Systems (NASDAQ: CSCO) recently announced its plan to acquire IT security company Sourcefire in a $2.7 billion deal. Cisco’s security revenues fell 5.2% at its last set of results, and this deal is clearly an attempt to regain positioning. It’s exactly the kind of deal that Cisco needs to do in order to counteract slowing growth in its core switching and routing divisions. The immediate takeover speculation will focus on fast growing companies like Fortinet and Palo Alto. However, this sort of deal usually helps to guide investors a sector, and Check Point can expect to benefit too.

The bottom line

In conclusion, while the recent results didn’t have many positive things to say about the IT spending environment, Check Point did report some underlying positives. Moreover, the valuation of the stock is attractive, and it’s a stock well worth considering for value investors looking for some tech exposure.

Thursday, August 1, 2013

What Intel Needs to do in the Second Half in Order to Hit Guidance

One of the most fascinating things about investing is how you can find yourself faced with the same sort of questions over and over again. In the case of Intel (NASDAQ: INTC), you're coming up against some classic propositions. What if you like the long term value of the stock, but are concerned about the near-term risk? Moreover, you might like the forward guidance, but how much do you believe in it?

Intel lowers guidance, again

It’s no secret that Intel’s core PC market has been weakening for some time, and the company has-- by its own admission-- been slow to react to the changing trend towards ultra-mobile PCs and smart phone devices. Indeed, it recently lowered its expectations for PC sales in 2013, but raised them for ultra-mobile devices.

Furthermore, the market didn’t have to wait long before Microsoft (NASDAQ: MSFT) confirmed these trends by reporting a decline in its Windows business, as the new device market takes precedence over traditional PCs.  In fact, Microsoft’s Windows revenue declined 5%, while it estimated that the consumer PC market was down a whopping 20%.

In the good old days, the release of a new Windows operating system was like a red rag to a tech bull, particularly for Microsoft and Intel investors. Unfortunately, those days are gone. Microsoft’s Windows 8 has hardly set the world on fire, and some analysts have blamed its release for slowing down PC sales. Consequently, Microsoft is struggling to remain relevant on new devices such as smart phones.

Turning back to Intel, its lowered expectations for PC sales (the PC client group currently makes up more than 63% of sales) caused it to lower full-year revenue guidance to ‘approximately flat’. Equally importantly, it lowered its full-year gross margin forecast to 59% from 60% previously.  On a more positive note, Intel also demonstrated its ability to adjust to weakening sales by lowering its capital expenditure forecast by $1 billion, to $11 billion.

I want to focus on gross margins, because this metric has tended to guide the share price.




INTC Gross Profit Margin Quarterly data by YCharts

It’s not a failsafe indicator, but generally speaking, you would want to buy Intel after its gross margins have bottomed. The good news is that on the conference call, management guided towards gross margins improving to 61% in the third quarter (Q3) and “at or maybe a little bit higher” for the fourth quarter (Q4).

So is it now the time to buy Intel?

The answer depends on your level of belief in the guidance. In order to graphically demonstrate this, I’ve created this chart from company accounts, using the latest guidance given by the management. Intel forecasted $13.1 billion in revenues for Q3 and full-year revenues to be flat.




Clearly, the guidance assumes a return to growth in Q3 & Q4. Furthermore, note that these two quarters tend to be the most important for Intel. In other words, the second half performance will be critical to Intel hitting its guidance.

A few bullet points on what bulls might look for:

  • The second half will see the launch of the Bay Trail processor, aimed at the entry-point ultramobile device market.

  • The energy-efficient Haswell processor should start to see sales ramp up as manufacturers integrate it into their new devices.

  • LTE-phone-based sales will start to accelerate.

  • Intel predicts its data-center-based revenues will grow in the low double digits for the full year.

  • The company is starting to lap weaker comparables from last year.

  • Management forecasts that an improving macro environment will lift Intel’s sales.

The key factors will probably be how well Haswell and Bay Trail are adopted by original equipment manufacturers (OEMs). Intel is trying to muscle its way into the ultra-mobile market currently dominated by ARM Holdings(NASDAQ: ARMH) processor designs. This is becoming an ever-more-important battle because -- as demonstrated above -- the trend towards mobile devices is accelerating. So far, the refusal to license ARM-based architecture for its chips has seen Intel struggle to compete against competitors like QUALCOMM (NASDAQ: QCOM) in the mobile device market.

In the end, the key decision makers in the Intel vs. ARM battle are going to be the device makers. If the latter are confident that they can create commercially viable products via shifting to Intel, then the battle will start to be won. Moreover, you can form your own view by looking at which tablets, ultrabooks, and mobiles are starting to be released with Intel chips.

The bottom line

In conclusion, the second half promises to be a better one for Intel -- and it needs to be, for the company to hit its guidance.  Thinking longer-term, even if Intel does fail to establish itself in the ultra-mobile device market, it could always change tack in future and start to license ARM's core technology. This is something for investors in ARM (positively) and Qualcomm (negatively) to ponder.

However, the near-term risk is if Intel misses the targets outlined above. Frankly, I think Intel will have challenges to hit these targets. But in any case, its valuation of around 12 times earnings will make it attractive to value investors who can stomach near- to mid-term volatility.