Earnings View

Why Tech Can Outperform the Market

2013-05-20T04:05:00.000-07:00

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

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

IT Staffing Companies are reporting good growth

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

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

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

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

Business survey’s are indicating strength

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

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

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

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

We’ve seen this before

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

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

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

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

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

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

The bottom line

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

Is Allergan a Buy?

2013-05-20T04:00:00.002-07:00

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

Allergan’s Outlook

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

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

What Allergan Reported

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

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

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

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

What Went Wrong?

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

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

Where Next For Allergan?

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

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

Time to Buy Stanley Black & Decker?

2013-05-19T05:20:00.004-07:00

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

End market prospects

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

A breakdown of segmental profits in the quarter.

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

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

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

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

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

Acquisitions working well

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

Strategic growth initiative

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

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

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

The bottom line

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

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

How AT & T Disappointed Over its Spending Plans

2013-05-17T07:09:00.000-07:00

After Verizon (NYSE: VZ) had given a mixed prognosis for the telco sector, the focus inevitably shifted onto AT&T (NYSE: T) and what it would be saying over spending. Going into the results there was a certain amount of hope and trepidation. Hope because it had previously excited the telco industry by outlining its plans to step up spending over the next few years. Trepidation because other tech companies have been warning of weak spending by the service providers. It looks like the pessimists won.

AT&T Giveth and AT&T Taketh Away

AT&T declared that it was keeping its capital expenditure forecast at $21 billion for this year but reducing it to $20 billion in 2014 & 2015 from $22 billion previously. Moreover, its subscriber numbers and revenue trends were disappointing, and the stock fell heavily on the day of the results. Nor was there any let up in the negative commentary over the levels of caution being exercised by the enterprise sector. Verizon had argued that its enterprise customers were being very cautious and still stuck in cost cutting mode. AT&T said pretty much the same thing.

So it is a story of a weaker trading environment coupled with less spending by the major carriers. This is not great for the service providers and neither is it good news for the companies that supply them. While AT&T is not the only telco carrier out there, it is a huge company whose conditions do strongly reflect overall market conditions.

The usual bugbears were mentioned: persistent unemployment, regulatory fears, political instability, government budgets etc. Frankly I’m coming round to the view that there is a bit more going on here, and the clues are in what the major carriers are saying about trends within their operations.

Simply put, things like smartphone penetration, cloud based activity and the shift to wireless from wireline services have increased in a quicker fashion than many companies had expected. It is a case of the good, the bad and the ugly. The good is the margin and revenue generating opportunities inherent in increasing smartphone penetration (they churn less, use more data etc). The bad is the implied loss in wireline revenues and small business choosing not to use them. And finally the ugly is the period of uncertainty that accompanies businesses when they adjust to unforeseen events. I want to talk more about the last point.

Certain Uncertainty

Apologies for going all ‘Donald Rumsfeld’ on you, but it’s the best way to describe the essence of the big question in technology investing. In other words, what effects will the rate of technological change have on my business?

A classic example of this--and it relates strongly to the telcos--is Intel (NASDAQ: INTC). The company does face criticism for not being prepared for the shift to tablets and mobiles, coming late to the LTE party and being too optimistic over a potential demand pull from Windows 8. It’s easy to criticize, but it’s a lot harder to predict these changes. Anyone who scoffs and says they can should show me how they invested in these trades, because that is what really matters here.

So just as Intel found itself structured for a world and cycle that didn’t look like it had before, so the telco service providers have also seen the same challenges. It’s certainly true that they have been pushing out these services (Verizon started investing in LTE over five years ago), but when AT&T cuts its capital spending forecast by around $4 billion (or 9%) for 2014-15, it is obvious that something has changed.

The reasons given for the cut are that it got better deployment from LTE than it had previously expected. Its much vaunted Project VIP includes a commitment to expanding 4G/LTE to 300 million points of presence (POPs) by the end of 2014. The good news is that it expects to achieve 90% of this figure by the end of 2013. The bad news is (from the suppliers point of view) that this greater efficiency is lessening the necessity for spending. It is also shifting spending into newer technologies and away from legacy systems. Again not good for the suppliers.

Where Next for Telco Spending?

Unfortunately it looks like a similar year to 2012 for the telco suppliers: some hope in the first half which then evaporates into a weaker second half. Some of the weakness in Q1 will possibly turn out to be temporary, but when there doesn’t appear to be a major stimulus for increased spending by Verizon and AT&T is cutting future projects it is hard to be too optimistic.

On a more positive note the increasing adoption of newer technologies like 4G/LTE, high bandwidth capability and corporate mobility solutions will surely spur other telcos to invest in them, so the focus on investing in the sector in 2013 must be in these areas. The problem is that the telco suppliers are not constructed to surgically target these areas alone. In conclusion If you are bullish on the telco sector it probably makes more sense to stick with investing in the carriers right now. The floodgates of telco spending aren't open yet.

Portfolio Review April 2013

2013-05-16T02:32:00.000-07:00

I would rather forget last month. After nine months of gains, I hit a nasty double digit loss. In truth, this sort of thing was inevitable and the preceding months were as much a part of the process as last month was. The previous month’s write-up and links to others can be found here. I do this stuff because I happen to believe that anyone writing about investment should disclose his own performance.

Philosophizing over, I'm going to confess to a certain amount of exasperation at being hit with accounting errors with Ixia, a weaker than expected tax return season at Intuit, the loss of a major customer contract with Regal Beloit, and when even Pfizer disappoints then you know it’s not going to be your month.

The weakness at IBM and Citrix Systems was a bit more predictable and I topped up on both. I suspected tech would be weak over earnings and held back buying more before their earnings. In fact, this approach helped me avoid disasters in companies I like and have held before, such as Fortinet and F5 Networks. It was definitely a month of dodging bullets! I’ve put some performance charts at the end of this post for those interested. I will update my current portfolio on my blog in a few days.

For now, it’s the usual format of reviewing the articles for January (i.e. three months previously) and picking out some investing ideas that readers might find useful. The companies in bold are those that I hold now. Acuity Brands was sold because it hit its price target. F5 Networks was sold because it hit its target and my general tech caution.

View	Company + Article Link	Performance Since Fool Article
Buy	Citrix Systems	-4.8%
Buy	Walgreen	19.1%
Buy	Wells Fargo	8.1%
Buy	Sanofi (Paris)	3.9%
Buy	IBM	.2%
Buy	Johnson & Johnson	14.5%
Positive	Acuity Brands	10.4%
Positive	Intel Corp	14.3%
Positive	Capital One	3.8%
Positive	F5 Networks	-39.8%
Positive	Google	8.3%
Evaluation	Covidien	6.9%
Evaluation	Cooper Companies	13.1%
Evaluation	Fastenal	-2.1%
Evaluation	Perrigo	13%
Caution	PPG Industries	6.7%
Caution	MSC Industrial	3.8%
Caution	Varian Medical	-11.8%
Caution	Quest Diagnostics	-.7%
Caution	Check Point Software	-4.4%
Caution	Dover Corp	1.6%
Caution	McDonald's	7.5%
BUY STOCKS		6.8%
NON BUY STOCKS		1.9%

Superficially these numbers look good, but let’s recall that the S&P 500 has put on over 12% in 2013. The ‘buy’ stocks averaged 6.8%, ‘positive’ recorded (0.6)%!, ‘evaluation’ returned 7.7%, and ‘caution’ did 0.4%. The difference between what I bought and didn’t was 6.8% to 1.9%.

Some observations and conclusions

It’s been a relatively tough period for tech stocks like Fortinet, F5 Networks, IBM, and Citrix, and cyclicals like Dover, Fastenal (NASDAQ: FAST) and MSC Industrial.

The defensives are starting to look fully priced with nice gains for Cooper Companies and Perrigo.

Tech ‘value’ ex Intel and Check Point Software (NASDAQ: CHKP) has held up better than the growth tech stocks.

Nothing but nothing seems to stop the market wanting to buy yield with stocks like Johnson & Johnson and McDonald’s.

In conclusion, think it’s time to start thinking about buying some select industrial and/or technology stocks.

Some stocks to consider

With these thoughts in mind, I think Intel (NASDAQ: INTC) and Check Point Software are worth a look. I’ve covered both after their recent results in articles linked here and here. Intel is a curious beast in the market place. It offers a high yield, good value, and cyclical exposure to consumer electronics, but it is also faces long-term challenges from ARM core processors. It also offers a restructuring story as it adjusts to the shift in computing devices. Gross margin appears to be bottoming and while it hasn’t turned the corner yet ,the potential upside in the stock remains.

As for Check Point, in retrospect, its last results were okay and there are some signs that its customers are more willing to buy its new products. Like Intel, it offers a genuine value proposition because of its high cash conversion and potential to leverage its technology into expanding its sales. On the other hand, I think the market is tired of seeing falling product and license growth and a ‘cash harvesting’ approach to its business development. If that should change, I’m sure the stock will go higher. But will it?

The next two stocks are both industrials. I still think Fastenal is expensive and am concerned with the falling sales growth, but if you are looking for some short-term upside from the idea that industrials will come back then, it is a great stock to look at. Its visibility is limited and it is exposed to short cycle decision making by purchasers, all of which leaves it susceptible to violent changes in sentiment by its customers. Bad when it’s bad, good when it’s good. If you like the industrial space and want a near-term play, then Fastenal is worth picking up

Another industrial worth considering is PPG Industries (NYSE: PPG). I like its end market exposure and its purchase of Akzo Nobel’s U.S. household paints division. Aerospace and automotive are the two stand out sectors within industrial, and PPG is well placed in both. Its long-term dividend record is excellent and it is a very good generator of cash and has the potential to generate some synergy-based cost savings with the acquisition. Despite reporting a good quarter -- notably better than so many other industrials -- the stock has lagged the overall market and looks decent value. I may pick some up.

The last stock for consideration is Capital One Financial (NYSE: COF). The stock has underperformed this year and the credit card companies do face challenges to net interest margins thanks to low interest rates and the maturing of higher rate loans. Moreover, the weak recovery has left the yield curve relatively flat and loan demand is not where it usually is at this stage of an economic recovery. No matter, if you believe that employment will keep increasing and the recovery is ongoing, then at some point demand will come back. Meanwhile, asset quality and delinquency rates carry on improving so Capital One is well positioned to catch an uptick in end demand.

Additional data

As discussed above, here is how this lousy month affected performance since inception. The blue line is my portfolio the red line is the S&P 500.

The Key Earnings of the Week

2013-05-16T02:27:00.003-07:00

Earnings season is starting to wind down, but we still have some interesting companies reporting this week. Since we are nearing the end of the season a lot of these companies’ peers will have already reported, so the market will be anticipating the direction of the results. I’m going to use this approach to preview what investors might expect from the results this week.

Tuesday

I can think of very few sectors as unglamorous as painting and coatings, but who cares? Anyone purely focused on making money couldn’t help but notice that these stocks have been hot over the last year or so. Valspar (NYSE: VAL) will give numbers, and following the recent solid results from Sherwin-Williams and others we can expect similarly good numbers here. However, it is somewhat a story of a two different markets.

The US consumer market has been strong--in line with an improving housing market--but industrial coatings have been more varied. The key thing to look for in these results will be how its mix of geographies and end markets are holding up. The industrial sector has been mixed so far this year, with areas like automotive and aerospace strong but general industrials growing weaker. Indeed, Valspar reported weakness in food and general line packaging last time around. Given the more positive news out of China recently we could see a bounce back.

Wednesday

A couple of bellwether’s report on Wednesday, with Deere outlining the state of play in farming and construction machinery, and Macy’s will be discussing high end consumer spending.

Thursday

Thursday is undoubtedly the most interesting day of the week. Bring your own device (BYOD) play Aruba Networks (NASDAQ: ARUN) has already pre-announced and disappointed by missing estimates and guiding lower. Frankly if you don’t know that the telco and enterprise technology sector has been weak in Q1 then you aren’t invested in technology. Company after company has pretty much repeated the mantra: customers are reluctant to sign off on big deals but the pipelines remain in place, etc. It is disappointing, but the correct tactic has been to buy after the crash. This is why the color around Aruba’s conference call will be so important. Investors will want to discern whether this is a company-specific issue or a macro one. If it is the latter then the stock can recover strongly given a cessation of sequester/macro fears. Unfortunately at this point it is hard to tell the difference.

Autodesk (NASDAQ: ADSK) is a company I’ve discussed at length in an article linked here. Frankly it is very hard to predict what it will report. It is a company with an enviable record of beating its guidance, so when it misses the stock gets trashed. If you follow the general ‘tech is weak in Q1’ approach then you should be braced for a miss. On the other hand, certain industrial sectors have been strong in Q1.

The question is does Autodesk have enough exposure to areas like automotive and aerospace? Moreover, it has long term secular growth prospects from the shift to a software as a service (SaaS) based company, and this should provide sales support. The one thing I’m sure of is that the stock will be volatile over the results. Its internal guidance is for $570-590 million in sales and Non-GAAP EPS of $0.41-$0.46.

Two vastly different retail names also give results. Wal-Mart is about as mass market as you are going to get, but Nordstrom Inc (NYSE: JWN) is arguably more of a high end play. It’s a company with a well regarded management team that it engaging in every initiative it can to generate future growth in the face of a difficult consumer environment.

There is an outline of its growth strategy in an article linked here. Nordstrom is expanding its lower priced Rack stores and investing heavily in its e-commerce facility and in store Point of Sales offerings. Over the next few years its revenue streams will be substantially changed. The key questions are whether this will cannibalize or denigrate its existing brand and if the investment program will be executed successfully. For the next few years it is all about investment for Nordstrom, and investors should focus on this (and its effect on margins) in the upcoming results.

Friday

Friday’s are usually quiet days, but I’m interested to look at industrial filtration company Donaldson (NYSE: DCI). Its prospects are largely dictated by conditions in China. Its exposure to transportation and industrial products (with a heavy weighting towards construction machinery) will always mean it is a cyclical play.

Construction, mining and heavy trucking are problematic end markets right now, and investors have seen the point of an anticipated pick up being pushed out to the end if 2013 in previous reports. The key thing in the upcoming results will be the commentary over the recovery in China and where the country’s stimulus spending will be directed. In general it has been a weakening environment for its industry bellwethers, with Caterpillar and Joy Global both struggling to convince. On the other hand, Alcoa reiterated its guidance for 2013 within China, and since this implies 12%-16% growth in its Chinese heavy truck and trailer division, I think this bodes well.

Time to Buy Some Estee Lauder?

2013-05-15T03:34:00.002-07:00

To be or not to be? To buy or not to buy? That is our question with The Estee Lauder Companies (NYSE: EL). Whether it is nobler in the mind to suffer not buying a stock that that the market loves, or to take arms against a high valuation, revenue forecasts at the bottom end of guidance, and a management initiative that thus far isn’t quite going as planned? The good news is that unlike Shakespeare’s Hamlet not everyone is going to end up being murdered--but, being the maverick type, I favor raising arms against Estee Lauder's evaluation.

Estee Lauder’s growth prospects

I can understand why the market loves this stock and why it is willing to award it an valuation of nearly 24 times earnings to June 2014. The company has a number of attractive growth drivers:

An aging demographic and cultural trends that will ensure the skin care business has good long term growth.

Strong emerging market growth prospects.

On a relative basis Estee Lauder has more focus on prestige brands than mass and is better placed than, say, Revlon (NYSE: REV) or Avon Products to benefit from the two-tier recovery whereby the high-end fares better.

Unlike Procter & Gamble (NYSE: PG), it is a more beauty-focused company and should find it easier to innovate and react to changing consumer trends. This is incredibly important as more cultures become a bigger part of its clientele, and unlike Nu Skin Enterprises it is relying on a traditional sales channels rather than multi-level marketing.

A strategic management initiative (SMI) is intended to considerably increase inventory management and therefore cash flow and return on investment. A key part of this is a SAP deployment.

Putting these things together creates a powerful case for the company.

On the other hand, these drivers have been known for some time. I’m not convinced that Estee Lauder is a good value or is outperforming to the extent that the market is rewarding it.

Estee Lauder’s performance could be better

For brevity’s sake I should note that I covered the stock previously in an article linked here for anyone looking for a primer or background. I have three main points to make on why I think it could do better.

First, the SMI was supposed to produce significant cost savings and improve its operational metrics. This is already happening, but by some measures we could have hoped for a bit more. In the previous article I discussed how Estee Lauder was hoping to increase inventory turn to 3x from 2x. In simple terms this just means it holds relatively less inventory and can decrease working capital requirements accordingly. Ultimately this would help increase cash flow.

Its performance over this issue is best expressed in a graph. These are my calculations based on company data.

I realize that I am probably being a bit harsh here – it is early in the SMI -- but we are still a ways away from the 3x figure. This is a metric worth following because it will guide cash flow in the future.

Secondly, the SMI has caused some short term customer service challenges, which led to some delays and products out of stock. Management claimed that these problems were largely dealt with and were expected to have been resolved by the end of the quarter, but I note that the next wave of the SMI roll out has been delayed by six months. The SMI is not entirely going as planned.

And finally, the full year revenue guidance has now been moved to 6%, which is at the lower end of the previous guidance of 6%-8%. The reason cited for this was that the overall market is now predicted to grow 3% instead of 5%.

What the industry is saying

Revlon is more exposed to the mass market and it is suffering accordingly. While declining sales in Europe are expected, the slowdown in its Chinese sales (in line with the economy) is more disappointing. Its Asia Pacific sales declined 2% mainly due to declines in its color cosmetics in China. This is not a good sign in a market that is supposed to provide its long term growth prospects.

Similarly, Procter & Gamble recently announced a net sales decline of 2% in its beauty segment. Organic volumes and sales were down 1% each. The company cited a heavy competitive and promotional environment in hair care and skin care, although sales increased in its salon professional sub-segment. This is further evidence of a bifurcation between the prestige and mass market. In fact, Procter & Gamble faces challenges in keeping market share in all of its categories.

The last two companies are somewhat less reliable indicators. Nu Skin has been reporting strong growth but I think this company is partly reliant on keeping its distributors active and motivated. Avon is in the middle of a restructuring program that will take time. Indeed, sales are still declining in the US and China. Avon is more of an internal restructuring story.

It is not a positive industry score card, and near term conditions do not look great for Estee Lauder.

The bottom line

In conclusion, while I think the company has good long term prospects, it is hard to argue that it is a good value. Moreover its near term prospects (despite the hike in EPS guidance) appear to have gotten worse. The market is giving it the benefit of the doubt for now but, I’m not sure it's time to follow it.

Will Fortinet Hit Guidance This Year?

2013-05-14T03:32:00.001-07:00

A few weeks ago IT security company Fortinet $FTNT helped kick off a pretty dismal reporting season for technology by pre-announcing a weak set of results. Since then a plethora of other companies have reported and given a myriad set of reasons and excuses for missing. I think it’s fair to conclude that there was a marked reluctance among business to sign off on large tech deals in the quarter. Given that this could be temporary, is it now time to start buying these names? And with Fortinet, what does its new guidance entail for 2013?

Fortinet Updates the Market

Before going into the color I want to outline the full year guidance changes.

The guidance changes are pretty significant but I think that if they are hit then Fortinet will be higher by the end of the year. As I write the Enterprise Value of the stock is around $2.4 billion. I’ve followed this stock for a while and never seen it trading on a forward free cash flow over enterprise value (FCF/EV) of around (145/2400)=6%. The reason I highlight this metric is to compare it with very low Government bond yields.

It is arguably cheap on this basis alone. Furthermore consider the new guidance was based on a continuation of the weak trends in Q1 continuing in Q2 and most notably coming from U.S. service providers. So if you think this weakness will prove temporary then there could be upside to come. On the other hand my concern is that the guidance appears to imply some pretty optimistic assumptions for the second half.

Is Fortinet’s Guidance Achievable?

Consider that Q2 revenues were guided towards $143 million at the mid-point with $135.8 million reported already for Q1. This makes $278.8 million for H1 but the full year guidance is for $600 million. In order to see what this implies I have included the Q2 guidance plus my guesstimates for what Q3 and Q4 are implied to be.

I’ve assumed that Q4 will contribute 28.3% of revenues as it has done in the last three years. The Q3 and Q4 numbers are my estimates.

As you can see the implication is for a pretty concerted resumption to growth in the second half and I’m not entirely clear how this can be accepted categorically given the weakness in H2.

Furthermore here is how these numbers look on a sequential basis.

From this graph it looks like the Q3 and Q4 assumptions are for ‘same again’ sequential growth. Fortinet may well do this but given that Q1 & Q2 are notably weaker it does seem to imply a return to better conditions.

Why Was the Q2 Guidance So Weak?

I must confess I was hoping a bit more from Fortinet than it gave in Q2 guidance. If you go back to the analysis of the Q1 results there were three reasons given for the billings miss of around $12 million. Fortinet attributed $6-9m to service providers, Latin America missed by $4-6m and there was an inventory shortage (due to product refresh) which caused a $2 million-4 million miss. The last two issues were believed to have been able to rectify in the short/medium term thanks to new management and better execution, with the service provider issue being more problematic. However in the latest statement Fortinet basically said that conditions remained the same in Q2 as Q1. Rather confusingly Fortinet cited challenges in Europe even though a few weeks ago it said Europe was only a bit weaker.

With regards the telco service providers, there can be little doubt that they have been reluctant to spend. F5 Networks $FFIV also reported very weak numbers from its key telco vertical . My suspicion with F5 is that its problems are a combination of weak telco spending, the success of Citrix Systems with its rival Netscaler product and the difficulties in protecting its dominant market position within the application delivery controller market. For F5 and Fortinet the following graph of the latter’s deal breakdown reveals a lot.

I think there is a case for a ‘budget flush’ in Q4 which caused some overdue optimism and lets recall that the previous quarter contained worries over the fiscal cliff while Q1 saw a lot of attention over the sequester. Telco customers tend to do large deals and it wouldn’t surprise if this boils down to a few deals that didn’t close in Q1. So will future quarters bounce back?

The Competitive Environment?

Looking back at the recent results in the quarter I thought Check Point Software (NASDAQ: CHKP) reported a mixed set of results. While Check Point probably needs to generate some product and license sales growth to truly convince, in the light of what the rest of the industry has reported its results are starting to look good. The good news is that yearly comparisons are likely to get easier going forward even if the company doesn't seem to ready to shake off its 'cash flow now but investors wont see any of it' image.

Amongst the discussion of the deal commentary it mentioned winning a seven figure contract with U.S. wire based carrier and replacing Palo Alto Networks (NYSE: PANW) as a consequence. In addition it won a large U.S. deal with a global retailer and beat out Check Point, Palo Alto, Juniper and Cisco in the process. These sorts of wins (and other large deals cited in the commentary) are actually quite impressive because Fortinet is coming from a position as being known as primarily a SMB focused company.

For Palo Alto this sort of thing must be a concern because as a young and fast growing company (with an evaluation top match) it is not a good thing to see others replacing it with security solutions. It has a lot of expectations built into its evaluation. Moreover its solutions are not known for offering a value proposition so given any kind of discounting in the industry it could see its margins cut.

F5 only has security as a very small part of its revenues (and only really in the data center) but many of its customers are in common with these companies and if CFO's have decided to 'go slow' then it will get hit accordingly. My only concern with F5 as a recovery play is that it is undergoing a product refresh which might take a quarter or two to fully filter in. We shall see.

Is Fortinet Worth Buying Now?

As the charts indicate the guidance assumes somewhat of a bounce back in the second half and there are some internal opportunities (Latin American leadership and inventory shortages) which can be rectified but the key issue will be with telco spending.

The good news is that we can keep an eye elsewhere at what other companies are seeing. It has been a miserable reporting season for most companies selling into them and cautious investors might want to wait until one or two companies with telco exposure start saying better things.

V.F.Corp Continues to Find Growth

2013-05-13T07:39:00.001-07:00

V.F. Corp is one of those infuriating stocks that never seems to be cheap precisely when you want it to be. The latest set of results kept up its tradition of raising EPS guidance even if the revenue numbers were far from stellar. Indeed the key takeaway from these results was the margin improvements achieved within difficult end markets. This is one of the best run stocks in the retail sector, but it faces some headwinds in 2013. Is it good value right now?

V.F. Corp Prospects and Challenges

With its key brands of The North Face, Vans, and Timberland the company has benefited from the trend towards wearing outdoor sports clothing as a kind of fashion statement. I doubt that most people wearing mountaineering or hiking clothing have ever been on a climb or a trail. Moreover wearing Vans and listening to Sonic Youth doesn’t necessarily qualify you as bona fide skate boarder, but who cares as long as it adds to the bottom line of the company’s numbers.

In order to explain how Timberland makes money here is a breakdown of its segmental profits in Q1. The key brands are in the outdoor & action sports wear division.

Throughout 2013 the company is going to be faced with the following challenges

Timberland’s has significant exposure to Europe and markets like Italy and Spain are some of its biggest existing markets. Fortunately, Vans and The North Face were ‘built out’ of Northern Europe.

J.C. Penney is a key retail channel and in particular with Lee jeans and Vans. The difficulties with the department store and ongoing restructuring efforts could affect sales generation.

It’s Chinese operations haven’t performing great and it is a key part of its international expansion plans

In general the mid-market consumer is challenged in the current environment. It offers neither the income secure spending of the high end or the potential to benefit from trading down by the mass market.

Of course much of this known and the plan to deal with challenging markets is to expand its direct to consumer (DtC) sales via increasing the number of stores and investing in e-commerce facilities. Indeed DtC made up 21% of revenues in 2012 and are expected to rise to 23% in 2013.

What makes V.F. Corp different is that its diverse set of brands, channels and end-markets allow it to select areas in which to focus to generate growth through the cycle. Moreover its brands benefit from some secular fashion trends (as discussed above) whereas a company like The Gap $GPS is more exposed to general macro trends. Indeed, The Gap has had to completely restructure its business and separate its three brands (The Gap, Old Navy and Banana Republic) into three global entities. The idea being that this will create the ability to focus and innovate in order to drive growth. Note the difference here, The Gap is trying to innovate its brands to make the ‘cool’ while V.F. Corp is innovating in its sales channels. I’d argue that the latter is easier to do.

The J.C. Penney question is an uncertain one. The store has been hit hard by consumer spending changes and a misguided strategy of promising lower prices in general instead of the kind of discounting and promotional activity that the rest of the sector has been using. Whether the restructuring will work is open to question and it’s something to consider for V.F. Corp shareholders.

Q1 Performance

We can see how well V.F. Corp is run by looking at the profit margin movements in the quarter.

Margins were the real story this quarter because overall revenue growth was only up a paltry 2.2% and significantly below the 6% target for the full year. EPS was ahead of expectations and full year guidance was raised to $10.75 from $10.70 previously.

The standout performers in the quarter were the North Face and Vans which increased revenues 6% and 25% respectively. Moreover they achieved growth in the DtC channels of 25% and 20% respectively. As for the troubled region of Europe, The North Face recorded ‘modest’ growth while Vans rose an incredible 30%.

As discussed earlier the problematic brands in 2013 are likely to be Timberland and Jeanswear. Timberland revenues were up only 2% and flat in the Americas. Fortunately mid-teens increases in Asia managed to offset mid-single digit declines in Europe.

Where Next For V.F. Corp?

As I write the stock trades on 16.3x forward earnings. It is certainly not the cheapest stock out there and it has some headwinds to meet in 2013. With that said some of its brands are recording very strong growth and the DtC expansion is very impressive.

The problem with buying the stock up here is that I get the sense that all the positives are priced into it already and as good as the management are, the target of 6% growth for 2013 when only 2.2% was achieved for Q1, raises more questions than answers. Cautious investors will want to monitor events here and wait for a more favorable risk/return proposition.

This Week's Key Earnings

2013-05-10T04:22:00.004-07:00

Earnings season is starting to wind down this week and most of the really big names have already reported. Nevertheless there are still plenty of interesting companies giving results this week and there is no excuse for not trying to unearth value when you see an opportunity.

Tuesday

There is a health care theme to today’s results as surgical knife company Accuray gave results. Medical distributor McKesson also reported but I think the most interesting stock to report today was health care distributor (medical, dental and veterinary) Henry Schein of which there is an article linked here. Infection prevention company Steris also gave numbers.

Wednesday

Today was probably the most interesting day of the week for me. Israeli company Nice Systems (NASDAQ: NICE) specializes in systems that monitor and analyze customer interactions. If you buy the whole big data analytics story (I do) then you must also buy the idea that data capture is going to grow too. The last earnings were confusing because bookings growth was stronger than revenues. This is mainly because its cloud based and analytics solutions grew faster than product sales. These results confirmed these trends and its clear that the second half will be stronger. Although the results were only in line they were pretty good in the context of a weak market for tech in Q1.

The second tech company reporting was Rackspace Hosting (NYSE: RAX). I confess I’m not the biggest fan of this company’s business model. Essentially the concern is that by effectively offering its customers the opportunity to outsource their IT expenditures, it is committing itself to capital spending on customer gear. This is okay when markets are trending upwards but it is problematic when they move down because cash flow generation would take a hit. The relationship is best represented in this graph.

Unfortunately it missed estimates and the stock is being severely punished for it. Going forward it needs to demonstrate that it can generate leverage from its capital expenditures rather than have to keep spending in sync with revenue growth. This is is obviously harder to do if sales are weakening and it is going to be a lot harder to ascertain whether it really does have the kind of scalability to justify its lofty rating.

Thursday

Thursday sees an interesting bunch of companies reporting. You don’t have to be Charles Murray in order to be aware that Western society is shifting in terms of family relationships and a child care ad early education company like Bright Horizons Family Solutions is likely to see increasing demand in future years.

NVIDIA and priceline.com are today’s tech highlights. Precision Castparts (NYSE: PCP) gives numbers and it will be another chapter in the fascinating story of the industrial sector this year. So far the real strength in the sector has come from the automotive and aerospace sectors. The latter makes up 57% of its customers, with power 22% and general industrials at 21%. Looking forward to the results, investors can be confident of the aerospace sector but power has been weaker with some companies and there has been a slowdown outside of the best performing sectors.

Another interesting company to give results will be Treehouse Foods (NYSE: THS). I’ve never held this stock but should imagine it’s a nerve racking experience to hold it over results. Theoretically the private label food manufacturers should have done very well out of the weaker consumer spending environment. Indeed ConAgra’s purchase of Ralcorp is a sign of the sector’s attraction. On the other hand, the changing environment has also meant that sales channels have changed and this has sometimes caused problems for Treehouse. It’s customers have seen their volumes and sales channels changing and this has had effects on Treehouse in the past.

Friday

Today’s highlight will be Beacon Roofing Supply (NASDAQ: BECN). I like this company and think it has a lot of long term upside drivers. It can benefit from consolidating a fragmented industry and if the housing market continues to recover then we can expect some upside from new build and consequently from commercial and industrial build going forward. The key thing to look out for in this set of results is the pricing outlook. Pricing was down at the last set of results but this was due to some tough comparisons caused by strong demand from Katrina last year. On a sequential basis, pricing was up at the last results (for the third quarter in a row) and the key will be to see if it forecasts further improvements for 2013. We shall see.