Alcoa (AA) kicked off third-quarter earnings season with a wimper, which had been preceded by Yum! Brands’ (YUM) doozy of a showing. Incremental news impacting the expected performance of Walmart (WMT), Boeing (BA), and CSX (CSX) hasn’t been great either. Investors continue to write off weakness as “normal,” even “macroeconomic” as if it doesn’t matter, pointing to the transient nature of a struggling global economy suffering from a slowdown in the pace of growth in China and weakness in export-dependent countries, not the least of which is Brazil, as somehow a “good thing,” but it may not matter. The trajectory of expectations of future free cash flow generation is being impacted, and so are fair value estimates as a result, and that’s why shares of some of the most well-known bellwethers have taken a pounding in recent weeks. Ignore the news at your own peril.
October 14 brought some rather interesting developments. We say interesting and not surprising because we had outlined in our August 18 piece, “Dark Days Ahead for Walmart” that the worst was still ahead for the retailing giant. We only make mention of such recent articles, not to showcase our good performance or excellent calls, but to make it known that there is a wealth of informational value in the commentary section on each firm’s stock landing page. If you’re not reading the commentary associated with the companies of interest to you, in conjunction with their 16-page stock reports and dividend reports (pdfs to the right of the real-time chart), you could be missing out on some of the most important information, particularly as we expand upon our views, which often don’t fit as well into the report structure.
At the retailing giant’s investor day in Arkansas, Walmart warned of the ongoing impact of higher wage levels on its operations, something we have been talking about for a while (see here). We’ve never included Walmart in the newsletter portfolios and the firm has never registered an 8 or above on the Valuentum Buying Index, meaning we’ve never really liked its stock, even as we say Walmart’s business model remains resilient. The brick-and-mortar retailing giant outlined a three-year plan that left investors reeling, as it spoke of a bloated expense profile, one saddled with investments in higher wages and better technology, the latter focused on e-commerce and digital initiatives.
There’s nothing wrong with such investment, and it may very well be that Walmart just doesn’t have a choice, particularly in today’s social-conscious world, but the focus will hurt the company’s earnings, which on a per-share basis are expected to decline between 6%-12% by fiscal year 2017. The company’s massive $20 billion share repurchase program will only cushion the earnings-per-share blow, and that’s what perhaps has investors spooked the most. Just how bad will operating earnings truly be if, in spite of share buybacks, earnings per share could still fall double-digits? The 10% sell-off in light of this could still be just the beginning, as we outlined a few months ago.
Retail – Discount: BIG, DG, DLTR, FDO, FRED, PSMT
We’ve been warning about a bubble in high-yielding equities that pay out a dividend greater than what they consistently generate in free cash flow, but Delta (DAL) thinks another “bubble” is in the making. CEO Richard Anderson noted on the airline’s third-quarter conference call that the industry is witnessing a “huge bubble in excess wide-body airplanes around the world,” speaking directly to Boeing and Airbus (EADSY) and their B787/B777 and A350/A330 programs specifically, in our view. That the US-based carrier may be moving out of the primary aircraft buying market, to a degree, translates into weakened bargaining power at the airframe makers, potentially hurting their pricing power. Even in light of weakness in China and a potential softening of the wide-body market, however, we would expect any near-term delays to easily be met with a “pulling-forward” of deliveries. Boeing’s and Airbus’ backlogs of unfulfilled deliveries extend for years into the future, and we expect the aerospace supply chain to handle any shifts in demand quite well, particulary at this stage of the economic cycle. The sell-off in Boeing’s shares is likely due to the equity’s high correlation with incremental orders, which may be pinched if Delta’s warning of a “bubble” is genuine.
Aerospace Suppliers: AIR, AIRI, AL, ATRO, COL, HEI, HXL, ISSC, PCP, SPR, TATT, TDY, TXT
All the rails aren’t doing well either. CSX reported third-quarter results that showed revenue falling nearly 9% and net earnings roughly flat from the year-ago period. CSX is more heavily tied to coal (KOL), and as we outlined in “Valuentum’s Joint Outlook for the Railroad and Coal Industries,” released July 2013, it and Norfolk Southern (NSC) are most exposed to a decline in US coal-fired power plant retirements (and higher-cost Central Appalachian—CAPP—coal), given their rail networks in the eastern US. CSX noted that it expects 2015 coal revenue to decline ~$450 million as a result of continued low natural gas prices and high inventory levels. Coal volume will fall more than 10% during the year, as the outlook for export coal volume remains ~30 million tons. Management muted expectations for 2016 as well, saying that “significant coal headwinds are now also expected to continue” into the year.
Industrial Minerals: ACI, ARLP, BTU, CCJ, CLD, CNX, HCLP, NRP
We’re not truly surprised by any of these developments, but we think the threat of ever-rising wage inflation across the retail arena is perhaps the most serious ongoing development. Walmart has been struggling for a while, in our view, and we think its weak social capital in particular is coming back home to roost. We’re not worried in the slightest about the health of the commercial aerospace market, but some traders like to place their bets on industry orders not on free cash flow, and in light of the massive backlogs and pressures in Asia and risks of over-ordering, some traders may be able to make some money in the event outlooks become less rosy or more conservative through the course of third-quarter earnings season. There’s nothing new about the weakness in the coal markets, and we continue to believe investors are best suited staying away from that group. Union Pacific (UNP) remains our favorite railroad idea and remains a core holding in the Best Ideas Newsletter portfolio.