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Bellwethers Drive Dow Jones Past 23,450 – Cheers!

publication date: Oct 24, 2017
author/source: Brian Nelson, CFA

Image: The stock market is partying like it's 1999 or 1929, or 1987. You pick. Cheers! Creative Commons, Ruth Hartnup.

The market is reacting positively to calendar third-quarter earnings reports during the trading session October 24, and the Dow Jones Industrial Average (DIA) has now surpassed 23,450+. The rally in US equities ensues. Stocks mentioned in this note: General Motors (GM), McDonald’s (MCD), and Caterpillar (CAT).

By Brian Nelson, CFA

General Motors Delivers!!!

We couldn’t be more excited for holders of newsletter portfolio idea General Motors. The auto giant released a solid third-quarter report October 24 that has sent shares rallying to ~$46 each. If you remember, GM’s stock was languishing in the mid-$30s when we penned our September piece, “Why Won’t GM Break Out Already:”

Unfortunately, in GM’s case, it doesn’t appear that valuation and the dividend will combine to act as the catalyst, so we think the executive team may need to find a way to improve the “story” around the stock. As a fundamental, cash-flow based research entity, we care very little about “stories,” but in a market where entities like Tesla are building “castles in the air” on the backs of the hopes of investors, we can’t help but think that some “rhetoric” around the future innovative direction of GM would serve investors well. We continue to believe GM is a fascinating investment consideration, but investors seem like they need something to talk about these days. Hopefully, the executive team at GM will deliver on this sooner than later.

GM: Get investors talking about your future! Your valuation is attractive, the dividend is sound, but investors are missing the “storyline.” You need to change the public’s perception from one of a tax-funded bailout to one where GM should not only garner a market multiple of 17+ times but arguably one that should be higher than that. There is absolutely no possible way you can sit idly by while the market assigns a castle-in-the-air valuation to Tesla. Do what you do best GM: make cars that consumers want but get them talking about “the next big thing” out of your pipeline. Shareholders might be rewarded handsomely if you do. Fantastic sales performance and improved inventory, as we witnessed in August, may not be enough. Start dazzling investors with your talk about the future. Give the public something to wonder about!

It didn’t take long for GM’s shares to break out in early October on talk of its autonomous vehicle program, “General Motors is Off to the Races,” and the company has delivered yet again. General Motors noted that in the third quarter of 2017 that it was profitable in all business segments for the first time since late 2014, and with revenue coming in better than expectations, the market was given a lot to talk about. We love to hear GM talking about the future of automaking, and that’s precisely what the stock needed:

In September, Chairman and CEO Mary Barra shared GM’s vision for a world with zero crashes, zero emissions and zero congestion. To support this vision, GM outlined its all-electric path to zero emissions, announcing it will launch at least 20 electric vehicles by 2023, including two in the next 18 months…

…GM and Cruise remain focused on developing self-driving all-electric cars to deploy at scale — to save lives, lower emissions and reduce congestion. In September, they unveiled the world’s first mass-producible self-driving car. GM believes this autonomous vehicle, the third-generation test vehicle produced in just 14 months, will meet the redundancy and safety requirements necessary to operate without a driver. A critical proof point of this effort is the testing of self-driving electric vehicles in the challenging driving environment of San Francisco, and deploying them to transport employees who use a ride-hailing app called Cruise Anywhere.

General Motors has its sights set on the future, and Tesla (TSLA) may not be able to stave off the momentum in Detroit, which is fighting back in a huge way. The market may be large enough for a number of players, but our bets are on the established giants, many of which have survived the Great Depression a couple World Wars and more. GM may have needed some assistance during the Financial Crisis, but a rich history (dating back to the year it was founded by William C. Durant in 1908) is simply hard to ignore. We continue to like its dividend and valuation. GM remains in the newsletter portfolios.

More Room for McDonald’s to Grow?

It’s simply hard to believe that McDonald’s can still have any more room ahead of it to grow (people have been eating burgers and fries from Mickey D’s since the mid-1950s), but its third-quarter results, released October 24, revealed an increase in global same-store sales of 6%! Make no bones about it: we completely underestimated McDonald’s new initiatives, not the least of which was all-day breakfast, and we simply can’t believe the restaurant’s current pace of same-store sales expansion, which is nearing the high-single-digit level. Kudos to management.

As the company’s refranchising initiatives take hold, McDonald’s revenue is expected to fall (as lower-margin operating revenue migrates to higher-margin franchise fees), so we’re paying the most attention to the operating earnings line, which advanced 5% (3% in constant currencies) in the quarter on a year-over-year basis. Surely, we would have liked to see better operating earnings expansion, but efforts to grow the top line are certainly paying off. Its national beverage and McPick 2 value promotions and its Signature Crafted premium sandwich platform have been big hits.

That we weren’t uber-bullish on McDonald’s is a particularly tough pill to swallow because, well, who doesn’t love McDonald’s?!?! That McDonald’s has “reached (its) target to refranchise 4,000 more restaurants more than a year ahead of schedule” only aids in its position to mitigate any impact from higher labor costs (rising minimum wage legislation) and volatile commodity prices. Remember – McDonald’s is becoming largely a franchisor, where its customers are more the franchisees (entrepreneurs) than the end consumer (customer). Where the franchisees take on all of the operating risks of potentially higher labor costs and volatile commodity costs, McDonald’s, the corporate, just keeps reaping in that higher-margin franchise fee.

We value McDonald’s in the mid-$140s at the high end of our fair value range at the time of this writing, but the restaurant has somehow become a growth darling. We’ve been too cautious on shares in the past, even as we say that today, shares still look overpriced.

Related: ARCA

Caterpillar Puts Up Fantastic Third Quarter, Raises Outlook

It wasn’t but a few months ago in late September that we were commenting on Caterpillar’s improving fundamentals and that it reached a new all-time high of $120+ back then, “How Strong Is Caterpillar’s 2.5% Dividend Yield?”:

Caterpillar is one of our favorite companies from a fundamental perspective, if we look past the cyclicality of its operations and exposure to potential weak credits at its captive finance arm. No matter how you slice it or dice it though, the company’s dealer network is a significant competitive advantage, and the executive team’s ability to manage costs through the course of the economic cycle continues to be impressive. That its shares have now surged past $120+ to all-time highs, levels that it had only come close to reaching during 2011-2012, speak to the resilience of Cat’s equity, especially given the myriad global economic growth concerns during the past decade. But should investors be celebrating the recent rise, or be more cautious because of it?

We think they should be doing both, of course! What a wild ride Caterpillar’s share price has experienced during the past 10 years, and those that held on through the ups and downs have been handsomely rewarded. They should be happy – and popping the champagne! That said, however, our ~$100 per-share fair value estimate suggests that the company’s stock price is starting to get a little bit ahead of itself, especially considering the cyclical dynamics of its operations, which always seem to rear their ugly head at the worst possible time. We had picked up on Caterpillar’s optimistic commentary in April of this year, “S&P 500 Poised to Make New Highs…Again?: “for the first time in more than two years, same quarter sales and revenues increased,” and we continue to like its recent performance.

Caterpillar’s shares have now eclipsed the $137 per share mark as of the time of this writing on the heels of what was a fantastic third-quarter report and improved outlook. What a comeback. Third-quarter 2017 revenue advanced to $11.4 billion compared with $9.2 billion in the third quarter of 2016, while third-quarter 2017 adjusted profit per share was $1.95 compared with adjusted profit per share of $0.85. Caterpillar’s cost-cutting and efficiency initiatives are playing a key role in generating the positive operating leverage it is reaping on the improved sales performance. The enhanced outlook for 2017 has the Street buzzing, and shares continue to gain ground:

Caterpillar continues to see strength in a number of industries and regions, including construction in China, onshore oil and gas in North America, and increased capital investments by mining customers. We are working with our supply chain to increase production levels to satisfy customer demand for those markets that have improved. In July 2017, Caterpillar provided an outlook range for full-year 2017 sales and revenues of $42 billion to $44 billion, with a midpoint of $43 billion. The company now expects full-year 2017 sales and revenues of about $44 billion. For the full year of 2017, Caterpillar now expects profit per share of about $4.60, or adjusted profit per share of about $6.25. The previous outlook for 2017 profit was about $3.50 per share at the midpoint of the sales and revenues outlook, or adjusted profit per share of about $5.00.

Caterpillar's equity is trading at 20+ times full-year adjusted profit per share of $6.25, so the company’s shares aren't necessarily cheap, but if the trajectory of sales improvement and operating leverage continues, earnings growth may continue to be fantastic in the quarters ahead. Don’t forget, however, that Caterpillar’s operations are highly cyclical, and one only has to look at the past few years to see how painful performance can get when end markets don’t cooperate.

Related: SPY

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