Image shown: Performance of the S&P 500 (SPY) since August 2017.
As US equities continue their newly-found volatility, let’s take a look at some recent earnings reports and other developments around the markets. Cisco, the workhorse of both simulated newsletter portfolios, put up a fantastic report and upped its dividend. Berkshire continues to love Apple, and we maintain the view that the 10-year Treasury rate may be the greatest determinant of how well stocks perform in the coming decades. Airlines, garbage stocks, the “gas tax,” and more.
By Kris Rosemann and Brian Nelson, CFA
Do you know how happy it makes us to say that Cisco (CSCO) has been a staple of both the simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio for years? Shares of the communication networking behemoth are now in the mid-$40s, and we must say its outlook and dividend health are as strong as ever. On February 14, Cisco exceeded estimates on both the top- and bottom-lines during the calendar fourth quarter (its fiscal second quarter), and it guided fiscal third-quarter bottom-line performance above consensus. Management also upped the quarterly dividend 14%, to $0.33 per share (or ~3% on a forward annualized basis). Cisco’s equity hasn’t been this high since the dot-com bubble, and we hope you’re as happy as we are about it!
Our appreciation for the duo on top of Berkshire Hathaway (BRK.A, BRK.B) has only increased in recent years, and we hope that both Warren Buffett and Charlie Munger continue to talk about the markets, long past the age of 100 (Charlie is 94 years young). With its latest 13F filing, Berkshire Hathaway increased its stake in Apple (AAPL) by more than 20%, to 165 million shares, and while we understand that this may be a passive stake, we hope the Oracle will encourage Apple to be cautious with its huge cash balance and not rush to scoop up assets in today’s frothy market, but instead be prudently opportunistic with new opportunities. Berkshire has also been slowly reducing its stake in IBM (IBM), and unfortunately this turned out to be a rare miscue for Berkshire. We think a focus on accounting earnings per share and buybacks (and not on long-term return on invested capital) left the executive suite at IBM asleep at the productivity-and-innovation wheel.
Interest rates are often a confusing topic for some, as many believe that they only impact bond valuations. Interest rates, however, impact the value of a number of financial instruments, including stocks, not just bonds. For example, the discount rate used in valuation processes (implicitly in the PE and explicitly in the DCF) generally makes use of the 10-year benchmark US Treasury. The higher the discount rate, the lower the valuation, all else equal. As concerns grow about the US’ sovereign health and as inflation worries pick up, the 10-year US Treasury yield (TLT, TBT) continues to move higher, to 2.94% at last check. During January, headline inflation rose 0.5% on a month-over-month basis compared to the 0.3% growth that was expected, while core inflation advanced 0.3% compared to expectations for 0.2% growth, perhaps suggesting to some that new Fed Chair Jerome Powell may increase the trajectory at which benchmark interest rates are raised during 2018. We reiterate, however, that what’s most important is where the 10-year Treasury ends up in 2020 or 2025, not where it ends up today, next week, or even next year. A long-term perspective is key.
The US Census Bureau estimates that US retail sales (XRT) fell 0.3% in the month of January on a sequential basis, but year-over-year growth came in at 3.9% as nearly every category experienced positive growth. Department store sales were an interesting area of strength as sales in the group rose 0.8% in January from December 2017, which might suggest an easing of or adjusting in the promotional environment that has weighed on the group’s performance of late. We’re still very cautious on the group and believe the days are numbered at Sears Holdings (SHLD) and J.C. Penney (JCP). Meanwhile, American consumers continue to take on increasing levels of debt as US household debt reached an all-time high of $13.15 trillion at the end of 2017, which is good for ~1.5% growth from the end of 2016. 2017 marked the fifth consecutive year of growth in household debt thanks to increases in the mortgage, student, auto, and credit card debt categories.
US airline fares (JETS) dropped 0.6% on a sequential basis and 5.1% on a year-over-year basis in the month of January despite the jump in overall inflation. January marked the third straight month of fare declines as capacity increases by major airlines in key US markets are creating more competition for bookings (and increased supply). Such a trend may not go away anytime soon as United Continental (UAL) plans to continue growing capacity at a 4%-6% rate per year through 2020. We have long argued that the structural characteristics of the airline business have not changed for the better, despite consolidation, and we think pressure on long-term real fares will not go away. In our view, airlines have benefited more from declining jet fuel costs and the cyclical economic recovery than anything else.
Healthcare real estimate investment trust (REIT), Omega Healthcare (OHI) reported underwhelming fourth-quarter earnings after the close February 13 as adjusted funds from operations (AFFO) per share fell to $0.79 from $0.88 in the year-ago period. A material portion of the company’s disappointing results can be attributed to nearly $300 million in impairments on direct financing leases related to one of its largest tenants, Orianna Health Systems, “Omega Healthcare and Holly Energy Partners: Case Studies in REIT and MLP Income Evaluation.” Omega parted ways with 35 non-strategic assets in the quarter, and it is evaluating $300+ million in assets for potential sale in addition to 22 facilities currently being held for sale. The REIT hiked is quarterly payout to $0.66 in mid-January, and shares now yield nearly 10.5% on an annualized basis. We’re watching the REIT closely, but we have to emphasize that a yield north of 10% reflects considerable risk to the payout.
In the cryptocurrency world, Bitcoin (XBT, GBTC) is working to recover recently-lost ground as it surpassed the $9,000 mark February 14 after falling below $6,000 earlier in the month. Other cryptocurrencies are rallying alongside Bitcoin, but tremendous levels of speculation related in part to regulatory uncertainty remain across the space. Interestingly enough, J.P. Morgan (JPM) CEO Jamie Dimon, who recently was quoted as saying Bitcoin is a fraud, the House of J.P. Morgan put out what many are calling the “Bitcoin Bible,” a huge 70+ page document that details “everything from the technology of cryptocurrencies, to their application and challenges.” Some of the findings included how cryptocurrencies have had better risk-adjusted returns than stocks the past year (despite their falls) and that cryptocurrencies may eventually find a way into diversified portfolios given their near-zero correlations with other asset classes. Given some of the logical pitfalls of using quantitative research blindly, we wouldn’t be surprised to see cryptocurrencies continue to gain traction.
Snacks and beverage giant PepsiCo (PEP) reported a solid finish to 2017 in its fourth quarter report before the open February 13. Organic revenue grew 2.3% on a year-over-year basis thanks to strength in the ‘Latin America’ and ‘Europe Sub-Saharan Africa’ regions offsetting weakness in the ‘Quaker Foods North America’ and ‘North America Beverages’ segments, and core EPS grew 8% on a constant currency basis to $1.31. Total core operating margin improved 90 basis points in the quarter from the year-ago period, but free cash flow in full-year 2017 faced some pressure as it fell to ~$7 billion from more than $7.6 billion (and is expected to do so again in 2018 as guidance has come in at $6 billion for the year on flat roughly capital spending). Management’s plans to return $7 billion in cash to shareholders via dividends and buybacks suggests free cash flow coverage of dividends and share repurchases is tight, but given the 15% dividend hike and $15 billion share buyback authorization that accompanied PepsiCo’s fourth quarter report, management is likely to remain quite shareholder friendly.
Shares of Under Armour (UA, UAA) shot higher after its fourth quarter report, released before the open February 13 as revenue grew 5% on a year-over-year basis to $1.4 billion thanks to 11% growth in its direct-to-consumer business, which accounted for 42% of global revenue in the period. Earnings are expected to continue facing pressure moving forward, but management anticipates low single-digit revenue growth in 2018–driven by International growth of 25%+ and a mid-single-digit decline in North America. The company also announced a restructuring plan that it expects to result in a minimum of $75 million in annual savings in 2019 and beyond. Nike (NKE) remains a powerhouse, however, and share-gains against that behemoth will not be easy. Of note, Fossil (FOSL) put up a wonder-of-a-report February 13 that sent shares up considerably. The market liked that comparable store sales expanded modestly (2%) relative to expectations of a significant drop (-6%). We maintain our view that the fashion category is just too fickle to handicap, and this was part of the reason why we shed Coach, now Tapestry (TPR), in the simulated Dividend Growth Newsletter portfolio recently.
Walgreens Boots Alliance (WBA) is reportedly interested in acquiring the remaining shares of AmerisourceBergen (ABC) it does not already own (it currently holds a ~26% stake and a board seat). Though there is no official offer on the table, the potential deal should not come as a surprise, given Walgreens’ stake and the drug purchasing partnership the two companies formed in 2013 that resulted in Walgreens being AmerisourceBergen’s largest customer with ~26% of revenue. The heathcare landscape continues to become increasingly more competitive, especially given Amazon’s (AMZN) entrance, and many are looking to hunker down to play defense as assets are looked to be scooped up. CVS’ (CVS) deal for Aetna (AET) is yet another example of entrenched competitors trying to shut out new entrants.
From where we stand, medical supply stocks are the latest “victim” of the broadening threat of Amazon, especially after the e-commerce giant talked with hospital executives in tailoring its Amazon Business service for medical supplies. A pilot program is targeting the price comparison between Amazon Business and current distributors, which typically negotiate and sign contracts directly with hospitals. Amazon is looking to disrupt another industry where overhead costs may have gotten out of hand as fees, administration, marketing, and shipping costs account for up to 30% of health-care supply costs. No industry may truly be safe from Amazon, and the thesis that “culture” could become a sustainable competitive advantage, a “moat” characteristic, is strengthening. Being the lowest cost provider will always be an advantage, however, all else equal.
We’re huge fans of the waste-management industry thanks to its oligopolistic nature and the scarcity of landfill space in the US. We’ve liked Republic Services (RSG) in the past as one of our favorite ideas, and we continue to monitor the space closely due to its attractive business characteristics. On February 15, Waste Management (WM) reported fourth-quarter results that showed a beat on both the top and bottom lines, as the company emphasized that its “core solid waste business is the strongest in two decades.” Unlike the airline industry, the structural characteristics of the solid waste space are strong, and we expect participants to remain rational with respect to pricing. Waste Management, for example, is looking for core price to increase by as much as 4% in 2018. Increased pricing works wonders on earnings (EBITDA) and levels of profitability. Waste Management’s free cash flow during 2018 is projected to be between $1.95-$2.05 billion, very healthy levels.
In commodity-related news, the IEA reiterated its expectations for the US to become the “world’s leading energy producer” in 2019, thanks in part to a second wave of growth being enjoyed by US producers, which it has claimed is so high that the increase in US liquids production could equal global demand growth. However, production cap agreements led by OPEC continue to help reduce global oil (USO, OIL) inventories, and Venezuela’s economic crisis has helped take some production off the table as well. The country’s oil output in January fell to its lowest level in nearly 30 years, excluding a brief strike in 2003, which has had a tremendously negative impact on the nation as oil accounts for ~95% of its exports. The impact of President Donald Trump’s proposal for a 25-cent increase in gas and diesel taxes to pay for his infrastructure plans is likely negative on energy (XLE) demand. Trucking stocks may feel the greatest pain, if they are not able to pass along the price increase to customers.
As we wrap up with the introduction to the February edition of the Best Ideas Newsletter, we wanted to make you aware of the recent improvements at Twitter (TWTR), and the market has taken notice, too, with shares approaching the mid-$30s. We think the news/social-media entity is starting to do some things right, and if it can come anywhere near as successful as Facebook (FB), investors may start to get excited. The final piece of news we wanted to make you aware of is the shift at the top of Taco Bell, a division of Yum Brands (YUM). Former Taco Bell CEO Brian Niccol is now the new CEO of Chipotle (CMG), and we must say we’re viewing this as a huge positive for Chipotle given the menu innovation and organic performance at Taco Bell in recent years. This could mark a strong turnaround in Chipotle’s fundamentals, which have been weighted down by health scares in recent years.
<the February edition of the Best Ideas Newsletter is released February 15, 2018>
Airlines – Major: AAL, ALK, DAL, HA, JBLU, LUV, SAVE, UAL
Air Freight & Logistics: CHRW, EXPD, FDX, FWRD, HTLD, JBHT, KNX, ODFL, HUBG, UPS, WERN
Environmental Services: CLH, CVA, CWST, DAR, ECOL, RSG, SRCL, WCN, WM
Healthcare Products Distributors: ABC, CAH, ESRX, HSIC, MCK, OMI, PDCO, STAA
Health Care Providers & Services: ALR, DGX, LH, PRXL, TVTY
Health Care Services: CYH, DVA, HLS, LPNT, MD, THC, UNH, UHS
Recreational Vehicles: BC, LCII, PII, THO, WGO
Retail – Multiline: DDS, JCP, JWN, KSS, M, SHLD
—–