We were pleased to see the recent performance of Hanesbrands, and we continue to think IBM is not yet out of the woods, despite some life with respect to revenue trends. Let’s cover this and more.
By Kris Rosemann
There are a lot of things happening in the markets these days. For starters, growth in the world’s second-largest economy accelerated for the first time in seven years as China’s reported growth of 6.9% in 2017 was slightly higher than the 6.7% it achieved in 2016 and the projected growth rate for 2017 of ~6.5%. However, many observers are anticipating a return to the slowing trends of years past as the Chinese government works to reduce risky lending in areas such as buildings, infrastructure, and factory goods. In any case, market proxies for China’s equity market such as the iShares China Large-Cap ETF (FXI) are reaching levels not seen since mid-2015.
The Organization of the Petroleum Exporting Countries (OPEC) continued compliance with its production cap agreement, but the cartel raised its expectations for 2018 production from outside the cartel by ~16% to 1.15 million barrels per day, bringing into question the effectiveness of the production caps. Inventories in developed economies continue to fall, however, suggesting OPEC’s strategy is working as its stated goal is to reduce such stock to the five-year average. As of the end of November were roughly 133 million above the five-year average after falling by 16.6 million barrels in the month.
The International Energy Agency (IEA) expects the US to set records in 2018 in terms of oil production, and it could surpass Saudi Arabia and compete closely with Russia, assuming the OPEC-led production agreements are adhered to. US shale producers have been a key beneficiary of the production cap agreements, and relentless growth in the group is expected to continue as global oil stocks continue to be reduced, which is precisely OPEC’s strategy. The US beat production growth expectations in 2017 as daily production grew 0.7 million barrels to 9.9 million barrels per day.
In earnings-related news, Kinder Morgan (KMI) reported better than expected third-quarter results on the top and bottom line after the close January 17, and the pipeline operator remains on track to raise its annual payout to $0.80 per share in 2018 from its current rate of $0.50. Shares of Alcoa (AA) have faced pressure after the company reported weaker-than-expected earnings as a result of bauxite production that was impacted by a drought in Brazil. This impacted its ability to take advantage of improved alumina and aluminum prices, and higher power prices in Spain pushed expenses upward. The company also noted that it does not expect US tax reform to have a meaningful impact on its 2018 results.
Generic drug makers are feeling some pain after a number of hospitals announced plans to begin providing various generic drugs in an attempt to aid in reigning in healthcare costs that have resulted at least in part from “an acceleration of both shortages and escalation of prices.” Though the development is in its infancy, the plans should be viewed as a shot at generic drug makers that have kept drug costs high. The hospitals plan to form a non-profit that will sell drugs manufactured by a third party only to hospitals. The generic drug makers are also facing heat from the US Department of Justice over alleged price fixing, and credit quality across the space is deteriorating. Moody’s recently downgraded Teva’s (TEVA) credit rating to Ba2 (“junk”) from Baa3.
As the market continues to worry about how the US government will pay for the recent tax cuts, the US 10-year Treasury yield (TLT, TBT) leapt to its highest point since 2014 on the morning of January 19, underscoring a broader move across bond markets as central banks continue to transition from monetary policies that resulted from the Financial Crisis. As the Fed continues on its journey in raising interest rates, inflation looks to be picking up, which is helping push bond prices away from the trend that has followed a nearly 30-year rally and driving yields higher. Many bond bears have been wrong in years past, but we can’t help but feel that the recent tax reform will result in the US having to take on more debt, and if sovereign yields increase, even entities with improving credit quality may see their all-in costs of borrowing rise.
Shares of IBM (IBM) faced pressure following its earnings report after the close January 18. The company reported revenue quarterly growth for the first time in nearly six years, but material margin erosion in ‘Global Business Services’ and ‘Tech Services’ and weaker than consensus 2018 earnings guidance appear to be the key factors weighing on shares. We have written extensively in the past about what brought down Big Blue, and we now use the company as an example of poor earnings quality, “How to Assess Earnings Quality.” We think IBM was one of the very few mistakes Warren Buffett made – in our view, the Oracle was caught up too much in buybacks and earnings per share growth. He should have been focusing more on return on invested capital and the competitive landscape.
In consumer-facing news, Amazon (AMZN) is reportedly planning to increase the monthly price of Amazon Prime to $12.99 from $10.99. The annual cost will remain $99, suggesting the company is looking to get more of a commitment from its members than anything, especially following the holiday season, in which consumers may have joined the service just to take advantage of the free two-day shipping before ditching the service when it becomes less valuable to them. We continue to believe that Amazon is a key long-term threat to Netflix (NFLX), but nothing seems to be able to stop the latter’s pace of membership growth. We have been perplexed at how the market seems to be comfortable assigning the prevailing price for Netflix’s shares, and we think the only support for today’s price levels is a buyout of Netflix from another media company.
The Securities and Exchange Commission (SEC) has sent a letter to two US trade groups, informing them that it would hold off on approving cryptocurrency ETFs until all concerns were addressed. It lists concerns related to transparency of information, trading, valuation, and other matters related to the nature of the underlying assets. Increased caution may be warranted due to the fact that many believe cryptos will have meaningful use in our financial markets, which makes them inherently different from most assets held in SEC-registered funds. We’re skeptical of the recent proliferation of cryptocurrencies, and we’ve been reading horror stories about how some speculators have been using credit cards to purchase Bitcoin (XBT, GBTC) and others. Be careful out there.
Read the full letter here: https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm
As we wrap up this news-related note, we wanted to make mention that Hanesbrands’ (HBI) stock price has been doing quite well recently, now trading north of $23 per share (again). We liked that the company loosened up the terms of its credit facility, and we can’t help but feel the company set up the Street with conservative guidance when it reported third-quarter performance November 1. We continue to include Hanesbrands in the simulated Dividend Growth Newsletter portfolio.
Related: XLE, OIL, USO