Quick Thoughts: MSFT – Not Your Father’s Microsoft

Written October 23rd, 2014 by

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-          MSFT’s 1QFY15 were stellar – 11% YoY organic sales growth, strength in both devices/consumer and commercial businesses, and a solid EPS beat.

-          MSFT is killing it in the cloud – commercial sales up 128% YoY, likely to a $5B+ annual run rate. Commercial Windows and Server both delivered double digit growth

-          Consumer was a surprise. Xbox sales doubled YoY. Surface Pro 3 is selling at 2X the pace of Pro 2. Office 365 up 25% QoQ. Even Nokia was surprisingly strong.

-          Margins are down, but the fruits of MSFT’s significant restructuring are yet to be felt. 2015 should yield significant earnings acceleration.

Microsoft delivered another extraordinary quarter under CEO Satya Nadella showing the “mobile-first and cloud-first” strategy articulated in July is working. Top line revenue was up 25% to $23.2B, and backing out Nokia, the organic growth was a still impressive 11%. The top line figure handily beat consensus expectations of $22.0B and the bottom line was a solid beat of $0.54 in EPS against $0.49 expected. The company’s restructuring expenses also came in at the lower end of guidance with some $1.14B in write offs related to the Nokia handset business. With other traditional enterprise IT players struggling to adapt their businesses for new cloud and mobile opportunities, Microsoft has shown it’s successfully making the transition.

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October 21, 2014 – Sensors: What’s in YOUR Smartphone?

Written October 21st, 2014 by

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Sensors: What’s in YOUR Smartphone?

In the growing functionality of high end devices, the spread of basic smartphones, and the emergence of new device types – wearables, etc. – sensors are a $60.4B market that is growing at a 9.2% CAGR. We categorize them into 5 groups – physical, optical, radio, electrical and chemical – each serving specific applications and requiring particular design and manufacturing disciplines. As such, competition amongst sensor manufacturers stays within these silos. For sensor functions already well embedded into portable devices, suppliers are challenged to minimize cost, footprint and power draw, often integrating multiple functions of a type into a single solution. Emerging functions, such as gesture control or biometric ID, have drawn approaches using different sensor types, although economics and performance will eventually drive standardization. New devices are a growth market for existing sensor types, but may also create opportunity for new sensor components suited to specific applications. While we are bullish on new portable device opportunities for sensor components, we note that many longstanding sensor products are commoditized, particularly within well established traditional end markets, such as automotive and industrial automation.

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The Most Important Question to Ask on Earnings Calls – Q4 Demand!

Written October 21st, 2014 by

We have touched on the subject of inventory drawdown in Q4 in a couple of recent reports, but the more we think about the subject and refer back to history, the more we believe that this could be the most significant year-end surprise across a number of industries, but most significantly those where crude oil is a major input.

Outside the US the economic news is worse, demand growth is slowing in Europe, and in large parts of Asia and Latin America.  Local sellers and distributors will likely look to lower inventories as a consequence of expected lower offtake.  Within our Industrials and Materials universe inventories are not low in absolute terms – see exhibit, but not particularly high as a percent of revenues.


More significantly, with the almost 25% decline in Brent Crude Oil pricing since its summer peak, any international consumer of products made from crude oil or its fractions, will be expecting much lower pricing going forward.  Consequently, if historical behavior is any guide, they will drop purchased volumes immediately (this will have already happened in October) – to the minimums that contracts allow, and wait for pricing to drop.  This behavior was very pronounced among Chinese plastics importers amid the crude oil volatility of the late 1980s and 1990s, and was last seen most obviously in the early months of the GFC, when demand vanished for a quarter or two.  The second chart is a repeat from recent work which shows short periods of negative demand surprises as crude oil prices fall.


As an example, Dow Chemical’s sales in Q3 2008 were 13% higher than the prior year – in Q4 they were 25% lower than the prior year and in Q1 2009 40% lower.  This was a combination of volume and pricing – with part of the volume swing driven by destocking as crude oil prices collapsed and part was the ensuing price response both to lower crude prices and lower demand.  We are not calling for a decline this significant this time, but we do expect a negative surprise for Q4 and possibly Q1 for all chemical producers and possibly for most industrial companies with significant international business.

The counter of course is that lower crude is likely very good for economic growth – longer term things should improve and our expected demand shortfall should be no more than a one or two quarter event.

Further, there are conflicting signals in the US as international chemical pricing specifically could fall much more quickly than US domestic pricing (because the US market is very short of some chemicals today) – it could take a couple of quarters for the US to catch up.  Additionally, given the constraints on rail and road traffic in the US today, consumers of chemicals and plastics will likely be reluctant to play the inventory game because of supply delay fears – at the margin we have seen inventories creep up in the US for supply security reasons in recent months.

Quick Thoughts: AAPL – SURPRISE! AAPL beats! (actually, not a surprise)

Written October 20th, 2014 by

-          AAPL delivered 4QFY14 EPS of $1.42 on sales of $42.1B, handily beating the published consensus, on very strong sales of the iPhone 6 and 6 Plus that had been widely anticipated

-          Sales growth of 12.4% was the best since December 2012. iPhone unit sales of 39.3M were up 16.2% YoY, with ASPs up 4.3% to $6.02. iPhone is 56.2% of AAPL sales, up 340bp YoY.

-          Mac sales had a big quarter, up 18% YoY and 15.7% of total. The iPad franchise, down 14% to 12.6%. of AAPL sales, is deteriorating. iTunes grew 8% YoY, falling to 10.9% of total sales.

-          We expect another big beat in December. Increasing dependence on iPhone raises risks as high end smartphone market saturates. Strong Apple Watch sales needed to sustain growth in 2015.

Having already reported selling 10 million units during the opening weekend sales of the iPhone 6 and iPhone 6 Plus, and ongoing press commentary of the vigorous global demand for Apple’s foray into modern larger screen form factors, it would have been shocking if the company had not blown out the published consensus numbers. In that context, the fairly sleepy after-hours response to the obviously excellent results is not all that surprising.

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SSR Health New Product Approval Portfolios & Supporting Data Update

Written October 20th, 2014 by

Drug, biotech, and research-based spec pharma stocks tend to outperform their peers in the year or so before and after regulatory actions (‘PDUFA’ dates) on major new products, with a large portion of total risks being concentrated in the days immediately preceding and following the PDUFA date

Since November of 2011 we’ve run model portfolios consisting solely of names with pending (i.e. ‘pre-PDUFA’) or recent (i.e. ‘post-PDUFA) major-product regulatory actions, respectively. Within each broader ‘pre-‘ and ‘post-PDUFA’ portfolios are three sub-portfolios that differ only in terms of how large the new product is as a percentage of the company’s total sales forecast. E.g. the ‘1% pre-PDUFA’ portfolio consists of all names with pending regulatory decisions on products that account for at least 1% of the company’s total sales forecast, and so on for the ‘5%’ and ‘20%’ pre- and post-PDUFA portfolios. To moderate risks, all portfolios follow rules to limit long positions in the days immediately before and after regulatory actions

Since inception the 1% pre-PDUFA portfolio has produced greater annualized returns (52% v. 31%) at a lower standard deviation annual of returns (11% v. 14%) than an ‘innovator index’ of nearly the entire universe of biopharmaceutical stocks. The 5% and 20% pre-PDUFA portfolios have outperformed by even greater margins as compared to the innovator index (68% and 79% v. 31%), though at higher s.d. of returns (25% and 43% v. 14%). Over the last twelve months, the 1%, 5%, and 20% pre-PDUFA portfolios have returned 43%, 66%, and 116%, respectively, versus 17% for the innovator index and 36% for the BTK, while also reducing relative risk

We expect US real pricing power for pharmaceuticals to fade, which will increase the importance of new product flow to relative performance. Thus screening for names with attractively priced new product flow is an appropriate first step to stock selection across the drug, biotech, and spec pharma sub-sectors. We offer two related tools, the first being these portfolios of names with major pending or recent regulatory actions (published monthly); the second being our Hidden Pipeline series of reports that identify undervalued phase 2 and earlier pipelines (published quarterly)

Please note: regularly included in this series of reports are detailed tables of all (major or not) pending new drug applications (NDAs) and biologics license applications (BLAs) for all US-listed drug, biotech, and research-based spec pharma companies; and, detailed tables of all phase 3 products under active development by these companies

For our full research notes, please visit our published research site

Quick Thoughts – Initially Apple Pay More Disruptive Online than at Point-of-Sale

Written October 17th, 2014 by

Apple’s new iPads (iPad Air 2 and iPad Mini 3) announced today will have TouchID and hence allow for Apple Pay purchases within apps supporting the Apple Pay API (albeit not at point-of-sale since the iPads do not have NFC radios). Apple Pay becomes available in the US this Monday with the release of iOS8.1; the initial bank partners are AXP, BAC, JPM, C and WFC with a reported additional 500 banks signed up for the service since the initial announcement on September 9th and to be included over time.

A likely impact of reduced payments friction for online purchases (since using Apple Pay is easier than entering card credentials into a tablet screen) will be to close the gap between tablet traffic (at 17% of the e-commerce total) and tablet orders (at 13% of the e-commerce total); as shown in the chart below, the gap is even larger for mobile. Furthermore, Apple Pay will likely encourage consumers to shop more frequently via app than browser giving the app-provider (typically a retailer) more control over data and advantaging the app-provider in tracking digital ads and offers through to purchase. As discussed in our October 6th note, “Expect Data Partnership between Google and Visa”, the current difficulty in achieving this trackability is one reason Google reports “mobile does not monetize as well as other forms”.

Chart: Purchase Orders on Mobile and Tablets are Low Relative to Traffic


The mobile or tablet wallet is a marketing platform, not just a payment facilitator. Payments consultant, Richard Crone, noting estimates for the annual revenue potential from ads and offers at $300 per active mobile wallet user, has commented that banks would prefer to recapture this revenue from their own branded wallets. However, this is not possible with Apple Pay because its implementation through the Passbook app means that Apple controls the user experience and can shape the options for tender-steering and marketing. Banks have more flexibility on Android devices (KitKat and above) because host card emulation (whereby an Android device “emulates” a payment card by storing credentials in the cloud) allows them to control payments-branding; however, ad tech company Fluent reports that over two-thirds of mobile transactions are on iOS devices.

A specific example of Apple shaping tender-options is that PayPal is not included in Apple Pay. Indeed, as noted in our October 2nd report “The Closing Window of Opportunity to Broaden the PayPal Acceptance Brand”, we see new solutions to simplifying online checkout – including Apple Pay and Visa Checkout announced in July – as significant threats to incumbent solutions such as PayPal and Pay-with-Amazon that involve the increased acceptance costs and data-leakage risks of an intermediating payments “aggregator” that acts as merchant of record. This is not the case for Apple Pay which acts simply as a conduit, and costs the retailer no more than acceptance of the customer’s payment card.

Quick Thoughts: GOOG – Moonshots are Expensive

Written October 16th, 2014 by

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-          GOOG missed 3Q14 EPS by 2.8%, failing to deliver an expected QoQ improvement in operating margins. Net sales were in line, with fractionally lower revenues offset by slightly better TAC.

-          Sales saw total paid clicks decelerate to 17% YoY growth, but cost per click was once again flat QoQ and down just 2% YoY, rebutting the popular bear narrative of chronic price deterioration.

-          Sites revenue grew 20% and “Other” revenue – including Play, devices, Docs and Compute Engine – grew 50%. Expenses were up nearly 30% YoY, driven by R&D and SG&A.

-          Modest CAPEX, up less than 6% YoY, may be a sign of future cost improvements, but like many other cloud-era leaders, GOOG is relatively unconcerned with delivering quarterly results.

Google missed its 3Q14 EPS bogie by $0.18, delivering $6.35, when the assembled sell side wanted $6.53. Predictably, in a tough tech tape, Google shares are trading down a bit over 2% after hours, drooping uncomfortably close to the 52 week low of $503. Still, despite the headline, 3Q14 was, more or less, a continuation of the trends set in the last couple of quarters.

Sales were, essentially, in line, up 20% YoY at $16.52B. While this was nominally $50M below the published revenue consensus, most investors care more about Google’s net sales after deducting traffic acquisition costs (TAC), and those were actually just a tick above expectations, since TAC was more than $50M lower than forecast. Inside the sales number, was more give and take. The total paid clicks were up just 17% YoY, decelerating from better than 25% click growth in each of the previous three quarters. Management drew a few questions about decelerating click growth on the conference call and asked investors not to panic, explaining that ad demand is pretty volatile quarter to quarter.

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Quick Thoughts: NFLX – One Strike is Not an Out

Written October 15th, 2014 by

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-          NFLX disappointed investors on sub growth, missing guidance for 3.7M new subs by 19% as a price hike and a relatively weak slate of new programming releases dampened demand

-          The disappointing results were amplified by TWX’s announcement that it would offer HBO as a stand-alone streaming service in 2015 – we expect a significantly higher price point than NFLX

-          While sales disappointed vs. consensus, they were up 89% YoY, an acceleration from 2Q14’s 85% growth, a better indicator of imperfect forecasting than real operating problems

-          We remain confident in NFLX’s long term trajectory and expect substantial further sub growth going forward. We also see significant opportunity for advertising revenues down the line.

This is why many technology CEOs hate to give guidance. After blowing out numbers for the past three quarters, NFLX honcho Reed Hastings offered a 3Q14 target of 3.7M new subscribers, a projection of 33.4% YoY growth in total subs and a slight acceleration against the 33.3% growth the company delivered in 2Q. OOOPS! NFLX only delivered 3.0M new subs in the quarter, missing the total sub number by 1.3%, and BOOM! NFLX stock is down 25% as I write this.

It turns out that when you raise prices by 12.5% on a mass market consumer good, it has a negative impact on demand volume. Who knew? Perhaps Hastings had grown confident in the warm glow of Emmy nominations for NFLX’s “Orange is the New Black” and “House of Cards”, both of which had launched new seasons in the spring amidst fanfare and drove strong sub numbers in the first half of the year. Unfortunately, there were no such publicity-magnet tent-pole shows arriving during 3Q and the impact was apparent in the sub numbers. Still, 33.3% YoY growth in subs and nearly 89% growth in revenues should not be taken as some sort of indicator of doom.

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Deere – The Floor Looks Robust

Written October 15th, 2014 by

In times when market momentum is very obviously directionally downward, certain stocks inevitably stick out as better insulated to the sell-off. With the S&P shedding more than 5% over the past week, DE has held firm around the $80 level and actually moved up as the market has moved steadily down – our prior work on the company and its historical valuation trends showed little room for further downside in the stock price.


Further downside to earnings remains likely, however, as certain tax incentives expire and farm incomes continue to be pressured by weak commodity pricing – but we retain our belief these effects are largely priced in, and DE’s recent performance offers some early support for this thesis. Notably, reports of bipartisan support for the reinstatement of a US farm equipment tax credit could be a source of marginal upside, though we note DE’s high non-US exposure, where agricultural industries will likely remain volatile but will also continue on the modernizing path that has driven growth for DE over the past decade.

In the more immediate term, history indicates we could see continued outperformance from DE in the fourth quarter – we modify an exhibit from our August report highlighting the company’s strong second half performances, noting that most of this outperformance tends to come in Q4. Additionally, valuation continues to be attractive, both relative to the broader Capital Goods sector and on an S&P relative P/E basis.


In short, farm economics remain a concern, but our belief that any weakness on this front is already priced into the stock has been confirmed by DE’s resilience in the face of the recent broad market sell-off. We believe considerable upside remains, with downside likely limited as demonstrated over the past few weeks, and our return on capital driven model shows a “normal value” of over $120 a share.

WAG/RAD: Pressure on generic dispensing margins likely to be much more permanent than guidance implies

Written October 14th, 2014 by

WAG & RAD both recently lowered guidance; both blame falling generic dispensing margins. In each case the companies point to pressures on both sides of the margin equation – rising generic acquisition costs, paired with lower-than-expected reimbursement

Unravelling the relative importance of these two effects is strategically crucial; rising generic acquisition costs are relatively transient; rising reimbursement pressures are more likely to be permanent

Evidence indicates generic acquisition costs played little if any role in reducing companies’ generic margin expectations; this implies falling reimbursement pressures played the major role, and that lower generic dispensing margins are here to stay

The companies make 3 arguments regarding the generic acquisition cost trend: 1) acquisition costs grew at a surprising rate on ‘existing’ products; 2) acquisition costs on newly launched generics fell more slowly than normal; and 3) newly launched generics are being made by fewer manufacturers than expected

None of these arguments are supported by evidence. On a sales-weighted basis, ‘existing’ product generic acquisition costs indeed experienced major hikes through February 2014, but they remained stable thereafter through the months when the companies issued/confirmed higher guidance (and subsequently lowered it). Also on a sales-weighted basis, acquisition costs of newly launched products fell faster more recently (Nov. 2013 – July 2014) than they did last year. Finally, the number of manufacturers for new generics has been no different than should have been expected given the dollar size of the parent brands, the presence or absence of an OTC version of the parent molecule, and the complexities of manufacturing any given new generic

By simple process of elimination this argues that reimbursement pressures are likely to be the major cause of falling generic dispensing margins at retail. The companies acknowledge the trend to narrow networks has played some role in reduced reimbursement; we would argue that narrowing of networks appears to have played a major role, will continue for some time, and will result in steady additional pressure on generic margins. As context, consider that REAL retail pharmacy dispensing margins have grown faster than real pharmaceutical prices since at least 2001, despite the fact that there are no fewer outlets now than in 2001

Unmentioned as a driver of lowered guidance is the shift toward reimbursing pharmacies on the basis of NADAC (which is likely to result in lower generic margins than reimbursements based on AWP). NADAC became available to all US retail pharmacies in April of this year, meaning 2014 has been the first negotiating season (for 2015 benefits) in which payors could reasonably be expected to ask retailers for NADAC-based contracts

For our full research notes, please visit our published research site

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