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August 24, 2015 – Quick Thoughts: Move Along Citizens, Nothing to See Here

Written August 24th, 2015 by

Quick Thoughts: Move Along Citizens, Nothing to See Here

The traffic back from the Hamptons may have set a record Monday morning as the Dow opened down a shocking 1000 points on general squeamishiness catalyzed by another sharp drop in Chinese stocks overnight. TMT stocks, seen as risky with their high multiples and high betas, have taken a beating over the past week, capped by the Monday rout. NFLX, hailed as a conquering hero on its 2Q earnings and environment, is off 12.3% vs. last week. AMZN, crushing it in both bellwether retails sales and in its recently broken out AWS business, is down 11.2%. GOOG is off10.3% despite solid numbers and a shareholder friendly restructuring announcement. MSFT may have seen its cloud revenues up 98% in 2Q, but its stock has declined 10.1%. AAPL? Down 9.3%.

With the strong performance of the TMT leaders prior to this recent slide and with the loft valuations accorded in private financings for companies like Uber and Snapchat, there has been chatter amongst pundits and value focused investors of a new tech bubble, a perspective that may have stoked the relatively strong downdraft amongst the tech stocks. Having been followed the networking sector through their rise and calamitous fall at the turn of the millennium, we don’t see it this time. Most of the highflyers brought to earth during this recent shock are robust businesses with long visibility to years of growth and to growing profitability. Indeed, we believe that some of these businesses could prove significantly MORE resilient to a global recession than the broader market.

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The Day the Bundle Died

Written August 13th, 2015 by

The Day the Bundle Died (Excerpt from August 12, 2015 – Video Media: The Cord Cutting Myth Gets Real)

One by one, media company CEOs have put a brave face on the state of the cable bundle despite the ample evidence of its deterioration. The shrinking number of pay TV subscriptions? “A slow leak that is unlikely to accelerate.” Falling ratings? “Nielson is not counting all of the viewers watching on a time shifted basis.” Weak upfront ad sales? “Ad buyers are simply choosing to hold back their decisions until much closer to the air date.” Ad revenues down year over year? “To be expected after the mid-term election spending in 2014.” Pay no attention to the man behind the curtain – the cable bundle is wise, powerful and eternal!

Or not. Media investors have awoken from a five year coma to discover that cord cutting is real after all. DIS CEO Bob Iger’s admission that even mighty ESPN was facing falling subscriber counts and soft ad sales shook them into a panic. The next day – a Black Tuesday for US media stocks – DIS, CBS, FOX, TWX, CMCSA, VIA, DISCA, and SNI dropped an average of 8.2%. After Wednesday, these 8 companies had shed a collective $46.2B in market cap. Ouch.

Separating out CMCSA and its massive cable system business, the remaining 7 media giants trade at a collective cap weighted P/E of 17.9, still suggesting better than market cash flow growth and ahead of their long term average. Consensus analyst expectations still suggest 4.7% sales growth over the next 5 years, perhaps due for some significant revisions.

Meanwhile, nearly a month prior NFLX CEO Reed Hastings laid out the picture from the opposite angle. Subscriptions were up 17% to 42M in the US, with domestic viewing hours up 40%. Assuming 1.5 viewers per stream, Netflix’s average audience is now bigger than any US network, cable or broadcast, and growing. Around the same time, Susan Wojcicki, head of GOOG’s YouTube business, shared some similarly impressive numbers. YouTube monthly viewership is up 40% YoY, and the total watch time is up 60%, the fastest growth in more than 2 years, to more than 10B hours per month. Mobile, which now accounts for more than half of those viewing, had a 100% jump in ad revenues YoY.

The TV industry’s response has been cautious, licensing live feeds to DISH, SONY and, likely, AAPL for skinny bundle OTT services, but refusing to allow cloud-based DVR functionality. Trends suggest that online linear TV may prove less than popular. Hub Entertainment Research recently reported that 53% of all US video viewing is time-shifted – DVR, on-demand, or streaming – with millennials even less likely to watch linear TV. TWX and CBS have jumped in with on-demand streaming versions of their premium channels, but at price points too high to encourage cord cutting.

We believe network TV is at the beginning of a long squeeze between weakening fees and ad sales on one side and rising content costs on the other. Streaming rivals will have increasingly larger scale, better data, and deeper pockets to buy more of the best content, including the life blood of linear TV – live sports. We acknowledge that the exodus that has begun will take many years to complete, but it is, nonetheless, inevitable. Media players that are diversified away from the cable bundle, e.g. DIS, or already moving to solidify their bona fides as streamers, e.g. TWX, may fare better than others, but all will suffer. Meanwhile, NFLX and GOOG should continue to reap the rewards of their dominance for online video. AMZN and FB have intriguing opportunities in what should be a huge market, but neither is likely to challenge for leadership. We also note that ad hoc live streaming, pioneered by TWTR’s Periscope and the startup Meerkat, is an intriguing extension to the YouTube paradigm and could be the “next big thing” in video.

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

August 12, 2015 – Video Media: The Cord Cutting Myth Gets Real

Written August 12th, 2015 by

Video Media – The Cord Cutting Myth Gets Real

The death of the multichannel cable bundle will take years to play out, but investors were reminded of its inevitability by the signs of erosion from even the best regarded media players. TV viewing is in decline. Pay TV subscriptions are falling. TV ad sales are down. Meanwhile, viewership is booming for NFLX and GOOG’s YouTube, as Americans are expressing a strong and growing preference for streaming on-demand video. The TV nets are coming late to the game, licensing linear streams to OTT players, like DISH, SONY and likely AAPL, offering skinny bundles online. We believe that the OTT bundles are unlikely to stem the tide toward on-demand streaming, damaging traditional media brands, and leaving them at a growing scale and data disadvantage in competing for creative content. Rising programming costs, particularly for live sports, will squeeze networks simultaneously suffering from top-line erosion. NFLX is the clear winner in subscription on-demand streaming, likely to continue its explosive sub growth with significant future monetization options. AMZN is best positioned to be number 2, ahead of TWX and its overpriced HBO Go. YouTube dominates the similarly fast growing ad driven, short-form video paradigm that it pioneered. We do not see FB as a threat to YouTube’s primary use cases, although its newsfeed has proven a robust channel for auto-play video ads.

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Quick Thoughts: Google’s New ABCs

Written August 10th, 2015 by

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Quick Thoughts: Google’s New ABCs

The announcement that Google would reorganize itself and take the name Alphabet had the ring of one of the company’s infamous April Fool’s pranks, posted to the same company blog used for the annual tomfoolery. The name itself is whimsical, and if this announcement had been made a few months earlier, it would have been hard not to take it as an elaborate joke – think of Larry and Sergey jumping in front of Apple in alphabetical order, just as Steve Jobs once picked the name Apple because it preceded his former employer Atari in the phone book. The move to add a layer of management and take a conglomerate style structure runs counter to the trend toward spinouts in the world of TMT.

Still, despite the whimsy and surprise, this creative move makes sense. It is a signal that the company is willing to accept more accountability for its investments, which will be easier for investors to evaluate extracted from the core business. This change also gives those investments more attention from management, perhaps encouraging more a more aggressive agenda of investing in long term winners while culling ideas that don’t pan out more quickly. Businesses like Nest, Fiber, Project Fi, autonomous vehicles, robotics, Calico and others could benefit from a bit more light and visibility.

The move also opens more C level jobs for the company’s deep bench of executives, many regular targets of recruiters looking to fill CEO slots elsewhere. In particular, it elevates highly regarded Sundar Pichai to the top slot at Google, putting the operating responsibility for Alphabet’s revenue and profit engine in the right hands, leaving co-founders Page and Brin to strategic positions at the top of the holding company. Core Google has many promising opportunities on its plate, and Pichai can pursue them aggressively without the distraction of moonshots. This is a good thing for the company and for investors.

Meanwhile, this move leaves Alphabet better able to pursue value-added acquisitions while it works to resolve antitrust charges from the European Union. Twitter, EBay, Spotify, and even Tesla become realistic possibilities under this structure. Imaging Elon Musk as CEO of a wholly owned Alphabet subsidiary with responsibility for the further development of autonomous vehicle technology. In the current environment, such moves would have been unthinkable if tied directly to Google’s core search business.

Investors apparently agree with my optimistic take on Alphabet, taking GOOG stock up 5% after hours once the blog post hit. The 2Q15 results, showing new discipline on expense controls and strong growth from the core business, assuaged a number of market concerns. This reorganization could provide the energy to keep the trajectory moving up and to the right.

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

DuPont – Investor Exodus

Written July 29th, 2015 by

DuPont management may still have the faith that the science based strategy is right, but everyone else seems to disagree.  Trian criticized the company for bloated costs and lack of returns on its R&D spend and we have echoed that in research both before and after the Trian involvement.

The bear case is winning today and it goes as follows: DuPont management takes the proxy win as an endorsement of the strategy and the path the company has followed for the last decade.  The company continues to waste money on ineffective R&D, continues to ignore its high cost base and possibly makes further bolt on acquisitions which disappoint and destroy value.  On this basis you would expect low earnings growth and a continuation of the recent history of negative guidance following too bullish expectations based on optimism around the R&D return and the value of novel products.  On this basis the stock at best moves sideways.

This is perhaps one of the least sophisticated analyses you will see from our group, but it illustrates a point.  In the exhibit below we show the cumulative spend on R&D for the last 20 years, divided by 2014 revenues.  The R&D spend at DuPont over the last 20 years is equivalent to almost 90% of the 2014 revenue level – overshadowing everyone else on the list with 20 year history.  Obviously we are not taking into account portfolio changes, but if you then compare this data with average 20 year TSR, you can see the disconnect.

DuPont will argue that the past is not a good predictor of the future, but we, and clearly many investors, believe that it is.

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The bull case is that all this could be fixed and that billions of dollars of value could be unlocked.  We would contend the following:

  • There is at least $3.0 billion of costs that could be cut out of DD without breaking up the company – the number would most likely be higher with a break-up
    • $3bn of costs – if all taken to the bottom line – would be worth $2.40 per share
  • At least $0.75bn of R&D could be abandoned with no impact on earnings
    • 35% of R&D – $0.60 per share
  • The balance of the R&D spend could be managed more effectively to generate a better return
  • Free cash can be deployed in share buyback and the company could buy back as much as 12% of the stock over the next two years including the one-time cash dividend from Chemours
  • Adding this all up gives a conservative $7.00-7.50 per share earnings number in 2018 versus current consensus of $4.50

Perhaps it would take more than 3 years to pull out all of the costs, but the opportunity is clear and this is what Trian was looking for and where the target price north of $100 per share came from.

Those selling the stock today are either convinced that the activists are not willing to have another go and/or that the DuPont board is willing to sit back and hope that a flawed strategy to date can suddenly come right.  We think neither conclusion is right. The bull case is much more believable

Eastman – The Silver Lining of the Propane Cloud

Written July 29th, 2015 by

Placing the wrong bet on propane prices may have been the best thing that could have happened to Eastman!  Eastman is a roll up story and the thesis is that as the company adds complimentary and sometimes overlapping product/technology platforms there are growth and, perhaps more importantly, cost opportunities.

Eastman is delivering on the costs and the improvement in overall operating margin drove a big earnings beat in a weak sales quarter, negatively impacted by price, volumes and currency.  Perhaps the company would have been less focused on the cost opportunity had it not been staring in the face of a major hedging headwind – nothing focuses the mind like having to overcome a major error/hurdle.

The portfolio remains confusing and complex, but the company is delivering. EMN’s well received Q2 results were highlighted by significant margin expansion in the Advanced Materials segment (9 percentage points). This improvement was notable for its magnitude but also in its demonstration that the company is beginning to derive value from its acquisitions, a condition we have previously noted would be necessary to realize the (still material) upside in the name. 50% of the Advanced Materials segment is comprised of legacy Solutia businesses (Performance Films and Interlayers), and the demand outlook here remains strong, though margins are expected to normalize at the blended 1H rate of ~17%.

That this run rate would represent just the fourth highest margin of EMN’s segments speaks to the company’s cash generative capability, and cash flow in Q2 indeed came in well above estimates. The company encouragingly offered a very shareholder-friendly view of capital allocation moving forward, favoring increased dividends and share repurchases with “large acquisitions” on hold “through 2017”, meaning investors will be paid as they wait for the still-considerable upside in the share price ($100 mid-cycle value on our model implies 23% from current levels).  This change in strategy with regard to use of cash is exactly what investors have been asking for and was highlighted in our initial work on the name.

Eastman’s ability to put up very strong earnings in the face of a major hedging headwind should significantly increase confidence in the stock, with the (re)allocation cash a further positive.  Note that EMN has a very low historic average relative multiple (to the S&P500), in absolute terms and relative to other chemical names. Restored/improved confidence could drive the relative multiple higher and our $100 per share fair value would then only be a starting point.

EMN remains one of the most attractively valued names in the Chemical space in our view.

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Quick Thoughts: Everybody Hates Twitter

Written July 28th, 2015 by

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Quick Thoughts: Everybody Hates Twitter

The monomaniacal focus on MAUs does TWTR a disservice – it is a lot more like YouTube than Facebook, and no one cares about Google’s MAUs. Project Lightning and an aggressive marketing campaign to educate consumers should stimulate engagement and keep the strong ad growth going. For now, TWTR is one of the few places to buy real growth – 64% growth in the face of 8% FX headwinds – at a discount.

The trading around TWTR’s 2Q15 earnings report was quite a ride for investors. At first, the stock rose more than 5% on sales and adjusted EPS that blew past expectations that had been tamped down after the widely reviled 1Q15 results. 64% top-line growth against a stiff FX headwind is nothing to sneeze at, and the $0.07 earnings number showed significant progress toward strong future profitability, even if the company is still dealing out shares to employees at a somewhat profligate rate.

Then came the second wave. First, naysayers glommed on to the fact that MOST of TWTR’s rise in MAUs came from users accessing the service via messaging platforms on feature phones rather than the full-fledged smartphone app. Fair enough, but Facebook, which doesn’t breakdown the number of its MAUs which access it via messaging apps, spent 10% of the company acquiring WhatsApp and its now 600M users for just the same type of access. Then, parsing the numbers a bit more, a new negative theme broke free – US MAUs were static quarter to quarter. By then, the stock had given back all of the rise and then some. At the end of the conference call, when management refused to give any information about the ongoing CEO search, TWTR shares settled to down more than 10% from the close.

This 2 hour frenzy of after hours action was a bit of a microcosm of TWTR’s life as a public company – fast out of the gate with big revenue growth and strong monetization trends, but slammed for its inability to post the kind of growth in registered monthly active users that had been delivered by Facebook. This investor fixation on MAUs has been a huge burden for the company, which is undoubtedly sorry that it had emphasized the metric so much in its IPO prospectus. It turns out that there are a lot of monthly visitors coming to TWTR and reading its content without registering. In this, it is a lot more like Google, which just threw in the towel on making its anonymous YouTube and Search users log in with Google+, than it is like Facebook, which bases its entire application around requiring each visitor to sign in. Google investors are happy enough with the billion plus YouTube users, even if they don’t know exactly who all of them are.

To that end, TWTR finally has some concrete plans to start monetizing the hundreds of millions of visitors that it claims to have – Project Lightning will let users immerse themselves in events and breaking news while getting relevant advertising, without logging in. A partnership with Google will lead new users to TWTR content. New marketing programs, long overdue, will promote and explain the value of Twitter to consumers long confused about its usefulness. Basically, a light bulb has come on above the heads of TWTR management, and maybe, the issues that have plagued it in the eyes of investors may be put behind it.

Meanwhile, I think the critics have gone a bit far. The Facebook favorite MAU metric is not fully indicative of TWTR’s assets – its critical mass of key opinion makers in every imaginable field, its timeliness advantage, the hundreds of millions who are aware of the service even if they haven’t registered. 64% YoY growth in the face of an 8% currency headwind despite the disappointing user number is evidence of the value of the platform to advertisers who understand the quality of TWTR’s interest data and the effectiveness of its native formats. Over a year ago, I pointed out that TWTR’s main problems were the poor design of its consumer app and the absence of effective marketing to sell its use case to the public. Finally, Project Lightening is due in 4Q, along with a real marketing campaign and, perhaps, a Chief Marketing Officer. Maybe this time the light at the end of the tunnel is not just another train.

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

ABBV: A Reluctant Farewell to the HCV Bull Case

Written July 28th, 2015 by

US HCV prescription demand has begun easing, and is likely to decline. Viekira Pak has maximized its share within the ESRX contract, meaning further share gains can only come from exclusive or preferred deals which don’t yet exist, or from convincing docs who can prescribe either drug to write for Viekira Pak instead of Harvoni

We don’t see any real possibility of ABBV gaining major exclusive / preferred formulary deals ahead of next year, by which time MRK will be entering the market with a third alternative that appears slightly inferior to the GILD and ABBV regimens, but which is effective enough to gain share – as long as it’s priced aggressively, as it surely will be

Share gains for Viekira Pak on ‘inclusive’ formularies, i.e. where both Harvoni and Viekira Pak are available at similar costs to patients, almost certainly will not occur. Prescribers prefer Harvoni, something no amount of promotion is likely to change

Share is stagnating, volumes are easing and soon likely to decline, and a major entrant who will presumably compete on price is due by 1Q16. And as all of this is occurring, in the US Viekira Pak has only a 9 percent share of total prescriptions and an 11 percent share of new prescriptions – well below the 20 percent lower bound of our original estimate

We believe ABBV will soon see its peak US HCV sales quarter, if it hasn’t already. On the bright side we do believe ROW sales prospects for the broader HCV market generally are too low; ultimately we expect aggregate ROW sales for the current generation of agents to be more than 2x aggregate US sales. Unfortunately US margins are higher, US sales are more relevant to near term expectations, and a larger percentage of ROW patients carry genotypes other than those (1a, 1b) against which Viekira Pak is effective

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

LyondellBasell – Hard To Fault

Written July 28th, 2015 by

First half oil prices were almost half the levels seen in 1H 2014, yet LYB has managed to produce 17% more net income than in the prior year.  EPS growth is greater because of the significant share buyback, which looks set to continue given high free cash flows and high cash on the balance sheet. The company produced good results in the US and better than expected results in Europe given operating limitations in Q2.

LYB could make close to $11 of EPS in 2015, and with the stock trading at 8.2x that number, it is hard to resist.  The stock has underperformed recently because of sentiment around oil, as it did in September and October of last year.  Despite the collapse in oil last year, LYB is putting up better numbers and EPS is further enhanced by the buy-back.  Furthermore, the company has again increased its dividend and now has a yield of 3.5%.  LYB’s ability to buy back 10% of its shares a year offsets the risk of possible lower oil prices and lower near-term US and European ethylene margins in our view and the TSR that LYB could generate looks much more interesting than for others in the space.

LYB’s return on capital has held up while WLK’s has fallen over the last two years (see chart) – WLK, LYB and DOW are exposed to the olefin and polyolefin markets – one of the few commodity subsectors where China does not have a surplus and where Chinese exports are not damaging global pricing.  The difference for both DOW and WLK is that they are exposed to other markets where China is a problems – chlor-alkali and PVC for WLK and chlor-alkali and epoxies for DOW (though DOW is divesting these businesses in 2015 to OLN).

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Nervousness around oil has brought LYB back down to a price that looks very attractive given earnings and cash flows.  There is clearly a risk that if oil weakens further you end up fighting a more general negative sentiment, but in our view the stock offers good value here.

The secondary risk would be that the strategy changes – the share buyback stops and LYB embarks on an acquisition spree.  This is unlikely, but would be very unpopular with shareholders most of whom own the stock for the return of cash to shareholders.

Note that consensus estimates going forward do not appear to account properly for the potential share buyback, suggesting that while forward estimates might be vulnerable to lower crude prices relative to natural gas, they have upside from a lower share count.

All of the ethylene names look a bit more interesting here – WLK could increase its dividend and buy back stock, given cash flows and we think the same is possible at DOW – see recent blog.  LYB is probably the cleanest story today, notwithstanding the change of strategy risk suggested above.

Dow Chemical – Neither Fish nor Fowl

Written July 28th, 2015 by

Dow Chemical’s second quarter demonstrated a problem that has concerned investors – both passive and active – for some time.  In the face of apparently very strong US and European basic plastics margins, the company did not do that well.  It will be interesting to see what the more pure play commodity polyethylene names do in the second quarter, as we suspect that they will show a better uplift than Dow.  Dow’s integration upstream into what are labeled “performance” products or “solutions” means that more and more of the commodity base materials within Dow are consumed into next stage derivatives that do not display the same level of cyclical pricing.  Polyethylene pricing may rise, but Dow’s advanced products have much more sticky pricing and do not move as much.

Dow is not displaying the cyclical swings that it used to, and as the chart shows, while returns on capital remain low and very close to the longer-term negative trend, the volatility is more muted.

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However, Dow is not really a growth story either.  Dow saw 3% volume growth in Q2 on a like for like basis (excluding business sold and its raw material business related sales/trading), which is not terrible given the state of the global economy, but it is also not a growth story.  It is certainly not enough of a growth story to support the significant R&D investment and capital investments that Dow is making.

The activist initial ideas are likely correct – the company is really two companies – a large efficient commodity chemical company and a large innovation driven growth company.  Dow may not appear to many to be a better company, or pair of companies on that basis, but it may be a much better stock.

  • Both pieces need a better focus on costs – with the commodity piece shedding the overheads associated with trying to “up-sell” and focusing on lowest cost production and highest quality
  • The growth piece needs to focus on an appropriate cost structure as well, and like DuPont needs to understand what it is getting for the R&D investment.

Right now the value investors are not getting their cyclical upside and the rest are not getting the growth.  Tactically the company has a couple of options; start moving down the path suggested, or increase TSR by significantly increasing the cash return to investors – the company has been buying back stock but its dividend remains below where it was on a per share basis before the financial crisis.

Either move would likely be positive for the stock near-term, though we may be looking at relative outperformance versus the sector rather than absolute if the commodity based sell-off continues.

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