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Quick Thoughts – CMG Q1 EPS

Written April 17th, 2014 by

There is very little not to like in CMG’s earnings release this morning (unless you care about margins or EPS results) – but we recognize that it is a growth stock and that top line growth is pretty much all that matters to some subset of investors and to CMG stock this morning.

  • +24.4% revenue growth year over year bested consensus by approximately $30 million;
  • Comparable restaurant sales increased an impressive 13.4% (we had heard whispers that were 10%+, but this result surely exceeds those expectations); one additional day in the quarter didn’t hurt either.
  • Restaurant level operating margins declined 40 bps, driven by 150 bps of higher food costs related to inflationary pressures in a number of commodities (we have discussed some of this in our work on agriculture);
  • EPS missed consensus in dramatic fashion, growing just 7.8% in the quarter, but is apparently an afterthought against the backdrop of sustained top line momentum.

Perversely, it seems that the more dramatic the impact of inflation, the more engaged investors become as the talk of CMG pulling the pricing lever moves to the forefront.

  • Acknowledging the traffic trends, it is abundantly clear that CMG is on point with respect to its offering to consumers, and we don’t doubt that the brand has sufficient equity to take pricing on a reasonable basis, even in an uncertain consumer spending environment.
  • On the other hand, if it ain’t broke don’t fix it can be applied to a large number of situations, this one included – we would not be buyers of CMG solely on the basis of an anticipated price increase because, even with substantial brand equity, there is an inherent riskiness to all price changes in terms of consumer response.

Ultimately, while we acknowledge the significant, positive momentum, likely on a multi-duration basis, behind the CMG brand, we can’t reasonably frame the risk/reward for investors and therefore can’t suggest being buyers of the name, particularly in light of our thematic work surrounding growth and value in the market.

Finally, there are a number of restaurant concepts whose positioning is far less fortunate than that of CMG in terms of brand equity and pricing flexibility and who are facing the same inflationary pressures (maybe not with respect to avocados) as CMG – beef and cheese sounds a lot like a hamburger, for example.  The restaurant sector remains one of our least preferred across consumer as we add concerns about inflation to our already existing concerns on valuation and consumer spending.

Quick Thoughts – PM Q1 EPS

Written April 17th, 2014 by

This morning, PM reported Q1 ’14 EPS of $1.19 per share, besting consensus estimates by $0.03 – we would characterize the quality as somewhat mixed (certainly not as strong as Q4 ‘13), but our view on PM is unchanged given what we see as one of the best risk/reward profiles in consumer staples, well-supported by a dividend yield of 4.4% and robust FCF.

  • Importantly, PM broke the recent cycle of negative EPS revisions, maintaining expectations for adjusted (excluding currency and charges) EPS growth of 6-8% for 2014.  Guidance on reported EPS improved by $0.07 per share ($0.10 more favorable currency, $0.03 in charges).  We tend not to get too bent out of shape on currency (in either direction), but it appears as if some of the pressure that we saw on reported EPS in ’13 is abating.
  • Currency drove most, if not all, of the ’13 negative EPS revisions even as the underlying business continued to deliver against plan – with currency moving to more of a tailwind (less of a headwind is technically more correct) in ’14, it would strike us as very odd for investors to now say, “It’s just currency”.
  • We continue to see sentiment as mixed, at best (just based on conversations we would tend more toward decidedly negative, but we don’t talk to everyone) and this quarter almost certainly isn’t the catalyst for investors to climb over the wall of worry.

The company’s reported 4.4% volume decline (against the easiest volume comparison of the year) may drive the stock reaction today.  The volume weakness was across multiple regions, but the company did suggest that the unfavorable timing of inventory movements in the quarter represented 2.4% of the volume decline.  Our main concerns with respect to volume weakness are Russia and Indonesia, but we are encouraged by the commentary suggesting early signs of improvement in the operating environment in Europe.  Our expectation is that volume trends will strengthen as we move through the balance of ’14.

Driven by the volume decline, constant currency organic revenue growth of -1.6% was disappointing, but the company was against the most difficult comparison of the year as pricing was nearly +10% in the first quarter of ’13.  Comparisons ease as we move through the balance of ’14.  Constant currency EBIT declined in the quarter as well (-3.1%), a contrast to the excellent currency neutral operating leverage that we saw in Q4.

We expect some small, positive adjustments to consensus estimates based on these results driven primarily by currency and continue to see PM as one of the better ideas in consumer staples across multiple durations.  The company is poised to deliver 6-8% currency neutral EPS growth in an investment year and while we appreciate the concerns investors may have regarding the company’s ability to return to its prior 10-12% EPS growth algorithm, we would argue that the current dividend yield and FCF profile make for an engaging investment case even if long-term growth is impaired, with investors essentially getting an inexpensive option on a return to prior growth rates.

Quick Thoughts: Another Annoying Google Quarter

Written April 17th, 2014 by

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-          While GOOG’s 1Q14 miss is disappointing, it is not particularly unusual in its history of focusing on the long term. To that end, 19% sales growth is a healthy indicator for the future.

-          Network ad sales grew just 4% as GOOG is capturing more ad dollars on its own sites through programmatic ad buying. TAC is now at a record 3 year low of 23.3%

-          The bottom line miss was exacerbated by a 400bp boost to OPEX, mostly due to unusual legal expenses and costs associated with integrating Nest that will be resolved by next quarter.

-          The miss had GOOG off over 3% after hours. We do not see the results as alarming, and would use weakness as an opportunity to add what we see as the best positioned player in the sector.

Earnings happen. Google, like its archrivals Amazon and Facebook, maintains a blasé attitude toward its short term results. This long-term approach, while ostensibly to be applauded, has an annoying tendency to periodically bite investors in the portfolio. Google’s first quarter report is an example of this habit. The numbers were short on both the top and bottom lines, and the stock tumbled after hours, eventually recovering to just 3.15% down. In its past 4 misses, Motorola’s hardware business was the prime culprit, but this time it seems to be a bit of over exuberance in sales estimates combined unusual items that drove OPEX up 400bp. Legal fees likely stemming from the recent stock split drove G&A up, while Nest’s heavy R&D flowed through the P&L taking the company from a historic R&D rate of 12% of revenue to 14%. Despite this little speed bump, things look more than alright in Mountain View.

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Medicaid HMOs: Growth Prospects Undervalued

Written April 16th, 2014 by

The outlook for commercial premium growth is sluggish; modest enrollment gains from the Affordable Care Act (ACA) and rising employment are offset by the rising tendency of beneficiaries to either buy cheaper policies, or forego coverage altogether

On top of this, the large ‘national account oriented’ commercial HMOs (e.g. CI, AET, WLP, UNH) stand to lose share of commercial beneficiaries, as employer sponsored beneficiaries move to the ACA’s exchanges or (more frequently) to private exchanges

Conversely, Medicaid is expanding; enrollment losses from rising employment are more than offset by more generous eligibility standards under the ACA; and by rising enrollment as states that have not participated in the expansion eventually choose to participate. Medicaid HMOs are gaining share of this growing population; and, average contract values stand to rise as dually eligible Medicare / Medicaid beneficiaries eventually enter HMOs

Importantly, we believe many of the Medicaid hold-out states would have expanded their programs to 100 percent of the federal poverty level (100 FPL) if Health and Human Services had agreed to pay the enhanced federal match on enrollees in these smaller expansions

Former Secretary Sebelius’ decision not to provide enhanced matching to partial expansions presumably was meant to encourage full expansions in most states, but this has not worked; more than 9 million Medicaid beneficiaries at or below 100 FPL remain on the sidelines in states that have not expanded. Former Secretary Sebelius’ policy was set to expire at the end of 2016, however we see some chance that the new Secretary nominee may choose to retire the policy sooner, bringing these additional 9 million beneficiaries into the program more quickly

We believe the relatively narrow difference between commercial and Medicaid HMOs’ valuations fails to reflect the broad differences in these subsectors’ growth prospects, and we conclude that the Medicaid HMOs are undervalued

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

April 15, 2014 – TMT: Don’t Rain on My IPO

Written April 15th, 2014 by

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TMT: Don’t Rain on My IPO

2013 was the biggest year for TMT IPOs since 2007, with 54 companies hitting the market, led by TWTR, but otherwise dominated by enterprise cloud software. 2014 began with a big backlog of 590 venture funded companies in the pipeline, up from 426 a year ago, representative of years of public market angst. 19 IPOs have issued YTD, with several high profile acquisitions as well. This year, the mix includes more consumer names, including 50%+of the IPOs YTD, and with Chinese e-commerce giant Alibaba expected to top FB’s 2012 offering as the biggest debut in history. For investors, we see 2014’s likely IPOs as a mixed bag. To date, intriguing plays like GRUB and OPWR have had strong launches, while riskier issues like KING have foundered. Looking ahead, we are more optimistic for enterprise cloud application plays like Palantir, New Relic and AppDynamics, than for the sub-scale infrastructure plays like Box and platform vulnerable consumer businesses like Dropbox and Evernote. Overall, we are bullish that paradigm shifts in advertising, retail, enterprise IT, entertainment, and telecom are opening huge new addressable markets to new paradigm TMT players, and that most valuations remain reasonable given this growth potential. Given this, strong cash flows and balance sheet liquidity, we believe talk of a new tech bubble is misplaced. On a side note, the IPO market may raise prices and slow the pace of sector M&A. We are adjusting our model portfolio – over the past 4 months, the large cap underperformed by 3200bp, driven by the recent pull back, while the small cap outperformed by 4600bp. FB and DATA are joining the large cap list, replacing CRM and CTXS, while OPWR and GRUB are added to the small cap portfolio, replacing GTAT and TYPE.

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Quick Thoughts – Corn, Inflation and the Consumer

Written April 15th, 2014 by

According to yesterday’s Crop Progress Report from the U.S. Department of Agriculture, 2% of the nation’s corn crop has been planted thus far, compared to 3% at the same time last year and 6% historically – small numbers, to be sure.

  • However, weather remains an issue with the small plantings year to date in primarily southern locations.
  • Cold weather is back in much of the Midwest, so we would expect only limited progress this week in terms of getting the crop in the ground and even with decent weather for the balance of April, getting ½ the corn planted by the first week of May (historical benchmark) looks a little dodgy.

Having said that, plantings started slowly last year and yields were right on trend – generally speaking, we are less concerned about the start of the crop year given the speed with which the U.S. corn crop can be planted and the steady improvement in crop genetics.

Continued weather related planting delays may, however, prompt a further shift in acreage away from corn to soybeans – this, in part, explains our more bullish bias on corn and bearish view on beans though our view on corn is also driven by demand (exports, feed and ethanol) and the bearish view on beans by the strength of the South American harvest.

Stepping away from the more micro details of potentially higher commodity prices, we note that the CRB Index is +11.3% YTD (CRB is an index comprised of 19 commodities, about 1/3 petroleum related as well as soft commodities) – Exhibit 1.

In the past, we have highlighted a number of puts and takes on consumer income in 2014 and it appears that inflation across the commodity complex is emerging as another “take”, forcing consumers that may already be struggling with lackluster income growth to ration purchases in more discretionary categories – there is only so much to go around.

Alternatively, to the extent that higher prices are not passed on to the consumer in certain categories (some packaged food, for example), we are concerned about margin pressure over time (at HSY, GIS and K, as examples) in part forming the basis for our less than constructive view of that subsector of staples, despite our more defensive overall positioning (prefer staples versus discretionary).

Finally, to the extent that our view on corn is correct and that the price of soybeans remains elevated, we continue to see the margin expectations at the protein companies as unrealistic (TSN, SAFM).

Quick Thoughts – KO

Written April 15th, 2014 by

KO this morning reported Q1 EPS of $0.44 per share, consistent with consensus estimates, a result that we expect will be sufficient to move the shares higher given just how bad we see the sentiment on the name currently.

Global volume of +2% exceeded consensus estimates, as did revenues (just slightly).

  • Europe was a negative standout with volumes down 4% in the quarter, whereas the strength versus consensus came from Asia Pacific and Latin America.

We doubt that this morning’s results represent meaningful upward pressure on current consensus estimates, but we would argue that expectations were that ’14 consensus was still too high (perhaps by as much as 2-3%)

We also note that volume comparisons ease as we move through ’14, so there is potentially a tailwind on optics for the balance of the current fiscal year.

We would stop short of calling KO cheap on an absolute basis, but sentiment is clearly more negative on the name when compared to the balance of consumer staples companies and it was an underperformer in 2013 (and 2014 looks to be an investment year).  Its historical premium versus its staples peer group has been eroded, with KO now trading 1.0 standard deviations below its two-year historical average P/E versus peers and 0.8 standard deviations on an EV/EBITDA basis.

Ultimately, it’s about what is discounted in the name and the optionality afforded investors at current levels – with the premium eroded, it appears to us that investors are getting an inexpensive look at a one of the premier global consumer brand franchises on the planet that, at a minimum, has some chance of returning to levels of global level growth seen in the not too distant past.

We continue to like the risk/reward on KO as we move through ’14, particularly in light of the fact that our sector positioning (staples versus discretionary) remains more defensive and sentiment on the name is mixed, at best – thematically, our view is similar to our opinion on PM – we like buying “broken” global consumer franchises with negative sentiment and favorable risk/reward profiles.

ACA Enrollment Round-Up – How Many Have Paid Premiums; How Many Were Already Insured Last Year; How Their Health Compares to Employer-Sponsored Beneficiaries’

Written April 13th, 2014 by

As of Thursday April 10th roughly 7.5 million persons have selected plans on the health insurance exchanges (HIEs); of these roughly 86 percent have paid (or are likely to pay) premiums; this points to a total of 6.5 million HIE enrollees

Best available evidence indicates that only 35 percent of these 6.5 million persons were uninsured in 2013, making the net gain in coverage as a result of the HIEs 2.3 million

The young (18-34) are underrepresented on the HIEs (28% of adult HIE enrollees as compared to 38% of the adult population); even if the HIE enrollees were of normal health for their age (which they’re not – see immediately below), the skew in age-mix to older enrollees appears large enough to result in adverse selection

Early prescription claims (January/February) show that HIE beneficiaries are significantly more likely than other commercial beneficiaries to consume prescriptions indicative of significant chronic disease – i.e. the early prescription claims indicate the HIE beneficiaries are on average sicker, and to a greater degree than would be expected simply because of their higher average age

Net gains in Medicaid enrollment year on year are 5.7 million; 3.6 million of whom were uninsured in 2013. Total reduction in un-insured is thus 5.9 million persons, 2.3 million on the HIEs and 3.6 million on Medicaid

It bears emphasizing that an additional 9.1 million persons would enter Medicaid if the non-participating states expanded the income eligibility cut-off to 100 FPL – which we believe they will do if HHS will pay enhanced federal matching rates on the new beneficiaries. Former Secy Sebelius refused to do this under a policy that expires at the end of 2016; her replacement could gain a larger percentage of these 9.1 million Medicaid beneficiaries by reversing that policy. We have no direct indication she intends to do so in the near term, but we continue to believe allowing these states to expand to 100 FPL is the most likely outcome. This of course augurs well for the Medicaid HMOs, which we favor

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

Quick Thoughts: First Data Announcement Highlights Increasing Integration of Payments and Marketing

Written April 10th, 2014 by

Yesterday, First Data (the leading US acquirer with 18% share – see below) announced the addition of support for loyalty marketing to its Clover platform which competes with Square Register, for example. Like Leaf from HPY and Square Register, Clover is an integrated point-of-sale (iPOS) solution replacing a traditional cash register for small-and-medium-sized businesses (SMBs) and integrating payments with marketing, revenue-tracking, inventory management and other business applications provided in a software-as-a-service (SaaS) format. iPOS is gaining share with one vendor reporting that 45% of single-location SMB’s had iPOS-capable solutions in 2012, up from 39% in 2010, and over 60% of new terminal shipments being iPOS-capable in 2013.

The strategic role of Clover is to create technology barriers-to-switching for merchant clients of First Data’s acquiring business, and provide the opportunity to sell add-on services. As iPOS becomes standard, channel-share in acquiring will move to direct salesforces and independent software vendors (ISVs) which can support the technology, and away from traditional “feet-on-the-street” ISOs. Mercury Payments Systems, which filed an S-1 on March 28th in preparation for an IPO under the ticker MPS, has ridden the trend to gain processing share (with 17% growth in 2013 versus 6% for the industry), but there are concerns about confusing sales practices. GPN seems vulnerable because of its distribution tilt to ISOs (only 20% of sales direct versus 60% at VNTV and 100% at HPY, for example) and because Mercury, which is a GPN ISO accounting for ~15% of volume, confirmed plans in the S-1 to in-source processing. This illustrates the broader vulnerability to acquiring processors of distributing through ISOs; they can be displaced either by another processor or as the ISO integrates back into processing.

We see the best play on the iPOS trend as VNTV. Aside from being a scale-player with one of the most best-integrated and hence most cost-efficient platforms in the industry (so that, for example, it is capable of competing head-to-head with First Data for the processing business of WMT), VNTV has chosen a distribution strategy with a likely reach-advantage in the SMB segment (where it is looking to expand from its core business serving large merchants). Rather than becoming a vendor of iPOS terminals like First Data or relying exclusively on a direct salesforce like HPY, VNTV made a July 2013 purchase of Element Payment Systems which has an industry-leading reputation as a service-provider to independent software vendors (ISVs). ISVs sell iPOS terminals and software to merchants but do not process transactions; Square, for example, is an ISV (although it uses Paymentech, not VNTV, for processing and also acts as a merchant-aggregator to simplify the on-boarding of micro-merchants who do not want the cost and compliance/credit checks of opening their own merchant account at an acquiring bank).

The shifting industry landscape is addressed in detail in our primer on merchant acquiring dated April 7th.

US Payments: A Primer on Merchant Acquiring

Written April 10th, 2014 by

Merchant acquiring – the business of providing merchants with authorization for card payments and settling and clearing transactions, often but not always through the branded (including EFT) networks, so that funds are moved from the merchant account to the cardholder account – will be transformed by the use of mobile phones by shoppers and cloud-serviced, often mobile, point-of-sale (POS) devices by merchants (rather than traditional POS computer systems with associated on-site maintenance and upgrade costs).

Winners will have: a processing scale advantage from serving large merchants; access to distribution channels, such as value-added resellers (VARs) including merchant banks and independent software vendors[1] (ISVs), where the sale is based more on system reliability and service than price alone[2]; and issuer-relationships generating the potential to (a) save network fees through direct bank-identification-number or “BIN” routing which by-passes the branded networks particularly for PIN-authenticated transactions (where lower fraud content reduces the need for network-level fraud risk management); and (b) add value through access to cardholder PII (personally-identifying information) which can support merchant-clients in the design of digital marketing campaigns.

Beyond Chase Merchant Services (which, with the cost-advantage of ChaseNet, will likely gain meaningful share of the acquiring volume on Chase-issued cards), our favorite name is VNTV which will gain share through leveraging its relationships with issuers (particularly in PIN debit where it is the leading acquirer) and by increasing diversification: geographically (from its Midwest roots as a wholly-owned subsidiary of FITB until June 2009); into e-commerce (with the acquisition in October 2012 of Litle); and into the SMB category through the merchant bank channel, with the 2010 acquisition of NPC, and with the acquisition of Element in July 2013 (improving access to ISVs).

  • In 2013, VNTV grew US purchase volumes at 9% which was exceeded among large acquirers only by bank-owned Chase at 15% and Elavon at 11%; WFC grew at 18% but off a small base with less than 5% share versus over 12% at VNTV (see Exhibit below).
  • Chase’s volumes growth is driven in part by its dominance of the e-commerce channel (with an estimated 25% share) where retail sales have grown at an annual rate of 16-18% since 2010 versus just under 5% for all total retail sales (excluding auto).

We are cautious on business models limited to the SMB segment, as at HPY and MPS[3], although these firms are acquisition candidates as the industry consolidates for processing scale and vertical integration with issuers; there is a particular concern around allegations that MPS is using confusing sales practices and misrepresenting costs to clients.

We do not see Square (with annualized volumes of ~$15bn versus over $500bn at VNTV) as a threat to large acquirers, and do not believe it (or anyone else) is generating adequate acquirer returns on the basic payments function in the micro-merchant segment given high churn and fraud rates. Square announced in November 2013 that it would seek to move up to SMB merchants but these typically operate on an interchange-plus pricing model where Square’s scale disadvantage will count more against it than with micro-merchants operating on a merchant discount rate (MDR) pricing model.

  • The edge from Square’s mobile POS is eroding as players with processing scale and distribution advantages offer me-too/better product. For example, the “Clover” mobile POS system (developed by First Data and distributed by it and Bank of America) has an open-API that will leverage third-party developers to compete with the proprietary reporting, analytics, and other applications available on the Square product.

PayPal faces increasing competition online as pay-with-iTunes/Amazon/Google expand from in-app and native-market purchases to e-commerce more generally, and as pay-with-Chase (announced this February). More generally, bank and network implementation of tokenization[4] eliminates the original case for PayPal (avoiding the need to enter card credentials into a merchant web-site) so that volumes will increasingly depend on consumer inertia and a value proposition to consumers that is independent of perceived security advantage. A spin-out from eBay would accelerate PayPal share declines by depriving it of its own native market.

  • Notwithstanding the acceptance partnership with DFS, PayPal will not gain meaningful share of mobile volumes because it does not have the economics to compete with issuer- and merchant-funded rewards; the experiment at HD indicates that convenience offerings (e.g. skip-the-line and order-ahead) are not enough.
Please see our published research for the full note and tables.


[1] ISVs bundle payments services in an SaaS format with other business management applications including customer-relationship and inventory management)

[2] In 2011, VARs and ISVs generated 15% of new merchant accounts up from 11% in 2009 and versus 32% from direct sales forces and 21% from independent sales organizations (ISOs); they were projected to account for 24% in 2013.

[3] MPS is the prospective ticker for Mercury Payment Systems which, last month, filed an S-1 registration; technically, MPS is an ISO for GPN which has responsibility for clearance with financial underwriting from WFC. MPS has announced that it will begin to take some processing in-house and so will become a processor in its own right.

[4] In a tokenized payment system, the card account information is replaced by substitute information (i.e. a “token”) with limited life and application (and so less value if stolen than the account information itself).

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