Quick Thoughts: AAPL & MSFT June Quarter Results – The Song Remains the Same

Written July 22nd, 2014 by

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-          AAPL’s 3QFY14 was mixed, with sales 1.5% below consensus but EPS 4% above on impressive 39.4% GMs. iPhones were in-line with strong expectations, but iPads were down YoY – again!

-          A revenue miss, 6% growth, the fast erosion of iPad sales, and tepid 4QFY14 guidance might have ordinarily spooked investors, but iPhone 6/iWatch hype has most looking ahead to Dec.

-          MSFT beat topline expectations by 1.7%, with 10% YoY organic growth driven by strong enterprise sales. EPS would have beaten by $0.06 without one-time Nokia and other charges.

-          More Nokia write downs and the costs of the upcoming layoffs will hit future quarters, but a 147% YoY increase in cloud sales, now 11%+ of total, speaks to MSFT’s real growth potential.

With the rise of the mobile/cloud era of computing, the nature of the Apple/Microsoft rivalry has changed dramatically. New rivalries with the likes of Samsung, Google and Amazon Web Services have pushed the traditional “Mac vs. PC” battles to the back burner. Still, with the two erstwhile enemies reporting on the same night, it’s an opportunity to engage in the nostalgia of comparing the two companies again.

Both companies’ results had a little bit of hair on them. Apple crushed its EPS bogie by 5 cents, juicing those earnings with 39.4% gross margins, 140bp higher than analyst expectations and the highest level since 4QFY12. However, and it’s a big however, Apple revenues were $600M below expectations at $37.4B, with disappointments in both iPad and iPhone sales not mitigated by the upside surprise in Mac revenues. Guidance for next quarter was weak, suggesting more of the same in September and pushing all of the chips on the Holiday quarter and the hotly anticipated debuts of the iPhone 6 and the iWatch. Microsoft, on the other hand, handily beat revenue expectations, with $23.4B versus the $23.0B expected, but fell short on earnings, delivering $0.55 in EPS versus the $0.60 consensus due to initial write downs associated with the acquisition of Nokia’s handset business. Absent the Nokia charges and some other one-time items, Microsoft could have beaten by $0.06.

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Quick Thoughts: NFLX 2Q14 – In Line is the New Upside Surprise

Written July 21st, 2014 by

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-          Media reports can’t seem to decide whether NFLX’s 2Q14 beat consensus or not, but it counts as an upside surprise anyway, because new subscriptions beat forecasts handily

-          US net sub adds were 570K, and Int’l was up 1.1M, collectively beating guidance by more than 14%, right after a price increase and in NFLX’s most challenging seasonal quarter.

-          NFLX’s recent Emmy nomination bonanza and European push should help keep the momentum for 2H14, with guidance implying revenues above the current $1.38B consensus

-          Management expects Int’l to lose $42M in 3Q, due to investment in Europe, putting EPS guidance well below consensus. Given the strong sub growth, this shouldn’t be a red flag.

Thomson Reuters says the analyst consensus for Netflix 2Q14 EPS was $1.16. FactSet says it was $1.14. Netflix decided to split the difference, reporting $1.15, and sending the news wire into a whirlwind of conflicting articles. The Wall Street Journal main site reported the miss against the Thomsen numbers, while the same company’s MarketWatch and MoneyBeat reporters went with the beat. Both sources of consensus estimates agree that Netflix revenues of $1.34B were in line with expectations, so perhaps, all together, it’s safest to call the quarter in line. Except, the stock isn’t reacting like the news is quite so “meh” – it was up more than a percent in after hours after trading up 1.75% during the regular session and after having risen more than 40% in just the past 2 months. It seems that Netflix delivered an upside beat, whether Thomson Reuters thinks so or not.

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Quick Thoughts: GOOG 2Q14 – In the Right Place at the Right Time

Written July 17th, 2014 by

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-          The paradigmatic shift of ad dollars drove 22% topline growth for digital advertising leader GOOG. The sales beat overshadowed an EPS miss that was largely due to a higher tax rate.

-          GOOG sites revenue was up 23% and Network revenue was up just 7%, a shift that saw TAC continue downward to a 3-year low of 22.9%. Paid clicks were up a whopping 25%.

-          CPC was down just 6% YoY and stable QoQ, quieting the bears, as advertisers are growing more comfortable with mobile and demand is starting to catch up with inventory.

-          GOOG’s results show an accelerating ad spending shift toward mobile, video and social, a shift that should have long legs and that will benefit on-line rivals like FB and TWTR as well.

For a company with as much going on as Google – 13 acquisitions in Q2, a dominant mobile platform supporting dominant on-line application franchises, 32% share of global digital advertising and on-line video streaming, and an impressive stable of inherently interesting moonshot projects – its earnings conference calls leave a lot to be desired. In the tradition of its rivals Amazon and Apple, Google is “Just the facts, Ma’am” and then maybe not all of those when it comes to answering questions from Wall Street. With little else to go on, the assembled crowd hangs obsessively on Paid Clicks, Cost Per Click (CPC), and Total Acquisition Costs (TAC). Fortunately for Google investors, the story told by those metrics was a good one this quarter, driving a significant top line beat and overshadowing an EPS miss, which can be largely blamed on unexpected taxes across various jurisdictions.

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Quick Thoughts: MSFT – Satya Nadella is no Steve Ballmer

Written July 17th, 2014 by

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-          MSFT will cut 18K jobs, most from the former Nokia device business, a repudiation of Ballmer’s “Devices and Services” strategy and a bold move toward a cloud future

-          Device operations will be pragmatic, targeting the low end and emerging world geographies still open to Windows. Expect hard push for apps on rival platforms.

-          Clear move toward focusing on cloud hosting and application opportunities, where MSFT has substantial advantages. Consumer apps critical for scaling cloud ops.

-          Evolving org from the “milking windows” strategy will be tough, but Nadella’s direction is bold and right. We remain bullish on MSFT as a leader in the cloud era.

After last week’s vague and meandering strategy memo, Microsoft CEO Satya Nadella got specific this morning with a company-wide email to announce job cuts of 18,000 employees, most of whom came to Microsoft in its recent acquisition of Nokia’s mobile device business. This is more than a slap in the face to former CEO Ballmer’s “Devices and Services” strategy and his controversial acquisition of the Nokia business in the months before his retirement. It is also a rejection of the organizational focus on the Windows operating system that marked the last 30 years of Microsoft strategy and acknowledged the ugly truth that the device platform battle has been largely lost to Google and Apple during the bungling of the past decade. Of course Windows is not entirely dead, and Microsoft will do what it can to perpetuate the standard, but Nadella prefers to put his resources against opportunities in the cloud, where it is not too late and where Microsoft has advantage and momentum.

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Worst Kept Secret on Wall Street – RAI Buys LO

Written July 15th, 2014 by

In a deal that is likely not a surprise to anyone, Reynolds American (RAI) this morning announced that it would be acquiring Lorillard (LO) for ~$69 per share in cash and RAI stock;

  • The complexity of the deal shows us why it took so long to consummate – 4 companies (Imperial Tobacco is buying brands from RAI/LO and British American Tobacco is making an investment in order to maintain its level of ownership of RAI), multiple brands, all with an eye toward appeasing shareholders, employees and regulators;
  • The price likely comes as a disappointment to many investors, with LO takeout values near $80 being bandied about – we never saw that as likely, as the value leakage on any brand sales (only one likely buyer for what are essentially tail brands) was almost certainly going to be significant (and it was, with after-tax proceeds from Imperial to RAI of approximately 5.5x the EBITDA of the brands sold – ouch)

The deal specifics are not AT ALL favorable to RAI in the short-term;

  • As mentioned above, the company is selling $800 million of EBITDA (according to the Imperial Tobacco press release) for after-tax proceeds of approximately $4.4 billion (5.5x);
  • So, net, the company is acquiring ~$1.4 billion in EBITDA (before synergies) for approximately $23 billion, or 17.0x EV/EBITDA – ouch, again
  • RAI also assumes any ongoing risk associated with menthol regulation, and while we can debate the magnitude and likelihood of such regulation, it certainly does not appear to be reflected in the EBITDA multiple paid by the company.

The conference call was a bit surreal, with as nearly as much time spent talking about the benefits of the transaction to Imperial as was spent talking about RAI and LO:

  • We get that establishing Imperial’s bona fides as a strong #3 competitor was one of the goals of this transaction and that echoing that belief during (throughout?) the conference call made some sense, but it struck as overkill nonetheless;
  • We think the time would have been better spent convincing investors that there are actually revenue synergies in the U.S. cigarette industry;
  • As we have written in the past, we are skeptical of revenue synergies, as a rule, and even more so in an industry where companies can’t communicate with consumers;
  • And while the discussion of the relative geographic foot prints of the two companies was interesting (RAI’s strength in the West versus LO’s strength in the East), it wasn’t unknown and our view is that LO’s relative weakness in the West isn’t due to lack of effort or ability, but rather a function of Newport’s position as an East Coast, urban brand.  That equity positioning is going to be difficult to change in an environment where advertising isn’t available as a tool to encourage brand switching.  In sum, don’t buy RAI for the revenue synergies.

The cost savings ($800 million, over time) are likely achievable, given the success that RAI has had in the past managing its cost structure, even in the face of meaningful volume declines (the company’s long-term volume profile has certainly improved with this transaction).

  • However, the forecasted synergies will only replace (and again, over time), the EBIT sold to Imperial, so the company will have to execute to get back to where it was (or could have been pre-divestitures).

RAI is no doubt a better company in the long-run for entering into this transaction with a superior top line profile, but we struggle to see the company’s valuation as anything but full in the short-run and would happily suggest that that long/short investors look to run MO or PM long versus RAI, or look elsewhere in the tobacco space for value, specifically PM.  Even assuming that RAI deserves a higher multiple of EBITDA due to a more robust long-term top line profile, the incremental debt and shares as well as divested EBITDA (only to be recovered over time via cost savings and organic growth) gets us to a fair value closer to $50 per share.  The company’s secure dividend of $2.68 per share likely precludes it trading at that level (indicated yield at $50 per share of 5.3%), but another 10% down from current levels is certainly possible.

Aluminum – A Short Term Bubble or the Real Thing

Written July 11th, 2014 by

Aluminum pricing has continued on the upward trend begun in late 2013 and frankly has moved further than we had anticipated.  While we are quite bullish on the space and have written positively in both the metal and Alcoa, we have not expected the price to move as quickly as it has so far this year – see chart.


Demand is increasing rapidly and pricing in 2013 dropped far enough to make it very difficult for all but the very best to generate positive cash flow.  Consequently we expected supply curtailments to help pricing bounce off the bottom.  What we have not seen, and this may represent a near-term risk, is a supply response to the higher recent prices.  We would have expected some operating rate increases and perhaps some plant restarts, particularly in China, and it is not clear that this is occurring – yet.   Chinese exports of Aluminum parts continue to trend upwards, suggesting that global demand continues to grow and perhaps this is enough on its own to keep Chinese operating rates high enough to prevent price competition – it is not clear how robust China domestic demand growth has been year to date but it is possible that this has soaked up much of the China surplus.


If this is the case the only supply response can come from outside China – from facilities shuttered by western producers as prices fell.  We would not expect this to happen until prices have both moved higher than they are today and have either shown some consistency or accelerated because of real shortage.  In either case prices have much further to go and Alcoa can keep appreciating from here.

The risk is that there is a China supply response waiting around the corner.  Our guess would be that if it coming it is imminent and if we do not see it by the end of the summer we have a sustainable broad market recovery in front of us – as much as 12-18 months earlier than we had originally expected.

July 10, 2014 – Apple and Google: On Your Wrist and In Your Car

Written July 10th, 2014 by

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Apple and Google: On Your Wrist and In Your Car

Despite slight recent design shifts toward each other, AAPL and GOOG still have very different world views – a contrast that is clear in their strategies to extend their platforms to new venues, like “wearables” or cars. While it moved to open iPhone hardware to 3rd party developers a bit, AAPL has not published APIs for its widely expected iWatch, , portending a highly proprietary device, perhaps tightly tied to the new HealthKit functionality. Meanwhile, GOOG’s AndroidWear gives OEMs leeway for design differentiation, and includes clean APIs for developers to deliver value-added extensions of their apps, aiming to increase user engagement by delivering notifications in a more immediate context. We are not overly bullish for demand, particularly if health/fitness is the salient use case, and expect total demand to be a modest fraction of the installed base for either platform. In this, we suspect “wearables” may better suit GOOG’s objectives (i.e. more frequent app engagement, broader user data profiles) than AAPL’s (i.e. smartphone share gain, profits from iWatch sales). In automotive, the companies have had to settle for the rough parity of APIs that enable users to interact with either smartphone platform via dashboard touchscreens and vehicle hands free controls. In the home, both companies are jostling for space in the crowded and competitive TV market, while swapping roles for home controls, with AAPL courting 3rd party device makers to adopt its iOS-integrated HomeKit solution and recent GOOG acquisition Nest disrupting traditional solutions with its slick connected devices.

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SSR Health New Product Approval Portfolios & Supporting Data Update

Written July 10th, 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 returns (56% v. 39%) at a lower standard deviation of returns (12% v. 14%) than an ‘innovator index’ of all companies eligible for inclusion in these portfolios. The 5% pre-PDUFA portfolio has outperformed by an even greater margin as compared to the innovator index (70% v. 39%), though at a higher s.d. of returns than the innovator index (26% v. 14%)

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

Maybe It Wasn’t Just the Weather?

Written July 10th, 2014 by

Earlier in the week, Wal-Mart US President and CEO, Bill Simon, suggested that the U.S. economy had “reached a point where it’s not getting any better but it’s not getting any worse – at least for the middle (class) and down.”

  • He went on to suggest that lower and middle income consumers appear to have made changes to their spending habits that were “not the best thing in the world for a retailer”, referring to a more event-based shopping dynamic.
  • None of this is likely news to investors, but it does set the backdrop nicely for some subsequent data points that may make Simon’s point more forcefully.

The Container Store (TCS) saw its shares tumble after posting its first negative comparable store sales decline (-0.8%) in 15 quarters.

  • Admittedly, TCS has had its issues managing consensus since it has gone public and may be looking to lay blame outside the company;
  • The company decided to evoke images of George Clinton with its description of the consumer as it stated “we’ve come to realize it’s more than just weather and calendar consistent with so many of our fellow retailers we’re experiencing a retail funk”.

Potbelly (PBPB) preannounced lower sales and earnings, suggesting that full-year sales would be flat to down as compared to prior guidance of up LSD.  The company also nearly halved its EPS guidance as well.

  • Again, PBPB has been anything but a high-flier since its IPO, and in a difficult restaurant environment the company appears to be having difficulty resonating with consumers, but the results seem to contribute to a broader theme.

Tractor Supply (TSCO) is another name that has underperformed the S&P by a wide margin in ‘14, and yesterday preannounced Q2 results below consensus expectations ($0.94/$0.95 versus consensus of $1.02).  Full year guidance was moved to the lower end of the existing range, so not a complete disaster.  The company cited weak sales of seasonal products (particularly in the Northeast) as the cause of the earnings shortfall – sort of a weather excuse.

Lumber Liquidators (LL) preannounced a dramatic decline in Q2 comp store sales (-7.1%) after multiple quarters of handily beating consensus.  The company offered a weather-related excuse as well (in part) suggesting that it had experienced out of stocks due to weather issues with its suppliers.  That may be part of the story, but we called out some weakness in housing related home improvement spending and it seems clear that the anticipated rebound in Q2 from Q1 weather-related weakness has not materialized for a number of retailers levered to housing.

Finally, Family Dollar (FDO) reported lower than expected EPS on slightly better than expected comps.  FDO is more of a special situations name at this point, and lackluster results there are certainly not uncommon, but it is part of the consumer mosaic, if you will.

Make no mistake, there are pockets of strength – COST continues to post enviable comparable store sales results driven by continued traffic gains, for example.

We have made clear our concerns about the state of the U.S. consumer and the rate of improvement that we have been seeing.  We continue to see a mismatch between valuations across consumer discretionary (specifically restaurants and retail) and the health of the consumer as reflected in business momentum.

Quick Thoughts: The Signal from the Rate-Markets on 2015 Margin-Lift for Large Banks is Deafening

Written July 9th, 2014 by

With 6-month Libor (6ML) at just over 30 basis points, the deposit franchises of US Commercial banks are contributing next-to-nothing to net interest margins; specifically, we estimate deposit franchises contributed less than 10 basis points to aggregate net interest margins of 3.1% in the first quarter (see table below). This will change in 2015 as rates back-up creating margin-lift and revenue-beats at large banks particularly those, such as WFC, with a weighting to “core” deposits.

Large-bank stocks are under-discounting a rate back-up in part because of skepticism about the Fed’s forecasts for recovery. For example, the Fed forecast is for a FF rate of 1.1% at end-2015 and 2.5% by end-2016 while the corresponding futures imply rates of 0.8% and 1.8% respectively. However, the gap is beginning to close with last month’s strong payroll data (creation of near-290,000 jobs) and consequent bring-forward by sell-side economists of the timing of Fed tightening.

Of course, the more relevant rate for bank deposit franchises is 6ML and the market signal is deafening: the forward rates are 1.8% for mid-2015 and 2.6% for mid-2016 vs. just over 0.3% today. These are extraordinary moves particularly given that they are not accompanied by meaningful flattening of the curve. Applying the 50% re-pricing beta (i.e. ratio of rate-increase on deposits to rate increase on short-term wholesale funds) of the last up-rate cycle to the $10tn of deposits held by US commercial banks suggests deposit franchises will add $75bn to after-tax earnings through 2016; this compares with total 2013 earnings for US commercial banks of $144bn.

There will be offsets as asset spreads continue to tighten (although bank executives are commenting that pricing may be stabilizing in the loan markets as demand improves and deposit outflow risk increases) and as the customary shift by savers to high-yield CDs occurs. Indeed, the latter will likely be more pronounced in this up-rate cycle given the impact of technology, including online services such as, on consumer switching (or “rate surfing”) behavior. For example, JPM is assuming a re-pricing beta in this up-rate cycle of 50% vs. 45% in the last up-rate cycle.

We agree deposit re-pricing betas will be 5-10% higher than historically but the dominant effect is variation across banks which will be greater than the already large divergence historically: in the last up-rate cycle, the beta was 33% for the best-performing quartile of the top-50 US banks while it was 78% for the worst-performing. We expect this range to widen in favor of large banks as they leverage information-scale and advantaged branch-networks to implement finely-segmented deposit pricing strategies and hence manage the trade-off between balance-formation and margin-enhancement. We note that this counter-consensus view on the value of branch networks is endorsed by a leading consultant: “the success of the largest banks in maintaining low volatility, low-cost deposits indicates that national banking capabilities (leading products and branch coverage) are most advantageous.”

Our 6/22 note, “The Role of Branch Networks and Information Scale in the Coming Deposit Re-price Cycle”, provides more detailed information on bank winners and losers.


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