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Author Archives: Chris Versace, Chief Investment Officer

About Chris Versace, Chief Investment Officer

I'm the Chief Investment Officer of Tematica Research and editor of Tematica Investing newsletter. All of that capitalizes on my near 20 years in the investment industry, nearly all of it breaking down industries and recommending stocks. In that time, I've been ranked an All Star Analyst by Zacks Investment Research and my efforts in analyzing industries, companies and equities have been recognized by both Institutional Investor and Thomson Reuters’ StarMine Monitor. In my travels, I've covered cyclicals, tech and more, which gives me a different vantage point, one that uses not only an ecosystem or food chain perspective, but one that also examines demographics, economics, psychographics and more when formulating my investment views. The question I most often get is "Are you related to…."
Introducing The Thematic Leaders

Introducing The Thematic Leaders

 

Several weeks ago began the arduous task of recasting our investment themes, shrinking them down to 10 from the prior 17 in the process. This has resulted in a more streamlined and cohesive investment mosaic. As part of that recasting, we’ve also established a full complement of thematic positions, adding ones, such as Chipotle Mexican Grill (CMG) and Altria (MO) in themes that have been underrepresented on the Select List. The result is a stronghold of thematic positions with each crystalizing and embodying their respective thematic tailwinds.

This culmination of these efforts is leading us to christen those 10 new Buy or rechristened Buy positions as what are calling The Thematic Leaders:

  1. Aging of the Population – AMN Healthcare (AMN)
  2. Clean Living – Chipotle Mexican Grill (CMG)
  3. Digital Lifestyle – Netflix (NFLX)
  4. Digital Infrastructure –  Dycom Industries (DY)
  5. Disruptive Innovators – Universal Display (OLED)
  6. Guilty Pleasure – Altria (MO)
  7. Living the Life – Del Frisco’s Restaurant Group (DFRG)
  8. Middle-Class Squeeze – Costco Wholesale (COST)
  9. Rise of the New Middle-Class – Alibaba (BABA)
  10. Safety & Security – Axon Enterprises (AAXN)

 

By now you’ve probably heard me or Tematica’s Chief Macro Strategist Lenore Hawkins mention how Amazon (AMZN) is the poster child of thematic investing given that it touches on nearly all of the 10 investing themes. That’s true, and that is why we are adding Amazon to the Thematic Leaders in the 11th slot. Not quite a baker’s dozen, but 11 strong thematic positions.

One question that you’ll likely have, and it’s a logical and fare one, is what does this mean for the Select List?

We wouldn’t give up on companies like Apple (AAPL), Alphabet (GOOGL), Disney (DIS), McCormick & Co. (MKC) and several other well-positioned thematic businesses that are on the Select List. So, we are keeping both with the Thematic Leaders as the ones that offer the most compelling risk-to-reward tradeoff and the greater benefit from the thematic tailwinds. When we have to make an adjustment to the list of Thematic Leaders, a company may be moved to the Select List in a move that resembles a move to a Hold from a Buy as it is replaced with a company that offers better thematic prospects and share price appreciation. Unlike Wall Street research, however, our Hold means keeping the position in intact to capture any and all additional upside.

Another way to look at it, is if asked today, which are the best thematically positioned stocks to buy today, we’d point to the Thematic Leaders list, while the Select List includes those companies that still have strong tailwinds behind their business model but for one reason or another might not be where we’d deploy additional capital. A great example is Netflix vs. Apple, both are riding the Digital Lifestyle tailwind, but at the current share price, Netflix offers far greater upside than Apple shares, which are hovering near our $225 price target.

After Apple’s Apple Watch and iPhone event last week, which in several respects underwhelmed relative to expectations despite setting up an iPhone portfolio at various price points, odds are the iPhone upgrade cycle won’t accelerate until the one for 5G. The question is will that be in 2019 or 2020? Given that 5G networks will begin next year, odds are we only see modest 5G smartphone volumes industry-wide in 2019 with accelerating volumes in 2020. Given Apple’s history, it likely means we should expect a 5G iPhone in 2020. Between now and then there are several looming positives, including its growing Services business and the much discussed but yet to be formally announced streaming video business. I continue to suspect the latter will be subscription based.  That timing fits with our long-term investing style, and as I’ve said before, we’re patient investors so I see no need to jettison AAPL shares at this time.

The bottom line is given the upside to be had, Netflix shares are on the Thematic Leaders list, while Apple shares remain on the Select List. The incremental adoption by Apple of the organic light emitting diode display technology in two of its three new iPhone models bodes rather well for shares of Universal Display (OLED), which have a $150 price target.

Other questions…

Will we revisit companies on the Select List? Absolutely. As we are seeing with Apple’s Services business as well as moves by companies like PepsiCo (PEP) and Coca-Cola (KO) that are tapping acquisitions to ride our Clean Living investing tailwind, businesses can morph over time. In some cases, it means the addition of a thematic tailwind or two can jumpstart a company’s business, while in other cases, like with Disney’s pending launch of its own streaming service, it can lead to a makeover in how investors should value its business(es).

Will companies fall off the Select List?

Sadly, yes, it will happen from time to time. When that does happen it will be due to changes in the company’s business such that its no longer riding a thematic tailwind or other circumstances emerge that make the risk to reward tradeoff untenable. One such example was had when we removed shares of Digital Infrastructure company USA Technologies (USAT) from the Select List to the uncertainties that could arise from a Board investigation into the company’s accounting practices and missed 10-K filing date.

For the full list of both the Thematic Leaders and the Select List, click here

To recap, I see this as an evolution of what we’ve been doing that more fully reflects the power of all of our investing themes. In many ways, we’re just getting started and this is the next step…. Hang on, I think you’ll love the ride as team Tematica and I continue to bring insight through our Thematic Signals, our Cocktail Investing podcast and Lenore’s Weekly Wrap.

 

 

Adding more Del Frisco’s to our plate following several bullish data points

Adding more Del Frisco’s to our plate following several bullish data points

Key points inside this issue

  • We are scaling into shares of Del Frisco’s Restaurant Group (DFRG) following several bullish data points from last week. Our price target for DFRG shares remains $14.
  • Our price target on Amazon (AMZN) remains $2,250
  • Our price target on United Parcel Service (UPS) shares remains $130
  • Our price target on Chipotle Mexican Grill (CMG) shares remains $550
  • Our price target on Costco Wholesale (COST) remains $250
  • I am reviewing our current price target of $130 for shares of McCormick & Co.
  • Last week’s podcast – Lithium Ion Batteries: The Enabler of the Digital Lifestyle
  • Last week’s Thematic Signals

Last Friday we received a number of positive data points for restaurant spending, which coupled with the latest US Department of Agriculture report on falling beef prices has me using the recent weakness in our Del Frisco’s Restaurant Group (DFRG) shares to improve our cost basis. Since adding DFRG shares to the portfolio, they’ve fallen nearly 10% since the end of August and just over 3% since we added them to our holdings despite favorable economic and industry reports. Part of that downward pressure came from Stephens throwing in the towel on its bullish stance on the shares last Wednesday. It would appear that Stephens jumped the gun given the favorable data that emerged later in the week.

Let’s review all of those data points…

 

August Retail Sales

The August Retail Sales report saw its headline figure come in at +0.1% month over month missing expectations of +0.4% and marked the slowest gain since February suggesting persistently high gas prices could be taking a bite out of consumer spending. With prospects for higher gas prices ahead following last week’s greater than expected crude inventory drawdown reported by the Department of Energy and the greater than expected jump in Total Consumer Credit for January, it would appear that Middle-Class Squeeze consumers slowed their spending in August vs. July. Hat tip to Tematica’s Chief Macro Strategist, Lenore Hawkins, and her coverage of those data points in last Friday’s Weekly Wrap. If I’m reading it, so should you.

Turning to the year over year view, August retail sales rose 6.2%, led by a more than 20% increase in gas station sales due to the aforementioned gas prices, and continued gains in Nonstore retailers (+10.4%) and food services & drinking places (+10.1%). Over the last three months, these last two categories are up 9.9% and 9.5% year over year, even as gas station sales are up nearly 21% by comparison. Those figures bode extremely well for our Digital Lifestyle positions in Amazon (AMZN) and United Parcel Service (UPS), our Clean Living holding that is Chipotle Mexican Grill (CMG) and Del Frisco’s Restaurant Group, a Living the Life company.

The report also offered confirming context for our shares in Costco Wholesale (COST) as its August same-store sales handily beat those contained in the August Retail Sales report. Also inside this latest missive from the U.S. Department of Commerce, grocery store sales rose 4.3% year over year in August, which keeps me bullish on our shares of McCormick & Co. (MKC) even as they hover over our current $130 price target.

In terms of areas reporting declines in August Retail Sales Report, we continue to see pressure at Sporting goods, hobby, musical instrument, & bookstores (-3.9%) and Department Stores (-0.7%), continuing the trend of the last few months. With Amazon continuing to flex its business model as well as its own line of private label products, including fashion, sportswear, and apparel, as well as continued digital commerce gains at Walmart (WMT) and its Bonobos brand, we see these retail categories remaining challenged in the coming months.

 

August restaurant data from TDN2K

On Friday we also received figures from TDn2K’s Black Box Intelligence that showed August same-store restaurant sales rose +1.8%, the best highest since 2015. TDn2K’s data is based on weekly sales from over 30,000 locations representing more than 170 brands and nearly $70 billion in annual sales. More positives for our positions in Chipotle and Del Frisco’s. I’ll tuck this data point away as well as the July and eventual September one to compare them against same-store sales quarterly results for out two restaurant holdings.

 

US Department of Agriculture

The most recent data published on Friday by the US Department of Agriculture showed cow prices were down 13.6% year over year in July, continuing the trend of double-digit year over year declines that began this past May. I see this as confirmation of deflationary beef prices that bode well for both margins and EPS gains at both Del Frisco’s and to a lesser extent Chipotle.

Later this week, I’ll look for further confirmation of beef deflation leverage when Darden Restaurants (DRI), the parent of Capitol Grill reports its quarterly earnings.

 

Scaling into Del Frisco’s shares

The net result of these three Friday data points has me adding to our Del Frisco’s Restaurant Group shares at current levels. If our Chipotle shares were lower than our entry point, I’d be doing the same, but they aren’t – if they do fall below the $473 layer, all things being equal I’d look to repeat today’s actions but with CMG shares.

  • We are scaling into shares of Del Frisco’s Restaurant Group (DFRG) following several bullish data points from last week. Our price target for DFRG shares remains $14.
WEEKLY ISSUE: Revisiting Aging of the Population theme and introducing a new position

WEEKLY ISSUE: Revisiting Aging of the Population theme and introducing a new position

Key points inside this issue

  • We are issuing a Buy on and adding shares of AMN Healthcare (AMN) to the Tematica Investing Select List with a price target of $75.

Today we complete the recasting of our 10 investment themes that we’ve undertaken over the last several weeks. That process has led to several new investment positions and today we have a new one as well as we revisit our Aging of the Population investing theme.

Stepping back a few paces, I recognize that we’ve introduced several new positions in as many weeks. Hang tight for a day or two, and I’ll share the logic behind what we’ve been up to, and I suspect you’re going to nod your head as you read it. For now, let’s get to Aging of the Population and that new pick.

 

There Is Just No Fighting Father Time

As we look around us, it’s rather obvious that people are living longer, which in many respects is a good thing, but those extra years have a significant impact on society. As we age our needs and abilities change, and with that so do the services and products that we consume.

According to a National Center for Health Statistics report released in 2016, the average life expectancy in the U.S. stands at 78.8 years on average, with women outlasting men by a few years 81.2 years of age vs. 76.6 years. By 2030, the Administration on Aging (AOA) estimates there will be about 72.1 million people aged 65 or older, more than twice their number in 2000. In 2010, the baby boom generation was between 46 and 64 years old, and that generation is now beginning to enter their 70s.

Over the next 13 years, all of the baby boomers will have moved into the senior generation, resulting in a major structural shift in demographics. From 2010 to 2030, the percent of the population over 65 will increase from 13 percent to 19 percent while the percent of the U.S. population aged 20-64, the primary working years, will decrease from 60 percent to 55 percent. The broadening of the upper age pyramid is poised to significantly impact demands on healthcare, housing and transportation and question the ongoing viability of social service programs like Medicare, Medicaid and Social Security. Ah, yes more fun times to be had in Washington over the next decade.

 

We in the United States are hardly alone in this demographic shift 

Canada, Japan, and most of Europe have an even higher percentage of their populations in the older age brackets. According to population projections from the United Nations published in its 2013 “World Population Ageing” report, the global population aged 65 and older will triple over the next 40 years, from 500 million in 2010 to 1.5 billion by 2050, thus doubling the share of this demographic across the world from 8 percent to 16 percent. There is a shift toward older age brackets in almost every country as people live longer and have fewer children. Digging into the specifics of that UN report one sees that:

  • Roughly 26 percent of Japan’s population is aged 65 or older, and 32.2 percent are expected to be senior citizens there by 2030
  • Germany has 17 million people who are aged 65 and older, and that number is expected to swell to 21 million by 2030.
  • By 2030, there are projected to be nearly 16 million retirees in Italy with 25.5 percent of Italian citizens anticipated to be 65 or older.
  • There are 8.4 million Spaniards age 65 or older, and they comprise 17.6 percent of Spain’s population. Those numbers are estimated to grow to 11.5 million in 2030 when this age group is expected to make up 22 percent of the population.

How does this stack up against what it used to be?

Per historical data from the UN, life expectancy was 65 years in 1950 in the more developed regions, as compared with 42 years in the less developed regions. (Note that the latter number was heavily skewed by higher child-mortality rates.) Between 2010 and 2015, these figures are estimated to be 78 years in the more developed regions and 68 years in the less developed regions. The gap is expected to narrow even further: By 2045 to 2050, life expectancy is projected to reach 83 years in the more developed regions, and 75 years in the less developed regions.

As the life expectancy gap narrowed between developed and less developed regions, the average age expectancy of both groups increased. The number of people 65 and older was 841 million in 2013, four times higher than the 202 million seen in 1950. This population is expected to nearly triple by 2050 when its number is expected to surpass the two billion mark. The proportion of the world’s 65-or-older population is expected to increase to 21 percent in 2050 from just 12 percent in 2013 and 8 percent in 1950.

This living longer is the basis for our Aging of the Population investment theme. It will lead to new products and services that cater to the needs of this increasing “older population ”demographic, but it also means greater demands on savings and investments. Unfortunately, according to a report by the Economic Policy Institute (EPI), the average household aged 56-61 has amassed a retirement nest egg of just $163,000 which equates to an average monthly income of just $681 across a 20-year retirement according to EPI. Worse yet, an estimated 41% of households aged 55-64 have no retirement savings at all and over 20% of married Social Security recipients and 43% of single recipients 65 and over rely on their monthly benefit checks to provide at least 90% of their income.

The big issue facing the nation is the assumption of a 20-year retirement time period when data from the Social Security Administration shows one out of every four 65-year-olds today will live past the age of 90, while one out of 10 will live past 95. It’s no wonder 60% of baby boomers claim they’re more afraid of outliving their savings than actually dying. This is a massive problem across much of the world as rising life expectancies place much greater strains on government managed retirement programs while the percent of the population paying into those programs declines. Payout levels are growing while relative contribution levels are declining.

 

Who will ride the Aging of the Population tailwind?

The bottom line with this massive worldwide demographic shift towards a more senior population is a reallocation of spending and consumption habits. Money that was once dedicated to supporting a young and growing family will increasingly shift toward spending that serves an aging population. Pronounced spending shifts such as these can have a dramatic impact and in this case, the snowballing of the “older population” likely means an even greater compounding effect will be had.

How big will this overall aging lifestyle-spending shift be?

According to research firm A.T. Kearny, worldwide spending (remember the aging of the population is global) by mature consumers is forecasted to reach $15 trillion annually by 2020. That’s a large opportunity for industries that are meeting the particular needs of consumers age 65 and older and with the aging population only expected to grow further between 2020 and 2030, spending by this cohort will grow substantially in the coming decade-plus. It also likely means that more companies will tailor products and services to meet this opportunity.

There are a number of industries that will likely be beneficiaries. Some are obvious — healthcare, pharmaceuticals and medical technology are what come to mind for most people and certainly receive significant weighting in the Aging of the Population index. Others are less obvious but just as important and likely to feel the same thematic impact. We’re talking about:

  • A shift in demand for different types of housing as seniors give up on the homestead and move into easier to maintain condos and townhouses.
  • An even greater focus on online retailers that will deliver purchases directly to the home, rather than having to go out and carry purchases from the store to the car and then into the home. Also driving this shift will be younger children making purchases for their aging parents and having them shipped directly to their home.
  • Financial Services stands right in the middle of the storm as the wealthiest generation in history starts to draw down on assets to fund retirement rather than accumulate more and more each year.
  • Fountain of Youth goods and services will be in even higher demand as Baby Boomers have shown they are not likely to let go of their youth easily.
  • And finally, technology and services that will help maintain independence— we’re talking about robots, digital assistants, monitoring equipment and even things such as the autonomous car.

 

Enter AMN Healthcare

One of the key aspects of our Aging of the Population investing theme centers on the aging of the baby-boomer generation and the corresponding needs and pain points. Looking at the domestic population, no matter the data or the source, it all points to the same thing — more people over age 65 than ever before.

Now for the real whammy: According to the National Council on Aging, 80% of older adults have at least one chronic condition, and 68% have at least two. Combined with the underlying demographic shift, this will place far greater demands on the domestic health care system in the coming years.

While many tend to focus on any one of the various aspects of the health care systems, the combination of the aging population and chronic conditions is a demand driver for nurses. But here’s the problem: The U.S. has been dealing with nursing constraints over the last few decades. Viewed against the aging population and an aging nursing workforce with limited capacity at nursing schools, that constraint is looking more and more like an outright shortage.

  • According to the Bureau of Labor Statistics’ Employment Projections 2014-2024, Registered Nursing (RN) is listed among the top occupations in terms of job growth through 2024. The RN workforce is expected to grow from 2.7 million in 2014 to 3.2 million in 2024, an increase of 439,300 or 16%. The Bureau also projects the need for 649,100 replacement nurses in the workforce bringing the total number of job openings for nurses due to growth and replacements to 1.09 million by 2024.
  • By 2025, the shortfall is expected to be “more than twice as large as any nurse shortage experienced since the introduction of Medicare and Medicaid in the mid- 1960s,” according to Vanderbilt University nursing researchers.
  • Roughly a million registered nurses (RNs) are older than 50, according to the American Nurses Association. What this means is roughly one-third of the current nursing workforce will reach retirement age in the next 10 to 15 years. Some estimates place the total number of nurses expected to exit the position as high as 700,000 over the next eight years.

 

Where does this leave us?

The nursing shortage that we’ve identified as part of our Aging of the Population theme looks to benefit from both a significant increase in demand but also a scarce-resource tailwind as well. That combined tailwind has been extremely beneficial to the shares of AMN Healthcare Services (AMN), a healthcare workforce and staffing solutions company with an emphasis on the nursing industry. Tematica Investing subscribers should be familiar with the company given the AMN shares resided on the Tematica Investing Select List from August 2016 until May 2017, when we were stopped out of the position.

Staffing Industry Analysts (SIA) estimates that the segments of the target market in which AMN primarily operate have an aggregate 2018 estimated market size of $17 billion, of which travel nurse, per diem nurse, locum tenens and allied healthcare comprise $5.4 billion, $3.7 billion, $3.7 billion and $4.2 billion, respectively. Based on the consensus revenue forecast of $2.15 billion this year for AMN, the company has approximately 12.5% market share across those aggregate markets. And as the population continues ages, those figures will continue to rise, giving the opportunity for AMN to place not only nurses but assist in other physician leadership searches as part of its Managed Service Program offering. Generally speaking, AMN’s revenue and profit stream reflect the number of healthcare professionals it has placed on assignment multiplied by the average bill rate. More than likely as the shortage continues, the company’s average bill rate is poised to move higher making for nice incremental margin gains.

The question to be asked now is if there is sufficient upside in AMN shares to have them rejoin the Select List at current levels?

Looking at the discrepancy in the monthly JOLTS reports between the number of healthcare job openings vs. the number of filled healthcare jobs, we know the healthcare workers shortage pain point remains. Over the 12 months ending June 2018, per the monthly JOLTS report, the ratio of healthcare and social assistance job openings to hires has remained near 1.9x.  The analysis of the nursing shortage over the last few pages also tells us that it’s not going to be solved in one year’s time let alone in the coming few years, which means the sting of that pain point of that shortage will be felt some time to come. This will likely translate into continued top and bottom line growth for AMN as its revenue model capitalizes on that pain point. Should we see an increase in the number of new nurses coming into the market, this will likely augment AMN’s revenue stream as it leverages its market position and places a percentage of those new entrants.

Over the 2012-2020E period, AMN is expected to grow its bottom line at roughly a 17% compound annual growth rate (CAGR). As the nursing shortage pain point has intensified over the last several years, AMN shares have peaked at more than 21x earnings and bottomed out at an average P/E multiple at 14x. Applying these historic multiples implies upside from current levels to $72, with downside risk to $48. With more Baby Boomers turning 70 years old every day, odds are those historic PE multiples, particularly to the downside, will move higher in the coming years as the severity of the nursing and aging pain point is more fully recognized. While we could stretch the P/E multiple to warrant a $75-$85 price target (and downside to just under the current share price), a better way to view it would be to place a discounted P/E placed on expected EPS of $4.00 in 2020, which gives us a $75 price target.

  • We are issuing a Buy on and adding shares of AMN Healthcare (AMN) to the Tematica Investing Select List with a price target of $75.

 

Companies riding the Aging of the Population investing theme

  • A V Homes (AVHI)
  • Amedisys Inc. (AMED)
  • ANI Pharmaceuticals (ANIP)
  • Athene Holding (ATH)
  • Brookdale Senior Living (BKD)
  • Caretrust (CTRE)
  • Charles Schwab (SCHW)
  • Cross Country Healthcare (CCRN)
  • CVS Health (CVS)
  • Ensign Group (ENSG)
  • Estee Lauder (EL)
  • Express Scripts (ESRX)
  • Lab Corp. (LH)
  • Lindblad Expeditions (LIND)
  • Omega Healthcare (OHI)
  • Nu Skin (NUS)
  • Physicians Services (DOC)
  • Quest Diagnostics (DGX)
  • Service Corp (SCI)
  • Spok Holdings (SPOK)
  • StoneMor Partners (STON) – basically the same and AMN
  • Wright Medical Group (WMGI)
  • Zimmer Biomet Holdings (ZBH)
  • Zoetis (ZTS)

 

Special Alert – Exiting shares of USA Technologies (USAT)

Special Alert – Exiting shares of USA Technologies (USAT)

Key point inside this special alert

  • We are issuing a Sell and removing USA Technology (USAT) shares from the Tematica Investing Select List. As we close out the position, we’d note a gain of 17% was had with the shares.

This morning shares of Digital Infrastructure company USA Technologies are getting hammered, yes hammered, on the news the company it is conducting an internal investigation into the accounting of certain of its present and past contractual arrangements and financial reporting controls. As a result, the company said it would not file its Form 10-K annual report with the SEC by the Sept. 13 deadline, but it will file a Form 12b-25 notification of late filing, to provide it with a 15-day extension.

As the trite saying goes, I’ve seen this movie before and there tend to be at least two issues at work. The first is management credibility, which has clearly been called into question. The second is the actual findings of the investigation, which could range from a restatement of past financials and re-jiggered expectation to a management change. All of those are likely to add an extra layer of uncertainty into the equation, which likely means the shares will be rangebound for a protracted period of time.

I’d rather leave with our profits intact and focus on the opportunity to be had with the several new thematic additions we’ve made over the last few weeks.

  • We are issuing a Sell and removing USA Technology (USAT) shares from the Tematica Investing Select List. As we close out the position, we’d note a gain of 17% was had with the shares.
Safety & Security – A robust tailwind that is more than just cyber security

Safety & Security – A robust tailwind that is more than just cyber security

KEY POINTS FROM THIS ALERT:

  • We are issuing a Buy on Axon Enterprises (AAXN) and adding them to the Tematica Investing Select List with a $90 price target.

 

The right to defend yourself and your property apply in today’s increasingly connected world, just as it did more than 200 years ago. While the public debate and much of the media coverage focus on the Second Amendment and the right to keep and bear arms, the threats we face today are changing, just as the way we interact with people, data and content are changing. As individuals, companies and countries, we must be increasingly on guard and behaviors need to shift away from reactionary defense towards always prepared and secure, much the way we’ve seen with homeland security and traditional national defense.

Tematica’s Safety & Security investing theme looks to tap into evolving needs across individual, cyber, corporate and homeland security. In turn, the Safety & Security Index targets companies that offer products and services across that range, from corporate security and monitoring solutions, to personal firearms arms and home-security, to individual, corporate and national cyber security to defense spending.

It wasn’t too long ago that the WannaCry and Petya cyber-attacks dominated the headlines. Over the past few years, cyber  security we have seen a significant increase in the number of cyber-attacks plaguing individuals, corporations and other institutions across the globe. In our view, there is little cybersecurity is a growth market as individuals, companies and other institutions look to ward off future attacks, shore up their existing cyber defenses, assess attack and intrusion analytics and become far more secure.

We see this reflected in the forecasts calling for cybercrime to cost $6 trillion annually by 2021, up from $3 trillion in 2015 according to Cybersecurity Ventures. From a somewhat different perspective, in the five years ending in 2021, worldwide spending on cyber security software, services, and hardware services is expected “to eclipse $1 trillion”. As one might expect one of the fastest growing tech categories through 2021 will be managed security services with CAGR 14.7%, according to International Data Corporation.

Here’s the thing, as crucial as cybersecurity will be in the coming years, it is still just one aspect of the far larger amount of spending that occurs each and every year to keep our nation, businesses, homes and families safe.

Case in point, total global cyber security spending represented roughly 23 percent of the $522 billion 2017 U.S. defense budget. Candidate Trump pledged to rebuild the US military and President Trump is looking to boost defense spending to $716 billion in 2019, a 10 percent increase from the amounts set for the Department of Defense in the continuing resolutions levels. Over the 10-year budget window, funding for the Department of Defense is $1 trillion above projections from the previous administration. In addition to big-ticket items like military aircraft, ships and other marine vessels, the budget includes national security spending, cyber defense, weapons procurement, as well as research and procurement.

Keep in mind that is just at the federal level. At the local and state level, we are seeing shifts in spending by law enforcement to more Disruptive Innovator led solutions such as body cameras and tasers to name a few. According to QY Market, the global market for body cameras is expected to reach about $1.5 billion by 2021 from $259.5 million in 2016. Forces driving the growth in the body camera market include the growing demand for monitoring police conduct as well as transparency in evidence collection and handling. The non-lethal weapons market comprised of military and law enforcement is estimated to reach $8.4 billion by 2020, a CAGR of 8.2 percent from 2015 to 2020.

Outside the US, rising global tensions have led to increasing demand for defense and military products in the Middle East, Eastern Europe, North Korea, the Far East and South China Seas. This is, in turn, instigating increased defense spending globally, especially in the United Arab Emirates (UAE), Saudi Arabia, South Korea, Japan, India, China, Russia. For example, the Middle Eastern Homeland Security market is slated to grow at a CAGR of 15.5 percent to achieve $17.05 billion by 2021, up from $7.19 billion in 2015, driven by government initiatives to create a smart and secure environment amidst high terrorist activities in the region.

 

Protections Gets Personal

With the media’s emphasis on cyber security (just Google “security” and see what comes up), attention is lost on other aspects of individual or personal security. The global home security solutions market, (which includes video surveillance, electronic locks, alarms, access control, sensors, detectors and corresponding services) is predicted to reach $30.3 billion by 2022, up from $8.3 billion in 2014.

The increasing acceptance of video surveillance systems is expected to propel the video surveillance sub-sector in the years to come with demand for IP-based video surveillance expected to increase due to its improved video capturing quality. This growth is not just U.S.-based as the number of monitored alarm systems in Europe is forecast to grow from 8.7 million in 2016 to reach 10.6 million in 2021, according to a new research report by Berg Insight. By comparison, in North America, the number of monitored alarm systems is forecasted to grow from 32.1 million at the end of 2016 to 37.1 million at the end of 2021.

 

THE SAFETY & SECURITY TAILWINDS

As much as the Safety & Security investment theme is demand-driven as people, corporations, governments and other entities spend on protecting and securing themselves, it is one that is ripe for change as industries evolve and in some cases embrace our Digital Lifestyle and Digital Infrastructure themes. Just one case in point, the M&A activity in the defense contracting sector for cyber firms as the “battlefield” increasingly expands into the virtual world.

Another component arises when we look to the Internet of Things (IoT) and the increasing reality that even our own personal possessions could be rendered useless through a cyberattack unleashed by a foreign government or other entity. In 2015 for example, Black Hat hacked a 2014 Jeep Cherokee over the internet and paralyzed it on I-64 forcing Chrysler to recall 1.4 million vehicles. Hackers have found security flaws in smart home connectors that are used to turn up the thermostat, turn on your lights or access your Wi-Fi network through your smart fridge.

It’s this reality that the Tematica Safety & Security investing theme taps into as it covers the full range of companies participating in the security and monitoring of our homes, families, companies and homeland.

 

Axon Enterprise – Not just Taser anymore

Given the wide lens of our Safety & Security theme, there are many companies to consider, but the one we are focusing on is Axon Enterprises, the company formerly known as Taser, of which most of us have heard. Why the name change? Odds are there were several reasons, but the most poignant one is the transformation of the company’s business model from one predicated on conducted electrical weapons (CEW), better known as Tasers, to a more balanced one between those weapons and connected wearable on-officer cameras (Axon), an in-car camera variant (Axon Fleet) and complimentary cloud-based digital evidence management software (Evidence.com). Evidence.com is the company’s data management system, chain-of-custody controls and security protocols that law enforcement agencies use to preserve and protect data from body cameras and in-car video systems.

There are several reasons why we like that transformation. The company now has more diversified business model and one that has aspects of recurring revenue streams that tend to receive more favorable valuation multiples, compared to the 15x-19x earnings at which firearm companies American Outdoor Brands (AOBC; formerly Smith & Wesson), and Sturm, Ruger & Company (RGR) are trading at based on expected 2019 EPS. There is also the replacement cartridge aspect of CEW weapons, which is very similar to ammunition in that continued replenishment is required, which results in an on-going revenue stream. Currently, munitions company Vista Outdoors (VSTO) is trading at 36x expected 2019 earnings.

As we touched on above, the outlook for the domestic body camera market looks vibrant over the next several years, and that augurs for growth for corresponding digital records management solutions.  Easing Axon’s entrance into this market and the transformation in its business model is its existing relationship with more than 20,000 public safety agencies worldwide that span law enforcement, corrections, and military forces as well as private security personnel and in the case of its CEWs, private individuals. At the end of 2017, 38 of the top 50 metropolitan areas in the U.S. were on the Axon network.

Strengthening Axon’s position in the body camera and digital storage markets was its May 2018 acquisition of VIEVU, a body camera and cloud-based evidence management system competitor. That acquisition expanded Axon’s customer base to include among others the New York City Police Department, the Miami-Dade Police Department, the Phoenix Police Department, the Oakland Police Department and the Aurora, CO Police Department as well as Mexico City and Mexico’s federal police. Given the timing of the acquisition, it had a modest impact on the June 2018 quarter, but should be a greater contributor over the coming quarters from a revenue and cost synergy perspective as Axon integrates its customers and platforms.

In June, Axon reached a partnership with Milestone Systems, a leading open platform IP video management software provider, that brings data from more than 6,000 models of cameras from 150 manufacturers, including CCTV footage, into Evidence.com. As with other data stored in Evidence.com, this new data will be trackable, easily shareable, and redactable.

Also, in the first half of 2018, Axon inked a strategic partnership with drone manufacturer DJI to sell its video-capable drones directly to police officers through a new Axon Air program. More than 900 American public safety agencies use drones to improve officer safety, support tactical actions, reconstruct traffic collisions, support public safety at large events and perform search-and-rescue missions. Axon’s strategy is to leverage its police and law enforcement customer base to sell the DJI drones bundled with access to Axon’s connected data network and Evidence.com services.

Exiting the June 2018 quarter, the company’s install base included 450,000 Tasers in the U.S, an active camera count of more than 300,000 and a growing subscription business at Evidence.com. While the bulk of the company’s business is inside the U.S., roughly 20% of its CEW business is international with fresh opportunities in both the UK and Italy. Based on the company’s current market share as well as recent moves to expand its reach with its VIEVU acquisition and partnership with DJI, Axon is well positioned to ride the expanding tailwind that is the body camera and digital support market. Exiting 2017 the global body-worn camera shipment market was 1.05 million units, up from 0.17 million, and is forecasted to reach 1.59 million units this year and more than 5.6 million units in 2021. While the US is the largest body camera market today, the adoption of body-worn cameras by the police officers in Europe region is growing and that is expected to be followed by Asia-Pacific in the coming years.

Following the completion of a 4 million share equity offering this past May that raised roughly $245 million in capital, Axon’s balance sheet had net cash of $311.6 million ($5.35 per share). Combined with its positive cash flow from operations, the company has ample funding to pursue other strategic initiatives, including additional acquisitions and alliances, to expand its business in both the domestic and international markets. Per the company, it sees its total addressable market in the near term as $7.7 billion, which breaks down to $1.5 billion in TASER weapons, $0.7 billion in hardware sensors/body cameras and $5.5 billion in cloud-based public safety software. Even if we were to annualize Axon’s June 2018 revenue, which would clock in at just under $400 million vs. the $344 million achieved in 2017, there are ample share gains to be had in this expanding market that are expected to drive its EPS to $1.07 in 2020, up from $0.52 this year and $0.27 in 2017.

Inherent in those EPS expectations is for its Software and Sensors business segment to turn from one generating operating losses to profits. In the first half of 2018 quarter, all of Axon’s operating profits were derived from its Taser business while Software and Sensors reported an operating loss of $16.9 million on $76 million in revenue. In comparing that time period with the first half of 2017, we see the Software and Services business made considerable ground in reducing the drag on the company’s overall profits as segment revenue continued to climb. For the first half of 2017, Axon’s Software and Sensor business reported an operating loss of $31.6 million on revenue of $48.2 million. Crunching the year over year change in operating losses vs. revenues tells us the Software and Sensor business achieved incremental operating margins of 52.5% in the first half of 2018, a very positive sign that says for every incremental revenue dollar, the company was earning $0.52 in operating profit. In other words, the likelihood that Software and Sensors becomes a profit generator in the coming quarters is rather high. Our analysis suggests the break-even level for the business is around $220-240 million in annual revenue vs. the annualized first half of 2018 level near $153.6 million and $96.4 million for the first half of 2017.

If there were one bone to pick with Axon, it would be the stock’s current valuation, which sits at a P/E ratio of more than 65x expected 2020 EPS of $1.07 and an eye-popping 102x consensus forecasted $0.69 in 2019. When faced with such robust valuations, we recognize the danger of solely focusing on a stock’ P/E ratio if one does not account for the underlying EPS growth. Hence our usage of the price-earnings to growth ratio for Amazon (AMZN) and here with Axon shares. Over the 2017-2020 period, Axon is forecasted to grow its EPS at a compound annual growth rate (CAGR) of 157%. Granted this slows to roughly 143% for the 2018-2020 time frame from 160% over the 2017-2019 period, but even if we utilize that slower growth rate it means Axon shares are trading at a steep discount on PEG basis using either 2019 or 2020 EPS expectations.

While it can be tempting to get all “pie in the sky” with that valuation potential, it does point to upside in the shares near $100-$110 if Axon delivers on the consensus 2019 EPS forecast with a PEG multiple of just 1.0x, we have to consider a potential profitability timing slip with Axon’s Software and Sensor business. This could impact EPS expectations, so to be conservative we’re haircutting both the company’s EPS CAGR and expected EPS in 2019 and 2020.

Applying either . . .

  • An EPS CAGR rate of 140% on potential 2019 EPS of $0.65 with a PEG ratio of 1.0 or
  • A 0.9 PEG ratio to an EPS CAGR of 145% on potential 2019 EPS of $0.69

. . . and both deliver a price target of $90. If Axon’s can hit the expected growth trajectory through 2020, a similar analysis implies upside to more than $130.

Yes we know, quite the math-Olympics in that last paragraph, but those efforts reveal upside of at least 28% from current levels over the coming year. On the downside, AAXN shares have bottomed out at an average of 58.5x forward earnings over the 2016-2018 period, which suggests downside to just over $60. That’s potential downside of 14%, which means net upside vs. downside in the shares over the coming year, on a conservative basis is 14%.

Recognizing the strong likelihood for continued adoption of its Software and Services business that will drive its business transformation, we are adding shares of Axon Enterprises (AAXN) to the Tematica Investing Select List with a $90 price target over the 15 months. Based on the company’s ability to wring profitability out of this business segment, we’ll look to revise that target in the coming months. Should AAXN shares come under pressure, all things being equal we would look to scale into the shares closer to $60.

As we monitor the position, we’ll continue to watch the further adoption of body cameras and Evidence.com by existing customers as well as new ones. We’ll also be keeping tabs on the patent litigation against Axon from competitor Digital Ally (DGLY), which has the date of January 16, 2019 for its Final Pretrial Conference. With a market cap of $20.4 million and roughly $11 million in net cash following a recent $10 million equity infusion, one way for Axon to remove this concern would be to utilize its balance sheet in a move that would further shore up its competitive position.

  • We are issuing a Buy on Axon Enterprises (AAXN) and adding them to the Tematica Investing Select List with a $90 price target.

 

 

Companies riding the Safety & Security tailwind:

  • American Outdoor Brands (AOBC)
  • Carbonite (CARB)
  • Check Point Software (CHKP)
  • Cisco Systems (CSCO)
  • F5 Networks (FFIV)
  • Fortinet (FTNT)
  • General Dynamics (GD)
  • Imperva (IMPV)
  • Lockheed Martin (LMT)
  • Northrop Grumman (NOC)
  • OSI Systems (OSIS)
  • Palo Alto Networks (PANW)
  • Proofpoint (PFPT)
  • Qualys (QLYS)
  • Raytheon (RTN)
  • Science Applications International Corp. (SAIC)
  • Sturm, Ruger & Co. (RGR)
  • Verisign (VRSN)
  • Vista Outdoor (VSTO)

 

UPDATE: Boosting our Costco Warehouse price target… again

UPDATE: Boosting our Costco Warehouse price target… again

Key points inside this issue:

  • We are boosting our price target on Costco Wholesale (COST) shares to $250 from $230.

 

Last Thursday night, Costco Wholesale (COST) once again shared blow away same-store-sales results this time for the month of August, which reflects the Middle-Class Squeeze tailwind as well as Costco’s positioning to ride our Digital Lifestyle investing theme as well. All told, sales for the period rose 12.2% to $11.0 billion, which capped the company’s August quarter with $43.4 billion, a 5.0% increase vs. the year-ago quarter, which was rather impressive given the year-ago quarter contained an extra week compared to this year. On a same-store sales basis, and stripping out foreign exchange and gas prices, Costco’s overall August sales climbed 8.0% year over year and 7.2% year over for the quarter.

Also impressive was the continued gains, both during August and the overall August quarter, for Costco’s e-commerce business, which was up 24.5% and more than 26%, respectively, when excluding the impact of gas and foreign currency.

And lest you think I forgot, Costco exited August with 762 active warehouse locations, up from 741 exiting a year ago, which bodes and 750 exiting its May 2018 quarter. The greater number of warehouse locations implies greater membership fees and higher membership fee income, which is not only a key differentiator vs. other retailers but also a prime driver of Costco’s EPS.

With consumers feeling the pinch of higher debt levels and inflation, with wage growth only now starting to move, I continue to see Costco extremely well positioned as we move into the seasonally strong shopping season that is the last four months of the year. As the company continues to ride these two thematic tailwinds, I see further upside ahead in the coming months and am boosting our COST price target to $250 from $230. A portion of that increase reflects the move up in EPS expectations over the last 90 days due to the robust same-store sales reports and increases in open warehouse locations, with the balance tied to multiple expansion as Costco continues to shake out Amazon concerns and deliver results that are the envy of the vast majority of brick & mortar retailers. Even as this price target is boosted, we would not chase COST shares at the current share price, but rather sit back and enjoy the ride.

  • We are boosting our price target on Costco Wholesale (COST) shares to $250 from $230.

 

Guilty Pleasures: the affordable treats that bring a moment of happiness

Guilty Pleasures: the affordable treats that bring a moment of happiness

 

There are several notions as to what constitutes a guilty pleasure. One definition is something one enjoys but would be embarrassed to have others know, while another is enjoying something even though it may not be held in high regard or may not be good for you. As one might expect there are a number of guilty pleasures to be had, ranging from certain films and TV programs (like the Bachelor, but we don’t judge), products ranging from tobacco, alcohol and marijuana to fast food, coffee and sugary treats as well as gambling and video games.

Some may label these as “vice” stocks, but that category tends to be limited to alcohol, gaming and tobacco and has a pejorative connotation vs. the little affordable treats and pleasures that bring a moment of enjoyment and happiness as well as much needed relief at certain times. By their nature, these guilty pleasures are ones that people will consume no matter the tone of the economic environment. In other words, they tend to be inelastic goods, and more often than not the companies behind them tend to be characterized as healthy cash flow generators and dividend payers.

These companies and brands differ from our Living the Life investing theme in that the pleasure derived is not a function of the premium price or image, but rather simply from the product or experience itself. Part of the joy of owning a Prada bag is having others see it whereas a guilty pleasure may be and often is, enjoyed in private.

In our view, Tematica’s Guilty Pleasure investing theme, like all of our other investing themes, cuts across several traditional Wall Street industry sectors, as the concept focuses on those companies that bring the kinds of products that consumers won’t do without, regardless of the economic climate. With that in mind, it should come as little surprise that the guilty pleasure group of stocks held up well during the last two recessions and performed even better on a relative basis when compared to several stock market indices. A 2009, report by Merrill Lynch that examined the performance of tobacco, alcohol, and casino stocks during all of the recessions since 1970 found that while the broad S&P 500 fell by 1.5% on average, guilty pleasure stocks rose on average 11%. During the great tech meltdown, the broad market fell 20% between June 2001 and June 2002, but during that time tobacco stocks gained 8% and gambling related stocks nearly 20%.

The inelastic nature of the products produced by these guilty pleasure companies has enabled them to weather price increases better than other products and services that are considered to be more of a commodity in nature. Perhaps the best example is in the tobacco industry. Consider that while the domestic tobacco business is in a decline as more people become aware of the health effects of smoking on their well-being and taxes are raised each year on cigarettes, price increases more than offset the decline in volume consumption by customers. Another example: despite the increasing concern over sugar as part of our diets, chocolate companies like Hershey Co., have been able to pass through price increases to offset any combination of higher raw material, fuel, utilities, and transportation costs.

When the price of key inputs of these guilty pleasure products, (such as commodities like coffee, beef, sugar, or cocoa) decline after a period of upward movement , the combination of lower input costs and prior price increases tends to deliver better margins, profit generation, EPS growth and cash flow. Think about it … when was the last time you saw the price of a beverage at Starbucks or the price for a package of Oreos decline? Demand for these products is such that rising costs are passed onto the consumer, but declining costs don’t result in much downward pricing pressure. Your wallet and your taste buds know what we’re talking about…

 

Altria: A Guilty Pleasure stock and a dividend dynamo as well

As mentioned above, tobacco is universally known to be harmful, yet people continue to smoke in one form or another. The US tobacco market saw a slight decline in volume sales and a slight increase in value sales in 2017 as Americans slowly continued to reduce their tobacco consumption, perhaps in part due to our Clean Living investment theme, while producers increased prices to maintain profits.

Big Tobacco has long been under threat from the steady decline of smoking, particularly in the developed world. But in recent years, the industry has been able to push through price increases to make up for falling volumes — boosting both their profits and stock prices. Those profits and cash flow have allowed tobacco companies to invest in smoking alternatives (e-cigarettes, vape pens and other devices) that deliver nicotine without as many of the harmful effects that come with lighting up as well as return capital to shareholders in the form of share repurchases and increasing dividends.

One such stock that falls into that grouping is Altria (MO), which is best known for cigarettes (primarily the Marlboro brand that has 43% market share in the US) and smokeless tobacco products (Copenhagen, Skoal, Red Seal, and Husky brands) and to a lesser extent wine under the brands Chateau Ste. Michelle, Columbia Crest, and 14 Hands. In the US, Altria has commanded 50%-51% of the cigarette market over the last year, and while primarily known for that product category, in cigars, the company has a 26% share with its large machine-made Black & Mild brand. In smokeless products, it has 55% share with the Copenhagen (32%) and Skoal (19%) brands.

Digging into Altria’s financials, roughly 85% of its revenue and profits are drawn from the smokeable products business, with smokeless accounting for 11% of sales and growing, and 14% of its operating profit. What that tells us is the smokeless products are a higher margin business for the company, thus a continued shift toward that product line bodes well for Altria’s profits and cashflow. Rounding out the revenue and profit mix at just under 4% and 1%, respectively, is the company’s wine business. What that business mix analysis tells us is even though we may hear some talk of the non-smokeable product potential, at least in the near-term, Altria is a smokeable product company.

That means we can expect additional tobacco taxes and further cigarette price hikes. As we’ve seen in the past, that should translate into rising profits, continued share buybacks and dividend increases. Current consensus estimates have Altria achieving EPS of $4.35 in 2019, up from $4.05 this year and $3.39 in 2017. Helping those EPS comparisons, during the June 2018 quarter, Altria repurchased 7.6 million shares at an average price of $57.65 and exiting that quarter, Altria had slightly more than $1 billion remaining in the current $2 billion share repurchase program. Management signaled it expects to complete that program by the end of the second quarter of 2019. As simple math shows us, shrinking share counts do wonders for EPS and their comparisons.

In terms of dividends, Altria recently announced it was boosting its quarterly dividend by 14% to $0.80 per share from the prior $0.70 per share – offering up a dividend yield of just over 5.4%. That marked the 53rd increase in the company’s dividend since 1968, which qualifies the company as a dividend dynamo company – one that increases its dividend year in, year out. That increase tends to lead to a step function higher in the share price overtime, something we’ve witnessed time and time again with Tematica Select List resident McCormick & Co. (MKC). With Altria, this latest dividend increase puts its annual 2018 dividend at $3.00, up from $2.00 in 2014.

If we look at other Guilty Pleasure stocks such as Hershey (HSY), Molson Coors (TAP), Constellation Brands (STZ) and your choice of a gaming company, the dividend yield range is 1.7% to 2.9%. If Altria shares traded in that dividend yield band, it would result in a share price well north of $100. Historically Altria shares have traded in the average dividend yield range of 3.74% to 4.8% over the last several years, which would suggest upside to $81 and downside to $63, which is well above the current share price.

Even after this latest quarterly dividend increase, Altria’s dividend payout remains close to 73% based on expected EPS of $4.35 in 2019 (vs. $3.39 in 2017) leaving ample room for additional dividend increases in the coming years. For example, if Altria kept its dividend payout ratio intact and achieved expected 2020 EPS of $4.70, it could mean a quarterly dividend of more than $0.85 per share. That would imply a potential annual dividend in the range of $3.30-$3.40, and further upside to be had in MO shares over the coming several quarters.

That’s a Guilty Pleasure company worth holding onto, especially if it manages to further transform its business from a tobacco centric one to something more evenly divided between smokeable and smokeless products. There is also the likely prospect of Altria entering the cannabis space as the legal status of marijuana continues to expand in the US. In many ways that move is a natural extension of its existing skill set – tobacco growth, processing, packaging and distribution – and it fits with the guilty pleasure framework of Altria’s business focus.

  • We are issuing a Buy on the shares of Altria (MO) and adding them to the Tematica Investing Select List with an $81 price target.

 

Companies riding the Guilty Pleasure Tailwind

  • ALTRIA (MO)
  • ANHEUSER-BUSCH (BUD)
  • BRITISH TOBACCO (BTI)
  • BROWN-FORMAN (BF.B
  • CAESAR’S ENTERTAINMENT (CZR)
  • CONSTELLATION BRANDS (STZ)
  • CRAFT BREW ALLIANCE (BREW)
  • DIAGEO PLC (DEO)
  • DOMINO’S (DPZ)
  • DUNKIN BRANDS (DNKN)
  • HERSHEY COMPANY (HSY)
  • L BRANDS (LB)
  • LAS VEGAS SANDS (LVS)
  • MCDONALD’S (MCD)
  • MELCO RESORTS AND ENTERTAINMENT (MLCO)
  • MGM RESORTS (MGM)
  • MOLSON COORS (TAP)
  • PEPSICO (PEP)
  • SHAKE SHACK (SHAK)
  • STARBUCKS (SBUX)

 

Breaking down the ISM Manufacturing Report plus Paccar and Costco updates

Breaking down the ISM Manufacturing Report plus Paccar and Costco updates

Key points inside this issue

  • While the August ISM Manufacturing Report shows an improving economy, it also confirms inflation is percolating as well.
  • An earnings beat and robust outlook at heavy truck and engine company Navistar (NAV), keeps us bullish on Paccar (PCAR). Our PCAR price target remains $85.
  • Our price target on Costco Wholesale (COST) shares remains $230 heading into the company’s same-store-sales report after tonight’s market close.

This week we started to get our first firm look at the domestic economy for the month of August. The first piece of data was the ISM Manufacturing Index for August, which came in at 61.3, the highest reading in the last 12 months and a sequential improvement from 58.1 in July. In pulling back the covers on the index’s components, we find the forward-looking components – net orders and the backlog of orders – move up nicely month over month suggesting the manufacturing economy will continue to grow this month. The same, however, can be said for the Price component, which registered 72.1 for August. While down from July’s 73.2 figure, sixteen of the surveyed 18 industries reported paying increased prices for raw materials in August. With the August Prices reading well above the expansion vs. contraction line that is 50, the modest tick down in that sub-index does little to suggest the FOMC won’t boost interest when it meets later this month.

With regard to the report and the current trade wars, new export orders in August ticked lower to 55.2, down a meager 0.1 month over month. We’ll continue to monitor this and related data to assess the actual impact of the current trade wars for as long as they are occurring. As a reminder, by the end of this week, the US could impose tariffs on roughly half of all Chinese goods entering the country. Estimates put that figure at $200 billion, a step up from the $34 billion that had tariffs placed on them in July and the additional $16 billion last month. Should this latest round of tariffs go into effect, odds are we will see China follow suit with another round of its own tariff increases on US goods.

Drilling into the employment component of the ISM Manufacturing Report, it jumped to 58.5 in August, up from 56.5 in July. Given the historical relationship between this component and the Bureau of Labor Statistics (BLS) Employment Report – a reading in the ISM employment index above 50.8 percent, is generally consistent with an increase in the (BLS) data on manufacturing employment – odds are Friday’s Employment Report could surprise to the upside. To us, the real figure to watch inside that report, however, will be average hourly earnings to see how it stacks up against the data pointing to mounting inflation to be had in the economy. As we’ve said before, if wage growth lags relative to that data, it could put the brakes on the robust consumer spending we’ve seen in recent months.

 

An update on Paccar and a reminder on Costco Wholesale

Turning to the portfolio, this morning heavy truck and engine company Navistar (NAV) reported better than expected quarterly earnings due to continued strength in the heavy truck market. We see that as well as Navistar’s upsized heavy truck industry delivery forecast to 260,000-280,000 from the prior 250,000-280,000 as a positive for our Paccar (PCAR) shares. The same can be said from the recent July report on truck tonnage released by the American Trucking Association that showed an 8.6% year over year increase for the month, sequentially stronger than the 7.7% increase in June. The activity had with that ATA report suggest not only a pick up in the domestic economy, but the pain point of the current truck shortage continues to be felt, which bodes well for continued new order flow.

  • Our price target on Paccar (PCAR) shares remains $85.

After tonight’s close, Costco Wholesale (COST) will report its August same-store-sales figures, which we expect will continue the recent string of favorable reports. We’ll also be looking for an update on the number of open warehouses, a leading indicator for its high margin membership fee revenue stream. Based on the report, we will look to revisit our current $230 price target on COST shares.

  • Our price target on Costco Wholesale (COST) shares remains $230 for now.

 

Adding Clean Living Play Chipotle Mexican Grill to the Select List

Adding Clean Living Play Chipotle Mexican Grill to the Select List

 

I’ve been keeping a close watch on the shares of Chipotle Mexican Grill (CMG) since we removed them from the Tematica Investing Select List in mid-2016. The company was previously part of what we now refer to as our Clean Living investment theme given its use of fresh, high-quality raw ingredients including meats that are raised without the use of non-therapeutic antibiotics or added hormones and none of the ingredients in the food (excluding beverages) in U.S. restaurants contain genetically modified organisms (GMOs).

The company was removed from the Tematica Select List back in 2016 when the share price dropped below our $390 stop-loss at the time.  Over the last 26 months, CMG shares fell to a low of $263 in November 2017 then rallied back to a recent high of just under $531. To refresh memories, Chipotle was once a darling of Wall Street as consumers flocked to eat its fast-casual Mexican fair that emphasized “food with integrity,” but its shares and management came under pressure following several outbreaks of foodborne illness that left diners ill and sent traffic, sales and shares plummeting in 2017. It appeared a recovery was underway until another outbreak occurred in mid-2017, once again hitting sales and the shares. This continued flow of bad headlines and whipsawing in the share price has kept us on the sidelines.

Management announced it would step down in November 2017 and in March 2018 Brian Niccol, the then CEO of Taco Bell, took over the Chipotle reigns. While Taco Bell may not be the poster child for refined cuisine, under Niccol’s watch Taco Bell same-store sales had grown an average of 4% a year at a time when the restaurant industry was experiencing a challenging environment as consumer preferences shifted toward healthier foods, snacks and beverages.

Investors loved the idea as the news of Niccol’s appointment started CMG shares on their current rebound. Niccol and his team quickly went to work on basic blocking and tackling, which led to declining guest complaints and improving guest satisfaction scores as shared on the June 2018 quarterly earnings call. Also on that call, following his first full quarter at the helm, Niccol shared his strategic plan for the company. It centered on four key areas: menu innovation, updated marketing, the introduction of a loyalty program, and a greater emphasis on digital sales.

That plan is already being put into action with the testing of several potential new menu items at its test kitchen in New York, including quesadillas, nachos, chocolate milkshakes (which personally perked up my ears), avocado tostadas, and a new salad. Once the company has confirmed these and other new test products meet consumer taste preferences and operational hurdles they will go national, a process that could take 18 to 36 months. Niccol also talked about overhauling the company’s marketing strategy, including more on TV spots and an overall campaign that is more  “engaging and lighthearted.” We’ll wait and see what this looks like before commenting, but historically Chipotle has shunned advertising and while this could weigh on margins in the coming quarters, it could help reinvigorate the company’s brand. Again, more on that in the coming months.

Coming later this year, Chipotle will test its loyalty program with the expectation of rolling it out in full force during 2019. We’ve seen the success of other loyalty programs, most notably at Starbucks (SBUX), and I am cautiously optimistic. As it is looking to improve its digital sales, the company has made some changes to its mobile app and recently added delivery at 1,800 of its locations via DoorDash through its app and website. By the end of 2019, customers “will be able to order delivery from within the Chipotle app in most locations.” We’ve seen the success of delivery at former Select List holding Habit Restaurant (HABT), and recognize it tends to come with premium pricing – a positive for Chipotle.

Rather than drink the new CEO’s Kool-Aid, let’s remember there is more work to be done with management’s “Big Fix” initiative, but as we have seen before, as the turnaround momentum begins to build, the benefits begin to kick in. As traffic rebounds, the company should see volume benefits paired with prior pricing actions improve the bottom line. Given the nature of its business, I will keep watch on trends in beef, pork and chicken, as well as other key ingredients such as avocados, and the potential benefit or hindrance to margins and EPS.

When examining CMG shares, I can see upside to at least $550, which equates to 45x expected earnings near $12 in 2019, up significantly from $6.60 in 2017. While that P/E figure is rich, it has the shares trading at a PEG ratio of roughly 1x. The 2019 EPS figure bakes in continued benefits from the company’s “Big Fix” turnaround and assumes management is able to squeeze meaningful margin leverage as it returns the company back to growth. While we will be patient we will also be tracking the company’s “Big Fix” progress.

So why now?

Simple, a recent downgrade from investment firm Wedbush hit Chipotle shares and led them to fall just over 9% during the last several trading days from $523 to the current $475. For some perspective, that followed a recent upgrade by Morgan Stanley to an Overweight rating and the reiteration of an Overweight rating by Piper Jaffray. I see Wedbush’s comment as very rear-view mirror relative to the company’s progress in turning the business around, a key point of our investment thesis. That 9% drop in the share price means we now have nearly 16% upside to that “at least” $550 price target. Yes, Niccol and the company have much further to go, and from time to time there will be missteps and setbacks along the way, but as the saying goes, our eye is on the long-term prize with Chipotle.

As such, we’re using the recent drop in the shares relative to the $550 price target to add CMG shares back to the Select List as part of our Clean Living investing theme. The strategy with this position will be to add to the shares on weakness provided the company continues to make progress on the new management team’s four-pronged initiative AND drives favorable traffic and sales metrics.

  • We are issuing a Buy on the shares of Chipotle Mexican Grill (CMG) and adding them to the Tematica Investing Select List with a $550 price target. 

 

WEEKLY ISSUE: Booking more Habit gains and redeploying into another Digital Lifestyle investment

WEEKLY ISSUE: Booking more Habit gains and redeploying into another Digital Lifestyle investment

Key points in this issue

  • We are issuing a Sell on Habit Restaurant (HABT) shares and removing them from the Tematica Investing Select List. As we say goodbye to Habit, we’d note the position generated a blended return of more than 80% over the last four months.
  • We are issuing a Buy on Alibaba (BABA) shares as part of our Digital Lifestyle investing theme with a $230 price target.
  • Chatter over Apple’s (AAPL) potential new products begins to swell ahead of its upcoming Fall event, and it’s looking for our Universal Display (OLED) shares as well. Our price targets for AAPL and OLED shares remain $225 and $150, respectively.

 

Exiting Habit Restaurant Shares

A few weeks ago we took some of our Habit Restaurant (HABT) shares off the table, which gave us a tasty 68% profit on that half of the position. In the ensuing weeks, Habit shares have continued their climb higher and with last night’s close, the remaining portion of our HABTshares were up almost 89% from our early May buy. Not only is that a hefty profit, but it equates to a very rich valuation as well.

As of last night’s close, HABTshares were trading at 278x expected 2019 EPS of $0.06 vs. a PE range of 16-80 for peers that that range from El Poll Loco (LOCO) to Shake Shack (SHAK). On a price to sales basis, HABTshares are trading near 1.15x expected 2018 sales, well ahead of the 0.9x takeout multiple at which Zoe’s Kitchen is being acquired by Cava Mezza Grill.

As we often hear, it pays not to fall in love with the stock one owns, lest we are tempted to not do the prudent thing. I still like the Habit Restaurant story, and that goes for its Ahi Tuna burger as well. That said, given the phenomenal run and rich valuation, I’m calling it a day and removing HABTshares from the Tematica Investing Select List. I’ll be keeping tabs on the company and its geographic expansion in the coming months, but I’d be more inclined to revisit the shares at a more reasonable set of valuation metrics.

  • We are issuing a Sell on Habit Restaurant (HABT) shares and removing them from the Tematica Investing Select List. As we say goodbye to Habit, we’d note the position generated a blended return of more than 80% over the last four months.

Gearing into Alibaba Shares

One of the shortcomings in the perspective for most investors is they tend to be focused on the geographic region in which they reside. Given the global nature of our investment themes, I try to keep an open mind and look for thematic opportunities no matter where they are. One such company that sits at the crossroads of our Digital Lifestyle and Rise of the New Middle-Class investments, and has a dash of Disruptive Innovators and Digital Infrastructure is Alibaba (BABA). Alibaba has long been heralded as the Amazon (AMZN) of China given its position in digital shopping (84% of revenue) but that’s about where the similarities end…. For now.

Last week Alibaba reported its latest quarterly results, in which revenue hit $12.23 billion for the quarter, beating consensus expectations of $12.02 billion. Paired with double-digit earnings before interest, tax, depreciation, and amortization (EBITDA) growth is more than overshadowing a $0.02 per share miss on the company’s bottom line, which came in at $1.22 per share.

At Alibaba, all the company’s operating profit is derived from its core commerce business with the remaining 16% of its revenue stream spread across cloud, digital media and innovation initiatives all weighing on that profit stream. By comparison, Amazon’s Amazon Web Services (AWS) is the company’s profit and cash flow secret weapon as I like to call it.

That’s the negative, but if we look at the year over year comparisons of the non-core commerce businesses, not only are they growing quickly, but year over year Alibaba is shrinking their losses across the board.

In many respects this is similar to one of the key concerns investors once had with Amazon not too long ago — can it turn a consistent profit? We have seen Amazon do just that for a number of quarters in a row, and investors have removed that objection, which has sent AMZN shares significantly higher.

With Alibaba, the question is not whether those businesses become profitable, but rather when. Yes, much like Amazon, Alibaba continues to invest for future growth as evidenced by the level of capital spending in the June quarter vs. the year ago and declining cash on the balance sheet.

Both of these reflect investments to — much like Amazon — move past its core commerce platforms, into physical retail and food-delivery services, as well as expanding its footprint in areas such as logistics and in overseas markets.

That said, the company is benefiting from the continued tailwinds of the Digital Lifestyle investment theme. This is evidenced by the continued growth in both active consumers on its retail marketplace as well as mobile monthly active users. Exiting June, the company’s annual active consumers reached 576 million, up nearly 24% year over year, while its mobile monthly active users hit 634 million, up 20% year over year.

Much like Amazon’s Prime business, as Alibaba expands its scope of product and services, at least in the near-term, it should continue to win new users and retain existing ones. Also much like Amazon, Alibaba will continue to grab incremental consumer wallet share. The combination should continue to drive top-line growth and pull its non-core commerce businesses into the black.

Following last week’s earnings report, consensus EPS sits at $5.71 per share, up from the $4.78 achieved in 2017, with expectations of $7.75 in 2019. What the math shows is an expectation for roughly 27% EPS growth over the 2017-2019 time frame, and against that backdrop BABA shares are trading at a PEG ratio of 0.85 based on 2019 EPS expectations.

In coming months, odds are we will see continued growth in China digital commerce as China consumers build up for the year-end holidays and Chinese New Year. That along with other gains in its cloud and digital media businesses should see Alibaba closing the profit gap leading to not only more comparisons to Amazon but to multiple expansion to a PEG ratio of 1.1x that offers upside to $230, if not more.

The one obvious risk is the impact of trade and tariffs between the U.S. and China, which stepped up today. My thinking is given the slowing economic data of late from China and potential mid-term election risk, President Trump could be angling for an October-early November trade win. Not only would that send the overall U.S. stock market higher, but it would remove the trade concerns from BABA shares as well.

  • We are issuing a Buy on Alibaba (BABA) shares as part of our Digital Lifestyle investing theme with a $230 price target.

 

Apple ChatterCcontinues to Build Ahead of its 2018 Product Launch

With Apple’s (AAPL) annual fall event inching closer, chatter about new products is increasing and the internet is filling up with speculation over the number of iPhones and other products that the company could ship later this year. The current buzz has three new models being released:

  • an iPhone X successor
  • a new 6.5-inch iPhone X Plus
  • a mass-market 6.1-inch LCD iPhone with thin bezels and Face ID just like the iPhone X

Accompanying this chatter is speculation concerning the impact on Apple shipments, with DigiTimes saying “new iPhone shipments should hit 70-75 million units through the end of the year, the highest level since the iPhone 6/6 Plus super cycle. This number is purely on new 2018 iPhone shipments, it does not include sales of older generations.”

These happenings help explain the favorable move higher in Apple shares registered in recent days as well as for fellow Select List holding Universal Display (OLED).

Based on the rumblings, it looks like Apple will have two iPhone models utilizing organic light-emitting diode display technologies, up from just one last year, a positive for Universal’s chemical and IP business, especially as shipments of those model will likely continue to grow in 2019. Remember, too, that some months ago Apple was expected to fully transition its iPhone lineup to organic light-emitting diode displays with its 2019 lineup. Going from one model to two or three of its new models appears to be a confirming step as organic light emitting diode capacity expands and display prices come down.

I continue to see an improving outlook for OLED shares as smartphone competitors follow suit and adopt the organic light-emitting diode technology, and its uses expand into other markets (interior automotive lighting, specialty lighting and eventually general illumination, much the way light emitting diodes did). Our price target on OLED shares remains $150.

With Apple, I expect the shares to continue to melt up ahead of its rumored mid- September event and look to revisit our $225 price target based on products the company does announce, not rumors.

  • Chatter over Apple’s (AAPL) potential new products begins to swell ahead of its upcoming Fall event, and it’s looking for our Universal Display (OLED) shares as well. Our price targets for AAPL and OLED shares remain $225 and $150, respectively.