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Doubling Down on Digital Infrastructure Thematic Leader

Doubling Down on Digital Infrastructure Thematic Leader

Key point inside this issue

  • We are doubling down on Dycom (DY) shares on the Thematic Leader board and adjusting our price target to $80 from $100, which still offers significant upside from our new cost basis as the 5G and gigabit fiber buildout continues over the coming quarters.

We are coming at you earlier than usual this week in part to share my thoughts on all of the economic data we received late last week.

 

Last week’s data confirms the US economy is slowing

With two-thirds of the current quarter behind now in the books, the continued move higher in the markets has all the major indices up double-digits year to date, ranging from around 11.5-12.0%% for the Dow Jones Industrial Average and the S&P 500 to nearly 18% for the small-cap heavy Russell 2000. In recent weeks we have discussed my growing concerns that the market’s melt-up hinges primarily on U.S.-China trade deal prospects as earnings expectations for this year have been moving lower, dividend cuts have been growing and the global economy continues to slow. The U.S. continues to look like the best economic house on the block even though it, too, is slowing.

On Friday, a round of IHS Markit February PMI reports showed that three of the four global economic horsemen — Japan, China, and the eurozone — were in contraction territory for the month. New orders in Japan and China improved but fell in the eurozone, which likely means those economies will continue to slug it out in the near-term especially since export orders across all three regions fell month over month. December-quarter GDP was revealed to be 2.6% sequentially, which equates to a 3.1% improvement year over year but is down compared to the 3.5% GDP reading of the September quarter and 4.2% in the June one.  Slower growth to be sure, but still growing in the December quarter.

Before we break out the bubbly, though, the IHS Markit February U.S. Manufacturing PMI fell to its lowest reading in 18 months as rates of output and new order growth softened as did inflationary pressures. This data suggest the U.S. manufacturing sector is growing at its slowest rate in several quarters, as did the February ISM Manufacturing Index reading, which slipped month over month and missed expectations. Declines were seen almost across the board for that ISM index save for new export orders, which grew modestly month over month. The new order component of the February ISM Manufacturing Index dropped to 55.5 from 58.2 in January, but candidly this line item has been all over the place the last few months. The January figure rebounded nicely from 51.3 in December, which was down sharply from 61.8 in November. This zig-zag pattern likely reflects growing uncertainty in the manufacturing economy given the pace of the global economy and uncertainty on the trade front. Generally speaking though, falling orders translate into a slower production and this means carefully watching both the ISM and IHS Markit data over the coming months.

In sum, the manufacturing economy across the four key economies continued to slow in February. On a wider, more global scale, J.P. Morgan’s Global Manufacturing PMI fell to 50.6 in February, its lowest level since June 2016. Per J.P. Morgan’s findings, “the rate of expansion in new orders stayed close to the stagnation mark,” which suggests we are not likely to see a pronounced rebound in the near-term. We see this as allowing the Fed to keep its dovish view, and as we discuss below odds are it will be joined by the European Central Bank this week.

Other data out Friday included the December readings for Personal Income & Spending and the January take on Personal Income. The key takeaway was personal income fell for the first time in more than three years during January, easily coming in below the gains expected by economists. Those pieces of data not only help explain the recent December Retail Sales miss but alongside reports of consumer credit card debt topping $1 trillion and record delinquencies for auto and student loans, point to more tepid consumer spending ahead. As I’ve shared before, that is a headwind for the overall US economy but also a tailwind for those companies, like Middle-class Squeeze Thematic Leader Costco Wholesale (COST), that help consumers stretch the disposable income they do have.

We have talked quite a bit in recent Tematica Investing issues about revisions to S&P 500 2019 EPS estimates, which at last count stood at +4.7% year over year, down significantly from over +11% at the start of the December quarter. Given the rash of reports last week – more than 750 in total –  we will likely see that expected rate of growth tweaked a bit lower.

Putting it all together, we have a slowing U.S. and global economy, EPS cuts that are making the stock market incrementally more expensive as it has moved higher in recent weeks, and a growing number of dividend cuts. Clearly, the stock market has been melting up over the last several weeks on increasing hopes over a favorable trade deal with China, but last week we saw President Trump abruptly end the summit with North Korea’s Kim Jong Un with no joint agreement after Kim insisted all U.S. sanctions be lifted on his country. This action spooked the market, leading some to revisit the potential for a favorable trade deal between the U.S. and China.

Measuring the success of any trade agreement will hinge on the details. Should it fail to live up to expectations, which is a distinct possibility, we could very well see a “buy the rumor, sell the news” situation arise in the stock market. As I watch for these developments to unfold, given the mismatch in the stock market between earnings and dividends vs. the market’s move thus far in 2019 I will also be watching insider selling in general but also for those companies on the Thematic Leader Board as well as the Tematica Select List. While insiders can be sellers for a variety of reasons, should we see a pronounced and somewhat across the board pick up in such activity, it could be another warning sign.

 

What to Watch This Week

This week we will see a noticeable drop in the velocity of earnings reports, but we will still get a number of data points that investors and economists will use to triangulate the speed of the current quarter’s GDP relative to the 2.6% print for the December quarter. The consensus GDP forecast for the current quarter is for a slower economy at +2.0%, but we have started to see some economists trim their forecasts as more economic data rolls in. Because that data has fallen shy of expectations, it has led the Citibank Economic Surprise Index (CESI) to once again move into negative territory and the Atlanta Fed’s GDPNow current quarter forecast now sat at 0.3% as of Friday.

On the economic docket this week, we have December Construction Spending, ISM’s February Non-Manufacturing Index reading, the latest consumer credit figures and the February reports on job creation and unemployment from ADP (ADP) and the Bureau of Labor Statistics. With Home Depot (HD) reporting relatively mild December weather, any pronounced shortfall in December Construction Spending will likely serve to confirm the economy is on a slowing vector. Much like we did above with ISM’s February Manufacturing Index we’ll be looking into the Non-Manufacturing data to determine demand and inflation dynamics as well as the tone of the services economy.

On the jobs front, while we will be watching the numbers created, including any aberration owing to the recent federal government shutdown, it will be the wage and hours worked data that we’ll be focusing on. Wage data will show signs of any inflationary pressures, while hours worked will indicate how much labor slack there is in the economy. The consumer is in a tighter spot financially speaking, which was reflected in recent retail sales and personal spending data. Recognizing the role consumer spending plays in the overall speed of the U.S. economy, we will be scrutinizing the upcoming consumer credit data rather closely.

In addition to the hard data, we’ll also get the Fed’s latest Beige Book, which should provide a feel for how the regional economies are faring thus far in 2019. Speaking of central bankers, next Wednesday will bring the results of the next European Central Bank meeting. Given the data depicted in the February IHS Markit reports we discussed above, the probability is high the ECB will join the Fed in a more dovish tone.

While the velocity of earnings reports does indeed drop dramatically next week, there will still be several reports worth digging into, including Ross Stores (ROST), Kohl’s (KSS), Target (TGT), BJ’s Wholesale (BJ), and Middle-class Squeeze Thematic Leader Costco Wholesale (COST) will also issue their latest quarterly results. Those reports combined with the ones this week, including solid results from TJX Companies (TJX) last week should offer a more complete look at consumer spending, and where that spending is occurring. Given the discussion several paragraphs above, TJX’s results last week, and the monthly sales reports from Costco, odds are quite good that Costco should serve up yet another report showcasing consumer wallet share gains.

Outside of apparel and home, reports from United Natural Foods (UNFI) and National Beverage (FIZZ) should corroborate the accelerating shift toward food and beverages that are part of our Cleaner Living investing theme. In that vein, I’ll be intrigued to see what Tematica Select List resident International Flavors & Fragrances (IFF) has to say about the demand for its line of organic and natural solutions.

The same can be said with Kroger (KR) as well as its efforts to fend off Thematic King Amazon (AMZN) and Walmart (WMT). Tucked inside of Kroger’s comments, we will be curious to see what the company says about digital grocery shopping and delivery. On Kroger’s last earnings conference call, Chairman and CEO Rodney McMullen shared the following, “We are aggressively investing to build digital platforms because they give our customers the ability to have anything, anytime, anywhere from Kroger, and because they’re a catalyst to grow our business and improve margins in the future.” Now to see what progress has been achieved over the last 90 or so days and what Kroger has to say about the late-Friday report that Amazon will launch its own chain of supermarkets.

 

Tematica Investing

As you can see in the chart above, for the most part, our Thematic Leaders have been delivering solid performance. Shares of Costco Wholesale (COST) and Nokia (NOK) are notable laggards, but with Costco’s earnings report later this week which will also include its February same-store sales, I see the company’s business and the shares once again coming back into investor favor as it continues to win consumer wallet share. That was clearly evident in its December and January same-store sales reports. With Nokia, coming out of Mobile World Congress 2019 last week, we have confirmation that 5G is progressing, with more network launches coming and more devices coming as well in the coming quarters. We’ll continue to be patient with NOK shares.

 

Adding significantly to our position in Thematic Leader Dycom Industries

There are two positions on the leader board – Aging of the Population AMN Healthcare (AMN) and Digital Infrastructure Dycom Industries (DY) – that are in the red. The recent and sharp drop in Dycom shares follows the company’s disappointing quarterly report in which costs grew faster than 14.3% year over year increase in revenue, pressuring margins and the company’s bottom line. As we’ve come to expect this alongside the near-term continuation of those margin pressures, as you can see below, simply whacked DY shares last week, dropping them into oversold territory.

 

When we first discussed Dycom’s business, I pointed out the seasonal tendencies of its business, and that likely means some of the February winter weather brought some added disruptions as will the winter weather that is hitting parts of the country as you read this. Yet, we know that Dycom’s top customers – AT&T (T), Verizon (VZ), Comcast (CMCSA) and CenturyLink (CTL) are busy expanding the footprint of their connective networks. That’s especially true with the 5G buildout efforts at AT&T and Verizon, which on a combined basis accounted for 42% of Dycom’s January quarter revenue.

Above I shared that coming out of Mobile World Congress 2019, commercial 5G deployments are likely to be a 2020 event but as we know the networks, base stations, and backhaul capabilities will need to be installed ahead of those launches. To me, this strongly suggests that Dycom’s business will improve in the coming quarters, and as that happens, it’s bound to move down the cost curve as efficiencies and other aspects of higher utilization are had. For that reason, we are using last week’s 26% drop in DY shares to double our position size in DY shares on the Thematic Leader board. This will reduce our blended cost basis to roughly $64 from the prior $82. As we buy up the shares, I’m also resetting our price target on DY shares to $80, down from the prior $100, which offers significant upside from the current share price and our blended cost basis.

If you’re having second thoughts on this decision, think of it this way – doesn’t it seem rather strange that DY shares would fall by such a degree given the coming buildout that we know is going to occur over the coming quarters? If Dycom’s customers were some small, regional operators I would have some concerns, but that isn’t the case. These customers will build out those networks, and it means Dycom will be put to work in the coming quarters, generating revenue, profits, and cash flow along the way.

In last week’s Tematica Investing I dished on Warren Buffett’s latest letter to Berkshire Hathaway (BRK.A) shareholders. In thinking about Dycom, another Buffett-ism comes to mind – “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” Since this is a multi-quarter buildout for Dycom, we will need to be patient, but as we know for the famous encounter between the tortoise and the hare, slow and steady wins the race.

  • We are doubling down on Dycom (DY) shares on the Thematic Leader board and adjusting our price target to $80 from $100, which still offers significant upside from our new cost basis as the 5G and gigabit fiber buildout continues over the coming quarters.

 

As the pace of earnings slows, over the next few weeks I’ll not only be revisiting the recent 25% drop in Aging of the Population Thematic Leader AMN Healthcare to determine if we should make a similar move like the one we are doing with Dycom, but I’ll also be taking closer looks at wireless charging company Energous Corp. (WATT) and The Alkaline Water Company (WTER). Those two respectively fall under our Disruptive Innovators and Cleaner Living investing themes. Are they worthy of making it onto the Select List or bumping one of our Thematic Leaders? We’ll see…. And as I examine these two, I’m also pouring over some candidates to fill the Guilty Pleasure vacancy on the leader board.

 

 

Weekly Issue: Looking Around the Bend of the Current Rebound Rally

Weekly Issue: Looking Around the Bend of the Current Rebound Rally

 

Stock futures are surging this morning in a move that has all the major domestic stock market indices pointing up between 1.5% for the S&P 500 to 2.2% for the Nasdaq Composite Index. This surge follows the G20 Summit meeting of President Trump and Chinese President Xi Jinping news that the US and China will hold off on additional tariffs on each other’s goods at the start of 2019 with trade talks to continue. What this means is for a period of time as the two countries look to hammer out a trade deal during the March quarter, the US will leave existing tariffs of 10% on more than $200 million worth of Chinese products in place rather than increase them to 25%.  If after 90 days the two countries are unable to reach an agreement, the tariff rate will be raised to 25% percent.

In my view, what we are seeing this morning is in our view similar to what we saw last week when Fed Chair Powell served up some dovish comments regarding the speed of interest rate hikes over the coming year – a sigh of relief in the stock market as expected drags on the economy may not be the headwinds previously expected. On the trade front, it’s that tariffs won’t escalate at the end of 2018 and at least for now it means one less negative revision to 2019 EPS expectations. In recent weeks, we’ve started to see the market price in the slowing economy and potential tariff hikes as 2019 EPS expectations for the S&P 500 slipped over the last two months from 10%+ EPS growth in 2019 to “just” 8.7% year over year. That’s down considerably from the now expected EPS growth of 21.6% this year vs. 2017, but we have to remember the benefit of tax reform will fade as it anniversaries. I expect this to ignite a question of what the appropriate market multiple should be for the 2019 rate of EPS growth as investors look past trade and the Fed in the coming weeks. More on that as it develops.

For now, I’ll take the positive performance these two events will have on the Thematic Leaders and the Select List; however, it should not be lost on us that issues remain. These include the slowing global economy that is allowing the Fed more breathing room in the pace of interest rate hikes as well as pending Brexit issues and the ongoing Italy-EU drama. New findings from Lending Tree (TREE) point to consumer debt hitting $4 trillion by the end of 2018, $1 trillion higher than less five years ago and at interest rates that are higher than five years ago. Talk about a confirming data point for our Middle-class Squeeze investing theme. And while oil prices have collapsed, offering a respite at the gas pump, we are seeing more signs of wage inflation that along with other input and freight costs will put a crimp in margins in the coming quarters. In other words, headwinds to the economy and corporate earnings persist.

On the US-China trade front, the new timeline equates to three months to negotiate a number of issues that have proved difficult in the past. These include forced technology transfer by U.S. companies doing business in China; intellectual-property protection that the U.S. wants China to strengthen; nontariff barriers that impede U.S. access to Chinese markets; and cyberespionage.

So, while the market gaps up today in its second sigh of relief in as many weeks, I’ll continue to be prudent with the portfolio and deploying capital in the near-term.  At the end of the day, what we need to see on the trade front is results – that better deal President Trump keeps talking about – rather than promises and platitudes. Until then, the existing tariffs will remain, and we run the risk of their eventual escalation if promises and platitudes do not progress into results.

 

The Stock Market Last Week

Last week we closed the books on November, and as we did that the stock market received a life preserver from Federal Reserve Chair Powell, which rescued them from turning in a largely across-the-board negative performance for the month. Powell’s comments eased the market’s concern over the pace of rate hikes in 2019 and the subsequent Fed November FOMC meeting minutes served to reaffirm that. As we shared Thursday, we see recent economic data, which has painted a picture of a slowing domestic as well as global economy, giving the Fed ample room to slow its pace of rate hikes. 

While expectations still call for a rate increase later this month, for 2019 the consensus is now looking for one to two hikes compared to the prior expectation of up to four. As we watch the velocity of the economy, we’ll also continue to watch the inflation front carefully given recent declines in the PCE Price Index on a year-over-year basis vs. wage growth and other areas that are ripe for inflation.

Despite Powell’s late-month “rescue,” quarter to date, the stock market is still well in the red no matter which major market index one chooses to look at. And as much as we like the action of the past week, the decline this quarter has erased much of the 2018 year-to-date gains. 

 

Holiday Shopping 2018 embraces the Digital Lifestyle

Also last week, we had the conclusion of the official kickoff to the 2018 holiday shopping season that spanned Thanksgiving to Cyber Monday, and in some cases “extended Tuesday.” The short version is consumers did open their wallets over those several days, but as expected, there was a pronounced shift to online and mobile shopping this year, while bricks-and-mortar traffic continued to suffer. 

According to ShopperTrak, shopper visits were down 1% for the two-day period compared to last year, with a 1.7% decline in traffic on Black Friday and versus 2017. Another firm, RetailNext, found traffic to U.S. stores fell between 5% and 9% during Thanksgiving and Black Friday compared with the same days last year. For the Thanksgiving to Sunday 2018 period, RetailNext’s traffic tally fell 6.6% year over year. 

Where were shoppers? Sitting at home or elsewhere as they shopped on their computers, tablets and increasingly their mobile devices. According to the National Retail Federation, 41.4 million people shopped only online from Thanksgiving Day to Cyber Monday. That’s 6.4 million more than the 34.7 million who shopped exclusively in stores. Thanksgiving 2018 was also the first day in 2018 to see $1 billion in sales from smartphones, according to Adobe, with shoppers spending 8% more online on Thursday compared with a year ago. Per Adobe, Black Friday online sales hit $6.22 billion, an increase of 23.7% from 2017, of which roughly 33% were made on smartphones, up from 29% in 2017.

The most popular day to shop online was Cyber Monday, cited by 67.4 million shoppers, followed by Black Friday with 65.2 million shoppers. On Cyber Monday alone, mobile transactions surged more than 55%, helping make the day the single largest online shopping day of all time in the United States at $7.9 billion, up 19% year over year. It also smashed the smartphone shopping record set on Thanksgiving as sales coming from smartphones hit $2 billion.

As Lenore Hawkins, Tematica’s Chief Macro Strategist, and I discussed on last week’s Cocktail Investing podcast, the holiday shopping happenings were very confirming for our Digital Lifestyle investing theme. It was also served to deliver positive data points for several positions on the Select List and the Thematic Leader that is Amazon (AMZN). These include United Parcel Service (UPS), which I have long viewed as a “second derivative” play on the shift to digital shopping, but also Costco Wholesale (COST) and Alphabet/Google (GOOGL). Let’s remember that while we love McCormick & Co. (MKC) for “season’s eatings” the same can be said for Costco given its food offering, both fresh and packaged, as well as its beer and wine selection. For Google, as more consumers shop online it means utilizing its search features that also drive its core advertising business.

As we inch toward the Christmas holiday, I expect more data points to emerge as well as more deals from brick & mortar retailers in a bid to capture what consumer spending they can. The risk I see for those is profitless sales given rising labor and freight costs but also the investments in digital commerce they have made to fend off Amazon. Sales are great, but it has to translate into profits, which are the mother’s milk of EPS, and that as we know is one of the core drivers to stock prices.

 

Marriott hack reminds of cyber spending needs

Also last week, we learned of one of the larger cyber attacks in recent history as Marriott (MAR) shared that up to 500 million guests saw their personal information ranging from passport numbers, travel details and payment card data hacked at its Starwood business. As I wrote in the Thematic Signal in which I discussed this attack, it is the latest reminder in the need for companies to continually beef up their cybersecurity, and this is a profound tailwind for our Safety & Security investing theme as well as the  ETFMG Prime Cyber Security ETF (HACK) shares that are on the Select List.

 

The Week Ahead

Today, we enter the final month of 2018, and given the performance of the stock market so far in the December quarter it could very well be a photo finish to determine how the market finishes for the year. Helping determine that will not only be the outcome of the weekend’s G-20 summit, but the start of November economic data that begins with today’s ISM Manufacturing Index and the IHS Markit PMI data, and ends the week with the monthly Employment Report. Inside those two reports, we here at Tematica be assessing the speed of the economy in terms of order growth and job creation, as well as inflation in the form of wage growth. These data points and the others to be had in the coming weeks will help firm up current quarter consensus GDP expectations of 2.6%, per The Wall Street Journal’s Economic Forecasting Survey that is based on more than 60 economists, vs. 3.5% in the September quarter.

Ahead of Wednesday’s testimony by Federal Reserve Chair Powell on “The Economic Outlook” before Congress’s Joint Economic Committee, we’ll have several Fed heads making the rounds and giving speeches. Odds are they will reinforce the comments made by Powell and the November Fed FOMC meeting minutes that we talked about above. During Powell’s testimony, we can expect investors to parse his words in order to have a clear sense as to what the Fed’s view is on the speed of the economy, inflation and the need to adjust monetary policy, in terms of both the speed of future rate hikes and unwinding its balance sheet. Based on what we learn, Powell’s comments could either lead the market higher or douse this week’s sharp move higher in the stock market with cold water.

On the earnings front this week, we have no Thematic Leaders or Select List companies reporting but I’ll be monitoring results from Toll Brothers (TOL), American Eagle (AEO), Lululemon Athletica (LULU), Broadcom (AVGO) and Kroger (KR), among others. Toll Brothers should help us understand the demand for higher-end homes, something to watch relating to our Living the Life investing theme, while American Eagle and lululemon’s comments will no doubt offer some insight to the holiday shopping season. With Broadcom, we’ll be looking at its demand outlook to get a better handle on smartphone demand as well as the timing of 5G infrastructure deployments that are part of our Disruptive Innovators investing theme. Finally, with Kroger, it’s all about our Clean Living investing theme and to what degree Kroger is capturing that tailwind.

 

Our Costco thesis remains intact

Our Costco thesis remains intact

Last night Costco Wholesale (COST) reported quarterly results that in our view are being misinterpreted by investors. While the company reported EPS for the quarter came in at $1.59 per share that included a $0.17 per share tax benefit that resulted from tax legislation passed by Congress vs. the expected $1.45 per share, it’s top line results continue to show Costco making wallet and market share gains. Net sales for the quarter came in at $32.3 billion, a 10.8% increase over the $29.1 billion achieved in the year-ago quarter. Excluding the impact of FX and gas, Costco sales rose 5.4% year over year for the quarter.

In our view, context is key and pitting Costco top-line results vs. those for Target (TGT) or Kroger (KR) confirm those share gains. For their latest quarters, Target reported adjusted top-line growth of 3.6% year over year, while this morning Kroger reported year over year sales growth of 2.7% excluding fuel. Also, scrutinizing Costco’s internal metrics confirm those share gains.  These include membership renewal rates (90.1% in the U.S. for the quarter) and membership growth (50.4 million member households vs. 49.9 million at the end of the prior quarter).

From a geographic perspective, U.S. sales rose 7.1% (5.7% ex-gas and FX); Canada + 8.7% (2.5% ex gas and FX); and Other/International up 15.7% (7.4% ex gas and FX) for the quarter with E-commerce sales up more than 28% year over year. Those share gains were also reflected in the February same-store sales data that was shared last night as well. For the month, net sales rose 12.8% to $10.21 billion with:

  • US up 9.0% (7.5% ex-FX and gas)
  • Canada +8.4% (up 3.2% ex-FX and gas)
  • Other/International up 22.2% (14.1% ex-FX and gas)
  • E-commerce +38% (up 37% ex-FX and gas)

In addition to the brick & mortar wallet share gains being had, we’d also note the reported E-commerce growth metrics. Management has continued to focus on improving its digital offering while also improving its search capabilities and checkout experience. I also suspect its relationship with Instacart and others is driving digital grocery, which should alleviate bearish concerns over Amazon as it relates to Costco’s business.

On a side note, I was at a local Costco this past weekend when it opened, and it was not only packed to the gills, but the checkout lines were several people deep as was the new membership line.

From a fundamental perspective, we see the company has benefitted and continues to do so from the lack of domestic wage growth for roughly 80% of the workforce over the last year that is prompting debt-laden consumers to stretch disposable spending dollars where they can. The latest data from the Federal Reserve showing a gap up in credit card charge-offs in 4Q 2017 vs. 4Q 2016 serves as a confirming point and sets the stage for more should the Fed boost interest rates as expected. The bottom line is given economic constraints, Cash-Strapped Consumers will continue to flock to Costco be it in person or online as the company continues to expand its offering.

As we have discussed previously, one of the key differentiators for Costco is its high margin membership fee business, which accounts for more than 70% of the company’s pre-tax income. During the quarter Costco slowed its pace of new warehouse openings to 1 from 5 in the prior quarter but shared it aims to open two in the current quarter followed by 18 openings and three relocations in the subsequent quarter. All told, Costco will open 22-23 new locations during the current fiscal year, which sets the stage for continued membership fee income growth in the coming quarters.

Understanding these two perspectives keeps us bullish on COST shares.

  • Our price target on Costco Wholesale (COST) shares remains $200

 

 

Kicking the tires on Rite Aid shares

Kicking the tires on Rite Aid shares

There are several facets to our Aging of the Population investment theme, ranging from the obvious — assisted living, pharmaceuticals, financial services and vitamins and supplements — to the not so obvious such as online shopping, disruptive technology and artificial intelligence which can help maintain independence as the physical realities of an aging body take hold.

We as a people are also living longer, and statistics tabulated by Milliman show an encouraging pattern of increased life expectancy which will trigger increased consumption patterns in the population for medical services and pharmaceuticals. This should be a positive tailwind to pharmacy companies, such as CVS Health (CVS), Walgreen Boots (WBA) and Rite Aid (RAD) that are also pivoting their businesses toward health and wellness offerings. This tailwind also bodes well for the pharmacy businesses at Tematica Select List holding Costco Wholesale (COST) and other companies, like Kroger (KR) and other grocery chains, that have pharmacies.

Looking back over 2017, it was a painful year for Rite Aid, as its shares fell around 75%. Part of that reflects regulators blocking the acquisition of Rite Aid by Walgreens Boots Alliance for some $9.4 billion. After attempts to structure a deal that would placate regulators, this past September the two companies announced that Rite Aid would instead sell off more than 1,900 stores and three distribution centers to Walgreens for $4.375 billion in cash. Rite Aid is in the process of transferring those stores and facilities over to Walgreens, a process that’s expected to span through most of 2018. In exchange, Rite Aid will be receiving an influx of cash, which it has earmarked to primarily reduce the outstanding debt on its balance sheet. That debt reduction should drive a favorable decline in interest expense, enabling the company to drop more to its bottom line in the coming quarters.

Current Wall Street expectations call for Rite Aid to post losses of $0.06 per share in 2018 and $0.03 per share in 2019. Those consensus figures are tallied from six active analysts following Rite Aid and their consensus price target is $2.07, with a consensus view of “Hold.”

As I mentioned above, we here at Tematica see the aging of the U.S. population unfolding as more baby boomers pass 70 years of age, making it a multi-year tailwind to the pharmacy business, particularly as people are living longer. That’s not to say it will be easy peasy for Rite Aid considering the pharmacy businesses at CVS Health, Walgreens, Walmart (WMT), Kroger (KR), Costco Wholesale and others. Note, we haven’t even mentioned the rumblings of bricks and mortar crusher Amazon’s (AMZN) potential entry into the category.

I’m not going to sugar coat it, folks. What all of this tells me is Rite Aid is a turnaround story, and expectations are low, which also makes it a “show-me story.”

The hope/opportunity is that the Rite Aid management team is able to transform the company quicker than expected by leveraging the 20.7 million customers in its loyalty program, improving its offerings and shrinking its operating costs as it looks to offset reimbursement pressure. Management has already identified some $96 million in administrative cost savings, and I suspect there could be more savings to be had in the coming quarters as Rite Aid continues to right size itself.

I also see the company’s predominantly domestic footprint making it a solid beneficiary in terms of tax reform. As I shared in yesterday’s weekly issue of Tematica Investing, tax reform related EPS benefits are arguably all over the map, but Rite Aid should see some lift to its 2018 EPS forecast – the question is how much? More than likely this combination will lead to better-than-expected EPS performance over the coming quarters, and with the current low expectations that would likely move RAD shares, especially if its analyst following became either more bullish or less bearish on the company.

The question is one of magnitude in terms of tax reform benefits vs. expectations, and for that reason, I’m inclined to hold off on adding RAD shares to the Select List until we have some clarity on this key issue, especially since Rite Aid has been received income tax benefits in recent quarters. With the company’s next earnings report likely to occur in early April, we can look at results from CVS Health and Walgreens to get a handle on the potential tax reform impact to be had at Rite Aid. CVS shared that as a result of tax reform it sees its effective tax rate to run near 27% this year, which should increase its cash flow by roughly $1.2 billion, but Walgreen’s recent guidance did not factor in any impact from tax legislation.

Not very helpful, and rather than jump the gun on this, I’ll continue to assess the potential benefit on Rite Aid’s business and what it could mean for its shares. Until that clarity arrives, I’m adding Rite Aid shares to the Tematica Contender List as part of our Aging of the Population investment theme.

United Natural Foods Reports In-line Quarterly Results, Still Riding the Fresh & Natural Wave

United Natural Foods Reports In-line Quarterly Results, Still Riding the Fresh & Natural Wave

Last night Food with Integrity company United Natural Foods (UNFI) reported in-line quarterly earnings of $0.50 per share on revenue that rose 11.7% year over year to hit $2.29 billion. Despite that double-digit revenue growth, revenue for the quarter fell short of expectations by $50 million — not a big deal in our view, but we suspect some will look past the double-digit growth and focus on this being the second consecutive quarter where revenue fell just shy of expectations. To us that shortfall is overshadowed by the more than 16% increase in earnings before interest tax & depreciation (EBITDA) and the 12% increase in net income — we always like to see profits growing faster than revenue as it denotes margin expansion.

Given the continued deflationary environment the food and grocery industry is contending with, all in all, we were rather pleased with United Natural’s quarterly results as it continues to benefit from shifting consumers preferences and reap the benefits from cost savings initiatives and synergies with companies acquired in the last year. With those deflationary pressures poised to continue, the company is undertaking another initiative that will shed roughly 265 jobs in the current quarter, with benefits to be had in following ones. This latest effort is expected to result in pre-tax charges of $3.5-$4 million.

Even after this new initiative the company guided 2017 in line with expectations:

  • fiscal 2017 revenue between $9.38-$9.46 billion, an increase of approximately 10.7%-11.7% over fiscal 2016, and consensus expectations of $9.4 billion;
  • adjusted EPS in the range of $2.53 to $2.58 vs. the current consensus forecast of $2.54 per share.

Stepping back, we continue to see consumer shifting preferences to fresh, organic and natural products. Last week, grocery chain Kroger (KR) commented that it continues to “focus on the areas of highest growth like natural and organic products” and we’ve seen companies like Costco Wholesale (COST) continue to expand their fresh and natural offering to boost basket size and shrink time between visits. Against that backdrop that is not occurring at just Kroger and Costco, we continue to like United Natural’s strategy to expand its footprint, including its UNFI Next program that looks for new products and emerging brands and its e-commerce platform.

  • Our price target on UNFI shares remains $60, which offers more than 30% upside from current levels. As such we are keeping our Buy rating intact.

 

 

Food Network teaming with Instacart shows increasing reach of e-commerce 

Food Network teaming with Instacart shows increasing reach of e-commerce 

Following Amazon’s Prime Fresh and Walmart’s teaming with Uber and Lyft for grocery delivery, the intersection of Content is King and the Connected Society is driving a shift in where and how people buy groceries and ingredients. Much like other industry shaking events associated with the Connected Society, this will have a profound impact on both a direct and indirect basis.

xpansion of online fulfillment availability is giving retailers new avenues for selling goods via the Internet.Food Network is teaming up with Instacart to integrate the online grocery delivery service with the Recipe Box and Grocery List features available on FoodNetwork.com and Food.com. The offerings allow consumers to search for online recipes and then create and share shopping lists of the necessary ingredients.

Source: Commentary: Food Network offering shows increasing reach of e-commerce | Chain Store Age