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Weekly Issue: As earnings season continues, the market catches a positive breather

Weekly Issue: As earnings season continues, the market catches a positive breather

Key points in this issue:

  • As expected, more negative earnings revisions roll in
  • Verizon says “We’re heading into the 5G era”
  • Nokia gets several boosts ahead of its earnings report
  • USA Technologies gets an “interim” CFO

 

As expected, more negative earnings revisions roll in

In full, last week was one in which the domestic stock market indices were largely unchanged and we saw that reflected in many of our Thematic Leaders. Late Friday, a deal was reached to potentially only temporarily reopen the federal government should Congress fail to reach a deal on immigration. Given the subsequent bluster that we’ve seen from President Trump, it’s likely this deal could go either way. Perhaps, we’ll hear more on this during his next address, scheduled ahead of this weekend’s Super Bowl.

Yesterday, the Fed began its latest monetary policy meeting. It’s not expected to boost interest rates, but Fed watchers will be looking to see if there is any change to its plan to unwind its balance sheet. As the Fed’s meeting winds down, the next phase of US-China trade talks will be underway.

Last week I talked about the downward revisions to earnings expectations for the S&P 500 and warned that we were likely to see more of the same. So far this week, a number of high-profile earnings reports from the likes of Caterpillar (CAT), Whirlpool (WHR), Crane Co. (CR), AK Steel (AKS), 3M (MMM) and Pfizer (PFE) have revealed December-quarter misses and guidance for the near-term below consensus expectations. More of that same downward earnings pressure for the S&P 500 indeed. And yes, those misses and revisions reflect issues we have been discussing the last several months that are still playing out. At least for now, there doesn’t appear to be any significant reversal of those factors, which likely means those negative revisions are poised to continue over the next few weeks.

 

Tematica Investing

With the market essentially treading water over the last several days, so too did the Thematic Leaders.  Apple’s (AAPL) highly anticipated earnings report last night edged out consensus EPS expectations with guidance that was essentially in line. To be clear, the only reason the company’s EPS beat expectations was because of its lower tax rate year over year and the impact of its share buyback program. If we look at its operating profit year over year — our preferred metric here at Tematica — we find profits were down 11% year over year.

With today’s issue already running on the long side, we’ll dig deeper into that Apple report in a stand-alone post on TematicaResearch.com later today or tomorrow, but suffice it to say the market greeted the news from Apple with some relief that it wasn’t worse. That will drive the market higher today, but let’s remember we have several hundred companies yet to report and those along with the Fed’s comments later today and US-China trade comments later this week will determine where the stock market will go in the near-term.

As we wait for that sense of direction, I’ll continue to roll up my sleeves to fill the Guilty Pleasure void we have on the Thematic Leaders since we kicked Altria to the curb last week. Stay tuned!

 

Verizon says “We’re heading into the 5G era”

Yesterday and early this morning, both Verizon (VZ) and AT&T (T) reported their respective December quarter results and shared their outlook. Tucked inside those comments, there was a multitude of 5G related mentions, which perked our thematic ears up as it relates to our Disruptive Innovators investing theme.

As Verizon succinctly said, “…we’re heading to the 5G era and the beginning of what many see as the fourth industrial revolution.” No wonder it mentioned 5G 42 times during its earnings call yesterday and shared the majority of its $17-$18 billion in capital spending over the coming year will be spent on 5G. Verizon did stop short of sharing exactly when it would roll out its commercial 5G network, but did close out the earnings conference call with “…We’re going to see much more of 5G commercial, both mobility, and home during 2019.”

While we wait for AT&T’s 5G-related comments on its upcoming earnings conference call, odds are we will hear it spout favorably about 5G as well. Historically other mobile carriers have piled on once one has blazed the trail on technology, services or price. I strongly suspect 5G will fall into that camp as well, which means in the coming months we will begin to hear much more on the disruptive nature of 5G.

 

Nokia gets several boosts ahead of its earnings report

Friday morning one of Disruptive Innovator Leader Nokia’s (NOK) mobile network infrastructure competitors, Ericsson (ERIC), reported its December-quarter results. ERIC shares are trading up following the report, which showed the company’s revenue grew by 10% year over year due primarily to growth at its core Networks business. That strength was largely due to 5G activity in the North American market as mobile operators such as AT&T (T), Verizon (VZ) and others prepare to launch their 5G commercial networks later this year. And for anyone wondering how important 5G is to Ericsson, it was mentioned 26 times in the company’s earnings press release.

In short, I see Ericsson’s earnings report as extremely positive and confirming for our Nokia and 5G investment thesis.

One other item to mention is the growing consideration for the continued banning of Huawei mobile infrastructure equipment by countries around the world. Currently, those products and services are excluded in the U.S., but the U.K. and other countries in Europe are voicing concerns over Huawei as they look to confirm their national telecommunications infrastructure is secure.

Last week, one of the world’s largest mobile carriers, Vodafone (VOD) announced it would halt buying Huawei gear. BT Group, the British telecom giant, has plans to rip out part of Huawei’s existing network. Last year, Australia banned the use of equipment from Huawei and ZTE, another Chinese supplier of mobile infrastructure and smartphones.

In Monday’s New York Times, there was an article that speaks to the coming deployment of 5G networks both in the U.S. and around the globe, comparing the changes they will bring. Quoting Chris Lane, a telecom analyst with Sanford C. Bernstein in Hong Kong it says:

“This will be almost more important than electricity… Everything will be connected, and the central nervous system of these smart cities will be your 5G network.”

That sentiment certainly underscores why 5G technology is housed inside our Disruptive Innovators investing theme. One of the growing concerns following the arrest of two Huawei employees for espionage in Poland is cybersecurity. As the New York Times article points out:

“American and British officials had already grown concerned about Huawei’s abilities after cybersecurity experts, combing through the company’s source code to look for back doors, determined that Huawei could remotely access and control some networks from the company’s Shenzhen headquarters.”

From our perspective, this raises many questions when it comes to Huawei. As companies look to bring 5G networks to market, they are not inclined to wait for answers when other suppliers of 5G equipment stand at the ready, including Nokia.

Nokia will report its quarterly results this Thursday (Jan. 31) and as I write this, consensus expectations call for EPS of $0.14 on revenue of $7.6 billion. Given Ericsson’s quarterly results, I expect an upbeat report. Should that not come to pass, I’m inclined to be patient and hold the shares for some time as commercial 5G networks launches make their way around the globe. If the shares were to fall below our blended buy-in price of $5.55, I’d be inclined to once again scale into them.

  • Our long-term price target for NOK shares remains $8.50.

 

USA Technologies gets an “interim” CFO

Earlier this week, Digital Lifestyle company USA Technologies (USAT) announced it has appointed interim Chief Financial Officer (CFO) Glen Goold. According to LinkedIn, among Goold’s experience, he was CFO at private company Sutron Corp. from Nov 2012 to Feb 2018, an Associate Vice President at Carlyle Group from July 2005 to February 2012, and a Tax Manager at Ernst & Young between 1997-2005. We would say he has the background to be a solid CFO and should be able to clean up the accounting mess that was uncovered at USAT several months ago.

That said, we are intrigued by the “interim” aspect of Mr. Goold’s title — and to be frank, his lack of public company CFO experience. We suspect the “interim” title could fuel speculation that the company is cleaning itself up to be sold, something we touched on last week. As I have said before, we focus on fundamentals, not takeout speculation, but if a deal were to emerge, particularly at a favorable share price, we aren’t ones to fight it.

  • Our price target on USA Technologies (USAT) shares remains $10.

 

 

 

WEEKLY ISSUE: Confirming Data Points for Apple and Universal Display

WEEKLY ISSUE: Confirming Data Points for Apple and Universal Display

Key points inside this issue:

  • The Business Roundtable and recent data suggest trade worries are growing.
  • Our price target on Costco Wholesale (COST) shares remains $250.
  • Our price target on Apple (AAPL) and Universal Display (OLED) shares remain $225 and $150, respectively.
  • Changes afoot at S&P, but they still lag our thematic investing approach

 

While investors and the stock market have largely shaken off concerns of a trade war thus far, this week the stakes moved higher. The U.S. initiated the second leg of its tariffs on China, slapping on $200 billion of tariffs on Chinese imports of food ingredients, auto parts, art, chemicals, paper products, apparel, refrigerators, air conditioners, toys, furniture, handbags, and electronics.

China responded, not only by canceling expected trade talks, but by also implementing tariffs of its own to the tune of $60 billion on U.S. exports to China. Those tariffs include medium-sized aircraft, metals, tires, golf clubs, crude oil and liquified natural gas (LNG). Factoring in those latest steps, there are tariffs on nearly half of all U.S. imports from China and over 50% of U.S. export to China.

Should President Trump take the next stated step and put tariffs on an additional $267 billion of products, it would basically cover all U.S. imports from China. In terms of timing, let’s remember that we have the U.S. mid-term elections coming up before too long — and one risk we see here at Tematica is China holding off trade talks until after those elections.

On Monday, the latest Business Roundtable survey found that two-thirds of chief executives believed recent tariffs and future trade tension would have a negative impact on their capital investment decisions over the next six months. Roughly one-third expected no impact on their business, while only 2% forecast a positive effect.

That news echoed the recent September Flash U.S. PMI reading from IHS Markit, which included the following commentary:

“The escalation of trade wars, and the accompanying rise in prices, contributed to a darkening of the outlook, with business expectations for the year ahead dropping sharply during the month. While business activity may rebound after the storms, the drop in optimism suggests the longer term outlook has deteriorated, at least in the sense that growth may have peaked.”

Also found in the IHS Markit report:

“Manufacturers widely noted that trade tariffs had led to higher prices for metals and encouraged the forward purchasing of materials… Future expectations meanwhile fell to the lowest so far in 2018, and the second-lowest in over two years, as optimism deteriorated in both the manufacturing and service sectors.”

As if those growing worries weren’t enough, there has been a continued rise in oil prices as OPEC ruled out any immediate increase in production, the latest round of political intrigue inside the Washington Beltway, the growing spending struggle for the coming Italian government budget and Brexit.

Any of these on their own could lead to a reversal in the CNN Money Fear & Greed Index, which has been hanging out in “Greed” territory for the better part of the last month. Taken together, though, it could lead companies to be conservative in terms of guidance in the soon-to-arrive September quarter earnings season, despite the benefits of tax reform on their businesses and on consumer wallets. In other words, these mounting headwinds could weigh on stocks and lead investors to question growth expectations for the fourth quarter.

What’s more, even though S&P 500 EPS expectations still call for 22% EPS growth in 2018 vs. 2017, we’ve started to see some downward revisions in projections for the September and December quarters, which have softened 2018 EPS estimates to $162.01, down from $162.60 several weeks ago. Not a huge drop, but when looking at the current stock market valuation of 18x expected 2018 EPS, remember those expectations hinge on the S&P 500 group of companies growing their EPS more than 21% year over year in the second half of 2018.

 

Any and all of the above factors could weigh on corporate guidance or just rattle investor’s nerves and likely means a bumpy ride over the ensuing weeks as trade and political headlines heat up. As it stands right now, according to data tabulated from FactSet, heading into September quarter earnings, 74 of 98 companies in the S&P 500 that issued guidance, issued negative guidance marking the highest percentage (76%) since 1Q 2016 and compares to the five year average of 71%.

Not alarmingly high, but still higher than the norm, which means I’ll be paying even closer than usual attention to what is said over the coming weeks ahead of the “official” start to September quarter earnings that is Alcoa’s (AA) results on Oct. 17 and what it means for both the Thematic Leaders and the other positions on the Select List.

 

Today is Fed Day

This afternoon the Fed’s FOMC will break from its September meeting, and it is widely expected to boost interest rates. No surprise there, but given what we’ve seen on the trade front and in hard economic data of late, my attention will be on what is said during the post-meeting press conference and what’s contained in the Fed’s updated economic forecast. The big risk I see in the coming months on the Fed front is should the escalating tariff situation lead to a pick-up in inflation, the Fed could feel it is behind the interest rate hike curve leading to not only a more hawkish tone but a quicker pace of rate hikes than is currently expected.

We here at Tematica have talked quite a bit over consumer debt levels and the recent climb in both oil and gas prices is likely putting some extra squeeze on consumers, especially those that fall into our Middle-Class Squeeze investing theme. Any pick up in Fed rate hikes means higher interest costs for consumers, taking a bigger bite out of disposable income, which means a step up in their effort to stretch spending dollars. Despite its recent sell-off, I continue to see Costco Wholesale (COST) as extremely well positioned to grab more share of those cash-strapped wallets, particularly as it continues to open new warehouse locations.

  • Our price target on Costco Wholesale (COST) shares remains $250.

 

Favorable Apple and Universal Display News

Outside of those positions, we’d note some favorable news for our Apple (AAPL) shares in the last 24 hours. First, the iPhone XS Max OLED display has reclaimed the “Best Smartphone Display” crown for Apple, which in our view augurs well for other smartphone vendors adopting the technology. This is also a good thing for our Universal Display (OLED) shares as organic light emitting diode displays are present in two-thirds of the new iPhone offerings. In addition to Apple and other smartphone vendors adopting the technology, we are also seeing more TV models adoption it as well. We are also starting to see ultra high-end cars include the technology, which means we are at the beginning of a long adoption road into the automotive lighting market. We see this confirming Universal’s view that demand for the technology and its chemicals bottomed during the June quarter. As a reminder, that view includes 2018 revenue guidance of $280 million-$310 million vs. the $99.7 million recorded in the first half of the year.

Second, Apple has partnered with Salesforce (CRM) as part of the latest step in Apple’s move to leverage the iPhone and iPad in the enterprise market. Other partners for this strategy include IBM (IBM), Cisco Systems (CSCO), Accenture (ACN) CDW Corp. (CDW) and Deloitte. I see this as Apple continuing to chip away at the enterprise market, one that it historically has had limited exposure.

  • Our price target on Apple (AAPL) and Universal Display (OLED) shares remain $225 and $150, respectively.

 

Changes afoot at S&P, but they still lag our thematic investing approach

Before we close out this week’s issue, I wanted to address something big that is happening in markets that I suspect most individuals have not focused on. This week, S&P will roll out the largest revision to its Global Industry Classification Standard (GICS) since 1999. Before we dismiss it as yet another piece of Wall Street lingo, it’s important to know that GICS is widely used by portfolio managers and investors to classify companies across 11 sectors. With the inclusion of a new category – Communication Services – it means big changes that can alter an investor’s holdings in a mutual fund or ETF that tracks one of several indices. That shifting of trillions of dollars makes it a pretty big deal on a number of fronts, but it also confirms the shortcomings associated with sector-based investing that we here at Tematica have been calling out for quite some time.

The new GICS category, Communications Services, will replace the Telecom Sector category and include companies that are seen as providing platforms for communication. It will also include companies in the Consumer Discretionary Sector that have been classified in the Media and Internet & Direct Marketing Retail subindustries and some companies from the Information Technology sector. According to S&P, 16 Consumer Discretionary stocks (22% of the sector) will be reclassified as Communications Services as will 7 Information Technology stocks (20% of that sector) as will AT&T (T), Verizon (VZ) and CenturyLink (CTL). Other companies that are folded in include Apple (AAPL), Google (GOOGL), Disney (DIS), Twitter (TWTR), Snap (SNAP), Netflix (NFLX), Comcast (CMCSA), and DISH Network (DISH) among others.

After these maneuverings are complete, it’s estimated Communication services will be the largest category in the S&P 500 at around 10% of the index leaving weightings for the other 11 sectors in a very different place compared to their history. In other words, some 50 companies are moving into this category and out of others. That will have meaningful implications for mutual funds and ETFs that track these various index components and could lead to some extra volatility as investors and management companies make their adjustments. For example, the Technology Select Sector SPDR ETF (XLK), which tracks the S&P Technology Select Sector Index, contained 10 companies among its 74 holdings that are being rechristened as part of Communications Services. It so happens that XLK is one of the two largest sector funds by assets under management – the other one is the Consumer Discretionary Select Sector SPDR Fund (XLY), which had exposure to 16 companies that are moving into Communications Services.

So what are these moves really trying to accomplish?

The simple answer is they taking an out-of-date classification system of 11 sectors – and are attempting to make them more relevant to changes and developments that have occurred over the last 20 years. For example:

  • Was Apple a smartphone company 20 years ago? No.
  • Did Netflix exist 20 years ago? No.
  • Did Amazon have Amazon Prime Video let alone Amazon Prime 20 year ago? No.
  • Was Facebook around back then? Nope. Should it have been in Consumer Discretionary, to begin with alongside McDonald’s (MCD) and Ralph Lauren (RL)? Certainly not.
  • Did Verizon even consider owning Yahoo or AOL in 1999? Probably not.

 

What we’ve seen with these companies and others has been a morphing of their business models as the various economic, technological, psychographic, demographic and other landscapes around them have changed. It’s what they should be doing, and is the basis for our thematic investment approach — the strong companies will adapt to these evolving tailwinds, while others will sadly fall by the wayside.

These changes, however, expose the shortcomings of sector-based investing. Simply viewing the market through a sector lens fails to capture the real world tailwinds and catalysts that are driving structural changes inside industries, forcing companies to adapt. That’s far better captured in thematic investing, which focuses on those changing landscapes and the tailwinds as well as headwinds that arise and are driving not just sales but operating profit inside of companies.

For example, under the new schema, Microsoft (MSFT) will be in the Communications Services category, but the vast majority of its sales and profits are derived from Office. While Disney owns ESPN and is embarking on its own streaming services, both are far from generating the lion’s share of sales and profits. This likely means their movement into Communications Services is cosmetic in nature and could be premature. This echoes recent concern over the recent changes in the S&P 500 and S&P 100 indices, which have been criticized as S&P trying to make them more relevant than actually reflecting their stated investment strategy. For the S&P 500 that is being a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value.

As much as we could find fault with the changes, we can’t help it if those institutions, at their core, stick to their outdated thinking. As I have said before about other companies, change is difficult and takes time. And to be fair, for what they do, S&P is good at it, which is why we use them to calculate the NJCU New Jersey 50 Index as part of my work New Jersey City University.

Is this reclassification to update GICS and corresponding indices a step in the right direction?

It is, but it is more like a half step or even a quarter step. There is far more work to be done to make GICS as relevant as it needs to be, not just in today’s world, but the one we are moving into. For that, I’ll continue to stick with our thematic lens-based approach.

 

Weekly Issue: Looking for Trump-Proof Companies

Weekly Issue: Looking for Trump-Proof Companies

We exited last week with the market realizing there was more bark than bite associated with President Trump’s steel and aluminum tariffs. That period of relative calm, however, was short-lived as the uncertainty resumed in Washington yesterday in the form of changeups in the administration with Trump letting go Secretary of State Rex Tillerson just after agreeing to talks with North Korea, and more saber rattling with trade actions against China for technology, apparel, and other imports. This also follows Trump’s intervention in the proposed takeover of Qualcomm (QCOM) by competitor Broadcom (BRCM).

While many an investor will focus on the “new” volatility in the market, I’ll continue to use our thematic lens to look for companies that are “Trump-Proof” in the short-term. That’s not a political statement, but rather a reflection of the reality that the modus operandi of President Trump and his Twitter habit often cause significant swings in the market as the media attempts to digest and interpret his comments.

How will we find these so-called Trump-proof companies? By continuing to use our thematic lens to uncover well-positioned companies that are benefitting from thematic tailwinds that alter the existing playing field, regardless of the latest noise from Washington politicians.

At least for now, volatility is back in vogue and that is bound to drive headlines and other noise. I’ll continue to focus on the data, and if you read this week’s Monday Morning Kickoff you know we are in the midst of a whopper of a data week. While the Consumer Price Index (CPI) for February was in line with expectations, and on a year over year basis core rose 1.8% — the same as in January — which should take some wind out of the inflation mongers. This morning we have the February Retail Sales report, which in my view should once again serve up confirming data for our positions in Amazon (AMZN) and Costco Wholesale (COST), which continue to benefit from our Connected Society and Cash-strapped Consumer investing themes.  Later in the week, the February reading on Industrial Production should confirm the demands that are exacerbating the current heavy truck shortage here in the U.S. – good news for the Paccar (PCAR)shares on the Tematica Investing Select List.

 

 

An Update on Our Once Star Performer, Universal Display (OLED)

A few weeks ago, I shared an update on Universal Display (OLED) shares, which have been essentially treading water following the company’s December quarter results. Later today, the management team will be presenting at the Susquehanna’s Seventh Annual Semi, Storage & Tech Conference. Odds are the management team will reiterate its view on market digesting the organic light emitting diode capacity additions made over the last several quarters, but I expect they will also describe the growing number of applications that will come on stream in the next 3-6 quarters.  As of late February, Susquehanna had a positive rating on OLED shares with a price target of $200 and I suspect they will have some bullish comments following today’s presentation.

 

Considering the ripples to be had with the latest Connected Society victim, Toys R Us

Over the weekend we were reminded of the situation facing many brick & mortar retailers that are failing to adapt their business to ride our Connected Society investing theme. I’m referring to toy and game retailer Toys R Us, the one-time Dick’s Sporting Goods (DKS) or Home Depot (HD) of its industry. Like several sporting goods retailers and electronic & appliance retailers such as Sports Authority, Sports Chalet, and HH Gregg that have gone belly up, if Toys R Us doesn’t get a last-minute lifeline or find a buyer it will likely file Chapter 7.

It’s been a rocky road for the one-time toy supermarket company as it entered bankruptcy in September, aiming to emerge with a leaner business model and more manageable debt. The company obtained a new $3.1 billion loan to keep the stores open during the turnaround effort, but results worsened more than expected during the holidays, casting doubt on the chain’s viability. The company entered this year with more than 800 stores in the U.S. — under both the Toys “R” Us and Babies “R” Us brands, but by January, it announced the shuttering of 180 locations.

The pending bankruptcy to be had at Toys R Us is but the latest in the retail industry, but it’s not likely to be the last. Claire’s Stores Inc., the fashion accessories chain with a debt load of $2 billion, is also preparing to file for bankruptcy in the coming weeks as is Walking Co. Holdings Inc.

What these all have in common is the increasing shift by consumers to digital commerce and the growing reliance on retailers for what is termed the direct to consumer (D2C) business model. Certain branded apparel, footwear, and other consumer product companies, like Nike (NKE) have embraced Amazon’s formidable logistics capabilities and this has benefitted our United Parcel Service (UPS) shares. As we have said before, and we recognize it sounds rather simplistic, when you order products online they have to get to where they are being sent. Hello UPS!

Now let’s consider the ripple effect of the pending Toys R Us bankruptcy.

When events such as this occur, there is a liquidation effect and a subsequent void. As we saw when Sports Authority went bankrupt, the businesses at Nike and Under Armour (UAA) were impacted by liquidation sales in the short term. At the same time, both lost the recurring sales associated with Sports Authority. Odds are we will see the same happen with Toys R Us with companies like Mattel (MAT) and Hasbro (HAS) taking it on the chin. In my view these companies are already struggling as teens, tweens and kids of all ages shift to digital games, apps and e-gaming, which are aspects of our Connected Society and Content

In my view these companies are already struggling as teens, tweens and kids of all ages shift to digital games, apps and e-gaming, which are aspects of our Connected Society and Content is King themes. When was the last time you saw an elementary schooler play with Ken or Barbie? More likely they are on an iPad or Microsoft (MSFT) Xbox while their older siblings are playing the new craze sweeping the nation – Fortnite. And yes, that it appears the rumors are true and Fornite will soon be available across Apple’s iDevices.

Looking at the financial performance of Mattel, not even the all mighty Star Wars franchise could save them from delivering declining revenue and earnings this past holiday shopping season. On the liquidation front, we are likely to see the toys businesses at Target (TGT) as well as Walmart (WMT) take the brunt of the blow. But here too this is likely just another hit as these two retailers have already been dealing with falling revenue at Mattel and Hasbro. Walmart is the largest customer for Mattel and Hasbro, accounting for about 20% of total sales for each toy maker. Both toy companies get nearly 10% of their revenue from Target too.

One of the investing strategies that I employ with the Select List is “buy the bullets, not the guns” which refers to buying well-positioned suppliers that serve a variety of customers. In situations like what we are seeing in the brick & mortar retail sector, we can turn that strategy upside down and uncover those companies, like Mattel and Hasbro, that we as investors should avoid given the multiple direct and indirect headwinds they are currently facing or about to.

 

Earnings from Apple, Amazon, Alphabet and UPS lead to several price target changes… and not all of them are moving higher

Earnings from Apple, Amazon, Alphabet and UPS lead to several price target changes… and not all of them are moving higher

 

In the last 24 hours we’ve had four Tematica Investing Select List positions – United Parcel Service (UPS) Amazon (AMZN), Alphabet (GOOGL) and Apple (AAPL) – report their quarterly earnings. Across the four companies, it was a mixed bag — on one hand, we have solid performance and profits at Amazon and Apple, while on the other hand, both United Parcel Service and Alphabet lagged in converting their respective topline strength into profits. We’re going to dig into company specifics below, but in summary:

  • We are increasing our long-term price target on Amazon shares to $1,750 from $1,400, which keeps our Buy rating on the shares in place. As a quick reminder, we continue to see Amazon as a company to own not trade
  • We are maintaining our $200 price target on Apple, which also keeps our Buy rating intact.
  • With Alphabet shares, we are now boosting our price target to $1,300 from $1,150, which offers upside of 15% from current levels. Subscribers that are underweight GOOGL shares are advised to let the full impact of last night’s earnings announcement be had and wade into the shares in the coming days.
  • We are trimming our United Parcel Service price target to $130 from $132.

 

United Parcel Service

Shares of United Parcel Service slumped throughout the early part of the day yesterday, and while they did recover off their lows, the day ended with the shares down just over 6% following the company’s December quarter earnings report. Inside that report, the company reported slightly better than expected top-line results of $18.83 billion, up 11.2% year over year, vs. the expected $18.2 billion. The issue that pressured UPS shares was revealed in the 2.5% year over year increase in EPS to $1.67 even though that figure was slightly ahead of expectations. Comparing those two growth rates as well as looking at the year over year drop in operating margin for the quarter to 12.2% from 13.1%, we find UPS’s network capacity was once again overwhelmed by the shift to digital shopping in the US. Outside of that business, its profits climbed at its International business as well as Supply Chain and Freight Segment.

Near-term following the year-end holiday shopping season we are entering the seasonally slower part of the year for UPS’s business. If historical patterns repeat, we’re likely to see the shares range-bound over the coming months with them trending higher as more data shows the continued shift toward digital shopping that is powering its UPS Ground business. With more pronounced share gains likely to reveal themselves in the shopping-heavy back half of the year, we’re inclined to be patient investors with UPS, reaping the rewards as more companies continue to embrace the direct-to-consumer business model either on their own or through partnerships with other companies, like Amazon. We will continue to monitor oil and at the pump gas prices, which could be a headwind to UPS’s efforts to improve margins at its US Domestic business in the coming months. In terms of the company’s 2018 outlook, it guided EPS between $7.03-$7.37 billion, a 20% increase year over year at the midpoint, which is in line with expectations.

 

Apple

After the market close yesterday, Apple reported December quarter results that bested Wall Street expectations on the top and bottom line even though iPhone shipments fell short of expectations and dipped year over year. More specifically, the company served up EPS of $3.89 per share, $0.04 ahead of consensus expectation on revenue of $88.29 billion, which edged out expectations of $87.6 billion. While Apple once again bested expectations, the truly revealing revenue and EPS comparisons are had versus the December 2016 quarter as revenue rose 12.6% year over and EPS 16%.

Year over year revenue improvement was had in the iPad and Services business — the latter benefitting from Apple’s continued growth in active devices, which hit 1.3 billion in January, up from 1.0 billion just two years ago. Mac sales, in terms of revenue and units, edged lower year over year and Apple Watch volumes rose 50% year over year on the strength of Apple Watch 3.  Despite the 1.2% year over year drop in iPhone shipments, the higher priced newer models drove the average selling price in the December 2017 quarter to hit roughly $795 up from $695 in the year ago quarter. That pricing surge led iPhone revenue to climb 12.5% to $61.6 billion. Digging into the results, we find the year over year improvements even more impressive when we consider iPhone X didn’t go on sale until early November and the December 2017 quarter had one less week compared to the December 2016 one.

All in all, it was a solid December quarter for Apple, and as we all know, there has been much speculation over iPhone production levels in the first half of the year, particularly for iPhone X. While Apple did issue its take on the March quarter – revenue between $60-$62 billion (vs. $52.9 billion in the March 2017 quarter), gross margin between 38%-38.5% and operating expenses $7.6-$7.7 billion – it was its usual tight-lipped self when it came to device shipments.

Let’s remember chatter over the last few weeks was calling for steep cuts to iPhone X shipments, but Apple ended the December quarter with channel inventories near the lower end of its 5-7-week target range. On the earnings call, Apple shared that iPhone should be up double digits year over year in the March 2018 quarter with the non-iPhone businesses up double digits as well. If we assume iPhone average selling prices remain relatively flat quarter over quarter, back of the envelope math suggests Apple is likely to ship 48-49 million iPhone units – roughly a 3%-5% drop in shipments year over year. That is far less than the talking heads were talking about over the last few weeks and explains why Apple shares rallied in aftermarket trading.

We see this as a positive for our Universal Display (OLED) shares as well – our price target on those remains $225.

From our perspective, the Apple story remains very much intact and with several positives to be had in the coming quarters. When Apple reports its March quarter results, we expect a clearer picture of how Apple plans to leverage the benefits of tax reform on its capital structure and share potential dividend and buyback plans. Next week, Apple’s HomePod will be released and before too long we expect to hear more about iPad and other product refreshes before the talk turns to WWDC 2018. Along the way, we hope to hear more concrete plans over Apple’s push into original content, a move we continue to think will make its ecosystem even stickier and likely result in even more people switching to Apple devices.

  • Our price target on Apple (AAPL) shares remains $200.

 

Amazon

Turning to Amazon, we were expecting a strong quarter given all the data points we received over the accelerated shift to digital shopping during the 2017 holiday season and we were not disappointed. For the December quarter, Amazon’s net sales increased 38% to $60.5 billion. Excluding the $1.1 billion favorable impact from year-over-year changes in foreign exchange rates, the quarter’s net sales still increased a robust increased 36% year over year. By reporting segments, North America revenues rose an impressive 42% year over year, International by 29% and Amazon Web Services (AWS) just under 45%.

More impressive than the segment revenue results was the year over year move in operating income in North America, which rose 107% for the quarter, and the increase in sales in AWS (Amazon’s cloud computing division), with sales increasing 46% for the quarter. That led the company’s overall operating income to climb to $2.1 billion in the quarter, up significantly from $1.3 billion in December 2016 quarter. In our view, after delivering 11 quarters of profitability, Amazon has shown the naysayers that it can prudently invest to drive profitable growth and innovation. Period.

The seasonally strong shopping quarter resulted in Amazon’s North America division being the largest generator of profit for the quarter, a role that is usually had by AWS. Looking at the profit picture for the full year 2017, we find AWS generated nearly all of the company’s operating profit. We continue to be impressed by Amazon’s ability to win not just profitable cloud market share but fend off margin erosion as players like Alphabet and Microsoft (MSFT) look to win share in this market.

If we had to find one issue to pick with Amazon’s December quarter report it would be the continued losses at its International business. Those losses tallied $0.9 billion in the December 2017 quarter and $3.06 billion for all of 2017.  We understand Amazon continues to expand its footprint in Europe and Asia, replicating the Prime and content investments it has made in the US, to drive long-term growth. As we have said before, Amazon is leveraging its secret weapon, AWS (10% of 2017 sales but more than 100% of 2017 operating profits), and its cash flow to fund these long-term investments and as patient investors, we accept that. We would, however, like to have a better understanding what the timetable is for bringing the International business up to at least to break even so it’s no longer a drag on the company’s bottom line.

In typical Amazon fashion, Amazon’s earnings press release contained a plethora of highlights across its various businesses, but the few that jumped out at us were:

  • In 2017, more than five billion items shipped with Prime worldwide.
  • More new paid members joined Prime in 2017 than any previous year — both worldwide and in the U.S.
  • Amazon Web Services (AWS) announced several enterprise customers during the quarter: Expedia, Ellucian, and DigitalGlobe are going all-in on AWS; The Walt Disney Company and Turner named AWS their preferred public cloud provider; Symantec will leverage AWS as its strategic infrastructure provider for the vast majority of its cloud workloads; Expedia, Intuit, the National Football League (NFL), Capital One, DigitalGlobe, and Cerner announced they’ve chosen AWS for machine learning and artificial intelligence; and Bristol-Myers Squibb, Honeywell, Experian, FICO, Insitu, LexisNexis, Sysco, Discovery Communications, Dow Jones, and Ubisoft kicked off major new moves to AWS
  • AWS continues to accelerate its pace of innovation with the release of 497 significant new services and features in the fourth quarter, bringing the total number of launches in 2017 to 1,430.

 

Those are but a few of the three-plus pages of highlights contained in the December quarter’s earnings press release. These and others show Amazon continues to expand its reach, laying the groundwork for further profitable growth in the coming quarters.

In characteristic fashion, Amazon issued revenue guidance for the current quarter that was in line with expectations – $47.75 – $48.7 billion – that equates to year over year growth between 34%-42%. Per usual, the company also issued it “you could drive a truck through it” operating income forecast calling for $0.3-$1.0 billion for the quarter.

  • We are boosting our price target on Amazon (AMZN) shares to $1,750 from $1,400 and we continue to view them as ones to own for the long-term as the company continues to disrupt the retail industry and is poised to make inroads into others.

 

Alphabet/Google

Rounding out yesterday’s earnings blitzkrieg, was Alphabet, which delivered yet another 20% plus increase in revenue for the December quarter. The performance bested Wall Street expectations, but the company’s bottom line disappointed and missed the consensus by $0.37 per share.

For the record, Alphabet reported December quarter EPS of $9.70 vs. the expected $10.07 on revenue of $32.32 billion. At 85% of overall revenue for the quarter, advertising remains the core focus of revenue. Year over year in the quarter, the company’s advertising revenue rose 22% with growth compared to the year ago quarter also had at its Network Members’ properties and other revenue segments.

The difference between the company’s top line beat and bottom line miss can be traced primarily to its Traffic Acquisition Costs (TAC) — the fees it pays to partner websites that run Google ads or services. Those fees climbed 33% year over year to resemble 24% of advertising revenue vs. 22% in the December 2016 quarter. The continued rise in TAC reflects the ongoing shift in the company’s mix toward mobile, which makes the increase not a surprising one as mobile search and content consumption continues to grow faster than desktop.

On a positive note, the company prudently managed operating expenses, which accounted for 26.6% of revenue in the quarter down from 27% a year ago. The net effect led Alphabet’s overall operating margin for the quarter to slip to 24% from 25% in the December 2016 quarter.

Outside of the core advertising business, the company continues to make progress on its other initiatives better known as Google Other, which includes cloud, its Pixel phones and Google Play. On the earnings call, the management team called out that Google Cloud has surpassed $1 billion, a notable achievement but to be fair the company lags considerably behind Amazon in the space. That said, ongoing cloud adoption leaves ample room for future growth in the coming quarters.

Turning to the company’s Other Bets segment, which houses its autonomous vehicle business Waymo, Google Fiber, home security and automation business Nest and its Verily life sciences business units, it continues to be a drag on overall profits given the operating loss of $916 million on revenue of $409 million. The positive to be had is the unit’s revenue climbed 56% year over year and size of the operating drag compressed 16% vs. the year-ago quarter and was less than $940 million it was Wall Street expected it to be. We see that as progress given the less than mature nature of the businesses housed in Other Bets. As they mature further, we expect them to be less of a drag on overall profits with several of them potentially adding to the valuation argument to be had for the shares as they become a more meaningful piece of the overall revenue mix.

On the housekeeping front, the company’s Board authorized the repurchase up to an additional $8.6 billion of its Class C capital stock. With more than $101 billion on the balance sheet in cash and equivalents exiting 2017 the company has ample funds to opportunistically repurchase shares.

  • The net impact of Alphabet’s bottom line miss looks to have the shares open lower this morning, which when paired with our new $1,300 price target (up from $1,150) offers some 15% upside to be had. That along with our view the company’s search and advertising businesses make it a core holding even as it grapples with the transition to mobile from desktop.