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.

 

 

Adding two Middle-class Squeeze call option positions ahead of earnings this week

Adding two Middle-class Squeeze call option positions ahead of earnings this week

Key point inside this issue

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, but also to share a new call option trade with you. The timing on that trade is important because the underlying company will report its quarterly results after Tuesday’s (March 5) market close. With that said, let’s get to the issues at hand…

 

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.

 

Tematica Options+

One of the key takeaways over the last few issues has been the growing consumer spending headwind that has become increasingly evident across the December Retail Sales report, falling Personal Income data and increasing delinquencies. At the same time, we learned that despite mild December weather Home Depot (HD) missed earnings expectations and set the bar lower. Macy’s (M) reported uninspiring results and guidance while Nordstrom missed quarterly revenue expectations and L Brands (LB), the home of Victoria’s Secret and Bath & Body works.

Meanwhile, last week TJX Companies (TJX), the parent of TJ Maxx, Marshalls, HomeGoods, and HomeSense, reported same-store comp sales of 6% for its most recent quarter as store traffic surged. The company also boosted its quarterly dividend by 18% and announced plans to upsize its share buyback plan to $1.75-$2.25 billion.

Quite a different story. Also last week, the Gap (GPS), a company that in my view has been lost for quite some time, announced it was splitting into two companies. One will house its Gap and Banana Republic lines, while Old Navy, a business that fits the mold of our Middle-class Squeeze investing theme, will stand on its own.

Then there is Thematic Leader Costco Wholesale, which has been simply taking consumer wallet share as it opens additional warehouse locations. Excluding the impact of gas prices and foreign exchange, Costco’s US same store sales climbed 7.1% year over year in December and 7.3% in January.

In my view, all of this sets up very well for solid earnings reports from both Ross Stores, which will issue those results after the market close on Tuesday (March 5), and Costco, which reports after the close on Thursday (March 7). To capture the upside associated with these reports, we will add the following call option positions:

 

Note the corresponding stop losses. These are tighter than usual because these are earnings related trades, and as we’ve seen of late guidance is as important as the rear-view quarterly results. These stops will help us limit that downside risk.

With regard to our Del Frisco’s Restaurant Group (DFRG) September 20, 2019, 10.00 calls (DFRG190920C00010000) and Nokia Corp. (NOK) December 2019 7.00 calls (NOK191220C0000700), we will continue to hold them. The Del Frisco’s calls traded off last week and finished the week at 0.85, which is rather close to our 0.80 stop loss. This will bear watching and should we get stopped out, while we’ll net a 33% return should it happen soon than later, I may be inclined to jump back into a DFRG call position ahead of the company’s March 12 earnings report.

 

 

Woeful Earnings from Kroger Has Us Tightening Position in UNFI

Woeful Earnings from Kroger Has Us Tightening Position in UNFI

While many have been focused on the retail environment —and we count ourselves among them here at Tematica — we’ve also been watching the painful restaurant environment over the past few months. It’s been one characterized by falling same-store-sales and declining traffic – not a harbinger of good things when paired with rising minimum wages.

For those that are data nut jobs like we are, per TDn2K, same-store sales for restaurants fell 1.1 percent in May, a decline of 0.1 percentage points from April. In May, same-store traffic growth was -3.0 percent. Now for the perspective, the industry has not reported a month of positive sales since February 2016 – that’s 15 months! One month shy of the bad streak the May Retail Sales Report has been on. Clearly not a good operating environment, nor one that is bound to be friendly when it comes to growing revenue and earnings.

Reading those tea leaves, we’ve avoided that the restaurant aspect of our Fattening of the Population investing theme, and with Ignite Restaurant Group filing bankruptcy, Cheesecake Factory (CAKE) warning about its current quarter outlook we confident we’ve made the right decision.

But people still need to eat, and we’ve seen consumers increasingly flock back to grocery stores in 2017. Year to date, grocery retail sales are up 1.7 percent through May. Breaking down the data, we find that in recent months those sales have accelerated, with March to May 2017 grocery sales up 2.8 percent year over year and standalone May grocery store sales up 2.2 percent year over year.

Yet, when grocery company Kroger (KR) reported in-line earnings for its latest quarter, it lowered its 2017 EPS outlook, cutting in the process to $2.00-$2.05 from the prior $2.21-$2.25, with the current quarter to be down year over year. Aside from price deflation in the protein complex and fresh foods, the company cited its results continue to be pressured by rising health care and pension costs for employees, as well as the need to defend market share amid “upheaval” in the food retailing industry. We see that as company-speak for Kroger and its grocery store competitors having to contend with our

We see that as company-speak for Kroger and its grocery store competitors having to contend with our Connected Society investment theme that is bringing in not only Amazon (AMZN), MyFresh, and FreshDirect into the fray, but also leading Wal-Mart (WMT), Target (TGT), and Safeway among others to expand their online shopping capabilities, which in some cases includes delivery. Another reason not to get off the couch when shopping.

Candidly, we’re bigger fans of companies that focus on profits over market share given that short-term market share led strategies, often times with aggressive pricing, tend to sacrifice margins, but focusing on profits tends to lead to better market-share over the long-term. We’ve seen the “strategy” that Kroger is adopting many times in the past and while it may have short-term benefits, increasing prices later on, runs the risk of alienating customers.

Getting back to Kroger’s guidance cut, that news sent Kroger’s shares down almost 20 percent on Thursday and led to United Natural Foods (UNFI) shares to fall more than 3.5 percent, while Amplify Snacks (BETR) slumped by 2 percent. In our view, most of Kroger’s bad news was likely priced into UNFI’s mixed guidance last week when it reported its own quarterly earnings. Without question, 2017 has been a rough ride for UNIF shares despite the Food with Integrity tailwind, but despite Kroger’s guidance cut, management shared on the company earnings call that it continues “to focus on the areas of highest growth like natural and organic products.” Even Costco Wholesale (COST) recently shared it has room to grow in packaged organic food items, excluding fresh), which plays to the strengths at both United Natural Foods and Amplify Snacks.

 

Tightening Our Position in UNFI, But Staying the Course with BETR

With our Food with Integrity thematic tailwind still blowing and UNFI shares down just 7.5 percent relative to our blended cost basis on the Tematica Select List, we’ll remain patient with the position. That said, from a technical perspective the shares are near support levels and if they break through $38.50 the next likely stop is between $33 and $34. Therefore, to manage potential downside risk, we’re instilling a stop loss on UNFI shares at $38.50. As we do this, we’ll acknowledge the tougher operating environment and reduce our UNFI price target to $50 from $65, which still offers upside of just over 25 percent from current levels.

  • We are keeping our Buy rating on United Natural Foods, but trimming our price target back to $50 from $65.
  • We are instilling a stop loss at $38.50 to manage additional downside risk near-term.

With regard to Amplify Snacks, with today’s close the shares are down just 6 percent from our late April Buy recommendation. Generally speaking, these single digit stocks tend to be volatile and require some extra patience, and that’s the tact will take with BETR shares. Our price target remains $11.

  • We continue to have a Buy on Amplify Snacks (BETR) shares and our price target remains $11.

 

 

 

May Data From ADP and Challenger Offer Confirmation for Several Tematica Select List Positions

May Data From ADP and Challenger Offer Confirmation for Several Tematica Select List Positions

This morning we received the Challenger Job Cuts Report as well as ADP’s view on May job creation for the private sector. While ADP’s take that 253,000 jobs were created during the month, a nice boost from April and more in line with 1Q 2017 levels, we were reminded that all is not peachy keen with Challenger’s May findings. That report showed just under 52,000 jobs were cut during the month, a large step up from 36,600 in April, with the bulk of the increase due unsurprisingly to retail and auto companies.

As Challenger noted in the report, nearly 40% of the May layoffs were due to Ford (F), but the balance was wide across the retail landscape with big cuts at Macy’s (M), The Limited, Sears (SHLD), JC Penney (JCP) and Lowe’s (LOW) as well as others like Hhgregg and Wet Seal that have announced bankruptcy. In total, retailers continued to announce the most job cuts this year with just under 56,000 for the first five months of 2017. With yesterday’s news that Michael Kors (KORS) will shut 100 full-price retail locations over the next two years, we continue to see more pain ahead at the mall and fewer retail jobs to be had.

Sticking with the Challenger report, one of the items that jumped out to us was the call out that,

“Grocery stores are no longer immune from online shopping. Meal delivery services and Amazon are competing with traditional grocers, and Amazon announced it is opening its first ever brick-and mortar store in Seattle. Amazon Go, which mixes online technology and the in-store experience, is something to keep an eye on since it may potentially change the grocery store shopping experience considerably, “

 

In our view, this means the creative destruction that has plagued print media and retail brought on by Amazon (AMZN) is set to disrupt yet another industry, and it’s one of the reasons we’ve opted out of both grocery and retail stocks. The likely question on subscriber minds is what does this mean for our Amplify Snack Brands (BETR) position? In our view, we see little threat to Amplify’s business; if anything we see it’s mix of shipments skewing more toward online over time. Not a bad thing from a cost perspective. We’d also note that United Natural Foods (UNFI) is a partner with Amazon as well.

  • Our price target on Amazon (AMZN) remains $1,100 and offers more than 10% upside from current levels.
  • Amplify Snack Brands (BETR) has an $11 price target and is a Buy at current levels.
  • Our target on United Natual Foods (UNFI) is $65, and the recent pullback over the last six weeks enhances the long-term upside to be had.

We’d also note comments from Chipotle Mexican Grill (CMG) that its recent cybersecurity attack hit most Chipotle restaurants allowing hackers to steal credit card information from customers. In a recent blog post, Chipotle copped to the fact the malware that it was hit with infected cash registers, capturing information stored on the magnetic strip on credit cards. Chipotle said that “track data” sometimes includes the cardholder’s name, card number, expiration date and internal verification code. We see this as another reminder of the down side of what we call both our increasingly connected society and the shift toward cashless consumption. It also serves as a reminder of the long-tail demand associated with cyber security, and a nice confirmation point for the position PureFunds ISE Cyber Security ETF (HACK) shares on the Tematica Select List.

  • Our price target on PureFunds ISE Cyber Security ETF (HACK) shares remains $35.

 

Shifting Consumer Preferences Favor Food with Integrity Bullets Not Restaurant Shares

Shifting Consumer Preferences Favor Food with Integrity Bullets Not Restaurant Shares

It’s no secret the restaurant industry is having a tough time given restaurant traffic data and less-than-flattering industry articles as it grapples with several consumer-centric issues. We received yet another indication of that restaurant pain last week when Sonic Corp. (SONC) reported a 7.4 percent decline in same-store-sales. The company’s management team chalked up the drop to “a sluggish consumer environment, weather headwinds and share losses…” amid a “very intense” competitive environment. Predictably, the company is retooling its menu offering and even though it’s late to the party, it is also jumping on the smartphone bandwagon.

Stepping back there is a larger issue that Sonic and other restaurants have to contend with – declining restaurant traffic that is due not only to lower prices at grocery stores but also to the shift in consumer preferences to healthier foods. That preference shift is toward natural and organic offerings as well as paleo, gluten-free and others and that’s one of the reason’s we’ve favored shares of United Natural Foods (UNFI) as grocers expand their offering to meet that demand.

Even as companies like Coca-Cola (KO) and PepsiCo (PEP) tinker with their carbonated soft drink formulas to reduce sugar, the new enemy, they have to do so without sacrificing taste. Some investors may remember the whole New Coke thing back in 1985 that was ultimately a failure given the different taste. As Coca-Cola, PepsiCo and even Dr. Pepper Snapple (DPS) look to reformulate to ride either the lower sugar or better-for-you shift, it bodes rather well for flavor companies like International Flavors & Fragrances (IFF) or Sensient Tech (SXT).

That shifting preference has led several restaurant companies such as Panera Bread (PNRA) and Darden’s (DRI) Olive Garden to change up their menus in order to lure eaters. Over the last several years, Panera has been working to eliminate artificial additives in its food to make it “cleaner” for consumers and in 2015 it released a “no-no” list of more than 96 ingredients that it vowed to either remove from or never use in food. Darden is shifting to lighter fare recipes that have far fewer calories than prior ones. Even Chipotle (CMG), the one-time poster child for our Food with Integrity investing theme until its food safety woes last year, has come to fulfill its pledge of using no added colors, flavors or preservatives of any kind in any of its ingredients.

These are all confirming signs of our Food with Integrity investing theme that Lenore Hawkins and I talked about on last week’s podcast. Here too with these new menu offerings, it’s a question of how can restaurants offer healthier alternatives without sacrificing flavor? To us, the answer is found in  International Flavors & Fragrances, McCormick & Co. (MKC) and Sensient shares as well as other flavor companies.

Against that backdrop — – the shift to eating not only at home but eating food that is better for you – we have serious doubts when it comes to the quick service restaurant industry. According to the data research firm Sense360, which analyzed data from 140 chains and 5 million limited-service visits, 38% of heavy quick-service restaurant users reduced their visits in February, compared with the period before Christmas. Not exactly an inspiring reason to revisit shares of Sonic or several other QSR (Quick Service Restaurant) chains like McDonald’s  (MCD) or Wendy’s (WEN) at a time when bank card delinquency rates are climbing, subprime auto issues are doing the same, student debt levels loom over consumers and real wage growth has been meager at best.

While more people eating at home is a positive for Kroger (KR) and Wal-Mart (WMT), our “buy the bullets not the gun” approach continues to favor shares of McCormick and International Flavors & Fragrances in particular.  For those unfamiliar with “buy the bullets, not the gun” it’s a strategy that looks to capitalize on select industry suppliers that serve the majority of the industry with key components or other inputs. Shining examples of this strategy have included Intel (INTC), Qualcomm (QCOM) and recently acquired ARM Holdings. Common traits among them include a diverse customers base and strong competitive position with a leading market position for their products. The same holds true for both McCormick and International Flavors & Fragrances, which are also benefitting from our Rise & Fall of the Middle Class investing theme.

Shifting Consumer Preferences Favor Food with Integrity Bullets Not Restaurant Shares

Shifting Consumer Preferences Favor Food with Integrity Bullets Not Restaurant Shares

It’s no secret that the restaurant industry is having a tough time, given restaurant traffic data and less-than-flattering industry articles as it grapples with several consumer-centric issues. We received yet another indication of that restaurant pain last week when Sonic Corp. (SONC) reported a 7.4 percent decline in same-store-sales. The management team chalked up the drop to “a sluggish consumer environment, weather headwinds and share losses…” amid a “very intense” competitive environment. Predictably, the company is retooling its menu offering and even though it’s late to the party, it is also jumping on the smartphone bandwagon.

Stepping back there is a larger issue that Sonic and other restaurants have to contend with — declining restaurant traffic that is due not only to lower prices at grocery stores but also to the shift in consumer preferences to healthier foods. That preference shift is toward natural and organic offerings as well as paleo, gluten-free and others and that’s one of the reason’s we’ve favored shares of United Natural Foods (UNFI) as grocers expand their offering to meet that demand.

Even as companies like Coca-Cola (KO) and PepsiCo (PEP) tinker with their carbonated soft drink formulas to reduce sugar, the new enemy, they have to do so without sacrificing taste. Some investors may remember the whole New Coke experiment back in 1985, which was ultimately a failure given the different taste. As Coca-Cola, PepsiCo and even Dr. Pepper Snapple (DPS) look to reformulate to ride either the lower sugar or better-for-you shift, it bodes rather well for flavor companies like International Flavors & Fragrances (IFF) or Sensient Tech (SXT).

That shifting preference has led several restaurant companies such as Panera (PNRA) and Darden’s (DRI) Olive Garden to change up their menus in order to lure eaters. Over the last several years, Panera has been working to eliminate artificial additives in its food to make it “cleaner” for consumers and in 2015 it released a “no-no” list of more than 96 ingredients that it vowed to either remove from or never use in food. Darden is shifting to lighter fare recipes that have far fewer calories than prior ones. Even Chipotle (CMG), the one-time poster child for our Food with Integrity investing theme until its food safety woes last year, has come to fulfill its pledge of using no added colors, flavors or preservatives of any kind in any of its ingredients.

These are all confirming signs of our Food with Integrity investing theme that Lenore Hawkins and I talked about on last week’s podcast. Here too, with these new menu offerings, it’s a question of how can restaurants offer healthier alternatives without sacrificing flavor? To us, the answer is found in International Flavors & Fragrances (IFF), McCormick & Co. (MKC) and Sensient shares as well as other flavor companies.

Against that backdrop — the shift to eating not only at home but eating food that is better for you — we have serious doubts when it comes to the quick service restaurant industry. According to the data research firm Sense360, which analyzed data from 140 chains and 5 million limited-service visits, 38 percent of heavy quick-service restaurant users reduced their visits in February, compared with the period before Christmas. Not exactly an inspiring reason to revisit shares of Sonic or several other QSR (Quick Service Restaurant) chains like McDonald’s  (MCD) or Wendy’s (WEN) at a time when bank card delinquency rates are climbing, subprime auto issues are doing the same, student debt levels loom over consumers and real wage growth has been meager at best.

While more people eating at home is a positive for Kroger (KR) and Wal-Mart (WMT), our “buy the bullets not the gun” approach continues to favor shares of McCormick and International Flavors & Fragrances in particular.  For those unfamiliar with “buy the bullets, not the gun” it’s a strategy that looks to capitalize on select industry suppliers that serve the majority of the industry with key components or other inputs. Shining examples of this strategy in the tech industry have included Intel (INTC), Qualcomm (QCOM) and recently acquired ARM Holdings. Common traits among them include a diverse customers base and strong competitive position with a leading market position for their products.

The same holds true for both McCormick and International Flavors & Fragrances, which are also benefitting from our Rise & Fall of the Middle Class investing theme.

  • Our price target on MKC shares is $110; we’d be more inclined to scale into the shares closer to $95.
  • Our price target on IFF shares remains $145; as new data becomes available, we’ll continue to evaluate potential upside to that price target. 
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.