Weekly Issue: Key Developments at Apple (AAPL) and AT&T (T)

Weekly Issue: Key Developments at Apple (AAPL) and AT&T (T)

Key points inside this issue:

  •  Apple’s 2019 iPhone event – more meh than wow
  •  GameStop – It’s only going to get worse
  •  Elliot Management gets active in AT&T, but its prefers Verizon?
  •  California approves a bill that changes how contract workers are treated
  • Volkswagen set to disrupt the electric vehicle market

I’m going to deviate from the usual format we’ve been using here at Tematica Investing this week to focus on some of what’s happening with Select List residents Apple (AAPL) and AT&T (T) this week as well as one or two other things. The reason is the developments at both companies have a few layers to them, and I wanted to take the space to discuss them in greater detail. Don’t worry, we’ll be back to our standard format next week and I should be sharing some thoughts on Farfetch (FTCH), which sits at the crossroads of our Living the Life, Middle Class Squeeze and Digital Lifestyle investing themes, and another company I’ve been scrutinizing with our thematic lens. 

 

Apple’s 2019 iPhone event – more meh than wow

Yesterday, Apple (AAPL) held its now annual iPhone-centric event, at which it unveiled its newest smartphone model as well as other “new”, or more to the point, upgraded hardware. In that regard, Apple did not disappoint, but the bottom line is the company delivered on expectations serving up new models of the iPhone, Apple Watch and iPad, but with only incremental technical advancements. 

Was there anything that is likely to make the average users, not the early adopter, upgrade today because they simply have to “have it”? 

Not in my view. 

What Apple did do with these latest devices and price cuts on older models that it will keep in play was round out price points in its active device portfolio. To me, that says CEO Tim Cook and his team got the message following the introduction of the iPhone XS and iPhone XS Max last year, each of which sported price tags of over $1,000. This year, a consumer can scoop up an iPhone 8 for as low as $499 or pay more than $1,000 for the new iPhone 11 Pro that sports a new camera system and some other incremental whizbangs. The same goes with Apple Watch – while Apple debuted a new Series 5 model yesterday, it is keeping the Series 3 in the lineup and dropped its price point to $199. That has the potential to wreak havoc on fitness trackers and other smartwatch businesses at companies like Garmin (GRMN) and Fitbit (FIT)

Before moving on, I will point out the expanded product price points could make judging Apple’s product mix revenue from quarter to quarter more of a challenge, especially since Apple is now sharing information on these devices in a more limited fashion. This could mean Apple has a greater chance of surprising on revenue, both to the upside as well as the downside. Despite Apple’s progress in growing its Services business, as well its other non-iPhone businesses, iPhone still accounted for 48% of June 2019 quarterly revenue. 

Those weren’t the only two companies to feel the pinch of the Apple event. Another was Netflix (NFLX) as Apple joined Select List resident Walt Disney (DIS) in undercutting Netflix’s monthly subscription rate. In case you missed it, Disney’s starter package for its video streaming service came in at $6.99 per month. Apple undercut that with a $4.99 a month price point for its forthcoming AppleTV+ service, plus one year free with a new device purchase. To be fair, out of the gate Apple’s content library will be rather thin in comparison to Disney and Netflix, but it does have the balance sheet to grow its library in the coming quarters. 

Apple also announced that its game subscription service, Apple Arcade, will launch on September 19 with a $4.99 per month price point. Others, such as Microsoft (MSFT) and Alphabet (GOOGL) are targeting game subscription services as well, but with Apple’s install base of devices and the adoption of mobile gaming, Apple Arcade could surprise to the upside. 

To me, the combination of Apple Arcade and these other game services are another nail in the coffin for GameStop (GME)

 

GameStop – It’s only going to get worse

I’ve been bearish on GameStop (GME) for some time, but even I didn’t think it could get this ugly, this fast. After the close last night, GameStop reported its latest quarter results that saw EPS miss expectations by $0.10 per share, a miss on revenues, guidance on its outlook below consensus, and a cut to its same-store comps guidance. The company also shared the core tenets of a new strategic plan. 

Nearly all of its speaks for itself except for the strategic plan. Those key tenets are:

  • Optimize the core business by improving efficiency and effectiveness across the organization, including cost restructuring, inventory management optimization, adding and growing high margin product categories, and rationalizing the global store base. 
  • Create the social and cultural hub of gaming across the GameStop platform by testing and improving existing core assets including the store experience, knowledgeable associates and the PowerUp Rewards loyalty program. 
  • Build digital capabilities, including the recent relaunch of GameStop.com.
  •  Transform vendor and partner relationships to unlock additional high-margin revenue streams and optimize the lifetime value of every customer.

Granted, this is a cursory review, but based on what I’ve seen I am utterly unconvinced that GameStop can turn this boat around. The company faces headwinds associated with our Digital Lifestyle investing theme that are only going to grow stronger as gaming services from Apple, Microsoft and Alphabet come to market and offer the ability to game anywhere, anytime. To me, it’s very much like the slow sinking ship that was Barnes & Noble (BKS) that tried several different strategies to bail water out. 

Did GameStop have its time in the sun? Sure it did, but so did Blockbuster Video and we all know how that ended. Odds are it will be Game Over for GameStop before too long.

Getting back to Apple, now we wait for September 20 when all the new iPhone models begin shipping. Wall Street get your spreadsheets ready!

 

Elliot Management gets active in AT&T, but its prefers Verizon?

Earlier this week, we learned that activist investor Elliot Management Corp. took a position in AT&T (T). At $3.2 billion, we can safely say it is a large position. Following that investment, Elliot sent a 24-page letter telling AT&T that it needed to change to bolster its share price. Elliot’s price target for T shares? $60. I’ll come back to that in a bit. 

Soon thereafter, many media outlets from The New York Times to The Wall Street Journal ran articles covering that 24-page letter, which at one point suggested AT&T be more like Verizon (VZ) and focus on building out its 5G network and cut costs. While I agree with Elliot that those should be focus points for AT&T, and that AT&T should benefit from its spectrum holdings as well as being the provider of the federally backed FirstNet communications system for emergency responders, I disagree with its criticism of the company’s media play. 

Plain and simple, people vote with their feet for quality content. We’ve seen this at the movie box office, TV ratings, and at streaming services like Netflix (NFLX) when it debuted House of Cards or Stranger Things, and Hulu with the Handmaiden’s Tale. I’ve long since argued that AT&T has taken a page out of others’ playbook and sought to surround its mobile business with content, and yes that mobile business is increasingly the platform of choice for consuming streaming video content. By effectively forming a proprietary content moat around its business, the company can shore up its competitive position and expand its business offering rather than having its mobile service compete largely on price. And this isn’t a new strategy – we saw Comcast (CMCSA) do it rather well when it swallowed NBC Universal to take on Walt Disney and others. 

Let’s also remember that following the acquisiton of Time Warner, AT&T is poised to follow Walt Disney, Apple and others into the streaming video service market next year. Unlike Apple, AT&T’s Warner Media brings a rich and growing content library but similar to Apple, AT&T has an existing service to which it can bundle its streaming service. AT&T may be arriving later to the party than Apple and Disney, but its effort should not be underestimated, nor should the impact of that business on how investors will come to think about valuing T shares. The recent valuation shift in Disney thanks to Disney+ is a great example and odds are we will see something similar at Apple before too long with Apple Arcade and AppleTV+. These changes will help inform us as to how that AT&T re-think could play out as it comes to straddle the line between being a Digital Infrastructure and Digital Lifestyle company.

Yes Verizon may have a leg up on AT&T when it comes to the current state of its 5G network, but as we heard from specialty contractor Dycom Industries (DY), it is seeing a significant uptick in 5G related construction and its top two customers are AT& T (23% of first half 2019 revenue) followed by Verizon (22%). But when these two companies along with Sprint (S), T-Mobile USA (TMUS) and other players have their 5G network buildout competed, how will Verizon ward off subscriber poachers that are offering compelling monthly rates? 

And for what it’s worth, I’m sure Elliot Management is loving the current dividend yield had with T shares. Granted its $60 price target implies a yield more like 3.4%, but I’d be happy to get that yield if it means a 60% pop in T shares. 

 

California approves a bill that changes how contract workers are treated

California has long been a trend setter, but if you’re an investor in Uber (UBER) or Lyft (LYFT) — two companies riding our Disruptive Innovators theme — that latest bout of trend setting could become a problem. Yesterday, California lawmakers have approved Assembly Bill 5, a bill that requires companies like Uber, Lyft and DoorDash to treat contract workers as employees. 

This is one of those times that our thematic lens is being tilted a tad to focus on a regulatory change that will entitle gig workers to protections like a minimum wage and unemployment benefits, which will drive costs at the companies higher. It’s being estimated that on-demand companies like Uber and the delivery service DoorDash will see their costs rise 20%-30% when they rely on employees rather than contractors. For Uber and Lyft, that likely means pushing out their respective timetables to profitability.

We’ll have to see if other states follow California’s lead and adopt a similar change. A coalition of labor groups is pushing similar legislation in New York, and bills in Washington State and Oregon could see renewed momentum. The more states that do, the larger the profit revisions to the downside to be had. 

 

Volkswagen set to disrupt the electric vehicle market

It was recently reported that Volkswagen (VWAGY) has hit a new milestone in reducing battery costs for its electric vehicles, as it now pays less than $100 per KWh for its batteries. Given the battery pack is the most expensive part of an electric vehicle, this has been thought to be a tipping point for mass adoption of electric vehicles. 

Soon after that report, Volkswagen rolled out the final version of its first affordable long-range electric car, the ID.3, at the 2019 Frankfurt Motor Show and is expected to be available in mid-2020.  By affordable, Volkswagen means “under €30,000” (about $33,180, currently) and the ID.3 will come in three variants that offer between roughly 205 and 340 miles of range. 

By all accounts, the ID.3 will be a vehicle to watch as it is the first one being built on the company’s new modular all-electric platform that is expected to be the basis for dozens more cars and SUVs in the coming years as Volkswagen Group’s pushed hard into electric vehicles. 

Many, including myself, have been waiting for the competitive landscape in the electric vehicle market to heat up considerably – it’s no secret that all the major auto OEMs are targeting the market. Between this fall in battery cost and the price point for Volkswagen’s ID.3, it appears that the change in the landscape is finally approaching and it’s likely to bring more competitive pressures for Clean Living company and Cleaner  Living Index constituent Tesla (TSLA)

 

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.

 

 

Weekly Issue: Factors making the stock market melt up a head-scratcher

Weekly Issue: Factors making the stock market melt up a head-scratcher

Key points inside this issue

  • Our long-term price target on Disruptive Innovator leader Nokia (NOK) shares remains $8.50.
  • We will continue to be long-term shareholders with Disruptive Innovator Select List resident Universal Display (OLED). Given the improving outlooks, our near-term price target for OLED shares is getting lifted to $150 from $125, and I will revisit that target as we move through the balance of 2019.

 

Reading the latest from the Oracle of Omaha

Over the weekend, the Oracle of Omaha, Warren Buffett, released his annual letter to shareholders of Berkshire Hathaway (BRK.A). This letter has become a must-read among institutional and individual investors alike because it not only reveals changes in Berkshire’s top investment portfolio positions, but it also has contained ample comments on the economy and markets as well as an investing lesson or two.

Out of the gate, we learned that once again Team Buffett outperformed the major stock market indices in 2018. As Buffett got underway, he casually reminded readers to be buyers of “ably managed businesses, in whole or part, that possess favorable and durable economic characteristics” and to do so at sensible prices. While it may seem somewhat self-serving this sounds very much like our thematic investing strategy that looks to identify companies benefitting from structural economic, demographic, psychographic and technological changes at prices that offer commanding upside vs. potential downside.

In the past, Buffett has commented that stocks are akin to pieces of paper and it’s the businesses behind them that are the drivers of revenue and profits. It’s an idea we are very much in tune with as we view ourselves as buyers of thematically well-positioned business first, their shares second. No matter how attractive a stock’s price may be, if its business is troubled or facing thematic headwinds, it can be a tough pill to swallow.

As Buffett later noted, “On occasion, a ridiculously high purchase price for a given stock will cause a splendid business to become a poor investment — if not permanently, at least for a painfully long period.” I certainly agree with that statement because buying a stock at the wrong price can make for a painful experience. There are times, to be patient, but there are also times when the thesis behind owning a stock changes. In those times, it makes far more sense to cut bait in favor of better-positioned companies.

Buffett then shared that “prices are sky-high for businesses possessing decent long- term prospects,” which is something we’ve commented on several times in recent weeks as the stock market continued to melt up even as earnings expectations for the near term have moved lower. We’ll continue to take the advice of Buffett and focus on “calculating whether a portion of an attractive business is worth more than its market price,” for much like Buffett and his team work for Berkshire shareholders, Tematica and I work for you, our subscribers.

Mixed in among the rest of the letter are some on Buffett’s investing history, which is always an informative read, and a quick mention that “At Berkshire, we hope to invest significant sums across borders” and that it continues to “hope for an elephant-sized acquisition.” While I can’t speak to any acquisition, especially after the debacle that is now recognized as Kraft Heinz (KHC), the focus on investing across borders potentially speaks to our New Global Middle-class and Living the Life investing themes. Given Buffett’s style, I suspect Team Buffett is more likely to tap into the rising middle-class over luxury and travel.

Several times Buffett touched on his age, 88 years, as well as that of its key partner Charlie Munger, who is 95. There was no meaningful revelation on how they plan to transition the management team, but odds are that will be a topic of conversation, as will Kraft Heinz Co. (KHC) at the annual shareholder meeting that is scheduled for Saturday, May 4. More details on that can be found at the bottom of the 2018 shareholder letter.

If I had to describe the overall letter, it was a very solid one, but candidly not one of the more memorable ones. Perhaps that reflects 2018 as a whole, a year in which all major market indices fell into the red during the last quarter of the year, and a current environment that is characterized by slowing global growth.

 

More signs that the domestic economy is a-slowin’

In recent issues of Tematica Investing and in the recent Context & Perspectives pieces penned by Tematica’s Chief Macro Strategist Lenore Hawkins, we’ve shared how even though the U.S. economy looks like the best one on the global block, it is showing signs of slowing. We had further confirmation of that in the recent December Retail Sales Report as well as the January Industrial Production data that showed a drop in manufacturing activity. The December Durable Orders report that showed orders for non-defense capital goods excluding aircraft dropped 0.7% added further confirmation. Moreover, the report showed a downward November revision for the category to a fall of 1.0% vs. the prior 0.6% decline.

Much the way we focus on the order data inside the monthly ISM and IHS Markit PMI reports, the order data contained inside the monthly Durable Orders report gives us a sense of what is likely to come in near-term. These declining orders combined with the January declines in Industrial Production suggest slack is growing in the manufacturing economy, which means orders for new production equipment are likely to remain soft in the near-term. 

This past Monday we received another set of data that point to a slowing U.S. economy. We learned the Chicago Fed National Activity Index (CFNAI) fell to -0.43 in January from +0.05 in December. This index tracks 85 indicators; we’d note that in January, 35 of those indicators made positive contributions to the index, but that 50 made negative contributions, which produced the month-over-month decline.

Before we get all nervous over that negative January reading for the CFNAI, periods of economic expansion have been associated with index values above -0.70, which means the economy continued to expand in January, just at a much slower pace compared to December. Should the CFNAI reading fall below -0.70 in February or another coming month, it would signal a contraction in the domestic economy.

In response, Buffett likely would say that he and the team will continue to manage the portfolio for the long term, and that’s very much in sync with our thematic investing time frame.

 

Watch those dividends… for increases and for cuts!

Ahead of Buffett’s shareholder letter, shares of Kraft Heinz (KHC) tumbled in a  pronounced manner following several announcements, one of which included the 35% cut in its quarterly dividend to $0.40 per share from $0.625 per share. That’s a huge disappointment given the commonplace expectation that a company is expected to pay its dividend in perpetuity. It can increase its dividend or from time to time declare a special dividend, but as we’ve seen time and time again, the cutting of a company’s dividend is a disaster its stock price. We’ve seen this when General Motors (GM) and General Electric (GE) cut their respective dividends and again last week when Kraft made a similar announcement.

Those three are rather high profile and well-owned stocks, but they aren’t the only ones that have cut quarterly dividend payments to their shareholders. In December, L Brands (LB), the company behind Victoria’s Secret and Bath & Body Works, clipped its annual dividend by 50% to $1.20 per share from $2.40 per share and its shares dropped from $35 to $24 before rebounding modestly. On the company’s fourth-quarter earnings conference call, management of Century Link (CTL)  disclosed it would be cutting the telecom service provider’s annual dividend from $2.16 to $1.00 per share. Earlier this month, postal meter and office equipment company Pitney Bowes (PBI) declared a quarterly dividend of $0.05 per share, more than 73% fall from the prior dividend of $0.1875 per share. Other dividend cuts in recent weeks were had at Owens & Minor (OMI), Manning & Napier (MN), Unique Fabricating (UFAB), County Bancorp (ICBK), and Fresh Del Monte (FDP).

What the majority of these dividend cuts have in common is a challenged business, and in some cases like that for Pitney Bowes, the management team and Board have opted to carve out a new path for its capital allocation policy. For Pitney, it means shifting the mix to favor its share buyback program over dividends given the additional $100 million authorization that was announced which upsized its program to $121 million.

As I see it, there are several lessons to be had from these dividends:

One, outsized dividend yields as was the case back in September with L Brands can signal an opportunity for dividend income-seeking investors, but it can also represent a warning sign as investors exit shares in businesses that look to have operating and/or cash flow pressures.

This means that Two, we as investors always need to do the homework to determine what the prospects for the company’s business. As we discussed above, Buffett’s latest shareholder letter reminds investors to be buyers of “ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics” and to do so at sensible prices. Through our thematic lens, it’s no surprise that L Brands and Pitney Bowes are hitting the headwinds of our Digital Lifestyle investing theme, while Kraft Heinz is in the grips of the consumer shift to Cleaner Living. Perhaps Kraft should have focused on something other than cost cuts to grow its bottom line.

Third, investors make mistakes and as we saw with the plummet in the share price at Kraft Heinz, it can happen to Buffett as well. There’s no shame in making a mistake, so long as we can learn from it.

Fourth and perhaps most important, while some may look at the growing number of dividend cuts on a company by company basis, if we look at them in aggregate the pace is greater than the number of such cuts, we saw in all of 2018. While we try not to overly excited one way or another, the pace of dividend cuts is likely to spur questions over the economy and where we are in the business cycle.

 

Putting it all together

As we move into March, more than 90% of the S&P 500 group of companies will have reported their quarterly results. As those results have been increasingly tallied over the last few weeks, we’ve seen EPS expectations move lower for the coming quarters and as of Friday’ stock market close the consensus view is 2019 EPS growth for the S&P 500 will be around 4.7%. That is significantly lower than the more than 11% EPS growth that was forecasted back at the start of the December quarter.

For those keeping score, the consensus for the current quarter points to a 2% growth rate. However, we’re starting to see more analysts cut their outlooks as more figures are reported. For example, JPMorgan (JPM) now sees the current quarter clocking in at 1.5% due to slower business investment spending. For now, JP sees a pick-up in the June quarter to a 2.25% forecast. But in our view, this will hinge on what we see in the coming order data.

Putting it all together, we have a slowing economy, EPS cuts that are making the stock market incrementally more expensive as has moved higher over the last 9 weeks, marking one of the best runs it has had in more than 20 years, and a growing number of dividend cuts. Sounds like a disconnect in the making to me.

Clearly, the stock market has been melting up over the last several weeks on increasing hopes over a favorable trade deal with China, but as I’ve been saying for some time, 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.

We will continue to tread carefully in the near-term, especially given the likelihood that following the disappointing December Retail Sales report and consumer-facing data, retailers are likely to deliver underwhelming quarterly results. Despite favorable weather in December, we saw that yesterday with Home Depot (HD),  and historically it’s been a pretty good yardstick for the consumer. In all likelihood as the remaining 10% of the S&P 500 companies report, we’re going to see further negative revisions to that current 4.7% EPS growth rate for this year I talked about.

 

Tematica Investing

A few paragraphs above, I touched on the strength of the stock market thus far in 2019, and even though concerns are mounting, we have seen pronounced moves higher in a number of the Thematic Leaders as you can see in the chart below. We’ll continue to monitor the changing landscapes and what they may bring. For example, in the coming weeks both Apple and Disney (DIS) are expected to unveil their respective streaming services, and I’ll be listening closely for to determine what this means for Digital Lifestyle leader Netflix (NFLX).

Nokia and Mobile World Congress 2019

We are two days into Mobile World Congress 2019, arguably THE mobile industry event of the year and one to watch for our Digital Lifestyle, Digital Infrastructure, and Disruptive Innovator themes. Thus far, we’ve received a number of different device and network announcements from the event.

On the device side, more 5G capable handsets have been announced as well as a number of foldable smartphones that appear to be a hybrid between a large format smartphone and a tablet. Those foldable smartphones are sporting some hefty price tags as evidenced by the $2,600 one for Huawei’s model. Interesting, but given the size of the device as well as the price point, one has to question if this is a commercially viable product or simply a concept one. Given the pushback that we are seeing with big-ticket smartphones that is resulting in consumers not upgrading their smartphones as quickly as they have in the past, odds are some of these device announcements fall more into the concept category.

On the network side, the news to center on comes from Verizon (VZ), which said it expects to have its 5G network in 30 U.S. cities by the end of 2019. That’s hardly what one would call a vibrant, national 5G network, and makes those commercial 5G launches really a 2020 event for the mobile carriers and consumers. It does mean that over the next several quarters, those mobile operators will continue to build out their 5G networks, which is positive for our shares of Nokia (NOK). As the 5G buildout moves beyond the U.S. into Europe and Asia, this tailwind bodes rather well for the company and helps back its longer-term targets. 

This 5G timetable was also confirmed by comments from Intel (INTC) about the timing of 5G chipsets, which are now expected to be available by the end of 2019 and are not likely to hit devices until 2020. Given the timing of CES in early January and the Mobile World Congress 2020 in February, odds are it means we will see a number of device announcements in early 2020 that will hit shelves in the second half of the year. Many have been wondering when Apple (AAPL) will have a 5G powered iPhone, and based on the various chipset and network comments, odds are the first time we’ll hear about such a device is September-October 2020. 

If history is to be repeated, we are likely to see something similar to what we saw with the first 3G and 4G handsets. By that, we mean a poor consumer experience at least until the 5G networks are truly national in scale and the chipsets become more efficient. One of the issues with each additional layer of mobile technology is it requires additional radio frequency (RF) chips, which in turn not only consume more power but also present internal design issues that out of the gate could limit the size of the battery. Generally speaking, early versions of these new smartphones tend to have less than desirable up-times. This is another reason to think Apple will not be one of those out of the gate 5G smartphone companies, but rather it will repeat its past strategy of bringing its product to market at the tipping point for the chipsets and network deployments. 

Circling back to our Nokia shares, while there are just over a handful of 5G smartphones that have been announced, some of which are expected to become available later this year, over the coming 18 months we will see a far greater number of 5G devices. This should drive Nokia’s high margin, IP licensing business in the coming quarters. As this occurs, Nokia’s mobile infrastructure should continue to benefit from the growing number of 5G networks being built out, not only here in the US but elsewhere as well.

  • Our long-term price target on Disruptive Innovator leader Nokia (NOK) shares remains $8.50

 

Universal Display shares get lit up

Last week I previewed the upcoming earnings report from Select List resident Universal Display (OLED) and following that news the shares were off with a bang! Universal posted earnings of $0.40 per share, $0.08 per share better than the consensus expectations, on revenue that matched the Wall Street consensus of $70 million. Considering the tone of the smartphone market, I view the company’s quarterly results as “not as bad a feared” and, no surprise, the guidance reflects the continued adoption of organic light-emitting displays across a growing number of devices and vendors. For the current year, Universal has guided revenue to $325 million-$350 million, which is likely to be a step function higher as we move through the coming quarters reflecting the traditional year-end debut of new smartphones, TVs and other devices.

Longer-term, we know Apple (AAPL) and others are looking to migrate more of their product portfolios to organic light-emitting diode displays. This shift will drive capacity increases in the coming several quarters — and recent reports on China’s next round of display investing seems to confirm this happening per its latest Five-Year Plan. As we have seen in the past, this can lead to periods of oversupply and pricing issues for the displays, but the longer-term path as witnessed with light-emitting diodes (LEDs) is one of greater adoption. 

As display pricing improves as capacity grows, new applications for the technology tend to arise. Remember that while we are focused on smartphones and TVs in the near-term, other applications include automotive lighting and general lighting. Again, just like we saw with LEDs.

  • We will continue to be long-term shareholders with Disruptive Innovator Select List resident Universal Display (OLED). Given the improving outlooks, our near-term price target for OLED shares is getting lifted to $150 from $125, and I will revisit that target as we move through the balance of 2019.

 

 

Weekly Issue: Favorable signposts have us adding a call option position

Weekly Issue: Favorable signposts have us adding a call option position

Key points inside this issue

  • We will continue to be long-term shareholders with Disruptive Innovator Select List resident Universal Display (OLED). Given the improving outlooks, our near-term price target for OLED shares is getting lifted to $150 from $125, and I will revisit that target as we move through the balance of 2019.
  • We are issuing a Buy on and adding the Nokia Corp. (NOK) December 2019 7.00 calls (NOK191220C0000700) that closed last night at 0.38 to the Options+ Select List with 0.20 stop loss.
  • We will continue to hold the Del Frisco’s Restaurant Group (DFRG) September 20, 2019, 10.00 calls (DFRG190920C00010000) that closed last night at 1.00, but we will boost our stop loss to 0.80, which will ensure a minimum return of 33% based on our 0.60 entry point.

 

Reading the latest from the Oracle of Omaha

Over the weekend, the Oracle of Omaha, Warren Buffett, released his annual letter to shareholders of Berkshire Hathaway (BRK.A). This letter has become a must-read among institutional and individual investors alike because it not only reveals changes in Berkshire’s top investment portfolio positions, but it also has contained ample comments on the economy and markets as well as an investing lesson or two.

Out of the gate, we learned that once again Team Buffett outperformed the major stock market indices in 2018. As Buffett got underway, he casually reminded readers to be buyers of “ably managed businesses, in whole or part, that possess favorable and durable economic characteristics” and to do so at sensible prices. While it may seem somewhat self-serving this sounds very much like our thematic investing strategy that looks to identify companies benefitting from structural economic, demographic, psychographic and technological changes at prices that offer commanding upside vs. potential downside.

In the past, Buffett has commented that stocks are akin to pieces of paper and it’s the businesses behind them that are the drivers of revenue and profits. It’s an idea we are very much in tune with as we view ourselves as buyers of thematically well-positioned business first, their shares second. No matter how attractive a stock’s price may be, if its business is troubled or facing thematic headwinds, it can be a tough pill to swallow.

As Buffett later noted, “On occasion, a ridiculously high purchase price for a given stock will cause a splendid business to become a poor investment — if not permanently, at least for a painfully long period.” I certainly agree with that statement because buying a stock at the wrong price can make for a painful experience. There are times, to be patient, but there are also times when the thesis behind owning a stock changes. In those times, it makes far more sense to cut bait in favor of better-positioned companies.

Buffett then shared that “prices are sky-high for businesses possessing decent long- term prospects,” which is something we’ve commented on several times in recent weeks as the stock market continued to melt up even as earnings expectations for the near term have moved lower. We’ll continue to take the advice of Buffett and focus on “calculating whether a portion of an attractive business is worth more than its market price,” for much like Buffett and his team work for Berkshire shareholders, Tematica and I work for you, our subscribers.

Mixed in among the rest of the letter are some on Buffett’s investing history, which is always an informative read, and a quick mention that “At Berkshire, we hope to invest significant sums across borders” and that it continues to “hope for an elephant-sized acquisition.” While I can’t speak to any acquisition, especially after the debacle that is now recognized as Kraft Heinz (KHC), the focus on investing across borders potentially speaks to our New Global Middle-class and Living the Life investing themes. Given Buffett’s style, I suspect Team Buffett is more likely to tap into the rising middle-class over luxury and travel.

Several times Buffett touched on his age, 88 years, as well as that of its key partner Charlie Munger, who is 95. There was no meaningful revelation on how they plan to transition the management team, but odds are that will be a topic of conversation, as will Kraft Heinz Co. (KHC) at the annual shareholder meeting that is scheduled for Saturday, May 4. More details on that can be found at the bottom of the 2018 shareholder letter.

If I had to describe the overall letter, it was a very solid one, but candidly not one of the more memorable ones. Perhaps that reflects 2018 as a whole, a year in which all major market indices fell into the red during the last quarter of the year, and a current environment that is characterized by slowing global growth.

 

More signs that the domestic economy is a-slowin’

In recent issues of Tematica Investing and in the recent Context & Perspectives pieces penned by Tematica’s Chief Macro Strategist Lenore Hawkins, we’ve shared how even though the U.S. economy looks like the best one on the global block, it is showing signs of slowing. We had further confirmation of that in the recent December Retail Sales Report as well as the January Industrial Production data that showed a drop in manufacturing activity. The December Durable Orders report that showed orders for non-defense capital goods excluding aircraft dropped 0.7% added further confirmation. Moreover, the report showed a downward November revision for the category to a fall of 1.0% vs. the prior 0.6% decline.

Much the way we focus on the order data inside the monthly ISM and IHS Markit PMI reports, the order data contained inside the monthly Durable Orders report gives us a sense of what is likely to come in near-term. These declining orders combined with the January declines in Industrial Production suggest slack is growing in the manufacturing economy, which means orders for new production equipment are likely to remain soft in the near-term. 

This past Monday we received another set of data that point to a slowing U.S. economy. We learned the Chicago Fed National Activity Index (CFNAI) fell to -0.43 in January from +0.05 in December. This index tracks 85 indicators; we’d note that in January, 35 of those indicators made positive contributions to the index, but that 50 made negative contributions, which produced the month-over-month decline.

Before we get all nervous over that negative January reading for the CFNAI, periods of economic expansion have been associated with index values above -0.70, which means the economy continued to expand in January, just at a much slower pace compared to December. Should the CFNAI reading fall below -0.70 in February or another coming month, it would signal a contraction in the domestic economy.

In response, Buffett likely would say that he and the team will continue to manage the portfolio for the long term, and that’s very much in sync with our thematic investing time frame.

 

Watch those dividends… for increases and for cuts!

Ahead of Buffett’s shareholder letter, shares of Kraft Heinz (KHC) tumbled in a  pronounced manner following several announcements, one of which included the 35% cut in its quarterly dividend to $0.40 per share from $0.625 per share. That’s a huge disappointment given the commonplace expectation that a company is expected to pay its dividend in perpetuity. It can increase its dividend or from time to time declare a special dividend, but as we’ve seen time and time again, the cutting of a company’s dividend is a disaster its stock price. We’ve seen this when General Motors (GM) and General Electric (GE) cut their respective dividends and again last week when Kraft made a similar announcement.

Those three are rather high profile and well-owned stocks, but they aren’t the only ones that have cut quarterly dividend payments to their shareholders. In December, L Brands (LB), the company behind Victoria’s Secret and Bath & Body Works, clipped its annual dividend by 50% to $1.20 per share from $2.40 per share and its shares dropped from $35 to $24 before rebounding modestly. On the company’s fourth-quarter earnings conference call, management of Century Link (CTL)  disclosed it would be cutting the telecom service provider’s annual dividend from $2.16 to $1.00 per share. Earlier this month, postal meter and office equipment company Pitney Bowes (PBI) declared a quarterly dividend of $0.05 per share, more than 73% fall from the prior dividend of $0.1875 per share. Other dividend cuts in recent weeks were had at Owens & Minor (OMI), Manning & Napier (MN), Unique Fabricating (UFAB), County Bancorp (ICBK), and Fresh Del Monte (FDP).

What the majority of these dividend cuts have in common is a challenged business, and in some cases like that for Pitney Bowes, the management team and Board have opted to carve out a new path for its capital allocation policy. For Pitney, it means shifting the mix to favor its share buyback program over dividends given the additional $100 million authorization that was announced which upsized its program to $121 million.

As I see it, there are several lessons to be had from these dividends:

One, outsized dividend yields as was the case back in September with L Brands can signal an opportunity for dividend income-seeking investors, but it can also represent a warning sign as investors exit shares in businesses that look to have operating and/or cash flow pressures.

This means that Two, we as investors always need to do the homework to determine what the prospects for the company’s business. As we discussed above, Buffett’s latest shareholder letter reminds investors to be buyers of “ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics” and to do so at sensible prices. Through our thematic lens, it’s no surprise that L Brands and Pitney Bowes are hitting the headwinds of our Digital Lifestyle investing theme, while Kraft Heinz is in the grips of the consumer shift to Cleaner Living. Perhaps Kraft should have focused on something other than cost cuts to grow its bottom line.

Third, investors make mistakes and as we saw with the plummet in the share price at Kraft Heinz, it can happen to Buffett as well. There’s no shame in making a mistake, so long as we can learn from it.

Fourth and perhaps most important, while some may look at the growing number of dividend cuts on a company by company basis, if we look at them in aggregate the pace is greater than the number of such cuts, we saw in all of 2018. While we try not to overly excited one way or another, the pace of dividend cuts is likely to spur questions over the economy and where we are in the business cycle.

 

Putting it all together

As we move into March, more than 90% of the S&P 500 group of companies will have reported their quarterly results. As those results have been increasingly tallied over the last few weeks, we’ve seen EPS expectations move lower for the coming quarters and as of Friday’ stock market close the consensus view is 2019 EPS growth for the S&P 500 will be around 4.7%. That is significantly lower than the more than 11% EPS growth that was forecasted back at the start of the December quarter.

For those keeping score, the consensus for the current quarter points to a 2% growth rate. However, we’re starting to see more analysts cut their outlooks as more figures are reported. For example, JPMorgan (JPM) now sees the current quarter clocking in at 1.5% due to slower business investment spending. For now, JP sees a pick-up in the June quarter to a 2.25% forecast. But in our view, this will hinge on what we see in the coming order data.

Putting it all together, we have a slowing economy, EPS cuts that are making the stock market incrementally more expensive as has moved higher over the last 9 weeks, marking one of the best runs it has had in more than 20 years, and a growing number of dividend cuts. Sounds like a disconnect in the making to me.

Clearly, the stock market has been melting up over the last several weeks on increasing hopes over a favorable trade deal with China, but as I’ve been saying for some time, 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.

We will continue to tread carefully in the near-term, especially given the likelihood that following the disappointing December Retail Sales report and consumer-facing data, retailers are likely to deliver underwhelming quarterly results. Despite favorable weather in December, we saw that yesterday with Home Depot (HD),  and historically it’s been a pretty good yardstick for the consumer. In all likelihood as the remaining 10% of the S&P 500 companies report, we’re going to see further negative revisions to that current 4.7% EPS growth rate for this year I talked about.

 

Tematica Investing

A few paragraphs above, I touched on the strength of the stock market thus far in 2019, and even though concerns are mounting, we have seen pronounced moves higher in a number of the Thematic Leaders as you can see in the chart below. We’ll continue to monitor the changing landscapes and what they may bring. For example, in the coming weeks both Apple and Disney (DIS) are expected to unveil their respective streaming services, and I’ll be listening closely for to determine what this means for Digital Lifestyle leader Netflix (NFLX).

Nokia and Mobile World Congress 2019

We are two days into Mobile World Congress 2019, arguably THE mobile industry event of the year and one to watch for our Digital Lifestyle, Digital Infrastructure, and Disruptive Innovator themes. Thus far, we’ve received a number of different device and network announcements from the event.

On the device side, more 5G capable handsets have been announced as well as a number of foldable smartphones that appear to be a hybrid between a large format smartphone and a tablet. Those foldable smartphones are sporting some hefty price tags as evidenced by the $2,600 one for Huawei’s model. Interesting, but given the size of the device as well as the price point, one has to question if this is a commercially viable product or simply a concept one. Given the pushback that we are seeing with big-ticket smartphones that is resulting in consumers not upgrading their smartphones as quickly as they have in the past, odds are some of these device announcements fall more into the concept category.

On the network side, the news to center on comes from Verizon (VZ), which said it expects to have its 5G network in 30 U.S. cities by the end of 2019. That’s hardly what one would call a vibrant, national 5G network, and makes those commercial 5G launches really a 2020 event for the mobile carriers and consumers. It does mean that over the next several quarters, those mobile operators will continue to build out their 5G networks, which is positive for our shares of Nokia (NOK). As the 5G buildout moves beyond the U.S. into Europe and Asia, this tailwind bodes rather well for the company and helps back its longer-term targets. 

This 5G timetable was also confirmed by comments from Intel (INTC) about the timing of 5G chipsets, which are now expected to be available by the end of 2019 and are not likely to hit devices until 2020. Given the timing of CES in early January and the Mobile World Congress 2020 in February, odds are it means we will see a number of device announcements in early 2020 that will hit shelves in the second half of the year. Many have been wondering when Apple (AAPL) will have a 5G powered iPhone, and based on the various chipset and network comments, odds are the first time we’ll hear about such a device is September-October 2020. 

If history is to be repeated, we are likely to see something similar to what we saw with the first 3G and 4G handsets. By that, we mean a poor consumer experience at least until the 5G networks are truly national in scale and the chipsets become more efficient. One of the issues with each additional layer of mobile technology is it requires additional radio frequency (RF) chips, which in turn not only consume more power but also present internal design issues that out of the gate could limit the size of the battery. Generally speaking, early versions of these new smartphones tend to have less than desirable up-times. This is another reason to think Apple will not be one of those out of the gate 5G smartphone companies, but rather it will repeat its past strategy of bringing its product to market at the tipping point for the chipsets and network deployments. 

Circling back to our Nokia shares, while there are just over a handful of 5G smartphones that have been announced, some of which are expected to become available later this year, over the coming 18 months we will see a far greater number of 5G devices. This should drive Nokia’s high margin, IP licensing business in the coming quarters. As this occurs, Nokia’s mobile infrastructure should continue to benefit from the growing number of 5G networks being built out, not only here in the US but elsewhere as well.

  • Our long-term price target on Disruptive Innovator leader Nokia (NOK) shares remains $8.50

 

Universal Display shares get lit up

Last week I previewed the upcoming earnings report from Select List resident Universal Display (OLED) and following that news the shares were off with a bang! Universal posted earnings of $0.40 per share, $0.08 per share better than the consensus expectations, on revenue that matched the Wall Street consensus of $70 million. Considering the tone of the smartphone market, I view the company’s quarterly results as “not as bad a feared” and, no surprise, the guidance reflects the continued adoption of organic light-emitting displays across a growing number of devices and vendors. For the current year, Universal has guided revenue to $325 million-$350 million, which is likely to be a step function higher as we move through the coming quarters reflecting the traditional year-end debut of new smartphones, TVs and other devices.

Longer-term, we know Apple (AAPL) and others are looking to migrate more of their product portfolios to organic light-emitting diode displays. This shift will drive capacity increases in the coming several quarters — and recent reports on China’s next round of display investing seems to confirm this happening per its latest Five-Year Plan. As we have seen in the past, this can lead to periods of oversupply and pricing issues for the displays, but the longer-term path as witnessed with light-emitting diodes (LEDs) is one of greater adoption. 

As display pricing improves as capacity grows, new applications for the technology tend to arise. Remember that while we are focused on smartphones and TVs in the near-term, other applications include automotive lighting and general lighting. Again, just like we saw with LEDs.

  • We will continue to be long-term shareholders with Disruptive Innovator Select List resident Universal Display (OLED). Given the improving outlooks, our near-term price target for OLED shares is getting lifted to $150 from $125, and I will revisit that target as we move through the balance of 2019.

 

Tematica Options+

It would have been wonderful to have been long Universal Display (OLED) calls, but again given what we’ve heard in recent weeks about the tone of the smartphone market, its results were far more “not as bad as feared” and I suspect in the short-term drove a fair amount of short covering. I still like the long-term prospects for the adoption of the technology, and it’s something to watch as adoption heats up.

By comparison, after months of what seemed like modest forward progress coming out of Mobile World Congress, the pace of 5G is about to get into gear from both a device and network perspective. As we move through 2019, that pace is poised to accelerate even further, which should bring favorable operating leverage to both businesses tucked inside Nokia.

For that reason, I am adding the Nokia Corp. (NOK) December 2019 7.00 calls (NOK191220C0000700) that closed last night at 0.38 to the Options+ Select List. The duration should capture that expected swell in 5G activity, and as we move through the coming months, I’ll consider a layered strategy that could include adding 2020 calls to the mix. Given the time span, we’ll set a wider stop loss berth than usual at 0.20.

 

 

Verizon’s 5G in 30 US cities by end of 2019

Verizon’s 5G in 30 US cities by end of 2019

As we enter Mobile World Congress 2019, arguably the mobile event of the year, 5G network and device launch details are coming into greater focus. Verizon is taking the early lead in the US staking out 5G to 30 cities in the US by the end of 2019. Of course, 30 cities is hardly national coverage, which means a continued deployment for this aspect of our Digital Infrastructure investing theme well into 2020 at least for the US if not into 2021. Factor in the competitive response from AT&T and the soon to be combined T-Mobile USA and Sprint, and it means the likely tipping point for 5G is looking increasingly like the second half of 2020. From an iPhone perspective, even though Samsung and Motorola have announced they will have devices ready by mid-2019,  this 5G network timetable means we should not be expecting any 5G news from Apple this year, but rather its annual iPhone event in September-October of 2020.

Verizon on Thursday said it’s working on deploying 5G to some extent in 30 U.S. cities by the end of 2019, another hint that the technology won’t appear in iPhones until 2020.

The first parts of Verizon’s 5G network should be up by mid-2019 though, since the carrier is the exclusive launch partner for the Samsung Galaxy S10 5G.

AT&T and T-Mobile are also working on 5G deployments. Neither carrier is expected to get very far by the end of 2019 however, owing to partly to lags in equipment. There are also relatively few 5G-ready devices on the market, offering little incentive to speed up.

Multiple reports have pointed to Apple waiting until 2020 to ship 5G-capable iPhones. The company’s preferred modem maker, Intel, is unlikely to have a 5G chip ready until that timeframe.

Source: Verizon says 5G coming to 30 US cities by end of 2019

Weekly Issue: Verizon is bulls up on 5G, paving the way for a Disruptive Innovator Leader position

Weekly Issue: Verizon is bulls up on 5G, paving the way for a Disruptive Innovator Leader position

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
  • We are issuing a Buy on and adding the Nokia Corp. (NOK) April 2019 call options (NOK190208C00006500) that closed last night at 0.30 with a stop loss of 0.15 to our options playbook this week.
  • Treading carefully after stopping out of our Del Frisco’s call option

 

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.

 

Tematica Options+

The positive developments associated with Disruptive Innovator leader Nokia outlined above strongly suggest the company will deliver an upbeat December quarter earnings report, and will likely guide at least if line, if not higher, for 2019 given the accelerating 5G deployments and improving competitive landscape. That’s why we are adding the Nokia Corp. (NOK) April 2019 call options (NOK190208C00006500) that closed last night at 0.30 to our options playbook this week.

Not only does the timing on these calls capture this Thursday’s earnings report, but it also includes the next major mobile industry conference, the 2019 Mobile World Congress (MWC) that will be held in Barcelona from Feb. 25-28. Historically, during times of new mobile technology rollouts, MWC has been a hotbed of announcements. As we stand on the cusp of commercial 5G network deployments, odds are high that history will once again repeat itself.

While signs are bullish for 5G and Nokia, we as investors will want to limit our downside, which is why I’m setting a stop loss at 0.15 for this position.

 

Treading carefully after stopping out of our Del Frisco’s call option

On the housekeeping front, last night we were stopped out of our Del Frisco’s Restaurant Group call option. With the company evaluating its strategic options, we’ll carefully look to revisit a call option position in this company. This extra sense of caution follows the 20+% drop in GameStop (GME) shares following its Board’s decision to forego being taken private by private equity investors and remain both public and independent.

I would note that GameStop is hitting the headwind of our Digital Lifestyle theme as gamers increasingly shed physical formats over downloading games to their devices and consoles. As if that weren’t enough, I’m hearing reports that Apple, Google (GOOGL), Amazon (AMZN) and Microsoft (MSFT) are eyeing a streaming game service similar to what Thematic Leader Netflix (NFLX) has done for TV and movie content. I see this as another potential nail in the GameStop coffin, which means GME shares are one to avoid… at least in a long position.

 

 

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.

 

 

 

Tematica Investing: Thematic Tailwinds for 2019 and Scaling into AXON

Tematica Investing: Thematic Tailwinds for 2019 and Scaling into AXON

 

Key Points Inside this Issue:

Last Friday’s favorable December Employment Report showed the domestic economy is not falling off a cliff and comments by Fed Chair Jay Powell reflected that the central bank will be patient with monetary policy as it watches how the economy performs. Those two things kicked the market off on its most recent three-day winning streak as of last night’s close. In many ways, Powell gave the market what it was looking for when he shared the Fed will remain data dependent when it looks at the economy and its next step with monetary policy.

Taking a few steps back, we’ve all experienced the market volatility over the last several weeks as it contends with a host of issues that we here at Tematica have laid out through much of the December quarter. These include:

  • U.S.-China trade issues
  • The slowing economy
  • A Fed that could boost rates twice in 2019 and continues to unwind its balance sheet
  • Brexit and political uncertainty in the Eurozone
  • And more recently the government shutdown.

These factors have led investors to question growth prospects for the global as well as the domestic economy and earnings in 2019.

Powell’s comments potentially take one of those issues off the table at least in the short-term. If the economy continues to deliver job creation as we saw in December, with some of the best year-over-year wage gains we’ve seen in years, before too long the Fed-related conversation could very well turn from two rate hikes to three.

Currently, that isn’t what the market is expecting.

The reason it isn’t is that outside of the December jobs report, data from ISM and IHS Markit continued to show a decelerating global and U.S. economy. With new orders and backlog levels falling, as well as pricing-related data, it likely means we won’t see a pronounced pickup in the January data. The JPMorgan Global Composite Output Index for December delivered its lowest reading since September 2016 due principally to the slowdown in the eurozone. Rates of expansion slowed in Germany (66-month low) and Spain (three-month low), while Italy stagnated. China, the UK, and Brazil all saw modest growth accelerations.

 

Despite the month over month declines in the December data for the US, it was the best performer on a relative basis even though the IHS Markit Composite PMI reading for the month hit a 15-month low. A more sobering view was shared by Chris Williamson, Chief Business Economist at IHS Markit who said:

“Manufacturers reported a weakened pace of expansion at the end of 2018, and grew less upbeat about prospects for 2019. Output and order books grew at the slowest rates for over a year and optimism about the outlook slumped to its gloomiest for over two years.”

That should give the Fed some room to hold off boosting rates, but it also confirms the economy is decelerating, which will likely have revenue and earnings guidance repercussions in the upcoming December-quarter earnings season.

There are several catalysts that could drive both the economy and the stock market higher in the coming months. These include a “good deal” resolution to the U.S.-China trade situation and forward movement in Washington on infrastructure spending. This week, the US and China have met on trade and it appears those conversations have paved the way for further discussions in the coming weeks. A modest positive that has helped drive the stock market higher this week, but thus far concrete details remain scant.

Such details are not likely to emerge for at least several weeks, which means the next major catalyst for the stock market will be the upcoming December quarter earnings season that begins in nine trading days.

 

Earnings expectations are being revised lower

Facing a number of risks and uncertainties over the last several weeks, investors have once again questioned growth prospects for both the economy and earnings growth for 2019. The following two charts – one of the Citibank Economic Surprise Index and one showing the aggregate profit margin for the S&P 500 companies – depict what investors are grappling with weaker than expected economic data at a time when corporate operating margins have hit the highest levels in over 20 years.

While expectations for growth in both the domestic economy and earnings for the S&P 500 have come in compared to forecasts from just a few months ago, the current view per The Wall Street Journal’s Economic Forecasting Survey calls for 2019 GDP near 2.3% (down from 3.0% in 2018) with the S&P 500 group of companies growing their collective EPS by 7.4% year over year in 2019.

 

Here’s the thing, in recent weeks, analysts lowered their earnings estimates for companies in the S&P 500 for the December quarter by roughly 4% to $40.93. The Q4 bottom-up EPS estimate (which is an aggregation of the median EPS estimates of all the companies in the index) dropped by 4.5% to $40.63. In the chart below, you can see this means quarter over quarter, December quarter earnings are expected to drop breaking the typical pattern of earnings growth into the last quarter of the year. What you can’t see is that marks the largest cut to quarterly S&P 500 EPS estimates in over a year.

 

 

Getting back to that 7.4% rate of earnings growth that is currently forecasted for 2019, I’d call out that it too has been revised down from 9% earlier in the December quarter. That new earnings forecast is a far cry from 21.7% in 2018, which was in part fueled by a stronger economy as well as the benefits of tax reform that was passed in late 2017. As we all know, there that was a one-time bump to corporate bottom lines that will not be repeated this year or in subsequent ones. The conundrum that investors are facing is with the market barometer that is the S&P 500 currently trading at 15.9x consensus 2018 EPS of $161.54, the factors listed above have investors asking what the right market multiple based on 2019’s consensus EPS of $173.45 should be?

And while most investors don’t “buy the market,” its valuation and earnings growth are a yardstick by which investors judge individual stocks.

 

Thematic tailwinds will continue to drive profits and stock prices

One of the key principles to valuing stocks is that companies delivering stronger EPS growth warrant a premium valuation. Of course, in today’s stock buyback rampant world, that means ferreting out those companies that are growing their net income. My preference has been to zero in on what is going on with a company’s operating profit and operating margins given that their vector and velocity are the prime drivers of earnings. That was especially needed last year given the widespread bottom-line benefits of tax reform.

At the heart of it, the question is what is driving the business?

As I’ve shared before, sector classifications don’t speak to that as they are a grouping of companies by certain characteristics rather than the catalysts that are driving their businesses. As we’ve seen before, some companies, such as Amazon (AMZN) or Apple (AAPL) capitalize on those catalysts, while others fail to do so in a timely manner if at all. Sears (SHLD), JC Penney (JCP) are easy call outs, but so are Toys R Us, Bon-Ton Stores, Sports Authority, Blue Apron (APRN), and Snap (SNAP) to name just over a handful.

Very different, and we can see the difference in comparing revenue and profit growth as well as stock prices. The ones that are performing are responding to the changing landscapes across the economic, demographic, psychographic, technological, regulatory and other playing fields they face. In short, they are riding the thematic tailwinds that we here at Tematica have identified. As a reminder those themes are:

 

As we move into 2019, I continue to see the tailwinds associated with those themes continuing to blow hard. Despite all the vain attempts to fight it temporarily, there is no slowing down the aging process. Consumers continue to flock to better for you alternatives, and as you’ll see below that has led Thematic Leader Chipotle Mexican Grill (CMG) to bring a new offering to market.

As we saw this past holiday shopping season, consumers are flocking more and more to digital shopping while hours spent streaming content continue to thwart broadcast TV and the box office. This year 5G networks and devices will become a reality as AT&T (T), Verizon (VZ) and others launch those commercial networks. The legalization of cannabis continues, and consumers continue to consume chocolate, alcohol and other Guilty Pleasures.

Whether you are Marriott International (MAR), Facebook (FB), British Airways or the Bridgeport School System, cyber threats continue to grow and as we saw last night during the presidential address and Democratic response, border security be it through a wall, technology or other means is a pain point that needs to be addressed. While the last two monthly Employment Reports have shown some of the best wage gains in years, Middle-class Squeeze consumers continue to face a combination of higher debt and interest rates as well as rising healthcare costs and the need to save for their golden years that will weigh on the ability to spend.

Like any set of winds, there will be times when some blow harder than others. For example, as we peer into the coming year the launch of 5G networks and gigabit ethernet will likely see the Digital Infrastructure tailwind accelerate in the first half of the year as network and data center operators utilize the services of companies like Thematic Leader Dycom Industries (DY) to build the physical networks. Some tailwinds, such as those associated with Aging of the Population, Clean Living and Middle-class Squeeze are likely to be more persistent over the coming year. Other tailwinds will gust hard at times almost seemingly out of nowhere reminding that they have been there all along. Given the nature of high profile cyber attacks and other threats, that’s likely to once again be the case with Safety & Security.

The bottom line is this – the impact to be had of the tailwinds associated with our 10 investment themes will continue to be felt in 2019. They will continue to influence consumer and business behavior, altering the playing field and forcing companies to either respond or not. The ones that are capitalizing on that changing playing field and are delivering pronounced profit growth are the ones investors should be focusing on.

 

TEMATICA INVESTING 

Scaling into AAXN, and updates on NFLX, CMG, and DFRG

As I discussed above, the December quarter was one of the most challenging periods for the stock market in some time. Even though we are just over a handful of days into 2019, we’re seeing the thematic tailwinds blow again on the Thematic Leaders with 9 of the 11 positions ahead of the S&P 500. Yes, we’re looking pretty good so far but it’s too early in the year to start patting our backs, especially with the upcoming earnings season. Odds are Apple’s (AAPL) negative preannouncement last week won’t be the only sign of misery to be had, and that’s why I’m keeping the ProShares Short S&P 500 ETF (SH) active for the time being. As I shared with you last week, while Apple and others are contending with a maturing smartphone market, I continue to like the long-term Digital Lifestyle aspects as it moves into streaming content and subscription-related businesses.

Of those 9 companies that are ahead of the S&P 500, as you can see in the table above, there are several that are significantly outperforming the market in the brief time that is 2019. These include Netflix (NFLX) shares, Axon Enterprises (AAXN), and Chipotle Mexican Grill (CMG)  as well as Del Frisco’s (DFRG).

After falling just over 28% in the December quarter as investors gave up on the FANG stocks, as of last night’s market close Netflix shares are up 20% so far for the new year. Spurring them along have been favorable comments and a few upgrades from the likes of Piper Jaffray, Barclays, Sun Trust, and several other investment banks. From my perspective, even though Netflix will face a more competitive landscape as AT&T (T), Disney (DIS), Hulu, Amazon (AMZN), Google (GOOGL), Facebook (FB), and Apple (AAPL), it has a substantial lead in the original content race over the likes of Facebook, Apple, Google and Amazon.

Candidly, only AT&T given its acquisition of Time Warner, and Disney, especially once it formally acquires with the movie, TV and other content from 21stCentury Fox (FOXA), will be streaming content contenders in the near term. And Disney is starting from scratch while AT&T lags meaningfully behind Netflix in terms of not only overall subscribers but domestic ones as well. For now, the digital streaming horse to play remains Netflix, especially as it brings more content to its service for both the US and international markets, which should drive its global subscriber base higher.

 

New bowls at Chipotle signal the Big Fix continues

Since its beginnings, Chipotle has been at the forefront of our Clean Living investing theme, but last week it took another step to attract those who are aiming to eat healthier when it introduced a line of Lifestyle Bowls. These included Keto, Paleo, Whole30, and Double Protein versions are only available through the company’s mobile app and the Chipotle website. Clearly, the new management team that arrived last year understands the powerful tailwind associated with our Digital Lifestyle investing theme. More on those new bowls can be found here, and we expect to hear more on the management team’s Big Fix initiatives when the company presents at the ICR Conference on Jan. 15.

 

Adding to Axon Enterprises as EPS expectations move higher

When we added shares of Axon Enterprises to the Thematic Leaders for the Safety & Security slot, we noted the company’s long reach into US police departments and other venues that should drive adoption of its newer Taser units but more importantly its body cameras and digital storage businesses. In the company’s November earnings report we saw that positive impact as its Axon Cloud revenue rose 47% year over year to $24 million, roughly $24 million or 23% of revenue vs. 18% in the year-ago quarter. Even better, the gross margin associated with that business has been running in the mid 70% range over the last few quarters, well above the corporate gross margin average of 36%-37%. Over the last 90 days, we’ve seen Wall Street boost its EPS forecasts for the company to $0.77 for 2018, up from $0.52, and to $0.92 for 2019 up from $0.73.

Even though we AAXN shares are on a roll thus far in 2019, the position is still in the red since joining the Thematic Leaders. Against the favorable tailwind of our Safety & Security investing theme and rising EPS expectations, we will scale into AAXN shares at current levels, which will drop our cost basis to around $61 from just under $73. Our $90 price target remains intact.

  • We are scaling into shares of Safety & Security Thematic Leader Axon Enterprises (AXON) at current levels, which will dramatically improve our cost basis. Our $90 price target remains intact.

 

Del Frisco’s shares jump on takeout speculation

Over the last few weeks, there has a sizable rebound in the shares of high-end restaurant name Del Frisco’s Restaurant Group. Ahead of the year-end 2018 holidays, the company’s board of directors was the recipient of activist investor action from Engaged Capital. During the holiday weeks, the company shared it has hired investment firm Piper Jaffray to “review and consider a full range of options focused on maximizing shareholder value, including a possible sale of the Company or any of its dining concepts.”

In other words, Del Frisco’s is putting itself in play. Often this can result in a company being taken out either by strategic investors, private equity or a combination of the two. There is also the chance a company going through this process is not acquired due primarily to a mismatch between the potential buyer(s) and the board on price as well as underlying financing.

From my perspective, 2018 was a challenging year for Del Frisco’s as it repositioned its branded portfolio. This included the sale of Sullivan’s Steakhouse and the acquisition of Barteca Restaurant Group, the parent of both Bartaco and Barcelona restaurants.

Transitions such as these can be challenging, and in some cases, the benefits of the transformation may take longer to emerge than planned. That said, given the data we’ve discussed previously on the recession-resistant nature of high-end dining, such as at Del Frisco’s core Double Eagle Steakhouse and Grille, we do think the company would be a feather in the cap for another restaurant group. As we noted when we added DFRG shares to the Thematic Leaders, there are very few standalone public steakhouse companies left — the vast majority of them have been scooped up by names such as Landry’s or Darden Restaurants (DRI).

From a fundamental perspective, the reasons why we are bullish on Del Frisco’s are the same ones that make it a takeout candidate. While we wait and see what emerges on the bid front, I’ll be looking over other positions to fill DFRG’s slot on the Thematic Leaders should a viable bid emerge.  Given the company’s restaurant portfolio, the continued spending on high-end dining and its recession-resistant nature, odds are rather high of that happening.

  • Our price target on Del Frisco’s Restaurant Group (DFRG) remains $14.

 

 

Tematica Options+: A Thematic Look at 2019 and a New Option Trade

Tematica Options+: A Thematic Look at 2019 and a New Option Trade

 

We’re kicking off 2019 trying something different with Tematica Investing and Tematica Options+. Instead of sending two separate reports each week and asking you to flip it back and forth to weave it all together, we’re going to try and combine it all together for you in a single report. On top of that, we’re going to lay the groundwork upfront on what’s going on from a market and macroeconomic standpoint, something we call Context and Perspectives. You’ll see a truncated version of this report posted on the Tematica Investing section of our website without the Options+ content, but rest assured that it’s the same as what’s included in this report. If you’re simply looking for the option trade for the week, which we do have this week, you can scroll down to the bottom on a new call position with Del Frisco’s (DFRG).

We hope this simplifies things for you. If you want to take a moment and let me know what you think, just email me at cversace@tematicaresearch.com . I always love to hear from subscribers!

 

Key Points Inside this Issue:

 

 

CONTEXT AND PERSPECTIVES

Last Friday’s favorable December Employment Report showed the domestic economy is not falling off a cliff and comments by Fed Chair Jay Powell reflected that the central bank will be patient with monetary policy as it watches how the economy performs. Those two things kicked the market off on its most recent three-day winning streak as of last night’s close. In many ways, Powell gave the market what it was looking for when he shared the Fed will remain data dependent when it looks at the economy and its next step with monetary policy.

Taking a few steps back, we’ve all experienced the market volatility over the last several weeks as it contends with a host of issues that we here at Tematica have laid out through much of the December quarter. These include:

  • U.S.-China trade issues
  • The slowing economy
  • A Fed that could boost rates twice in 2019 and continues to unwind its balance sheet
  • Brexit and political uncertainty in the Eurozone
  • And more recently the government shutdown.

These factors have led investors to question growth prospects for the global as well as the domestic economy and earnings in 2019.

Powell’s comments potentially take one of those issues off the table at least in the short-term. If the economy continues to deliver job creation as we saw in December, with some of the best year-over-year wage gains we’ve seen in years, before too long the Fed-related conversation could very well turn from two rate hikes to three.

Currently, that isn’t what the market is expecting.

The reason it isn’t is that outside of the December jobs report, data from ISM and IHS Markit continued to show a decelerating global and U.S. economy. With new orders and backlog levels falling, as well as pricing-related data, it likely means we won’t see a pronounced pickup in the January data. The JPMorgan Global Composite Output Index for December delivered its lowest reading since September 2016 due principally to the slowdown in the eurozone. Rates of expansion slowed in Germany (66-month low) and Spain (three-month low), while Italy stagnated. China, the UK, and Brazil all saw modest growth accelerations.

 

Despite the month over month declines in the December data for the US, it was the best performer on a relative basis even though the IHS Markit Composite PMI reading for the month hit a 15-month low. A more sobering view was shared by Chris Williamson, Chief Business Economist at IHS Markit who said:

“Manufacturers reported a weakened pace of expansion at the end of 2018, and grew less upbeat about prospects for 2019. Output and order books grew at the slowest rates for over a year and optimism about the outlook slumped to its gloomiest for over two years.”

That should give the Fed some room to hold off boosting rates, but it also confirms the economy is decelerating, which will likely have revenue and earnings guidance repercussions in the upcoming December-quarter earnings season.

There are several catalysts that could drive both the economy and the stock market higher in the coming months. These include a “good deal” resolution to the U.S.-China trade situation and forward movement in Washington on infrastructure spending. This week, the US and China have met on trade and it appears those conversations have paved the way for further discussions in the coming weeks. A modest positive that has helped drive the stock market higher this week, but thus far concrete details remain scant.

Such details are not likely to emerge for at least several weeks, which means the next major catalyst for the stock market will be the upcoming December quarter earnings season that begins in nine trading days.

 

Earnings expectations are being revised lower

Facing a number of risks and uncertainties over the last several weeks, investors have once again questioned growth prospects for both the economy and earnings growth for 2019. The following two charts – one of the Citibank Economic Surprise Index and one showing the aggregate profit margin for the S&P 500 companies – depict what investors are grappling with weaker than expected economic data at a time when corporate operating margins have hit the highest levels in over 20 years.

While expectations for growth in both the domestic economy and earnings for the S&P 500 have come in compared to forecasts from just a few months ago, the current view per The Wall Street Journal’s Economic Forecasting Survey calls for 2019 GDP near 2.3% (down from 3.0% in 2018) with the S&P 500 group of companies growing their collective EPS by 7.4% year over year in 2019.

 

Here’s the thing, in recent weeks, analysts lowered their earnings estimates for companies in the S&P 500 for the December quarter by roughly 4% to $40.93. The Q4 bottom-up EPS estimate (which is an aggregation of the median EPS estimates of all the companies in the index) dropped by 4.5% to $40.63. In the chart below, you can see this means quarter over quarter, December quarter earnings are expected to drop breaking the typical pattern of earnings growth into the last quarter of the year. What you can’t see is that marks the largest cut to quarterly S&P 500 EPS estimates in over a year.

 

 

Getting back to that 7.4% rate of earnings growth that is currently forecasted for 2019, I’d call out that it too has been revised down from 9% earlier in the December quarter. That new earnings forecast is a far cry from 21.7% in 2018, which was in part fueled by a stronger economy as well as the benefits of tax reform that was passed in late 2017. As we all know, there that was a one-time bump to corporate bottom lines that will not be repeated this year or in subsequent ones. The conundrum that investors are facing is with the market barometer that is the S&P 500 currently trading at 15.9x consensus 2018 EPS of $161.54, the factors listed above have investors asking what the right market multiple based on 2019’s consensus EPS of $173.45 should be?

And while most investors don’t “buy the market,” its valuation and earnings growth are a yardstick by which investors judge individual stocks.

 

Thematic tailwinds will continue to drive profits and stock prices

One of the key principles to valuing stocks is that companies delivering stronger EPS growth warrant a premium valuation. Of course, in today’s stock buyback rampant world, that means ferreting out those companies that are growing their net income. My preference has been to zero in on what is going on with a company’s operating profit and operating margins given that their vector and velocity are the prime drivers of earnings. That was especially needed last year given the widespread bottom-line benefits of tax reform.

At the heart of it, the question is what is driving the business?

As I’ve shared before, sector classifications don’t speak to that as they are a grouping of companies by certain characteristics rather than the catalysts that are driving their businesses. As we’ve seen before, some companies, such as Amazon (AMZN) or Apple (AAPL) capitalize on those catalysts, while others fail to do so in a timely manner if at all. Sears (SHLD), JC Penney (JCP) are easy call outs, but so are Toys R Us, Bon-Ton Stores, Sports Authority, Blue Apron (APRN), and Snap (SNAP) to name just over a handful.

Very different, and we can see the difference in comparing revenue and profit growth as well as stock prices. The ones that are performing are responding to the changing landscapes across the economic, demographic, psychographic, technological, regulatory and other playing fields they face. In short, they are riding the thematic tailwinds that we here at Tematica have identified. As a reminder those themes are:

 

As we move into 2019, I continue to see the tailwinds associated with those themes continuing to blow hard. Despite all the vain attempts to fight it temporarily, there is no slowing down the aging process. Consumers continue to flock to better for you alternatives, and as you’ll see below that has led Thematic Leader Chipotle Mexican Grill (CMG) to bring a new offering to market.

As we saw this past holiday shopping season, consumers are flocking more and more to digital shopping while hours spent streaming content continue to thwart broadcast TV and the box office. This year 5G networks and devices will become a reality as AT&T (T), Verizon (VZ) and others launch those commercial networks. The legalization of cannabis continues, and consumers continue to consume chocolate, alcohol and other Guilty Pleasures.

Whether you are Marriott International (MAR), Facebook (FB), British Airways or the Bridgeport School System, cyber threats continue to grow and as we saw last night during the presidential address and Democratic response, border security be it through a wall, technology or other means is a pain point that needs to be addressed. While the last two monthly Employment Reports have shown some of the best wage gains in years, Middle-class Squeeze consumers continue to face a combination of higher debt and interest rates as well as rising healthcare costs and the need to save for their golden years that will weigh on the ability to spend.

Like any set of winds, there will be times when some blow harder than others. For example, as we peer into the coming year the launch of 5G networks and gigabit ethernet will likely see the Digital Infrastructure tailwind accelerate in the first half of the year as network and data center operators utilize the services of companies like Thematic Leader Dycom Industries (DY) to build the physical networks. Some tailwinds, such as those associated with Aging of the Population, Clean Living and Middle-class Squeeze are likely to be more persistent over the coming year. Other tailwinds will gust hard at times almost seemingly out of nowhere reminding that they have been there all along. Given the nature of high profile cyber attacks and other threats, that’s likely to once again be the case with Safety & Security.

The bottom line is this – the impact to be had of the tailwinds associated with our 10 investment themes will continue to be felt in 2019. They will continue to influence consumer and business behavior, altering the playing field and forcing companies to either respond or not. The ones that are capitalizing on that changing playing field and are delivering pronounced profit growth are the ones investors should be focusing on.

 

TEMATICA INVESTING 

Scaling into AAXN, and updates on NFLX, CMG, and DFRG

As I discussed above, the December quarter was one of the most challenging periods for the stock market in some time. Even though we are just over a handful of days into 2019, we’re seeing the thematic tailwinds blow again on the Thematic Leaders with 9 of the 11 positions ahead of the S&P 500. Yes, we’re looking pretty good so far but it’s too early in the year to start patting our backs, especially with the upcoming earnings season. Odds are Apple’s (AAPL) negative preannouncement last week won’t be the only sign of misery to be had, and that’s why I’m keeping the ProShares Short S&P 500 ETF (SH) active for the time being. As I shared with you last week, while Apple and others are contending with a maturing smartphone market, I continue to like the long-term Digital Lifestyle aspects as it moves into streaming content and subscription-related businesses.

Of those 9 companies that are ahead of the S&P 500, as you can see in the table above, there are several that are significantly outperforming the market in the brief time that is 2019. These include Netflix (NFLX) shares, Axon Enterprises (AAXN), and Chipotle Mexican Grill (CMG)  as well as Del Frisco’s (DFRG).

After falling just over 28% in the December quarter as investors gave up on the FANG stocks, as of last night’s market close Netflix shares are up 20% so far for the new year. Spurring them along have been favorable comments and a few upgrades from the likes of Piper Jaffray, Barclays, Sun Trust, and several other investment banks. From my perspective, even though Netflix will face a more competitive landscape as AT&T (T), Disney (DIS), Hulu, Amazon (AMZN), Google (GOOGL), Facebook (FB), and Apple (AAPL), it has a substantial lead in the original content race over the likes of Facebook, Apple, Google and Amazon.

Candidly, only AT&T given its acquisition of Time Warner, and Disney, especially once it formally acquires with the movie, TV and other content from 21stCentury Fox (FOXA), will be streaming content contenders in the near term. And Disney is starting from scratch while AT&T lags meaningfully behind Netflix in terms of not only overall subscribers but domestic ones as well. For now, the digital streaming horse to play remains Netflix, especially as it brings more content to its service for both the US and international markets, which should drive its global subscriber base higher.

 

New bowls at Chipotle signal the Big Fix continues

Since its beginnings, Chipotle has been at the forefront of our Clean Living investing theme, but last week it took another step to attract those who are aiming to eat healthier when it introduced a line of Lifestyle Bowls. These included Keto, Paleo, Whole30, and Double Protein versions are only available through the company’s mobile app and the Chipotle website. Clearly, the new management team that arrived last year understands the powerful tailwind associated with our Digital Lifestyle investing theme. More on those new bowls can be found here, and we expect to hear more on the management team’s Big Fix initiatives when the company presents at the ICR Conference on Jan. 15.

 

Adding to Axon Enterprises as EPS expectations move higher

When we added shares of Axon Enterprises to the Thematic Leaders for the Safety & Security slot, we noted the company’s long reach into US police departments and other venues that should drive adoption of its newer Taser units but more importantly its body cameras and digital storage businesses. In the company’s November earnings report we saw that positive impact as its Axon Cloud revenue rose 47% year over year to $24 million, roughly $24 million or 23% of revenue vs. 18% in the year-ago quarter. Even better, the gross margin associated with that business has been running in the mid 70% range over the last few quarters, well above the corporate gross margin average of 36%-37%. Over the last 90 days, we’ve seen Wall Street boost its EPS forecasts for the company to $0.77 for 2018, up from $0.52, and to $0.92 for 2019 up from $0.73.

Even though we AAXN shares are on a roll thus far in 2019, the position is still in the red since joining the Thematic Leaders. Against the favorable tailwind of our Safety & Security investing theme and rising EPS expectations, we will scale into AAXN shares at current levels, which will drop our cost basis to around $61 from just under $73. Our $90 price target remains intact.

  • We are scaling into shares of Safety & Security Thematic Leader Axon Enterprises (AXON) at current levels, which will dramatically improve our cost basis. Our $90 price target remains intact.

 

Del Frisco’s shares jump on takeout speculation

Over the last few weeks, there has a sizable rebound in the shares of high-end restaurant name Del Frisco’s Restaurant Group. Ahead of the year-end 2018 holidays, the company’s board of directors was the recipient of activist investor action from Engaged Capital. During the holiday weeks, the company shared it has hired investment firm Piper Jaffray to “review and consider a full range of options focused on maximizing shareholder value, including a possible sale of the Company or any of its dining concepts.”

In other words, Del Frisco’s is putting itself in play. Often this can result in a company being taken out either by strategic investors, private equity or a combination of the two. There is also the chance a company going through this process is not acquired due primarily to a mismatch between the potential buyer(s) and the board on price as well as underlying financing.

From my perspective, 2018 was a challenging year for Del Frisco’s as it repositioned its branded portfolio. This included the sale of Sullivan’s Steakhouse and the acquisition of Barteca Restaurant Group, the parent of both Bartaco and Barcelona restaurants.

Transitions such as these can be challenging, and in some cases, the benefits of the transformation may take longer to emerge than planned. That said, given the data we’ve discussed previously on the recession-resistant nature of high-end dining, such as at Del Frisco’s core Double Eagle Steakhouse and Grille, we do think the company would be a feather in the cap for another restaurant group. As we noted when we added DFRG shares to the Thematic Leaders, there are very few standalone public steakhouse companies left — the vast majority of them have been scooped up by names such as Landry’s or Darden Restaurants (DRI).

From a fundamental perspective, the reasons why we are bullish on Del Frisco’s are the same ones that make it a takeout candidate. While we wait and see what emerges on the bid front, I’ll be looking over other positions to fill DFRG’s slot on the Thematic Leaders should a viable bid emerge.  Given the company’s restaurant portfolio, the continued spending on high-end dining and its recession-resistant nature, odds are rather high of that happening.

  • Our price target on Del Frisco’s Restaurant Group (DFRG) remains $14.

 

TEMATICA OPTIONS+

Adding a call position on Del Frisco’s Restaurant Group

That combination of solid fundamentals and a prospective takeout bid are prompting me to add a call option position on the shares of Del Frisco’s. Given the nature of the “up for acquisition” process, bidders have to emerge, the company’s advisors and Board have to review the bids, and there could be a second round of bidding. All of this takes time. For that reason, we’re going to go out several months longer than usual with the strike date to June. Given our preference for out of the money calls, that brings us to the June 10.00. calls.

One potential risk with any prospective acquisition play is that a viable bid fails to emerge. It could be a lack of bidders, which in this case is rather unlikely, or it could be because the negotiating parties aren’t able to agree on a transaction price. That has happened in the past, and while it’s likely a low probability in this instance, it is a risk to consider. For that reason, we want to set a rather tight stop loss.

Putting all of these factors together, we are adding the Del Frisco’s Restaurant Group (DFRG) June 2019 10.00 (DFRG190621C00010000) calls that closed last night at 0.47 to the Select List with a stop loss of 0.35

As we gear up for the upcoming earnings season that will kick off in earnest the week of Jan. 21, which currently has more than 250 companies reporting quarterly results and offering a fresh look at 2019, we will continue to keep the ProShares Short S&P 500 Jan 2019 30.00 calls (SH190118C00030000) position intact for now.