Author Archives: Chris Versace, Chief Investment Officer

Earlier this week, we provided a slew of updates as we scaled into the Trade Desk (TTD) position on the Tematica Investing Select List, boosted a few price targets and prepped for Thursday’s earnings from Applied Materials (AMAT).

Normally in these weekly issues of Tematica Investing we tend to focus on our thematic investing framework, but from time to time one particular ingredient to that framework can bubble up and take a commanding presence in the market. In today’s case, we’re referring to the political environment as Washington focuses on tax reform. After months of speculation over tax reform, we now have competing proposals on how to reduce corporate taxes and put more capital in the hands of individual taxpayers.

From an investing perspective, there has been much buildup over what this could mean for both the U.S. economy as well as corporate profits and earnings per share as early as 2018. If you’re thinking this sounds like expectations are likely ahead of themselves, we’re right there with you.

As I shared in this week’s Monday Morning Kickoff, differences between the competing House and Senate tax reform plans have brought a new layer of uncertainty to the market as evidenced by the retreat in major market indices over the last several days. This has been especially true for small-cap stocks as the businesses underneath those companies tend to be primarily U.S.-based, which means changes to tax reform relative to what was expected are bound to cause investors to re-bake the cake that is 2018 forecasts, potentially to the downside. Moreover, potential aspects of tax reform proposals could make it more difficult for small-cap companies to retain or attract talent needed to drive their businesses.

Let’s review WHERE WE ARE WITH TAX REFORM 

We recently received the GOP’s Tax Cuts and Jobs Act, which on its face looks to promote job growth, overhaul and simplify the tax code and reduce taxes. Over the last week, a competing plan from the Senate has emerged that, while it has the same basic framework as it cuts the corporate tax rate to 20%, has several more tax brackets than the House plan, establishes a lower tax rate for pass-through businesses and cuts individual rates.

As one can imagine, there are several differences that include pushing out corporate tax cuts until 2019 and preserving popular tax breaks, such as mortgage interest and medical expenses, and keeps a minimum tax rate of 10% for lower earners. It also removes the state and local tax deduction entirely.

As these competing plans gets parsed and negotiated, the one potential change that will rankle investors is delaying the cut in corporate taxes until 2019 and what that could mean to economic projections, corporate spending and job creation for 2018. The Conference Board is forecasting real GDP to reach 2.5% in 2018, up from 2.2% this year and 1.5% in 2016, despite there being headwinds associated with the dollar’s recent rise as well as prospects for higher interest rates year over year. While there will be some debate over the impact of pushing out tax cuts, odds are at a minimum it increases the headwinds to growth to be had in 2018.

As Larry Kudlow pointed out over the weekend, there are several risks to pushing out corporate tax cuts, including a greater use of tax avoidance and sheltering strategies next year and potential revenue loss as the tax delay could “deter foreign companies from coming to the United States.”

What I like about Kudlow is he points out there are issues with tax plans from both the House and Senate, but he also goes on to say that “differences between the two plans should narrow in conference.” Meaning the current proposals are a work in progress.

Kudlow is not alone, but there are others, like the pro-growth, limited-government Club for Growth, that are raising red flags that could make the closing of differences not quite so easy. For example, the Club for Growth argues the provision relating to “pass-throughs,” such as small and family-owned businesses, is misleading. While the first 30% of their income would be taxed at 25%, the remaining 70% would be taxed at as much as 45.6%.

Even the blended rate equates to at least 35%, which the club points out “means no tax cut at all for most small business and family-owned companies.” Let’s remember that new businesses, which tend to start out as pass-throughs, “account for virtually all new job creation in the U.S. and nearly 20% of gross job creation,” according to a 2015 study by the Kauffman Foundation.

It seems fairly logical that if we want to spur job creation and grow the taxable base, the pass-through item will need to be revisited. If not, it means potentially recalculating consumer spending expectations for 2018 and beyond, and as we know, consumer spending is directly or indirectly responsible for roughly two-thirds of the domestic economy.

Another provision that has gone largely ignored, yet will impact the ability of corporations to retain good talent, is the provision that imposes retroactive taxes on “nonqualified deferred compensation” (NQDC) plans. For more on the ins and out of these plans, here’s a good overview.

As reported by Bloomberg, the issue is this:

“The initial version of the Tax Cuts and Jobs Act (H.R. 1) would have severely curtailed the use of nonqualified deferred compensation plans by lumping that compensation into an employee’s taxable wages. The bill also would have expanded these packages to include stock options and stock appreciation rights, making them all subject to wage taxes. 

“Under the amendment to the House bill, nonqualified deferred compensation packages — including future commission payments and stock options — will continue to follow current law in tax code Section 409A and will be subject to tax only when compensation is cashed out.” 

Turning to the Senate bill, in its current form it would tax money set aside in nonqualified deferred compensation plans immediately compared to today, as explained by Fidelity, “you don’t pay income taxes on deferred compensation until you receive those funds.”

If the policy change in the Senate proposal finds its way into the final tax reform bill, the growing consensus is it “could force many U.S. companies to stop offering these types of programs,” and that calls into question how companies would retain key executives and other talent. While it could be argued that larger companies may possibly weather the storm better, this would appear to be another headwind for smaller companies that more often tend to rely on less than a handful of key people to drive the company and execute its vision.

Where do we go from here? 

According to House Speaker Paul Ryan, the Ways and Means Committee has approved the Tax Cuts and Jobs Act and now the bill will head to the House floor for a vote later this week. Let’s remember the bill must not only pass the House, but also the Senate, and that likely means there will be much back and forth to be had in the coming days.

With no identifiable market catalyst on the horizon, odds are stocks, especially small-cap ones, will be range-bound until we have clarity one way or another on tax reform and its timing. While the market waits, we’ll continue to look for well-positioned companies that meet our investment mandate as well as parse data points using our time-tested and trusty thematic lens.

KEY POINTS FROM THIS POST:

• As Amplify falls out of the slipstream of our Food with Integrity investing tailwind, we are issuing a Sell rating on BETR shares and removing them from the Tematica Research Select List.
• Our price target on Apple (AAPL) shares remains $200, but as we move through the next several weeks, we will assess iPhone demand data for potential upside.
• Our price target for Costco Wholesale (COST) shares is $185, which is in line with recent peak price-to-earnings (P/E) and dividend yield multiples over the last few years when applied to expected 2017 earnings prospects.
• Our $150 price target for International Flavors & Fragrances (IFF) is under review with an upward bias.
• We are increasing our price target on Universal Display (OLED) to $200 from $175, which keeps our Buy rating intact.

Over the last several trading days, we’ve had a number of companies on the Tematica Select List report their quarterly earnings. This has us focusing today’s issue on recapping what was said, and sharing our views as well as making any price target adjustments.

Earlier this week, we added a new position to the Select List – Trade Desk (TTD), which we see as riding both our Connected Society and Content is King investing themes. If you missed the special alert, you can find it here. Our price target is $80, and we expect to have more on this following the company’s earnings report this Thursday (Nov. 9^th). As we shared in the alert adding TTD shares, while we don’t expect any post-earnings weakness, our strategy will be to use any such development to improve our cost basis as advertising increasingly accelerates toward digital platforms.

You’ll notice that over the last few weeks, we’ve added both Apple and now Trade Desk to the Select List. In the next few weeks, we’ll be looking to position the list for 2018, and that likely means we will do some proactive pruning, shedding those companies that have underperformed significantly or whose tailwinds aren’t blowing as hard. As we do this, we’ll also look to reshape our Contender List as well.

Now, let’s break down those earnings reports and other key items from the last few days…

Exiting Amplify Snacks

Following the second quarter in a row of lackluster quarterly results last night — results that included missing expectations as well as guiding the coming quarters below expectations — we are removing Amplify Snacks (BETR) shares from the Select List and exiting the position. While revenue for the September quarter rose roughly 40% year over year, it didn’t cross the bar that was consensus expectations. Weighing on the company’s performance, however, was the tumble in margins, which reflected the launch of newer snack products as well as increased promotional activity.

Aside from the company’s performance, we are also seeing what looks to be a far more competitive snacking landscape. At the recent 2017 National Association of Convenience Stores Show in Chicago, protein was the snacking buzz word. New products from ConAgra (NYSE) include a Slim Jim Premium line, while Kraft Heinz (NASDAQ) had protein focus with Oscar Mayer meat trays, Philadelphia Bagel & Cream Cheese Dips, Planters NUT-rition mixes and coated Crunchers Nuts. Kellogg (K) highlighted Special K trail mixes and Protein/Nourish Bites. We see these companies and others looking to tap into the paleo and keto snacking wave, and in our view, this helps explain the kicked up use of incentives by Amplify.

• As Amplify falls out of the slipstream of our Food with Integrity investing tailwind, we are issuing a Sell rating on BETR shares and removing them from the Tematica Research Select List.

Apple — Beats Expectations

Last week Connected Society investment theme company Apple (AAPL) delivered better-than-expected earnings and revenue for the third quarter. Management also guided the current quarter in line with expectations, which drove the shares higher. On the earnings call, CEO Tim Cook said the production ramp for iPhone X is going well, but noted that Apple can’t predict a supply/demand balance timeframe at this point.

We see that as Apple being Apple — purposely vague. Even so, the key is that despite reports of tepid iPhone 8 demand, Apple did not disappoint with its guidance for the current quarter, which contains mass production of the higher-average- selling-priced iPhone X as well as the arrival of the holiday selling season. Third- party surveys suggest that smartphones will be in high demand this holiday season.

• Our price target on AAPL shares remains $200, but as we move through the next several weeks, we will assess iPhone demand data for potential upside.

Costco Wholesale — Withstanding Amazon

Last week, Costco Wholesale (COST) reported its October sales, which rose 10% year over year with total company same-store sales up 7.5% (5.6% excluding gas and foreign currency) and e-commerce sales up 31% year over year.

In our view, these results confirm Costco’s ability to withstand the “Amazon effect.” We see Cash-strapped Consumers embracing Costco to stretch their disposable dollars while it opens 25 new warehouses in the coming year following the 26 it unveiled over the last 12 months. As a reminder, the company’s high-margin membership fee is a key driver of its bottom line. We also like that Costco management is stepping up its game to counter grocery moves by Amazon (AMZN) and others by partnering with Instacart.

• Our price target for Costco Wholesale (COST) shares is $185, which is in line with recent peak price-to-earnings (P/E) and dividend yield multiples over the last few years when applied to expected 2017 earnings prospects.

International Flavors & Fragrances — Bested the Top and Bottom Line

Earlier this week the Rise & Fall of the Middle Class and Food with Integrity company that is International Flavors & Fragrances (IFF) reported third-quarter 2017 results that bested both top- and bottom-line expectations. The combination of better-than-expected operating performance during the quarter with continued share count shrinkage led IFF to deliver earnings of $1.42 per share vs. the expected $1.37. With the shares bumping up against our $150 price target, we are parsing the company’s outlook and earnings call comments to revisit potential upside to be had in the shares from current levels.

Breaking down the quarter’s revenue, the higher-margin Flavor’s business accounted for 47% of the quarter’s sales and posted 12% sales growth year over year with organic growth benefiting from across the board growth in its products, especially Sweet. We see that as a confirming sign of the shift toward “better for you food” as food and beverage companies look for sugar alternatives. Sales at the Fragrance business (53% of sales, 51% of operating profit) rose 13% year over year (12% on a currency neutral basis). Of note, the segment’s Fine Fragrance business advanced 20% year over year, which included a helping hand from the acquired Fragrance Resources business.

• Our $150 price target for International Flavors & Fragrances (IFF) is under review with an upward bias.

Universal Display — Continues to Pop

Last week, Universal Display smashed third-quarter top- and bottom-line expectation and guided the current quarter ahead of consensus expectations. That beat and raise popped the shares over the last several days. As we only half-joked about over the summer, we are once again boosting our price target to $200 from $175 as we continue to see further upside in the shares as industry capacity ramps for organic light-emitting diode displays. These continued capacity additions should improve display pricing, making it more cost competitive and foster adoption for new applications, such as automotive lighting and eventually general lighting, beyond smartphones and TVs in the coming quarters.

Next week’s earnings report from Applied Materials (AMAT) should offer even further bullish commentary on the organic light emitting diode market.

• We are increasing our price target on Universal Display (OLED) to $200 from $175, which keeps our Buy rating intact.

More earnings on deck this week

This week we’ll get results from several more Select List holdings, including MGM Resorts (MGM), USA Technologies (USAT), Disney (DIS) and newly added Trade Desk (TTD). All of this means, that yes it will once again be another busy week for us here at Tematica. Next week, we have earnings from Applied Materials (AMAT) coming at us, but all in all, it should be a much calmer week… of course, that may depend on what happens with tax reform.