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Weekly Issue: Thematic M&A and Adding Back a Digital Infrastructure Position

Weekly Issue: Thematic M&A and Adding Back a Digital Infrastructure Position

Key points inside this issue

  • Despite the stock market’s year to date gains, concerns remain for December quarter earnings season
  • Thematic M&A was rampant in 2018
  • Our price targets on AMN Healthcare (AMN), Chipotle Mexican Grill (CMG) and Netflix (NFLX) remain $75, $550 and $500, respectively.
  • Putting shares of Guilty Pleasure thematic leader Altria (MO) on watch
  • We are issuing a Buy on and adding back shares of Digital Infrastructure company, USA Technologies (USAT), to the Tematica Select List with a price target of $10.

 

Despite the stock market’s year to date gains, concerns remain for December quarter earnings season

Over the last week, stocks continued to move higher placing all the major domestic stock market averages higher. Quite the turn from what we saw in much of the December quarter that evaporated all of 2018’s gains. Part of the rebound reflects the harsh beating that many stocks received as investors came to grips with the various factors that I’ve been discussing here over the last two months. The down and dirty summation of those factors is this: the global economy continues to slow and it is raising questions over not only GDP prospects for the coming year but also earnings.

Stoking those earnings growth concerns were negative pre-announcements from Apple (AAPL), Samsung, LG, Macy’s (M), Target (TGT) and Kohl’s (KSS) over the last two weeks. That combination points to slower smartphone demand, but I continue to see it picking up in the coming quarters as the Disruptive Innovation that is 5G ripples its way across our Digital Infrastructure and Digital Lifestyle investing themes.  This week we can add Delta Airlines (DAL), Dialog Semiconductor (DLGNF), Nordstrom (JWN), Electronics for Imaging (EFII), Sherwin Williams (SHW) and Ford Motor Company (F) to that list as well as earnings misses from Wells Fargo (WFC), BlackRock (BLK) and others. Not exactly a vote of confidence for the December quarter earnings season.

Adding fuel to the uncertainty, this morning rail company Genesee & Wyoming (GWR) reported traffic volumes for December fell 4.8% year over year. That piles on the limited data we are getting, which included the January reading for the Empire State Manufacturing Survey General Business Conditions Index that fell to 3.9 from 11.5 in December. That drop was led by a deceleration in new orders, inventories, and the number of employees. The survey’s six-month outlook also dropped, falling to 17.8 from 30.6 last month. These data points fit the view that there is a slowdown in manufacturing activity, which has piqued concerns about a broader slowdown in economic activity unfolding in 2019.

On top of that, yesterday Sen. Chuck Grassley said U.S. Trade Representative Robert Lighthizer saw little progress on “structural issues” in last week’s talks with China. These issues include intellectual property, stealing trade secrets, and putting pressure on corporations to share information with the Chinese government and industries. These issues are the very ones I was concerned about in terms of the trade negotiations. With China cutting its growth forecast some days ago to 6% from 6.5% and more data pointing to that economy cooling, there is likely room for the trade talks to include those issues, but my concern remains the ticking timeline until tariffs jump further. If that comes to pass, it would be another headwind to the global economy and corporate earnings for the coming quarters.

Given all of that, I remain concerned with the December quarter earnings season that will kick into gear next week and what it could do for the stock market’s recent rebound. We’ll continue to keep the long position in ProShares Short S&P 500 (SH) in play as we watch and listen to the thematic signals we see. One great thematic signal this week for our Guilty Pleasures investing theme is that Pizza Hut, owned by Yum Brands (YUM) is expanding beer delivery to 300 restaurants across seven states later this month. Amazing to think that only now Pizza Hut is realizing one of the great culinary pairings of Pizza and beer as it looks to offer customer one-stop shopping as well as capture that incremental revenue and profits. Odds are there will be some element of our Digital Lifestyle theme at play, given the push toward mobile orders we are seeing across the restaurant industry. Now to see what beer they offer… hopefully, it will be more than just the big brand beers like Budweiser.

Another signal that points to the bleeding over of our Digital Lifestyle, Disruptive Innovators and Aging of the Population themes is the partnering between Walgreens Boots Alliance (WBA) and Microsoft (MSFT). Over the next several years, the two will research and develop new methods of delivering healthcare services through digital devices, including virtually connecting people with Walgreens stores.

We at Tematica see thematic signals for our 10 investing themes practically everywhere… and that means we will continue using them to build and refine our investing mosaic in the days, weeks and months ahead. As we navigate the next few weeks, we may have a change or two on the Thematic Leaders and a few companies that make it onto the Contender List for when the stock market finds its footing.

 

Thematic M&A was rampant in 2018

Over the last two weeks, we here at Tematica have been reviewing the thematic database of more than 2,400 stocks that we’ve ranked based on their exposure to our 10 investment themes. That was no small project let me tell you, and it was a key initiative for 2018. In looking back over that body of work, I noticed more than a dozen companies that were in the database at the start of last year had been acquired during the second half of 2018. Here’s a short list of what I’m talking about:

As you can see, the acquisition activity was spread across a number of our themes and included both strategic and financial buyers. In each case, the buyer looked to fill a competitive hole be it a product, market or technology. That’s the classic finance take on it, but we know those buyers were looking to solidify their exposure to the thematic tailwinds that are powering their businesses or in some cases expose themselves to another one.

Are we likely to see more thematically based M&A in the coming months?

My view is yes, particularly as the global economy slows and companies look to deliver top and bottom line growth be it on an organic or acquired basis.

Adding back shares of Digital Infrastructure company USA Technologies

Today I am calling shares of mobile payments company, USA Technologies (USAT),  back onto the Tematica Select List following news earlier this week about the results of an internal investigation into its accounting practices. You may recall that last year, USAT shares were a high flyer for the Select List. However, upon learning that the USAT board would conduct an internal investigation into the accounting of certain of its present and past contractual arrangements and its financial reporting controls and would miss filing the company’s 10-K, we smartly jettisoned the shares near $10.25 last September.

We had been trimming the position at higher levels near $14 in the preceding months, but in light of those developments we “got out of Dodge”, so to speak, and did not stick around for the free fall to $3.44 by early December. While we continued to see growing adoption of mobile payments, especially at USAT’s core market of vending machines and unattended retail, we also saw the stock price pain associated with these investigations and potential financial restatements. “No thanks” was my thinking.

The company on Monday announced both the findings of its internal investigation and remedial actions to be implemented by the board. It also shared that it is working to file its 10-K as soon as possible and disclosed the departures of both its chief financial officer (CFO) and chief services officer (CSO). In tandem with those announcements, USAT also shared it is in negotiations for a new CFO.

In terms of the investigation and the planned responses, the company’s Audit Committee found that, for certain transactions, USAT had prematurely recognized revenue and, in some cases, the reported number of connections associated with the transactions under review. The committee went on to recommend the company enhance its internal controls and its compliance and legal functions; expand its public disclosures; and consider appropriate employment actions related to certain employees as well as splitting the roles of chairman and CEO.

These measures, along with the departure of the CFO and CSO, are not surprising, but they do put USAT on the path to restoring investor confidence in its reporting. While this investigation was happening the market for mobile payments continued to be on a tear as companies such as PepsiCo (PEP) inked a new five-year agreement with USAT.

Clearly, there is more work to be completed, and there is the risk that we are re-entering these shares on the early side. However, as we have seen in the past, as these clouds lift investors will focus on the tailwinds of the business, which in this case are centered on mobile payments and are improving. Therefore, we will resume ownership of USAT shares and look to scale on potential stock price weakness when the company formally restates its revenue and other key metrics. Better a bit early than too late is my thinking on this one.

Our previous price target on USAT shares was $16. However, we should prudently assume that several of the underlying financial metrics will be restated lower. Consequently, I’m taking a haircut relative to our prior target and putting out a new price target of $10. As the company releases its updated financials, I’ll look to fine-tune that price target as needed

  • We are issuing a Buy on and adding back shares of Digital Infrastructure company, USA Technologies (USAT), to the Tematica Select List with a price target of $10.

 

The Thematic Leaders

As the stock market moved higher week over week as of last night’s close, we saw several Thematic Leaders move higher. These included Aging of the Population leader AMN Healthcare (AMN), and Clean Living leader Chipotle Mexican Grill (CMG) as well as Thematic King Amazon (AMZN). The big winner, however, was Digital Lifestyle leader Netflix (NFLX), which yesterday announced it would boost prices for its monthly memberships by 13% to 18%. This marks the company’s biggest price increase and I suspect was well thought out by the management team, given the increasingly competitive playing field. That price increase should drive Wall Street’s revenue expectations higher and improve its ability to not only spend on proprietary content but also its ability to service its quarterly debt costs.

  • Our price targets on AMN Healthcare (AMN), Chipotle Mexican Grill (CMG) and Netflix (NFLX) remain $75, $550 and $500, respectively.

 

Putting Altria shares on watch

Even though we’re just a few weeks into 2019, shares of Guilty Pleasure leader Altria have been underperforming on both an absolute basis and a relative one compared to the S&P 500. Weighing the shares down are questions over its ability to recoup the $12.8 billion investment for a 35% stake, in e-vapor market leader Juul Labs (JUUL). While this is part of the company’s efforts to reposition itself, given prospects for continued declines in its core tobacco market, complicating things is the FDA’s move to stub out youth access to e-vapor and flavored cigarettes.

Odds are this will take several years to come about but it raises questions as to whether Altria is trading one shrinking market for another. Candidly, I would have preferred Altria take that $12.5 billion and spread it across several cannabis investments. I’ll continue to be patient for now with this thematic leader, however, I’ll be looking at several in the coming days that could offer a far better risk to return tradeoff.

 

Adding downside protection and naming a new Thematic Leader

Adding downside protection and naming a new Thematic Leader

Key points inside this issue

  • As more investors reassess coming growth expectations, we are adding ProShares Short S&P500 (SH) to hedge both the Thematic Leaders and the Select List. While not a thematic position but one that will limit near-term downside, we will evaluate this position on as needed basis in the coming weeks.
  • Calling Nokia up to the Thematic Leaders
  • Adding Skyworks Solutions to the Contender’s List
  • Cannabis rumors swirl around Altria

 

Adding some downside protection with SH shares

It’s not often we get a mid-week break for the stock market, and the reason behind yesterday’s stock market closure was a solemn one. It did offer a respite from the wild swing we saw in the market between Monday and Tuesday, which resulted in a demonstrable move lower for all the major market indices. As I shared on Monday, despite the seeming forward motion on US-China trade, there remains much work to be done and a number of headwinds that, as expected, are leading investors to question 2019 EPS growth prospects.

Yesterday, China’s Commerce Ministry released a statement calling trade talks between Presidents Xi and Trump at the G20 Summit in Argentina “very successful.” The statement said the Chinese and U.S. trade and economic delegations will “actively advance the work of consultation” in 90 days in accord with “a clear timetable” and “road map” but offered little concrete details. Odds are this will add to the uncertainty that led Monday’s rally to finish the day off its highs and helped drive the market lower on Tuesday.

In my view, this will keep the market on pins and needles as we digest the coming economic data points to be had that I shared on Monday as well as those for next week that include November reports for inflation, Retail Sales and Industrial Production. As more investors question earnings growth prospects vs. the current stock market multiple, the risk is we could see more downside, especially if those same investors suspect tariffs will indeed be eventually raised to 25% from 10% along with further interest rate hikes. A recent survey of 500 institutional investors by Natixis showed that 65% see a change coming, with the biggest threats being geopolitical tensions and rising interest rates. Between the wage data to be had in Friday’s Employment Report and next week’s PPI and CPI reports, we also run the risk of seeing potentially hawkish comments following today’s latest Fed Beige Book. That report showed tariff driven price increases have spread more broadly through the U.S. economy.

As we get these and other data points ahead of the Fed’s essentially baked in the cake rate hike on December 19, I’ll continue to heed the Thematic Signals we collect each week. Given the market mood, however, I’m adding some downside protection to help insulate subscriber assets in the near-term in the form of ProShares Short S&P500 (SH), an inverse ETF for the S&P 500.

  • As more investors reassess coming growth expectations, we are adding ProShares Short S&P500 (SH) to hedge both the Thematic Leaders and the Select List. While not a thematic position but one that will limit near-term downside, we will evaluate this position on as needed basis in the coming weeks.

 

Samsung set to bring 5G into the prime time

Amid the trade news between the United States and China out of the G-20 summit, there was other news that we’ve been waiting on patiently. Subscribers know that one of our core investment thesis for our positions in Dycom Industries (DY),  AXT Inc. (AXTI), Nokia (NOK) and to a lesser extent Applied Materials (AMAT) shares is the deployment of 5G networks and devices. In the last few months, we’ve heard of beta rollouts from both AT&T Inc. (T) and Verizon Communications Inc. (VZ) as well as fixed wireless testing that could be a replacement for broadband to the home. The thing that has been missing is the to-date elusive announcement on a 5G smartphone that will ride 5G networks and their data speeds, something that will make the speed of the current 4G LTE network look something out of the dial-up days. If you remember those days, you know what I’m talking about — all that’s missing is the wonky connect garble noise.

Let me rephrase: That announcement was elusive until this past Monday when Verizon shared that smartphone users in the United States will be able to use Verizon’s 5G wireless network in the first half of 2019 starting with devices from Samsung. While details of the devices were scant — no models or price points — it is expected that Samsung will be revealing a proof concept this week at the annual Qualcomm Inc. (QCOM) Snapdragon Summit in Maui, Hawaii. Given the location of the unveiling, it seems like a sure bet Qualcomm and its chipsets will be powering the device. No surprise, considering that Samsung long has been a core customer of Qualcomm.

The key point here is the largest smartphone company by volume will be debuting its first 5G market in the coming months.

 

Calling Nokia up to the Thematic Leaders

From our perspective, I see this development as confirming our view on a few levels. Operators are not ones to launch a network unless devices are available for them to monetize that network and all the investments that led to it. That’s a positive for Nokia as it confirms the pending multi-year upswing in 5G infrastructure demand is firmly in front of it, as is the opportunity for its IP licensing business. Second, given Verizon’s timetable of “the first half of 2019,” it means the supply chain soon will be firing up to deliver the components necessary for these devices, including the incremental number of RF (radio frequency) semiconductors needed for 5G. That means incremental wafer demand for AXT during what is a seasonally slow period for smartphones.

As a result, I am calling shares of Nokia up from the Select List to the Thematic Leaders to fill the Disruptive Innovatorsvoid. With Samsung, AT&T, and Verizon having now laid out a timetable for 5G deployments for both networks and devices, we now have a far firmer timetable for a pick up in demand for mobile infrastructure business as well as high margin licensing business. My price target on NOK shares remains $8.50.

  • We are adding Nokia (NOK) shares to the Thematic Leaders for our Disruptive Innovators investing theme. Our price target remains $8.50

 

Adding Skyworks Solutions to the Contender’s List

That incremental RF semiconductor demand for 5G I mentioned a few paragraphs above also means more power amplifiers, switches, filters and other components that will once again increase the dollar content per device for Skyworks Solutions (SWKS) and its competitors. We’ve owned SWKS shares before, and more recently they’ve been battered around as more signs of stalling smartphone demand have emerged leading suppliers to cut their forecasts.

I’ve no intention in jumping into that fray ahead of the seasonally slowest time of the year for smartphone demand – the first half of the calendar year. Rather, we’ll put a pin in SWKS shares, add them to the Contender List and look to revisit them as a Disruptive Innovator play as we either put the March quarter behind us or a new US-China trade deal is inked.

 

Cannabis rumors swirl around Altria

After we published Monday’s Tematica Investing issue, there was much chatter suggesting that Guilty Pleasure Thematic Leader Altria Group (MO) could be interested in acquiring Cronos Group (CRON), a Canadian cannabis company. That speculation sent CRON shares 11% higher on the day and also lifted MO.

As you know, I have held the view that Altria would look to diversify its business away from tobacco and ride the wave of cannabis legalization in the U.S. The key here is legalization across the entire U.S., which would ease manufacturing, distribution, sales and marketing efforts by Altria rather than being an ad-hoc effort. Until the federal ban is lifted, there are also issues with how a company such as Altria would deposit its revenue and profits.

For those looking at Cronos as a positive for Altria’s U.S. business, I think that is a bit presumptuous as the timing of U.S. cannabis legalization remains tenuous. A potential acquisition such as this, however, would give Altria a toehold in the cannabis space, which is legal in Canada, and allow it to learn the business and test market product for an eventual launch in the U.S. when the time is right.

For now, a potential acquisition of Cronos is just speculation, but in principle, it fits with our long-term view of where Altria is likely headed. Now we have to see what Altria does next.

 

 

Weekly Issue: Economic reality is catching up with the stock market

Weekly Issue: Economic reality is catching up with the stock market

 

Coming into this week I said it would likely be another volatile one, and as much as I would like to say I was wrong, I wasn’t. Over the last five days, the individual price charts of the major stock market indices resembled a roller coaster ride, finishing lower week over week. This trajectory continued what we’ve seen over the last few weeks, which has all the major market indices in the red for the last month and that has erased most of their year to date gains.

Stepping back, yes, the market is trading day to day as expected but while there are pockets of strength we are seeing a growing number of companies miss top-line expectations. Coupled with guidance that in some cases may be conservative, but in other reflects a syncing up with the economic and other data of the last few months, investors have become increasingly nervous. This is evidenced in the wide swing over the last month at the CNN Fear & Greed Index, which now sits at Extreme Fear (6) down from Greed (65) several weeks ago. Looking at the AAII Investor Sentiment Survey this week, bullish sentiment fell to 28% from 34%, the fourth weakest reading for bullish sentiment this year. Bearish sentiment rose from 35% to 41%, the highest reading since the last week of June.

What this tells us is pessimism over the near-term direction of the stock market is at its highest level in months, which in turn is likely giving way to what we call a “shoot first and ask questions later” mentality. As almost any seasoned investor will say, that is one of the biggest mistakes one can make as it tends to let emotion, not logic and fact, rule the day.

What times like this call for is stepping back, collecting data shared in earnings releases and corresponding conference calls and presentations, to update our investing mosaic. We’ve had several Thematic Leaders and residents on the Tematica Investing Select List, including Chipotle Mexican Grill (CMG), Amazon (AMZN), Altria (MO),  Alphabet/Google, and Nokia (NOK) report this week as well as a dozens of others, such as AT&T (T), Verizon (VZ), Lockheed Martin (LMT), McDonald’s (MCD), iRobot (IRBT), and Hilton (HLT) report this week. That’s why I’ll be spending the weekend pouring over earnings releases and conference call transcripts, using our thematic lens to update our investing mosaic as needed. It also means furnishing you with a number of updates very early next week.

As I revisit our investing mosaic, the questions being asked will include ones like “Are we seeing any slowdown in the shift to digital commerce, the cloud, streaming content, the move to foods that are better for you?” and so on. Odds are the answers to those and similar questions will be no, which means we will continue to sit on the sidelines as earnings expectations for the market are adjusted likely leading the risk to reward dynamics in share prices to become more favorable. As calmer waters emerge in the coming weeks, we will use one of our time-tested strategies and scale into our Thematic Leader positions as well as those in the Select List where it makes sense.

 

What to Watch Next Week

As we trade the end of October and Halloween for the start of November next week, we have another barn burner one ahead for September quarter earnings as more than 1,000 companies will report their results and update their outlooks. We also have a full plate of economic data coming at us, some of which will influence the second edition of the September quarter’s GDP reading while others will start to put some shape around the GDP reading for the current quarter. To set the table for that data following the initial September quarter GDP print of 3.5%, the New York Fed’s Nowcast model is looking for 2.4% while The Wall Street Journal’s Economic Forecast Survey of more than 60 economists is calling for 2.9%. Thus far we have yet to see any forecast from the Atlanta Fed’s Nowcast model for the December quarter, however, odds are it will once again start out overly bullish and find its way closer to the economic reality of the quarter. We like to kid the Atlanta Fed, but it did start out modeling September quarter GDP of 4.7%. Of course, we would have loved to have seen that, but we’re in the business of letting the economic data talk to us. The fact the Citibank Economic Surprise Index (CESI) has been negative for several months, meaning the data is coming in below expectations, was a clue the Atlanta Fed would have to refine its outlook.

So, what do we have on tap from an economic data perspective?

Monday will bring the September Personal Income and Spending report, one that will we will be watching closely to see if consumers continued to spend above wage gains. Tuesday has the October Consumer Confidence reading for October, and the recent stock market gyrations could take some wind out of the September confidence gains. As we gear into the holiday shopping season, we’ll be closely watching the Expectations component for signs of any softening. Also, on Tuesday, we have Apple’s (AAPL) latest event at which it is widely expected to unveil its latest iPad and Mac models. The ADP Employment Report for October, as well as the 3Q 2018 Employment Cost Index report, will be had on Wednesday, and we expect them to receive more than a passing scrutiny given the growing scarcity of workers with needed skillsets and wage gains.

Thursday we will get the October auto and truck sales and we’ll be looking to see if those sales continue to resemble what we’ve seen in the housing market of late – fewer unit sales, but ones with higher price tags. Also, in focus, that day will be the October ISM Manufacturing Index, where we will be eyeing its order and backlog data as well as employment metrics. Rounding out Thursday, we’ll get the September Construction Spending Report. The first Friday of the new month usually means it’s time for the employment report, and yes, we will indeed be getting the October Employment report one week from today. While we expect many to be focused on the speed of job creation, we’ll be digging into the qualitative factors of the jobs created and who is taking them as well as focusing on the degree of wage gains.

Turning to next week’s earnings calendar, it is simply chock full of reports and once again Thursday will be the day with the heaviest flow – just under 400 companies on that day alone.  Just like this week, among the sea of reports to be had, there will be several, including Facebook (FB) and Apple that will capture investor attention given the impact they could have on the market. As we move through the week, we’ll be adding to our investment mosaic along the way.

Enjoy the weekend, stock up on all those tricks and treats and get some rest for the week ahead. I’ll be back with more early next week.