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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). 

 

Weekly Issue: September Looks Like a Repeat of August

Weekly Issue: September Looks Like a Repeat of August

Key points inside this issue

  • We are establishing a buy-stop level at 9.50 for shares of Veeco Instruments (VECO), which will lock in a profit of at least 13% on this short position.
  • The Hershey Company: Tapping into Cleaner Living with M&A


We ended a volatile August… 

Stocks rebounded from some of their recent losses last week as trade tensions between the U.S. and China appear to have cooled off a bit. For the month of August in total, during which there seemed to be one market crisis after another, most of the major stock market indices finished down slightly. The outlier was the small-cap heavy Russell 2000, which shed around 5% during the month.

Looking back over the last few weeks, the market was grappling with a number of uncertainties, the most prominent of which was the announced tariff escalation in the U.S- China trade war. There were other uncertainties brewing, including the growing number of signs that outside of consumer spending, the economy continues to soften. We saw that consumer strength in Friday’s July Personal Income & Spending data, but also in the second June-quarter GDP revision that ticked down to 2.0% from 2.1%, even though estimates for consumer spending during the quarter rose to 4.7% from 4.3%. I would note that 4.7% marked the strongest level of consumer spending since the December 2014 quarter. We are, however, seeing a continued shift in where consumers are spending — moving from restaurants and department stores to quick-service restaurants and discount retailers as well as online. This raises the question as to whether the economy is prepared to meet head-on our Middle Class Squeeze investing theme?

Another issue investors grappled with as we closed out August was the yield curve inversion. While historically this does raise a red flag, it’s not a foregone conclusion that a recession is around the corner. Rather it can be several quarters away, and there are several stimulative measures that could be invoked to keep the economy growing. In other words, we should continue to mind the data and any potential monetary policy tweaking to be had.

Closing out August, more than 99% of the S&P 500 have reported earnings for the June-quarter season. EPS for that group rose just under 1%, which was far better than the contraction that was lining up just a few weeks ago. Based on corporate guidance and other factors, however, EPS expectations for both the September and December quarters have been revised lower. Some of this no doubt has to do with the next round of tariffs that took effect on Sept. 1 on Chinese imports, but we can’t dismiss the slowing speed of the global economy either.

That overall backdrop of uncertainty helps explain why the three best-performing sectors during August were Utilities, Real Estate and Consumer Staples. But as we saw in the second half of last week, a softer tone on the trade war led investors back into the market as China said it wished to resolve the trade dispute with a “calm” attitude.

Without question, investors and Corporate America are eager for forward progress on the trade war to materialize. While there have been several head fakes in recent months, we should remain optimistic. That said, we here at Tematica continue to believe the devil will be in the details when it comes to a potential trade agreement, and much like deciphering economic data, it will mean digging into that agreement to fully understand its ramifications. Those findings and their implications as well as what we hear on the monetary policy front will set the stage for what comes next. 


… and it looks like more ahead for September

This week kicks off the last month of the third quarter of 2019. For many, it will be back to work following the seasonally slow, but volatile last few weeks of summer. The question to be pondered is how volatile will September be? Historically speaking it is the worst calendar month for stocks and based on yesterday’s performance it is adhering to its reputation.

As a reminder, on Sept. 1 President Trump authorized a tariff increase to 15% from 10% on $300 billion in Chinese imports, many of which are consumer goods such as clothing, footwear and electronics.  As we saw, that line in the sand came and went over the holiday weekend and now Trump is once again rattling his trade saber, suggesting China should make a deal soon as it will only get worse if he wins the 2020 presidential election.

In addition to that, yesterday morning we received the one-two punch that was the August reading on the manufacturing economy — from both IHS Markit and the Institute of Supply Management. The revelation that manufacturing continued to slow weighed on stocks yesterday. The direction of Tuesday’s official data, however, was not a surprise to us given other data we monitor such as weekly rail car loadings, truck tonnage and the Cass Freight Index.  But as I have seen many a time, just because we are aware of something in the data doesn’t mean everyone is. 

What I suspect has rattled the market as we kick off September is the August ISM Manufacturing Survey, which showed the U.S. manufacturing sector declined to 49.1 in August. That is the lowest reading in about three years, and as a reminder, any reading below 50 signals a contraction. Data from IHS Markit also released yesterday showed the U.S. manufacturing PMI slowed to 50.3 in August, its lowest level since September 2009. Slightly better than the ISM headline print, but still down. Digging into both reports, we see new orders stalled, which suggests businesses are not only growing wary of the trade uncertainty, but that we should not expect a pickup in the month of September.

In my view, the more official data is catching up to the “other data” cited earlier and that more than likely means downward gross domestic product expectations ahead. It will also lead the market to focus increasingly on what the Fed will do and say later this month. I also think the official data is now capturing the weariness of the continued trade war. The combination of the slowing economy as well as the continued if not arguably heightened trade uncertainty will more than likely lead to restrain spending and investment in Corporate America, which will only add to the headwinds hitting the economy. 

Taking those August manufacturing reports, along with the data yet to come this week – the ISM Non-Manufacturing readings for August, and job creation data for August furnished by ADP and the Bureau of Labor Statistics — we’ll be able to zero in on the GDP taking shape in the current quarter. I would note that exiting last week, the NY Fed’s Nowcast reading for the September quarter was 1.76%, below the 2.0% second revision for June-quarter GDP. There is little question that given yesterday’s data the next adjustment to those forecasts will be lower. 

Adding to that view, we’ll also get the next iteration of the Fed’s Beige Book, which will provide anecdotal economic commentary gathered from the Fed’s member banks. And following the latest data, we can expect investors and economists alike will indeed be pouring over the next Beige Book.

No doubt, all of this global macro data and the trade war will be on the minds of central bankers ahead of their September meetings. Those dates are Sept. 12 for the European Central Bank (ECB) followed by the Fed’s next monetary policy meeting and press conference on Sept. 16-17. Given the declines in the eurozone, the ECB is widely expected to announce a stimulus package exiting that meeting, and currently the CBOE FedWatch Tool pegs a 96% chance of a rate cut by the Fed. With those consensus views in mind, should the economic data paint a stronger picture than expected it could call into question those likelihoods. If central banker expectations fail to live up to Wall Street expectations, that would more than likely give the stock market yet another case of indigestion. 

All of this data will also factor into earnings expectations. Earlier I mentioned some of the more recent revisions to the downside for the back half of 2019 but as we know this is an evolving story. That means effectively “wash, rinse, repeat” when it comes to assessing EPS growth for the S&P 500 as well as individual companies. And lest we forget, companies will not only have to contend with the effect of the current trade war and slowing economy on their businesses, but also the dollar, which as we can see in the chart below has near fresh highs for 2019. 

The biggest risk I see over the next few weeks is one of economic, monetary policy and earnings reality not matching up with expectations. Gazing forward over the next few weeks, the growing likelihood is one that points more toward additional risk in the market. We will continue to trade carefully in the near-term and heed what we gather from the latest thematic signals.


The Thematic Leaders and Select List

Over the last several weeks, the market turbulence led several positions, including those in Netflix (NFLX), Dycom (DY) and International Flavors & Fragrances (IFF) — on both the Tematica Leader board and the Select List to be stopped out. On the other hand, even though the overall markets took a bit of a nosedive during August, several of our thematic holdings, such as USA Technologies (USAT), AT&T (T), Costco Wholesale (COST), McCormick & Co. (MKC) and Applied Materials (AMAT) to name a few outperformed on both an absolute and relative basis.

Even the short position in Veeco Instruments (VECO) has returned nearly 18% since we added that to the Select List last March. That has been a particularly nice move, but also one that is playing out as expected. Currently, we have do not have a buy-stop order to protect us on our VECO position, and we are going to rectify that today. We are establishing a buy-stop level at 9.50 for shares of Veeco Instruments (VECO), which will lock in a profit of at least 13% on this short position. 

  • We are establishing a buy-stop level at 9.50 for shares of Veeco Instruments (VECO), which will lock in a profit of at least 13% on this short position.


The Hershey Company: Tapping into Cleaner Living with M&A

When we think of The Hershey Company (HSY) there is little question that its candy, gum and mints business that garnered it just over 30% of the US candy market lands its squarely in our Guilty Pleasure investing theme. Even the company itself refers to itself as the “undisputed leader in US confection” and we look at its thematic scorecard rankings, its business warrants a “5”, which means nearly all of its sales and profits are derived from our Guilty Pleasure theme. 

Not exactly a shock to even a casual observer. 

But as we’ve discussed more than a few times, consumers are shifting their preferences for food, beverages and snacks to “healthier for you” alternatives. These could be offerings made from organic or all-natural ingredients, or even ingredients that are considered to promote better health, such as protein over sugar. Recognizing this changing preference among its core constituents, Hershey hasn’t been asleep at the switch, but rather it has been making a number of nip and tuck acquisitions to improve its snacking portfolio, which aligns well with our Cleaner Living investing theme. 

These acquisitions have played out over a number of years, starting with the acquisition of the Krave jerky business (2015);  SkinnyPop parent Amplify Snacks (2017), Pirate Brands, including the Pirate’s Booty, Smart Puffs and Original Tings brands (2018). Then, just last month, Hershey acquired ONE Brands, LLC, the maker of a line of low-sugar, high-protein nutrition bars. August 2019 turned out to be a busy month for the executives of Hershey, as also in that month, the company announced minority investments in emerging snacking businesses FULFIL Holdings Limited and Blue Stripes LLC. FULFIL is a one of the leading makers of vitamin–fortified, high protein nutrition bars in the UK and Ireland, while Blue Stripes offers cacao-based snacks and treats instead of chocolate ones. 

Clearly the Hershey Company is improving its position relative to our Cleaner Living investing theme. The outstanding question is to what degree are these aggregated businesses contributing to the company’s overall sales and profits? While it is safe to say Hershey has some exposure to the Cleaner Living theme, the answers to those questions will determine Hershey’s overall theme ranking. That level of detail could emerge during the company’s September quarter earnings call, but it may not until it files its 2019 10-K. 

As we wait for that October conference call, I’ll continue to do some additional work on HSY shares, including what the potential EPS impact is from not only falling sugar prices but also the pickup in cocoa prices over the last six months. In a surprise that should come to no one, given the size and influence of the company’s chocolate and confectionary business to its sales and profits, cocoa and sugar are two key inputs that can hold sway over the Hershey cost structure. 

In my mind, the long-term question with Hershey is whether it can replicate the nip and tuck transformative success Walmart (WMT) had when it used a similar strategy to reposition itself to better capture the tailwinds of our Digital Lifestyle investing theme? No doubt transformation takes time, but now is the time to see if a better business balance between our Guilty Pleasure and Cleaner Living themes emerges at Hershey.

Introducing The Thematic Leaders

Introducing The Thematic Leaders

 

Several weeks ago began the arduous task of recasting our investment themes, shrinking them down to 10 from the prior 17 in the process. This has resulted in a more streamlined and cohesive investment mosaic. As part of that recasting, we’ve also established a full complement of thematic positions, adding ones, such as Chipotle Mexican Grill (CMG) and Altria (MO) in themes that have been underrepresented on the Select List. The result is a stronghold of thematic positions with each crystalizing and embodying their respective thematic tailwinds.

This culmination of these efforts is leading us to christen those 10 new Buy or rechristened Buy positions as what are calling The Thematic Leaders:

  1. Aging of the Population – AMN Healthcare (AMN)
  2. Clean Living – Chipotle Mexican Grill (CMG)
  3. Digital Lifestyle – Netflix (NFLX)
  4. Digital Infrastructure –  Dycom Industries (DY)
  5. Disruptive Innovators – Universal Display (OLED)
  6. Guilty Pleasure – Altria (MO)
  7. Living the Life – Del Frisco’s Restaurant Group (DFRG)
  8. Middle-Class Squeeze – Costco Wholesale (COST)
  9. Rise of the New Middle-Class – Alibaba (BABA)
  10. Safety & Security – Axon Enterprises (AAXN)

 

By now you’ve probably heard me or Tematica’s Chief Macro Strategist Lenore Hawkins mention how Amazon (AMZN) is the poster child of thematic investing given that it touches on nearly all of the 10 investing themes. That’s true, and that is why we are adding Amazon to the Thematic Leaders in the 11th slot. Not quite a baker’s dozen, but 11 strong thematic positions.

One question that you’ll likely have, and it’s a logical and fare one, is what does this mean for the Select List?

We wouldn’t give up on companies like Apple (AAPL), Alphabet (GOOGL), Disney (DIS), McCormick & Co. (MKC) and several other well-positioned thematic businesses that are on the Select List. So, we are keeping both with the Thematic Leaders as the ones that offer the most compelling risk-to-reward tradeoff and the greater benefit from the thematic tailwinds. When we have to make an adjustment to the list of Thematic Leaders, a company may be moved to the Select List in a move that resembles a move to a Hold from a Buy as it is replaced with a company that offers better thematic prospects and share price appreciation. Unlike Wall Street research, however, our Hold means keeping the position in intact to capture any and all additional upside.

Another way to look at it, is if asked today, which are the best thematically positioned stocks to buy today, we’d point to the Thematic Leaders list, while the Select List includes those companies that still have strong tailwinds behind their business model but for one reason or another might not be where we’d deploy additional capital. A great example is Netflix vs. Apple, both are riding the Digital Lifestyle tailwind, but at the current share price, Netflix offers far greater upside than Apple shares, which are hovering near our $225 price target.

After Apple’s Apple Watch and iPhone event last week, which in several respects underwhelmed relative to expectations despite setting up an iPhone portfolio at various price points, odds are the iPhone upgrade cycle won’t accelerate until the one for 5G. The question is will that be in 2019 or 2020? Given that 5G networks will begin next year, odds are we only see modest 5G smartphone volumes industry-wide in 2019 with accelerating volumes in 2020. Given Apple’s history, it likely means we should expect a 5G iPhone in 2020. Between now and then there are several looming positives, including its growing Services business and the much discussed but yet to be formally announced streaming video business. I continue to suspect the latter will be subscription based.  That timing fits with our long-term investing style, and as I’ve said before, we’re patient investors so I see no need to jettison AAPL shares at this time.

The bottom line is given the upside to be had, Netflix shares are on the Thematic Leaders list, while Apple shares remain on the Select List. The incremental adoption by Apple of the organic light emitting diode display technology in two of its three new iPhone models bodes rather well for shares of Universal Display (OLED), which have a $150 price target.

Other questions…

Will we revisit companies on the Select List? Absolutely. As we are seeing with Apple’s Services business as well as moves by companies like PepsiCo (PEP) and Coca-Cola (KO) that are tapping acquisitions to ride our Clean Living investing tailwind, businesses can morph over time. In some cases, it means the addition of a thematic tailwind or two can jumpstart a company’s business, while in other cases, like with Disney’s pending launch of its own streaming service, it can lead to a makeover in how investors should value its business(es).

Will companies fall off the Select List?

Sadly, yes, it will happen from time to time. When that does happen it will be due to changes in the company’s business such that its no longer riding a thematic tailwind or other circumstances emerge that make the risk to reward tradeoff untenable. One such example was had when we removed shares of Digital Infrastructure company USA Technologies (USAT) from the Select List to the uncertainties that could arise from a Board investigation into the company’s accounting practices and missed 10-K filing date.

For the full list of both the Thematic Leaders and the Select List, click here

To recap, I see this as an evolution of what we’ve been doing that more fully reflects the power of all of our investing themes. In many ways, we’re just getting started and this is the next step…. Hang on, I think you’ll love the ride as team Tematica and I continue to bring insight through our Thematic Signals, our Cocktail Investing podcast and Lenore’s Weekly Wrap.

 

 

WEEKLY ISSUE: Scaling deeper into Dycom shares

WEEKLY ISSUE: Scaling deeper into Dycom shares

Key points from this issue:

  • We are halfway through the current quarter, and we’ve got a number of holdings on the Tematica Investing Select List that are trouncing the major market indices.
  • We are using this week’s pain to improve our long-term cost basis in Dycom Industries (DY) shares as we ratchet back our price target to $100 from $125.
  • Examining our Middle-Class Squeeze investing theme and housing.
  • A Digital Lifestyle company that we plan on avoiding as Facebook attacks its key market.

 

As the velocity of June quarter earnings reports slows, in this issue of Tematica Investing we’re going to examine how our Middle-Class Squeeze investing theme is impacting the housing market and showcase a Digital Lifestyle theme company that I think subscribers would be smart to avoid. I’m also keeping my eyes open regarding the recent concerns surrounding Turkey and the lira. Thus far, signs of contagion appear to be limited but in the coming days, I suspect we’ll have a much better sense of the situation and exposure to be had.

With today’s issue, we are halfway through the current quarter. While the major market indices are up 2%-4% so far in the quarter, by comparison, we’ve had a number of strong thematic outperformers. These include Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), AXT Inc. (AXTI), Costco Wholesale (COST),  Habit Restaurant (HABT), Walt Disney (DIS), United Parcel Service (UPS), Universal Display (OLED) and USA Technologies (USAT).  That’s an impressive roster to be sure, but there are several positions that have lagged the market quarter to date including GSV Capital (GSVC), Nokia (NOK), Netflix (NFLX), Paccar (PCAR) and Rockwell Automation (ROK). We’ve also experienced some pain with Dycom (DY) shares, which we will get to in a moment.

Last week jettisoned shares of Farmland Partners (FPI) following the company taking it’s 3Q 2018 dividend payment and shooting it behind the woodshed. We also scaled into GSVC shares following GSV’s thesis-confirming June quarter earnings report, and I’m closely watching NFLX shares with a similar strategy in mind given the double-digit drop since adding them to the Tematica Investing Select List just over a month ago.

 

Scaling into Dycom share to improve our position for the longer-term

Last week we unveiled our latest investing theme here at Tematica – Digital Infrastructure. Earlier this week, Dycom Industries (DY), our first Digital Infrastructure selection slashed its outlook for the next few quarters despite a sharp rise in its backlog. Those shared revisions are as follows:

  • For its soon to be reported quarter, the company now sees EPS of $1.05-$1.08 from its previous guidance of $1.13-$1.28 vs. $1.19 analyst consensus estimate and revenues of $799.5 million from the prior $830-$860 million vs. the $843 million consensus.
  • For its full year ending this upcoming January, Dycom now sees EPS of $2.62-$3.07 from $4.26-$5.15 vs. the $4.63 consensus estimate and revenues of $3.01-$3.11 billion from $3.23-$3.43 billion and the $3.33 billion consensus.

 

What caught my eyes was the big disparity between the modest top line cuts and the rather sharp ones to the bottom line. Dycom attributed the revenue shortfall to slower large-scale deployments at key customers and margin pressure due to the under absorption of labor and field costs – the same issues that plagued it in its April quarter. Given some of the June quarter comments from mobile infrastructure companies like Ericsson (ERIC) and Nokia (NOK), Dycom’s comments regarding customer timing is not that surprising, even though the magnitude to its bottom line is. I chalk this up to the operating leverage that is inherent in its construction services business, and that cuts both ways – great when things are ramping, and to the downside when activity is less than expected.

We also know from Ericsson and Dycom that the North American market will be the most active when it comes to 5G deployments in the coming quarters, which helps explain why Dycom’s backlog rose to $7.9 billion exiting July up from $5.9 billion at the end of April and $5.9 billion exiting the July 2017 quarter. As that backlog across Comcast, Verizon, AT&T, Windstream and others is deployed in calendar 2019, we should see a snapback in margins and EPS compared to 2018.

With that in mind, the strategy will be to turn lemons – Monday’s 24% drop in DY’s share price – into long-term lemonade. To do this, we are adding to our DY position at current levels, which should drop our blended cost basis to roughly $80 from just under $92. Not bad, but I’ll be inclined to scale further into the position to enhance that blended cost basis in the coming weeks and months on confirmation that 5G is moving from concept to physical network. Like I said in our Digital Infrastructure overview, no 5G network means no 5G services, plain and simple. As we scale into the shares and factor in the revised near-term outlook, I’m also cutting our price target on DY shares to $100 from $125.

  • We are using this week’s pain to improve our long-term cost basis in Dycom Industries (DY) shares as we ratchet back our price target to $100 from $125.

 

Now, let’s get to how our Middle-Class Squeeze investing theme is hitting the housing market, and review that Digital Lifestyle company that we’re going to steer clear of because of Facebook (FB). Here we go…

 

If not single-family homes, where are the squeezed middle-class going?

To own a home was once considered one of the cornerstones of the American dream. If we look at the year to date move in the SPDR S&P Homebuilders ETF (XHB), which is down nearly 16% this year, one might have some concerns about the tone of the housing market. Yes, there is the specter of increasing inflation that has and likely will prompt the Federal Reserve to boost interest rates, and that will inch mortgage rates further from the near record lows enjoyed just a few years ago.

Here’s the thing:

  • Higher mortgage rates will make the cost of buying a home more expensive at a time when real wage growth is not accelerating, and consumers will be facing higher priced goods as inflation winds its way through the economic system leading to higher prices. During the current earnings season, we’ve heard from a number of companies including Cinemark Holdings (CNK), Hostess Brands (TWNK), Otter Tail (OTTR), and Diodes Inc. (DIOD) that are expected to pass on rising costs to consumers in the form of price increases.
  • Consumers debt loads have already climbed higher in recent years and as interest rates rise that will get costlier to service sapping disposable income and the ability to build a mortgage down payment

 

 

And let’s keep in mind, homes prices are already the most expensive they have been in over a decade due to a combination of tight housing supply and rising raw material costs. According to the National Association of Home Builders, higher wood costs have added almost $9,000 to the price of the average new single-family since January 2017.

 

 

Already new home sales have been significantly lower than over a decade ago, and as these forces come together it likely means the recent slowdown in new home sales that has emerged in 2018 is likely to get worse.

 

Yet our population continues to grow, and new households are being formed.

 

This prompts the question as to where are these new households living and where are they likely to in the coming quarters as homeownership costs are likely to rise further?

The answer is rental properties, including apartments, which are enjoying low vacancy rates and a positive slope in the consumer price index paid of rent paid for a primary residence.

 

There are several real estate investment trusts (REITs) that focus on the apartment and rental market including Preferred Apartment Communities, Inc. (APTS) and Independence Realty Trust (IRT). I’ll be looking at these and others to determine potential upside to be had in the coming quarters, which includes looking at their attractive dividend yields to ensure the underlying dividend stream is sustainable. More on this to come.

 

A Digital Lifestyle company that we plan on avoiding as Facebook attacks its key market

As important as it is to find well-positioned companies that are poised to ride prevailing thematic tailwinds that will drive revenue and profits as well as the share price higher, it’s also important to sidestep those that are running headlong into pronounced headwinds. These headwinds can take several forms, but one of the more common ones of late is the expanding footprint of companies like Alphabet (GOOGL), Amazon (AMZN) and Facebook (FB) among others.

We’ve seen the impact on shares of Blue Apron (APRN) fall apart over the last year following the entrance of Kroger (KR) into the meal kit business with its acquisition of Home Chef and investor concerns over Amazon entering the space following its acquisition of Whole Foods Market. That changing landscape highlighted one of the major flaws in Blue Apron’s subscription-based business model –  very high customer acquisition costs and high customer churn rates. While we warned investors to avoid APRN shares back last October when they were trading at north of $5, those who didn’t heed our advice are now enjoying APRN shares below $2.20. Ouch!

Now let’s take a look at the shares of Meet Group (MEET), which have been on a tear lately rising to $4.20 from just under $3 coming into 2018. The question to answer is this more like a Blue Apron or more like USA Technologies (USAT) or Habit Restaurant (HABT). In other words, one that is headed for destination @#$%^& or a bona fide opportunity.

According to its description, Meet offers  applications designed to meet the “universal need for human connection” and keep its users “entertained and engaged, and originate untold numbers of casual chats, friendships, dates, and marriages.” That sound you heard was the collective eye-rolling across Team Tematica. If you’re thinking this sounds similar to online and mobile dating sites like Tinder, Match, PlentyOfFish, Meetic, OkCupid, OurTime, and Pairs that are all part of Match Group (MTCH) and eHarmony, we here at Tematica are inclined to agree. And yes, dating has clearly moved into the digital age and that falls under the purview of our Digital Lifestyle investing theme.

Right off the bat, the fact that Meet’s expected EPS in 2018 and 2019 are slated to come in below the $0.39 per share Meet earned in 2017 despite consensus revenue expectations of $181 in 2019 vs. just under $124 million in 2017 is a red flag. So too is the lack of positive cash flow and fall off in cash on the balance sheet from $74.5 million exiting March 2017 to less than $21 million at the close of the June 2018 quarter. A sizable chunk of that cash was used to buy Lovoo, a popular dating app in Europe as well as develop the ability to monetize live video on several of its apps.

Then there is the decline in the company’s average total daily active users to 4.75 million in the June 2018 quarter from 4.95 million exiting 2017. Looking at average mobile daily active users as well as average monthly active user metrics we see the same downward trend over the last two quarters. Not good, not good at all.

And then there is Facebook, which at its 2018 F8 developer conference in early May, shared it was internally testing its dating product with employees. While it’s true the social media giant is contending with privacy concerns, CEO Mark Zuckerberg shared the company will continue to build new features and applications and this one was focused on building real, long-term relationships — not just for hookups…” Clearly a swipe at Match Group’s Tinder.

Given the size of Facebook’s global reach – 1.47 billion daily active users and 2.23 billion monthly active users – it has the scope and scale to be a force in digital dating even with modest user adoption. While Meet is enjoying the monetization benefits of its live video offering, Facebook has had voice and video calling as well as other chat capabilities that could spur adoption and converts from Meet’s platforms.

As I see it, Meet Group have enjoyed a nice run thus far in 2018, but as Facebook gears into the digital dating and moves from internal beta to open to the public, Meet will likely see further declines in user metrics. So, go user metrics to go advertising revenue and that means the best days for MEET shares could be in the rearview mirror. To me this makes MEET shares look more like those from Blue Apron than Habit or USA Technologies. In other words, I plan on steering clear of MEET shares and so should you.

 

 

Walking a Tight Rope as the Fed Faces a Stagflating Economy

Walking a Tight Rope as the Fed Faces a Stagflating Economy

The big question that’s been overhanging the market this week was cleared up yesterday when the Fed announced the next upward move in interest rates, something the stock market has been increasingly expecting over the last several weeks. In looking at the Fed’s new forecasts compared to those issued three months ago, there were no material changes in the outlook for GDP, the Unemployment Rate, on expected inflation.

We find the Fed’s action yesterday rather interesting against that backdrop, especially given its somewhat lousy track record when it comes to timing its rate increases —  more often than not, the Fed tends to raise interest rates at the wrong time. This time around, however, it seems the Fed is somewhat hellbent on getting interest rates back to normalized levels from the artificially low levels they’ve been at for nearly a decade. Even the language with which they announced the rate hike — “In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent” — makes one wonder exactly what data set they are using to base the decision.

The thing is, recent economic data hasn’t been all that robust. Yesterday morning, the Fed’s own Atlanta Fed once again slashed its GDPNow forecast for 1Q 2016 yesterday to 0.9 percent from 1.2 percent last week and more than 3.0 percent in January. That’s a big downtick from 1.9 percent GDP in 4Q 2016! Given the impact of winter storm Stella, particularly in the Northeast corridor, odds are GDP expectations will once again tick lower as consumer spending and brick & mortar retail sales were both disrupted. As Tematica’s Chief Macro Strategist Lenore Hawkins pointed out yesterday, real average hourly earnings decreased 0.3 percent, seasonally adjusted, year over year in February.

Despite that lack of wage growth, we have seen inflation pick up over the last several months inside the Purchasing Managers’ Indices published by Markit Economics and ISM for both the manufacturing and services economies as well as the Producer Price Index. Year over year in February, the Producer Price Index hit 2.2 percent, marking the largest 12-month increase since March 2012. Turning to the Consumer Price Index, the headline figure rose 2.7 percent this past February compared to a year ago, making it the 15th consecutive month the 12-month change for core CPI was between 2.1 percent and 2.3 percent. We’ve all witnessed the rise in gas prices, up some 18 percent compared to this time last year, and while there are adjustments to strip out food and energy from these inflation metrics, our view at Tematica is food and energy are costs that both businesses and individuals must bear. Rises prices for those items impact one’s ability to spend, especially if wages are not growing in tandem.

It would seem the Fed is caught once again between a rock and a hard place — the economy is slowing and inflation appears to be on the move. The economic term for such an environment is stagflation. In looking to get a handle on stagflation the Fed is walking a thin line between trying to get a handle on inflation while not throwing cold water on the economy as it continues to target two more rate hikes this year.

Once again, we find ourselves rather relieved that we don’t have Fed Chairwoman Janet Yellen’s job. We’re far more content to look at the intersecting and shifting landscapes around us to look for companies positioned to prosper from multi-year thematic tailwinds like those found on the Tematica Select List. Great examples include Buy rated Applied Materials (AMAT), Dycom Industries and Universal Display (OLED) among others. As we do this, we recognize the stock market is out over its ski tips and yet to fully bake in the current and likely near-term economic reality into its thinking especially as the likely timing on potential Trump economic policies look further out than previously thought. This is likely to offer the opportunity to find such thematic beneficiaries at better prices in the coming weeks compared to today.

While we may be a tad ahead of the herd on this, we’ll continue to be prudent investors and let the data, the hard data, talk to us as we navigate our next moves with the Tematica Select List.