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WEEKLY ISSUE: Adding to the Select List as we continue to ride the smartphone wave

WEEKLY ISSUE: Adding to the Select List as we continue to ride the smartphone wave

In this Week’s Issue:

  • As Trump Bump Gives Way to Trump Slump, What Will the Fed Do?
  • Putting UNFI and AT&T Under the Microscope
  • Nuance Communications – Big Deals for this Disruptive Technology Player
  • AXT Inc. – More Than Riding the Smartphone Wave

 

Welcome to this week’s issue of Tematica Investing. Following last week’s addition of Guilty Pleasure company MGM Resorts International (MGM) to the Tematica Select List, we’re adding another new name in compound semiconductor substrate company AXT Inc. (AXTI) – more on it and exactly what compound semiconductors are will be had shortly. But first, let’s have a quick look at what’s coming across our desk this week . . .

 

As Trump Bump Gives Way to Trump Slump, What Will the Fed Do?

We’re just several hours away from the Federal Reserve announcing what is likely to be a modest bump higher in interest rates, a move that is widely expected by investors. We here at Tematica continue to see it as the Fed looking to re-arm itself ahead of the next eventual recession. Note we said eventual, for even though we continue to see step downs in 2Q 2017 GDP expectations, the domestic economy continues to chug along at a sluggish pace. That’s a speed we expect to be with us as we head into the summer doldrums. After today’s market close there will be 12 trading days left in the quarter, which means companies are on the cusp of entering their quiet periods, and before too long we’ll get any and all negative earnings preannouncements.

As we get more June economic data and those preannouncements, we could see the stock market revisit last week’ move lower for reasons that we recapped in this week’s Monday Morning Kickoff. With the Eurozone elections being a non-event, a sense of calm returned to the market this week, but once we’re past the Fed’s expected action, the next item to preoccupy investors will be expectations for the second half of 2017. We continue to suspect expectations for both GDP and earnings will have to be adjusted given the Trump Slump, but that’s for the market, not the positions we’ve identified as benefitting from thematic tailwinds that reside on the Tematica Select List:

  • We will continue to keep shares of Amazon (AMZN), Alphabet (GOOGL), Dycom (DY), Facebook (FB), Applied Materials (AMAT), Universal Display (OLED) and others on the Select List.
  • We will be revisiting stop loss levels over the following weeks in order to have them in position for 2Q 2017 earnings, which will commence soon after the July 4th holiday weekend.

 

 

Putting UNFI and AT&T Under the Microscope

We are putting shares of United Natural Foods (UNFI) on notice, as they’ve slumped after reporting above-consensus quarterly earnings of $0.77 per share on an 11.1 percent year-over-year jump in revenue to $2.37 billion, which was shy of expectations. Looking ahead, UNFI reaffirmed its bottom-line guidance for the full year, expecting earnings between $2.53-$2.58 per share. However, revenue guidance was lowered and the company now expects below-consensus sales between $9.29 billion and $9.34 billion after previous guidance called for sales between $9.38 billion and $9.46 billion.

  • As we review our position in UNFI, we’ll be recalculating our price target, which currently sits at $65. Expect more on this in the coming days and weeks.

We’re also keeping close tabs on AT&T (T) shares. We’ve been patient with this position, but year to date it’s fallen 9 percent before factoring in dividends paid. Our thesis over the changing business model following the merger with Time Warner (TWX) remains, and we expect more concrete details to emerge in the coming months given the timetable to close the deal by year-end.

  • Our inclination is to scale into T shares below $38, which would modestly improve our cost basis.
  • Stay tuned for more on this as well.

 

 

Nuance Communications – Big Deals for this Disruptive Technology Player

It’s been a bit since we updated subscribers on speech recognition and virtual assistant provider Nuance Communications (NUAN), but that’s primarily because until recently the business has been chugging along. For its March quarter, the company hit consensus expectations and guided the current quarter in line with Wall Street forecasts, which laid the groundwork for the shares to climb more than 8 percent over the last three months. More recently, however, things are once again shaking at Nuance as the company inked deals with Amazon (AMZN), Apple and Alphabet (GOOGL) to bring its Nina platform to power customer service chatbots on iMessage, Alexa and Google Home devices.

Already, Nuance’s Nina platform powers customer service bots for about 6,500 companies and organizations, including many telecoms, banks, and airlines. The reality is, you may have already used this Nuance solution and not recognized it. Per Nuance, Nina-powered bots can resolve 80 percent of customer requests, such as transferring money, or changing airline seats.
We’d point out this is in addition to Nina powering other messaging services, including Facebook Messenger, WeChat, and text messaging applications.

As it relates in particular to Apple, the chatbot capability is scheduled to appear within iOS 11, and the plan is to integrate Nuance’s solutions with Apple Business Chat to enable a new breed of artificial intelligence (AI)-based intelligent assistants within Messages. What this means is users will see a messages icon pop up on brand websites, in search results, and elsewhere that will allow people to contact those brands with one tap.

From our perspective, this could prove to be an interesting behind the scenes development that if it were to spread to Siri and Apple’s new HomePod, could make for more robust offering that currently expected. It also reaffirms our view that at some point Nuance is likely to be a takeout candidate.

  • With 13 percent upside to our $21 price target, we continue to have a Buy on NUAN shares.
  • As we get a better understanding, and some hands-on experience with these new capabilities across Apple, Amazon and other recent wins, we’ll look to revisit our price target.

 

AXT Inc.  – More Than Riding the Smartphone Wave

Over the last decade, RF semiconductor companies like Skyworks Solutions (SWKS) and Qorvo (QRVO) have seen strong moves in their businesses as well as stock prices. RF semiconductors are what allows that cellphone in your pocket to communicate wirelessly with networks (RF stands for radio frequency) and it enables that communications at a far more battery efficiency than its silicon semiconductor counterpart.

As the Connected Society investment theme plays out in the marketplace, it’s easy to see the two factors driving demand for these semiconductors.  First, the move from 2G to 3G and 4G technologies has resulted in greater RF semiconductor content per device, beginning in mobile phones and now in smartphones. The second factor is the
adoption of wireless technologies across multiple devices ranging from gaming controllers to tablets, GPS devices, and wearables to name a few.
We are now on the cusp of seeing these two forces step up once again as mobile carriers get ready to beta 5G technologies, which will add another layer of RF content to connected devices, and newer connected markets, like the Connected Home, Connected Car and the Internet of Things approach their tipping points. Speaking of Connected Car, later this week, we’ll have more on the Connected Car market when Ted Cardenas from Pioneer joins us on this week’s Cocktail Investing Podcast. Be sure to catch it on TematicaResearch.com or head on over to iTunes and subscribe.

Back to the matter at hand, each of these connected devices requires a bevy of RF semiconductors ranging from switches and filters to power amplifiers. In the silicon semiconductor world, chips are fabricated on wafers. With RF semiconductors, they are grown on substrates based on elements found on the periodic table. We’ll keep it simple here when it comes to compound semiconductors, and will post more background information on the website. For now, what you do need to know is RF semiconductors’ performance characteristics across their varied applications lend themselves to our Disruptive Technology investment theme.

Again, the basic building block of these disruptive semiconductors is the substrate and brings us to AXT Inc. (AXT) a worldwide manufacturer of compound and single element substrates that include Gallium Arsenide (GaAs), Indium Phosphide (InP), and Germanium (Ge) flavors. The company has manufacturing facilities and investments in 10 subsidiaries and joint ventures in China that produce raw materials as part of its vertically integrated supply chain. Applications for the company’s InP substrates include fiber optic networks, passive optical networks and data center connectivity among others. Moving to Ge substrates, key markets for the material include satellite solar cells and optical sensors and detectors including infra-red detectors.

The substrate category that has the greatest volume opportunity remains GaAs, which as mentioned above is used in smartphones and other burgeoning connected device markets such as augmented and virtual reality devices, gaming applications as well as facial recognition security applications like the one in beta by Jet Blue (JBLU) as well as SmartTV, auto, medical, gaming and industrial applications. Pretty much any device is poised to include RF semiconductors, but let’s remember the single largest market by volume remains the smartphone market. With greater RF semiconductor content per device as more of the globe migrates to 4G and LTE technologies, we see rising demand for AXT’s GaAs substrates. With RF semiconductor content taking another step up with 5G, the outlook for AXTI’s GaAs substrates looking favorable over the next several years.

Given the wide array of end markets served, no particular customer accounted for more than 10 percent of revenue in 2016, but we suspect key customers include Skyworks Solutions and Qorvo, given their position in the RF semiconductor space. Consensus estimates call for Skyworks to grow its revenue 10 percent this year and again next year, while forecasts for Qorvo call for its revenue to grow 4-9 percent over the next several quarters. As we’ve noted with Applied Materials (AMAT), we are seeing China invest heavily in developing its in-country semiconductor capabilities, and based on order books for both Applied and Veeco Instruments (VECO), this includes compound semiconductors. As such, we could see the mix of customers and geographies at AXT shift over the coming quarters. In our view, that plays to AXT’s strength given its existing operations in China.

Much the way we are watching Applied Materials and Veeco for cues on organic light emitting diode demand, we will also be watching them for compound semiconductor capacity additions. Applied in particular has reported strong order growth, which led the company to recently boost its outlook. As part of its first-quarter results, Veeco reported a third consecutive quarter with bookings above $100 million vs. $94 million in revenue for the quarter, bringing its backlog at the end of the quarter to more than $200 million.

Let’s Have a Look at AXT Fiscal and Stock Performance

Current expectations call for AXT to deliver revenue of $91 million this year, up from $81.3 million last year, but there could be upside based on the deployment of 5G networks as well as reception for Apple’s (AAPL)next iPhone. As several compound semiconductor technology applications mature over the coming quarters, revenue at AXT is expected to rise to $103-$107 million, with EPS forecasted to climb to $0.31 per share, up from $0.19 this year. We’d note that over the last year, AXT has managed to beat analyst expectations in all four quarters, even as EPS expectations have ticked higher. One other item to point out, the company has no debt and $77 million in cash (roughly $2 per share) and is generating positive cash flow.

Historically, smartphone demand has ramped in the second half of the calendar year. Apple (AAPL) is set to take the wraps off its latest iPhone model this fall. Given the likely competitive response from Samsung, HTC, LG and others, we expect the seasonal pattern to hold, which means we should see a pick-up in demand for AXT’s substrates in late July. Other connected devices, ranging from connected speakers, gaming consoles and so on, should also see a seasonal bump in the back half of the year as part of the year-end holiday shopping season. With the seasonal pattern expected to hold, this likely means AXT shares will move higher as revenue and earnings are poised to climb meaningfully in the second half of the year compared to the first half. While the positive is that tends to result in favorable multiple expansion, it also means that we need to be mindful about the typical revenue fall off from the fourth quarter to the first quarter, given the seasonal drop off in smartphones and other volumes as we move into late January and February.

With all of that said, we see AXT shares reaching $9 over the coming months. We derive that price target through a confluence of historical P/E and enterprise value (EV) to revenue metrics. Our plan will be to either use market weakness during the summer months to scale into the shares, or to build our position on signs the seasonal smartphone ramp is trending stronger than expected.

The Bottom Line in AXT Inc (AXTI):

  • We are adding AXTI Shares to the Tematica Select List, which at market close yesterday traded at $6.45 per share.
  • We are setting a price target on the shares of $9, and anticipate it reaching that level over the coming months. We derive that price target through a confluence of historical P/E and enterprise value (EV) to revenue metrics.
  • Our plan will be to either use market weakness during the summer months to scale into the shares, or to build our position on signs the seasonal smartphone ramp is trending stronger than expected.

 

Market finally catches up to reality — something we’ve warned about since the Trump Trade took off

Market finally catches up to reality — something we’ve warned about since the Trump Trade took off

Monday was the start of spring, which usually brings in some milder weather and a breath of fresh air. The latter was certainly what the stock market received yesterday when it had its worst day in a number of weeks.

For us here at Tematica, we’ve been talking about the growing disconnect between the stock market, the real speed of the economy and the growing likelihood that President Trump’s stimulative policies will arrive far later than the mainstream expected. The fact that there are several other snafus helping to deter progress is Washington — like the FBI investigation into potential links with Russia, judicial pushback on the second attempted travel ban and an attempt to repeal the Affordable Care Act that doesn’t have full support of Republicans in the House and Senate — are pushing out the focus on infrastructure spending and tax reform.

The good news is that once again the herd is catching up to what we’ve been saying. The not so good news is it means we’re likely to see the stock market give back some of its 2017 gains as these GDP expectations and subsequent earnings expectations get reset. If we look at several companies that reported earnings this week, including Rise & Fall of the Middle-Class contender Nike (NKE), and Economic Acceleration/Deceleration players FedEx (FDX) and Actuant (ATU) each of them have given their own warning signs:

  • Nike’s future orders fell 1 percent;
  • FedEx missed quarterly expectations and cut its 2017 global GDP forecast to 1.6 percent from the prior 2.6 percent;
  • Actuant guided its current quarter earnings and revenue below consensus and reduced the top end of its 2017 EPS guidance.

Overnight we’re also reading that Payless (PSS) may file for bankruptcy next week and Sears (SHLD) mentioned in its latest 10-K filing just a day or two ago that, “substantial doubt exists related to the company’s ability to continue as a going concern.” Candidly given the rise of Connected Society company Amazon (AMZN) in apparel, as well as its Zappos business, we’re a little surprised that Payless has hung on as long as it has.

 

 

The point is we’re starting to see 2017 expectations get adjusted, and the new question we need to focus on is the degree of those negative revisions. With hindsight being 20/20, last year we saw a steady move lower in earnings expectations for the S&P 500 and we wound up seeing 2016 earnings growth come in at a whopping 0.5 percent for those 500 companies.

As we entered 2017, the expectation was those 500 companies would grow their collective earnings more than 12 percent compared to 2016. Even before we get March quarter results, the view on 2017 earnings growth for the S&P 500 has fallen to just over 10 percent. With several highly anticipated policies getting pushed out, odds are companies will have to reset EPS expectations for 2Q 2017 and most likely 3Q 2017 as well, which means we are likely to see full year 2017 expectations come down further.

As this happens, the market will likely continue to wake up to current valuation levels, especially since if the price of the S&P 500 remains steady and earnings get cut, the market valuation will climb. Odds of that happening are rather low given the market’s stretched valuation and it would mean paying more for even slower earnings growth. What this means is we’re likely to see the market move lower over the coming weeks as all of these expectations get rejiggered lower.

 

We’ve been patient as well as selective, and we’ll continue to do so.

The most recent addition to the Tematica Select List, the Connected Society “missing link” that is United Parcel Service (UPS), was one month ago. While we use the expected retrenchment in the market to identify new players for the Tematica Select List, we’ll continue to look for confirming data points for the existing positions. A great example was the piece we published earlier this week on Applied Materials (AMAT) and Universal Display (OLED) as well as Disney (DIS) that saw Barron’s backing our thematic rationale for having these three companies on the Select List.

With 8 trading days left in the quarter, a number of companies will soon be entering their “quiet periods” and that means we’re going to have our “scope up” as it were for potential earnings pre-announcements. If we get more negative warnings than usual, or from some larger blue chip companies, we could see the market get a little bouncy. In times like that, we’ll look to scale into positions where it makes thematic sense, especially if we can reduce the cost basis on the Tematica Select List. It’s a strategy that’s paid off for Dycom (DY), AMN Healthcare (AMN), International Flavors & Fragrances (IFF) and several others positions.

Be sure to check the website for more comments and insights, and be sure to listen to our Cocktail Investing Podcast — it’s all the insight with some good humor and more than few laughs as well.

Hope and enthusiasm can only carry the market so high for so long

Hope and enthusiasm can only carry the market so high for so long

Waiting for the Fed’s Economic Forecast Update

What a week it’s been! We’ve received a solid February jobs report, endured a March snow storm and late last night even saw another round of would-be news on President Trump’s 2005 tax return. Those two later stories were far less newsworthy than was widely anticipated as Trump paid a 25 percent tax rate and winter storm Stella’s impact wasn’t as extreme as expected, although it did leave trading volumes rather light yesterday. They would have been so regardless, as the market is still in wait-and-see mode as it eyes today’s afternoon announcement from the Federal Reserve on interest rates.

What was once thought of as a long shot, has reversed course and picked up steam with the market now widely anticipating the Fed to modestly boost interest rates. The rate increase is expected even though, as we pointed out in this week’s Monday Morning Kickoff, the Atlanta Fed has done nothing but trim its GDP expectations for 1Q 2017 over the last few weeks. Odds are, today’s latest iteration of that GDPNow report will see a boost up from the dismal 1.2 percent reading owing to the February Employment Report, but it will be hard pressed to break past the 1.9 percent GDP print for 4Q 2016.

Keeping in mind the Fed has a knack for boosting interest rates at the wrong time, and it looks increasingly like Trump’s fiscal policies will take longer than many have expected to take hold and boost the economy, we here at Tematica will continue to tread prudently and cautiously in the near-term.

 

Hope and enthusiasm can only carry the market so high for so long.

Yes, each week we continue to see confirming data points for our 17 investment themes, which you can see in our Friday missive that is Thematic Signals, but we remain concerned over the market’s stretched valuation and the simple fact that expectations have to catch up with the current economic reality.

Now when many hear talk like that, the first reaction is to get nervous. It’s understandable, but we’re not suggesting a market correction is coming. Even though there are signs the economy has slowed, it is still growing as evidenced by the recent reports from Markit Economics and ISM. Our thinking is that a market pullback — something we define to be in the 3-6 percent range — may not be popular to all the recently returned investors, but it would take, to quote former Fed Chief Alan Greenspan, some of the “irrational exuberance” out of the market. Not a bad thing as it would allow us to revisit some thematic contenders that have moved higher and faster than they probably should over the last four and a half months.

Like Warren Buffett is often quoted saying, “Price is what you pay, value is what you get.”

We couldn’t agree more.

Aside from the now largely expected interest rate increase itself, let’s remember the Fed tends to be very vague in its language and the market has a habit of not really listening to what the Fed is trying to communicate. As the Fed boosts interest rates, we’re likely to get an update on its economic and inflation forecasts in its policy statements and its that language that will either soothe the market or give it some indigestion.

 

You’ve probably come to the conclusion that it’s best to stand pat for now, and we certainly agree. 

We’ve got a number of positions on the Tematica Select List that are benefitting from pronounced multi-year tailwinds, like Connected Society company Dycom Industries (DY) and the 5G deployment; Disruptive Technology plays Universal Display (OLED) and Applied Materials (AMAT); Aging of the Population and AMN Healthcare (AMN) and the PureFunds ISE Cyber Security ETF (HACK) that is part of our Safety & Security investing theme to name just a few.

Two stocks we will be watching closely are Food with Integrity United Natural Foods (UNFI), which reported good quarterly earnings last week and recently stopped out Costco Wholesale (COST) shares. Both stocks drifted lower last week, with UNFI a tad below the average cost basis of $42.95 on the Tematica Select List and Costco shares breaking through their 50-day moving average at $167.34. When we’ve seen such moves in COST shares previously, it tends to take more than a few weeks for the shares to settle out. Given our Cash-strapped Consumer investing theme and the Costco’s continued expansion, as well as announced membership price hike, that should drive membership-related profits higher.

  • We’ll continue to keep our eyes on COST for an opportunity to jump back in.

 

Ways to Get Prepared for Future Moves

Be sure to listen to the latest edition of Cocktail Investing, in which Tematica Chief Macro Strategist Lenore Hawkins and I talk with Steve Fredette of Toast, a restaurant technology company at the intersection of the Connected Societyand Asset-lite investment themes. We’ll have another episode out tomorrow that will wrap up all the key market and economic data with a special guest Jack Mohr, who up until recently worked with Jim Cramer — yes that Jim Cramer — managing his Action Alerts Portfolio.

Also be sure to come back to Tematica Investing during the week to see our latest thoughts and comments on the economy, the market and stocks, both in and out of the Tematica Select List.

A Wait-and-See Approach as Trump Inauguration and Earnings Cocktail Unfolds

A Wait-and-See Approach as Trump Inauguration and Earnings Cocktail Unfolds

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

As you sit down and digest this latest issue of Tematica Investing, you’ll notice it’s a tad shorter than the usual 6-10 pages that we fill to the brim. On the one hand, we’re inclined to say “you’re welcome,” but the reality is with the market rangebound over the last 20 plus days, the presidential inauguration about to take-over the news cycle, the velocity of earnings reports about to pick up, and Eurozone drama likely to re-emerge in the coming days, we’ve opted to see how things unfold over the next several days before making any new moves with the Tematica Select List.

That said, the thematic tailwinds are still blowing for a number of our positions with a “Buy” rating, including: Facebook (FB), Nuance Technologies (NUAN), McCormick & Co. (MKC), Dycom Industries (DY), Universal Display (OLED), CalAmp Corp. (CAMP), United Natural Foods (UNFI), Starbucks (SBUX) and International Flavors & Fragrances (IFF).

With the market move over the last several weeks, we’d recommend subscribers continue to hold their positions in AT&T (T), Costco Wholesale (COST), Disney (DIS), Alphabet (GOOGL) and Amazon (AMZN), but wait for a pullback before adding any more capital to those positions. For new subscribers that means we’d recommend you watch from the sidelines for now on those positions.

 

Is the Trump Rally Over as Investors Keep the Markets Range Bound Since the New Year?

Since last week’s Tematica Investing, we’ve seen the overall stock market little changed, with the Dow Jones Industrial Average down slightly, the S&P 500 essentially flat and the Nasdaq Composite Index up a tick.

range-bound index

We’ve had a number of favorable moves on the Tematica Select List, with Facebook (FB) climbing more than 2 percent and Amazon (AMZN) up more than 1.5 percent with favorable moves in International Flavors & Fragrances (IFF), AT&T (T), Costco Wholesale (COST) and Universal Display (OLED) were had. Several Tematica Select List positions moved relative sideways during the week, like Alphabet (GOOGL) and Nuance Communications (NUAN), but we see that as treading water ahead of the earnings report deluge.

As the market braces for the deluge of fourth quarter earnings announcements, we continue to find confirming data for our active positions. Case in point, reports that smartphone vendors are concerned Apple (AAPL) could “monopolize OLED supply capacity for this year’s iPhone 8,” and are looking to secure organic light emitting diode capacity fits with our thesis and bodes well for our Universal Display (OLED) shares.

Another, even though we just added Disruptive Technology theme company Nuance Communications (NUAN) to the Tematica Select List last week, we continue to hear about new voice-enabled applications like the one from Adobe Systems (ADBE) called “intelligent digital assistant photo editing” that is more simply put a voice-controlled photo editor. We have to admit, we are rather excited for that one assuming it helps reduce the trial and error effort to touch up photos and get rid of all those red eyes.

As we mentioned above, we are preparing to drink from a firehose-like deluge of earnings announcements this week and the next few. As evidenced by what we’ve seen thus far from JPMorgan Chase (JPM), Bank of America (BAC), PNC Bank (PNC), United Continental (UAL), WD40 (WDFC), CSX (CSX) and Gigamon (GIMO) it’s going to be a rather mixed bag of reports over the coming weeks. Once again we’re seeing earnings misses relative to expectations lead to falling stock prices. Not a bad thing considering how far and how fast the stock market has jumped since early November, especially if you’ve been a prudent investor like we have been these past several weeks. During that time we added Rise & Fall of the Middle Class McCormick & Co. (MKC), Facebook (FB) as our latest Connected Society play and last week Nuance Communications (NUAN) given its disruptive voice technology.

While we could point out that all three have moved nicely higher, especially Facebook, which certainly has us feeling pretty good, it’s the opportunity to circle back to the ones that got away that has us rather excited this earnings season. It’s not that we want bad news, but rather the opportunity to buy well positioned, thematically driven businesses at better prices. That’s how we added Facebook shares to the Tematica Select List — we knew the company was a key player in our Connected Society investing theme, but we waited until we had a compelling risk-to-reward tradeoff in the share price.

This reminds us of one of “Uncle” Warren Buffet’s most used sayings, “Price is what you pay. Value is what you get.”

We suspect there will be far more value to be had in the stock market over the next few weeks compared to the last several as December quarter earnings kicks into gear. As we’ve shared in the last several issues of The Monday Morning Kickoff, expectations have been running high, but recently more investors have been scratching their heads as they put the economic reality puzzle pieces together and reassess what is “expected.” Making this even more challenging is we have the Volatility Index near its lowest levels in over a year. Looking at the chart below, the words “reversion to the mean” ring in our head.

What this tells us is should the news turn to something less than expected, we are bound to see a far more bumpy time in the market than the smooth sailing we’ve seen since early November.

 

President-elect Trump’s Tweets and Interviews Suggest a Bumpy Ride 

Unless you live under a rock or are stuck under a very large piece of furniture with no access to a TV or the internet (yes, the internet has become so ubiquitous that it now lowercase), you know this week also marks the presidential inauguration, which will dominate headlines over the next few days. While we will watch the events of the week and listen to the speeches and confirmation hearings for clues as to what’s to come from the new Trump administration, we won’t be shedding a tear as we move past the event and onto the work that needs to be done.

As that happens, we also hope that President Trump rethinks his Twitter (TWTR) usage, but not necessarily for the same reasons as the media. While we like the push to bring jobs back to the US and put a more effective healthcare program in place, as investors we are not fans of the policy-by-bullhorn we have seen.

What makes this even more challenging is we have yet to receive a holistic view on what President-elect Trump’s policies will be, and this “keep them guessing” approach of one-off pronouncements may be good for his intended deal making, it’s added a layer of uncertainty for the stock market, and as we know the market doesn’t like uncertainty.


As we’ve seen from president-elect Trump’s tweets and interviews, his words have the potential to be very disruptive to the investment playing field:

  • Earlier this month, close to $25 billion was shaved off the value of the S&P 500’s top nine pharmaceutical companies in a matter of minutes, following President-elect accusing them of “getting away with murder.”
  • Last week following a newspaper interview with President-elect Trump in which he warned he would impose a border tax of 35 percent on vehicles imported from abroad to the US market, German carmaker stocks sold off sharply.
  • The US dollar slumped to a seven-week low against Japan’s yen late Tuesday, and continued to trade lower against a slew of currencies early this morning after President-elect Trump said that the buck was “too strong”. In an article in The Wall Street Journal, Mr. Trump said the strength of the US dollar against China’s yuan “is killing us.”

 

Amidst All This Uncertainty, We’re Taking a Wait and See Approach 

We’ve encountered many disruptions in the past and odds are these current events won’t be last. Over the last few years, we’ve seen earnings season become a greater source of stock price volatility — miss EPS expectations by a penny, and we now see share prices fall 10-20 percent, far greater than the single digits selloffs that had been the norm. These tend to be short-term disruptions that give way to market forces, which means that as we continue to focus on thematic fundamentals, we’ll be vigilant for opportunities presented by wide swings in stock prices.

With this in mind, we’re holding off making any moves with the Tematica Select List this week as we instead digest company comments regarding the tone of the economy, impact of the dollar on their business outlook and of course the strength of our thematic tailwinds.

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is above; however downloading the full issue provides detailed performance tables and charts. Click here to download.

Making a Nuanced Move With The Tematica Select Investment List

Making a Nuanced Move With The Tematica Select Investment List

DOWNLOAD THIS WEEK’S ISSUE
The full content of Tematica Investing is below; however downloading the full issue provides detailed performance tables and charts.Click here to download.

Over the last week, while many have been watching the Dow Jones Industrial Average flirt with 20,000, the Nasdaq Composite Index continued to climb higher. That led our Connected Society investment theme positions in Facebook (FB), Alphabet (GOOGL) and Amazon (AMZN) higher over the last week.

  • Even so, we still have ample room to our respective price targets for each of those positions and our buy rating on all three remains.

 

Over the last few months, we’ve been talking about the impact of food deflation, which has been confirmed by our Cash-strapped Consumer play that is Costco Wholesale (COST) as well as grocery chain Kroger (KR) and others.

We’ve also called out the inability of restaurants to harness that deflation for their own margins given minimum wage increases and other cost drivers. The latest findings from Fitch Ratings sees restaurant sales slowing this year, and the NPD Group expects traffic will be flat this year, with a 2 percent decline at dine-in restaurants offsetting a 1% increase at quick-service concepts.  We expect confirmation to be had this coming earnings season, and if Kona Grill’s (KONA) 4 percent decline in same-store sales for the December quarter is any indication it’s not going to be pretty.

Still, we know that people need to eat and are continuing to shift toward organic and natural foods and other products, which bodes well for our McCormick & Co. (MKC) and United Natural Foods (UNFI) shares. Recent findings from a new poll conducted by Pew Research Center underscore our bullish position. According to the Pew poll, 55 percent of Americans believe that “organic food, particularly organically grown fruits and vegetables, are healthier than conventional.” The same poll also showed a growing distrust of GMO foods and concern over pesticide use.

A different study conducted by the European Parliament’s Independent Research Service, titled “Human health implications of organic food and organic agriculture,” concluded that eating organic food improves early development, reduces pesticide exposure, strengthens the nutritional value of food, and mitigates disease risks.
We do not see this as a short-term fad and point to a recent report from Research and Markets that forecasts the global market for organic food to grow at “a CAGR of over 14 percent during 2016-2021, on account of high demand for organic food.”

  • Both MKC and UNFI remain Buys at current levels.

 

rogueonecharact-6d3c3120104-originalOn the continued strength of Rouge One at the box office and the news that Content is King investment theme company The Walt Disney Co. (DIS) is firming up plans for a streaming ESPN service, our Disney shares moved higher over the last several days.

The same can be said with our CalAmp (CAMP) shares following management’s presentation at the annual Needham Growth Conference that focused on its expanding market opportunities across fleet management, Connected Car and enterprise asset tracking markets.

Adding Nuance Communications (NUAN)
to the Tematica Select List as Voice Goes Big

Last week was the tech world descended upon Las Vegas for CES 2017. The annual trade show kicks off the new year and introduces a number of new consumer gadgets that we’re likely to see — some this year and others in the coming ones.

Among the sea of announcements, there were a number that focused on one aspect of our Disruptive Technology investing theme and that is the area of voice recognition technology. Over the years we’ve seen various incarnations of this technology, most recently with Siri from Apple (AAPL), Cortana from Microsoft (MSFT), Google Assistant from Alphabet (GOOGL) and Alexa from Amazon (AMZN). Each of these has come to the forefront like in products like Amazon Echo and Google Home that house these virtual digital assistants (VDAs), but for now one of the largest consumer-facing markets for voice interface technology has been the smartphone. Coming in 2016, Parks Associates found that nearly 40 percent of all smartphone owners use some sort of voice recognition software such as Siri or Google Now.

 

 

In 2016, the up and comer was Amazon as sales of its Echo devices were up 9x year over year this past holiday season and “millions of Alexa devices sold worldwide this year.” If you’re a user of Amazon Echo like we are, then you know that each week more capabilities are being added to the Alexa app such as ordering a pizza from Dominos (DPZ), calling for an Uber, checking sports scores and weather to getting holiday cocktail recipes.

As we entered 2017, Amazon announced that Prime members can voice-order their next meal through Amazon Restaurants on their Alexa-enabled devices including the Amazon Echo and Echo Dot. Once an order is placed, Amazon delivery partners deliver the food in one hour or less. Pretty cool so long as you have Amazon Restaurants operating in and around where you live.

 

 

Virtual digital assistants cut across more than just smartphones and devices like Amazon Echo and the recently announced Google Home. According to a new report from Tractica, while smartphone-based consumer VDAs are currently the best-known offerings, virtual assistant technologies are also beginning to penetrate other device types including smart watches, fitness trackers, PCs, smart home systems, and automobiles.

We saw just that at CES 2017 with some landscaping changing announcements for VDAs. Alphabet had several announcements surrounding its Google Home product at CES 2017, including integration into upcoming Hyundai and Chrysler models; and acquiring Limes Audio, which focuses on voice communication systems, and will likely be additive to the company’s Google Home, Hangouts and other products. Microsoft also scored a win for Cortana with Nissan.

While those wins were impressive, the big VDA winner at CES was Amazon as it significantly expanded its Alexa footprint on deals with LG, Dish Network (DISH), Whirlpool (WHR), Huawei and Ford (F). In doing so Amazon has outflanked Alphabet, Microsoft and even Apple in the digital assistant market. To us, that’s another leg to the Amazon stool that offers more support to the share alongside the digital shopping/services, content, and Amazon Web Services businesses. You don’t need to read between the lines to think that we still see big upside to our $975 Amazon price target.

To be fair, Apple originally did not license out its Siri technology and only in June 2016 did it announce that it would open the code behind Siri to third-party developers through an API, giving outside apps the ability to activate from Siri’s voice commands, and potentially endowing Siri with a wide range of new skills and datasets.
Tractica forecasts that unique active consumer VDA users will grow from 390 million in 2015 to 1.8 billion worldwide by the end of 2021.  During the same period, unique active enterprise VDA users will rise from 155 million in 2015 to 843 million by 2021.  The market intelligence firm forecasts that total VDA revenue will grow from $1.6 billion in 2015 to $15.8 billion in 2021.

 

An Overlooked Player in the VDA Segment

Nuance Communications logoThe one drawback when it comes to the VDA market is the players mentioned above have large existing businesses, which means their respective VDA businesses, at least in the next few yeas, will have at best modest influence on their overall financial picture. In keeping with our “buy the bullets not the guns,” coming out of CES 2017 we find ourselves looking at speech technology and voice recognition company Nuance Communications (NUAN).

Nuance’s voice solutions compete in four markets:

  • Healthcare (49 percent of revenue): In this business, Nuance supports clinical documentation workflows and electronic medical record (EMR) adoption through flexible offerings, including transcription services, dictation software for the EMR, diagnostics workflow, and mobile applications. Recently Nuance released Dragon Medical Advisor, an AI Assistant for doctors. More than 500,000 clinicians and 10,000 healthcare facilities worldwide use Nuance’s healthcare solutions, which are sold through customers that include Cerner (CERN), Epic, McKesson (MCK), UPMC, Cleveland Clinic, Siemens, and the Mayo Clinic. Over the last few quarters, Nuance has been transitioning this business from a perpetual license business to a software as a service (SAAS) one, but with that shift expected to be largely completed by the second half of 2017 that revenue drag should be eliminated.
  • Enterprise (20 percent of revenue): This business segment offers automated intelligent self-service solutions that include speech and artificial intelligence (AI) technologies that reduce or replace human contact center agents with conversational systems, across voice, mobile, web and messaging channels. Think of when you call your bank, broker or even consider using the phone to call for a pizza from Dominos (candidly we’re not sure why you would call given the ease of the Domino’s app that can be used on either your smartphone, Apple TV, or Amazon’s Alexa, but hey that’s us). Representative customers include Avaya, BT, Cisco, DiData, Genesys, Huawei, MoshiMoshi, NICE, Telstra, and Verint. Nuance’s customers include: American Airlines, Amtrak, Bank of America, Barclays, Dominos, Delta, Deutsche Telekom, e*trade, ING Bank, Lloyds Banking Group, T-Mobile, Telefonica, Telstra, and Vodafone.
  • Mobile (19 percent of revenue): Here Nuance offers a portfolio of specialized virtual assistants and connected services built on voice recognition, text-to-speech, natural language understanding, dialog, and text input technologies across automotive, device and mobile operator solutions. With regard to automotive in particular, Nuance has announced Daimler, Ford and BMW as customers, and as evidenced at both CES 2017 and the 2017 North American International Auto Show we are nearing the tipping point for the Connected Car, which should bode well for this business segment.
  • Imaging (12 percent of revenue): In this division, segment Nuance provides software solutions and expertise that help professionals and organizations to gain optimal control of their document and information processes. Customers and partners include Ricoh, Xerox, HP, Canon, and Samsung. This business has been bumping along at around 11 to 12 percent of revenue the last few years as Nuance has reorganized itself over the last several quarters.

When we step back from Nuance’s business segments and look at the overall market growth for voice recognition technologies, BCC Research sees it growing to $184.9 billion in 2021, up from $90.3 billion in 2015. Breaking these two markets down into Consumer and Enterprise markets, BCC expects the Consumer market to grow to $95.9 billion in 2021 from $54.4 billion in 2016 and the Enterprise market to reach $79.0 billion by 2021 up from $44.0 billion in 2016. Viewed against that larger market, we see ample room for Nuance to expand beyond the $1.9 billion in revenue it generated in 2016.

Over the last few years, after delivering significant revenue growth during 2010-2014,  the pace of revenue growth, while positive, has dipped. Part of that is due in part to erosion for the transcription business in the company’s Healthcare business, as well as the shift from a contract business model to a Cloud based one that offers integrated solutions. In 2016, roughly 70 percent of the company’s revenue stream was recurring in nature, up from 65 percent or so in 2015.

What this tells us is the bulk of the revenue shift is largely behind the company. Like a turning tanker, these changes take time, but once they catch momentum they tend to pick up speed and Nuance should see its recurring revenue growth to 70-75 percent of overall revenue during 2017. As investors, we like the nature of a recurring revenue model, given that it affords far greater visibility and shares tend to be rewarded with better multiples given that predictability.

We’ve seen the power of this business shift already at Adobe Systems (ADBE), which now has more than 70 percent of its revenue recurring in nature, up from 19 percent in 2011, and its shares that have climbed to just over $108 from $28 at the end of 2011.

Looking Ahead to 2017 for Nuance

The growth businesses at Nuance include its automotive, voice biometrics, omni-channel customer care, unified print and scan solutions, Dragon Medical, CDI and diagnostics. Paving the way is the company’s most recent quarterly bookings, which were up 45 percent year on year. Longer-term we expect more applications across the consumer electronics market to develop. As noted above, Whirlpool is working with Amazon and odds are that means before too long we’ll see VDAs built into various appliances across the kitchen and laundry rooms. In our view, that’s just scratching at the surface.

The big question circling Nuance is the competitive landscape, particularly the move by Amazon, Alphabet and Apple to open up their application programming interface (API) to third-parties. Just like Rackspace (RACK) specializes in Cloud computing, but thus far has remained unharmed by Amazon’s AWS, Nuance specializes in selling to global brands, health care, and large corporations, which are not likely to utilize Google’s free API for its business needs. As you’ve probably notice with Android, one of the issues with a free API is malware and cyber hacking.

It’s also not lost on us that Alphabet recently acquired Limes Audio to improve its voice recognition capabilities. As anyone who has used Apple’s Siri knows, it’s far from perfect in voice recognition and voice to text. In our view, this means Nuance could be an attractive candidate for a larger player that needs to improve its technology positioning.

 

What are NUAN shares worth?

In looking over historic multiples, including P/E and Enterprise Value to Revenue, and applying them to consensus 2017 earnings expectations that call for EPS of $1.59 on revenue of just over $2 billion, we see upside to $21 and downside to just under $15.

At the current share price — $15.45 as of market close on 1/10/17 — NUAN shares are trading at under 10x expected 2017 earnings of $1.59 per share. We certainly like that risk-to-reward trade-off in NUAN shares at a time when voice technology is expanding its market size across the device, automotive and Internet of Things markets.

 

Bottomline on Nuance Communications (NUAN)
  • We’re adding NUAN shares to the Tematica Select list with a price target of $21.
  • Because this is a new position, we are holding off with a stop loss recommendation at this time, preferring to use near-term weakness to scale into the position and improve the cost basis.

 

* We strongly recommend you use the link below to download the full report on Nuance Communications (NUAN), which includes background on our Disruptive Technology thematic as well as financials on NUAN.

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