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Doubling Down on Digital Infrastructure Thematic Leader

Doubling Down on Digital Infrastructure Thematic Leader

Key point inside this issue

  • We are doubling down on Dycom (DY) shares on the Thematic Leader board and adjusting our price target to $80 from $100, which still offers significant upside from our new cost basis as the 5G and gigabit fiber buildout continues over the coming quarters.

We are coming at you earlier than usual this week in part to share my thoughts on all of the economic data we received late last week.

 

Last week’s data confirms the US economy is slowing

With two-thirds of the current quarter behind now in the books, the continued move higher in the markets has all the major indices up double-digits year to date, ranging from around 11.5-12.0%% for the Dow Jones Industrial Average and the S&P 500 to nearly 18% for the small-cap heavy Russell 2000. In recent weeks we have discussed my growing concerns that the market’s melt-up hinges primarily on U.S.-China trade deal prospects as earnings expectations for this year have been moving lower, dividend cuts have been growing and the global economy continues to slow. The U.S. continues to look like the best economic house on the block even though it, too, is slowing.

On Friday, a round of IHS Markit February PMI reports showed that three of the four global economic horsemen — Japan, China, and the eurozone — were in contraction territory for the month. New orders in Japan and China improved but fell in the eurozone, which likely means those economies will continue to slug it out in the near-term especially since export orders across all three regions fell month over month. December-quarter GDP was revealed to be 2.6% sequentially, which equates to a 3.1% improvement year over year but is down compared to the 3.5% GDP reading of the September quarter and 4.2% in the June one.  Slower growth to be sure, but still growing in the December quarter.

Before we break out the bubbly, though, the IHS Markit February U.S. Manufacturing PMI fell to its lowest reading in 18 months as rates of output and new order growth softened as did inflationary pressures. This data suggest the U.S. manufacturing sector is growing at its slowest rate in several quarters, as did the February ISM Manufacturing Index reading, which slipped month over month and missed expectations. Declines were seen almost across the board for that ISM index save for new export orders, which grew modestly month over month. The new order component of the February ISM Manufacturing Index dropped to 55.5 from 58.2 in January, but candidly this line item has been all over the place the last few months. The January figure rebounded nicely from 51.3 in December, which was down sharply from 61.8 in November. This zig-zag pattern likely reflects growing uncertainty in the manufacturing economy given the pace of the global economy and uncertainty on the trade front. Generally speaking though, falling orders translate into a slower production and this means carefully watching both the ISM and IHS Markit data over the coming months.

In sum, the manufacturing economy across the four key economies continued to slow in February. On a wider, more global scale, J.P. Morgan’s Global Manufacturing PMI fell to 50.6 in February, its lowest level since June 2016. Per J.P. Morgan’s findings, “the rate of expansion in new orders stayed close to the stagnation mark,” which suggests we are not likely to see a pronounced rebound in the near-term. We see this as allowing the Fed to keep its dovish view, and as we discuss below odds are it will be joined by the European Central Bank this week.

Other data out Friday included the December readings for Personal Income & Spending and the January take on Personal Income. The key takeaway was personal income fell for the first time in more than three years during January, easily coming in below the gains expected by economists. Those pieces of data not only help explain the recent December Retail Sales miss but alongside reports of consumer credit card debt topping $1 trillion and record delinquencies for auto and student loans, point to more tepid consumer spending ahead. As I’ve shared before, that is a headwind for the overall US economy but also a tailwind for those companies, like Middle-class Squeeze Thematic Leader Costco Wholesale (COST), that help consumers stretch the disposable income they do have.

We have talked quite a bit in recent Tematica Investing issues about revisions to S&P 500 2019 EPS estimates, which at last count stood at +4.7% year over year, down significantly from over +11% at the start of the December quarter. Given the rash of reports last week – more than 750 in total –  we will likely see that expected rate of growth tweaked a bit lower.

Putting it all together, we have a slowing U.S. and global economy, EPS cuts that are making the stock market incrementally more expensive as it has moved higher in recent weeks, and a growing number of dividend cuts. Clearly, the stock market has been melting up over the last several weeks on increasing hopes over a favorable trade deal with China, but last week we saw President Trump abruptly end the summit with North Korea’s Kim Jong Un with no joint agreement after Kim insisted all U.S. sanctions be lifted on his country. This action spooked the market, leading some to revisit the potential for a favorable trade deal between the U.S. and China.

Measuring the success of any trade agreement will hinge on the details. Should it fail to live up to expectations, which is a distinct possibility, we could very well see a “buy the rumor, sell the news” situation arise in the stock market. As I watch for these developments to unfold, given the mismatch in the stock market between earnings and dividends vs. the market’s move thus far in 2019 I will also be watching insider selling in general but also for those companies on the Thematic Leader Board as well as the Tematica Select List. While insiders can be sellers for a variety of reasons, should we see a pronounced and somewhat across the board pick up in such activity, it could be another warning sign.

 

What to Watch This Week

This week we will see a noticeable drop in the velocity of earnings reports, but we will still get a number of data points that investors and economists will use to triangulate the speed of the current quarter’s GDP relative to the 2.6% print for the December quarter. The consensus GDP forecast for the current quarter is for a slower economy at +2.0%, but we have started to see some economists trim their forecasts as more economic data rolls in. Because that data has fallen shy of expectations, it has led the Citibank Economic Surprise Index (CESI) to once again move into negative territory and the Atlanta Fed’s GDPNow current quarter forecast now sat at 0.3% as of Friday.

On the economic docket this week, we have December Construction Spending, ISM’s February Non-Manufacturing Index reading, the latest consumer credit figures and the February reports on job creation and unemployment from ADP (ADP) and the Bureau of Labor Statistics. With Home Depot (HD) reporting relatively mild December weather, any pronounced shortfall in December Construction Spending will likely serve to confirm the economy is on a slowing vector. Much like we did above with ISM’s February Manufacturing Index we’ll be looking into the Non-Manufacturing data to determine demand and inflation dynamics as well as the tone of the services economy.

On the jobs front, while we will be watching the numbers created, including any aberration owing to the recent federal government shutdown, it will be the wage and hours worked data that we’ll be focusing on. Wage data will show signs of any inflationary pressures, while hours worked will indicate how much labor slack there is in the economy. The consumer is in a tighter spot financially speaking, which was reflected in recent retail sales and personal spending data. Recognizing the role consumer spending plays in the overall speed of the U.S. economy, we will be scrutinizing the upcoming consumer credit data rather closely.

In addition to the hard data, we’ll also get the Fed’s latest Beige Book, which should provide a feel for how the regional economies are faring thus far in 2019. Speaking of central bankers, next Wednesday will bring the results of the next European Central Bank meeting. Given the data depicted in the February IHS Markit reports we discussed above, the probability is high the ECB will join the Fed in a more dovish tone.

While the velocity of earnings reports does indeed drop dramatically next week, there will still be several reports worth digging into, including Ross Stores (ROST), Kohl’s (KSS), Target (TGT), BJ’s Wholesale (BJ), and Middle-class Squeeze Thematic Leader Costco Wholesale (COST) will also issue their latest quarterly results. Those reports combined with the ones this week, including solid results from TJX Companies (TJX) last week should offer a more complete look at consumer spending, and where that spending is occurring. Given the discussion several paragraphs above, TJX’s results last week, and the monthly sales reports from Costco, odds are quite good that Costco should serve up yet another report showcasing consumer wallet share gains.

Outside of apparel and home, reports from United Natural Foods (UNFI) and National Beverage (FIZZ) should corroborate the accelerating shift toward food and beverages that are part of our Cleaner Living investing theme. In that vein, I’ll be intrigued to see what Tematica Select List resident International Flavors & Fragrances (IFF) has to say about the demand for its line of organic and natural solutions.

The same can be said with Kroger (KR) as well as its efforts to fend off Thematic King Amazon (AMZN) and Walmart (WMT). Tucked inside of Kroger’s comments, we will be curious to see what the company says about digital grocery shopping and delivery. On Kroger’s last earnings conference call, Chairman and CEO Rodney McMullen shared the following, “We are aggressively investing to build digital platforms because they give our customers the ability to have anything, anytime, anywhere from Kroger, and because they’re a catalyst to grow our business and improve margins in the future.” Now to see what progress has been achieved over the last 90 or so days and what Kroger has to say about the late-Friday report that Amazon will launch its own chain of supermarkets.

 

Tematica Investing

As you can see in the chart above, for the most part, our Thematic Leaders have been delivering solid performance. Shares of Costco Wholesale (COST) and Nokia (NOK) are notable laggards, but with Costco’s earnings report later this week which will also include its February same-store sales, I see the company’s business and the shares once again coming back into investor favor as it continues to win consumer wallet share. That was clearly evident in its December and January same-store sales reports. With Nokia, coming out of Mobile World Congress 2019 last week, we have confirmation that 5G is progressing, with more network launches coming and more devices coming as well in the coming quarters. We’ll continue to be patient with NOK shares.

 

Adding significantly to our position in Thematic Leader Dycom Industries

There are two positions on the leader board – Aging of the Population AMN Healthcare (AMN) and Digital Infrastructure Dycom Industries (DY) – that are in the red. The recent and sharp drop in Dycom shares follows the company’s disappointing quarterly report in which costs grew faster than 14.3% year over year increase in revenue, pressuring margins and the company’s bottom line. As we’ve come to expect this alongside the near-term continuation of those margin pressures, as you can see below, simply whacked DY shares last week, dropping them into oversold territory.

 

When we first discussed Dycom’s business, I pointed out the seasonal tendencies of its business, and that likely means some of the February winter weather brought some added disruptions as will the winter weather that is hitting parts of the country as you read this. Yet, we know that Dycom’s top customers – AT&T (T), Verizon (VZ), Comcast (CMCSA) and CenturyLink (CTL) are busy expanding the footprint of their connective networks. That’s especially true with the 5G buildout efforts at AT&T and Verizon, which on a combined basis accounted for 42% of Dycom’s January quarter revenue.

Above I shared that coming out of Mobile World Congress 2019, commercial 5G deployments are likely to be a 2020 event but as we know the networks, base stations, and backhaul capabilities will need to be installed ahead of those launches. To me, this strongly suggests that Dycom’s business will improve in the coming quarters, and as that happens, it’s bound to move down the cost curve as efficiencies and other aspects of higher utilization are had. For that reason, we are using last week’s 26% drop in DY shares to double our position size in DY shares on the Thematic Leader board. This will reduce our blended cost basis to roughly $64 from the prior $82. As we buy up the shares, I’m also resetting our price target on DY shares to $80, down from the prior $100, which offers significant upside from the current share price and our blended cost basis.

If you’re having second thoughts on this decision, think of it this way – doesn’t it seem rather strange that DY shares would fall by such a degree given the coming buildout that we know is going to occur over the coming quarters? If Dycom’s customers were some small, regional operators I would have some concerns, but that isn’t the case. These customers will build out those networks, and it means Dycom will be put to work in the coming quarters, generating revenue, profits, and cash flow along the way.

In last week’s Tematica Investing I dished on Warren Buffett’s latest letter to Berkshire Hathaway (BRK.A) shareholders. In thinking about Dycom, another Buffett-ism comes to mind – “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” Since this is a multi-quarter buildout for Dycom, we will need to be patient, but as we know for the famous encounter between the tortoise and the hare, slow and steady wins the race.

  • We are doubling down on Dycom (DY) shares on the Thematic Leader board and adjusting our price target to $80 from $100, which still offers significant upside from our new cost basis as the 5G and gigabit fiber buildout continues over the coming quarters.

 

As the pace of earnings slows, over the next few weeks I’ll not only be revisiting the recent 25% drop in Aging of the Population Thematic Leader AMN Healthcare to determine if we should make a similar move like the one we are doing with Dycom, but I’ll also be taking closer looks at wireless charging company Energous Corp. (WATT) and The Alkaline Water Company (WTER). Those two respectively fall under our Disruptive Innovators and Cleaner Living investing themes. Are they worthy of making it onto the Select List or bumping one of our Thematic Leaders? We’ll see…. And as I examine these two, I’m also pouring over some candidates to fill the Guilty Pleasure vacancy on the leader board.

 

 

Weekly Issue: The Changing Mood of the Market

Weekly Issue: The Changing Mood of the Market

Over the last several days, volatility in the stock market has been rampant with wide swings taking place. Part and parcel of this has been a mood change in the stock market as high-flying stocks, including a number of technology ones, have come under pressure as investors re-think their growth prospects. That continued yesterday as shares of iPhone maker Apple (AAPL) became the latest one to dip into bear market territory with last night’s close following renewed concerns over the company’s device shipments in the near-term. This, in turn, has led to a few downgrades by Wall Street analysts, that at least in my view, are being somewhat short-sighted as the company continues to morph its business into one that is more reliant on high margin services rather than just the iPhone.

The same can be said with Amazon (AMZN), which has seen its shares tumble despite there being no slowdown in the shift to digital commerce as evidenced by the October Retail Sales Report. That report showed Nonstore retail sales for the month climbing just shy of 3x as fast as overall retail sales year over year. That was certainly confirmed in the latest earnings reports this week from Macy’s (M) and Walmart (WMT).  All indications, as well as expectations, have this aspect of our Digital Lifestyle investing theme accelerating into the all-important holiday shopping season. And yes, this keeps me bullish on our shares of United Parcel Service (UPS)

Now here’s the tough part to swallow – while we and our thematic way of investing are likely to be right in the medium to long-term, the mood in the stock market tends to prevail in the short-term. And with several of the concerns I’ve talked about here as well as in Tematica Investing and on our podcast, Cocktail Investing, rearing their heads odds are the stock market will continue to be a volatile one in the very near-term. This will likely see the current expectation resetting continue, especially for the sector-based investor view of “technology” stocks. Talk about a multi-headed sector that is simply a mish-mash of things – I’ll stick to our thematic lens approach, thank you very much. That said, with “tech” being in the doghouse, I’m using the time to evaluate a number of companies for the currently open Disruptive Innovators slot in our Thematic Leaders. Some of the current contenders include cloud-focused companies Dropbox (DBX), Instructure (INST) and Okata (OKT) among others.

This week

What’s been driving the latest round of roller coaster like thrills in the stock market can be found in the intersection of the latest earnings reports, economic data, and political developments. From sector investing perspective, we continue to get mixed results as evidenced by this week’s earnings reports as JC Penney (JCP) lagged expectations while Walmart (WMT) and Macy’s (M) beat them. From a thematic one, however, we see the dichotomy in those results as strong confirmation in our Digital Lifestyle investing theme as both Macy’s and Walmart delivered strong digital shopping performance in those quarterly reports, while JC Penney continues to struggle with its brick & mortar business.

Our Living the Life investing theme was also the recipient of positive confirmation this week as high-end outerwear company Canada Goose (GOOS) simply smashed top and bottom line expectations. Similarly, profits at luxury car company Aston Martin (AML.L) soared as its sales volume doubled year over year in the September quarter.

 

Sticking with Del Frisco’s

And while the Living the Lifestyle Thematic Leader that is Del Frisco’s (DFRG) reported a sloppy quarter following the disposal of its Sullivan’s business, the company shared a vibrant outlook, including the plan to grow its revenue and EBITDA to at least $700 million and $100 million by, respectively, by 2020 from the September quarter run rates of $420 million and $74 million, respectively. The intent on average will be to roll out two to three Double Eagles, two to three Barcelona Wine Bars and six bartacos restaurants each year, which is a measured move over the coming years and one that could be scaled back quickly should the domestic economy begin to falter several quarters out.

Near-term, Del Frisco’s should benefit from a pick-up in activity quarter to date following the arrival in the third quarter of its new chief marketing officer. On the earnings conference call, management shared Double Eagle’s private dining is up almost 20% in the first few weeks of the quarter and bookings for the rest of the quarter are up more than 20% compared to last year at this time.

The company also confirmed one of the key aspects of our investment thesis, which centers on margin improvement due in part to beef deflation. As discussed on the earnings call, the company’s total cost of sales as a percentage of revenue for the quarter decreased by 60 basis points to 27.3% from 27.9% in the year-ago period due to margin improvements at Double Eagle, Barcelona, and bartaco. This improvement and the year-over-year jump in bookings certainly point to the expected holiday inflection point panning out, which is also the most seasonally profitable time of year for Double Eagle and Grille. Cost-reduction efforts put in place earlier this year at these two brands should lead to visible margin improvement versus year-ago levels as the holiday volumes take effect.

  • For now, we’ll keep our long-term price target of $14 for Del Frisco’s (DFRG) shares intact, revisiting as needed should the company’s rollouts begin to slip.

 

Several headwinds remain in place

Despite these positive signals and happenings, we have to remember there are several headwinds blowing on the overall stock market. These include Italy standing firm with its latest budget, which puts it at odds with the European Union; Brexit limping forward; inflationary readings in both the October Producer Price Index and Consumer Price Index that will more than likely keep the Fed’s rate hike path intact, a looming concern for consumer debt and high levels of corporate debt; and the pending trade talks between the US and China at a time when more data shows a cooling in the global economy.

On a positive note, the NFIB Small Business Index’s October reading continued the near-two year string of record highs with more small businesses than not citing a bullish attitude toward the economy and expanding their businesses. A note of caution here as most businesses tend to exude such sentiment at or near the economic peak – few see the looming the downside. The NFIB’s report once again called out the lack of skilled workers with 53% of those surveyed reporting few or no qualified applicants.

This signals potential wage pressures ahead, however, the sharp fall in oil prices, which follows the notion of the slowing global economy and rising inventory levels, is poised to give some relief to both businesses and consumers as we head into the holiday shopping season. Yes, average gas prices have fallen to $2.68 per gallon from $2.89 a month ago, but they are still up vs. $2.56 per gallon this time last year. When it comes to gas prices, most consumers think sequentially, which means they are recognizing the drop in recent weeks, which in their minds offers some relief.

Noticed, I said some relief – consumers still face high debt levels with larger servicing costs vs. the year-ago levels. And let’s be honest, a consumer with a 12-gallon gas tank in his or her car that fills up twice a week is saving all of $4.80 per week compared to this time last month. In today’s world, that’s about enough to buy one pizza with some toppings a month. In other words, it will take more pronounced declines in gas prices to make a meaningful difference for those investors that resonate with our Middle-Class Squeeze investing theme.

 

What to watch next week

In looking at the calendar for next week, we have the Thanksgiving holiday, which long-time subscribers know is one of my favorites. While the stock market is only closed for that holiday, we do have shortened trading hours next Friday – better known as Black Friday – and that will kick off the race for holiday shopping. That means we can expect the litany of headlines over initial holiday shopping sales over the post-holiday weekend as we ease into Cyber Monday. And yes, I will be paying close attention to those results given our positions in Amazon and UPS.

Before we get to share our thankfulness with family and friends, we will have a few economic reports to chew through including October Housing Starts, Durable Orders and Existing Home Sales. This week even Fed Chair Powell recognized the softening housing market as a headwind to the economy, and in my view that sets the stage for yet another lackluster housing report next week. Inside the Durable Orders report, we’ll be watching the all-important core capital goods line, a proxy for business investment. The stronger that number, the better the prospects for the current quarter, which tends to benefit from “use it or lose it” capital spending budgets.

On the earnings front next week, we will continue to hear from retailers, such as Best Buy (BBY), Kohl’s (KSS), Ross Stores (ROST) and TJX Companies (TJX). With regard to our own Costco Wholesale (COST) shares, we’ll be paying close attention to results from competitor BJ Wholesale (BJ). Outside of those retailers, I’ll be listening to what Nuance Communications (NUAN) has to say about the adoption of voice interfaces and digital assistants next week.

Looking past this week’s market relief rally

Looking past this week’s market relief rally

As expected, the last few days in the market have been a proverbial see-saw, which culminated in the sharp market rally following the mid-term elections. The outcome, which saw the Democrats gain ground in Washington, was largely expected. We’ll see in the coming weeks and months the degree of gridlock to be had in Washington and what it means for the economy, but we have to remember several other concerning items remain ahead of us. To jog memories, these include the next round of budget talks between Italy and EU, which should occur next week; continued rate hikes by the Fed as it looks to stave off inflation and get more tools back for the next eventual recession; and upcoming trade talks between the US-China.

While we like the mid-week, market rebound and what it did for the Thematic Leaders as well as positions on the Select List, the upcoming events outlined above suggest near-term caution is still warranted. Shares of McCormick & Co. (MKC) International Flavors & Fragrances (IFF) as well as Altria (MO), AMN Healthcare (AMN) and Costco Wholesale (COST) have been on a tear of late. Earlier this week, Costco reported its October same-store sales results, which once again confirmed this Middle-class Squeeze company is taking wallet share.

Yesterday, mobile infrastructure company Ericsson (ERIC) held its annual Capital Markets event at which it spoke in a bullish tone over 5G rollouts, so much so that it raised its 2020 targets. I see that along with other similar comments in the last few weeks as very positive for our positions in Digital Infrastructure leader Dycom (DY) and Disruptive Innovator Nokia Corp. (NOK) as well as AXT Inc. (AXTI) shares.

 

Axon’s – September quarter earnings and an upgrade

Over the last few weeks, share of Safety & Security Thematic Leader Axon Enterprises (AAXN) have come under considerable pressure, but on Tuesday night the company reported September quarter earnings of $0.20 per share, crushing the consensus view of $0.13 per share as both revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA) soared. Axon then reiterated its full-year guidance which hinged on the continued adoption of its Axon camera and cloud-storage business. Year over year, the number of cloud seats booked by customers rose to 325,200 exiting September up from 187,400 twelve months earlier. The combination of the 25% pullback in the shares quarter to date and that upbeat outlook led JPMorgan Chase to upgrade the shares to Overweight from Neutral.

Yes, we are down with the shares, but as the market settles out I’ll look to add to the position and improve our cost basis along the way. I continue to expect Axon will eventually acquire rival Digital Ally (DGLY) and its $31 million market cap, removing the current legal overhang on the shares. Our price target remains $90.

 

Disney earnings on deck tonight

After tonight’s market close, Disney (DIS) will report its quarterly results, and while we are not expecting any surprises for the September quarter, it’s the comments surrounding the company’s streaming strategy and integration of the Fox assets that will be in focus. Expectations for the September quarter are EPS of $1.34 on revenue of $13.73 billion. Our position on Disney has been and continues to be that based on the success of its streaming services, investors will need to revisit how they value DIS shares as it goes direct to the consumer with a cash-flow friendly subscription business model. Our price target for DIS shares remains $125.

 

Del Frisco’s earnings to follow next week

Monday morning, Del Frisco’s Restaurant Group (DFRG) also postponed its quarterly earnings report from until Tuesday, Nov. 13, citing “additional time required to finalize the accounting and tax treatment of our acquisition of Barteca Restaurant Group, disposition of Sullivan’s Steakhouse, a secondary offering of common stock and debt syndication.”

Coincidence? Perhaps, but it raises questions over the bench strength of these companies as they reshape their business. If you’ve ever been in a negotiation, you know things can slip, but following GNC’s postponement, we are at heightened alert levels with Del Frisco’s. We knew this was going to be a sloppy earnings report and we clearly have confirmation; our only question is why didn’t the management team wait to announce its earnings date until it had dotted its Is and crossed its Ts on all of these items?

To some extent, I am expecting a somewhat messy report in light of the sale of its Sullivan’s business and its common stock offering early in the quarter that raised more than $90 million. In parsing the company’s report, I will be focusing on revenue growth for the ongoing business as well as its profit generation considering that earnings-per-share comparisons could be challenging if not complicated versus the year-ago quarter. Nonetheless, the reported quarterly results will be gauged at least initially against the consensus view, which heading into the weekend sat at a loss per share of $0.25 on revenue of $120 million. For the December quarter, one of the company’s seasonally strongest, Del Frisco’s is expected to guide to EPS near $0.23 on revenue of $144 million.

So far this earnings season we’ve heard how restaurant companies including Bloomin’ Brands Inc. (BLMN), Ruth’s Hospitality Group (RUTH), Del Taco Restaurants Inc. (TACO), Chipotle Mexican Grill Inc. (CMG) and more recently Wingstop Inc. (WING) are seeing their margins benefitting from food deflation. Along with a pickup in average check size owing to prior price increases, these companies have delivered margin improvement and expanding EPS. I expect the same from Del Frisco’s. When coupled with an expected uptick in holiday spending and consumer sentiment running at high levels, we remain bullish on DFRG shares heading into Monday’s earnings report. Our price target on DFRG shares remains $14.

 

What to Watch Next Week

On the economic front, we’ll get more inflation data in the form of the October CPI report next week, which follows tomorrow’s October PPI one. In both we hear at Tematica will be scrutinizing the year over year comparisons and given the growing number of companies issuing price increases we expect to see those reflected in these October as well as November inflation reports. If the figures come in hotter than expected, expect that to reignite Fed rate hike concerns. Also, next week, we have the October reports for Retail Sales and Industrial Production as well as the first look at November with the Empire Manufacturing and Philly Fed indices.

With the October Retail Sales report, we’ll be once again parsing it to compare against the October same-store sales reported yesterday by Costco Wholesale (COST), which were up 8.6% year over year (+6.6% core). Odds are we will once again have formal confirmation that Costco is taking consumer wallet share.

Compared to the more than 1,200 earnings reports we had this week, the 345 or so next week will be a proverbial walk in the park. there will be several key reports to watch including Home Depot (HD), Macy’s (M), JC Penney (JCP), Williams Sonoma (WSM), and WalMart (WMT). We’ll be matching their forecasts for the current quarter up against the 2018 holiday shopping forecasts from the National Retail Federation, Adobe (ADBE) and others that call for overall holiday shopping to rise 4.0%-5.5% with online shopping climbing more than 15% year over year. I continue to see that as very positive for our shares in Amazon (AMZN), Costco and United Parcel Service (UPS) as well as McCormick & Co. (MKC).

Perhaps the biggest wild card next week will be the Italian budget and as we near the end of this week, things are already getting heated on that front. Today, the Italian government said it is sticking with its plan to rapidly increase public spending despite the budget dispute with the European Union, and it has no intention of revising its plan by next week. As background, Italy is the third largest economy in the EU, and if a joint resolution is not reached we expect this to reignite talk of “Italeave,” which will stoke once again questions over the durability of the EU. Given its size compared to Greece, the Italian situation is one we will be watching closely in the coming days.

Weekly Issue: Among the Volatility, We See Several Thematic Confirming Data Points

Weekly Issue: Among the Volatility, We See Several Thematic Confirming Data Points

Key points inside this issue:

  • As expected, news of the day is the driver behind the stock market swings
  • Data points inside the September Retail Sales Report keep us thematically bullish on the shares of Amazon (AMZN), United Parcel Service (UPS) and Costco Wholesale. Our price targets remain $$2,250, $130 and $250, respectively.
  • We use the recent pullback to scale further into our Del Frisco’s Restaurant Group (DFRG) shares at better prices, our price target remains $14.
  • Netflix crushes subscriber growth in the September quarter; Our price target on Netflix (NFLX) shares remains $500.
  • September quarter earnings from Ericsson (ERIC) and Taiwan Semiconductor (TSM) paint a favorable picture from upcoming reports from Nokia (NOK) and AXT Inc. Our price targets on Nokia and AXT shares remain $8.50 and $11, respectively.
  • Walmart embraces our Digital Innovators investment theme
  • Programming note: Much commentary in this week’s issue centers on the September Retail Sales Report. On this week’s Cocktail Investing podcast, we do a deep dive on that report from a thematic perspective. 

 

As expected, news of the day is the driver behind the stock market swings

If there is one thing we can say about the domestic stock market over the last week, it remains volatile. While there are other words that one might use to describe the down, up, down move over the last week, but volatile is probably the most fitting. Last week I shared the market would likely trade based on the data of the day — economic, earnings or political — and that seems to have been the case. While we’ve received several solid earnings reports, including one from Thematic Leader Netflix (NFLX), several banks and even a few airlines, the headline economic data came up soft for September Retail Sales and Housing.

And then there was yesterday’s FOMC minutes from the Fed’s September monetary policy meeting, which showed that even though the Fed expects to remain on its tightening path, subject to the data to be had, several members of the committee see “a period where the Fed even will need to go beyond normalization of rates and into a more restrictive stance.”

Odds are we can expect further tweets from President Trump on this given his prior comments that the Fed is one of his greatest risks. I also expect this to reignite concerns for the current expansion, particularly since the Fed has historically done a good job hiking interest rates into a recession. From a thematic perspective, continued rate hikes by the Fed is likely to put some added pressure on Middle-Class Squeeze consumers. Before you freak out, let’s check the data. The economy is still growing, adding jobs, benefiting from lower taxes and regulation. It’s not about to fall off a cliff in the near term, but yes, the longer the current expansion goes, the greater the risk of something more than just a slower economy. More reasons to keep watching the monthly data.

Here’s the good news, inside that data and elsewhere we continue to receive confirming signals for our 10 investing themes as well as favorable data points for the Thematic Leaders and other positions on the Tematica Investing Select List.

 

Several positives in the September Retail Sales report for AMZN, UPS & COST

Cocktail Investing Podcast September Retail Sales Report

With the consumer directly or indirectly accounting for nearly two-thirds of the domestic economy and the average consumer spending 31% of his or her paycheck on retails goods, this monthly report is one worth monitoring closely.

Let’s take a closer look at this week’s September 2018 Retail Sales report. First, let’s talk about the headline miss that was making the rounds yesterday. Yes, the month over month comparison Total Retail & Food Services excluding motor vehicles & parts fell 0.1%, but Retail rose 0.4% on the same basis. The thing is, most tend to focus on those sequential comparisons, but as investors, we examine year over year comparisons when it comes to measuring revenue, profit and EPS growth. On that basis, Total Retail & Food Services rose 5.7% year over year while Retail climbed 4.4% compared to September 2017. That sounds pretty solid if you ask me. Now, let’s dig into the meat of the report and what it means for several of our thematic holdings.

Right off the bat, we can’t ignore the 11.4% year over year increase in gas station sales during September, which capped off a 17.2% increase for the September 2018 quarter. With such an increase owing to the rise in oil and gas prices, we would expect to see weakness in several of the retail sales categories as the cost of filling up the car saps spending at the margin and confirms our Middle-Class Squeeze investing theme. And we saw just that. Department stores once again fell in September vs. year ago levels as did Sporting goods, hobby, musical instrument, & bookstores. Given recent construction as well as housing starts data, the Building material & garden eq. & supplies dealer category posted slower year over year growth, which was hardly surprising.

Other than gas station sales, the other big gainer was Nonstore retailers – Census Bureau speak for e-tailers and digital commerce that are part of Digital Lifestyle investing theme,  which saw an 11.4% increase in September retail sales vs. year ago levels. That strong level clearly confirms our investment thesis that digital shopping continues to take consumer wallet share, which bodes well for our Amazon (AMZN), United Parcel Service (UPS), and to a lesser extent our Costco Wholesale (COST). With consumers feeling the pressure of our Middle-Class Squeeze investing theme, I continue to see them embracing the Digital Lifestyle to ferret out deals and bargains to stretch their after-tax spending dollars, especially as we head into the holiday shopping season.

Sticking with Costco, the company recently reported its U.S. same-store-sales grew 7.7% for September excluding fuel and currency. Further evidence that Costco also continues to gain consumer wallet share compared to retail and food sales establishments as well as the General Merchandise Store category.

  • Data points inside the September Retail Sales Report keep us thematically bullish on the shares of Amazon (AMZN), United Parcel Service (UPS) and Costco Wholesale. Our price targets remain $2,250, $130 and $250, respectively.

 

Scaling deeper into Del Frisco’s shares

Now let’s dig into the report as it relates to Del Frisco Restaurant Group, our Thematic Leader for the Living the Life investing theme. Per the Census Bureau, retail sales at food services & drinking places rose 7.1% year over year in September, which brought its year-over-year comparison for the September quarter to 8.8%. Clearly, consumers are spending more at restaurants, than eating at home. Paired with beef price deflation that has been confirmed by Darden Restaurants (DRI), this bodes well for profit growth at Del Frisco.

Against those data points, I’m using the blended 12.5% drop in DFRG shares since we added them to our holdings to improve our costs basis.

  • We are using the recent pullback to scale further into our Del Frisco’s Restaurant Group (DFRG) shares at better prices, our price target remains $14.

 

Netflix crushes subscriber growth in the September quarter

Tuesday night Netflix (NFLX) delivered a crushing blow to skeptics as it served up an EPS and net subscriber adds beat that blew away expectations and guided December quarter net subscriber adds above Wall Street’s forecast. This led NFLX shares to pop rather nicely, which was followed by a number of Wall Street firms reiterating their Buy ratings and price targets.

Were there some investors that were somewhat unhappy with the continued investment spend on content? Yes, and I suppose there always will be, but as we are seeing its that content that is driving subscriber growth and in order to drive net new adds outside the US, Netflix will continue to invest in content. As we saw in the company’s September quarter results, year to date international net subscriber adds is 276% ahead of those in the US. Not surprising, given the service’s launch in international markets over the last several quarters and corresponding content ramp for those markets.

Where the content spending becomes an issue is when its subscriber growth flatlines, which will likely to happen at some point, but for now, the company has more runway to go. I say that because the content spend so far in 2018 is lining its pipeline for 2019 and beyond. With its international paid customer base totaling 73.5 million users, viewed against the global non-US population, it has a way to go before it approaches the 45% penetration rate it has among US households.  This very much keeps Netflix as the Thematic Leader for our Digital Lifestyle investing theme.

One other thing, as part of this earnings report Netflix said it plans to move away from reporting how many subscribers had signed up for free trials during the quarter and focus on paid subscriber growth. I have to say I am in favor of this. It’s the paying subscribers that matter and will be the key to the stock until the day comes when Netflix embraces advertising revenue. I’m not saying it will, but that would be when “free” matters. For now, it’s all about subscriber growth, retention, and any new price increases.

That said, I am closely watching all the new streaming services that are coming to market. Two of the risks I see are a recreation of the cable TV experience and the creep higher in streaming bill totals that wipe out any cord-cutting savings. Longer-term I do see consolidation among this disparate services playing out repeating what we saw in the internet space following the dot.com bubble burst.

  • Our price target on Netflix (NFLX) shares remains $500.

 

What earnings from Ericsson and Taiwan Semiconductor mean for Nokia and AXT

This morning mobile infrastructure company Ericsson (ERIC) and Taiwan Semiconductor (TSM) did what they said was positive for our shares of Nokia (NOK) and AXT Inc. (AXTI).

In its earnings comments, Ericsson shared that mobile operators around the globe are preparing for 5G network launches as evidenced by the high level of field trials that are expected to last at such levels over the next 12-18 months. Ericsson also noted that North America continues to lead the way in terms of network launches, which confirms the rough timetable laid out by AT&T (T), Verizon (VZ) and even T-Mobile USA (TMUS) with China undergoing large 5G field trials as well. In sum, Ericsson described the 5G momentum as strong, which helped drive the company’s first quarter of organic growth since 3Q 2014. That’s an inflection point folks, especially since the rollout of these mobile technologies span years, not quarters.

Turning to Taiwan Semiconductor, the company delivered a top and bottom line beat relative to expectations. Its reported revenue rose just shy of 12% quarter over quarter (3.3% year over year) led by a 24% increase in Communication chip demand followed by a 6% increase in Industrial/Standard chips. In our view, this confirms the strong ramp associated with Apple’s (AAPL) new iPhone models as well as the number of other new smartphone models and connected devices slated to hit shelves in the back half of 2018. From a guidance perspective, TSM is forecasting December quarter revenue of $9.35-$9.45 billion is well below the consensus expectation of $9.8 billion, but before we rush to judgement, we need to understand how the company is accounting for currency vs. slowing demand. Given the seasonal March quarter slowdown for smartphone demand vs. the December quarter and the lead time for chips for those and other devices, we’d rather not rush to judgement until we have more pieces of data to round out the picture.

In sum, the above comments set up what should be positive September quarter earnings from Nokia and AXT in the coming days. Nokia will issue its quarterly results on Oct. 25, while AXT will do the same on Oct. 31. There will be other companies whose results as well as their revised guidance and reasons for those changes will be important signs posts for these two as well as our other holdings. As those data points hit, we’ll be sure to absorb that information and position ourselves accordingly.

  • September quarter earnings from Ericsson (ERIC) and Taiwan Semiconductor (TSM) paint a favorable picture from upcoming reports from Nokia (NOK) and AXT Inc. Our price targets on Nokia and AXT shares remain $8.50 and $11, respectively.

 

Walmart embraces our Digital Innovators investment theme

Yesterday Walmart (WMT) held its annual Investor Conference and while much was discussed, one of the things that jumped out to me was how the company is transforming  itself to operate in the “dynamic, omni-channel retail world of the future.” What the company is doing to reposition itself is embracing a number of aspects of our Disruptive Innovators investing theme, including artificial intelligence, robotics, inventory scanners, automated unloading in the store receiving dock, and digital price tags.

As it does this, Walmart is also making a number of nip and tuck acquisitions to improve its footing with consumers that span our Middle-Class Squeeze and in some instances our Living the Life investing theme as well our Digital Lifestyle one.  Recent acquisitions include lingerie company Bare Essentials and plus-sized clothing startup Eloquii. Other acquisitions over the last few quarters have been e-commerce platform Shoebuy, outdoor apparel retailer Moosejaw, women’s wear site Modcloth, direct-to-consumer premium menswear brand Bonobos, and last-mile delivery startup Parcel in September.

If you’re thinking that these moves sound very similar to ones that Amazon (AMZN) has made over the years, I would quickly agree. The question percolating in my brain is how does this technology spending stack up against expectations and did management boost its IT spending forecast for the coming year? As that answer becomes clear, I’ll have some decisions to make about WMT shares and if we should be buyers as we move into the holiday shopping season.

 

Making thematic sense of the July Retail Sales report

Making thematic sense of the July Retail Sales report

Key points for this alert:

  • Our price target on Amazon (AMZN) remains $2,250.
  • Our price target on Costco Wholesale (COST) remains $230.
  • Our price target on Habit Restaurant (HABT) is getting a boost to $17 from $16.
  • We are also bumping our price target on McCormick & Co. (MKC) shares to $130 from $110 as we get ready for seasons eatings 2018.

 

Following on the heels of the July Retail Sales report we received Wednesday, this morning Walmart (WMT) reported stellar July quarter results led by stronger than expected same-store sales and a 40% year over year increase in its e-commerce sales. From our perch, we see both reports as positive for our positions in both Amazon (AMZN) and Costco Wholesale (COST) as well as Habit Restaurant (HABT) and McCormick & Co. (MKC) shares.

Digging into the better than expected July Retail Sales report that showed Retail up 0.4% month over month and 6.0% sequentially, top performers were Food Services & drinking places (up +9.7% year over year), Nonstore retailers (+8.7%) and Grocery Stores (+4.9%) year over year. In response to that report, as well as the news that China and the US are heading back to the trade negotiation tables, our Habit Restaurant shares continue to sizzle. That stellar showing in July for Food Services & drinking places brought the trailing 3-month comparison to up more than 8% year over year.

To me, this echoes the data we’ve seen of late that points to the rebound in monthly restaurant sales, which is due as much to price increases as it is to improving customer volume, particularly at Fast Casual restaurants like Habit. As evidenced by Habit’s recent blowout June quarter earnings report, the company continues to execute on the strategy that led us to add the shares to the portfolio back in May. On the heels of the July Retail Sales report, I find myself once again boosting our price target on HABT shares to $17 from $16 as the underlying strength is continuing into the current quarter.

With just over 6% upside to our new price target for Habit, it’s not enough to commit fresh capital to the position. Given the surge in HABT shares – more than 80% since we added them to the Tematica Investing Select List this past May – as well as their current technical picture (see the chart below), I’m inclined to opportunistically use the position as a source of funds in the coming weeks.

 

 

While one might think those gains have come at the expense of grocery stores, and in turn, a potential blow to McCormick’s, the July figure for grocery was also the best in the last three months. What this tells us is people are likely paying more for food at the grocery store and at restaurants, which reflects the combination of higher food prices as well as the shift to food, drinks, and snacks that are healthier for the consumer (and a bit more expensive in general). On that strength and the forward view that will soon have us waist deep in season’s eatings, we are boosting our price target for MCK to $130 from $110. That includes some post-June quarter earnings catch up on our part for McCormick and its ability to grow its top line as part of our Clean Living and Rise of the New Middle Class investing themes, as well as wring out cost synergies associated with acquired businesses. In the coming months, I expect we will once again see this Dividend Dynamo boost its quarterly dividend, keeping MKC shares as one to own, not trade.

Getting back to the July Retail Sales report, the Nonstore retail July figure bodes very well for continued share gains at Amazon and other retailers that are embracing our Digital Lifestyle investing theme as we head into the holiday shopping season. Moreover, I see the e-commerce sales gains at Walmart – up +40% in the July quarter as well as those by Costco Wholesale, up  33% year to date — serving to confirm the accelerating shift by consumers to that modality of shopping as more alternatives become available. Helping Walmart is the addition of over 1,100 brands year to date including Zwilling J. A. Henckels cutlery and cookware, Therm-a-Rest outdoor products, O’Neill surf and water apparel, Shimano cycling products and the brands available on the dedicated Lord & Taylor shop, like Steve Madden footwear. Let’s remember too that Amazon continues to pull the lever that is private label products across a growing array of categories, and those margins are superior to those for its Fulfilled by Amazon efforts.

Speaking of Costco, its July sales figures showed a 6.6% year over year increase in same-store sales, which as we learned by comparing that with the July Retail Sales report was magnitudes stronger than General Merchandise stores (+3.3% year over year) and Department Stores (+0.3% year over year). Yes, Costco was helped by its fresh foods business, but even there it topped Grocery sales for the month. The clear message is that Costco continues to win consumer wallet share, and more of that is likely to be had in the coming months as consumers contend with the seasonal spending pickup.

The big loser in the July Retail Sales report was the Sporting goods, hobby, musical instrument, & bookstores category, which is more than likely seeing its lunch eaten by Amazon, Walmart, and Costco. All three of these companies are embracing the increasing digital lifestyle, targeting rising incomes in the emerging markets and helping cash-strapped consumers in the US stretch those dollars. As we have said many times before, the only thing better than the tailwinds of one of our investing themes is the combination of several and these companies are benefitting from our Digital Lifestyle, Rise of the New Middle Class and Middle-Class Squeeze investing themes.

All in all, the last 24 or so hours as very positive for our AMZN, COST, HABT and MKC shares on the Tematica Investing Select List.

  • Our price target on Amazon (AMZN) remains $2,250.
  • Our price target on Costco Wholesale (COST) remains $230.
  • Our price target on Habit Restaurant (HABT) is getting a boost to $17 from $16.
  • We are also bumping our price target on McCormick & Co. (MKC) shares to $130 from $110 as we get ready for seasons eatings 2018.

 

Recasting Our Rise and Fall of the Middle Class and Cash-Strapped Consumer Themes

Recasting Our Rise and Fall of the Middle Class and Cash-Strapped Consumer Themes

 

KEY POINTS FROM THIS POST

  • As we recast our Rise & Fall of the Middle Class into two themes – the New Middle Class and the Middle-Class Squeeze, which also folds in our Cash-Strapped Consumer theme, we are calling out Costco Wholesale (COST) shares as a top Middle-Class Squeeze pick, reiterating our Buy rating on the shares, and bumping our price target from $210 to $220.

At the end of yesterday’s Tematica Investing issue, I mentioned how at Tematica we are in the process of reviewing the investing themes that we have in place to make sure they are still relevant and relatable. As part of that exercise and when appropriate, we’ll also rename a theme.  Our goal through this process is to streamline and simplify the full list of 17 themes.

Of course, first up is our Rise & Fall of the Middle-Class theme that we are splitting into two different themes — which I know doesn’t sound like an overall simplification, but trust me, it will make sense. As the current name suggests, there are two aspects of this theme — the “Rise” and the “Fall” part. It can be confusing to some, so we’re splitting it into two themes. The “Rise” portion will be “The New Global Middle Class” and will reflect the rapidly expanding middle-class markets particularly in Asia and South America. On the other hand, the “Fall” portion will be recast as “The Middle Class Squeeze” to reflect the shrinking middle class in the United States and the realities that it poses to our consumer-driven economy.

As we make that split, it’s not lost on us here at Tematica that there is bound to be some overlap between The Middle-Class Squeeze and our Cash-Strapped Consumer investing theme given that one of the more powerful drivers of both is disposable income pressure and a loss of purchasing power. As such, as we cleave apart The Middle-Class Squeeze we’re also incorporating Cash-Strapped Consumer into it. It’s repositionings like this that we’ll be making over coming weeks, and while I hate to spoil a surprise as we say good bye to one or two themes, we’ll be saying hello to new one or two as well.

 

 

Why America’s Middle Class are Feeling the Squeeze

As both I and Tematica’s Chief Macro Strategist, Lenore Hawkins, have been sharing in our writings as well as our collective media hits, we’re seeing increasing signs of inflation in the systems from both hard and soft data points and that recently prompted the Fed to boost its interest rate forecast to four hikes this year, up from three with additional rate hikes in 2019. That’s what’s in the front windshield of the investing car, while inside we are getting more data that points to an increasingly stretched consumer that is seeing his or her disposable income under pressure.

According to LendingTree’s May 2018 Consumer Debt Outlook, Americans owe more than 26% percent of their disposable personal income on consumer debt, up from 22% in 2010. And just so we are clear, LendingTree is defining consumer debt to include non-mortgage debts such as credit cards, personal loans, auto loans, and student loans. These outstanding balances of consumer credit, per LendingTree, have been growing at a steady rate of 5% to 6% annually over the last two years, and this has it to forecast total consumer debt to exceed $4 trillion by the end of 2018.

Part of the reason consumers have been turning to debt is the lack of wage growth. Even as tax reform related expectations have been running high for putting more money in consumer pockets data from the Bureau of Labor Statistics revealed compensation for civilian workers rose 2.4% year over year in the March quarter. By comparison, gas prices have risen more than 24% over the last 12 months, and the average home price in the US was up more than 11% in April 2018 vs. April 2017. So, while wages have moved up that move has paled in comparison to other costs faced by consumers.

Then there’s the data from Charles Schwab’s (SCHW) 2018 Modern Wealth Index that finds three in five Americans are living paycheck to paycheck. According to other data, consumers more than three months behind on their bills or considered otherwise in distress were behind on nearly $12 billion in credit card debt as of the beginning of the year — an 11.5 percent increase during Q4 alone.

And it’s not just the credit card debt — mortgage problem debt is up as well, 5.2% to $56.7 billion.

As that debt grows, it’s going to become even more expensive to service. On its recent quarterly earnings conference call, Lending Club’s (LC) CFO Tom Casey shared that “Borrowers are starting to see the increased cost of credit as most credit card debt is indexed to prime, which has moved up 75 basis points from a year ago…We have observed a number of lenders increase rates to borrowers…We know that consumers are feeling the increase in rates.”

And that’s before the Fed rate hikes that are to come.

The bottom line is it likely means more debt and higher interest payments that lead to less disposable income for consumers to spend.

 

More US consumers getting squeezed

All of this points to an already stretched consumer base that has increasingly turned to debt given that real wage growth has been tepid at best over the past decade. And this doesn’t even touch on the degree to which the American consumer is under-saved or has little in the way of an emergency fund to cover those unforeseen expenses. Per Northwestern Mutual’s 2018 Planning & Progress Study, which surveyed 2,003 adults:

  • 78% of Americans say they’re ‘extremely’ or ‘somewhat’ concerned about not having enough money for retirement. Another 66 percent believe that they’ll outlive their retirement savings.
  • 21% of Americans have nothing at all saved for the future, and another 10 percent have less than $5,000 saved or invested for their golden years.

Adding credence to this figures, Bankrate’s latest financial security index survey, showed that 34% of American households experienced a major unexpected expense over the past year. But, only 39% of survey respondents said they would be able to cover a $1,000 setback using their savings. Other findings from Bankrate, based on data from the Federal Reserve, showed that those Americans between the ages of 55 and 64 that have retirement savings only have a median of $120,000 socked away. A similar 2016 GOBankingRates survey found that 69 percent of Americans had less than $1,000 in total savings and 34 percent had no savings at all.

Nearly 51 million households don’t earn enough to afford a monthly budget that includes housing, food, childcare, healthcare, transportation and a cell phone, according to a study by the United Way ALICE Project. That’s 43% of households in the United States.

As the New Middle Class in the emerging economies like China, India and parts of South America continue to expand, it will drive competitive world-wide pressures for food, water, energy and other scarce resources that will drive prices higher given prospects for global supply-demand imbalances.

 

Middle-Class Squeeze pain brings opportunity with Costco and others

What this tells us is that there is a meaningful population of Americans that are in debt and are not prepared for their financial future. In our experience, pain points make for good investment opportunities. In the case of the Middle-Class Squeeze investment theme, it means consumers trading down when and where possible or looking to stretch the disposable dollars they do have.

It’s no coincidence that we’re seeing a growing move toward private label brands, not only at the grocery store for packaged foods and beverages but by the likes of Amazon (AMZN) as well. We’re also seeing casual dining and fine dining restaurant categories give way to fast casual, and as one might expect the data continues to show more Americans eating at home than eating out.

From my perspective, the best-positioned company for the Middle-Class Squeeze investing theme is Costco Wholesale (COST). By its very nature, the company’s warehouse business model aims to give consumers more for their dollar as Costco continues to improve and expand its offering both in-store and online. To me, one of the smartest moves the company made was focusing not only on perishable food but on organic and natural products as well. That combination keeps customers coming back on a more frequent basis.

Let’s remember too, the secret sauce baked into Costco’s business model – membership fees, which are high-margin in nature, and are responsible for a significant portion of the company’s income. As I’ve shared before, that is a key differentiator compared to other brick & mortar retailers. And Costco looks to further expand that footprint as it opens some 17 more warehouse locations in the coming months.

I’ll continue to monitor Costco’s monthly sales reports, which have clearly shown it taking consumer wallet share, and juxtaposing them against the monthly Retail Sales report to confirm those wallet share gains.

  • As we recast our Rise & Fall of the Middle Class into two themes – the New Middle Class and the Middle-Class Squeeze, we are calling out Costco Wholesale (COST) shares as a top Middle-Class Squeeze pick, reiterating our Buy rating on the shares, and bumping our price target from $210 to $220.

 

Examples of companies riding the Middle-Class Squeeze Tailwind

  • Walmart (WMT)
  • Amazon (AMZN)
  • McDonald’s (MCD)
  • Dollar Tree (DLTR)
  • TJX Companies (TJX)
  • Ross Stores (ROST)
  • Kohl’s (KSS)

Examples of companies facing the Middle-Class Squeeze Headwind

  • Dillard’s (DDS)
  • JC Penney (JCP)
  • Macy’s (M)
  • Target (TGT)
  • Gap (GPS)
  • Red Robin (RRGB)

Again, those are short lists of EXAMPLES, not a full list of the companies benefitting or getting hit.

Over the next several weeks, I’ll be revisiting our investment themes, both the ones being tweaked as well as the ones, like Safety & Security, that are fine as is.

WEEKLY ISSUE: Robust Earnings and March Retail Sales Bode Well for Select List

WEEKLY ISSUE: Robust Earnings and March Retail Sales Bode Well for Select List

 

Once again, the stock market has shrugged off moves in the geopolitical landscape and mixed economic data to start the week off higher. Not surprising as the highly anticipated 1Q 2018 earnings season has gotten underway and based on what we saw the last two days so far so good. For the record, we had 44 companies that reported better than expected top and bottom line results, a number of them high profile companies such Bank of America (BAC), Netflix (NFLX), Goldman Sachs (GS), Johnson & Johnson (JNJ), and CSX (CSX).

Like I said, so far so good, and while we’re getting some additional nice EPS beats this morning, we’re still very early on in the 1Q 2018 earnings season. Make no mistake, it’s encouraging, but we have a long way to go until we can size up 1Q 2018 earnings performance vs. the high bar of expectation that calls for roughly 18% EPS growth year over year for the S&P 500.

That’s why I’ll continue to parse the data — earnings and otherwise — as it comes through. Last week and this week, we’ll get more of that for March, and that means we can get a view on how those data streams performed in full for 1Q 2018. Case in point, on Monday we received the March Retail Sales Report, which on its face came in at 0.6%, better than expected, and excluding autos and food services the metric also 0.6% vs. February. That translated into a 4.7% increase for retail ex-auto and food services year over year for the month. Stepping back, the data found in Table 2of the report showed that line item rose 4.3% year over year for all of 1Q 2018.

With that information, we can size up which categories contained in the report gained wallet share and identify those that lost it. The two big winners for 1Q 2018 were gasoline stations, up 9.7%, which was no surprise given the rise in gas prices over the last three months, and Nonstore retailers, which also rose 9.7%. We see that data as very favorable for our Amazon (AMZN) shares and boding well for Costco Wholesale (COST) given its growing e-commerce business. Contrasting that figure against the -0.6% for department store sales in 1Q 2108 confirms the ongoing shift in how and where consumers are shopping. Not good news in our view for the likes of JC Penney (JCP) and other mall anchor tenants.

The hardest hit category during 1Q 2018 was Sporting Goods, hobby, book & music stores, which fell 4% year over year. Remember, we’re seeing these categories impacted as well by the shift to digital commerce, streaming services such as newly public Spotify (SPOT) and programs like Amazon’s Kindle Unlimited that looks to be the Netflix (NFLX) of books, audiobooks, and magazines. In my view, the other shoe to drop for this Retail Sales Report category is the Toys R Us bankruptcy that is poised to do to the toy industry what the Sports Authority bankruptcy and subsequent liquidation sales did to Under Armour (UAA), Nike (NKE) and Adidas among others. We’ll get a better picture on that when toy company Mattel (MAT) reports its quarterly results later this week.

I’d also call out that Clothing & Clothing Accessories store retail sales for 1Q 2018 rose just 3.0%, signaling slower growth than overall retail sales – a sign that consumers are spending their disposable dollars on other things or elsewhere. Over the last year, we’ve more than touched on the transformation that is underway with digital shopping, and we continue to see Amazon as extremely well positioned. Likely augmenting that Amazon has moved its Amazon Prime Wardrobe service, its “try before you buy offering,” from beta to launch.

Of course, it requires Prime membership and we see this service as helping drive incremental Prime subscriptions, especially as Amazon continues to improve its apparel offering, both private label and branded. Another headwind to clothing retailers looks to be had in Walmart’s (WMT) upcoming website overhaul that is being reported to have a “fashion destination” that will leverage its partnership with Lord & Taylor. With branded apparel companies looking to reach consumers, some with their own Direct 2 Consumer businesses and others by leveraging third party logistic infrastructure, we’ll keep tabs on Walmart’s progress and what it means for brick & mortar clothing sales. If you’re thinking this should keep our Buy rating on shares of United Parcel Service (UPS), you’re absolutely right.

The bottom line is the March Retail Sales report served to confirm our bullish view on both Connected Society companies Amazon and UPS as well as Cash-Strapped Consumer play Costco.

  • Our price target on Amazon remains $1,750
  • Given its strong monthly same-store sales data and ongoing wallet share gains as it opens additional warehouse locations, we are boosting our Costco Wholesale (COST) price target to $210 from $200
  • Our long-term price target on United Parcel Service (UPS) shares remains $130

 

 

Robust Earnings from Lam Research Bode Well for Applied Materials

Last night Applied Materials (AMAT) competitor Lam Research reported stellar 1Q 2018 earnings and issued an outlook that topped Wall Street expectations. For the quarter, shipments of its semiconductor capital equipment rose 19% year over year, which led revenue to climb more than 30% year over year for the quarter. Higher volumes and better pricing led to margin expansion and fueled a $0.43 per share earnings beat with EPS of $4.79. All in all, a very solid quarter for Lam, but also one that tell us demand for chip equipment remains strong. Those conditions led Lam to guide current quarter revenue to $2.95-$3.25 billion vs. the consensus view of $2.94 billion.

From growing memory demand, 5G chips sets, 3D sensing, smarter automobiles and homes, and augmented reality to virtual reality and the Internet of Things, we continue to see a number of emerging technologies that are part of our Disruptive Technologies investing theme driving incremental chip demand in the coming years that will fuel demand for semi-cap equipment. We see this as a very favorable tailwind for our Applied Materials shares. Also, let’s not forget Applied’s recently upsized dividend and buyback programs, which, in my view limits potential downside in the shares.

  • Our price target on shares of Applied Materials (AMAT) remains $70.

 

The Habit Restaurant – Loving the Burgers and Shakes, but Not the Shares Just Yet

People need to eat. That’s a pretty recognizable fact. Some may eat more than others, some may eat less; some may eat meat, others may not. But at the end of the day, we need food to survive, but in some cases for comfort at the end of a long day.

As investors, we recognize this and that means considering where and what consumers eat, and also identifying companies that are poised to benefit from other opportunities as well. One such opportunity is geographic expansion, and with restaurants, it often means expanding across the United States.

Typically, expansion is driven by new store openings, which in turn drive sales. Tracing back its expansion over the last several years, Chipotle Mexican Grill (CMG) had to build up to 2,363 locations. Even with that number of locations, per Chipotle’s recently filed 10-K, the company still expects to “open between 130 and 150 new restaurants in 2018.” At that pace, it would take quite a while before Chipotle had as many locations as McDonald’s (MCD) (more than 14,000) or Starbucks (SBUX) (just under 14,000) in the U.S. exiting last year.

A little over a year ago, Restaurant Brands (QSR), the company behind Tim Hortons and Burger King, acquired Popeye’s in part for food-related synergies but also the opportunity to grow Popeye’s through geographic expansion. In 2016, Popeye’s had some 2,600 locations compared to more than 7,500 Burger Kings in the U.S. For those wondering, that’s greater than the 2,251 locations Jack in the Box (JACK) had in 2017.

This brings us to  The Habit Restaurants (HABT), a Guilty Pleasure company if there ever was one.

With just 209 Habit Burger Grill fast-casual locations in 11 states spread between the two coasts, Habit has ample room to expand its concept serving flame char-grilled burgers and sandwiches, fries, salads and shakes. And if you’re wondering how good Habit is, don’t just listen to me (one of those 209 locations is just a few miles away from him), the company was named “best tasting burger in America” in July 2014.

In 2017, the company recorded revenue of $331.7 million from which it generated EPS of $0.16. For this year, consensus expectations have it serving up revenue near $393 million, up around 18% year over year, but EPS of $0.05 — a sharp drop from 2017.

What I’m seeing is Habit hitting an inflection point as it engages a national advertising agency, opens 30 new locations this year (7-10 in first-quarter 2018) and contends with higher wage costs (up 6%-7% vs. 2017), as well as test markets breakfast. Making matters challenging, the overall restaurant industry has been dealt a tough hand during the first two months of 2018 as winter weather and cold temperatures led to reduced traffic and same-store sales industry-wide, according to research firm TDn2K.

While a recent survey of March restaurant sales published by Baird showed a pick-up, the question I am pondering is to what degree will restaurant sales rebound on a sustained basis as the winter weather fades? I’m asking this question full well knowing the level of credit-card and other debt held by consumers as the Fed looks to hike interest rates several times this year.

Do I like the long-term potential of Habit?

Yes, and I would recommend their burgers, fries, and shakes – without question. That said, the company is not without its challenges, especially as McDonald’s begins to roll out its fresh beef offering nationwide. I had one of those a few days ago and in my view, it’s a clear step up from what Mickie D’s had been serving. You may be getting the idea that I like burgers, and I can easily confirm that as well as my fondness for chocolate shakes.

By most valuation metrics, HABT shares are cheap, but as we all know, cheap stocks are usually cheap for a reason. As such, we want to see how the company performed during the first quarter, the quarter in which the greatest number of new locations were to be opened. Typically, new locations drive up costs, and given the uptick in wage costs, this combination could weigh on the company’s bottom line.

All of this has us sitting on the sidelines with Habit Restaurants shares, which means adding them to Tematica Investing Contender List as part of our Guilty Pleasure investing theme.

WEEKLY ISSUE: Examining an Aging of the Population Contender as we wait for the Fed

WEEKLY ISSUE: Examining an Aging of the Population Contender as we wait for the Fed

 

Key Points from this Issue:

  • We’ll continue to stick with Facebook shares, and our long-term price target remains $225.
  • We continue to have a Buy rating and $1,300 price target on Alphabet (GOOGL) shares.
  • Our price target on Amazon (AMZN) shares remains $1,750.
  • We are adding shares of Aging of the Population company Brookdale Senior Living (BKD) to the Tematica Investing Contender List

 

The action has certainly heated up this week, with more talk of trade restraints with China, two more bombings in Austin, Texas and renewed personal data and privacy concerns thanks to Facebook. And that’s all before the Fed’s monetary policy concludes later today when we see how new Fed Chair Jerome Powell not only handles himself but answers questions pertaining to the Fed’s updated forecast and prospects for further monetary policy tightening. Amid this backdrop, we’ve seen the major US stock market indices trade off over the last week, but as I shared in this week’s Monday Morning Kickoff, what Powell says and how the market reacts will determine the next move in the market.

I continue to expect a 25bps interest rate hike with Powell offering a dovish viewpoint given the uncertainty emanating from Washington, the lack of inflation in the economy and the preponderance of weaker than expected data that has led to more GDP cuts for the current quarter than upward revisions. As of March 16, the Atlanta Fed’s GDP Now reading stood at 1.8% for 1Q 2017 vs. 5.4% on Feb. 1 – one would think Powell and the rest of the Fed heads are well aware of this.

We touched on these renewed personal data and privacy concerns earlier in the week, and the move lower in Facebook (FB) shares in response is far from surprising. As I wrote, however, I do expect Facebook to instill new safeguards and make other moves in a bid to restore user trust. At the heart of the matter, Facebook’s revenue model is reliant on advertising, which means being able to attract users and drive usage in order to serve up ads. As it is Facebook is wading into original content with its Watch tab and moves to add sporting events and news clearly signal there is more to come. I see it as part of a strategy to renews Facebook’s position as a sticky service with consumers and one that advertisers will turn to in order to reach consumers as Facebook focuses on “quality user engagement.”

The ripple effects of these renewed privacy concerns weighed on our Alphabet/Google (GOOGL) shares, which traded off some 4% over the last week, as well as other social media companies like Twitter (TWTR) and Snap (SNAP). The silver lining to all of this is these companies are likely to address these concerns, maturing in the process.

Not a bad thing in my opinion and this keeps Alphabet/Google shares on the Tematica Investing Select List, while the company’s prospect to monetize YouTube, mobile search, Google Express (shopping) and Google Assistant keep my $1,300 price target intact. Per a new report from Reuters, Google is working with large retailers such as Target Corp (TGT), Walmart (WMT), Home Depot (HD), Costco Wholesale (COST and Ulta Beauty (ULTA) to list their products directly on Google Search, Google Express, and Assistant. I see this as Alphabet getting serious with regard to Amazon (AMZN) as Amazon looks to grow its advertising revenue stream.

  • We’ll continue to stick with Facebook shares, and our long-term price target remains $225.
  • We continue to have a Buy rating and $1,300 price target on Alphabet (GOOGL) shares.
  • Our price target on Amazon (AMZN) shares remains $1,750.

 

On the housekeeping front, earlier in the week, we shed Universal Display (OLED) shares, bringing a close to one of the more profitable recommendations we’ve had over the last year here at Tematica Investing. Now let’s take a look at a Brookdale Senior Living and our Aging of the Population investing theme.

 

Brookdale Senior Living – A well-positioned company, but is it enough?

One of the great things about thematic investing is there is no shortage of confirming data points to be had in and our daily lives. For example, with our Connected Society investing theme, we see more people getting more boxes delivered by United Parcel Service (UPS) from Amazon (AMZN) and a several trips to the mall, should you be so inclined, will reveal which retailers are struggling and which are thriving. If you do that you’re also likely to see more people eating at the mall than actually shopping; perhaps a good number of them are simply show rooming in advance of buying from Amazon or a branded apparel company like Nike (NKE) or another that is actively embracing the direct to consumer (D2C) business model.

While it may not be polite to say, the reality is if you look around you will notice the domestic population is greying More specifically, we as a people are living longer lives, which has a number of implications and ramifications that are a part of our Aging of the Population investing theme. There are certainly issues of having enough saved and invested to support us through our increasingly longer life spans, as well as the right healthcare to deal with any and all issues that one might face.

According to data published by the OECD in 2013, the U.S. expectancy was 78.7 years old with women living longer than men (81 years vs. 76 years). Cross-checking that with data from the Census Bureau that says the number of Americans ages 65 and older is projected to more than double from 46 million today to 75.5 million by 2030, according to the U.S. Census Bureau. Other data reveals the number of older American afflicted with and the 65-and-older age group’s share of the total population will rise to nearly 25% from 15%. According to United States Census data, individuals age 75 and older is projected to be the fastest growing age cohort over the next twenty years.

As people age, especially past the age of 75, it becomes challenging for individuals to care for themselves, and this is something I am encountering with my dad who turns 86 on Friday. Now let’s consider that roughly 6 million Americans will have Alzheimer’s by 2020, up from 4.7 million in 2010, and heading to 8.4 million by 2030 according to the National Institute of Health. Not an easy subject, but as investors, we are to remain somewhat cold-blooded if we are going to sniff out opportunities.

What all of this means is we are likely to see a groundswell in demand over the coming years for assisted living facilities to house and care for the aging domestic population.

One company that is positioned to benefit from this tailwind is Brookdale Senior Living (BKD), which is one of the largest players in the “Independent Living, Assisted Living and Memory Care” market with over 1,000 communities in 46 states. The company’s revenue stream is broken down into fives segments:

  • Retirement Centers (14% of 2017 revenue; 22% of 2017 operating profit) – are primarily designed for middle to upper income seniors generally age 75 and older who desire an upscale residential environment providing the highest quality of service.
  • Assisted Living (47%; 60%) – offer housing and 24-hour assistance with activities of daily living to mid-acuity frail and elderly residents.
  • Continuing care retirement centers (10%; 8%) – are large communities that offer a variety of living arrangements and services to accommodate all levels of physical ability and health.
  • Brookdale Ancillary Services (9%; 4%) – provides home health, hospice and outpatient therapy services, as well as education and wellness programs
  • Management Services (20%; 6%) – various communities that are either owned by third parties.

 

In looking at the above breakdown, we see the core business to focus on is Assisted Living as it generated the bulk of the company’s operating profit stream. This, of course, cements the company’s position in Tematica’s Aging of the Population theme, but is it a Contender or one for the Tematica Investing Select List?

 

Changes afoot at Brookdale

During 2016 and 2017, both revenue and operating profit at Brookdale came under pressure given a variety of factors that included a more competitive industry landscape during which time Brookdale had an elevated number of new facility openings, which is expected to weigh on the company’s results throughout 2018. Also impacting profitability has been the growing number of state and local regulations for the assisted living sector as well as increasing employment costs.

With those stones on its back, throughout 2017, Brookdale surprised to the downside when reporting quarterly results, which led it to report an annual EPS loss of $3.41 per share for the year. As one might imagine this weighed heavily on the share price, which fell to a low near $6.85 in late February from a high near $19.50 roughly 23 months ago.

During this move lower in the share price, Brookdale the company was evaluating its strategic alternatives, which we all know means it was putting itself up on the block to be sold. On Feb. 22 of this year, the company rejected an all-cash $9 offer as the Board believed there was a greater value to be had for shareholders by running the company. Alongside that decision, there was a clearing of the management deck with the existing President & CEO as well as EVP and Chief Administrative Officer leaving, and CFO Cindy Baier being elevated to President and CEO from the CFO slot.

Usually, when we see a changing of the deck chairs like this it likely means there will be more pain ahead before the underlying ship begins to change directions. To some extent, this is already reflected in 2018 expectations calling for falling revenue and continued bottomline losses. Here’s the thing – those expectations were last updated about a month ago, which means the new management team hasn’t offered its own updated outlook. If the changing of the deck history holds, it likely means offering a guidance reset that includes just about everything short of the kitchen sink.

On top of it all, Brookdale has roughly $1.1 billion in long-term debt, capital and leasing obligations coming due this year. At the end of 2017, the company had no borrowings outstanding on its $400 million credit facility and $514 million in cash on its balance sheet. It would be shocking for the company to address its debt and lease obligations by wiping out its cash, which probably means the company will have to either refinance its debt, raise equity to repay the debt or a combination of the two. This could prove to be one of those overhangs that keeps a company’s shares under pressure until addressed. I’d point out that usually, transaction terms in situations like this are less than friendly.

While I like the drivers of the underlying business, my recommendation is we sit on the sidelines with Brookdale until it addresses this balance sheet concern and begins to emerge from its new facility opening drag and digestion. Odds are we’ll be able to pick the shares up at lower levels. This has me putting BKD shares on the Tematica Investing Contender List and we’ll revisit them in the coming months.

 

 

Weekly Issue: Looking for Trump-Proof Companies

Weekly Issue: Looking for Trump-Proof Companies

We exited last week with the market realizing there was more bark than bite associated with President Trump’s steel and aluminum tariffs. That period of relative calm, however, was short-lived as the uncertainty resumed in Washington yesterday in the form of changeups in the administration with Trump letting go Secretary of State Rex Tillerson just after agreeing to talks with North Korea, and more saber rattling with trade actions against China for technology, apparel, and other imports. This also follows Trump’s intervention in the proposed takeover of Qualcomm (QCOM) by competitor Broadcom (BRCM).

While many an investor will focus on the “new” volatility in the market, I’ll continue to use our thematic lens to look for companies that are “Trump-Proof” in the short-term. That’s not a political statement, but rather a reflection of the reality that the modus operandi of President Trump and his Twitter habit often cause significant swings in the market as the media attempts to digest and interpret his comments.

How will we find these so-called Trump-proof companies? By continuing to use our thematic lens to uncover well-positioned companies that are benefitting from thematic tailwinds that alter the existing playing field, regardless of the latest noise from Washington politicians.

At least for now, volatility is back in vogue and that is bound to drive headlines and other noise. I’ll continue to focus on the data, and if you read this week’s Monday Morning Kickoff you know we are in the midst of a whopper of a data week. While the Consumer Price Index (CPI) for February was in line with expectations, and on a year over year basis core rose 1.8% — the same as in January — which should take some wind out of the inflation mongers. This morning we have the February Retail Sales report, which in my view should once again serve up confirming data for our positions in Amazon (AMZN) and Costco Wholesale (COST), which continue to benefit from our Connected Society and Cash-strapped Consumer investing themes.  Later in the week, the February reading on Industrial Production should confirm the demands that are exacerbating the current heavy truck shortage here in the U.S. – good news for the Paccar (PCAR)shares on the Tematica Investing Select List.

 

 

An Update on Our Once Star Performer, Universal Display (OLED)

A few weeks ago, I shared an update on Universal Display (OLED) shares, which have been essentially treading water following the company’s December quarter results. Later today, the management team will be presenting at the Susquehanna’s Seventh Annual Semi, Storage & Tech Conference. Odds are the management team will reiterate its view on market digesting the organic light emitting diode capacity additions made over the last several quarters, but I expect they will also describe the growing number of applications that will come on stream in the next 3-6 quarters.  As of late February, Susquehanna had a positive rating on OLED shares with a price target of $200 and I suspect they will have some bullish comments following today’s presentation.

 

Considering the ripples to be had with the latest Connected Society victim, Toys R Us

Over the weekend we were reminded of the situation facing many brick & mortar retailers that are failing to adapt their business to ride our Connected Society investing theme. I’m referring to toy and game retailer Toys R Us, the one-time Dick’s Sporting Goods (DKS) or Home Depot (HD) of its industry. Like several sporting goods retailers and electronic & appliance retailers such as Sports Authority, Sports Chalet, and HH Gregg that have gone belly up, if Toys R Us doesn’t get a last-minute lifeline or find a buyer it will likely file Chapter 7.

It’s been a rocky road for the one-time toy supermarket company as it entered bankruptcy in September, aiming to emerge with a leaner business model and more manageable debt. The company obtained a new $3.1 billion loan to keep the stores open during the turnaround effort, but results worsened more than expected during the holidays, casting doubt on the chain’s viability. The company entered this year with more than 800 stores in the U.S. — under both the Toys “R” Us and Babies “R” Us brands, but by January, it announced the shuttering of 180 locations.

The pending bankruptcy to be had at Toys R Us is but the latest in the retail industry, but it’s not likely to be the last. Claire’s Stores Inc., the fashion accessories chain with a debt load of $2 billion, is also preparing to file for bankruptcy in the coming weeks as is Walking Co. Holdings Inc.

What these all have in common is the increasing shift by consumers to digital commerce and the growing reliance on retailers for what is termed the direct to consumer (D2C) business model. Certain branded apparel, footwear, and other consumer product companies, like Nike (NKE) have embraced Amazon’s formidable logistics capabilities and this has benefitted our United Parcel Service (UPS) shares. As we have said before, and we recognize it sounds rather simplistic, when you order products online they have to get to where they are being sent. Hello UPS!

Now let’s consider the ripple effect of the pending Toys R Us bankruptcy.

When events such as this occur, there is a liquidation effect and a subsequent void. As we saw when Sports Authority went bankrupt, the businesses at Nike and Under Armour (UAA) were impacted by liquidation sales in the short term. At the same time, both lost the recurring sales associated with Sports Authority. Odds are we will see the same happen with Toys R Us with companies like Mattel (MAT) and Hasbro (HAS) taking it on the chin. In my view these companies are already struggling as teens, tweens and kids of all ages shift to digital games, apps and e-gaming, which are aspects of our Connected Society and Content

In my view these companies are already struggling as teens, tweens and kids of all ages shift to digital games, apps and e-gaming, which are aspects of our Connected Society and Content is King themes. When was the last time you saw an elementary schooler play with Ken or Barbie? More likely they are on an iPad or Microsoft (MSFT) Xbox while their older siblings are playing the new craze sweeping the nation – Fortnite. And yes, that it appears the rumors are true and Fornite will soon be available across Apple’s iDevices.

Looking at the financial performance of Mattel, not even the all mighty Star Wars franchise could save them from delivering declining revenue and earnings this past holiday shopping season. On the liquidation front, we are likely to see the toys businesses at Target (TGT) as well as Walmart (WMT) take the brunt of the blow. But here too this is likely just another hit as these two retailers have already been dealing with falling revenue at Mattel and Hasbro. Walmart is the largest customer for Mattel and Hasbro, accounting for about 20% of total sales for each toy maker. Both toy companies get nearly 10% of their revenue from Target too.

One of the investing strategies that I employ with the Select List is “buy the bullets, not the guns” which refers to buying well-positioned suppliers that serve a variety of customers. In situations like what we are seeing in the brick & mortar retail sector, we can turn that strategy upside down and uncover those companies, like Mattel and Hasbro, that we as investors should avoid given the multiple direct and indirect headwinds they are currently facing or about to.

 

Blue Apron and GNC, two examples of the struggle to fight against thematic headwinds

Blue Apron and GNC, two examples of the struggle to fight against thematic headwinds

 

In Tematica Investing, we focus on companies that are benefitting from tailwinds associated with our investment themes. As a good institutional portfolio manager knows, avoiding problematic investments is critical as they can sabotage returns to be had from well-positioned ones. In our Tematica lingo, that means avoiding companies that have thematic headwinds bearing down on their businesses and buying companies that are rising the tailwinds.

 

No need to revisit Blue Apron shares

We’ve been bearish on shares of Blue Apron (APRN) and we’ll try not to pat ourselves too hard on the back as we take a victory lap on that call.

As we saw yesterday, there is a good reason to remain that way as Walmart (WMT) is formally getting into the meal kitting business. While many were expecting Amazon (AMZN) to leverage its Whole Foods Market business with its own meal kitting offering (we still are), Walmart is leveraging its position as the largest grocer to enter the fray. The goal for the brick & mortar retail giant is to help build its digital footprint as well as take share from the restaurant industry, which has been pressured by weak traffic and average ticket pressure. Odds are Walmart is also looking to ride the consumer shift toward healthier eating and snacking that is part of our Food with Integrity theme along with a hefty dose of our Connected Society one.

All in all, this looks like a good extension for Walmart and one that is poised to make an already challenging environment even more so for Blue Apron.

 

 

Struggling GNC Holdings looks East

Another company that has been running into a significant thematic headwind is GNC Holdings (GNC). Once a dominant player in the sports performance and nutrition space (otherwise known as body-building), the supplement retailer has been attempting to reposition itself to a wider audience as a seller of “health, wellness and performance products.” As the performance market has moved online and to other sources, GNC has been attempting to capture more women and appeal to the Boomers and their set of nutritional needs, which are far different than the iron clangers in the free weight section of the gym.

To say this stock price chart looks like a one-way roller coaster that only goes down would be an understatement. A better comparison would be an alpine slide that starts extremely high up a mountain, has several twists and turns, but only goes in one direction – down. Since peaking in late 2013 near $60, that’s exactly what we’ve seen with GNC shares as its profits turned to losses despite a comparatively modest dip in revenue over the last few years.

 

 

In perusing the company’s latest 10K filing, the company offers up an explanation of sorts: “Prior to 2017, we had been experiencing declining traffic trends leading to decreasing same-store sales in our retail stores. After extensive consumer research and market analysis, we determined that our business model needed to be reimagined.”

Not exactly what a shareholder, existing or prospective one, wants to hear, but at least we can credit the management for not acting like an ostrich with their head in the ground as Amazon rolled into space as did others. The combination of having to “reimagine” its business model as well as fend of competitors led annual Selling, General & Administrative expenses to rise over 2015-2017 as revenue shrank, pushing GNC to deliver bottom-line losses.

Digging into the financials, the company experienced negative same-store sales in every quarter during 2016 and the first two of 2017. Making matters worse, average transaction amount was in negative territory over the last five quarters, and sales at GNC.com sales were falling as well. December 2017 quarterly sales were up 0.2% in company-owned stores vs. down 1.2% in the September 2017 quarter.

Not exactly a recipe for success, but clear signs the company could be in turnaround mode. What makes this potential turnaround interesting is the new partnership with CITIC Capital and Harbin Pharmaceutical Group. As a way of background, CITIC Capital is a global investment firm with a strong position in China and the Harbin Pharmaceutical Group is a joint venture of several China-based pharmaceutical companies. CITIC will invest $300 million in the form of a newly issued convertible perpetual preferred security with a 6.5% coupon payable in cash or in kind and a $5.35 conversion price. GNC will use the funds to repay existing debt and for other general corporate purposes, and on an as-converted basis, CITIC will hold roughly 40% of GNC’s outstanding equity. That’s a significant shareholder and one that will also appoint a total of five members to GNC’s newly expanded 11 member board.

The company expects the transaction to close in the second half of 2018, but it will require regulatory approval in both the U.S. and China. Given the current geopolitical tensions we are reading about almost daily, there could be some speed bumps associated with these approvals. Also too, GNC is ramping marketing associated with its recently launched pricing strategy and loyalty program, One New GNC strategy in the current quarter. This likely means margin pressure is poised to continue.

The bottom line is even though GNC is facing steep competitive domestic pressures, it’s new relationships could pivot its business but there are several hurdles to be overcome. Keyword being “could.” The risk related question I find myself asking is “Yes, I understand what the management team is saying, but what if the pivot or turnaround doesn’t happen as expected?”

We’ve seen many a company that in the face of thematic headwinds and mounting competitive pressures have attempted to reposition their businesses. Few have succeeded. My gut tells me that GNC, much like Blue Apron, Blackberry (BBRY), Angie’s List, GoPro (GPRO), Fitbit (FIT) and others, is on the road to nowhere for investors. But that’s my gut, which means reminding myself to keep an open mind and watch the data as it becomes available.