The equity markets continue to propel higher despite what we would describe to be a mixed third-quarter earnings season. Let’s walk through a number of earnings reports from popular companies reporting so far this week. Some of them we include in the newsletter portfolios. Others we don’t. But all are worth keeping tabs on.
Annaly (NLY)
Annaly is a mortgage REIT (mREIT) with principal business objective to generate net income for distribution to shareholders. Being critical of the mREIT business is certainly unpopular, and we understand that many retirees generate vital income streams from such investments. Bulls and bears, however, both benefit from our independent voice, and we call out risks as we see them. Annaly and American Capital Agency (AGNC) are not investments for the faint of heart. The blogosphere has become overcrowded with supporters of these types of companies, and we can’t help but feel the primary reason is to attract unsuspecting investors to buy them. For general industrial/retail operating entities, we tend not to put much weight into book value, but for financially-tied firms, book value is important in the valuation process (it is the starting point of any residual income valuation model). In Annaly’s third quarter, book value declined to $12.87 per share from $13.28 in June 2014, revealing a fundamental make-up moving in the wrong direction. We think there are much better ideas than risky mREITs for yield-seeking investors.
Energy Transfer Partners (ETP)
In fact, one of those better ideas is our favorite master limited partnership (MLP), Energy Transfer Partners. Kinder Morgan (KMI), which we added to the Dividend Growth portfolio recently, has decided to re-consolidate its MLP holdings, and while we have held Kinder Morgan Energy Partners (KMP) in the portfolio in the past, the latter will cease trading once the re-consolidation is complete. Energy Transfer Partners currently yields 6.1%, and the firm’s distribution has returned to growth as of late. In the MLP’s third quarter, distributable cash flow, which is a unique measure for MLPs that excludes growth capex, advanced by $77 million over the same period a year ago, to $610 million. Its distribution coverage ratio was 1.13x in the quarter and 1.25x through the first nine months of the year. Future distribution expansion is on the horizon at Energy Transfer Partners, and we like capitalizing on such income growth potential in the Dividend Growth portfolio.
Continental Resources (CLR)
Continental Resources is an independent crude oil and natural gas exploration and production company with properties in the North, South and East regions of the US, including the Bakken and Red River units. The firm is the #1 producer in the Rockies, the #1 leaseholder in the Bakken, and it remains heavily focused on crude oil (as opposed to natural gas). More than 70% of its total proved reserves are of the black-liquid variety. Its position in the Bakken is so valuable that we view it, along with EOG Resources (EOG), as acquisition targets. Continental’s third quarter results revealed EBITDAX growth of 9%, and while the firm noted that it will slow drilling somewhat in 2015, we still believe it has one of the most attractive growth profiles within the independent oil and gas space. For risk-seeking long-term investors, Continental may be one of the strongest performers in an advancing crude-oil price market, once such a market inevitably returns (the timing of which is the only uncertainty, in our view).
Emerson Electric (EMR)
Former Dividend Growth portfolio holding Emerson put up a solid fiscal fourth quarter. Underlying sales increased 4% in the period thanks to strength in North America and emerging markets, though expansion in Asia slowed to 2%. Earnings per share, excluding charges, increased 10% thanks to gross-margin expansion of 120 basis points, to 42.4%. Emerson’s Process Management and Industrial Automation segments were the primary drivers behind the profitability improvement. Perhaps most impressive was that the firm put up record operating cash flow of $3.7 billion in fiscal year 2014, showcasing the primary driver behind continued dividend growth. The year also marked the 58th consecutive year of dividend increases, and management is now targeting a dividend increase of 9%, to $0.47 per quarter in the first quarter of fiscal 2015. We may add back Emerson to the Dividend Growth portfolio at the right price, and that may happen in the event oil prices stay at current depressed levels for some time. The firm’s shares have an anticipated forward yield of ~2.9% at the time of this writing.
HCP (HCP)
From a technical standpoint, HCP looks really good here (November 5, 2014). We recently added this gem to the Dividend Growth portfolio.
The healthcare REIT posted fantastic third-quarter results and raised its full year guidance. Funds from operations were $0.75 per share on an adjusted basis, and the REIT achieved comparable cash net operating income growth of 3.2% for the period. HCP raised its full-year guidance for adjusted funds from operations to $2.98-$3.04 per share (was $2.97-$3.03 per share). The REIT will pay its next quarterly dividend of $0.545 per common share on November 25, revealing a ~4.9% annualized yield. HCP is the first healthcare REIT selected to the S&P 500 and the only REIT included in the S&P 500 Dividend Aristocrats Index. The firm will remain a key holding in the Dividend Growth portfolio.
Offshore Drillers – ATW, DO, ESV, NE, RDC, RIG, SDRL
What can we say about this group? How about what we’ve always said: “The offshore drilling industry is driven by hydrocarbon demand and spending by oil and gas companies. The group has traditionally been subject to intense price competition and volatility. Periods of high demand and higher day rates are often followed by periods of low demand and lower day rates. Contracts vary in terms and rates depending on the nature of the operation to be performed. An oversupply of drilling rigs in any market area is a key risk to pricing dynamics and underlying profitability. We’re not big fans of the industry structure, though long-term contracts can offer stability to performance.” The entire group has experienced pain along with the slide in crude oil prices. We’ve never liked the offshore drillers, and we’re not changing our tune now. For investors that listened to us on Seadrill (SDRL) late in 2013 and continuously through today, we saved them a bundle.
PPL (PPL)
The only utility in the Dividend Growth portfolio, PPL Corp continues to defy gravity. The company has skyrocketed from under $30 per share at the beginning of 2014 to more than $36 per share today, while paying a nice dividend along the way. In its third-quarter report, earnings per share advanced to $0.74 on a reported basis from $0.62 in the year-ago period. Management was very optimistic, crediting strong year-to-date performance in both the regulated and competitive energy supply business. Such strength has led to increased guidance for 2014 earnings from ongoing operations to the range of $2.37-$2.47 per share, a 5%+ increase over the previous range of $2.20-$2.40 per share. The spinoff of its competitive generation into Talen Energy remains on track, and PPL will remain in the Dividend Growth portfolio for now. Shares yield ~4.2%.
Qualcomm (QCOM)
Very few companies have a stronger balance sheet than that of Qualcomm. The firm has revolutionized the mobile phone industry. Through its own R&D and through partnerships with other firms, the company develops breakthrough technology and then licenses it across the wireless industry. The lack of capital intensity makes it better positioned than most, and Qualcomm’s strong patent portfolio in CDMA and OFDMA helps protect its elevated margins and strong returns on capital. The firm’s fiscal fourth-quarter report and outlook could have been better, but we’re not reading too much into the quarterly results. With $32 billion in cash on the books at the end of fiscal 2014, Qualcomm has a lot of financial flexibility. We value shares at nearly $100 each, and the company has one of the highest rated Economic Castles in our coverage universe.
Stratasys (SSYS)
We think 3D printing is an excellent technology with a long runway of growth ahead of it. But buying a company with an excellent technology and fantastic growth potential is not investing. Investing is identifying when the future free cash flow stream of a company has become mispriced, and making a stand via purchasing the equity that price-to-fair value convergence will eventually occur over a time period that generates a sufficient return for the level of risk. See: You Don’t Understand Speculation. Dividend growth investing is a whole other ball of wax, but for wealth creation, buy and hope, which is what investors are doing when dabbling in 3D printing stocks, is not a good strategy. Stratasys faced margin pressure in the third quarter, said full-year earnings would be lower than expected, and indicated that spending in 2015 will surge. Clearly, we’re not interested in gambling and that includes dabbling with shares of Stratasys and other 3D printing fan-favorites, including 3D Systems (DDD). Behemoth Hewlett-Packard (HPQ) looks determined to become a credible threat in this space, and long-term profitability will inevitably shrink for participants.
Tesla (TSLA)
Tesla is a speculative idea. Investors should expect the stock to move 10%, 20%, or more in any given quarter, either up or down. Remember, equity prices are set by the market’s expectations of the future free cash flows generated by a given entity via buying and selling, and for Tesla, the trajectory of these future free cash flows remains far and wide. This is why our fair value range for shares is relatively large ($146-$244). During the third quarter, Tesla delivered its highest-ever quarterly deliveries at 7,785 vehicles, despite a factory shutdown in July. Profitability was hindered due to higher R&D expenses related to the Dual Motor electric drive, but the company’s non-GAAP automotive gross margin in the period was still respectable at 23%. Tesla expects to experience a 50% increase in both net orders and deliveries for the Model S alone in 2015. Fundamentals continue to move in the right direction at the electric car giant, and the Dual Motor Model S is sure to turn heads as “the world’s fastest accelerating four-door production car of all time, with a 0 to 60mph time of 3.2 seconds.” Too bad having the fastest car isn’t a guarantee of investment success for shareholders.