By Brian Nelson, CFA
During the trading session January 27, Apple (AAPL) failed to turn the tide of a disappointing fiscal 2016 first-quarter report (calendar fourth-quarter), “Apple Will Go Lower…And It Will Be ‘Forced’ Into Acquisitions,” and coupled with a Fed statement, where the Committee left interest rates unchanged, as expected, many market observers read between the lines and hit the sell button. On the basis of some of the concerns we’ve outlined, “Not Doom and Gloom – But Just Cautious,” we can completely understand the hesitancy by participants to stay fully exposed to this tumultuous equity market. In many ways, that the Fed has hit the brakes just a few weeks after the long-anticipated rate hike means the global economic environment may be far worse than even we’ve outlined in previous pieces. We continue to believe a 35%+ cash position in the newsletter portfolios is prudent.
The biggest news after the close January 27 was Facebook’s (FB) solid fourth-quarter report. Unlike its ill social-media brother Twitter (TWTR), Facebook is putting up tremendous revenue growth, earnings expansion and phenomenal free cash flow generation, the latter to the tune of $6.2 billion for 2015 (it hauled in $2.1+ billion in the fourth quarter alone). We’ll be taking a hard look at whether an allocation to the fast-growing social media giant in the Best Ideas Newsletter portfolio makes sense, though valuation will always be a primary concern with the social network breaching the “century mark” in after-hours trading. Our fair value estimate for Facebook is $114 per share (suggesting more upside), and with a healthy net-cash position of $18 billion and no debt, it’s hard not to like the company. We simply love equities that generate material traditional free cash flow generation that have excellent net-cash rich, debt-free balance sheets and are growing both revenue and earnings at a fantastic pace. Facebook fits that definition almost perfectly, but we’re already very “tech-heavy” in the newsletter portfolios.
The Dividend Growth Newsletter portfolio continues to impress. One of the largest weightings, Johnson & Johnson (JNJ) released a nice calendar fourth-quarter report, “Johnson & Johnson Reports Strong Underlying Performance,” and shares have reacted well. The company may be setting up to power to new highs in an otherwise weak stock market; our valuation still implies upside at J&J. Procter & Gamble (PG), yet another holding in the Dividend Growth Newsletter portfolio also impressed with its update. The consumer brand giant put up fantastic pricing strength in its fiscal second-quarter (calendar fourth-quarter) report, “Procter & Gamble Puts on Impressive Display of Pricing Strength,” where constant-currency core earnings per share leapt more than 20% in the period. Unlike J&J, however, Procter & Gamble’s shares are starting to get pricey (we have a high-$60s fair value estimate), though its lofty multiple isn’t inconsistent with that of most others in the consumer staples sector, as equity portfolio managers seek exposure to “recession-resistance, safe havens.” J&J yields 3.1%, while P&G yields 3.4%.
We also witnessed some “life” out of handbag maker Coach (COH), one of our more speculative Dividend Growth Newsletter portfolio holdings, and while the market applauded its fiscal second-quarter (calendar fourth quarter) results, we took a more cautious view of results. It was great to see the company raise its operating-income outlook for fiscal 2016, but we weren’t at all pleased with its free cash flow generation in the period, and its balance sheet has deteriorated following the Stuart Weitzman purchase, which absorbed a good “chunk” of its net cash balance. Coach’s price has been acting well lately, as measured by the 10% jump January 26 and the follow through by 2.5% today, but we’re not especially pleased. We’d view it as a source of cash in the Dividend Growth Newsletter portfolio, especially if it starts to move aggressively through our fair value estimate of $38 per share. At the moment, Coach yields more than 4%.
The order backlog of unfulfilled deliveries at Boeing (BA) and Airbus (EADSY) will continue to pad profits for much of the aerospace supply chain for many years to come, but Boeing’s outlook for 2016 released January 27 raised a red flag. If you recall, a few months ago, we had gotten word, “Surveying the Aerospace Arena,” that executive teams at the largest airlines, namely Delta (DAL), believed that a “bubble” in the widebody market was brewing. Boeing’s decision to cut its estimated deliveries for 2016 to the range of 740-745 from 762 in 2015 due primarily to a cut in 777 (“triple-7”) deliveries, one of Boeing’s most-efficient widebody aircraft after the smaller, widebody 787 Dreamliner, there may be some truth to that initial concern.
That said, the market may be over-reacting to a degree, having pummeled the commercial aircraft giant’s shares, as aircraft customers may in part be waiting for the next-gen 777X (expected to enter into service in 2020). In any case, the data points pointing to this current robust cyclical upswing in commercial aerospace deliveries approaching a plateau, if not a peak, are adding up, especially in the context of emerging market economic weakness and ultra-low jet-fuel costs, which may not be stimulating fleet upgrades at the pace of $100-per-barrel crude oil. Program accounting can be “tricky” at times, but the legacy 777 is arguably Boeing’s highest-profit margin platform, helping to explain the large miss in its core 2016 earnings per share outlook ($8.15-$8.35) relative to consensus ($9.43). We still believe Boeing is rock-solid, though there is a downward bias to our intrinsic value estimate in light of the incremental news.
We’re going to take it on the chin tomorrow with performance of eBay (EBAY), which released a disappointing outlook along with its fourth-quarter report, but most of that pain will be offset by its now independently-traded payment arm and Best Ideas Newsletter portfolio holding, PayPal (PYPL), which put up a very strong fourth-quarter beat and outlook. eBay and PayPal split in July of last year, and we believe the market is just getting a feel for eBay’s standalone performance. A reported 1% slide in eBay’s revenue on a year-over-year basis, material operating-income headwinds, and a swing to a net debt position from a net cash position in the quarter will do even further damage to its “market” multiple. We included shares of eBay in the Best Ideas Newsletter portfolio one quarter too long, it seems, and we’ll look to take profits on the next “bounce,” which may not be soon. PayPal’s outlook for 2016 was excellent, on the other hand, with net revenue expecting to advance as much as 19% on a currency-neutral basis.
Midstream energy MLPs (AMLP, AMZ) continue to struggle to keep distributions flowing in a very difficult credit market environment, but a foretelling Bloomberg report released January 27 noted that Energy Transfer Equity (ETE), in deciding to keep deal terms with Williams Cos. (WMB) unchanged, will mean “lower-than-expected distribution to unitholders.” We’ve noted time and time again that the distributions of midstream equities are disconnected from the true operating fundamentals of their businesses, and the fallout in the space may not be completely over if energy resource pricing continues to swoon. The energy MLP space, overleveraged and generating free-cash-flow deficits, continues to bounce violently up and down, but we posit the pain is not over just yet. Even if there is some sort of temporary bounce this year, the depths of the current downdraft in the energy cycle may very well not be until 2017 or 2018 or longer, and then it may take years for a recovery. Long-term income investors should continue to exercise caution in these vehicles, particularly in light of the growing probability of an unexpected, adverse event within upstream over the next few years.
Aerospace Suppliers: AIR, AIRI, AL, ATRO, COL, HEI, HXL, ISSC, PCP, SPR, TATT, TDY, TXT