The most important variable to keep your eye on, the 10-year Treasury, is rising, and the long-term implications on equity values could be considerable. We don’t think the moves thus far have been too disruptive, but continued concerns over US tax receipts and infrastructure/defense spending could send sovereign yields roaring higher. As fourth-quarter earnings season marches on, let’s take a look at some meaningful recent quarterly reports. We’re also shedding two companies from the simulated newsletter portfolios.
By Kris Rosemann and Brian Nelson, CFA
The market continues to be on edge as it considers what the borrowing cost of US debt might be in the event of the next downturn, the timing the only uncertainty, now that it has significantly reduced tax receipts with tax reform and as it pursues infrastructure and defense spending. We think the capital-expensing provision of the new tax code may be the most punitive, and we wouldn’t be surprised to see the US government having to issue debt at very high (higher) yields or reverse corporate tax reform (pursue tax hikes) if tax receipts fall short when the economy starts to slow. We think this is what has the market jittery: it’s possible the tax code is only built for good times and may not capture the severity of economic cyclical activity. The 10-year Treasury yield keeps rising, and it’s the most important variable to keep your eye on, “Why The Fed Matters (2016)”
We’re also paying very close attention to what’s been happening in China (FXI, MCHI, KWEB) the past few days. We’re hearing that China’s top economic planner is warning about the risks of a “Black Swan” event this year, and while expectations for the economy are that it will still grow at a robust rate, shares of many Chinese-focused ETFs have felt the pain the past few days. The rating agencies are worried about China’s debt levels, and given the context of the US’ increased leverage, the global economy is functioning more and more on a mountain of debt. The iShares China Large-Cap ETF has fallen from mid-$50s to the mid-$40s amid a broader global rout in equities driven by rising risk-free yields and their implications on equity values over the long run.
Simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio idea CVS Health (CVS) beat expectations in its fourth quarter report, released before the open February 8. Net revenues advanced 5.3% on a year-over-year basis to $48.4 billion thanks to 9.3% growth in its ‘Pharmacy Services’ segment (70%+ of total revenue), which was driven by growth in pharmacy network and specialty pharma volume and partially offset by price compression and generic drug competition. Adjusted EPS grew to $1.92 in the quarter from $1.72 in the year-ago period. In 2018, CVS expects full-year adjusted operating profit to be between down 1.5% and up 1.5% over 2017 levels.
We think we’ve seen enough with the myriad risks that have found their way into the CVS “story.” From the Amazon (AMZN)-Whole Foods scare to Amazon teaming up with Berkshire Hathaway (BRK.A, BRK.B) and JP Morgan (JPM) to form a new healthcare company, the long-term outlook for CVS has become even more cloudy. Its purchase of Aetna (AET) may have been the straw that broke the camel’s back to our thesis, and we can neither see relief with respect to the structural dynamics of the industry in which it operates, nor can we see its increased leverage and competitive environment a positive for the dividend. We are removing CVS from both the simulated Dividend Growth Newsletter portfolio and the simulated Best Ideas Newsletter portfolio.
Simulated Dividend Growth Newsletter portfolio idea Hanesbrands (HBI) faced substantial selling pressure following its fourth quarter 2017 report, released before the open February 8. Fourth quarter sales grew 4% from the year ago period, but operating profit fell more than 41%, due in part to a meaningful increase in SG&A expenses. Nevertheless, cash from operating activities remained robust and grew to ~$666 million in full-year 2017 from ~$606 in 2016. However, the core drivers of the drop in Hanesbrands’ share price were the lack of a dividend hike announcement and disappointing profit guidance relative to consensus for 2018.
The company’s net sales are expected to be $6.72-$6.82 billion, adjusted operating profit is projected to be $950-$985 million, and adjusted EPS guidance has been issued in a range of $1.72-$1.80, the last of which came in below consensus expectations. A cautious outlook in the US brick-and-mortar retail environment, higher commodity costs (cotton), and increased marketing investment are expected to impact results. As with CVS, Hanesbrands’ acquisitive activity with Australian intimate apparel retailer Bras N Things, announced February 8, simply doesn’t fit the mold of what we had been looking for in this dividend payer. We are removing Hanesbrands from the simulated Dividend Growth Newsletter portfolio.
Simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio idea Gilead Sciences (GILD) received a nice boost from the FDA’s approval of its triple combo pill BIC/FTC/TAF, which is branded as BIKTARVY, for the treatment of chronic HIV-1 infection in adults February 7 despite reporting a material decline in fourth quarter revenues after the close February 6. HCV product sales were more than halved in the quarter from the year-ago period, though HIV and HBV sales growth was able to partially offset the decline. Top-line erosion is expected to continue in 2018 as net product sales are expected to be in a range of $20-$21 billion compared to $25.7 in 2017, but management remains optimistic on the potential of its oncology and cell therapy programs with the approval of Yescarta, the first CAR T cell therapy for the treatment of adults with relapse or refractory large B-cell lymphoma after two or more lines of systemic therapy, a key positive in the fourth quarter.
Social media platform Twitter (TWTR) also released its fourth-quarter results before the open February 8, and the company’s shares surged following the report as it reported GAAP profitability for the first time. Average monthly active users remained flat at 330 million, but daily active users grew 12% from the year-ago period, marking the fifth consecutive quarter of double-digit growth in DAUs. Our opinion of Twitter has evolved as it continues to build a growing track record of solid free cash flow generation, and GAAP profitability is yet another step in the right direction in establishing a consistently successful business model. Free cash flow grew to ~$547 million in 2017, up from $444 million a year earlier. We plan to review our fair value estimate following the impressive results, and the increased character-count for tweets might very well be the main driver behind the improved financial performance.
As Elon Musk’s roadster is headed for the asteroid belt, Tesla (TSLA) reported its fourth quarter results after the close February 7. Production issues persist in its Model 3 vehicle, but the company’s top-line continues to grow at an impressive rate as 2017 revenue leapt 55% from 2016. Executives avoided putting a specific number on the run rate of Model 3 production, but the firm is targeting a production rate for the Model 3 of 5,000 per week by the end of the second quarter of 2018. Given past production and supply chain issues, however, this guidance should be taken with a grain of salt. While we acknowledge Tesla’s potential and thirst for innovation, we must note that the company remains a speculative bet, and its road to a mass-production automaker will not be an easy one. It continues to burn through cash as free cash flow fell to nearly negative $3.5 billion in 2017 from negative $1.4 billion in 2016, and its long-term debt load grew to nearly $9.5 billion at the end of 2017 from less than $6 billion a year earlier.
We’re watching the markets closely, and we hope you are, too.
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Kris Rosemann and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.