Economy is Steady but Slower than Expected
This week has been a busy one as many longstanding financial deals and events have come to pass. The Federal Reserve is leaving rates unchanged for now as Brexit is fading into the past a bit, although the Fed has suggested they may raise rates as early as next month. The Democratic National Convention has formally nominated Hilary Clinton, as Bernie Sanders fully endorsed her, securing party unity. The race is on – The Donald vs. The Hilary. We hope you realize that we don’t make predictions in politics here at The Bull Market Report and we find it very difficult to predict what the markets may do if one or the other is victorious. Anyone who claims they know is just grasping at straws in our opinion.
Apple reported earnings this week and we cover it at great length just below. Alphabet investors are also hoping to see an increase in operating margins alongside a 17% increase in revenue. These stocks and more are covered in more details below.
U.S. economic growth unexpectedly remained lukewarm in the second quarter. We saw business investment weakening further with inventories falling for the first time in five years, despite strong consumer spending. GDP increased at a 1.25% annual rate according to the Commerce Department. And they said the 3rd and 4th quarters look weak as well. They are looking for GDP to come in around the 1% mark. Economists aren’t as pessimistic going forward, as they believe consumers will continue their high spending levels.
Excluding inventories, GDP growth rose at a 2.4% rate and domestic demand increased at a 2.7% pace, not really all that bad. Interest rates should remain low, although the Fed is hinting of raising in the next few months. But what else is new? They’ve been threatening this for years. They raised in December and look what happened in January. We think little or nothing will happen on the interest rate front for many months.
The Bull Market Report Companies and Commentary:
Apple (AAPL: $104, up 6%)
Apple saw a big move higher this Wednesday after reporting earnings that exceeded analysts’ predictions. Raymond James Financial recently upgraded the company from a “market perform” to an “outperform” rating. The target price is now $129, which is about a 33% increase from last week’s close of $97. Our Target is $140 and we do not have a Sell Price, as we have said many times that if the stock goes to $90 or $85, we would buy more.
Apple ran up 6% Wednesday to close at a three-month high. The split-adjusted price gain of $6.30 was the second-biggest one-day rise in Apple’s history, due to the better-than-expected quarterly results. It was close to the biggest-ever gain of $7.10 on April 25, 2012. (A 7-for-1 stock split went into effect on June, 2014, meaning the actual April 2012 price gain was really $50).
Apple reported revenues of $42.4 billion and quarterly net income of $7.8 billion with EPS of $1.42. Last year, Apple had revenues of $49.6 billion and net income of $10.7 billion with EPS of $1.85 in fiscal 3Q15. Revenues fell 14.5% YoY driven by lower iPhone sales and a 33% decline in sales from Greater China.
iPhone revenue fell 27% $24.0 billion in fiscal 3Q16 from $33 billion in fiscal 3Q15. iPhone unit shipments also fell 21% to 40 million units from 51 million units in the same period last year.
Revenue from services rose 19% to almost $6 billion from $5 billion. Services revenue accounted for 14% of Apple’s total revenue in fiscal 3Q16, a rise from 10% a year ago. The Services segment is now the second-largest revenue producer for Apple. It consists of revenue from the iTunes, App Store, AppleCare, and Apple Pay businesses. Apple’s App Store revenue rose 37% YoY. The CEO of Apple, Tim Cook, stated, “In the last 12 months, our Services revenue is up almost $4 billion year on year to $23 billion, and we expect it to be the size of a Fortune 100 company next year. Most of our terrific Services performance during the quarter was fueled by our active installed base of devices, with installed base-related purchases of $10.3 billion accelerating to 29% growth year on year.”
This is interesting: Warrant Buffett disclosed in May that his Berkshire Hathaway owned 10 million shares of Apple as of the end of the first quarter. We knew this but hadn’t focused on it recently. We wonder if he is adding to his position.
Listen, we know that this wasn’t a great quarter for Apple as iPhone shipments in China fell 25% YoY to 7.3 million units. This was steeper than its worldwide unit sales decline last quarter of 15%. Part of the iPhone shipment decline in China is related to the company’s effort last quarter to reduce its bloated sales channel inventory. Tim Cook had this to say: "By far, the largest portion of our global channel inventory reduction was in Greater China, so our underlying business there is stronger than our results imply." But, note that Apple's iPhone installed base in China has grown by 34% over the last year alone.
Apple also announced this week that the billionth iPhone had been sold. Plus 2016 marks an even numbered year in which Apple generally launches another flagship product. We should see the iPhone 7 in September.
And finally, we note that Apple raised $7 billion this week in the bond markets through a complex bond sale. Listen to these low interest rates they received: They sold notes consisting of $350 million maturing in 2019 with a floating interest rate based 14 points over three month LIBOR; $1.15 billion maturing in 2019 with a fixed 1.1% interest rate; $1.25 billion maturing in 2021 with a fixed 1.55% interest rate; $2.25 billion maturing in 2026 with a fixed 2.45% interest rate; and $2 billion maturing in 2046 with a fixed 3.85% interest rate. That’s the beauty of having a AA+ bond rating on Wall Street.
BMR TAKE: The bad news: Two down earnings quarters in a row. The good news: Apple is still selling iPhones like crazy (40 million in the quarter) and they have $232 billion in cash with just $70 billion in long term debt. We are buyers here at $104 and expect many more good things coming from the company this year and next.
Google (GOOG: $769, up 3%) reported blowout earnings this week for 2Q16. Google (Alphabet) shocked Wall Street by posting earnings of $8.42 per share, smashing the consensus of $8.04 per share. Revenue also beat consensus by $1 billion, coming in at $21 billion, up 21% from a year ago.
Google’s market cap is trying to catch Apple. The company is valued at $538 billion with Apple at $571 billion. Of course, Google is at their all-time highs and Apple is off 30% from theirs. It’s going to be an interesting dog fight from here on out. We hope it’s a dead heat.
Many analyst firms upped their targets for Alphabet. Credit Suisse raised their target from $920 to $940. Pacific Crest moves from $910 to $960, and Stifel Nicolaus raised its target from $888 to $925. Goldman Sachs upped their target from $810 to $930, while Morgan Stanley analysts moved from $865 to $880 per share. The Bull Market Report has a target of $850 and if it hits that Target you can be assured that we will raise it to $1000 or more. Our Sell Price? We would not sell Google.
BMR TAKE: See the last sentence above!
Facebook (FB: $124, up 2.5%)
Facebook defied all previous expectations as it reported stellar second-quarter earnings. Sales totaled $6.4 billion for the quarter, 59% more than the same period a year ago. Facebook has an active count of 1.7 billion monthly users. The company makes an average of $14 per user per year in United States and Canada, its most important markets. Mobile advertising revenue for Facebook represents approximately 84% of total revenue, an increase of nearly 8% from last year.
Facebook has come across a problem, one that’s actually a good one. The company is running out of space to display more advertisements, the crux of the business. Instead of cramming more in there, it is focusing on developing more targeted and better performing ads. It hopes to remedy this by producing commercial grade advertisements while continuing to add new Facebook users at a constant rate.
Last quarter Facebook added 60 million new users to its base. Facebook is a company that is adept at shifting towards new ad formats and incorporating them into its core business. This is evident in the desktop to mobile switch that occurred in the past five years. Facebook easily captured all of that revenue, showing it’s a company that can shift with the times.
Dig this: Facebook just passed Berkshire Hathaway in market cap. Facebook: $360 billion. Berkshire Hathaway (BRK.A, $216,000 (not a misprint!), $356 billion. Who’s going to win this race? We have our money on Facebook. Don’t get us wrong. We LOVE Warren, but we are backing Zuckerberg with our cash.
Facebook had its price target raised by analysts at Credit Suisse from $145 to $154 on Thursday. This is a 24% upside from current prices. They now have an "outperform" rating on the stock. Our Target is $140 and we are going to hold that here. But we are raising our Sell Price from $105 to $115.
Home Depot (HD: $138, up 1%)
This home improvement store has constantly outperformed over the past 10 years, through thick and thin, with “thin” being the housing crash of 2008-2011. The stock is up over 300% since 2006. Home Depot can count itself among the ranks of other blue-chip stocks. During July, Home Depot’s stock was up 6%.
No major events seem to be affecting the stock at the moment. Home Depot remains as safe a buy as ever for investors. There is a lot of upside to continuing to invest in this company, as more people require home services. The company’s earnings report will be coming out on August 16th.
Gilead Sciences (GILD: $79)
This company had a terrible week, dropping 8%. The company reported last week that it had $7.8 billion in revenue and $3.08 in EPS. Estimates had called for $3.02 in EPS on revenue of $7.8 billion. A year ago it posted EPS of $3.15 and $8.25 billion in revenue. Revenues down a bit, earnings down a bit, but so far, not so bad.
Gilead repurchased $1 billion of stock in open market in the 2Q16 after the $8 billion buyback in 1Q16. They have a strong balance sheet consisting of $25 billion in cash, $24 billion of debt, and nearly $20 billion in cash flow per year so we expect more stock buybacks, but certainly not at the pace of the first quarter. They will be spending more money on R&D instead of buying back stock. OK by us.
Another reason for the pullback was that a few firms lowered their ratings on the stock. Credit Suisse still has a Buy rating but lowered its price target to $115 from $120. Barclays reiterated an Overweight rating. S&P Equity Research reiterated a Strong Buy rating.
We are not too happy about the stock lately. We think the selling is way overdone as consensus has earnings for 2016 of $11.80. That puts the stock at a PE of 7. Downright silly. Our Sell Price is “We would not sell this stock,” but what worries us is not so much the company, but the stock market as a whole. We don’t believe the stock market will fall from here, but IF IT DOES, then a rising tide lifts all boats with the opposite true as well. Please read between the lines here and be careful.
Kinder Morgan (KMI: $20, down 3%) The stock was down a little for the week, but up from the $18-19 level a month ago. The company restructured significantly in 2014 and it has taken two years for the market to digest what the company has done. They rolled all of the their limited partnerships into one entity. (We like.) They cut the dividend by 75% from 50 cents to 12.5 cents (which they paid last week.) This is a yield of 2.5% down from a yield of 3-4 times that. Forget crude. We believe it has a lot to do with the price of natural gas, which has run from $1.55 earlier this year to the $2.75 level. Their balance sheet is strong now with the dividend cut and the sale of an electric utility (why were they in electricity delivery?) They got $1.5 billion from that sale and it went right to paying down debt.
Revenue has been down just a bit over the past two years, but earnings after non-recurring items have actually been steady. We don’t like the company’s long term debt situation. It’s very high and thus highly leveraged. So for that reason we are going to watch this one like a hawk. Our Target is $27 which we are going to leave there, but we are raising our Sell Price from $15 to $18, the price we added the stock at in February. If it hits that level we are out. The high debt level worries us.
Twitter (TWTR: $16.64, down 9%) had a bad week. They reported decelerating revenue growth for 2Q16 and forecast lower-than-expected revenue for 3Q16. Shares fell 15% on Wednesday but bounced a bit on Thursday and Friday. The stock actually had a good run in July starting at this same level, rising to the $18 level, and now dropping back to where it started at the beginning of July.
Revenue was $602 million, in the top half of the company's guidance range for the quarter of $590 - $610 million. Some are saying that 2Q16 YoY revenue growth of 20%, which was down from 1Q16 YoY growth of 36%, is disappointing. But advertising revenue - 90% of the company’s total revenue - increased 18%. Not bad, but lower than the 35% growth in 1Q. Earnings were 13 cents vs. 15 cents a year ago.
Future: Management guided for 3Q revenue in the range of $590 - $610 million, but consensus expectations are for 3Q revenue of $680 million. This is one reason why the stock got hammered.
Average monthly active users reached 313 million, up 3% YoY. But engagement and daily active usage improved. Management said: “This growth was driven by marketing initiatives, organic growth and product improvements, including better relevance in both the enhanced timeline and push notifications. We are seeing the direct benefit of recent product changes, and with disciplined execution, we believe we can drive improved engagement and audience growth over time.”
BMR TAKE: The company is going through a huge internal turnaround and it may or may not work out. If it doesn’t, the stock is going to $10. If it does, we can see $20 or $25. With $2.4 billion of revenues, it’s certainly not going out of business. We like it better here at $16 rather than its all-time high of $69, and $52 a little over a year ago. Will Apple buy them out? Will Google? Will Facebook? Maybe. Maybe not. (Will Donald Trump? He sure is an advocate!) So if this one is too hot for you, get out of the kitchen. We are watching and waiting.
HIGH YIELD CORNER
We are moving this section up a little higher in The Bull Market Report because it is our best performing portfolio. Not only are the stocks in this portfolio paying 5% and 8% and 10% and higher, but the stocks themselves are up 5% and 15% and 25% and more! We generally think of stocks in the High Yield portfolio as being slow and a bot boring and STEADY.) But with the stocks up so much we are loving it.
Are cracks showing in the world of high yield investments?
We've seen many weeks of persistent strength for many high yield asset classes, so it's no surprise that some would start to take a break. This isn't a cause for concern, but some investors might worry that any pause in the continued bull market for high yield might be the beginning of a turn. While this may be true, a sudden free-fall is unlikely to come in the short term because of several tailwinds at the backs of some of these investments.
To understand those tailwinds, let's first consider the big news: the GDP report. Second quarter expectations were upgraded several times from several quarters, with 2.6% growth the average estimate before Friday's bombshell: actually GDP growth was less than half that, at a meager 1.2%. Markets rallied on the bad news, as paradoxical as that might seem, for one simple reason: We now can expect a more dovish position from the Federal Reserve.
That's why the 10-year U.S. Treasury fell to 1.45% on Friday, reversing an increase that we have seen in July as Brexit fears were replaced with macro optimism. But America's economic recovery isn't as great as many may have expected, and so Janet Yellen company will have no choice but to pause the interest rate hikes - which are inherently bad for high yield investments - for the foreseeable future. Thus high yield assets rallied on Friday after a sluggish week.
Weak growth means a monetary policy that will benefit high yield, but it doesn't mean companies are going to struggle to pay their bills and cause a rife of corporate defaults. That's good news for BDCs and junk bonds, which would decline in value if bankruptcies began to accelerate. Why are we so confident that companies can continue debt payments? Simple: despite the weak economic growth, the U.S. consumer is actually gaining ground.
Within the Census Bureau's data was a startling and somewhat paradoxical data point: household purchases rose 4.2%, the strongest growth rate in two years. That's a continuation of the first quarter of this year, when retail sales rose 8% YoY. Even as the U.S. economy stumbles, consumer spending is not.
What this means is that companies exposed to the Retail world will continue to survive, even if they don't thrive. High yield investments exposed to Retail will also continue to do well.
This means REITs that specialize in anything retail related - strip mall REITs, hotel REITs, and apartment REITs - will be fine. If anything, they may see funds from operations (FFO) grow as more activity in those sectors creates expansion opportunities and drives higher rents.
This is good news for Bull Market Report pick Kimco Realty (KIM: $32), which rose 2% this week and is up 21% year-to-date and 17% since we added it on March 24th. Kimco's specialty in outdoor shopping centers and strip malls, and its portfolio of top tier tenants, makes it a great hold even though it has surpassed our previous target price. This is why we are upgrading Kimco with a new target sell price of $38, which is likely to come later this year. If there is a market correction and Kimco falls, it will just be a great opportunity to buy more. We are raising our Sell Price from $25 to $28. All of this can be found on the website, of course, at https://www.bullmarket.com/high-yield
Similarly, a stronger consumer means more Americans will have fewer problems paying their mortgages, or buying new homes, especially if mortgage rates continue to sink with the U.S. Treasury rates. This is great for the secondary mortgage market, which in turn is great for Pimco Dynamic Income Fund (PDI: $29), another Bull Market Report favorite that is up 3% over the last week. Like Kimco, the Dynamic Income Fund has just edged past our previous sell price and so we are again upgrading the fund with a new Target of $33 (and a new Sell Price of $24, up from $21.) With continued strength in the mortgage backed security market where the fund invests, finding income should remain no problem for the fund--and a strong special dividend at the end of the year is becoming likelier than ever, especially as the fund has recorded a significant amount of undistributed net income over its last fiscal year.
A final word about the high yield market: The iShares High yield Corporate Bond ETF (JNK: $85) fell 1% last week but remains up 6% year to date. With several weeks of strength and a raging bull market since February, this decline appears worrying on the surface. However, we remain unconcerned for the reasons stated above. With default rates remaining at a similar, albeit slightly elevated level, junk bonds remain attractive as a hold in funds like the Pimco Dynamic Income Fund. While some future slight declines in value may affect high junk bond funds that are poorly allocated to underperforming companies, our picks are managed much better than that. This again demonstrates the need to choose high yield assets carefully.
The same goes even more for BDCs, which is why Main Street Capital (MAIN: $33, up 1%) remains a favorite. This is an extremely well managed Business Development Company and one of the few to grow NAV (Net Asset Value), dividends, and share price since inception. The company's ability to consistently provide value is also the reason why we have our Target price at $40, a level far above the BDC's NAV and a level it only briefly touched in early 2014. We do not expect it to reach that Target any time soon, if ever - and that's a good thing, because we don't want to sell MAIN and lose out on the 6% yield and special dividend upside.
That’s all for now on High Yield. Suffice it to say that we are very pleased to have these consistently high returns (stock appreciation and dividend) in this portfolio, in the midst of a very turbulent world.
Thoughts from Gary Jefferson
First Vice-President, Investments
Jefferson Financial Group
UBS Financial Services, Inc.
Earnings season heated up this past week with a whole host of big names reporting. According to Thomson Reuters, 65% of S&P companies that reported earnings so far have beat Wall Street estimates.
Art Cashin (managing director of UBS Financial Services) said last week, "Earnings slipped but not as much as some had feared…." Normally, that would in and of itself not be enough to spark a stock rally. So what is behind the recent move to new highs? If we had to guess it would be because investors like a low interest rate and no recession environment. And, they like the US market better than the rest – there are few places around the globe to invest that have the appeal of today's US equity market. As one market guru recently commented, "If the US stock market is the de facto standard bearer for global equities, then this new move higher is only in its early stages and will steal the thunder from the political theatre we're all having to endure".
Well, that may be stretching it somewhat since the S&P500 is trading at 19 times trailing 12-month earnings. If stocks go higher they will need higher earnings (which have to be supported by rising sales). Fortunately, the consensus forecast is for higher earnings for both the 3rd and 4th quarters. And, one has to remember that many groups of stocks endured bear markets over the past year. For example, the iShares Nasdaq Biotechnology ETF is still down 30% from its August 2015 high. Many other sectors are at or near highs but have yet to "break out". As we repeatedly say, "it is all about earnings, earnings and earnings".
The US dollar staged a massive breakout that could snap the greenback out of a 16-month funk. We’ve already seen the effects of a stronger dollar on crude. Oil topped out at $51 in early June and has slowly dropped lower ever since. At $41/barrel, it’s now 20% off its highs.
All of this brings to mind one of the oldest and most respected stock market epigrams: "Stocks always climb a wall of worry". Meaning, without worry there would be no opportunities in the stock market. There's plenty to worry about – oil, the dollar, rates, the election, Brexit, China and terrorism, just to name a few. What we see is a wall that will crumble under the pressure of good earnings notwithstanding all the worries. Likewise, we see a wall that the market likely can't climb over should earnings surprise to the downside. The majority of experts believe the earnings will be there, and if they are right the market should continue to climb its way higher by year end.
Thank you, Gary Jefferson.
Whole Foods Market (WFM: $31, down 10%) The company’s results for this quarter were not good. L&F Capital Management refers to them as “Not that appetizing” and this certainly seems accurate. Their latest quarter can only be described as weak. Earnings have been sliding and show no signs of reversing. Comparable store sales haven’t increased in an entire year, decreasing by 3% in this last quarter.
The shares, which have declined 18% in the past 12 months, trades at 22 times forward earnings, compared with the competition at 19.
"The most worrisome development about Whole Foods' latest results is the continued sales deceleration heading into 2017," Pivotal Research Group wrote in a note.
The company is getting badly hit by competition from cheaper alternatives such as Kroger, Wegmans and H-E-B supermarkets, which have successfully expanded into fresh and organic products that Whole Foods pioneered. Walter Robb, co-CEO, added: “That’s the world we’re in, and customers have lots of choices.”
Whole Foods has responded by lowering prices on produce. Robb noted that customers are “trading down” to cheaper products, too. On top of the discounts, Whole Foods has launched a pilot loyalty program that will cut into profits even more.
Whole Foods, dubbed as "Whole Paycheck" for its lofty prices, has been spending heavily on a new chain called "365 by Whole Foods Market", which offers lower prices.
In the last year, net income fell by 22%. Free Cash Flow margin is also very low at 1.1%. Revenue of $3.7 billion missed estimates and on Tuesday, Goldman Sachs cut Whole Foods to a sell. Until then, their view on the retailing chain had been neutral. They had this to say on the subject; “Whole Foods is experiencing a competitive barrage, losing share in its core natural and organic business to a variety of players.” When asked about Whole Foods’ long-term potential, they stated that “Wellness has gone mass market, and it is not coming back, never again to be relegated to niche specialty retailers serving price-insensitive, early adopters.”
Goldman Sachs just might be correct when they spoke negatively of Whole Foods’ long-term potential. Analysts believe that a turnaround in sales will not come quickly, especially given the decline in comparable-store sales. L&F Capital Management is skeptical of the long-term potential as well. During a previous cycle, they presented an original bear thesis in which they suggested that “the mainstreaming of natural organics” presented great risk to a company such as Whole Foods. It certainly seems to be coming true, given the numbers from this quarter.
The company has discussed a plan to improve on costs and spending. If it works, the plan could save them $300 million in annual expenses, but given the rising costs of healthcare expenses that the chain continues to face, there is some speculation as to just how feasible such a plan is. Gross margins have declined a full point to 35%, but the company claims that it is intentional, as it is part of a recently engineered strategy aiming to lower their prices. This strategy includes an anticipated decline of 200 more basis points.
BMR TAKE: It seems that the organic foods giant has become too successful for their own good. The stiff spike in competition that we are seeing is troubling and only seems to be getting worse. Management has expressed deep concerns regarding the competition and if they are concerned, then we should be as well. Unfortunately this appears to be a good time to exit Whole Foods Markets. We added the stock in January at $29 so we are going to eke out a profit here, but we are not at all happy. We are just tired of waiting and waiting and waiting. We hereby remove it from our Stocks for Success.
Mazor Robotics (MZOR: $23) had a great week, up 13%. It’s still a relatively small cap at just less than $500 million, and the company is certainly a buyout candidate for one of the big Healthcare stocks. We like this one a lot. Let’s see what happened this week. Well, for one thing, Medtronic (MDT) is set to enter the robotic surgery market through a partnership deal with Mazor. As you know, Mazor manufactures robotic systems, specifically the Renaissance Guidance System, which is used for spinal surgeries.
The US robotic surgery market is dominated by Intuitive Surgical (ISRG). Another recent major entrant in this market space is Verb Surgical, a joint venture of Johnson & Johnson (JNJ) and Google.
The Medtronic-Mazor partnership includes co-development, co-promotion, and global distribution for some of Mazor’s spine products. Medtronic is expected to invest about $50 million in three separate cash infusions. Initially, the deal entails a co-promotion phase in the United States. If the expected milestones in this phase are met by the end of 2017, Medtronic will gain the sales and distribution rights of Mazor’s future spine product sales. Medtronic will earn commission on sales of the products, and Mazor will earn the consumable and service revenues. The Renaissance Guidance System will continue to be sold and distributed by Mazor.
The Renaissance Guidance System enables surgeons to execute spine and brain surgeries more accurately and more safely. It allows the surgeon to execute minimally invasive guided procedures instead of freehand surgery, thus reducing risks of complications during surgery. The system also reduces the patient’s exposure to radiation due to the minimal need for X-rays. Radiation levels in robotic-assisted surgeries are 56% lower than in traditional surgeries. Also, patients are found to have a shorter recovery time and better outcomes.
Mazor Robotics sells its Renaissance Guidance System on the “razor and blades” business model similar to Intuitive Surgical’s (and Gillette.) The Renaissance Guidance System sells for $850,000. The disposables sell for $1,500 per procedure. In comparison, Intuitive Surgical’s system sells for $1.5 million on average, and the disposables cost $1,840 per procedure. Surgeons have used the Mazor Renaissance Guidance System over 12,000 times for spinal surgery successfully.
BMR Take: We like 13% up-weeks. We are looking for a much higher stock ahead. We hereby raise the Target from $25 to $29 and the Sell Price from $14 to $18.
That’s it for this week.
Good Investing,
Todd Shaver
Editor in Chief