Greetings from Norway.
I’m in the land of fjords, Viking ships, and stave churches. It’s a quick trip with a few days in Oslo (where we are now) and then a train ride over the mountains to Bergen and some fjord-seeing with a flight back on Saturday. The site will be dark for this week with normal posting to resume on Monday, August 29.
Hope everyone is enjoying the last days of summer.
Update August 19, 2016. It’s not often that you’ll see a stock climb 13.49% on the day when the company announces that full year sales will fall 10%, worse than the 9% drop it had forecast earlier.
But that’s the story today for Deere (DE.) The stock’s move, I think, says as much about the market consensus about economic and earnings growth–or actually the lack thereof–as it does about Deere itself.
Deere announced today, August 19, earnings of $1.55 a share for the June quarter, up a scant 2 cents a share from the $1.53 that Deere earned in the June quarter of 2015.
That scant earnings growth, however, was hugely better than the 94 cents a share that Wall Street analysts had been projecting. Analyst pessimism was fully justified because Deere’s business is at a cyclical low. A record corn crop this year has sent grain prices–and farm incomes–falling and sales of Deere’s farm equipment closely track the rise and fall of farm incomes. Tractor inventories are a a seasonal record and there’s no sign of an early turn around in sales. Revenue fell to $5.86 billion for the quarter, from $6.84 billion in the June quarter of 2015, and well short of the $6.06 billion in revenue forecast by Wall Street.
What analysts did under-estimate, though, was Deere’s ability to cut costs and then cut them some more. For the quarter Deere managed a 16% reduction in the cost of sales. That isn’t a one-time reduction either. By the end of 2018 Deere expects to boost pretax income by at least $500 million–even if the current farm downturn continues, Deere CFO Rajesh Kalathur said in a post-earnings release conference call. Today the company raised its forecast for net income for the full fiscal year that ends in October 2016 to $1.35 billion from a May forecast of $1.2 billion.
Is this kind of earnings growth based on cost-cutting worth a 13.49% one-day jump in the share price? Maybe not in an economy and stock market were companies are finding it easy to grow top line revenue and bottom line earnings.
But that isn’t the economy or the stock market we have right now. Earnings for the Standard & Poor’s 500 stocks were down again this quarter and are now forecast to fall again in the third quarter, although by a smaller percentage. A drop in third quarter earnings would mark a sixth straight drop in quarterly earnings. That’s a real earnings recession.
In that context earnings from cost cutting (or any source, in fact) look really good–especially if a company can produce a cost reduction in the neighborhood of 16% and also forecast that it believes that it can continue to cut costs even as the company’s business continues to limp along the bottom of a deep cyclical downturn.
Deere has been a member of my 50 stocks portfolio since December 30, 2008. The shares are up 131.93% in that period as of the close on August 19. The stock comes with a decent 2.75% yield.
Given the kind of cost cutting that Deere has promised and that management looks capable, on the record, of delivering, I’d certainly hold onto these shares. The trailing 12-month PE ratio is just 16.92. The shares are down 2.1% over the last year and up only 14.49% for 2016 to date.
There’s really nothing wrong with the shares of Capital One Financial (COF) that a stronger U.S. economy, a more confident U.S.consumer, and an interest rate increase–or two–from the Federal Reserve wouldn’t fix.
It’s just that I don’t see any of these in the cards in the near term–December at the earliest for a move by the Federal Reserve. And the Fed seems to be deep into holding the course until it can collect some evidence that inflation is a real danger (especially with an election looming.)
I bought shares of Capital One for my Jubak Picks portfolio back on December 10, 2015, when it looked like the Fed might actually deliver not just a December interest rate increase but two more increases in 2016. That would have given banks a big boost toward higher net interest margins on their capital and would have been a sign that the Fed was optimistic about the U.S. economy.
If those interest rate increases aren’t pending and if faith in the economy seems increasingly a matter of faith and not data, I think it’s time to call this buy “premature” and sell these shares. Shares of Capital One are up 18% from the June 27 low as of the close today, August 18. (But my position in these shares is still down 13.66% since that December purchase.) That recent gain brings them pushing up against the 200-day moving average at $69.57 and to a position near the top of their recent volatility range as sketched by the Bollinger Bands indicator. The stock has shown a recent pattern of lower highs with the shares failing to reach the April 26 high of $75.91 or the May 27 high of $73.83. The July 14 high was $68.85. By all these measures Capital One is starting to look, if not expensive, at least stretched.
The bank’s second quarter results fed into my decision to sell because they show a bank that is itself acting as if it sees dangers in the economy. For the second quarter, Capital One reported operating earnings of $1.76 a share, slightly below the Wall Street consensus at $1.86.
The miss was largely the result of a build in reserves as the bank added $465 million to the money it has put aside for troubled loans and credit card accounts. $298 million went toward reserves for the bank’s big U.S. credit card business, but the bank also set aside $58 million largely for its subprime auto loan portfolio.
The caution evidenced in the results as of the end of June looked well founded when the bank reported on July operations recently. Credit losses in its international credit card business rose 12 basis points to 3.64%. Credit losses were down 12 basis points from June but up 76 basis points year over year. Dollar delinquencies rose 18 basis points as percentage of loans from June. Credit card loss rates historically improve in the second quarter at Capital One and then increase again in the fourth quarter.
In its second quarter earnings call bank management said that it expects to see margin compression in the second half of the year driven by declining margins on auto loans and by the current and continuing low level of interest rates. (In July credit losses from auto loans increased by 25 basis points to 1.71% from June. That’s only a tick higher than the 1.70% rate of credit losses in June 2015.
Wall Street analysts have been lowering their earnings estimates for the third and fourth quarters of 2016. The consensus estimate of $2.08 for the third quarter 30 days ago is now down to 1.96 a share. For the fourth quarter the consensus estimate of 30 days ago at $1.70 has crept lower to $1.66 a share.
I still like the bank’s credit card business as a driver of future revenue growth but I just think the current interest rate environment makes it very hard for the bank to generate earnings growth from this business.
Time to review these shares when Fed policy clearly turns toward higher interest rates.
The trend toward tougher rules on emissions and fuel efficiency for trucks continues–with Cummins as a key beneficiary
Update August 17, 2016. New rules proposed by the Obama administration that would require up to a 25% reduction in carbon emissions from heavy-duty trucks over the next 10 years are good news in the long run for Cummins (CMI.) The proposed rules are 10% tougher than the rules put forward for public comment last year.
The rules mean that Cummins will eventually sell a lot more of its low emissions, high efficiency truck engines as truck makers and truck operators move to meet these standards. (The new standards won’t be implemented, in all probability if Donald Trump wins the presidential election since he has promised a big reduction in government and especially environmental regulation. They will be implemented if Hillary Clinton wins. Figure the odds on victory by either candidate into your investment analysis.)
Cummins has made developing products to meet what it sees as a global trend toward energy efficiency and emissions reductions in trucks. That approach is the leading wedge for the company’s drive to increase market share in China and in India, for example. Designing engines for lower emissions and greater fuel efficient without giving up the power to pull big loads isn’t a trivial task. Cummins has not only continued to invest in research and development–with new products such as natural gas powered engines and a plug-in hybrid coming to market now–but it has organized itself in a way that most competitors can’t match. It’s a lot easier to implement these strategies in an engine if you make all the pieces–including the turbo chargers that let more fuel efficient engines deliver needed power. Many of Cummins’ competitors buy these components–often from Cummins. (Caterpillar (CAT), for example, has decided not to invest in the R&D necessary to meet increasingly tough standards from the Environmental Protection Agency. Caterpillar, which a decade ago had a 35% share of the North American market now has an effective market share of zero.) Cummins makes them all in house and gets to design and fine-tune turbocharger and after-treatment engine systems itself.
All these are reasons to expect that–in the long run–Cummins will continue to gain market share–it owns a 40% share of the North American heavy-duty truck engine market and 73% of the market for medium-duty engines. And all this is the reason that Cummins is a member of my long-term 50 Stocks portfolio. (The shares are up 14.39%, as of the close on August 17, since I added them to this portfolio on May 3, 2013.)
But–and it’s an important “but”– in the near term, the big challenge facing Cummins and the one that will determine its near-term share price is how the company manages the current cycle downturn in the truck market. You could see the challenges clearly in the second quarter earnings reported on August 2. Revenue of $4.5 billion fell 10% year over year on lower truck sales in North America. Total units sold came in at 140,000 against 153,000 in the second quarter of 2015. On the lower revenue and unit sales, gross margin dropped to 12.6% versus 14.3% in the second quarter of 2015.
In its post earnings conference call Cummins clearly forecast that the down leg of this cycle will continue for the rest of 2016. For the full 2016 year, the company said sales will fall 8% to 10%–that’s worse than the 5% to 9% drop the company had forecast earlier. But the company also believes that it can find further cost reductions to support earnings and margins. (Cummins kept its EBIT–earnings before interest and taxes–margin forecast at 11.6% to 12.2% for 2016. Some longer term trends also work in the company’s favor in this down cycle. The growth of the company’s components business means that it’s getting a significant hunk of revenue–22%–from a business that carries higher margins than the core truck engine business. Cummins projects that component sales will fall just 6% to 9% in 2016 and that margins will be 12.75% to 13.75%. The push into international markets also helps with the company now forecasting 9% growth and 10% growth in sales in China and India, respectively. (Sales in Latin America, especially Brazil, continue to show weakness.) And finally, investing in improved production is paying off concretely on the bottom line. Warrenty expenses as a percentage of sales have fallen to the lowest level in a decade.
For the quarter Cummins reported earnings of $2.40 a share, which beat Wall Street estimates of $2.16 a share. Revenue of $4.528 billion was above Wall Street projections of $4.449 billion.
The shares are up 43.75% year to date but are ahead only 1.99% for the last 12 months. That appreciation, however, has left the shares at a price-to-equity ratio of just 15.02. That’s modest, especially when you consider that the price-to-earnings ratios of cyclical stocks rise at the bottom of the cycle as earnings and revenue growth lag. On these numbers, I’d call Cummins a relative buy right now for my long-term portfolio on the belief that this company will effectively manage the down part of the truck cycle. I added the shares to my dividend portfolio back on October 12, 2015 because the shares carried an attractive yield of near 4%. The gains in the shares have sent that dividend yield down to 3.23%, which is still very attractive in the current market, particularly since the pay off from the shares seems secure. The price gain on the shares since that October add is 13.05% as of the close on August 17.
Update August 16. All the traders who had jumped into shares of Hain Celestial Group (HAIN) on a bet that the company would be the next in the organic food space to be sold at a huge premium abandoned ship today on a warning by the company that it would delay reporting its fiscal 2016 results while it investigates accounting issues. The company was due to report on Wednesday.
The shares, which had suffered through a brutal 2015 as management seemed to lose control of costs, had recovered nicely in 2016–going to $55.13 on August 11 from $33.46% on January 16, on news that Danone would acquire WhiteWave Foods (WWAV) for $10.2 billion. That seemed to continue the trend of larger food companies buying smaller players in the organic and natural foods market begun with the purchase of Annie’s by General Mills (GIS) two years ago. There aren’t a whole lot of potential buyout candidates in the space and traders put Hain Celestial on their short list. (I added Hain Celestial to my Jubak Picks portfolio on March 26, 2015 at $63.20. The position is down 37.7% as of the close on August 16.)
I understand the logic behind dumping the stock if you are a trader betting on a quick buyout. Until Hain reports the results of its accounting investigation these issues will hang over the stock like a black cloud. Who will want to buy Hain Celestial when these issues cloud the state of the company’s business? The fear seems to be that the premium in any acquisition will be much lower because of these accounting problems and that any sale will be significantly delayed. In the meantime, traders and investors who worried that management had lost its ability to run the company effectively have received plenty of additional reason to worry.
We don’t know how bad the accounting problems are. It seems, from the company’s limited statements so far, to be a revenue recognition problem with issues in how and when concessions granted to some distributors in the United States were accounted for. In short it looks like the company may have been recording revenue when product was shipped to these distributors instead of when the product was actually sold. If this is simply a timing question, then all we’re looking at is revenue being shifted from one quarter to another (and from the current fiscal year to the next.) If the concession accounting resulted in the inflation of revenue numbers, the problem is more serious. Especially if the accounting issues go back for a large number of quarters. The market decided today that the company’s decision to delay the scheduled Wednesday report for the fiscal year argues for the worst–in reality it just says that the company has found significant accounting issues that it can’t resolve in order to release the report on schedule. (Which does legitimately add to worries about management competency.) The company’s additional statement that it would not meet previous guidance certainly don’t make anyone, myself including, feel all warm and fuzzy, but again a shift in when revenue should be recognized would move revenue from one fiscal year to another and with a big effect on guidance.
Wall Street analysts pretty uniformly downgraded the stock and marked it down as a sell today. The general take was to sell on uncertainty and then maybe re-buy when the results of the accounting investigation are clear. A research note from Barclays was typical of this stance: After downgrading the stock and cutting its target price to $43 from $51, Barclays added, “That said, we recognize that there is no guarantee that the outcome of the review will be materially unfavorable and it could simply reflect timing,” the note said. “As such we would revisit our rating once additional clarity is provided.” Most of the cuts in price targets seem to be to the vicinity of $40 or so–which indicates that analysts are basically following the trend in the market price.
The uncertainty in the stock has certainly been ratcheted up by today’s news. Hang on–or maybe even buy on the 26.3% drop–and you risk getting clobbered if the accounting problems turn out to be huge. Sell on the possibility that accounting problems will be large enough to cut into the value of the company’s assets and you risk missing a quick and big pop if accounting issues turn out to be relatively minor.
From my point of view, the big question is how these accounting issues will wind up depressing the value of the brands owned by Hain Celestial. Certainly a potential acquirer would offer less if the accounting issues reveal that the company has significantly inflated revenue and earnings. Given that the company has struggled to show growth in recent quarters, it doesn’t look like to me Hain Celestial has systematically cooked the books. The books would, simply, have looked better if the company were intentionally cheating. Management, if you chose to believe them, has said that these accounting issues over revenue recognition will not change the total amount of revenue recognized by the company and that the accounting issues do not reflect questions about the validity of underlying transactions.
If that’s the case, we’re looking at issues that certainly undermine faith in current management, but that do not significantly change the value of Hain Celestial to any potential acquirer–although they certainly do delay any potential acquisition.