Just two months into the year, our cautiousness on the debt and equity markets over the last few months seems justified. As we anticipated in last month’s email, after Tunisia’s revolution spread to Egypt, uprisings continue to spread in and around major oil producing countries.
There is plenty of uncertainty, but here’s what we know for sure: Successful attempts to overthrow the Tunisian monarchy set up a chain of revolts in North Africa, the Middle East, and now Sub-Saharan Africa. Mubarak is gone from Egypt, Qaddafi has pledged to fight to the end in Libya, and we’re watching Bahrain for indications of – far more important – Saudi Arabian stability.
The Saudis have pledged internal reforms, including a 15% hike in wages to cover inflation, while showing a willingness to open their oil spigots in an effort to stabilize the West (and pocket a few Euros). Yes, their king has been “friendly” to the West, but recall that he is in fragile health, and that “friendliness” may be fragile as well.
What has astonished us most in demonstrations across the region is the power of the Internet. Hundreds of thousands of people – all ages and social classes – have come together via social media. It has provided the means for the masses to organize against dictatorships with the message, “We’re mad as hell, and we’re not going to take it anymore.” Attacks filmed on cell phones are immediately uploaded and posted to millions around the globe. Dictators can close the physical borders, but cannot stop the truth from immediately spreading through information networks.
China’s rulers are also nervous. Their hyper-growth economy needs to be curbed in order to hold down dissent by citizens overwhelmed by the high rate of inflation.
Brent (North Sea) oil futures reached nearly $120 per barrel, creating fears of a double dip in economic activity. Fourth quarter GDP was adjusted down from 3.2% to 2.8%, well below initial expectations of 3.5%. With the Saudi commitment to ship enough oil to offset disruptions from North Africa, however, Brent oil futures dropped to just over $112 per barrel at the end of February, double-dip fears were eased, and the stock market picked up.
Prior to the spike in oil, consumer sentiment rose for the month to the highest level in three years, driven by stock market gains. For households with better incomes (over $75,000), job and income prospects were viewed much more favorably than in the past and offset concerns about food & fuel inflation. The consumer remains our glimmer of hope.
One of the biggest concerns as companies reported earnings this month was government spending. If Federal legislators cannot agree on spending cuts or pass another temporary resolution, approximately half of all government services will shut down by this Friday, March 4. Services that will remain in place are Social Security payments, the U.S. Postal Service, FBI, border patrol, the Coast Guard and the Armed Forces.
On the other hand, National Park Services as well as national museums and monuments will close, passports will not be processed, hazardous waste clean up at over 600 sites will stop, and services for Veterans will be curtailed. Reduced Federal spending will be a drag on economic activity, which is already threatened by drastic reductions in spending by state and local governments (which are forced to operate balanced budgets). Once tough legislative decisions have been made, we expect clarity on government spending, especially as it relates to the technology sector.
With heightened stock market aversion to risk, domestic equities and larger capitalization names are seen as the safe havens.
In bonds, individual investors have been shying away from municipals since the November elections. Rising yields (up .50 percent to 3.46 percent on a high-quality 10-year bond) are now attracting hedge funds and other money managers who typically do not buy muni bonds, indicating attractive values in the sector. (Financial Times of London, February 28, 2011).
During February, we added to our model weighting in Unilever (NYSE: UN), the global food & household products company. Volume sales were the strongest in their sector during the fourth quarter, indicating that new management has begun the necessary changes to drive growth and another 3 percentage points of profitability. With a 4.5 percent dividend yield and the potential for mid-teens earnings growth, we believe UN could generate nearly 20 percent average total shareholder return over the next 2-3 years.
3M (NYSE: MMM) was crowned the “Heartland Tech Titan” in Barron’s on February 26, 2011 for its record of innovation and outlook for accelerating growth. Nearly 5% of revenue is earmarked for research and development, which is $1.4 billion on annual revenues of $26.7 billion. Already 31% of sales are generated from products introduced in the last three years, and the goal is 40% by 2015.
Overseas markets account for 48% of sales today and generate above average profit margins. By 2015, those markets are planned to account for 60% of sales. Following record sales and earnings in 2010, the company raised guidance for 2011, boosted the dividend by 5% and increased their share repurchase authorization. We continue to believe that the shares should sell at a traditional 10-20% premium to the market, versus par today, and expect above average returns for long-term owners.
Target Corp. (NYSE: TGT) is regaining market share from Wal-Mart as same store sales reaccelerate at this Minneapolis-based national retailer. Much work is yet to be done, but recent strategies to pick-up traffic and average spending at the stores has given management confidence to declare two goals for 2018: 1) $100 billion in retail sales, and 2) doubling earnings per share to $8.00, which represents a 10-12% annual growth rate. A small urban format will have pilots in four major cities in 2011. While the addition of 100-150 stores in Canada will likely have a 10-cent drag on EPS this year, we believe it is the right strategy longer term. Another major part of the story is the proposed sale credit card operations, which should remove volatility from the earnings & stock.
The 2011 outlook for Thompson Reuters (NYSE: TRI) was in line with or slightly ahead of our estimates of 6% revenue growth. On the quarterly call, guidance for cost savings was raised to “at least” 3 percentage points. Sales growth to Legal clients was the strongest in several years, and the litigation pipeline is picking up. Markets (74% recurring revenue via subscriptions) saw margin improvement on minimal sales growth.
We should see a significant wind-down of integration expenses in 2011 following 2 years of headwinds and a wind-down of cash outflows for capital expenditures and acquisitions, freeing up more cash for returns to shareholders. We continue to believe that Thompson Reuters is well positioned to benefit from improved financial and legal markets over the near and longer terms.
NetApp (NYSE: NTAP) met expectations for its most recent quarterly sales and profits (up 25% and 40%, respectively). Some parts delays from vendors were reported. The outlook disappointed due to ongoing delays as well as the board’s decision to increase spending on employees and capital in an effort to increase share of a growing market.
Thus, following many quarters of expansion, margins look to be flat over the coming quarter as very strong cash flow (25% of revenues) is purposefully reinvested in the business. At 25 times forward earnings-per-share and an expected growth rate of 30-40% for the coming year, we continue to believe that this is a premier data storage management company with attractive valuation to own for the intermediate to longer term.
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