Friday File: Earnings Thoughts and Updates

So many thoughts, so little space -- CRTO, FOSUF, LCSHF, ROIC, VTR, COR, DSEEX, NXPI, VC and more

By Travis Johnson, Stock Gumshoe, July 29, 2016

This week I’ve got a lot of thinking to catch up on — there are several stocks in our Gumshoe Universe that have reported or generated some news of late, many of which I own, and I’ve got some thoughts on a lot of them to share with you.

I started with my reaction to the Facebook (FB) quarter in a separate note earlier in the week, and I stand by that relative optimism about Facebook’s continuing long-term potential (yes, even with the news today that they might have an additional tax liability), and remain encouraged by Alphabet/Google’s (GOOG) progress as well.

And what other stocks caught the eye this week? I thought you’d never ask…

Criteo (CRTO) has gotten a fair amount of attention lately, originally because there’s been a fairly high-profile lawsuit between Criteo and a US ad tech company called Steelhouse, and now because the Facebook and Google earnings were so fantastic that everyone’s getting a little excited about online advertising in general… and perhaps sniffing around for the possibility of a wave of mergers and acquisitions that could again spur takeover rumors for the smaller players like Criteo.

The lawsuit I can’t help you with — Criteo sued Steelhouse for click fraud, and Steelhouse countered with allegations that Criteo’s clicks look suspicious and it’s slandering Steelhouse and scaring away customers. Steelhouse is well-funded, they got their largest venture funding round of $49 million back in December, but they’re a lot younger and smaller than Criteo (CRTO was founded in 2005, Steelhouse got its first funding in 2010). Presumably there’s some long tail risk there of something happening, but I’m not specifically worried about that legal fight.

Criteo is really an outlier in the ad tech space, and that really is a big part of the reason I like it. I am currently long CRTO artificially in my personal account, through options, but would also be happy to own the equity in the low $40s. This Wall Street Journal piece from last month sums up the situation pretty well when it comes to Criteo’s fundamentals and stock performance: They are often lumped in with other “ad tech” companies, but unlike almost all of them Criteo has been consistently profitable for years and has a strong and growing base of customers with whom they have a pretty deep data connection, and a revenue stream that’s based on performance (which advertisers love, of course — they’d rather pay $5 for a click if that person buys a $300 item than pay 50 cents per click for ten different people who browse but don’t buy anything). Criteo is also a buyer of some ad space on Stock Gumshoe sometimes, so I should note that as a potential source of bias (so is Google). If you’re in a space where everyone is fighting for virtual real estate and customers and you’re the one that’s most consistently profitable and growing (the others are rarely profitable, and are mostly not even growing revenue right now with the exception of Rubicon (RUBI)), then you’re simply doing something better.

Analysts think they’ll grow earnings better than 30% this year and 25% next year. Those analysts could obviously be wrong (they’ve had trouble forecasting CRTO earnings in the past), and there are real challenges — not just this lawsuit and countersuit, whatever merit they might have, but currencies (their growth is in the US and Asia, but their largest market is still Europe) and competition are always right around the corner, and they are going to have to remain integrated with Facebook and Google and on good terms with those advertising platforms to remain a viable business, which creates risk because of their vulnerability to changes in those businesses…. but that’s excellent growth for a company that’s only trading at 19 times next year’s earnings, and CRTO remains both a good growth stock and a “maybe someday” acquisition candidate… and the only one of the sometimes high-profile small “ad tech” companies that has any kind of reasonable fundamental performance when it comes to their income statement…

… but though the ad market has folks a little smiley again after Facebook and Google, we should remember that Criteo hasn’t reported yet — their second quarter numbers will come out on Wednesday next week, so don’t jump in to do anything crazy unless you’re consciously making a bet about whether the earnings will be great or lousy in relation to analyst estimates or whether they’ll say something about market conditions or the remainder of the year that makes investors crow or cringe (they’ve beaten estimates handily in the last two quarters, but trailed estimates in the two quarters before that, for whatever that’s worth).

Fosun (656.HK, FOSUF) has been an interesting story for years, as Guo Guangchang tries to build an insurance-fueled subsidiary on top of a Chinese portfolio of steel and pharmaceutical companies and emulate the early days of Berkshire Hathaway’s growth. The challenge has always been that Fosun has been far, far more aggressive than Berkshire ever was in using a lot of debt to fuel their acquisitions, and that ha come back to bite them a few times and recently put the kibosh on two of their insurance acquisitions — they canceled their acquisition offer for an Israeli insurance company and a private banking firm in Europe, and recently have pushed forward with the spinoff of their recently acquired Ironshore insurance company, largely because regulators have complained that an insurance company being controlled by a heavily indebted conglomerate presents too much risk. They have filed the registration statement for Ironshore, and will probably float a portion of the company in an IPO, but they’re likely to have a controlling stake for the foreseeable future — ideally, I expect, the IPO will be well-received and they’ll be able to get down to a minority stakeholding and get the regulators off Ironshore’s back. Ironshore has had solid results, growing book value and reporting a good combined ratio below 90 last quarter, so though insurance is a tough market now it’s probably as good a time as any to try to entice investors with their income statement.

So Fosun changed tack a little bit, no longer acquiring financial sector assets willy nilly but still certainly an acquirer. They’re now moving to acquire Gland Pharma in India from KKR, and recently bought the Wolverhampton Wanderers English soccer team. Pharma fits right into the consumer-focused “health and happiness” strategy Fosun is pursuing as plays on the domestic market in China, and China is also catching football fever in a big way and acquiring lots of European stars to play in the Chinese leagues, I imagine Fosun is hopeful that they can create a popular fan base in China for the Wolves to complement their Chinese consumer businesses (they’re not the only ones, Aston Villa was sold to a Chinese buyer not long ago). Buying the team is not a huge deal financially, the Wolves are currently relegated and aren’t in the Premier League with the likes of Manchester United so the acquisition was pretty cheap at about $60 million, but it looks like a “value” buy as much as you can say that buying a trophy asset like a professional sports team can ever be a “value.” I sold half of my Fosun shares quite a while ago when they hit a stop loss, but am happy to continue holding the rest — they generate a lot of interesting news.

I wouldn’t want to make this a particularly large position because that debt will be sitting there for a long time as a potential problem — Fosun is funded largely by relatively short-term debt, which means they have significant potential sensitivity to any debt crisis in China that makes it tough to roll over their debt (which is, of course, what sunk so many US companies during the financial crisis — short term debt is great and cheap as long as you can keep rolling it over to a new lender… when no one will lend, things can get ugly). That’s a risk, not a prediction, but China’s financial system is so controlled and unpredictable, at least to me, that it’s enough of a risk that I keep this position muted. I like management, I like China’s long term growth potential, and they have a portfolio of valuable assets around the world… but growing fast and being opportunistic has not been great for their balance sheet.

Lancashire (LRE.L, LCSHF), our British insurance firm, posted earnings recently as well — there’s a good summary here, full reports on Lancashire’s site here, but the basic takeaway is “insurance still stinks, but we’re still underwriting better than other people.”

They’ll likely pay another special dividend late this year, as they have for several years in providing an average dividend payout of better than 10%, but my expectation is that the payout will be substantially smaller this year. They’re still very profitable, but they’re not writing as much business — which means there aren’t as many profits, but there is likely to be excess capital and they tend to return excess capital to investors. Annual earnings this year are likely to be down at least 20% from last year, but will probably be in the neighborhood of 60 cents a share, and the company is saying all the right things about continuing to manage for long term success through the cycle, staying disciplined on underwriting, and using the available cheap reinsurance these days to soften the blow of disasters (like the Fort McMurray wildfires, for example, to which they were exposed but also had substantial reinsurance coverage), and unlike some of the insurers I’ve looked at they’re extremely conservative with their investment portfolio (which can be a bad thing too, of course — Markel (MKL), one of my best investments ever and a top-ten personal holding for years, is successful because they’re the opposite of Lancashire: they keep all their profits, compound earnings, and invest more in equities than most insurers). I’ve been tepid on Lancashire of late because of the fact that insurance is a tougher business than I expected this year

Retail Opportunity Investments Corp (ROIC) is at all-time highs again, and released “better than expected” earnings and also levered up a little this week — $200 million of 3.95% 10-year unsecured bonds were offered this week, which follows a recent equity sale that raised about $120 million. Debt to equity is pretty much maxed out at about 1:1, so, like most REITs, they’ll have to keep staggering equity sales and debt as they grow, and they’ve been doing so pretty consistently in recent years as they sign deals to acquire properties, use short-term debt, and then put that financing onto the balance sheet in a more sustainable way by raising both debt and equity funding that’s longer-term in nature.

But the period of outperformance because they were both performing well and gradually coming up to a relatively standard level of leverage has been over for a while now. Access to capital is still pretty easy, since if they raise half debt/half equity their cost of capital is between 3.5-4% (assuming the dividend, right now 3.2%, is the cost of raising equity capital). That means they need the profit from their investments to come in well above that to help cover operating costs, capital improvements and the like. Cap rates are under pressure as well, thanks to the big pools of money going after any kind of decent and reliable income source, so that margin is likely not going to be fantastic.

ROIC is fairly small with a $2 billion market cap and about 75 properties in their portfolio, but it’s no longer an upstart, it’s no longer a underlevered “growth at a value price” play as it was when we first bought into the company in the early days (it was early in 2011 when I first wrote about and bought ROIC, if you’re keeping track). It’s more clearly about operational performance if they’re to distinguish themselves from other income-focused retail/shopping center real estate REITs like Kimco (KIM) or Realty Income (O). I still like ROIC partly because it’s still showing great operational performance in terms of FFO growth, which comes to some degree from upgrading the undermanaged assets they acquire (mostly shopping centers anchored by grocery stores), and their management team remain strong and add significant value — particularly CEO Stuart Tanz, who seems to have a nose for acquiring “upgradeable” shopping centers on the West Coast. But if I were going in at this level and primarily focused on income I’d take a good hard look at Realty Income as well. Realty Income is much larger, and not growing nearly as quickly (ROIC has grown their FFO per share by 9% over the past year and O’s FFO per share has shrunk about 2% year over year), but the self-styled “Monthly Dividend Company” is also more geographically and otherwise diversified thanks to its large size, and they have a less-levered balance sheet so could theoretically be more opportunistic if opportunities present themselves.

And really, of course, it’s hard to call just about any mainstream REIT a “buy” here with yields down near 3% in most cases… unless, of course, you think that interest rates will remain extremely low for a long time. Would you buy an investment property if the return after maintenance and borrowing costs was 3% a year? Maybe, because there’s the potential that the equity you invest in the house could grow at something similar to the rate of inflation, and that rents should also go up if we see inflation… but it’s certainly not a no-brainer. I’m holding ROIC because I’m loath to sell solid income investments just because they’re richly valued (I’ve seen too many occasions on which my definition of “overvalued” is a lot different than the overall market’s), but I will be keeping an eye on them.

Coresite Realty (COR), my favorite data center REIT, had a solid quarter — but not a breakout quarter that got people excited. The stock fell slightly after the quarter was released, into the low $80s, and it’s still expensive for a REIT and even got an analyst downgrade… but it’s arguably not all that expensive for a growth stock or a dividend growth stock.

I didn’t think the shares would reach these high levels with this kind of speed, it’s really been an incredible year for many REIT stocks. I’ve been covering COR shares for more than five years, and for most of that time it’s been a slow and steady grower, with some fits and starts as the “story” of data centers changed in some folks’ minds (including some brief panics about competition from Amazon and Google) or the interest rate expectations changed… and really, slow and steady growth and income is what REITs are supposed to provide. The stock started to outperform its fundamentals late last year, if you draw a five-year line of share price growth and FFO per share growth those lines run pretty much together… until January, when the share price leapt forward by 50% or so and the FFO per share growth got left in the dust.

I started getting nervous when the dividend dipped close to 3%, and worrying in earnest when the dividend dropped well below 3% (which is why I sold covered calls, and those calls were exercised so I lost most of my shares earlier this Summer)… now, finally, we’re seeing a little softness come back in after the “too much, too fast” run to the low $90s. I expect the company to continue to perform well in the long run, they are genuinely profitable even without the real estate depreciation that you take out to get to Fund from Operations (FFO), and they can probably continue to raise the dividend by at least 15% per year, which is a remarkable pace. They do have capacity in some of their major data centers, they can grow with less dilution and debt than most REITs because of their high margins, and they continue to expand some of the centers for future growth. They continue to lift expectations for investors… but perhaps we’ll slow down to a more rational share price appreciation now.

I still plan to rebuild some of my position if we get back to prices that are more reasonable to me, either nibbling on dips or selling puts if the pricing looks attractive, so my current small position in COR could easily increase if we have any anxiety about the Fed raising rates in September, or just a weak market as the summer trails to a close. After seeing the growth they’re still able to generate, both because of new customers and because of decent rental price increases on renewals, I’m very comfortable with buying the shares up to 20X FFO, which would be around $72 (the shares are around $82 now). That also gives just about a 3% dividend — or, if you assume that they’ll bump the dividend this year by another 15% (not guaranteed, but likely given their history), a forward yield of 3.4%. Not really cheap, perhaps, but not bad, and we’re not likely to get to “cheap” unless there’s an interest rate panic or a market crash (or they surprisingly lose a few really big customers). I haven’t been able to convince myself to invest in any of Coresite’s data center REIT competitors, largely because their performance just doesn’t compare when it comes to earnings and revenue growth, dividend growth, and profitability — that could change, of course, and recently I’ve seen some promising signs out of Dupont Fabros (DFT) and QTS (QTS), but COR continues to look better on just about every front… it’s just a little too pricey for me to get excited about it in the $80s.

On the watchlist, Whole Foods Market (WFM) continues to keep me watching but not buying — I do have a small LEAP option position in WFM, but I can’t get a handle on whether or not they’ll get through this period of competition with Kroger and return to a growth rate befitting their still-pretty-lofty valuation. The earnings this time, with profits still soft and revenues not really growing in a meaningful way, didn’t do anything to resolve that question in my mind. It’s still a great company that I think will be an enduring brand… but I have not enough certainty about that, nor enough of a margin of error on the valuation at more than 20 times trailing earnings, to commit more than just a tiny bit of speculative capital to it at the moment.

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And there have been plenty of earnings that were essentially “no news,” as most earnings reports really are for most companies in the long run, despite our constant desire to react to each bit of news. Ventas (VTR) is doing fine and should remain a dividend growth star, NXP Semiconductor (NXPI) had a well-covered earnings release more because of their connection to the auto business and to iPhone sales than because the release was surprising, and they are on track with what most analysts expected — the real answer about their potential is not coming until a few quarters from now when we see real results of cost synergies from the merger and learn whether the company is really as undervalued as I think it is. NXPI I like because it’s a low PEG ratio stock exposed to two strong sectors (mobile device security and ID, including NFC chips, and automotive), and there’s no change to my thinking on that after this quarter.

Visteon (VC), which I featured in tandem with NXPI a few months ago as compelling ideas based on automotive electronics, is still really in turnaround — but there were a couple good signs this week: First was that they lowered their sales guidance for the year when they released their earnings, but still had the share price recover completely from the knee-jerk drop almost immediately… and second was that Ford (which reported at roughly the same time) had a very rough quarter and forecast an end to auto sales growth in the US, and Visteon recovered much more strongly than Ford did following that announcement.

That’s important because Visteon is a major Ford supplier, with about a third of their sales going into Ford vehicles, and is still largely joined at the hip with Ford in the eyes of many investors — a little separation in the stock reactions is perhaps a positive sign. This one’s a longer-term bet and isn’t as obviously undervalued as NXPI, but I think they’re positioned in the right trends to benefit from increasing automotive electronic demand even if the actual number of autos sold in the US is peaking. Of course if auto sales drop by 20% then all the auto suppliers, including both NXPI and VC, are likely to suffer — but as long as the business is OK, those two should be in the sweet spot to supply what is most wanted in new cars, and Visteon’s quarter reassured me that investors are willing to wait for that transition for at least a little while.

There are plenty of other companies in the earnings pipeline over the next few weeks, of course — including Douglas Dynamics (PLOW) on Monday and AIG (AIG) on Tuesday in addition to Sandstorm Gold (SAND), Criteo and Markel on Wednesday when it comes to my portfolio, along with results from most of my healthcare REITs (Ventas has already reported a “steady as she goes” quarter, but the rest of them are still on deck)… and also dozens of large and market-moving companies that will give us a much better idea of whether we’re going to end what folks are calling the “earnings recession” anytime soon.

And further out when it comes to some little stocks, I’m particularly interested to see how Grenville Strategic Royalty’s second quarter performance looks, and they should report in mid-August. As you might remember, I sold half of my position when they hit a stop loss on bad news and weakening credit quality among their investee companies earlier in the year, and they’ve cut the dividend and are trying to cut costs and stabilize — this quarter will be a significant indicator, I think, of how that progress is going.

And also North of the Border, Crius Energy Trust will be reporting probably a few days before Grenville — that’s the energy marketing firm that is attempting to build their customer lists and cross-sell customers, with the potential growth drivers being their access to Comcast customers through that relatively new (and expanding) partnership and the substantial commissions they get on solar installations. So far it’s been steady, and they’ve continued to gradually increase the dividend (and earlier this year took full control of their operating subsidiary, which should be a good thing because control investments should always be more valuable than junior partner investments), but things can fluctuate quickly because of their lack of hard assets (they have to re-sell many of their customers each year, churn is relatively high). Will be worth watching, but we won’t see that for probably two weeks.

Finally, a quick note on DSEEX. I don’t talk a lot about mutual funds, but roughly half of my portfolio is in funds — both index funds and actively managed ones, which is part of a strategy I like to call “diversify away from yourself.” If you don’t manage all your money actively, you can’t put it all at risk because of your failure to see outside of your world view… in a world where each investor tends to be his portfolio’s worst enemy, getting some of that portfolio far away from the “buy” button in your online trading account is more valuable than many people understand.

The DoubleLine Shiller Enhanced CAPE fund (DSEEX) continues to outpace the market this year, which is nice since it’s been a recent addition to my portfolio — these short time periods are not all that telling, of course, but now year to date the fund has returned about 12.5% vs. 7.5% for the S&P, and that improvement has been pretty consistent. It’s been a strong market, but this particular interpretation of “value” investing has now generated 6% returns since I started buying it, versus 3.75% for the S&P. And that during a time when traditional “value” indexes have done slightly worse than the overall market, mostly because of the “value trap” sectors that this rules-based index follower tries to avoido. Time will tell whether this is truly a “better mousetrap” that can endure, but so far in this fund’s young life (it was launched in 2013) it is proving to be exceptional in a pretty boring way, and at relatively low cost… which is what I want for this part of my portfolio.

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