Portfolio Manager Sonu Kalra of Fidelity Management & Research Company says a big trend right now is the penetration of e-commerce, with Amazon.com, Inc. (AMZN) being the lead player. He says Amazon has done a phenomenal job of building their e-commerce platform over time.
“I think we are getting to a point where customers are becoming accustomed to buying on Amazon, and knowing that they are going to get a fair price and have the convenience of having those products delivered to their homes in a timely manner. That is the e-commerce portion of the business,” Kalra says.
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Kalra says another big business for AMZN is Amazon Web Services, where they provide IT infrastructure as a service to many companies around the world. With these two businesses together, Kalra says Amazon has the potential to generate significant amounts of free cash flow.
“Over the past year, Amazon has had more of a focus on improving profitability, and investors have become more comfortable with their profit model and gaining confidence that they can make money in the future. I think some of the doubts in their ability to make profits have been put to rest with some of the results that we’ve seen this year,” Kalra says.
William Blair & Company Analyst Nick Heymann says divestitures are increasing in the aerospace & defense sector. For instance, United Technologies Corporation (UTX) is selling Sikorsky to Lockheed Martin.
“So we’re starting to see a tremendous amount of divestitures of businesses that simply are facing perhaps an extended period of challenge, like Sikorsky as it awaits the next-generation replacement for the Black Hawk, the Light Attack Helicopter that won’t enter production until perhaps the early or middle part of next decade,” he says.
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However, Heymann says that even when the net proceeds from the sale of $6.2 billion are used to reduce UTC’s share count, the company is still going to end up with a roughly 20% dilution on the $0.45 of EPS that Sikorsky was expected to contribute to UTC next year. Heymann says that highlights another change in the role of M&A for multi-industrial companies.
“Divestitures are increasingly unable — despite a very strong valuation market — to increase shareholder value in the near term,” he says.
Portfolio Manager Joshua Honeycutt of Mar Vista Investment Partners says that as the largest off-price apparel and home goods retail chain in the world, TJX Companies Inc (TJX) operates a competitively advantaged global sourcing platform.
“Unlike Nike or Tiffany, who predominantly built their moats around global brands, TJX has built its economic moat around global scale and cost advantages,” Honeycutt says. “The company operates a competitively advantaged global sourcing platform, which consists of 900 buyers and 16,000 vendors. This sourcing advantage allows TJX to acquire and sell consumer products 30% to 40% below department-store prices while turning inventory 40% faster.”
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Honeycutt says TJX should continue compounding intrinsic value in the low double digits through new store expansion and consistent same-store sales growth. He also believes the company can triple its international store base.
“The management team at TJX are excellent stewards of capital. Future uses for free cash flow will be international store growth and smart share repurchases. TJX currently trades 18 time normalized free cash flow, which is a slight premium to the market. Although it is not as cheap as it once was, we think TJX represents an above-average business at an average price,” Honeycutt says.
William Blair & Company Analyst Nick Heymann says that aerospace & defense companies are increasingly dealing with challenged components of their businesses by setting up companies to enjoy a quicker rate of recovery when circumstances improve. Craig Arnold, the new CEO of Eaton Corp plc (ETN), is currently trying to figure out whether to exit the vehicle business.
“The vehicle business is running well, but as I mentioned, trucks are peaking this year,” Heymann says. “They make automatic truck transmissions, as well as a lot of lifters and valve components that go into auto engines.”
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Heymann says Eaton’s new CEO could take a fresh look at how to focus the company’s portfolio. Ideally, he says, whatever the company decides to sell, it will be able to minimize near-term earnings dilution.
“If Eaton were to exit its vehicle business, it would remove one of the largest and more cyclical components of its current business portfolio,” Heymann says. “These are the kinds of decisions that many diversified industrial companies are going through now.”
Portfolio Manager Sonu Kalra of Fidelity Management & Research Company says Tesla Motors Inc (TSLA) is revolutionizing the auto industry by providing an experience consumers haven’t had before. He says the big opportunity for TSLA is delivering a car at a mass-market price.
“The great thing about the auto industry is that it is a very large industry, and Tesla has very small market share, less than 1% market share today. The big opportunity and challenge for them is to deliver an automobile that is 100% electric at a mass-market price. They have targeted the 2017/2018 time frame for that,” Kalra says.
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Kalra became familiar with Tesla at its IPO and had a life-changing experience when driving one of their cars. As part of his research process, he has become very familiar with Tesla’s battery technology and ability to commercialize their technology.
“There were a lot of doubts in the marketplace that they would be able to commercialize their first vehicle. They clearly did that, and the stock has responded nicely. As I mentioned earlier, I think the big opportunity and challenge ahead of them is whether they can come out with a mass-market car. If so, they could take market share and become a much bigger company than they are today,” Kalra says.
Mentor Graphics Corp (MENT) CEO Walden Rhines says his company offers investors an opportunity for exposure to technology with less volatility than is typically associated with the sector. He says semiconductor R&D, which drives Mentor Graphics’ business, has grown almost every year of semiconductor history.
“I’d say, in recent years anyway, like many software companies, it has been very rewarding for shareholders and generated a lot of cash,” Rhines says. “If you look over the last year, the whole EDA industry is up about 15% over the last year, and if you look over last five years, the EDA industry, and particularly Mentor, has done much better than the semiconductor industry.”
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Rhines says Mentor is up 160% over the last five years. Meanwhile, he says the semiconductor industry is up around 50%.
“The third thing I would point out is that there is an opportunity for a company like Mentor to repeat this whole industry evolution all over again by automating electronic design in cars, planes, and trains and other systems because they have not yet gone through the transition that the semiconductor industry went through over the last 30 years,” he says.
Rajvindra Gill, Senior Analyst at Needham & Company, LLC, says semiconductor investors should look for companies that have specific product cycles that are tied to things going on in the industry, companies that are acquiring other companies that have scale and efficiencies, or companies that are in the midst of margin expansion. As such, one of the stocks he is currently recommending is NXP Semiconductor NV (NXPI).
“We like companies like NXPI because they will be a huge player in the automotive semiconductor market, they will be a big player on mobile payments, and with the merger with Freescale they will generate significant earnings power,” Gill says.
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When NXPI’s merger with Freescale matures, Gill says he expects the company to have $9.00 to $10.00 in earnings.
“So NXPI is one of the names that we like,” he says.
Co-Founder and Portfolio Manager Brian Massey of Mar Vista Investment Partners says his firm recently purchased U.S. Bancorp (USB) for its Strategic Growth portfolio. Mr. Massey says USB has differentiated itself from its peers in how the company generates revenue in the face of challenges.
“The key difference is, USB generates as much revenue from fee-based services — like merchant processing, issuing credit and debit cards — and investment management services as they do from lending. So for every dollar of deposit, USB generates higher profitability with much better capital efficiency than the typical bank. Even in the current market where the average bank is earning high-single-digit returns on equity, USB is generating midteens returns,” Massey says.
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Massey says another important part of U.S. Bancorp’s moat is the management team, where CEO Richard Davis continues to lead a conservative underwriting culture.
“Unlike nearly all its peers who experienced massive losses and shareholder dilution during the Great Recession, USB was profitable every quarter and was able to protect its fortress balance sheet. The company remains well-capitalized today, even across the more stressed scenarios, which — again — creates an important competitive advantage,” Massey says.
Stephens Inc. Analyst John Campbell says one of the stocks he favors is Zillow Group, Inc. (Z). He says the early stages of the home-search process are clearly happening online, creating an opportunity for Zillow.
“Just to frame it up and why we like the setup so much long term, Zillow is currently doing 50% or so of the total category of real estate search, and an even more impressive 70% or so of total mobile-only real estate search,” Campbell says. “They are getting 50% to 70% of the eyeballs that view properties, but they are getting only a fraction of the overall total addressable market, which is $10 billion or so of real estate agent ad spend.”
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Campbell says many realtors are still spending advertising dollars in traditional channels like radio, TV, newspapers and bus benches. But, he says consumers have made it clear that they want to move the process online, and Campbell believes eventually the ad dollars will follow consumer activity.
“That has been more of a slow-moving process in real estate, as many agents tend to stick to what’s comfortable,” Campbell says. “Eventually you’ve got enough inertia there that that’s going to equal out, in our view, especially as younger agents rise through the ranks.”
Stephens Inc. Analyst John Campbell says he sees a significant opportunity for NIC Inc. (EGOV) if the company is successfully able to penetrate the federal government market. He says the company has found a good niche in state government, and has an impressive ROIC around 30%.
“They set up a large-scale enterprise-level agreement with the state and essentially do all of the services online,” Campbell says. “EGOV is kind of behind the scenes, and their focus is to allow the state to get all the credit with its citizens. For instance, if you were to go to Texas.gov or something like that from a state level, it would look like the state’s branded website, but it’s all basically EGOV on the back end.”
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EGOV’s management believes it can roll up every state in the U.S., Campbell says. He says the team is looking to go upstream into the federal side, which would really open up runways for future growth.
“They’ve got one federal contract right now with the Motor Carrier Safety Administration to do some driver history records, and they want to continue to go upstream to the federal side because the economics are better,” Campbell says. “There’s a lot more opportunity because obviously at the state level, you are capped by the amount of states.”
