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Walking on Broken Glass

(Guest Commentary by Rick Konrad – April 7, 2011)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick again discusses the lingering macro and technical issues that are bothering him, and what kind of equities he is currently focusing on.  Rick also discusses in detail a couple of large-cap companies that he sees as undervalued.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see “Finding Value in an Economic Tsunami” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

Most of us are familiar with the spectacle of having a mystic or magician walking on coals or broken glass and surviving unscathed. That's the way the first quarter felt to me. There were plenty of opportunities to get injured, plenty of events to derail our progress, yet, momentum continued to carry through and the S&P was up 5.9%.

Unlike Henry, and I suspect most of our readers, most of my clients require that I be fairly fully invested at all times. This certainly helped in the first six weeks of the quarter when the market gained about 7%. We have fought the tape by raising some cash as my discomfort rose. Little wonder...replaying the newsreel since that time highlights some rather unbelievable global shocks. North African, not to mention Middle Eastern politics has transformed itself in three months and the situation continues to be fluid at best. The Japanese earthquake, tsunami, and radiation disaster have disrupted a major slow growth economy into a standstill economy. The European situation also provided little good news. Sovereign risk and bank sector problems continue to plague the outlook. Ireland's credit rating dropped to BBB+ which still seems courageous given Irish 10 year bonds yield over ten percent.  Portugal tonight finally admits that it needs aid from the EU, a U-turn in policy after too many months of denial and resistance despite sharply deteriorating financial conditions. Lisbon had held out hope that by steadily meeting budget goals and cutting spending, it could regain investor confidence and avoid a bailout. But the situation deteriorated after its government resigned, yields went flying and ratings headed in the other direction. Although stateside, we see some encouragement in the job numbers, politically the bitter feud resembling the Hatfields and the McCoys at a time when leadership is needed gives little encouragement. Fed bond purchases seem to be coming to an end and corporate profit margins, currently fat, are likely to face pressure from rising input costs and slowing end demand. Even in Canada, politics is up in the air as Prime Minister Harper's Conservative minority government fell, forcing an election. As gasoline prices continue to surge day after day (and with WTI touching $109 today this may continue for some time), the consumer is bound to feel threatened. President Obama today gave a presentation to some workers at a wind turbine plant where he mentioned rising energy prices. His advice? "If you're complaining about the price of gas and you're only getting 8 miles a gallon, you know," Obama said laughingly. "You might want to think about a trade-in.” Hence, it's tough for me to justify the market's resilience. Low volume demonstrates that many others feel this way. It also seems to me that leadership is narrowing. Yet, optimism seems high, corrections have no conviction and last intra-day, and some corporate M&A activity seems completely mystifying (not unlike my glass walker). Stock correlations have been falling as well, a fact that should encourage the stock pickers among us. Though index players have held sway for the last two quarters as correlations tended to one (A statistical measure that indicates that stocks are moving in tandem or parallel), there may be greater value add opportunities for those of us who don't abide by indices.

What's right about this market? Corporations seem to be taking the opportunity to ride the economic recovery wave at what seem to be rather hefty prices at first blush. Texas Instruments (TXN) agreed to buy National Semiconductor (NSM) for $25 per share or $6.5 Billion. TI has about a 14% share in the $42 Billion analog market, and the combined company will have about 17% market share. TI is likely to finance the deal with some $3-$4 billion in debt and management has indicated that earnings accretion is a fairly low hurdle in a low interest rate environment. Valuation consideration was based on study of revenue, growth opportunity, and as TI management emphasized, product portfolio/innovation. TI has also made it clear that there are significant synergies. TI's sales force is about ten times that of National and the product lines have minimal crossover. NSM's orientation to industrial applications such as high voltage power management and supply, electric vehicle power management, and solar is additive to TI's strengths in computer and handset management applications. As well, TI has much more cost efficient and current fab capabilities that could easily improve costs for NSM product.

Another interesting deal was the sale of Pringles by P&G (PG) to Diamond Foods (DMND). Pringles' financials weighed down P&G results.  Pringles sales of about $1.4 billion generated EBIT of only about $170 million or 12% of sales versus P&G's corporate average of 20.3%. Similarly, EBITDA margins for Pringles ran around 17% of sales versus near 25% for P&G itself. Again, this seems to be a rather beneficial deal for P&G. Diamond, known for walnuts, suddenly develops distribution relationships across 140 new geographies versus DMND's current 80% domestic focus and gets into a higher operating margin business.

So much for deals that are in the hopper. Where should investors position portfolios now? I believe that this is a great time for bipolar thinking in portfolios, some aggressive names combined with a few mainstay dividend paying securities. Let's talk about a couple of more aggressive names this week. We'll get a little more conservative and dividend oriented next time.

We like Applied Materials (AMAT). According to DataMonitor, the global semiconductor equipment market generated total revenues of $16 billion in 2009, representing a compound annual “growth”  of -16.4% (yes that's negative) for the period spanning 2005-2009. The performance of the market is forecast to accelerate, with an anticipated compound annual growth rate (CAGR) of 27.6% for the five-year period 2009-2014, which is expected to drive the global semiconductor equipment market to a value of $54.3 billion by the end of 2014. Providing equipment to one of the most cyclical industries is hyper-cyclical. The Asia-Pacific market represents about 65% of total market with the Americas at about 21%.

Applied Materials is, by far, the world's largest maker of semiconductor production equipment. It is also a supplier of LCD fabrication equipment to the flat panel display industry and is the major supplier of solar PV manufacturing systems to the solar industry. Applied's machines vie for supremacy in many segments of the chip-making process, including deposition (layering film on wafers), etching (removing portions of chip material to allow precise construction of circuits), and semiconductor metrology and inspection equipment.

AMAT possesses substantial intellectual property. Its scale and reputation have allowed it to develop close relationships with customers, giving the firm insight into current and future customer technology needs. Few firms can rival its roughly $1 billion annual R&D budget. Applied Global Services, the firm's service business, is expected to achieve significant growth. Applied has less than 5% share in the $40 billion market and will be able to leverage its scale and vast presence to quickly expand this business.

Wall Street estimates long term growth at only 10.5%. This appears very conservative relative to the DataMonitor industry forecast. Even with a conservative 12% growth forecast, we could justify a $20 handle on the stock, about 20% north of here. The balance sheet is also clean with debt representing just 2% of total capital. Cash is $2.75 billion as compared to debt of $200 million and a market cap of $22 billion.

AMAT yields 1.7%. The dividend has grown at a compounded rate of 24.5% over the last five years.

Japan obviously is both a problem and an opportunity. AMAT has been in Japan for over 30 years, so there are a well-developed number of Japanese suppliers servicing 22 AMAT facilities. While some facilities sustained some minor damage, apparently everything is operating at this time. It is unclear whether all suppliers are able to maintain their production. We are certain that there will be many opportunities to sell capital equipment to Japanese customers as the country recovers. However, the timing of orders and the potential for supply disruptions remains uncertain.

Another firm that intrigues us is Amgen (AMGN). AMGN discovers, develops, manufactures and markets medicines for "grievous" illnesses. It focuses on human therapeutics and concentrates on medicines based on advances in cellular and molecular biology. Amgen markets primarily recombinant protein therapeutics in supportive cancer care, nephrology and inflammation.

Amgen's denosumab first received approval for osteoporosis in June 2010 under the trade name Prolia. In November 2010, the agent received an approval for a second indication under the trade name Xgeva for the treatment of skeletal related events (SREs) in patients with bone metastases from solid cancer tumors. Though AMGN had a relatively modest launch for the drug in osteoporosis, having been prescribed by only about 2% of osteoporosis specialists, as Xgeva, it has already been prescribed by 13% of prostate cancer specialists. Despite the fact that Xgeva's cost of therapy is nearly double that of Novartis' Zometa, many physicians have expressed enthusiasm for Xgeva's superior efficacy and relatively low-risk safety profile.

AMGN has five drugs with annual sales above $1 billion currently on the market, and more recent drugs Sensipar and Nplate, as well as Prolia/Xgeva potentially adding to this list. While Aranesp safety concerns have impacted sales, AMGN has moved quickly to cut costs to offset the revenue shortfalls. Despite the fact that generic versions of Epogen and Neupogen have commenced sales in Europe, the impact so far has been negligible. AMGN is successfully switching patients to newer, patent-protected versions, Aranesp and Neulasta which have patent lives into 2014-15.

Recently, the company also dodged a potential bullet because of concerns that the CMS (Centers for Medicare and Medicaid Services) would restrict Epogen use further in a National Coverage Decision (NCD) relating to kidney dialysis.

Of the company's $2.9B in R&D spend, ~25% is early stage research, ~12% preclinical, ~5% phase1, ~15% phase 2/3, and ~43% marketed products. In addition, R&D staff comprises 39% of Amgen's 17,400 employees (the largest employee group). There is some feeling that AMGN could improve profitability by honing its research efforts to create greater focus.

The company may well clarify its vision in its planned April 21st update. We think that there is a reasonable chance that AMGN will begin a dividend policy in addition to its long-standing policy to repurchase stock. We think AMGN may clarify whether it will push into biosimilars. Since the expiry of the patent of the first approved recombinant drugs (e.g. insulin, human growth hormone, interferon, erythropoietin, and more) ‘copying' and marketing of these biologics (thus called biosimilars) can be offered by any other biotech company. While biosimilar products are similar to the original product, they are not exactly the same. Small distinctions in the cell line, the manufacturing process or the surrounding environment can make a major difference in side effects observed during treatment, i.e. two similar biologics can trigger very different immunogenic response. Therefore, and unlike chemical pharmaceuticals, substitution between biologics, including biosimilars, can have clinical consequences. Hence, biosimilars are subject to an approval process which requires substantial additional data to that required for chemical generics, although not as comprehensive as for the original biotech medicine. The FDA has been given authority to approve biosimilars under "Obamacare" but has yet to approve its first.

We think AMGN is worth in the low to mid $70s based on fairly conservative assumptions. We think the April 21st “show” will be an opportunity to showcase candidates in the pipeline, maybe some cost controls, and most importantly, some insight into capital allocation strategy and the choices of share buyback, dividends, or acquisition.

Indeed, the structural issues of this economy and others provide ample reasons for concern. Despite what seems like a heady market that ignores most of the bad news, there are some captivating values that I think investors should consider.

As always, good luck and be careful out there.

Disclaimer: I, my family, or clients have positions in TXN, PG, AMAT, and AMGN.

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