July update

BY ERIC STURDZA

Monthly Fund Commentary
1 Sep 2017

BY ERIC STURDZA

With 2017’s second quarter earnings season almost completed, this report will include: (1) a look at the overall results and how the market reacted, and (2) a closer dive into the results of the Fund’s holdings.

As at the end of July, around 60% of the S&P 500 companies published their second quarter earnings. Historically, the average bottom line estimate is beaten by 53% of the companies, compared to 73% of the companies this season. Furthermore, 69% of companies met or beat revenue expectations – the highest top line beat ratio the market has seen in a decade. Telecom Services, Information Technology and Materials were the sectors that performed best in terms of upside beats.

Among the companies that reported their results, average year-on-year earnings grew by +10.2%, while revenue grew +5.1% (more than double the consensus forecast before the start of the second quarter earnings season). Even though results are lower than in the first quarter, it still depicts the second quarter of double-digit earning’s growth since Q3 and Q4 2011. Similar to the first quarter, eight out of eleven sectors showed a solid growth with respect to both, top and bottom lines. Moreover, the weaker dollar was a nice tailwind for multinationals and helped them post 5.5% higher earnings growth than more domestically-oriented businesses.

Market reactions were relative erratic and despite some large and positive surprises, companies that beat earning’s estimates were on average 100bps down, while growth for those who beat top and bottom line estimates on average stagnated. The reason for this appears to be that investors seemed to focus on year-end results and stock price fluctuations, which were more correlated with guidance than the actual results. Going forward, consensus estimates now expect a +5.2% earnings growth and a +4.9% revenue growth for the next season.

With respect to the Fund, the earnings season on average went well. Most companies confirmed their double digit EPS growth trajectories and ongoing fundamental trends. This in turn supported the Fund’s overall superior earnings growth profile (in terms of the portfolio’s aggregate 10 year historical EPS CAGR and relative to its benchmark).

The Bank of the Ozarks had a couple of rough trading sessions after earnings were announced alongside an executive departure. The head of the Bank’s Real Estate Specialties Group (RESG), Mr. Dan Thomas, announced his departure on 27th July. In combination with the negative sentiment that most CRE lenders are facing given increased regulatory scrutiny, this led the stock price to decrease by approximately 12% the same day. The Investment Adviser saw this as a good opportunity to purchase stocks in a best-in-class lender, with a highly profitable, unique, and fast-growing franchise, at a considerably higher absolute and relative discount.

The Investment Adviser believes that the market is overlooking a couple of key factors: First, the market appears to be discounting the Bank’s ability to grow loans from this point on, despite management changes. RESG still has 107 employees across the country, thereby giving the Company a sufficient base on which to increase growth. Ozark’s fast growth has been driven by its niche approach offering complex, high-value added constructive lending, with excellent service and a growing number of relationships. Moreover, the Investment Adviser thinks that the market also does not seem to be giving the company any credit for its ability to maintain its through-the-cycle below-peer credit losses. After all, the Investment Adviser believes that the Bank’s credit quality has only improved as a larger share came from the RESG. According to the team, one must not forget that all RESG loans must pass through the Director’s Loan Committee, consisting of the CEO, Chief Credit Officer, and 3-5 rotating board members. This multi-layer process reduces the risk of an executive departure translating into higher credit losses for the business. Finally, OZRK is far more profitable than its peers (2016 ROA of 2.1%, given its above-peer Net Interest Margin (NIM) of 5.6% and a 35.8% efficiency ratio). Trading at just 10.5x of most analyst’s 2019 P/E estimates and a 19% discount to peers, the market seems to be pricing in a far slower loan growth and/or a significantly higher credit loss than the Investment Adviser.

ePlus was another company that reported solid results. The company secured a major enterprise customer, which significantly boosted revenue. Net assets were also boosted by several large projects with said customer. While the company’s top line grew 23% year-on-year, with roughly three-quarters of the growth being organic, its gross margin declined approximately 150bps on a year-on-year basis, due to competitive bidding for projects with the same large customer. The Investment Adviser views this deal as a validation that the company is pursuing the right strategy to scale the business and create incremental value for customers, especially given the focus on high-growth areas such as cloud, security and digital infrastructure. In the cloud segment, the acquisition of OneCloud Consulting has enhanced cloud capabilities and enables the company to take a consultative approach to its clients’ cloud strategies. Furthermore, the security segment continues to grow fast with a 17% revenue growth, up from roughly 13% last year. The Investment Adviser continues to be bullish on the Company’s strategic transformation and focus on new technologies.

The team continues to believe that gross margins will improve due to trends such as the shifting of the sales mix towards higher-margin products and increased gross profit from services. At the same time, the team is aware of the possibility that margins may face some pressure in the near-term, as the Company is scaling up and bringing on more large enterprise customers. Overall, the Investment Adviser is in favour of the stock and its fundamental story and for now believes that the price is trading at a fair level.

All in all, the team is confident with the continued execution of the overall portfolio and expects the Fund’s superior growth profile (in terms of the portfolio’s aggregate 10 year historical EPS CAGR and relative to its benchmark) to translate into superior value accretion for its investors over time.

 

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 15/08/2017 and are based on internal research and modelling.