May payroll report surprises on the upside

BY ERIC STURDZA

Monthly Fund Commentary
26 Jun 2018

BY ERIC STURDZA

By the end of May most – if not all – of the companies in the S&P 500 had published their 1st quarter earnings, with more than ¾ able to meet or beat bottom line consensus expectations. Technology, healthcare, and industrials were the sectors with the most upside surprises.

Strong growth was broad- based as all 11 sectors reported positive growth on both top and bottom lines, led by energy. Nonetheless, good news had already been priced in, so that any misses were generally hit hard. This quarter, market reactions to earnings and revenue beats were mostly flat to slightly down for “crowded” stocks, while “uncrowded” ones, posting upside surprises, were generally rewarded positively.

According to the Investment Adviser one point to keep in mind is the tax reform, leading to a rise in earnings adjustments, which should however not be taken into consideration as they are one-time events. The main concern is that adjustments (such as stock based compensations) will most likely be recurring as companies that are aggressive in making these types of adjustments tend to report lower growth in subsequent quarters.

Another subject to highlight for the month of May is the surprisingly good payroll report. Many (if not all) of the right boxes were checked in the Investment Adviser’s opinion, the most important of which are highlighted below:

(1) A useful and well known barometer of how citizens are feeling about the labour market is the job leavers’ rate, which surged in the latest report, indicating that people are feeling good when it comes to having multiple opportunities. This barometer is also a leading indicator for wage growth, thereby yielding further evidence that wage pressures are expected to remain.

(2) Wage pressures were already very much present in the past. The latest increase in average hourly earnings was broad based and shows that one must not forget that pressures are already increasing at a solid pace. According to the Investment Adviser, spending growth is well poised to increase moving forward.

Another argument that could be put forward is the under-employment rate falling to a cycle low of 7.6%, the lowest level in a long time.

All of the above developments will be factored in by the Fed. It is however important to keep in mind, that the unemployment rate declined to 3.8%. In the context of the Philips Curve (which states that inflation and unemployment have a stable and inverse relationship and is still strongly referred to by the Fed) and a non-accelerating inflation rate of unemployment (NAIRU) of approximately 4.5%, these numbers indicate a higher pressure on wages/inflation. This could hence result in steeper inflation growth than is currently priced in by the market. This said, the Investment Adviser still believes the Fed is more prone to take its time rather than rush and risk a policy mistake.

In May, the Fund returned +1.53% against +2.37% for the benchmark. In terms of contribution to return, Envision Healthcare was the largest contributor followed by Broadcom and Alibaba (+0.36%, +0.09% and +0.10% select ion effect respectively). On the other hand, Dollar Tree was the largest monthly detractor followed by Celgene and Cognizant Technologies (-0.51%, -0.27%, -0.49% selection effect respectively). As has been largely speculated over the past couple of weeks, Envision Healthcare is finally set to be acquired by KKR in an all-cash deal for approximately $9.9 billion, translating to $46/share. The transaction was fully approved by the Company’s board of directors, following a prolonged review period of strategic alternatives, and is now expected to be finalised during the 4th quarter of 2018. The Investment Adviser views the above as a fair multiple for the Company given the number of headwinds the industry is facing. Accordingly, the team sees little to no potential at all for other bidders emerging and as such will be progressively closing the position as the share price gap closes.

After Broadcom’s management published its preliminary revenue guidance on 30th April, the stock price reacted positively. More recently, the Company reported in line fiscal second-quarter results, whilst also providing a consistent outlook in its preliminary guidance. As expected, the firm’s wireless segment was negatively impacted by a sharp drop in Apple iPhone channel shipments and modestly offset by the increase in product shipments to Samsung for its latest Galaxy S9 smartphone. In contrast, the Company’s other three business segments posted solid sequential growth, illustrating the breadth and sturdiness of the Company’s offerings.

The Investment Adviser remains very positive regarding Broadcom’s future as it is poised to capitalise on its leadership position to drive future growth and potential accretive acquisitions. As such, the position will be maintained as a top holding in the Fund.

Alibaba, a position initiated at the end of January 2018, has transitioned from a traditional e-commerce platform to a large data-centric conglomerate, with transaction data from its marketplaces, financial services, and logistics business allowing the Company to move into cloud computing, media/ entertainment, and online-to-offline services. The Investment Adviser actively seeks companies like Alibaba which can utilise its strong network to reach into other growth avenues.

Dollar Tree, the largest detractor during the month, has seen its stock price under pressure since their last earnings report mainly attributable to Family Dollar’s disappointing performance. The Dollar Tree banner had started well by posting encouraging results in the 2nd and 3rd quarters of 2017 but lacked continued positive signs in the 1st quarter of 2018. Against this backdrop, the Investment Adviser would however like to highlight the fact that despite all of the concerns around Family Dollar, the Dollar Tree banner generates approximately 50% of enterprise sales and approximately 75% of EBIT, while producing 3%-5% comparables and high single digit sales growth – results which are increasingly difficult to find in the retail world.

Furthermore, the Investment Adviser still believes that Dollar Tree’s stores remain highly attractive to consumers. The Company’s expanded food and consumables offering have greatly increased Dollar Tree’s addressable customer market, thereby reinforcing its moat. Management has also shown highly consistent gross margin performance and an ability to leverage Selling, General & Administrative (SG&A) expenses even on a low-single-digit comp. Against this backdrop, the team would expect high-single digit sales growth, and low doubledigit EBIT growth. With an estimated potential of a combined and approximate 4% annual new store growth over the next several years across Dollar Tree, Family Dollar and its Canadian operations, the Investment Adviser believes the Company has one of the best (if not the best) store growth profiles in retail. Hence, the position was maintained and reinforced at lower price levels as any drawdown under the current fundamentals is perceived as a buying opportunity.

Celgene is currently in a tough situation, which has recently been reinforced due to current valuations reflecting the worst outcome possible for a generic entry (April 2020) of Revlimid (the Company’s largest revenue generator). The priced-in outcome is far from certain as issued patents are “presumed valid” and competition could gain more by settling than launching. Thus, both win and settlement scenarios are still possible. Additionally, 4 approvals of material products are due in the next 24 months – Luspatercept, bb2121, JACR 17 and Ozanimod, potentially changing market sentiment and valuations. Against this backdrop, the Investment Adviser sees a compelling risk/reward profile at current levels.

Lastly, Cognizant Technology Solutions reported its 1st quarter 2018 results at the beginning of May and saw its share price decline because of lower than expected organic constant currency revenue and EPS, higher attrition and a higher tax rate outlook. Against the bullish sentiment the quarter was disappointing and highlighted the bear case which stipulates that organic revenue growth will decelerate and that management’s margin expansion plan is full of challenges. A key question which hence arises is whether there is meaningful upside because the stock is simply too cheap for a Company that will most likely deliver high teens EPS growth for 2018 and further.

The Investment Adviser believes that the Company could face multiple compressions on execution challenges as it is going through various transformations around its pivot to digital, onshore hiring and margin improvement. Nonetheless, these execution risks are near term and thus constitute the headwinds related to resurfacing M&A in the healthcare space. Moreover, the team believes that the Company’s management is serious about its pivot to digital because after reorganising the Company around 3 digital practice areas (Digital Business, Digital Operations, and Digital Systems and Technology) last year, the business is now also ramping up organic and inorganic investments to further scale the digital business across industries. While these efforts are late compared to other peers and execution will face challenges, the Investment Adviser believes that Cognizant’s management is exhibiting the kind of laser focused required to transition the business successfully.

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 13/06/18 and are based on internal research and modelling.