Fed Preaches Patient on Interest Rates

Nothing like an old friend at this time of the year to cheer you up, right?

Today, the market heard from its very best friend in recent years, the Federal Reserve, and got at least temporary relief from the recent headaches. In fact, it felt more like a holiday party. The Fed and some stability in oil prices were enough to send stocks to their best day in more than a year with the major indexes gaining around 2%.

Today’s Fed statement was closely watched for hints as to when Chair Janet Yellen and company could start to raise interest rates in 2015. In essence, the Fed said it can be “patient,” and that word should be used in context with its previous phrase, “considerable period.” So it’s out with one catchphrase and in with another, but the bottom line is the same: The Fed is in no hurry to start raising rates, and there is still no telling when the current range of Fed Fund rates from 0% to 0.25% will be lifted.

I’ve suspected it would be a while yet before rates were increased, and it still appears that we’re not likely to see anything early in the year. This is especially true in light of the fact that the Fed will be incrementally more dovish next year as three hawkish members of the Open Market Committee will be replaced by more dovish ones.

Of course, the Fed has not been on the high list of the market’s problems recently. The economic situation in Russia is growing increasingly perilous, and we’ll need to watch for signs it is spilling over to the already struggling economies in Europe and Asia.

It’s also worth noting that with the S&P 500 still just 3% below its all-time highs, a lot of good news is already priced into stocks. Some of the leaders in this year’s rally – stalwarts like Microsoft (MSFT), FedEx (FDX) and Home Depot (HD) – performed badly this week for various reasons. An analyst downgraded MSFT due to slowing Windows Pro sales, and FedEx reported disappointing earnings and also guided below expectations. So apart from the potential overseas concerns, we could see stocks continue to adjust and money continue to rotate in the new year.

In the very short term, today’s Fed announcement may be the beginning of a typically quieter couple of weeks on Wall Street, and perhaps even lead to the “Santa Claus rally” we often see between Christmas and New Year’s if oil prices stabilize and there are no surprises from other parts of the world, especially Russia. Looking ahead, we’ll definitely need to keep a close eye on several possible challenges to start 2015. Still, the Fed’s new phrase “patience” should be supportive, and even in a choppy environment, careful analysis and stock selection can bring us strong opportunities in the year ahead.

We’ll talk in much more depth about my outlook for 2015 and our strategy as we begin the new year, but we’re still taking advantage of good opportunities this year. In fact, I have a new recommendation for you today in an innovative company with new products on the horizon that should boost already improving earnings even more.

New IT Innovators Buy: NATI

The world has changed so much over the last few decades that we now take for granted things that were once not even imagined by most of us. From some of the everyday technologies we use, like cell phones and computers, to cures for once fatal diseases to self-driving cars, I’m always amazed by what scientists and engineers have been able to create.

There are a lot of steps involved for all of this cool stuff to see the light of day, and one that we can easily overlook is testing. This is done through instrumentation that’s used to observe, understand and manage the real-world (or analog) phenomena, such as voltage, current and power, as well as temperature, pressure, and more.

We all use instrumentation pretty much every day without even realizing it. Home security systems consist of sensors (like switches to detect door openings or algorithms to detect intrusion), as do refrigerators and toasters, which operate by temperature measurements, and so much more.

To conduct these tests, engineers and scientists have historically used a variety of expensive systems that operated independently and were difficult to customize. Adapting them to ever-changing needs is expensive and time-consuming, and users often had to purchase multiple single-purpose instruments.

The game has changed when it comes to testing thanks to National Instruments (NATI). This company is one of these great entrepreneurial stories where, just like some of the most successful companies in the world (like Apple, Amazon.com and Google), NATI was started in a garage in 1976 after its founders grew tired of the status quo.

Data collection methods they were using to conduct research were inefficient, and the founders set out to find that better way and simplify the process. From that garage, the company has grown to more than 35,000 customers around the world, which gives it a nicely diversified revenue base. I like that no single customer accounted for more than 3% of total sales last year.

So how did they do it? They call their approach the NI graphical system design. It is an integrated software and hardware platform for measurement and control systems that can be defined entirely by the customer, a significant improvement over traditional systems that were defined by the vendor. With NI’s products, the customer can more easily adapt to changing requirements and technologies over time. As a result, the systems are more flexible and cost-efficient, and all stages of testing are significantly sped up.

Customers generally purchase the company’s hardware and software packages together. Management believes that the strength and flexibility of its software packages help promote hardware sales.

NATI’s flagship product the last 25 years has been LabVIEW, a comprehensive development software program with hardware integration and wide-ranging compatibility that engineers and scientists need to design and deploy measurement and control systems. LabVIEW has been used in lots of interesting ways, including helping secure airports by creating a more cost and time-efficient baggage screening system, and even controlling a robot to make it walk!

Other software products include TestStand, which is used in test and measurement applications in a manufacturing environment; VeriStand, which configures real time testing applications; and DIAdem, which configures test technical data  and reports back to users to help them make informed decisions.

Improving Profitability and Future Growth

While these products have helped establish NATI within its industry, the real driver of future sales growth will be new products. National Instruments believes strongly in ongoing innovation. President and CEO Dr. James Truchard cites Thomas Edison’s goal of building a small invention every 10 days and a big invention every six months. The company has plans to introduce new radio frequency (RF) controllers, a new enterprise software tool for distributed systems, big analog data for condition monitoring and a new platform for semiconductor test equipment built on the company’s PXI platform.

The pipeline of new products has caught the attention of analysts and industry consulting firms like International Data Corporation (IDC), which has said that the next few years will be a transformative time for National Instruments, as it will evolve from a test management company to an enterprise class systems company driven by opportunities in software design and big analog data management. I agree.

I like that NATI already has a solid sales base to grow from, as it has benefited nicely over the last few years from its own innovations along with industry growth and improving world economies. Revenues from 2009 through 2013 more than doubled from $676.6 million to $1.72 billion, with gross margins remaining relatively stable at high levels of 74%–77%. Earnings growth has not been as consistent, coming in as high as $1.05 a share in 2010 before falling to $0.89 a share in 2013, but it’s important to note that the lack of growth here is largely due to investments in research and development (R&D) and developing the sales force, which will benefit the company in the long term.

We’re starting to see the payoff now. Profitability improved nicely through the first nine months of this year as NATI has begun to realize some operating leverage from the sales growth. Revenues were up 4.6% to $911 million through the first nine months of the year, with the fastest growth of 8% coming in the third quarter.

Higher sales were driven by the company’s line of CompactRIO controllers, PXI sales and data acquisition products. In addition, renewal rates for LabVIEW were at record levels in the third quarter. Gross margins held steady at 74%, and a pause in R&D investments allowed adjusted EPS to increase to $0.82 from $0.57 over the first nine months of the year and to $0.37 from $0.19 in the third quarter.

For the fourth quarter, management guided for revenue growth of 9%, with EPS ranging from $0.29-$0.41 a share. If the company earns just the midpoint of that range at $0.35, earnings for the year will come in at $1.17 a share – an impressive 31% improvement from 2013.

NATI has underperformed the last couple of years, trading mostly between $27 and $33. While the market respected the company’s revenue growth, the limited improvement in profitability restricted share gains. In addition, NATI’s quiet nature and limited analyst coverage has kept the stock off of many investors’ radars.

That is now changing. With profitability improving, I believe the company can earn $1.40 a share (adjusted) next year, which would be strong growth of around 15%. I also like that NATI generates a lot of cash, giving it a very strong balance sheet with cash and investments of $448 million (or $3.52 a share) and no long-term debt. Adding to the attraction, we can collect a 1.9% dividend yield while we own it.

Buy NATI under $33 for our $40 target. This is a strong company with good growth potential. The stock is not cheap, but it’s not overly expensive considering the growth potential, so I’m assigning NATI a moderate risk rating.

CWCO, DGI and SSTK Regain Momentum

Consolidated Water (CWCO) had a wild day yesterday, dropping to $8.50 early before rebounding back to $10. It has been weak here in December, and I believe the company, which sells primarily in the Caribbean, is being impacted by fears of contagion from the crises in Russia and Venezuela. However, I am confident CWCO will be able to handle any crisis, thanks to its very strong balance sheet, with cash and investments of $90 million and total liabilities of only $19.1 million. I continue to like the company’s prospects with its ability to convert salt water into fresh water and transport it to some of the most underserved areas around the world. Given the recent volatility, I am lowering the buy limit a bit more to $10.50 and our target to $13.

DigitalGlobe (DGI) has had a strong week, popping nearly 13% since last Wednesday. I believe the turnaround is in part due to DGI’s valuation becoming increasingly attractive, and while there could still be a few bumps in the road, I see the stock moving higher in 2015 as the company moves closer to the additions to its satellite constellation and the prospect for double-digit revenue growth. Continue to buy DGI up to $27.

Shutterstock (SSTK) has rebounded an impressive 16% since Friday’s low after Adobe (ADBE) announced that it was acquiring Fotolia, one of SSTK’s competitors. In addition, ADBE stated that it would be integrating Fotolia’s 3.4 million images into its Adobe Creative Cloud service for Web application developers and digital media professionals.

The sell-off was due in part to concerns that Fotolia, which claims to offer royalty free images, would gain market share with the financial backing of Adobe and force Shutterstock to  cut its pricing. However, I do not think Adobe will be able to undercut SSTK’s market leadership. First, Shutterstock offers a much larger library with 44 million images, which is nearly 14X the amount Fotolia offers. And second, SSTK’s pricing is more than reasonable at $49 for a monthly subscription and single images starting at just $0.33.

I remain confident in Shutterstock’s long-term potential, but because we may see further sporadic weakness in the shares—especially in the current market environment, I am keeping SSTK as a hold for now. 

GameChangers News & Notes: MASI, SFM

Masimo (MASI) was one of our biggest movers today, jumping 8%. Yesterday, the company announced it had received an approval for a new module of its Root patient monitoring and connectivity platform. The module, OR+ Multigas Monitoring, monitors the inhaled and exhaled concentration of five anesthetic gas agents, along with carbon dioxide, oxygen and nitrous oxide. When the technology modules are connected with Root, multiple additional parameters are available for operating room physicians to help them make sound decisions.

This module is another good example of MASI’s technology, which should boost revenues and earnings over time. MASI remains a good buy up to $26.50.

Sprouts Farmers Market (SFM) has been relatively quiet on the news front lately, although it remains a steady performer as it continues to benefit from the lower gas prices and limited exposure to the turbulent foreign markets. I believe the company will be able to grow EPS more than 20% per year for the next 3-5 years, especially as it continues to roll out new locations and enjoy solid low to high single-digit comparable store sales growth as it makes natural and healthy foods more affordable. Buy SFM only on dips below $30.

Have a great rest of the week! And here’s a quick reminder about trading next week. The market will close at 1:00 p.m. EST next Wednesday, December 24, and will be closed all day on Thursday for Christmas. I’ll send you next week’s issue on Wednesday as usual, and of course, be in touch right away with an alert if anything comes up in the meantime.

Sincerely,

Hilary Kramer
Editor, GameChangers

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