A Mix of Comfort and Warning
Another year is coming to a close, and as has been a theme for much of 2014, the market has once again shrugged off a scare like nothing ever happened.
We are now up nearly 6% already from last Tuesday’s low and settling at (or near) all-time highs in most major indexes, including the Dow topping 18,000 today for the first time in history. Comforting words out of the Federal Reserve last week and a typical year-end rally have allowed the market to move away from the fears caused by the sharp decline in oil prices and the rapid economic deterioration in Russia.
Of course, these problems have not completely gone away. Just over the weekend former Russian Finance Minister Alexei Kudrin warned that the country still faces a “full-blown economic crisis.” And while Fed Chair Janet Yellen said last week that the Fed can be patient with interest rate increases, today’s final third-quarter GDP report of 5% growth suggests that they are more likely to come sometime next year.
Still, low interest rates and moderate but steady earnings growth have given the market underlying momentum. Earlier today, famed hedge fund manager David Tepper said in an email that we could start seeing some excesses and that 2015 may turn out like 1999 – a very strong year for the indexes, but one where excesses helped set the stage for the bear market of 2000-2002. Mr. Tepper’s warning is certainly an interesting one, and should the Fed stay too loose on rate increases for too long, it is a genuine risk.
But that’s a potential problem for down in the road. In the here and now, as we’ve talked about in our recent issues, we’ll continue with our conservative strategy regardless of how these trends play out, as investing in undervalued stocks with less risk and strong catalysts puts us in the best position for profits. I continue to see new value opportunities in the current environment, and my newest recommendation in Google (GOOGL) at depressed prices has solid upside potential that we’ll talk more about in just a moment. As long as we stay positioned in solid companies at the right valuation, our Buy List should continue to hold up over the long term no matter what 2015 brings us.
GOOGL: Advertising to the Modern Masses
Google (GOOGL) is a name we all know well, and while the financial media has focused on its move beyond its traditional business through acquisitions, this remains first and foremost a search and advertising company. It is also now interesting to us as value investors who like to see growth.
Internet advertising accounted for 89.6% of total revenues through the first nine months of 2014, and while the industry is certainly maturing, there is still plenty of room to grow within it. According to market research firm Zenith Optimedia, online advertising is expected to increase to $121 billion in 2014 (23% of total advertising spend) and another 16% in 2015 and 2016.
Google drives the majority of its advertising revenue through its own websites, with 68.2% of revenues coming from its extremely popular search pages and YouTube, and another 21.4% coming from the websites belonging to members of its Google Network. Also, many third party websites use GOOGL’s advertising programs to deliver relevant ads to their own consumers, with the revenues split between Google and the third-party hosts.
There are two key programs that make up Google’s entire advertising business: AdWords and AdSense. AdWords is used to deliver advertising that is both useful and relevant to specific search queries and web content. Through this program, advertisers are able to create simple text-based ads that appear beside related search results or web content on GOOGL’s websites, as well as on thousands of partner websites in the Google Network.
AdSense enables Google Network websites to deliver ads from AdWords advertisers that are relevant to the search results or web content on their own sites. The ability to place these ads directly related to what the consumer is looking for is a critical part of the advertising game, as Google is primarily paid when consumers click on the ads. In fact, this has given rise to the term “paid clicks.”
Google has grown rapidly into the behemoth that it is today, with 2013 revenues of $59.8 billion and net income of $12.9 billion on a GAAP basis. With a market capitalization in excess of $300 billion, only Apple (AAPL), Exxon Mobil (XOM) and Microsoft (MSFT) are larger. So it’s not a surprise that GOOGL’s growth has slowed recently as the rule of large numbers has started to take effect. Revenue growth, which was 29% in 2011, slowed to 19% last year, and while revenues were up 20% through the first nine months of 2014, the results largely reflected an increase in “other” revenues as core advertising revenue growth slowed to 17.6%.
Additionally, margins have recently come under pressure from lower costs per click, continued investments in research and development (R&D) and the increased contribution of non-ad revenue. Adjusted operating margins declined from 34% to 32% and adjusted earnings through the first nine months of the year were up only 17.2% – less than the growth rate of sales.
While 2014 numbers so far have been solid, the slowing growth and lighter margins have caused the stock to decline from its February 52-week high of $614.44 – it’s still down around 12% from that price, even after the recent move from $500 to $540. I also believe the weakness is due in part to strong rallies in “old tech” companies like Microsoft and Intel (INTC), as hot money chased these behemoths that Google had been outperforming for years.
However, this sell-off has provided us a great buying opportunity. Not only is GOOGL’s current price/earnings (PE) ratio of 17X 2015 EPS estimates of $30.37 roughly in line with the market multiple, it’s not much greater than the roughly 16X forward PE’s of Intel and Microsoft, which are not growing as quickly. Plus they both still have great exposure to PCs, which I believe will continue to face potential technological obsolescence issues.
In addition to continued growth in Internet advertising, GOOGL has plenty of opportunities to better monetize YouTube and its Android operating system, and its line of Chromebooks that include its Google Docs cloud-based productivity tools could potentially be a threat to Microsoft’s consumer business. Finally, the company could use its vast cash hoard (of $52 billion net of debt) to continue its intriguing acquisitions, like its most recent purchase of Nest, which makes thermostats and other home devices that can connect to the Internet.
Google often makes a significant move in one direction or another after releasing earnings, and with expectations currently muted, I believe the risk versus reward characteristics ahead of the January report are too attractive to pass up. Therefore, I continue to recommend you buy GOOGL below $525 for our $600 target. It moved up above our Buy Limit yesterday, so I hope you were able to get in, but if not, keep an eye out and look to buy on a pullback.
Ask Hilary: Value Buys in Oil?
Since we are value investors, aren’t some of the blue chip quality oil companies great buys with low share prices, low P/E, still solid earnings and lower debt? Plus, those with natural gas are diversified. Are you looking there? – Russ
Thanks for your question, Russ! Oil’s dominance in the headlines has certainly put the sector on investors’ radars for both opportunities and dangers. While I have been looking at some oil companies, the problem is that they have been experiencing rising costs even as the price of oil is falling. Shale, which is a much lower return-on-investment business, finally got enough scale to lower returns for everyone.
For example, one of those blue chip companies that you’re referring to, Exxon Mobil (XOM), currently has a 19% return on equity (ROE) while the industry average is 17%. These levels are not sustainable for a commodity business and I believe the shares will suffer in the long run. Earnings could decline as much as 50% next year, so I still see more risk than we would like here as I am not sure they’ve gotten to the point yet where there is enough future potential value to get us interested. However, I will continue to watch this sector closely for any potential opportunities and keep you updated on my outlook.
Thanks for sending in your question, Russ! If you have a question about one of our stocks, our strategy or the market in general, please feel free to email me at valueauthority@kramersgamechangers.com or simply click the green “Ask Hilary” button on the website.
Buy HIBB on Pullback
Hibbett Sports (HIBB) pulled back close to 3% last Friday following Finish Line’s (FINL) dramatic 20% decline on weaker-than-expected quarterly results as the company was forced to drop prices to work off excess inventory. HIBB has remained weak in sympathy of the news, but it’s important to keep any comparisons between the two companies in context.
Approximately 90% of Finish Line’s sales are derived from footwear, and 40% of those sales are from the weak running shoes category. While HIBB is also a big retailer for footwear, the segment only accounts for 40% of the overall sales mix (less than half of FINL’s) and it does not rely heavily on the sale of running shoes. In addition, Hibbett has a history of efficient operations, which makes me doubt they’d fall victim to the same excess inventory issues that hurt Finish Line.
The company’s long-term story remains intact and I continue to like its valuation. The current weakness is presenting an attractive opportunity to buy HIBB under $52.
TDC Increases Share Buyback Program
Teradata (TDC) has rebounded nicely from the market’s downturn after announcing that it will raise its share repurchase authorization by $300 million for an available total of $450 million, or roughly 6.7% of the company’s market capitalization. TDC has already repurchased $282 million worth of shares this year, reducing the share count by roughly 6%, so I believe it is safe to assume that we will continue to see these repurchases come to fruition, which will help EPS comparisons into next year. While TDC is currently experiencing some growth issues as its top 50 customers have cut back on spending, the company’s cash generation and strong balance sheet should easily be able to fund the program.
With its most recently-announced acquisition of RainStor – a privately-held company specializing in archiving Big Data on open source database software Hadoop – TDC is clearly addressing its growth issues. This was Teradata’s fourth Big Data-related acquisition this year, and I believe that over time these acquisitions, as well as a better understanding by customers of the advantages and limitations of Hadoop, will help drive an improved top line. TDC is a buy under $44.
Lower Buy Limit and Target for IOSP
Innospec (IOSP) has struggled recently as the market remains concerned over the impact that the company’s Russian operations and less oil drilling will have on its Fuel Specialty segment. While I do share some of these concerns, it’s important to keep in mind they are relatively small parts of the Fuel Specialty business, which has been built up by acquisitions over the last few years. I believe the total risk to 2015 EPS estimates of $3.25 is no greater than $0.25 a share, so most of the bad news is already priced into these shares at current levels in the low $40s. However, given the recent weakness I am lowering my buy limit to $43 and our target price to $50.
Happy Holidays!
The year is quickly winding down and Wall Street is already starting to pack up to head out of town for the holidays. Don’t forget that the market will close early at 1 p.m. tomorrow, December 24, and will be closed all day on December 25 and January 1.
I’ll be back in touch with your next issue on January 13, but you can expect Flash Alerts – like today’s alert to sell Hillenbrand (HI) – with trading activity before then as we look to get 2015 off to a strong start.
I wish you and your loved ones a very happy and safe holiday season!
Sincerely,
Hilary Kramer
Editor, Value Authority