Research Blog – INTERNAL USE ONLY

Good morning,

 

We are buying Xylem (ticker XYL) with a 2% position using cash on hand (IVV). Please see presentation attached (not client approved). We will send out the one pager once it is ready.

 

Xylem’s investment thesis is:

 

         Xylem has strong sustainable secular growth drivers in a fragmented industry:

         Access to clean water is a necessity

         Population growth & urbanization

         Aging infrastructure

 

         More defensive sales base thanks to:

         50% of sales to utility sector

         sticky client base due to high switching costs

         high level of replacement parts demand

         Long-term contracts with ½ of the revenue base recurring

 

         Margin expansion overtime from productivity efforts

 

         M&A strategy has increased their scope in the water cycle

         Valuation is attractive today

 

 

Thanks,

Julie

 

 

 

 

 

 

 

 

 

 

 

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

Key Takeaways:

 

·         FY20 guidance withdrawn, update should be done in June 2020 at the next earnings call

·         COVID-19 in China to have a negative impact on FY20 sales of 1-2%

·         More cooking at home and increased demand from packaged food companies, offset by decrease in demand from restaurants and food service sector

·         ERP system upgrade & some business transformation projects have been delayed (we mentioned this possibility in our debt level analysis earlier)

 

 

Current Price: $141         Price Target: $162 (NEW – to reflect lower 2020 results)

Position size: 2.81%        1-Year Performance: -7%

 

McCormick released its 1Q FY20 earnings results this morning. Organic sales were down -1.4% in the quarter, due to a ~28% decline in China’s Consumer segment. EPS declined 4%. As expected, the COVID-19 impact is being felt in their restaurant and food service end markets, while “cooking at home” and packaged food companies have seen an uptick in demand (pantry stocking). Because each regions MKC serves sees a different mix of end-markets and confinement orders, they cautioned investors from generalizing the sales drop in China in Q1 to the rest of the world for next quarter. The outbreak in China reduced sales by 3% and adjusted operating income by 10% in Q1, but China is less than 9% of company revenue, while away-from-home categories comprise 20%. The management team also withdrew its guidance for the year. As we thought they would, MKC is delaying some of its ERP implementation and business transformation. There is enough liquidity to fund current operations and financial needs so we believe the dividend is not at risk. The long-term thesis is still valid for MKC, even if near-term drivers to the business have shifted due to the coronavirus. We updated our price target to reflect a lower 2020 performance.

 

The Thesis on MKC:

•          Industry Leader: McCormick & Company (MKC) is a leading manufacturer of spices and flavorings. MKC has been in business for 120 years and the founding family still has ownership interest

•          Growth opportunity: Spice consumption is growing 3 times faster than population growth. With the leading branded and private label position, MKC stands to be the biggest beneficiary of this global trend

•          Offense/Defense: MKC supplies spices to major food companies including PepsiCo and YUM! Brands giving it a blend of cyclical and counter-cyclical exposure

•          Balance sheet and cash flow strength offer opportunities for continued consolidation through M&A in the sector

 

$US.MKC

[tag MKC]

[category earnings]

 

 

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

Couple updates on TJX. No change in long-term thesis. TJX announced a couple steps they need to take in the current environment to strengthen their balance sheet and preserve capital.

 

·         They suspended Q1 dividend – TJX indicated in their 10K that they do not intend to declare a dividend for the first quarter of fiscal 2021. They had already indicated they were “evaluating” their dividend about a week ago. This should be a temporary cut. Mgmt. said they remain committed to paying their dividends whenever the environment normalizes.

·         Debt offering – Today TJX filed for a $4B debt offering. This is an additional step in strengthening their financial position and balance sheet to maintain financial liquidity and flexibility.  

·         Credit Suisse and Wells Fargo both upgraded TJX to a buy today.

 

 

 

Sarah Kanwal

Equity Analyst, Director

 

Direct: 617.226.0022

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square, Suite 500

Boston, MA 02109

www.crestwoodadvisors.com

 

 

$TJX.US

[tag TJX]

[category equity research]

 

 

·         Alphabet has not updated its guidance but others in the ad space have given negative warnings including Facebook (yesterday) and Twitter (Monday). Facebook said, “we’ve seen a weakening in our ads business in countries taking aggressive actions to reduce the spread of COVID-19.” Twitter withdrew their guidance. Neither company issued a specific revision to their revenue projections.

·         Although people are spending more time online, with vast business closures many advertisers are temporarily curtailing ad spend. Promisingly, data from parts of Asia where the virus has diminished show a rebound in advertising as workplaces have begun to re-open. 

·         The travel industry is obviously one such industry that’s curtailing ad spend and travel is the 6th largest online ad category, at about $20B of online ad spending during 2019. At just Booking and Expedia, the two companies spend back a massive portion of their revenue on advertising. At Booking it’s ~33% or $5B and at Expedia it’s also ~$5B or 42% of revenue. The two companies spend a large portion of this with Google.

·         The travel industry accounts for an estimated $11B in ad spend at Google or ~10% of revenue.

·         While this will clearly be a hit to Alphabet’s revenue(which is almost entirely ad revenue) in the near term, their competitive position long-term is unchanged.

·         Regulatory risk could be on the back burner: the current environment is causing regulators in Europe to take a different tone with tech companies (at least for now). See link to FT article below. Maybe the US will as well, as it’s not the highest priority issue and tech companies, w/ their massive resources, have been demonstrating their ability to be a force for social good (like their subsidiary Verily’s coronavirus screening site). Not suggesting the regulatory risks are gone…but it’s possible they are delayed/changed.

·         Balance sheet strength: Alphabet has a huge cash hoard to ride through this time of uncertainty. They have no net debt and ~14% of their market cap in net cash.

 

Coronavirus prompts delays and overhaul of EU digital strategy

https://www.ft.com/content/f3fd4707-db62-4367-83b1-1b73f1b77862

 

Apple, Google and others partner with Ad Council and US govt to expand coronavirus messaging

https://www.thedrum.com/news/2020/03/25/apple-google-and-others-partner-with-ad-council-and-us-govt-expand-coronavirus

 

 

Sarah Kanwal

Equity Analyst, Director

 

Direct: 617.226.0022

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square, Suite 500

Boston, MA 02109

www.crestwoodadvisors.com

 

$GOOG.US

[tag GOOG]

[category equity research]

 

 

 

·         At the end of last week they re-affirmed their 1Q guidance for sales growth of 2% to 5%.

·         While they have experienced headwinds related to the coronavirus pandemic, it’s been primarily outside the U.S. Production operations in Asia are returning to pre-crisis levels. Across the US and Europe they have experienced minimal disruption to their supply chain and facility operations. At this time, the vast majority of their North American paint stores continue to operate and provide customers with multiple options for ordering and receiving product, including through their existing and extensive delivery system and store pick-up.

·         They have large customers involved in mission critical applications such as food and beverage packaging, health care equipment and facilities, military equipment and energy infrastructure.

·         The CEO said, “although near-term market conditions are likely to remain unpredictable, we believe our underlying long-term demand fundamentals remain intact.”

·         Sherwin stands to benefit from the recent decline in oil prices (about 43% of Sherwin’s raw material costs are tied to petrochemicals including resins, solvents and packaging) and lower interest rates which aid housing market fundamentals. Certain raw material prices have increased related to lower Chinese production but these make up a smaller % of their raw material basket and China seems to be returning to pre-crisis production. Raw materials are ~80% of the cost of a coatings product.

·         Valuation is not expensive at 5.5% TTM FCF.

·         Balance sheet:

o   Sherwin’s leverage ratio is 2.6x – their leverage ratio was elevated related to their Valspar acquisition. They have been working this down.

o   Their debt is rated BBB and has not seen a big price decline relative to issues of similar credit quality.

o   They have ~$400m in maturities this year which is manageable from their cash flow.

 

 

 

Sarah Kanwal

Equity Analyst, Director

 

Direct: 617.226.0022

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square, Suite 500

Boston, MA 02109

www.crestwoodadvisors.com

 

$SHW.US

[tag SHW]

[category equity research]

 

While we view medtech names somewhat immune to economic cycles and having low correlation to GDP growth, this time has been different, with names down 30-40%.

 

There are 2 reasons for this:

·         Hospitals shifting their focus on treating coronavirus patients rather than performing elective surgeries. Two states in the US have specifically asked their hospitals to stop elective procedures (NY and MA). We could see more states following the same path.

·         Patients also are choosing to delay their surgery out of caution.

 

This has also happened in China and Italy: at a conference, Zimmer Biomet noted a 85-90% decline in elective procedures in China during January and February.

 

While this is not great news, the long term thesis on our medtech holdings is not broken and we do not recommend to sell them.

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

The Mexican voted against Constellation’s plant development in Mexicali on fear it would use too much water (it had all the approvals/permits/testing done prior) but local groups pushed for a vote.

The stock is down 8% on the news.

The Mexican government will compensate STZ for the loss, but we do not know yet the terms, and if STZ will recover the $ it put in (total investment was to be $2.5B for the brewery to open in 2021). Constellation will now have to go look elsewhere for its expansion project. The Mexicali plant was being built to support future growth demand for its beer.

This does not affect the current production plant that is located elsewhere (see map).

 

I’ll send more news once the company communicates its next step.

 

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

The stock has held well in this turbulent market until today. A reminder that a small portion of Resmed’s portfolio is the sale of ventilators (Resmed sells a type of ventilator that can be used in hospital settings), but they mostly market sleep apnea/COPD respiratory masks and devices (different machines than ventilators).

 

Here’s a perspective on why the stock is moving so much today:

 

ResMed notes it has not seen sleep apnea demand materially affected to date by COVID-19 but it could still see a slowdown in new patient diagnosis. While a near term drop in new sleep patient setups is possible, we think the long-term thesis of RMD is not affected.

 

On the positive side:

AA Homecare has sent a letter to CMS on recommendations in light of  COVID-19, requesting delaying the implementation of the Competitive Bidding program for one year and suspending all audits to allow suppliers to  focus on emergency activities. This would be positive for ResMed if implemented but would have few implications for near term demand.

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

I wanted to bring some clarification regarding the US-Mexican border closure announced by the US President: this only restricts tourism and recreation travel. Mexico has yet to instate broad containment measures and has kept airports open, saying a total shutdown would paralyze the economy and hurt the poor.

A reminder that this weekend the Mexicali population will vote on keeping the Constellation brewery plant open or not (on fear it consumes too much water).

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com

 

 

We are trimming IBB by 50bps and allocating the proceeds to ZTS. Valuation for IBB did better relative to ZTS as IBB’s main holding is Gilead, a stock that has moved on the news it is developing a drug to treat COVID-19 (no proven efficacy yet). We want to take advantage of this relative strength and distribute it to a name we have a strong conviction will outperform over time.

 

 

 

Julie S. Praline

Director, Equity Analyst

 

Direct: 617.226.0025

Fax: 617.523.8118

 

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

 

www.crestwoodadvisors.com