Research Blog – INTERNAL USE ONLY

CVS – 2 causes for today’s weakness

CVS is seeing some pressure today as the FTC chairman said Aetna and CVS shouldn’t get a free pass because this is a vertical integration. Just a reminder that UnitedHealth is already a vertical integration at play, and has never been highlighted as being anti-competitive.

There are also comments coming from a proposed regulation entitled “removal of safe harbor protection for rebates to plans or PBMs involving prescription pharmaceuticals and creation of new safe harbor protection” (wow that was long to type!). Details are not currently available. This is yet another push from the Trump administration to reform the healthcare system. Drugmakers are seeing pressure too and trying to avoid damages to their business models: Pfizer and Novartis recently announced holding off raising prices for the rest of 2018, in response to Trump’s attacks.

As a reminder, a key function of the PBM is to leverage scale and competition to reduce drug costs for clients. PBM keep up to 10% of the “saving”, although CVS mentioned being closer to 5%. Per Goldman Sachs, the rebates business represents a mid-single digit % of its EBITDA. Below is Goldman’s calculation:

[tag CVS}

$CVS.US

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

PLEASE NOTE!

We moved! Please note our new location above!

Wells Fargo (WFC) Q2 2018 Results

Wells Fargo (WFC) reported core Q2 EPS of $1.11 versus street expectations of $1.12. Results were a bit messy and included several one-timers. Wells continues to make progress on improving relations with employees and customers as they look to put the various scandals behind them. Wells is becoming a return of capital story with over $25b in excess capital. Wells plans to increase dividends and double their already sizable share repurchase program – increasing shareholder yield to over 11%.

Current Price: $56.7 Price Target: $60 (increased from $56 15x 2018 earnings)

Position Size: 3.6% Trailing 12-month: 6.1%

Highlights:

  • Update on settlements, lawsuits and balance sheet restrictions
    • Expects the Federal Reserve to lift balance sheet restriction during first half of 2019
    • Accrued charges in Q2 2018 to refund customers for pricing of foreign exchange transactions and fee calculations for wealth management area
    • On 4/20/18 Wells reported a $1b settlement with OCC and CFPD relating to forced car insurance and mortgage fees.
    • Wells still needs to settle with DOJ over residential mortgage policies dating back to the financial crises. Estimates place the settlement at $2b, but Wells has already set aside reserves of $3.2b
    • Additional lawsuits exist for overdraft fees, foreign exchange, mortgage fees, improper account closing and other smaller suits. Wells is not out of the woods, yet.
    • Replaced former Chairman, John Stumpf with CEO, Tim Sloan, and CFO Elizabeth Duke, a former Fed member, as independent chairman.
    • Named 6 new independent directors
    • Plans to spend 2% of earning to philanthropy (up from 1.3%)
    • Recent moves to improve standing of employees
      • Increased base minimum hourly wage to $15.00 an increase of 11%
      • Increased 401k and profit sharing programs
      • Increased stock incentive compensation
    • Recent improvements to help customers
      • Overdraft rewind, zero-balance alerts, debit card on/off capability, and P2P payments
  • Wells is a return of capital story
    • Common Equity Tier 1 Ratio of 12.0% with a target of 10% – $25b in excess capital
    • ROE 10.6% (Return on tangible equity 12.6%)
    • Returned $4.0b to shareholders through dividends and share repurchases.
    • Increased dividend 10% from $.39 to $.43.
    • Increased share repurchases from $4b to over $8b which is shareholder yield of over 11%.
  • Excellent banking business
    • Strong balance sheet – Net charge offs and Nonperforming loans near historic lows.
    • Balance sheet restrictions has allowed trimming of lower quality loans – autos loans and pick-a-pay mortgage loans
    • Return on tangible equity 12.6%
    • Generates $5b per quarter in earnings
    • $1.27 trillion deposits with average cost of 40 bps
  • Noninterest revenue down -8% yoy – area affected most by changes to companies practices
    • Weak Mortgage banking with drop in margins for origination
    • Consumer fees (deposit service, card fees and other) were down in effort to please customers
    • Noninterest expenses were up 3% YoY mainly on higher salaries and benefits
    • Efficiency ratio improved to 64.9
  • Net interest income improved 1% yoy
    • Average total loans down 1% yoy
    • Consumer loans down $6.6b with largest reduction in auto loans
    • Rate paid on deposits has risen from 0.17% 1Q17 to .40% 2Q18
  • Valuation is fair on depressed earnings WFC now trades at 14.5x P/E. WFC is targeting $4.0b in cost savings over the next two years – an aggressive target.

WFC Thesis:

  • Best franchise in banking due to disciplined loan writing and quality mortgage underwriting
  • Large deposit base that provides low cost funding
  • Strong capital ratios put WFC in a good position to be opportunistic, invest for the long-term and return capital to shareholders
  • Fair valuation and potential for earnings rebound in 2018

($WFC.US)

John R. Ingram CFA

Managing Director

Asset Allocation and Research

Direct: 617.226.0021

Fax: 617.523.8118

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

www.crestwoodadvisors.com

JNJ 2Q18 earnings results strong thanks to growth in Pharma

Key Takeaways:

JNJ reported 2Q18 earnings results that beat consensus thanks to very strong Pharma sales (+17.6% organic). Medical Devices grew 1.9% organic, still experiencing weakness in diabetes and Ortho. Their consumer segment is still showing weak growth, but the re-launch of the baby care business in the US should help lift sales in the coming quarters. JNJ has now experienced its 5th consecutive quarter of sales growth acceleration, as new drugs gains are over time offsetting older drugs facing generics competition (although 2H18 should see increased generics pressure). Guidance for operational sales growth in 2018 is up slightly, now 4.5-5.5% from 4-5%, and EPS guidance was lifted by 2 cents. Reported numbers will see more impact from currency however. As Pespi’s CEO did last week, JNJ’s CEO mentioned their recently released ESG report “Health for Humanity” during his presentation.

Continue reading “JNJ 2Q18 earnings results strong thanks to growth in Pharma”

Pepsi 2Q18 earnings: some relief from good growth but margins going forward still need monitoring

Key Takeaways:

Pepsi released Q2 earnings that were better than expected (granted on recently lowered sell-side expectations). Organic growth was +2.6% (consensus +2.2%). North America beverages remains soft, but saw sequential improvements following additional advertising efforts + new products (Bubly and Gatorade Zero), and should see continued positive momentum in 2H18. Frito Lay’s good performance in price and volume helped lift the overall company’s gross margin (positive mix impact). The emerging markets had strong growth +6% even with the Brazil truck driver strike limiting distribution of goods. As I had mentioned leading up to this earnings season, the company (as well as other consumer staples) is experiencing higher commodity and freight costs. Since a good portion of this quarter’s growth came from one-time items (Thailand beverage refranchising for example), the quality of growth going forward needs to be monitored. The company reiterated its FY18:

ü organic revenue growth of at least +2.3%

ü EPS +9% y/y.

Continue reading “Pepsi 2Q18 earnings: some relief from good growth but margins going forward still need monitoring”

McCormick 2Q18 recap

Key Takeaways:

Last week McCormick released its 2Q18 earnings, with a sales and gross margin beat (+340bps y/y à leading to a 330bps operating margin expansion) and EPS +24% y/y. Revenue ex-FX grew 16% (+13% from the addition of Frank’s and French’s brands), driven by +2.5% volume/mix and 0.5% price. China had the strongest Consumer segment growth with +5.7% volume growth. In its Flavor segment, Americas was the leading geography with +5.3% volume growth. The addition of new brands helped expand the company’s overall margins. MKC reduced its cash conversion cycle by 9 days, a sign of good cash flow management skills, supporting faster debt pay down.

Continue reading “McCormick 2Q18 recap”

Empirical Research’s take on trade

Empirical Research has provided some insight on potential tariff effects.  Key points:

1) Manufacturing matters more to the markets than to GDP.  40% of S&P 500 earnings versus 12% of GDP.

2) Most exports to China are agricultural products and commodities, which are not as costly to source elsewhere.

3) High-tech imports from China are roughly half of all imports.  A third of imports from China are consumer goods.

Portfolio Strategy – U.S. – China Trade War, Margins and Tax Havens, Restructurings – Jun 20 2018

QMNIX – Recent Underperformance, Long Term Thesis Intact

Good Afternoon,

Below I address the recent performance of Market Neutral and why we are comfortable holding this fund long term.

We still believe that owning market neutral is a strong investment over the long term. The main pillars of our thesis remain intact.

1.) Diversification Benefits: The fund’s return correlations to traditional asset classes should be very low, targeting a beta of zero over time.

2.) Alternative to Fixed Income: Based on its risk parameters and expected return profile, QMNIX should provide an alternative to core bonds.

3.) Opportunity for positive risk adjusted returns: The fund seeks long term Sharpe Ratio of approximately 0.7 – 1.0.

Continue reading “QMNIX – Recent Underperformance, Long Term Thesis Intact”