As widely anticipated, recent economic data still point to a strengthening economy. After a soft first quarter in terms of growth (+2.2% revised from +2%), real GDP for Q2 rose at an annual rate of +4.1% according to advance estimates which have been released.
Strength in Q2 was concentrated in consumer spending (rebounding from a weak Q1) and a surge in agricultural exports – most certainly resulting from escalating fears over trade tensions. For the Federal Reserve, the current trend most probably warrants further increases in short-term rates. According to the Investment Adviser, one must however keep in mind that growth is also expected to slow in the second half of 2018.
In July, the Fund returned +3.58% against 3.56% for the benchmark. In terms of stock selection, IQVIA Holdings Inc was the largest contributor followed by Financial Select Sector SPDR and Celgene (0.74%, 0.43% and 0.40% contribution to return respectively). On the other hand, Broadcom was the largest monthly detractor, followed by Bank OZK and Signature Bank (-0.26%, -0.14% and -0.10% contribution to return).
Like many in the large cap biotech industry, Celgene’s stock price is a function of the cash generation (vs patent expiry) of its aging products and pipeline fruition. As such, Celgene’s solid beat on both top and bottom lines for Q2 2018 showed continued resilience, existing product robustness and trajectory stability. This said, the lack of any material update on pipeline progress kept the stock price from rebounding significantly. Looking ahead, the Investment Adviser believes that the stock still offers a compelling upside scenario contemplating ongoing commercial execution, pipeline achievements, and possibly some more transparency with regard to the Revlimid settlement. As negativity decreases, the Investment Adviser believes the stock will offer solid upside from current levels.
Allergan also reported a good quarter, beating expectations on revenue and EPS. The results were nicely spread across products, with Restasis contributing $76m and lower Selling, General & Administrative (SG&A) expenses helping further. Free cash flow came at $1,180m and top line guidance was raised by $275m and 35c on EPS. Importantly, the earnings call revealed a change of tone as management appeared more confident and questions were balanced, looking at both positive and negative developments.
The debate around Allergan is gradually evolving. As clarity on the financials is provided post the LOEs (Loss of Exclusivities) and pipeline candidates move from pivotal to registration, the revenue outlook is likely to shift from a flat/declining to a low mid single digit revenue growth. In the Investment Adviser’s opinion this would be sufficient to finally close the valuation gap between the current price and the Company’s intrinsic value. Generally speaking, these results have reaffirmed the Company’s ability to execute, whilst also providing firmer revenue trajectory for core products. In the Investment Adviser’s opinion, a good starting point for the next six months is a wave of clinical data which is expected alongside the first round of competition on Botox, and (possibly) the final step of company restructuring (divestitures).
Cognizant reported Q2 2018 results with a beat and raise on EPS. The Company’s stock price was nonetheless under pressure due to weaker-than-expected revenue growth and higher attrition. The weak revenue growth emphasises the dilemma Cognizant is facing between balancing a margin expansion with revenue growth. The high attrition rate (an important gauge of health for labour-based businesses) of 22.3% was due to seasonality, a tight labour market and involuntary reasons.
On the positive side, margins were strong (constituting an important reason behind the beat and raise). At the same time, the move to digital continues to progress well, with the Company making progress in the creation of verticals beyond healthcare and financial services. All in all, the same question of whether this is an inexpensive growth story or a maturing player with execution risks remains.
The Investment Adviser believes that the stock is cheap for a Company which is delivering low double-digit long term EPS growth. According to the team, the downside is limited as current expectations are low and enterprise IT demand is l ikely to strengthen. However, execution challenges are present and it is not easy to balance a move towards digital with onshore hiring and a margin expansion (as the latter works against the two prior objectives). As such, the Investment Adviser sees some upside for the stock in the shorter term, however from a longer-term perspective, the Company requires revenue growth to stabilise or accelerate in order for more upside potential to be unlocked.
Another company that reported earnings with a modest beat during the month was Union Pacific Railway. Despite what the Investment Adviser considers a decent quarter, the tone during the earnings call was subdued. As such, a clear disconnect between management and sell side pessimism is present but the Investment Adviser thinks that the market’s frame of reference may not account for the differences in business mix between railroads. For example, fuel is a larger expense for Union Pacific and at present constitutes a bigger headwind for its margin line.
As the fuel lag catches up, the team expect a significant lift from net fuel expenses during each quarter throughout the second half of 2018. This, coupled with the benefits of a strengthening market for freight transportation services, should mean the Company is well positioned to outperform on both top and bottom lines for the full year.
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 10/08/18 and are based on internal research and modelling.
For detailed performance information based on complete 12-month periods since inception, please refer to the Fund’s factsheet, which is obtainable from https://eisturdza.com/funds/fund-documents.