ARGUS Independent Equity Research Since 1934 1934 - DJIA: 104.04 2016 - DJIA: 19,762.60 TUESDAY, NOVEMBER 14, 2017 NOVEMBER 13, DJIA 23,439.70 UP 17.49 Good Morning. This is the Market Digest for Tuesday, November 14, 2017, with analysis of the financial markets and comments on Brinker International Inc., Cheesecake Factory Inc., First Solar Inc., General Electric Co., CBS Corp., Kohl s Corp. and Westar Energy Inc. IN THIS ISSUE: * Growth Stock: Brinker International Inc.: Earnings match consensus despite hurricane impact (John Staszak) * Growth Stock: Cheesecake Factory Inc.: Maintaining HOLD on slowing comps (John Staszak) * Growth Stock: First Solar Inc.: Maintaining HOLD despite strong 3Q results (David Coleman) * Growth Stock: General Electric Co.: Management cuts dividend (John Eade) * Value Stock: CBS Corp.: Disappointing 3Q17; lowering EPS estimates (Joseph Bonner) * Value Stock: Kohl s Corp.: Maintaining HOLD in a volatile sector (Chris Graja) * UtilityScope: Westar Energy Inc.: Merger plan moves forward; stock fairly valued (Gary Hovis) MARKET REVIEW: Vickers Stock Research, Argus sister company, calculates proprietary Sell/Buy Ratios using data from recent Form-4 filings (through which insiders register purchases and sales of their stock with the SEC). Insiders are deemed to be in a bullish mood when the Sell/Buy Ratio comes in at 2.00 or below; they are neutral in the 2.00 to 2.50 range; and they are bearish if results are 2.50 or above. Short-term (one-week) insider sentiment has improved significantly this week. The progress has not been enough to stop the longer-term (eight-week) readings from weakening, but the rate of long-term deterioration has quieted for now. Vickers current NYSE/ASE One-Week Sell/Buy Ratio is better by 215 basis points in the past seven days, landing at 3.75 compared to 5.90 last week. The eight-week reading, which worsened by 24 basis points last week, is off by only 4 bps this week. In similar fashion, Vickers current Total One-Week Sell/Buy Ratio improved by 264 basis points this week while the eight-week reading is off by only 6 bps (compared to 28 bps last week). The change in the week-over-week data comes about because of a 20% decline in the number of sell transactions, as well as a 43% increase in the number of buy transactions. This week, analysts at Vickers highlighted insider transactions of interest at Consolidated Communications Holdings Inc. (NGS: CNSL) as well as Consolidated Edison Inc. (NYSE: ED). (David Coleman) A R G U S R E S E A R C H C O M P A N Y 6 1 B R O A D W - A 1 Y - N E W Y O R K, N. Y. 1 0 0 0 6 ( 2 1 2 ) 4 2 5-7 5 0 0 LONDON SALES & MARKETING OFFICE TEL 011-44-207-256-8383 / FAX 011-44-207-256-8363
BRINKER INTERNATIONAL INC. (NYSE: EAT, $33.07)... HOLD EAT: Earnings match consensus despite hurricane impact * While Brinker has traditionally relied on above-peer-average increases in same-store sales to drive earnings growth, it has seen weaker comps in recent quarters. * In addition, management now appears to be relying mainly on stock buybacks, as well as delayed G&A spending and other cost-reduction efforts, to drive growth in EPS. * We are concerned that Brinker will need to boost G&A spending in the coming quarters, and that competitors promotions will require it to lower menu prices. We believe this could weigh on earnings going forward. * For investors seeking to invest in a restaurant company with stronger growth prospects, we recommend the shares of BUY-rated McDonald s Corp. (MCD). ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on Brinker International Inc. (NYSE: EAT). While Brinker has traditionally relied on above-peer-average increases in same-store sales to drive earnings growth, it has seen weaker comps in recent quarters. In addition, management now appears to be relying mainly on stock buybacks, as well as delayed G&A spending and other costreduction efforts, to drive growth in EPS. We are concerned that the company will need to boost G&A spending in the coming quarters, and that competitors promotions will require it to lower menu prices. We believe this could weigh on earnings going forward. If comp sales recover more than we anticipate or food costs moderate significantly, we would consider returning the stock to our BUY list. For investors seeking to invest in a restaurant company with stronger growth prospects, we recommend the shares of BUY-rated McDonald s Corp. (MCD). Based on potential benefits from additional refranchising, our long-term rating remains BUY. RECENT DEVELOPMENTS On October 25, Brinker reported results for fiscal 1Q18 (ended September 27). First-quarter revenue fell 2.5% from the prior year to $739 million. The decline reflected 3.4% lower comps at domestic Chili s, as well as 2.6% lower same-store sales at Maggiano s and the impact of two hurricanes. Revenue came in $9 million below the consensus estimate. Excluding special items, EPS fell 14% from the prior year to $0.42 but matched the consensus estimate. Reflecting an 8.7% decline in restaurant traffic, offset in part by a 2.5% contribution from a more favorable product mix and a 2.8% contribution from improved pricing, first-quarter same-store sales at company-owned Chili s in the U.S. fell 3.4%. We believe the disappointing comps also reflected aggressive promotions by quick-service restaurants and overall weakness in the casual dining industry. The consensus estimate had called for comps to decline 2.2%. Maggiano s saw comps decrease 260 basis points, as a 0.1% pricing increase and a 0.1% improvement in product mix were outweighed by a 2.8% decline in restaurant traffic. The consensus estimate had called for comps to decline 0.4%. Systemwide comps were down 3.5%, below the consensus call for a 1.9% decline. Domestic franchise comps fell 170 basis points from the prior year, while international franchise comps decreased 7.9%. G&A fell to $32.4 million from $32.5 million, but increased 10 basis points as a percentage of revenue, to 4.4%. The consensus estimate had called for G&A of 4.2% of revenue. Reflecting higher restaurant expenses as a percentage of revenue, offset in part by a lower cost of sales, the restaurantlevel margin fell 70 basis points to 12.6%, below the consensus estimate of 12.9%. Shares outstanding fell to 48.7 million at the end of the quarter, down 12.4% from the prior year. Interest expense rose from $8.8 million to $13.9 million. As discussed in a previous note, for all of FY17, revenue decreased 3.3% to $3.1 billion, while earnings fell to $3.29 from $3.58 in FY16. EARNINGS & GROWTH ANALYSIS In fiscal 1Q18, the restaurant-level margin missed our estimate, and fell 70 basis points to 12.6%. The margin deterioration reflected higher restaurant expense as a percentage of revenue, partially offset by a lower cost of sales. However, we expect technology initiatives and kitchen upgrades implemented over the last several years to benefit margins over time. To further lower the cost of sales, management is spending $20 million on new fryers, which are expected to add 100 basis points to the restaurant-level margin. - 2 -
For FY18, management projects EPS of $3.25-$3.35. It expects same-store sales to be flat to 1.5% higher and full-year revenue to be up 0.5%-1.5%. It also looks for the FY18 restaurant-level margin to decline 25-40 basis points. The company continues to buy back stock and has authorized an additional $250 million in share buybacks, bringing the total available authorization to $365 million. It expects a year-end share count of 47-49 million. Reflecting management s current guidance, we are maintaining our FY18 EPS estimate of $3.40. For FY19, we are lowering our estimate from $3.60 to $3.50. Both estimates are above consensus. FINANCIAL STRENGTH & DIVIDEND We rate Brinker s financial strength as Medium, the midpoint on our five-point scale. The shareholders deficit rose from $494 million at the end of 1Q17 to $539 million at the end of 1Q18, and long-term debt rose from $1.3 billion to $1.4 billion. Interest expense rose from $8.8 million to about $13.9 million. The credit agencies rate Brinker s debt as investment grade. Brinker has raised its quarterly dividend from $0.34 to $0.38 per share, or $1.52 annually, for a yield of about 4.6%. Our dividend estimates are $1.52 for FY18 and $1.72 for FY19. RISKS Like all restaurant companies, Brinker faces the risk that higher food and beverage costs may reduce earnings. The company s results could also be affected by issues related to food contamination at restaurants or increased public perceptions of disease risk. COMPANY DESCRIPTION Brinker International, based in Dallas, Texas, is a leading casual restaurant operator. The company owns or franchises more than 1,600 restaurants under the Chili s Grill & Bar and Maggiano s Little Italy brand names. Brinker also holds a minority investment in Romano s Macaroni Grill. The shares are included in the S&P MidCap 400. VALUATION EAT shares trade at 9.8-times our FY18 EPS estimate and at 9.5-times our FY19 estimate, versus a three-year historical range of 5-18. Based on prospects for continued weak same-store sales and management s current guidance, we believe that the shares are fairly valued. If comp sales recover more than we anticipate or food costs moderate significantly, we would consider returning the stock to our BUY list. On November 13, HOLD-rated EAT closed at $33.07, down $0.67. (John Staszak, CFA, 11/13/17) - 3 -
CHEESECAKE FACTORY INC. (NGS: CAKE, $44.29)... HOLD CAKE: Maintaining HOLD on slowing comps * Management has lowered its 3Q same-store sales guidance from growth of 0.5%-1.5% to a decline of 1%. * Cheesecake s earnings are driven by same-store sales, and we expect declining comps to weigh on EPS. * We are lowering our EPS estimates from $2.80 to $2.70 for 2017 and from $3.00 to $2.92 for 2018. * We believe that CAKE is fairly valued at 16.5-times our revised 2017 EPS estimate, below the average for other casual dining chains. ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on Cheesecake Factory Inc. (NGS: CAKE). The company recently posted lower third-quarter comp sales. The third-quarter decline follows 29 straight quarters of growth in same-store sales. Management attributed the weakness in part to Hurricanes Harvey, Irma and Maria. Excluding the impact of the hurricanes, comps would have fallen 1.5%. We are disappointed that third-quarter comps and earnings missed expectations and believe that the weak comps will continue into the fourth quarter and 2018. RECENT DEVELOPMENTS On November 1, Cheesecake Factory reported 3Q17 adjusted EPS of $0.56, down $0.14 from the prior-year period and below management s $0.60-$0.64 guidance range. EPS missed the consensus forecast by $0.04. Earnings benefited from the repurchase of approximately 1.6 million shares during the quarter. Same-store sales declined 2.3%, reflecting in part an 80-basispoint headwind attributable to the hurricanes. Management had forecast a 1.0%-1.5% decline in comp sales, and the Street had called for a decline of 2.0%. In 3Q17, total revenues fell nearly 1.0% to $555 million, below the consensus estimate of $566 million. For 2017, management continues to project EPS of $2.62-$2.70 and lower 1% comps. It plans to open up to eight new restaurants in 2017, and expects labor costs to rise 5%. The company plans to spend a total of $125-$150 million on share repurchases in 2017. For 2018, management projects earnings of $2.50-$2.75 per share, with flat to 1.0% higher same-store sales. Food costs are expected to increase 3%, compared to 1%-2% higher in 2017. Management plans to open 4-6 new restaurants in 2018, down from 8 in 2017. Plans for fewer restaurant openings reflect rising wages for construction workers following the hurricanes and plans to repurchase more shares following recent weakness. EARNINGS & GROWTH ANALYSIS Cheesecake Factory s earnings are driven by same-store sales, and we expect declining comps to weigh on EPS. In view of soft casual-dining demand and an excess of casual-dining restaurants, we believe a return to strong comp growth is unlikely. Wage inflation has also weighed on earnings this year. Looking ahead, prospects for Cheesecake Factory appear unimpressive. Management said the company has outperformed the casual dining industry. However, it now expects a 1% decline in full-year same-store sales. We look for comp sales to decline 1.0% this year, after previously projecting a 0.5% decline. We are lowering our fourth-quarter EPS estimate from $0.74 to $0.64 and our full-year estimate from $2.80 to $2.70. We are also lowering our 2018 estimate from $3.00 to $2.92. Based on ongoing cost-cutting efforts and management s guidance, our long-term earnings growth rate estimate is 15%. Over the long term, we also expect the company to exceed its goal of operating 200 Cheesecake Factory restaurants and 150 Grand Lux Cafes. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on Cheesecake Factory remains Medium-High, the second-highest rank on our five-point scale. Operating income covered interest expense of $1.6 million by a factor of 21.4 in the third quarter, up from 20.0 in the prioryear period. In June 2017, the company raised its quarterly dividend by 21% to $0.29, or $1.16 annually, for a yield of about 2.6%. Management has targeted a payout ratio of 25%. Our dividend estimates are $1.06 for 2017 and $1.32 for 2018. - 4 -
RISKS Higher food and beverage costs are an ongoing risk for restaurant companies. Dairy costs, in particular, affect Cheesecake Factory, as cream cheese is the primary ingredient in the company s namesake product. In addition, increased labor turnover, as well as higher wage and benefit costs, may reduce the company s earnings. COMPANY DESCRIPTION Based in Calabasas, California, Cheesecake Factory operates a chain of upscale casual dining restaurants and offers a menu of more than 200 items. In addition, it operates a bakery that produces more than 50 varieties of cheesecake and other baked products for the company s restaurants and other foodservice operators, retailers and distributors. INDUSTRY We have lowered our rating on the Consumer Discretionary sector to Market-Weight from Over-Weight. On top of the well-documented pressures on traditional retailers in this sector, the housing market is facing pressure from insufficient home supply and the new model year has failed to trigger higher purchases of new vehicles. While demand for big ticket consumer goods falters, we expect consumer discretionary investors to focus on leisure-related stocks. The sector accounts for 12.3% of the S&P 500. We think investors should consider allocating 12%-13% of their diversified portfolios to the group. Over the past five years, the weighting has ranged from 8% to 13%. The sector underperformed in 2016, with a gain of 4.3%, after outperforming in 2015, with a gain of 8.4%. It is underperforming thus far in 2017, with a gain of 9.6%. Consumer Discretionary earnings are expected to increase 11.0% in 2018 and 4.8% in 2017 after rising 9.4% in 2016 and 9.9% in 2015. On valuation, the 2018 projected P/E ratio is 18.9, above the market multiple of 17.1. The sector s debt ratios are high, with an average debt-to-cap ratio of 52%. Yields are below average at 1.4%. VALUATION Given prospects for weaker same-store sales and less rapid earnings growth at Cheesecake Factory, we believe that a multiple near that of other casual dining chains is warranted. Applying a peer-average multiple of 17 to our revised 2017 EPS estimate, we calculate a fair value near $46, above current prices but not enough to warrant a BUY-rating. Our revised discounted cash flow model also points to a value slightly above current levels. As such, our rating remains HOLD. On November 13, HOLD-rated CAKE closed at $44.29, down $0.02. (John Staszak, CFA, 11/13/17) - 5 -
FIRST SOLAR INC. (NGS: FSLR, $61.57)... HOLD FSLR: Maintaining HOLD despite strong 3Q results * FSLR shares have been strong performers over the past three months, rising 25.7% while the S&P 500 has advanced 4.3%. * The company recently reported 3Q17 EPS that topped the consensus forecast. * On valuation, FSLR is trading at 24.3-times our revised 2017 EPS forecast, near the high end of the company s historical average range and above the peer average of 22. * Given that the company earned $2.84 per share in the first nine months of the year, its full-year guidance of $2.40- $2.60 implies a 4Q loss of $0.24-$0.44 per share. We expect a loss of $0.33 per share in 4Q17. We also expect EPS to decline in 2018. ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on First Solar Inc. (NGS: FSLR), a leading solar energy company, as it transitions from its Series 4 to its Series 6 module. We view FSLR as well positioned in the solar industry based on its positive cash flow, solid balance sheet, and focus on cadmium telluride technology, which should provide a cost advantage relative to more commoditized technologies like polysilicon. In particular, FSLR s technological investments have enabled the company to lower the cost of solar generation on a per-watt basis and to improve its conversion efficiency. They have also helped the company to expand its opportunity set of utility-scale projects. On valuation, FSLR is trading at 24.3-times our revised 2017 EPS forecast, near the high end of the company s historical average range and above the peer average of 22. Investors should expect FSLR s financial results to be uneven on a quarter-toquarter and year-to-year basis due to the timing of revenue recognition. We would like to see a stronger company and industry outlook before considering a higher rating on FSLR. RECENT DEVELOPMENTS FSLR shares have been strong performers over the past three months, rising 25.7% while the S&P 500 has advanced 4.3%. The shares have also outperformed over the past year, with an increase of 80% compared to a gain of 22% for the index. The beta on the volatile shares is 1.99. On October 26, the company reported 3Q net sales of $1.1 billion, up from $681 million in 3Q16. The increase was driven by the sale of the California Flats and Cuyama projects and higher third-party module sales. Third-quarter net income came to $208 million, up from $127 million in the prior-year period. Third-quarter adjusted EPS rose to $1.95 from $1.22 in 3Q16, topping the consensus forecast of $0.84. In the first nine months of the year, the company earned $2.84 per share. Along with the 3Q results, management updated its full-year guidance. It continues to expect 2017 revenue of $3.0-$3.1 billion. It now expects a gross margin of 18%, up from its prior forecast of 17%-18%. It has raised its non-gaap operating income projection to $210-$230 million from $170-$220 million, and its non-gaap EPS guidance to $2.40-$2.60 from $2.00-$2.50, which assumes a full-year tax benefit of $25-$30 million. It reiterated its cash flow forecast of $850-$950 million and its operating expense estimate of $370-$395 million. FLSR expects to produce approximately 2.3 GW of solar modules in 2017. EARNINGS & GROWTH ANALYSIS Reflecting challenging conditions in the solar industry and decreased demand in China, First Solar announced in November 2016 that it would accelerate production of its Series 6 module into 2018 and entirely bypass the previously planned Series 5. It will also phase out production of the Series 4. Management believes that the revised schedule will better position the company for long-term growth. As of September 30, 2017, the company had 18 installed production lines at its manufacturing facilities in Perrysburg, Ohio and Kulim, Malaysia. It produced 0.5 GW of solar modules in 3Q17, down 32% from the same period in 2016. The decrease was driven mainly by the decision to phase out production of the Series 4 and accelerate the transition to the Series 6. The transition will include the start of operations at a new manufacturing plant in Vietnam. We expect lower earnings in 2018 as the company converts to the Series 6. On the 3Q conference call, management said that it expects to begin Series 6 production in Ohio in 2Q18 and in Malaysia in the second half of 2018. - 6 -
We are raising our 2017 EPS estimate to $2.51 from $2.07 based on the better-than-expected 3Q earnings and management s revised guidance. We are maintaining our 2018 estimate of $1.28. Given that the company earned $2.84 per share in the first nine months of 2017, its full-year EPS guidance of $2.40-$2.60 implies a loss of $0.24-$0.44 per share in 4Q17. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on First Solar is Medium, the middle rank on our five-point scale. The company is not rated by any of the rating agencies. In 3Q17, the company had a GAAP operating margin of 19.0%. Cash and cash equivalents totaled $2.72 billion at the end of 3Q17, up from $2.09 billion a year earlier. Cash from operations was $581 million, compared to cash used in operations of $84 million in 3Q16. Long-term debt rose to $330 million from $161 million in the prior-year period. The long-term debt/cap ratio at the end of the quarter was 5.6% up from 2.4% a year earlier. The company has a 28% stake in 8point3 Energy Partners LP, a company formed by First Solar and SunPower Corp. in 2015. FSLR has received a total of $17 million in distributions from the company thus far in 2017. First Solar does not pay a dividend and is unlikely to implement one in the near term. The company does not repurchase stock. MANAGEMENT & RISKS James Hughes retired as CEO in June 2016 and was succeeded by CFO Mark Widmar. Alex Bradley became interim CFO in July 2016 and permanent CFO in October. Philip Tymen dejong became the company s COO in July 2015. Georges Antoun was appointed chief commercial officer in July 2016. The greatest risk for First Solar is that in radically reworking its go-to-market model, the company miscalculates the available market opportunity, particularly in the solar utility market outside the U.S. We believe that the company has the large project personnel, experience, and track record to lead in the solar utility market on a global basis, much as it dominates in the U.S. At this stage, we believe that a primary risk to an investment in FSLR remains a resetting of industry valuations, as energy prices remain volatile, industry competition remains fierce, and strained government budgets coupled with a changing political climate create increased risk for subsidies. Pricing in some markets has become fiercer, affecting both Purchase Power Agreements (PPA s) and First Solar s modules; the company must maintain a balance so that the return on capital will be commensurate with the underlying risks. If the market for utility scale solar power generation does not expand significantly over the next few years due to cost factors or technological or political developments, First Solar would likely experience slower-than-anticipated growth. The company also faces interest rate and foreign currency risks, though it does use hedging to mitigate these risks. First Solar s foray into the ownership of solar projects increases the company s financial risks and may significantly extend the time for a return on investment from such projects. This is a factor for investors to watch if it becomes a significant piece of the business going forward. In December 2015, Congress extended its 30% investment tax credit on solar systems to 2019. While this strengthened the broad outlook for the solar power industry, the earlier deadline resulted in a rush to complete installations, benefiting results in early 2016. However, with the deadline extended, customers have felt less urgency to complete projects in 2017 and 2018. In addition, the outlook for federal programs supporting solar power has become less certain under the Trump administration. COMPANY DESCRIPTION First Solar designs, develops, manufactures and markets a line of thin-film semiconductor photovoltaic (PV) cells and modules that convert sunlight into electricity. The company s products, based on cadmium telluride technology, are used to provide reliable and environmentally friendly electric power. Using a very thin coating of semiconductor material over a glass sheet allows FSLR to produce PV modules at a much lower cost than traditional wafer technology. The group has installed over 17 GW in solar energy solutions worldwide. INDUSTRY Solar energy still constitutes only a little more than 1% of the world s total energy supply; however, demand has increased dramatically over the past several years. In May 2016, the U.S. Energy Information Administration (EIA) reported that solar was the world s fastest-growing form of renewable energy, with net solar generation increasing by an average of 8.3% per year. Given growing concerns about global warming and pollution from fossil fuels, more than 30 countries have established national solar generation capacity targets for 2020, and many other countries have set targets for years before or after 2020, with a combined target of more than 350 GW. In March 2017, the Guardian reported that solar power generation rose 50% in 2016 and accounted for 305 GW of power globally, largely due to growth in the U.S. and China. The U.S. market is projected to exceed 100 GW by 2021 as solar power becomes more cost-competitive. - 7 -
VALUATION We believe that FSLR shares are fairly valued at current prices near $61. The shares have traded between $25 and $62 over the last 52 weeks and are currently near the high end of the range. From a technical standpoint, the shares have been in a bullish pattern of higher highs and higher lows since establishing a double-bottom in March-April 2017. The shares recently broke through resistance at $50 following the company s stronger-than-expected 3Q17 results. From a fundamental standpoint, valuations are mixed. FSLR trades at 24.3-times our revised 2017 EPS forecast, near the high end of the historical average range and above the peer average of 22. It also trades at 2.1-times sales, below the industry average of 4.4 but above the five-year average of 1.4. The price/book ratio is 1.2, below the peer average of 4.2 but above the fiveyear average of 1.0. The price/cash flow ratio is 5.2, below the peer average of 20. While 3Q17 was solid, management s guidance implies a loss in the current fourth quarter. We would like to see a stronger company and industry outlook before considering a higher rating on FSLR. On November 13, HOLD-rated FSLR closed at $61.57, down $0.02. (David Coleman, 11/13/17) - 8 -
GENERAL ELECTRIC CO. (NYSE: GE, $19.02)... BUY GE: Management cuts dividend * We are maintaining our BUY rating but lowering our target price. * We think the stock has been oversold during the past six months and offers value. * But earnings growth is going to be difficult until at least 2019. * We now think that GE may not reach our EPS target until 2020, and are scaling back our target price to $22. ANALYSIS INVESTMENT THESIS Our rating on the GE shares remains BUY, but we are disappointed with management s decision to cut the dividend. We also think that the tactical steps management is taking to reignite growth will not likely have an impact on earnings for several quarters at least. That said, GE in 2-4 years will undoubtedly look different than the company of today. Management s strategic plan to sell up to 25% of the current portfolio and focus even more closely on important verticals of Aviation, Healthcare and Power on the surface make sense. The old management team was unable to execute and is now gone. The new management team is now under enormous pressure to produce results. RECENT DEVELOPMENTS New GE CEO John Flannery delivered his long-awaited outlook on Monday, and it disappointed on numerous counts. For one, the company cut the dividend by 50% only the third cut in its long history. We had argued that management should maintain the dividend for at least a year while focusing on saving cash and restructuring the company. For another, even after the dividend cut, management is not able to forecast growth in earnings for at least another year. For a third, the presentation was long on the company s innovative history and the latest advances in management science, but short on concrete steps the company can take to restart earnings growth any time soon. The GE share price fell another 7% in active trading after the presentation. It remains in free-fall mode. EARNINGS & GROWTH ANALYSIS We had lowered our 2018 EPS estimate to $1.08 after the company reported 3Q results. That estimate is now above the high end of management s new guidance range of $1.00-$1.07. Given recent trends in revenue and margins, we think the midpoint of the guidance range is probably more likely. Thus, we are lowering our 2018 estimate to $1.03. Our estimate for 2017 remains $1.07. We are also lowering our five-year EPS growth rate from 6% to 4%. Going forward, we will be focusing most closely on the company s stated three core vertical markets: Power, which will account for about 30%-35% of sales; Aviation, which is expected to account for 25%-30% of sales; and Healthcare. Healthcare and Aviation are in good shape. However, Power, which became the company s largest segment after it acquired Alstom in 2015, faces numerous problems ranging from changes in the marketplace, to timing issues related to the closing process, to recent losses in business. A new management team has come on board, and the first task will be to take as much as $2 billion out of the cost structure. But that s going to take at least two years. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on General Electric is Medium, the midpoint on our five-point scale. The company receives average marks on our three focus areas of debt levels, fixed-cost coverage and profitability. GE pays a dividend, which it has now cut by 50%. The current annual rate of $0.48 yields about 2.5%. Our dividend estimates are now $0.96 for 2017 and $0.48 for 2018. The company has a share buyback program but has slowed repurchases to conserve cash. The new management team, as part of the restructuring plan, will be borrowing $6 billion to prepay pension obligations for the next three years. So GE does have access to capital. MANAGEMENT & RISKS GE is undergoing numerous transitions, including a change in top management. Longtime CEO Jeffrey Immelt stepped down on August 1, and has been replaced by John Flannery, 55, who has had a long finance career at GE. In his presentation to investors, Mr. Flannery frequently talked about a focus on the core, and a disciplined returnsbased approach. He is under enormous pressure to focus on generating returns in the market. - 9 -
Investors in GE shares face risks. Although GE s massive size and product diversity have helped it to smooth earnings in the past, the company s results during the 2007-2009 recession also demonstrated that it can be susceptible to a broader economic meltdown. The company also faces the challenge of large numbers, as it is difficult to grow a company that generates almost $125 billion in sales. VALUATION We think that GE shares are undervalued at current prices near $19, near the bottom of their 52-week range of $18-$32. On a technical basis, the shares are in a bearish pattern of lower highs and lower lows that dates to July 2016. To value the stock on a fundamental basis, we use peer and historical multiple comparisons, and a dividend discount model. The shares are trading at 18-times projected 2018 earnings, below the average of 19.6 for GE s traditional peer group (Honeywell, United Technologies, 3M Corp.). The dividend yield of about 2.5% is in line with the average for traditional peers. We think GE s earnings power with an improved Power business is closer to $1.50 than $1.00. If we apply an industry average multiple, the valuation is close to our previous target of $27. We now think that GE may not reach our EPS target until 2020, and are scaling back our target price to $22. On November 13, BUY-rated GE closed at $19.02, down $1.48. (John Eade, 11/13/17) - 10 -
CBS CORP. (NYSE: CBS, $55.92)... BUY CBS: Disappointing 3Q17; lowering EPS estimates * CBS reported flat earnings on 3% revenue growth in 3Q17, though EPS benefited from significant share repurchases over the last year. * CBS expects its new digital initiatives CBS All Access and Showtime OTT to have more than 4 million subscribers by the end of 2017. The company will also expand CBS All Access into international markets in 2018 and launch a digital sports stream. * License fees from new virtual multichannel video program distribution services are helping to boost revenue growth. * We are lowering our 2017 EPS estimate to $4.25 from $4.39 and our 2018 forecast to $5.07 from $5.13. Our estimates imply 17% EPS growth over the next two years, above our long-term growth rate forecast of 12%. ANALYSIS INVESTMENT THESIS We are maintaining our BUY rating on CBS Corp. (NYSE: CBS) to a target price of $79. Media stocks have been volatile due to investor concerns about the tectonic shifts in the television/cable ecosystem. However, CBS has been proactive in its response to these shifts, launching online services of its own while also becoming an anchor network for other over-the-top services. The subscriber gains at CBS All Access show that the company has gained traction in online distribution even before it began to air much of its new originally produced content on the new platforms. The addition of the NFL to CBS All Access should further boost subscriber numbers this fall. CBS s unique reach may actually provide opportunities as new OTT services proliferate, enabling it to charge higher distribution rates than it does for its traditional distribution partners. CBS is also benefiting from a healthy advertising market and a robust off-network syndication market for the domestic and international licensing of hit television series. We see CBS as one of the best-managed businesses in media. Although the company may not have always had the best hand (that honor might go to Disney), it has played its cards exceptionally well, with management setting clear goals and then meeting them, usually earlier than expected. We also like the company s shareholder-friendly management, and note that its return on capital of 15.6% is by far the highest in its peer group. The forthcoming split-off of the Radio division may provide another opportunity to boost shareholder returns. RECENT DEVELOPMENTS CBS reported third-quarter results on November 2 after the market close. Revenue rose 3% year-over-year to $3.17 billion. Affiliate and subscription fees were the primary drivers of revenue as the company broadcast the Mayweather/MacGregor pay-per-view boxing match and saw a 27% increase in retransmission revenue as well as growth from new digital initiatives. These revenue streams offset a 22% decline in Content Licensing due to the timing of license sales and a 5% decline in advertising that reflected a tough comparison with 3Q16, which benefited from presidential election advertising. Operating income fell 2% from the prior year to $707 million and the operating margin contracted by 110 basis points to 24%. Adjusted net earnings from continuing operations were flat at $421 million. Adjusted EPS from continuing operations rose 11% to $1.04, reflecting the impact of stock buybacks over the last year. Adjusted results exclude a $47 million or $0.11 one-time tax benefit in 3Q16. GAAP EPS rose to $1.46 from $1.07 in 3Q16. CBS has reclassified its Radio segment as a discontinued operation pending CBS Radio s split-off and merger with Entercom Communications. The net income from discontinued operations was $174 million in 3Q17, compared to net income from discontinued operations of $12 million in 3Q16. On February 2, CBS announced that it had entered into an agreement to split-off its Radio division and subsequently merge CBS Radio into Entercom, a third-party radio station company, in a Reverse Morris Trust transaction. The transaction is expected to be tax-free to CBS and its shareholders, and CBS shareholders are expected control approximately 72% of Entercom shares after the closing. To effect the split-off, CBS has initiated an exchange offer, enabling CBS shareholders to exchange CBS shares for CBS Radio/Entercom shares at a 7% discount per share subject to an upper limit of 5.7466 shares of CBS Radio/ Entercom for each CBS class B share. CBS expects to retire about $1 billion of its stock through the transaction. The exchange offer expires on November 16, 2017. CBS Radio shares will be converted into Entercom shares on completion of the merger. - 11 -
Aside from share retirement, the CBS Radio split-off achieves a number of goals for CBS. Most importantly, it further diversifies CBS s revenue away from the volatile and perhaps secularly declining broadcast advertising market. CBS management expects advertising to decline to 45% of total revenue. We remember when advertising was more than 60% of revenue less than three years ago. Clearly, the Radio division was not a core asset; is in a no-growth sector, i.e. broadcast radio; and has likely been retained only for cash flow. Other large entertainment companies like Disney exited general-interest broadcast radio many years ago. We also think that the tax-free nature of the Entercom transaction was important for CBS. CBS had already saddled CBS Radio with $1.46 billion in incremental debt in October 2016, and then used the proceeds to repurchase stock. The split-off has already received DOJ and FCC approvals. The parties expect to complete the transaction within weeks. EARNINGS & GROWTH ANALYSIS We are lowering our 2017 EPS estimate to $4.25 from $4.39 and our 2018 forecast to $5.07 from $5.13. Our estimates imply 17% EPS growth over the next two years, above our long-term growth rate forecast of 12%. The launch and now expansion of CBS All-Access and other digital streams, as well as the pending split-off of CBS Radio, are just the latest in a series of pivots by the company away from its traditionally cyclical revenue base of advertising, and toward emerging high-margin revenue streams, including retransmission consent and reverse compensation fees, homegrown over-the-top services, and third-party OTT services. We must also mention the company s extraordinarily profitable off-network licensing of hit content both in the U.S. syndication market and overseas. The company will have 200 more episodes available for syndication in 2017, which should significantly boost license fees. These strategic shifts are underpinned by CBS s efforts to create premium hit content and to own more of the programs on its network schedule. CBS already owns 80% of its primetime flagship CBS Network schedule, as well as many of the shows on Showtime. Investors have been mightily concerned about the tectonic shifts in the television/cable ecosystem, as multichannel video program distributors continue to lose subscribers (driven in part by cord-cutting or cord-never millennials); as over-the-top, internet-delivered video proliferates (as seen with the success of Netflix and Hulu); and as video follows the internet in its shift to mobile distribution. We think that CBS correctly recognizes that developing and distributing premium long-form (and more and more short-form) video content gives it a unique advantage whether that content is distributed worldwide on its own or on others broadcast, cable, and digital platforms. CEO Les Moonves remains sanguine, noting that over-the-top distribution will only increase the company s ability to monetize its content as the company gets much better rates from digital distribution than from the traditional cable bundle and that CBS remains a must-have anchor network in just about any skinny channel bundle. CBS itself was one of the first traditional content providers to launch its own wholly owned streaming digital distribution platforms. CBS launched CBS All Access, an OTT broadband-delivered video service for $5.99 per month, on October 16, 2014. All Access subscribers are able to download episodes from current primetime shows one day after their initial broadcast, to live-stream local broadcasts from CBS-owned and affiliated stations in most of the U.S., and to access the CBS library. CBS launched Showtime online for $11.99 per month on July 7, 2015. In August 2016, CBS launched an advertising-free version of All Access for $9.99 per month. CBS scored again in December 2016, when it announced the addition of the NFL to All Access. CBS began to add programming originally produced for CBS All Access earlier this year. The long-awaited premiere of Star Trek Discovery in September provided a nice boost to subscriber sign-ups. Management will continue to roll out original content for All Access and recently announced a reboot of the Twilight Zone. Management has predicted that CBS All Access and Showtime OTT will together have more than 4 million subscribers by the end of 2017. This would bring CBS halfway to its 2020 target of 8 million digital subscribers. CBS also announced that it would begin to roll out CBS All Access in international markets in the first half of 2018 Australia looks to be first up. It will also launch CBS Sports HQ, a digital sports stream, over the next few months. These announcements show that CBS, once considered a staid, value-oriented dividend play, is successfully managing the broadcast/cable television transition to OTT digital channels from traditional cable channel distribution. Moreover, CBS is able to control its own fate with CBS All Access and Showtime OTT, rather than just licensing content to other distributors. These announcements also align with management s multiyear efforts to diversify revenue away from inherently volatile advertising and toward more stable revenue streams like digital subscriber fees. According to CEO Moonves, the company s new digital services target the growing number of broadband subscribers who do not subscribe to a multichannel video programming distributor. This group is said to number about 10 million and is heavily skewed toward millennials, a fairly undefined demographic that presumably includes people in their 20s and early 30s. CBS is deliberately not targeting its cable company distribution partners, who already pay for CBS content. Since CBS launched its service, many other players have jumped into OTT, including HBO; DISH Network, with its Sling TV; Sony; AT&T s DirecTV - 12 -
Now; Hulu; and Google s YouTube TV. Hulu is backed by a host of Hollywood content partners (Disney, Comcast/NBC Universal, Twenty-First Century Fox.) CBS is also a component of almost all of the new OTT services, something that management sees as a means of obtaining even greater distribution. CBS s third-quarter network advertising (excluding political) fell 2% from 3Q16, though management expects a flat performance for the year. CBS reported that its scatter pricing is up in the double digits above its upfront or prebuy pricing. Most new advertising sales are based on the C7 rating, i.e., the audience rating over the first seven days after original broadcast, though deals are also being made for up to 35 days after the original broadcast. These new ratings metrics benefit CBS since ratings inevitably rise over time; CBS has even boasted about a 53% increase in ratings from day 2 to 35. In the Content Licensing and Distribution segment, revenue fell 22% year-over-year in 3Q17 due to the timing of sales. The fourth quarter will benefit from the sale of Madam Secretary. We think that CBS is also well positioned to replenish the content licensing pipeline given its strong ownership position across network schedules. Affiliate and Subscription fees rose 52% in 3Q17, driven by pay-per-view boxing and a 27% increase in retransmission and reverse compensation fees, along with subscription growth both at CBS All Access/Showtime OTT and at third-party OTT distributors. CBS will be renegotiating retransmission agreements on 20% of its cable affiliate base and affiliate fee agreements on 10% of its TV station affiliate base in 2018. Management has outlined $3.75 billion in incremental revenue growth opportunities through 2020, implying a compound annual growth rate of 5%. Of course, the new revenue would be incremental to the company s primary growth driver, network and local advertising. The first pillar of growth would be an incremental $1.7 billion in revenue from retransmission and reverse compensation payments; CBS has already grown retrans and reverse comp revenue to $1 billion, up from just $150 million in 2010. Management expects another $800 million in revenue to come from the expansion of the company s two primary OTT platforms, CBS All Access and Showtime OTT. CBS projects approximately 4 million subscribers for each of these services in 2020. We have viewed this number as conservative and management now agrees. It expects another $800 million in incremental revenue to come from the International business, including the licensing of CBS programming. While CBS has traditionally licensed shows piecemeal in overseas markets, it has begun to do output deals for its Showtime programming, with the goal of building the Showtime brand outside the U.S. Such deals, together with growing international OTT and streaming services, should provide a solid framework for international licensing through 2020. Finally, management expects $450 million in incremental revenue from the exploitation of new skinny bundles in the U.S., perhaps including out-of-home rights to CBS programming. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating for CBS is Medium, the midpoint on our five-point scale. CBS levered up in 2015, taking advantage of low interest rates. Debt/total capital was 76% at the end of 3Q17, up from 51% at the end of 2014, though the increase in the debt/cap ratio also reflects a significant decline in shareholders equity (due to share retirement). The CBS Radio debt will, of course, be spun out with that segment in 2017, which should return CBS to more normal parameters. Adjusted OIBDA covered interest expense by a factor of 6.6 in 3Q17, down from 7.5 in 2016. The ratings agencies rate the company s debt in the high B s, investment-grade and two notches above junk; outlooks are stable. CBS s quarterly dividend is $0.18 per share, or $0.72 annually, for a yield of about 1.3%. The dividend has grown at a five-year compound annual rate of 19%. Like many companies that focused on cash-conservation during the recession, CBS slashed its quarterly dividend, to $0.05 from $0.27, in 2009. However, in May 2011, it doubled the payout back to $0.10. It announced a further 20% increase, to $0.12 per share, in June 2012; a 25% increase, to $0.15 per share, in August 2014; and a 20% increase in July 2016. Our dividend estimates are $0.72 for both 2017 and 2018. The dividend yield remains below the average for the company s integrated media peers. CBS also has a robust share repurchase plan. It repurchased $1.1 billion of its common stock in the first nine months of 2017 and expects to retire another $1 billion in common stock with the Radio division split-off. The share count fell by 40 million shares or 9% year-over-year in 3Q17. MANAGEMENT & RISKS The advertising market s extreme sensitivity to the economic cycle is a major risk for CBS. Advertising still accounts for about 45% of revenue even though management has worked to diversify away from the volatile advertising sector with deals like the America Outdoors split-off, the impending CBS Radio split-off, and the start-up of new direct-to-consumer digital distribution streams. The company also faces the usual entertainment-industry risks, including the hit-or-miss nature of creative programming. In addition, the company faces regulatory risk on a number of fronts, including indecency and media-ownership regulations; however, we believe that regulatory risk has diminished under the new administration in Washington. - 13 -
Broadcast television s share of the media audience has been in a long-term secular decline. Further, the process of media audience fragmentation continues, with the internet, in particular, gaining ground against traditional media platforms. Even within television itself, audiences are fragmenting, as cable channels have proliferated, DVR use remains high, and streaming services become more popular. Mitigating this risk is the critical need of many large advertisers to reach a mass audience that only a network like CBS can deliver. Add to this the fact that sports broadcast rights for almost all the major leagues are wrapped up in long-term network agreements, a critical issue since sports are generally not DVR-time-shifted; this makes the advertising more valuable to networks like CBS in its contracts with the NFL and NCAA. Chairman Emeritus Sumner Redstone still holds the ultimate reins over CBS through his controlling interest in the company. That said, we think that Chairman and CEO Les Moonves runs his own show with minimal interference, and note that he is under contract through June 2019. At 91 and in reportedly bad health, Mr. Redstone s age makes succession a vital issue for CBS, and litigation related to this issue is an obvious source of headline risk. Although Viacom and CBS are separate entities, Mr. Redstone, through his National Amusements Inc. (NAI) investment vehicle, remains the controlling shareholder of both companies. This means that for regulatory purposes, the two companies are viewed as one entity. CBS may therefore be prohibited from investing in some entertainment businesses because of conflicts with Viacom. The common-control issue also raises the specter of conflicts of interest for Mr. Redstone and the few other people who are directors of both companies, including Shari Redstone. COMPANY DESCRIPTION CBS is a worldwide media entertainment company. It produces and distributes television and cable programming over its networks, including the flagship CBS broadcast network, owns its own network of local broadcast television stations, and partners with Time Warner in the CW network. The company s businesses and trademarks include the CBS and CW television networks, the Showtime cable network, CBS Television Distribution, and Simon & Schuster. VALUATION Our valuation analysis has several components, including a peer group comparison and an analysis of historical multiples. CBS is down 11.8% year-to-date on a total-return basis, compared to a 17.5% gain for the S&P and a 1.9% gain for the S&P 500 Media Index. The stock s trailing enterprise value/ebitda multiple of 11.5 is below the peer group average of 19.9. The forward EV/EBITDA multiple of 9.4 is 8% above the peer average, above the average premium of 5% over the last two years. We are maintaining our BUY rating on CBS with a target price of $79. On November 13, BUY-rated CBS closed at $55.92, down $0.82. (Joseph Bonner, CFA, 11/13/17) - 14 -