This is a big week for the economy and market. Major events included the release of the U.S. GDP growth rate, unemployment rate and interest rate. The U.S. economy expanded 3% in the third quarter of 2017 beating the market expectation of 2.5%. The expansion was driven by Personal Consumption Expenditure (+2.4%), which was primarily driven by the spending in durable goods, offsetting a slowdown in non-durable goods and services. Exports rose 2.3% (3.5% in Q2) while imports slowed to 0.8% growth.
The Fed interest rate stayed unchanged with the target rate remaining at 1% to 1.25%, but the rate is expected to rise in December. The unemployment rate was down to 4.2% with the private sector hiring 235,000 workers in October.
In the U.K., the Bank of England raised its interest rate by 25 bps to 0.5%, its first rate hike in a decade as the inflation rate stood above 2% for eight straight months.
As the fundamentals stay bullish on the housing market, we see more consolidation in the housing construction market. This week, Lennar Corp. agreed to buy CalAtlantic Group for $5.7 billion. The acquisition will create the nation’s largest homebuilder by revenue of $17.4 billion. The consolidation in the housing market by the large players will increase pricing pressure on the smaller ones, including Toll Brothers (TOL), which is ranked sixth in our portfolio. Toll has $5.2 billion in revenue, and could witness some pricing pressure due to such events. However, as reported in our last update, continued seasonally-adjusted growth in the sale of single-family houses (667,000) and previously-owned houses (5.39 million) is good news for home construction companies. At the same time, the S&P Case-Shiller composite home price index rose 5.9% year over year, nearing its all-time high of 206.52 reached at the peak of the housing bubble in July 2006.
Many companies reported earnings this week, including many of our recommendations. In this week’s update, I update my position on Biogen (BIIB), EQT Midstream (EQM), LKQ Corporation (LKQ), T. Rowe Price Group (TROW), Alphabet (GOOG), Gilead Sciences (GILD), Alliance Resource Partners (ARLP) and Stifel Financial Corp. (SF).
Biogen (BIIB)
BIIB reported quarterly revenue growth of 13% to $3 billion excluding Hemophilia, which was spun off last year, with a diluted EPS of $5.79, a 23% increase over the prior year. Biogen partnered with Elsai to jointly develop and commercialize Aducanumab, an Amyloid-related immunotherapy drug for Alzheimer’s disease which is in Phase 3 trials. Multiple Sclerosis sales stood at $2.3 billion, with $1 billion revenue contributed by oral MS prescription drug TECFIDERA. Under Spinal Muscular Atrophy, SPINRAZA enjoyed robust growth to $271 million, led by its launch in global markets. Biogen also recorded healthy growth in Biosimilar products from $31 million in Q3 2016 to $101 million in Q3 2017. Sales of Biogen’s MS drugs, TECFIDERA and Tysabri, seem to have plateaued with hopes remaining on the FDA approval of Aducanumab. In the near future, there is still room for growth for SPINRAZA with expected annual sales of $1.5 to $2 billion. There seems to have been no immediate impact on the top line from Biogen’s Parkinson’s and other neuroimmunology/neuromuscular disorder drugs, which are in phase 1 and phase 2 trials. Although Biogen looks cheap compared to its historical price-to-earnings ratios, there is a fear that market will value it at a lower price-to-earnings ratio due to less promising growth expectations. SELL A PORTION.
EQM (EQT Midstream Partners)
EQT Midstream Partner reported a third-quarter EBITDA of $170 million, with a distributable cash flow of $150 million. $0.98 per share of cash distribution was announced, a 20% jump from Q3 2016. However, the distribution growth of EQT GP Holding (EQGP), which holds around 30% in the total partnership interest, increased to 38%. Although EQM and EQGP look attractive with reasonable credit rating and high return on invested capital, I’m worried about the ongoing support from their parent EQT Corporation (EQT), which is likely to take over Rice Energy (RICE) by the end of this year. Downward pressure on natural gas prices would likely affect the credit quality of EQT (and RICE), at which stage the pricing pressure from EQM’s parent will push the margins of EQM lower. On paper, this is not likely to happen because most of the revenue is from capacity reservation charges from long-term contracts. However, the terms of the agreements will likely change due to their shared management interests. Its structural complexity as a two-tiered MLP further adds to the uncertainty of making a sound value-based decision. SELL.
LKQ Corporation (LKQ)
LKQ Corporation reported Q3 2017 revenue of $2.4 billion, an 11.7% increase from Q3 2016, driven by 4% organic growth and ongoing acquisitions (+6.5%) especially in Europe, and favorable foreign exchange gains (+1.2%). Income from continued operations increased to $122 million compared to $110 million in Q3 2016. Expansion in North America seems to have saturated, while there is sufficient room for top-line growth in Europe. I forsee overall profit margin pressure as growth is driven by relatively less profitable business in Europe than in North America. The current valuation would not be justified unless the EPS growth stays at around 18%, which is doubtful based on its recent trend. SELL A PORTION.
T. Rowe Price Group (TROW)
TROW reported net revenue of $1.2 billion, an increase of 11.8%, with a net profit of $390 million, an increase of 19.2% from the Q3 2016. The average assets under management (AUM) increased 15.4% to $927.4 billion. In the past three months, the company received an inflow of $6.5 billion to its bonds, money market and stable value accounts, while a $600 million flowed from its stock accounts. The net inflow of $5.9 billion was the highest inflow since the first quarter of 2014. However, the capital appreciation in equity portfolios seems to have boosted the total AUM. Blackrock (BLK) seems to be sucking most of the money from the market led by its passive funds, leading to stiff competition for mutual fund managers like TROW to attract capital and fees. HOLD.
Alphabet (GOOG)
Alphabet reported third-quarter revenue of $27.8 billion, up 24% from last year. Operating income was up 35% to $7.8 billion, led by a lower rate of increase in operating expenses of 11%. Cash is at $100.1 billion, with around 60% of it is overseas. Traffic acquisition cost (TAC) was $5.5 billion, up 32% from last year indicating that TAC in high growth mobile advertising is higher than the rest of the advertising platforms. Subscription-based YouTube Red and YouTube TV are seeing rapid growth, further strengthening the profit from other “revenues,” which also include hardware, cloud and play, to $3.4 billion, 40% year-over-year growth. Under advertising revenue of $24 billion (+21%), revenue from Google-owned websites was $19.7 billion (+23%), and $4.3 billion (+16%) from network members. Such a disparity in growth between the advertisement revenue growth in Google-owned websites and network members may indicate increasing competition by other ad services. Should Alphabet’s other bets like Waymo realize, the stock could be highly undervalued, otherwise, it seems fairly valued. Adding the speculative element with the expected growth in Asia-Pacific and the Americas, GOOG appears undervalued. HOLD.
Gilead Sciences (GILD)
Yescarta is approved in the U.S. for adult patients with lymphoma and Solvadi. Gilead’s HCV drug is approved in China, where 10 million people are estimated to be living with HCV. Quarterly revenue is down 13% from $7.5 billion to $6.5 billion year-over-year, while diluted EPS is down 17% from $2.75 per share to $2.27 per share. This is primarily due to a 34% year-over-year fall in revenue in HCV sales. TAF containing HIV drugs, Genvoya, Odefsey and Descovy have had good growth of 14% to $1.6 billion of the total $3.6 billion in HIV Sales. There is still room for growth in the HIV category as HIV diagnosis improves, but the stiff competition in HCV space will add pressure to Gilead unless the decline in the HCV drug sales is offset by growth in Kite Pharma’s Yescarta, or from Galapagos’s filgotinib if Gilead successfully acquires Galapagos. HOLD.
Alliance Resource Partners (ARLP)
Total revenue was down 17.9% year-over-year to $453.2 million, due to adverse geological conditions encountered at the Hamilton mine, leading to a 9.1% decline in the average price to $45.12 per ton and a 31.8% decline in net income to $61.3. Year-over-year cash distribution increased 15.4% to $0.505 per unit. Potential from export revenue, particularly to India and Europe, could improve the top line in the long run. Note that ARLP pays a dividend yielding close to 10% with good distribution coverage. HOLD.
Stifel Financial (SF)
Net revenue increased 12% year-over-year to $721 million, driven by investment banking and asset management fees which were partially offset by a reduction in brokerage fees. Net interest income almost doubled to $100 million, driven by higher net interest margin. Stifel, with its strong book value growth, stays attractive even at reasonable growth expectations. HOLD.
