Gavin Graham writes:
The strong performance by global equity markets since the beginning of 2013 seems to indicate that the thesis I put forward in my year-end review is coming to pass.
Readers may recall that I felt that continued money printing (quantitative easing) by central banks worldwide would be reflected in investable assets such as equities, commodities, property, and "hard assets" that would retain their value when eventually the wave of liquidity led to a return of inflation.
Of course, there are those who feel the deflationary circumstances of the last few years will continue for the foreseeable future. But the fact is that what some commentators have called "the Great Rotation" has begun in earnest over the last few months. This is the movement of money out of supposedly safe assets such as developed country government bonds into "riskier" assets. These include corporate and high yield bonds, equities, and assets dependent upon continued economic growth, such as emerging markets and commodities. You can see the proof that this rotation is under way by looking at the cash flows out of fixed-income funds and into equity and balanced products in the U.S., Canada, and the U.K.
Mead Johnson Nutrition (MJN)
Looking for companies that will be beneficiaries of this trend as well as the continued strong growth in the emerging markets' middle class, I would like to recommend Mead Johnson Nutrition. It is a play on one of the strongest and most predictable factors in economic life, namely demography.
Birth rates in some developed countries, notably Japan but also most of continental Europe, have fallen well below the replacement rate of 2.1 children per couple, averaging 1.2 to 1.5 in most of these nations. However, this is emphatically not the case in most emerging markets.
Mead Johnson, one of the largest global manufacturers of infant formula under such well-known brands as Enfamil, Sustagen, and Enfagrow, was spun off from its parent, drug manufacturer Bristol Myers Squibb, in 2009. Since then it has delivered strong and consistent growth in revenues and earnings. This has happened despite occasional hiccups such as over-stocking in its China operations last year, which led to slower revenue growth than anticipated.
Mead Johnson is one of the most global companies listed in North America, selling more than 70 products in 50 countries around the world. Its Enfa range of infant formulas exceeded $3 billion in sales for the first time last year (figures in U.S. currency). More than two-thirds of its $3.9 billion in 2012 revenue was from its Asia/Latin America division ($2.72 billion, up 11% from 2011). Compare that to the 4% decline to $1.18 billion from its North America/Europe division and you can clearly see what impact demographic trends are having on the business.
For the company as a whole, revenues in constant currency terms grew 7%. The increase in Asia/Latin America was 12% against a 3% decline in the more mature markets. While some of that can be attributed to the long-term decline in the birth rate in more developed countries, CEO Stephen Golsby mentioned higher dairy and other commodity costs as factors. This was exacerbated by lower production volumes, partially due to unfounded rumours of contamination at the beginning of the year which took time to recover from.
Operating net earnings per share were up 10% for the year to $3.08. The company forecast a range of $3.22 - $3.30 for 2013, an increase of between 4.7% and 7.2%.
Interestingly, Mead Johnson is experiencing sales growth even in China, where the one child policy has seen the birthrate plummet to well below replacement level. After a fall in sales in the first half of 2012 due to overstocking by wholesalers in China, the company regained market share in the second half and sales grew more than 5% in constant currency terms for the year for China/Hong Kong.
Excluding China, the other Asia/Latin America markets had organic revenue growth in the mid-teens in the fourth quarter of 2012. Including an Argentine acquisition made in March last year, the segment experienced over 20% revenue growth, of which 6% was from price increases.
Even North America/Europe saw sales growth of 4% in the fourth quarter, although this was comprised of a 5% price increase and 1% volume decline. The volume drop was partially due to the termination of several Women, Infants and Children (WIC) contracts with the U.S. government for the provision of Mead Johnson products to less affluent parents.
The combination of strong revenue growth and price insensitive products has made Mead Johnson an attractive investment over the period since its spin-off. With revenue growth for the three years ending Dec. 31 averaging 11.3% annually and net profits and earnings per share growing by more than 14%, the stock price has more than doubled since the spin-off in October 2009 and is up 75% over the last three years.
Due to its stumble in China, however, Mead Johnson sold off sharply last year, and is only 3.5% higher than it was a year ago. This makes it reasonably priced for a growth stock with a p/e ratio of 25 times 2012 earnings and 21 times 2013 forecast earnings.
Generating over $200 million of free cash flow each year, Mead Johnson has paid down $500 million of the $2 billion in debt it inherited from Bristol Myers four years ago. The stock pays a modest dividend of $1.20 per share, equivalent to a 1.6% yield. However, it is worth noting that the dividend has increased by 70% since 2009.
Action now: Mead Johnson is a Buy for its exposure to the fast-growing emerging markets' middle class, its ability to raise prices for its products even in a deflationary environment, and for its strong cash generation. The stock closed on Friday at $77.51.
WestJet (TSX: WJA)
Originally recommended on Aug. 27/12 (#21230) at $16.92. Closed Friday at $21.39.
Everything that could go right did go right for discount Canadian airline WestJet, which I recommended less than six months ago at $16.92. The company announced another set of excellent results for its fourth quarter and for 2012 as a whole. Net earnings were $60.9 million ($0.46 per share), up 76.9% on a per share basis from the same quarter the previous year.
For the year as a whole, the airline earned $242.2 million ($1.78 per share), an improvement of 67.9% on an EPS basis from 2011. Total revenue was $3.43 billion, up 11.6%. The load factor (percentage of available seats occupied) rose 3.1 points to 82.8% and the yield (revenue per revenue passenger mile) increased 3.2% to $0.1877. Revenue per available seat mile rose 7.1%. That was better than the 4.4% increase in costs per available seat mile. WestJet expects this measure to increase 2% - 3% again this year.
With the introduction of premium seating at the front of the plane and by exit rows, the launch of WestJet Encore, their feeder service from smaller towns, and its transformation of four interline agreements with Delta, British Airways, Korean Air, and China Eastern to codeshares, West Jet has plenty of factors to drive its earnings higher this year. It raised its dividend 40% to $0.10 a quarter, equivalent to a 1.9% yield, as a sign of confidence.
However, with airlines, even well-run ones like WestJet and Southwest, the time to sell them is when everything looks rosy. So many factors over which management has no control can affect this business: weather, fuel costs, aircraft recalls (as with the Boeing Dreamliner), or a downturn in the economy affecting the number of people flying and the price they're willing to pay. So it would foolish not to take a good profit when it's available.
As the old maxim goes, airlines are made to be bought and sold, not held. With a gain of 26.4% plus a couple of $0.07 dividends since the recommendation, it's time to take our profits on this one. Incidentally, BMO Nesbitt Burns analyst Fadi Chamoun downgraded the stock to market perform on a higher price/earnings ratio of 13.5 times 2012 earnings and increased operational risks from its capacity expansion of 7.5% - 8.5% this year, half a point higher than previously forecast by the company. However, he remains positive over the long term with a $24 target price.
Action now: Sell WestJet at $21.39 for a total return of 27.2% in less than six months.
- end Gavin Graham