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Growth Drivers

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John W. Ransom
Raymond James

Earlier this week [in mid-August], we hosted meetings with management of CVS Caremark (CVS). We highlight the following key takeaways:

Reform is likely to drive retail prescription (or Rx) volume; mail-order growth could be challenged: As the implementation of the Affordable Care Act drives increased health-care utilization among the newly-insured population, prescription drug volumes are expected to rise accordingly.

Since government programs (Medicare, Medicaid) do not permit mandatory mail order requirements, management expects the vast majority of the initial incremental dispensing volume will flow through retail pharmacy channels. Notably, current mail order penetration rates among existing Medicaid and Medicare Part D subscribers remains very low, estimated to be less than 5%.

Taking a conservative approach to international expansion, first “test” market in Brazil: Regarding international growth opportunities, management maintains a cautious approach toward expansion opportunities, targeting only markets that meet specific criteria.

For example, markets must support chain drug stores, must have similar characteristics to the U.S. market in terms of brand/generic dispensing and margin profiles, and must not have been consolidated or dominated by a single player.

After careful evaluation, CVS entered Brazil as a “test” market, with 45 stores currently in operation and a goal to grow the footprint to approximately 1,000 locations; management targets a No. 1 or No. 2 market position vs. the current market leader’s 9-10% share (about 900 stores). Following this disciplined approach, management believes the company could sell/exit the market fairly easily if the investment does not develop as planned.

In terms of future expansion, China remains an attractive market, though current government regulatory issues present a challenge; assuming the market evolves toward more retail Rx distribution (vs. current hospital-based fulfillment), CVS could pursue a joint venture with a local company. Interestingly, management indicated that the U.K. was never viewed as a particularly attractive opportunity; likewise, Canada has become overly concentrated (following the recent Loblaw transaction) with an unfavorable growth profile.

Zacks Investment Research

Based on a strong selling season, CVS is perfectly on track to continue positive growth performance for its pharmacy benefits management (or PBM) franchise through 2013. Apart from that, CVS is also focusing on the 2014 selling season.

Gross new wins for 2014 amounts to $4.4 billion while net new business wins are expected to be $1.7 billion. We are impressed to note that the recent client wins include major Fortune 100 companies, as well as regional health plans in both the commercial and Medicare or Medicaid segments.

CVS also recorded strong claims growth on the back of new client wins and higher membership. Further, in February 2013, CVS extended its Pharmacy Advisor program to cover five additional chronic conditions, namely asthma, depression, osteoporosis, breast cancer and chronic obstructive pulmonary disease. Prior to the extension, the company’s Pharmacy Advisor was directed at diabetes and cardiovascular conditions.

CVS expects to enroll over 900 clients representing 16 million lives in 2013. Moreover, management is progressing well to attain annual savings run rate of $225million to $275 million in 2014 from its PBM streamlining initiative. Specialty pharmacy represents another high-growth avenue.

The soaring demand for specialty pharmacy, especially in the ongoing decade, is likely to accelerate growth for the company. Specialty revenue rose roughly 19% in the second quarter. In fact, CVS expects to cross the $20 billion sales mark on the back of specialty revenue.

Moving forward, management expects drug price inflation, new product launch, higher utilization and new PBM clients to fuel growth. We expect the segment to serve as a stable growth platform going forward.

Christopher R. Growe
Stifel, Nicolaus & Company

Kraft Foods Group (KRFT) reported its 3Q13 EPS of $0.65 (-17%) which was in line with our estimate and $0.04 below the consensus estimate. This quarter’s earnings includes $50 million in one-time costs burdening the earnings (-$0.05 in EPS terms), a $43 million drag on profits from less commodity hedging gain here in 3Q13 (-$0.05 in EPS terms), and a lower than expected tax rate (+$0.03 in EPS terms).

The company reiterated its base business guidance for 2013 EPS of $2.78 (excluding the large pension mark-to-market benefit, but including the 33 cents of one-time charges), $1.2 billion in free cash flow (in line with its guidance last quarter, but up 20% from its initial guidance for 2013), and revenue growth to be in line with or slightly below the growth of the North American food/beverage market. So, while this quarter was below our expectations on a sales and operating-profit basis, the fourth-quarter trends are expected to pick up nicely while benefiting from easier comparisons as well.

The company’s guidance for the year implies EPS guidance for 4Q13 of $0.60 for the quarter predicated on underlying growth well ahead of the North American food/beverage market and up significantly against the easy comparison in the prior year. Restructuring charges trailed our estimate in the third quarter, which should provide a larger drag on fourth quarter earnings as our full year estimate of $325 million in restructuring costs remains in place.

We continue with our Buy rating and $60 target price. This quarter was burdened by a difficult volume comparison, a high level of restructuring charges, and modest revenue growth after adjusting for the unique factors affecting the quarter.

We continue to believe the productivity program will be a significant contributor to earnings and margins for the foreseeable future, particularly during a period of light cost inflation, and the improving rate of revenue growth, should support the 8%-type underlying EPS growth we currently estimate for 2014 and beyond.

Our EPS growth estimate should benefit in 2014 from a normalization of its restructuring costs, but also solid underlying growth for the business. We believe Kraft will continue to showcase a consistency to its growth over the next several years that investors will begin to appreciate. In addition, the nearly 4% dividend yield provides solid downside support for the shares even in a rising interest rate environment, in our opinion.

Ghansham Panjabi, Ph.D.
R.W. Baird
[email protected]

RPM International Inc. (RPM) is a specialty coatings player with exposure to the high-end commercial roofing, flooring and sealant markets While we remain Neutral-rated on the shares ($40 price target), RPM’s new product execution and share gains in consumer and quick turnaround in industrial are encouraging, though sustainability remains uncertain, in our view. Our $40 price target is based on 11.5 times fiscal year ‘14 estimated [ratio of] enterprise value to earnings before interest, tax, depreciation and amortization.

Consolidated revenue for RPM International increased 11.0% during [the quarter ended August 2013] as growth in consumer sales (+26.2%, including acquisitions) was compounded by improving industrial demand (+3.5%). The consumer group benefited from share gains during the quarter, while industrial demand improved due to continued improvement in the North American (NA) commercial construction market and an earlier than expected turnaround for the company’s Europe and NA roofing businesses. Overall organic sales were up 5.1% during [the recent quarter], while M&A contributed positively (+6.2%) and foreign exchange was unfavorable (-0.3%). Meanwhile, on an adjusted basis, overall profitability increased 80 basis points to 14.1% EBIT margins.

On an operating segment basis, RPM‘s industrial segment (65% of FY13 sales) reported a year-over-year improvement (sales up 3.5%), as volumes contributed positively during the quarter (up about 2.5% year over year) for the first time since the second fiscal quarter of 2013. Industrial volumes improved in the first fiscal quarter of 2014 as a result of a modest increase in NA roofing, Europe and commercial construction demand (sealants/flooring/corrosion-control coatings).

RPM’s consumer segment (35% of FY13 sales) reported robust year-over-year sales growth (+26.2 %) primarily as a result of positive contributions from M&A (+17.4%). The company received positive contributions from its acquisitions of Synta and Kirker during FY12. Moreover, organic sales were up 9.1% as the company reported improved volumes (+8.0%) and pricing (+1.1%) year over year. New product introductions and improved U.S. housing turnover drove growth, with trends expected to persist throughout FY14.

As for profitability, operating margins increased 200 basis points year over year, to 19.1%, as higher volumes and pricing more than offset higher raw material costs. In order to “rightsize” the company’s geographic footprint, RPM previously announced the closure of two plants (Rockford, Illi./Roosendaal, The Netherlands), the latter of which is to offset weak demand for Rust-Oleum in Europe.

Finally, as for the outlook, FY14 EPS guidance was increased to $2.00-$2.07, which brackets the Street at $2.05 (from $1.98-$2.05 previously), and is predicated upon continued momentum in consumer and an earlier-than-expected improvement in NA roofing/Europe. Moreover, the company expects sales to increase 5-7% during FY14, with consumer sales performing above the higher end of the range (+6-8%), while Industrial trending towards the lower end (+4-6%)—highlighting the stable overall sales base driven by two different end-market cycles.

RPM is forecasting flat flattish raw material inflation in FY14, with the company benefiting from lower year-over-year costs for several raw materials. In addition, capital expenditure is expected to be about $95 million during FY14.

David Whiston
[email protected]

In 2010, Toyota Motor formed a new quality committee, which has a chief quality officer from every region. This should improve Toyota’s internal communication and let headquarters be more aware of customer concerns. We think giving local designers more control will let Toyota finally start making more exciting vehicles.

President Akio Toyoda’s vision includes cost efficiencies under its Toyota New Global Architecture, or TNGA, which seeks to develop multiple vehicles at the same time using large amounts of common parts. The first cars from this move are due in 2015 and will first focus on three front-wheel-drive platforms that make up about half of Toyota’s production.

The goal is to streamline engineering and increase product development efficiency by as much as 30%. The company can then reinvest the savings into technology and design.

A big change in the parts side is that the company will use more parts on a global standard as opposed to Toyota-specific standards. The long-term goal is for vehicles that share a platform to have 70%-80% common parts, but the commonality will start at 20%-30%. This efficiency will increase the risk of a major recall should a part be defective, but we think these changes are necessary to keep pace with other major common platform moves under way across the industry.

We are raising our fair value estimate to $130 per share from $126. The change is mostly the result of a lower net investment modeled in our forecast period, which increases free cash flow. Mitigating this factor, we also reduced our assumed operating margin by about 50 basis points on average, because of the yen strengthening since our last report; however, the yen-based fair value reduction from this currency impact to margin is partially offset by the stronger yen translation to our U.S. dollar fair value estimate (we project Toyota’s financials in yen).

We assume a global foreign exchange impact to operating income of Japanese Yen (JPY) 44 billion (about 0.2% of nonfinancial services revenue) for every one-yen change against the dollar and other major currencies.

To translate our yen fair value estimate to U.S. dollars, we now use an exchange rate of JPY 97.28 per $1 instead of JPY 99.57 per $1. We forecast revenue to increase at nearly 8% on a five-year compounded annual growth rate basis and model the operating margin, excluding the finance arm, to average about 9%.

We expect capital expenditures will average about 5% of sales, and we employ a weighted average cost of capital of just over 10% to discount projected cash flows. Although we have provided a single-point estimate for Toyota’s intrinsic value, the firm’s high degree of operating leverage makes our fair value estimate very sensitive to our assumptions. For example, changing our year five operating margin of 8.6% by 1 percentage point, while holding all other assumptions constant, would increase or decrease our fair value estimate by as much as $8. We also model a JPY 486.4 billion payment for what we expect will eventually be a settlement for all lawsuits related to sudden acceleration incidents. This payment only reduces our fair value estimate by $3. We have valued Toyota’s financial services business at book value because the subsidiary has no mortgage exposure, and Toyota is a strong automaker.

Daniel L. Kurnos, CFA
Benchmark Company LLC
[email protected] (FLWS) is a leading retailer in the consumer floral and gift food industry. We believe Flowers has manufactured a number of avenues through which it can achieve better-than-industry average growth.

We think total company sustainable revenue growth could be in the mid- to high-single digits, with upside to our forecast given any recovery in the consumer environment. Furthermore, as Flowers adds complementary brands in the gift food category both organically and through acquisition, we expect scale benefits could drive EBITDA margins higher, potentially eclipsing 10% long-term.

The floral industry is a mature, highly fragmented industry, with sales reaching $34.3 billion in 2012, according to the U.S. Bureau of Economic Analysis (BEA), 36% ahead of the $25.3 billion mark set in 2000, representing a 3% compound annual growth rate.

On a normalized basis, we think Flowers’ unique, organically developed offerings could help drive sustainable long-term consumer floral revenue growth approaching 5% vs. the industry at 1-3%. The success of themed launches including the Happy Hours, a-DOG-able and Vase Expressions collections, highlights Flowers’ ability to bring differentiated product to this highly competitive industry.

Michael Kupinski
Noble Capital Financial Markets
[email protected]

We were actually encouraged by FLWS’s quarterly results, which were largely in-line with our estimates. Revenue and operating cash flow were $123.1 million and a loss of $2.4 million versus our estimates of $123.6 million and a loss of $2.1 million, respectively.

The revenue growth in the quarter was 2.9% from continuing operations, slightly below management’s stated goal of mid-single digit revenue growth, but we anticipate the fiscal second and fourth quarter to more than compensate for the slight deviation. In addition, total company gross margins improved 40 basis points to 41.7%, 80 basis points higher than our 40.9% estimate.

In our view, the company has compelling growth opportunities, in particular in its Gourmet Food and Gift Baskets) businesses in 2014 … In addition, we believe that the company has the ability to enhance margins going forward.

Notably, the company has a pristine balance sheet and generates a significant amount of free cash flow (expected to be roughly $20 million in fiscal 2014). Absent of small, tuck-in acquisitions, we believe that share repurchases are the mostly likely use of its cash.


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