Tag Archives: industry

HACK: Too Much Industry Hype, Too Little Fundamental Support

Summary Cyber-security market top line growth doesn’t necessarily translate to profit growth for companies. Most companies are still spending a large portion of gross profit on R&D for new software/hardware solutions and marketing & selling to boost brand recognition and gain market shares. Until the industry consolidates and SG&A costs stabilize, it’s hard for these companies to retain profits. Recommendation: Sell Although the cybersecurity market is expected to grow at a phenomenal rate, in my opinion it doesn’t necessarily translate to profit growth for companies. Since cybersecurity is a relatively new industry, most companies are still spending a large portion of gross profit on R&D for new software/hardware solutions and marketing & selling to boost brand recognition and gain market shares, resulting in negative bottom line for most companies. Choppy as the cash flow from operation (CFO) growth is, most cybersecurity companies have positive operating cash flow and incur little CapEx. Going forward, keeping up with hacker’s technology requires constant R&D spending on upgrading and updating technology, and large marketing & selling expense to compete for market shares remains a headwind for these companies in this highly fragmented market. Until the industry consolidates and SG&A costs stabilize, it’s hard for these companies to retain profits. ETF Info Price 27.16 52 Wk H 33.91 52 Wk L 18.29 30D Avg Volume 396,270 Market Cap 1,114,917,969 Shares Out 41.05 Return YTD 3.66% Excess Return YTD -1.97% Tracking Error 1.70 Inception Date 11/12/2014 Expense Ratio 0.75% ETF Summary The PureFunds ISE Cyber Security™ ETF (NYSEARCA: HACK ) tracks the price and yield performance of the ISE Cyber Security™ Index, which includes companies or ADRs that are hardware/software developers for cyber security (“Infrastructure Providers”) or non-development service providers (“Service Providers”). The ISE Cyber Security index assigns weights to companies according to category (“Infrastructure providers”/”service providers”) and then is adjusted according to liquidity and market cap. For more information, you can refer to the PureFunds website . Companies Updates When looking at financial statements of the holding companies, other than 6 companies that had negative sales growth for the past year (~-5%), 26 companies had 10%+ sales growth with on average 70% gross margin. A large chunk of gross profit goes to R&D and Selling & Marketing expenses, resulting in negative profit margin for some of the companies. The gap between sales growth and net income growth is largely attributable to SG&A spending. Most of these companies don’t incur much CAPEX and have positive free cash flow when adding back non-cash charges (mostly stock-based compensation and debt amortization). However, the stock-based compensation is a meaningful real expense and will likely to continue due to continuous talent acquisitions. Operating cash flow growths are choppy and unpredictable. These companies have a median forward PE of 22.7x and average forward PE of 40x (vs. S&P 500 average 18.7x forward PE). Among the top 10 holdings, 5 are experiencing fast sales growth for the past several years, 4 have stagnant growth, and 1 had negative growth (shown later in this article). MIN MAX MEDIAN AVERAGE S&P 500 Sales growth (%, FY) -23.2 163.5 8.2 16.1 Net Income growth (%, FY) -2620.1 1865.2 -11.4 -70.9 EBITDA growth (%, FY) -230.5 123.6 5.2 -14.5 CFO growth (%, FY) -122.4 302.8 3.7 21.3 FY Gross margin 9% 95% 76% 67% FY EBITDA margin (adj) -89% 62% 11% 8% FY Operating margin -111% 56% 9% 4% FY Net margin -112% 44% 5% -1% FY CFO/sales -31% 59% 19% 18% FY FCF/sales -47% 56% 14% 14% FY capex -3879.7 -1.4 -14.5 -244.8 FY FCF/capex -2.9 60.7 4.4 8.0 PE(forward) 13.7 312.1 22.7 40.4 18.7 PB 0.9 38.8 5.1 7.5 2.8 *data gathered from yahoo finance and Bloomberg, compiled by author Looking at the table above, the median sales growth is 8%, meaning more than 50% of these companies are doing fine on the top-line. However, median net profit growth is negative, meaning profits for more than 50% of the companies are shrinking. Would you buy into an industry where profits for companies are stagnant or shrinking? Probably not. What worsens the situation is the assigned weights. This ETF is almost as if it’s assigning equal weight to all the companies – the largest holding is 4% and the smallest is

Connecticut Water Service – A Stable Business With A Twist

Summary The company is primarily a water utility business. While the utility business is highly profitable, the return on equity is capped at around 10%. The Services and Rentals could generate significant value in the future. Connecticut Water Service (NASDAQ: CTWS ) is a utility company that focuses on water distribution. As a water utility company, the company does not have to worry about commodity fluctuations, unlike a natural gas utility company . Unfortunately, the company was not able to escape the pessimism in the market. Despite on the way to post another year of growth, the stock barely budged in 2015, fluctuating around $36. In the chart above, we can see that over the long-term, the stock tracks the company’s top-line growth. This makes a lot of sense because the company primarily runs a regulated business, so margins will be fairly consistent from year to year. More recently, the company seems to have benefited from economy of scale, as the operating margin climbed along with the growth in revenue. For any other company, this track record would suggest an extremely well-run business with the potential to generate a lot of profit. Unfortunately for investors (and fortunately for citizens), the utility business is regulated for this exact reason. The company’s two main water subsidiaries in Connecticut and Maine have a rate cap (return on equity) of 9.75% and 9.5%, respectively As you can see, ROE has fluctuated around the 10%, reflecting this cap. What this means is that the maximum growth equity investors can expect from the company’s regulated business over the long-run is around 10%. Because the company provides a critical service, I have no doubt that the company will achieve this rate of return over the long term. Of course, the company can try to apply for rate increases, but I wouldn’t count them since there is no way to know in advance whether they will be approved. While most of the revenue comes from the regulated water utility business (~90%), the company does have some non-regulated operations. On the non-regulated side, the main segment is Services and Rentals. The segment’s operation is quite diverse, ranging from typical repairs to providing emergency drinking water. While small, the company is highly profitable. Year to date, the segment’s net profit margin was 24%. This is pretty much on par with the margin of the water business (25%)! However, it would seem that the management has trouble growing it. Quarter on quarter, revenue only increased by 5%. That being said, the segment could generate significant value if the management figures out a way to scale it. While I am not seeing any promises right now, it nevertheless has good option value, after all, the segment’s services do go hand in hand with the water business. Conclusion If you are satisfied with the rate of return (~10%) over the long-term, then I think Connecticut Water Service represents a good opportunity. Due to the nature of water utility (a critical service), the company should be able to reach the rate cap over the long-run. While the non-regulated side of the business is still small, I believe that once the management finds a way to convince more water business customers to use the company’s maintenance services, there could be significant upside. Overall, I believe that the company will continue to deliver stable profits from its water business, and the non-regulated activities are an added bonus for investors.

Heading Into Winter, Propane Sales Look To Repeat 2014 Results

Summary Propane distributors like Suburban Propane and AmeriGas Partners count on the next few months for substantially all their income. With propane supply near all-time highs, wholesale prices have fallen through the floor. Consumers look to benefit this year, but pricing spreads indicate a repeat of 2014 results. The early indicative data for propane distributors such as Suburban Propane (NYSE: SPH ) and AmeriGas Partners (NYSE: APU ) is a mixed bag heading into the incredibly important winter season. This period running from November-March of each year is an incredibly stressful time for these propane distributors, who derive substantially all of their operating income during the winter heating season. The first hurdle for these companies is the weather. The chance of a deep winter chill currently looks decent for some areas of the United States and mediocre for the rest . Most meteorologists forecast above average temperatures for the Northeast, with below average temperatures for much of the Southeast and East Coast. As the South and Midwest form the largest markets for propane, these forecasts end up being a mixed bag and are hard to call as solidly favorable in one direction or another. (click to enlarge) * Source: EIA.gov From a market perspective, available supply of propane continues to peak well above long-term historical averages, due to the significant bounce in production of the commodity from ever-increasing domestic production. Shortages that were widespread in many markets in 2014 seem unlikely to repeat themselves this time around. This excessive supply has brought wholesale and residential propane prices down, yielding what should be solidly lower prices going into this year’s heating season for consumers. This is a bright spot for those that count on propane to heat their homes, but what does it mean for propane distributors? Fixed Margin Pressures Usually, low propane prices provide a boost for propane distributors like Suburban Propane and AmeriGas Partners. All else equal, low propane costs increase the demand for their products and protects against customers switching to alternatives, such as heating oil or electricity. With propane and other alternative heating fuels more commonly used among rural homes with lower annual incomes, these consumers are much more cost sensitive to price changes than the heating markets served by traditional utilities. Propane distributors, while keeping that fact in mind, still try to maintain a fixed spread between the wholesale and residential cost of propane. This is where they can derive their profit, and we can see the results of that in a comparison from 2014 to 2015 below. (click to enlarge) Trying to protect this fixed margin per gallon is why we see the current market situation in propane today with resiliently high residential propane prices. While wholesale propane prices are down 46% from a year ago according to EIA data, skirting along at $0.50/gallon in 2015 from $0.93 gallon in 2014. Residential prices have remained stubbornly high in the meantime, and are only down 19% year/year. In my opinion, wholesale prices in the U.S. cannot fall much further, so this year will be as good as it can get for propane consumers. At these prices, it is barely worth it for producers to ship, store, and market it for sale. Look for propane exports to increase, as unlike natural gas, propane is more easily shipped abroad for sale, and these price declines make exporting increasingly attractive. (click to enlarge) Heating oil, a chief competitor of propane, looks more profitable going into the winter of 2015/2016. The profit spread is up, but heating oil is primarily used in the Northeast , where it heats nearly 30% of all households. If we remember our 2015 weather forecast data, this area is at this point expected to be a little warmer than usual. The demand may not simply be there for the product compared to 2014. Conclusion With margin spreads down and supply up, propane producers are counting on a chilly winter to drive some additional demand to make up the difference. Without old man winter swirling up some unexpected cold, investors should expect operating income flat to slightly down from 2014 levels. Suburban Propane has the most opportunity for surprise earnings upside over 2014 due to its heating oil exposure, but only if the Northeast comes in much colder than expected. Heating oil is set up to be better currently year/year, and with supply running at long-term averages, a cold shock in the Northeast could drive significant demand for the company.