The Fed's Balancing Act
In September, the Federal Reserve lowered interest rates for the first time in four years in recognition of the progress made in reducing inflation. The half of one percent cut was larger than anticipated, leading many investors to wonder: Where is the Fed taking rates and how fast will it get there?
A little over a year ago, core inflation (which excludes food and energy) was around 4%, double its “2%” target. The Fed raised interest rates to a 20-year high to tamp down economic activity to lower inflation, although hopefully not by an amount that would trigger a recession.
With demand moderating and supply chain issues resolved, businesses could no longer increase prices at will; and the labor market cooled down. By August, core inflation fell to an estimated 2.7% while the unemployment rate increased from 3.5% to 4.2%. Private-sector job growth slowed to half the pace of a year earlier. These considerations gave the Fed the impetus to lower rates by half of one percent – or 50 basis points.
It is difficult to say at this juncture whether a recession has been forestalled. Economists have been sensitive to any clues that a recession is in store after two years of higher interest rates. Prior to the rate cut, the average interest rate on credit cards was 21.5%, up from around 15% in 2019. According to the August report from the Federal Reserve Bank of New York, around 9% of credit card balances are delinquent, the highest rate in over a decade.
Parallel to the rise in delinquent accounts, some banks are writing off credit card balances at a higher rate, having determined that some borrowers are unlikely to pay them off. Synchrony Financial reported it is seeing higher charge-off rates than before the pandemic.
Such economic data is of concern, but on the plus side the economy is less rate sensitive than in prior cycles as a lot of private sector debt is now fixed at lower rates for longer periods, both for large enterprises and mortgages.
Economic signals are often mixed, and investors should be careful about reading too much into historical examples, such as the predictive ability of inverted yield curves or over emphasizing selective points of economic data. Even the Fed’s own guidance is an unreliable indicator as to what it will do. Just this year its median rate forecast has varied from forecasting three (normal quarter-point) rate cuts by the end of 2024, to one three months ago, and now back up to four, including last week’s cut.
The Fed’s balancing act for the immediate time frame has paid off; the recession did not materialize as the forces that drove inflation so high in the first place began to unwind.
Given the number of inflationary pressures at work – such as a spendthrift fiscal policy, higher trade barriers, tighter immigration, labor strikes, deglobalization and an ageing population – it will be challenging for the Fed to manage inflation. Trying to anticipate and / or act on the direction of interest rates or market volatility can lead to disappointing results, which is why Delta Asset Management focuses on the fundamentals of individual companies. We continue to believe the best investment stance is an actively managed diversified portfolio invested with a long-term outlook that reflects an investor’s risk tolerance.
Company Comments
Comments follow regarding common stocks of interest to clients with stock portfolios managed by Delta Asset Management. This commentary is not a recommendation to purchase or sell but a summary of Delta’s review during the quarter.
Adobe is one of the most diversified software companies in the world, with solutions that span from digital media to digital design experience. Based on San Jose, CA, Adobe’s products are organized into primarily two segments: the flagship Digital Media segment, which comprises over 70% of the revenue and includes the Creative Cloud and Document Cloud business with applications such as Acrobat, Flash Player and Photoshop ; and the Digital Experience segment, which includes the legacy web analytics business.
Founded in 1982, the company’s products are used by content creators, game developers, graphic and experience designers, photographers and video editors from businesses of all sizes. Its products and services are marketed directly to enterprise customers through its sales force and local field offices.
Adobe licenses its products to end users through its own app and website, using term subscription and pay-per-use models. In fact, nearly all of its products are now sold through a
subscription software model where customers purchase access to a product for a specific period of time during which they have the right to use the most recent version. The company automatically provides updates and enhancements when available. Benefits of Adobe’s subscription model include improved revenue visibility, the elimination of piracy and a much lower cost to provide the service.
Nearly all of Adobe’s products are now sold through a subscription software model where customers purchase access to a product for a specific period of time during which they have the right to use the most recent version. Benefits of the subscription model include improved revenue visibility, the elimination of piracy and a much lower cost to provide the service.
Some of the company’s first products – Acrobat and the well-known portable document format (PDF) file standard created by the company – are now a $2 billion business. The ascent of smartphones and tablets combined with flexible and mobile work arrangements have made these flexible use products more relevant than ever. Adobe believes the addressable market for Document Cloud is greater than $200 billion.
Another iconic product – Photoshop, introduced in 1989 – has quickly become the industry standard for image editing software. Adobe has consistently upgraded the product by introducing new features and adding applications. Such products benefit from a network effect. By virtue of widespread adoption, users have a significant incentive to become well versed and invested in the software. Photoshop has become such a standard in the creative world that major university design programs incorporate Adobe’s Creative Cloud applications into their curriculum.
The debut of the Firefly product in 2023 introduces artificial intelligence (AI) solutions that should attract new users. Adobe is able to increase prices as it adds AI solutions to its suite of products and expands cross-selling opportunities, which should help drive strong growth for the next several years.
Shantanu Narayen, the company’s CEO since 2007, is responsible for converting to the subscription model. Post this transition, top line and margin growth has accelerated. In place of paying a dividend, the company reinvests its substantial cash flow into its existing business and new acquisitions.
Adobe is well positioned to capture AI opportunities given its sizable and knowledgeable user base and the company’s rapid development of its AI applications. Based on our assumptions, we project Adobe’s stock price offers a long-term annual rate of return of 7.5%.
Emerson, formed in 1890 and headquartered in St. Louis, MO, is a diversified global manufacturing company that provides solutions to customers by bringing technology and engineering together in the industrial, commercial and consumer markets around the world. The company operates in a wide variety of businesses, including diagnostic controls and measurement products for industrial processes, data network power, manufacturing automation and climate technologies. Emerson CEO, Lal Karsanbhai, is only the fifth CEO in 45 years. He was formerly head of the automation solutions segment and is a 26-year veteran of the firm.
Although Emerson generated over $15 billion in global sales in 2023, it has the flexibility of a smaller, nimbler player due to its regional operating structure. Emerson innovates, engineers, sources, manufactures and sells within each region of the world. What is made in Asia is sold in Asia, what is made in Europe is sold in Europe and what is made in the US is sold in the US. Sales in emerging markets have expanded to over a third of sales.
Emerson’s competitive advantages stem from its industry-leading installed base of equipment, valued at over $120 billion, which allows it to benefit from decades of high margin parts and service sales. In addition, its manufacturing scale provides a cost advantage versus most competitors. Emerson has shifted from a pure manufacturer to providing services such as equipment monitoring for maintenance and repairs and consultancy on efficiency and manufacturing as well. Skilled services such as these are generally provided under long-term agreements provided at higher margins than equipment sales.
The company is increasing its investments in research and development spending as well as customer service, project management and sales globally to enhance its relationship with customers, support product development and increase market penetration.
The Intelligent Devices segment, which is 76% of total company revenues, offers leading technology and system solutions that allow the company to earn profit margins comfortably above peer levels. Customers from various industries, including chemical, life sciences, oil and gas and power, pay a premium for Emerson’s complete front-to-back automation solutions. Emerson estimates the total addressable market for automation is over $200 billion.
Emerson purchased National Instruments in October 2023 in a deal valued at $8.2 billion. National Instruments is a leading provider of software-connected automated test and measurements systems. This acquisition should enable Emerson to increase its exposure to high growth industrial software markets and help execute Emerson’s strategy as an automation leader.
Emerson spent over $520 million on research and development in 2023, resulting in new and value-added services. Emerson’s control engineering software Plantweb was ranked number one in its category. According to the Boston Consulting Group, 40% of Internet of Things (IoT) customers prefer to use traditional and well-established companies for IoT solutions. The IoT describes the network of connecting physical equipment through sensors and software to other devices to monitor and exchange data. Analytics gleaned from customers is valuable for Emerson as it leads to innovative technology and a tailored software solution for the customer. Emerson also benefits from high margin recurring software sales since companies typically update their system software every few years. The company is increasing its investments in research and development spending as well as customer service, project management and sales globally to enhance its relationship with customers, support product development and increase market penetration.
Emerson is still a cyclical company and does face risks within its portfolio of businesses. Any slowdown in the global economy or reduced capital spending in the oil and gas industry would have a negative impact on revenue and profits. Emerson has historically been an acquisitive company in order to gain technology and expand its market footprint. There is always the risk of overpaying or a failure to integrate new businesses leading to a less than adequate return on investment.
We believe the company’s extensive installed base and long-term customer relationships should provide support for its transition to a services and solutions strategy. We expect Emerson will grow revenues by low single-digits on average with cash flow margins of 21% over our 10-year modeling period. Based on these assumptions, our stock valuation model indicates Emerson’s current stock price offers an average annual long-term rate of return of approximately 9.8%.
Founded in 1843, Stanley Black & Decker is a global leader in providing hand and power tools and related accessories to consumers and industrial customers. The company has some of the leading tool brands including Black & Decker, Craftsman, Cub Cadet, DeWalt and Stanley.
Reliability and brand loyalty are important factors in the North American tool market. Customers have long memories and can be unforgiving if a manufacturer cuts corners. This brand consciousness helps Stanley in positioning with big box retailers. Retailers look for strong brands that command a premium margin and provide a broad umbrella of products to satisfy core customers. In 2023, the Tools and Storage segment of Stanley accounted for 84% of revenues. Brand loyalty of tools is very high across markets, and many users are willing to pay a premium price for quality products.
Brand loyalty of tools is very high across markets, and many users are willing to pay a premium price for quality products.
Historically, Stanley has been a serial acquirer and has a successful track record of integrating over 70 acquisitions since 2004. On average, Stanley has improved operating margins by six percentage points on acquired businesses. It absorbed the larger Black & Decker in 2010, significantly broadening its product portfolio and yielding revenue and cost synergies well beyond the original expectations. The merger has created the largest provider of hand and power tools with enormous global reach and channel access, including high-growth emerging markets. More recent acquisitions include the purchase of the 90-year-old Craftsman brand from Sears and the purchase of Irwin and Lenox from Newell Brands.
Stanley is sharply focused on driving organic growth, which has matched the robust recovery in housing and home improvement. Research and development investment is over $362 million or 2.2% of sales. The R&D budget is up over 30% from two years ago. With its increased investment in innovation, the company’s product development plans are robust as it aims to nearly double the number of professional products offered over the next three years.
Stanley has taken a pause in acquisitions to focus on simplifying and streamlining manufacturing and sourcing and consolidating its tools and outdoor products where appropriate. Longer term, acquisitions will continue to play a role in the company’s outlook. The branded tool and storage products are critically important aspects of the company that provide strong free cash flow. Stanley will continue to invest in new product development, such as Smart Tools and higher battery voltage power tools, and to increase its brand support through marketing and promotional activities.
Acquisitions always introduce the risk of overpaying and later facing asset impairments or inadequate returns on invested capital. Stanley also faces commodity price risk. The company does have the benefit of a domestic supply chain as approximately 50% of the company’s North American tools are manufactured domestically. However, the company’s consolidated customer base and competitive markets may prevent Stanley from fully passing along rising costs in the form of price increases.
We believe Stanley can grow organically in the low-single digits. We also expect Stanley to resume its acquisition program and, when appropriate, to fund it through free cash flow and debt financing. Based on our projections, we anticipate operating margins of over 9% over the forecast period. Given these assumptions, our valuation model indicates that the company’s stock is priced to generate an average long-term annual rate of return of approximately 9%.
The Bank of New York Mellon {BK}
The Bank of New York Mellon is the world’s largest custodian bank by assets. It enables clients to create, trade, hold, manage, service, distribute or restructure investments. BNY Mellon has over $47.8 trillion in assets under custody and $2.0 trillion in assets under management at fiscal year-end 2023. The company has a vast global footprint, delivering investment management and investment services in 35 countries. The global custody business is an oligopoly with six firms administering 75% of all financial assets. BNY Mellon is estimated to have approximately 20% of global market share in assets under custody.
BNY Mellon is a uniquely positioned company with a business model that is quite attractive in the banking industry. The bank provides a full spectrum of the investment process and ability to provide sophisticated solutions to many of the most advanced and complex financial companies and investors across the globe. While others offer similar services, few other firms offer the scale or breadth of products necessary to service customers in this technology-driven business at a competitive cost. BNY Mellon is deeply involved in the operations of its clients. These strong relationships result in sticky customers due to the high switching costs associated with back-office disruption that changing providers would entail. These competitive strengths have consistently delivered the highest profit margins and returns on tangible capital in the industry.
While others offer similar services, few other firms offer the scale or breadth of products necessary to service customers in this technology-driven business at a competitive cost.
The bank tends to have the top market share in most of the servicing businesses in which it competes. Although it does face some cyclicality due to asset valuations, most revenues are recurring in nature with high switching costs. Historically, asset values have outpaced global gross domestic product (GDP) growth, with anticipated continued growth in cross-border investment and capital flows along with expanding international market client relationships. BNY Mellon also should continue to benefit from changing regulations, driving client demand for new solutions and services while encouraging many asset managers to outsource their back-office operations for greater security and oversight.
Technology remains at the core of operations as the CEO, Robin Vince, considers the firm a software-as-a-service (SaaS) company at its core. Technology will continue to grow in importance in banking, particularly the types of services provided by BNY Mellon. The firm is seeing a payoff with faster execution, lower costs and faster time to market for new applications, which further strengthen client relationships. Going forward, the firm remains at the forefront in utilizing new technologies to enhance the user experience, including cloud-enabled service platforms, developing business and client analytics, faster access to data, improved search capabilities as well as expanding mobile access for clients.
Given the current level of assets under custody and management, we believe BNY Mellon will be able to grow revenue in the low-single digits on increased services, modest market share gains and international market expansion. We expect the custody bank can generate a return on equity approaching 8% over the next decade. Based on these assumptions, our financial model indicates that at the current stock price BNY Mellon’s stock offers a potential long-term annual return of approximately 7.2%.
September 30, 2024
Specific securities were included for illustrative purposes based upon a summary of our review during the most recent quarter. Individual portfolios will vary in their holdings over time in relation to others. Information on other individual holdings is available upon request. The information contained herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy. The opinions expressed are subject to change from time to time and do not constitute a recommendation to purchase or sell any security nor to engage in any particular investment strategy. Any projections are hypothetical in nature, do not reflect actual investment results and are not a guarantee of future results and are based upon certain assumptions subject to change as well as market conditions. Actual results may also vary to a material degree due to external factors beyond the scope and control of the projections and assumptions.