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The Friday Five

Fri, 18 Jul 2014

This week: Financial-services firms post lukewarm earnings, two tech giants strike a deal, Time Warner turns down a foxy offer, and more.

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Video Transcript

Christine Benz: Hi, I'm Christine for Morningstar, and welcome to the Friday Five. Joining us as always to dig more deeply into five headlines of this week is Jeremy Glaser. He is markets editor for Morningstar.com.

Jeremy, it was a busy news week. Let's get into some of the business headlines from this past week. We had some of the big banks reporting earnings this week. How did it go for them?

Jeremy Glaser: We did. Generally, results looked OK, but not exceptional. Looking at some of the really big ones, JPMorgan, Bank of America, and some of the investment banks like Goldman Sachs and Morgan Stanley, I think it's a difficult environment for a lot of these banks to be operating, and you have very low interest rates, which could be challenging for earnings. Mortgage lending still remains a relatively slow. Again that could be a major headwind. So you are facing that, at the same time you are trying to still deal with some legacy legal issues, particularly for Bank of America, which continues to have these litigation costs come up, which really is hurting earnings.

But everything isn't all bad. A strong equity market certainly can be helpful for earnings at a lot of these corporations. Generally expenses are being kept in line. JPMorgan had to spend a little bit more for some new internal controls after some issues they had, but generally expenses look pretty good, and capital levels look pretty strong, too. So, generally speaking, having strong banks is good for the strength of that rest of the economy. That's certainly good to see, but right now it just doesn't seem like there are a lot of good investable ideas in that space just given some of the headwinds.

Benz: Valuations right now are so-so?

Glaser: Exactly.

Benz: Turning over to the technology sector, Microsoft announced a big round of job cuts. Let's talk about the catalyst for the job cuts and whether we think that this will help Microsoft's bottom line?

Glaser: Sure. This was a big announcement. People had expected Microsoft to make some of these cuts. CEO Satya Nadella kind of said that he needs to refocus the company a little bit, but at 18,000 jobs, that's 14% of the company's global workforce, that's a huge number. And that really is transformative. A lot of these job cuts are coming from former Nokia employees--Microsoft had their own phone division--getting rid of some of the redundancies there. We knew that was coming. They had said during the acquisition that they had expected to cut a number of jobs. So those, you really can see is just kind of right-sizing, but 30% of it, Microsoft is getting rid of a lot of middle managers, a lot of these layers that they are going to let go in order to create a more flat organizational structure.

Nadella really hopes that this is going to create some more innovation in the company, that's going to allow them to get things to the market faster, and that you won't have to go through so many layers of bureaucracy to get there. And Norman Young, who covers Microsoft for us, thinks that this could be a step in the right direction, but he expects there to be a lot of potential growing pains, or I should say shrinking pains, of laying off 14% of your workforce. It's not going to be an easy process and there could be some turbulence particularly in the near term as they kind of work out exactly how to do that and try to transform the company.

Benz: So Microsoft, like the big banks is not a screaming buy at this point?

Glaser: It's not. It looks again fairly valued, which I guess is kind of a theme these days, but it will be, I think, maybe if we see some turbulence from this and that creates a buying opportunity, that might again be something for investors to kind of keep on the radar.

Benz: Elsewhere in the technology sector we had Apple and IBM announcing a big deal. Let's talk about what's going on there and how these two giant firms are collaborating?

Glaser: This is an interesting tie-up that IBM is going to help Apple get into the hands of more enterprise customers and work on developing custom apps and other services that will help enterprises really deploy iOS devices across their workforces. This is kind of the bread and butter Blackberry has had for quite some time. And Brian Colello, our Apple analyst, thinks this really helps reinforce Apple's narrow moat, and that moat is really founded on the idea that there are switching costs to what cellphone platform you have. That if you have all the apps that you've already purchased or everything is already in Apple's cloud, you might be somewhat hesitant to move to say an Android device. That's even more true in enterprise and in education markets because they're doing a lot of custom apps that are being written just for them. It will be expensive to move those to those new platforms, so he sees that if this does well and more enterprises adopt iOS, that is going to increase the switching costs, and Apple could sell more units and keep them there for some time. So Colello views this deal positively.

Benz: Johnson & Johnson came in with a pretty strong quarter.

Glaser: They had nice results, and it was really driven by their pharmaceutical part of their business and their hepatitis C treatment that's doing very well. Now that particular treatment is going to face some competition in the coming years from other companies, so that growth will moderate. But they have a pretty strong pipeline, and Damien Conover, our Johnson & Johnson analyst, really sees that their patent losses are pretty manageable. [Those patent losses] tend to be in products that would actually be difficult to produce for generic versions of which helps give J&J some price protection there, and that pharmaceutical group should continue to drive earnings. This is particularly important because Johnson & Johnson's device business is not doing great right now, and their consumer business is really still rebounding off of the some issues in manufacturing, the recall issues they had recently, so really pharmaceuticals are driving that story right now.

Benz: So I know at one point a few years ago all the pharma stocks looked pretty cheap to us, how about right now, especially J&J?

Glaser: Yeah, let's keep this theme going. We just aren't seeing a lot of value in those names. There's a few--Baxter looks like it's probably pretty well-positioned right now and looking relatively inexpensive--but there just aren't a huge number of values there.

Benz: Lastly Jeremy, let's touch on Time Warner's rebuff of 21st Century Fox's offer to buy them out.

Glaser: More M&A news this week, and this deal is a little bit different than some of the ones we've seen announced recently. A lot of deals have been focused on tax savings and are less strategic, and this one is very clearly strategic. I think it stems from really going back to the Comcast-Time Warner Cable merger which is obviously still pending and the idea that that's really reshaping the media landscape and the pay-TV landscape. After that you have AT&T maybe going after DirecTV trying to bulk up, now we see some of the media companies saying, "Wow, those are much bigger competitors. We probably need to continue to become larger, as well." So 21st Century Fox made an $80 billion offer to Time Warner, which they have rebuffed. But I think the story is far from over.

21st Century Fox CEO Rupert Murdoch is not known just to give up that easily. He's likely to continue to approach Time Warner and maybe increase that offer somewhat. Pete Wahlstrom, who is a media analyst here, actually thinks that some more unusual players like Google could get into the bidding war, as well. So we'll have to keep an eye on it, and I think that this won't be the last deal in the media space. If some of these mergers pass regulatory approval, I think there will be even more strategic rationale [for firms] to become even larger.

Benz: OK, a busy and dramatic week on a lot of different fronts. Jeremy, thanks for being here to share your insights.

Glaser: You're welcome Christine.

Benz: Thanks for watching. I'm Christian Benz for Morningstar.com.

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