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Friday Five: Companies in Transition at Midyear

Jeremy Glaser
Karen Wallace

Karen Wallace: Hi, I'm Karen Wallace for Morningstar filling in for Jason Stipp. Welcome to the Friday Five--Morningstar's take on five stories in the market this week. Joining me is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Karen.

Wallace: There were three big tech companies reporting earnings this week--and the reports were slightly disappointing. The first was Apple (AAPL). Was the big story there the Apple Watch?

Glaser: Yeah, the market certainly was disappointed in Apple's quarter, and I think part of that was the Watch. Either the disclosure or maybe lack of disclosure about Watch sales, I think, show that this is not a product that's off to the kind of rollicking start that maybe the iPad had. Brian Colello, our Apple analyst, said that this isn't much of a surprise, given the supply constraints that the Apple Watch had, given the fact that it's a little bit more complicated of a product than, say, the iPad. It doesn't have as robust of an app store yet; people are probably waiting for newer versions, more software updates before they make the plunge. We should expect this to be a product that is going to build slowly over time. It's not going to be a huge success or a huge profit driver right away. He says it's way too early to say that this is a flop of a product and that it's not going to be a big impact. It's really something we are going to have to wait and see about.

What we should be focused on instead is the iPhone business. This really is the big driver. If you look at the robust demand for the iPhone, particularly in China, which had really good sales growth again in the quarter, I think you can see some very positive signs there. You see signs that Chinese consumers are choosing the higher-end iPhone--again, another thing that's good for Apple. So, we stuck with our fair value estimate after this quarter. Shares are trading below that right now. It looks like a margin of safety is opening up, so Apple, as always, maybe is an interesting company to watch and maybe an interesting one to put on the radar screen as the stock price comes down somewhat.

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Wallace: Also, Microsoft (MSFT)--that's a firm a little bit in transition there.

Glaser: It very much is. Norm Young, who's our Microsoft analyst, said that this is the kind of quarter where you see the highs and lows of a firm like this in transition. The lows are very much on the hardware side. Their phone business continues to really struggle. They are not getting a lot of traction in breaking up that Android/Apple duopoly when it comes to smartphones. So, that was certainly not a great sign for them. Also, on their software business, some of their older software products that maybe are being cannibalized by some of the newer cloud products showed some weakness as well.

But the good side is that some of their new products--things like their cloud services, Office 365--are seeing robust demand from enterprises; they are really having their next-generation products gain wide acceptance, and they are seeing good demand for that. That's something that bodes well for the future of Microsoft. Right now, I think the shares are about fairly valued. But there definitely are signs that Microsoft is really kind of moving toward that future direction and is not getting hung up on some of these legacy businesses.

Wallace: Finally, IBM (IBM), which is another firm in transition.

Glaser: IBM is probably a more challenging story in a lot of ways. They saw revenue from continuing operations fall 13% in the quarter. Some of that is due to currency issues, but a lot of it is due to some weakness in their legacy-hardware businesses. I think it shows that they really are under a tremendous amount of pressure. There were signs at IBM as well that some of their new initiatives are doing better--things, again, like cloud computing, analytics has been a big push for them. IBM saw really robust growth in those areas, which are not very small. It's not an insignificant part of the business, but it certainly sometimes gets drowned out by some of these legacy businesses that continue to be under pressure here. Pete Wahlstrom, who's our IBM analyst, thinks that it could be some time--it could be years--before they are really able to drive free cash flow growth again and re-orient the business toward these bigger growth initiatives. He's sticking by his fair value estimate; he thinks shares look a little bit cheap right now. They are trading below that estimate. Investors are going to have to be pretty patient with this story.

Wallace: Then, General Motors' (GM) quarter showed that it's very much on the turnaround track.

Glaser: GM had a quarter that was well above expectations. There were a few things driving this. North America continues to look pretty good, particularly on the profitability side. One of the big initiatives for the firm has been to improve profitability there. One of their goals was to have this 10% EBIT margin in 2016; they were above that in the quarter. They were close to that for the first half of 2015. So, it looks like it's very much an attainable goal. That's something that obviously bodes well for the firm.

Europe was a little bit less bad than it had been--again, something that looks positive. But I think one of the big worries going into the quarter was about China. Would a slowing Chinese economy really put a dent in their Chinese sales? The answer is that it's having an impact. Dave Whiston, who's our GM analyst, actually did bring down its fair value estimate slightly because of those concerns in China, but it's not a disaster by any stretch of the imagination. Releasing some new models that had been popular and managing dealer inventories carefully have really helped actually improve profitability a little bit even in this difficult sales environment. That's something that really shows that GM is being thoughtful about how they approach China through what's potentially going to be a challenging couple of years there. So, that's a good sign for GM, too.

We still think that these shares look pretty cheap. GM has been a stock that we've thought for a while is trading below its intrinsic worth, and we still think that today. If you look at their ability to potentially become more profitable over time, if you look at their ability to return that capital shareholders over time, we think that there is a lot to potentially recommend it. But investors do need to keep in mind that this is a company that has a high degree of uncertainty around it. It's a no-moat business. It's not one that we think has very sustainable competitive advantages. But at the right price, it could still be an interesting part of a portfolio.

Wallace: So, I guess this week's theme is firms in transition.

Glaser: Yes.

Wallace: The final story is American Express (AXP).

Glaser: And it's very much in keeping with that theme. American Express has a lot of headwinds that it's facing right now, and that definitely showed in its quarterly results. You have everything from the Costco deal, where they will no longer be the card of Costco. Obviously, that's not in the results yet, but that's something that investors are worried about. Also, currency headwinds are a problem. More competition for the higher-end customers that have really been American Express' bread and butter has been a challenge. But Jim Sinegal, who is our American Express analyst, thinks that the company really has the tools that it needs and has the competitive advantages it needs to overcome any of these concerns over the long term. They are building better relationships with merchants, and they are really showing their value proposition at being able bring customers who are going to be able to spend more and are going to want to spend more. They are showing that it's a good thing for those merchants to accept American Express.

From the consumer standpoint, they are trying to provide reasons why you would want to use American Express. They are trying to show through good customer service and through customer-friendly policies that it's worth having that card in your wallet. He thinks that these core propositions really still very much remain intact. He sees the shares as trading in pretty attractive territory right now. They are rated 4 stars at the moment. So, again, this is potentially another interesting opportunity in a market that doesn't have a ton of values.

Wallace: Great. Thanks a lot, Jeremy.

Glaser: You're welcome, Karen.

Wallace: Thanks for watching. For Morningstar, I'm Karen Wallace.