Friday Five: Fed Plays It Close to the Vest

Christine Benz: Hi, I'm Christine Benz for Morningstar.com and welcome to the Friday Five. Joining me to provide insight into the top business and market news of the past week is Morningstar editor Jeremy Glaser.

Jeremy, thank you so much for being here.

Jeremy Glaser: You're welcome, Christine.

Benz: Let's start with the Federal Reserve. I don't think many people expected them to raise interest rates at this latest meeting. But what did they say?

Glaser: No, no one expected a rate increase. But we're hoping for maybe a little bit of insight into what they were thinking about in terms of their June meeting, where it is possible they could raise rates, or their thinking about the state of the economy, we really did not get a lot of new information out of the report. They still see the labor market as looking pretty strong but are seeing signs that the economy overall is not performing as well, and I think we saw that with the GDP report this week that did show very slow growth in the first quarter. There was some idiosyncratic stuff there, but clearly growth is not off to the races. We'll get more information on employment next week with the jobs report. But that really seems to be kind of the key tension that they are dealing with--inflation, economic growth remain kind of low, while the labor market and the jobs market remains relatively robust.

So, the June [meeting] is definitely still on the table. It's certainly a possibility, but they have not kind of put their finger on the scale one way or another to help us really know if it's going to happen or not. But I think overall, big picture, kind of the thinking that the Fed is going to keep rates very low for a long time that any increases are going to be incredibly slow to come and are going to be probably pretty small. That thesis still seems to be very much intact after this release.

Benz: Kind of the prevailing wisdom there is, wait and see. Let's talk about earnings. We are still in earnings season. Let's talk about Facebook actually issuing some really nice earnings numbers, but you think one of the really noteworthy things is that it is issuing a new class of shares. So, let's talk about earnings first and then talk about the new share class.

Glaser: Sure. It's a busy earnings week and Facebook had another really strong quarter, ahead of expectations both in terms of revenue and in terms of profit. They are just really finding a way to continue to grow user engagement and then sell ads against those users in a robust way. We saw that again, and the shares popped quite nicely on that report.

But like you mentioned, I think it's noteworthy to talk about this new share structure that they are putting in place. They are going to issue these non-voting shares, which basically will ensure that Mark Zuckerberg will retain control of the company even if he ends up selling some shares for charitable endeavors or to diversify his holdings, or to issue shares for an acquisition, or something like that. And this isn't with that precedent; Google did something similar. We've seen a lot of corporations, particularly in the tech world, try to protect their founders.

But I think for shareholders it does mean that you do have to take a step back a little bit and realize that you are very much counting on Mark Zuckerberg when you do invest in Facebook, that you are assuming that he is going to be able to make those right capital allocation decisions that if Facebook's fortunes were to change in some way that he is going to be able to kind of navigate that ship because given that he is really consolidating his control even more than he already has, he is really going to be the key person there. So, I think that's something investors really do need to consider before they would think about investing in Facebook, just like you need to think about stewardship whenever you invest in any company. 

And speaking of investing right now, we do think the shares, particularly after this latest runup, do look a little bit frothy.

Benz: A little bit rich, OK. Apple, kind of end of era here in some ways; actually a really tough quarter for Apple. Let's talk about those numbers. They really had the market's attention here earlier this week.

Glaser: They did. Apple saw their first decline in sales since 2003, so really when they started on this current upward trajectory. And what happened is, the iPhone just wasn't selling and isn't selling as strongly as it was before. We are seeing a real slowdown there. And there's a lot of other headwinds, too--macroeconomic, currency headwinds, things that are really holding Apple back right now.

But Brian Colello, who covers Apple for us, thinks that this is not really a time to panic or to think that we're kind of going back or going away from growth altogether. He thinks that, yes, these are going to be short-term issues, but in the medium term even as soon as the launch of the iPhone 7, they will be able to return to growth and that, no, that growth is not going to be incredibly gaudy numbers that we saw when the iPhone was being launched, but it will still be solid numbers and that right now the market is pricing in kind of the begin of a permanent secular decline in the iPhone that this is basically it. It's all downhill from here. He doesn't believe that that's the case. He thinks the ecosystem is strong enough that people continue to upgrade and that this has created an attractive entry point into Apple shares.

Benz: One question for you, Jeremy, kind of a follow-up and maybe you know this from talking to Brian, is maybe an impediment for Apple simply that the products are really good and you can keep them a long time if you are not the type of person who needs the latest iPhone or needs the latest MacBook or whatever it might be--that you can actually hang on to these devices for quite a long time and they work well for you?

Glaser: Yeah, that has slowed down the upgrade cycle. And one of the interesting things of the quarter is that services revenue was up quite a bit. So, people are continuing to buy apps; they are continuing to use these devices; they are continuing to go and maybe get some music. So, I think that shows that people aren't just kind of sticking this in a drawer and saying, "Oh, I'm sick of this," or "I'm moving to another platform." They are just kind of extending that cycle a little bit and that services revenues points to that. That services [revenue] isn't going to save Apple, but you're right that this points to kind of maybe a problem that they are facing right now.

Benz: Speaking of problems, let's talk about Chipotle. This is a company that has been dogged by some issues related to food safety. Its quarterly results were not good. Let's talk about what's going on there.

Glaser: Yeah, going into the quarter the question was, will they be able to rebuild trust with their customers and get people back to the stores? And the answer appears to be "not yet." Same-store sales were down almost 30% which is a pretty dramatic decline for them. The second quarter looks like it's also going to be pretty bad for them; maybe not quite down quite as much, but certainly another big decline. So, they had their first-ever loss as a public company in the quarter and it definitely is going to take some time to rebuild this trust I think as they have noted.

But RJ Hottovy, who covers Chipotle for us, thinks that it is possible for them to do it, but it's going to be a rocky recovery. It's going to be uneven. It's not going to be, OK, they flip a switch and everyone feels comfortable going to Chipotle all of a sudden. But he thinks that it is something that is possible and given their other advantages, given some of the brand equity that they do have left, they will be able to get people into the stores again, they will be able to come back to growth and that this has created a buying opportunity as the concerns over this really have created depression in the stock price.

Benz: The last story I want to cover with you Jeremy is Abbott Labs announced that it's going to acquire St. Jude Medical. Let's talk about that acquisition. Why this is happening, mainly, and also what the analysts think of this news.

Glaser: Sure. This is a $25 billion deal. So, it's a sizable one, where Abbott Labs is really trying to make itself more relevant in the medical device space. And Debbie Wang, who covers this space for us at Morningstar, thinks that after healthcare reform there are really two major strategies that these device manufacturers took. One was to become bigger; so it would be a one-stop comprehensive shop for hospitals to have devices across a lot of different types of surgeries, and other was to become more innovative and to come up with devices that will kind of command a higher price, will justify a higher price for but in very narrow areas. And Abbott Labs really didn't have either of these things. They didn't have the kind of breadth to be a one-stop shop and they weren't particularly innovative, either.

So, by buying St. Jude they really get some more of that innovation and there are also some complementary products that they have that they think will work well together. And Debbie Wang agrees with that. She thinks that this is a deal that from a strategic standpoint does make sense. She is going to revisit the moat for the company. Abbott is a narrow moat company. St. Jude is a wide moat company. She will have to see if they are able to see moat upgrade there. But it does seem to help their competitive advantage on some fronts. Abbott is paying a hefty price for this. It's a 20% premium to what we think St. Jude is worth, so not getting this strategic benefit for free by any stretch of the imagination, but it does help them compete better in this space.

Benz: OK, Jeremy, busy week for the markets, busy week on the earnings front. Thank you so much for being here to share your insights.

Glaser: You're welcome, Christine.

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