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Friday Five: China Chills and Apple Hits Some Speed Bumps

Jason Stipp
Jeremy Glaser

Note: Today's Friday 5 was filmed prior to news of Bill Gross' departure from PIMCO to join Janus. For more on that story, please see our related reports: PIMCO Funds Under Review Following Gross' Exit and PIMCO Investors: Time to Reassess, Not Panic

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five: Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week is China. There was some news happening recently, including some rumors that they may replace the head of their central bank. This seems to be stoking some underlying fears about China that have been around for a while.

Glaser: There is still concern about how much China is going to be able to grow from its current base. They are struggling to reach that 7.5% growth target that's set by the government, and what we've seen now is a bit of tension within the Chinese government, with some factions that want more short-term stimulus measures to get back to that 7.5% growth rate, and others that want to focus more on reforms and try to create a base that's going to make it easier for the economy to grow in a more stable, more sustainable fashion over time.

The head of the central bank is known as someone who is more in the reform camp rather than being in that short-term [stimulus] camp, and the fact that there is talk of him being replaced could be a sign of what side, at least internally, is starting to win that debate.

Dan Rohr, an analyst here at Morningstar, has done a lot of work on China and what's happening with Chinese growth. He also sees this tension over spending a lot of money on infrastructure, particularly in areas where it may not be needed. It can boost growth in the short term, but it's not sustainable. You really need that consumer-led growth, but how are you going to have that hand off?

I think how China manages that transition is going to be a big determinant of whether we see a gradual slowdown over time, or if we see the kind of hard landing that people have been concerned about.

Stipp: We also got news this week that the government is taking steps to crack down on tax inversions. We saw tax inversions driving a lot of recent M&A activity. What's the latest news?

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Glaser: A lot of the M&A activity recently has been these tax inversion deals, where you take some earnings that were being taxed in the U.S. and have them taxed in Europe primarily, which has lower corporate tax rates, in order to lower that bill. One of the big risks in these deals was always a political risk, and that came to the forefront this week as the Treasury announced some new rules around trying to make tax inversions more difficult--not impossible, but just a little bit more difficult.

This is probably just the start of this conversation. Given that these are executive and not congressional actions, they probably will be challenged in court [on the grounds] that the Treasury doesn't have the authority to make these changes, and given that they are relatively small changes to the tax code, my guess is that companies will find other loopholes to make these deals work--that [new rules may] diminish some of the benefit, but not all of it, and that there are still enough synergies to really make these deals happen.

So I think this is probably just the start of the conversation about inversions, another shot fired, but we are going to be hearing about how the tax code could be changed probably throughout the mid-term elections into next year's elections. It's a topic that's not going away.

Stipp: Starbucks is paying over $900 million to acquire the 60.5% stake in Starbucks Japan that it didn't already own. So why are they doing this now, and is there upside for Starbucks?

Glaser: There could be some upside for them. They are paying a fair price, according to our Starbucks analyst R.J. Hottovy, and this really allows them to take what is their second-largest market by sales, completely integrate it, and use some of the techniques that have worked well in North America for their resurgence, in terms of getting more brands and opportunities, having tighter digital and mobile integration, and maybe launching some new brands like Teavana, in order to continue to drive growth there. If these are successful, there could be even more upside for Starbucks.

Right now Starbucks shares look about fairly valued, maybe a little bit undervalued, but this does seem like it's going to be a transaction that will work out over the long run.

Stipp: Bed Bath & Beyond reported this week, and their same-store sales were better than expected, but the margins didn't look so hot.

Glaser: If you've been getting a ton of 20% off coupons in the mail, you're not the only one. Couponing really did take its toll on gross margins in the quarter. They declined, despite that better-than-expected 3.4% rise in same-store sales, and I think that's a sign of couponing taking its toll, and also of where their competitive position is, that they need to offer that in order to get people into the stores.

They are also continuing to make very big investments in technology to make sure that there is tighter integration between the website and mobile and what's actually happening in the store. Our analyst Jaime Katz thinks these investments are worthwhile, and that they need to do this to stay competitive, but it's going to be very challenging. Particularly in the online space, the switching costs for home decor products are relatively low, and people are going to seek out the best price. It could be an uphill battle for Bed, Bath, and Beyond.

The shares actually did pop quite a bit on this report because of management's guidance for the fourth quarter. The holiday is looking a little bit better, and they think it's going to be strong, but given that the shares trading around our fair value estimate, and that it is a no-moat company, investors are better off looking elsewhere.

Stipp: Apple hit a couple of speed bumps this week--first with phones that are bending and also a botched software release. Is this going to affect the rollout of this product and the promise that it had?

Glaser: I guess people are getting a little bent out of shape over the new phone. Apparently for some people, it is bending somewhat. Apple is saying that it's a relatively small problem. We'll see if that turns out to be the case.

If you remember, this is not the first time that Apple has launched new hardware that's had some issues. When the iPhone 4 launched, there were concerns that, depending on how you held it, it dropped calls, and the antenna strength went down very quickly. Apple ended up giving out free cases to a lot of buyers in order to ameliorate those concerns. So, this is not the first time this has happened. It won't be the last. And it's not going to derail the entire product.

They sold 10 million phones throughout the first weekend. That's a record for them, and according to them, a lot of those really were pass-throughs to consumers--it wasn't that phones were just being sold to their partners and then … sitting on store shelves somewhere.

They also had a botched software update. Again, this is probably something that, if it wasn't happening at the same time as this phone bending, it wouldn't even merit mentioning. This is something that happens occasionally.

I think investors need to be more focused on those actual sales numbers, not the short-term issues. That being said, given where shares are trading, even with the sell-off on some of these issues, they are still not particularly attractive.

Stipp: Great insights as always, Jeremy. We'll see you next week.

Glaser: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.