​Headquartered in Cambridge, MA, Biogen is a biopharmaceutical company that specializes in the discovery and development of drugs for people suffering from neurological and autoimmune diseases. Their core business is a portfolio of medicines to treat multiple sclerosis (MS) and spinal muscular atrophy. Their CEO since 2017, Michel Vounatsos, was previously with Merck for 20 years.

According to NeurologyToday, neurological diseases are the leading cause of disability worldwide. Founded in 1978, Biogen rapidly became a global leader in developing medicines to treat serious neurological diseases. They have the largest portfolio of treatment options for MS, and an estimated 35% of MS patients globally use Biogen medicines. Their core MS medicine business coupled with continuous development of drugs for other neurological diseases including dementia provides them with robust growth potential moving forward. Within the next few years, the company intends to expand their neurological portfolio to better address neuromuscular diseases, strokes, and movement disorders. Biogen’s disciplined capital allocation framework and high research and development spending (19% of revenue) provides the potential for consistent growth. 

Biogen is trading at a large discount compared to their historical operating performance. Investor concerns caused the price move in March of 2019 after the company abandoned a late stage Alzheimer’s drug. While disappointing, and given the current price, we feel we are buying their still-expanding core MS business for free, and benefitting from future growth potential on their remaining portfolio. Even with modest growth assumptions over the next business cycle, the company is trading at a 20-30% discount to fair value. If our assumptions turn out to be incorrect, we believe this provides a margin of safety.
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Risks that we intend to monitor going forward involve regulation of drug prices and pipeline development. Weighing both potential rewards and risks, we are optimistic that Biogen is a good long-term investment.

Headquartered in Calabasas Hills, CA, The Cheesecake Factory is involved in the restaurant and baking industry. David Overton, CEO and Chairman of the Board, founded the company with his parents in 1978. Today they own and operate over 200 upscale yet casual dining restaurants in 36 states and Puerto Rico under the names ‘The Cheesecake Factory,’ ‘Grand Lux Café,’ ‘RockSugar Southeast Asian Kitchen,’ and ‘Social Monk Asian Kitchen.’

With strong brand recognition and customer loyalty, The Cheesecake Factory is a leader in the upscale, casual, and eclectic dining space. In 2018, their sales surpassed US$2.3 billion. Though mature, the company’s core Cheesecake Factory brand offers consistent sales growth and cash flows which they supplement by diversifying their restaurant portfolio across dining concepts. Fueling growth outside of their core brand, expansion plans involve healthy but fast casual dining opportunities via the brand Flower Child, which features locally sourced ingredients for vegetarian and vegan customers, and Social Monk, which is a modern Asian kitchen experience. They additionally hold a minority stake in North Italia, which focuses on upscale, made-from-scratch Italian cuisine in a modern urban atmosphere. The Cheesecake Factory plans to acquire the entire brand in late 2019 and open six new North Italia restaurants per year over the next few years (there 
are currently 23 locations).

The Cheesecake Factory is trading at attractive valuation levels. At their current sales and cash flow multiples, they are trading at a 20% discount compared to their historical operating performance. Investor concerns over rising wage costs and core brand growth are putting short-term pressure on shares. Based on conservative growth assumptions that The Cheesecake Factory will grow cash flows in tandem with broad economic growth, shares should be valued at close to $65, not the mid $40’s. These growth rate assumptions are much lower than their historical operating performance. If our assumptions turn out to be incorrect, we believe this supplies a margin of safety.
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Risks that we will monitor going forward involve growth rates of new concept restaurants and wage inflation pressures. Weighing both potential rewards and risks, we are optimistic that The Cheesecake Factory is a good long-term investment. 

​Cairn Investment Group and its affiliates (“Cairn”) produces Company Spotlight reports (“Reports”) for its clients and the general public. The Reports are impersonal and do not provide individualized advice or recommendations for any specific investor or portfolio. Investing involves substantial risk. Cairn makes no guarantee or other promise as to any results that may be obtained from using the Reports. Past performance should not be considered indicative of future performance. No reader should make any investment decision without first conducting his or her own research and due diligence. At various times Cairn may own, buy or sell the securities discussed for purposes of investment or trading. Cairn disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the Reports prove to be inaccurate, incomplete or unreliable or result in any investment or other losses.

The Reports commentary, analysis, opinions, advice and recommendations represent the then current views of Cairn, and are subject to change at any time. The information provided in the Reports is obtained from sources the author believes to be reliable. However, the author has not independently verified or otherwise investigated all such information.

​This is not a solicitation or offer to buy or sell any securities. Cairn does not receive any compensation from any of the companies featured in the Reports. Any redistribution of the Reports or the information contained therein, without the written consent of Cairn is strictly prohibited.

How to absorb all of this noise, and move on? I like a bit of quiet time with the Wall Street Journal and a cup of coffee on the weekends. This particular end-of-the-first-quarter newspaper even had a few pink cherry blossoms stuck to it as I pulled it out of our paper box. How beautiful, the scents of spring blossoms, fresh pressed coffee, and printer’s ink not quite dry on the sunrise edition.

And then the crazy stuff begins. Parliament rejected… The FBI has embarked… Trump again threatened… The Justice Department… Emails in a lawsuit… U.S. and Chinese trade… The Red Cross said… The Vatican issued… Lyft shares jumped… and then the clincher… U.S. stocks notched their biggest quarterly gains in nearly a decade, lifted by bets that central banks would hold interest rates at low levels as global growth slows.

Patrick, what does it all mean?

With the markets regularly acting like a kid bouncing on a pogo stick, you are forgiven if you are wondering what will happen next. In the third quarter of 2018, U.S. stocks (measured by the S&P 500) rose 7.71%, followed by the fourth quarter decline of -13.52%. And just when pundits were calling for continued declines, the S&P 500 rebounded 13.65% during the first quarter. Predicting short-term market movements is usually an exercise in futility, which is why we spend our time looking at long-term valuations on which we base our expectations. While the decline that happened during the fourth quarter made the broad market “cheaper,” it did not move the needle very much, from a long-term perspective. So while we were able to invest in some new companies, at cheaper prices, we still view the broad market as rather expensive.

The topic du jour over the last few weeks has been the Treasury yield curve and the inversion of the 3-month/10-year U.S. Treasury yield. On March 22 the shorter yield was higher than the longer yield, thus inverted. Inversion of the yield curve has predicted the previous nine U.S. recessions with few false signals, so you can see why this news has become so prevalent. News articles and TV pundits will confidently make predictions about the timing ​of the next downturn, but, like many events in both finance and economics, inversion of the yield curve is not always a direct cause and effect relationship regarding stock market returns, or an accurate predictor of when a recession will emerge. The chart below graphs the yield spread versus the one-year future return of the S&P 500 Index.

When we examine the data, a few things become clear. First, taking a look at the previous three recessions, the average time from yield curve inversion to recession was twelve months, with the longest being twenty-two months in 2007. Second, future one-year market returns were inconsistent with no discernable pattern. When the yield curve inverted in 1989, rolling one-year returns post-inversion were positive and continued that trend through the recession that followed. In 1998, there was a false signal during the Asian Currency Crisis. No recession followed and market returns were positive as the tech bubble took hold. After the inversion in 2000, market returns were negative approximately 16-20% and would continue that trend through the recession. Most recently, in 2006, rolling one-year returns were positive for almost a year before turning decidedly negative as the housing bubble burst. A hard look at the data is always needed to see what historical outcomes have unfolded. Does it signal that caution should be warranted? Yes, especially when combined with other market data points. We have been in that camp for some time now as market valuations remain elevated. Does it signal that the twelve-year economic expansion is getting long in the tooth? Yes, but that is what should be expected after a twelve-year economic recovery. To quote famed value investor Howard Marks when discussing cycles, “We may never know where we’re going, but we’d better have a good idea where we are… and act accordingly.”

We will not try to guess when the next recession or bear market will start, but we do have a good idea of where we are in this cycle and our research has us acting conservatively.
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Please feel free to email or call with any questions regarding these topics and how we are managing through them. Thank you!

Thank you, Patrick.

These are exciting times, made more comfortable by having a plan and sticking to it. Maybe we will change Patrick’s name to “Col. John Hannibal Smith” the leader of the renegade commando squad “A-Team”… or not?

Please take me up on my standing offer of swinging in for coffee. The pot is always on.

Happy Trails,
​Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered outside of Chicago in Deerfield, Illinois, Walgreens is one of the largest pharmacies in the United States, with nearly 9,600 locations in all 50 states, Puerto Rico, and the US Virgin Islands. Founded in 1901, Walgreens has three arms: retail US pharmacy, retail international pharmacy, and wholesale pharmaceuticals.

Walgreens CEO, Gregory Wasson, is serving his tenth year.

The Walgreens Company purchased United Kingdom-based Alliance Boots (pharmacy and distribution services) in 2014, becoming the Walgreens Boots Alliance Inc. This acquisition cemented their position as a global leader in retail pharmacy, health, and wellness services. In the US and US territories, Walgreens operates nearly 9,600 pharmacy locations that focus on prescription drug fulfillment and sale of household goods. In 2017, Walgreens filled around 20% of prescription drugs in the US, accounting for around 70% of their revenue.
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Due to the large disparity in revenue between pharmacy and retail household goods, Walgreens is partnering with other companies such as Kroger to expand their grocery offerings, and United Health Group’s MedExpress to introduce clinical services at their locations. These initiatives are expected to increase top line sales, and counterbalance their more mature pharmacy business. Large cash generation allows Walgreens to reward shareholders through dividend increases and strategic share buybacks. 

Walgreens is trading at very attractive valuation levels. At their current sales and cash flow multiples, they are trading at roughly a 30% discount compared to their historical operating performance. Investor concerns over Amazon entering the health care space is putting short-term pressure on Walgreen shares. Based on conservative growth assumptions that Walgreens will grow cash flows at 3% in the near future, Walgreens should be valued at close to $88, not the low $60s. These growth rate assumptions are much lower than their historical operating performance. If our assumptions turn out to be incorrect, we believe this provides a margin of safety.
​
Risks that we will monitor going forward surround the ever-changing landscape of health care services and the continued results from Walgreens’ growth initiatives. Weighing both potential rewards and risks, we are optimistic that Walgreens Boots Alliance is a good long-term investment. 

Greetings from the Northwest.

The News: Lower inflation has reduced the Fed’s sense of urgency to prevent economic overheating.

The Result: The Fed may slow the rate increase pace… I think.

The news, and yes, the fake news, is flying through the airwaves at an amazing pace. As someone who attempts to keep track of the investment world, I would vote for a breather so we can look objectively at both the good and the bad economic news.

The current U.S. economic expansion has already had a long life. That doesn’t mean it will end now. Periods of growth don’t end just because of old age; they generally end when something goes wrong, such as unchecked inflation, or a bubble in housing prices, or a central bank pushes interest rates up too fast. Patrick is going to cover more of the economics of today in his comments.
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In general, but not always, our investors’ portfolios performed quite well. Relative returns versus the market can be measured in many different ways; volatility, income flow, relative expensiveness, liquidity, and environmental and social objectives are just some variables. The 4th quarter of 2018 has been tough. But our portfolios are up to the task. Generally, we hold a group of companies that have lower price/earnings, lower price/sales, lower price/cash flows and higher dividends than the S&P 500. Patrick touched on this in our September letter. Please give your reports a good read, and then give us a call. Tim, Patrick, and I are available.

Optimism about the economy, and more specifically about equities, clearly faded during the 4th quarter as stocks experienced a U-turn from the exuberance that they had felt during most of the year. The S&P 500 Index closed down -13.52% for the quarter and -4.38% for the year, after posting impressive gains through the first nine months. International stocks fared slightly better during the quarter, only retreating -12.86% for developed stocks and -7.63% for emerging market stocks. High quality bonds and cash were safe havens during the quarter as investors flocked to safety during December. We have spent many quarters talking about the risks in equity markets and how we manage those risks through patience, not paying a premium for growth, and waiting for compelling value investments to come to us. As volatility increased during the quarter, we sent out an email in December describing our investment process. Our viewpoint and process have not changed over the last few weeks.

One of the primary areas of financial markets that we feel need to improve, in order for investors to feel comfortable taking increased risk again, are the credit markets (i.e., corporate bonds). During this current market cycle, many companies used the low interest rate environment to issue billions of dollars in debt (bonds) to fund share (stock) repurchases and dividends. In essence this was a large, debt for equity swap, and that changed the dynamics of how companies are now capitalized. This generally has no effect on the financial markets, as long as interest rates remain low and profitability for companies remains high so the debt can be serviced. Concerns over the level of corporate debt start to arise when the interest rate environment and maturity schedule start to change. The Federal Reserve has continued down the path of raising short-term rates, which sends a ripple effect through the rest of the bond market as rates across all risk spectrums adjust accordingly. When rising interest rates combine with slowing corporate profits, which we are witnessing due to higher wage and input costs, and large volumes of maturities need to be rolled over at higher rates, the bond market starts to become more volatile. The chart below shows the upcoming maturity schedule for U.S. corporate bonds (both investment-grade and high-yield).

As the chart illustrates, there are large amounts of corporate debt that will need to be refinanced in the coming years at potentially higher interest rates than when the original debt was issued. This should not have a heightened effect for companies that have low leverage and high profits, but will be much more worrisome for companies that already have bloated balance sheets and a lower ability to fund operations internally. When you have excessive valuations in broad U.S. stocks, combined with rising interest rates and economic growth that is showing signs of slowing down, markets can become skittish. Needless to say, highly indebted companies will have some big decisions to make as a large volume of maturities start to take place.

Another reason we bring up the corporate debt topic is that the amount of debt and financial leverage a company has is an important part of our analysis when considering an investment. It’s not just the amount of debt that is important; it’s the ability to service the debt with consistency of cash flows and profits while also having the ability to repay that debt without having to issue additional stock. The low interest rate environment of the previous ten years has truly created some interesting times for corporate America as senior management make decisions on how to navigate the next market cycle.
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Please feel free to drop me a line if you have any follow-up questions or concerns as we navigate through this choppy market environment.

Thank you, Patrick.

The coffee pot is stocked with a new grind of Nossa Familia Coffee medium roast. Seven scoops in a #4 filter make a great 12-cup pot. We are always excited to have investors stop by for a visit at our world headquarters.

​Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Greetings from the Northwest. 

The unexpected has become the expected, the bizarre has become commonplace, and the unpredictable is where we are. As investors our goal is to purchase equity in companies or debt from a variety of sources at a value price. Later, our goal is to sell equities at a higher price and debt instruments at their maturity value. The single biggest question over the last quarter from our clients has been: “Can this economic expansion keep on going?” The most common concern is that no one wants a repeat of the past recession or corrections. Got it. No easy task. We have found that it is extremely difficult to “time” the market. So we don’t. What we can do is pay attention to valuations and the “expensiveness” of what we own. Expensiveness? Patrick will explain. We are reducing our exposure to market fluctuations by reducing the “expensiveness” of our investors’ portfolios. 

The U.S. equity markets pushed aside many headline risks to finish up 7.71%, as measured by the S&P 500 Index. Its best quarterly return since 2013. The same could not be said for international equities, as concerns over global trade and growth caused broad-based international indices to return only 0.76%, lagging behind their U.S. counterparts by a wide margin. The large positive return for U.S. stocks over the quarter did nothing to improve valuations, which are near historical highs. We have talked about this numerous times over the last couple of years, so we want to touch on our process and how we are generating positive returns with much lower risk of permanent impairment of capital. Lastly, I will go over some updates that have taken place within the S&P 500 Index which could cause some changes in how investors view certain sectors going forward.

Through our quarterly letters and individual meetings we have discussed our process for uncovering successful investments, our current view of U.S. stocks, and how we are managing assets concurrent with that view. First, we are always on the lookout for industry leading companies that generate significant cash flows, with balance sheets that can provide financial flexibility. The final, and what we believe is the most important piece, is paying a price for a company that is significantly lower than what our analysis says the business is worth. We use a combination of cash flow analysis and the historical operating performance of the business to identify suitable investments, avoiding ones for which we would be paying too high a price, therefore limiting appreciation potential. The end result is that your portfolios are less “expensive” than the broader market, which should help us to weather bouts of higher volatility ​that will eventually take place. The chart below shows the aggregate of the companies we own and how their valuation metrics compare with the S&P 500 Index:

As you can see, by all metrics listed (Book Value, Cash Flow, Sales, and Earnings) your portfolios trade at a lower price than the broader market. We believe our focus on valuation, combined with the patience to wait for value, and a disciplined sell process, will provide satisfactory returns if the market continues to levitate higher, while being prepared for when the market decides it’s time for a reversal period. We don’t know when that will happen, but we want to be prepared for that inevitable event as we enter year 10 of this market rebound.

My second topic surrounds a new sector in the S&P 500 Index and the reclassification of companies into that new sector. On September 28, the Communication Services sector was created, replacing the Telecommunications sector. The chart opposite shows the changes that took effect and the companies that now make up this new sector. The main takeaway from this change is that the historically “boring” telecom companies such as AT&T and Verizon are going to be included in the same sector as Alphabet (Google), Facebook and Netflix. Needless to say, sector index investors might be in for a much different experience from what they historically had envisioned ​investing in some “old school” communication stocks. Though it’s not a primary point of emphasis in our company analysis, we do pay attention to index representation in the companies we own so we can try to gain an understanding of what might cause excessive volatility besides company specific events.

In closing, we continue to find good companies that the market has ignored; however, the number is not as plentiful as it was a few years ago. In light of higher than normal valuations in U.S. stocks, we are pleased that opportunities exist, but remain acutely aware that risks are higher than normal. Thank you for your continued trust and please drop me a line if you want to discuss any of these topics in greater detail.

Thanks, Patrick. Please take him up on his offer to talk about anything related to his analytical work.

Most readers will recognize that it just would not be a Cairn Newsletter if I didn’t say “Come on by, the coffee pot is always on.”

​Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered in Bellevue, WA, PACCAR is a global leader in the design and manufacturing of light, medium, and heavy-duty trucks. The trucks are sold worldwide under the Kenworth, Peterbilt, and DAF names. PACCAR also designs and builds engines and powertrain components for its own use, and for sale to third parties.
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Ron Armstrong has been the CEO since 2014 and has spent over 20 years with the company.

Originally founded in 1905 as a railway and logging equipment manufacturer, PACCAR became a heavy-duty truck manufacturer in 1945 with its acquisition of Kenworth. Since this transition over 70 years ago, PACCAR has become the global leader in truck manufacturing. Their high degree of product customization and brand name recognition has allowed them to maintain a strong competitive advantage. As an example, PACCAR controls over 30% of the heavy duty truck market share in the U.S. and Canada while generating operating margins in excess of the major competitors on a consistent basis. Over the last 18 months PACCAR has been focused on technological advancements with the opening of their Innovation Center in Northern California. This group has partnered with chip maker, NVIDIA, to develop self-driving technologies for trucks, and has developed hydrogen-fuel-cell powered trucks which emits only water vapor at the tailpipe.

PACCAR’s strong balance sheet, focus on operational efficiency, and consistent cash flow generation (over $2 billion annually) allows them to invest in projects that will continue their leadership position in heavy duty trucks.

PACCAR is trading at attractive valuations compared to both historical operating performance and to free cash flow projections. PACCAR is trading at 1.09 times sales and 9 times operating cash flows which is over a 15% discount compared to its five and ten year averages. We expect the company to grow free cash flow along with overall economic growth which is averaging 2% after inflation. This is well below their historical growth rate as the economic cycle shifts towards the later stages of growth. If our conservative assumptions turn out to be overly optimistic, there is a margin of safety built into the current price based on the company’s current valuation compared to its historical operating performance, and strong financial position.

Risks that we will monitor going forward surround market share strength and growth in the heavy truck market. Weighing both potential rewards and risks, we are optimistic PACCAR will be a good long-term investment.

Greetings from the Northwest.

Summer sunshine is warming us up in the West. It feels so good! The last few days have been the hot type, where individual bones in your spine feel like they are melting out the last of the ice and chill of winter.

The stock market has also been hot for a while. But not all parts or sectors have been feeling the heat. Frustratingly, the hottest sectors and companies are also the most richly valued companies and hence not attractive to us as value or momentum investments. The purchase prices of our investments are of paramount importance to us. Time can heal a lot of investment wounds, but it is most difficult to recover from overpaying.
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I hope the world is laughing with me when I ask, “Have you noticed the volcano of crazy, off-the-cuff, wacko ideas and plans that are being trotted out, run around the test globe and then re-evaluated?” Probably the biggest, loudest worries are coming from trade-war concerns. This has fired up volatility in currencies and stock markets around the planet. There is a lot of noise about potential longer term effects from tariffs and trade wars on U.S. companies and in particular industrial manufacturing. Please remember that manufacturing is only about 12% of GDP and we are in the 1st inning of a potentially long, hot, and politicized season.
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Patrick and Tim are both itching to add to this quarter’s letter, so I shall go back to the dugout.

The proposed DOL Fiduciary Rule, scheduled for implementation last year, was delayed numerous times before being terminated through court action in June. The courts determined that the Department of Labor had overreached its authority and that the topics addressed are better dealt with by the SEC, which in most other ways is responsible for the regulation of investment advisors.

What was this “DOL Fiduciary Rule” and why is this topic important? The growth of the employer sponsored retirement plan, such as the 401(k), has been tremendous over the last 35 years, with combined assets now above $6 trillion. These employer sponsored plans are now the primary tool for retirement savings, with fewer than 2% of Americans being enrolled in a traditional pension plan. The financial security of our next generation of retirees depends heavily on the success of these newer plans. This explosive growth has attracted much attention from the financial industry, which provides the investment platforms for these plans and for the various “Individual Retirement Accounts” or IRAs. Holding these assets, managing them, and providing advice on them is good business, and a core profit center for almost any investment oriented financial institution (Fidelity, Vanguard, Cairn, etc.).
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For decades the employer sponsored plans have been tightly regulated by ERISA (Employee Retirement Income Security Act). IRAs and the transfer of assets from employer plans into IRAs (rollovers) are not generally subject to ERISA. Some business models in the industry are intently focused upon this rollover process, and, like all great business opportunities, sometimes the interests of the consumer get overshadowed by the interests of the service and product providers, particularly without specifically designed legislation.

The DOL rule set out to fix this by making everyone involved in the process a“Fiduciary,” someone who must be true to the consumer and put the consumer’s interests first. This has caused major shifts in the industry, as firms were forced to evaluate their business models to determine how they were at risk of violating the new rule, how to eliminate conflicts of interest, and how to implement the prescribed procedures that came with this rule. An example of this is that Vanguard stepped away from advising clients on IRA assets. How could they maintain fiduciary standing when advising clients to purchase Vanguard funds? With the funds themselves being Vanguard’s primary business, they quickly and preemptively made the decision to stop advising.

For Cairn and other fee-only investment advisers, the DOL Fiduciary Rule had a much lower impact as we already were, are, and will continue, to act as a fiduciary. For us the change was the implementation of some required documentation that detailed why a rollover or IRA transfer was appropriate in each circumstance.

The DOL rule is dead, but the genie is out of the bottle, with many firms continuing to implement planned changes with the expectation that the SEC will soon roll out their own rules with a similar goal of improved consumer protection. What may be different is a more nuanced approach by a more informed SEC that recognizes the difference between commission-based brokers and insurance agents, and the fee-only advisers who are already acting as fiduciaries. Time will tell.

For now you can be assured that we will continue to act and advise in your best interests as we wait for the regulators to sort things out.

The takeaway from this chart is that higher wages should depress corporate profit margins, which are already sitting close to an all-time high. The possible retreat in profit margins due to higher wage costs is currently not being priced in by market participants (let alone higher input costs if large tariffs take place). As we continue to navigate a market that is on the expensive side, we continue to watch for other indicators that could change the corporate landscape. Rising wages are one data point we are keeping a close eye on. Our investment discipline helps combat these possible pressures as we consistently look for market leaders that have the ability to pass on higher costs to their end customer, regardless of the type of industry.

We firmly believe that risk management is of high importance as we get to the later innings of the market and business cycle. However, we are still finding opportunities in the marketplace, and we will take advantage of them if the price is right. Please feel free to reach out to me with any questions regarding this or any topic.

As I’m fond of saying, please come on by when you are near. The coffee pot is always on.

​Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.

Headquartered in Kansas City, MO, Cerner is a supplier of health care information technology solutions and services. Cerner is a leader in electronic medical records solutions for hospitals and health clinics worldwide.
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Brent Shafer took over as CEO on February 1, 2018 after the passing of Co-Founder and CEO Neal Patterson. Mr. Shafer joined Cerner after serving as CEO of Phillips North America.

Founded in 1979, Cerner is a global leader in healthcare IT solutions. Cerner enjoys a strong competitive advantage due to the high costs for customers to change to a competitor and long lead times for sales and product implementation. They are the number two provider of electronic medical records systems and services to hospitals, and the number one provider across the entire medical field. The company’s customer base is well diversified across numerous private companies and public entities. Recently, Cerner has gained contracts with the U.S. government starting a multi-year transition to the Cerner platform for the Department of Defense. Cerner is also a strategic partner with Adventist Health (an OHSU partner), in charge of the company’s day-to-day operation of their revenue management and clinical IT staff.

Cerner has been very conservative with their capital allocation strategy, choosing to reinvest most cash flows back into the business to remain competitive with software and solutions research and development. The company’s operating performance has been very strong over time. The firm generates high operating margins, averaging 19% over the previous 5 years.

The firm also generates over $700 million annually in free cash flow and has historically had a return on capital in the mid-teens. Their strong financial performance combined with their high quality balance sheet allows the company to fund operations internally, which we find attractive at this stage of the economic cycle.

Cerner is trading at attractive valuations compared to both historical operating performance and to free cash flow projections. Cerner is trading at 3.7 times sales and 11.9 times operating cash flows which is over a 20% discount compared to its ten year average. On a free cash flow basis, we expect the company to grow free cash flow on average at 9% annually, below its current growth rate of 20% over the previous 10 years, due to a more challenging health care spending and regulatory environment. If our conservative assumptions turn out to be overly optimistic, we feel there is a large margin of safety built into the current price based on the com­pany’s current valuation compared to its historical operating performance, and strong financial position.

Risks that we will monitor going forward surround market share strength and new client additions. Also, we would like to see the company continue to spend most of their excess cash on research and development to remain competitive. Weighing both potential rewards and risks, we are optimistic Cerner will be a good long-term investment.

So much for the low volatility that investors have become accustomed to over the previous couple of years. The first quarter saw markets rise to an all-time high by the end of January, only to finish the quarter in negative territory. The S&P 500 Index finished down 0.76% for the quarter while developed international stocks fared a bit worse, -2.2%. Emerging market equities fared the best of the major asset classes, returning over 2.4%. Bonds were also mixed as yields were quite volatile, reflecting consistent economic growth while the U.S. Fed continues on its interest rate hike path. As we have written previously, we view broad U.S. stock indices as richly valued and that view has not changed during the quarter. Finding bargains in this environment is challenging but we remain vigilant in our search for quality investments selling at compelling prices, while decreasing our exposure to companies that have become more fully valued. As Jim mentioned, I am going to discuss some of the changes that companies will be facing regarding tax rates and the rising costs of borrowing.

Last quarter we briefly touched on the changes in tax law that focused on individuals. There was also a broad overhaul to the corporate tax structure that many companies are still trying to dissect three months after the fact. The two primary changes that are being talked about the most are the lowering of corporate tax rates from a high of 35% down to a flat rate of 21%, and the changes to the deductibility of interest expense on corporate debt. The latter change is not talked about as frequently, but could be of more importance in the years to come.

We spent a lot of time in early 2017 identifying companies that could benefit the most from a lower corporate tax rate. That benefited portfolios later in the year, as companies with high effective tax rates were strong performers in the back half of 2017. Companies that benefited the most had similar qualities: low debt and a large proportion of U.S. revenues. The use of funds that companies are netting, resulting from lower tax, is still not completely clear, so it will be interesting to hear executives speak about their plans during upcoming earnings announcements. While an increase in productive spending (research, capital equipment, employee training and technology enhancements) would be welcome news, we remain skeptical, as historically tax savings have been used to increase executive compensation and share buybacks. Also, the increased chatter of trade tariffs/wars and possible effects on corporate profits could weigh on the benefits that were perceived from lower corporate tax rates.

A very important part of the tax law change surrounds the deductibility of interest expenses for corporations. Historically, the interest expense on the debt issued by companies was fully tax deductible. Over the last 10 years, this allowed these firms to access the bond market at historically low interest rates and have the interest expense be tax deductible (what a deal!). Under the new tax law only part of the interest expense is tax deductible (up to 30% of operating earnings before depreciation). Companies that have large amounts of debt or increasing interest expenses are now more susceptible to lower profits. We feel this is a risk that is currently underappreciated by equity markets. As the chart below shows, corporate America has taken on large amounts of debt over this past cycle, rising from roughly $3.6 trillion to over $6 trillion. This is at a time when the costs of corporate debt have started to rise (indicated by the red line, 3 month LIBOR). See chart below.

We will get past this tariff noise. We’re going to continue to keep our eyes open and try to dance around those surprising puffs of dry dust that are poofing up near our feet. Please remember that any time you are in town we’d love to see you. Don’t hesitate to come on in. The coffee pot is always on.

Happy Trails,
Jim Parr, Principal
Cairn Investment Group, Inc.