Make the Most of Disappointment

 | Jan 28, 2014 | 2:30 PM EST
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We are generally wary about buying into earnings disappointments shortly after the release date. This is especially the case when the company is addressing real business problems. But a selloff can create an opportunity if a miss is very short-term or relates to various timing issues, rather than a business problem. If a company is doing well and has a favorable outlook in the upcoming three to 12 months, these short-term selloffs can be an opportunity.

Two recent disappointments that fall into this camp are Johnson Controls (JCI) and State Street (STT). We would be buying into the aftermath of last week's earnings reports and subsequent stock price weakness.

Since reporting on Jan. 23, Johnson Controls' shares are off $4, or close to 8%. The maker of automotive parts and systems reported better-than-expected revenue of $10.9 billion vs. a $10.7 billion consensus estimate. Unfortunately, earnings per share fell short at $0.69 vs. $0.70 expectations. Johnson Controls reported very strong Automotive Unit numbers out of both Europe and China that tracked above projections. Where the company fell short was weaker-than-expected numbers out of the Building Controls and Power Systems units. This combined with the mix shift to lower margin Automotive sales led to the earnings shortfall. Even with the penny miss, the company reaffirmed the full year's revenue and earnings guidance.

We believe this shortfall should be considered a hiccup in a very good 2014 story. During the call, management said the Power Systems business has picked up in January 2014. Management also believes the economy is still in the early stages of a broader recovery in building construction, which will ultimately aids the Building Controls unit.

Investors will also benefit from the recent elevation of a new CEO, who has laid out a plan to exit the lower-margin automotive businesses and expand higher-margin multi-industry product lines. Thursday's earnings disappointment has created an attractive entry point for investors. Johnson Controls is trading at 14.8x 2014's EPS estimate of $3.25. The company has strong operating momentum and an improving mix going into 2014 and 2015.

State Street is the other earnings disappointment that we would step in and buy. The bank reported disappointing earnings numbers on Jan. 24. The stock price was off more than 4% on the announcement. Revenue was better than expected at $2.53 billion vs. a $2.5 billion expectation. Unfortunately, EPS was below expectations at $1.15 vs. $1.19 consensus.

Beyond its earnings metric, Sate Street had a heroic fourth-quarter finish to the year, with record assets under custody and assets under management. It also outperformed the industry with new client wins. Nevertheless, earnings fell short of expectations due to higher expenses and a negative fee-mix shift during the quarter. The company gave in-line guidance for the upcoming year, which we believe is based on overly conservative assumptions about the capital markets.

We believe that last week's market selloff, which accelerated Friday, creates a very good entry point into Sate Street's stock. The shares are reasonably priced at 13.9x 2014's EPS estimate of $5.05, and should have multiyear double-digit earnings growth. The stock should also get a nice earnings kicker in the upcoming 18 months from a rising interest rate environment.

While we are normally hesitant to buy into a disappointment, we believe Johnson Controls and State Street should be the exception to that rule.

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