Should You Avoid Citigroup, Cisco, and Lockheed Martin?

Investor director, Mark Hawtin of Gam U.K, an asset management firm that manages 120 billion, was recently seen on Bloomberg TV saying they’d expect the stocks/sectors below to have a sizable decline in the next six to twelve months. Hawtin’s technology fund, which recently returned 13.2%, show that Hawtin isn’t just an asset manager with sizable assets, but has strong performance to back up his credentials. Hawtin suggested that investors should avoid stocks like Citigroup Inc (NYSE:C), Cisco Systems Inc (NASDAQ:CSCO), and Lockheed Martin Corporation (NYSE:LMT). We’ll analyze the three sectors Hawtin isn’t excited about and explain his reasoning.

Citigroup Inc (NYSE:C)

1. Avoid Financial Services:  It’s normally easier to regulate an industry that the public media is frustrated with. Recent issues such as Knight’s algorithm trading and Barclay’s Libor scandal haven’t been helpful to public perception. Hawtin see financial services -such as Bank of America (NYSE:BAC), Goldman Sachs Group Inc (NYSE:GS), and Citigroup Inc (NYSE:C) – being hit with increasing regulation that will erode into profits until banks operate similar to utilities with “very low returns on capital” (See our analysis on Bank of America and Citigroup Inc (NYSE:C)).

While increasing regulation would impact profits, Hawtin’s prediction of financial services being over-regulated until they operate similar to utilities appears to be farfetched. Given the Presidential election year and the amount of financial lobbying, additional financial regulation may not be easily passed. If anything, banks have demonstrated over the last couple of decades an uncanny ability to bypass regulation.

We’re not saying financial services won’t take a hit in the next six months; we’re saying that if they do it won’t be due to regulation. Whiles banks will continue to see volatile earnings based on management (and lots of luck), it is unlikely that other companies will have similar algorithm trading issues as Knight’s 400m loss, or JPMorgan’s 2+ billion dollar loss on a trade.

If we take a look at the US Financials using the Dow Jones US Financials Index (DJUSFN), from a six-month perspective, financial services are up 2.45%.  From a one-year perspective, financial services are up 12.98%. DJUSFN is currently at 279.19. This is still far below its 2006-2007 peak at 609.77, but it is representative of banks having shed many of their proprietary trading arms due to the Volcker Rule. The lack of internal hedge funds has already been discounted in many of the banks. Many of the large internal prop arms such as Goldman Sachs’ Global Macro Proprietary Trading were spun off in 2011, which sell-side analysts already priced-in their recommendations.

Conclusion: While Hawtin’s prediction on financial services being negatively impacted by additional regulation has merit, we don’t necessarily agree. The current tone of regulation has already been priced in and substantial declines would likely be from other variables.

2. Avoid Technology (specifically Cisco): Hawtin sees Cisco Systems Inc (NASDAQ:CSCO)’s operating margins (62%) falling in the upcoming quarters due to competition from its Chinese counterparts. CSCO’s increased competition, new emerging companies, and uncertainty about product demand from emerging markets (specifically EMEA) could result in share price of Cisco Systems Inc (NASDAQ:CSCO) to fall. While its stock price has dropped 15% from 20.09 to its current trading price of 17.16 over the past 6 months, will there be another decline?

Cisco’s net sales in 2011 were $43.2 billion. This was split – 80% in products and 20% in services. Across the product line, Cisco divides its sales into four distinct categories: Routers (20.6%), Switches (38.9%), New Products (37.7%) and Other Products (2.8%). To investigate Hawtin’s points, we take a look at areas at product lines that are susceptible to additional competition, namely routers and switches.

Cisco routers are categorized as high-end, midrange and low-end. Its high-end routers still sell rapidly; this includes its premium product line, ASR 5000/1000/9000. However, Cisco’s mid-range and low-end routers experienced an increase of sales of only 2% (compared to 8% in high-end). Mid to low-end routers are where Cisco’s competition is competing to take market share from.  Cisco could see its operating margins get eroded here.

Cisco switches are already facing lower revenues. Switches arguably face more competition than routers and because a large portion of sales (25%) is from the public sector, continued reductions in public sector spending have a negative impact on Cisco’s bottom line.

In addition, Cisco Systems Inc (NASDAQ:CSCO) is seeing its New Product Line (VoIP, Security Products, Unified Communication Products, etc) take a larger component of Product Sales. This is a double-edged sword as Cisco’s bread and butter has historically been routers/switches. One on hand, it makes sense to expand. On the other, Cisco is still adapting to the environment. As a result, new competition in these areas will face less entrenched beliefs.

Cisco’s competitors include Hewlett-Packard (NYSE:HPQ) and Alcatel Lucent SA (NYSE:ALU), which have both seen 34.11% and 40% declines in their six-month stock prices respectively. (As compared to Cisco’s 15% drop). While the technology industry has already taken a hit in the last six months, Hawtin is still expecting more declines in the near future (see Why Jim Chanos is shorting HP).

Conclusion: We agree that technology stocks are going to face a tough time in the upcoming months; the technology landscape is changing rapidly; we’re seeing existing tech companies are making expensive acquisitions for market share. Unfortunately, they are often later forced to make write-offs for such expensive acquisitions.

3. Avoid Sectors Dependent on Government Spending: Hawtin is avoiding and selling companies that are dependent on government spending. This should come as no surprise, but European governments are not looking to ramp up fiscal spending at the moment. As a result, Hawtin recommends to sell/short Straumann LLC, a Swiss-based company that specializes in providing government-subsided dental equipment.

Hawtin works from London, so his focus may be more toward European markets. What about United States? We may not be in a bind fiscally as those Europeans (at least not now), but is the government expected to cut back on spending? Yes and No. Yes, because cuts on defense contracts will continue. IT cuts may occur. Healthcare spending will probably rise. Most other sectors you might as well flip a coin on who’s getting elected and what the public momentum is.

With that, we take a look at companies that are dependent on defense contracts since these are ones most likely to see hits on their revenues in the upcoming quarters.

Companies such as Lockheed Martin Corporation (NYSE:LMT), Boeing (NYSE:BA), (see discussion of Boeing and its competitors), General Dynamics (NYSE:GD), Raytheon (RTN), and Northrop (NOC) are all companies that are dependent on government spending. These five are the top contractors by revenue from the US Gov’t.

The last six months have shown the defense contract companies to have moderate price movements except for General Dynamics. General Dynamics (NYSE:GD) saw a notable price decline of ~10% which may likely be attributed to two reasons that its CEO Jay Johnson described as difficulties: delayed contract awards for encryption hardware and slower transition to newer product development. With the exception of Boeing, all of the companies mentioned above derive over 70% of 2011 revenues from government spending (Boeing was 38%). Can we see the rest of these companies also have a price correction in the upcoming months?

While it was only a year ago that we witnessed S&P downgrade the United States credit rating, and the continued debates within the Senate and House about the debt ceiling, even the hints of a government shutdown could have these five companies see a drop in their stock prices.

Conclusion: We agree with Hawtin on this assumption that reduced government spending could severely impact companies that are overly-dependent on government contracts.