AB Analytical Services

Natural Gas Strip Slip Suggests Time to Bail on Shale

Around Labor Day, I noted that the relationship between near-term and future natural gas prices was off the chart, literally.  Here is the chart I shared in that article suggesting caution on Gas E&P companies:

Since then, spot prices have shot up (perhaps seasonal), but, more importantly, the one-year out price has fallen sharply after trying to rally (and remains in a downtrend).  You can see this divergence in the top two panels in this chart:

At an 18% premium, the forward gas is still somewhat expensive to spot gas historically, but it is certainly a more normal relationship now.  With every asset up in value over the past year, why is gas lower?  More importantly, is there potentially a disconnect that will allow investors to potentially profit (or avoid losses)?

Gas bulls will tell you that it's only a matter of time before gas goes up.  We are working off the excess of supply that came onto the market in the bubble at the same time as industrial demand has plunged.  All one has to do is to look at the rig count to see that supply will be curtailed.  What they miss, as I pointed out in that prior article, is that we are learning that supply is much higher than ever imagined due to major discoveries in shale formations.    In that last article, I discussed how several leading companies are cranking out production despite the plunge in gas.  They are doing this because they have been able to sell forward.  Call me cynical, but I believe that the recent hit to forward prices took place as companies prepared to update investors following Q3 results and wanted to show themselves as being even more hedged than they had been previously (except for Cheasapeake (CHK)). 

As far as a disconnect, let me try to connect the dots.  The leading natural gas producers rallied sharply with spot, but have been pulling back lately.  A few of them are actually lower in price today than when I wrote about them in early September (despite the big rally in spot).  I believe that their valuation should tie more closely to future prices, and that is why I am concerned.  It's not surprising that the future price of gas has stayed high, but can these companies continue to count on hedging gains to fuel their profitability?  The buyer forward is most likely a regulated utility.  How long is it that regulators and consumers will tolerate gas prices well above market prices?  I expect over time, as spot prices remain well below the spike levels of 2008, there will be less willingness to lock into longer term purchases, but the producers, who have made very large investments in their leases and who have reasonable debt to service (and pay down), will continue to put pressure on the forward price. 

I want to share some comments from the industry about what's going on in terms of shale developments.  All of these come from Seeking Alpha transcripts from Q3 conference calls, with links back for the reader to investigate further:

First up is Devon Energy (DVN), which likes shale so much it is divesting other assets to concentrate:

We are currently adding drilling rigs in our major shale development plays and will continue to do so in 2010. The step up in activity for the remainder of the year will move us outside the range of our previous 2009 E&P capital guidance.  link

Chesapeake (CHK), as usual, offered all sorts of things to think about.  They are not one of the companies hedging, as they have a publicly stated view that gas prices are going higher per their model.  This will make them rich, of course, as they intend to crank out production:

On the operational side our daily production hit a new quarterly record for production at a daily rate of 2.483 Bcfe. In October, our net production has already been as high as 2.6 Bcfe. So we are on track to continue capturing gas production market share in the months and years ahead.  By year-end 2010, we expect our daily net production to exceed 2.8 Bcfe and by year-end 2011 we expect our daily net production to exceed 3.1 Bcfe, which would be an increase of 25% from our third quarter 2009 average daily production. These production increases continue to be led by growth from our Big 4 shale and Granite Wash play. link

Next, let's hear from XTO, which is increasing production despite a massive cut in rigs:

Great quarter for us from a production standpoint, from the fact that we were running 100 rigs last year, down to 47 rigs in this quarter. So, less than half the rigs we started this year with about a 14% growth target 4% organic. We’re going to end the year with a 23% growth target and 13% organic for the drill bit... 

On hedging:

As released today the company has approximately 55% on 2010, anticipated production hedged at $9.62. We will see that for 2010, we have begun to selectively lock in pricing that will continue to propel the company in value and reserve... link

Southwestern Energy (SWN) is cranking it out:

During the third quarter of 2009, we produced 73.2 Bcfe, up 38% from third quarter of 2008. Our Fayetteville Shale production was 58.8 Bcf, 60% greater than the 37.2, we produced in the third quarter of 2008.

They are a hedger just above the market price:

The hedges we put on in 2011 were in the mid $6, and then we have got one right around the $7 range, and that kind of tells what you we're targeting for overall prices. As we see those, you will see us work up hedges in both years. link

EOG (EOG) is not optimistic on gas in general (targeting just 3% growth due to weak prices in the first part of the year - must not use the CHK model!), but they are excited about the Haynesville:

We plan to run 10 Haynesville rigs in 2010 and increase our Haynesville net gas production from the current 40 million cubic feet a day to 200 million cubic feet a day by year-end 2010. The Haynesville will be the primary driver of our 2010 North American gas production increase.  Link

Finally, Petrohawk (HK) is probably the single most leveraged shale play.

Our development and drilling programs in our core shale place have outperformed our expansion in the Haynesville and Eagle Ford has been collectively executed by the land team and our geoscience professionals. And we have developed new and better ways of analyzing the explosion of data now available in both of these areas...  Production growth drives this conversion and with today's announcement we are on track to grow production 75% over last year and we have set 2010 guidance at 43% over this year.  link

An interesting aside and a lead-in to a future article regarding ways to invest in the move towards these shale plays is a drill bit that was mentioned by HK.  President Stoneburner stated:

The use of rotary steerable systems in certain applications has shown benefit as well as rotating case in the bottom. However, the most single significant factor has been the development of a PDC bit by our staff-drilling engineers that to this point has only been utilized by Petrohawk.

This bit has shown to increase the rate of penetration in the lateral dramatically. An example of the improved penetration rate is evidenced by the number of days that we have drilled more than 800 feet in a lateral.

In June and July, we only had three days with greater than 800 feet drilled. But during August and September, we had 20 of those days. More recently a 4500-foot lateral was drilled in five days and over 3200-feet of lateral was drilled in three successive days.

I believe that the mystery manufacturer is Ceradyne (CRDN), which stated in its recent Q3 Earnings press release:

A recently completed successful oil and gas drilling event in which Ceradyne’s proprietary ceramic bearing allowed the drilling of a directional hole through a difficult Texas formation without removing the drill and changing the bearing. We believe this bearing is the beginning of a series of proprietary ceramic bearing products for oil and gas drilling.

CRDN can use a little help, so hopefully my deduction is correct.  While Carbo Ceramic (CRR) is clearly a huge beneficiary of increased shale production, there must be other plays. 

It's a very interesting dynamic.  Higher prices will seemingly bring on an infinite supply of gas.  What happens with lower prices?  Already conventional production has plunged, as reflected in the rig count, but the highly productive shale wells have been gushing away.  These companies all have reasonable debt loads and typically generate negative free cash flow.  Plus, they have sold their story to growth investors who are counting on them to continue to crank out production.  With demand unlikely to rise substantially due to a tepid economy and supply likely to increase, it seems as though the price in the future will be pressured.  The shale producers have all rebounded sharply from a year ago despite gas prices continuing to fall.  Thus far, their hedging activities appear to have cushioned the blow, but, looking ahead, their realization is unlikely to be as high.  After participating in the recovery by investing in names like Carbo Ceramic (CRR), Chevron (CVX), Contango (MCF), Lufkin (LUFK) and Tidewater (TDW) earlier this year in a portfolio I manage as well as my model portfolios, I am sitting it out now.

Disclosure:  No position in any stocks mentioned except Ceradyne (CRDN), which is in the Top 20 Model portfolio as well as in a foundation I manage for a family member.

Sramana Mitra's Entrepreneur Journeys Volume 3 Kicks SaaS

It seems like a different world when I reviewed Sramana Mitra's first book, Entrepreneur Journeys, last year.  For those not familiar with the venture capitalist, business consultant and frequent Forbes contributor, she has taken a serial approach to sharing her unique and insightful views on the whole process of starting companies and succeeding.  Her first book was really an overview, and it concluded with an indication that it was just the first volume in what would be a series.  I should have known that her schedule for other volumes would be quite aggressive!  Positioning:  How to Test, Validate and Bring Your Idea to Market, her third volume, actually includes titles and a time-frame for volumes 4 and 5 in the coming months.  While I skipped Volume 2, Bootstrapping:  Weapon of Mass Reconstruction, I must say that I am looking forward to Innovation:  Need of the Hour this winter.

As I mentioned when I reviewed her first book, her content appeals to entrepreneurs who want to leverage her deep knowledge, but her case stories have a much broader reach.  As one who likes to understand the factors that influence the success of companies in general, I found once again a lot of specific lessons in Volume 3.  What makes the book work, once again, is that Mitra asks the right questions of very interesting people.  While some of these companies are now public or have been acquired since her interview, there are also several interviews with dynamic entrepreneurs whose stories most of us don't know at all.

Mitra devotes the first part of the book to "Going Vertical", with interviews of the folks behind TheFind, Kosmix, Stardoll and Glam Media, each of which is focused on a very narrow domain.  While I found these success stories interesting, the real appeal of the book for me was the focus on "Cloud Computing".  The interviews in this section included LucidEra, Fabrik, Salary.com (SLRY), InsideView, PayCycle (acquired by Intuit (INTU)), and Emergence Capital (an early investor in Salesforce.com (CRM)).  Mitra's interviews with these successful SaaS (Software as a Service) entrepreneurs helps the reader to understand the appeal of that business model.  She uses this section to warn Indian outsourcing companies that they risk being supplanted by technology solutions.  If you are an investor in any of these companies, this conversation alone merits a read of the book.  The balance of the book touches upon collaboration (ON24 and DimDim) and content publishing (iUniverse, Shutterfly (SFLY) and Playfirst).

I enjoyed "Positioning" as much as her first Entrepreneur Journeys despite its being more narrowly focused.  It's quite an easy read given that it is essentially a collection of short stories used to illustrate some key insights.  For those curious about what makes companies successful, how technology can lead to solutions or perhaps the more specific goal of Mitra - how to "go to market", "Positioning" delivers.

Disclosure:  I received a complementary review copy.

Small-Cap Smackdown: Russell 2000 in Reverse

Smaller stocks have spent Q4 correcting while the rest of the market has seemingly confirmed the primary bull trend (or are we still calling this a bear-market correction?).  Since month-end, the Russell 2000 has bounced back a bit from its October thrashing, but the index is down about 3% QTD while the S&P 500 has rallied over 3.5%.  While smaller and larger stocks don't always move in lock-step, it is quite odd to see them move in opposite directions.  As you can see in the chart below, the R2000 looks a bit toppy (or is it building a base for a year-end run?):

The relationship has been fairly tame all year, with a nice run from the market low in March through September favoring smaller stocks. Since peaking in mid-September, the Russell 2000 failed once to take out that high and has now clearly lagged by giving up over 1/2 its relative advantage over the past year in a brief period.  What's going on?

I believe that three factors have been influencing the recent underperformance, including the strength of the dollar, hedge-funds locking in gains potentially  and tax-loss selling/window-dressing. 

As far as the dollar, which has recently moved sharply back to the lows of a year ago, larger companies tend to have more of their sales and earnings coming from overseas than smaller companies.  I reviewed the data over the past few years, and there is a general correlation (though the very volatile action a year ago certainly questioned the relationship). 

My theory on hedge-funds is just a hunch, but one in which I have confidence.  Most hedge-funds are up big this year.  Their incentive fee structure encourages them to reduce risk as the marking period comes to an end.  Given that they are generally long smaller stocks, where their research efforts carry more impact, it makes sense that they would be selling out smaller stocks to reduce positions. 

Finally, selling pressure from tax-loss selling and window-dressing traditionally takes a higher toll on the less liquid smaller stocks (i.e. the "January effect", one of the few seasonal trades confirmed by researchers).

I last wrote about smaller stocks making more sense than larger ones just a bit early in late January.  The call ended up being right, but for the wrong reason I suppose. In any event, the relationship is back to where it was then, and I believe that this could be an opportunity.  Specifically, in a market that is relatively overbought, there are many smaller companies that are quite oversold due to tax-loss selling and perhaps window-dressing.  The portfolio I manage has a few of these!  I have been adding to some of these names in my model portfolios as well.  Additionally, there are many stocks that are in a corrective phase but that look attractive.   

I believe that as the calendar turns, investors will be taking a closer look at laggards as well as increasing their tolerance for illiquidity that is typically associated with smaller stocks. Smaller stocks typically have slightly higher PE ratios but are valued similarly to larger ones on a debt-adjusted basis.  I guess I am looking for the January effect to work, but noting that sometimes it comes early. 

Disclosure:  No stocks mentioned 

Cardiac Science: Time to Defibrillate

Cardiac Science is a long-term dud, to say the least, falling from a peak of 235 in 1993 by 98% over the past 16 years and by 96% since peaking at 98 in 2000.  Based in Bothell, Washington, CSCX (3.22, $75mm market cap), this manufacturer of automated external defibrillators and cardiac monitoring equipment somehow managed to snag what appears to be a good CEO, and that is why I am interested.

I first learned of the company when a client asked me about it in August.  The company had just resumed shipping its AEDs after a quality issue had led to a short-term halt in shipments.  Management suggested that it might have to take a large charge to cover the expense to fix the problem.  Two days ago, it did so, announcing an $18.5mm cash charge to cover a software upgrade for a problem that impacted 2 out of 300k installed units.

CSCX now has a tangible book value of $34mm after taking the charge to cover the workaround (cash charge) plus a big hit on the write-down of a tax deferred asset.  My calculations indicate that the company will probably generate cash of about $8mm over the next year, with sales growing modestly due to new product offerings.

CEO Dave Marver, who joined the firm from Omega Advisors late last year as COO, took the helm as CEO in March.  Marver has 14 years of experience as a fixer-upper at Medtronic (MDT).  Unfortunately for him, he walked into a really bad situation.  In addition to the recent quality issue, the company saw its distributor in Japan become a competitor.  Marver, who bought 10k shares in May near 4, picked up options upon joining the firm and upon his promotion to CEO

I believe that the AED business is a growth business, while the balance is more of a cash cow.  Marver will stimulate sales growth by launching new products over the next six months.  Most recently, the company began distributing a device for Japanese company Omron, indicating the value of their distribution channel. 

ZOLL Medical (ZOLL) trades at 1.1X trailing sales with a gross margin in the low 50% area.  CSCX, with 48% GM, trades at just 0.5X.  I think that CSCX can yield a 1X trailing sales valuation, which suggests to me a price in excess of 7 a year from now.  Here is the history for the past 5 years:

I am betting that Marver can fix the problems that have long afflicted this company.  It has no debt and sufficient cash, even after the recent charge.  Tax-loss selling and mutual fund window-dressing are creating quite the opportunity here.

Disclosure:  Long in an account I manage and long in the Top 20 Model Portfolio.

Another Hard Look at EZCORP

I first wrote about EZCORP (EZPW) (14.28, $704mm market cap) in early 2008 and have followed it closely every since.  In fact, it is one of only two names I have held since inception over the past 18 months in my Top 20 Model Portfolio (Catalyst Health (CHSI) is the other).  It has been quite the ride, as it ended 2008 up about 35% but was cut almost in half from its Q4 peak at the March lows.  This year has seen some sharp moves up and down, but it is still down 6% y-t-d after surging post-earnings on Friday.  I expect the stock could move to an all-time high price over the next year, potentially appreciating 60% to 23.

EZPW is primarily a pawnshop operator with a secondary business in payday lending.  In the big picture, the company provides credit to those without access (a large and growing population!).  The company is classified as a Financial, but it is really a hybrid.  Unlike most financial companies, it isn't leveraged (pro forma net debt to cap is <10%).  It derives a significant portion of its earnings from the sale of used goods, so it is a retailer as well.  The pawn business remains very attractive.  The company did two acquisitions last year and plans to open six de novo stores this year.  Payday lending expansion has stopped, with the company pursuing additional products to mitigate regulatory risk, including auto title loans and installment loans.  Mexico has been a source of growth, and the company will open about 50 stores in the coming year.  Some of these are typical general merchandise stores, but the majority are 400 s.f. jewelry-only establishments.  Another area of expansion is Canada, where the company is rapidly expanding its payday lending presence.  Finally, it is important to note that the company has a 30% stake in an UK pawn company and just made a 30% investment in an Australian company.  The earnings of these entities are booked beneath the operating income line.

The company just completed its fiscal 2009.  Sales grew 30%, but they were boosted by two acquisitions.  EPS grew 17% for the year, with half the increase attributable to the acquisitions.  This growth was quite impressive considering the negative impact the economy had on pawn sales.  To the company's credit, credit-losses on payday lending fell during the year.  The company guided above expectations, suggesting that it will earn 1.65-1.69 per share in FY10 (18% growth at the mid-point).

Before I demonstrate how cheap the stock is, allow me to explain the factors that have led it to become undervalued and why that may change.  I believe that one of the biggest problems this year was related to their purchase of Value Financial Services.  This deal was problematic from the get-go, with an initial announcement in June 2008 followed by an abrupt termination in July.  A new and more expensive deal was announced in September and closed in December.  The problem for the stock was that the sellers had a price protection plan with the company.  It was poorly crafted, as it required the sellers to actually sell the stock if they wanted to get reimbursed for a decline in price.  On top of this, the company surprised mid-year with weakness in its pawn retail operations, leading them to lower guidance for the year from 1.51 to 1.42.  Finally, an overiding issue for the entire year has been concerns over payday lending regulation, though the central commanders in Washington have been too busy with Healthcare reform to go there.  Another drag on the stock has been a lack of understanding about its minority investments in non-U.S. pawn and unsecured lending.  If you listen to the last call, many analysts (including me) questioned the most recent investment rather than repurchasing stock.  Finally, I don't believe that investors are aware of the large drag the decline in the Mexican peso was.  Against this backdrop, I believe that the recent addition of the stock to the S&P 600 index and the realization that the company has several growth drivers to mitigate any payday lending curtailment concerns are catalysts for driving a higher valuation.  I also believe that a better appreciation of the diversification and growth opportunities from its minority investments will help too.

As I said, this stock is very cheap.  Based on recent guidance, which was slightly above the prevailing consensus at the time, the company trades at about 8.5 times one-year forward numbers.  On a trailing basis, its Enterprise Value to EBITDA ratio is just 6X.  The stock trades at 2.2X Tangible Book Value.  This is for a company with very little net debt (after the Cash Converters deal), 5 year trailing EPS growth of 43%, Great Recession EPS growth over the past year of 17% and expected one-year EPS growth of 18%.  The stock is cheap on all of these metrics compared to its closest peers, First Cash (FCFS) and CashAmerica (CSH) and also has a better balance sheet.  A final note on valuation:  The company carries its investment in A&B at cost, while its market price exceeds that level by $26mm.  Here is the last 5 years on several valuation metrics:

I have recently raised my target to 23 a year from now.  Here is how I get there:

• 12PE
• 2011 EPS of 1.92 (up 15% from 2010)

I think that the chart is excellent too.  This year has been a consolidation continuation - three and a half years now.  Given the low valuation and the high potential growth, I would expect to see it catapult out of the base:

I like stocks where I see growth potential and deep value characteristics.  I believe that I understand, as elaborated above, why the stock has cheapened.  I like the management team, though I should note that the long-time CFO will be retiring (replacement to be named by year-end).  The company isn't widely followed (5 analysts), which suggests some potential for being a hidden gem.  Most investors don't really know the company, as their customers aren't likely to be investors!  The company fills an important need, has done so ethically as far as I can tell and has done so in a manner that has generated double-digit return on capital for years.  Free cash flow this past year ( a year of investment) was $61mm, suggesting a FCF yield of almost 9%.   As I look at the stock technically, I see one point down to support but 9 points up to my target.  I don't think 12 PE is a stretch at all - it has traded there in the past and its growth certainly seems to justify it.  EZPW seems easy to recommend.

Disclosure:  Long in a portfolio I manage and in my Top 20 Model Portfolio 

3 Consumer Stocks That Could Fall by a Third

The long-awaited correction appears to have finally arrived.  Like a yo-yo that has climbed up sharply and is now heading back down, this fall will probably not be as sharp or as deep as many pundits would suggest.  I am going with a SPY target of 87.50 to 92 as the most likely bottom for this move.  For those that follow my work, you may recall that this happens to be the area that I initially thought would contain the rally from March.  Clearly I was too conservative.  I get to my zone using several different metrics, including Fibonacci retracements as well as charting and volume-at-a-price.   To be very successful in the last few months, one had to set aside one's fundamental views in my opinion and roll with the liquidity.  As long as interest rates aren't rising, I do believe the pullback will be orderly and contained, but the bear is back on if we can't finance our federal debt at a low cost.

Even though my expectations are that stocks in general have about 15% downside from here (two weeks or two months - who knows), I believe that many stocks have considerably more risk.  In the past few months, companies with leveraged balance sheets have roared back as the capital markets have reopened.  Many companies have addressed liquidity issues by extending their debt or issuing stock, but several others have not taken advantage of what I view as a good opportunity.  I am cautious on companies in general that have high levels of debt relative to their potential to generate free cash flow, especially in an environment of economic weakness or stagnation at best.  With that in mind, I want to share three ideas, all of which have lots of debt relative to FCF and short-interest that has come down significantly over the past several months.  None of these companies had moved to address their weak capital structures.

Weight Watchers (WTW) is a broken company in my view.  I have written about this one before, and it has had the least recovery of the three that I am discussing today.  I think the tell is that it trades at 10PE - clearly big money doesn't believe those numbers.  The problem is that if the numbers aren't right, the debt becomes a problem.  They report next week, so we shall see.  As of 6/30/09, the company had debt net of cash of about $1.5 billion.  The company's FCF is essentially its net income, so this year, last year, next year and the year after all look about the same:  $200mm.  The company repurchased so much stock that it left its equity negative.  In a harsher environment, the debt will become a burden in my opinion.  I think that this one could see an earnings miss which could drive the price back down towards the 52-week low below 17.

Collective Brands has been more than a 5-bagger off the bottom, and I don't get it.  Since April, the estimates for 2010 have increased 5% yet the stock has doubled.  I do know that shoes had a good quarter on pent-up demand, but this is a company that can ill afford a weak economy.  The company is spending significantly less in CapEx this year as it retrenches ($85mm, down $44mm), so FCF conversion will be healthy this year:  NI of approximately $70mm, D&A of approximately $140mm and thus $125mm of FCF compared to $119mm last year.  Not bad for earnings being down so much.  The problem is that total debt less cash is about $500mm.  If the FCF were sustainable, the burden wouldn't be that great, but the company is unlikely to grow if it continues to shrink.  I look for this one to test 12.

My last pick  for a potential sharp decline is Carnival Cruise Lines (CCL), which typically doesn't produce significant levels of FCF.  The stock has rebounded 100% off the lows.  I sense that this business will be challenged for years to come.  While the $8 billion in debt seems to pale in comparison to the equity and the market cap, it is important to realize that the multiple of FCF is tremendous.  I expect this one to test the 20 area again.

 

I do believe that this pullback won't be as indiscriminant as the decline earlier this year or the rally, with companies with better capital structures and less aggressive earnings ramps performing better.  As always, you can check out my disclosure to learn more about what I am thinking from that perspective.

Disclosure:  No position in any stock mentioned

Large Stocks Could Lead the Market Much Higher

A few weeks ago, I was participating in a research meeting with one of my clients.  The most bullish in the bunch, who has been that way since May, was trying to make the case that stocks are attractive.  While they typically focus on small companies, we were going through big stocks, one at a time.  Sure enough, every time we looked at one, it seemed pretty attractive on a PE basis compared to its history.  More recently, we were focused on stocks near their all-time highs, some of which happened to also make the list in the prior discussion.  As one who has been reluctant to embrace this rally as sustainable, I can't deny what is plain and clear:  Big stocks are potentially cheap and technically capable of extending their rallies.

I continue to think that the economy will be challenged for quite some time and that the earnings estimates out there are too optimistic.  But what if I am wrong?  If rates stay low and earnings recover, what is the upside?  What follows is a simple excercise.  I took the largest 20 stocks in the S&P 500.  Here they are ranked in descending market cap:

The combined market cap of the top 4% of the index represents about 1/3 of the total market cap of the index.  As you can see, the typical forward PE is 15X, though the median for the past decade has been closer to 19.  Furthermore, if one looks out two years, the current median PE is about 12 (as earnings are projected to rise substantially in the following year).

In the table below, I projected the total return for each stock by assuming that a year from now it trades at its 10yr median PE and earns its current dividend.  I then added up the total returns by their contributions and, as you can see below, got an astounding one-year return of 53%:

Again, while this is not my prediction, I do accept that PE ratios should be high when rates are low and when earnings are closer to trough than peak.  So, if companies hit the projected earnings and multiples rally to median levels, just these 20 stocks could propel the market higher by almost 18% (33% of the market up 53%).  I don't believe that smaller stocks wouldn't rally as well - the same dynamics are at work,  though perhaps to a lesser extent.

So, absent higher interest rates and/or companies failing to meet projections over the next two years, a reversion to the mean would fuel a massive rally.  I have not embraced this potential, but my eyes are certainly open to it.  The market made two horrible mistakes earlier this year:  Overestimating earnings declines and placing low multiples on trough earnings.  Surely we could be overestimating the recovery now, but the multiples are certainly not extreme in the other direction.  I found it helpful to look at these stocks one by one.  If you click the link below, you can go through the 10 largest stocks and see what the PE history and price history look like. I have included the targets that are derived from the exercise of reversion to the median.

 Download Top 10 S&P 500 Stocks

While some stocks don't seem likely to perform as well as the exercise might suggest, others appear capable of doing even better.  If the worst is behind us and better times ahead, stocks could have an even better year in 2010 than they have in 2009.

Disclosure:  Long JNJ and CVX in a model portfolio
 

MedTech M&A Heats Up: 8 Potential Ideas

The recent pick-up in mergers and acquisitions has spilled over into MedTech companies too, with Covidien (COV) announcing the purchase of Aspect Medical (ASPM) in late September and Kimberly-Clark (KMB) announcing the purchase of I-Flow Corp (IFLO) last week.  I didn't even know that KMB had a Healthcare division (6% of sales in 2008)!

While I am somewhat disappointed that my keen interest in the space hasn't yet yielded me any buyouts of companies I have purchased or recommended, I do believe that the buyouts signal that some big companies are on the prowl in the sector.  Covidien, the former Tyco Healthcare, also bought Vnus Medical earlier this year as well as some private companies.  One thing that I have noticed about the acquisitions has been that the targets have had very high gross margins and strong balance sheets.  Further, the companies have had high recurring revenue due to the sale of consumables rather than capital equipment.  With that in mind, I screened my 70-stock universe of medical consumables companies for the following:

• GM > 70
• Positive PE
• EV/Sales < 4X
• Net Debt to Capital < 0

Here is what came up, including ASPM and IFLO:

The companies are sorted in descending market cap.  I know some of them fairly well, while others not as much.  A few general observations:

• Most of the stocks are up YTD, with the median ahead of the market
• In contrast to most companies, sales are growing
• For the most part, these companies don't carry a lot of inventory
• Several companies are enjoying positive earnings revisions

As far as my specific views on these companies:

Immucor (BLUD) has always fascinated me with its small-footprint blood analyzer for hospitals doing blood transfusions.  In late June, the company announced an FDA problem that killed the stock, but it has more than recovered since then.  To learn more about the company, click here.

Align Technologies (ALGN) sells Invisalign allows dentists and orthodontists to offer an alternative to braces which is more aesthetically pleasing.  They won a huge court battle a few years ago, leading to a quadrupling of the stock price.    This story has had a lot more permanence than I would have expected.  To learn more about the company, click here.

Surmodics (SRDX) is one that I have followed closely and wished that I had owned last week when they announced a licensing deal with Roche.  The company was a one-trick pony (coated stents for JNJ), but it has diversified dramatically over the last few years.  This is a technology company that is all over the place, with applications for drug delivery, diagnostics and devices.  I owned in in 2008 when their huge deal with MRK terminated - boy was I disappointed.  It seems like the recent deal, also related to their eye drug-delivery technology, has pulled a lot of folks in, but I am not biting yet.  While it is way up over the last week, it is way down from when I wrote about it 2 years ago.  To learn more about the company, click here.

Cyberonics (CYBX), is located just up the highway from me in Houston.  This company has been controversial for years, with founder and CEO Skip Cummins skipping out in late 2006.  The company uses vagus nerve stimulation (through an implantable device) to treat depression and epilepsy.  Boston Scientific (BSX) used to own 14% of the company but liquidated its remaining position in 2007.  Icahn currently maintains a long-standing 7% stake.  To learn more about the company, click here.

Kensey Nash (KNSY) is a neat little company.  I actually spoke to the CFO in the summer.  At the time, he said that he wasn't seeing any changes in ordering patterns that have plagued so many companies, but, due to their business model, they will be late to find out.  Their growth has been a bit slower than I like in this space as well (7% sales growth over the past 5 years).  I note that their inventory is up while sales have been falling recently.  The company manufactures products that are distributed by other companies  Angio-Seal (STJ) is the largest, while Orthovita's (VITA) Vitoss Foam is a more exciting growth product.  The company has relationships with 30 companies involved in cardiovascular, endovascular, sports medicine, spine and trauma.  To learn more about the company, click here.

I have never looked at Micrus Endovascular (MEND), which treats cerebral vascular problems (brain aneurysms) in a less invasive manner than traditional surgery.  The CEO, who has led the company since 2004 and has an extensive sales and marketing background that includes stints with Guidant and Boston Scientific, owns 2% of the company (with insiders totaling 8%).  To learn more about the company, click here.

Somanetics (SMTS) is one of my largest holdings in a portfolio I manage as well as in my Top 20 Model Portfolio.  I wrote in depth about it recently.  The company sells a monitor and sensors that help prevent strokes in cardiac patients as well as critical issues with infants and children who are having surgery or are in the hospital. I spoke to the CFO about the Aspect Medical purchase, given the similarities between the company and the fact that Covidien distributes for them in Europe, and I liked what he had to say.  You can learn more about the company by clicking here.

Ditto on Synovis Life Technologies (SYNO), which is also in the portfolio I manage and the Top 20 Model Portfolio.  I wrote in depth about it even more recently, though it has pulled back since it reported earnings.  SYNO makes several different biological materials used in surgeries.  I rank it as slightly more attractive than SMTS, as it has a terrific near-term driver in terms of the recent Pegasus transaction.  You can learn more about the company by clicking here.

I never like to count on being acquired for an investment to make sense, and I certainly don't have any evidence than any of these 8 companies are likely to be purchased.  They do share, though, several traits that could make them appealing to a potential buyer.  In any event, these high gross-margin companies generally seem to be growing in a profitable manner and maintaining strong balance sheets and at least reasonable valuations.  Happy hunting!

Disclosure:  Long SYNO and SMTS in an account I manage as well as my Top 20 Model Portfolio

St. Jude: Unlikely to Keep Flatlining

St. Jude (STJ) (38, $13bln market cap), the smaller of the two Minnesota-based global "cardiogiants", has been on my watchlist since late 2006, standing out for its tenure with absolutely no action from me ever.  Companies go onto my watchlist and usually are ultimately either bought or expelled as circumstances change.  STJ just sits there, just like its stock:

I almost called this a "38 Special", as the stock has traded at 38 in each of the past 6 years.  Since I started watching the stock closely, it has outperformed the market, but only marginally.  The next chart, though, shows that it's only the stock that has been sitting, as sales and earnings growth have both been quite healthy:

While it hasn't all been organic, with several acquisitions in recent years, the stock has flatlined while earnings have compounded at  almost 17% for the past five years.  While I struggle to differentiate the cheapness here from the rest of the Med-Tech sector (see my holdings if you want to know my view), I can't help but conclude that this stock has a fantastically favorable risk-reward potential.

Reasonable people can question the future growth potential and the risks of Obamacare, but the stock sure seems to price in a lot less prosperous future than the past decade.  The stock is pretty close to the lowest valuation over the past decade in terms of P/E, P/S and /PB:

So, this is really an elevator pitch today, not a hard-sell.  I am not sure if I will end up buying it or not.  As I said previously, there are so many choices available in the Healthcare sector  for those interested in "franchise" names like STJ.  Here are some of the things I like, in random order, besides the low valuation:

• CEO owns 8mm shares, CFO 900k
• Higher R&D than peers with tangible evidence of success
• High International (almost 50%)
• AF is hot
• Decent, but not stellar, balance sheet - $800mm net debt before large Q3 share repurchase
• Since 2006, it has been outperforming the market despite cheapening

Here are a few concerns:

• CapEx is consistently significantly higher than Depreciation
• Lots of legal activity (especially Epicor DoJ issue)
• A couple of GMP warning letters
• I am not so sure about the push to Neuromodulation

Maybe I'll just keep "watching" this one, but you can bet I will be watching it much more closely than usual given its tantalizing valuation.  I suppose if it drops enough below 38 I will play for the chance of seeing it get back there for the 7th consecutive year.  Big Pharma seems busted forever, but Med-Tech continues to realize innovation.  I believe that the intersection of a global recession and fears of price controls are creating a great entry in the space for growth to meet value, and STJ is a great example.

Disclosure:  Just watching!

 

A look at Q3 Equity Returns

The 3rd quarter was one that saw an obviously quite strong continuation of Q2 trends in general, but the performance wasn't as uniform as in the 2nd quarter.  As you can see in the table below, which allows us to look across capitalizations by sector, there were some stellar performers as well as some really weak areas.  I have color-coded the entries to reflect relative performance of the sector to the overall index price return, with a 5% differential for Q3 and a 7% differential for the YTD:

First, looking at the overall returns, the Mid-Caps trounced both the smaller and larger stocks once again.  Russell data confirmed this trend yet again.  On a YTD basis, the performance has been stellar.  For the quarter, "Value" beat "Growth" across capitalizations, though "Growth" maintained its clear year-to-date lead.

Looking at the S&P 500, Energy stocks did poorly and remain one of the weaker groups YTD.  Clearly, this weakness is confined to the very largest companies, as Mid-Cap and Small-Cap Energy companies flew this quarter and are among the better performing sectors in 2009 for the S&P 400 and the S&P 600.  I pointed out this opportunity earlier this year but admit to jumping off the bandwagon way too early. In any event, the weakness in the S&P 500 Energy stocks is quite misleading, as the median returns on the quarter and YTD respectively are 19% and 37.5%.  The issue is that 3 of the largest members, all integrated oil companies and representing currently over 1/2 the market cap of the sector, are still down YTD. 

Materials had a great quarter across the board, and the sector is one of the strongest thus far in 2009.  Not a single stock declined on the quarter. This sector is highly leveraged typically, and it looks like the best names this quarter and this year are the ones that performed the worst last year.

Industrials performed better for Large-Caps than the smaller companies, with 10 of the 56 names, including the very largest, General Electric (GE), up in excess of 40%.  Interestingly, the sector remains a laggard YTD, especially in Small-Caps.  I believe that there may be an opportunity in some of the smaller names and have my eyes on a few.  One factor may be the recent weakening in the dollar leading to some macro trades that have helped bigger stocks but not the smaller ones.

Consumer Discretionary, which was so hot early in the year, did a nice job in essentially keeping pace to slightly outperforming.  Some of 2008's biggest dogs continue to put up very strong returns.  It is very clear in the chart below that the bigger the fall, the higher the bounce:

Consumer Staples had a lackluster quarter, not surprisingly given the big rally.  Interestingly, the Small-Caps have been a strong performer on the year.

Healthcare was relatively weak in all market caps and remains far behind the benchmarks on a YTD basis.  I have a very high weighting towards Small-Cap Health and am hopeful that this sector becomes better appreciated for its strong balance sheets and potential growth.

Financials were the best Large-Cap sector.  While the smaller companies did well during the quarter, they remain very weak  on a YTD basis.  Representing over 17% of the total index, S&P 600 Financial stocks could be ready to play some catch-up this quarter, as they are down YTD still.

What can one say about Technology?  The sector kept pace during the quarter and remains exceptionally strong on the year.  With strong balance sheets and high international exposure, it's not surprising that the sector continues to draw a lot of focus.

Telecommunications Services, outside of the S&P 500 members, is a tiny component of the indices. 

Utilities have been poor performers across market capitalizations.  In addition to higher Treasury rates this year, there has been some concern about regulation.

Disclosure: None