AB Analytical Services

Foot Locker Turnaround May Have Legs

For those who follow me, you know that Shoe Carnival (SCVL), has been a favorite of mine over the past couple of years.  It remains in my Top 20 Model Portfolio despite a big run this year.  As I review the shoe retailers, though, I find Foot Locker (FL) to be cheaper and certainly meriting closer investigation.

For those not familiar with FL, you must not visit the mall very often!  Kidding aside, a trend away from malls towards strip-centers has been one of the factors hurting the company.  Additionally, with such a heavy emphasis on athletic shoes, the company hasn't fully participated in the big trend towards boots that other retailers have reported.

The big catalyst for the company may be the late June hiring of a new CEO, Ken Hicks, who joined from JC Penney (JCP), where he was President and Chief Merchandising Officer and a member of the Board of Directors.  He has experience in the industry, serving as President of Payless Shoesource (part of Collective Brands (PSS)) prior to JCP.  With the recent turnarounds at Chico's (CHS) (the real deal in my opinion - a brilliant hire) and DSW (DSW), who both hired new CEOs, this one is worth investigating further.  Hicks is a West Point grad and a Harvard MBA.  In my initial review, it is not yet clear to me how his leadership will differ from his predecessor.

FL saw sequential growth last quarter and expects to see it again, but its same-store sales are still negative.  The company has done a good job of controlling inventory and has avoided excessively promotional pricing.  In fact, its merchandising margin increased from a year ago by almost 1%.  The company has a strong balance sheet, with $300mm cash net of debt.  FL operates about 3500 stores, mostly in the U.S. but with significant exposure to Europe as well.  It has been reducing its footprint modestly.

No matter how I look at it, the stock looks very cheap.  Tangible book value of $1.7 billion exceeds the $1.56 billion market cap.  Compared to estimates for the coming fiscal year, the stock trades at a reasonable 14.6 PE.  Compared to peers, the EV/Sales ratio is among the lowest.  The 6% dividend is possibly sustainable, though the company could certainly decide that it isn't the best use of capital. In the chart below, one can see how attractive the current valuations are historically:

I think that the chart looks pretty decent as well.  The stock made a "V" bottom a year ago and has been basing between 10 and 12 mostly since then.  While it might shake-out towards 9.50 over the next few days, I wouldn't be surprised to see this one play some catch-up relative to its peers and test that 52-week high of 13 (a 30% gain).  The stock remains down about 2/3 from its all-time high in 2005:

I think that this one is probably worth watching very closely, though I haven't yet added it to my watchlist. The stock is cheap, and I think I understand why.  I plan to try to get a better handle on the new CEO - that seems likely to be the most important catalyst ahead.

Disclosure:  No position in FL

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

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!

 

Time to Take a Swing at Callaway Golf Company?

In my normal weekend activities of running through several screens, I noticed that Callaway (ELY) (7.50, $484mm) is one of the few companies in Consumer Discretionary that still trade below tangible book value (though it really doesn't - see below).  I am not a golfer, and I have never looked that closely at this company until today.  I intend to add it to my secondary watchlist and to try to get a better understanding of the "drivers".  Kidding aside, while this one appears to be very cheap, it has gone nowhere for the past 15 years.  Take a look at what hitting the wall looks like:

The company has grown sales at an annualized rate of just 7% over the past 15 years, a time when golf has exploded.  In the bottom panel, you can see that as sales stagnated, margins cratered progressively over time.  In the panel below, you can see that the stock bottomed well after the rest of the market:

In early June, the company slashed its dividend.  Since 1997, it had paid a constant .28 per share annually, but, in order to conserve cash, it lowered the payout to just .04.  An even bigger sandtrap for investors was the $140m convertible preferred that was priced the following day.  Facing a liquidity issue that had been clearly pressuring the stock, the company used the proceeds to pay off its entire short-term debt.  This move must have been quite embarassing to management, as the company had been acquiring shares from the time current CEO Fellows arrived in 2005 (with no debt on the balance sheet) through 2007.  Fellows had served as CEO of Revlon in the late 90s, where clearly he learned about employing financial leverage.  It looks like the stock took a month or so to digest this news, which was bad short-term (dilution) but clearly positive longer-term by eliminating the liquidity risk.  Interestingly, its large shareholders added during Q2 (especially AXA and Fisher, its 2nd and 4th largest), though Allianz, previously its largest holder, puked out its entire stake.  Now the stock looks to be recovering, as it has forged through the conversion price for that offering (7.05). 

If one includes the preferred as converted shares (additional 19.9mm shares), the common stock is currently valued at about $633mm compared to equity of $697mm and tangible equity of $522mm.  The chart below, which is a bit off because it doesn't include the preferred shares, shows that this is a cheap as this stock has been in the past decade:

Cheap is nice, but it isn't sufficient.  The company will report a loss this year, with the cost of the preferred equity (.09 per share) as well as weak business trends contributing.  Analysts do forecast a strong recovery over the next two years, but these are the same guys who were predicting that the company would earn over $1 this year as recently as January.  The preferred stock can be called (and the dividend cost eliminated as it is converted to common) if the stock closes above 10.53 for 20 out of 30 days.  One positive that I note is that the company has substantial exposure outside the U.S. (50%).  The bulk of sales come from clubs, but even sales of balls have been hammered.  The company cites pricing primarily and share loss as a secondary cause to this 20% YTD decline.  According to the company, it has gained share in clubs.

For all the talk of innovation, I note that the company historically spent 5% and now spends 3% on R&D.  The company has certainly moved to cut costs, even before sales turned down, so any sort of improvement in demand should really help EPS.  Management doesn't have a lot of skin in the game, with CEO Fellows at just 1.2% and the entire team and the Board at under 3%.  It is worth noting that the Chairman of the Board has purchased stock and excercised options in the past few months.  Short-interest is quite high at almost 8mm shares, but it seems as if a portion of it is against the convertible preferred stock.

All in all, I find this to be cheap enough to merit watching a little more closely.  I don't have a lot of confidence that this is the management team to make the company better - they are still in the box as far as I am concerned for placing the shareholders in harm's way by leveraging the balance sheet with short-term debt.  I wish I had been paying attention to the story back when they diluted massively, but there is probably still some upside despite the 50% rally off the low. 

Disclosure:  No position

Can Synovis Soar on Pegasus?

When Life Technologies (SYNO) (15.72, $181mm market cap) reported in late May, I thought I had let a great opportunity slip away.  I had recently added this pure-play in biological materials used in surgery to my watchlist, as it is a member of an elite group of companies in the Med-Tech space with gross margins above 60% and little or no exposure to capital spending.  I have written about a couple of others, including Somanetics(SMTS) last week and Volcano(VOLC) earlier this summer.  SYNO reported a great quarter, yet again, but it announced that it was going to be hiring salespeople.  I mistakenly took this long-term bullish but short-term costly action as a possible catalyst for the stock to pullback even further than it already had.  Instead, it ran from its close of 14.24 to a high of almost 20 in the next few days and a peak of almost 22 five weeks later.  As you can see in the chart below, it looked like I had let a great one get away:

Well, just a few days later, the company announced that it had won an auction of a company in bankruptcy, Pegasus Biologics.  Investors reacted extremely negatively to the news, hitting the stock hard for the next week and driving it back to the gap in the mid-14s that had been left when they reported earnings.  You can see that action in the up-to-date chart below:

The deal closed, the market has been rallying and SYNO has been locked in a tight holding pattern since they announced the deal and trashed the stock.  I expect that what had investors so excited in late May will be evident yet again when the company reports Q3 on September 2nd.

As I mentioned, I had been trying to get up to speed on this tiny company before it blasted off.  I was attracted to the gross margins in the mid-60s, the strong top-line growth (19% through the first 1/2 of the year, all organic, and expected to grow 18% this quarter) and the overall theme of biological materials.  While it is a competitive space, with much larger companies than SYNO, this is a very underpenetrated market.  The value proposition is the triple-win I like to see in Healthcare, where the 3 "Ps", the patient, physician and payor, are all happy.  Instead of harvesting tissue from the patient, a timely process with potential adverse side effects, the doctor uses products such as those provided by SYNO.  These materials tend to come from cows, pigs or horses.  In the case of Synovis, the company offers both products as well as surgical tools.  The products are used to reinforce staples as well as to repair soft tissue.  Some applications include bariatric, thoracic, cardiac, vascular and other surgeries.

I view these guys as a potential take-out candidate, so I was surprised to hear about the Pegasus transaction.  I shouldn't have been, as they had hired Tim Floeder in May, 2008 specifically to explore opportunities and even spell out parameters on their website.  I tuned into the call to discuss the buy and even got to ask questions.  I was curious about how much due diligence the company had done primarily.  I followed up with a discussion with the CEO a few days later. 

Here is my take on Pegasus:  Little downside, likely success, possible grand-slam.  Pegasus was enjoying similar growth to Synovis, but they got caught up in the financial crisis.  Unlike SYNO's pristine balance sheet, Pegasus had a lot of debt and was forced to shut its doors abruptly in May.  SYNO was familiar with the company but didn't consider acquiring them as a going concern due to its being more expensive than its focus (the company had raised over $40mm).  I agree with the company that it would have been worth in excess of $30mm.  Instead, SYNO picked up 2 products on the market and an additional recently approved one, for $12mm (1.33X 2008 sales).  Of course, the company had ceased operations, so SYNO assumed the cost and risk of restarting operations.  Not surprisingly, it hasn't been too hard in this market to get back key employees.  When the company announced the buy, they indicated that the deal would be dilutive initially as it re-started the company, which is being run initially as a separate subsidiary.  They estimate a loss in 2010 of up to $5mm after a 4th quarter loss of $1-2mm for this new division.

The Pegasus buy could be a flop - the CEO assures me that they won't throw additional resources at it if that proves to be the case.  It is likely, however, to work out just fine, possibly spectacularly.  I believe that the company could make this happen quicker than they initially expected.  The acquisition gets them products that would have been costly and time-consuming to develop internally and in front of a potential FDA rules change that makes it more difficult for Medical Device companies to gain approval.  The only unfortunate aspect of the transaction is that the focus areas of Pegasus aren't the same as Synovis, with products geared towards sports medicine and chronic wounds, so there is no sales synergy.  Ultimately, if successful, the company will be able to consolidate manufacturing into its Minnesota factory, so there could be synergy in that regard.

Even after the buy, SYNO is rich with cash and will still be quite profitable despite the burden of the additional expense.  Without making heroic assumptions about Pegasus sales ($4mm over the next 3 quarters), I estimate that the company can get their annualized sales to $74mm a year from now.  I believe that the EV/S multiple can expand to 3X.  Assuming what I expect to be cash of $52mm (excluding LT cash tied up in ARS), I get a target of 24 a year from now.  Alternatively, I get 24 by using a PE target of 22X and adding back in the cash.  Below is a longer-term valuation view.  I put in a line for my price target, which coincidentally was the high in 2007 and 2008 (and the company has grown since then!).  Also, my key valuation metric of EV/Sales of 3.0 looks reasonable.  The current PE is off of depressed earnings (Pegasus dilution, salesforce expansion) - the thesis is that EPS can grow to .90 or so over the next year (implying a PE of 26.5, or unchanged).

So, why the huge negative reaction to the deal?  It seems to me that the shareholders were not happy about the dilution, which may prove to be a lot less than the company indicated.  As CEO Kramp explained to me, the company had been consistently producing record EPS, and this will no longer be the case, at least in the near-term.  The whole thing is amazing to me, as the company is committing less than $20mm to the transaction (purchase price plus assumed initial losses), yet investors wiped 1/4 of the market cap out - about $60mm.  In an optimistic case, this new division could add $15mm in sales (or more) in fiscal 2010 (though I assume much less).  That level is probably a reasonable conservative estimate for fiscal 2011.  If that is the case, the company will most likely have created at least $25mm of value (rather than destroyed $60mm).  And who says markets are efficient!

I am betting that SYNO's bid for Pegasus will prove to be a great anecdote for the Great Recession, where a well capitalized company was able to take advantage of a good company that had a challenged capital structure.  I own it in a portfolio I manage as well as in my Top 20 Model Portfolio (7/15 at 15.34), which is up 46% YTD.  Even if Pegasus doesn't pan out, I believe that the company will keep growing sales and earnings even if the economy continues to struggle.

Disclosure:  Long SYNO

Somanetics: Monitor this Cheap MedTech Company

Somanetics (SMTS) (14.02, $169mm), the tiny manufacturer of a non-invasive patient monitoring system that measures oxygen levels in the brain and other vital organs, made news this week when it filed suit against an even tinier want-to-be competitor, CAS Medical (CASM).  I have been amazed at how cheaply SMTS has been trading.  Could this patent infringement suit serve as a potential catalyst?

SMTS, which I own in a portfolio I manage as well as in my Top 20 Model Portfolio, is a neat little company.  It sells the INVOS system (In Vivo Optical Spectroscopy), which consists of a monitor (razor) and sensors (blades).  The primary markets are for cardiac surgery as well as neonatal and pediatric surgeries, none of which are elective.  It fits a theme that I have been pursuing (MedTech companies with high recurring revenue), and I first got involved after they reported in June.  The stock has fallen about 15% since then despite an overall strong market, so I have been checking my assumptions.

One of the things that caught my attention is how much published research supports this technology, especially in the initial focus area of adult cardiac surgeries.  Additionally, I view the company as very aligned with the potential changes in our healthcare system.  Use of INVOS makes a lot of sense from a cost-benefit view, as it prevents catastrophes such as strokes, the need for ventilation and costly extended hospital stays. 

The company has placed over 2700 systems in 750 hospitals in the U.S. and another 1200 world-wide (where it partners with Edwards Lifesciences (EW) in Japan and Covidien (COV) in Europe).  While you might think that the business has been bad, sales (all organic) grew 14% over the past year.  Not surprisingly, new system placements have stalled, as capital equipment purchases have been slow across the entire hospital universe.  In the past quarter, overall sales fell 7% from a year ago, but the consumables grew.  System sales in North America plunged 76%, while sensors units increased over 11%, signifying continued use by existing customers but delays in new implementations.  The company traditionally gets over 2/3 of its sales from sensors.  It adjusted its outlook for the year slightly lower.  If it hits its guidance, it will still grow sales by 5% this year despite the tough environment.

SMTS is essentially a monopoly:  Hospitals buy its "insurance" or risk negative outcomes.  Gross margins have been running in the mid/upper 80s and were still 86% despite the short-fall last quarter.  While it is easy to get caught up in the short-term negatives of a tough selling environment, I believe investors may have overlooked the extension of the Covidien relationship as well as some improved labeling, both of which should help drive sales growth in the future.  Additionally, the company will be rolling out a new product that it acquired (and which has been depressing earnings as it has been under development) that could really enhance its overall value proposition.  Vital Sync, which will tie in both its own INVOS as well as other sources of data, will provide doctors with a single view in order to monitor patients.

CEO Bruce Barrett has been with the company since 1994 and owns about 5% of the company.  I like the skin-in-the-game that this former Abbott (ABT) exec and his Board/management team exhibit (12% of the company).  Further, I find the stock extremely inexpensive.  With almost 1/2 the market cap in cash and investments, it is even cheaper than it appears.  The stock trades at 18.5X 2010 estimates, which rise sharply as revenue growth resumes and the Vital Sync spending as well as some other short-term projects tail off.  The chart below shows how cheap the stock is relative to its history on several metrics.  The Enterprise Value ratios account for most, but not all, of the cash, as the company maintains LT cash that isn't included in the calculation.  Note that the company has total liabilities of just $2mm.  Further, over 80% of the assets is cash/investments,with only $2mm in intangibles, $3mm in net PPE and $11mm in AR and Inventory.  Balance sheets don't get much better than this!

 

While the company might have another challenging quarter, it is difficult to imagine new placements getting much worse for much longer given that they are down 56% in the first half of the year.  Most likely, the consumables will continue to grow at double-digit rates, which is important given their high representation in the mix.  I think that the company could become an acquisition candidate given its unique technology and its wad of cash.  The expense structure is quite high - it would be easy for a larger acquirer (perhaps one of its international distribution partners or another company that sells to hospitals) to cut some of the SG&A.  While I think that potential offers some downside protection, I am optimistic that the market will begin to value the company significantly higher later this year when the system placements begin to reaccelerate.

I believe that the stock could double over the next 15 months.  My year-end target for 2010 is that the PE reaches 20 and the company is credited for its cash of $6 per share.  The current consensus of 1.03 for fiscal 2011 (3 analysts) may be a little low (range is .90-1.19 and I independently calculate 1.15), but that would give a price of 27 (20.60 plus the cash, which should grow over the next year).  I had expected the stock to hold the 14 area, but it briefly failed.  The chart isn't as clearly positive as I would like to see, but that could certainly change quickly.  Until then, I think that this is a value play waiting for growth to reemerge.

Disclosure:  Long SMTS

Allegiant Travel: A Consumer Stock that Could Fly

It took me quite some time to warm up to Allegiant Travel (ALGT) (43.71, $874mm market cap), the Las Vegas-based operator of an airline and provider of other travel services.  After all, I practically preach that the consumer of tomorrow won't be spending anything like the consumer of the past.  Leisure travel is one of those areas that will likely struggle in the scenario I envision.  Nevertheless, I see ALGT as poised to do very well whether the consumer retrenches or returns.

Another reason I was slow to embrace the story is that it operates an airline.  While I have had a long-term respect and appreciation for Southwest Airlines (LUV), I view the airline industry as perhaps even worse than the auto industry.  For me to buy into an airline story, it has to be unique.  Having read public filings and other company information, listened to conference calls and crunched a few numbers, I find that this is not your typical airline. 

Before their recent report, I started a position and then added to it following the report on modest weakness.  I also added it to my Top 20 Model Portfolio.  The stock certainly isn't for everyone.  An investor should consider it only if they appreciate the following characteristics:

• Net cash on the balance sheet
• Positive FCF generation
• Terrific management alignment with shareholder interest
• Business model built upon profitable growth
• Underserved markets with limited competition
• Strong unit demand growth
• Adjacent market expansion
• Low valuation
• High short-interest

What is Allegiant Travel?

A look at this company must start with the people behind it.  CEO and Chairman Maurice Gallagher, who owns 21% of the company, is a serial entrepreneur who ran WestAir in the 80s (Mesa acquired) and was a founder of ValuJet (AirTran predecessor) before forming the CLEC MPower in the late 90s.  He was a lender to the original Allegiant Air, which, after bankruptcy, emerged in its current form with Gallagher as a major equity holder.  He has surrounded himself on his Board of Directors and his senior management team with people from his prior companies, so the team is more cohesive than one might normally expect for a relatively new company.  Gallagher earns no salary and receives a cash bonus , like other senior managers, only if operating income exceeds 5% of sales.  He has taken total cash compensation of $100K per year for the past two years.

The company owns and leases a fleet of MD80s that serve to fly leisure travelers from small cities to leisure destinations such as Las Vegas, Phoenix, Florida and, more recently, Southern California.  Their service is non-stop and not frequent, allowing them to have very high capacity on these big planes.  Every sale they make is direct to the consumer.  Beyond air fares, which are extremely low, the company generates ancillary revenue from both add-ons (insurance, baggage, assigned seats and in-flight products) as well as hotel, rental car and attraction bookings.  This ancillary service revenue is about 1/4 of overall non-charter sales.

This is not your typical airline.  Note several factors that serve to differentiate, including limited service, exclusive focus on the leisure traveler in small cities, low prices, and ancillary revenues that come from the philosophy of selling the entire leisure experience rather than just the transportation element.  When one thinks about the business model, it is very much focused on efficiency, similar to cruise lines but with much lower capital investment.  They price the planes to fill.  Their major expense is fuel (see below), but there are other expenses that are highly variable.  Unlike other airlines, since they own very inexpensive planes and have so much variable cost, they can take advantage of flexibility to balance fares, input costs and route capacity.  In seasons of lower leisure travel, they charter their planes to the military, always focusing on getting the highest EPS per plane possible.  One has to appreciate the very limited competition that they face directly.  The real competition is the willingness of the leisure traveler to drive to a different city and/or to endure multiple stops.

What makes the investment work?

When one looks at ALGT, it has successfully navigated an extreme spike in its largest input cost, fuel.  Sales have grown 17% over the past year despite significant erosion in fares as well as some recent challenges to its ancillary revenues.  EPS have grown at a 32% rate over the past 5 years.  The growth has been driven by the addition of new markets, increased penetration of existing markets, its ancillary revenue stream and improvement in its cost structure (ex-fuel) as it achieves scale.  The company has more origination cities as well as potential destinations to add to its network.  In a continued soft economic environment, the high value offering to consumers as well as a potentially increasing role the company plays to the downstream or "on-the-ground" service providers (car, hotel, attractions) bodes well for unit demand and the potential for robust ancillary revenue capture.

The company's financials are very strong, with equity (mainly its fleet investment) of $257mm (as of 3/31 - waiting for 10-Q this week).  Total debt is $61mm, with cash of $228mm ($133mm net of future travel liability).  Again, not one's typical airline expectations!  The company generates FCF.  Total Capex this year is expected to be $35mm, down sharply from the past two years but in line with D&A.  The company uses its capital very wisely, recently buying some planes as cadavers for their parts.  As of Q2, it has also repurchased $17.6mm of stock at an average cost of 37.79.

So, what makes the investment work is that the market begins to appreciate better both the operating model as well as the capital allocation decisions that management makes (not surprisingly given the huge amount of skin in the game).  I think that the company can continue to succeed in both a challenging economy as well as in one that improves.  In the weak economy, their value appeal as well as their continued share gains works, while an improved fare environment in a recovering economy would be beneficial.

What are the risks?

The stock has a massive short-interest, reported as of 7/15 at 6mm shares (15 days of trading volume and 30% of all shares), which is down from 9mm in April but still quite high given that insiders own almost 25% of the company and 5 institutions own another 50% (as of 3/31).  There are no convertible securities that would offset this massive bet.  Why are these folks so concerned?  FUEL PRICE RISK.  There may be a few other reasons, such as a macro bet against Las Vegas and concerns about the aged fleet and the potential for higher maintenance costs down the road or additional capex to upgrade, but judging from the questions on the last call, many are wondering why the company doesn't hedge.  CFO Levy reminded that the company historically has hedged and may again in the future.  While I think I get it, it appears than many others don't understand or agree with the company's position that it has a natural hedge in fare pricing.  In a stronger economy, while fuel prices may edge up, fares should too.  In a protracted weaker economy, pressure will stay on fares (but they are already extremely low), but fuel prices should fall.  Additionally, the company can control its risk by cutting flights.  Unlike more traditional airlines, they don't have to fly at a loss.  Funny, though, all these other airlines started hedging when fuel prices were quite high for the most part.  There doesn't seem to be an example of a profitable airline over the long haul (except LUV), so I question the traditional thinking of hedging. 

I looked into jet fuel prices.  After all, if they are really "low", it would seem foolish to not lock in.  What I found are that they aren't low and that locking in is quite expensive from what I can gather.  First, here is a chart of Jet Fuel prices (courtesy of IATA - www.iata.org):

 

Note that prices have increased by about 33% over the past six months.  This index, by the way, begins in 2000 and 100 is equivalent to 0.87 per gallon.  For a longer-term perspective in comparison to oil:

It appears that the prices, not surprisingly, track oil fairly closely.  From what I understand, there is no jet fuel futures.  To hedge, one would buy forward oil prices or perhaps heating oil from what I have learned.  The problem now is that both of these markets are in massive contango - the future prices far exceed today's price.  I have a chart that demonstrates the relationship traditionally as being a discount, which makes sense unless the spot price is temporarily depressed:

 
As you can see, for both crude oil and the refined product, the current price for the near-term future and one-year out requires the buyer to pay a 10% premium, while the typical relationship has been a discount.  The company didn't discuss this dynamic, but I would expect that part of why they aren't hedging is that the expense is astronomical.  No one knows how the dynamic between fares and fuel costs will play out, but I believe that this "risk" could prove to be an opportunity.  The chart below shows the possible outcomes for fares and fuel prices:

While clearly rising jet fuel prices and flat or falling air fares is potentially problematic, the company wins in the opposite scenario as well as in avoiding hedging costs in flat fuel price environments.  In a continued weak economy, it could be that fares don't fall much further as capacity in general comes out due to bankruptcies or consolidations, while fuel prices might be under pressure.  Traditionally, airlines have been able to revive themselves after bankruptcy, but today's credit crunch has changed that dynamic.  Also, it is more difficult for new entrants to come into the market these days.  In a stronger economy, while fuel prices might rise (and might not), it would seem that air fares could go up.  This is an industry that won't forever fly people at a loss!  

I believe that the company is essentially internally hedged and shouldn't hedge unless fuel prices get "low" relative to the fare structure.  I suggest that those who fear this risk consider hedging it themselves by purchasing an E&P company leveraged to oil or oil itself.
 

What's it worth?

What's appealing about high growth and low PE stocks like ALGT is that there are two ways to win.  On one hand, the PE can expand as investors become more appreciative of the business model and risks.  On the other hand, continued earnings can grow the stock even if the multiple doesn't expand.  I think both can happen here.  Analysts project that earnings will more than double this year, but they don't have great expectations for 2010 or 2011.  I believe that they are missing the strong unit growth despite unfavorable fares as well as other challenges and have a more optimistic view of the out years.  Clearly, they don't expect margins to stay this high.  Rather than argue that point, I propose that multiple expansion potential alone justifies investment, with higher EPS a potential kicker that gets a much higher return.  In the chart below, it is clear that the company trades at a low valuation:  10.5 PE and <5X trailing EV/EBITDA (7X adjusting for advanced purchases).  I believe that the market fails to take into account the growth potential and the strong balance sheet and treats this company like a more typical airline. 

 
I have a 65 target for a year from now (up about 50%) due to primarily multiple expansion from 10.5X to a more appropriate 15X (using consensus estimates, though they might prove to be too low).  Note that the median PE since the IPO has been closer to 17X.  I also arrive at a similar target based upon a sales metric.  I expect that sales will grow at least in line with current forecasts of 19%.  That would yield June 2010 trailing sales of $631mm.  Assuming an EV/Sales ratio of 1.7X(just above the median) and adding back net cash of $200mm a year from now, the enterprise value would be $1.07 billion implying an equity value of $1.27 billion ($64 per share).

Of course, this would be an all-time high for the relatively young stock and a double off of the recent March low.  Not too much of a stretch from panic evaluations for a company that has superior growth characteristics and a strong balance sheet.  As you can see in the chart below, the stock has acted a bit out of sync with the market lately, but it has been a relatively strong performer despite the recent pullback.  The way I look at it is that investors hung with this one as fuel prices escalated in 2008 (it was a market performer), and then breathed a sigh of collective relief when the madness stopped.  Net-net, it has survived that major challenge as well as an absolutely terrible overall consumer spending environment, generating strong growth and beating the market soundly.  I expect that 40 should hold as support and look forward to seeing the shorts potentially reconsidering their large bet against this company.

By the way, yes I see the potential "Head & Shoulders" formation and will be watching closely for a break of 40.

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

Martek Biosciences: Time to Revisit

In 2004, when Martek Biosciences (MATK) (21.70 --> $721mm market cap) was a high-flying growth stock, I had the opportunity to meet with the CFO.  While what they did sounded real interesting, I walked out of that meeting wishing that I worked at a place that could short stocks.  Long story short, the company was way overly optimistic regarding the prospects for continued growth.  Since then, they have been in my almost permanent "penalty box", but a recent appearance on a few of my screens convinced me to spend some time refreshing myself.  I am glad that I overcame a bias of permanently labeling a company or management team, and I believe I have uncovered a pretty decent growth story.  Here is what I like:

• Recession resistant
• Healthcare name with zero Obama exposure
• Strong Financials and FCF generation
• Valuation bordering on deep value despite growth potential
• The chart looks good
• DHA play is very timely

For those not familiar with Martek, they are all about DHA, the amino acid that has been proven to offer cardiovascular and cognitive benefits.  I personally can testify to the cardiovascular side, though I get mine through fish oil.  Martek uses a biotech process to create DHA from algae, offering the benefits of avoidance of both mercury exposure and a fishy taste.  The major catalyst for the company's growth earlier this decade was the rapid adoption by the oligopolistic baby formula industry of Martek's DHA.  Back in 2004, the company was very excited about the opportunity to add it to other types of food, but I correctly expected that this would be a much more challenging endeavor.  The company not only failed to gain traction quickly, but they also paid the price for relying upon an Italian sole-source supplier of a critical ingredient when their power failed at about the same time as a fire destroyed a warehouse in New Jersey as well as several capacity issues.  The stock fell  from its peak of 70 or so in 2003 to a recent March low of 15 before rebounding to 23 or so.

Despite taking much longer to break into the functional food business than they had expected, the company has gained traction and has its DHA in many products, including dairy products like yogurt, milk, and soymilk, juices, and baked goods.  Baby formula related sales still remain the vast majority of revenue, but supplements and additives are growing rapidly.  Expanding international penetration is another growth driver.  While the recent reset shows that the company isn't recession-proof, I do believe that it is resistant.  The set back was due to inventory destocking at formula manufacturer customers.  Nevertheless, sales should be flat in 2009 with EPS slightly higher.

Healthcare valuations are generally attractive these days, but everyone is afraid of reimbursement risk as we revamp the delivery system.  I am on the lookout for names in the sector that aren't subject to that risk, as they might command a premium for the generally non-cyclical elements due to investor fears about the other companies subject to that risk.

MATK used to consume cash, but now it spits it out faster than its formula additives run through babies.  In FY08, it generated $55mm after producing $36mm of NI, $29mm of D&A and just $10mm of CapEx.  The past several years have seen a dramatic dropoff compared to the massive spending prior to 2005.  The balance sheet is very strong, with Total Liabilities of just $57mm, cash of $118mm, Net PPE of $260mm and Equity of $613mm.

Valuation strikes me as very fair if not downright cheap.  On the one hand, the stock trades at 16X forward EPS, less than 1/2 the 5yr median.  On the other hand, despite having such a strong balance sheet, it trades at just 1.2X book value (1.4X tangible book value).  The FCF yield is almost 10%! As you can see in the chart below, it is cheap on EV/Sales and EV/EBITDA as well:

As I look at the chart, I like what I see.  While I think that it should hold 20, I see very strong support at 18.  When they reported in early June and shared very disappointing guidance, the stock traded down on very high volume very briefly violating the 20 level and has sense traded much better than the market as it has consolidated.  To the upside, I see the obvious resistance at 22.50, a bigger hurdle at 25 but then nothing until 28.  As you can see in the chart below, playing for 28 with hopefully risking a drop just to 20 can be supported.  20 was support in 2006 and twice in 2007, while 28 was resistance earlier this year, support in early 2008 and resistance exactly 2 years ago.

 

I would be remiss if I didn't mention an extremely timely catalyst, as the company is hosting a call on Monday 7/13 to discuss some new research on DHA for Alzheimer's.  While I hope that we don't see a buy the rumor sell the news reaction and certainly don't expect a buy the news reaction, the bigger picture is that there are some likely boosts ahead for demand for DHA.  So many supplement stories over the years have been just hype, but DHA appears to have a lot of clinical support.

While I like the story and added it to a charitable foundation I manage for my parents (see my disclosure) as well as to my Top 20 Model Portfolio (as part of a massive Small-cap Healthcare skew), I have my concerns.  First, I prefer to bet on good management teams, and this is one that I can say only that I hoped that they learned from their prior mistakes and aggressive promotion.  Second, there are some patent issues in a few years, though I don't expect that there are any binary events.  For the story to work, the company needs to see continued traction in food supplements.  I mentioned technical resistance at 28, and valuation issues won't impede that goal at all.  In fact, I believe that very conservatively the stock gets there over the course of a year.  All it has to do is be on track to hit the consensus number for FY10 of 1.45 and achieve a 18 multiple of likely earnings of 1.58 in the year ending 7/31/09 (assuming 1.64 or 13% growth for FY11).

As one who always appreciates a potential contrarian play, I took satisfaction in how quickly several of my clients rejected the idea without even hearing anything but the symbol.  That was pretty much my initial reaction too.  If these guys can keep generating FCF and improving their margins, investors should take notice in what will most likely remain a market starved for growth.  Short-interest plunged at the lows in March but still remains high at about 14% of shares outstanding. Some big institutional sales in Q1 certainly pressured the stock, with Friess selling its entire 1mm+ share postion (5%) and Fidelity and Putnam selling another combined 4%, with a lot of it going to the shorts in retrospect.  I look forward to seeing the Q2 data in coming days.

One final piece of advice:  Whether or not you like the stock, you should learn more about DHA.  I have been a big fan of DHA while not being a fan of Martek - we'll see if owning the stock is as healthy for the portfolio as their products are for the body.

Disclosure:  Long MATK