AB Analytical Services

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

8 Small-Caps Below Book Value with Net Cash

Those who follow my work know that I spend way too much time running screens on the weekends.  My goal is to find new ideas.  I run various types of screens, looking across broad market capitalization ranges or within sectors or even narrow industries.  Many of the screens are value-focused, others pursue growth.  I tweak my screens, and I try to come up with new ones.  The screen I ran today extends upon some screening I was doing at the end of last year within the Consumer Discretionary sector, which was laden with companies trading below tangible book value.

Today, I applied several of those parameters to the broad market and tried to hone in on companies that not only have strong balance sheets but that appear to have weathered the storm.  While the 8 names I am about to share are up a lot this year, they were down a lot last year and appear to be cheap yet.  Lots of people like to buy value stocks when they are beaten down, but prices 50% higher aren't necessarily bad prices.  In the case of this group, they fell pretty much with the market last year, about 47% on average.  While they have rallied 57% on average in 2009, they are still down over the past 21 months.  While I know only one of these companies very closely, the group certainly appears to be worth investigating.

In order to narrow the universe, this is what I did (and why):

• Market cap:  $100mm to $2bln (my definition of small-cap)
• YTD Price Return > 0 (eliminate poorly performing stocks)
• Book Value <1 and TBV < 1.2  (potential downside protection)
• Forward PE < 25 (profitable and not excessively valued)
• Net Debt <0 (downside protection)
• ROE (Trailing 4Q) > 0 (weathered the storm)

Here are the results:

The list is sorted by economic sector, with 6 of the 10 sectors represented.  Before sharing some brief thoughts on each one, I wanted to share some general observations.  First, while the PE ratios are somewhat elevated vs. the market and relative to their 5-year medians, I believe that the explanation is depressed margins.  Note that the P/S ratios are all at a discount to their 5-year medians.  Second, I included a measure of BV relative to the 10-year median P/B ratio to see if any of these "always" trade below book value.  As you can see, each of the 8 stocks is trading below its long-term median, with most trading substantially lower.

Gulf Island Fabrication (GIFI) is involved in off-shore platforms, primarily in the Gulf of Mexico but with 1/4 of its business international.  Though the company is debt-free, it slashed its dividend 90% earlier this year.  Capex has been rather lumpy for the company, though they have cut it sharply this year.  I note the backlog is shrinking rapidly.  Here is a link to their website.

Kaiser Aluminum (KALU) has rallied back strongly with the commercial aerospace sector.  The company, which came out of bankruptcy in 2006, has evolved from a mining company to a fabricator.  Kaiser began paying a dividend in 2007 and has hiked it each year, offering a current yield of 2.6%.  While there are 5 institutional holders who owned in excess of 5% as of 6/30, it is worth noting that the union owns 24%.  Here is a link to their website.

Griffon Corp (GFF) is a holding company with three unrelated businesses, all of which are about the same size in terms of sales.  Their Clopay Building Products is a residential garage door manufacturer.  Clopay Plastics Products sells specialty plastic into a broad array of markets, including baby diapers and surgical gowns.  Telephonics, which is actually growing due to homeland defense and border security, makes radar equipment that is sold globally.  The company raised a war-chest with a rights offering last September ($246mm) at 8.50, selling to an affilliate of Goldman, Sachs, which subsequently reduced its stake rather dramatically to a still substantial 17%.  While they certainly enhanced their balance sheet, they doubled their share-count.  In a strange governance twist, the CEO, who joined in 2008, is the son-in-law of the Chairman-of-the-Board and had previously served as President for Wynn Resorts.  He joined with a golden parachute package that pays $13mm.  Seems like the CEO might have been brought in to get this one sold.  He also owns 2% of the company.  Here is a link to their website.

You are probably familiar with Footlocker (FL), the old Woolworths.  My son is a big fan of their direct-to-consumer CCS.  I am not sure why this one is so inexpensive.  The company pays a 5% dividend (though that is about all of FCF), hiking it every year since implementing it in 2002.  Shoe-stores have been doing fairly well recently (pent-up demand), especially athletic wear.  From what I can tell, investors aren't keen on the heavy mall focus of this company.  Here is a link to their website.

Shoe Carnival (SCVL) has been one of my best investments this year, and I continue to hold it in an account I manage as well as in my Top 20 Model Portfolio (6% position).  I have written about the company on several occasions, most recently contrasting it to a peer and before that more in depth.  I visited a store near my house recently - not my kind of place at all, but I can see how it appeals to their target market.  With large inside ownership and a much improved inventory situation, I like it here.  Here is a link to their website.

Specialty Underwriters' Alliance (SUAI) was really cheap.  This provider of niche property & casualty insurance was engaged in a proxy battle when another company, Tower Group (TWGP) entered the fray and acquired them.  It looks like they are getting a pretty good deal, so it might be worth checking out.  Here is their website.

Mercer Insurance Group (MIGP) is a more traditional P&C company focused on small and medium-sized businesses in the West and in NY/NJ/PA.  Their investment portfolio is very high quality.  The company has 19% insider ownership as well as a 10% ESOP stake.  Here is a link to their website.

The last company is Comverse (CMVT), the Israeli software company leveraged to communications.  The company hasn't filed with the SEC in quite some time - 2005. Let's just forget about this one!

So, the screen kicked out several names, some of which aren't really investable.  I know and like SCVL.  A few others look interesting.  In any event, screening is always a step and not a conclusion, so treat these as ideas and not recommendations.
 

Disclosure:  Long SCVL in a portfolio I manage

Chasing the Market: Smaller Laggards

Is this what you are looking for?

Playing "Catch-up"?  My article from last weekend, "15 Stocks Having a Tough Quarter, But Worth a Look" drove the most traffic to my websites in over a year.  It tells me that the crowd is looking for beta, not alpha.  There's probably a whole other story here, but rather than talk about why I think everyone is downright silly chasing stocks, I will offer more ideas to investigate.

In that last article, I narrowed the 40 stocks in the S&P 500 down QTD, leaving just 15 companies worth investigating.  Today, I will offer up the same screen but on the Russell 2000, but I tightened it up to restrict to companies with cash in excess of debt.  I also eliminated any company with estimates declining in excess of 10%.  The data is as of Tuesday's close.  Here it is:

Most likely, you aren't too familiar with most of these companies.  I know a few of them.  In the Industrials, I actually own Met-Pro (MPR) in an account I manage and both the Top 20 Model Portfolio and the Conservative Growth/Balanced Model Portfolio.  Buckle (BKE) had a stellar year in 2008 and is strong this year as well.  I saw that they jacked the dividend the other day.  WD-40 is one that you may know.  It is a bit too slow of a grower for me, but it has a long history of above-market dividend yield. 

In the Healthcare sector, which covers about 1/2 the names, I will point out ICU Medical (ICUI).  Some of you may know that I have had a lot of interest in the Med-Tech sector, specifically in high GM stories like this one (with predominantly consumables).  This one is run by George Lopez.  He is an amazing guy, but not the comedian that I like so much (the Mexican Bill Cosby).  I digress...

Big picture, this list was roughly unchanged in price in 2008 during the mother of all bear markets, and it is down just slightly.  Some of these stocks are probably correcting mistakes from last year, but some are probably just correcting period.  If you are looking for potential long ideas, all of these stocks are in uptrends and probably worth a look.

Disclosure:  Long MPR

15 Stocks Having a Tough Quarter But Worth a Look

The S&P 500 ended moved into the green in May and has never looked back.  So far in Q3, it's up a whopping 16.8%, even better than Q2's 15.9% total return.  Despite the large advance, 40 of the members are actually down QTD.  Thinking that there might be some opportunities from the long side, I wanted to take a closer look, so I created a screen in StockVal to narrow the list.  Here is how I constrained the group:

• 50dma > 200dma (maximum 10%)
• PE F12M <120% of 5yr Median
• Net Debt to Capital < 60%

The first constraint is to assure that the trend is up but it isn't overextended.  The second constraint makes sure the PE isn't super-inflated.  The final factor kicks out balance-sheet disasters.  Here are the 15 stocks:

Note that several different sectors are included (7 out of 10).  As a group, these stocks are certainly lagging the market this year, but they did better last year for the most part.  The group also has a lower PE than the market in general.  I also included a measure of earnings revisions.  In general, the group isn't seeing large negative revisions that are driving the price declines, as the median is about unchanged.

Running through the list, I do have a few observations.  The lone Industrial stock, Stericycle (SRCL), is certainly a defensive stock.  The lone Consumer Discretionary stock, Family Dollar (FDO), has pulled back recently after being up strongly in 2008.  This stock looks very inexpensive to me - I recently added it to the Conservative Growth/Balanced model portfolio. 

There are several Healthcare stocks on the list.  LabCorp (LH) and Quest Diagnostics (DGX) are down a bit this year after being down just slightly last year, with investors somewhat concerned about reimbursement.  Gilead (GILD) was up last year, but it has retreated this year and is at the lowest PE in quite some time.  St. Jude (STJ), which has been at 38 for six years, is on my watchlist.  It sure seems inexpensive.  I recently added Becton Dickinson (BDX) to the Conservative Growth/Balanced model portfolio too.  Analysts were caught off guard when the company indicated that 2010 EPS wouldn't benefit from the currency hedging that helped boost 2009.  I like the broad product portfolio and the high international exposure.

I don't really have too much to say about the two Finance names that made the list.  Electronic Arts (ERTS) seems rather inexpensive considering its large cash hoard and its decade-low PE.  Akamai (AKAM) is one that I own both in a portfolio I manage as well as my Top 20 model portfolio (up 54% YTD).  Verizon (VZ) made the cut, but I am suspicous.  Finally, there are three Utilities that probably merit a look.

Many of these stocks are defensive and have given up some ground as investors have become a bit bolder.  It probably makes sense to take a closer look at these names, as they could play catch-up if the market continues its strong bid or come back into favor if it pauses or retrenches.

Disclosure:  Long AKAM in a portfolio I manage

Thriving to Diving: 36 Winners Last Year Struggling This Year

I was looking at a portfolio that I manage and was struck by some of the metrics.  While the account is up over 20% YTD (it is balanced 60/40 Stocks and Bonds), the current median equity return YTD for the 14 stocks in the account is -11%.  Long story short, I have had a lot of turnover this year and have picked up some stocks, especially in the Healthcare sector, that have lagged over the past few months or even quarters.  As always, I disclose these holdings on my website. 

This morning, I decided to look purposefully for stocks that are down this year after having a strong relative year last year.  There are lots of reasons to be out of sync with the market, but sometimes it's just mean reversion at play.  I took the Russell 3000 and found that 22% of the members are down over 10% this year.  Of that group, 253 were down less than 10% in 2008.  I wanted to make sure that these were companies with good balance sheets (net debt to cap <0) and earning profits (PE <30), so I constrained those areas.  I also decided to kick out any stocks down 40% or more this year to avoid stepping into a falling knife situation.  Here is what I got, sorted by sector:

As you can see, most of these companies are relatively small.  From my own experience with a few of these names, they are good companies but they should have fallen more last year.  Perhaps they benefited from fundamentals being slow to deteriorate, or perhaps they were just the beneficiaries of crowding in and momentum due to lack of downside or perceived upside.  In some cases, the bad news certainly came late.  In any event, the smaller the stock, the more likely it is to diverge from equilibrium, so it's good to see so many small-caps make this list.  It's also interesting that 7 of the 10 economic sectors are represented.

I am familiar with several of these companies, some intimately.  I just updated my 100-member Watchlist, and 8 of these companies are ones I follow closely.  A portfolio that I manage owns 5 of these names, including Aceto (ACET), Met-Pro (MPR), Martek (MATK), Synovis Technologies (SYNO) and EZCORP (EZPW).  Each of these is also in my Top 20 Model Portfolio, which is up almost 40% YTD, and ACET and MPR are also in my Conservative Growth/Balanced Model Portfolio.  EZPW is the only one that I have held the entire YTD, adding to the position in the model after the recent pre-announcement despite having a large weighting already. 

I have written about some of these, including MATK earlier this month.  My purpose today isn't to judge any or all of these stocks individually, but rather to suggest that in many cases we will find that the price action is less about valuation or fundamental changes as opposed to pure supply and demand changes.  Just as I don't understand why some folks were running these stocks up or holding them from falling last year, in many cases the valuations and fundamentals for these companies prospectively look fine.  Perhaps the sellers are restructuring their portfolios to be more aggressive (more cyclicality or more financial leverage).  At a time when the market is running up beyond the expectations of many (including me), it wouldn't surprise me to see folks looking to play catch-up take a look at some of these.  While not all of these will work, I expect that there are several here worth considering.

Disclosure:  No personal position in any securities mentioned, but long ACET, EZPW, MATK, MPR and SYNO in a charitable foundation I manage as well as in one or more model portfolios.

When Free Cash Flow Isn't so Free

Today is the 4th of July, which ranks right up there with Thanksgiving at the top of my list of favorite holidays.  This is a day where we celebrate the freedom in our country that we still enjoy after declaring our independence 233 years ago.  Political freedom is a value that we typically associate with countries in which the entrepreneurial spirit thrives and the economy grows.  We shouldn't take our freedom for granted, as most people on our planet still don't enjoy the opportunities that we do.  It is exciting, however, to see individual rights improving for many in lesser developed countries, as we can expect these new-found freedoms to help them improve their standards of living in coming decades.  So, to all my fellow Americans, I wish you a Happy 4th, and to those who don't yet enjoy political and economic freedom, I offer my wishes for improvement in those areas.

Just as individuals who are free are more able to realize their potential, companies too flourish when they aren't so encumbered.  The world has changed greatly over the past year, and I continue to be extremely cautious regarding companies that are encumbered with too much debt and other liabilities.  Yes, a very strange segue and not exactly analogous, but stay with me!  We have moved to a world of deleveraging, where only the fittest will survive.  I have been harping on this subject as my number one theme for 2009 since late last year, though I have stayed off the soapbox for the past few months.  How soon investors forget, it seems, as many of the most unfit companies as measured by their earnings power and balance sheet strength relative to their debt burdens have been among the best performers.

Today, I want to discuss the notion of free cash flow.  There are a couple of ways to define it, which can lead to vastly different results.   A very popular method is to take the working capital changes that contribute to Cash From Operations (change in AR, change in Inventories, etc) and subtract Capital Expenditures.  In recessionary times, this method can mislead as AR and Inventory decline creating cash and CapEx gets cut to the bone as companies look to save cash.  It leads to a very positive view of a negative situation.  Another method is to take Net Income, add back depreciation (a non-cash expense) and then subtract CapEx.  In a receding economy like ours, often the depreciation gets slashed due to the write-off of Goodwill, creating a very negative change in the future FCF compared to the past FCF (income is falling and now depreciation gets cut).

Investors tend to value companies with "high" generation of FCF relative to the market cap.  If FCF is "real", it is a measure of what is truly available to equityholders for potential dividends.  There are many ways in which FCF isn't real - too many for me to discuss here and probably lots that go well beyond my accounting knowledge.  I already mentioned how declining companies generate increases in cashflow generation that are not sustainable unless the company totally shrinks away (which isn't usually a good thing!).  Another factor that can diminish the value of the calculation is when the company is a serial acquirer.  If the business model depends upon more and more acquisitions (using that "free" cash), what happens when the music stops (as it is in this environment)?  Similarly, often an investment in the business isn't classified as "Capital Equipment", but it is a necessary investment.  An example of this is the rental-car industry.  Finally, is FCF "real" when the company is spending all of it and then some on share repurchases? 

When it's all said and done, I think that there are a lot of "fake" FCF stories out there.  These tend to be companies that see their debt go up year after year despite all this "free" cash flow.  In this environment, where it is increasingly difficult and more expensive to borrow, paying down debt has become the highest priority for most of these companies.  For the next few years, many companies will have to cut dividends despite generating all this "free" cash flow.  I decided to run a screen of some companies with very high historical FCF generation relative to their current market caps but that are encumbered with debt and other liabilities.  In this environment, future FCF isn't likely to be as high as historical FCF, so anyone blindly buying these "high" yielding stocks (FCF/Market Cap) is potentially assuming solvency risk without adequate compensation.

In my screen, I took the S&P 500 and kept all companies trading at less than 12.5X P/FCF (i.e. an 8% or higher FCF yield).  Note that we are skipping some real potential pigs by omitting companies that don't even generate FCF.  Next, I constrained net debt to capital (total debt less cash) to 35%, which is slightly higher than the median of all companies in the index.  The next parameter is that I wanted to make sure that the Total Liabilities were at least 5X the trailing FCF, so I constrained FCF/TL to a maximum of 20%.  In order to strip out any companies that are growing so fast that they aren't likely to face potential liquidity or solvency issues, I constrained maximum EPS growth of 0% this year and 25% next year (though I am probably omitting some companies that still deserve to be on the list because they won't actually achieve the expected growth).  Finally, I limited my analysis to the Energy, Materials, Industrials, Consumer Discretionary and Consumer Staples sectors. 

These companies are down a bit more than the market year-to-date after being down as a group slighlty more than the market in 2008.  I also included a column that highlights the Total Liabilities relative to the Current Assets (the higher, the worse).  These stocks have a median forward PE of just 11, which perhaps looks good to naive investors that don't look past that single metric.  As a group, these companies have debt and other liabilities in excess of 10X historical FCF.  Most of these companies have very little or perhaps negative tangible equity.  Many of these companies may seem beaten up enough, but who knows.  Gannett (GCI), for instance, trades at just 2.5X expected earnings, but they have immense burdens and an imploding business.  In general, I don't expect good things for most of these companies.  I have written specifically about General Electric (GE) in the past and am very negative on that name again after calling off the dogs in March (see the comments from that article).  I called GE a "value" pit in that article, and I think that the description applies to most of these companies as well.

I decided to forge ahead and apply the same parameters to the S&P 400 Mid-Cap members.  For those unaware, this index is up sharply year-to-date.  The results from the screen kicked out several names with similar characteristics (not surprisingly).  The shocker was that this group is up a median of 17% after declining a bit more than the large-cap group in 2008.  So, some of this year's performance may be making up for last year's action.  In some ways, the big companies have bigger problems in absolute dollars, but some of the names on this list are likely to encounter unfriendly financiers as well.

I know that Oshkosh (OSK) just won a big contract, but is it enough to overcome their horrible balance sheet?  United Rentals (URI), a failed LBO, is a great example of fake free cashflow.  We found that out when they wiped out a lot of the Goodwill late in 2008.  This is a company that had $726mm in equity at the end of 1998 and $2.04 billion at the end of Q3-2008 only to end up with -$29mm at the end of 2008.  In a decade, it paid no dividends and saw its equity wiped out.  Its total debt grew by over $1.7 billion during that decade.  Ironically, its share count went up but came back right to where it started after they repurchased a bunch in 2008.  That was a brilliant move - 31% of the company at 22, spending $600mm.  Oh, over that decade they produced FCF of $5.5 billion.  Go figure.  The answer is that the calculation of FCF is flawed - the company has minimal "capital equipment expenditures" but massive investment in its rentable inventory (not called inventory though, as that is stuff for sale).  So, they spend big bucks every year on something that's not inventory and not capital equipment but used as the core of their business.  There are lots of companies out there like this (as an aside, this is my issue with Aaron's Rentals (AAN) about which I wrote recently).

Let's conclude with a quick look at Regis (RGS), which is a serial acquirer in a very slow-growth industry (hair salons) that is actually more economically sensitive than many recognize.  They last did an acquisition in early 2008, and their sales growth, which was steady for so many years, declined sharply (down 14% in Q4 and 11% in Q1) after the following annual growth rates: 

• 6/2008:   4% (store closings)
• 6/2007:   8%
• 6/2006:  11%
• 6/2005:  14%
• 6/2004:  14%
• 6/2003:  16%
• 6/2002:  11%
• 6/2001:  15%

Organic growth slipped from 4% to 3% to 2% over the past few fiscal years before falling to -1.4% in the first three quarters of FY09.  The company generated FCF of $538mm over the past 5 years ending in June 2008.  It paid dividends to shareholders of about $36mm.  The company repurchased stock in 2008 and 2007, spending a total of $135mm to repurchase about 4mm shares at about $34 per share.  The rest of the FCF went to pay for acquisitions.  Going forward, it's a slow-growth industry, these guys have a ton of debt and the game is over (acquisitions).  I wish them luck!

Tying it altogether, more than ever (after this big rally that has lifted some of these overleveraged companies) investors need to be very cautious about investing in any company.  The economy isn't likely to grow significantly until the next Presidential election in my opinion, and it could contract again.  Companies are slashing expenses and investments today to survive until tomorrow.  In that environment, overall sales are not likely to rebound.  If one feels compelled to invest in any stocks (rather than corporate bonds, which offer better downside protection by far), they ought to be investing in debt-free companies that aren't likely to endure losses.  The exercise I have shared today helps to avoid high FCF-yielding companies whose shareholders aren't likely to ever get their hands on that "free" cash flow.  I would turn the whole thing around and look at companies with no net debt, with FCF no less than 50% of total liabilities and FCF yields in excess of 4%.  There are 33 in the S&P 500 Large-Cap(in all 10 sectors, not just the ones in the screens above), 31 in the S&P 400 Mid-Cap and 69 in the S&P 600 Small-Cap (yes, I still prefer smaller vs. larger companies).

Disclosure:  No position in any of the stocks included in the discussion or the tables

24 "Expensive" Stocks that May Go Higher

In a bull market, valuation plays second fiddle to growth and momentum.  Even in a bear market, if one can identify companies that have the capacity to stand up to the headwinds, one can benefit from "crowding in".  Simply put, the investors that like growth have very few options, so they all focus on the same few names, driving them potentially to very rich valuations. 

I believe that we are in a bear market, though, as I have described, I expect the investment climate to be good this quarter.  My views are based less on any change in the economic outlook (still lousy) but more on valuation for the most part.  Simply stated, stocks overreacted during Q1, with too many stocks of good companies pounded beyond merit while the bad ones were perhaps pounded even more.  I have written about small-caps generally being attractive (back to same relative price now after getting worse subsequent to my article), but I am a bit nervous about the valuations of some of the ones I have favored and have sold or trimmed many of them  (America's CarMart (CRMT), Dorman Products (DORM), Men's Wearhouse (MW), Met-Pro (MPR), Shoe Carnival (SCVL), and Thor (THO)).  I have written about several of these companies, all of which were deep value plays.  I was definitely early on most, but, fortunately, I used the lower prices to build larger positions.  I credit the strong YTD performance of my Top 20 Model Portfolio (up 9.9%) to the massive recoveries in these small-cap names (primarily consumer discretionary).

So, what now?  Many of the deep value names have been snapped up.  While I believe that we are nearing the top of the range and will be careful about deploying capital immediately, I am not expecting that the next pullback will create the kind of values that we saw last month at the lows.  I continue to believe that investors should and probably will trim companies with inferior capital structures.  We are too far from the next economic upturn to place bets on those companies for now (I expect a very long period of weak growth to follow the negative growth rather than a "v-shaped" economic recovery).  One area that could get some focus, though, are the few high-growth companies, but ones with strong balance sheets.

To try to identify potential candidates, I screened for the following attributes:

• Market Cap > $100mm
• Price vs S&P 500 (13 weeks) > 0 (favorable price momentum)
• Total Debt to Cap < 20% & Net Debt to Cap < 0 (strong balance sheet)
• 3 yr historical EPS growth >20 (Company has grown)
• 3 yr historical RPS growth >10 (Company has grown top-line)
• FY2 EPS / FY1 EPS > 15% (Company is expected to grow)
• PE > 18 (Market views it as a growth stock)

That last attribute may confuse readers, but I am not looking for a company that is totally underappreciated by the market.  If you can find those, they are obviously better!  In this case, I am trying to identify companies that have grown historically and, for whatever reason, are expected to continue to grow.  My thesis is that the PE for these stocks MAY be too low.  Even if not, the growth itself could help the stock hold up better in a weak economy.  Here is what StockVal kicked out:

I intend to check back on this screen in the coming weeks, as no doubt it will change.  I like that several different economic sectors are represented.  Not surprisingly, given the recent rally, the group is overbought (last column) for the most part, though a few names aren't.  The PE ratios are generally high at 27-30 typically.  They tend to be lower than they have been over the past 5 years.  Generally, I would like to buy stocks with rising estimates.  The data I share represents not this year's estimates but the following year's.  In most cases, the estimates are probably falling for this year, which is ok with me.  Note also that the typical stock is still 35% below its 52-week high.  Given how weak Healthcare has been lately, some of these names could actually be timely now.  Generally, I would look to buy stocks that have a Price Momentum Index below 1 (9 of the 24 are there now).

So, this is just a first step, not a buy recommendation (just to be clear).  Some of these stocks will not meet expectations and will most likely get crushed due to the high valuation relative to the market.  After all, who wants to pay Dom Perignon prices for non-vintage champagne?  If you want proof, I can send you the 15 stocks (one of which I own) that meet all the criteria except that they have been underperforming over the past 13 weeks.  I bought the one after it got slammed, and, in fact, this might be an even better strategy (buying long-term growth companies that hit the speed-bump and reset the bar).  With that said, though, at least conceptually. buying winners can work, even in a bear market. 

This rally has been massive and has been driven by a reversion to the mean for some deeply oversold stocks.  If I am correct that this has been a valuation rally and not a reflection of better times ahead generally, then investors should want to own companies that can better weather the storm.  Companies that can grow (as reflected at least by high historical growth and high expectations as evidenced by PE multiples above the market) or companies with strong balance sheets both fit the bill.  The screen above hopefully incorporates both of these attributes. 

Disclosure:  No position in any of these stocks

Big Opportunity in Small Energy Stocks

Small Energy stocks have been hammered compared to medium and large ones.  When I see something that looks out of whack, I try to take a look at it and understand it better.  Often, there are good reasons for the changes in the relationship between various stocks, but often there aren't.  Segmented buyers can often explain the discrepancy, and I believe that is the case here.  In the graph below, I have plotted the YTD returns of all of the S&P 1500 Energy stocks by the logarithm of their market caps.  As you can see, the log regression has a pretty good fit (and an R-squared of 19%).  In reality, as you can see in the table below, it is the medium-sized companies that are doing best.

 

  

I have gone on the record recently as being supportive of Energy and of Small-Cap (both for similar reasons - balance sheet), so naturally when I see the average small-cap Energy stock down 17% when medium and large ones are up, I get a little excited.

Let's get some perspective before continuing.  The entire S&P 600 Energy sector has 24 companies with a total market capitalization of $13 billion, just marginally above the median S&P 500 company at $9.6 billion.  So, we are dealing with a very different animal potentially.  There are some other differences too.  In the table above, I have listed some attributes, and clearly the S&P 600 is skewed more towards Services rather than E&P.  While the median company has higher liabilities relative to trailing EBITDA (negative), you can look at the tables below and see that the S&P 600 companies relative to the S&P 500 companies have slightly more net debt relative to capital (also negative).  Though not a favorable comparison, the differences aren't signficant.  Offsetting this, though, is the valuation, with the S&P 600 companies trading below tangible book value and almost 1/2 the relative level of the S&P 500 companies.  PE ratios are similar.  All in all, while there are some differences that perhaps need further explanation, the stark performance difference doesn't make a lot of sense.

I believe that the universe of buyers is segmented.  Most institutional money managers live in a bucket (not literally, but if this market keeps declining, maybe so) known as the "style bucket".  They are restricted by market cap or growth/value segmentation among other attributes.  While the overall fundamentals for an industry should translate roughly across the universe, the valuation sometimes doesn't.  Before continuing, let's look at the three groups of stocks:

The S&P 500 is overloaded with producers by number and by market cap.  Interestingly, the very largest stocks among the producers are dragging down the group, particularly XOM and COP.  Note that the service companies are almost all UP on the year, while the producers are split with a break-even on average (which is better than the average S&P 500 stock).

The mid-cap stocks are rocking.  Here, we see a shift towards more service companies, but still the E&P guys are the majority.  Again, we see the service companies performing better on average.  Note that the small E&P guys are getting hammered, but the average return is still zero for the group.  In fact the average returns are similar for the S&P 500  and S&P 400 by group.  The better absolute performance for the S&P 400 is a function of the large E&P guys bringing down the S&P 500 as well as a better "mix" for the S&P 400 (more service companies). 

Ok, now it get's very interesting.  Note our conclusions so far:  Service is beating E&P, but the average E&P stock is still about unchanged on the year.  For the S&P 600, which is heavily weighted towards service, we find the average service stock is down 7%, while the few E&P stocks (except HOC) are getting crushed.  While there could be some issues here like these are bad service companies, the downturn could hurt small companies more, etc., there is a lot of explanation necessary to justify this big difference.  The E&P companies may have some issues, but I don't see it.  But for the service companies, I don't see any major differences in the metrics compared to the S&P 400:

• PE lower
• FY2 estimate changes similar
• P/TB lower
• Net Debt/Cap lower

So, I want to be a buyer of the best looking names on this list.  I have, in fact, bought one, my old friend Carbo Ceramics (CRR), which I sold a little too early last year.  As always, I publicly disclose my holdings.  I also added CRR to my Top 20 Model Portfolio today, and I should note that I added Tidewater (TDW) earlier this month to my Conservative Growth/Balanced Model Portfolio.  Chevron (CVX) is a member of both.  Some of the other names that stand out in my opinon:  Lufkin (LUFK), and Matrix (MTRX), though they are both up year-to-date, as well as Seacor (CKH), Bristow (BRS) and Gulf Island (GIFI).  As a caveat, I don't know these other companies very well.  This list is intended as a tool for readers to use as part of their dilligence.

While I do believe that this opportunity is mainly a function of segmentation of buyers, I am open to other suggestions.  Usually these situations correct in rather short order.  I recall when I bought CRR last year that it had lagged its 3 largest customers, all of whom are much bigger, and I am hopeful that is the case today as well. 

Disclosure:  Long CRR (and long CRR, CVX and TDW in model portfolios)

The Strongest Balance Sheets in the S&P 500

I have written extensively over the past several months about the need to focus more on the balance sheet.  I have explored several metrics to help identify companies with inferior financial strength or at risk of dividend cuts.  With my expectation that we are now in a trading range with an upwards bias (730-880 on the S&P 500), I thought that it might make sense to use these same metrics to identify potential buys.  If I am correct about further weakness later this year, it would seem as though we should be using the rally to upgrade the portfolio.

Comparing total liabilities (which include not only debt but also other obligations that can sometimes exceed debt quite significantly) to various components of the financial statements and also comparing the value of the stock to its accounting book value could allow us to identify companies better able to weather the storm.  I constrained the universe to the S&P 500 and included the following parameters:

• Liabilities/Current Assets <1
• Liabilities/EBITDA <3
• Liabilities/FreeCashFlow <5
• Price/Tangible Book <4

While these are nice attributes and do suggest a potential margin of safety, they are no guarantee that the stock price won't decline.  In fact, as you can see in the table below, many of these stocks have declined significantly this year (though the entire list is doing better on average than the market).  It is worth remembering that using accounting statements implies relying upon historical events - EBITDA and FCF are backwards looking.  Additionally, assets may become impaired, so CA could be overstated (AR, Inventory) and, consequently, Tangible Book too may be lower than the balance sheet indicates.  With those caveats, here are the 28 names that made the cut:

Several economic sectors are represented, though clearly Tech is represented disproportionately.  While almost all of the charts look like they are potentially bottoming or basing, a few stand out:  AKAM, CTSH and XLNX.  Perhaps they are "ahead of themselves", but they have all penetrated longer-term moving averages.

If you like the concept of upgrading to companies with strong balance sheets and are open to smaller companies, I have good news:  Using these same metrics, there are a lot more names that meet the criteria.  While less than 6% of the S&P 500 made this list, 8% of the Russell 2500 does (the Russell 3000 less the top 500 names).

Finally, I included a column for dividend yields.  While one can never be sure how defensive a company might become in this environment, it seems very unlikely that any of these companies would cut their dividend.  With that said, though, I am aware that at least one did:  Titanium Metals (TIE).  Perhaps some of the ones on the list that haven't paid a dividend historically will decide to do so now.

Disclosure:  Long ISRG and ZMH

Cash Mirages: Lilly, Procter & Gamble, Verizon and Wal-Mart

We all know that "cash is king" these days.  As investors continue to change the ways they look at companies, clearly they appreciate more than ever substantial cash reserves on the balance sheet of companies in which they invest.  Unfortunately, appearances and reality aren't always the same.  While a company may show a large cash balance, often there is something on the other side of it, whether it is debt or some other liability. 

Imagine a company that has no debt and no cash.  It sells a bond to the public and pockets the cash.  Is it richer or in any better long-term financial situation than before?  No!  There are many examples of non-debt liabilities that can act as claims on cash, like deferred taxes or deferred revenue, and there are asset impairments (such as AR or Inventory ) that can create a short-term claim on cash as liabilities must be met.  A whole other issue is that often cash is domiciled off-shore or restricted in some way.  Suffice it to say, the reported cash is never understated and often potentially overstated.

I wanted to look at some "cash rich" stocks, so I took all of the S&P 500 companies with $5 billion or more in "cash and short-term investments".  To see if there were claims on that cash, I compared the current assets and the current liabilities. I then defined the notion of "free" cash by crediting all of the cash in excess of the difference of CA and CL, up to the amount of cash.  So, for example, if a company has $1 billion in cash and its CA exceeds its CL by $1.5 billion, then all $1 billion of its cash is "free".  On the other hand, if its CA exceeds its CL by just $300mm, then it has "free" cash of just $300mm.  While this isn't scientific by any means, it gives a general sense of how available the cash might be.

The 30 stocks are sorted by cash as a percentage of market capitalization.  Note that I did make an adjustment to both United Health (UNH) and Lilly (LLY) for long-term investments.  I considered that adjustment only for companies whose cash appeared to be a mirage (so, UNH was ok after the adjustment).  The results of this analysis indicate that Lilly (LLY), Procter & Gamble (PG), Verizon (VZ) and Wal-Mart (WMT) aren't as cash-rich  as a naive analysis might imply.  The bigger takeaway is that investors need to dig deeper than just looking at stated cash.

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Disclosure:  No position in any stock mentioned