Value Portfolio

Buckle (NYSE: BKE) reported second-quarter financials that were solid, with revenue growth of 7.9 percent beating analyst expectations and earnings-per-share growth of 6.1 percent matching expectations. Operating profit margin of 17% was flat year-over-year, but remains one of the absolute best in the specialty retail space.

The stocks of several mall-based teen specialty retailers (e.g., Aeropostale (ARO), Abercrombie & Fitch (ANF), and American Eagle (AEO)) have gotten crushed this year as teen unemployment remains above 20% (since May 2009), consumer confidence lags, and weekly store traffic is poor (11 declines in last 14 weeks). The one exception is the stock of Buckle, which is up more than 21% for the year while the other three retailers mentioned are all down 24% or more each. In the post-earnings conference call, an analyst asked Buckle CEO Dennis Nelson how Buckle has been able to “buck” the downtrend. Nelson replied:

We take a true specialty store approach, where not only the selection of the product of continuing to flow new product in to create the excitement, but we really have a high quality sales management team throughout the company that supports our managers who are promoted from within. And they do a very nice job of developing teams that can help the guest and really benefit them in finding the right fits and the outfits.

The young customer shopping our store is brand-focused and always looking for new colors, new ideas, new fabrics. And we’re able to show them quite a wide selection of product. We’re not narrowing deep. We show a lot of SKUs in all of the categories and give them a lot of options to work with. And I think that seems to be hitting well with our guests.

If Buckle can do so well in a weak retailing environment, just imagine how well the company will do when retail sales improve!

Short term, Buckle announced better-than-expected sales in August. In addition, the first three weeks of September have experienced the coolest temperatures since 2009, which may help apparel retailers sell cold-weather items such as sweaters and coats. Longer term, Kiplinger forecasts stronger retail sales in 2014 as the economy strengthens and customers recover from the shock of higher payroll taxes in 2013:

Retail sales will accelerate steadily in 2014, after less-than-impressive growth in 2013. Look for a gain in the range of 5.2% to 5.7% for the year, following a more modest increase of 4.5% in 2013. A stronger economy will help. By next year, consumers will have adapted to the increase in the payroll tax and be benefiting from a bit more than a 3% increase in personal income.

Sales during the first quarter of 2014 will top year-earlier sales by around 5.5%, after constrained growth during the final half of 2013. For now, spending increases are limited by take-home pay that remains under pressure and consumers’ continued cautiousness about incurring credit card debt to sustain their spending. However, ongoing job creation — albeit at a modest pace — along with stock market gains and the impending holiday season should encourage more spending in the remaining quarter of the year, with sales starting to climb later in the fall. Significant growth in the retail sector won’t take root until the new year, however.

Carbo Ceramics (NYSE: CRR) hosted an analyst day where it introduced its most high-tech ceramic proppant to date: Kryptosphere. This new proppant targets the deepest (30,000+ feet down), highest-pressure deep-water wells in the Lower Tertiary of the Gulf of Mexico. The pressure per square inch (OSI) in these deep-water wells can exceed 20,000 pounds and Kryptosphere is the only proppant that can handle this enormous stress level without collapsing. According to Carbo, Kryptosphere is the “strongest, highest conductivity proppant ever made.” (slide no. 9).

Besides the fact that Carbo has raised its dividend for 13 consecutive years and has a debt-free balance sheet, the main reason I like Carbo is its technological leadership. Many oil and gas drillers are penny wise and pound foolish, choosing cheap proppant based on sand or inferior ceramics from China, Brazil, or Russia. Although these inferior proppants have a quick payback period, they damage the wells and make them much less productive over their lifespan than would be the case if they had used Carbo’s state-of-the-art proppant.

Carbo CEO Gary Kolstad has been making the rounds of investment conferences educating analysts and the investing public about the increased estimated ultimate recovery (EUR) available from using Carbo’s proppant and hopefully he is making headway. Drillers aren’t stupid and eventually will understand that it is better to spend more up front for high-quality proppant if it means a higher present value of total profit over time.

Furthermore, Carbo’s technological advances in deep-water proppant will have beneficial effects on its entire line of proppant. CEO Kolstad stated the following about Kryptosphere at the September 14^th Barclay’s investment conference:

What we’ve learned in creating this new proppant will now benefit the rest of our proppant. I would be surprised if we don’t obsolete all of our products. My dream is that we are going to create something here and obsolete everything we’ve ever made up to this time. And in fact, we’re in little bit of a journey right now to figure out the capital cost to do conversions on plants to that. So if we do that and we hope we can maintain a similar cost structure, we certainly will obsolete a lot of these poor proppants like the Chinese.

One of the main components of competitive advantage is differentiation, and Carbo’s Kryptosphere technology may be the differentiator that maintains Carbo’s market-leadership position with high profit margins for years to come.

Gentex (NYSE: GNTX) hosted an investor and analyst meeting day that emphasized:

1. auto-dimming mirror market is far from saturated with only 24% of global vehicles offering auto-dimming rear-view mirrors and only 6% offering auto-dimming side-view mirrors.
   
   
2. Customer base is diversified with no single client representing more than 14% of total revenue.
   
   
3. Lower engineering, research & development (ER&D) spending is not indicative of lower growth opportunities. Quite the opposite – previous years’ ER&D was higher than normal because growth opportunities outran the company’s ability to hire permanent engineers and therefore had to spend extra on outsourced engineering contracts. Now that in-house hiring has caught up with the demands of projects, ER&D has fallen to more-normal levels.
   
   
4. The company is adding new features to its auto-dimming mirrors, including a compass, roadmap navigation, microphone, interior lighting, rear-camera display, and HomeLink applications (e.g., garage door and estate gate opener, turn on house lights).
   
   
5. HomeLink’s garage-door opening application is not vulnerable to competition from smartphones because use of smartphones requires burdensome Wi-Fi modification, doesn’t work with garage doors installed before 1998, suffers a 15-second time lag and the entry of up to two passwords, and necessitates dropping any phone call.

Speaking of HomeLink, the acquisition closed on Friday September 27^th. Gentex remains excited about HomeLink’s technology, not only for enhancing the capabilities of its mirrors, but for allowing the company to diversify its business beyond mirrors.

Child-safety advocacy groups have sued the U.S. Department of Transportation with the aim of forcing the DOT to issue final rules mandating the installation of rear-camera displays (RCDs) in all new cars. A 2008 law required the DOT to issue final rules for RCD implementation by February 2011, but the agency has unilaterally extended the deadline until January 2015. If RCD rules were promulgated, it would be a plus for Gentex because rear-view mirrors are one way for auto manufacturers to satisfy the RCD mandate.

Momentum Portfolio

HMS Holdings (Nasdaq: HMSY) dropped in reaction to a September 26th announcement by the Centers of Medicare and Medicaid Services (CMS) that effective Oct. 1, 2013 there will be a moratorium until December 31st on Recovery Audit Contractors (RACs) reviewing the validity of inpatient claims for hospital stays of less than two midnights (CMS Rule 1599-F) .

This type of review constituted about 5 percent of HMSY’s revenues in 2012, but the stock sell-off is an overreaction based on the small amount of revenue involved and the temporary three-month nature of the moratorium. If the moratorium continues into 2014, then it could have a “material impact” on the business of the company’s HealthDataInsights subsidiary, but that is pure speculation and unlikely to occur given that reviews of inpatient claims have historically been a significant source of cost recovery for the federal government.

The long-term need for cost savings in Obamacare government spending, combined with the fact that HMS Holdings is one of only four RACs nationwide, make its future profit growth virtually assured. HMS wins when the government wins and the government almost always wins. The company continues to be recognized as one of the country’s most innovative users of business technology and CEO Bill Lucia has repeatedly stated that 2013 should mark a trough and that business is primed to accelerate into 2014.

On the positive side, director Richard Stowe recently purchased 30,000 shares of the stock at a price of $23.71 through option exercise and he has not sold the exercised shares, which is a bullish sign.

HomeAway (Nasdaq: AWAY) was downgraded by Morgan Stanley to “equal weight” on fears that the introduction of a pay-per-booking option will cannibalize its existing annual subscription-fee model. The Morgan analyst stated: “We like the fundamentals of HomeAway’s business but think shares offer a balanced risk / reward.” That language sounds pretty positive to me, so this downgrade appears useless and – more importantly for HomeAway investors — harmless.

Much more useful and informative is a positive research note from Pacific Crest Securities that defended HomeAway in response. Analyst Chad Bartley – who is the top-ranked analyst on HomeAway – reiterated his “outperform” rating based on a recent survey of property managers showing strong interest in the new pay-per-booking option:

Nearly every property manager we spoke with was interested in, or planned to use, the new pay-per-book solution for at least some of their listings.

Bartley believes the pay-per-booking option will not cannibalize existing subscriptions but instead attracts new business by “tapping into a new segment of the market that prefers a success-based option for vacation rentals.” He continues to model HomeAway generating annual revenue growth of 20%-plus for “several years.”


LeapFrog Enterprises (NYSE: LF) was downgraded by BMO Capital Markets to “market perform” based on rumors that that some customers of the new LeapPad Ultra have complained about bugs in the device — specifically, that the operating system is very slow. On my Bloomberg terminal, I looked up the track record of BMO analyst Gerrick Johnson and it turns out that Johnson is rated at or near the bottom in accuracy among analysts for his market calls on LeapFrog over the past 3-year, 2-year, and 1-year time periods.

Bugs in new products are common and corrected quickly. LeapFrog has already issued a downloadable software upgrade on its website to correct the problem.

I bought the Ultra for my son and he loves it! We downloaded the software upgrade and it works well. The tablet has a bigger screen, WI-FI Internet capability that is kid-safe, and is super durable. The Ultra was recently given the seal of approval from the National Parenting Center: Reviews on the Toys R Us and Amazon.com websites are generally positive, as are other website reviews here and here.

Critics who argue that the LeapPad Ultra is unnecessary because a regular tablet computer costs about the same are off the mark, in my view. The LeapPad Ultra is Internet-safe for kids and super durable, neither of which is true for regular tablets. I think the children’s market needs a specialized device and LeapFrog Ultra is it.

Furthermore, LeapFrog’s real value is its intellectual property and its development of creative educational content. Hardware will eventually become a commodity and high profit margins will be limited to the content creators. LeapFrog has the best intellectual property in childhood educational content and the company will prosper for years to come.

Legendary hedge fund manager Joel Greenblatt increased his position in LeapFrog by 2,170% in the second quarter at an average price of $9.06. Furthermore, several LeapFrog insiders collectively purchased more than 100,000 shares around $7.70 in November 2012 and none have sold any shares in the open market since then.

Ocwen Financial (NYSE: OCN) agreed to redeem 100,000 preferred shares owned by private equity firm WL Ross for $158.7 million. This redemption represents 61.7% of the 162,000 preferred shares Ocwen had originally issued in partial payment for its $750 million acquisition of residential-mortgage servicer Homeward Residential at the end of 2012. Wilbur Ross said he was partially cashing out “strictly for portfolio management reasons and does not reflect any change in our enthusiasm for Ocwen.” According to Zacks:

The preferred stock carried an annual dividend of 3.75%. Therefore, redemption of these shares relieves Ocwen of the obligatory dividend burden and releases fund that can be used in other profitable ventures.

Ocwen also amended its bank loan agreement so that it can repurchase all of its preferred stock and up to $1.5 billion in common stock. According to Ocwen Chairman Bill Erbey:

We believe that our cash generating capability and debt capacity are sufficient to fund substantial growth and return earnings to our shareholders in the form of stock repurchases. We view the amendment to our Senior Secured Term Loan Facility Agreement and the opportunity to make this repurchase from WL Ross & Co. as consistent with our long-term plans.

I view these developments as very positive for Ocwen because it confirms the company’s tremendous ability to generate free cash flow and willingness to return it to shareholders. Fewer shares outstanding increases earnings per share and enable the company to increase its dividend more easily.

News that Wells Fargo – the largest U.S. home mortgage lender — is selling $41 billion worth of mortgage-servicing rights (MSRs) is also a positive for Ocwen because the more MSRs it possesses, the more money it makes in fees. Banks are intent on reducing their mortgage liabilities in an effort to come into compliance with Basel III international regulations, which require higher capital levels and lower asset leverage.

Oppenheimer recently initiated coverage on Ocwen with an “outperform” rating and a $66 price target, stating that “changes in the mortgage servicing industry are a multi-year story that is only in the early to middle innings.”

Based on these positive news developments, I’m raising my valuation of the stock by 10% and consequently am also raising the buy-below price on Ocwen Financial from $46 to $50.50.

SolarWinds (NYSE: SWI) was downgraded by Goldman Sachs to a sell based on “complexity” of the network software marketplace:

A growing product portfolio, an evolving go-to-market, new geographies, and serving managed service providers (MSPs) all add to complexity and risk not fully reflected in consensus. We also note a slow macro and potential secular challenges as customers shift to MSPs. We see stabilization taking longer than consensus implies, which may cause SWI to sacrifice sales growth to maintain margins, or give up some margin for sales, pressuring FCF, EPS, and the multiple. 

It’s true that the macro environment is challenging, as evidenced by software competitor Red Hat’s (NYSE: RHT) disappointing earnings report, but if any company can thrive in a difficult macro environment it is a low-cost provider such as SolarWinds. I continue to be excited about SolarWinds’ long-term growth potential given its disruptive sales model and use of Internet search for business development leads. Not to denigrate anyone, but I checked on Bloomberg and Goldman analyst Greg Dunham has the worst track record of any analyst listed who covers the IT software industry. I would just note that even Dunham does not base his downgrade on anything company-specific about SolarWinds. Technology is inherently “complex” and uncertain, so this downgrade appears to be a late justification for the price decline that SolarWinds has already experienced rather than forward-thinking.