Value Portfolio

Buckle (NYSE: BKE) had performed well despite the general retail-spending weakness that had obliterated the stocks of several other mall-based specialty retailers (e.g., Aeropostale (ARO), Abercrombie & Fitch (ANF), and American Eagle (AEO)), but the company’s sales finally succumbed to the deteriorating macroeconomic forces in September. Same-store sales for September were down 4.5%, which was worse than the consensus analyst estimate of a 1.2% gain.

Buckle management does not provide commentary on its monthly sales figures, but I believe the problem is not company-specific as much as macroeconomic. The U.S. consumer is simply cutting back purchases. According to ShopperTrak, U.S. store traffic was down 5.9% year-over-year for the week ending October 5^th, marking the 13^th weekly decline in the last 16 weeks. Furthermore, according to Gallup, economic confidence plunged during the first week of October by the largest amount since the Lehman Brothers bankruptcy in September 2008. Uncertainty surrounding the length of the U.S. government shutdown, higher-than-expected Obamacare insurance premiums, and the possibility of a U.S. debt default if the debt ceiling is not raised by October 17^th are all weighing heavily on the psyche of U.S. consumers.

The good news is that many of these issues may be short-term in nature and consumer confidence and spending could rebound quickly. Store buyers (including from the Buckle) were recently seen shopping for spring 2014 merchandise at a Los-Angeles trade show, where buyer traffic was characterized as “busy.”

Ascendiant Capital Markets also speculated that Buckle may be suffering from a short-term rotation by consumers away from “embellished” denim clothes, which is Buckle’s specialty, but denim should come back into consumer favor in 2014.

Given the September sales miss, it is possible that Buckle may not pay a special dividend in 2013 as it has in recent past years. One could argue that the huge $4.50 special paid in December 2012 was meant to cover both 2012 and 2013 because it was double the average special dividend paid since 2008 and could have been an attempt to avoid the dividend tax-rate increase in 2013.  

The stock has fallen 15% from its August high of $57.68 and is now near my $47 buy-below price. Consequently, if you missed the earlier opportunity to buy into Buckle, the next few months may be a low-risk time to initiate a position in this long-term moneymaker. A recent Seeking Alpha article values the stock at $64.50 per share.

Diamond Hill Investment Group (Nasdaq: DHIL) released its third-quarter mutual-fund guide and investment results year-to-date for its seven equity mutual funds and one fixed-income fund have been pretty good. The immediately-completed third quarter was less impressive, but high management fees (page 11) keep pouring in nonetheless. Most of the funds’ 10-year returns outperform on a gross basis (before fees), but returns on a net basis (after fees) are only average. Even utilizing a Buffett-Graham value philosophy, it’s hard to beat the market!

Virtually all of the equity funds suffered underperformance against their respective benchmarks over the past 3 and 5-year trailing time periods, but have much better relative returns on a 10-year and one-year basis. The Large Cap Fund is one of the better equity performers, which is good since it possesses more than half of the firm’s total mutual-fund assets. The company’s assets under management continue to climb and at $11.04 billion are up 17.1% year-to-date.

The stock has been one of Roadrunner’s best performers, up more than 59% since being recommended on January 24^th.  Given the increase in assets under management and the decent investment returns on its portfolios, I am raising the buy-below price on Diamond Hill Investment Group from $74 to $89.

Fresh Del Monte Produce (NYSE: FDP) disappointed investors with its third-quarter financial report and the stock dropped 9% in reaction. Although FDP achieved 9.2% growth in third-quarter sales, earnings declined 73% because of increased wholesale costs of purchasing bananas from independent growers, along with increases in packaging costs and ocean freight shipping costs.

In the conference call, CEO Mohammad Abu-Ghazaleh also said that a global oversupply of bananas caused retail prices to be lower than expected, which also hurt earnings. I’m still trying to understand how independent growers had the power to raise wholesale prices of bananas at a time when there was an oversupply of bananas in the retail market. It is also unclear to me why packaging and ocean freight costs rose so much at a time of low global inflation.

The stock is cheap, the company is a market leader with growing sales, and the food industry is relatively stable, so I am willing to give the investment more time to work out. But I didn’t find the company’s explanation for the higher expenses and earnings shortfall coherent. For a more positive view, there is a recent Seeking Alpha article.

In other news, on October 10th Fresh Del Monte’s joint bid with Pinnacle Foods to acquire the canned food business of Del Monte Foods ended in failure with the announcement that Philippines-based Del Monte Pacific was buying the Del Monte Foods canned foods business for $1.7 billion. Del Monte Pacific is not affiliated with other Del Monte companies in the world, including Fresh Del Monte Produce.

I was hoping Fresh Del Monte would succeed in acquiring the canned food business because it would end the seemingly-constant trademark litigation over the Del Monte brand and what constitutes “fresh.” Litigation not only wastes financial resources but distracts management from meeting competitive challenges. Now it seems that trademark litigation will continue, but with Del Monte Pacific the opponent rather than Del Monte Foods.

Gentex (Nasdaq: GNTX) reported excellent third-quarter financials that saw earnings jump 31% on top of 8% revenue growth. Both figures easily beat analyst estimates. CEO Fred Bauer stated:

We’re very pleased to report continued strong revenue and earnings growth despite year-to-date reduced light vehicle production in Europe and the Japan/Korea regions, and we’re excited by the momentum that the continued strong financial performance gives us as we move into a future that will include the growth that comes with our HomeLink acquisition.

In the conference call, Gentex CFO Steven Downing discussed how the gross profit margin skyrocketed year-over-year from 33.6% to 36.7% — a huge increase — thanks to an improvement in product mix (i.e., more exterior mirrors compared to interior mirrors) and customer purchase reductions (i.e., lower raw material costs). Sales of higher-margin exterior mirrors were up 33% and CEO Bauer sees similarly high revenue growth for exterior mirrors in the future because Gentex exterior mirrors are only in 6% of vehicles compared to 24% of vehicles fitted with Gentex interior mirrors.

Fourth-quarter guidance was very positive thanks to the HomeLink acquisition which is forecast to permanently improve gross profit margins by an additional 1.5%, thus increasing the already-high 36.7% to 38.2%. Sales are expected to grow 20-25%, which is much higher than the 8% growth in the third quarter.

Lastly, CEO Bauer said that capacity utilization is currently only around 75%, so if the economy improves further and demand increases, the company’s manufacturing plants have plenty of “room to run” to fill additional demand at low variable operating costs that would boost profit margins further.

All in all, the future for Gentex looks very bright and the HomeLink acquisition is starting to look like a real profit enhancer and growth opportunity. I am raising the buy-below price on Gentex from $20 to $26.

Stewart Information Services (NYSE: STC) reported third-quarter financials that reflected a housing slowdown caused by rising interest rates. Pre-tax earnings dropped 25%, but the $0.63 earnings per share reported managed to beat analyst estimates by $0.02. CEO Matthew Morris said that rising interest rates had crimped mortgage refinancings — borrowers are less likely to seek out new loans to pay off old loans if the rates on thee new loans is high. Fewer refinancings mean fewer title searches and other mortgage-related services:

Our third quarter 2013 financial results reflect a changing industry environment. The steady improvement in the residential resale market was not sufficient to offset the decline in refinancing title orders, slowing the rate of revenue growth.

In addition, the ongoing improvement in the housing market, with the attendant reduction in distressed properties, resulted in our mortgage services revenues declining more than previously expected. Our mortgage services operation continued its transition to a provider of broad-based outsourcing services, and while that transition is yielding lower than desired short term results, we are confident in our strategy as we continue to expand relationships with existing clients while using broader service offerings to attract new clients.

No doubt about it, the housing market has slowed down, but I firmly believe the slowdown is temporary given the likelihood that U.S. economic growth will pick up in 2014. Furthermore, the company is still growing if you look at the first nine months of the fiscal year rather than just the last quarter. Over the first nine months, pre-tax earnings are up a whopping 36.5% on revenue growth of 6.4%.

I also like Stewart’s recent acquisition of Allonhill because providing services for the mortgage-backed-securities (MBS) capital marketplace is a completely new business line that will go a long way to diversifying the company’s business away from mortgage refinancings. As a Stewart spokesman said at the time of the acquisition:

Stewart did absolutely nothing in this line of business. This is literally being added as a business line, and our intention is to grow it. The business that Allon’s in is not tremendously refinance sensitive. That’s very important to us at Stewart. Real estate is cyclical, so having countercyclical and noncyclical business lines to balance out our title side is key.

Momentum Portfolio

CommVault Systems (Nasdaq: CVLT) reported second-quarter financials that continued a string of impressive quarterly growth numbers. Earnings per share rose 20.7% on revenue growth of 20.1%. Both figures beat analyst estimates. In addition, the company increased the company’s existing $220 million share repurchase program by $47.2 million (i.e., $267.2 million total). As of yesterday, the Company had repurchased $117.2 million of common stock. With the additional $47.2 million just authorized, there is $150 million remaining in the repurchase program.

Despite the great results, the stock temporarily dropped as much as 11% on the news because management’s forward guidance was cautious. In the conference call, CEO Bob Hammer stated:

While we believe our business fundamentals are strong, our outlook needs to be tempered with the following words of caution: As noted earlier, tech spending has moderated. Many companies in the industry have reported big deal cancellations and push outs. We are assuming there will be some softness in big deal demand, as stated on prior earnings calls, big deal growth is critical to achieving our financial goals. By big deals we mean software deals greater than $500,000.

In summary, the company had a good first half fiscal 2014, and is in good position to successfully achieve our annual objectives for FY ’14. We expect to continue to significantly outpace the growth of the market and pick up market share. However, on a relative basis, since last quarter’s earnings call, we do believe revenue and earnings risk has marginally increased due to big deal demand and strategic execution risk.

My takeaway: CommVault continues to execute and grow better than virtually any other big-data company, but it is not immune to a macroeconomic tech slowdown that causes customers to delay orders. Examples of a tech slowdown can be seen in several recent earnings reports, including IBM, Oracle, and LinkedIn. If one wants to maintain tech exposure in an investment portfolio, sticking with market leaders like CommVault makes a lot of sense.

Piper Jaffray wasn’t discouraged by the cautionary  guidance, reiterating its overweight rating and stating:

Bears are pointing to the company’s decelerating software revenue growth. However, the firm thinks the deceleration was entirely due to timing and software revenue growth is expected to rebound next quarter.

Hill-Rom Holding (NYSE: HRC) reported fourth-quarter and full-year financials that didn’t show much growth. Revenue was up 1% for the quarter and 5% for the year, whereas adjusted earnings were up 16% for the quarter but down 7% for the year. GAAP earnings were down in both the quarter and the year. Despite the flat results, analysts were expecting less and Q4 earnings actually beat estimates. The stock reacted positively, jumping above $40 for the first time in more than two years (i.e., since July 2011).

In the press release, CEO John Greisch touted the “strong” Q4 earnings results, but remains “cautious” about 2014 because he “continues to see uneven capital order trends.” Indeed, financial guidance for 2014 was tepid, with revenues forecast to grow only 1% for the year and actually decline 5-6% in the first quarter. Adjusted earnings are forecast to rise 3.8% for the year and decline 5-6% in the first quarter.

The company’s 2014 guidance is very conservative, which means that it could surprise on the upside. In the conference call, CEO Greisch admitted that the 2014 guidance assumes no macroeconomic improvement:

I’d say the biggest opportunities for improvements would be any tailwinds behind the U.S. capital spending environment. If you look at the last 2 years, the choppiness in both our revenue and orders has been remarkably consistent, as crazy as that sounds. We’ve had ups and downs quarter-to-quarter, really over the past 8 quarters. If that trend changes and we see some confidence come back in our North American customer base, some improvement in capital spending for our products, that’s going to be the biggest tailwind that we could hope for as we move through 2014. We haven’t planned on that. I think we prudently assumed the same picture we’ve seen the last 2 years, which is steady but choppy trends on a quarter-to-quarter basis, is what we have planned for, for 2014. If that improves, I think that’s the biggest opportunity for us to see some improvement going forward.

The North American customer base is comprised primarily of hospitals and their capital spending on big-ticket items such as Hill-Rom’s hospital beds has been retarded by uncertainty over federal reimbursement rates and how much insured patient traffic will increase under Obamacare. If Obamacare is fully implemented, uncertainty will diminish and Hill-Rom will benefit more than most.

Bottom line: Hill-Rom is not much of a growth story, but it is a cost-reducing restructuring story (especially in Europe) that is expected to improve operating profit margins by 300-400 basis points over the next 4-5 years. The company is also a cash-flow machine that enabled the company in September to almost quintuple its share repurchase program to $190 million from $40 million and increase its quarterly dividend by a hefty 10%. In 2013, the company returned almost 50% of operating cash flow to shareholders, which is amazingly high and the right thing to do in a slow-growth environment. I have confidence in Hill-Rom’s capital-allocation decisions. Shareholder value can increase from cost reduction just as easily as from revenue growth, and Hill-Rom has substantial cost savings still to achieve.

SolarWinds (NYSE: SWI) has acquired another business and the market responded by pushing the stock down to another 52-week low. On October 7^th, SolarWinds announced the acquisition of privately-held Confio – the maker of database performance management software – for $103 million in cash. Confio grew revenues 50% in 2012 and its products are used by 40% of Fortune 50 enterprises. SolarWinds big buy comes on the heels of the company’s acquisition of remote monitoring and management (RMM) software expert N-able Technologies for $120 million in cash back in May. I’m glad that the company paid cash for both of these acquisitions (thanks in part to a new $125 million credit line at a 1.4% interest rate) rather than stock because it means shareholders’ ownership stakes were not diluted. Even after both acquisitions, SolarWinds’ balance sheet is still strong with $133 million in cash.

According to SolarWinds CEO Kevin Thompson, the Confio acquisition is the “last meaningful piece of the puzzle” in the company’s strategic initiative to become a one-stop shop for all of an IT manager’s software needs. Sounds good, so why do investors continue to punish the company’s share price for making these acquisitions? The reason may be that investors view the acquisitions as evidence that the company’s core business is slowing down and the only way SolarWinds can continue growing is to buy the growth of other businesses. Furthermore, integrating multiple acquisitions is rarely a smooth process and often takes longer than expected, sometimes diverting management’s attention from the competitive marketplace. According to JP Morgan, these fears are misplaced and SolarWinds is merely experiencing the healthy growing pains of a young business:

We believe that much of the company’s recent performance issues have had to do with the macro backdrop and some execution issues which equate to growing pains. We do not believe that growing pains are a bad thing and if the company is able to reaccelerate organic growth, investors will likely express renewed confidence. We note that the execution by SolarWinds’ management team has been impressive up until recently.

Furthermore, both N-able and Confio have seasoned and fully-functional management teams that SolarWinds has decided to leave alone through the end of the year, so no integration will occur until 2014 at the earliest. In the conference call explaining the acquisition, I found SolarWinds’ management quite convincing in their rationale for the deal. CEO Thompson stated:

The addition of Confio’s Ignite database performance management solution to the SolarWinds family is the last major component needed to round out our systems management product portfolio. We believe we are now able to solve virtually all of the major problems faced on a daily basis by system administrators.

Unlike N-able Technologies, which markets to third-party managed services providers (MSP), Confio markets directly to IT managers similar to SolarWinds’ traditional business. Consequently, because Confio’s sales model is, as CEO Thompson puts it, “very similar to what we do,” any integration in 2014 should prove to be easy. Certainly much easier than an integration of N-able will be, because N-able really constitutes a new line of business for SolarWinds.

Analysts on the conference call asked CEO Thompson about the company’s execution problems during 2013 and whether it indicated recognition that SolarWinds’ business opportunity of selling software directly to IT managers was less than originally expected. Thompson’s answer exuded confidence that the business opportunity remains as huge as ever:

We absolutely believe in the strategy that we have created. We believe in the business, and the business model that we’ve worked so hard to build over the last really seven years as I’ve been here. We’ve got confidence in the size of the market opportunity in front of us. We’ve got confidence in our ability to cause this business to grow. And while we definitely started the year a little slower than what we had anticipating having, in no way has that shaken our confidence in what we created or in the size of the opportunity in front of us.

We think the timeframe for our opportunity is now. We don’t see any reason that we shouldn’t continue to be aggressive. We are about building a $1 billion software company and beyond. And the fact that we had six months that wasn’t as great as we like to have it be, it doesn’t in any way change what we’re trying to create. So, we got confidence in what we’re doing.

The other issue Thompson addressed impressively was the company’s growth rate and the importance of matching growth to costs. Despite the slowdown in SolarWinds’ license revenue, SolarWinds remains a very profitable and high-growth company! Returns on invested capital (ROIC) have been above 23% each year since the company went public in 2009. I appreciate Thompson’s focus on profitable growth and not just growth for growth’s sake. In other words, a company should not maximize growth but rather maximize shareholder value, which often occurs at less-than-maximum growth:  

We’re still growing 25% faster than the average public software company. We’re not growing much slower than our high-growth peers, which are growing 10 points or 12 points faster than us. They’re spending 50% more than we are to create that extra growth. They’re spending 4 percentage points of revenue for every 1 percentage point of growth that they are growing faster than we are. So, the way I look at it, I’ve got a better business than companies growing faster right now. So, why should we be afraid to continue to make the moves we need to make and to build the technology company we’re trying to build?

The decision to incur $40 million in debt to partially pay for the Confio acquisition is also an indication of Thompson’s smart use of capital. While $40 million constitutes less than one fiscal quarter’s worth of corporate cash flow and Thompson could have easily paid for the acquisition totally with the company’s cash on hand, it’s better to borrow at the obscenely-low interest rate of 1.4% — which is virtually free money. Why reduce business flexibility by crimping your cash balance, when virtually-free money is available to acquire valuable technologies? Leave the cash balance alone because it is needed for share buybacks and other value-producing corporate purposes.

Bottom line: Although SolarWinds no longer qualifies as a momentum stock, and its EV-to-EBITDA ratio of 16.7 still is too high to qualify it as a value stock, it is definitely a high-quality growth stock that should generate annual earnings and revenue growth of 20%-plus for years to come and outperform the overall market – especially at its current depressed price. In fact, SolarWinds is one of my favorite buys in the entire Roadrunner universe right now. Two very-smart hedge fund managers – Steven Mandel and Lee Ainslie — have been picking up SolarWinds shares recently at prices in the $37.66 to $45.82 range.

Valmont Industries (NYSE: VMI) reported solid third-quarter numbers that showed good growth and profitability, with operating profit margin reaching a record high for a third quarter. Sales and earnings comparisons were positive in each reportable segment. Granted, the company’s third-quarter numbers missed analyst estimates, but the miss was small and easily explained:

It should be noted that investors bid the stock higher by 1.5% on the earnings news. Whenever a stock rises after supposedly “bad” news, it is a good indication that the news isn’t actually that bad and the stock price has already discounted it.

Since the fourth quarter of 2005, Valmont’s quarterly financial report have missed analyst estimates only three times (including this quarter). The other two times were in April 2010 and October 2010. Both of those times the stock sold off on the news (-4.0% in April 2010 and -1.5% in October 2010), unlike this time when the stock rose 1.5%. In April 2010, the stock was near a 52-week high when the earnings came out and sold off for the next four months before bottoming. In October 2010, the stock price was depressed — like it is now — and recovered from the earnings miss to rise 50% from $77.33 to $116.02 four months later. I’m not saying that the future will replicate the past exactly, but my point is simply that an earnings miss does not mean the stock will drop lower over the next few months. In fact, between now and December options expiration, Valmont’s stock has risen in each of the past 10 years!

As to the substance of the earnings miss, CEO Mogens Bay explained that it was a one-time, non-cash charge necessitated by a reduction in the United Kingdom’s corporate tax rate. In other words, the earnings miss had nothing to do with the strength of Valmont’s business:

Earnings per share met our expectations, save for the onetime $8.3 million tax expense that lowered diluted earnings by $0.31 per share. A decrease in the corporate tax rate in the U.K. necessitated the reduction in our deferred tax asset, thus, an increase in deferred tax expense. This should have a positive impact on taxes going forward.

Furthermore, a stronger U.S. dollar reduced foreign operating income by $2 million (7.5 cents per share), another non-business effect caused by foreign exchange fluctuations.

Even better was the business outlook for 2014. During the conference call, CEO Bay stated:

1. “Farmer sentiment remains strong as the value proposition for pivots remain compelling even at current crop prices.”

2. “The fourth quarter for Utility is shaping up to be our largest ever. Our expectations are for Utility sales to grow in both 2014 and again in 2015. We see traction for 2014 to be another record year in the Utility business.”

3. “We have a good cash position. We have great leverage capabilities while still staying conservatively eager. When we do make acquisitions, we really do need to see a quick route to beating our cost of capital, which we currently look at being about 8.5% after tax. It’s easy, relatively, to make an acquisition today and have good EPS improvement, but that’s not the test that we use.” (Note: company uses economic value added (EVA), which is a much better measure of shareholder value than EPS).

4. “Based on our experience, I would expect Irrigation sales next year to weaken a little bit compared to this year. But I thought the same thing last year this time, and 2013 turned out to be a record year. So one thing we’ve learned in that business is it’s very difficult to predict. And even though commodity prices are down, net farm cash income is going to be very solid, yields are going to be up. So it’s not just the commodity type and price, it’s tying into the number of bushels that you harvest. Investing in irrigation equipment, if you have water, whether it’s new development or if you can convert from less efficient irrigation, is a very good investment also at today’s commodity prices.”

I found CEO Bay’s outlook for U.S. 2014 irrigation-equipment sales encouraging because it is much more optimistic than the 2014 forecast of competitor Lindsay Corp.:

Valmont could be expecting to take U.S. irrigation market share away from Lindsay in 2014, which would mitigate any industry-wide irrigation slowdown. During the conference call, CEO Bay said market-share gains were likely in the Utility division, pointing out that the company had missed some sales in 2013 due to capacity constraints that will no longer be an issue in 2014 when two new production facilitites in Oklahoma and Nebraska ramp up. I see no reason why similar market-share gains could not also be possible in the irrigation-equipment division. Furthermore, as a I mentioned in the original recommendation of Valmont, irrigation equipment is one of the few types of agriculture equipment that some analysts (e.g., BlueShift Research) expect to “buck the trend” of an industry slowdown and continue growing in 2014.

Bottom line: Valmont Industries remains inexpensive with an EV-to-EBITDA ratio of only 7.0 and a price-to-earnings ratio below its five-year average earnings multiple of 15.4. Valmont Industries appears to be a rare opportunity to buy a growing and profitable company at a bargain-basement price. One of the analysts during the conference call said that Valmont has “dramatically sizable firepower to do acquisitions or share buybacks” and CEO Bay did not disagree.

Western Refining (NYSE: WNR) jumped almost 8% over a two-day period (Oct. 10-11) on news that the Environmental Protection Agency (EPA) is considering a significant 16% reduction in the amount of renewable fuels (e.g., corn-based ethanol and bio-diesel) that must be blended into fuel during 2014. Specifically, the EPA may cut the mandate from 18.15 billion gallons of renewable fuels to only 15.21 billion gallons.

Such a reduction would benefit refiners because procuring and blending renewable fuels into gasoline is costly and reduces refiner profit margins. Furthermore, a combination of falling gasoline demand and increased renewable-fuel blending would force refiners to blend more than 10% ethanol into gasoline. Without a downward adjustment, the 2014 renewable-fuels mandate could force production of 15% ethanol gasoline, which is undesired by many customers because too much ethanol can damage vehicle engines and inhibit the proper operation of emission-control systems.

In other good news, the much-anticipated debut of Western Refining Logistics (NYSE: WNRL), the company’s master limited partnership focused on pipelines and storage, occurred on Thursday October 10^th. The MLP units were issued at $22 (above the expected range of $19 to $21) and jumped a healthy 9.5% on their first day of trading. The IPO raised more than $302 million with a portion being used to pay back parent Western Refining for certain expenses. The MLP structure is tax-advantaged and consequently raises the value of Western’s pipeline assets. After the IPO, parent Western Refining continues to own more than 65% of WNRL which is expected to pay an annual cash distribution of $1.15 per unit.