Value Portfolio

Carbo Ceramics. When a stock skyrockets as much as 19% in reaction to the release of a quarterly financial report, you know things must be looking good for the company. On January 30^th, this high-tech proppant producer reported its fourth-quarter numbers and both revenues and earnings blew away analyst estimates, up 7% and 5%, respectively. Such single-digit percentage gains may not seem like much, but investors have been worried that Carbo couldn’t grow in a climate of weak natural gas drilling and a supply glut of much-cheaper Chinese proppant. So, any growth was very welcome news.

CEO Gary Kolstad stated that the company experienced “solid demand” in the second half of 2013:

Ceramic proppant volumes in 2013 set a record, topping 1.7 billion pounds, despite a market that was over-supplied with low-quality Chinese ceramic proppants. We finished the year on a strong note. Activity rebounded in December after heavy rains and icy weather hampered sales volumes in both the Eagle Ford and the Permian during the early part of the fourth quarter.  Although the marketplace remains competitive, our proppant pricing was stable when compared to the third quarter of 2013. 

The fact that Carbo was able to sell a record amount of proppant despite Chinese imports is proof that its high-tech proppant truly is better quality and worth a premium price.  Fourth-quarter proppant sales were up a whopping 38% in North America but down 33% outside North America primarily due to weakness in the emerging markets of China and Mexico.

Good times are expected to continue in 2014, with Kolstad offering a very optimistic outlook:

An increase in capital spend on the part of E&Ps in 2014 should result in solid industry activity.  Consequently, we anticipate demand for our industry-leading production enhancement services and products to remain intact. 

Specifically regarding proppant sales, we believe 2014 will be another good year for volumes, aided by our technical marketing campaign that continues to highlight the superior conductivity of CARBO’s ceramic proppant compared to low-quality Chinese ceramic proppant.  In the near term, we expect ceramic proppant volumes for the first quarter of 2014 to increase when compared with the fourth quarter of 2013.

Drilling activity is increasing in North America because natural gas prices are rising. In late January, natural gas prices rose above $5.00 per thousand cubic feet (Tcf) for the first time in 3 ½ years! Although the price spike is primarily due to the extreme cold weather caused by the “polar vortex,” some analysts believe that drilling demand for proppant will be so strong all year that is it is “highly unlikely” that gas prices will fall below $4.00 at any point during 2014.

The next big catalyst for Carbo is the introduction of Kryptosphere-H, the company’s new ultra-high conductivity, ultra-high strength proppant technology that is ideally suited for high-pressure deepwater drilling. The launch is scheduled for the third-quarter of 2014, which CEO Kolstad projected to be the “highest activity quarter in calendar years ahead.” The key to meeting the Q3 deadline is quickly retrofitting Carbo’s existing manufacturing plants to enable them to produce Kryptosphere. If Carbo can launch Kryptosphere to take advantage of the third-quarter boom in demand, then 2014 may prove to be a banner year for the company and the stock pop is a reflection of investor optimism about 2014.

Morgan Stanley was so impressed with the fourth quarter financial results that it boosted its price target on the stock by 68% — from $73 to $123.  Given the likelihood that proppant growth will accelerate in 2014 thanks to increased drilling demand and the introduction of its state-of-the-art Kryptosphere product in the third quarter, I am raising my buy-below price on Carbo Ceramics to $100 per share.

 

Momentum Portfolio

 CommVault Systems reported excellent third-quarter financials that blew away analyst estimates for both revenues and earnings. In fact, the company set all-time records on several metrics including revenues, adjusted operating income and adjusted earnings per share. Operating profit margins were also higher than expected. Nevertheless, the stock fell 8.8% on the news because investors apparently didn’t like hearing CEO Neil Robert Hammer make cautionary remarks during the conference call:

Our visibility going into Q4 has increased over Q3. While we have strong consistent growth in revenue and earnings, our business fundamentals are strong, I would like to add the following words of caution regarding our future outlook. We have — we continue to have quarterly revenue and earnings risk due to the timing of large million-dollar deals. We have still not met our hiring objectives in sales or field technical teams. While major firms are forecasting improvements in IT spend for calendar 2014, one recent survey indicates a slower start to 2014. And as I stated last quarter, there’s execution risks tied to the implementation of our All Things Data strategy, which is a major corporate-wide endeavor. 

Such generic cautionary comments are pretty routine for CommVault and are no cause for alarm given the company’s continued strong operating results. It just goes to show how difficult it is for high-priced stocks to continue to advance in the face of any uncertainty. Still, CommVault’s financials are currently so strong and the business outlook for cloud computing is so optimistic that I am confident investors will have no choice but to bid the stock higher as corporate capital spending grows. For goodness sake, the company said analyst estimates for full-year fiscal 2014 results are “reasonable,” business fundamentals are “strong,” its visibility has increased for the fourth quarter, and that “for 2015, we believe we will be able to achieve solid double-digit revenue and EBIT growth.” CEO Hammer also said:

For the first time in many years, we’re experiencing improvements in all the major regions of the global economy. The situation in the U.S. is improving, Europe has come out of recession and there’s positive momentum in Asia Pacific. 

Bottom line: There is simply no reason for investors to spin those comments negatively!

Several analysts continue to beat the drum for CommVault – JMP Securities upgraded the stock with an $80 price target, Needham reiterated its buy rating with an $85 price target, and Lake Street Capital reiterated a buy with a $93 price target. 

CommVault must agree with the analysts’ bullishness because the company took advantage of the stock-price decline to repurchase $48 million worth of shares at an average price of around $64.90 per share, stating:

These recent share repurchases are consistent with our current policy of purchasing our shares when they are at attractive prices.  We are confident about our near and long-term prospects and will remain opportunistic with share repurchases.

More repurchases may be in the offing, as the company still has $102 million worth of repurchasing authorization through March 2015.

 HMS Holdings.  The Centers for Medicare and Medicaid Services (CMS) recently suspended new appeals for two years. That’s good news for recovery audit contractors (RACs) and bad news for hospitals. Although hospitals win a majority of appeals, HMS already reserves for this in its financial statements, so it is an expected cost of doing business.

On October 1^st 2014, CMS regulations require that doctors begin using ICD-10 diagnosis codes. The new codes will benefit RAC companies — especially HMS — because coding will increase five-fold from 14,000 codes to 70,000 codes.

The more codes, the more important the ability of RAC companies to crunch data to find fraud and discrepancies. HMS is the market leader in computing power and will be needed more than ever to navigate the increase in coding data.

As one commentator puts it:

Where RAC and ICD-10 go much more hand-in-hand and this goes back to how sophisticated the various RAC contractors are going to be because let’s face it traditionally they are large data management companies, collection-agency type companies that have sophisticated technology to screen through average trends. So the opportunity of ICD-10 and RAC coming together is that it will be really easy to identify someone who’s really not fully deployed with ICD-10 codes. That should come out pretty easily through a RAC data diving exercise.

On January 31^st, CMS suspended RAC auditing of the 2-midnight rule, which I first discussed in January, for an additional six months until after September 30^th 2014. Since auditing claims made for inpatient hospital admissions (higher Medicare reimbursement) versus outpatient admissions (lower reimbursement) constitutes half of HMS’ Medicare RAC recoveries, this 6-month extension of the suspension will cut HMS revenues by a further $25 million. Combined with the $25 million revenue cut between October 2013 and March 2014, total lost RAC revenue during the 2014 federal government fiscal year (ending Sep. 30, 2014) equals $50 million. HMS stock dropped 9.3 percent on the news, but this negative reaction should be short-lived because RAC revenue should jump significantly from $50 million this year to $120 million in 2015 when the 2-midnight auditing suspension is finally lifted.

On January 8^th, CMS announced that the awarding of new RAC contracts would be delayed for “several months” past the expected March re-procurement date. The delay doesn’t hurt HMS because it is the largest RAC and will without question be one of the re-appointed contractors. In fact, the delay could be a positive development because it gives HMS more time to be paid under the current RAC contract, which may prove to be more generous than the payment terms of the new RAC contract.

Needless to say, government regulatory delays are unpredictable and frustrating for investors in HMS, but the fact remains that HMS is the best at what it does (saving money for the government) and the government’s need for cost control in healthcare spending will only increase in the years ahead. For more detail about HMS’ business opportunity based on these healthcare growth trends, see slide nos. 10-12 of a Jan. 13^th investment conference presentation.

On February 3rd, Wells Fargo reiterated “outperform” on HMS with a $28-$30 price target, concluding:

Determining health insurance coverage and appropriate reimbursement is exceedingly complex and likely to get worse with the health reform legislation and changes in coding, both happening in 2014. We believe HMSY is very well positioned to help insurers with the issues of eligibility, overpayment, and fraud.

International Speedway released its fourth-quarter financials on January 28^th and the results were only okay. Earnings beat expectations whereas revenues lagged expectations and fell slightly year-over-year. CEO Lisa France Kennedy blamed the revenue shortfall on “softness in certain markets and inclement weather impacting fourth quarter admissions.” On the bright side, she saw “encouraging signs of stabilization in our core business, driven by slowly improving economic conditions and solid consumer and corporate marketing strategies.”

Some analysts downgraded the stock based on the revenue miss, and the stock has fallen 11% since its January high of $38, but I think the price decline is a buying opportunity. Overlooked is the fact that 2013 marked the first year in six that annual revenues rose. Details about how much revenue growth racetrack owners will receive each year from NASCAR’s ten-year $8.2 billion contracts (2015-24) with both NBC and FOX have yet to be announced, but should offer investors a pleasant surprise when the specifics become available during the first quarter of 2014.

As CEO Kennedy pointed out during the conference call:

ISCA’s risk profile improved significantly during 2013 with the sale of our Staten Island property and NASCAR negotiating the largest TV rights contract in the sport’s history, which is giving us strong earnings visibility through 2024.

What other industry has the largest revenue stream locked in for the next 11 years? As a result, we feel increasingly confident about our financial condition and strategic initiatives to grow our business.

ISCA’s earnings have been depressed by investment spending that is necessary for future growth. Top of the agenda is the $400 million “Daytona Rising” project, which will transform the Daytona racetrack into a year-round entertainment and sports destination similar to Las Vegas or Walt Disney World and include events such as music concerts and college football games.  According to the press release announcing a multi-year partnership with Toyota Motors, Daytona Rising will feature 11 “neighborhoods” – each the size of a football field — focused on different themes with custom bar, retail and dining areas. What fun!

If it works at Daytona, the same concept can be implemented at ISCA’s 12 other racetracks around the country. As CEO Kennedy puts it:

Over the longer term, we believe this initiative will influence attendance trends, corporate involvement in the sport and the long-term strength of future broadcast media rights revenues.

In other words, the company is transforming itself into something completely different from a racetrack – and with a much bigger multiplier effect for ancillary sales and broadcast rights — yet many investors don’t have the vision or patience to see it unfold. In contrast, Roadrunner Stocks sees the value of this entertainment transformation and has the investment patience to reap the benefits over the long term. ISCA is smart to invest the money now while the economy remains sluggish, so that the facilities will be complete and the company will be ready to fully benefit from resurgence in consumer spending when it occurs sometime over the next couple of years.  International Speedway is a solid buy at its current price in the mid-$30’s.

Ocwen Financial has continued to sell off (down 40% from its Oct. high) on regulatory concerns with the federal Consumer Financial Protection Bureau (CFPB), New York State’s Department of Financial Services (DFS), and some private owners of mortgage-backed securities.

Interestingly, the CFPB required Ocwen to engage in $2 billion worth of loan modifications (i.e., reduced principal balances on mortgages), whereas the MBS owners are complaining about these loan modifications because they fear such modifications reduce the value of their MBS holdings! Ocwen can’t be wrong both ways and in its fourth-quarter conference call CEO Ronald Faris stated that all of Ocwen’s loan modifications are intended to be “net present value positive for the investor.”

Furthermore, New York State’s suspension of the Wells Fargo transaction is probably only temporary. Regulators have encouraged big banks to sell off their mortgage servicing rights (MSRs) to non-bank specialty servicers by imposing increased capital requirements on bank MSRs. These regulators can’t now turn around and prevent banks from doing what needs to be done to improve their capital ratios! Ocwen has stated that it “will continue to work closely with the NY DFS to resolve its concerns about Ocwen’s servicing portfolio” and I believe an amicable settlement will be reached.

Sterne Agee analysts are not concerned, recently reiterating their “buy” rating, stating:

This is short-term posturing by the Department of Financial Services and is part of an ongoing conflict they are having with Wells Fargo. We do not think the DFS cares who services mortgages in its state as long as everything is done to help struggling borrowers stay in their homes. Wells Fargo’s deal with Ocwen could be approved within a month.

 A good case can be made that Ocwen continues to acquire servicing over time, that the cash flow from the business can now be used to buy back stock, and that over time the shares will move higher. We do not think the game is over, just more complicated.

 Compass Point upgraded Ocwen after the bad DFS news hit, stating that the stock’s price decline was a buying opportunity and reiterating its $57 price target:

 If DFS’ concerns are prospective, meaning the regulator is concerned with the company’s capacity to on-board new loans, we feel confident that OCN can take steps to ensure future compliance (e.g. installing a monitor). Given the historical precedent with the DFS and mortgage-related approvals, we believe their concerns are likely prospective.

New York DFS head Benjamin Lawsky has made it clear that his concerns are prospective, voicing a fear that “the explosive growth in the nonbank mortgage servicing industry” may somehow cause homeowners to get hurt. If Ocwen can provide assurances to Lawsky, the deal should eventually go through. Inside Mortgage Finance reported on Friday (Feb. 21^st) that approval will occur by late March, but the report was quickly denied. Keep in mind that this is not the first time DFS has objected to one of Ocwen’s MSR acquisitions; it also objected back in December 2011 when Ocwen acquired Litton’s MSR portfolio and that deal eventually went through. This time around, however, Lawsky has upped the ante by initiating an investigation of the financial interests Ocwen’s management has in the companies Chairman William Erbey has labeled “strategic allies” (AMCC, ASPS, HLSS, RESI), suggesting that conflicts of interest may need to be corrected. Again, this is not a deal breaker for the Wells Fargo deal, but just another hoop Ocwen needs to jump through.

A Financial Times article lauds Ocwen for building a global “empire” of mortgage servicing, discounting its current legal troubles and stating that “the biggest concern is not regulatory scrutiny or legal clashes with investors, but what happens when its MSR purchasing spree ends.” With more than $1 trillion in MSRs banks are still looking to unload (Ocwen is only servicing $455 billion in loans right now), the Financial Times‘ premature concern seems far down the road.

All in all, the legal controversies are overblown and have enabled value investors to buy Ocwen at a tremendous bargain price. Fourth-quarter financials were strong with revenue up 135% and earnings up 57%. Chairman Erbey emphasized three reasons why the company should continue to perform well:

First, prepayments continue to trend lower, lengthening the duration of our assets. Secondly, Ocwen’s continued ability to help homeowners with foreclosure alternatives along with an improving economy continues to drive down delinquencies on loans we service and further slows prepayments. Lastly, the OASIS financing that we just closed should enhance our prime origination business. Oasis enables us to reduce our exposure to prepayment risk and lower our cost of capital disadvantage vis-à-vis commercial banks.

I continue to recommend Ocwen up to $50.50.

SolarWinds finally reported a quarter with good revenue growth (up 32%, including 19.6% growth in the all-important license revenue). The company’s problems with growth opportunities exceeding the capabilities of its sales infrastructure appear to have been resolved and the future looks very bright. At least five different equity analysts raised their price targets on SolarWinds after the fourth-quarter report.

Fourth-quarter financials were strong across the board and easily exceeded analyst estimates for both revenues and earnings. Importantly, the results were strong in absolute returns, not just relative to low expectations. According to SolarWinds CEO Kevin Thompson:

I am pleased to report that we delivered a strong performance in the fourth quarter. After a challenging start to the year, we implemented a number of improvements in our business focused on the ways in which we generate and respond to demand within our marketing and sales organizations.

We believe those improvements, along with the continued efforts of the entire SolarWinds team, translated into a solid level of license and recurring revenue outperformance relative to our outlook for the fourth quarter. We feel positive about the momentum we have created in our business exiting 2013 and we are focused on driving strong growth in new business, both license and subscription, in 2014.

Even better, the company increased its revenue guidance for full-year 2014 from a range of $395.5 to $411.9 million to a range of $408.0 to $420.0 million. For the upcoming first quarter, revenue growth should be a very-strong 26-29%.

In the conference call, CEO Thompson discussed the company’s move into network security software, which is a big potential growth area given several high-profile data loss incidents over the last 6 to 9 months (e.g., Target and Apple).

The company’s past investments in a stronger sales workforce are starting to bear fruit, but the leveraging of earnings growth has only just begun, with full benefits to play out over the next couple of years. In other words, the best in profit growth is yet to come! As one analyst concluded:

SolarWinds is out of the woods. The company addressed the problems it had in the past, and is on its way to deliver strong revenue growth in 2014. Margins are probably going to bottom in 2014, and start to expand in 2015 and beyond, as the company leverages its revenue growth. Increased investments and larger sales force should become less of a drag on the company’s bottom line in 2015, and we should see rapidly expanding earnings in 2015 and 2016.