Value Portfolio

Lydall. The industrial fibers and filtration company has seen its stock skyrocket almost 24% in the three weeks since Valentine’s Day (mid-February) on two pieces of news: (1) the transformative acquisition of a filtration business; and (2) strong fourth-quarter financials.

The stock surge began on February 14^th on no real news, other than general strength in conglomerate stocks, led by giant 3M. Perhaps word of Lydall’s pending acquisition leaked early, but on February 20^th the announcement was made: Lydall was acquiring the industrial filtration division of U.K.-based Andrews Industries for $83 million in cash. The acquisition is projected to be accretive to 2014 full-year earnings and cash flow inclusive of transaction expenses. Normally, transaction expenses are excluded from accretion claims, so Lydall’s inclusive accretion claim is extraordinarily bullish. Furthermore, the deal is expected to generate $4 million in annual cost savings by 2016.

Lydall CEO Dale Barnhart stated that the acquisition:

expands our global footprint, adds complementary and new technologies, as well as substantial scale that provides a platform for long-term growth, and better positions us to deliver meaningful shareholder value. With this acquisition, Lydall’s filtration and engineered materials segments are expected to contribute approximately 50 percent of Lydall’s consolidated revenue.

We expect that new growth opportunities will result from manufacturing and selling complementary products and leveraging Andrew Filtration’s well-established presence in faster-growing Asian markets. We also expect to apply Lydall Lean Six Sigma principles to the acquired businesses and achieve margin and working capital improvements as we have previously demonstrated in our existing operations.

More information on the acquisition was revealed in the conference call following release of fourth-quarter financials on March 5^th. In the conference call, we learned that Lydall paid less than five times EBITDA for Andrews (after all synergies are realized), which is a real bargain. Furthermore, the acquisition was likely to generate up to $0.45 per share in additional annual earnings for Lydall by 2016. When you consider that Lydall’s full-year 2013 earnings were $1.00 per share, it turns out that this acquisition alone may increase the company’s earnings by 45%! As one analyst remarked: “That’s amazing.” No wonder the stock has taken off! Stock price follows earnings, so if earnings will now be 45% higher, the stock should also be worth 45% more (actually, somewhat less than 45% due to time value of money and the fact that the synergies won’t be fully realized for two years).

The Andrews acquisition is the future, but the present looks great also. In the fourth quarter, Lydall reported revenue and earnings-per-share growth of 10.4% and 78.6%, respectively. The EPS gain was especially noteworthy because it occurred despite a “significantly higher effective tax rate year-over-year.” The great earnings were due to an impressive improvement in the operating profit margin, which more than doubled from 2.2% of net sales to 5.3%. The company’s implementation of “Lean Six Sigma” principles of manufacturing efficiency are really paying off.

Lastly, the company continues to return cash to shareholders in the form of stock repurchases, spending $6.1 million in 2013 to acquire 423,000 shares (equal to 2.6% of shares outstanding), which is on top of 310,000 shares repurchased in 2012.

The earnings-boosting power of the Andrews acquisition, combined with the company’s efficiency gains in operating margin, have led me to raise the buy-below price for Lydall to $26.

ManTech International released fourth-quarter financials that looked worse than they actually were and provided forward guidance that was near-term mixed but long-term optimistic. Q4 GAAP earnings per share were a $1.77 loss compared to last year’s $0.55 gain, but the loss was entirely due to a one-time $118.4 million goodwill impairment charge related to the more rapid withdrawal of troops from Afghanistan than previously expected. Absent the impairment charge, fourth-quarter earnings were $0.54, which actually beat analyst expectations by $0.12, and full-year 2013 earnings were $2.14 instead of -$0.17.

Granted, Q4 revenues missed estimates because of both defense budget uncertainty and the federal government shutdown in October 2013, but the shutdown is over and the budget uncertainty is temporary.The two-year budget deal removes uncertainty about defense spending and eliminated half of the planned sequestration cuts in the upcoming 2015 fiscal year (Oct. 2014 to Oct. 2015). As founder CEO George Pedersen explained in the earnings press release:

Most important, the future funding picture is becoming much clearer. The Bipartisan Budget Act of 2013 creates a two-year framework for discretionary spending and eases harmful sequestration cuts. With full-year 2014 appropriations in place, our customers are actively carrying out plans for the future. We now have the clarity we need to use our strong balance sheet to aggressively pursue corporate acquisitions in growth segments of the budget.

Despite the sequestration reprieve in fiscal 2015, the threat of defense budget cuts remain, thanks both to mandated sequestration cuts in later years and Defense Secretary Chuck Hagel’s decision to reduce the size of the U.S. army to pre-WWII levels.

The good news is that ManTech focuses on cybersecurity and intelligence gathering, which are areas that Hagel has budgeted increases for. When I recommended ManTech, I was fully aware of the sequester and shrinking defense budgets. I intentionally chose a defense stock that operated in the winning sectors of the future military.

ManTech’s guidance for full-year 2014 is $2.0 billion in revenue and $1.50 earnings per share, assuming no further acquisitions. Both forecasted figures are below 2013 numbers ($2.3 billion and $2.14, respectively) and overly conservative in my view, because ManTech’s history is built on acquisitions and the company has stated that more acquisitions are likely. Indeed, ManTech’s cash balance has grown considerably in the past year, almost doubling from $134.9 million to $269.0 million – a record high. Cash flow from operations in 2013 was very strong at $188 million and was an amazing 2.4 times net income. Whenever cash flow is higher than net income, you know that – thanks to the cash/earnings convergence inherent in accrual accounting – that future earnings growth are very likely to rise.

In the conference call, CFO Kevin Phillips said that the company’s high cash balance will be used for earnings-accretive acquisitions and to pay off $200 million in high-yield 7.25% debt:

Our strong and steady cash flows enable us to support organic growth, diversifying acquisitions, and our ongoing dividend program. After the close of the quarter, we acquired Allied Technology Group for $45 million, still leaving ample cash on hand.

In April, the no–call provision on our high yield debt expires and we expect to pay off the $200 million note at that time. Our debt expense will have initial impact on earnings per share for 2014 given the fees to call the bonds, but we will save $50 million annually in interest–related expenses beginning in the second half of the year and in the future years.

Phillips also said that business is picking up:

In just the last few weeks, we have seen a surge in proposal activity, where we had $400 million of proposals in process as of December 31^st, we now have over $1.4 billion in active proposals. So we expect the logjam to clear as the newly appropriated funds are making their way now to programs.

Still, 2014 is seen as a “transition year” where the Afghanistan revenue is killed off once and for all and future growth is tied almost exclusively to cybersecurity, intelligence, and healthcare. That said, military readiness in the Pacific theater remains a growth area thanks to an increasingly-aggressive China and ManTech is benefitting. The first half of 2014 is seen as the “trough” with strong growth resuming in the second half of 2014 and thereafter:

Continued wind down in Afghanistan and the lingering effects of delayed awards given the prior budget environment, will weigh on our results in the first half of 2014, which represents a revenue and earnings trough for ManTech. We expect the increased flexibility and clarity that our customers now have to translate into a sharp increase in new awards, revenue and earnings as we progress through the year.

Bottom line: ManTech’s future in cybersecurity, intelligence, and healthcare is very bright and growing rapidly. Value investors should be willing to wait out the mid-year trough and benefit from the resurgent growth and lower debt expense costs later in 2104 and beyond. I’m heartened by the minimal investor reaction to the lowered guidance, which suggests that the stock is already in the strong hands of value investors and the stock price has already discounted all of the current news on a Afghanistan-based slowdown. Downside risk appears limited while upside potential is large. Cowen & Co. agrees with me, upgrading the stock on Feb. 25^th (a week after Q4 earnings) “due to valuation and improving pre-order indicators.” ManTech is one of the defense-stock winners.

Momentum Portfolio

Darling International. The stock of this meat and oil recycler and biodiesel manufacturer has gone nowhere since October because of: (1) buyer reluctance to purchase forward, exacerbated by unfavorable pricing in its fats and proteins end markets; (2) production snafus at its biodiesel plant; and (3) regulatory uncertainty concerning biodiesel production volumes required under the federal renewable fuel standards (RFS).

Fourth-quarter financials were mediocre with sales flat and earnings down. CEO Randall Stuewe stated:

I would characterize fiscal 2013 as one of the most pivotal years in the company’s 131-year history. Fiscal 2013 was a year of tremendous growth for the Company.  We focused on strategic, long-term opportunities while managing a massively volatile fourth quarter in 2013.

Two acquisitions over the past year have transformed Darling from a U.S.-centric company into a global powerhouse: (1) $2.2 billion for Netherlands-based Vion Ingredients; and (2) $611 million for Canada-based Rothsay. The Vion deal was so big that Darling had to sell 46 million shares in a public offering to help finance it, which increased its shares outstanding by 39% (164 million vs. 118 million) and its market cap by a similar percentage ($3.3 billion vs. $2.3 billion).  Short-term integration challenges exist, but the long-term benefits should be worth it. The deals are so transformational that the company plans to change its corporate name from Darling International to Darling Ingredients. In the conference call, CEO Stuewe explained the transformation:

We are in process of establishing a new identity, and we’ll shortly be asking the shareholders to approve the changing of the company’s name to Darling Ingredients Inc. with operating units of Darling USA, Darling Canada and Darling International.

With our new company, we have established a global ingredients footprint across 5 continents, with 200 operating facilities and a diversified product portfolio of more than 400 offerings. Our global presence provides access to raw material sourcing in the USA, Europe, Australia, South America and China, delivering value-added products to world-class brands in the gelatin, casings, pet food and aquaculture ingredients and specialty products markets.

We more than doubled the enterprise value of the company from $1.7 billion in revenue to approximately $4 billion, and now we’ll operate across 3 principal segments: food, feed and fuel.

Stuewe clarified that the Q4 “volatility” referred primarily to an “unprecedented reduction in corn prices” which dropped 29% during the quarter on a sequential basis (i.e., since Q3) and 41% year-over-year. Corn is a key ingredient in Darling’s “Cookie Meal,” which is used to feed poultry and swine. The problem is that Darling buys its corn in the MidWest and sells its Cookie Meal in the Southeast, and the corn prices plunged most in the Southeast which was flooded with cheap corn from Brazil. The result was that Darling suffered a profit-margin squeeze because prices for its end-product Cookie Meal were pushed down by the low corn input prices in the Southeast, even though Darling’s input costs didn’t benefit from the low Southeastern corn. Low soybean prices also hurt the company’s meat-rendering protein business (which competes against soybeans).

The other big problem was excess inventory of input fats and missed profits at the Diamond Green Diesel plant because the plant was periodically offline due to a series of heat exchanger failures that needed to be replaced and the replacement parts for the heat exchangers took time to fabricate and install. In other words, at a time of extremely-good profit margins for biodiesel, Darling’s production problems caused the company to miss out (unlike FutureFuel, which took full advantage). Also hurting was a collapse in the prices of renewable identification number (RIN) credits thanks to rapid completion of the 2013 renewable fuel standard (RFS) production quantities, as well as news in November that the FDA was proposing not to increase2014 RFS production quantities – including the 1.28 billion gallon mandate for biodiesel.

On the positive side, Darling sees improving corn, soybean, and RIN pricing in 2014, as well as the Diamond Green Diesel plant manufacturing at capacity with no more logistical problems. Furthermore, the Environmental Protection Agency (EPA) is likely to reverse its November decision and increase mandated RFS production quantities in 2014 for two reasons: (1) RIN prices are rising in anticipation of a policy reversal; and (2) EPA administrator Gina McCarthy stated in February that the final rule for 2014 RFS will be “in a shape that you will see that we have listened to your comments.” Although the biggest beneficiary of an RFS reconsideration would be ethanol, biodiesel would likely benefit also.

In other words, all of the problems in 2013 are primed to reverse in 2014 – yet the Darling stock price doesn’t yet reflect the likely 2014 improvement. FutureFuel is performing much better right now because of its primary focus on biodiesel, but Darling has the potential to outperform in the future with its global, diversified ingredients footprint. This is a good time to buy Darling before investor expectations reset to the upside and the synergies from the global transformation are realized. Goldman Sachs agrees with me, initiating the stock with a buy rating in mid-January and setting a $25 price target.  I am raising the “buy below” price on Darling International to $21.50.

U.S. Physical Therapy reported solid, if not spectacular, fourth-quarter financials, with revenues up 10% and earnings per share down 8.6%. Both numbers slightly missed estimates, but the company has a good excuse. On the revenue side, the number of patient visits was up a nice 11.1%, but Medicare’s latest multiple procedure payment reduction (MPPR), which went into effect on April 1, 2013, caused the average net patient revenue per visit to decline by $0.85. On the earnings side, EPS was reduced by $0.09 due to the company incurring a charge for a $393,000 income-tax “true-up” adjustment and an $850,000 refund to a payer for a four-year overpayment to one of the company’s clinics.

The MPPR reimbursement cuts have been a real thorn in the company’s side, but management has worked hard to reduce clinic operating costs in an effort to neutralize the lower reimbursement rate. For full-year 2013, cost savings totaled $4.7 million, which was slightly short of the $5 million goal, but the remaining cost savings will happen in 2014 – primarily by cutting the number of work hours by the company’s 1000 part-time employees (36% the total 2800-member workforce). One of the company’s strengths is acquiring talented but underperforming clinics and whipping them into financial shape. Often the best therapists make the worst businessmen and they know this, which is why they sell out to USPH (but keep a significant minority ownership interest).

CEO Chris Reading summed up the company’s financial performance in the past year as one of both organic and acquisition-led growth:

2013 was in many ways a challenging year largely as a result of government reimbursement cuts, however, I am proud of our team for rising to the challenge. We were able to finish 2013 with same store volume growth for both the quarter as well as the year.

Additionally, this was by far the best development year in the Company’s history. We made five acquisitions adding 42 clinics. These new partnerships, in combination with our strong base of existing partners, position us well for 2014. Given the continued challenges for standalone physical therapy practices, we expect to continue to provide a good home to those owners who wish to partner with a company which will robustly support them.

Earnings-per-share guidance for 2014 is a range of 1.54 to 1.60 per share. At the midpoint of 1.57, this constitutes 8.3% earnings growth from the past year’s EPS of 1.45. Not bad, considering that the first quarter of 2014 will be another (and last) comp against the pre-MPRR first quarter of 2013.  In addition, one of the coldest winters on record throughout the eastern half of the U.S. has resulted in the cancellation of more than 10,000 office visits since January 1^st and the winter isn’t over yet. The canceled visits have cost the company at least $0.04 per share in first-quarter earnings. Combined with an estimated $0.075 per share negative effect from MPRR being in effect in Q1 2014 but not in Q1 2013, full-year earnings in 2014 will be $0.115 per share less than a normalized comp would be. Put another way, USPH’s inherent earnings growth for 2014 if these abnormal deductions were added back in is 16.2% [(1.57+0.115)/1.45] – almost double the projected GAAP growth rate of 8.3%.

Evidence that management has confidence in the company’s true annual EPS growth rate of 16.2%, it raised the quarterly dividend by a whopping 20% to $0.12 from $0.10. Nothing generates investor confidence in a company’s future business prospects more than a dividend hike because dividends – once raised — are rarely cut and management consequently wouldn’t raise the dividend if it thought earnings growth was unsustainable.

In the conference call, CFO Larry McAfee confirmed that the company would continue to make “accretive” acquisitions of therapy clinics in the year ahead with cash obtained from a $50 million expansion in its bank line of credit. The last acquisition of 2013 was a 12-clinic practice that focused on workmen’s compensation claims. Workmen’s comp is a great segment of physical therapy because it serves a large segment of the U.S. workforce (employers pay out $1 billion in claims each week) and often pays higher rates for physical therapy services than does health insurance. USPH CFO McAfee said that the workmen’s comp acquisition will drive up the company’s net revenue per visit by a full $1.00. In fact, many workers hurt on the job will seek reimbursement for medical expenses through workmen’s comp even if they have health insurance because workmen’s comp not only pays medical expenses but also pays a portion of the worker’s salary. In rough terms, commercial health insurance comprises 50% of the company’s business, Medicare and Medicaid comprise 25%, and workmen’s comp makes up 20%. For USPH, the most important thing is diversifying their clinical work among different sources of payers and partnering with talented and hard-working therapists.

Bottom line: the first quarter will have a bad comp against the year-earlier period and likely will mark the trough for 2014. After Q1, revenue and earnings should accelerate and a few acquisitions (especially any more focusing on workmen’s comp) will cause the company to easily beat analyst estimates. The continued aging – and extended athleticism — of America is a great tailwind that will power USPH forward for years to come.

WisdomTree Investments. On March 19th, a Citigroup analyst downgraded the ETF pioneer. The analyst’s rationale is unpersuasive, not based on any facts, and pure speculation. He’s worried about fund inflows slowing (no evidence), relatively high valuation (it’s growing faster than its peers so it deserves the higher valuation), and reduced chance of a buyout because the company is investing in new distribution infrastructure (increased investment makes the company more valuable and attractive).

Lastly, he is concerned about a recent increase in insider selling, but it’s less than in the recent past. WisdomTree only re-listed on the Nasdaq in July 2011 and only started selling shares to the public in February 2012, so it is normal for long-time insiders to cash out some of their holdings. They can afford to cash out at low stock prices because their initial investments were bought at pennies, so their profit is huge and they don’t care if the stock can go higher (which it has subsequently done).

The insider selling recently in 2014 is nothing compared to the insider selling that occurred in 2012 when the company had two secondary offerings — one in February 2012 and one in November 2012. In both secondaries, tens of millions of shares were sold by insiders around $6 per share. What happened in 2013 after these huge insider sales? The stock almost tripled! If you had run for the hills in 2012 after seeing the WisdomTree insider selling, you would have missed out on a huge gain.

Corporate insiders have many reasons for selling their stock. They may have automatic plans to sell shares every now and then, regardless of the stock price. They may be selling for diversification purposes. They may also need the cash for a variety of personal reasons, like sending their kids to college, buying a house or getting a divorce.

One of the greatest investors of all time, Peter Lynch, was noted for saying that “insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”

As I wrote in the February issue, insiders still own 20 percent of the company, including Michael Steinhardt (13%) and Jonathan Steinberg (4%). Current insider ownership is much higher than exists in the average company and ensures that insiders have confidence in the future prospects of the business and that their financial interests are aligned with the average shareholder.

Bottom line: WisdomTree remains a high-growth and innovative company that is the only pure play in the exploding financial sector of exchange-traded funds. On March 20th, the company was voted “Most Innovative ETF Issuer of the Year”.

WisdomTree’s future in the growing ETF space is bright and the stock continues to be heavily owned by insiders. This Citigroup report is a prime example of the short-term thinking and trading mentality that boosts Citigroup’s commission fees by churning client accounts but loses its clients money over the long term.

Other analysts have recently upgraded the stock including Bank of America/Merrill Lynch and Sidoti.