Value Portfolio

Fresh Del Monte Produce. The banana stock jumped as high as 11% and closed up more than 9% on release of excellent first-quarter financials that saw revenues grow 7% and earnings per share up a whopping 46%, both numbers absolutely crushing analyst estimates. According to CEO Mohammad Abu-Ghazaleh:

Our results in the first quarter of 2014 demonstrate progress toward our strategic initiatives. We benefited from efforts to hold the line on costs, achieved higher profitability in our offshore melon business and continued growth in our Middle East operations.

My confidence in Del Monte’s management team has been shaken by the poor communication in previous earnings reports, so the good news this quarter allays my concerns about the company’s long –term prospects only partially.

Gentex. After years of regulatory delay, on March 31^st the National Highway Traffic Safety Administration (NHTSA) published its final rule requiring rear-visibility technology in a percentage of new vehicles under 10,000 pounds manufactured on or after May 1, 2016 and all new vehicles under 10,000 pounds manufactured on or after May 1, 2018.  Since Gentex manufactures a mirror-based rear camera display, this new regulation is somewhat good news for Gentex. The effect of the rule won’t be large because auto manufacturers have been anticipating this rule for six years (since 2008 federal legislation mandated it) and already include rear-camera displays (RCDs) in 60% of the cars that are manufactured today. Furthermore, the NHTSA rule does not specify what type of RCD technology to install and most auto manufacturers have chosen to build RCDs into car consoles rather than in rearview mirrors.

First-quarter financials were strong, with revenues up 25% and earnings per share up 47%, both numbers beating analyst estimates. Also impressive was the 440 basis point jump in gross profit margin (39.1% vs. 34.7%), which was due primarily to the HomeLink acquisition and the higher profit margins available from selling home garage door openers to retail customers. Guidance for the upcoming second quarter was also upbeat, with revenues expected to grow between 15-20%.

GrafTech International.  Proxy fights are so much fun! Former director and 11.2% stakeholder Nathan Milikowsky is waging a battle with the industrial materials company’s current management to appoint three dissident members to GrafTech’s board of directors (including himself). The shareholder vote on directors will occur on May 15^th at the company’s annual meeting. Two letters have been sent to GrafTech shareholders soliciting their votes:

• Milikowsky letter
• Management letter

Regardless of the proxy fight’s outcome (and I hope Milikowsky wins), the company’s business continues to improve with the cyclical upturn in the steel industry. First-quarter revenues were better than expected and the company increased its 2014 forecast for cash flow from operations to $150-$180 million, which is $20 million more than previous guidance thanks to accelerated working capital rationalization (i.e., increased efficiency).

Insiders apparently believe that the stock has more upside. During late April, four directors increased their stock holdings in the company by more than 10% each.

Momentum Portfolio

CommVault Systems. The stock of this big-data software company plunged more than 30 percent after releasing fourth-quarter financials that disappointed investors despite reporting a 27% increase in adjusted earnings (27%) that beat analyst estimates.

Disappointment centered on revenues missing estimates (although up 13%) and CEO Robert Hammer acting surprised and clueless about why revenues in the Americas failed to meet management forecasts “given our large enterprise deal funnel and good outlook for the quarter as of our prior earnings call.” While the company provided vague revenue guidance for fiscal 2015 (“solid double digit”), it refused to provide earnings guidance which disconcerted some analysts. Furthermore, in the conference call CEO Hammer said that fiscal 2015 would be a year of “aggressive” and “increased” operating expense investments that will depress profitability, but are necessary to rejuvenate growth back up to historical rates by the second-half of fiscal 2015. The company’s revenue slowdown appears to be focused on inadequate sales-force infrastructure – similar to the problem SolarWinds faced last year. In both cases, the problem is not product quality or end-user demand, but simply an understaffed sales team.

Financials and valuations at the two companies are similar. Both are profitable and growing with no debt, but valuation remains high. That’s okay if the price momentum confirms the financials, but momentum has lagged for both companies:

• Return on invested capital: Solarwinds (18.9%), CommVault (16.6%)

• Five-year annualized revenue and earnings growth: Solarwinds (29.2% and 32.1%), CommVault (20.1% and 20.7%)

• Debt: Solarwinds (zero), CommVault (zero)

• Earnings quality (cash flow/net income): Solarwinds (1.7), CommVault (1.8)

• Trailing 12-month P/E ratio: Solarwinds (35.7), CommVault (36.1)

• Estimated five-year annualized future earnings growth: Solarwinds (22.5%), CommVault (20.9%)

• PEG Ratio: Solarwinds (1.35), CommVault (1.60)

Bottom line: Although I still like the long-term prospects of CommVault, the technical damage from the stock-price collapse is severe and the company is just getting started building up its sales team. Financial performance at historical levels of revenue growth is at least six months’ away. The stock is now trading at a 45% discount to its 52-week high, which doesn’t qualify as momentum, so I am downgrading CommVault Systems’ rating to a hold.

HMS Holdings. After the Centers for Medicare and Medicaid Services (CMS) postponed recovery audit contractor (RAC) auditing of hospital in-patient reimbursement claims based on the “two-midnight rule” for two consecutive six-month periods (12 months total from October 1^st 2013 to October 1^st 2014), the U.S. Congress decided to get into the act and pass legislation extending the auditing moratorium for yet an additional six-month period until April 1^st 2015. As I wrote back in January, the hospital lobby is strong. In passing this auditing delay, members of Congress have proven themselves more concerned with personally receiving campaign contributions from hospitals than they are with saving U.S. taxpayers money from Medicare fraud through health-spending audits. Sad but true. As one commentator recently put it:

The ongoing efforts by hospitals to eliminate Medicare oversight, and the complicity of Congress, are deeply concerning. 

This third six-month auditing delay may not be the last, as the Congressional Budget Office (CBO) scores these delays as causing no negative revenue impact, despite the fact that audit recoveries of fraudulent Medicare payments can save the government hundreds of millions of dollars. My previous estimate that HMS would start generating its normal audit commission run rate in 2015 is no longer valid and frankly it has become impossible to predict when the federal government will get serious about the RAC program and combatting health-care fraud. HMS has stated that it cannot forecast its earnings until it gets regulatory clarity on RAC auditing and no such clarity is forthcoming. According to Obsidian Research Group:

The Medicare RAC program is undergoing significant changes both administratively and through legislative action and the RACs will likely bear the brunt of those changes. Given the protracted nature of the governmental contracting process and the fact that CMS is attempting to placate both the provider community and the RACs in its revision of the Medicare RAC program, we believe that the earliest the Medicare RAC program is back up and running will be sometime in late 2015.

Another regulatory delay that hurts HMS involves implementation of international classification of diseases (ICD)-10, which will now go into effect on October 1, 2015 instead of October 1, 2014. The American Medical Association (AMA) lobbied for delay because many smaller physician practices weren’t ready for the change. Back in March, I wrote that ICD-10 would boost business for HMS because ICD-10 would increase the number of billing codes five-fold from 14,000 to 70,000 and “the more codes, the more important the ability of RAC companies to crunch data to find fraud and discrepancies.” Never mind.

Equally troubling is news that the HMS chief financial officer is leaving in June 2014 to “pursue other opportunities.” With bad news everywhere and the stock trading at a 40% discount to its 52-week high, I am downgrading HMS Holdings’ rating to a hold.

LeapFrog Enterprises. Fourth-quarter 2013 financials were weak, with revenues down 23.7% and earnings per share showing no growth year-over-year. According to CEO John Barbour:

The holiday retail environment was very challenging. Unfortunately, tough retail conditions, deep retailer price discounting, and increased competition impacted our business. Additionally, our handheld gaming business declined significantly as more consumers played games on tablets.

First-quarter 2014 financials were even weaker, with revenues down 36.6% and earnings per share showing a loss of -$0.16 – four times larger than last year’s Q1 loss of -$0.04. CEO Barbour said that the second half of 2014 should be better than the first half:

Our first quarter performance was about as we expected given the calendar shift of Easter into Quarter 2, higher levels of retail carryover inventory from Holiday 2013 across the key categories we play in and a continued challenging retail environment in our major markets. With a tough start to the year and our major new product launches scheduled for the second half, we expect our sales to be significantly more back-end focused in 2014 than last year. Our line-up of major new product introductions will begin shipping in late summer and fall.  

Skeptics say that adult Android and iOS-powered tablets can be used for children’s games, so a child-specific LeapFrog tablet is not necessary. My answer is that adults don’t want to share their tablets with kids because they’ll either break them or mess up the settings. Furthermore, the future of LeapFrog is in its intellectual property software, not in its LeapPad hardware, so LeapFrog is working to monetize its gaming and educational software on Android and iOS platforms. The transition from a business focused on hardware to one focused on software is time-consuming and often painful, but there is a rainbow at the end of the tunnel for patient, long-term LeapFrog investors.

The company continues to innovate and just announced that it August it will release its first wearable computing device for kids called the LeapBand:

The LeapBand, designed for kids ages 4 to 7, gives kids commands like “wiggle like a worm” or “pop like popcorn” and then rewards the activity by giving points that can be used to unlock special game features on the band. When kids get a certain amount of points, they can redeem a virtual pet like a cat, dog, donkey or unicorn. Additional points are accrued to let children interact with their pets in different ways.

The device connects to a website or app, where parents can monitor their kids’ activity and select from a list of physical challenges. It gamifies fitness for kids, at a time when childhood obesity is getting attention as a public health issue.

Although the stock has performed miserably since last summer, I can’t help but like the company and continue to be optimistic. First, it’s one of the “good guys” in terms of helping children develop their minds and bodies. Second, it’s so darn cheap, with an EV-to-EBITDA ratio of only 6.7 and zero debt. LeapFrog’s board recently authorized a $30 million share repurchase program to take advantage of the stock’s undervalued price and Wall Street analysts continue to name LeapFrog as an attractive takeover target.  Mattel’s acquisition of construction-building-set manufacturer Mega Brands for $460 million (9.8 times EBITDA) has fueled speculation that the big toymakers may be on the prowl for other small toymakers – including LeapFrog. A 9.8 times EBITDA valuation is 46% higher than LeapFrog’s current 6.7 times EBITDA valuation.

Lastly, earnings estimates for LeapFrog are rising, which is a good sign for improved stock performance in the second half of 2014.

Bottom line: LeapFrog is attractive as a value investment but not as a momentum investment. The stock is now trading at a 42% discount to its 52-week high, which doesn’t qualify as momentum, so I am downgrading LeapFrog Enterprises’ rating to a hold.

Ocwen Financial. Benjamin Lawsky, head of the New York State Department of Financial Services (DFS), continues to harass Ocwen with new inquiries insinuating wrongdoing. In February, Lawsky froze indefinitely Ocwen’s planned acquisition of $39 billion in Wells Fargo mortgage servicing rights (MSRs) and sought information about management’s cross-ownership interests.

The latest insinuation is that Ocwen may engage in self-dealing when it sends mortgage foreclosures to the auction site Hubzu, which is owned by Ocwen affiliate Altisource Portfolio Solutions (ASPS). Allegedly, Hubzu charges 4.5% of auction value when the foreclosed home involves an Ocwen-serviced mortgage compared to only 1.5% for home auctions conducted on behalf of non-Ocwen mortgage servicers. Ocwen issued a statement saying that it will “fully address the questions raised by the DFS in our response to the letter, which we will plan to provide by April 28.”

From a purely economic viewpoint, Ocwen’s cost-efficient and innovative loan servicing/modification of home mortgages is the solution to the problem of troubled home loans. The big banks don’t want to service troubled home loans because of new, stricter capital ratio regulations and will continue to offload mortgage servicing rights (MSRs) to specialty finance companies like Ocwen, which is the biggest and best at modifying mortgages in order to prevent foreclosures and keep mortgagees in their homes. Consequently, Ben Lawsky’s quixotic fight against the macroeconomic tailwinds in favor of MSR outsourcing are bound to fail and I am confident Lawsky will eventually stand down from his political, non-economic hostility.

Lawsky’s political theatrics are not just pestering Ocwen, but are having a deleterious effect on the entire MSR industry. Ocwen Chairman Bill Erbey recently stated that “the whole MSR market has stopped until this gets resolved.”

The full weight of the entire mortgage industry will soon come to bear on Lawsky and demand an unfreezing of the MSR market. It’s just a matter of time.

Hedge-fund manager Doug Kass recently recommended Ocwen, stating persuasively:

1. “Ocwen will come up with a settlement with the New York banking regulators, as it is in the interest of both parties.”

2. “More regulation is a positive for Ocwen: Regulation provides a clearer path for industry participants that are well positioned (capital and operationally speaking) such as Ocwen. Ocwen’s critical mass, portfolio size and efficiency ratios position the company well to produce steady and superior industry returns. (Note: The company possesses more capital than all its non-bank competition combined.).”

3. “At about six times 2015 consensus estimates of $5.75 a share, the shares are inexpensive by almost any standard or metric.”

Nevertheless, the stock is no longer exhibiting momentum characteristics (43% discount to 52-week high) and the expense burden of the increased regulatory scrutiny caused the company to miss analyst estimates for first-quarter earnings per share by a whopping 46% ($0.54 vs. $1.00 expected). I am downgrading Ocwen Financial’s rating to a hold.

WisdomTree Investments. First-quarter earnings per share doubled year-over-year and beat analyst estimates, whereas revenues grew 46% but missed estimates.  Net fund outflows of $500 million compares with $5.9 billion in net fund inflows last year. That’s a big change. Furthermore, on a quarterly sequential basis, assets under management (AUM) fell between December and March and have continued to fall during the first month of the second quarter. The AUM problem centers around the Japanese stock market, which dropped 8.9 percent during the first quarter and was the worst-performing major stock market. Since more than 35% of WisdomTree’s total AUM (slide no. 11)  is concentrated in the Japan Hedged Equity Fund (DXJ), the company’s fortunes are hurt badly when Japan’s stock market doesn’t perform well. The long-term prognosis for Japan’s economy is grim, but Morgan Stanley recommends remaining overweight Japanese equities in 2014 because of unprecedented fiscal and monetary stimulus by Prime Minister Shinzo Abe. Nobody seems to be listening.

The stock is now trading at a 39% discount to its 52-week high, which doesn’t qualify as momentum, so I am downgrading WisdomTree Investments’ rating to a hold.