Value Portfolio

Brocade Communications. Second-quarter financials were “solid” with revenues beating analyst estimates and revenue guidance for Q3 that was also higher than expectations (page 20). The company announced a “strategic shift” away from capital-intensive hardware and towards asset-light software solutions which should conserve substantial cash flow for other uses, such as shareholder-friendly stock buybacks and dividends. For example, Brocade continued to buy back stock in the second quarter ($50 million worth after buying back $140 million worth in Q1), reflecting its policy of returning a minimum of 60% of adjusted free cash flow to shareholders.

In addition, thanks to “continued strength of our operational performance and cash flow,” the company initiated its first-ever quarterly cash dividend at $0.035 per share ($0.14 annually) payable on July 2^nd with an ex-dividend date of June 6^th.  The dividend represents 13% of annual adjusted cash flow and an annualized yield of 1.50% (0.14/9.31). The initiation of dividends is often interpreted positively by investors because it means that the company has confidence in sustainable cash flow growth.

The stock sold off slightly immediately after the earnings announcement based on the report of flat revenues, but the stock has risen strongly ever since as investors focus more on the company’s commitment to returning cash to shareholders. One analyst has written that Brocade is currently undervalued and is worth $11 per share, which is 18% above its current price of $9.31.

Buckle.  Teen unemployment has been above 20% since May 2009 and that has crimped spending growth at teen retailers for a long time. From a contrarian viewpoint, such tepid consumer spending can’t last forever and an upswing in economic growth during the second half of 2014 could cause a nice rebound in retail stocks. In fact, JP Morgan issued a report in early May stating:

Following a brutal holiday season, a cooler February and March, and concerns about the April uplift, sentiment was the lowest we have seen in years for our softlines specialty retailers. March and April are typically two of the strongest months of the year for our group, but 2014 was the exception with the group underperforming the S&P 500 by 3% and 5% in March and April, respectively. Short interest too is on the rise, up 32% year-over-year for our softlines group on average and 10% in the last two months.

Simply stated, more investors are taking the bearish view that the tough weather pass issued to the group in 1Q14 will soon face the reality of ongoing market-share shifts towards fast fashion players, online pure-plays, and off-pricers.

At extremes, investor sentiment is wrong and this appears to be one of those times. Retailers are forecasting a “hockey stick” year in terms of earnings growth, with the second half of 2014 much stronger than the first half thanks to stronger same-store-sales comparisons and higher operating margins.

Buckle should benefit more than most retailers from a stronger second half. According to JP Morgan, Buckle has industry-leading operating profit margins of 23%. Furthermore, the company is “executing well in a difficult environment” – as evidenced by the fact that same-store-sales in the first quarter of 2014 were down only 0.9% compared to the double-digit percentage declines suffered by its competitors.

In Buckle’s May 22^nd first-quarter conference call, CEO Dennis Nelson said the company plans to continue growing in 2014 with 17 new store openings and average selling prices for denim are going up, which should help earnings growth:

Higher price points have been well received and that has raised the average price of the denim. So we’re seeing good response to our denim selection and looking forward to the back-to-school season.

I would see inventory growth at the end of the second quarter probably in the high single-digits. But we’ve had a nice response to our selection and we feel good about our inventory at this point.

Although CEO Nelson wouldn’t comment on the likelihood or amount of another special dividend later this year (it was $1.20 in 2013), JP Morgan says that the annual special dividend is a “compelling reason to own the stock.”

Two recent articles are very bullish on Buckle:

• Shareholder friendly dividend policy
• 20% upside potential using conservative growth assumptions.

FutureFuel.  The renewable fuels and chemical company released first-quarter financials that saw revenues down 11% and earnings down 58% year-over-year. Not great, but revenues beat estimates and much of the decline was caused by reduced government subsidies, not a reduction in biofuel demand. In fact, CEO Lee Mikles reassured investors that the company is on the right track:

The first quarter was characterized by flat revenue and much lower profitability in biodiesel due to the expiration of the $1 blender’s tax credit on 12/31/13 and somewhat lower volume of our chemical division. Comparisons to first quarter of 2013 were also skewed by the $2.5 million retroactive credit for 2012 biodiesel volumes.

We continue to explore acquisition opportunities in both biofuel and chemicals to further our presence in both industries. Our strong balance sheet gives us tremendous flexibility in driving our business.

In the conference call, CEO Mikles stated that customer demand for biodiesel was actually stronger than ever:

Moving on to biodiesel. Our demand for the product actually increased and I’ve heard other say that they saw decrease in volume in the first quarter. We didn’t see that. We saw strong demand for the product from our customers.

The Renewable Identification Number values today are about $0.50, a year ago they were $0.93, but it is actually more dramatic than that. It was $0.93 plus a $1.00 credit so it is effectively $1.93 versus $0.50 per day. So the fact that in that type of environment we could still make money, it is pretty remarkable because I think there are few who are going to be able to do it so I was pleased with our performance given the challenges and the changes in that business.

Upside catalysts would be a retroactive renewal of the blender’s tax credit and the EPA reconsidering its November 2013 decision to lower the renewable fuel standard for 2014 to 15.21 billion gallons, down from 16.55 billion gallons in 2013. An EPA reconsideration decision is expected on June 20th.

GrafTech International.  The proxy fight is over and activist shareholder Nathan Milikowsky won. On May 15, at the company’s annual shareholder meeting, GTI shareholders elected Milikowsky and two of his hand-picked allies to the board one year after he was ousted on allegations he leaked confidential company information to a hedge fund.

Milikowsky, who owns 11.2 percent of GrafTech, was joined on the board by financially-savvy allies Karen Finerman (hedge-fund manager) and David Jardini (investment partnership) . In a released statement, Milikowsky said:

This is a terrific outcome for GrafTech’s investors, customers and employees,”  “We are gratified by the strong shareholder support our plan has received, and we are looking forward to working constructively with Joel Hawthorne and our other fellow directors to adopt sound strategies that will improve operations and enable the Company to realize its full potential.

GrafTech executives fought to keep Milikowsky off the board, branding him during the run-up to the vote as an  “unfit for service.” But once the vote was finalized and Milikowsky’s faction was victorious,  company executives sought reconciliation:

We appreciate the consideration and support of our stockholders, as well as the valuable insight they have offered our Board and management team throughout this process,” the company said in a May 15 release. “GrafTech welcomes the directors from the Milikowsky Group and looks forward to working together to continue to successfully execute the company’s strategy for the benefit of all stockholders.

Proxy advisory firm Institutional Shareholder Services (“ISS”) supported the insurgents and ISS support may have been the deciding factor. During the proxy campaign, the “Save Graftech” faction (pp. 44-52) headed by Milikowsky pushed for: (1) value-added non-commodity production of graphite electrodes ; (2) reduced excess inventory; (3) reduced Selling, General, and Administrative (SG&A) expenses; (4) expand capacity at Seadrift, the needle coke manufacturer; (5) streamline management communication channels; and (6) consider spinning off the high-growth Engineered Solutions division to increase total shareholder value.

The stock didn’t jump on the news of Milikowsky’s proxy-fight win, as investors take a “wait and see” approach, but I believe the insurgent directors will shake things up for the better and the stock price will eventually rise on efficiency improvements.

Stepan Company. Stepan is a cyclical chemical company that got hurt by the economic slowdown in Q1 (U.S. GDP contracted 1.0% annualized), so its first-quarter earnings missed analyst estimates due to high energy costs, but the problem was temporary thanks to one of the coldest winters in U.S. history. The company’s financial performance should bounce back strongly if the U.S. economy rebounds in the second quarter and beyond.

But even as earnings per share took a downward trend in the first quarter of 2014, net sales were up, so demand for Stepan products remains strong. In the earnings press release, Stepan management stated:

Lower earnings were directly attributable to higher maintenance, energy and freight costs from the adverse weather in North America and lower North American surfactant demand. Progress on strategic objectives remains on track.

In the post-earnings conference call, CEO F. Quinn Stepan, Jr. reiterated that point, and pointed to several potential high-growth areas for the company:

Despite the disappointing first quarter results, we continue to make progress on our strategic initiatives, specifically recent investments in Brazil, Singapore and Europe and European polymers along with our 2013 polyester resin acquisition in Columbus to Georgia, all delivered significant growth. March was much better than January and February and April should be another good month.

Our balance sheet remains strong and we continue to pursue further investments and opportunities to improve efficiency, accelerate earnings growth and deliver greater returns for our shareholders.

An insider is bullish on the stock at its current price level. CFO Scott Beamer purchased 1,000 shares on May 27th at an average price of $52.10 per share, which was the first insider purchase since last November.

Momentum Portfolio

Darling Ingredients. First-quarter financials saw a 109% uptick in revenue from $445 million to $931 million, attributable to its acquisition of Netherlands-based VION Ingredients, now known as Darling Ingredients International. Both earnings and revenues missed analyst estimates, but the unusually cold winter weather was to blame and in the conference call Darling CEO Randall Stuewe stated that business has improved since the first quarter:

In the global feed segment earnings were a little lighter than anticipated, but they gained significant momentum during March and carried good velocity into Q2. Severe winter weather hindered operations in North America. In the Midwest and Canada we lost a significant number of operating days to extreme cold weather and natural gas curtailment.

This led to higher operating costs and directly impacted earnings both in the USA and Canada. Given the structure of our raw material formulas, we expect to claw back some of these costs in Q2. From a volume and demand perspective raw material volumes across the globe were steady to modestly higher. Finished ingredient prices for proteins increased throughout the quarter, and pet food demand gained momentum after a slow start to the year.

Barron’s likes waste-removal stocks because they benefit from a macro tailwind: humanity continues to generate more and more waste around the globe:

Man produces 11 billion tons of waste annually, a $1 trillion market set to double by 2020, as fast-growing Asia and South America get waste systems up to snuff.

Darling is one of the magazine’s favorites because it is reasonably priced at a P/E ratio of only 15.5.

Hill-Rom Holdings. After an unexpectedly weak first-quarter financial report that missed analyst estimates for everything, the hospital-bed company bounced back in the second quarter with both revenue and earnings beating estimates. Furthermore, it reiterated its full-year guidance so no more nasty surprises in the near future. The company continues to be very shareholder-friendly in terms of returning cash to shareholders. During the second quarter, $29 million in stock buybacks occurred and in March Hill-Rom raised its quarterly dividend by a substantial 11% to $0.1525 per share so that the stock now yields 1.5%.

In the May 2^nd conference call,   Hill-Rom CEO John Greisch reiterated key areas of strength, especially adjusted earnings per share, which finished the last quarter above the top-end of our guidance and ahead of the second quarter last year:

We saw over a 50% increased in adjusted earnings compared to the first quarter this year on a sequential revenue increased of only 6%,” Greisch added. “Improved product mix and our discipline cost management drove the earnings increase.

As you all know, we started the year with a weak performance in the first quarter in our key North America capital business. In the second quarter, we saw a strong recovery in this business with a 16% increased in orders compared to the first quarter and up 2% compared to the second quarter last year.

Hill-Rom has done a great job increasing profits with wise capital allocation and increased efficiency (cost savings) during a period when its core business of hospital beds is not growing. When asked how the company would start growing again, CEO Greisch spoke glowingly of the strong 7-8% organic growth in the company’s surgical and respiratory division and also was optimistic about growth through acquisitions and research and development:

We look forward to portfolio additions through M&A activity as well as to a smaller degree through our R&D investments to drive growth in the portfolio.