Value Portfolio

Alliance Fiber Optic Products (Nasdaq: AFOP) dropped 22% after issuing disappointing third-quarter revenues, but CEO Peter Chang assured investors that the revenue miss was a temporary “inventory correction” by its largest customer:

“During the third quarter, we experienced the effect of inventory control by our largest Web 2.0 customer, which resulted in a sequential decrease in our third quarter revenue. Despite that, our revenue from other customers grew on a year over year basis to help us achieve a similar level of revenues compared with the year ago quarter. We believe we adjusted to this temporary shortfall well and continued to deliver strong financial performance within our industry peer group. Most importantly, we made good progress meeting our customers’ needs, extending our product technology and improving our operations during the quarter.”

Small-cap companies often rely on a few large customers for their revenues, so when a large customer cuts back purchases from time to time as part of a temporary inventory correction, the small-cap supplier can suffer a severe revenue miss. In the conference call, CEO Peter Chang assured analysts that the large customer would resume purchases at normal levels in future quarters, so I view this stock-price decline as a gross overreaction to a temporary revenue fluctuation.

I think debt-free AFOP is a great long-term investment at this reduced price.

Diamond Hill Investment Group (Nasdaq: DHIL) announced strong third-quarter financials, with revenue up 14% and net operating income up 29%.  The company also announced a “special” dividend of $5.00 per share, with the stock going ex-dividend on Wednesday, December 2nd. This marks the eighth consecutive year that Diamond Hill has paid a substantial special dividend near year-end and it is the largest dividend since 2012. I love the following statement in the press release:

While this is the eighth consecutive year that the company has paid a special dividend, there can be no assurance that the Company will pay a dividend in the future.  The Board of Directors and management continually review various factors to determine whether the company has capital in excess of that required for the business and the appropriate use of any excess capital.  The factors considered include the Company’s investment opportunities, the company’s risks, and future dividend and capital gain tax rates.  We believe that we should retain a larger portion of our operating profits so that we can adequately seed new strategies and support existing strategies, which we believe will help us to continue to grow the Company’s intrinsic value per share over the long term.

Evaluating management’s stewardship of capital for shareholders is a central part of our intrinsic value investment discipline that we practice for our clients.  We hold ourselves to the same standard that we look for when evaluating investments for our clients.

Diamond Hill has been a great investment for Roadrunner and a large reason its stock has performed so well is that it operates its money-management business in the same pro-shareholder Buffett-like way that it looks for in the capital-allocation policies of the companies it chooses to invest in. This stock provides us with a double-whammy of value creation.

The stock market rally doesn’t hold a candle to “Best Buy” Stepan Company (NYSE: SCL). Since October 1, shares of the specialty chemicals producer are up about 9%, leaving the S&P 500’s roughly 5% gain in the dust.

A big reason investors are piling into Stepan: dividends. They know the firm traditionally announces a dividend raise when it reports third-quarter earnings, and they’re betting the next report on October 21st will include such an announcement. Odds are they’re right. Stepan has raised its payout 48 consecutive years, through thick and thin.

This quarter, the company increased its quarterly dividend by $0.01, or about 6%, to $0.19 a share. Annualized, that currently translates to nearly a 1.7% yield—very healthy for a small cap.

Share prices should also have plenty more room to run. Stepan is in the early stages of a rebound from a tough 2014 in which its stock plunged 39%, mainly because higher raw materials costs and poor currency exchange rates thwarted its flagship surfactant business. Surfactants are chemicals found in many household products such as shampoo and soap. Stepan is also exceling with polymers, chemicals used to make foam insulation and other construction materials.

During the second-quarter conference call, CEO F. Quinn Stepan, Jr. highlighted the progress of these two key businesses:

Our second quarter results benefited from earnings momentum in surfactants and polymers partially offset by a decline in specialty products. Actions taken in 2014 to improve product mix, reduce cost and improve efficiency enabled income growth despite the negative impacts of a strong U.S. dollar.

Vice President and CFO Scott Beamer elaborated with some hard numbers:

Our two largest segments, surfactants and polymers, which accounted for 97% of our total operating income, each delivered $5 million of operating income improvements, increases of 26% and 27% respectively.

Though sharply higher, Stepan’s stock still sells for just 12.5 times 2016 estimates—more than a 12% discount to the company’s historical P/E of 14.3. That’s an enticing deal for a dividend champ of Stepan’s caliber.

U.S. Ecology (Nasdaq:ECOL) reported weak third-quarter financial results based on lower-than-expected industrial activity and deferral of environmental projects. CEO Jeff Feeler assured investors that the slowdown is temporary and growth should re- accelerate in 2016:

We believe the current quarter challenges are short-term and reflect a changing business cycle as manufacturers and select Base business customers adjust for slowing growth in 2015. As we cycle through the completion of some of our larger project-based business, market opportunities continue to be strong. We have secured work that has commenced the reloading of remedial cleanup projects for 2016 and with a solid pipeline we remain optimistic in our long-term prospects and market position.

Bottom line: don’t give up on this wide-moat  business which operates six of only 23 facilities in North America that are licensed to accept hazardous waste and process low-level radioactive waste.

Down more than 20% since joining our value portfolio a year ago, industrial equipment components maker Vishay Precision Group (NYSE: VPG) may be out of favor on Wall Street, but hedge funds and other institutional investors love the stock. As of the second quarter, institutions held 83% of Vishay’s approximately 13.5 million outstanding shares.

And many are ramping up their ownership. From September 23 to October 7, for example, Dallas-based hedge fund Nokomis Capital acquired more than 82,000 shares of Vishayworth about $950,000 at the time of purchase (the value has since risen a few percent).Because it owns more than 10% of Vishay, Nokomis is considered a company insider and must immediately disclose all Vishay stock trades to the SEC.

What might Nokomis and other institutional investors see in beaten-down Vishay that the Street may be overlooking? In a word, potential.

A few years ago, the company rolled out two major advances, one being a new line of “smart” sensors that optimize the function and control of many types of equipment used in the medical, agricultural, transportation and other industries. The second advance was a lineup of improved onboard vehicle weight indicators that help prevent commercial vehicles from being overloaded.

Both are gaining traction in the marketplace, especially the advanced smart sensors. As CEO Ziv Shoshani wrote in Vishay’s 2014 annual report:

Over the past 12 months, the revenue from our VPG Advanced Sensors platform…was up 145% year-over-year.

Shoshani reported a 70% gain in sales of the smart sensors during Vishay’s first-quarter conference call. We’ll be looking for similar reports in subsequent conference calls when those transcripts are released.

In the meantime, Vishay will have to contend with familiar obstacles that have long stymied its overall financial performance and stock price, including poor exchange rates and weak demand from customers in sectors plagued by excess capacity such as steel and energy. But once those headwinds subside, Vishay is a good bet to rebound strongly. On October 12th, research firm B. Riley initiated coverage of Vishay with a “buy” rating.

Momentum Portfolio

Apogee Enterprises (Nasdaq: APOG) reported that second-quarter revenue rose 4% to $240.8 million. Adjusted for constant currency, revenues were up 6% driven by strong growth in its U.S businesses which were up in the double digits. Earnings jumped 45% to $0.50 per share, compared to $0.35 per share the corresponding quarter last year. Its backlog also rose to near record levels during the quarter, adding $41 million in orders, or 7% to $511.9 million.

The business segments of Architectural Glass and Architectural Services both saw double-digit growth, with revenues up 10% to $92.4 million and 12% to $52.2 million, respectively. Architectural Framing Systems contributed $80.7 million, up 5% from the prior year’s quarter.

Due to construction delays which pushed some of its work to fiscal 2017, management lowered its revenue outlook for fiscal 2016 to high single-digit growth, from a prior estimate of 10% to 15%. It reaffirmed its full-year earnings outlook of $2.10 to $2.25 per share.

“Best Buy” CBOE Holdings (Nasdaq: CBOE) is delivering the goods, soaring by a third since we added it to the portfolio in January 2014. The company has been beating estimates left and right thanks to, of all things, volatility.

CBOE owns and operates the Chicago Board Options Exchange, the preferred stomping ground of investors who use options to cushion losses or speculate on stocks, exchange-traded funds and indexes.

The options market is usually abuzz when volatility surges as investors add protective hedges or swing for the fences betting on wild price swings. For CBOE, this spike in trading volume means more transaction fees and increased sales of two popular volatility-related products it exclusively owns: options on the S&P 500 and the VIX, the widely followed “fear gauge.” (CBOE owns the actual VIX index, too.)

For August, the most volatile month for stocks since the financial crisis, total volume on CBOE’s options exchange jumped 26% from August 2014 levels to an average of 5.3 million contracts daily. VIX and S&P 500 options both set all-time volume records, averaging about 990,000 contracts and 1.3 million contracts per day, respectively, for the month. Volumes waned a bit in September, though business remained brisk because volatility was still much greater than usual.

After such a busy quarter, CBOE offered plenty of good news when it posted third-quarter financial results on October 30th: record trading volume in index options and futures, operating earnings up 26%, and earnings per share up a whopping 42% that beat analyst estimates.  Even better, analyst estimates for the upcoming fourth quarter are rising.

In coming quarters, shareholders will want to keep an eye on trading volumes for new options products CBOE introduced October 8: VIX Weeklys, which expire weekly rather than monthly like traditional VIX options. Weeklys should prove even more popular because volatility traders have long wanted a faster-expiring VIX option that lets them track the VIX index more precisely.

Concordia Thereapeutics (Nasdaq: CXRX) $3.5 billion acquisition of Amdipharm Mercury looks very attractive to me — actually transformational as it doubles the size of the company. It will vastly increase the number of drugs in its pipeline, provide the Canadian company with global marketing reach into 100 countries, diversify its revenue stream, and boost its long-term growth rate. The deal is expected to be immediately accretive to earnings by 35%.

I am in full agreement with both TD Securities and Bloom Burton & Co. that Concordia deserves a higher valuation from this acquisition, even though Concordia shareholders will experience an 8.49-million share dilution and the assumption of $1.4 billion in Amdipharm debt. Concerns that Concordia overpaid for the Amdipharm are unreasonably pessimistic given the improved growth profile. As one fund manager that owns Concordia shares puts it, even after the acquisition Concordia is still cheaper than much-larger Valeant Pharmaceuticals (VRX), which until the recent accounting scandal involving specialty pharmacies had been a great stock performer:

“At Valeant they had debt-to-EBITDA levels north of 7x at one point in time, and Concordia’s probably going to come in at 6x,” he said.

“If you look at where they’ve been from a valuation standpoint, Valeant is 13x right now but it’s been as high as 20x if you go back over the last couple years. Concordia is probably about 11.5x next year. Certainly you’ve seen richer valuations for Valeant and higher debt levels than Concordia has right now.”

Since early September, Concordia’s stock price has dropped by two thirds in sympathy with both: (1)  a general biotech selloff caused by Hillary Clinton’s threat to regulate drug prices; and (2) Valeant’s accounting troubles. Neither issue should materially hurt Concordia, however, so this massive selloff in Concordia’s stock price is unjustified for two reasons:

1. Concordia charges less for its drugs than most of its competitors, and only 40% of its business is in the U.S., so any price regulation from a Hillary Clinton administration would probably be inapplicable to the company;

2. The controversy surrounding fellow Canadian pharmaceutical firm Valeant concerning its mail-order pharmacy relationships is completely inapplicable to Concordia, which doesn’t have similar mail-order pharmacy relationships.

Bottom line: I believe that Concordia is severely undervalued and a great buy after this unjustified selloff.

Hill-Rom (NYSE: HRC) has completed its $2.05 billion acquisition of medical equipment supplier Welch Allyn after it announced the purchase in June. None of the two companies’ products overlap but instead are complementary which is expected to drive synergies and revenues.

After some reorganization which may involve job cuts, management expects to save the combined companies at least $40 million in costs by 2018.

At an investor conference, management updated its 2015 adjusted earnings per diluted share outlook to include the recent acquisition. Adjusted earnings per diluted share for the fourth quarter are now expected to be in the range of $0.80 to $0.82, up from $0.76 to $0.79 previously. This lifts its expected full-year EPS outlook to $2.55 to $2.57, compared to $2.51 to $2.54 previously.

The acquisition has nominal impact on its fiscal 2015 earnings, for fiscal 2016 which begins on Oct. 1, Welch Allyn is expected to contribute 10% to adjusted EPS.

The news prompted some action among analysts. Last month, Vetr upgraded shares of Hill-Rom from a “buy” to a “strong buy” with a price target of $60 and Zacks upgraded shares of Hill-Rom to a “buy” from a “hold” rating with a price target of $59.

A temporary lull in earnings’ growth due to currency fluctuations has put the brakes on Gentherm (Nasdaq: THRM), but higher growth is right around the corner. After several quarters of beating estimates, investors found Gentherm’s second-quarter results disappointing. Revenue of $213 million slightly missed estimates of $222 million and earnings per share were $0.03 shy of $.56 estimates.

Gentherm, who primarily manufactures cooled and heated seats for autos, saw its foreign sales hit by the strength of the U.S. dollar.  Adjusting for the currency impact, revenue would have been $227 million, handily beating estimates.

The most exciting news, however, was that the company was recently awarded an initial contract for its revolutionary thermal management systems in a car’s motor.  This product helps to reduce the heat emitted from a car’s battery.  Excessive heat erodes the life of a battery and creates a problem for car manufacturers.  As Daniel R. Coker, Chief Executive Officer, noted on the company’s conference call, this contract puts Gentherm in the forefront of innovation with this new technology:

Our knowledge of thermoelectrics and how to package them, manage them and manufacture our devices with them was our strength, and that allowed us to win a very sophisticated customers concept competition. And then we were able to beat out all comers once the concept had been determined to be a thermoelectric device. We were the guy who won the contract based upon our strengths.

These strengths are not only the technological know-how but years of experience negotiating contracts and supplying reliable, proven products to automotive manufacturers.  Gentherm’s thermal management system will help improve the reliability of new electric cars and lower the cost of battery warranty protection.

Unlike heated or cooled seats, this new feature is built into a car’s drive train so demand is not predicated on consumer preference but from the manufacturer’s desire to improve functionality and lower costs.

This new contract will start to add to revenue later this year and should continue to boost profits for many years if Gentherm wins more awards, a likely scenario based on its success rolling out other products to multiple manufacturers.

Gentherm trades at a PE of 18 on 2016 estimates, reflecting the expected 18% growth for 2016. However we think this new contract boosts growth and the stock should move higher as the new contracts begin to flow through earnings.

Paycom Software (NYSE: PAYC) seems to have the winning formula for a rising stock price- beat estimates, rinse and repeat.  For the second quarter, reported on 08/04/15, Paycom did what it had done the previous 2 quarters, beat earnings’ estimates by roughly 60% and beat revenue estimates by roughly 10%.  

Revenue of $49 million was up 47% and earnings per share of $0.10 were up from a loss of $0.01 last year.  The company sells human resource software on a subscription basis to employers.  Its software suite helps companies manage their employees’ full life cycle from recruitment to retirement.  It’s five modules, Talent Acquisition, Time and Labor Management, Payroll, Talent Management and HR Management are seamlessly tied together.  The company’s unique single database solution allows companies to pick and choose which functions to subscribe to and allows all of them to share the same data.  No longer does the Human Resource department have to manually enter hours or rates that the Payroll Department has already downloaded.

The beauty of Paycom’s business model is that its customers are sticky.  Once an employer has signed on for one service, it is a monumental and risky task to switch over to a different supplier. Paycom’s team is constantly adding new functionality, like Paycom Learning, which automates employee training and onboarding.  Its internal salesforce can quickly reach out to captive customers and entice them with new offerings.

Paycom’s stock is expensive on a pure PE basis but when compared to a basket of other Software as a Service (SaaS) companies, trades at the lower end of the valuation range. Continually complicated regulations on healthcare and wages should keep Paycom’s customers coming in the door.

Paycom is up 18% since being added to the Roadrunner Momentum Portfolio in April 2015.

Taro Pharmaceutical Industries (NYSE: TARO) continues to tread water so far in 2015, but the stock is up 10% since our December 2014 inclusion in the Roadrunner Momentum Portfolio.

The company reported impressive revenue growth of 40% for the June quarter.  However, growth adjusted for a charge against revenue last year reveals revenue growth of 10%, a more likely marker for future growth.  Net income more than doubled to $2.42 per share.

The maelstrom surrounding Turing Pharmaceuticals, the company Hillary Clinton blasted for “price gouging” due to its abrupt price increase from $13.50 to $750 per pill, may also be hanging over Taro’s shares.  Although Taro’s price increases are not nearly as large as Turing’s, the company notes that sales volume declined 10% in the quarter with the improvement in revenue coming from price increases.  

Management does not conduct conference calls or offer any earnings’ guidance to investors, but in its press release CEO Kal Sundaram sounded cautious about pricing pressure in generics:

As we have stated in the past, we remain cautious of the ever-increasing pressure on our business from strong competition and the continuing industry and customer consolidations. We continue our commitment to building a strong, quality pipeline of products through our investment in our R&D efforts which, along with our business development efforts, will help to fuel our medium and long-term growth.

Analysts estimate Taro will earn $13.73 for the year ending March 2017 up 15% from March 2016. With a PE of 11 and earnings’ growth of 15% it certainly looks like the current stock price reflects the political risks of the industry.

Taro has consistently generated positive cash flow and currently holds $23 of cash per share. The recent news that the company won FDA approval for proprietary drug Keveyis should alleviate some investor concern over the generic pricing pressure that CEO Sundaram describes above.