Sunday, July 29, 2007

Earnings preview -- TSRA, NVT UEPS

TSRA -- I don't expect much from this call just an update on new technologies, guidance probably won't change -- the wireless business is still going to be hurting but DRAM strength should offset again.

One key issue to keep in mind in terms of the stock is the tax rate -- in 2008 the tax rate starts to move up from near zero towards its ultimate level of 40%. That will soak up a lot of income growth in the next couple of years (i.e. pre-tax income might grow 50% but EPS might barely budge because of the increase share going to taxes). Hard to get the stock moving up when that happens. Its possible it will take 2 years to reach 40% in which case TSRA might be able to show 15-20% growth in EPS, which is much better than zero.

NVT -- unfortunately even if the portable GPS business has a big upside surprise its less than half the total -- in dash units account for more than half of revenues and they are unlikely to see much upside. handsets and online maps are too small to make a difference. I sold some because I knew at $57.75 that the price had jumped on deal talk and I figured it would pull back. It has but not too bad. I have read some street reports that point out there is not too much room for upside -- even if you assume 100% growth in portable units, you get a 4 cent EPS increase -- not enough to matter. If the stock pops on a market rally this week (say to $55 or higher), I will look to sell some more.

UEPS -- Three things that matter:

1. Update on what is going on with the South Africa welfare contract?
2. Update on the south africa wage payment system -- what progress have they made and any hint about how big this will be over the next year or so?
3. Update on Nigeria -- have they gotten started yet or when do they think they will get started? early numbers on how many have signed up so far, etc.

MDT buys Kyphon

My first reaction to this deal was that I need to sell MDT -- if they need to do a deal like this then their growth prospects are worse than I thought. My latest reaction is that I don't have to panic but my bar for finding a better opportunity is lower than it used to be for MDT. BTW, that is what portfolio management is about -- opportunity costs. Its about making sure that your portfolio has the best names that it can have on a secular basis. That means I am not switching just to get a minor improvement in but in MDT's case its not as fast a grower as I thought.

One look through the 291 slides from the recent analyst meeting helped my thinking -- this is a 10% grower not a 15% grower. The stock has had a tough time since it peaked in 2000 -- 7 years and its at $50 -- no movement in 7 years. I bought in 2001 at $40 so I have made some money but that is only on about half of my shares -- the rest were bought in the last couple of years at $48-52. First the stock was at a ridiculous multiple in 2001 -- over 40X earnings. That was way too high for the future growth potential of mid teens.

The company hit its mid teens growth numbers for the next several years -- yet all that happened is the earnings caught up with the stock (valuation multiple dropped). Now just when the valuation is reasonable the growth drivers have been falling away one by one. First we lost the ICD's -- Guidant's safety issues has caused too many patients to have second thoughts about getting an ICD despite the fact that its a life saving device. What was supposed to be a 20% grower (and the biggest driver of results given its 25% of revenues) is now a 10% grower IF the international side grows 20% to offset the US's puny 6-8% growth.

Stents -- too many issues about safety and efficacy -- it is no longer a growth market. This was once considered the main growth driver for 2008 and 2009.

Spinal -- Medtronic was supposed to be able to compete against Kyphon but now they have thrown in the towel and decided to buy them. I would prefer they were able to compete against them -- the fact that they can't doesn't say much for MDT's R&D as well as marketing/sales in the spinal area.

Its still a great company and they are doing everything they can to manage through the issues and come up with more growth drivers but all the good stuff is years away. I think for me the stock is a source of cash -- I will sell half the position and then it will be the right size for its potential.


Listened to the conference call on Graco (GGG) and had some more points to make:

1. As I said, cash flow improved, revenue growth numbers showed sequential improvement (not a surprise given stronger GDP of Q2) but they are not out of the woods yet -- growth comparisons get harder in the 2H and both housing and auto production are struggling.

2. These are cyclical issues that will be resolved over time -- note that as growth in the economy accelerated in Q2 the company also saw better growth -- nothing wrong with the franchise that couldn't be fixed by faster growth in the industries they serve.

3. It's a great business -- in a recent presentation that is on the website, the company points out that earnings have a growth rate over the last few years of 23% while their stockholder's equity has only grown 10% and other than recently they have had no debt (short term debt is up due to share repurchases). That means they are able to grow earnings without needing a coresponding growth in capital -- that is a wonderful business.

4. new product process -- they are constantly coming out with new and improved products -- that keeps customers willing to pay good prices for products -- they also use the new product process to appeal to new customers. What I mean is they tweak some existing products to better suit a new set of customers -- that's a great growth driver because you are getting more revenues from little incremental costs.

5. Its a tough time now but this is a wealth builder over time.

Another tough day on Friday -- CME and more on DFR

Market was down 1.6% but the secular value investor's portfolio was down only 1.35% -- another 25bps of outperformance or close to 160 for the quarter and over 300 for the year.

This time AB in a delayed earnings driven boost as well as CME were the standout performers going up on a big down day. In hindsight, CME was the opportunity on Thursday as the stock was down but exchange volumes (i.e. revenues) were soaring. Over the weekend, Barron's had positive comments on CME so its possible the stock will move higher on Monday too.

Is it all over? I have seen some commentary that suggests the market will return to its lows of near 800 -- around a 50% drop and that you should sell now! Its always possible but I believe very unlikely. A fast scary correction designed to get as many investors out of the market as possible so they miss the rebound? you betcha. Right now many investors are afraid and are searching for safety and for liquidity. At some point investors that have liquidity will step forward and offer it to those who want out -- and those that sell will later regret they panic'd. Are we there yet? Hard to say -- my advice as always is to focus on companies and industries and not get so tied up in macro concerns.

That said, I realize now in hindsight I screwed up -- it happens to everyone. I reread a post written a few weeks ago titled "Yeah but what about...." where I tried to address all the concerns being talked about in the market. At one point, I made the comment that I would not want to own high yield bonds right now. That has proven correct as credit spreads have widened -- meaning high yield bonds have lost value. Unfortunately, my ownership of DFR means that I DID OWN high yield bonds in the form of CDO's or CLO's in DFR's portfolio. That stock has dropped hard because of that exposure. What was I thinking? I was too focused on the bullish story with DFR and not on the risks -- or what could go wrong. A mistake I would warn you not to make. This is partly the "value" part of being a secular value investor -- finding situations where the probability of significant upside is far greater than the probability of significant downside is by definition finding value.

I continue to believe there is significant upside in DFR -- a potential $30 stock price in 2-3 years. On the otherhand, it would be foolhardy of me not to recognize that the liquidity issues and widening spreads in high yield bonds translates to a potentially lower probability of that $30 goal being reached. For me its more of a question of position size -- when I bought more recently it was with the goal of making it one of my larger positions because I thought it was one of my best opportunities. In hindsight, I realize I made the position size too big given the risks. If we get a good bounce back in the stock, I may decide to sell those shares I just added as a way of keeping the position size reasonable. All that said, I do not see a reason to panic -- no reason to believe that DFR is about to suffer a permanent loss of capital -- a cyclical one maybe but I believe the stock has value and that its value will hold up even if the market's continue to struggle.

Friday, July 27, 2007

Earnings updates (AB, GGG)

Another icky day in the market thanks most likely to liquidity concerns in the bond world and fears that private equity is "over". The Secular Value investor outperformed again -- only down 1.83% vs. the S&P 500's -2.33%.

That was partly due to lucky timing -- the portfolio actually had 2 stocks that were up yesterday -- GGG which had better than expected earnings and ILMN which went up for a second day on the strength of their earnings. Several of the low beta stocks continued to do their job by not going down nearly as much as the market. That's the key to this game -- diversification. Make sure you are diversified enough to survive the down days so that you are still around for the rebound.

GGG's earnings weren't great -- they showed organic revenue growth of 1% year to date but they weren't bad either. Key points were improved cash flow, industrial sales rebounded and unless I'm mistaken the contractor business in the US did not get any worse. Improved cash flow means earnings quality improved and suggests the pressures on the business from the US housing slump are no longer getting worse. The stock popped 6% or so mostly on relief and short covering. I would not expect the stock to break out of its trading range on these results -- though I would certainly appreciate it if the stock did!

AB's earnings were strong -- 1.16 vs. consensus at 1.08. They also raised the range of expected earnings for the year to $4.90 to $5.25 with almost $2 of that coming in the 4th quarter. Hedge fund assets are up 45% year to date to $10.5 billion -- that's mostly high net worth money right now and it bodes well for performance fees in Q4. They plan to start selling hedege fund services to their institutional clients -- that could really raise some money and grow management/incentive fees since they have $500 billion in existing institutional assets under management vs. only $106 billion in high net worth assets. Even if the growth in hedge fund assets comes entirely from existing money under management, the higher fees for the hedge fund services would make that a great deal for AB.

I will have more to say on the markets this weekend.

Wednesday, July 25, 2007

Earnings updates (CME, ILMN, LH, PEP)

CME -- good solid report but nothing great. I was hoping for more on the volume growth front but it turns out the big volume gains I saw merely offset the volume weakness of the early part of the quarter. I still think estimates are too low for the next several quarters. Volumes on the acquired CBOT were stronger. Free cash flow remains strong. Company intends to do a tender offer for shares at a price less than $360 -- this could have a positive effect on EPS growth if they are able to buy a lot of shares. Volatility usually leads to gains in derivative volumes.

ILMN -- not much detail yet -- they just reported tonight and I have not had the chance to listen to the conference call. Revenues and EPS were better than expected and the stock popped a little after the news. This is a great secular story about the growth in genetics -- genomic analysis. New products have meant an order of magnitude improvement in the cost of genomic tools and that means big jumps in volume.

LH -- solid quarter with in line revenues and cash flow. steady as she goes.

PEP -- have not had the chance to look at this one but headlines suggested they beat and raised guidance -- always a good thing.

More on DFR

Ugly -- so the secular value investor decides to buy more DFR and within 24 hours he has already lost $1 per share or about 7%. The portfolio had a few other uglies like AB, Genvec (biotech), UEPS, Navteq and the energy related stocks. Bright spots included Asia, some of the lower beta stocks (FDS, LH, EPD, PEP, TECH, etc) and Illumina -- just got upgraded on Monday and reported after the close (next post). Overall, the portfolio was flat with the S&P 500 -- meaning down 2%, which means its still outperforming by 2.3% for the year.

DFR is a bet on management -- their ability to differentiate credit risks so that the portfolio is able to produce the kind of dividend income that will get the stock moving towards $30. Today they announced the dividend for this quarter will be 42 cents -- 3rd quarter in a row at that level but I am guessing they are waiting for high yield debt/loans to get more attractive before boosting their exposure to alternative assets and they are waiting for the deal to buy the management company to close before raising the dividend.

Was I early in buying more DFR? You betcha! Will I be vindicated in the future -- I expect to be but I expect the stock could see more pain before it gets better.

Right now DFR has about 25% of its equity invested in alternative assets -- mostly higher yielding areas like CDO's and high yield bonds. The management company's status as a manager of CDO's -- that's what makes up about 80% of their assets under management provides the source for the deals that DFR participates in. The goal for DFR's alternative assets is to reach 50% of equity or about 20% of assets. Once that happens the ROE potential will be higher and therefore the dividend potential is higher too.

Deerfield has a track record of managing credit risks that is very impressive -- I am betting that continues. If they suffer credit losses in either the mortgage portfolio or the alternative asset side, the dividend will be vulnerable and the stock will keep dropping. A rise in credit losses could also offset the expected increase in income from the higher percentage of equity invested in alternative assets -- meaning DFR's portfolio could complete the shift to 50% of equity being in alernatives and yet due to credit losses the firm could see the dividend remain at 42 cents. I do not believe that is likely.

One reason I like the deal to buy the management company is the potential for growth from new products -- Deerfield capital management develops a new fixed income product; they use the new product in the REIT -- the REIT provides seed money to build a track record for a new product. Over time the management company markets the performance of the new product and is able to grow client assets under management. This way the combined firm has a growth path to go along with the high yield.

DFR's stock is dropping in line with other financials -- including the banks, brokers and other credit related financials. To me that means the stock is not assuming a worse result -- there are no company specific issues that have led investors to question the company's future any more than they are questioning the future of all credit related entities. While today was ugly, I still believe the future is higher -- $20's.

Tuesday, July 24, 2007

DFR? Am I crazy to buy more?

Deerfield is a mortgage REIT with a twist -- they still have a large portfolio of residential mortgage backed securities but they also have a growing portfolio of high yielding corporate credit such as loans, collateralized debt obligations and commercial mortgage securities. They use leverage at a 12X overall rate (not much different from most banks) to turn a 5% interest rate on mortgages into a 12% return on equity. The REIT is also buying its management company -- Deerfield Capital Management which will mean almost half of the REIT's income will be generated by asset management fees including incentive fees. DCM is a hedge fund manager.

If Deerfield's strategy works, then over the next few years the dividend could jump from the $1.68 range to more like $2.50+. I think the stock could go from $13.3 to $30 as the dividend rises.

The crazy part of my buying more is that they are effectively a lender to consumers (mortgages) and corporations and the credit cycle is peaking -- this means increased loan losses for most lenders are coming. Chances are even if Deerfield doesn't experience higher losses the market will assume they will -- hence a declining stock price.

more to follow.....

Monday, July 23, 2007

Navteq -- taking some off the table

Wow that was fast. In only a couple of months I made 50% on my NVT shares as of today. I went ahead and sold 20% of the position because the stock seems to be ahead of the fundamentals. I say seems because sales of navigation devices are red hot right now so its possible that NVT's earnings estimates will catch up with the stock after they report -- then again maybe they won't. I still have plenty of skin in the game so I am hoping the stock goes higher.

While GPS sales are strong, a big driver of the stock's gain is takeover speculation -- today Tele Atlas got an offer from Tom Tom that was at a big premium to the current price. NVT jumps for a few reasons: they could be the next buyout; with Tom Tom spending so much to acquire Tele Atlas their ability to discount pricing is reduced; Tom Tom has just admitted that one of the biggest components of value in a GPS system is the map. NVT's stock could pull back if a deal doesn't come through for the stock or if their earnings report doesn't drive higher estimates.

Determining that GPS services are a growing area that will only become more valuable as time passes and more mobile devices with GPS capabilities are sold is not difficult -- that is the easy part. The hard part is determining how to play that trend -- which company do you choose? Garmin? Tom Tom? SiRF (semiconductor supplier to GPS)? or Navteq (maps database)? other companies in the space? I went with NVT because there are only 2 large global suppliers of map databases -- Navteq and Tele Atlas. Lots of GPS devices counting Tom Tom, Garmin, et al. but only 2 maps. Less competition is always better.

Over the last year prior to my purchase ($37.75) Navteq's stock had struggled due to fears of rampant price discounting -- NVT dominated Garmin and the US while Tele Atlas dominated Tom Tom and Europe. There was some pricing pressure as each tried to gain share in the others stronghold but it should have been obvious that pricing pressure between the two was unsustainable -- markets with key performance attributes (meaning its not all about price) where there are only 2 players do not have pricing pressure longer term -- no need to ruin the business when there are enough profits to go around. Navteq has great margins because the business has high fixed costs (map development and maintenance costs) but very little incremental costs (its just a database afterall -- high operating leverage). When industries like this one start to have pricing problems, usually the management team is replaced and pricing improves.

That was the reason I could make good money quickly -- the trend was there for all to see but the stock did not reflect the positive growth and margin prospects because of concerns that pricing would get bad for the industry. Investment success requires you to think differently from the crowd -- to identify situations where a temporary issue has hurt the stock but where the long term trends are positive -- time is the friend of the wonderful business.

I decided to buy more DFR and UEPS -- I also sold a little MSFT and ERF to complete the deals. I have already talked about UEPS -- another high operating leverage business that has big growth prospects. Stay tuned for comments about DFR.

Saturday, July 21, 2007

Google hurts but Secular Value still outperforms on tough day

Thankfully Google is only about 3% of my total -- otherwise today might have been ugly. How did I outperform by 26 basis points today? 1. Asia -- my funds were flat to up. 2. Energy -- not down as much or in some cases up. 3. low beta stocks like TECH, FDS, etc, actually worked. 4. NVT was up today -- I think the GPS world is having a strong quarter.

Google's stock was up about 70-90 points since mid May -- or just 2 months ago. Could it be that expectations just got a little ahead of reality? Sounds good to me. As far as the business goes, how many $12 bill (rough annualization) company's do you know growing revenues 58%? exactly -- not many. Conference call remained bullish -- I think the universal search is interesting -- I know I did a search recently and ended up reading through a few pages of a book trying to get my answer. I think its going to be a big deal over time -- and its hard to do so I think Google's head start will help. Google takes the pause that refreshes and goes to new highs either later this year or early next year.

Wednesday, July 18, 2007

UEPS more info

A few posts ago I commented on what has been a favorite stock of mine -- UEPS -- the South African smart card payment system company. In the last few days the Robert Baird analyst upgraded the stock and today I got the chance to read his note.

He laid out the case including an estimate for earnings in 2012 -- the fact that he feels able to put a number in print for that far out should tell you something about this company vs. most technology companies -- its business is far more predictable than most technology stocks. His 2012 estimate of $4 is very much in line with my own and roughly assumes a 25% growth in earnings annually.

He also estimated how much each of UEPS' new initiatives and growth drivers would contribute to that $4 estimate. The existing SA welfare distribution business would cover almost half -- $1.85. The surprise for me was the 25 cent estimated contribution of the wage payment business and the $1.50 contribution of Nigeria. So in effect the analyst is arguing that the only 2 areas that matter are the SA welfare and Nigeria -- all the rest from wage payment to Ghana to Namibia to Botswanna to all the other areas are barely rounding errors in terms of their contribution to 2012 earnings.

I have seen previous street reports that claimed the wage payment business had the potential to be equal in size to the welfare business! Quite a shock to learn that in 5 years it could only be at a .25 run rate. His estimate is based on 2 million cards generating $2 in operating profit per card per month or about 40% penetration of the total market. I had heard the total market was more like 8 million employees and that they all were paid more than what welfare recipients received (higher fee potential for UEPS). Not sure which is right -- Baird or what I have read previously.

Nigeria is a real risk in that Baird estimates 12 million cards in force in 2012 -- vs. only 3.8 mill in SA. Its quite possible 12 million will prove conservative -- Nigeria does have 3X the population of SA. On the other hand, because the service is only starting this quarter, we have no data on which to base a Nigerian projection. Once December quarter results are reported in early 2008, we should have a good idea of the growth trajectory of Nigeria.

While I knew Nigeria was important, I didn't realize just how important to future growth Nigeria could be to UEPS. 1.50 of $4 in earnings -- and half of the growth between now and then. I am hopeful the company will sign other countries and or that wage payment will be much bigger in size than 25 cents.

still a great story my main concern is timing -- it could take until 2010 or so before the non-welfare businesses are able to contribute a meaningful percentage of earnings.

Tuesday, July 17, 2007

CME -- monopolies generally make good investments

When writing my last post about AAPL and RIMM, I could have easily included CME -- the Chicago Mercantile Exchange. Its a stock that is up substantially since coming public but again -- what matters is the future earnings power vs. current investor expectations and the probability that CME's earnings power will exceed expectations.

First, some background on CME. I first learned about the story when the stock was in the low $300's -- it was "expensive" at the time based on the consensus estimates but the company managed to produce earnings well in excess of those estimates -- today the stock closed at over $580. I wasn't willing to bet on the continued growth in the futures contracts that are traded at the Merc so I passed on the stock and it went up almost $300 without me. A couple of years later and I have a better understanding of the company and the growth picture.

CME is a virtual monopoly because of the liquidity they provide in the futures and options contracts traded at the Merc exchange. The business model is similar to eBay except that the products traded at the exchange are all financial related -- equities, interest rates, foreign exchange and commodity futures. CME gets a cut from every contract traded -- like collecting tolls on a highway for each car that drives by, CME collects a fee every time a hedge fund, institution, company or individual trades a futures contract at a CME exchange.

The growth of hedge funds as well as the need for traditional institutions to control risk and become more competitive with hedge funds has led to almost 30% annual growth in contract volumes. CME is also benefiting from trading moving to electronic forums like CME Globex -- margins are higher because the costs are lower.

Growth drivers -- 1. growth in alternative managers that use derivatives to manage risk and or speculate for higher returns. This is a secular trend for managers to deliver better risk adjusted returns in all environments. Derivatives provide flexibility.

2. Secular trend towards electronic trading -- helps margins.

3. move from OTC to centralized electronic exchanges like Globex -- secular trend as investors seek best sources of liquidity plus transaction speed. CME's fees are a low percentage of the total cost of a contract.

4. Merger with CBOT -- provides equity options and other derivatives. CME gets to diversify revenues by adding new product areas plus they should be able to introduce new products that take advantage of their new combined strengths. Costs should drop as they leverage technology costs.

The stock is near its highs but it hasn't done nearly as well as RIMM or AAPL. The estimates for CME are low -- all previous years they have showed strong growth from Q1 to Q2 and yet this year estimates assume zero growth. Revenue growth is expected to decelerate sharply over the next several quarters and yet trading volumes (already reported) hit record levels in the month of June and show no signs of slowing.

I expect the merger to have a positive impact on estimate revisions. Running an exchange is about high start up costs yet low incremental costs as volume builds -- i.e. high operating leverage. Margins hit 60% last quarter. Free cash flow is equal to reported earnings. Returns on assets equals 28%. Trading goes to where the liquidity is -- CME dominates the trading of futures and other derivatives which has created a virtuous circle whereby more trading equals more liquidity which encourages more trading etc.

High returns, big competitive moat, strong secular growth trends, low estimates, etc. -- for me that equals a high probability this investment will outperform.

I sold my ACAS position to buy the CME. After purchasing ACAS, I discovered the overlap with DFR was greater than I realized and the movement towards increasing management fees was likely to take longer than I first thought. While ACAS will likely do fine, I would rather diversify my exposure a bit -- more confidence in DFR's ability to navigate current private equity related debt trends and in DFR's growth prospects.

Monday, July 16, 2007

RIMM/AAPL -- its the future that matters

In 2002, during the depths of the bubble burst, one could have purchased both Apple (AAPL) and Research in Motion (RIMM) for around $6 per share. With the two at $137 and $228 respectively as of Friday's close, either would have been wise purchases.

Many would look at these 2 stocks and say that they have missed them -- better off looking for something that has not done as well. The truth is that one must always look to the future to determine whether an investment is a good idea or not.

Estimates for RIMM's current fiscal year are almost $6 per share in earnings. So in 2002, anyone could have paid 1 times FY 2008 (FEB) earnings for RIMM. Obviously no one thought they could earn anywhere near that much in 2002 otherwise the stock would not have sold at $6.

Will the next 6 years be as good for RIMM as the last 6? unlikely. That doesn't mean earnings won't grow faster than most other stocks and that doesn't mean we can't have higher confidence in RIMM's future earnings estimates than other stocks.

Investing is about predicting future earnings power of a company and comparing that to the expectations embedded in the stock. You make the most money where the difference between those two is the greatest.

What if I told you that RIMM produces that $6 of earnings on just 1% market share of the handset market and that they could easily reach 5% or more in the next 5 years. What if I told you that RIMM earns roughly $6 per blackberry subscriber per month in service fees in addition to the profits they earn on the sale of blackberry units. That's a nice annuity stream isn't it? I can envision a scenario where RIMM's earnings 5 years from now were around $30 per share and that the stock is only trading at 7.5x those estimates -- a bargain.

Now I could also paint a scenario where RIMM's key attribute -- mobile email -- becomes commoditized to the point where everyone offers it (Apple, Nokia, Motorola, Samsung) using their own software standards or at least a non RIMM standard. At that point RIMM may not be able to earn the $6 they are currently earning in 5 years. That would make the stock very expensive.

Apple has much the same profile -- between iPods, Mac's, iPhones, iTV, etc. their earnings power could be significantly greater than today's numbers -- several times higher. or they could begin to miss product cycles and their innovation run could come to an end.

The key is to have some edge -- to be able to tell with some degree of certainty what scenario is the right one for a stock you are considering. Right now I don't know the answer on AAPL or RIMM. But I do know that EVERY smart phone, regardless of who makes it, will use TSRA's packaging technologies to enable the small form factors required.

Wednesday, July 11, 2007

Tough day but Secular Value investor outperforms

S&P 500 down 142bps, while the secular value portfolio only dropped about 100bps. Some of the energy related stocks were up plus Asia didn't decline as much and TSRA was flat on the day.

Graco (GGG) got whacked for 4.5% thanks to a downgrade from CIBC -- did not see the note but I'm guessing continued housing weakness as can be seen from Home Depot's earnings miss are the reasons cited. Graco is a long term holding -- I got in too early but I believe my risk is limited and the business is really really good. They sell fluid handling equipment to housing contractors and industrial customers.

Its a niche business that relies on new product innovation to drive growth. Overseas, many painters still use brushes rather than paint sprayors like the kind that GGG sells. Graco's international growth has been very strong but the deterioration in US housing related revenues has been too much to overcome. The company said on its last conference call that their housing related revenues generally lag trends in housing starts by 6 months.

May's housing start data showed a 2.4% M/M decline and a 24% year over year decline. pretty ugly so I expect Graco to miss numbers -- I am guessing that Graco's housing related business will bottom a year from now. Good news is that with the shrinkage in US housing and the strength in international sales this problem area is becoming a smaller issue all the time.

One other stock that got whacked today was Deerfield Triarc Capital (DFR). Subprime mortgages had a rough day and that impacted a lot of financials. DFR is a mortgage REIT that also has some alternative assets that include a lot of high yield and private equity debt related securities. Investors are nervous about these areas given the subprime credit issues. The managers of DFR's portfolio generated very strong results during the last credit downturn during 2000-2002. DFR's credit losses were 1% vs. the Merrill high yield index, which suffered over 10% defaults.

I see DFR as a $30 in 2 years with little risk of downside. I will cover this one more at a later date.

Tuesday, July 10, 2007

Lab Corp: possible LBO?

Hello? where were these LBO types a few years ago when Lab Corp was selling for only 10X free cash flow? I figured for sure as I was buying the stock that the company would either take itself private or the stock would recover.

Turns out the stock recovered -- what was once a stock in the high 20's at 10X cash flow, is now a stock near $80 and a high teens multiple of free cash flow. I think a deal is more likely with Quest Diagnostics because that stock is cheaper and there is more room for improvement post UNH loss (Lab Corp won exclusive deal with UNH last year -- likely cutting 7% of Quest's revenues this year). The great thing about a deal for Quest is that the pricing concerns that have been surrounding Lab Corp should go away -- hard to see Quest handle the debt of a buyout and start a price war.

I like Lab Corp because of the strong free cash flow, the disciplined capital allocation of management, the fact that lab testing provides all the info doctors use, while only generating 4% of health care costs and the consistent growth for the industry driven by new genomic related tests. Not to mention that the valuation is still reasonable.

If Quest goes, I will be happy because my LH should become more valuable. If LH goes, I will be sad to lose such a consistent outperformer but I will redeploy the money -- probably some into Techne (TECH).

Quest makes perfect sense so I expect it to happen. I don't expect a LH deal unless the stock stumbles.

Sunday, July 8, 2007

NET 1 UEPS Technologies (UEPS)

Another one of my favorite stocks is UEPS -- I think they will triple their earnings over the next 5 years (25% CAGR) potentially driving the stock to the $80 level from its current $25. This company has multiple growth engines; is very profitable and yet a near term issue is holding the stock back.

Description: They provide an offline smart card payment system -- offline in that the merchant and the user do not have to have a communication link -- just once a day the merchant has to connect to UEPS' systems to settle up. The smart card readers run on batteries -- which is necessary in the rural areas of South Africa. UEPS makes money by charging the government to load welfare payments on to card accounts; the transaction fee when the card is used with a merchant; loans, insurance, bill payment can be done through the card account -- each with fees; other services including distributing medicines can be done due to the 10 finger finperprinting security system which keeps out fraud.

Growth engines:
1. number of people getting welfare payments and the amount of payments in SA is going up -- driving fee growth.

2. the more often the cards are used to buy from merchants rather than just to get cash the more often UEPS receives transaction fees.

3. Wage payments in SA required a banking license, which they have just acquired, so now they can offer a payment system to employers that does not involve cash -- that drives fees for loading payments, also drives transaction fees for when the cards are used to buy things. The potential is equal to the current size of the company.

4. New countries: -- Nigeria has 3 times the population as South Africa -- that means potential for a lot more cards. includes more than just payments -- will offer financial services through card. Also have several other countries including Botswanna, Nambia, Ghana, etc. and going after more.

5. Growth in other services -- easy pay and VTU -- in other countries (came from Prism deal). VTU is about prepaid wireless services while easy pay is an online payment service within SA to complement the offline nature of UEPS.

Say there is 3 billion people that are unbanked or underbanked in the world because they are too poor to afford banking services. UEPS offers a low cost solution to provide financial services -- electronic based -- to these people and even if they just get 1-2% share of 3 billion people that's equal to 30-60 million smart cards vs. their current user base of 3.8 million cards.

Profitability: initial set up costs but once the network is in place the operating leverage is huge -- little incremental cost while rising usage drives rising revenues --- margins run in the 40% range. They may dip as new countries are added but as those countries grow users, the margins will return. cash flow requirements are low -- again some start up costs but then all free cash flow. new countries are generally 50% ownership with local banks owning the remaining 50%. UEPS also sells the technology that is used to operate the network.

valuation -- less than 18 times FY 08 (Jun) estimates. Growth in 2007 is estimated to be low teens in US dollars but in SA Rand, the growth is closer to 30%. The rand fell vs. the dollar during 2H of 2006 and 1H 2007 (ie. FY2007) but the Rand has been flat to the dollar for some time now -- meaning we are about to anniversary the decline and once we do our growth comparisons will change -- the gap between dollar growth and rand growth should close.

Catalyst -- the stock is being held back because the SA government has a RFP out for a welfare payment system to cover the entire country -- right now UEPS has 5 of 9 provinces and this represents about 70-75% of UEPS' revenues. IF UEPS loses this contract, the company will shrink dramatically. However, odds are very hight they will at least keep their 5 provinces and may actually win other provinces. They are politically connected, their system is the lowest cost and provides the best service to the welfare recipients. There is no reason for UEPS to lose. Within the next week the government is expected to announce their decision -- I expect UEPS to win at least their 5 provinces but the removal of the risk should lead to a sharp jump in the stock to the low 30's or at least a 20% gain.

Given my robust outlook for growth and the low valuation, even if you wait until after the big risk is resolved, there is still lots of potential -- again my view is $80 in 5 years.

A Question of Style -- Don't Fall for the Growth/Value Debate

Lots of ink used in the debate over whether you should buy "growth" or "value" stocks. In the mid to late 90's so called growth stocks outperformed so called value stocks dramatically. Then the bubble burst and value stocks trumped growth stocks -- at this point value has outperformed growth by around 100% since 2000. Many believe its time for growth to outperform again -- year to date growth is outperforming.

First point to make is that the question of what is a growth stock and what is a value stock is more of a marketing question -- the Frank Russell company is the one that determines what stocks go into the Russell 1000 Growth index and the Russell 1000 Value index. Frank Russell Company's background is as a consultant for institutions trying to pick money managers -- sure sounds like marketing doesn't it?

From an investment point of view you can't value a stock without making a determination of future growth prospects. Quickest way to lose money in the stock market is to buy the fastest growth company without regard for its valuation. In the mid 90's tech stocks were cheap but they were considered growth stocks -- hence the idea that growth outperformed value dramatically. The gap was so wide only because people labeled the stocks wrong.

Why is value underperforming this year? because financials -- which make up 35% of the Russell 1000 Value index vs. less than 10% of the growth index are a poor performing group this year. Are financials really value stocks? they sell at low price to earnings but they always do -- they may be cheaper vs. other industries but since they always are cheaper it makes more sense to know where they are vs. their own history -- not cheap.

Why has value done so well over the last several years? Because many so called value industries -- energy, materials, industrials and for a time financials -- had much faster growth than so called growth areas like tech, health care, etc. Finally, many growth managers are starting to buy energy, material and industrial companies Its about time -- the secular value investor bought energy in 2003 -- the trend was obvious then and the stocks were much cheaper. Skate to where the puck is going to be not to where its been.

Don't pay attention to labels -- evaluate all industries and companies based on their growth and valuation characteristics to find the most attractive investment choices. don't fall for the trap of what growth or value are supposed to be -- go to where the growth will be before others figure it out. That's one key to success -- if you can identify future growth before others, you can buy the stocks at attractive valuation and ride their growth.

Wednesday, July 4, 2007

Check out these Buffett links

These two links provide some insights into Buffett -- the first at Jeff Matthews' blog describes his trip to Berkshire Hathaway's annual meeting this year -- quite an experience.

The 2nd is a Q&A session Buffett participated in with what I believe was an MBA class in the fall of 1998. The link is for part I -- there are 10 parts in all (youtube has a 10 min max). What I find most fascinating about this talk is his going on and on about Coca Cola stock and yet he never discusses the very high valuation of the stock. 9 years later the stock is STILL lower than where it was when he made his glowing comments -- proof that even the greatest investors make common mistakes -- assuming the future will look like the past at precisely the moment when a business is as good as it can get.

My main takeaway on Buffett's methods --

extreme as in EXTREME selectivity.

Stick with what you know -- only buy companies where you know the industry and can predict the future with the odds in your favor that you will be right in terms of which companies have a big protective moat that will last -- can you pick the best businesses that will be the best 10-20 years in the future.

ignore the noise of wall street -- pay more attention to the long term economics of the business and the industry and less about the current cyclical issues. ignore all macro factors about the economy -- you are buying a business not an economy.

only play when the odds are in your favor -- and bet big when they are. this is what is meant by selectivity -- narrow your portfolio to the absolute best situations where the odds are so in your favor that they are almost sure things.

Don't forget that an attractive valuation is necessary for the odds to be in your favor. Notice in the video that the one question he really does not answer at all is how to value a company. He argues 6 stocks are enough diversification if chosen well. You will do better having 6 incredible businesses then a mixture of 30 great and ok businesses.

obviously this leaves out a lot but these are some key highlights. (thanks to Eddy at Crossing Wall Street for finding the youtube Buffett videos).


That's great but aren't you worried about ....

There is always a reason to worry -- I learned this by way of my natural optimism during the 1980's and 1990's. The media are filled with stories about the issue of the day and how this has to end our good fortune.

Its compelling -- and that is what is necessary to gain an audience as a media company. We are now at 25 years and counting with only 2 recessions -- unheard of in modern times. My natural optimism and long time horizon keeps me invested despite the worries. I used to tell people in the 90's that there were only 2 periods in our history where you didn't want to own stocks -- the 1930's and the late 1960's through the 1970's. Why? because those were times when your odds of a permanent loss of capital was greatest.

In the first, due to the 90% decline from peak to trough from 1929 to 1932, as the excesses of the great 20's bull market were removed amid disasterous policy mistakes by government leaders -- many stocks never recovered. In the second, because again -- too many one decision stocks (dot com like fad of the period) never recovered after achieving valuation heights that were eerily similar to what the growth stocks reached in 2000.

Funny, I was right in the 90's except for not being quick enough to recognize that 2000 was another one of those times when permanent loss of capital was at hand. Knew my history and what to look for but the easy gains were too intoxicating. lost more than I should have during that bust.

Who cares about a so called bear market that lasts several months or so and takes stocks down 20-30% but then recovers quickly to new highs over the next several months -- check the charts and other than the 3 periods mentioned that's what you see -- what looked scary at the time now looks like small blips in an ever rising long term trend.

So we just have to be on the watch for large imbalances -- periods where certain stocks or the whole market becomes wildly overvalued -- where the valuations are built on unsustainable economics. Do we have that now? Some are arguing that the liquidity boom that is driving strong growth in private equity deals is creating imbalances that will prove very ugly when they are unwound in the next downturn.

I disagree -- its true that PE is very strong and the main players have raised billions but our public markets are measured in trillions -- PE is bigger than ever but still a small number in total. Now some investors will get hurt no doubt -- I would not want to be an owner of high yield bonds now.

Some argue that stocks valuations are very high if you normalize for corporate margins -- which are at record levels. Its true that margins are higher than in the past but we have different kinds of companies now than in the past -- the capital intensive wealth reducing pigs of the past have been replaced by low capital businesses with high barriers to entry that allow them to earn higher margins -- i.e. we have better businesses now -- Microsoft, Google, Apple, etc are superior to Ford, GM, International Harvestor, etc.

Housing -- many people talk incessantly about how big the subprime mortgages of the last couple of years were -- hundreds of billions representing 30? 40? or even 50% of annual new mortgage volumes -- and how these mortgages are all going to default and the drop in home prices will hurt consumer spending, etc. Keep in mind that our total housing stock and even the mortgage industry as a whole is measured in trillions.

if you believe, we are about to start having more recessions and that imbalances have built up that will lead to many stocks and investors losing permanent value then by all means sell -- take money off the table. I can see a correction but not the collapse -- seems hard to imagine it could happen again so soon after 2000.

Over 40% in Asia and Money Management?

Yep, that's right -- over 40% of the portfolio is invested in Asian mutual funds or in stocks of money managers or related companies. These are 2 powerful themes that I believe provide the portfolio a key advantage in terms of outperforming.

My only international exposure from a fund perspective is in Asia (I own or have owned individual stocks that are based in other countries). Free markets and free people will create the most wealth IMHO -- and Asia has one of the best backgrounds of free market policies and more or less democratic institutions -- relative to other emerging/developed markets I think that is true. Latin America has too many socialists as does Europe. I could see potential in eastern europe but so far I haven't done the research to identify the right way to play that region.

I use the Matthews Asian funds because their philosophy fits in well with mine -- long term, focused on fundamental research -- benefiting from trends, while not being closet indexers (too similar to their index benchmarks) and they perform well in down markets.

To me money management stocks have a great tailwind -- their revenues and profits are driven by the amount of assets under management, which benefits from market appreciation plus any new cash flows into their funds -- that is the growth kicker that allows some managers to really outperform the market. My main position is in AllianceBernstein (AB) -- they have had very strong growth in assets both due to market appreciation and to new cash flows. The stock has been a strong performer for many years although I have owned it only since 2001. In the past I have also owned Franklin Resources (BEN) and T Rowe Price (TROW) -- both excellent choices as well.

Alliance's growth is driven by global equities -- international markets have performed better so that helps asset growth; their growth has also been driven by new cash flows from non-US clients. The market for asset management is less mature overseas -- its more tied into the big banks, which is where the US market was 40 years ago -- I expect specialists like Alliance to gain share. The other aspect of Alliance that I really like is the high net worth business -- they have 13% of their assets from this distribution channel but it represents 23% of management revenues -- nice fees. It is an area they are growing especially with new international offices. Alliance has 1% of assets in hedge funds which doesn't sound like much but the incentive fees they earned last year were enough to represent 20% of management fees in the 4th quarter.

While my exposure to asset managers, especially Alliance, is large, I see the stocks as more exposed to global equity markets and therefore not as tied to how one source of earnings performs (such as Pepsi with snacks or beverages).

Money management is also very profitable both in terms of margins but more importantly in terms of free cash flow production and returns on capital. its a great business in general and I think Alliance is a well managed choice at an attractive valuation -- their MLP status provides over a 5% yield based on 2007 estimated EPS.

I will cover DFR, ACAS and FDS -- my other money management related stocks in future notes.

Sunday, July 1, 2007

Tessera Technologies TSRA

As my 2nd largest individual stock holding, I am very positive on this story -- it has everything that I look for in a secular value stock.

Trend -- miniaturization of electronics. how? Tessera has developed packaging technology that allows semiconductors to be packed very tightly into a device like a handset without heat or interference worries. Other uses for their technology include packaging DDR II DRAMs because previous packaging technology could not operate at the speeds or with the level of input/output required. Tessera is coming out with next gen technology that allows even smaller electronics as well as a complete solution for handset cameras.

Packaging technology takes years to be developed and deployed because of the capital investment required by the packaging industry -- not to mention any new packaging tech has to be designed into products. The good news is that once the industry picks a solution, that technology will be in place for many years -- say 10 years.

Business Model: Of all the ways to play the growth in semiconductors I think TSRA is the best long term investment -- obviously if you want to trade the cycle this stock is not for you. Tessera is a IP royalty company meaning they license their intellectual property to those that use it. Their IP is their packaging technology. Their licenses are on a per pin connection per unit basis -- roughly 2 cents per unit given current pin counts. That means if semiconductor prices fall -- which they generally do -- Tessera's royalties do not change -- or if anything they go up because falling chip prices should mean higher unit volumes. Tessera's costs are not that great -- easily a 50% operating margin business without the need for expensive manufacturing either -- lots of free cash flow.
In 2004, the company's royalties were based mostly on handsets -- the products most concerned with miniaturization. As chips get smaller and faster, even areas not thought of as miniature -- like PCs, find that Tessera's packaging is necessary. So in addition, to the growth of handsets, the company has benefited from gaining new products that use their technology called Chip Scale Packaging (CSP). With their latest announcements, Tessera is dramatically expanding their area to include NAND flash, microprocessors, package on package, and other areas of the industry -- a potential incremental $200 mill in royalties per year.
Valuation -- I continue to think the stock is attractively valued given the high profitability, the high growth and the relatively high odds of success. I assume TSRA can earn around $3 in EPS in 2010 -- put a 24X PE on that and the stock is in the low $70's not counting a few dollars in cash. With a 50 mill shares outstanding, a 40% tax rate, a 50% operating margin goal -- to reach $3 requires over $500 mill in revenue in 2010 vs. only $200 mill in 2006. pretty good growth but its all based on the number of units that will be using their technology by then -- if you have seen a demonstration of their technology, you would agree it is very impressive. At $40.5 the stock is around 13.5X 2010 EPS -- that low $70's stock price works out to a 21% annualized return over the next 2.5 years assuming all goes as planned.
Tessera is a skate to where the puck is going kind of a company -- they pay attention to the road maps for semiconductors and by understanding physics they can predict the packaging challenges their customers will face. they then develop solutions to meet those challenges -- their customers generally do not have the resources to solve all engineering challenges -- letting Tessera do some for them speeds time to market on an area that is generally not value added (certainly not compared to the chips design or functionality). That's the beauty of Tessera's position -- to them its a great niche market with big potential but to any of their customers its not an area they can really add value -- perfect for a buy vs. build decision.
The stock has pulled back primarily in my view due to a lack of near term catalysts -- most of their new technologies will begin deployments in 2008 and their main litigations (to get some customers to start paying for using Tessera technology) are also in 2008 -- so not as much can really impact the company's numbers this year. If you can time your purchases that's great -- for me I am playing the double in 3 years and not worrying about the daily noise.
hope this helps explain my philosophy and why I like TSRA.

Portfolio on

If you go to and search for the secular value investor

you will see my portfolio -- the percent at the start of each description is the percent of the portfolio the name represents. I have included a brief description of the investment attributes for each name. I intend to provide more commentary in this blog on these stocks over time.