Author: Mady Carr

Is Anything Cheap?

10% Growth for 10x Earnings 

• Only 8 companies in the S&P 1500 are growing at least 10% and trade less than 10x earnings
• All 8 have strong current franchises but face longer-term strategic uncertainty
• These are “story stocks” with unique fundamentals and adamant investors on both sides
• Half present attractive entry points from a technical perspective

On last week’s podcast I asked whether anything is still cheap. It’s certainly a worthwhile question as defensive sectors like Utilities and Telecom drive the S&P 500 Index to new highs, and global pension funds plough record billions into negative yielding sovereigns. Push me a little and I’ll say “No, nothing is cheap. Global central banks have penalized cash balances to ensure we deploy every cent of capital. We’ve bid up asset prices to the point of absurdity. NY condos go for $90M!” Okay, quantitative easing has made me cynical, but not oblivious to data, nor the power of the Bloomberg Terminal. Screening the S&P 1500 for growth and price, I did indeed uncover a handful of companies which are truly cheap –one even got acquired the day before publishing. Value does exist.

Bloomberg offers users a powerful screening function which narrows large groups of securities into specific baskets based on quantitative search criteria. While my goal was to identify stocks I thought were cheap, I also wanted to consider growth forecasts and gauge sell-side support. In other words, I wanted stocks which are cheap but probably deserve to trade higher, both because they are growing and the analysts love them. Starting with the S&P 1500, I applied the following metrics:

• Forward 12-month price to earnings ratio less than 10x
• 2016 earnings growth of at least +10% (Q1 and Q2 actuals plus Q3 and Q4 estimates)
• 2017 earnings growth forecast of at least +10%
• Analyst buys outnumber sells plus neutrals
• No more than one sell allowed
• Minimum 20% upside to target based on consensus estimates

Cheap & Growing

Only 8 of 1500 Meet Criteria 

Stocks are generally cheap for a reason, and a forward P/E of less than ten in an environment when the S&P 500 Index trades at 18.5x implies something is awry. Yet each of these companies is growing and is well-admired by the analysts covering them. Hence the potential opportunity for us. While my discussion is primarily fundamental, note some of these charts. They look ready to bounce. Happy hunting.

Air Methods Corporation (AIRM)

Air Methods provides emergency airlift services across North America. If you’re a stranded hiker in Death Valley and need a emergency helicopter, or a transplant patient in Atlanta awaiting a donated organ from LA, these guys are probably involved. They serve hospitals on a contract basis with 500 aircraft (mostly helicopters) from 229 bases across the U.S. They also operate emergency call centers, and about 11% of revenues come from using idle helicopters for tourism in certain locales. At an average of $12k per flight, medical cost scrutiny under the Affordable Health Care Act has weighed on shares. In addition, the tourism business slipped 1.6% YoY in the recent quarter and may obscure the core business. That said, margins have risen each of the past 3 years and the company is buying back stock.

AMAG Pharmaceuticals Inc (AMAG) 

AMAG looks down and out, but it’s not. The concern stems from upcoming patent expirations for its two lead drugs: Makena which delays prenatal births and Feraheme which treats iron deficiency for patients with kidney disease. Each drug is involved in studies which could potentially broaden approved applications and extend patent protection. Makena requires injections that can create adverse side effect, so AMAG is pioneering alternative administrations which could earn seven years of protection under orphan drug status. In the case of Feraheme, the company is engaged in a trial of 20,000 people with iron deficiency unrelated the current kidney disease application. Results will become available next year and could potentially provide new applications for the drug by 2018. As with most biotechs, the outcomes are binary and analysts are split between targets ranging from $27 to $80. The stock currently trades at $24, which suggests risk-reward favors the longs.

AMC Networks Inc (AMCX)

What makes AMC interesting is its ability to consistently produce exceptional hits like Mad Men, Breaking Bad and The Walking Dead. That is also the challenge however… Can they do it again? So far, the Walking Dead spin-offs have done quite well. Better Call Saul attracted 3.2 million viewers  per episode in the first season and Fear the Walking Dead 7.2M. By comparison, Mad Men attracted just 2.1M per episode in its first season. Distribution accounts for 56% of revenue, and advertising constitutes the balance of 44%. Strong penetration across digital platforms is a positive, as is the international exposure provided by the 2014 acquisition of Chellomedia, but again you’re betting on hits here.

ARRIS International plc (ARRS)

Okay, this is a crazy chart and I’m not crazy about it. A lot of gaps, and right now it looks like it’s levitating, which suggests it’s vulnerable short-term. That said, this company is the global leader in set-top box and video infrastructure equipment. Do you watch TV or stream content online? ARRIS makes it possible. The company currently controls 45% of the home broadband market in the U.S. according to IHS. There are two issues for potential buyers: 1. Whether this dominant share is as good as it gets 2. Whether mobile supplants fixed box distribution over time, and if so how ARRIS will adapt. These hypotheticals are hard to answer. Right now the company is sitting on nearly a billion in cash and posting strong growth. It’s also quite cheap at 9.3x earnings and 0.7x sales.

Bofl Holding, Inc (BOFI)

This is a hairy dog. A staggering 44% of BofI’s stock is sold short based on a lawsuit filed last October by former a employee which alleges multiple improprieties (inflated appraisals, loan doc forgery, insufficient due diligence, etc). That said, all six analysts covering the company maintain their buy ratings as the bank continues to post double digit asset growth and strong earnings. In the most recent quarter, assets rose 30.5% YoY to $7.6B, net interest margins held at 3.7% and ROE for the 12 months ended June 30 was 19.43%. The partnership with H&R Block to cross sell IRAs is moving forward. CEO Greg Garrabrants addressed the current litigation on the most recent earnings call, “The bank is in strong regulatory standing with no enforcement actions, has not been fined a single dollar by any regulatory agency, has not been required to modify its products or business practices. Additionally, we do not foresee any further impact to the underlying business as a result of the frivolous lawsuit and the short-seller thesis. Our management team and employees remain focused on running the business.”

Mylan NV (MYL)

David Einhorn’s Greenlight Capital doubled its position in Mylan during 2Q to 4.9M shares (14 of the top 25 shareholders increased positions during the quarter, 9 sold and 2 held steady). I like seeing a value minded activist investor increase his stake in a company, especially in Mylan’s case as it has never recovered from the gap created last year when Teva abandoned its hostile takeover bid. 86% of Mylan’s business is generic, which means margins are lower and upside is less than non-generic drug makers. In addition, there’s no dividend. Of the 8 companies in my screen results, this is probably the least compelling –though 8.9x earnings for mid-teens growth seems awfully cheap.

Rovi Corporation (ROVI)

Rovi is like TV Guide for the 21st century. It creates interactive programming guides for cable companies  and video ad campaigns appearing on digital devices. The company is currently in the process of acquiring TiVo and the deal is on track to close by Oct. 1. In addition, George Soros bought 3.6M shares during 2Q to become the seventh largest shareholder. As for why it trades so cheap, the 2017 earnings estimate of $2.30 is LESS than the 2011 earnings of $2.40. Also of note, the company has missed estimates seven times since… that’s nearly two years worth of disappointments. As noted earlier, stocks are generally cheap for a reason, or in this case seven reasons.

United Insurance Holdings (UIHC)

Take a bow United Insurance! I ran the screen on Wednesday night and Thursday morning it announced a merger of equals with RDX Holdings. The stock popped 9%. If only every trade were this easy! This underscores the value of running regular stock screens for growing companies trading at a discount. If we don’t buy them, someone else will.

Industrial Surprise

Guiding Down but Getting Bought 

• AMTEK Inc. (AME) issues two disappointing earnings reports and notable buyers acquire shares
• Volume spikes on down days establish $45 as triple bottom underpinning stock price
• Management trims guidance for second time and offers detailed outlook by segment
• $1B cash available for opportunistic and accretive acquisitions my provide upward catalyst

I’ve been trying to get excited about beleaguered industrials on the assumption every dog has its day. Now I finally have reason to pay attention. 13-F filings released this week reveal activist investor Dan Loeb of Third Point Partners has initiated a position in oft-overlooked AMETEK, Inc. (AME). To quote one of my favorite special situations strategists, Don Bilson of Gordon Haskett “It’s hard to find a name more under the hedge fund radar than AMETEK… coming out of Q1, not a single hedge fund manager was a top-30 holder.” Nonetheless, Mr. Loeb now has a stake and he’s been buying on terrible news. So have the top three shareholders (Fidelity, BlackRock and Vanguard). When avowed activists hedge funds and and deep-pocked mutual funds join forces, I pay attention.

Take a look at the one-year chart of this $11B roll-up of electronics manufacturing businesses. Three times since April the company has sold off on terrible news, including two earnings disappointments and lowered guidance. Yet each case proved a buying opportunity, which is what makes this picture interesting. Again, when strong-handed pros buy on bad news, we should try to understand why.

Buying Bad News

AMETEK, Inc (AME)

Note the volume spikes each time the stock sold-off. Clearly a lot of disappointed investors were voting with their feet, though buying ultimately trumped selling and the stock rebounded. I’m especially intrigued by the near instantaneous bounce two weeks ago when new CEO David Zapico lowered guidance. With 11 of 17 analysts rating the stock a buy, and not a single seller among them, there’s something happening here. This action is unusual, especially for an industrial stock unaccustomed to headlines.

To get a better sense for what’s happening, I’ve extracted key moments from the earnings call on August 4th, when the stock opened down 7.5% but managed to close nearly flat. You can hear how the tone of the conversation changes, beginning with the guidance cut. CEO David Zapico’s words appear in italics.

Visibility has remained limited as customers are cautious and are aggressively managing their inventory levels and capital spending plans. We do not anticipate a modest second half improvement, as we had expected. As a result, we now forecast revenue to be down low single digits. 

Stifel Nicolaus: Is it unlikely will we get another cut?

There is not going to be another cut. We feel the business has stabilized, especially energy. Our customers are telling us, based on some of the commentary you’ve heard from Halliburton, Baker Hughes and Schlumberger that rig counts have bottomed.

The two markets that are down, about 20% of our company –oil and gas and metals– are down 30%. That’s a difficult headwind to offset but we still have 22.4% operating margins and we’ve had a good operating quarter. Free cash flow was strong at $175 million in the second quarter, up 15% over last year.

BMO Capital Markets: But the truck is falling apart… 

Many of you have followed Ametek for quite a while, and in the past our forecasting process has yielded very consistent results, but it hasn’t the last few quarters. It’s a difficult environment. Customers are delaying capital projects and managing inventory aggressively. Emerging markets are challenged.

So we’re taking a different approach to forecasting. We got our entire executive office involved. We took a deep analytical review of each niche business to understand their specific forecasts and to better assess potential risk. We spoke to the financial community. It’s a more time consuming process but we felt it’s the right thing to do at this point. It’s a rigorous process and I feel confident in the results.

BMO Capital Markets: Is there a lift to the cost savings number?

Our cost reductions are $130 million for the year. We are purchasing less material… we are balanced in revenues and expenses so we have a natural hedge. Uncertainty is going to go on for some time, but we’re feeling pretty good about our exposure.

No area is immune from efficiency improvement. We are going to look at things like global sourcing, low-cost region production, value analysis, value engineering, plant consolidation… with all of the tools that we have we are going to get a healthy cost reduction target. And we are going to pair that with acquisitions and that’s how we are going to grow our earnings next year.

Robert Baird: Should we think about downshifting core growth to more of a GDP number?

Through the cycle of the last 10 years we grew earnings 16% compounded annually. We need to adapt our strategy to the new reality in the marketplace, in order to ensure we’re going to be able to double earnings over the next five years… with a combination of mid-single digit organic growth and adding acquisitions of 5-10% a year.

Stifel Nicolaus: How do you think about M&A and public deals in this environment?

We have a solid pipeline. Our sweet spot is that $50 to $200 million dollar deal, but we’ve expanded our horizons are looking up to $500 million in revenue. We do deals that add the most value and we are very selective. We have four deals done this year and we deployed $360 million in capital. We have $1 billion of capacity within our existing credit lines and cash on hand. More importantly our operating cash flow is $750 million and I think this can be a significant driver for 2016 and 2017 performance.

Jefferies: Can you give us some color on emerging markets?



Sure, I’ll go around the world. In the U.S. we were down high single digits versus last year… oil, gas and metals… in Europe low single digits. Asia is stabilizing, China is stabilizing and one emerging market I’d point out that is doing better is India with mid-single digit growth. With the strong dollar we are relocating to low cost locations, and in most situations we don’t have competitors so that give us an advantage. We are naturally hedged in most of our markets.

RBC: Do you have orders or backlog to give you confidence about stabilization?

Yes. Our backlog is $1.1 billion. If we look at the run rates, and we’ve spent a lot of detail on it, it gives us confidence in the back half of the year.

Some of the questions got a little testy, as you might expect when a company guides down twice in three months and effectively bags the analysts in the process. However, Mr. Zapico has worked at the company  for several decades and his intimate knowledge of the businesses paid off. In addition, he handled himself like a pro. Harvard Business Review contributor John Baldoni has written extensively on how effective leaders react to crises. His checklist includes five basic categories, and Mr. Zapico scores five for five.

Crisis Management Checklist

Admittedly, this is all a little touchy-feely so we need some NUMBERS. What distinguishes Ametek from other electrical/industrial manufacturers is its 2x wider Operating Margins and superior Return on Equity. As for valuation, its P/E is comparable to the market but well below the group. It’s also down on the year, which provides additional room to play “catch up.” Bottom Line: What we’re buying in AME is a management team and its ability to identify, acquire and integrate complementary businesses. I think of Ametek as a medium-term call option on improving economic growth and rotation into overlooked industrials. This theme may take time to play out, but I like betting alongside Loeb and Fidelity.

Vital Stats

Subscribe at https://bullseyebrief.com

Slippery When Wet

3 Energy ETFs for Rational Investors 

• Baker Hughes Index of active U.S. land-based drilling rigs rises 10% in 10 weeks
• IEA ups its forecast of global refinery throughput to all-time high on strong refining margins
• Mideast OPEC producers still engaging in price war over market share for term contracts
• Energy equities up significantly since Feb lows but flat since May

Misinformation is everywhere, and it’s especially entertaining in the oil business when OPEC ministers chirp about pumping rates. Saudi Arabia’s oil boss Khalid al-Falih promises a ministerial meeting in Algeria next month to stabilize the market, even as he directed Saudi Aramco to pump a record 10.67M barrels in July at the request of customers. He’s quite the chess player, jawboning markets higher while opening the spigots and claiming it’s all about the customer. Does the world really need more oil, Mr. al-Falih? Chinese demand fell to a two year low in July, and U.S. demand has been sideways since May. Oh never mind. Your Kingdom faces a 15% budget deficit and you’re Mr. Fix It.

Maybe I’m being too harsh on Mr. al-Falih. He’s got a hard job. Sunni Saudi Arabia is effectively waging a price war with Shiite Iran to capture share, even as it desperately needs revenue for capital investment and economic diversification. Mr. al-Falih is caught in the middle, and so are the rest of us. On the one hand, OPEC’s need for cash, coupled with U.S. producers’ ability to frack new fields creates an unprecedented supply overhang. On the other, drilling shut-ins and regulatory resistance to build any new refineries in the U.S. since 1977 keeps retail product prices robust. Bull or Bear, depends who you talk to.

Say What

The Absurdity of Labels

Amid all this noise, from pundits arguing on CNBC to record energy bankruptcies in Houston, something amazing appears to happening in the oil business: people are going back to work. The number of rigs actively drilling new wells in the U.S. has risen each of the past ten weeks and now stands at 447 according to the Baker Hughes Rig Count Index. While still 75% below the level seen in 2014 when oil cost over $100/bbl, it’s the strongest indication yet the worst may be over for the drillers.

The rebound in drilling coincides with the International Energy Agency increasing its own forecast for crude demand, arguing strong refining margins incentivize higher operating rates. The IEA now says refinery throughput will rise by 600kb/d to a record 80.6Mb/d in the second half of 2016.

Recognize even unbiased agencies like the IEA are having trouble sorting out all the conflicting signals. Oil’s decline from $110/bbl in 2014 to a low of $26.21 last February –and about $45 today –means everyone is struggling to retool and identify a path to long term equilibrium. Drillers have slowed production volumes to ration supply and moth-balled all but the most promising wells. Bankruptcies and asset sales have concentrated firepower and operational expertise into fewer, stronger hands. It’s been painful, but forward guidance on recent 2Q earnings calls suggests some industry executives believe the market has turned and may launch a modest up-cycle in 2017.

“We are beginning to see some green shoots and key unconventional plays in the U.S. onshore business suggesting that the worse maybe behind us. We expect to see an increase in the international activity by mid-2017 as governments look to replenish some of the loss revenues with lower risk projects. Similarly, we would expect shelf and shallow-water activity to file a suit in mid to second half of 2017.”

-Jeff Bird, CEO Frank’s International NV

Frank’s International NV (FI) is the largest supplier of tubular steel pipes to the oil industry, with a 35% market share of the U.S. land market alone. As the only pure play in the business, coupled with a $581M war chest of cash and no debt, Mr. Bird has expressed openness to bolt-on acquisitions. Admittedly, he just cut the dividend and sees declining cash flow into the fourth quarter, but he sees a tighter supply balance materializing in coming months and he’s cautiously bullish 2017.

Investors apparently agree with his view, having voted with their wallets this year to lift the sector 13.8%, compared to 6.3% for the S&P 500 Index. Three energy exchange traded funds (ETFs) provide exposure with varying degrees of risk and reward, depending on your own risk tolerance: E&Ps for upside; MLPs for income; Big Oil for exposure.

The Trade

I like a combination of Upside and income, meaning I’ll get paid while I wait for my gains. So split the usual position allocation of 3% into two positions of 1.5% each, where half goes into exploration and production (XOP) and half into master limited partnerships (AMJ). Like Mr. Bird, I sense a sufficient weeding out has occurred and we can begin to think about the next up-cycle. I will also add, there is no rush to own a full position. The damage was immense, so repair will take time. Buy only on down days and pick your spots. (Note: I include the basic energy ETF XLE for your reference.)

1. Most Bang for the Buck (XOP)

Investors looking to maximize operating leverage within the energy sector should focus on the SPDR S&P Oil & Gas Exploration & Production ETF (XOP). It’s a cap-weighted portfolio of 59 companies with an average one-year Beta of 1.69, meaning this group tends to move 1.69 times more than the broader market. When oil and equities in general move higher, these stocks rise even faster. Here’s why: As oil prices rise and pumping rates increase, fixed costs can be distributed over higher per unit volumes, which drives margin improvement on the incremental barrels. Ultimately, this causes earnings to accelerate, and this is what analysts mean when they speak of operating leverage.

Investors have already begun placing their bets on this group, clearly taking the same side as the tempered Mr. Bird. XOP is up 19% YTD and shares outstanding have tripled since 2014. Holdings include well-known E&P names like Chesapeake Energy Corp (CHK), Devon Energy Corp (DVN) and EOG Resources Inc (EOG). When all the easy oil is drilled and production starts to slip, prices will have to rise to incentivize drilling and this group will benefit disproportionally.

2. Pay Me While I Wait (AMJ)

Unlike the Boom/Bust nature of the oil and gas E&Ps, the 44 companies in the Alerian MLP Index ETN (AMJ) focus on the more mundane but predictable aspects of the oil business: Storage, Transport and Processing. They are effectively the toll both operators which collect fees from oil companies. They generate significant cash flow and distribute the money to investors in the form of generous dividends. The AMJ represents 85% of total market cap for the group and pays a dividend of 6.9%, one of the highest of any ETF/ETN baskets in the world. By comparison, the widely held iShares junk bond ETF HYG yields 5.5% currently. If there’s a catch, it’s the risk of a dividend cut, though the current quarterly payout of $0.54 is only slightly below the all-time high payout of $0.60 in 4Q 2014. This group is incredibly resilient. The AMJ basket trades at a P/E of 29x and the fund’s annual expense ratio is 0.85%, so it’s not exactly cheap. Still, the 6.9% yield gets my attention.

3. Steady as She Goes (XLE)

When I was a young oil trader working for one of the largest and oldest private commodity companies in the world, Exxon’s head of trading graciously invited me to lunch. Mostly we talked about life, but I do recall a very specific comment: “Adam, once a year we figure out our drilling budget for the next 12 months. Then we put it into action, produce a lot of oil and everyone makes a lot of money.” Translation: Don’t overthink this. Companies like ExxonMobil Corp. (XOM) are slow and steady. They are aircraft carriers that require many miles to change direction or come to a stop. Just follow their wake and you’ll probably do fine. The Energy Select Sector SPDR Fund (XLE) is the largest of the energy ETFs and its expense ratio is just 0.14%. ExxonMobil and Chevron Corp (CVX) constitute a third of the index, while E&Ps represent about 40%. Oil field service and pipelines make up the remaining 25%. The XLE yields 2.8%, and if you simply want exposure without the worry, this is your index.

Energy ETF Vital Stats

Subscribe at https://bullseyebrief.com