Friday File — Casey’s “Important News” flop and some updates on favorites

by Travis Johnson, Stock Gumshoe | August 8, 2014 10:49 pm

This week there’s been quite a bit of news in stocks that I follow fairly closely or own or have featured in the past as “Idea of the Month” candidates for the irregulars, so I do have a bit of a teaser campaign to talk to you about (that’s the Casey bit), but I’m going to start by running down some quick updates on my thinking on several of these companies.

Seadrill (SDRL) — I still think this stock should be closer to $40 for a 10% yield, as I consider that a fair valuation for a risky, levered stock in this environment, there’s not a lot of good reason for it to go below $35 or above $40 right now in my mind. There’s no strong reason why the dividend would have to be cut in the near term and abundant possibilities for it to be increased by 2016, even with rates a bit soft still for their ultra-deepwater rigs. There was a rare bit of optimism from a Seadrill analyst reported here[1], which is encouraging, but the general tendency of Wall Streeters these days is to be pessimistic about expensive offshore drilling in the wake of the huge onshore (shale) discoveries in the US. Brazil and Kenya and Angola and Mexico aren’t going to stop exploring for deepwater oil just because the US is producting more, but when oil prices dip the marginal offshore projects get less funding, which cuts into the demand for the rigs. I still think that Seadrill is right in their long-term optimism, the demand for oil will continue to be strong and onshore fields aren’t big enough or cheap enough to destroy offshore drilling, so demand for deepwater drilling rigs should still be rising over the longer term. That’s despite the fact that oil company headlines say they want to cut back on costs, and in some cases are actually doing so.

Seadrill is well-booked with backlog to cover a substantial chunk of their earnings. I think it will be 2016, likely, before there’s substantial recovery in Seadrill shares to the $40s or above, but absent a recession that crushes oil prices I think there will be a recovery and I’m happy to hold for the 10% dividend (and continue reinvesting that dividend) for now. They just put West Saturn, one of their newbuilding drillships, under contract this week[2], that was one that had some investors questioning demand because it was still available just a month before it’s expected to come out of the shipyard, and they got a good rate on it (albeit for only 2 years — their sister ship West Jupiter got a five-year deal a couple months ago).

There’s still certainly risk if oil prices drop or if demand for ultra-deepwater offshore rigs collapses, because Seadrill remains levered and has a half-dozen high-spec (meaning, “expensive”) rigs and drillships coming available over the next 12-18 months which will need customers, but the majority of the fleet is booked out several years and provides a strong backlog of revenue.

When it comes to Arcos Dorados (ARCO), I underestimated the negative impact of World Cup (people stayed home to watch games instead of braving the traffic to hit the golden arches), and investors as a whole underestimated the impact of the change in Venezuelan currency calculation (including writedowns of assets valued in that currency). The story remains the same — good organic top-line growth, but a dip in Brazil with the World Cup and continued soft currencies (and sometimes slowing economies) in most of Latin America that make their earnings look weak (declining revenue, even) in US$ terms. So the stock came down pretty hard after earnings, and I just bought more when it hit $8.50 or so — it’s well below that as I type.

Momentum works on the downside, too, and the disappointing overall numbers for McDonald’s this week further pressured the stock and has helped investors to sour on the whole enterprise. This time the chatter is about the surge in “healthier” eating and how McDonald’s is part of the problem — which is no doubt true to some extent on a philosophical level, but the slow trend toward healthier eating is also impacting the McDonald’s menu and, frankly, the last time there was a big “this is unhealthy, no one should eat McDonald’s” trend socially the angst among McDonald’s investors peaked around the time Supersize Me came out… and that was a spectacular opportunity to buy McDonald’s in 2004. That’s not the opportunity here, of course, and we don’t have the benefit of hindsight — but betting against the appeal of McDonald’s and their ability to engineer menus to entice the world has been a mistake for decades.

I continue to think the fall in ARCO shares is short-sighted, and that Arcos Dorados is managing a hugely valuable and popular brand that is being operated well and is performing well on a local level — but we really end up with a macro bet here because, in truth, this ends up being a bet on the resurgence of Brazil and Latin America. The company is well-run and profitable and growing in most of its locations but it won’t appear appealing until those locations are again beloved by investors. Or, at least, until the currencies in those countries strengthen a bit against the dollar (which also is not happening this week — the drums of war always send investors fleeing for safety, and to most of the investing world safety still means US Treasury bonds).

ARCO’s CEO, Woods Staton, put it thus in their press release[3] — when they also announced they were reducing their guidance, further disappointing investors:

“Expectations for economic and consumption growth across our territories have deteriorated substantially versus our original outlooks for this year. In response to the effect of the deteriorating macroeconomic conditions on our first half results, recent developments in one of our major markets and the short-term impact of the FIFA World Cup, we are revising our full year guidance. In this environment we will be balancing our focus on maintaining traffic in our restaurants with our long-term plans to realize operational cost savings, become more efficient and improve profitability”.

“Despite current challenges, the QSR industry in Latin America is backed by strong, long-term demographic trends. As operators of the region’s dominant QSR brand with an unmatched footprint, I am confident that we will be at the forefront of the recovery in growth.”

I don’t know when Brazil, Argentina, Mexico and the other engines of Latin America will hit a new wave of growth, but I suspect the pessimism is overdone. I’ll continue to own this good company and pretend I’m a local shareholder in Santiago who doesn’t care that much about how the performance translates into US dollars — and in so doing, I’ll get a bit of a dollar hedge in my portfolio even if, clearly, I jumped on this one a bit too early in the downdraft. I’ll let you know, as always, if my opinion (or my portfolio position) changes. Your opinion, of course, may end up being wildly different.

Criteo (CRTO) was featured pretty recently as an “Idea of the Month” and had a great quarter [4]in my eyes. This is an almost ideal kind of company if you think about it abstractly — it’s extremely scaleable, so each dollar of growth should come at higher margins, and it is growing very fast in a market that is still a high-growth market. Their unique proposition is that they can target and retarget online retail customers more efficiently than standard online ad networks, and deliver very measurable real-world results in increased sales for online stores. They do this because of their access to transaction data — they know who among their customers is buying, so they can better predict which non-customer of theirs might buy, which differs in some ways from the “prediction engines” used by other advertising technology companies. The risk is partly economic — in a down economy, marketers spend less — and partly competitive, since other companies are vying for those ad dollars as well, but CRTO is on pace to continue its torrid rate of growth. I am still holding my shares, bought right around where they are right now, but if you want to see a more pessimistic take on the sector check out this article on Criteo’s competitor Rocket Fuel (FUEL)[5], which I think is a lower-quality company but has a similar risk profile and has gotten clobbered.

There’s something to be said for owning the far more dominant players in a rapidly growing industry (Google is, of course, the one real “no brainer” in internet search and this is my ninth year owning GOOG, and Facebook is the second most important stock in the sector, in my opinion… I still hold long-term call options on facebook but haven’t bought the equity. Twitter doesn’t interest me yet, not that anyone’s asking.) But the growth is there for Criteo, we just need to see if they can keep it up to continue earning a premium valuation — I’m impressed with their growth in clients and in revenue, so I’m optimistic, but a premium valuation means they come down hard (as they did just before I wrote about it the first time) if either the company or the sector disappoints or if growth and momentum investors stay home and wring their hands about Russia or Israel or Iraq or the Federal Reserve.

Third Point Re (TPRE) is one of my four insurance stocks, all of which really end up being based on the strategy that I want to have a great manager run a portfolio for me and juice it with “free” leverage from the insurance float. I don’t love the conventional insurance companies, though many of them are very well run, because so many of the big ones are so overwhelmingly risk averse in investing that they can’t earn much money when rates rise or when insurance operations have limited profitability (ie, in soft or competitive insurance markets). Last week I told you that I’d buy a bit more before earnings, and I did add a few shares but it didn’t drop quite as much as I (greedily) hoped — the stock popped up over $15 after a good earnings release on Thursday evening.

Earnings were a bit stronger than I had expected, largely because the underwriting performance was better — they had a combined ratio on the quarter of 102.7, so they are indeed getting closer to “break even” on the insurance side (100 is break even, above that is an underwriting loss and below that is an underwriting profit). The book value jumped up to $13.72, so if you’re comfortable buying the stock up to 1.1X book value, which seems reasonable to me given the underwriting improvements and Dan Loeb’s continued strong portfolio management (Loeb’s Third Point hedge funds invest the cash and float of Third Point Re), that means you could buy it up to $15.10. It’s a hair over that today, but it will probably continue to fluctuate so I imagine we’ll see more buying opportunities in the future. (Loeb gets covered pretty closely in the press, so you can often get an idea of how he’s investing “our” money in Third Point — there was a Bloomberg piece just today[6] about his expectations for faster US growth next quarter that will “force the hand” of the Fed).

The most similar company to Third Point Re on the public markets is the more mature Greenlight Capital Re (GLRE), which I own a larger stake of — I missed the chance to pick up a few shares immediately after earnings, when they briefly dropped below $32, but I did add a small nibble to my holdings at $32 and change this week. Book value rose despite a slight underwriting loss (combined ratio 100.7, new book value $30.47 per share), and David Einhorn’s portfolio management continued to shine in delivering an 8% return to generate a nice profit on the quarter. The stock came down largely because Einhorn said some pessimistic things about finding opportunity[7] and because most of the big hedgies, including both Einhorn and Loeb, had weak investment performance in July[8] (not reflected in this last quarter, but these firms report investment performance monthly so investors are speculating that this will hit the current quarter), but I expect his excellent long-term performance to continue… and as it does, it compounds on itself by growing the value of the portfolio and earning more each year on that larger portfolio.

When this kind of thing works well, you can wake up ten or 20 years later and end up with Markel or Berkshire Hathaway — I don’t know if Dan Loeb or David Einhorn will have that staying power or develop companies with that kind of niche strength in their insurance businesses to sustain the growing investment portfolios, but I like how they’re doing so far and will probably continue to nibble from time to time. If you’re willing to be patient through some ups and downs I think you can buy Greenlight Re, which has a more established business, better underwriting performance currently, and a better deal with its investment manager (Einhorn gives them a small discount on the management fee, Loeb doesn’t do the same for TPRE), at up to 1.2X book value, which would put it at $36.50… it’s well below that now.

Markel (MKL) and Berkshire (BRK-B), by the way, are both large personal holdings, bigger than GLRE or TPRE in my portfolio, and are both a bit too expensive for me to want to buy more at the moment. I’d like MKL if it gets back down near $600 (it had a fairly weak quarter, but still boosted book value to $511). Berkshire is still reasonably priced, I suppose, if you want to assess the value of all their holdings, but is now so industrial and cyclical with all its underlying businesses and all its large equity holdings that it’s going to be very comparable to the S&P 500. I still own it as a core holding, and think there’s an outside chance of it beating the market if Buffett does something spectacular with his extra $50 billion in cash, but I think their best chance to do something great will come the next time the overall market gets clobbered — at which point Berkshire will be cheaper, too, probably. There’s no real rush to get into Berkshire, from my perspective, unless Uncle Warren is seen in an ambulance and the stock overreacts and broaches that magical 1.2X book value level where Buffett has indicated he’d use some of the cash hoard to buy back stock (it’s way above that now, close to 1.4X book).

Aware (AWRE) has been brought up by readers a few times this month — Aware has been a speculative stock I’ve watched for a while now, largely because it was transforming its business to become a biometric technology provider and it had a huge cash hoard largely from the sale of patents and other business lines. Part of the cash hoard was paid out last month, when shareholders got $1.75 in a special dividend, but the company still has roughly $1.50 in cash on the books (per share). So now, if you back out that $1.50, the underlying operations — R&D and sales of software licenses for biometric applications — are valued at a PE of about 15. I wouldn’t stomp up and down on the table and holler about buying that without being more expert than I am about the potential for this technology and the number of licensees they’re likely to get, but it remains what it was a year ago — a reasonable risk in a growing sector with some downside protection from the cash (though now the downside is down below $2, instead of at $3.25). If I held this one I would probably be patient, since they’ve been steadily earning for a year and may be able to grow that business and, if we’re lucky, the sector will get hot again and they’ll be talked up as an acquisition candidate (they’re brutally tiny, the market cap is only $100 million). Right now I’d call it a hold, though I’ve never owned it personally.

My favorite hospital stock, the REIT Medical Properties Trust (MPW), is still growing this quarter[9]. Hospitals in general are still doing well (increased traffic in hospitals is widely seen as a boost from the newly insured and may even out over time, but the big publicly traded hospitals had a solid start to the year), which means their customers are in solid shape and, in some cases, eager to expand.

MPW still has good inflation protection should we ever see inflation again (their leases generally have escalators built in near the CPI rate), still solid triple-net leases with excellent operators, acute health care is still a growing industry globally, and they’re paying out a relatively conservative amount of their funds from operations and should be able to grow the dividend. The worry for me is that they don’t grow the dividend for whatever reason, because they have a very limited history of doing so — the dividend has only been raised once since 2008. If they were a consistent dividend raiser, they would not trade with the current 6.5% yield but would likely be in the 4-5% yield neighborhood. I think there’s a decent chance, though certainly not a guarantee, that they will hike the dividend by another penny per quarter at the end of the year, and that if they become seen as a dividend grower again they could trade up to a 5% yield pretty easily. That would mean a share price of about $17.50 in January. No guarantee, of course, but I think that’s the upside potential and I’m pleased with the 6.5% yield currently and think it should be very stable if it does not grow, and the company will not collapse if inflation heats up. I’d be interested in adding to my position if it got much below $13 a share. With hospitals doing well and interest rates remaining low for a long time, most likely, I think those interested in steady income with some inflation protection have to have substantial fear of future interest rates to dislike this one.

Ligand (LGND) continues to be a battleground, largely between the promotional management and the exaggerating short seller. Now there are real numbers for the last quarter[10], though they were instantly assailed by Lemelson[11] (Lemelson Capital is a short seller in Ligand shares, which means he borrowed shares and sold them earlier this year and expects the stock to continue to fall so he can buy it back cheaper to return it to the shareholders from whom he borrowed it).

I’m not sure what to think about Ligand right now — it’s a little surprising that no other short sellers have jumped on the bandwagon with Lemelson (the short position is a little smaller than it was a couple months ago when they publicized their short, though it’s still quite high at about 20% of the float), and that may be partly because I don’t think Lemelson’s primary argument is particularly compelling (that Promacta and Kyprolis are worthless and doomed to rapid decline)… but he keeps increasing his short bet (the stock goes down a bit pretty much every time he gets some press attention, as it did yesterday afternoon on this note[12]) and his other arguments do help to illuminate some of the risks in Ligand, particularly that they over-reward their management (you have to ignore share-based compensation in order to make the earnings numbers look reasonable), and that they have essentially spun off entities to own some of their research programs because no one wanted to invest in them (they would like to IPO at least one of those companies, but in the current environment that’s not necessarily going to be a lucrative event). I’m holding now, waiting to see how it works out and whether Kyprolis gets closer to an expanded indication to help boost revenues — rarely has a stock gone consistently down when short sellers complained about overvaluation or stock-based compensation if the company’s revenue is still rising, but if other things go bad at Ligand they’re certainly pricey enough to still fall hard, they were expensive when I first wrote about them a year ago in the mid-$30s and they were expensive at $80 and they’re expensive now at $50 — I think the business model is working and I think the revenue growth is likely to continue, so I’m holding… but I’m not so confident that Lemelson’s wrong on the big picture that I’d add aggressively to my bet, I want to see it play out over time first.

So those are a few of the stocks that came to my mind this week. And there’s also been an interesting teaser campaign this week from the Casey folks.

Did you notice the pitch from Alex Daley over at Casey Extraordinary Technology earlier this week? He was really putting it on the line for one of his favorite stocks, a pick he said he’d been recommending for a while and which was about to announce earnings (it did, earlier this week on my birthday). Here’s a bit from his ad:

“… tomorrow – August 7 – we expect the company’s upswing to start in earnest. That’s the first trading day after its next quarterly results call with analysts, in which we expect the company to announce that revenue has more than doubled since this time last year. We’re not the only ones who see this. The stock is up 24% since its 52-week low in June, so there are already people positioning themselves for the news. But we see plenty more room for growth.

“As if 100+% annual revenue growth weren’t enough, it’s not the news we’re most anticipating. That revenue growth is fueled mostly by early customers of the remarkable testing platform I mentioned. It’s a “razor and blades” business model, you see.

“The more “razors” the company sells today (i.e., new customers), the faster “blade” sales grow tomorrow. It’s exponential. And this company isn’t a one-trick pony, either. That doubling of revenue came on the back of a single test for the rare bacterial infection called sepsis. Now the company has had another test approved for bacterial enteric pathogens (like Salmonella poisoning), which the CEO says doubles the revenue potential from each machine it’s sold.”

What’s he touting? It seems virtually certain that he was again touting the stock he teased back in December, Nanosphere (NSPH), which sells the Verigene testing system … and the company did indeed release earnings on Wednesday[13], but the results were disappointing and, perhaps more importantly, the company cut their forward guidance for the rest of the year by about a quarter. Companies hate to cut guidance, so they only do it if they really think they’re going to do poorly — and investors hate guidance cuts more, as you can see from the fact that the stock dropped by about 30% yesterday following the earnings miss.

I put the stock on my watchlist as an interesting business model back when Casey teased it with his “Heads you live, tails you die” spiel[14], and am quite pleased to have just watched and not bought at this point — the business still looks interesting, I still don’t know much about competition in the space but a good story can still be spun, and the real result seems to be they are having a really hard time getting their installed base of machines in hospitals (“razors”) up to a level that could provide a sustainable amount of cash flow for their “blade” sales. Will that change with approvals for new tests? Who knows.

But what we do know is that growth tailed off in the last quarter — way back in December they were looking at 100%+ year over year revenue growth, but this quarter it was more like 40%, and it was actually down sequentially from the last quarter. This is a seller of machines, and selling a few more or less in a quarter is meaningful for them, so it’s going to be lumpy — but with the level of operating expenses they have (they’ve consistently spent about 9-11 million/quarter on SG&A and R&D) they will have to increase sales by at least 500% to make a profit even if their margins get substantially better (margins have improved somewhat). If margins don’t improve a lot, at this rate they’d have to increase sales by something like 1000% to make a profit. It happens, but if it’s going to happen with Nanosphere it is apparently going to happen a lot more slowly than investors (and Alex Daley) anticipated. At this rate, unless they slow the cash burn they’ll have to raise money again within a year — if they do that before things start to turn around (if they do), it will probably clobber the shares.

As of this afternoon, though, Daley was back out on the email trail with an update — which included, good for him, a mea culpa about the stock not working out as he expected (he’s still not naming it, of course, that’s the tease)… here’s a bit of what he said in the email with the subject line “Important news on the stock I told you about”:

“If you saw my note, we projected that this revolutionary firm would report 100%+ annual revenue growth during Thursday’s earnings call. It’s what we were projecting, and most of Wall Street agreed with us.

“Today, however, the stock is trading down a good bit. Why? Well, let’s start with the good news. The company knocked it out of the park on revenue growth as predicted. Consumables revenue was up a solid 108% over last year.”

Refreshingly honest, that. More:

“… as happens with startups, there was a misstep as well. Now, we accurately predicted test sales would double. But the company surprised us by reporting that it underperformed in terms of new-systems sales – coming in at 37 units (just below the previous year).

“The reason? Hospitals are proving stubbornly bureaucratic, and the time to get trial customers into signed deals hasn’t accelerated as expected. So, while the company has a healthy backlog of trials in place and has added another 15% to its installed network just as another test hits the market next quarter, it had to scale back its projection for this year to match the reality of sales’ lead times.”

And he remains quite optimistic — no longer with colorful language about how “it’s been a year in the making” and it’s all coming together on August 7, but still pretty bullish on the prospects:

“Now is just such a time to be buying when others are selling.

“We regularly tell subscribers to take advantage of Wall Street’s short-term thinking. You see, this company is growing quarter after quarter. This isn’t a trade for us. It’s a long-term investment. When we originally told subscribers about it last year, we said it would be a three-year payoff, and we stand by that. On our horizon, the company is continuing to perform as we would hope, with only small missteps so far.”

That wasn’t enough to drive the stock back above a dollar, but perhaps it helped to stabilize the shares around 90 cents, I guess we’ll find out as the story plays out over time and as we learn whether they sell more machines to hospitals or get usage up with their new tests — they’re going to have to get either a dramatic increase in revenue or a really clear runway to steadily climbing revenue to get investors happy again, methinks, but they could get cut in half again or double on pretty limited news because they’re so very small with a market cap now down to $68 million.

So … I’m sorry that I didn’t write about this one for you earlier in the week, when Daley was pushing it so heavily as a big buy before earnings… but, well, also “you’re welcome.” I didn’t know they’d stink up the room on earnings either, though I wasn’t betting one way or the other — I’ll keep it on the watchlist, I’m now quite curious to see whether they’ll be able to goose their equipment sales high enough that they don’t need to raise capital in the next few quarters.

That’s what I’ve been thinking about this week — anything you think should be hitting our radar screen? Let us know with a comment below.

  1. reported here:
  2. West Saturn, one of their newbuilding drillships, under contract this week:
  3. press release:
  4. great quarter :
  5. this article on Criteo’s competitor Rocket Fuel (FUEL):
  6. Bloomberg piece just today:
  7. finding opportunity:
  8. weak investment performance in July:
  9. this quarter:
  10. real numbers for the last quarter:
  11. assailed by Lemelson:
  12. yesterday afternoon on this note:
  13. release earnings on Wednesday:
  14. Casey teased it with his “Heads you live, tails you die” spiel:

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