Europe Fears Continue

The U.S. stock market is facing its biggest test so far of the massive rally that began in early October. The problem, as always, is Europe, because the U.S. economy continues to hang in there.

This week’s concern is rising yields on troubled European debt. Spain became the latest country to see the price of its 10-year bonds hover near 7% following a poorly received government auction earlier today. While there is nothing particularly magical about the 7% mark, it is considered the point at which borrowing costs may not be sustainable, and it is the yield level at which Ireland and Portugal sought bailouts from the European Union (EU).

The market’s preference for Spanish debt over that of Italy, whose 10-year bonds also yield around 7%, came to an abrupt end late last week. Italy has an overall larger public debt than Spain, but it also has more tools to deal with the problem. Spain has fewer options due to its weak economy (a record 5 million people out of work and unemployment at 21.5%) and the worst of the real estate crashes. What makes the situation with Italian and Spanish debt even more troubling is the fact that yields have risen even with European Central Bank (ECB) trying to lend support by purchasing bonds.

Perhaps the biggest development, though, is the rise of yields in France to 3.8%. While that’s nowhere near as high as Spanish or Italian bonds, it is now nearly 200 basis points higher than Germany’s 10-year bond yield. France has the second-largest economy in the euro zone after Germany and was expected to be one of the stalwarts to help lead the continent out of crisis.

The high yields in Italy and Spain are not sustainable, and a corresponding spike in France would really spook investors. If there is a bright spot in this, it would be that these latest developments could light a fire under the European Union to really come up with a comprehensive solution. Progress has been made in Italy and Greece, and French President Nicolas Sarkozy implemented austerity measures over the summer, but the approach so far has been more piecemeal, putting out fires as they spring up. The market is telling leaders over there that this is not acceptable, and I’m hopeful the message will finally be received. One idea that is reportedly being kicked around is having the European Central Bank (ECB) lend to the International Monetary Fund (IMF) so it would have enough money at its disposal to bail out even the biggest nations.

Here in the U.S., the economic news has again been a little better than expected. Weekly jobless claims fell to a seven-month low this morning, and housing starts were down less than expected. The Philadelphia Fed manufacturing report for the Mid-Atlantic region showed a slowdown, but even there, some elements were better than expected, including employment and the six-month outlook.

Still, the stock market’s recent pattern of a morning decline followed by a rally after the European markets closed came to an abrupt end on Wednesday after rating agency Fitch said U.S. banks could be harmed if Europe’s debt crisis spreads, and the selling continued today as stocks fell with the mounting concerns over Spain and France. While Fitch’s statement was a warning and not any proclamation of doom, it was another reminder that the United States is impacted by the crisis. This is especially true of U.S. multinational corporations that derive a good bit of revenues from Europe.

The big question for investors is how significant that impact will be. We should learn more shortly after the Thanksgiving holiday as companies hold analyst meetings in December and begin to offer 2012 guidance. That will give us some information about what companies themselves are expecting for 2012, and then we will see if any adjustments are already priced into stocks.

As we’ve discussed, I believe companies can lower 2012 earnings expectations within reason without the market reacting strongly. Valuations remain attractive right now, and savvy investors know these volatile times can offer excellent buying opportunities in stocks that have dropped dramatically in price. I have one such opportunity to tell you about now. It falls outside our usual target of stocks under $5, but I don’t want us to miss out on its real breakout potential, so it’s worth bending the rules a little bit. It should be a familiar name to many of you: a one-time industry leader that has fallen out of favor but is itching for a rebound.

New Breakout Buy: Research in Motion (RIMM)

It may be hard to remember a time before the iPhone (and many of us wouldn’t want to), but it was not the first all-in-one mobile innovation. That distinction belongs to the BlackBerry, which revolutionized the industry with its introduction in 1999. The iconic technology captured a very loyal customer base, and I myself still use a BlackBerry and find it easier to use than an iPhone.

But with the majority of folks having moved on to a whole new generation of smartphones, it’s no surprise that the BlackBerry’s manufacturer, Research in Motion (RIMM), has lost its once-dominant market share, in part due to the emergence of Apple products and smartphones that utilize Google’s popular Android operating system. The company has also struggled to develop a popular touch-screen phone, with some of its past offerings plagued by screens freezing. And you may remember the well-publicized four-day service outage in October, which left millions of BlackBerry users on five continents (including yours truly) without email, instant messaging and browsing.

After hitting $70 earlier this year, RIMM is now trading under $20. The market is valuing the stock as though it expects it go out of business.

But that’s not going to happen. Instead, even at just over $18 a share, this is a stock that fits our Breakout model so well that the risk/reward characteristics are too good to pass up. Let’s take a look at what is going to help this beaten-down company break back out.

Loyal to the End

It’s often said in business that getting new customers to increase sales isn’t the best way to improve your bottom line. Instead, it’s focusing on the smaller but ultimately more lucrative percentage of repeat buyers. RIMM’s BlackBerry still has a significant customer base of 70 million subscribers worldwide. While it’s natural for there to be some defections as more smartphone alternatives become available, features like an intuitive keyboard keep it very popular among corporate users – a segment I do not expect to suddenly migrate away.

Most importantly, Research in Motion is developing new and better devices for these customers. Just this week brought the introduction of the BlackBerry Bold 9790, which features the company’s popular keyboard and touch-screen capabilities. The phone also offers enhanced social and multimedia applications, as well as powerful productivity features that allow for document creation. RIMM’s product offerings also include BlackBerry Playbook, the first professional-grade tablet, and software systems. The new BlackBerry 7 operating system contains NFC (Near Field Communication) “virtual wallet” technology, which lets devices wirelessly transmit data such as payment info, loyalty points and coupons to nearby receivers. Management believes that NFC in their phones will make a big difference in efforts to maintain and grow corporate accounts.

While BB7 has been well-received, the buildup to it was rocky. Management claims that the second quarter was hurt by a product transition to the operating system. While this statement has been met with some skepticism, 50% of retail sales in international markets through the first two weeks of the third quarter (to be reported in December) were due to the introduction of BlackBerry 7 products. In addition, 35% of retail sales in the United States in the last week of the second quarter were BlackBerry 7 products. So while the company may be overstating the impact of the product transition in their analysis of the disappointing quarter, it looks like the wait for BlackBerry 7 did hurt sales to some extent.

Attractive Profitability

While the stock has taken a hit, RIMM’s products have helped it remain highly profitable. Through the first six months of fiscal 2012, which ends next February, the company earned over $1.1 billion (adjusted for expenses related to a cost optimization program). While this is less than the $1.5 billion earned through the first six months of fiscal 2011, RIMM still has a solid operating margin of 14.2%. In addition, the balance sheet is solid with net cash of around $2.50 a share in cash.

Earnings in fiscal 2012 are expected to decline to $4.74 a share from $6.34 a year ago. But with the stock selling at less than 4X expected earnings for the current year, the market is pricing in more earnings declines ahead. I think a lot of the bad news is already priced in, and if the new products are as successful as the first signs indicate they will be, the stock could move quickly from these very low valuations. In fact, the low prices have has not been lost on some accomplished investors. Billionaire investor Lee Cooperman of Omega Advisors, a man with a reputation as a shrewd value investor, purchased 1.4 million shares of RIMM in the third calendar quarter of 2011. This is good company to be in.

As I’ve mentioned, RIMM’s stock price is higher than our usual $5 limit, but this is an exciting opportunity to get an iconic name at a very discounted price as it trades on the low end of its 52-week range at a time when the future is looking brighter. The company has struggled, but it is not falling apart, and its vast installed base of customers and interesting new products will keep it afloat until operating declines begin to level out. That’s when the stock should break out. Buy RIMM below $21 with a target price of $30, which would be 60% gains from today’s closing price.

Top 3 Buys: ESIC, LMLP, RUTH

In addition to RIMM, here are three companies currently on our Buy List that are strong buys this week:

Easy Link Services (ESIC) shares are still depressed due to an ongoing patent infringement suit against the company by I2 Global Communications. But even the worse-case scenario – an affordable settlement – would not weaken ESIC’s balance sheet. Despite the pullback, the company is doing well operationally and selling at an attractive 8X fiscal July 2012 earnings. ESIC is a buy below $6.

LML Payment Systems’ (LMLP) winding down of its patents rights operations has had the market concerned, since it has netted LMLP a ton of cash. However, the market is missing the fact that the company has approximately $1 a share in cash, as well as a profitable payment system business that is growing revenues at a rate of 27% a year. The stock has shown some strength recently, and I feel further gains are ahead. Buy LMLP up to $2.50.

Ruth’s Hospitality (RUTH) remains one of our most attractive opportunities right now, due to improving sales and earnings, and favorable valuation. Management has done an excellent job of managing rising commodity costs, and still has plenty of room to raise prices if necessary given their competitive pricing. The company is entering the seasonally critical fourth quarter with good momentum, and remains a viable takeover candidate with its attractive 5.08 enterprise value/earnings valuation. RUTH is a buy under $5.50.

Breakout Earnings: CMRG, YMI

A couple of our companies reported earnings this week, including Casual Male (CMRG), which took a 10% hit today after this morning’s disappointing third-quarter report that saw total revenues of $89.4 million fall well short of the expected $94 million. Comparable store revenues gained 0.7% on top of a 3% gain last year.

Management blamed the poor revenue performance on warmer-than-expected weather, and pointed out that many of the Destination XL stores – which is where I see the growth – have only been open a year and faced difficult comparisons. However, management was pleased with sales at their new, larger Destination XL stores, which hosts all of the company’s existing formats in one location. These new stores produce on average 15% more sales than the conventional stores they replace, so management remains confident in the concept. With the addition of 50 new Destination XL locations in 2012, the company hopes they can resume solid growth next year.

Gross margins hung in very well considering the sales shortfall, with a decline to 45% from 45.7%. Operating expenses were well controlled, and excluding a $1.4 million charge, operating income was $14,000 versus a loss of –$827,000 last year. CMRG lost ––$0.03 a share in the quarter. Excluding expenses related to a lawsuit, earnings were flat. Expectations were for $0.02.

Due to the current sales struggles, which have continued into November, management lowered earnings guidance for the year to $0.35–$0.38 a share from $0.40–$0.45. While we never like to see guidance lowered, I still believe that results will improve as more Destination XL stores open. With the lowered expectations, I am lowering our buy limit for new money to $3.75 and adjusting our target to $5.75.

YM Biosciences (YMI) saw results improve in the third quarter, reporting a loss of C$0.01 versus a loss of C$0.14 a year ago.

The company ended the quarter with $73.5 million in cash and equivalents, which should be sufficient to fund its operations for the foreseeable future, given YMI’s cash burn rate of $6.3 million in the quarter.

As a developmental stage company that had just $250,000 in revenues in the quarter, the results are not as important as the upcoming preliminary results it presents at the American Society of Hematology Annual Meeting on December 12 for its Phase I/II myelofibrosis study of CYT387, a JAK1/JAK2 inhibitor. Strong data here should allow the drug to enter Phase III testing, and perhaps enable the company to earn a lucrative marketing agreement with a major drug company, which would be a significant catalyst for the stock.

As expected, a potential competitor drug for CYT 387, Incyte’s Jakafi, was approved by the FDA for treatment of myelofibrosis. While Jakafi has the advantage of being approved first, its tests have not shown the effectiveness of treating anemia associated with myelofibrosis that CYT 387 has. I still see significant upside potential in the stock, and YMI remains a buy below $3.30.

ETFC Trading Stats Rise

E*Trade (ETFC) saw trading statistics rise in October, as market volatility sent trades up 8.5% year-over-year and 3.2% from September. End-of-period brokerage accounts of $2.77 million were up 4.2% from a year ago and down just slightly from September.

As I discussed last week, Goldman Sachs’ review of strategic alternatives for ETFC has concluded a sale of the company is not its best way to maximize shareholder value. The news disappointed the market, and shares have declined 10% since the announcement. However, I believe this is the best move for the company and think better times are ahead as ETFC returns to profitability. It has a strong consumer franchise in discount brokerage, and at some point, the losses in the legacy mortgage business will subside and profits will increase significantly. With the stock selling at a discount to tangible book of $10.26 a share, I believe the market is overly negative about future mortgage losses. ETFC remains a buy under $12 for a target of $16.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10