Best Buys for the New Year

This has been a pretty remarkable year in the markets already, with the Dow hitting several new all-time highs. Even with Europe’s never-ending debt crisis and fears over a slowing global economy, the market has gained and kept its momentum.

As I expected, the fiscal cliff was avoided, but nothing was done to stop the sequestration. But I am confident that Congress will eventually come together, much like they did with the fiscal cliff, and reach a deal to stop the deep spending cuts. I have my doubts we’ll get a full-blown plan by the end of the year, although that would be my preference because it would keep more people from becoming unemployed.

The other big factor that will influence stocks in 2013 is corporate earnings. The recent earnings season was a roller coaster ride, but the market managed to hold steady dispite some lackluster numbers.

Even though the economic recovery has been slow and we still face several uncertainties, I do see solid opportunities in the right kind of stocks. Nothing has changed my view that 2013 can be a good year for innovative companies with a proven history of growth, strong potential for additional growth in the future, and earnings that should be predictable even in a slower economy. Here are 10 of my favorite stocks that fit that description.

AutoNation (AN)

After being relegated to the dog house in the last couple of years, the auto retailing industry is starting to turn a corner. U.S. auto sales in 2012 reached $14.5 million, up 13% from 2011. Things are off to a good start in 2013, with January monthly sales at $15.24 million on an annualized basis – the third straight month to exceed the $15 million mark.

It’s clear that sales are finally beginning to pick up momentum, and that’s being complemented by the 11-year life span of a U.S. car. Consumers will begin replacing plenty of ageing vehicles over the next several years, which should add stability to results, and ultimately fuel growth as the U.S. economy picks up additional steam.

My favorite pick to benefit from continued improvement in sales is AutoNation (AN), a dynamic force that is changing the way cars are sold in the United States with a “no muss, no fuss” approach to the disdainful art of haggling. The company has been an industry consolidator, and this past week decided to house all of its dealerships under the “AutoNation” name, giving national brand recognition in an industry where local dealerships have dominated. It also does not have the European exposure or legacy pension and health benefit costs of the automobile manufacturers, which makes this a less risky play.

AutoNation’s roots go back to 1996, when business legend Wayne Huizenga’s Republic Industries began purchasing and building auto dealerships. AutoNation was born out of his rent-a-car business, and currently operates 210 domestic auto car dealerships in 15 states. Florida is the largest market for the company, with approximately 58 stores, followed by California with 36 stores and the Southwest/Rockies region accounting for the remainder.

One of the things I like best about this company is its large scale since it offers distinct competitive advantages. AutoNation can invest in planning and tracking systems that allow them to manage inventory profitably. Management is confident that they can respond to customer requests better than independent automobile dealers, while at the same time keeping inventory levels as low as possible to minimize carrying costs.

The company also believes its scale is helpful in securing desirable used car inventory, which it can then price competitively. Here is where AN puts its game-changing strategy to work. Last March, AutoNation began to roll out SmartChoice pricing, already in their Florida dealerships, on a nationwide basis. This pricing consists of separately showing the Manufacturer’s Suggested Retail Price (MSRP) and the dealer’s SmartChoice sticker price.

This was a nod to consumers, who in recent years have been increasingly negotiating new car prices since they are coming in with more pricing information from competitors thanks to the Internet. While the new pricing does not end negotiating completely, (AutoNation claims they still encourage negotiations) it does limit the amount of it, saving the consumer time and effort. With both prices put in front of them, consumers can start negotiations at a price lower than the MSRP, and they can feel more assured that they are getting a better deal.

This may sound like a similar set up to CarMax (KMX), a auto retailer that has also done well recently. I don’t like KMX as much as AN because it is also involved in financing. This adds an element of risk, especially since KMX exclusively sells used cars that will generally need to be replaced faster.

Revving Up For More

Like the overall industry, AutoNation’s revenues have been improving rapidly in recent years. After bottoming at $10.75 billion in 2009, down from amounts in excess of $19 billion earlier in the decade, revenues reached a post-recovery high of $15.67 billion in 2012. Operating profit of $645.3 billion was also a post-recovery high, and up from $387 million in 2009. However, where the company really excelled was earnings, which reached a record $2.52 a share last year. The EPS gains were driven by lower borrowing costs on outstanding debt to the current low level of interest rates, and a very aggressive share buyback program, with total shares outstanding falling from 273 million in 2004 to just 120.9 million as of December 31, 2012. The company is practically doing a leveraged buyout of itself, and should continue to benefit stock holders over the long term.

AN has the benefit of most of its gross profit coming from the less cyclical repairs business. In 2012, new vehicles contributed 59.3% of total revenues, but only 24.5% of gross profit. Parts and services, while only 14.4% of total revenues, contributed 39.9% of gross profits. Finance and insurance items, such as extended warranties and extended protection plans, are also critical to profitability. This is why after you purchase a vehicle, you are escorted to the office of the F&I manager, who tells you of the benefits of their program. Finance and insurance operations accounted for just 3.6% of sales, but contributed 23.5% of gross profit in 2012.

The company is beginning 2013 with a lot of momentum, after reporting strong results last Thursday. Earnings of $0.67 versus $0.50 a year ago were $0.03 better than expectations. Revenues were up 13.3% to $417, while operating profit advanced 17.5% to $168.7 million. The stock had a nice rally on the news, but has since pulled back along with the overall market to an entry price I feel comfortable with for further upside ahead. While U.S. consumer spending could be spotty at times this year, the long-term need for them to upgrade their automobiles will be a powerful tailwind for the company.

I also think the company will benefit from operating under the one brand name, which CEO Mike Jackson pushed for. Mr. Jackson has invested $3.1 billion in facilities since he became CEO in 1999, and he wants to make sure that his investment does not go to waste. I agree with him that building a powerful national brand is a good way to do that for both him and shareholders. Plus, in an industry where clarity, service and reputation are critical, the company’s effort to limit haggling for a price could build further customer good will. Buy AN below $50 for a target of $62.

MAXIMUS (MMS)

MAXIMUS (MMS) provides cost-effective processing services to government health and human services agencies in the United States, Canada, United Kingdom, Australia and Saudi Arabia. One of its main focuses is health care, providing administrative services for many of the programs we just talked about, including Medicaid, Children’s Health Insurance Program (CHIP) and Medicare.

MMS operates in two main segments: Health Services and Human Services. The Health Services Segment accounted for 64% of revenues in the last fiscal year (ending September 2012), and half of these revenues came from the states of California and Texas. The segment’s services include government health insurance enrollment and eligibility determination, health insurance exchange design and operations, consumer outreach to encourage enrollment, including operating portals to make enrollment easy, and independent medical reviews and health plan oversights.

The Human Services segment accounted for the remaining 36% of fiscal year revenues, with half of the revenues coming from outside the United States, primarily from the United Kingdom and Australia. This unit focuses on comprehensive welfare-to-work services, including eligibility determination, job-readiness preparation, job search and employer outreach. It also provides child support case management services and K-12 special education case management solutions.

The company performs all of its services through contracts with government agencies. The most common of these contracts are performance-based, which accounted for 44% of revenues in fiscal 2012. MMS is not paid under these contracts until certain performance milestones are met, although collection has not historically been a problem. MAXIMUS also performs services on fixed-price and cost-plus contracts.  At the end of the September 2012 fiscal year, the weighted average life of MAXIMUS’ contract was 4.6 years.

Our Opportunity

The company has some exciting catalysts for growth ahead that put it right in the middle of the game-changing developments the healthcare industry is experiencing right now. For starters, governments are currently under financial pressure, and at the same time have an increasing number of citizens seeking human services. There is also a growing need for governments to update and modernize these programs. MAXIMUS has the scale and capabilities to deliver these services more efficiently than governments can on their own.

In addition, more states will opt to shift more Medicaid patients to managed care programs from fee-for-services programs as costs rise. The company currently manages 17 state Medicaid managed care programs – that’s 52% of the total Medicaid managed care population.

The Affordable Care Act (ACA) will also have a very positive impact on the company’s results, as the ACA will lead to expansion of Medicaid and CHIP programs. MAXIMUS currently administers the CHIP program in 19 states that account for 59% of the total CHIP population.

In addition to these macro shifts moving the company’s way, MAXIMUS has competitive advantages that will help ensure future growth. The company has a long track record (dating back to 1976) of providing its government customers quality services and delivering successful outcomes. These services require a certain amount of experience and expertise that does lead to high barriers of competitive entry.  MAXIMUS has gained this expertise through real-world case histories. For example, when Texas expanded its CHIP program in 2007, MAXIMUS helped the state meet the challenges of increased enrollments, and collaborated with a state website to offer CHIP credit card payments online. The company also started TexKid.org, which allows residents to apply for CHIP benefits and search for a plan or doctor.

As I mentioned, MMS has a strong track record behind it, with solid growth, strong returns on capital, and a good amount of free cash flow generation relative to net income. The company also maintains a virtually debt-free balance sheet. From fiscal 2005 through fiscal 2012, revenues have increased from $648 million to $1.05 billion – an annual compound increase of 7.1%. Since 2009, this growth rate accelerated to 9.6%, aided by acquisitions. Operating earnings since 2005 have increased faster than sales, rising an average of 13% a year from $0.93 to $2.32 a share.

With many growth drivers in place, MMS is a solid company offering us a good buying opportunity. Buy MMS under $38.50 for a target of $47.50.

Cognizant (CTSH)

Cognizant Technology Solutions (CTSH) is well-positioned in one of the dominant themes in information technology (IT): the continued outsourcing and off-shoring of many functions overseas. Cheap labor allows companies to save a lot of money – money that can be the difference between survival and bankruptcy, especially in tough economic times.

There’s no question the game-changing country when it comes to IT outsourcing is India. This is no accident, as the government has instituted policies to encourage development of the IT outsourcing industry and focus on education to build a pool of talented professionals. In fact, there are more IT engineers in Bangalore than in Silicon Valley.

According to NASSCOM (India’s National Association of Software and Service Companies), India’s IT services offer a cost advantage of 60%–70%. I realize that statistic is from an association with a vested interest, but even if that number is a little inflated, it’s still a huge savings that businesses are attracted to.

Cognizant provides custom IT, consulting and business-process outsourcing services primarily for large global corporations, nearly half of which come from the financial services industry. The company is actually headquartered in Tea Neck, NJ, and it generates 80% of its revenues from North America, but more than 80,000 of its employees work in Asia.

Cognizant offers traditional outsourcing services including applications (i.e. customer service or accounting) and consulting (IT solutions and upgrades), and in the last few years, it has expanded to include two new growing areas: infrastructure and business/knowledge process outsourcing. Management is particularly excited about the latter, which provides value-added services to clients.

Stunning Growth

CTSH has been a poster child for growth over the years, with revenues increasing more than 225% from $1.4 billion in 2006 to $4.6 billion through 2010. That’s a phenomenal average of 26.8% per year, as the company benefitted from both the outsourcing trend as well as the breadth and quality of its offerings. Even in the recession year of 2009, revenues increased 16.4%. Earnings growth has been equally impressive at 28% a year those four years.

And here’s one of the things that makes Cognizant a game-changer: The company targets operating margins around 20%, which is well below many competitors with margins closer to 30%. The reason is CTSH’s commitment to future growth. A lot of their gross profits are reinvested into knowledge-building to better understand clients and their industries. Management believes gunning for higher margins limits long-term growth, and I think they’re right.

The stock had a slow start to the last quarter but bounced back 16% after reporting solid second-quarter earnings of $0.88 on a 20.9% revenue gain. The company gave full-year earnings guidance of $3.64 a share, which is solid growth of approximately 20% from 2011. Selling at less than 20X this year’s estimate, I see more upside as double-digit earnings gains are likely for years to come.

I like the company’s growth and its dominant position in an important global industry. The long-term trend for increased outsourcing remains strong, and CTSH will be one of the big beneficiaries. The company says it continues to take market share from competitors, and its higher margin consulting business is growing faster than the company as a whole. The company has also launched new services to drive growth, and earnings are expected to grow around 18% in each of the next two years. A lot of companies would kill for that kind of growth. Buy CTSH under $63.

Quality Systems (QSII)

Quality Systems (QSII) is a software-centric company in the medical information field that’s well positioned to ride a wave of healthcare IT spending. Its software is used to track patient health records to make sure that professionals – within and outside points of care – are able to collect, receive and use data in real time.

This kind of documentation is critical because it also helps healthcare providers and the government that ponies up payments to eliminate bloated costs. According to QSII, health care industry statistics claim that 25%-30% of lost medical practice income comes from improper billing. That’s a significant number, and Quality Systems has created software to help solve the problem.

QSII’s software extends across four segments: NexGen (helps physicians manage all aspects of their business), Hospital Solutions, Revenue Cycle Management, and QSI Dental. About 75% of total revenues and 94% of its operating profits are derived from the proprietary software known as NexGen Ambulatory Services, so NexGen is a key segment for the company.    

QSII has experienced what I believe will prove to be a short-term bump in the road, and which gives us a chance to get in for the turnaround. The company had signed more service agreements that carried lower gross margins, which slowed license growth and led to only 7% revenue growth in the latest fiscal year (ending March 31) vs. mid-teen growth in previous years. Operating income dropped by double digits as its hospital division lost money.

Knowing what was coming, management lowered its fiscal year guidance last July and the stock dropped 30%. Quality Systems has reacted quickly to cut costs, restructure its operations, and make its selling cycle more efficient, including renewed efforts to cross-sell among its platforms. In addition, an activist director, who had been looking to replace the board with his own nominees, recently resigned, so now QSII can focus on its day-to-day operations.   

Share prices have stabilized since, and while it will take some time for these efforts to show results and boost the bottom line (QSII missed earnings expectations by $0.05 last quarter), valuation indicates that expectations for the company are low and the stage may be set for positive surprises.

The Demographic and Political Wave

A lot of that has to do with what’s going on the industry right now. Overall demographic and technological trends in QSII’s key markets point to a strong recovery. Healthcare IT spending is growing at a 28% annual clip, according to industry research firm RNCOS, and should reach $13 billion by next year. The return on investment for healthcare practitioners is significant, as the Medical Group Management Association reports that nearly 60% of providers who use outsourced billing technologies see decreased denial claims, and 73% see better cash collection cycles. NexGen’s provider-installed base at the end of its recent fiscal year (March 31) stood at 75,000 users, who utilize the company chiefly for managing their health records, and allow Quality Systems to enjoy a visible revenue stream, of which 73% is recurring.

One important catalyst for growth in that installed base comes from the U.S. government’s push for healthcare IT spending that has been gathering momentum since 2009, when the American Recovery and Reinvestment Act was passed by Congress. The act earmarks $60 billion (via grants and incentives) for the adoption of healthcare IT – and $20 billion of that sits squarely in QSII’s sweet spot of records automation. Simply put, the move to better and faster IT in the healthcare industry is a game changer, and QSII is ready to benefit. 

How much of a game changer? Healthcare spending is 17% of U.S. GDP, and as Baby Boomers age and need more healthcare services, knowing where every dollar goes and squeezing that dollar for efficient services, will be of paramount importance. And the opportunity to tap into growth is significant, as Quality Systems estimates that 35% of all physicians and hospitals still do not have electronic health record systems.        

QSII also believes that there is ample opportunity to grow into markets that have already adopted some form of healthcare IT. In its latest presentation to investors and analysts, the company estimated that only 50%-60% of ambulatory services (i.e. outpatient physician care) have adopted software programs. This is a sizeable $6 billion market, so that leaves plenty of untapped customers. Even more impressive is that the Revenue Cycle Management market, which is a $50 billion market in terms of revenue potential, has seen only 20%-25% penetration.

It’s safe to say the runway is clear for more adoption of technology. Healthcare legislation passed by the Obama administration mandates better documentation of diagnoses and treatment to ensure that Medicare and Medicaid are not overpaying, and also includes cash incentives for IT expansion.   

Against this strong fundamental backdrop, QSII trades for 15X forward Street estimates and has an EV/EBITDA multiple at about 9.5x. The company also has an impressive free cash flow at nearly 6%, even in the past year when there was significant reinvestment in the business. In addition, the stock has a very attractive 3.9% dividend yield, so we can collect income while waiting for shares to reach our target.

Driven by severe under penetration in its key markets, support from government initiatives, and its sizable market position/mindshare, QSII appears well positioned to ride the healthcare IT spending wave for both the near and long term. Add this to already healthy margins, a promising-looking turnaround and an undemanding valuation, as earnings and sales take off, so, too, should the stock. Buy QSII below $19 for a target of $25.

HomeAway (AWAY)

I’m recommending today’s stock because the arrival of spring – it’s a breezy 75 degrees in New York today! – means summer is not far behind and I’m ready for vacation. OK, just kidding. Well, sort of. I would obviously never buy a stock because I’m ready for vacation, but I would because other people are.

Chances are you’re thinking about upcoming vacation plans, and if you’re like most folks, perhaps the biggest game changer of all – the Internet – will be part of your planning. It’s not only a great place to research potential destinations and read reviews from other vacationers, but it’s also a place to find the best deals on a getaway. And with cautious consumers still watching their wallets, many are turning to vacation home rentals as a popular and economical alternative to hotels.

Spending your vacation in a “home away from home” does have some nice benefits. Vacation homes offer more for the money, literally. The average vacation rental home of the company I’m recommending to you today is 1,850 square feet, more than five times the average hotel room’s 325 square feet. Most rental homes and condos come equipped with a kitchen and dining space, allowing travelers to save money by eating in if they choose. And there are additional amenities you don’t often find in hotels. Some owners provide freebies, like portable playpens or high chairs so you don’t have to haul everything from home, and many are dog-friendly as well. (And no, I’m not recommending this company because I’m a dog lover either!)

More and more people are looking for these kinds of accommodations, and that’s why I see a good opportunity for us in HomeAway (AWAY), the world’s leading online marketplace of vacation rentals. HomeAway’s bevy of web sites include over 711,000 paid listings of homes for rent in 171 countries. The sites put travelers in direct contact with property owners who can showcase pictures, availability and pricing for homes, condos, villas and cabins.

I really like AWAY’s global reach. Take a look at its web site, and you’ll see almost every country in the world represented, giving travelers nearly limitless options. Its portfolio of websites is growing, too, with sites ranging from Germany and France to Brazil and Australia. Current U.S. sites include some you may well be familiar with: HomeAway.com, VRBO.com (stands for “vacation rentals by owners”) and VacationRentals.com. HomeAway also operates BedandBreakfast.com, a global site for finding bed-and-breakfast properties for travelers looking for another lodging alternative, and AWAY has also developed software solutions for property managers and innkeepers.

With the Internet, it almost always comes back to the deal you can get, and AWAY has smartly capitalized on this by offering big savings on nightly rates. For example, a night in New York City runs $219, while a hotel is $350 on average. A night in Rome is $180 versus $222 for a hotel. The larger size of the dwelling can also accommodate larger groups for those traveling with children, extended family (including the dog-friendly properties!) or for special events such as graduation.

Once and Future Growth

One reason AWAY is especially attractive right now is that it is in the midst of solid growth, and there is a high degree of confidence that growth will continue. Last year was a strong one, with HomeAway growing revenues 21% in 2012 to $280.4 million. The company’s bread and butter are sales from rental listings, which accounted for 85% of total revenues and were up a nice 19% from the prior year. Adjusted earnings grew at a similar rate, rising 20% to $80.3 million. I also like that free cash flow, one of the best indicators that a company is doing well, jumped more than 30% to $85.3 million.

The most recent quarter was similarly strong. Listing revenue increased 22.8% to $62.4 million, and free cash flow grew an excellent 47.1% to $21.9 million. The company was consistently in-line and even ahead of their expectations.

One of AWAY’s most significant accomplishments last year was migrating VRBO.com to the company’s common network. That allowed HomeAway to achieve critical mass, with 75% of total listings now accessible on their global platform. This is important for long-term growth because it paves the way for a more robust tiered pricing system, with new bundled product offerings, the advancement of e-commerce and an improved user experience for property owners, managers and travelers. In fact, HomeAway’s primary focus in 2013 is the continued rollout of their e-commerce capabilities, particularly the introduction of their pay-per-booking pricing model and continued distribution of value-added services.

The company has also continued to expand its offerings. In March, AWAY announced a partnership with Travelmob, an Asia-based site that matches owners of vacation rental properties with travelers. The deal led to an upgrade by Morgan Stanley. And just this week, HomeAway announced a distribution partnership with three leading timeshare entities, Island One Resorts, Welk Resorts and ResorTime.com to list timeshare inventory on HomeAway.com.

For 2013, management has guided for more 20%+ growth, with revenues expected to increase to $339-$343 million and adjusted earnings to $97.5-$100.5 million. HomeAway is scheduled to report first-quarter earnings in about two weeks (on April 23), and I expect the company to do well. Positive guidance for their busiest months to come – the summer and year-end holidays – should be another catalyst for the shares.

AWAY hit a 52-week high of $34.09 after bumping up following the last earnings report and news of the latest partnerships. A wave of understandable profit-taking brought the stock down to $30, and now is a good time to get in. Buy AWAY below $32.50 for a target of $45.

Cree (CREE)

Cree (CREE) is one of the few pure-play, publicly-traded companies that makes and sells LED bulbs at an attractive price.

While there are larger players dipping their toes in the LED lighting market, including General Electric and Philips, these companies also have other product lines that can take away from their ability to bully Cree out. Even so, there’s plenty of room for everyone as the pie gets bigger. IMS Research estimates that there are 5.6 billion light bulbs in U.S. residences, of which 4.2 billion are incandescent and another 1 billion are fluorescents. That’s a pretty “greenfield” market. As a result, the industry is expected to hit $94 billion in revenues over the next six years, and LEDs are now estimated to account for 45% of general lighting in 2016, and as much as 70% in 2020.

Cree’s potential to grab a big slice of this pie has been evident in its numbers over the past few years. In 2007, CREE had $394 million in revenues, of which 77% came from LED lighting and components. It managed to keep growing through the recession, and since 2009, revenues have increased at a 25% compound annual rate, while operating income has pretty much kept pace over the same period, at nearly 24%.

Cree currently gets 94% of its revenues from its LED segment. Of that, 58% is tied to LED components (lighting components, and specialized semiconductor materials) and the remainder, or 38%, comes from actual lighting fixtures and bulbs. 

Pricing has traditionally kept LED lights out of many people’s homes, but Cree has a leg up here, too. The company is bringing LED lighting to the masses with a much easier to digest price tag. Its 40-watt LED bulb costs $9.97, and its 60-watt bulb is $12.97. Management believes these price points will attract residents to make a change, and claims that consumers can save $61 a year by replacing old bulbs with Cree’s LED lights in a home’s five most frequently used light fixtures.

Cree is able to sell bulbs at such an attractive price point because it has a vertically integrated model.  This means that the company sources materials, builds its components, uses them in its lighting, and sells them while controlling key points along its manufacturing chain to help keep costs in check. As a result, margins have been steady, with gross margins in the high 30% range over the past few years, and operating margins (non-GAAP) in the low to mid-teens. 

Cree sells these bulbs at retail exclusively through Home Depot, which represents 10% of total sales. Home Depot stocks the bulbs at more than 2,000 outlets nationwide, giving Cree strong exposure that will help garner a growing base of residential sales. The company also has a nice presence globally, garnering 30% of its revenues from China. The Chinese government has been quite vocal about its initiative to phase out incandescent lighting by 2016, so management sees this as a growing market opportunity.

Cree has had a very strong 2013, but pulled back over 25% from a recent mid-$70’s high to $55 in August on a quarterly earnings report that disappointed investors. The company missed revenues by a paltry $3 million on the top line (due in part to some lighting project push outs that have since recovered in the current September quarter), fell just shy of earnings estimates by a penny (on a slight shift in lighting mix to lower-priced LED), and gave revenue guidance for the current fiscal year that, although broadly in line with estimates, spooked the market. Management guided for quarterly revenues of $380-$400 million, while consensus was at $398 million, and earnings of $0.36-$0.41 a share, with analysts expe