Happy Anniversary!

Let me start this week’s issue by extending a heartfelt “thank you” to you and your fellow Breakout Stocks Under $10 members. One year ago yesterday we started this service together, so it was fitting that we got an opportunity to lock in our latest doubler this week when we sold Zale’s (ZLC). I sent you a Flash Alert on Tuesday recommending you cash in. The stock is still trading around where it was at that time, so if you didn’t get a chance to sell, I recommend you do so tomorrow.

A year after we began, I find myself more committed than ever to finding low-priced stocks with breakout potential. And you know what? Even though market weakness can be frustrating with its impact on stocks we currently own, it also expands our universe of opportunities. Already cheap stocks become even cheaper, and stocks that have been above $5 are coming back down into our target zone. I expect to add several such opportunities in the coming weeks, so stay tuned.

It means a lot to me that you’ve been with us in our inaugural year of Breakout Stocks Under $10.  I’ve convinced my publisher to help us show our appreciation with a special gift. You can click here for the details. Here’s to a fun and profitable second year for us!

Cautious, But Not Bearish

We may be celebrating our first anniversary here in Breakout Stocks, but any lingering cheer from the long holiday weekend quickly evaporated in the rest of the market yesterday as investors reacted very unfavorably to economic reports that suggested economic growth may be slowing. The monthly employment report from payroll processor ADP showed a net gain of only 38,000 jobs in May, well below expectations of 175,000 additional jobs. The government’s monthly employment report comes out tomorrow morning, and you know it will be an important one.

The market actually took ADP’s report somewhat in stride, but the selling intensified following the release at 10:00 a.m. of the Institute for Supply Management’s (ISM) gauge of manufacturing activity in May. It fell to 53.5% from 60.4% in April. A reading over 50% still indicates an expansion in manufacturing, but it was the largest monthly decline since 1984. The index is now at its lowest level since last September, the last time we hit a “slow patch” in the economy

When you combine these data with somewhat disappointing U.S. auto sales for May (hurt in part by supply shortages from the Japanese earthquake), softening manufacturing activity in China, and concerns over European debt and whether austerity programs will slow the economy there, it all adds up to caution over corporate profits.

None of the economic data leads me to believe that we are heading for a double-dip recession and a sharp decline in earnings growth, but it is possible that earnings estimates for the rest of this year are too high and may be revised. It’s still too early to speculate about earnings in 2012, but as we move through the second half of the year, that will become a more important barometer.

This week’s news actually doesn’t change our strategy here in Breakout Stocks Under $10. I still think the stock market may remain volatile at least until companies begin to report second-quarter earnings next month and we hear what the various managements say about their outlook for the third quarter and the second half of the year.

While we’re smart to be cautious, we need to guard against getting overly bearish. The evidence just doesn’t support it yet. On a technical basis, the market is still in a strong uptrend, with the S&P 500 more than 25% above its lows last August and just 4% off its highs a month ago. And as we’ve talked about, a certain amount of caution and worry is healthy for stocks as it prevents overheating.

From an economic standpoint, recent data may increase the likelihood of a slowdown, but it does not show a contraction in economic activity. I found it interesting that Ford, in releasing their monthly sales activity, said it would maintain its planned levels of production for the second and third quarters, which are solidly above 2010 production. Plus, interest rates have retreated sharply since February, with the 10-year Treasury note now below 3%. Low yields like this indicate a flight to safety, but they are also quite supportive of equity prices. Corporate borrowing rates remain low as well, which sparks M&A activity. That can be especially profitable for those of us investing in lower-priced stocks, as those companies are often attractive buyout candidates.

My view is that we are in a sometimes unpleasant but ultimately healthy period of consolidation. It’s even possible we could see a true “correction,” which is technically defined as a pullback of 10% – but keep in mind that we are already almost halfway there.

So we’re right on track with our strategy of taking profits like we did with ZLC, staying invested in stocks with specific catalysts to cause them to break out, and taking advantage of the selling to get into more breakout stocks at bargain prices and set ourselves up for nice profits when the market strengthens.

This Week’s Top Buys: C, RUTH, SIMG

Speaking of opportunities, I mentioned earlier that I’ve got my eye on several that I expect us to act on soon, so stay tuned. In the meantime, let me tell you about three stocks from our current Buy List that are compelling right now. Look to these stocks first if you’re just joining us or have new money to put to work:

1. Citigroup (C): I know we don’t plan to stay in C for a long time after the stock’s reverse split, but with most commentators very negative on financial stocks right now, this has the makings of a very good shorter-term contrarian play. The valuation is increasingly compelling, with shares now selling close to where they were a year ago despite an increasingly strong capital position that should give regulators the green light for a more significant dividend next year. There are also growth opportunities, as evidenced by the Chinese joint venture that we’ll talk more about in a moment. Buy C under our new limit of $44. 
2. Ruth’s Hospitality (RUTH): This a stock that has shown good relative strength recently but is still a compelling value, as we talked about last week, selling at less than 12X expected 2012 earnings per share (and only 5.36X trailing Enterprise Value/EBITDA earnings). Earnings should remain solid as long as business travel continues to improve. There is significant upside to our $8 target, which is based on multiples paid by private equity to acquire California Pizza Kitchen, arguably a less attractive business. Buy RUTH while it’s still below $5.50.
3. Silicon Image (SIMG) has pulled back in recent selling and is now trading right around previous support levels, so we could see a bounce. Last quarter’s results were very strong, and the company appears to be off to a good start in its mobile consumer electronic offerings. Buy SIMG under $8.50.

Get Ready to Sell LVLT, RDNT

In addition to buying opportunities, we’re also taking profits when it makes sense. Along those lines, we have two stocks that remain close to their targets that I expect us to sell soon, Level Three Communications (LVLT) and RadNet (RDNT). Let’s talk briefly about each.

LVLT has been strong because the market likes its proposed merger with Global Crossing. As we’ve talked about, the merger will yield tangible benefits. While the company is clearly headed in the right direction, it will be a while before it becomes profitable. With the stock up more than 65% for us and now just shy of our $2.25 target, I expect us to sell into strength (which, as you know, I always prefer to do). The stock has held up relatively well in the selling and looks to be consolidating around that price. With interest in the stock high right now, I look for another leg up, and we’ll likely lock in our gains at that point.

RDNT popped briefly over our $5 target last Thursday and Friday, and it pulled back to $4.50 on profit-taking. I expect it to move back over $5 as the company is still benefiting from improved results – imaging locations report an increase in “same store sales” – selective acquisitions and new financing that was put into place last year. The stock was incredibly undervalued at the start of the year, and it’s up 60% so far in 2011. RDNT dipped into the $4.30s in mid May before running up over $5, and I expect it to do that again. I’ll keep you posted, but we’ll probably sell if we get a solid move over that price. I will send you an alert when it’s time to bank our profits.

OPTR Receives FDA Approval

Just as we expected, Optimer Pharmaceuticals (OPTR) received FDA approval for its anti-infection treatment DIFICID, a new drug for c. difficile infection (CDI) of the stomach lining often acquired through hospital stays. And also as we expected, the stock got a bit of a lift on the news, but a lot of it was already priced in.

One of the most encouraging developments related to FDA approval was the label Optimer can put on the drug. The company can say that DIFICID was superior in clinical trials to vancomycin (the current standard of treatment) in sustaining clinical response through 25 days beyond the end of treatment. Earlier, there was a split vote among an FDA panel on whether the DIFICID’s superiority was statistically significant, but being able to declare this on the drug’s label knocks out most of the concerns raised by the vote and bodes well for early sales when the drug is launched next quarter.

I think DIFICID has the potential to be a real breakout drug because of its effectiveness in treating the serious and widespread CDI problem. Continue to hold for our $17 target. Depending on the broader market and launch developments, we may raise both our buy limit and target, but I want more information before making that decision.

Answers to Your Questions: Is It Time to Sell Sprint?

Sprint Nextel (S) is a fascinating story right now. Despite the initial sell-off when the AT&T/T-Mobile merger was announced, it has climbed back from under $4.50 in March to today’s prices around $6.

Hopewell recently posted a good question about S on the message boards:

Hillary: please update your advice on S in view of the recent strength and good gains since initially recommended. Is this the right moment of strength into which we perhaps should sell? As you noted in your comment, there are many outstanding issues, not the least of which is as to if and when S will actually start making money, Would really appreciate your current thoughts, particularly given the current uneasy, and possibly “toppy” market. Thanks.

Those are the right questions to ask, Hopewell, and I recorded the video below to share my latest analysis of S and what I recommend you do now:

Breakout News & Notes: LLEN, C, COWN, MPG, YMI

L&L Energy (LLEN) is in another bad stretch, falling down close to $5 and within striking distance of its 52-week lows of $4.29. There’s no real “new news,” but the double whammy of concerns about China’s growth and accounting questions surrounding many Chinese companies have intensified pressure on the stock once again. I believe in the long-term trends of coal, LLEN still appears to be a legitimate company, and I was hopeful that the recent shareholder visit to operations in China would have more of a lasting impact on the stock than we’ve seen.

I’m re-evaluating LLEN now and will let you know what to do soon, but I will say that my patience is wearing thin with management in the way they are addressing the financial integrity questions. Hold LLEN for the moment, but don’t put any new money into it.  

Citigroup (C), as we mentioned earlier, and Shanghai-based Orient Securities agreed to set up a Chinese joint venture for investment banking services. Citigroup will own one-third of the operation, which will offer equity and debt underwriting and advisory services,

This agreement is significant not only in the potential source of income and business diversification for Citigroup, but also in putting their difficulties during the financial crisis further in the rearview mirror. It shows us that Citigroup is no longer in a consolidation and divestiture mode, but now has the ability to selectively grow its businesses. While the recent performance of the stock has been disappointing, I feel that as long as earnings remain solid, investors will bid the stock higher.

Cowen (COWN) and LaBranche’s (LAB) proposed merger received a boost when Institutional Shareholder Services, a proxy advisory firm, recommended that shareholders of both companies approve the merger. In its report, ISS recommended approval based on the strategic opportunities and operating leverage the company would gain through the transaction.

The merger will almost surely be approved by shareholders of both companies at a special June 15 meeting. We’ve talked before about how the deal increases COWN’s share base by more than a third, and that has pressured the stock. Business, however, is improving, and the valuation is very attractive, so I want to see how Cowen management executes their strategy. Continue to buy COWN under $5.

MPG Office Trust (MPG) completed the disposition of the Westin Pasadena Hotel in California. That’s good news because, as you’ll recall, getting rid of underperforming properties is what I expect will unlock the value in this stock.

In this case, MPG received $92 million, net of transaction costs, of which $79 million was used to repay the mortgage loan secured by the hotel and an office building. The remaining $13 million, along with reserves totaling $2 million, were returned to MPG upon repayment of the mortgage loan. It is unrestricted cash, giving MPG a minor improvement in liquidity as it continues to dispose of non-core properties. MPG remains a buy up to $4.

YM Biosciences (YMI) said it stopped clinical trials of nimotuzumab for treatments of brain metastasis from non-small cell lung cancer. Nimotuzumab studies will continue with YM’s Phase II study in children with progressive diffuse intrinsic pontine glioma (DIPG), a cancer of the brain stem. YMI has concluded recruitment at multiple sites in the U.S., Canada and Israel and anticipates reporting results in the third quarter.

More importantly, YMI obtained orphan drug status in Europe for CYT387 for the treatment of certain forms of myelofibrosis. The potential new drug already received orphan drug status in the U.S. It’s a special classification given by the government for drugs that treat rare diseases. It provides benefits like tax incentives, extended patent rights and research subsidies to encourage development of such drugs. Buy YMI on dips below $3.30.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10

P.S. Don’t forget about our special one-year anniversary gift. It’s only available for a short time, so please don’t delay. You can click here for all of the details. Once again, thank you for being with us, and Happy Anniversary!