What Comes Next?

There’s no question we are in a panic market. As evidenced by today’s wipeout, investors are dumping stocks just to dump stocks, and the suddenness and severity of it has caught me – and many others – by surprise. I think a very accurate perspective on the situation came from veteran market observer Laszlo Birinyi, who said there have never been so many factors, inputs and issues directly and indirectly affecting the stock market.

In other words, investors are having a hard time making sense of all the swirling headlines right now and figuring out what’s next. The lack of clarity has been building in recent months as our elected officials bickered on and on and pushed the debt crisis to a last-minute resolution over the weekend. That had investors already on edge, and the spate of weaker-than-expected economic data have brought on the sell-first-ask-questions-later mentality.

Should we a) adopt the same mentality, or b) instead of figuring out whether the market will be down again tomorrow, make our decisions based on where we think our investments will be in six months, a year, 18 months from now?

For us as investors in lower-priced stocks whose stories often take some time to play out, the best answer is “b.” That doesn’t mean it’s the easy answer, and I fully realize that. In this kind of market, nobody can say with certainty whether stocks will be up or down tomorrow. I can tell you that we’re due for some sort of bounce from extremely oversold conditions, but I also think stocks will remain volatile for a while with all of these sometimes-contradictory inputs.

On the positive side, the “meat and potatoes” of the stock market – earnings, valuation and interest rates – actually paint a pretty good picture, even with signs of slower growth. But when sentiment is negative, everyone focuses on the slower growth or, as we’re now hearing bandied about, the possibility of another recession.

Based on all of the evidence so far, I do not think another recession is very likely. One story I read today argued that investors are now pricing in a second recession. That may well be true, but if it is, I think they’re overshooting the mark and setting the stage for a rebound as we finish out the year.

My view is that we are clearly in a soft patch economically, but the evidence so far points to a slowdown and not a contraction. Corporate earnings may be slowing, but they are not collapsing. Guidance has become more cautious over the last couple of weeks, but again, most companies still expect to grow.

The blended earnings (reported results combined with expected results) growth rate for the second quarter is currently around 11%. Looking ahead to the third quarter, current estimates call for growth of more than 16%. We’ll have to watch for downward revisions, but it’s clear that growth – and potentially pretty good growth – is expected.

Perhaps the biggest factor of all is one that has not been talked about as much in the last few days: the Federal Reserve. Ben Bernanke and company meet next week and will issue their next policy statement. They have said before that the central bank stands ready to step in and support the economy if needed. Well, it’s looking more and more like it’s needed, especially if tomorrow’s unemployment report is bad. Part of that support will be in the form of low interest rates, which are easy to dismiss because we’ve gotten accustomed to them, but they really are a powerful tool for promoting growth. In addition, I would not be at all surprised if the Fed kicks off additional quantitative easing to stimulate the economy.

With today’s big sell-off, the market has hit the 10% drop that technical analysts consider a “correction.” In any correction, an awful lot of babies get thrown out with the bath water, and we’re seeing that right now. Believe me, I know how unpleasant these kinds of markets are; I invest my money right alongside yours. As we’ve talked about before, the lower-priced stocks we own here in Breakout Stocks Under $10 are, by their very nature, impacted more by volatility than higher-priced stocks.

I know how strong the urge can be to join the panic selling and just dump your stocks. But after more than two decades as a professional investor, my best advice to you is to resist that urge and hang in there. Stay focused on the longer-term outlook, which, paradoxically, is often easier to see than trying to figure out what stocks will do tomorrow.

I also know it takes guts to buy stocks in a falling market, but I can tell you that some of the most profitable investments I’ve ever made came by being a bit of a contrarian and jumping in to great stocks when everybody else was bailing out. Along those lines, let me tell you about a company that I’ve been watching for a while, and now that the stock has come back down everything else, it has even more upside potential for us.

New Breakout Buy: XPO

Express-1 Expedited Solutions (XPO) is a shipping company, and while it may seem counterintuitive to invest in such a company in the midst of concerns about a slowing economy, I would tell you this is actually a very good time. We can get in at cheaper prices and be in excellent position for when the economy picks up steam again.

Let me give you a brief description of the company. XPO has three main business units:

Express-1 is the biggest division, producing 48% of revenues in 2010. It provides expedited surface transportation and has helped XPO become one of the largest ground-expedited freight carriers in North America. The key word here is “expedited,” as Express-1 transports time-critical, time-sensitive or high-priority freight, much of which also has special handling needs.

Concert Group Logistics (CGL), which brought in 40% of revenues last year, provides domestic and international freight forwarding services. One thing to note here is that XPO is a “non-asset” service provider, which means that practically all of the vehicles used in the transportation services are actually owned by other providers. CGL basically operates a network of independently owned freight forwarders. These independent owners operate stations within exclusive geographical regions under long-term contracts with CGL. The business is built on the concept that customer’s needs are served best when owners deliver the freight. (The company is actually very customer-focused, which is one of its strengths. It pledges that an employee will answer the phone by the second ring.)

Bounce Logistics provides premium truckload brokerage services to customers in the trucking industry, so that match up customers that need goods hauled with the truckers who transport them. This is a relatively new segment that began operations in 2008. It accounted for the remaining 12% of sales last year. Like CGL, this division takes pride in their premium customer services. They refer to themselves as the “un-broker” on their website, believing their service is superior to that of their rivals.

A Proven New Leader

XPO is well-managed and has performed solidly in tough economic times before. I believe will become an even stronger, faster-growing company because of new ownership and leadership.

Bradley Jacobs has agreed (along with minority partners) to invest $150 million in the company in warrants and convertible preferred stock that would give him and his partners 73% of XPO. He will also become chairman and CEO.

What’s so special about Bradley Jacobs? He has a track record of building multibillion-dollar companies through acquisitions, including United Rentals, a company that rents construction and industrial equipment, and United Waste Systems, the fifth-largest solid waste company in the U.S. at the time of its sale.

His big investment clearly shows he feels he can do same for XPO. In fact, Jacobs believes it could be easier with XPO because the freight forwarding industry is less mature and more fragmented than the waste and equipment rental industries. He thinks XPO, with its strong industry position, has the ideal platform in place to grow it into his next multibillion-dollar business.

We will probably not have a lot of specific details on Jacobs’ plans until the deal closes and he officially takes over as CEO. However, we know his track record, and we know XPO’s market position. We also know what investors initially thought of the news. The news was announced on June 14, and XPO ran from a closing price of $2.19 the day before to a 52-week high of $4.38 on July 22.

In the recent sell-off, XPO is now back down to $3.09, an attractive entry point for those of us focusing on the longer-term opportunity. XPO is a solid business and now has the additional breakout factor of a proven new leader, giving us an exciting opportunity to partner with a man who has built great companies and created significant shareholder wealth in the past.

Buy XPO up to $3.50. The stock could continue to get bounced around in the current volatility, and I view additional pullbacks as even better buying opportunities. There should be another move up once Mr. Jacobs takes over and lays out his plans for growth. Our initial target is $5, which would be gains of 60% from today’s closing price.

This Week’s Top Buys: LF, SIMG, LMLP

In addition to XPO, if you’re ready to scoop up buying opportunities in this market, here are three stocks currently on our Buy List that look good right now:

LeapFrog (LF) has fallen back in the market weakness; however, I remain very upbeat about the company’s prospects for the remainder of the year. As I’ve mentioned before, the new LeapPad tablet should provide a nice boost. Strong pre-order sales and favorable reviews make me optimistic it will be a winner for the company in the second half and beyond.

LF’s recent second-quarter earnings release (which we’ll talk more about in a moment) was encouraging, and point-of-sales revenues for the company have been solid all year. LF is a buy below $4.50.

Silicon Image (SIMG) reported very strong second-quarter earnings this week that show the company is building a solid presence in the growing mobile HD field. The results are especially impressive given weak industry conditions and slow sales of HDTV, and they are further evidence management has SIMG well-positioned to take advantage longer-term trends. With just 20% to 25% of smartphones equipped with HD video, there is room for significant growth.

Buy SIMG under $8.50.

LML Payment Systems (LMLP) has given back most of its gains in the midst of the market correction, and it is now back under our buy limit. LMLP has nearly $1 a share in cash thanks to the company’s recent patent enforcement efforts. These settlement payments have been a lucrative boost, but not its only source of gains. One of its main divisions, the transaction payment processing unit, grew an impressive 30% last year, and expansion of its electronic payment systems is looking promising.

LMLP is a buy while you can get it under $3.25.

Breakout Earnings: FIG, OPTR, MGIC, RUTH, SIMG, LF, GLUU, LOCM, MPG

It’s been another very busy week in terms of earnings, with nine of our companies releasing results. Even though the stocks have gone down, the reports were generally quite encouraging. Here’s the latest on each, starting with two that reported this morning:

Fortress Investment Group (FIG) reported second-quarter pretax distributable earnings of $46 million, down from $73 million in the second quarter of last year, as the rough macro environment hurt hedge fund performance. On a per-share basis, this worked out to a decline to earnings of $0.09 from $0.14 a share. Pretax distributable earnings per share were $0.19 in the first quarter of this year.

One positive note: The board has reinstated the dividend, signaling their confidence in the company and its future. The payment will be based on the company’s results, not a fixed amount. The distribution will be $0.05 a share to Class A shareholders in the fourth quarter of this year.

Book Value closed the quarter at a little over $2 a share, which is down slightly from the start of the year. Deferred incentive income, which the company does not calculate as part of pretax distributable earnings, increased.

Results were slightly worse than expectations of $0.11 of pretax distributable income, but once we get through the current selling, the stock could be supported by the initiation of a dividend. If the market stays tough for a while, that could be a challenge for FIG, but I view the valuation as quite favorable and still like its long-term potential. I may adjust our buy limit in the wake of recent selling, but I continue to recommend it, and I still like our $12 target over time.

Optimer Pharmaceuticals (OPTR) lost $0.52 in the second quarter on sales of $24.2 million. These results are largely irrelevant to the company’s future prospects, as they were without product revenues in the quarter. However, with DIFICID now approved, that will change in the third quarter.

The stock has been weak with the market recently, probably reflecting the uncertainty over DIFICID sales as well. The company will appear at a growth conference next week and hopefully will bring some positive news on the early revenues for DIFICID. Continue to buy OPTR under $12.

Magic Software (MGIC) reported double-digit growth in the second quarter with a record-breaking $3.5 million in net profit – an 84% year-over-year increase. Earnings were in line with expectations at $0.086 a share, up 34% from last year’s $0.064 a share.

Revenues, helped by acquisitions, increased 27.5%, the seventh straight quarter the company had revenue growth of 10% or more. Gross margins fell slightly as services were a higher part of the revenue mix, but overall margins widened on higher volume. Non-GAAP net income attributable to common shareholders increased 48%, although EPS gains were limited because of a higher share count due to acquisitions.

Magic’s CEO, Guy Bernstein, was upbeat about the company’s near-term prospects, including the release of their key middleware product uniPaaS 2.0 and a new cloud computing offering. He said MGIC will also have further acquisitions, which have traditionally been in software services.

This was an excellent quarter for Magic, and with the recent pullback, the stock is selling at just 12x a reasonable estimate of $0.40 this year, and the company has net cash of $1.20. The stock received a nice boost after earnings but has given it all back in this horrible market. I continue to recommend you buy MGIC while it’s under $5.25 as we target $7.25.

Next: RUTH, SIMG, LF

Ruth’s Hospitality Group (RUTH) earned $0.10 in the second quarter, up from $0.08 in 2010 and essentially in line with expectations. Revenues increased 4.8%, as a 5.8% gain in comparable store sales at Ruth’s Chris Steakhouses was partially offset by a 1.4% decline in comps at Mitchell’s Fish Market. Despite the pressure of higher beef costs, which ate into margins by 150 basis points in the quarter, the overall operating margin increased in the quarter to 9.1% from 8.2% on the higher sales volume and good cost controls.

The 5.8% comp gain at Ruth’s Chris consisted of a 3.3% increase in entrees ordered and a 2.4% increase in check size. On the conference call, the company acknowledged their unit gains trailed the steakhouse industry average, which they attributed to competitive discounting. The company will not follow this approach, preferring value over discounting. They pointed to the success of their prix fixe menu, which accounts for 30% of sales, as an alternative to discounting.

Also nice, the company maintained its full-year guidance, so analysts’ estimates for earnings of $0.36 for the quarter are still reasonable. Through July, there were no signs of a slowdown from a weakening economy.

Considering acquisition multiples given to lesser-performing restaurants, RUTH is a bargain at just 5.8X trailing enterprise value/earnings. Buy RUTH on dips below $5.50 for a target of $8.

I gave you a quick update last week on earnings from our other steakhouse, Morton’s Restaurant Group (MRT), but wanted to expand a couple of points. Like RUTH, the stock fell with the market since reporting earnings and has since come back below our $6.50 buy limit

MRT is currently growing a little faster than RUTH, with sales up 10.7% on the quarter and comparable sales up 8.2%. Adjusted earnings rose to $0.05 a share from $0.02. While the company expects to report a loss in the seasonally slow third quarter, management guided to full-year earnings of $0.45–$0.49, which is in line with existing estimates, on comparable store sales gains of 6% to 8%. Similar to RUTH, Morton’s is not seeing any signs of a slowdown yet, and they are a company whose results are correlated to business travel.

One significant difference between the two is that MRT does not franchise while 55% of Ruth’s restaurants are independently owned. This is why RUTH has higher margins, 9.1% in the current quarter compared with 3% for MRT. Morton’s will have greater growth in a sustained economic recovery as its strictly company-owned-and-operated model allows for greater margin expansion. This explains in part why MRT currently has a higher enterprise value/earning valuation of 7.9X. On the other hand, RUTH will have more stability in the event of a downturn.

If you’re trying to decide between the two, conservative investors may prefer RUTH to MRT right now, given its lower operating and financial leverage and more attractive valuation. However, MRT is still a good buy up to $6.50.

Silicon Image (SIMG) rallied sharply after reporting second-quarter earnings and giving third-quarter guidance that did not show any softening of business, unlike many other semiconductor companies. Diluted earnings were $0.05 a share compared with $0.03 from a year ago. Sales rose 20% year-over-year and 20% from the last quarter, as the company continues to benefit from increased adoption of high-definition video in smartphones.

SIMG estimates that 20%–25% of smartphones sold in 2011 will be HD enabled, so there appears to be a lot more room for the company to grow as HD continues to increase its presence in mobile devices. Mobile products are now as large as the company’s consumer electronics business, which has been weak due to the ongoing struggles of the HDTV market.

Shares have been hurt by weakness in the semiconductor industry, HD televisions and the market in general. This quarter, however, goes a long way in differentiating the company and gives credibility to the likelihood of future earnings growth. SIMG remains a buy under $8.50. 

Leap Frog (LF) has been weak in this tough market but had some encouraging news in its second-quarter earnings release. Revenues were down 13% to $54.4 million; however, excluding inventory liquidations that the company warned about in January, point-of-sale revenues were up 7%.

International sales were also strong, up 11%, including a 6% help from currency. Despite the lower revenues on a GAAP basis, cost cuts limited an increased net loss by just a penny, to $0.21 a share from $0.20 last year.

I’m optimistic about what’s to come for LF in the remainder of the year. Pre-order sales of its new LeapPad tablet have been strong, and initial limited shipments of the product sold out in two weeks last month. The new LeapPad has received favorable reviews, so I’m looking for this to be a winner for the company this year and beyond.

Management gave third-quarter earnings guidance of $0.24, which is the lower end of Street expectations of $0.24–$0.28. Earnings growth should accelerate with the likely success of the new LeapPad and the additional $25 game cartridges for the new system. Selling at less than 10X expected EPS of $0.40 in 2012, the shares offer good value here. LF is a buy below $4.50.

Next: GLUU, LOCM, MPG

Glu Mobile (GLUU) had a nice quarter with revenues of $17.9 million beating expectations of $14 million. On a non-GAAP basis, the company lost a penny a share, but that was better than the anticipated $0.04 loss and a loss of $0.02 a year ago.

GLUU’s transition to smartphones continues to be strong, with total smartphone revenues of $9 million, up 43% from the prior quarter. Total installation of their games on smart phones increased over 30 million and now stands at over 100 million. Monthly active users of GLUU’s games increased 70% to 16.5 million at the end of June. Smartphones accounted for 54% of revenues in the quarter, so GLUU’s move away from premium phones is going quite well and is ahead of schedule, according to the company.

I’m looking for strong growth in 2012, as the company will continue to expand into smartphones but have less of a traditional revenue base to lose. I think estimates for $0.02 a share next year are too low given how GLUU outperformed this quarter. However, the true value of the stock may not be in its income stream but rather in its content, with popular games such as Big Time Gangsta and Bug Village. This content makes the company a takeover candidate by a larger developer. Overall, this story is looking better each quarter. Buy GLUU up to $5.25.

Local.com (LOCM) took a hit in the second quarter as a decline in operating performance continues to reflect the end of a user agreement with Yahoo. Earnings came in at –$0.09 a share, compared with $0.20 in first quarter of 2010. Revenues were $15.6 million versus $23 million.

Revenue guidance of $21 million, while up nicely from the $15.6 million this quarter, was below some expectations. What is also bothering the market is the company’s refusal to give more specific income guidance for the third quarter, other than to say the loss will be lower than the one realized in the second quarter. Executives did not want to give more specific guidance due to limited monetization data from the new blend of ad partners in the quarter.

While I wish there was more clarity, the company feels monetization will improve with its recent deal with Google, which went into effect on Monday. Plus, the acquisition of Screamin Media Group, which provides local daily deals, looks like it has some promise. These changes will cause the stock to be completely different in the next quarter, so while this one has had a few twists in the road, I continue to like where it’s going. I recommend you buy LOCM below $4.50.

MPG Office Trust (MPG) reported a second-quarter funds from operations (FFO) loss of $0.03 before special items, compared with a loss of a penny a year ago. The company disposed of four properties in the quarter, which led to GAAP earnings of $2.42 a share.

Management believes it will end the year with $80 million–$90 million in cash in the bank, and has no plans to look for joint venture partners in an effort to raise cash. It looks like the company is self sufficient in its cash needs for now.

Since the start of the year, MPG has reduced its mortgage debt outstanding to $3.14 billion from $3.58 billion by disposing of properties unable to meet their mortgage obligations. For the first time this quarter, we saw the balance sheet benefit from disposing of these troubled properties – one of the main reasons we go into the stock, and I’m happy to see that is now coming to fruition. As they continue to dispose of bad properties, the underlying value of the shares will become more apparent. MPG is a buy under $4.

Breakout News & Notes

Wet Seal’s (WTSLA) revenue at stores open at least a year rose 7.4% in July, easily beating Wall Street’s estimate of 3.3% increase for the teen clothing chain. The company announced this morning that the figure climbed 7.8% for Wet Seal stores and 5% for its Arden B women’s clothing chain during the month. Total July revenue rose 13% to $46.4 million.

For the whole of the second quarter, revenue at stores open at least a year rose 6% while total revenue rose 13% to $148.8 million, also beating analyst predictions. Wet Seal expects second-quarter net income to be $0.02 per share, the high end of its previous guidance. These are encouraging results, especially as the back-to-school season begins. Buy WTSLA below $5.

Citizens Republic Bancorp’s (CRBC) symbol has been changed back to CRBC (dropping the D), as you may have seen in our Buy List. As we discussed in last week’s update, the bank printed a surprisingly strong quarter, reporting earnings of $0.45 a share, which included a tax gain of $0.26 a share. The company said on the conference call that they have turned the corner on credit and expect the profitability to continue. CRBC has even hired new loan officers to attempt to grow their portfolio.

I would remain somewhat cautious on the shares in the near term due to an impending capital raise to fund growth and pay off the company’s $300 million in TARP-related preferred stock. I will re-evaluate our position once this is completed, but for now, hold on to your shares for our $10.50 target.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10