Active Autumn Ahead

The “slow” summer month of August has been anything but in the stock market, and a lot has happened since our last issue. After the upcoming Labor Day weekend, kids will be back in school, we’ll be done with summer vacations, Wall Street will be back to work in full force, and everyone will turn their attention to the last four months of the year.

That’s exactly what we’re going to do right now. In this month’s visit, we’ll talk about our game plan for the rest of the year, including and adding several new buys that are poised to do well, even in a slower-growth economy.

As we wrap up August, the S&P 500 lost more than 5.5% for the month and is down 3% for the year. It reached its 2011 high of 1370.58 on May 2, and in the recent sell-off, fell to its low of 1101.54 on August 9. The market has been up as much as 9% and as down as much as 12% for the year, and experienced a bear-market type sell-off of 19.6% from its high to low.

We’ve talked about all of the various factors moving the market and contributing to the historic volatility, so we won’t rehash those now. We want to look ahead to the rest of the year and what it means for us as investors.

Most importantly, we know that economic growth has slowed. The question investors have wrestled with is whether we’re headed for another recession or are in a temporary “soft patch,” from which it would be easier to jump-start growth. The most recent data have continued to show a weak economy but one that is hanging in there and continues to grow, and I believe the odds of a second recession remain low.

The Federal Reserve’s fairly strong willingness to step in with policies to stimulate growth and higher employment decrease the odds of a recession. The last round of quantitative easing (QE2) ended two months ago, and if there is a QE3, it probably won’t be as large as QE2. The Fed can also only do so much, but I believe the market understands this, and recent strength has been in large part because investors like the idea that the Fed will act if needed. The next scheduled meeting has been expanded from one day to two (Sept. 20–21) specifically to discuss next steps.

We can expect volatility to remain heightened, as there will continue to be plenty of headlines likely to move stocks. The European debt crisis is among the most important. There will be good news days and bad news days as resolution to such a complicated crisis is a messy process, but I do believe there will eventually be a resolution the market can get comfortable with. We just don’t know how long it might take to get there.

Other big events on the horizon are President Obama’s plan to help the economy and stimulate job growth, which is now expected to be presented next Wednesday. Also in September, we will watch closely for how many companies warn that they will miss earnings and lower expectations. Many companies guided lower in the just-concluded earnings reporting season, so at least some of the adjustment to slower growth has taken place. The next reporting season will begin in early October, and that, too, will be critical, to see if there is more is to come.

Looking further ahead, the super-committee in Washington is supposed to come up with its plan to reduce the U.S. budget deficit by Thanksgiving. Let’s hope the wrangling in Congress is not as ugly as the battle to raise the debt ceiling a month ago. I’m hopeful those on the committee and all members of Congress and the administration learned an important lesson from the last go-round, but again, we’ll have to see what the tone is and how it impacts stocks. And in November and December, of course, we’ll be in the middle of the all-important holiday shopping season that is usually a good time of year for stocks.

My expectation is for stocks to finish the year in positive territory, though we may endure more volatility to get there. In addition to a still-growing economy and an at-the-ready Fed, interest rates will remain extremely low. The yield on 10-year U.S. Treasury notes is just 2.19%. When fear subsides, those low yields will drive a lot of investors into stocks seeking higher returns, and that makes now a good time to buy since so many stocks are really attractive after the recent sell-off.

That’s why in this issue we want to focus on buying opportunities in select game changers that are aimed to deliver end-of-the-year profits. I’ve been hard at work digging for such opportunities, and I have three that I want to tell you about now. Each one is well off its highs of the year, has characteristics that separate it from other companies, and is poised to continue to grow even in a slower economy. And best of all, I’m looking for 20%–30% profits – and possibly more – over the next six months or so. After we talk about the new buys, I’m also recommending that you sell two of our stocks with limited upside potential in the current environment.

We have a lot to talk about as we prepare to finish out the year, so let’s get started.

New Buy #1: Netflix

No one can doubt that Netflix (NFLX) has been a significant game changer when it comes to renting movies, first by delivering the videos quickly via mail and then by allowing instant download through Internet streaming. Along the way, the company eliminated competitors, including industry giant Blockbuster. But now that the movie mogul has clearly risen to the top, is it still a stock worth buying? In a word: yes.

Netflix is a true growth story. Total subscribers, which stood at 6.3 million at the end of 2006, jumped to 20 million by the end of 2010. The rate of subscriber growth accelerated last year when the company started offering downloads of movies and television shows online. By the end of this year’s second quarter, Netflix had a total of 25.6 million subscribers, growth of nearly 70% over the prior year.

The company has had what’s referred to as a “virtuous cycle” working for them, sort of like a snowball effect. Subscriber growth allows Netflix to acquire more content, which in turn leads to more subscriptions. It also helps word-of-mouth advertising, which is the most cost-effective way to drive more traffic. In fact, Netflix’s costs to add subscribers have declined dramatically through the years, which lifts profit margins and frees up the company to spend more on customer services.

With the incredible growth has come great financial success. Revenues increased an incredible 30% a year from 2003 to 2010, soaring from $272 million $2.16 billion. Over the same period, operating income rose nearly 7,000% from $4 million to $278 million, and earnings grew 2,500% from $0.11 to $2.96.

Now Is Our Chance

As with all great growth stories, there are occasional hiccups along the way, and that is what’s giving us our opportunity in NFLX. In addition to the market sell-off, the company recently hit a small rough patch over subscriber concerns. Second-quarter earnings were solid at $1.26 a share, up from $0.80 the year before and well above expectations. Margins were up because of lower-than-expected expenditures on streaming content and continued leverage of DVD shipments with higher volumes.

However, the company added a net of two million subscribers in the quarter, which was slightly shy of expectations of 2.1 million. In addition, management guided to a decline in paid domestic subscribers here in the third quarter. The stock fell nearly 7% the day after earnings were announced, and in the broader market sell-off corrected approximately 30% from the stock’s high of $304 on July 13.

Customer churn is always important, but in NFLX’s case, there are a couple of mitigating factors that make this an opportunity. First, it comes on the heels of an abnormal number of new subscribers gained in recent quarters. And second, management changed prices. Instead of both unlimited DVDs and streaming video for $7.99 a month, subscribers essentially had to choose one or the other. They could stick with unlimited DVDs, one at a time, for $7.99, or opt for unlimited streaming for $7.99. (There is also an unlimited two-at-a time DVD plan for $11.99 a month.)

While the change will inevitably cause some customers to cancel their subscriptions, many will remain and pay twice the price. In addition, those who opt for streaming only will save the company money on shipping costs. So while the price changes increase churn for the moment, I don’t see them as long-term issues that will derail the company’s growth. In the end, the remaining business should ultimately be more profitable, and subscriber growth should pick up again. There are also opportunities for international expansion and the potential to continue increasing the number of videos available, such as recent television shows.

Let’s take advantage of this golden opportunity to buy a once and future darling of Wall Street at discounted prices. Netflix is still the dominant game changer in its industry right now, with no other company able to offer such a wide range of video services at a low cost. With all the first-mover advantages, even a strong player like Apple’s iTunes would be hard-pressed to displace Netflix.

Buy NFLX below $245. I look for the stock to move back up toward $280 by the end of the year and probably keep going to $300 after that.

New Buy #2: Novo Nordisk

Our next new GameChanger has made it its goal to help fight off a dreaded and growing disease that is plaguing citizens all over the world: diabetes. A University of Chicago report outlined in the December 2009 issue of Diabetes Care projected that in the next 25 years, the number of Americans living with diabetes will nearly double, increasing from 23.7 million in 2009 to 44.1 million in 2034. Over the same period, spending on diabetes will almost triple, rising from $113 billion to $336 billion. This will occur even with no increase in the prevalence of obesity, due to population growth and the aging U.S. population.

Internationally, the picture is not much brighter. According to the World Health Organization, nearly 200 million people worldwide have type 2 diabetes, and this number is predicted to increase to 333 million by 2025.

And that’s only part of the picture. There is also a condition called pre-diabetes in which individuals have blood glucose or A1C levels higher than normal but not high enough to be classified as diabetes. This, of course, leads to an increased risk of developing diabetes, heart disease and stroke.

Somewhere around 80 million Americans 20 years and older are estimated to have pre-diabetes. People with this condition who lose weight and increase their physical activity can often prevent or delay the onset of type 2 diabetes, but the truth is that most don’t and instead wait for diabetes to develop before taking action with insulin therapies like those developed by Novo Nordisk (NVO).

Next-Generation Diabetes Care

Novo Nordisk (NVO) is the leading provider of diabetes care products in the world. The company draws on 90 years of research and development that continue to produce ever-improving therapies, and it is considered an expert marketer with a loyal base of medical professionals and customers. When you add that its global leadership is in an area producing millions of new patients annually, you have the makings of a game changer.

In an effort to remain the undisputed industry leader, NVO has a full line of new anti-diabetic agents and next-generation insulin products in its pipeline, including a drug that can regulate glucose levels for up to 24 hours. If you’ve ever known anybody with diabetes who struggled to manage their blood sugar, you know how much this would be appreciated.

Demographic trends are further strengthened by a market shift toward modern insulin analogs (such as NVO’s Levemir and NovoLog), which offer improved convenience for patients but are more expensive than regular human insulin. Novo Nordisk also recently launched a long-acting drug therapy, Victoza, which has been proven to lower glucose while having a lower risk of hypoglycemia (blood sugar that’s too low) and weight gain.

NovoNordisk’s ongoing success was seen once again in its second-quarter earnings report. Net profit rose 17% on the year, helped by strong growth in Victoza (sales up 253%), and management raised sales and profit guidance for the full year.

However, the stock dropped certainly because of the jittery market but also when sales of modern insulin rose by only 3% to $6.97 billion, falling below predictions of $7.3 billion. I view this as a short-term blip in the longer-term growth story, especially considering that management pointed out it will soon file an application for registration of “degludec” in the U.S. This is an ultra long-lasting product and is expected to be the leader of next-generation insulin therapies. While it could be a year or 18 months before it is approved and available to consumers, the company believes degludec will be a blockbuster with annual sales over $1 billion.

Still, we don’t have to wait for degludec for the company to grow. Sales in North America increased 15% in the first six months of 2011, and the next big area for Novo Nordisk is China, which has edged ahead of India with the highest number of afflicted citizens. A group of researchers from Tulane University and colleagues from China concluded that the disease has reached epidemic proportions. According to their calculations, more than 90 million Chinese over age 20 have diabetes, and nearly 150 million have pre-diabetes. They also concluded that the majority of cases are undiagnosed and untreated. Those are pretty shocking numbers considering the disease wasn’t even seen in the country until a decade ago. About 8% of NVO’s sales in the first half of this year came from China, an increase of 22%, and I expect that number to grow significantly going forward.

NVO has pulled back from its April high of $132 down to current prices under $110, giving us a nice entry point for a company whose growth drivers remain firmly in place. Buy NVO up to $111 for a move toward $130 by year-end and $140 over the next six months.

New Buy #3: Panera Bread

Panera Bread (PNRA) is a really interesting story because the company is changing the way fast food is served and the experience consumers expect. In many ways, Panera reminds me of Starbucks and how it changed the way we buy and drink coffee. We used to stop at 7-11, McDonald’s or mom-and-pop shops, but now many people expect a much richer experience filled with quality brews, varied choices, a sense of freshness and an appealingly hip aura. Panera’s strategy is obviously working, as it remains popular at peak times, during off hours, on down stock market days, even when consumer confidence is low.

We Americans love to eat out. Last year, total sales in the restaurant industry were $583 billion, which is huge. In fact, it’s bigger than 90% of the world’s economies. Sales continued to grow in the first decade of the new century – up 4.4% despite two recessions and a lackluster stock market. For this year, the National Restaurant Association projects slower growth of 3.6%, still relatively strong but an indication that the industry is feeling the impact of a slow economy.

If you dig into the numbers, you’ll see that independent restaurants are taking the brunt of it. According to market research firm NPD Group, nearly 92% of restaurants that closed in the last year were independent. It’s too bad, but individually owned operations have trouble competing in this environment, hamstrung in their ability to negotiate prices with vendors, absorb escalating labor, insurance and food costs, and their ability to advertise effectively.

The number of chain restaurants remained relatively stable, as was the number of total restaurant visits by consumers. In fact, NPD Group estimates that consumer spending was actually up 2% in that same period, so you can see that more people are eating at chain restaurants. Panera’s game-changing model puts it in terrific position to grab more of that share.

Growth Remains on Track

You are probably familiar with Panera Bread. If not, it has added quality to fast food. The menu includes everything from freshly baked breads to sandwiches, soups, salads, deserts and gourmet coffees. In addition to the better food, the restaurants have a warm and comfortable environment, even though you stand in line at a counter and carry your food on a tray to your table.

As the name says, Panera’s primary platform is bread. Instead of the memorable, “Where’s the beef?” phrase from Wendy’s in the 1980s, Panera’s version is, “A loaf of bread in every arm.”  Its key menu groups feature some sort of bread, including fresh bagels, breads, muffins, scones, rolls and sweet goods, as well as made-to-order sandwiches on those same breads.

Whether you’ve experienced a Panera Bread restaurant or not, the most important item for us as investors is the company’s tasty growth. Revenues increased from $356 million in 2003 to $1.54 billion in 2010, which is impressive annual growth of 23%. Earnings have also grown, jumping from $1.01 a share in 2003 to $3.62 in 2010.

Growth has continued so far in 2011. Revenues were up 18% in the first six months of the year, with comparable store sales up 3.8% at company-owned stores. Gains have been helped by growth in the company’s hot sandwiches after Panera Bread installed new Panini machines last year. Operationally, a plan to lower wage and health-care costs is benefiting the bottom line, and earnings increased 36% to $2.27 a share in the first half of the year.

For the full year, management is expecting $4.54–$4.58, which would be impressive growth of about 25%. Margins gains from the first half will likely reverse at least somewhat in the second half, as the company completes its cost-savings programs, and food inflation historically becomes most severe in the fourth quarter. Longer term, Panera targets annual earnings growth of 15%–20%, and current forecasts are for the lower end of that range in 2012 in anticipation of possibly higher food inflation.

Even with slow growth in the broader economy, Panera Bread should continue to grow solidly and be in an excellent position to accelerate growth when the economy strengthens. The company is still adding over 100 stores a year, and a recently instituted customer loyalty program should encourage more repeat visits. It’s also interesting that Panera Bread has grown largely through word of mouth, spending just 1%–1.5% of sales on media, which is less than other national chain restaurants. That not only makes past growth more impressive, it is also a potential opportunity to increase money spent on advertising to boost the top line.

Buy PNRA under $120. The stock has strengthened recently, which is good, and it remains below recent highs of $133. We’ll start with a target of $150 over the next six months or so.

Two Sells: DLR and MBLX

In addition to buying companies likely to continue growing in the current environment, our strategy is to also sell stocks that now have limited upside potential or whose fundamentals are not what they were earlier in the year. Along those lines, it’s time for us to sell Digital Reality and Metabolix.

Digital Realty (DLR) is up 16.5% since we added it at the beginning of this year. That’s a lot better than the S&P 500’s loss of 5% in the same time. The reason I recommend you take your profits is that fundamentals for the industry are moderating, with supply and demand for outsourced data centers now more in balance. When we bought the stock, REITs such as Digital Realty were benefiting from demand outpacing supply. In addition, growth is starting to slow at DLR, with expected Funds from Operations (FFO) projected to increase 8.8% in 2012, down from 20% this year. The stock is trading around 13X expected FFO for 2102, which looks to be pretty fairly valued given declining growth and fundamentals.

Also, when fundamentals starting turning negative for real estate-related companies, it often happens quite suddenly. Even though DLR is not too far off its 52-week high of $64.25, there is now a 15% short-interest ratio in the shares. It’s also worth noting that DLR has a good deal of financial leverage, so if there is a downturn in the business, earnings (FFO) would decline much faster than operating results.

Sell DLR and focus on better opportunities, such as the ones we’ve talked about this month.

As you probably remember, we’ve also been talking about selling Metabolix (MBLX) for a while. The company did finally produce some decent news about its Mirel bioplastics in its last earnings report, and the stock started to move higher. Unfortunately, that was late July, and MBLX soon got caught in the hyper selling in early August. It has stagnated between $5 and $5.50 since, unable to mount a sustainable rally. It is now down 48% since I recommended it to you last December.

Even though the company has indicated it is close to making Mirel (its biodegradable plastic product) commercially available, it still has a long road ahead of it. Profitability is likely several years away. In addition, there is no guarantee there won’t be additional frustrating delays in the launch. While the company’s balance sheet is stronger after a recent offering – that greatly diluted shareholders – the start-up of Mirel production will lead initially to higher losses and greater outlays of cash. It is conceivable the company could require another injection of cash that would further dilute shareholders in the future.

Sell MBLX. The loss is frustrating, but it’s the right thing to do. Risk around the stock is increasing, and we’re much better off putting our money in better opportunities.

Actions to Take This Month

You’re probably ready to start looking ahead to the upcoming holiday weekend. If you get some time in the next few days, I recommend you take advantage of the lower prices to buy the three new game-changing companies we’ve talked about this month: Netflix (NFLX), Novo Nordisk (NVO) and Panera Bread (PNRA).

All three are exciting growth stories that will continue even in a slower economy, and the sell-off in August is giving us a good opportunity to get in and ride them to year-end gains. And, of course, if everything is rockin’ and rollin’ four months from now, we may well hold them longer.

Along those lines, I want to revisit two stocks we added earlier this month: Cenovus Energy (CVE) and Cummins (CMI). Both are above their buy limits, but I encourage you to buy on pullbacks if you don’t own them already.

Cenovus is the Canadian oil sands company, and it received some important good news on Friday when the State Department agreed to the $7 billion 1,711-mile Keystone XL pipeline that would carry oil from Canada to terminals in Oklahoma and the Gulf Coast. While there will remain some opposition to this project, I believe it will eventually be put into place, and President Obama reportedly likes the fact that a lot of jobs would be created to build it. Buy CVE on dips below $35.

Cummins (CMI) actually could face some near-term cyclical headwinds, but the long-term outlook is very bright. Catalysts between now and the end of the year include increasing market share in medium-duty trucks, where the company now has a 51% share, and the building out of the distribution business into new products and geographies. Cummins is also separated from many of its peers by its prominent “green” component, including a diesel engine for light-duty trucks. As we’ve talked about, President Obama recently announced higher fuel-economy standards for cars and light trucks in fleets, so CMI’s green segment figures to be an important growth driver. Buy CMI when you can get it below $90.

As we also discussed, now is the time to sell Digital Reality (DLR) and Metabolix (MBLX), which have limited potential and increasing risk. There are too many good opportunities out there right now, and we want to focus on those, such as the stocks we’ve highlighted this month. And in next week’s update, I’ll talk more about the stocks already on our Buy List that are well-positioned for gains between now and the end of the year.

I hope you have a terrific and safe Labor Day weekend!

Sincerely,

Hilary Kramer
Editor, GameChangers