New Year Rally

The stock market has been flirting with investors this week, with the S&P hovering tantalizingly close to 1,300 – a level it has not seen since August 1. Based on pre-market futures, it appeared poised to make an assault on that level today, but was held back by disappointing retail sales (which gained only 0.1% in December) and a jump in the first-time unemployment claims (back up to 399,000). It’s too early to let that last number scare us. A lot of year-end factors may have gone into the unemployment claims, so I would not take that as a sign that the recent improvement in the employment picture is coming to an end.

Stocks have started 2012 with signs they want to rally. The S&P 500 is up 3% in a little over a week, and the Russell 2000 index of small-cap stocks is up 4%. Our Breakout stocks are outpacing both with an average gain of 7% so far in the new year.

Despite today’s disappointing data, the U.S. economy appears to be chugging along. Yesterday’s Beige Book report from the Fed showed moderate growth over the last part of 2011. We even got some help from Europe today, with yields on Italian and Spanish bonds moving lower on a successful auction of one-year Italian notes. Yields declined to 2.73% from 5.95% in December as European banks began utilizing the extra liquidity provided to them last month.

Most important of all, however, is the earnings season that kicked off this week with Alcoa’s (AA) report on Monday. Though the results were hardly stellar, Alcoa indicated that it expects a 7% gain in aluminum shipments this year, which has positive implications for key industries such as aerospace and automotive. This gave the market hope that this round of earnings will not be as dire as some had feared, and AA itself has jumped 8.5% since.

For us here in Breakout, our earnings calendar remains light for the time being. Most of our companies have yet to announce their reporting dates, but we do know Citigroup (C) is first up next Tuesday, January 17, with Janus Capital Group (JNS) scheduled for January 26.

While we know there will be positive and negative surprises in this first round of earnings, I remain confident that 2012 will go into the books a solid year for stocks, despite ongoing uncertainty on some global issues. I am especially excited about the low-priced stocks we focus on here in Breakout, as I expect investors to be more comfortable with risk this year, which bodes well for our kind of stocks. Last year’s aversion to risk was both historical and excessive, and the pendulum should start to swing the other way.

As you know, I’ve been reanalyzing all of the stocks on our Buy List for 2012, and I really like the potential in our stocks. This week, I have a new opportunity to tell you about in a stock that could pop quickly, and in keeping with our efforts to make sure our money is in only the best opportunities right now, I’m recommending you sell two stocks whose upside potential has diminished. As always, I also have a new list of Top Buys for the week. Let’s start with today’s new stock, which may be a familiar name to some of you.

New Breakout Buy: Cablevision (CVC)

Cablevision (CVC) provides cable, phone and Internet services in New York City and four Western states. The stock took a beating last summer, falling from $36 to 52-week lows of $11.57 last month. It is now an incredibly cheap stock whose downside looks to have stabilized, and there are a couple of near-term catalysts that could move the stock higher in a hurry.

Founded in 1973 as a cable television operator with 1,500 Long Island customers, Cablevision has kept pace with technological change and today offers digital television, voice and high-speed Internet services to millions of households. At the end of the last quarter, the company had 65% of potential customers: 3.63 million customers out of 5.57 million serviceable households. Most customers subscribe to more than one service, and CVC also provides its services to businesses through their Optimum Lightpath product, which accounts for 5% of revenues.

The company has other interests as well. It operates news and information networks that it shows exclusively on its cable networks, operates a chain of movie theatres, and through its Rainbow Media Holdings division has ownership interests in national and international programming networks. Last June, Rainbow became a separate public company named AMC Networks (AMCX), which includes several popular and award-winning cable channels such as AMC (originally American Movie Classics), Sundance Channel, WE tv (formerly Women’s Entertainment), Independent Film Channel (IFC) and IFC Films.

In the first part of the new century, CVC enjoyed strong earnings growth thanks to new services such as digital cable, high-speed Internet and voice. From 2003–2009, earnings (EBITDA) grew an average of 13% a year from $1.2 billion to $2.5 billion. The new services also provided higher margins, so earnings growth of 13% exceeded annual revenue growth of 11%.

In 2010, as some of the company’s new services were maturing and programming costs increased, growth then began to slow. Excluding the impact of spinning out Madison Square Garden (MSG) operations, earnings growth fell to 5.7%, which was also in line with revenue growth.

Growth deteriorated even more last year as the company began losing subscribers to competition, primarily Verizon (VZ) and its Fios television service, which operates in the same area. Through the first nine months of 2011, revenues grew 10.8%, and even that came mostly from the December 2010 acquisition of Bresnan Broadband Holdings that brought in 300,000 basic video subscribers in Montana, Wyoming, Colorado and Utah. Earnings grew just 4% as higher programming costs again hit margins. Profitability was also hurt by added interest expense from the acquisition, and operating pretax income declined 17% to $320.3 million

The final blow last year came when the company’s respected Chief Operating Officer, Tom Rutledge, resigned in mid-December. To make matters worse, Rutledge defected to a competitor, Charter Communications (CHTR, currently trading around $57), the fourth-largest cable operator in America, to become President and CEO. He is expected to bring focus and expansion to enhanced services such as broadband and digital voice to Charter.

Buy Now for a Potentially Fast Breakout

Those are some significant challenges, and you can see why the stock has gotten pummeled. So why would we buy the stock now? Three main reasons: 1) a new COO will be appointed soon; 2) recent market share losses have stabilized, and 3) the company could get acquired or even go private at a premium to current stock prices.

CVC hit its 52-week low of $11.57 on December 16, the day after Tom Rutledge resigned. The stock has moved forward since then, trading between $14 and $15 over the last three weeks. The Dolan family, which controls CVC through 75% ownership of Class B stock, is strongly interested in protecting their investment. This is a well-known New York family that also owns the New York Knicks. James Dolan, CEO of Cablevision and also Chairman of Madison Square Garden, is nothing if not feisty, and I expect him to appoint a new strong COO that will command Wall Street’s respect at this critical stage of the company’s life. If he does so, I think the stock could move 20% in a day.

That’s the most immediate potential catalyst, but this stock is now extremely cheap. The company should generate free cash flow of close to $600 million this year, yet sells for a market capitalization of $4 billion. That’s a real bargain. Competition from Verizon is certainly a concern, but market share losses have not been dramatic, and I don’t expect them to increase substantially.

And finally, there have been talks of CVC being taken over before, including an attempt by the Dolans to take the company private back in 2007. Unfortunately, this deal failed when shareholders decided that the company’s price of $36.26 was not acceptable. Going private again remains a possibility, given the stock’s cheap price relative to cash flow. The Dolans would not offer that price again, but it would have to be at a premium for shareholders to agree.

Buy CVC under $15 for a conservative initial target of $22, where it traded less than six months ago. That would be just 10X free cash flow of $2.18 per share, which is very reasonable.

Sell YMI and SIMG

As we talked about a few moments ago, I’m excited about the prospects for our stocks this year, so here in this first full week of trading in 2012, we want to continue to make sure we’re invested in only the best opportunities. That includes moving out of stocks that no longer have enough potential or clarity about the year ahead. That is now the case with YMI Biosciences (YMI) and Silicon Image (SIMG).

YMI has been unable to get the market interested in the positive clinical data from the company’s myelofibrosis drug, CYT-387. Instead, investors seem to be focused on the fact that if CYT-387 is approved, it would be introduced at least two years later than Jakafi, Incyte’s drug for myelofibrosis that was just approved in November. This would be a hurdle for YMI to take market share from an established treatment.

More worrisome for me is the fact that YMI has not yet found a partner to help develop and market CYT-387 despite the promising Phase II data. This was one of the main catalysts I was waiting for to drive the stock, and with no signs that it will happen soon, we’ve waited long enough. The outlook has become less clear for the company, and I recommend you sell YMI.

Silicon Image, as you know, makes chips that help with video. The company has had success developing new products for the mobile high-definition video market, but they haven’t yet been enough to offset weakness in the company’s core market of HDTV, which remains weak. The longer it takes for the newer products to become a bigger part of the revenue mix, the higher the risk that SIMG’s legacy products could drag down growth and sales. As a result, I now question whether the company will hit earnings estimates of $0.32 a share this year.

Overall, I think Silicon Image is a decent company that is generally heading in the right direction. At the moment, however, it doesn’t have enough breakout potential for us to stick around. The stock has bumped up about 15% from last month’s lows in the latest technology rally, so let’s take advantage and sell SIMG.

While it’s disappointing to sell these stocks at losses of 30% (YMI) and 38% (SIMG), both now carry greater risk, and there are much better investments for our money. Sell both now and move into more attractive opportunities, including today’s new recommendation, Cablevision (CVC), and the top buys we’ll talk about now.

Top 3 Buys: ESIC, CMRG, ERT

Last week, I introduced to you my Top Stocks to Start 2012, consisting of five companies from our Buy List that are strong buys for the first quarter. Two of those stocks appear again in this week’s Top Buys, and the third could easily have been on the list, too. If you’re just joining us or have new money to put to work, start with these three picks:

EasyLink Services (ESIC) has picked up some momentum to start the year. The stock is up 13% in 2012, including a 9.5% pop this week, and is well-positioned to see those gains continue. ESIC had its own patent claims upheld this week, and I look for a settlement in a separate lawsuit against the company that should also help relieve pressure on the stock. Its simple formula of using significant free cash flow to reduce acquisition-related debt should add significantly to shareholder value this year. ESIC is a buy below $5.50.

Casual Male Retail Group (CMRG) is the number one big and tall men’s specialty store in the United States, and has a promising year ahead. The retailer will continue to roll out its successful Destination XL store format that combines all three of its product platforms in one location, as well as continue to explore online expansion. CMRG is a solidly run company, generating a good amount of free cash flow and remaining debt-free. The stock sells for just 9X expected earnings for the Jan. 2013 fiscal year. Buy CMRG under $3.75.

eResearchTechnology’s (ERT) momentum has stalled slightly since the start of the year, but I expect it to resume. The medical data collector will benefit greatly this year from increased pharmaceutical research and improved results from its German division that specializes in respiratory data. ERT is cheap, selling for just over 10X expected 2012 EPS, and it is also a good choice if you’re looking to diversify away from more economically sensitive industries. ERT is a buy up to $5.25.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10