Slip Slidin’ Stocks

Stocks have hit their bumpiest stretch of 2012 in recent days, as the S&P 500 has pulled back over 4% from an intraday high of 1415 on May 1 to 1354. That’s  similar to a month ago when the S&P fell 4.2% from 1420 to 1360 before bouncing back up close to its 52-week highs.

This latest round of selling got started with last Friday’s U.S. employment report, which showed that a disappointing 115,000 jobs were created in April. Then, over the weekend, uncertainty in Europe increased after some elections shifted the political landscape in places like Greece and France. We’ve also had some select late-season earnings misses that have added fuel to the fire.

Not surprisingly, there has been extensive selling in some commodity stocks and other economically sensitive names as investors focus just how much growth we’ll see – or not see – in the U.S., Europe and important emerging markets like China. Financial stocks have also taken a hit, which is usually the case when uncertainty in Europe increases.

I know the selling is unsettling, and I think there are a few important points for us to keep in mind. First, the S&P 500 is now down 4.8% percent from its April 2 high of 1422. That’s not fun, but it’s also not outside the realm of normal market patterns. In fact, it’s still quite a bit less than the 10% decline most market observers feel constitutes a “correction.” For the year, the S&P is still up 7.7%, and going back to the lows of last October, it’s up a strong 23%.

We know the market couldn’t keep up its recent pace, but looking out over the balance of 2012, I still see a generally good environment with the usual concerns we need to watch. The U.S. economy is still growing, and interest rates are still historically low, which is very positive for stocks. If the U.S. does begin to falter, the Fed will almost surely step in with some form of easing, and we’ve seen how happy investors are when central banks get involved.

Europe is even more of a mess than usual right now, but the truth is that none of what’s happening was unexpected. Greece is especially messy, as the different political factions are having trouble forming a coalition government, casting doubt on whether the current bailout deal will remain in place and even on whether Greece will stay in the eurozone. It seems pretty likely that another election will need to take place next month. An eventual default or exit from the eurozone would be worst-case outcomes, but quite honestly, I think the market is in a much better spot to deal with either of those now than it was last fall.

As you probably know, France also had an election, and Nicolas Sarkozy will step down as President May 15 as Socialist party candidate Francois Hollande takes over. He has been critical of austerity measures to deal with Europe’s debt crisis and has been vocal about boosting growth. I expect a deal to be worked out to keep the European agreement in place.

We also shouldn’t forget our own election coming in November. The rhetoric between President Obama and Mitt Romney will no doubt intensify, and we’ll be sick and tired of political commercials by the time November rolls around, but election years are historically very good for stocks. As I mentioned last week, the S&P 500 has moved higher from June to December in 13 of the last 15 Presidential election years.

Dealing With Down Markets

I’ve seen your recent questions on the message boards and emails about what to do when stocks are down, so let me take a few moments to share some thoughts. First and most important, we need to stay focused on our goal here in GameChangers of building wealth by investing in companies that are changing an industry, at the front of developing trends and/or have unique competitive advantages. These companies are solidly positioned to grow over the long term, and we may need to ride through some broader-market bumps as the stories play out.

It’s also smart to make sure you’re diversified as much as possible. You ideally want to own around 20 or 25 stocks, preferably spread among different industries and different market capitalizations. I realize not everybody can start with that number of stocks, so my general advice is to put no more than 5% of your investable dollars into any one stock, and try to factor in diversification as you add more stocks and build out your portfolio.

Some of you have asked about stop losses. If you’re not familiar with stop losses, they are essentially limit orders that you set with your broker to sell a stock when it falls to a certain point. Some investors like to identify a specific price; others use a percentage drop.

I rarely use stop losses myself, and I almost never recommend them when investing for the longer term. My biggest concern with a stop loss is that it’s mechanical. It doesn’t factor in fundamentals, growth strategies, news flow, trading patterns, etc. I’d rather make the decision myself on a stock-by-stock basis and weigh all of the important factors to determine if selling is misguided (a buying opportunity) or for good reason (time to get out).

In my experience, stop losses can also be as harmful as they are helpful for reasons related to execution. First, there is no guarantee you’ll get your desired price. If there is bad news about a stock and it gaps down sharply at the start of trading the next day, it may have blown right through your limit, and you may end up selling much lower than you wanted to. And second, I’ve seen many investors stopped out of a stock that bounced right back after they sold it, and they missed out. Here’s another factor to remember: If you want to take a loss as a tax deduction, the IRS requires you to wait for over 30 days to buy a stock back, so it’s not like you can sell and get right back in (unless you want to forgo the deduction).

That said, everyone needs to be comfortable with the way they invest. If you sleep better at night knowing that you have stop-losses in place, you should absolutely feel free to use them. Just be aware that they are not a perfect solution. And whether you use them or not, I will always let you know whenever I recommend you sell a stock, and that happens to be the case today with Teva Pharmaceuticals (TEVA) after this morning’s earnings report.

Sell TEVA

Teva Pharmaceuticals (TEVA) reported earnings this morning, and the numbers were decent. The company earned $1.47 a share in the first quarter, which beat expectations for $1.43. Profits were well above $1.04 in the first quarter of 2011, but it’s worth noting that the comparison was pretty easy as Teva had an unusually weak first quarter in 2011 due to disappointing generic drug results in North America.

TEVA, however, was down today as new CEO Dr. Jeremy Levin said the company will not provide any guidance for full-year 2012 earnings until he completes a performance review. The general skittishness about Europe is also a factor, as sales declined 2% there. Europe is an important market for Teva, contributing 26% of revenues in the quarter.

I have become increasingly concerned about the lack of visible growth at TEVA, and this morning’s report reinforced those concerns. That’s evidenced in part by management’s refusal to provide guidance, but even more importantly, the company has been unable to come up with sufficient growth to replace what it will lose when its star drug, Copaxone for multiple sclerosis, comes off patent in 2014 in the U.S. and 2015 in Europe. Copaxone accounts for over 40% of branded drug revenues, and I’m disappointed nothing has emerged from the pipeline yet with the potential to help grow revenues significantly. 

Copaxone’s patent expirations are well-known by the market, so much of this is factored into the price. However, with no clear products to replace the lost growth, TEVA’s upside potential isn’t nearly as strong as many of our other opportunities, and there is some risk that the stock could get hit further because the company has not been specific about Copaxone’s contribution to operating profit, which I suspect is very significant.

In addition, there has been speculation that Dr. Levin was considering some changes to try to put TEVA on a path to more rapid growth, including separating the branded drugs and generic drugs into two companies. Such changes often require investments and/or acquisitions that lower near-term earnings, and I do not think lower earnings would be accepted well by the market initially. I will continue to follow the company’s efforts to jump-start growth, and it’s always possible that we could get an opportunity down the road if we like what we see and have better visibility.

Sell TEVA. The stock is down 21% for us, and while it is up 4.5% so far this year, it has been stuck between $42 and $46 for most of that time. With the outlook for the company more uncertain, I don’t see it breaking out significantly anytime soon. And with the recent sell-off giving us a chance to buy stocks with more upside potential at cheaper prices, we want to focus our efforts there.

One of those stocks is a new opportunity I want to tell you about this week: Shutterfly (SFLY). The stock was over $34 last week and is now trading closer to $28. I like this company and want us to take advantage of the buying opportunity.

New GameChangers Buy: Shutterfly (SFLY)

You may already be familiar with Shutterfly (SFLY). I first came across it in 2005 when I started to receive invitations and announcements on high-quality paper and featuring photos of loved ones. Soon afterwards, I was invited to share and view friends’ and family members’ photo books online. Today, it’s a very popular site for uploading, storing and sharing photos, and of course you can buy all sorts of photo-related products, too.

The company generates the majority of its revenues by producing and selling professionally bound photo books, greeting and stationery cards, personalized calendars, other photo-based merchandise and high-quality prints. They manufacture most of these items in their facilities in Charlotte, North Carolina, and Phoenix, Arizona. This is an advantage. By controlling the production process in their own facilities, Shutterfly is able to produce the products it wants, innovate faster and maintain a favorable cost structure. The company also sells merchandise manufactured by third parties, such as calendars, mugs, canvas prints, mouse pads, magnets and puzzles.

Shutterfly generates pretty much all of its revenue in the United States, and most of it comes from personalized products and services. Personalized products and services as a percentage of total net revenues grew from 66% in 2009 to 71% in 2010 to 79% in 2011. This reflects a broader shift in consumer spending to online shopping as well as the increasing adoption of personalized content. I look for this trend to continue as a catalyst for Shutterfly’s growth and profitability.

These personalized products obviously make great gifts, so it’s not surprising that sales are highly seasonal, with 50% of revenue coming in the fourth quarter. In order to use available print capacity during slower times, Shutterfly began providing commercial printing services in 2008 to the direct marketing industry and continues to expand that business.

Expanding Offerings

Growth is being driven by both acquisitions and new areas of business. A year ago, SFLY bought Tiny Prints, which was privately held and offered two online brands for printing stylish cards, invitations and personalized stationery, including tinyprints.com and weddingpaperdivas.com. I believe the acquisition will accelerate growth in their cards and stationery business, and it provides the opportunity for significant synergies through vertical integration.

Most recently, Shutterfly bought Kodak Gallery for $23.8 million, and because Kodak has filed for bankruptcy, the sale needed to be approved. That happened last week, and Kodak will close its online photo service on July 2. The two companies offer similar services, with free basic photo-sharing and then users can order prints, photo books, digital copies on DVDs and other products. This should be a plus for Shutterfly, which needs to keep bringing in new customers as competition has emerged to a degree from places like Facebook, where people can simply share photos.

Recent internal initiatives include Treat.com, just launched in mid-April, which is a place for users to personalize and send unique greeting cards. This is Shutterfly’s expansion into the one-to-one greeting card market, which complements its existing one-to-many card business. In February, Shutterfly launched a school yearbook business that provides parents and elementary schools in the United States (more than 100,000) with easier and cheaper ways to produce yearbooks with everything from page templates to bulk discount pricing. (I wish we had that when I was in high school!)

We’ll talk in more depth about the company’s finances next week, but Shutterfly’s growth strategies are paying off. For the first quarter of 2012, revenues grew 60% to $91.3 million, with much of the growth coming from the Tiny Prints acquisition. That was above the high end of the company’s revenue guidance and reflected solid growth across all three of their business categories: Personal Products & Services, Print and Commercial Print services. As a result, Shutterfly improved its market leadership during the quarter despite heavy promotional activity from competitors.

For all of 2012, Shutterfly estimates that net revenues will total $576 million–$586 million, which would amount to growth of up to 24% on a reported basis and approximately $21 million in revenue from Kodak.

In short, Shutterfly’s market-leading scale and profitability enable the company to grow through strategic investments that enhance and expand current products and services, launch new product categories and reach new customers.

Buy SFLY under $30, which is a terrific price. The stock was as high as $65 last summer, and I look for it to get back to $50 on the company’s own growth initiatives and as the synergies of the Kodak Gallery acquisition kick in.

GameChangers Earnings: CTSH, GEOY, SNCR

Cognizant Technology Solutions (CTSH) dropped nearly 20% on Monday after meeting earnings expectations but lowering revenue guidance. As we talked about on the message boards, I believe the decline was an overreaction by Wall Street and continue to recommend using it as a buying opportunity. The stock did bounce back 5% yesterday in a down market as investors bought up shares at bargain prices.

The IT consulting firm reported an in-line quarter with earnings of $0.69 a share, up 21% from $0.57 a year ago on an impressive 25% gain in revenue. North America sales, which represent 80% of total revenues, led the way with a 27.2% increase. Cash flow was strong, as the company increased cash and investments by $69 million while at the same time reducing liabilities by $254 million.

The problem came when management lowered its revenue growth outlook for 2012 to “at least 20%,” compared with previous estimates of 23% and well below the 30% gains Cognizant has realized in recent years. Management cited weakness in the pharmaceutical industry and North American banks as firms are saving discretionary IT projects for the future.

Still, many companies would die for at least 20% revenue growth, and there were some encouraging signs from the first quarter. Most importantly, management said on the call that its business remains healthy, and the company continues to take market share from competitors. The consulting business, which has high margins, is growing faster than the company as a whole, and Business Process Outsourcing (BPO) remains a source of growth. Also, results from Europe were not as bad as some may have feared, with revenues up 11% year-over-year and 3% from the previous quarter. IT outsourcing in Europe is underpenetrated compared with the United States, and it is another source of potential growth for CTSH even with the current troubles there.

In valuing the company, we want to take the conservative approach and assume that current 2012 earnings projections for $3.45 a share will come down, probably to around $3.35. That would still be an impressive 21% higher from the $2.85 earned in 2011. With the stock currently selling at a little more than 17X this revised estimate, we can see that lower growth expectations are well priced into CTSH. The company has also expanded its share purchase program from $600 million to $1 billion, which should also support the shares.

Monday’s sell-off was rough, but I believe it was an overreaction in an already jittery market. In view of the action, we need to adjust our buy limit and target price, but Cognizant is still a dominant company with a lot of growth ahead of it – even in the current environment and especially when IT spending picks up again. Buy CTSH under our new limit of $65 for a revised target of $85, which is 40% above current prices.

GeoEye (GEOY) posted solid first-quarter results last Thursday that beat both earnings and revenue expectations, and showed significant growth from a year ago.

Earnings of $0.58 a share were seven cents better than analyst estimates and 32% higher than last year’s results. Revenue was up 3.1% year-over-year to $89.3 million, driven by an increase in international revenues that benefited from recent business wins.

Much of the earnings beat was driven by lower net interest expenses that reflected greater capitalization of interest related to the construction of GeoEye2. Management maintained its guidance for 2012 for earnings of $1.95–$2.35 per share, versus $2.19 last year.

Margins also improved. Gross margin was 200 basis points better than a year ago at 65.9%, and operating margin of 28.8% was 90 basis points higher. Net margin was up 350 basis points from a year ago at 17.6%. Overall, adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) was up 5.4% to $46.2 million.

GeoEye generated even more attention by making an unsolicited offer to acquire DigiGlobe (DGI), a larger rival satellite-imagery company, citing significant pressure on the U.S. defense budget and intensifying foreign competition as reasons to create a unified business. DGI rejected the $792 billion bid, which wasn’t a surprise at all, stating the 28.6% premium to shareholders “substantially undervalues” its stock. However, the issue is not dead yet, as GEOY has retained Goldman Sachs and Latham and Watkins to advise them in this transaction.

I agree with GEOY’s outlook on the merger, and I think there’s a good chance a deal will eventually be completed. It would create cost-savings synergies that would offset potential budget cuts and save the government money by dealing with one less supplier. The main issue is who would have primary control. DGI said it countered GEOY’s original offer with its own proposal, one where DigiGlobe’s stockholders would own approximately 60% of the combined company, and GeoEye stockholders would own about 40%. Although this would not bring an immediate premium to us as GEOY shareholders, it would set the stage for the combined company to eventually be acquired by another defense contractor.

We do need to keep an eye on potential budget cuts, but I still see upside potential in the company with its next-generation satellite, GeoEye2, on schedule to launch next year. The stock is also pretty cheap right now, selling at less than 11X the $2.15 midpoint of 2012 earnings guidance, and there clearly continues to be a lot of M&A chatter surrounding the company. Buy GEOY under $25 for a revised target of $35, which is where it topped out last fall and would be an increase of more than 50% from current prices. 

Synchronoss Technologies (SNCR) is another company that had a sharp reaction to an earnings report, falling as much as 27% on Tuesday. The drop was not caused by earnings results, which were largely in line with expectations at $0.26 a share and a 22% increase in revenue, but primarily on concerns about its business with AT&T Wireless.

Sales from AT&T, which account for 50% of SNCR’s revenues, were unchanged from the fourth quarter, but sales guidance going forward was lowered from growth of 10% to growth of 5%–10%. The reason is that transactions are being delayed by AT&T’s decision to add additional voice automation functionality to a new activation channel. This transition to incorporate technological enhancements takes away revenues from Synchronoss for the next few months, but it has the potential to lead to new opportunities down the road. I was encouraged that full-year earnings guidance remains in line with expectations.

I was also encouraged that SNCR is compensating for the loss of AT&T business with additional business from Verizon and Vodafone. In fact, with flat sales from AT&T in the last quarter, we can infer that revenues from other customers were up 9.2% from the fourth quarter. On the conference call, management said it believes it has obtained potential business from Verizon that could lead to $200 million in revenues over the next five to six years – none of which is reflected in the current quarter’s revenues.  

Today, the company announced it may repurchase up to $25 million of its stock, representing a little less than 4% of its market value at current prices. While that’s not a huge amount and won’t have a dramatic impact on earnings per share, it’s still a positive and shows that management has confidence in the company’s future.

SNCR is still positioned to enjoy solid long-term growth as it recoups the business from AT&T (hopefully within the next couple of quarters or so), adds business from other wireless carriers, and continues to add value services for its wireless customers beyond activation – including marketing opportunities. As I mentioned, the company maintained full-year earnings guidance still in line with expectations, and as the market feels more assured of that, I expect the stock to move higher. In view of Tuesday’s action and as we monitor the situation with AT&T, I am lowering our buy limit for SNCR to $22 and our target to $30.

Sincerely,

Hilary Kramer
Editor, GameChangers