Showing Confidence

The market had another back-and-forth day as fiscal cliff negotiations continued, but ended higher despite some negative comments from House Speaker John Boehner that no substantive progress was made, indicating Wall Street still has confidence a solution will be found. Investors are also eyeing the next Federal Reserve Open Market Committee meeting in two weeks, which could lead to another round of quantitative easing to replace Operation Twist once it expires at the end of the month.

Also supporting the market right now are special dividends companies have been paying to distribute money to shareholders before a likely dividend tax hike. Costco (COST) was perhaps the most prominent company to do this, and was in fact willing to borrow money at today’s favorable rates to pay a special $7 dividend. The dividend has helped the stock, at least in the short run, rising from $96.50 per share before the announcement to over $100.

We talked about this shift toward special dividends in last week’s update and how even lower-priced stocks are getting in on the action. You may have noticed that our own FutureFuel (FF) closed today at $11.10 – much lower than yesterday’s closing price of $11.62 – yet was still indicated up for the day. That is because it went ex-dividend for its special dividend of $1.20 a share. The dividend was taken out of the stock price, per standard procedure, but will be paid to shareholders on December 16, even if you sell the stock before then. Another of our Breakout companies declared a special dividend this week, which I’ll tell you more about in just a bit.

With just one day to go, November has been a rocky month, and the factors that drove market performance will continue to have an impact in December. The big one, of course, is the fiscal cliff, as well as Wall Street starting to anticipate the corporate earnings outlook for 2013.

While today’s upward revision of third quarter GDP to 2.7% from 2% looks good for the economy and earnings, it was due in large part to upward inventory revisions that will take away growth from future quarters. Several disappointing retail sales reports were also released today, and while Hurricane Sandy was a contributor, it brought into question consumer demand beyond promotional Black Friday Events. It’s these kinds of reports that make it tricky to predict where the market will head in the short term. Longer term, I continue to expect some kind of deal to lessen the impact of the fiscal cliff, and I believe 2013 will bring its share of opportunities for us as long as we’re selective.

Our strategy in this kind of environment remains going after companies with a clear outlook ahead, and along those lines, I have a new stock to share today that is positioned to provide solid returns no matter what happens in Washington. Let me tell you about it now, and then I will update you on how our Fourth-Quarter Top Buys have performed.

New Breakout Buy: Lannett (LCI)

Lannett (LCI) could easily fit in several of our categories here in Breakout Stocks Under $10. It’s an absolute bargain, has solid growth prospects, and has turned around operational momentum in the last couple of years. The company also has promising catalysts on the horizon to boost the stock higher, and downside risk should be limited because management has promised to buy back shares if the stock dips to a certain price.

You can see why it’s such an interesting opportunity right now.

Lannett develops, makes and sells generic drugs, which are versions of brand-name drugs whose patent protection has expired. The whole generics industry should see strong growth as health care reform moves ahead in President Obama’s second term. That should be a nice tailwind for a company already in solid growth mode, with revenues increasing 70% from fiscal 2008 to fiscal 2012 (which ended in June).

LCI has approximately 30 products on the market. The top five are the real workhorses, bringing in nearly 70% of revenues in the last fiscal year, with the top two contributing 50%. They are Levothyroxine Sodium tablets, a generic version of the thyroid treatments Synthroid and Levoxyl, and Digoxin, a generic version of the congestive heart failure drug Lanoxin. Both products are part of a distribution agreement Lannett entered in 2004 with Jerome Stevens Pharmaceuticals. That agreement ends in two years, and the companies have entered preliminary talks to extend it. A successful outcome should be a nice catalyst for the stock.

Another catalyst is the large number of potential new products, including several that are in the late stages of development and have large potential markets. In total, LCI has 40 drugs in development, and 15 of them are waiting on approval at the FDA. Several of those would expand the company’s pain management franchise. There’s also a potential new chemotherapy drug that has annual sales of $207 million. If it is approved, LCI would receive higher than normal margins because it is the first generic company to file for approval.

Lannett sells its products primarily to wholesale distributors as well as chain drug stores and pharmacies. The pharmaceutical industry’s largest wholesale distributors, McKesson, Cardinal Health and Amerisource Bergen, accounted for 9%, 12%, and 11% of net sales in the last fiscal year. Lannett’s largest chain drug store customer, Walgreens, accounted for 18% of net sales in fiscal 2012.

Back to Growth Mode

Lanett’s last fiscal year was an important one because it showed marked improvement from fiscal 2011, when results fell after the company was forced to cut prices on its thyroid and cardiovascular products to retain a major customer. In addition, sales were impacted when LCI was forced to withdrawal a generic version of a vitamin product after reaching an agreement with the vitamins’ maker that conceded existing patents were still valid. Fiscal 2011 revenues declined 17.6% from $125 million to $103 million, and earnings per share fell from $0.31 to $0.03.

Last year was much better. Net sales in FY 2012 increased 15% to $129.9 million, and earnings grew to $0.14 a share. Among the contributing factors to the rebound were a price increase for the company’s C-Topical Solution product used as anesthesia during ear, nose and throat surgery, and new pain management and cardiovascular products.

Strong results continued into the first quarter of the new fiscal year, as Lannett is still benefitting from its new cardiovascular drug as well as newly introduced obesity drugs. In addition, prices for thyroid products began to firm up. Revenues in the last quarter jumped 22% to $35.3 million. The greater sales volume increased efficiency of the company’s manufacturing resources, and the gross profit margin soared to 39% from 30%. That is a dramatic increase, and given the company’s sufficient manufacturing capacity, any future increases in sales volume will boost margins higher and have an even bigger impact on profitability.

It’s also important to note that strong results came even with higher R&D spending, which lays the foundation for future growth. LCI increased R&D spending by over 50% to $3.8 million, but operating income still increased 120% to $3.7 million from $1.4 million. Earnings excluding unusual items were $0.07 a share versus $0.03 the prior year.

The key for the company going forward will be to continue to grow sales to drive further margin expansion and enable similarly strong operating leverage in the coming quarters. I expect some of the company’s pipeline candidates to be approved and add to those sales, making earnings estimates of $0.18 this fiscal year and $0.31 next year very achievable. That would be earnings growth of 157% and 72% in the next two years.

To top it all off, the stock is really cheap right now, especially given Lannett’s growth potential. LCI has cash and investments net of debt of $25 million, or $0.88 a share. Current assets less all liabilities come to $64 million, or $2.26 a share. The stock sells for only 2X this number, which is roughly equivalent to a liquidation value.

I was also very interested in managements comments on the most recent earnings call that they would support LCI by repurchasing shares should it drop to $4. That puts a bit of a floor underneath the stock, so our risk is lower than it would be otherwise as potential downside is more limited.

Lannett operates in an industry poised to flourish under health care reform; it has regained strong operational momentum; a number of new products that should drive future growth await FDA approval; and the stock is a bargain. Buy LCI under $5 for a first target of $7. I look for the stock to move higher over both the near term and the long term.

Fourth-Quarter Top Buys Update

It’s been an eventful fourth quarter on Wall Street, so I wanted to take a moment to review how our Top Fourth-Quarter Buys have performed so far this quarter and share my latest outlook on them heading into the final month of the year. Overall, our five stocks are down just 0.5% on average, compared to a decline of 1.9% in the Russell 2000, the small-cap index that tracks the kind of companies we go after. Considering the tough time low-priced stocks often have in difficult markets, I am pleased with how our top five have handled the volatility and believe this positions them well to benefit from any year-end rally. Let’s take a look at each one:

Universal Insurance Holdings (UVE) has been our best performing stock, gaining over 17% as the Florida hurricane season passed without a major incident and UVE benefitted from its bargain basement valuation. While third-quarter earnings were noisy, they reflected solid results except for prior period loss adjustments.

I mentioned last week that UVE could pay out a special dividend, and management announced yesterday that in addition to their regular dividend of $0.08 a share, the company will pay a $0.12 a share special dividend to shareholders of record as of December 15. The company has a very solid balance sheet, and I believe it will be able to both pay this dividend and retain its A.M. Best A- rating. With a regular dividend yield in excess of 7%, and with the company selling close to book value per share, I think further gains are ahead. UVE is above our buy limit, so continue to hold for our target of $5.50.

Crown Media (CRWN) is not a very volatile stock, so it has weathered the fourth-quarter storm well to realize a 7% gain. Third-quarter earnings were good, with revenues up 4% and adjusted EBITDA up 32% in the absence of a license expense. With subscriber and rating trends looking good for both the Hallmark Channel and The Hallmark Movie Channel, I expect we’ll see further earnings gains. Also helping annual results will be the strong upfront season the company had over the summer. CRWN closed above our $1.75 limit today, so buy only on pullbacks as we target $2.25.

Magic Software (MGIC) is flat this quarter as concerns about the global demand for technology have kept the stock depressed. But sales re-accelerated last quarter, with revenues up 9% after a low single-digit gain in the second quarter, and earnings gained to $0.12 from $0.10 a share. Although this was not the robust move I was hoping for, it was certainly in the right direction and should mean further gains ahead.

The company has a large cash balance of around $1.00 a share, and we could see some of this start to come back to shareholders. MGIC has no regular dividend, but it did declare a $0.10 a share dividend back in October. MGIC is a buy below $5.25.

The two stocks down the most in the top 5, CBIZ (CBZ) and Hackett Group (HCKT), remain two of the most attractively valued stocks on our entire Buy List. Both represent good bargain buying opportunities for the next month:

CBIZ (CBZ) fell after reporting what I felt were generally positive quarterly results of $0.11 versus $0.10 a year ago on a 3.2% gain in revenues. I think the market may be somewhat confused by expense reclassifications related to the company’s deferred compensation plan, which taken in their entirety do not impact earnings. Since the start of the quarter, CBZ shares are down 7%.

This week, the company announced that it will acquire the non-attest (non-auditing) assets of PHBV Partners, a professional consulting and accounting service provider specializing in health care compliance on behalf of federal and state government agencies. The deal will be highly accretive to CBZ, and is expected to add $0.04-$0.05 a share in diluted earnings in 2013.

With cash EPS of $0.80 likely this year, the stock is a great value at current prices. More accretive acquisitions will likely follow, and as the market gains greater comfort for the company’s results in 2013, I look for the stock to do very well. Buy CBZ under $6.25.

Hackett Group (HCKT) is down 19% so far this quarter, hurt by fears of a global economic slowdown that would impact its consulting business. However, the company’s third-quarter earnings of $0.11 versus $0.09 beat expectations by a penny, and management expects Europe to return to growth in the current quarter. Despite some negative impact from Hurricane Sandy, the company estimates earnings to be $0.09-$0.11 a share.

The important thing to remember about HCKT is this: The company repurchased 28% of its stock earlier this year through a Dutch auction at $5.00 a share. As long as it remains profitable, the company will retire the debt it incurred from the auction, and then be set up to potentially do another one to add to shareholder value. I remain confident in this stock and recommend you take advantage of its price pullback to buy HCKT up to $4.50.

WTSLA Beats Sales Expectations

Wet Seal (WTSLA) showed signs of improvements in its recent sales report, beating expectations with a November comparable same-store sales decline of 4.6%. Sales at Wet Seal stores fell 3.2%, after a 1.8% decline last year, and Arden B sales were down 12.8% after falling 11.2% last year. Hurricane Sandy contributed about a 1% decline in overall results.

Management said the results indicate re-merchandising efforts are paying off and helping to bring back long-time customers, and that further efforts should continue the trend. The company has sold the majority of its back-to-school and fall inventory and will eliminate the rest by mid-December.

I was very encouraged by these results. While Arden B is still experiencing sharp declines in sales, Wet Seal is by far the more important franchise, and when a new CEO is appointed, Arden B could be closed. The appointment of a new CEO is a key catalyst right now that I think the market is waiting on, and any hiring should help move the shares quickly toward our $3.50 target. Continue to hold WTSLA.

Sincerely,

Hilary Kramer
Editor, GameChangers