Monday, January 15, 2018

CK Asset Holdings Prizing Profits Over Property Pure-Play

When CK Asset Holdings (OTCPK:CHKGF) [1113.HK] was originally created as Cheung Kong Property, the idea is that this would be more or less a pure play on property development and management in China and Hong Kong. That lasted about a year or so, before management announced an intention to diversify beyond property and pursue more of a conglomerate-type structure with investments outside of property development or property management.

Although there are some concerns and drawbacks to this move, net-net, I think it is a positive decision for shareholders. Rather than being tied to the ups and downs of the property cycle (which is looking more “down” in CKA’s core markets), the company’s managers can see fit to recycle and allocate capital wherever the best long-term opportunities may lie. The company hasn’t abandoned property, but can now (I believe) make better long-term decisions without having to stick to a rigid mandate.

Valuing this company ahead of what is almost certain to be additional investments in non-property assets is challenging. I believe the company can generate good adjusted earnings growth (around 7%) even with single-digit ROEs, supporting a fair value of over $10.50 for the ADRs, but there are a lot of unknowns about the composition of earnings five or 10 years down the line.

I would note that CKA’s ADRs do not offer good liquidity. Investors who have the option to invest in the Hong Kong-listed shares should certainly consider doing so.

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CK Asset Holdings Prizing Profits Over Property Pure-Play

CapitaLand Broadening Its Focus To Include More Higher-ROE Services

Singapore's largest property developer, CapitaLand (OTCPK:CLLDY) (CATL.SI) had a pretty good 2017. Helped by improving conditions in Singapore and China, not to mention significant project openings, CapitaLand's local shares climbed 20% and the ADRs did even better.

Although these aren't the easiest shares to own, and it's not a simple company to model, I continue to believe the story and opportunity are worthwhile. CapitaLand management has shown repeatedly that they can successfully develop and manage properties and recycle capital into new value-creating projects. What's more, the company is a good play on the rising middle class in China, and to a lesser extent, Vietnam, India, and Indonesia. With the shares still about 10% to 15% undervalued, CapitaLand looks like a reasonable option for investors who want exposure to consumer-centric real estate in China and Southeast Asia.

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CapitaLand Broadening Its Focus To Include More Higher-ROE Services

K2M Looking To Move Past A Disappointing 2017 With Innovation-Fueled Growth

The last year, and especially the last six months or so, hasn't been very friendly to the pure-plays in the spine space like K2M (KTWO) and NuVasive (NUVA), and though Globus (GMED) has had no such problems. In the case of K2M, this company's focus on complex and degenerative cases hasn't spared it from some of the same overall pressures that have hit the sector, and the shares were down about 15% from the time of my last article before a recent rally shrunk that underperformance a bit.

Although K2M's recent underperformance is a little concerning, the company still has a strong line-up that should drive better results in 2018 and beyond. Competition remains a risk, but K2M has brought innovation to a space that has generally been overlooked and that has helped serve as a "force multiplier" for the sales effort of this relatively small company. While I wouldn't buy (or recommend) a stock on the basis of M&A potential, K2M looks like an attractive digestible target, but the shares have enough standalone upside to justify a closer look.

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K2M Looking To Move Past A Disappointing 2017 With Innovation-Fueled Growth

Thursday, January 11, 2018

Gruma Looks Like A Simple, Undervalued Story With Multiple Levers

Gruma (OTC:GPAGF)(GRUMSAB.MX) hasn’t been an especially rewarding stock for investors in recent years, as the shares have traded within a somewhat narrow band over the past two and a half years. Despite that lackluster recent history, I believe shareholders could see better returns in the coming years as the company leverages improving growth prospects in markets like the U.S. and Europe and drives simultaneous margin improvement. In the shorter term, Gruma should also benefit from lower input costs, new plants scaling up, U.S. tax reform, and a potentially weaker Mexican peso.

I’m looking for mid-single-digit long-term revenue growth from Gruma, as the company continues to expand its branded products business in the U.S. and leverages underlying volume growth, while also seeing more market expansion in Mexico. My FCF growth expectations are considerably more ambitious, but driven by my expectation that Gruma will pass through some “breakpoints” where FCF generation should scale up quickly. All told, I believe Gruma shares are about 20% undervalued today.

Investors should note that since Gruma canceled its ADR program, the ADRs are not very liquid. That is a drawback (and a risk factor) to the investment thesis, though investors can consider the option of buying the local shares (most brokers that offer international trading include Mexico in their offerings).

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Gruma Looks Like A Simple, Undervalued Story With Multiple Levers

MSC Industrial Can't String Together Two Strong Quarters

With a higher valuation come higher expectations. MSC Industrial (MSM) had been enjoying a solid run since its last quarterly report, a report which brought some much-needed encouragement back to analysts and investors after a prolonged stretch of lackluster results and increasingly threadbare explanations from management. Fiscal first quarter results were unfortunately a step in the wrong direction, with the company coming up a little short on revenue and margins and management not really having a lot to say to brighten the story.

I’ve been conflicted about MSC shares for a while now, as I think the underlying trends in margins are more worrisome than management wants to acknowledge and that management’s comments on the business have not instilled confidence. On the other hand, this is a company with a long track record of double-digit returns on capital (even at the bottom of the cycle) and good share in a manufacturing/industrial sector seeing a strong rebound.

I don’t think MSC shares are ridiculously expensive, but then I also think we’re at a place in the market where you have to be more careful about company quality, valuation, and momentum (momentum in the sense of business conditions/performance, not stock performance). As I’ve said many times, I’m reluctant to part with the shares of a company that has performed well for me, but I will say I’m much closer to the exit now than the entrance.

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MSC Industrial Can't String Together Two Strong Quarters

Globus Medical Revving Up Into 2018

I’ve thought highly of Globus Medical (GMED), but I really didn’t expect the strength in the stock that the market has delivered since my last write-up. The shares have risen more than a third in a little more than six months and close to 80% in the past year, with the stock really taking flight after third quarter earnings. I believe at least some of this is due to Globus Medical offering pretty clean growth in a spine market where growth has become harder to find recently, not to mention the upside from the company’s entry into trauma.

It’s not all that comfortable to be on the negative side of a story with momentum, but I struggle to make the numbers work with Globus now. I do believe the company’s new robot platform, trauma products, and strong overall portfolio in spine can drive high single-digit revenue growth and double-digit FCF growth, but that’s already in the share price and I’m not comfortable paying more than 5.5x forward revenue. That being the case, I’ll be cheering from the sidelines for the time being.

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Globus Medical Revving Up Into 2018

A Sluggish Spine Market Keeping The Pressure On NuVasive

NuVasive (NUVA) is a case in point for a couple of things I've long believed about stocks. First, the process of revising earnings and expectations usually takes multiple quarters. Second, "buy on pullbacks" is actually hard advice to follow, as good companies don't often get all that cheap unless there are some legitimately scary (or at least nerve-wracking) issues going on with the company.

Although NuVasive shares eventually showed a little positive momentum after my last piece, the shares are down about 10% from that level now after another sell-off tied to the company's guidance at a major sell-side industry conference. With a less robust outlook for 2018, I've trimmed back my expectations some, but I still believe the shares are undervalued on the basis of long-term growth in the mid-single-digits. NuVasive has work to do to restore investor confidence, though, so I don't expect a sharp turnaround outside of an unexpected event like a buyout.

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A Sluggish Spine Market Keeping The Pressure On NuVasive

DMG Mori Running On A Global Tool Recovery

Companies appear to be opening their wallets for capital investment once again, and that has been very good news for DMG Mori (OTCPK:MRSKY) ((6141.TO)). This Japanese (and German) leader in the machine tool space has seen its share price almost triple from its early 2016 lows and rise almost 80% in the last year as the company starts to leverage its strengths into an improving order cycle.

With 2017 being the first year of growth off a trough, DMG Mori ought to be looking forward to at least a few more years of solid order growth, fueled by underlying drivers that include a need to replace aging machinery, a need to automate to remain cost-competitive and deal with a skilled worker shortage, and new technologies. Even so, the strong run in the shares has already captured a sizable chunk of the value, and I would note that analysts don't seem ready to believe that this cycle will be as strong as past cycles.

DMG Mori is more richly-valued than Hurco (HURC) (which I own), and there are valid reasons why it should be - it's the largest player in the field, and it has exceptional scale and operating leverage, among other reasons. What's more, there would seem to be room for analysts to raise their expectations in the future if this cycle matches prior upswings. That said, a lot here is riding on the overall health and growth of global manufacturing, so the current spread between the share price and fair value isn't as robust as I'd like.

I would also warn U.S. investors that the ADRs for DMG Mori are not liquid at all. The Japanese shares, however, have no such problem and are a better option for those investors able and willing to go to the added trouble.

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DMG Mori Running On A Global Tool Recovery

Wednesday, January 10, 2018

Alnylam Intensifies Its Focus On Rare Disease

Alnylam (ALNY) had an active 2017, with its first new drug application (or NDA) submitted to the FDA and multiple clinical read-outs, and 2018 is likely to be no less busy. This new year should see the company get its first FDA approval and begin its first commercial launch, in additional to more incremental data on several programs, including data that could potentially support an NDA filing for givosiran before year-end. Moreover, management has not been shy about leveraging good news to raise funds, leaving the company with close to $1.7 billion in cash to start the year.

Alnylam remains a risky biotech. While approval for its lead drug seems highly likely, the FDA could still surprise the company and there are still relevant questions about how the drug will fare in the real world. The company’s pipeline likewise still contains ample risk, though Alnylam has actively worked to identify biomarkers that can help point toward efficacy relatively early in development. With upside close to $140, there are still valid reasons to own Alnylam, but this is now a well-liked stock with a robust market cap that is many years away from generating the sort of earnings to support that optimism.

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Alnylam Intensifies Its Focus On Rare Disease

Hurco Rebounding With The Machine Tool Cycle

With machine tool orders picking up around the world, these are better days for Hurco (HURC), a small and somewhat specialized manufacturer of machine tools. The shares have reflected at least some of the improving market conditions, with the stock up over a third over the past year, beating the S&P 500, but lagging fellow small-cap tool manufacturer Hardinge (HDNG) over that time.

This past year (2017) marked a return to growth in the industry and a switch from the “peak to trough” to “trough to peak” cycle. If this next cycle is anything like the past, there should be another three to five years of growing orders, fueled by ongoing factory automation, the replacement of older, inefficient tools, and growth in markets like aerospace. Even if this cycle is on the shorter end, Hurco should be looking at a few years of revenue growth and margin leverage opportunity, and management has shown in the past that they can capitalize on healthy markets.

Valuation is tricky. Cash flow-based modeling in such a cyclical industry is hard and it tends to lead toward undervaluing companies on the way up and overvaluing them on the way down. Moreover, there are opportunities for Hurco to exceed my expectations in the U.S. and with gross margin improvement. So although the shares aren’t especially cheap on a DCF basis, a 7.5x multiple to my 2018 EBITDA estimate offers some additional upside.

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Hurco Rebounding With The Machine Tool Cycle

Wednesday, January 3, 2018

Valeo Stuck In A Construction Zone, But An Attractive Highway Awaits

This has been a challenging year for French auto parts supplier Valeo (OTCPK:VLEEY
, VLOF.PA). With recent disappointments in the company’s revenue growth and ongoing investments in electric vehicle (or EV) and driver assistance technologies pressuring margins, the shares haven’t performed quite as well as investors might have hoped. What’s more, there are near-term challenges like the status of Korean OEMs within China that could continue to pressure revenue in the short term.

Even so, I believe these are short-term impediments to a strong long-term story. Along with rival Continental AG (OTCPK:CTTAY), Valeo is carving out a strong position in the emerging EV ecosystem, and the company is well placed to capture significant content share in hybrids and pure electrics. Other opportunities like driver assistance remain attractive as well, with Valeo having an uncommonly broad technology footprint. A long-term target of 8% revenue growth and low-teens free cash flow growth is hardly conservative for any established auto parts company, but I believe Valeo’s leverage to EVs and ADAS can support it, and those projections in turn support a fair value about 10% higher than today’s price.

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Valeo Stuck In A Construction Zone, But An Attractive Highway Awaits

Rexel Plugged Into Improving Trends

Distribution is a tough business, and Amazon's (AMZN) entry into industrial distribution has not made life any easier for companies like Grainger (GWW), Fastenal (FAST), Rexel (OTCPK:RXEEY), or WESCO (WCC). Even so, I think there's a worthwhile opportunity in Rexel today, as the market seems to be overestimating the threat from Amazon, and underestimating the benefits to be had from an improving construction market in Europe, self-directed internal improvements, and the benefits to be had from further consolidation.

I don't expect torrid revenue growth from Rexel, but I do expect some growth and improving margins to drive more compelling FCF growth, as new management responds to an activist investor's involvement with far-ranging self-improvement initiatives. With around 20% to 25% upside from here, Rexel looks well worth considering.

Rexel's ADRs are not liquid, and that is a shame. Investors can nevertheless look to the Paris-listed shares (RXL.PA) which have far more liquidity and which are available through many larger brokerages.

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Rexel Plugged Into Improving Trends

2018 Will Have Challenges, But Itau Unibanco Poised For A Return To Growth

This latest downturn in Brazil has been a challenging one for the banking sector, and management at Itau Unibanco (ITUB) has consistently overestimated loan growth and underestimated credit deterioration. That notwithstanding, management has steered this bank well through a tough period, and the shares have done well in 2017 as conditions in Brazil continue to improve.

2018 is likely to be a challenging year for the banking sector, as loan growth is likely to improve but not enough to offset compression to net interest margins. With likely limited options to reduce costs and cost of risk, I would expect earnings growth to be "meh" in 2018, but with a much stronger outlook for 2019 and 2020. Further complicating this outlook is the presidential election cycle in Brazil and its potential impact(s) on the cost of capital.

I think Itau Unibanco can beat the S&P 500 over the next couple of years, but I think the likely returns (low teens) are pretty well offset by the risks, so I wouldn't call this a slam-dunk buy. As a quality play on Brazil, and Brazil's return to growth, though, it's not a bad longer term holding to consider and especially on dips/pullbacks.

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2018 Will Have Challenges, But Itau Unibanco Poised For A Return To Growth

Veeco Instruments Battered As Doubts Mount

This has been a lousy year for Veeco Instruments (VECO), as this supplier of tools for the LED and semiconductor markets has seen its share price cut in half on repeated earnings disappointments, an unexpected litigation outcome, and growing worries about the company's long-term margin and growth leverage. While the acquisition of Ultratech earlier in the year achieved the company's goal of diversification, it seems to be coming at the cost of even more volatility and uncertainty in the business.

I can see some upside in the shares from here, but it's not clear to me that it is worth the hassle and the risk. Veeco is going into 2018 with a strong backlog, but the MOCVD market could be approaching a near-term peak and serious emergent competition is eroding margins. In the advanced packaging and semiconductor businesses, Ultratech's historical volatility is continuing and there are no guarantees on the timing or magnitude of LSA or packaging-driven growth.

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Veeco Instruments Battered As Doubts Mount

Carpenter Technology About To See A Significant Ramp

The three-year period from mid-2014 to mid-2017 wasn't especially kind to specialty alloy companies like Carpenter Technology (CRS), Allegheny Technologies (ATI), Haynes International (HAYN), and Universal Stainless & Alloy (USAP), as a sharp market decline in energy and several heavy industrial end-markets coincided with a sluggish period in aerospace that was exacerbated by many industry players (especially on the fastener side) moving to a more efficient inventory management approach.

It's a different part of the cycle now, though, and Carpenter should enjoy several years of good revenue growth and improving margins - not only due to improving end-market demand and volume-driven leverage but also significant changes brought about by the CEO in how the company operates. Although the shares don't look like a bargain on the basis of long-term cash flow, I think there's a credible argument for a fair value in the mid-$50's to low $60's on an EBITDA basis, though I would remind and caution investors that this is a stock to "date", not "marry".

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Carpenter Technology About To See A Significant Ramp

Friday, December 29, 2017

Gerdau On A Better Path, But Higher Utilization Is Essential

With Brazil looking healthier and the U.S. government taking a stronger position with respect to protecting domestic steel production from imports, Gerdau’s (GGB) outlook has improved in many respects. Even so, the share price performance since my last update in late 2016 hasn’t been all that special – the 30% move isn’t bad, but you’d have done only slightly worse with the S&P 500 (without the attendant risk and volatility), and other steel companies like Steel Dynamics (STLD), Nucor (NUE), and Ternium (TX) would have delivered even better returns.

I expect that Brazil will continue to recover, and I’m cautiously optimistic that the U.S. market will support better margins for Gerdau’s long steel products. I continue to believe that Gerdau can generate long-term FCF growth in the mid-single digits, with double-digit growth in both FCF and EBITDA from 2018 out through 2021. The valuation picture is mixed; the shares are no longer a bargain on a DCF basis (not surprising for a cyclical company in a recovery cycle), but EV/EBITDA suggests some potential upside is still in play.

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Gerdau On A Better Path, But Higher Utilization Is Essential

Argo Growing Its Business, But Profitability Remains A Concern

Argo Group (AGII) has been an interesting, albeit frustrating, stock to follow for a number of years. There are a lot of positives, including strong underwriting quality, dividend growth, and recently reinvigorated premium growth, but there are also ongoing concerns related to issues like persistently sluggish tangible book value growth and weak returns on earnings. To that end, the shares are only up about 10% from my last write-up in early 2016, and investors would have done better with other insurers like Arch Capital (ACGL), Chubb (CB), Travelers (TRV), or W.R. Berkley (WRB).

I can't say that I really like the valuation on Argo today. I do think the company's efforts to grow its premiums will eventually help its expense leverage (a long-sought goal), and I likewise think that expanding its Lloyds business through M&A should help long-term leverage there. Offsetting that are worries about industry loss trends and the company's persistent issues with generating attractive operating leverage. While I do believe that Argo can generate double-digit EPS growth over the long term and eventually get its return on tangible equity above 10% on a consistent basis, I think the valuation amply reflects that.

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Argo Growing Its Business, But Profitability Remains A Concern

MTN Group: Light At The End Of The Tunnel, Or Another Oncoming Train?

For those who don't own MTN Group (OTCPK:MTNOY) shares, the experience has been like something out of a Charlie Brown cartoon. You think things are going to be different, that the company is going to push through its execution issues, only to end up flat on your back, looking at the sky, and wondering how you got fooled again and let the ball get yanked out in front of you. Although these shares actually have beaten the S&P 500 over the past year, currency moves had a lot to do with that and the shares are down pretty meaningfully over the last five years (not unusual for an emerging market stock, but still…).

So, now what? MTN Group has new leadership and a new plan, a plan that involves improving network quality, restoring some luster to the brand, and running the business on the basis of sound principles like risk-adjusted returns and ROIC. That sounds like exactly what the company should be doing, and there is significant potential to do better here, but that has to be set next to the risks. Those risks include over-spending on capex (and generating little-to-nothing from it), cutting the dividend, and regulatory and economic risk across its operating footprint.

In a bullish scenario, I could argue for a price in the $12-$13 range, but I can just as easily argue for a bearish scenario in the $8 to $9 range. Given the risk-reward trade-off, today's price seems fair - I believe investors can expect better-than-S&P 500 returns, but the real opportunity will come if and when management restores investor confidence and drives a rerating process.

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MTN Group: Light At The End Of The Tunnel, Or Another Oncoming Train?

Monday, December 25, 2017

Despite Ongoing Operational Improvements, Cosan Still Undervalued

Following and modeling Cosan Ltd. (CZZ) is a little like training for endurance sports - you spend a lot of time while you're doing it wondering why you're bothering to do it. After all, there are two share classes, a somewhat complicated holding company structure, and many commodity moving parts to account for in an analysis. With the shares up more than 30% over the last year and close to 250% from the 2015 lows, though, I think you can certainly argue that there has been some gain for shareholders willing to take on that pain. Better still, I continue to see upside in these shares from both operational improvement and a shrinking discount to the underlying value.

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Despite Ongoing Operational Improvements, Cosan Still Undervalued

W.R. Berkley Has A Lot To Live Up To

I understand that good companies should trade at a premium, but it is getting harder for me to reconcile W.R. Berkley’s (WRB) valuation with the realities in the insurance market today and the likely trajectory over the next few years. W.R. Berkley is a very well-run specialty insurance company, but rate growth is hard to find, claims severity is worsening in some lines, and reserves are looking a little thin across the industry.

The insurance industry is cyclical and the difficult market conditions of today will eventually improve, but the shares seem to be pricing in high single-digit long-term earnings growth, and I don’t think that leaves much upside in the share price.

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W.R. Berkley Has A Lot To Live Up To

Canadian Western Bank Has Restored Itself As A Growth Bank

From the summer of 2014 through the summer of 2017, Canadian Western Bank (OTCPK:CBWBF) (CWB.TO) endured an ugly downturn brought about by the sharp decline in oil prices and the resulting impact (real and perceived) on the economy of Western Canada. Although this downturn did knock Canadian Western back a bit, it didn’t appear to do any lasting damage. More importantly, management stuck to its long-term plans throughout the downturn, plans that included expanding its equipment leasing operations, its mortgage operations, and its business mix outside of Alberta.

With the shares having doubled of the February 2016 low, risen more than 50% from my last write-up, and risen more than 20% over the past year, this isn’t an undiscovered turnaround story. Instead, it’s back to being a growth story, with management targeting strong lending growth in the coming years and progress towards mid-teens ROEs offering double-digit earnings growth potential. As the share price largely reflects those growth prospects, I’d call this more of a hold (or a watch list candidate), but it’s a name I’d keep an eye on for occasional pullbacks.

I would also recommend that investors considering an investment in Canadian Western strongly consider the Toronto-listed shares (CWB.TO). While the ADRs do trade, the liquidity is unattractively low (whereas the Toronto-listed shares trade over 300K per day).

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Canadian Western Bank Has Restored Itself As A Growth Bank

COPEL's Potential Value Mitigated By Ongoing Execution Concerns

A management team's ability to execute is often the difference between "value" and "value trap", and Brazilian electrical utility COPEL (NYSE:ELP) has been far more of the latter over the past three years, leading the shares to significantly underperform peers like Eletrobras (EBR), CTEEP, and Equatorial Energia (OTCPK:EQUEY), as well as the broader Brazilian market. The weak state of the Brazilian economy is not the fault of COPEL's management, but the company's ongoing operational inefficiencies in its distribution operations ("Disco") certainly fit under their umbrella of responsibilities and the company's position/exposure to spot pricing likewise lands on their doorstep.

Even with a higher discount rate to account for the elevated debt situation and management's missteps, COPEL shares look undervalued on the basis of long-term revenue growth in the mid-single digits and improving FCF margins. I'd also note that the shares trade at a pretty sizable discount to tangible book value. All of that said, I can only give a tepid endorsement to these shares given the skill (or lack thereof) management has shown during this challenging time. The Brazilian electricity market is not an easy place to compete, and the value I see in the shares is tempered by real questions as to whether management will be able to realize that value for shareholders.

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COPEL's Potential Value Mitigated By Ongoing Execution Concerns

The Ciena Roller Coaster Is Back In The Buy Zone

I’ve warned before that Ciena (CIEN) really isn’t a great buy-and-hold stock (unless you have a lot of patience…), and the past few months have backed that up. While the shares did well after my last write-up and a strong second quarter, the shares started to weaken in July with growing concerns about the near-term growth outlook pushing the stock back below $20 for a time.

The outlook for optical in 2018 is not particularly strong, with expectations for basically no growth in long-haul and concerns in metro that Verizon (VZ) spending has already peaked. While Ciena still has some company-specific drivers like its datacenter interconnect business, its new WaveLogic Ai chipset, and its growing software business, this company has long struggled to regain credibility from the Street and confidence in management’s long-term goals for revenue and margins.

With the shares back down in the low $20’s, I’m more bullish on Ciena. I believe you have to be careful with cyclical stories (and the 100G rollout is a cyclical driver), but I believe Ciena has taken a lot of smart steps to improve and expand its business, and I believe long-term revenue growth in the 4% to 5% range is attainable, supporting a double-digit FCF growth rate and a mid-$20’s fair value if management can generate modest margin improvement from here.

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The Ciena Roller Coaster Is Back In The Buy Zone

Wednesday, December 20, 2017

Silicon Labs Continues To Build On Its Strengths

Committing to the Internet of Things (or IoT) has been a transformative decision for Silicon Labs (SLAB), as this smallish semiconductor company continues to leverage its broad wireless capabilities to benefit from the growth in IoT deployments. These shares are up more than 40% over the past year, and revenue looks on track to continue high single-digit to low double-digit growth for some time, pushed along by the strength in IoT, but also aided by exposure to markets like optical networking and electric vehicles. The company's recent announcement of the acquisition of Sigma Designs (SIGM) furthers the story, adding another wireless standard and a decent chunk of fast-growing revenue with expense synergies.

Silicon Labs has performed well relative to expectations, and the shares are being richly rewarded for the company's above-average revenue growth and improving margins. While I do expect high single-digit revenue growth over the long term (including Sigma) and double-digit free cash flow growth, valuation is definitely in the "bull cycle" part of the range, and I cannot find enough value to get comfortable with the idea of buying for my own account.

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Silicon Labs Continues To Build On Its Strengths

F5 Needs Some "Creative Destruction"

One of the hallmarks of the best-run companies is that they’re not the last to leave a party; well-run companies recognize that self-obsolescence and “creative destruction” are often essential parts of maintaining a healthy business over the long term. To that end, I would note that companies like Cisco (CSCO), Palo Alto (PANW), and VMware (VMW) often are building toward the next big thing while the current big thing is still generating meaningful cash flow.

That has not been the case, in my opinion, with F5 (FFIV). Although there’s nothing wrong with F5 getting everything they can out of the fading application delivery controller (or ADC) opportunity, I believe the company has not gone far enough, fast enough, to position the company for ongoing growth in the new cloud and hybrid cloud enterprise world.

These shares are up a little from when I last wrote about them, with a solid double-digit rally off the October lows, but I cannot muster much enthusiasm for the shares again. While I expect F5 to generate ample cash flow for some time, I really would like to see management use the company’s balance sheet to acquire more growth and relevance in the emerging networking world.

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F5 Needs Some "Creative Destruction"

Mellanox Knocked Around, But Definitely Not Knocked Out

It’s not uncommon for elevated volatility and controversy to surround growth stocks, but Mellanox (MLNX) seems to get more than its share. It certainly doesn’t help that the company competes with heavy-hitters like Intel (INTC) and Broadcom (AVGO), nor has it helped that the company’s InfiniBand revenue (once the prime attraction of the story) has fallen off significantly. Add in elevated spending concerns, and it has been a bumpy ride for shareholders.

That bumpy ride has also been relatively productive for shareholders recently. Between a well-known activist shareholder taking a stake and management ratcheting down operating expenses, the shares have shot up this year and finally started outperforming the sector again.

I liked Mellanox back in May of this year, but as things sit today, I think most of the remaining value lies in the extent to which Mellanox attracts solid M&A attention and/or provides credible visibility to renewed InfiniBand growth. The stock price already assumes mid-teens growth in adjusted free cash flow, but a buyout bid would likely start in the high-$60's, if not the $70's.

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Mellanox Knocked Around, But Definitely Not Knocked Out

Can Fifth Third Grasp All That It's Reaching For?

Plans and goals can be great things, but reaching them can be tricky and a set-up for disappointment. In the case of Fifth Third (NASDAQ:FITB), management has had no problem laying out bold targets tied to its Project North Star self-improvement plan, but recent performance creates some valid questions about the magnitude of growth this Midwestern bank can really achieve and where that growth will come from.

The Street is already expecting a lot of improvement from Fifth Third, and I struggle to see how these shares are a bargain. Even with a lower tax rate, today’s share price more than rewards Fifth Third for the robust Project North Star targets, as well as a healthy overall banking environment.

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Can Fifth Third Grasp All That It's Reaching For?

Sunday, December 17, 2017

BBVA Posting Better Results And Making Better Decisions

Spanish banks have done alright over the past year, with BBVA (BBVA), Santander (SAN), and Caixa (OTCPK:CAIXY) all up between 20% and 30%, in line with other well-liked European banks like ING (ING), and well ahead of some of their other large European peers. Even with the turbulence in Catalonia, economic conditions have been improving in Spain, and with that so has credit quality. What’s more, both BBVA and Santander have gotten a little more proactive about selling underperforming assets.

While BBVA has done fine over the past year, there could still be a little upside left in the shares. Even though I don’t think BBVA will get to the psychologically important 10% ROE level for a few years, I do expect double-digit earnings growth over the next five years and high single-digit growth over the long term, supporting a fair value around $9/ADR.

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BBVA Posting Better Results And Making Better Decisions

AerCap Holdings Still At A Double-Digit Discount To Fair Value

The last year or so has seen aircraft leasing company AerCap (NYSE:AER) finally get some of its due. While the Street seemingly ignored the value that management has created by selling older planes above book value, buying back stock below book value, and maintaining a high-quality, virtually fully-leased fleet, the last year has at least seen the shares outperform the S&P 500.

I liked AerCap back in the fall of 2016 and I still like it now. I do expect lower net spreads, net income, and share buybacks over the next two years, but I expect AerCap to continue growing earnings at a long-term rate around 4% and to maintain a double-digit ROE. With aircraft productivity likely plateauing and ongoing growth in passenger traffic, AerCap should have ample opportunities to grow its fleet while maintaining attractive utilization and spreads.

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AerCap Holdings Still At A Double-Digit Discount To Fair Value

Innospec Offers More Upside On Growth And Margins

The last year or so has been a choppy one for Innospec (IOSP), as volumes and price/mix have been choppy across the business and the company absorbs the lower-margin business it acquired from Huntsman (HUN) at the end of December 2016. As far as peer comparisons go, Innospec is a tricky stock to benchmark given its mix of businesses, but I’d call its performance since October of 2016 “middle of the pack,” with companies like NewMarket (NEU) and Solvay (OTCPK:SOLVY) doing worse and companies like Ecolab (ECL), BASF (OTCQX:BASFY) and Lonza (OTCPK:LZAGY) doing better.

Looking ahead, I believe it will be quite a while before the electric vehicle revolution materially impacts the fuel specialties business, and I think the company has a long growth runway for its performance chemicals business. Its oilfield chemicals business should continue to benefit from improving U.S. onshore activity, while the octane additives business will continue to exist in a regulatory twilight zone.

If Innospec can generate mid-single-digit revenue growth and drive FCF margins back toward 10% on sustained improvements in the performance and oilfield chemical businesses, a fair value in the low-to-mid $70s seems reasonable and can support a long position today.

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Innospec Offers More Upside On Growth And Margins

Hartford Financial Services Repositioned For Better Returns

The sell-side had long been waiting for Hartford (HIG) to “do something” on the M&A front, with widespread expectations that the company would eventually sell its Talcott run-off annuity business as well as rumors that Hartford could be a buyer or a seller in other areas of insurance. The last couple of months have seen most of these expectations come true, as the company sold its Talcott business and acquired Aetna’s (AET) group insurance business.

These deals leave Hartford better-positioned to reach and exceed that elusive 10% ROE threshold and shrink the valuation gap with peers like Travelers (TRV) and Chubb (CB). To that end, the shares are up about 25% since my last write-up, more or less running in line with Travelers and Chubb over that time.

At this point, I would consider Hartford more of a strong hold than a buy. The company has improved itself over the past two years and is active in attractive segments of the market, but there are increasing competitive risks and opportunities to improve returns that management may or may not be able to execute.

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Hartford Financial Services Repositioned For Better Returns

AGT Looks Undervalued, But This Pulse Business Has Taken A Pounding

As I have written in the past, one of the hardest parts of “buy the pullback” advice is that it sometimes leads you to grab at falling knives. Such has been the case with AGT Food and Ingredients (OTCPK:AGXXF) (AGT.TO), where the shares have fallen another 20% since my mid-May update as management (and I) seriously underestimated the depth and breadth of the business downturn spurred by a robust 2017 pulse crop in India.

Feeble volumes have hammered margins in the traditional pulse processing and handling/distribution operations, while the company’s food and ingredients businesses are not yet large enough to do much more than slightly cushion that blow. This company has been through this before, with the last serious downturn in 2012, and there are some reasons to think that business will bottom out in the second half of 2017. Even if that’s the case, though, it seems unlikely that 2018 is going to be a “business as usual” year and investors have to consider the long run of negative free cash flow here, as well as the debt situation and management’s sometimes-questionable strategic priorities and decisions.

I may be a glutton for punishment here, but I’m keeping this on my watchlist. A long-term revenue growth rate of 5%, underpinned by ongoing global growth in pulse consumption and growth in pulse-derived ingredients, and a mid-single-digit FCF margin can support a fair value about 15% higher than today’s price. I’m not buying today, though, as I would like to see fourth quarter results before making a commitment.

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AGT Looks Undervalued, But This Pulse Business Has Taken A Pounding

Microsoft Looks Like An Elephant That Can Still Dance

Very large companies tend to struggle to innovate and grow, and large tech companies in particular historically have a very hard time remaking themselves over time. With that, yesterday’s leaders in tech are seldom today’s leaders and today’s leaders seldom become tomorrow’s leaders.

And then there’s Microsoft (MSFT). This company certainly has several missteps in its scrapbook, including multiple failures in mobile devices (phones especially), but with Azure, Office 365, and Dynamics 365, Microsoft looks to be in a good place with respect to cloud computing, and businesses like LinkedIn and Xbox offer additional avenues to growth.

It is admittedly hard to come up with a novel scoop or thesis on a huge, well-covered stock like Microsoft, but I have nevertheless large companies like this trade at attractive multiples and generate above-average returns. If my expectation of mid-single-digit growth is valid, a fair value of $90 or more seems appropriate and these shares are worth considering even late in this bull market.

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Microsoft Looks Like An Elephant That Can Still Dance

Tuesday, December 12, 2017

Orbotech's Multi-Prong Growth Strategy Looking Better And Better

I liked Orbotech (ORBK) back in the summer of 2016, but my bullishness then underestimated the emergent momentum in the company’s business and the market’s enthusiasm for tool/machinery plays leveraged to trends like OLEDs. While Orbotech’s revenue growth can be erratic from quarter to quarter, the third quarter saw all the pieces coming together and management’s November analyst day laid out a bullish outlook for the next three years.

Valuation is less clear-cut to me now, with the shares up about 60% over the past twelve months and close to 250% over the past three years. Demand tied to advanced smartphones, AR/VR, OLED, and other applications should be able to drive double-digit revenue growth for the next few years and high single-digit growth for the long term, but it’s hard to have confidence that the good times will just keep rolling in what has long been a cyclical industry. Although, I think you can make a cogent argument that the company’s growth and margin prospects over the next three years can support a higher price; there’s not much of a safety net from discounted cash flow and I consider this a higher-risk prospect from valuation and earnings predictability standpoints.

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Orbotech's Multi-Prong Growth Strategy Looking Better And Better

A Little Near-Term Softness Hasn't Changed The FEMSA Story

Although FEMSA (NYSE:FMX) haven’t done all that well since my last write-up, I think the modest pullback could be another opportunity for long-term investors to acquire shares in one of the best-run Mexican companies, not to mention one with consider room left to grow. FEMSA shares have been hurt by a combination of currency moves, natural disaster-related traffic disruptions, and some concerns about capital allocation, but I believe these are all short-term issues that don’t impinge upon the underlying value.

I continue to believe that FEMSA will leverage long-term high single-digit revenue growth into double-digit FCF growth, supporting a fair value in the $105 to $115 range. FEMSA has several NPV-positive potential capital projects to choose from, including accelerating the growth of OXXO, acquiring more drug stores, or expanding further outside Mexico, and I believe pullbacks below $100 are good buying opportunities.

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A Little Near-Term Softness Hasn't Changed The FEMSA Story

Roche Delivers Some Clinical Wins, But Skepticism Remains Largely Intact

Even though Swiss drug giant Roche (OTCQX:RHHBY) has managed to deliver a series of largely better-than-expected clinical trial results, you wouldn’t really know it from the share price. Despite a lot of skepticism going into the IMPower 150 read-out for Tecentriq in first-line lung cancer, Roche’s successful result seems to not to have done much to resolve questions and concerns about how it will stack up with rivals like Merck’s (MRK) Keytruda. So too with the very positive results from the HAVEN 3 study of Hemlibra.

As IMPower 150 was only the first, and arguably the riskiest, of five front-line Tecentriq trials in lung cancer, I think Roche is in a good position going into further read-outs in 2018. Likewise, I believe Roche has a long-term winner with Hemlibra even as gene therapy approaches look to gain meaningful share in the hemophilia space. At a minimum, then, I would argue that Roche has established three strong new drug platforms (Tecentriq, Hemlibra, Ocrevus) with blockbuster potential on top of a very robust R&D pipeline.

I believe Roche is undervalued up into the mid-$30s. Competition from biosimilars is going to do its damage to near-term reported financial results, but the market has known about this for some time. With Roche having, at least in my opinion, reestablished credibility that it can develop meaningful new therapeutics, I believe the shares are undervalued today on the basis of both its existing business and the potential pipeline contributions over the next decade.

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Roche Delivers Some Clinical Wins, But Skepticism Remains Largely Intact

Orchids Could Bloom Again After Withering Competitive Pressure

Orchids Paper Products (TIS) has been an awful call for me over the past 18 months, as this manufacturer of primary private-label tissue products was hit hard by pricing moves from the competition and its own elevated costs and challenges tied to getting a new plant up and running. At the worst, the company saw revenue drop more than 20% year over year, leading to its first quarterly operating losses in a decade, serious liquidity pressures, and the suspension of the dividend. With all that, the shares are less than half the price they were the last time I wrote about this company.

On the positive side, the company's new Barnwell facility is up and running, the company has been successful in targeting more premium business, and the book of business over the next year would suggest record revenue and EBITDA. On the negative side, price and cost pressures remain a risk and the company must do something about its liquidity situation, as there is little room for error here.

I believe a lot of things went wrong for the company all at the same time, but I don't believe the story is broken. If the new business comes through as expected, Orchids should be back on a path toward high-single-digit/low-double-digit revenue growth and a return to operating and free cash flow margins in the mid-teens. Those, in turn, support a fair value in the mid-to-high teens, making Orchids a high-risk story that does at least offer some upside.

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Orchids Could Bloom Again After Withering Competitive Pressure

Trouble With ING Is That Everyone Knows It Is Good

I’ve liked Dutch multinational bank ING Groep (NYSE:ING) for quite some time now and seen investors run hot and cold on the bank due to issues like its unbalanced exposure to dollar-denominated lending, its exposure to energy lending (which wasn’t that large), its capital requirements, and economic concerns about the markets in which it operates. More recently, though, ING seems to be getting more of its due on the basis of its solidly profitable retail banking franchises, its expense leverage, and its best-in-class digital offerings.

ING shares have performed toward the upper end of its peer group range over the last few years, lagging ABN Amro (OTCPK:ABNRY) a bit, but otherwise performing well next to KBC Group (OTCPK:KBCSY), BNP Paribas (OTCPK:BNPZY), Erste Bank (OTCPK:EBKDY), Deutsche Bank (NYSE:DB), Banco Santander (NYSE:SAN), and Nordea Bank (OTCPK:NRBAY). With that, I can’t really say these shares are undervalued anymore. There are certainly worse things than holding the shares of a fairly valued bank that is executing well and that pays a good dividend, but this isn’t really a name for bargain hunters looking to pay $0.80 and get a dollar back.

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Trouble With ING Is That Everyone Knows It Is Good

Compass Continues To Offer Some Value

It has been a while since I’ve written on Compass Diversified Holdings (NYSE:CODI), a trust that specializes in acquiring stakes in small-to-mid-sized companies, letting those management teams do their thing, and then harvesting the cash flow for distribution to shareholders and/or reinvestment in expanding the business. In the interim, CODI has basically stuck to its core model – disposing of a few assets, raising some capital, and redeploying capital into new acquisitions that should provide growing distributable cash flow into the future.

CODI shares are up about 15% since I last wrote about the business, but during that time, shareholders also collected sizable distributions (which are taxed differently than regular dividends). Although I do still have some concerns about the modest long-term growth prospects of the portfolio and the frequent quarter-to-quarter turbulence in portfolio company results, I still see enough value to make this a worthwhile name to consider for investors who want returns that are more skewed toward income. Should opportunities like 5.11 Tactical live up to their potential, though, there may be a little more growth potential than commonly appreciated.

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Compass Continues To Offer Some Value

Wednesday, December 6, 2017

It's Early, But PRA's Fundamentals Looking Better

It's too soon to sound the "all clear" and much too soon to just assume that PRA Group (NASDAQ:PRAA) will get back to historical levels of productivity and financial success, but there is a stronger base for a positive view now than there has been in some time. PRA still has to get its staffing situation sorted out (and improve productivity), and there are still big challenges in Europe, but the supply situation is looking better, and yields could potentially improve from here.

The "but" is that the shares are up about a third from their lows in the fall. However much of that was short-covering, the reality is that the current valuation reflects what I think is a reasonable recovery scenario. There are still avenues toward higher estimates (improved collections is the key one), but I'd say a mid-$30s price is pretty fair for the time being.

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It's Early, But PRA's Fundamentals Looking Better

A Drawn-Out Reset Of Expectations Should Lead To Better Days For Lenovo Shares

Lenovo's (OTCPK:LNVGY) bold and controversial decisions to try to work its PC magic in the mobile handset and server markets has thus far proved the doubters right. Margins have eroded since the acquisition of IBM's (IBM) x86 server business and Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Motorola business, and the share price has fallen by two-thirds from its mid-2015 high as investors have grown weary of the delays in transforming the acquired businesses into profitable contributors and grown more concerned about the long-term health of the PC business.

There are still valid reasons to worry that Lenovo shares could be a value trap, but expectations have been beaten down to a low bar. Lenovo's strategy to target higher-performance, higher-value markets in mobile and servers is a break with the company's past, but a logical one. What's more, management has not had to surrender much market share in PCs in its effort to support margins.

If Lenovo can grow revenue at a long-term rate between 2% and 3% and pull its adjusted free cash flow margins back up into the 2%-3% range, a fair value in the range of $15 to $17 still makes sense, even with a double-digit discount rate. The key question, though, remains whether or not the company can turn its mobile and server businesses into positive contributors (and/or jettison them) and restore investor confidence in Lenovo's business model and strategy.

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A Drawn-Out Reset Of Expectations Should Lead To Better Days For Lenovo Shares

Geared To Growth, Societe Generale's New Plan Doesn't Offer Much That's New

Between disappointing third quarter earnings and a new multiyear strategic plan that I believe many investors found underwhelming, Societe Generale (OTCPK:SCGLY) (GLE.FR) has seen its shares pressured once again. Although there have been some signs of life in this French bank’s international operations, the domestic operations have been lackluster, as have the capital markets businesses. Still, this is a bank that is structurally geared toward growth, and if economic growth does in fact pick up across Europe, Societe Generale may yet hit its long-awaited 10%-plus ROE target and unlock meaningful value.

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Geared To Growth, Societe Generale's New Plan Doesn't Offer Much That's New

GenMark's Credibility Is Dented, But The Sell-Off Is Excessive

If anything has been consistent about GenMark (NASDAQ:GNMK) over the past couple of its years, it has been this small diagnostic company’s difficulties in meeting its own development timelines. While the company did see the approval of its key ePlex multiplex molecular diagnostics system this June (after a roughly two-year delay), the company recently missed earnings expectations in a big way, lowered guidance for both revenue and system placements, and announced further delays for its blood culture cartridge.

GenMark is the kind of stock that will make investors prematurely grey as they wrestle with the meaningful potential of the system (and the molecular diagnostics market more generally), management’s execution issues, and the competitive landscape. I do believe the major downward move in the stock since August has created another opportunity for aggressive investors, but that opportunity has to be balanced against the very real risk that this is a company that will never get its ducks in a row and/or will not be bailed out by a buyout at an attractive multiple.

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GenMark's Credibility Is Dented, But The Sell-Off Is Excessive

Familiar Concerns Dogging Middleby

Even though value-oriented investors tend to approach the investment process with more patience than growth or momentum investors, timing still matters. Had I been writing this article on Middleby (MIDD) just three weeks ago, I’d probably have concluded that the shares offered a rare chance to pick up a proven (if controversial) grower at a reasonable valuation. With the third quarter results in the books, though, the shares have shot up more than 15%.

Although Middleby isn’t back at peak multiples, I’m more cautious on the shares with that recent run. There are still growth issues here, and I’m not fully convinced that the Commercial Foodservice and Residential businesses are in the clear. There are still ample growth opportunities for Middleby, but Welbilt (WBT) seems to be performing better than it has in recent years and it’s tough to make the cash flow numbers work unless you’re willing to accept what I believe is a relatively low required rate of return given the risks in the business model.

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Familiar Concerns Dogging Middleby