Monday, March 19, 2018

Waiting For The Next Overreaction With Exact Sciences

Although Exact Sciences (NASDAQ:EXAS) isn’t that old of a company, a couple general rules of thumb seem to have emerged – the company’s non-invasive Cologuard test for colorectal cancer is going to continue to gain share, and shorts are going to continue to look for any cracks in the wall as a way to keep holding on to their bearish thesis. With the company outperforming expectations in 2017 (to the tune of nearly 170% revenue growth and 70%-plus gross margins) and the share price up nearly another 150% over the past twelve months, patient longs have been well-rewarded for sticking with this up-and-coming molecular diagnostics company.

Not surprisingly, given the robust growth, these shares are trading at a pretty rich multiple today. Although more beat-and-raise performances are certainly possible, and the company has only penetrated somewhere around 3% to 4% of its addressable market, I would wait for another bad news event (likely more perceived than real) before making a big commitment to the shares.

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Waiting For The Next Overreaction With Exact Sciences

Lundbeck Pays Up For A New Clinical Trial Asset

I have maintained for some time that one of the biggest issues for H. Lundbeck (OTCPK:HLUYY) (LUN.CO) is the feeble state of its pipeline. While Lu AF35700 is an interesting and promising asset in late-stage testing for treatment-resistant schizophrenia and Lu AF20513 is an intriguing but totally unproven asset in Phase I for Alzheimer’s, there’s not much else in the pipeline apart from some expanded indications for existing drugs. 

With Lundbeck having recently indicated that the board was more receptive to M&A, the company put its money behind that, announcing Friday morning that it had agreed to acquire privately-held Prexton in a deal heavily skewed to milestones down the road. Although this deal doesn’t meaningfully alter the current investment credentials for Lundbeck, it adds an interesting asset and may mark a more active stance toward recharging the company’s pipeline.

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Lundbeck Pays Up For A New Clinical Trial Asset

Rates And Loss Ratios Remain Risks, But Chubb's Valuation Is Getting Interesting

I have long thought that the managers of ACE, now operating under the name of Chubb (NYSE:CB) after that merger, are some of the best in the business and I continue to believe that that is a strong foundation for a positive investment thesis. That said, the P&C business has been flooded with capital and only recently have there been signs of rate improvement. At the same time, underwriting margins are getting squeezed and I’m worried about the outlook for loss trends.

Like many other insurers, Chubb has seen some share price weakness since January of this year, with the shares off about 10% from the 52-week high and up only a little bit over the last year. While I have some concerns about the impact of higher losses and lower reserve releases, that’s balanced by the reality that good names like Chubb don’t get all that cheap all that often. I do have some “falling knife” worries here, but the share price is getting to a point where long-term investors might want to freshen up their due diligence.

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Rates And Loss Ratios Remain Risks, But Chubb's Valuation Is Getting Interesting

Arch Capital Sliding Back To An Interesting Long-Term Valuation

Although Arch Capital (NASDAQ:ACGL) remains a very well-regarded insurance company, the last year hasn't been so friendly to this company or its peer group. A lot of contributing factors have been at play, including large cat losses in 2017, rising costs, regulatory/competitive changes and so on, pushing the shares down more than 10% and below the performance of peers like Everest Re (NYSE:RE), RenRe (NYSE:RNR), and W.R. Berkley (NYSE:WRB).

When I last wrote about Arch Capital, I said I preferred to wait in the hopes of getting an opportunity to buy the shares in the mid-to-low $80's. That opportunity has arrived, even though analyst estimates have continued to head higher. While these stocks generally don't perform especially well during periods of higher rates (which may seem counter-intuitive given the benefits to their investment income), and pricing power is still limited, I think this may be an opportunity to start a position. Arch Capital looks priced to generate double-digit annual returns from here and this has been one of the best-run insurance companies in the business - a trend I expect to continue, and to continue to benefit shareholders, into the future.

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Arch Capital Sliding Back To An Interesting Long-Term Valuation

Almost Everything Going Right For Shin-Etsu Chemical

When an uncommonly well-run company intersects with stronger than expected underlying end-markets, very good things can happen for the stock. Such has been the case for Shin-Etsu (OTCPK:SHECY), where strong results up and down the line have pushed the shares up another 25% or so from where they were when I last wrote about the company, even after a double-digit pullback from the January high.

I still lean positive on these shares. Although I fully expect the company's growth rate to slow from its recent trajectory, I believe the company's exposure to the strong PVC and wafer cycles as well as exposure to other growing specialty markets, biases the story in a favorable direction. Although the shares have enjoyed a very strong run since 2016, healthy end-markets should still support a high single-digit annual return at this point.

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Almost Everything Going Right For Shin-Etsu Chemical

Healthy Spreads And International Expansion Helping Braskem, But Mind The Risks

Compared to what Braskem (NYSE:BAK) was 15, 10, or even just five years ago, I think it’s fair to say that management has done a good job of improving the business. Braskem is now much less dependent upon naphtha as a feedstock and the company has made strides in diversifying beyond Brazil. The company’s involvement in the Brazilian “Car Wash” scandal was certainly a major black mark against it, but Braskem has nevertheless established itself as a major global chemical company with room for further growth and improvement.

Braskem is leveraged to an emerging recovery in Brazil as well as ongoing demand growth in markets like Mexico and the U.S., as well as other export markets. There are risks tied to a corruption investigation in Mexico that could threaten its supply of attractively-priced ethane, but the company is moving forward with greenfield growth in the U.S. and the shareholder structure may become simpler in the relatively near future. With a discount tied to uncertainties in Mexico and the ownership situation the shares look only a little undervalued, but absolution in Mexico and a cleaner shareholder structure could support a fair value in the mid-$30s even as polyolefin spreads look as though they’ll decline.

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Healthy Spreads And International Expansion Helping Braskem, But Mind The Risks

Weyerhaeuser's Improved Execution Should Pay Dividends

For me, Weyerhaeuser (NYSE:WY) is an example of why valuation always matters. Generally well-valued (if not richly-valued) for its high-quality timberlands and wood products operations, Weyerhaeuser has lagged the S&P 500 for total returns for quite some time. Even when you account for the tax benefits of its REIT status and the housing slump, I would argue that shareholders have had to pay a price for Weyerhaeuser’s often-rich valuations, as well as several strategic missteps in the past.

I believe that Weyerhaeuser is now a better-run company and I do see some upside in the shares now. The Wood Products segment may be nearing its peak, but I expect healthy ongoing contributions from the Timberlands segment, and I believe Weyerhaeuser is a leaner, better-run, and more focused company than it has been in a long time. Coupled with a reasonable valuation, there could be some opportunity here for patient investors.

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Weyerhaeuser's Improved Execution Should Pay Dividends

Louisiana-Pacific Making The Best Of The Cycle

When I last wrote about Louisiana-Pacific (NYSE:LPX) (or “LP”) back in October of 2016, I thought the shares still had upside on the basis of ongoing price/margin leverage in OSB, continued growth in housing, and the growth of the company’s siding business. The shares are up about 50% since then, outperforming most of its peers like Norbord (NYSE:OSB), James Hardie (NYSE:JHX), and Weyerhauser (NYSE:WY) over that time (Ply Gem (NYSE:PGEM) has nearly matched LP, while Boise Cascade (NYSE:BCC) has outperformed), as OSB pricing has exceeded expectations on uncommonly responsible competitor behavior and as the company has executed well on its operating improvements and siding growth plans.

It’s harder to see as much upside now. While OSB pricing has held up, and likely will remain above $300 despite oncoming capacity growth, and siding continues to have strong growth potential, I believe a lot of that is in the share price. I don’t think LP shares are overvalued on the basis of cycle-average EBITDA, but I do believe that 2018 could be the near-term peak and the returns could look more “market-like” from this point.

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Louisiana-Pacific Making The Best Of The Cycle

Hurco Off To A Strong Start

Manufacturers continue to expand and upgrade their capital equipment, and that trend is benefiting small-cap machine tool manufacturer Hurco (HURC). As a company that makes things, Hurco is clearly very leveraged to the health of the global manufacturing economy, but particularly in Germany, the U.S., the U.K., France, and Italy. Although industrial production growth has slowed a bit recently, the overall trends remain healthy in the U.S. and Western Europe, and most industrial companies have guided toward a healthy 2018.

A bi-annual tradeshow in September of this year is likely to create some volatility in quarterly results (with orders slowing into the show, as many companies introduce new models/features at the show), but I expect that Hurco will generate double-digit revenue growth and at least come very close to double-digit operating margin. With the current share price still offering double-digit return potential, I don’t think it’s too late for the stock, but I do think the industrial recovery story is pretty mature at this point.

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Hurco Off To A Strong Start

Komatsu Offers More Than An Upswing In Mining

As often happens with companies that serve deeply cyclical end-markets, the timing and magnitude of the swings in Komatsu's (OTCPK:KMTUY) end-markets have defied expectations. While improving construction and mining markets have been part of the Komatsu story for a while now, the strength of the recoveries (especially in mining) has exceeded expectations, as has Komatsu's operating leverage and execution.

With major mining companies only starting to reinvest in equipment and plenty of room to grow in automation-driven investments, I believe Komatsu could still offer some upside from here. The shares aren't cheap on a free cash flow basis, but that's not all that unusual and a forward multiple in line with long-term averages suggests 10% more upside from here with the possibility of further upward revisions.

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Komatsu Offers More Than An Upswing In Mining

Sunday, March 11, 2018

Chart Industries Riding A Recovery But Also Shifting The Business In Meaningful Ways

Chart Industries (GTLS) shares were hammered during the downturn in energy and process industries but are already up about 4x from the early 2016 bottom as the company has benefited from recovering demand in natural gas processing and recovering demand for industrial gasses. Better still, not only has management expanded and diversified its business with the Hudson deal, management seems more interested in backfilling the service and aftermarket opportunities.

With the shares up so strongly (up 80% in the last 12 months), I'm not too surprised that I don't see a lot of low-hanging value here. There are still meaningful opportunities in LNG and I believe the market often underrates the company's core industrial gas business, but today's valuation looks pretty reasonable for a company that should generate mid-single-digit revenue growth and double-digit FCF growth over the next decade.

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Chart Industries Riding A Recovery But Also Shifting The Business In Meaningful Ways

Maxwell Shareholders Could Finally See Some Rewards For Their Patience

Maxwell Technologies (MXWL) hasn't been the easiest stock to hold over the last few years, as the promise of the company's ultracapacitor and dry battery electrode technology has been offset by significant revenue volatility and numerous false starts in what were supposed to be exciting growth markets. With all of that, the shares have lost about 20% of their value over the last three years and have spent most of the last year between $5.50 and $6 (with excursions down to $4.50 and up to $6.50 along the way).

Maxwell remains a tough stock to value, as there is little more to go on than a handful of design wins and potential end-market developments. That said, I think the company deserves more credit than it gets for "keeping the lights on" and using opportunities like the Chinese hybrid bus market to fund R&D and product development in areas like auto electrification, renewables, mass transit, and grid management that could start to pay off in the next couple of years.

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Maxwell Shareholders Could Finally See Some Rewards For Their Patience

HollySys Growing, But Consistency Remains An Issue

HollySys (HOLI) has built a respectable business in process automation and train signaling in China, but inconsistent execution and order growth remain key challenges for management. Expanding its factory automation business has likewise proven challenging, though there has been more progress on this front and Chinese government policy could be a tailwind.

HollySys shares have done well as revenue has rebounded, but the soft order growth in industrial automation could become more of a headwind. I continue to believe HollySys can generate high single-digit revenue and high single-digit to low double-digit FCF growth, and those growth rates can support a double-digit total return, but future growth is tied to management's ability to grow the business beyond its historical strengths.

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HollySys Growing, But Consistency Remains An Issue

Ongoing Share Gains, Innovation, And Leverage Propelling IPG Photonics

Fiber laser innovator IPG Photonics (IPGP) is a good example of why I'm willing to pay up for good companies (and/or hold stocks that otherwise seem richly-valued) - the really good companies out there always seem to find ways to innovate and expand their addressable markets, as well as generate improved operating leverage. IPG has continued to exceed my expectations on both fronts, and the trailing return metrics over the past one, three, and five years (and beyond) have been exemplary.

I don't mind paying up for good companies, but IPG shares do have a track record of significant pullbacks from time to time - whether due to the company not meeting lofty expectations on a quarterly basis or wider concerns about the health of manufacturing spending. The valuation today seems to be pricing in total expected returns in the high single digits, which isn't bad, but I'd much prefer to buy in when the expected returns are in the double digits.

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Ongoing Share Gains, Innovation, And Leverage Propelling IPG Photonics

Air Transport Not Just An Amazon Story

Air Transport Group (ATSG) shares have done well over the past year, but the shares have been stuck in a $6/share trading range since May, as inconsistent execution has blunted some of the benefits of the company’s transformative relationship with Amazon (AMZN). Despite those inconsistencies, management continues to build the business outside of Amazon, adding more 767 customers and launching a long-term effort to expand its potential operating fleet.

I believe Air Transport still has some upside from here, driven by my expectations for high single-digit revenue growth and improving free cash flow generation. I also believe that significant upside remains in the Amazon relationship, as Amazon seems to be serious about building out its independent logistics operations.

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Air Transport Not Just An Amazon Story

PerkinElmer Riding A Strong Cycle And Making Positive Long-Term Shifts

These are good times for PerkinElmer (PKI). The life sciences/pharma tool market is about as strong as it has ever been, and the company's pivot toward diagnostics and services should pay off in the years to come in the form of more revenue stability and better margins. If management can reverse a pretty uninspiring historical trend of underwhelming M&A integration and missing long-term revenue and margin targets, the future could be pretty bright for this company.

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PerkinElmer Riding A Strong Cycle And Making Positive Long-Term Shifts

Sunday, March 4, 2018

Microsemi Finds Its Last Deal

Management at Microsemi (MSCC) is known for commenting that in semiconductor M&A, "You buy until you get bought." There have been rumors off and on about potential bidders circling Microsemi for a little while now, and the executive management's compensation plan was certainly structured to reward a deal. Now Microsemi finally found its buyer - Microchip Technology (MCHP), a seasoned semiconductor M&A veteran that should reap meaningful revenue and cost synergies from the deal.

Given the deal price, I don't think Microsemi investors have a compelling need to stay to the very end; a rival bid is always possible, but the price offered isn't such that I think another bid is highly likely. Pre-market indications are that Microsemi won't trade up to the full bid price just yet, though, so Microsemi investors can at least get paid a little for waiting unless and until they have a better idea.

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Microsemi Finds Its Last Deal

Double-Digit Growth Continues To Propel Old Dominion

Forget its top-level performance in the less-than-truckload (or LTL) sector, Old Dominion (ODFL) is one of the better-run companies I've followed for the past decade-plus. Management sticks to what it does best, doesn't jeopardize the model just to please Wall Street in the short term, and continues to build the business for further growth. The only issue with that top-level performance is that it is no secret and Old Dominion's shares are seldom cheap outside of those cyclical downturns where the outlook for the sector is bleak.

Today is the opposite; demand for freight is expanding and Old Dominion is once again demonstrating that it can win share with service quality during such expansions. The shares are already pricing in double-digit EBITDA growth, and I think outperforming those expectations is going to be difficult. While I'd be very slow to sell Old Dominion if I already owned these shares, it's tough for me to argue for it as a buy at today's valuation.

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Double-Digit Growth Continues To Propel Old Dominion

Yet Again, Investors Have To Readjust Expectations For GenMark

The past 12 months have been rough for GenMark Diagnostics (GNMK), as this molecular diagnostics company has struggled to meet its own timelines and live up to Wall Street expectations. While better-than-expected fourth-quarter results gave investors a little renewed confidence, guidance for 2018 brought that honeymoon to a quick end.

GenMark remains a high-risk, high-reward speculative play in molecular diagnostics. This recent flu epidemic has solidified the place of multiplex systems in clinical practice, but GenMark is facing an increasingly difficult competitive market, and there doesn't seem to be as much excitement in the channel as there once appeared to be. A revenue figure of $200 million in 2022, growing to over $400 million in 2027, with double-digit FCF margins can support a meaningfully higher share price, but the company's cash situation is far from ideal, and it really needs to start posting beat-and-raise quarters soon.

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Yet Again, Investors Have To Readjust Expectations For GenMark

FEMSA Continues To Offer Attractive Value

Shares of FEMSA (FMX), a large Mexican consumer conglomerate, are always going to twitch with concerns about Mexico's economy (including the exchange rate with the U.S.), but management has demonstrated over the years that it knows how to build value for shareholders. Recent endeavors like drugstores and gas stations will take time to mature, but the underlying growth story for the company remains intact.

I continue to believe that $105 to $115 is a good fair value range for the ADRs and that opportunities to buy below $100 should be considered by investors who want some exposure to emerging market (especially Mexican) consumer spending growth. Although 2018 could be a little more challenging due to political issues, I believe high single-digit growth potential continues to support a healthy outlook for double-digit long-term returns.

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FEMSA Continues To Offer Attractive Value

PRA Group Back On Firmer Footing

The recent past hasn't been pretty at PRA Group (PRAA), but with a couple of better quarters in hand, it seems reasonable to think that this collector of charged-off receivables is back on track. I don't believe it is realistic to expect the company to get back to the ROE levels of yesterday - the market has changed, and PRA is a much bigger share of the market now - but double-digit ROEs seem possible again, as well as a return to healthy free cash flow generation.

PRA Group is a tough company to analyze, but I expect to see improving collection efficiency metrics, as well as increasing supply, in the coming years. That supports a fair value in the high $30s to low $40s today and makes this a name worth considering on pullbacks.

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PRA Group Back On Firmer Footing

Wright Medical May Be Hobbled Until The Ankle Business Re-Accelerates

Wright Medical (WMGI) shareholders didn't seem to be thrilled about the merger with Tornier, but looking back, it is the Tornier investors who probably have more to regret about that deal. Although backward-looking hypotheticals only get you just so far, it has been the shoulder business that Wright acquired in the Tornier deal that has been driving the business, while Wright's prior core lower extremity/ankle business has weakened considerably in the last two years.

I don't believe the lower extremity business is damaged beyond repair, but management absolutely has to execute better than it has and start regaining momentum versus rivals like Stryker (SYK) and Integra (IART) if the shares are to perform better. I'm still modeling long-term revenue growth in the high single digits and long-term FCF margins in the 20%s, which supports a mid-$20s fair value, but Wright Medical's weak execution makes this a "show me" stock at this point.

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Wright Medical May Be Hobbled Until The Ankle Business Re-Accelerates

At BRF SA, The Flesh Is Still Weak And Investor Spirits Aren't So Willing

It has gone from bad to worse at BRF SA (BRFS), as frequently happens when a company reaches a "critical mass" of mismanagement and poor decision-making. BRF's big miss with fourth quarter results put the cap on what was already a pretty poor 2017, and though BRF has a new management team and a new plan, major investors seem to want yet more change.

I've always thought it was going to take time and patience (a lot of patience…) for BRF to develop, and I don't believe the company is unfixable. That said, there's a lot of work to be done in both the domestic and international operations and plenty of volatility inherent in a commodity-driven business with significant international emerging market exposure. I believe mid-to-high single-digit revenue growth is still possible and, coupled with mid-to-high single-digit FCF margins, can still support a $10-plus fair value from here, but this is a high-risk call that is going to need a couple of years to really play out.

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At BRF SA, The Flesh Is Still Weak And Investor Spirits Aren't So Willing

Outside Of Energy, SPX Flow Still Waiting For The Turn

At a time when many industrial companies are seeing strong cyclical recoveries, SPX FLOW (FLOW) is still well off the pace of many of its industrial peers. Although markets like energy, air treatment, and chemical processing still have scope to improve from here, the company's food and beverage segment is likely to be a slower grower and SPX FLOW is going to have to start making more progress on share-of-wallet and internal margin improvement efforts.

Up more than a third from when I last wrote about the stock, I'm not as bullish on SPX FLOW now as I think the catch-up opportunity has largely materialized. There are multiple places where management could execute better over time, but I think those opportunities have to be considered in hand with the likely slower growth that SPX FLOW will see compared to many other industrials. I don't dislike the shares, but I don't see the opportunity I once did.

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Outside Of Energy, SPX Flow Still Waiting For The Turn

Everest Re's Strong Reinsurance, And Improved Insurance, Operations Are Building Value

Everest Re (NYSE:RE) has long had a very good reinsurance business - although skewed toward property-catastrophe, the company’s focus on specialty/smaller lines and low overhead costs have helped generate pretty good returns even through recent weakness in pricing. What has been more impressive, though, has been the improvements in the insurance business - a business that management had elected to continue growing aggressively despite a pretty poor history of underwriting losses.

Everest Re management has done a lot to repair investors’ opinion of the insurance operations, and the company has also managed to benefit from M&A-driven dislocations in the market. Now, with insurance prices showing a little strength and higher rates supporting better investment returns, it’s not a bad set-up for the company. Between the too-high highs of last summer and the too-low lows of this past winter, I think Everest Re is more reasonably priced now, but “reasonable” in this case still suggests a total expected annual return in the low double digits.

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Everest Re's Strong Reinsurance, And Improved Insurance, Operations Are Building Value

Is It Too Late For An Early-Cycle Name Like Parker Hannifin?

Investors have an uncanny knack for swinging between worrying about nothing and worrying about everything. In the case of Parker-Hannifin (PH), it would seem that poorly-communicated, near-term margin issues are disappointing investors who favor margin improvement stories within the multi-industrial space, while worries about where Parker-Hannifin sits in the short-/mid-/late-cycle ecosystem are troubling other investors.

Although I do have some concerns about growth with Parker-Hannifin, I think the stock's valuation is interesting on both an absolute and relative basis, particularly given acceleration in orders and high valuations in the peer group. To me, the shares look priced for high-single-digit to low-double-digit total returns, and you could make an argument that a fair value in the $220s or $230s wouldn't be ridiculous.

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Is It Too Late For An Early-Cycle Name Like Parker Hannifin?

For Roper, More Of The Same Looks Like A Good Plan

What do you say about a company that has averaged a total annual return to shareholders of over 20% the last 15 years, has outgrown its multi-industrial peer group on organic revenue, and generates FCF margins in the 20%’s while shifting the model towards more recovering revenue? All I can really say about Roper Technologies (ROP) is that this is definitely a stock to keep in mind when the music stops and the market cools off.

I discussed the challenges of valuing a stock like Roper the last time I wrote about the company (in which time the stock has risen another 30%), and it’s no easier now. Including the company’s near-term M&A plans into the valuation would suggest a mid-to-high single-digit total annual return is still in play, and I would also note that Roper’s valuation relative to other multi-industrials like Danaher (DHR), Honeywell (HON), Illinois Tool Works (ITW), and 3M (MMM) hasn’t really changed all that much compared to a trailing multiyear average.

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For Roper, More Of The Same Looks Like A Good Plan

Another Phase III Win For Neurocrine Biosciences

Good news continues to stack up for Neurocrine Biosciences (NBIX), with the company's partner AbbVie (ABBV) announcing on Wednesday that its first of two Phase III studies of elagolix in uterine fibroids met all of its efficacy endpoints. This continues a pretty good run of success with Neurocrine's late-stage pipeline and brings another potential multi-billion-dollar drug that much closer to approval and commercialization.

While there are still more steps to go through with elagolix in uterine fibroids (namely, full results from both studies, including safety data), the similarities between the Phase III and Phase II results thus far would suggest that there's not much reason for worry (then again "surprises" are by their nature not expected…). Approval of elagolix in 2019 or 2020 would bring another important revenue generator to market for Neurocrine and this incremental step does modestly boost my fair value.

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Another Phase III Win For Neurocrine Biosciences

Alfa-Laval Still Offers Recovery-Driven Upside And The Potential For Improved Execution

For the most part, well-run multi-industrials exposed to recovering markets are not trading at very attractive prices today, and that makes Sweden’s Alfa-Laval (OTCPK:ALFVY) worth a look. It’s certainly too soon to sound an “all clear” on the company’s large marine business, but order growth has been steadily improving and margin leverage is starting to emerge again. With leadership in multiple recovering markets and the potential to significantly improve returns on capital from here, Alfa-Laval is worth a look.

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Alfa-Laval Still Offers Recovery-Driven Upside And The Potential For Improved Execution