Friday, December 7, 2012

The Risk of the Direct Selling Business Model


Herbalife (NYSE: HLF), after being a 10 bagger in more than 3 years, has plunged significantly after the famous hedge fund manager, David Einhorn, questioned the company in its earnings call in May. Because of his fame for short selling, the market might think Herbalife was one of his targets, and dampen its share price. To take advantage of the free fall, on Nov. 28, Richard Goudis, the company’s COO, stepped up and bought 45,516 shares at an average price of $43.89 per share, with the total transaction value of nearly $2 million. So at least one insider has been bullish about the company. Should we?
Network marketing is all about the in-house distributor network. I personally think that for this business model, the in-house distributors would actually be the main consumers of the products. In 2011, Herbalife reported to have around 2.7 million independent distributors in around 79 countries, and its main product is weight management, accounting for 62.5% of its total revenue. Avon Products (NYSE: AVP), which makes direct selling of the beauty products, had around 6.4 million independent representatives with sales operations in around 65 markets. Other peer, NuSkin (NYSE: NUS), with its anti-aging products, had around 850,000 active distributors in 52 countries globally. The business model seems to be intriguing, however, it has to rely on its distributors’ network for its sales. The risk is that if any distributor leaders leave the company, they would bring along their whole networks along with them. Thus the company would suddenly lose a great deal of its existing “internal consumers.” 
David Einhorn was showing his concern for the same issue as well. In the recent earnings call of Herbalife, he focused on three issues: the sales outside the network, the incentives between recruiting new distributors and selling the product for the markup, and the sales percentage between three groups of distributors.
On the first issue, Einhorn would like to know the sales level made outside the network and sales consumed within the distributor base. Rather than giving him the clear answer, Herbalife just generally said that it had a 70% custom rule, stating that 70% of products were sold for personal consumptions, either to consumers or to its own distributors. The company also said that it didn’t have the exact percentage of sales sold to non-distributor consumers. 
On the second issue, the supervisor will get a 50% discount if he buys the products directly. So if he sells products to consumers, he would make 50 points. If the consumer signs up with a distributor and buys the product himself directly from Herbalife, the supervisor would get the 25%.
The third issue raised by Einhorn was the company disclosed the percentage sales of three distributor groups but it didn’t repeat in the subsequent 10-K. Herbalife explained that the company took those percentages out of the 10-K due to a change in the CFO, noting further that the current CFO didn’t see it was a valuable information for both business and investors.
Indeed, the distributors are the real customers for the network marketing business model. If they are loyal, the business will benefit a whole lot. Valuation-wise, Herbalife seems to be quite cheap, at only 12x trailing earnings, or a 0.7x PEG ratio. However, it is quite comparable to its 5-year historical average valuation, of 12.9x P/E.  Herbalife is currently paying a 2.6% dividend yield. NuSkin is more expensive, with 14x P/E and a 0.9x PEG, but paying lower dividend yields of 1.7%. Avon is the one which pays the highest yield, about 5.4%, but it also the most expensive, with a 50.8x P/E and a 2.1x PEG.
Foolish Bottom Line
Herbalife seems to be cheap in terms of valuation. However, we do not know about the stickiness level of its distributor network. The more sticky the distributors, the higher value I would place on the company. However, since there's many unknowns surrounding this company, I would rather not place a bet at the moment. 

This Sheepshoe Maker is a Long-Term Buy


I have written about Deckers Outdoor (NASDAQ: DECK) when it was trading at only $29.48 per share, noting that it was a cheap, high-return stock to buy. Recently, it made a big daily jump of more than 10% because of two analyst upgrades. Jefferies Research and Sterne Agee have given the company price targets of $50 and $65, respectively, on this sheepskin shoemaker. DECK is now trading at $41.61 per share, with a total market capitalization of $1.47 billion. Should investors initiate positions in this company now?
Dated back in the end of October, DECK has bent to the bearish momentum of the market by lowering its FY12 guidance. It expected sales in 2012 to have year-over-year growth of 5%, much lower than the previous guidance of 14%. In addition, the EPS would experience a decline of 33%, not 9% or 10% as in the previous guidance. After that, its shares have been sent to the lowest since the end of 2009, at around $28.60 per share. In the last 5 years, DECK’s investors have really been on the roller coaster, and the stock delivered a nearly 19% loss during that period.
 
The 5-year stock performance has lagged behind its peers, including Nike (NYSE: NKE)and Wolverine World Wide (NYSE: WWW). It was the only stock that created losses for shareholders, whereas Nike gained 48% and Wolverine gained nearly 67%.
The majority of the business revenue comes from one famous shoe brand, UGG, accounting for more than 87% of its total sales in 2011. The business has experienced a slowdown due to the rising cost of raw material (sheepskin) and recent unusually warm weather. However, Jefferies now becomes bullish on the stock because of the performance improvement of its main brand. Jefferies commented:
“We see significant upside in the coming quarters due to improving performance of the UGG brand which we think is far from dead. Further, we expect growth from the retail storerollout, international expansion, brand extensions, and the smaller brands. Meanwhile, margin tailwinds are on the way. With valuation attractive, we would aggressively buy DECK at current levels. Resuming coverage with a Buy rating and $50 PT.” 
Sterne Agee has upgraded DECK from Neutral to Buy because it saw the comeback of the company in 2013. It said that the FY12 EPS estimate was lowered from $3.16 to $3.06, but the FY13 EPS was estimated to range from $3.31 to $3.78. Thus, the price target of $65 was set. Actually in May 2012, Ron Baron remained bullish on the company, saying that the sheepskin price has reached its peak and will decline in the next year. That would lead to the increase in 2013 earnings, and the unusual weather pattern would revert to the mean. However, after his comment on the company at the end of May, one month later, he reported that he has sold out DECK shares in the second quarter of the year. 
The good thing about DECK is the debt-free position and the consistent historical double-digit return on invested capital. Trailing twelve months, its ROIC was 18.12%, along with a net margin of 11.10%. Nike has a little higher ROIC, 20.6%, but lower net margin of nearly 8.7%. Wolverine delivered the lowest return among the three, of 15.86% ROIC and 7.7% net margin. 
In terms of valuation, DECK seems to be the cheapest among the three.

DECK
NKE
WWW
Forward P/E
9.1
15.8
14.8
PEG
1.4
1.4
1.5
Dividend yields (%)
N/A
1.5
1.1
DECK has only a 9.1x forward P/E and 1.4x PEG. Nike had the same PEG ratio with DECK but much higher forward P/E, of 15.8x. Among the three, only DECK didn’t pay dividends, whereas the dividend yields of Nike and Wolverine are 1.5% and 1.1%, respectively.
The only thing that I am worried about is the building up of its inventory. Trailing twelve months, the days inventory has shot up to nearly 117 days, compared to the range of 88 – 97 days annually since 2005. It might indicate that DECK had a hard time of selling its shoes. The high level of inventory might affect its earning results in the fourth quarter of this year.
Foolish Bottom Line
In the short-term, DECK might experience weak earnings in the next quarter or two because of the recent inventory buildups. However, with a cheap valuation and high return on invested capital, I think investors couldn’t go wrong in buying UGG brand owner at the current price.

Why I Like This Snack Giant


Warren Buffett has repeatedly mentioned a thoughtful phrase: It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  Indeed, long-term investors will be rewarded very well if they just stick to great businesses over time. It would be much better than jumping from one position to another, as the brokerage fees and taxes would eat into the capital gains over time. That is why I am always looking for sustainable businesses, which are holding the largest global market share.
The old Kraft Foods was already technically divided into two separate businesses: the newKraft Foods (NASDAQ: KRFT) operates as a North American grocery business, andMondelez International (NASDAQ: MDLZ) focuses solely in the snack food business. The breakup creates a lot of value in the market for both of these focused businesses. Kraft Foods, with Kraft, Maxwell House, Oscar Mayer, and JELL-O, is the fourth largest consumer packaged foods and beverage company in North America. Whereas Mondelez is holding the market leader positions in many countries with its brands including Cadbury, Oreo, Dairy Milk, Chips Ahoy and Chiclets, etc. As operating in the mature grocery business in North America, Kraft Foods is thought to be slower growing and a more stable dividend payer than high growth Mondelez. Personally, I am quite bullish for Mondelez long-term potential future because of four main reasons: 
Global market leadership positions in many brands
Globally, Mondelez holds the number one position in Biscuits, Chocolate, Powdered Beverages and Candy, and the number two position in Gum and Coffee. Following itsfactsheet, the 15 Global Power Brands including Chips Ahoy, Oreo, Club Social, Lacta, Toblerone, Trident, Chiclets, etc. These account for 70% of the company’s growth. Chocolate and Biscuits are the two segments that bring the majority of Mondelez’s revenue. The biscuits segment accounted for 30% and the chocolate segment accounted for 27% of the total sales. Interestingly, around 44% its $36 billion revenue was from high growth developing markets, whereas North America and Europe accounted for 19% and 37%, respectively.

 
Source: Mondelez’s factsheet
Irene Rosenfeld becomes Mondelez’s chief
Mondelez has a talented and shareholder oriented chief, Irene Rosenfeld, the ex-CEO and Chairman of the old Kraft Foods. She has a well-known leader with nearly 30 years of experience in the food and beverage industry. She was successful with the integration of several businesses into Kraft Foods, such as Nabisco, LU, and Cadbury. Although Warren Buffett didn’t like her move to sell the pizza business and purchase Cadbury, he still supported Irene Rosenfeld overall. He said: “I think Irene has done a good job in operations. I think she’s a good person.”
Stronger growth ahead
Mondelez is expected to enjoy organic revenue growth of 5%-7%, led by the double-digit growth in developing markets, where it derived the majority of its revenue. The operating income would be double-digit on a constant currency basis, driven by operating expense leverage and productivity savings. Irene Rosenfeld expected the emerging markets to be the significant growth engine for the company. She said Mondelez would focus on BRIC markets:
“Our first priority is the BRIC markets. Brazil, India, Russia and China represent about a third of our developing market revenues and will receive the lions share of our resources. Over the next five years, these countries are expected to grow mid- to high-teens and account for a significant portion of our growth.”
Cheapest growing food giant
Valuation-wise, Mondelez is the cheapest food giant in the market, with the lowest PEG. It is trading at $25.53 per share, with the total capitalization of $45.37 billion. The market is valuing it at 8x EV/EBITDA and 1.5x PEG. H.J.Heinz Company (NYSE: HNZ), with a market capitalization of only $18.71 billion, less than half of Mondelz, is more expensive, with 11.3x EV/EBITDA and 2.3x PEG. Kellogg (NYSE: K), a $19.84 billion convenience food maker, is trading at 11.57x EV/EBITDA and 2.48x PEG. 
My Foolish Take
With the global market leader positions of many brands, cheap valuation, potentially high growth and talented chief, Mondelez is destined for greatness. It could be a great long-term pick in the diversified portfolios of patient investors.   

This Restaurant Chain is a Long-Term Buy


McDonald’s (NYSE: MCD) has been considered a great stock for long-term income investors over several decades. However, it has just experienced the first slowdown after many years of growth. Along with that, insiders of McDonald’s have kept exercising stock options at much lower prices and selling their shares at the market prices. The total sell transaction is worth more than $22 million since October. Notably, Donald Thompson, the CEO and Director of the company, exercised 42,300 shares at $35-$39 per share and sold the same amount of shares at $87.56 per share. Should we be bearish on these recent insiders’ sells? Let’s find out.
Recently, McDonald’s announced its decrease in comparable sales in all corners of the world. The US and Europe’s operations experienced the same decrease of 2.2%, whereas emerging markets, including Asia Pacific, the Middle East, and Africa were down 2.4%. Total, the global comp sales reduced by 1.8%.
Similarly, one of its peers in the quick service restaurant industry, YUM! Brands (NYSE:YUM) expected that in the fourth quarter it would experience a contraction of 4% in same-store sales in China, which derived more than 44% of its total revenue. Lazard Capital Markets analyst have downgraded McDonald’s from “Buy” to “Neutral,” because the company was losing its market share in the US, and the fast-food consumption was weakening globally. Year to date, McDonald’s has lost nearly 12% of its market value, when it decreased from more than $100 to only $87 currently.
One of the main reasons contributing to McDonald's success in the last 10 years was the Dollar Menu. However, if McDonald’s just focused on value, it was hard to charge a much higher price for premium items. That was why it launched the Extra Value Meal, with the cost of less than $2 to narrow the gap. For several years, McDonald’s had shifted its focus to Extra Value Meals for a higher profit margin, but due to its current environment, the company said it was important to get more customers into the restaurants, so it would focus back on the Dollar Menu. I
nterestingly, when McDonald’s first launched its Dollar Menu in the late 2002, its stock price had experienced significant decline from $48 in 1999 to only around $13.5 in 2003. The net income in 2002 was only more than half of 2001's net income, due to the operating restructuring pretax charges of $853 million. At that time, comparable store sales in the US fell 1.3% in October and November. So historically, McDonald’s has experienced the similar slowdown.
Even with the recent slowdown, McDonald’s has still been a market leader in the quick service restaurant market for more than 5 years. It even increased its US market share from 46% to 49.6% from 2006 to 2011. The second largest player in the market, Wendy’s(NASDAQ: WEN), was much further away with only 12.3% market share in 2011.
 
Currently, McDonald’s is trading for $87.04 per share, with the total market capitalization of $87.39 billion. The market is valuing McDonald’s at only 14.6x forward P/E and 1.6x PEG. YUM! is more expensive, with 17.5x forward earnings, but only 1.4x PEG due to the historical high growth in the Chinese market. In terms of forward earnings, Wendy’s is the most expensive with 22.8x P/E but only 1.1x PEG. However, it is generating trailing twelve month losses. Among the three, McDonald’s is paying highest dividend yield (3.3%), whereas YUM! and Wendy’s are paying 1.8% and 2.2%, respectively.
My Foolish Take
With the leading position in the US quick service restaurant market, and the refocus on the Dollar Menu, McDonald’s is still the stock of choice for the long-term. In the short-term, I think it would still be struggling, and the stock price will continue to be sluggish. Personally, I would rather wait for some decline in the stock price before initiating positions in this stock. 

Is Darden a Good Buy After a Plunge?


Darden Restaurants (NYSE: DRI) just lost nearly 9.6% of its market value within a trading day, dropping from $52.42 to $47.40 per share. It seems to be a good drop for income investors to accumulate shares of this consistent and growing dividend-paying restaurant stocks. However, in order to determine its attractiveness, investors need to factor in the potential operating performance, the balance sheet strength, and the valuation of this business.
Darden is considered to be the largest full service restaurant company globally with around 1,994 restaurants located in the US and Canada, with several famous brand names such as Red Lobster, LongHorn SteakHouse, Olive Garden and Bahama Breeze. Interestingly, Darden doesn’t follow the franchise model; all of its restaurants in the US and Canada are owned and operated by the company.  It has around 28 franchised restaurants based in Puerto Rico, Japan, and Dubai. Its business is divided into two segments: quick service and full service. 
The recent plunge in its stock price was caused by the weak guidance the company provided in the second quarter, along with the gloomy growth outlook for the full year 2013. Although the average second quarter EPS analysts expected was in the range of $0.47, the company expected only $0.26 - $0.27 EPS for the second quarter. In addition, Darden estimated the overall decline of the same-store sales in all restaurant brands, of 0.8%, with a 2.7% drop in Red Lobster’s same-store sales and 3.2% decline of LongHorn Steakhouse’s. 
Because of the company-owned business model, Darden employs a large amount of debt on its balance sheet, with the high level of goodwill and intangibles. As of August 2012, it had nearly $1.9 billion in stockholders’ equity, only $52 million in cash, but more than $2 billion in both short and long-term debt and more than $1 billion in goodwill and intangibles. The total contractual obligations including operating leases and purchase obligations totaled $45.3 billion, with nearly $1.6 billion due in less than a year. The good thing is that Darden has been generating increasing positive operating cash flow consistently over the last 10 years. Trailing twelve months, it generated nearly $900 million in operating cash flow, but only nearly $250 million in free cash flow, due to the high maintenance capital expenditure.
One of its peers, DineEquity (NYSE: DIN), the owner of Applebee’s and International House of Pancakes, has just finished its five year strategy to turn its casual dining chain into fully franchised restaurants. At the moment, the refranchising program is helping to transition itself into a 99% franchised restaurant system. It was a quite smart move for the long-term business results. Indeed, year-to-date, DineEquity has outperformed Darden and another restaurant company, Buffalo Wild Wings (NASDAQ: BWLD), drastically.
 
DineEquity gained nearly 50% year-to-date in the stock market; whereas at the same time, Buffalo Wild Wings and Darden only gained 10.6% and 9.2%, respectively.
In terms of valuation, it seems that all three restaurant stocks are quite reasonable, with their PEG ratios.

DRI
DIN
BWLD
Forward P/E
11.6
5.6
19.6
PEG
0.9
0.5
0.8
Div yield
3.6
N/A
N/A
DineEquity is the cheapest, with only 5.6x forward P/E and 0.5x PEG, whereas Buffalo Wild Wings is the most expensive, with nearly 20x forward earning and 0.8x PEG. Darden is the only stock that is paying a dividend, which has a yield of 3.6%.
My Foolish Take
Darden is reasonably priced after the plunge in its share price. However, the business of owning restaurants would keep Darden reinvesting substantially back into the business, which potentially eats into its growing operating cash flows. Along with DineEquity’s cheapest valuation, I would prefer the business transition into the franchise model going forward.

3 Dividend Stocks to Avoid


Income investors love dividend-paying stocks. However, not every dividend is created equal. We should look deeper in each situation to determine whether the dividend is sustainable or not, and whether that stock is a buy or a sell. Certainly, we should avoid potentially unsustainable dividends. Here are the 4 criteria, which could help to raise red flags on dividends in despair: (1) Negative revenue per share growth rate for 10 years, (2) Debt/Equity is larger than 1x, (3) Interest coverage is below 1x, and (4) Payout ratio is greater than 1x. Here are the three companies, which “meet” all red flags criteria above:
Copano Energy (NASDAQ: CPNO) is the midstream service provider including transportation, fractionation to natural gas producers with its own assets including 6,800 miles of natural gas pipelines and 10 processing plants in four states such as Oklahoma, Wyoming, Louisiana and Texas. It is a good example of diluting existing shareholders when the company has kept issuing shares. Dated back in 2002, it had around 2 million shares, and the number kept rising to more than 70 million shares currently. Even though the revenue increased from $225 million to $1.345 billion for the last 10 years, but because of the increasing number of shares outstanding, the revenue per share decreased from $112.50 in 2002 to only $19.50 currently.
As of September, it booked $863 million in stockholders’ equity, including a negative $848 million in retained earnings and $285 million in preferred stocks. It had only $53 million in cash and more than $1.09 billion in long-term debt. Thus, the debt/equity is 1.9x. The situation of Copano is alarming as it had the interest coverage of only 0.52x. Historically, it paid consistent dividends and the current dividend yield is quite high, at 7.3%. However, the payout ratio in 2011 was 1.43x, meaning that it paid out in dividends more than what it has earned last year. In addition, over the last 12 months, it has created losses with negative free cash flow. 
Cogent Communications Group (NASDAQ: CCOI) is the Internet protocol provider for small and medium businesses in North America and Europe, with 43 data centers in more than 175 metropolitan markets in those two regions. Cogent is also the example of diluting existing shareholders by issuing more shares in the last 10 years. It had only 170 thousand shares in 2002, and now the total number of shares has expanded to 47.14 million currently. Thus, its revenue per share decreased from $305 in 2002 to only $6.75 now.
As of September, it had only $161 million in total stockholders’ equity, including a negative $333 million in retained earnings. It booked $256 million in long-term debt. However, it was good that Cogent had a decent amount of cash, of $232 million. The debt/equity is currently at 2.4x, and the interest coverage is only 0.96x, meaning that the operating income it generated is less than the interest expense it had to pay. Cogent just began to pay a dividend in the third quarter of 2012. in the trailing twelve months, it earned $0.03 per share, but it paid out $0.21 per share in dividends, thus the dividend payout was as high as 7x. 
UMH Properties (NYSE: UMH) is a REIT, which is operating 40 manufactured home communities with 8,900 sites and leasing them to residents on a month-to-month basis. In the previous 10 years, UMH has kept issuing more shares to the public, however, at the less significant dilution rate than the other two mentioned-above companies. In 2002, it had around 7.63 million shares outstanding, and it has increased to 16.47 million shares now. Because of that, the revenue per share declined from $3.86 in 2002 to $2.64 in 2011.
As of September, it had $143 million in total stockholders’ equity, including $60 million in preferred shares. The long-term debt was grown 11.46% to $107 million compared to the previous quarter, and the short-term debt was booked at $25 million. The debt/equity is currently at 1.3x, but the interest coverage is extremely low, at only 0.29x. The company has its history of issuing new debt. It has issued nearly $42 million of debt in the last 3 years. Like other REITs, the dividend yield is high at 7.1%.
In REIT, investors should use Funds from Operations (FFO) rather than net income, as the business nature of REIT is quite different from other conventional businesses. Depreciation in the normal business is an annual non-cash charge to allocate the initial outlay to acquire fixed assets employed in the business operation. However, real estate often appreciates in value, rather than depreciates. That is why Funds from Operations, which does not include depreciation charges, is a better measurement. In 2011, UMH's adjusted FFO was nearly $9 million, or nearly $0.6 per share, but it paid out $0.72 per share in dividends. So the payout ratio of UMH was 1.2x. 
Foolish Bottom Line
The dividend might be good for income investors, and we might be excited when we see high dividend yields. However, when a company pays out more than what it earns in dividend, we should be worried. In addition, the low interest coverage and high debt/equity ratio indicate the high level of risk that the business is facing. Investors might dig deeper for their own judgments. Personally, I would avoid these three stocks for now. 

Thursday, December 6, 2012

A Fast Growing HealthCare Stock for Your Porfolio


Questcor Pharmaceuticals (NASDAQ: QCOR), the darling of the stock market in 2010 and 2011 has plunged significantly in the middle of 2012. Year-to-date, Questcor has lost more than 35% of its market value, to the current share price of $25.66 per share. Interestingly, the insiders have been accumulating its shares since the beginning of November this year at the average price of $24 per share, after the series of significant sells at around $35 - $53 per share since the beginning of this year. I personally would think at the current price, Questcor represents a good value for patient investors.
With its main product, H.P. Acthar Gel to treat 19 indications, Questcor is helping patients who have serious medical conditions such as rheumatic disorders, multiple sclerosis, collagen diseases, infantile spasms, and nephrotic syndrome. In the US, its Acthar product is sold to exclusive customer, CuraScript SD, and then resold to around 12 specialty pharmacies and children’s hospitals. The other company’s product, Doral, the insomnia treatment, is sold to pharmaceutical wholesalers.
The plunge in its stock price came in September when the reimbursement coverage for Acthar would be limited by the insurer Aetna (NYSE: AET), the third biggest U.S.health insurer. The insurer pointed out that Acthar is “medical necessary” only for West syndrome, the cause of infantile spasms. However, in the statement released by Questcor, Aetna only accounted for 5% of total Questcor’s prescriptions. Thus, Questcor didn’t think that would have a material impact on the company. Don Bailey, Questcor’s CEO commented:
It’s clear that Aetna needs to receive some additional information from us. You could tell with the various information they put out that they did not have a complete understanding of Acthar.”
On the fundamental side, Questcor seems to be quite interesting. Since 2008, it has managed to deliver a significant high return on invested capital. Trailing twelve months, the ROIC was as high as 113.47%, along with the net margin of nearly 39.5%. As of September, it held $122 million in stockholders’ equity and $112 million in cash and short-term investments. Especially, Questcor remains a debt-free company. In October this year, it just paid out its first dividend, of around $0.20 to shareholders, creating a yield of more than 3.1%.
Questcor seems to be the smallest, fastest growing and the most attractive compared to its other peers including Novartis AG (NYSE: NVS) and Sanofi SA (NYSE: SNY).

QCOR
NVS
SNY
Net margin (%)
39.5
15
16.2
ROIC (%)
113.5
9.7
8.56
D/E
0
0.2
0.2
Forward P/E
7.2
11.9
6.7
Div yield (%)
3.1
4
3.8
Questcor has the potential to deliver superior returns compared to the other two peers, with its nearly three times higher net margin and ten times higher ROIC. It also employs no leverage at all. Even though its dividend yield is the lowest among the three, the growth potential is remarkable. The forward P/E of Questcor is lower than Sanofi, but its PEG ratio is only 0.2x, much lower than those of Novartis, of 7.9x and Sanofi, of 9.3x.
As Fool contributor, Keith Speights pointed out, the company simply has been raising prices for its Acthar since 2007, from $2,000 to nearly $30,000 per vial, indicating its nice and neat ability to charge higher prices. It is even more intriguing when the insiders confirm its bullish momentum for the stock as indicated above. The CTO and CBO have accumulated around $1.5 million worth of shares since the beginning of November.
Foolish Bottom Line
At the current price, Questcor offers quite an attractive investment opportunity for investors, with its potential growth, cheap valuation, nice dividend yield and insider buys. At the moment, investors could consider Questcor to be a long term stock for their diversified portfolios. 

52-Week Low and High Return Stocks


As a value investor, I often screen for bargain-priced stocks, which experienced significant falls in their stock prices. The good place to start is the 52-week low list. This simple starting point was recommended by Walter Schloss, the famous “cigar butt” value investor, who studied with Warren Buffett under Benjamin Graham. However, I would demand more. In the 52-week low list, I would like to pick the stocks with good profitability and cheap valuation. This time, I would run the screen using several simple criteria: (1) market capitalization is more than $1 billion, (2) the price decline in 52 week is greater than 30%, (3) return on invested capital is greater than 15%, and (4) the EV/EBITDA is less than 6x. Here are the top three results:
Dell (NASDAQ: DELL) has been considered a very big player in the PC industry. Thus, investors have conflicting ideas about whether Dell is a value play or a value trap. However, looking at the revenue breakdown, we can see that revenue segments are quite spread out. The majority of its revenue was from Mobility Client, accounting for 31% of the total revenue. The second biggest revenue sub-segment was Desktop PCs. The other three sub-segments included servers and networking (13%), Services (13%) and Software and peripherals (17%).
Over the 52-week period, Dell experienced a decline of nearly 36.9% in its stock price, mainly because of investors’ pessimisms about its business reliance on the PC industry. Trailing twelve months, it delivered a 17.65% return on invested capital. Dell is trading at $10.06 per share, with the total market capitalization of $17.45 billion. The EV/EBITDA is only nearly 3.5x. On a last note about Dell, it just paid the first dividend to shareholders in September this year: $0.08 per share.
Apollo (NASDAQ: APOL) is one of the largest private education providers globally, with several educational institutions including University of Phoenix, CFFP, BPP, Western International University, ULA, etc. Out of $4.25 billion in revenue in fiscal 2012, it derived nearly $3.9 billion from the University of Phoenix segment. Apollo is operating in the for-profit education industry, which received criticism from Jim Chanos, the famous short-seller, because of its business model. He mentioned that the business was flawed because it depended on the taxpayers’ money.
Apollo, along with other for-profit educational institutions, have plunged significantly during the last 52 weeks. It lost 61.5% of its market value. Trailing twelve months, it returned 24.24% on invested capital. It is currently trading at $19.06 per share, with the total market capitalization of $2.14 billion. The market is valuing Apollo at only 1.75x EV/EBITDA.
Joy Global (NYSE: JOY) is the leading mining equipment maker for extracting many kinds of minerals, including copper, iron ore, coal, oil sands, etc. It was reported by the company that the majority of its sales (41% in 2011) was made to the mining industry. It is a good thing that the company does not have a customer concentration, as no customer accounted for more than 10% of its total revenue. During the previous 52-week, Joy delivered a loss of nearly 38%. However, the business has been generating double digit return on invested capital since 2005. Trailing twelve months, its ROIC was nearly 21%.  The stock is trading at $56.18 per share, with the total market capitalization of $5.95 billion. The market is valuing Joy at 5.5x EV/EBITDA. Joy just paid 17.5 cents per share in dividends in November to shareholders. 
Foolish Bottom Line
The three stocks above are cheap, and they are cheap for good reasons. In addition, they have been beaten down by the overly pessimistic sentiment of the overall market. With the historically good returns on invested capital, cheap valuations, and significant declines in the last 52 weeks, I personally think by betting small portions of their portfolios in each of those stocks, investors would have a much higher probability of winning than losing.

3 Dividend Stocks to Avoid


Income investors love dividend-paying stocks. However, not every dividend is created equal. We should look deeper in each situation to determine whether the dividend is sustainable or not, and whether that stock is a buy or a sell. Certainly, we should avoid potentially unsustainable dividends. Here are the 4 criteria, which could help to raise red flags on dividends in despair: (1) Negative revenue per share growth rate for 10 years, (2) Debt/Equity is larger than 1x, (3) Interest coverage is below 1x, and (4) Payout ratio is greater than 1x. Here are the three companies, which “meet” all red flags criteria above:
Copano Energy (NASDAQ: CPNO) is the midstream service provider including transportation, fractionation to natural gas producers with its own assets including 6,800 miles of natural gas pipelines and 10 processing plants in four states such as Oklahoma, Wyoming, Louisiana and Texas. It is a good example of diluting existing shareholders when the company has kept issuing shares. Dated back in 2002, it had around 2 million shares, and the number kept rising to more than 70 million shares currently. Even though the revenue increased from $225 million to $1.345 billion for the last 10 years, but because of the increasing number of shares outstanding, the revenue per share decreased from $112.50 in 2002 to only $19.50 currently.
As of September, it booked $863 million in stockholders’ equity, including a negative $848 million in retained earnings and $285 million in preferred stocks. It had only $53 million in cash and more than $1.09 billion in long-term debt. Thus, the debt/equity is 1.9x. The situation of Copano is alarming as it had the interest coverage of only 0.52x. Historically, it paid consistent dividends and the current dividend yield is quite high, at 7.3%. However, the payout ratio in 2011 was 1.43x, meaning that it paid out in dividends more than what it has earned last year. In addition, over the last 12 months, it has created losses with negative free cash flow. 
Cogent Communications Group (NASDAQ: CCOI) is the Internet protocol provider for small and medium businesses in North America and Europe, with 43 data centers in more than 175 metropolitan markets in those two regions. Cogent is also the example of diluting existing shareholders by issuing more shares in the last 10 years. It had only 170 thousand shares in 2002, and now the total number of shares has expanded to 47.14 million currently. Thus, its revenue per share decreased from $305 in 2002 to only $6.75 now.
As of September, it had only $161 million in total stockholders’ equity, including a negative $333 million in retained earnings. It booked $256 million in long-term debt. However, it was good that Cogent had a decent amount of cash, of $232 million. The debt/equity is currently at 2.4x, and the interest coverage is only 0.96x, meaning that the operating income it generated is less than the interest expense it had to pay. Cogent just began to pay a dividend in the third quarter of 2012. in the trailing twelve months, it earned $0.03 per share, but it paid out $0.21 per share in dividends, thus the dividend payout was as high as 7x. 
UMH Properties (NYSE: UMH) is a REIT, which is operating 40 manufactured home communities with 8,900 sites and leasing them to residents on a month-to-month basis. In the previous 10 years, UMH has kept issuing more shares to the public, however, at the less significant dilution rate than the other two mentioned-above companies. In 2002, it had around 7.63 million shares outstanding, and it has increased to 16.47 million shares now. Because of that, the revenue per share declined from $3.86 in 2002 to $2.64 in 2011.
As of September, it had $143 million in total stockholders’ equity, including $60 million in preferred shares. The long-term debt was grown 11.46% to $107 million compared to the previous quarter, and the short-term debt was booked at $25 million. The debt/equity is currently at 1.3x, but the interest coverage is extremely low, at only 0.29x. The company has its history of issuing new debt. It has issued nearly $42 million of debt in the last 3 years. Like other REITs, the dividend yield is high at 7.1%.
In REIT, investors should use Funds from Operations (FFO) rather than net income, as the business nature of REIT is quite different from other conventional businesses. Depreciation in the normal business is an annual non-cash charge to allocate the initial outlay to acquire fixed assets employed in the business operation. However, real estate often appreciates in value, rather than depreciates. That is why Funds from Operations, which does not include depreciation charges, is a better measurement. In 2011, UMH's adjusted FFO was nearly $9 million, or nearly $0.6 per share, but it paid out $0.72 per share in dividends. So the payout ratio of UMH was 1.2x. 
Foolish Bottom Line
The dividend might be good for income investors, and we might be excited when we see high dividend yields. However, when a company pays out more than what it earns in dividend, we should be worried. In addition, the low interest coverage and high debt/equity ratio indicate the high level of risk that the business is facing. Investors might dig deeper for their own judgments. Personally, I would avoid these three stocks for now. 

Should You Buy This Authoritative Registry Operator?


Do you want to own a piece of a major Internet registry operator that has the right to deliver .com and .net domains for website owners? Many investors might think now is the time to accumulate shares of VeriSign (NASDAQ: VRSN) because it has experienced a significant plunge from more than $49 per share in October to only $34.15 currently. Being investors, what should be our course of action? Let’s dig deeper.
VeriSign is the major Internet domain registry and infrastructure assurance service provider, with its exclusive registry of domain names ending in .com, .net, and .name. The majority of its revenue, around $472.7 million, or 61.2% of the total revenue, was from the US region. There is a customer concentration in its business, as one customer accounted for around 30% of the total operating revenue in 2011. Previously, VeriSign had operated .org domains as well until 2003 in exchange for the continuation of the .com domain’s operation with around 34 million registered users. As of December 2011, VeriSign had around 113.8 million users in both .com and .net registries. In July of last year, the .net operation has been renewed for the company for 6 years.
VeriSign is allowed to be the registry operator for .com domain for another six years, but the glitch is that it couldn’t raise prices automatically (of up to 7%) like before. The annual price would be the current price of $7.85 per name. With 105 million names for .com domain, it would bring to VeriSign sustainable revenue of more than $824 million. The discontinued automatic price increases had restricted VeriSign to charge as much as $10.29 by the end of the sixth year, wiping out the addition $256 million per annum from price increases. The cap on price increases precluded a free fall in the market.
Since the beginning of 2009, investors have enjoyed a gradual upward trend of its stock price. However, the recent drop has wiped out most of its gains in the last 5 years. Among its peers including Tucows (NYSEMKT: TCX)Symantec (NASDAQ:SYMC) and Innodata (NASDAQ: INOD), VeriSign hasn’t provided a great 5-year return to shareholders.
 
Tucows has been the best performing stock, with the gain of 92.11% over the last 5 years, whereas Innodata is the worst, creating a loss of nearly 9.4% for investors.
In terms of the profitability of shareholders’ equity, VeriSign seems to be the best, and its return on equity has skyrocketed since the beginning of 2012.

However, investors should not be misled by the recent shot up in its ROE in the beginning of 2012. If we look closer, we can see that for the rest of 2012, its return on equity turned out to be negative. It was due to the negative book value on the denominator of the ratio.
In 2007, it had more than $1.5 billion in stockholders’ equity, along with more than $1.2 billion in goodwill and intangibles, and $1.27 billion in long-term debt. However, as of September, the goodwill and intangible assets have been wiped out, only totaling $53 million. Its long-term debt also significantly decreased to only $100 million. The cash position has improved a little from $1.38 billion in 2007 to nearly $1.5 billion now. With the goodwill and intangibles wiped out, it dragged its equity into a negative number, -$27 million.
Currently, VeriSign is trading at $35.88 per share, with the total market capitalization of $5.57 billion. It is currently valued at 15.9x forward earnings and 1x PEG. It was much more expensive than Tucows 5.2x forward P/E. Symantec and Innodata are also valued much cheaper, at only 10.9x and 8.1x forward earnings respectively. 
Foolish Bottom Line
I would not worry so much about the negative book value, as the goodwill and intangible items have been wiped out. The regulation has given VeriSign its economic moat for its authoritative registry operation on.com and .net domain names. However, nobody knows the customer concentration and the regulatory framework change could affect the company within the 6-year contract term. I personally would demand a cheaper price in order to establish the position in the company. 

Wednesday, December 5, 2012

This Juvenile Stock Has A Low Margin of Safety


Do you feel bad when you miss a significant price rise in a short period of time? Should you join the long list of “momentum buyers” that anticipate further increases in the future, or should you just ignore it? My advice, price alone means nothing, you need to look at the fundamentals of the business to figure out whether the current price undervalues or overvalues the company’s future business potential. One example of this rise is Dorel Industries (NASDAQOTH: DIIBF). Dorel had been beaten down to $20.90 in September 2011, and has advanced to $37.80 in November, creating a gain of nearly 81% in just more than a year.  Let’s look at Dorel’s fundamentals to determine our course of action.
Dorel is a Canadian based company, which sells juvenile products and bicycles in around 22 countries; with three main operating segments: Juvenile, Recreational/Leisure, and Home Furnishings. In 2011, out of $561.6 million in revenue, nearly $240 million came from the Juvenile segment, accounting for 42% of the total revenue, whereas Recreational/Leisure and Home Furnishings segment contributed $202.4 million and $119.7 million to total revenue, respectively. The largest customers of Dorel have been major retail chains including department stores, home centers, and mass merchant discounters.
In the last 10 years, Dorel has been growing its revenue and earnings per share at a quite decent rate, along with maintaining a consistent number of shares outstanding during this period.
USD million
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Revenue
992
1,164
1,685
1,761
1,771
1,814
2,182
2,140
2,313
2,364
Net Income
62
75
100
91
89
87
113
107
128
105
EPS (US$)
2
2.32
3
2.77
2.7
2.63
3.38
3.21
3.85
3.21
We can see that in the period of 2002-2011, its revenue experienced uninterrupted growth with an annualized rate of 9%. Its net income followed, but with a more fluctuating pattern. Its EPS has grown from $2 in 2002 to $3.21 in 2011, creating annualized growth of more than 4.8%. In addition, Dorel is a quite consistent cash flow generator as it has continued to generate positive operating cash flow and free cash flow in the last 10 years. In fiscal 2011, the operating cash flow and free cash flow were $162 million and $114 million, respectively.
The earnings and cash flow stream seems to be quite stable. However, what worries me is the high level of goodwill and intangibles on its balance sheet. As of September, Dorel had $1.27 billion in stockholders’ equity, $361 million in long-term debt and around $992 million in goodwill and intangibles, including the value of customer relationships and supplier relationships, patents and non-compete agreements. That leads to the low tangible book value of only $9 per share, whereas the shares are trading at $37.00 per share.
Currently, its total market capitalization is $1.17 billion, with the enterprise value of $1.51 billion. It is valued at 10x forward P/E and 8.38 EV/EBITDA. Compared to its peers includingKid Brands (NYSE: KID) and Fortune Brands Home & Security (NYSE: FBHS), Dorel is the only company paying dividends among the three. The dividend yield that Dorel is paying is currently 0.8%. Kid Brands is a much smaller company, with only $37.13 million in market capitalization. It has a trailing twelve month loss, and it is valued at 7.4x forward earnings and more than 29.5x EV/EBITDA. FBHS is the largest company among the three, with $4.88 billion in market capitalization. It is a spin-off from Fortune Brands dated back in the last quarter 2011.  It was quite expensively priced at 25.6x forward earnings and 18.12x EV/EBITDA.
Foolish Bottom Line
The probability of writing off its goodwill and intangibles seems to be low, as its operating performance has been quite stable, but it doesn’t mean that it won’t happen in the future. To me, the current market price doesn’t offer enough margin of safety for investors to invest in the company. I would rather wait for price corrections before initiating positions in this stock.