SINLetter – July 2006
Welcome to edition 12 of the Suria Investment Newsletter (SINLetter), a free monthly newsletter that highlights two publicly traded companies. The objective of this newsletter is to provide you with unbiased initial research and basic facts about individual stocks so that you can then research them further before deciding to add them to your portfolio or not. For those of you who are reading this and are not already subscribed, you can subscribe by going to www.sinletter.com/subscribe.aspx and you will start receiving this newsletter from next month. I have provided relevant links throughout this newsletter, but if you have any questions or comments, feel free to write to me.
Announcing the Launch of MustFeed.com: About three months ago we started toying with the idea of creating a website that would aggregate the latest financial headlines from both blogs and traditional media across various categories like Stocks, Exchange Traded Funds (ETFs), Emerging Markets and Personal Finance. This idea has finally been realized (leading to a brief hiatus from blogging) and we are now ready to launch the beta version of MustFeed. Please take it for a test drive, check out categories like Stocks and send us your thoughts. We plan to go live with MustFeed in August 2006 to coincide with the first year anniversary of SINLetter and would appreciate your feedback.
The SINLetter model portfolio fared better than the S&P500 and the Nasdaq with a loss 1.64% in the second quarter of 2006. The S&P 500 and the Nasdaq reported a loss of 1.9% and 7.2% respectively. The Dow Jones however managed to eke out a gain of 0.4% thanks in large part to a 40% jump in General Motors (GM) in the 2nd quarter of 2006. Defensive large cap stocks like Johnson & Johnson (JNJ), Eaton (ETN) and Safeway (SWY) along with spectacular returns from Medifast (MED) certainly helped the SINLetter portfolio weather this quarter, which was very harsh on the technology sector and emerging markets like India, Russia and Brazil. Mutual funds in the technology sector posted a loss of close to 10% in the second quarter while emerging market mutual funds had a loss of about 6.6%. Even healthcare was not spared with health and biotechnology mutual funds posting a loss of about 7.6% in the second quarter.
The overall SINLetter model portfolio is now registering gains of 55.01% since its inception in August 2005. This compares with a gain of 4.96% for the Dow Jones Industrial Average, a loss of 1.06% for the Nasdaq and a gain of 2.82% for the S&P 500 over the same time period. Medifast (MED) remains the top performing stock in the SINLetter model portfolio with gains of 231.54%. Medifast had a very volatile June, running up to $20.90 per share before dropping to $14.78 and then finally closing the month at $17.87. Some of the reasons for this volatility have been discussed in the Portfolio Readjustment section below.
The biggest shocker was the precipitous 34% drop in shares of Airspan Networks (AIRN) on June 30. Airspan shares started heading lower after the company reported a bigger than expected loss last quarter as they had to defer recognition of $5.5 million of revenue from a contract with their biggest customer Yozan Inc. The recent sharp drop was on account of continued problems with the Yozan contract and you can read about it here. Since the company plans to raise $10 million for liquidity reasons, existing shareholders could face dilution if Airspan decides to issue more shares through a private placement (Sirius Satellite Radio has mastered this art).
Until there is more visibility regarding the Yozan contract or how Airspan plans to raise the additional $10 million, I plan to hold on to my Airspan shares. On the positive side, even without the Yozan contract, Airspan expects to generate about $24 million in revenue this quarter. This is flat when compared to the first quarter of 2006 but almost 20% above the revenue generated in the second quarter of 2005. Another positive is the $10 million contract that Airspan signed in May with Tulip IT Services in India.
Last month’s SINLetter pick Infosys (INFY) had a good month and was up 8.23% as the Bombay Stock Exchange Sensex rebounded with enthusiasm from its bottom on June 14th. Logitech (LOGI) did not do quite as well, registering a loss of 4.81% for the month. I believe that Logitech is very well positioned to benefit from headset demand driven by Voice-Over-IP (VOIP) applications like Skype and the launch of new gaming consoles like the Nintendo Wii and the Playstation 3. Logitech shareholders approved a 2 for 1 stock split, which will go into effect on July 14th, 2006.
Medifast has seen a meteoric rise in recent months and I am personally seeing returns of almost 600% on my investment since I picked up some shares when they were trading at about $3. This rapid rise has been driven by strong fundamentals and a clean balance sheet. The company has been profitable for 26 consecutive quarters, raised guidance three quarters in a row, reported revenue growth of 130% and profit growth of 230% in the latest quarter. Their guidance for the rest of the year is conservative when compared to how well they did in the first quarter, leading me to believe that they are likely to beat expectations in future quarters.
However I have decided to book some more profits in Medifast by selling 1,000 shares at $17.87 and realizing a profit of 231.54%. While it is always best to take some profits off the table, I am also selling part of our Medifast position because the CEO Bradley T. MacDonald sold 440,000 shares in May and the shares are richly valued right now. I will continue to hold 500 shares in our model portfolio to realize gains from any potential price appreciation in the future. For those of you who are interested in why the stock dropped suddenly from $20.90 to $14.78, check out this negative report by StockLemon.com. While they do raise some valid concerns about the massive insider selling and the approval of a new obesity pill called Acomplia by the European Union, I think that they have a very active imagination. A lemon (car) as defined by Wikipedia is “A lemon is a defective car that, when purchased new or used, is found by the purchaser to have numerous or severe defects not readily apparent before the purchase.” By no stretch of imagination does Medifast have anything in common with a particular citrus fruit. The market seems to agree and after the sharp sell-off, Medifast rebounded strongly.
I am also liquidating our position in CMGI (CMGI) and taking a loss of 16.67%. The results from the last quarter were disappointing as most of the $21.7 million profit was driven by liquidity events from the sale of WebCT and Realm Business Solutions. If I did not require the capital to finance this month’s featured stocks, I could have given CMGI some more quarters to see if the bread and butter supply chain management business could achieve profitability or not.
Other Interesting Events:
June proved to be a very interesting month for the housing sector. A number released one day would foretell a dire future for housing such as the homebuilder confidence index that fell to a 11 year low of 42 in June while the very next day the May new home sales number would herald that the softness in housing is not as bad as previously expected. Yet again, a 6.7% drop in mortgage loans in the third week of June (a 31% drop when compared to year-ago numbers) painted a picture of doom and gloom. What does all this data imply? Is it time to stop being bearish (negative) about the home builders who have lost close to half of their value and are even sporting very attractive valuations – Toll Brothers (TOL), Hovanian (HOV), DR Horton (DHI), KB Home (KBH) and Meritage Homes (MTH) each have low single digit P/Es – and identify the ones to buy in 2007? While I am no longer as bearish on the housing sector as I was in September 2005, I realize that housing cycles are very long and there is a lot of excess inventory that has to be worked off (6 and half months as of May 2006) before the home builders will see any sustained growth. Sure, the entire sector could experience a dead cat bounce after prices have been depressed well beyond rational levels, but I don’t think the carnage is over yet and plan to stay away from the sector through the rest of 2006 and quite possibly 2007.
Big pharma has taken some aggressive steps in their battle against generic drug companies like Teva Pharmaceutical (TEVA), Mylan (MYL), Dr Reddy’s Labs (RDY) and Ranbaxy Laboratories. Merck (MRK) decided to drop the price of its cholesterol lowering drug Zocor while Pfizer (PFE) plans to release a generic version of its antidepressant drug Zoloft soon after its patent expires. Current SINLetter pick Johnson & Johnson (JNJ) won the bid to buy Pfizer’s consumer health care division that includes brands like Listerine, Visine and Neosporin for $16.6 billion. I still like the long-term prospects of Pfizer, which was featured in the January edition of SINLetter and continue to hold it in my personal portfolio.
Gold fell briefly to $544 per ounce (31.1035 grams) before rebounding and closing the month at $613.40. If you are interested in buying gold, you can buy the physical asset or the exchange traded fund (ETF) called streetTracks Gold (GLD), which as the name implies, tracks the price of gold. I first heard about streetTracks Gold (GLD) when I was looking for ways to buy gold in August 2005. At that time gold was trading at about $425 an ounce and soon started its amazing rise all the way to over $720 an ounce in just a few months. A friend of mine mentioned this in a comment he left on my blog back in December. StreetTracks Gold sells part of the gold bullion it holds to pay for expenses but when compared to the premiums you have to pay to buy the physical asset (there can be a large premium for coins based on age, condition and availability), GLD looks like an excellent option. You can also choose to go a different route and buy shares in a gold mining company like Newmont Mining (NEM) or Barrick Gold (ABX).
Two more ethanol-producing companies went public in June. Aventine Renewable Energy Holdings (AVR) was priced at $43 a share and closed it first day of trading down more than 10% while VeraSun Energy Corp (VSE) which priced its debut at $23 a share fared much better and closed up almost 30% on its first day of trading. Without digressing any further, here are the two stocks for this month.
Intel Corporation (INTC)
I never thought I would see a day when Intel would become a high dividend yielding stock. When compared to the average dividend yield of 1.6% for the S&P500, Intel now yields 2.10%. Yet this is exactly what has occurred as Intel has lost a quarter of its market cap over the last six months falling from around $25 to its current price of $19. This drop was on account of many problems and concerns. Some of these issues are discussed below,
- Intel has been steadily losing market share to rival Advanced Micro Devices (AMD) over the last two years. According to this article in BusinessWeek, AMD’s share of the worldwide processor market has grown to 15.3% in the first quarter of 2006 when compared to 5.7% a year ago.
- AMD’s multicore processors consume less power than equivalent Intel processors and have become the first choice for servers. AMD now commands 26% of the server market and an impressive 48% of the multicore server market.
- Dell (DELL), which has exclusively used Intel chips in all of its computers and servers, announced that it will start using AMD’s processors in its multiprocessor servers by the end of 2006.
- Intel’s margins may also face pressure in the future thanks to its decision to enter the highly competitive and (often) low margin business of consumer electronics. Dell and Gateway (GTW) tried the same strategy with mixed results.
- Both Intel and AMD face a common adversary in the revolutionary nine core Cell processor developed jointly by IBM, Sony and Toshiba for the Playstation 3. IBM has already announced plans to use these processors in a line of blade servers.
- Intel is ditching its brilliant marketing slogan “Intel Inside” for something called “Leap Ahead” and is also changing its 37 year logo, replacing it with a series of new logos based on the type of processor.
Why would I decide to feature Intel if it is facing so many problems? Some of the reasons why I like Intel are listed below,
- Wall Street’s pessimism of Intel has driven the stock to a level where its valuation looks very attractive. Intel currently sports a Price/Earnings ratio of just 14.77, Price/Sales of 2.93, has over $9 billion in cash and short-term investments on its balance sheet and has operating margins of 28.48%.
- In spite of all the problems discussed above, Intel still generates well over a billion dollars of free cash flow each quarter.
- Intel is restructuring its business and selling off unprofitable divisions such as the mobile chip unit that was recently sold to Marvell Technology Group (MRVL) for $600 million.
- Intel recently launched a price war on AMD for its existing line of processors while getting a new line of energy efficient processors code named Woodcrest, Conroe and Merom ready for launch. Woodcrest, now referred to as Xeon 5100 was released on June 26 and will be used in servers. Conroe is slated for release in the last week of July and will be used in desktops while Merom, the notebook version, is slated for release in the second half of August.
- Apple (AAPL) computers now use Intel processors. Most Apple followers expect Apple to increase its market share of personal computers and based on the ads I am seeing these days, it certainly appears like Apple is following that strategy. On a side note, the new Apple computers that come equipped with Intel chips are jokingly referred to as “mactels”.
- Intel has invested in (and some say hyped) WIMAX technology, which allows wireless connections over a much larger distance when compared to the current wireless standards. Intel plans to roll out the next-generation “Rosedale 2″ WiMAX chip by the end of 2006 and we can expect to see WIMAX enabled laptops sometime in 2007.
- Intel’s venture capital arm has been investing in nanotechnology companies as well as regular technology companies like Six Apart, the creators of Typepad blogging software.
Longtime SINLetter subscribers are probably aware that I have considered featuring Intel for quite some time now. While it is very hard to call a bottom, I was looking for a catalyst before I featured Intel as a SINLetter pick. The release of Intel’s new generation of processors was exactly the catalyst I was looking for. I picked up shares of Intel for my personal portfolio in May when it hit $18 and I think we have seen the bottom when Intel dropped to $17.11 on June 8th. According to Mark Hulbert of MarketWatch.com, as many as 11 newsletter editors were recommending Intel as of May 31st, 2006 and this chart showing the disconnect between Intel’s earnings growth and stock price probably explains why so many of us are now bullish on Intel.
- Intel remains a highly profitable company that is trading at a very attractive valuation and has a dividend yield of 2.1%.
- Intel recently released a new line of energy efficient processors code named Woodcrest. Similar processors targeting the desktop and notebook markets will be released in coming months.
- Apple computers are now using Intel processors and it is widely expected that Apple will gain market share in the personal computer sector.
- Intel plans to start rolling out WIMAX devices in late 2006 and 2007. WIMAX is gaining traction in countries that do not have a strong internet infrastructure already in place.
- Loss of market share to AMD in the desktop, notebook and especially the server market.
- Shrinking margins on account of a price war with AMD.
- Decision to enter the highly competitive consumer electronics business could impact margins even more.
- The next PC upgrade cycle may not start until well after Microsoft launches Windows Vista in early 2007.
|P/E||14.77||Long Term Debt||$2.04 Billion|
Procter & Gamble (PG)
Procter & Gamble is a company that requires no introduction as many of its brands like Gillette, Crest, Tide, Duracell and Bounty are ubiquitous amongst consumer products. Why have I chosen a blue chip stock like P&G for this newsletter when I should be uncovering some hidden company that has an edge through the latest exotic technology? Large defensive stocks like P&G are very important for the health of a diversified portfolio, especially when there is uncertainty in the economy or the possibility of a recession. However the reason I decided to feature P&G was because of another trend that I have noticed over the last few months. Just as Eaton Corp (ETN) was a proxy for increased activity in the aircraft parts sector, P&G is a proxy for a trend that I would like to call “the return of the baby boom”.
While having coffee with a close friend a couple of weeks ago, she remarked that everyone seems to be having babies these days. This observation confirmed what I had been noticing over the last few months. Try walking past the baby diaper aisle at your neighborhood Target Store (substitute store of choice here) and you will know what I am talking about. The US Census Bureau has stated that the number of children aged 5 and under is expected to grow more than 10% over the next decade. Diapers are an excellent way to invest in this trend, as it is a product that has to be bought over and over again while at the same time fosters brand loyalty.
The two most recognizable brands of diapers are Pampers and Huggies. Pampers, a P&G brand, sells at a premium of almost 20% over Huggies. My first thought was that Huggies was probably the stronger and more recognized brand based on the number of ads I have seen over the years. Brand valuation is extremely difficult especially when you are comparing two strong brands. I decided to use a novel but highly unscientific tool to determine which brand was stronger. Plugging in both Pampers and Huggies into Google Trends brought up the following chart showing that the number of searches done for Pampers over the last few years far outnumber the number of searches done for Huggies. This obviously shows higher brand interest in Pampers and probably translates into higher sales for P&G.
* Pampers * Huggies
The fact that Pampers sells for a premium above Huggies also means higher margins for P&G. Since Pampers probably contribute only a small portion of the company’s overall sales, I checked the overall profit margin for P&G. Procter & Gamble has an impressive profit margin of 13.17% when compared to Kimberly-Clark’s 8.67% profit margin and more than twice Unilever’s 6.68%. Apart from Pampers, P&G also owns 20 other “billion-dollar brands”, brands like Always, Iams, Olay, Head and Shoulders, Pantene, Charmin and Downy that generate over a billion dollars in annual sales.
P&G is not very attractively valued as its P/E of 20.19 is above the average P/E of the S&P500 but with its strong brands, dividend yield of 2.2% and excellent free cash flow, the slight premium is justified. The only things that I do not like about P&G are its large debt load ($37.75 billion) and the stupendous amount of goodwill that it carries on its balance sheet. A large part of the $54.69 billion goodwill is on account of P&G’s acquisition of Gillette for about $57 billion last year. However with net income of $2.2 billion last quarter, the debt load appears manageable.
If you are interested in pure play companies that could benefit from the return of the baby boom, you could consider Gymboree (GYMB), Carter’s (CRI) LeapFrog Enterprises (LF) or even Mothers Work (MWRK). I blogged about Mothers Work here and Catablast Media has a nice write-up about Gymboree here.
Unilever (UL) with its brands like Dove, Caress, Knorr (soups), Lipton, Slim-Fast and Vaseline is a strong competitor of Procter & Gamble. Other well known competitors include Johnson & Johnson (JNJ), Colgate-Palmolive (CL) and Kimberly-Clark (KMB), which makes the Huggies brand of diapers discussed above.
- P&G is a large defensive stock with 21 “billion dollar brands” and an impressive profit margin of 13.17%.
- The Pampers brand could benefit from “the return of the baby boom”.
- P&G generates a lot of free cash flow and has a dividend yield of 2.2% with a 50-year history of raising dividends.
- Procter & Gamble carries $54.69 billion of goodwill on its balance sheet primarily on account of its costly acquisition of Gillette.
- The balance sheet is highly leveraged with $37.75 billion in short-term and long-term debt.
|P/E||20.19||Long Term Debt||$33.92 Billion|
Every month we will add the two featured stocks into a model portfolio started with a cash position of $100,000 on August 2, 2005. To keep calculations simple, trading costs and regular dividends are not included. Prices reflect the closing price as of the last trading day of the previous month (June 30, 2006 for the July 2006 newsletter).
|Stock/Cash||Number of Shares||Cost||Current Value||Difference($)||Difference(%)|
Voluntary Disclosure: I currently own shares of Airspan Networks (AIRN), ATI Technologies (ATYT), Royal Philips (PHG), Nokia (NOK), Medifast (MED), Tata Motors (TTM), RCM Technologies (RCMT), Logitech (LOGI), CMGI (CMGI), Intel (INTC) and VA Software (LNUX).
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