SINLetter – June 2006
Welcome to the eleventh edition 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.
May was quite harsh on the US markets with the Nasdaq falling 6.19% and wiping out all of its gains for 2006. International markets did not fare much better either and India fell as much as 20% in May. While some individual stocks in the SINLetter model portfolio shared a similar fate, the overall portfolio managed to eke out a small gain in May thanks in large part to an astounding return of 233.95% from Medifast (MED). Medifast released first quarter 2006 results with income increasing 230% year-over-year, well beyond my wildest expectations. If you are interested, I have summarized the quarterly results here. The overall SINLetter model portfolio is now registering gains of 63.57% since its inception in August 2005. This compares with a gain of 5.13% for the Dow Jones Industrial Average, a loss of 0.75% for the Nasdaq and a gain of 2.81% for the S&P 500 over the same time period.
Tata Motors (TTM) was one of the hardest hit SINLetter picks in May, losing as much as 18.96% of its value thanks to the sell-off in emerging markets and after reporting a 17% increase in fourth quarter net profit that did not meet forecasts. While Ford (F) and General Motors (GM) cut capacity and close plants to reach profitability, Tata Motors reported a 29% increase in fourth quarter revenue and a 24% increase in full year profit. Tata Motors also continues to invest heavily in its infrastructure and plans to increase its capacity to produce medium and heavy trucks by more than 200%. Tata Motors has identified a site in the state of West Bengal to build its radical new car, which will cost approximately $2,000 (or 100,000 rupees). The company plans to sell as many as half a million of these small cars each year in India. I still like the long-term prospects of Tata Motors and plan to continue holding it both in the SINLetter model portfolio and my personal portfolio.
While Johnson & Johnson (JNJ) managed to post a small gain in May, I was surprised to see Royal Philips (PHG) head lower. Philips was referred to as the disrespected GE of Europe in last weekend’s Barron’s. According to Barron’s, analysts put the true value of Philips at $40 to $45 per share, almost 30 to 45% above its current price of $31.61. I am in strong agreement and feel that Royal Philips has a lot of potential over the next three years. RCM Technologies (RCMT) lost ground in May when it reported income that was flat when compared to the year-ago period and revenue that increased a modest 7%. April employment numbers coming in worse than expected also put downward pressure on RCMT. Management expects operational profits to increase in subsequent quarters and unless we hit a recession or the story changes, I am going to stick with RCM Technologies.
According to an analyst with RBC Capital Markets, Intel’s (INTC) archrival Advanced Micro Devices (AMD) may merge with SINLetter pick ATI Technologies (ATYT). The analyst, Apjit Walia, has a $23 price target on ATI Technologies and this report helped ATI edge up $1.36 or almost 8.98% on May 31st. Even if this merger or acquisition by AMD does not pan out, ATI Technologies should benefit from sales of the XBOX 360 and the upcoming Nintendo Wii gaming consoles, both of which use ATI graphic chips. Word on the street is that the Nintendo Wii with its revolutionary controller will be priced at $249, which is about half the price of a Sony Playstation 3. ATI Technologies was featured in the first edition of SINLetter back in August 2005 and is now registering gains of 26.51%.
To finance this month’s purchases I am going to sell 500 shares of Medifast (MED), which represents 1/4 of our original purchase of 2,000 shares. Medifast continues to remain an excellent long-term holding but after its recent run-up, it may be prudent to take some profits off the table.
I am also selling the second half of our stake in Wipro (WIT) and recognizing the 20.99% gain since we added it to our portfolio in September 2005. As you can see from the historical trades page, we sold the first half of our stake in Wipro three months ago. I am selling Wipro because we will add Infosys Technologies (INFY) to our model portfolio this month and I did not want exposure to two large Indian IT consulting firms at the same time.
Other Interesting Events:
On Monday May 23rd, the Indian BSE Sensex fell as much as 10% intraday and trading was halted for an hour. Trading then resumed and the market bounced back a little before continuing to slide during the rest of May. The Russian market also fell a little over 11% on the same day and trading was suspended until the next day. It appears that almost all the markets across the world fell in unison. All the talk about a global economy certainly seems to be true. This map is an excellent visual representation of the widespread carnage in emerging markets that occured in May. While exchanging a few emails with an investor (who also writes for a leading online financial website) about the performance of our portfolios, he aptly remarked “I’m getting treated like a farm animal come harvest time”.
Bausch & Lomb (BOL) decided to pull its entire line of Renu lenscare products after multiple cases of fungal eye infections were reported. Investors cheered the news by sending the stock up 12.69% to $50.08. As a contact lens wearer, this decision by Bausch & Lomb does make sense because it is highly unlikely that I would ever buy a Renu product again. However, discontinuing the Renu line will knock off about $100 million per year in revenue and there will be spillover effects on other Bausch & Lomb products. Bausch & Lomb will also have to settle numerous lawsuits in the coming months and years. A fellow blogger, Ashish Kelkar, has done an excellent job of analyzing the fallout from this fiasco and you can check out his blog entry here.
The Voice-Over-IP (VOIP) telecommunications company Vonage (VG) went public in May at a price of $17 per share. The stock closed down 12.65% on the first day of trading and then continued drifting lower before closing down at $12.02 on May 31st, making it the worst IPO of 2006. Vonage decided to offer IPO shares to its current customers and those who did take up Vonage on its offer are not very happy right now. One of the reasons investors lost their appetite for the Vonage IPO was the announcement by Skype (now a part of ebay) that it would allow users to call any landline or cell phone in the US and Canada for free until the end of the year. Venture capitalist Kevin Chao made an excellent call by stating “Avoid it like a rabid dog stumbling down your street” before Vonage went public. You can read his complete post about why the Vonage IPO should be avoided here.
MasterCard (MA) went public on May 25, 2006 and the opening was “priceless”. The company priced its shares at $39 and the stock ended its first day of trading at $46, a jump of almost 18%. The stock drifted lower over the next two trading sessions before perking up a little on May 31st. I plan to stay away from MasterCard on account of the number of lawsuits the company currently faces. Interestingly enough, MasterCard mentioned raising money to pay for these lawsuits as one of the reasons for going public. Another reason I would stay away from MasterCard is the emergence of biometric payment options offered by companies like San Francisco based Pay By Touch that could put pressure on MasterCard, Visa and AmEx in the future. Pay By Touch raised upwards of $150 million from hedge funds in a very short period of time, embarked on an acquisition binge and is very likely to go public within a year.
After briefly flirting with a price of $720 an ounce, Gold declined along with most other commodities to close at $649 on May 31st.
Logitech International (LOGI)
Stock splits are events where the number of shares you own double while the price drops by 50%, leaving the net value intact. However if you have ever owned a stock that split or looked at the long-term chart of a stock that has split in the past, one thing stands out. Stocks of companies that declare splits rise after a split is declared and they tend to outperform the market. While this might not be universally true of every stock that splits or for stocks that split during a boom, it seems to be true for the vast majority of stocks. To verify this theory, I started looking for any long-term studies that were done to compare the returns of stocks that split vs the general market. I found an interesting LA Times article that mentioned an academic paper called “What Do Stock Splits Really Signal?” by professors David Ikenberry, Graeme Rankine and Earl K. Stice. This paper looked at the returns of 1,275 companies that declared stock splits between 1975 and 1990 and found that in the first year after the effective date of the split, these stocks outperformed a benchmark group of companies by 8%. Over a period of three years, the results were even more impressive with these stocks outperforming the benchmark group by 16%.
I then contacted the authors of this paper to see if they had continued this research and if they did, was there a significant change in the results. Professor David Ikenberry who is currently the Chair of the Department of Finance at the University of Illinois, Urbana-Champaign was kind enough to write back to me and sent me another paper called “Underreaction to Self-Selected News Events: The Case of Stock Splits” that he had published along with Sundaresh Ramnath. The results of this second study which looked at stocks that declared splits between 1988 and 1997 were similar to the first study. The mean return of stocks in this group was 9% higher in the first year after the split and the median return was 6.37% higher when compared to a control group. The reason for these higher returns? After ruling out factors such as increased coverage by analysts, Ikenberry and Ramnath concluded that 85% of companies that declare stock splits tend to have higher earnings growth in the ensuing years and analysts that follow these companies are slow to revise their earnings expectations upwards. This underreaction contradicts conventional wisdom and the efficient market hypothesis. However based on data from over 30 years, this underreaction to stock splits is an anomaly that could be exploited to boost returns. The two stocks featured in this month’s SINLetter are based on this research as they have both proposed stock splits in recent weeks.
Switzerland based Logitech International recently proposed a stock split and a $250 million share buyback program. In addition to the study of stock splits discussed above, numerous academic studies have also shown that companies that announce share buyback programs and then actually execute them (strangely enough some companies do not follow through on a buyback announcement) outperform the general market. Logitech is a company that makes a wide range of computer accessories and is well known for its web cams, computer speakers, cordless mice and keyboards. The company also has strong product lines for computer headsets, bluetooth headsets for cell phones, iPod speakers, game console accessories such as racing wheels and remote controls.
I recently started using Skype to communicate with my off-site project team and visited the neighbourhood Circuit City (CC) looking for a headset. The Logitech headset I was looking for was out of stock and so I picked up a Cyber Acoustics headset instead. Much to my disappointment, I realized that I must have a larger head than the designers at Cyber Acoustics imagined. I returned the Cyber Acoustics headset and picked up a Logitech one instead at a different Circuit City. With over 74.7 million registered Skype users at the end of 2005, the popularity of massively multiplayer online role-playing games (MMORPG) like World of Warcraft, the proliferation of iPods and the use of web cams for communication and security, it should come as no surprise that Logitech is doing well. This is probably what lead to the following comment made by the Chief Financial Officer of Logitech during the quarterly earnings conference call “PC headsets really are riding Iâ€™d say the wave of the voice-over-IP communications and contributed to sales growth of 61% and unit growth of 69%.”.
Skype’s recent move to offer phone calls for free when calling any phone in the US or Canada from a computer should further ignite the sales of headsets for Logitech. Another driver of growth would be the next generation of gaming consoles such as the Microsoft XBOX 360, the Nintendo Wii and the Sony Playstation 3 that can connect wirelessly to the internet to enable online gaming. Logitech’s high end Harmony line of universal remote controls that have a color LCD display, a recharging station and a USB interface to download updates from a computer (I never imagined a day would come when my remote control would require software updates) is gaining traction in Europe.
With the business obviously doing well, lets look at some of the numbers. With a forward P/E of 17.73, a P/S of 2.07, a strong balance sheet that sports $245 million in cash when compared to just $14 million in debt, a quarterly revenue growth rate of 15.7% and a quarterly earnings growth rate of 27.1%, Logitech appears to be attractively valued. According to the latest quarterly results, inventory dropped from $258 million in the fourth quarter of 2005 to $197 million in the fourth quarter of 2006, which is very positive. Cash flow from operations was up 15% year-over-year reaching a record-breaking $137 million in the fourth quarter of 2006. Their tax rate for the latest quarter was a little over 13% and will be around 14% going forward. Comparing that with a tax rate of almost 40% for SINLetter pick Medifast makes one realize why Logitech is generating a healthy amount of free cash flow each quarter. Logitech certainly appears to have excellent long-term potential and I personally plan to start a position in Logitech after this newsletter is sent out to subscribers.
Logitech faces competition from Plantronics (PLT), Creative Technology (CREAF) and Motorola (MOT) in the headset segment, Singapore based Creative Technology in the web cam and speakers segments, and Microsoft (MSFT) in the wireless mice and keyboard segments.
- Logitech recently announced a stock split and a $250 million share buyback program.
- Attractive valuation with a forward P/E of 17.73 and a Price/Sales of 2.07.
- Logitech is likely to benefit from increased Voice-Over-IP (VOIP) activity from Skype users.
- The next generation of gaming consoles such as the XBOX 360, Wii and Playstation 3 will contribute to future growth.
- A very strong balance sheet and excellent free cash flow.
- Sales in retail gaming fell thanks to a drop in sales of console accessories and in spite of an uptick in sales of PC gaming accessories. The release of the Playstation 3 and the Nintendo Wii should hopefully reverse this trend.
- The tax rate will increase marginally from a little over 13% in the latest quarter to about 14% going forward.
- Competition in the headset segment is stiff as evidenced by the disappointing quarterly results released by Plantronics.
|P/E||22.16||Long Term Debt||$14 Million|
Infosys Technologies Ltd. (INFY)
Infosys is one of the largest Indian IT firms with annual revenue of $2.15 billion and over 52,000 employees worldwide. The rapid pace of IT outsourcing has definitely helped Infosys grow at an annual rate of over 30% over the last few years. During a recent conference call discussing the fourth quarter and full year results, CEO Nandan Nilekani remarked “it took us 23 years to reach our first billion and itâ€™s taken us 23 months to reach our second billion” referring to the annual revenue of Infosys. Just like close competitor Wipro who is expanding in the Middle East, Infosys is seeing robust growth in Europe, with 25% of its revenue now coming in from Europe when compared to 63% from the United States. When it released its full year results in mid-April, Infosys proposed a stock split and the stock rallied 13.07% to $83.74. This was before the sell off in the Indian stock market and the stock is now at $70.60, well below where it was when the split was announced. As discussed above, stocks that declare splits tend to outperform the general market and hence I picked Infosys as a dual play on international investing and the stock split theory.
Infosys has a very strong balance sheet with $1,509 million in total current assets when compared to just $209 million in current liabilities. Interestingly, given the number of acquisitions that Indian IT firms have embarked upon over the last year, only $8 million is listed under goodwill on the balance sheet.
Looking at the following table that compares four of the largest Indian IT companies, it becomes clear that while Infosys does not have the scorching earnings growth of Satyam Computer or Cognizant Technology, it enjoys the best profit margins and hence generates the maximum earnings amongst this group. I have not included Tata Consultancy Services (TCS) in this comparison as it not quoted on the NYSE. I have instead substituted TCS with Cognizant Technology Solutions (CTSH) which is based in the United States and is not an ADR (American Depository Receipt) like Wipro, Infosys and Satyam. Cognizant was included in this comparison as it has a business model that is similar to other large Indian IT firms and has a strong presence in India.
|Infosys (INFY)||Wipro (WIT)||Satyam (SAY)||Cognizant (CTSH)|
|Annual Revenue Growth||35%||30%||38.14%||50.99%|
|Annual Earnings Growth||32.46%||28%||62.20%||65.86%|
|Annual Revenue||$2,152 million||$2,380 million||$1,096 million||$885.8 million|
|Annual Earnings||$555 million||$464.5 million||$249.4 million||$166.27 million|
IT consulting and outsourcing is a highly competitive sector with many large and small companies vying for a piece of the same pie. As mentioned above, Infosys faces competition from Wipro (WIT), Satyam (SAY), Cognizant (CTSH) and Tata Consultancy Services. Apart from these companies, Infosys also faces competition from IBM (IBM), Accenture (ACN), BearingPoint (BE), Sapient (SAPE) and iGATE (IGTE). With this much competition, it is impressive to see that Infosys has been able to maintain a profit margin of 25.79%.
- Infosys continues to grow both revenue and earnings at greater than 30% a year.
- Infosys maintains one of the best profit margins in this industry and with revenue exceeding $2 billion last year, it generated more than half a billion dollars in earnings.
- The balance sheet is rock solid with over a billion dollars in cash and short-term investments and no debt.
- The company has proposed a stock split and two special dividends amounting to 86 cents a share.
- Consulting and outsourcing is a highly competitive sector with numerous large and small players.
- Infosys along with other Indian IT firms faces problems like employee attrition and rapid wage expansion.
- Earnings could be impacted by currency fluctuations.
- If expectations of continued high growth are not met, the stock could face a steep decline.
|P/E||35.48||Long Term Debt||$0 Million|
Every month we will add the two featured stocks into a model portfolio started with a cash position of $100,000 on August 2, 2005. To keep calculations simple, trading costs are not included. Prices reflect the closing price as of the last trading day of the previous month (May 31, 2006 for the June 2006 newsletter).
Model Portfolio – June 1, 2006
|Stock/Cash||Number of Shares||Cost||Current Value||Difference($)||Difference(%)|
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