Stocks 2011 The Investor's Guide To The Year Ahead

STOCKS 2011
TheInveslorsGuidelolheYearAhead
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Published November 2010
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Editor: Tracy Dahl
Financial Editor: Bryan White
Publishing Manager: Adrienne Perryman
Design and Production: Sara Klieger
Cover Design: Dari Fitzgerald
STOCKS 2011
Contents
T H E M O T L E Y F O O L | S T O C K S 2 0 1 1 : T H E I N V E S T O R S G U I D E T O T H E Y E A R A H E A D | P A G E I I I
I NTRODUCTI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I V
BY BRYAN WHI TE
APPLE:
I T S NOT TOO LATE TO TAKE A BI TE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
BY DAVI D GARDNER AND TI M BEYERS
ARRI S GROUP:
THE BACKBONE OF A MEGATREND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
BY NI CK CROW
CI T GROUP:
NOT AS NAUGHTY AS I T SEEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
BY ALEX SCHERER, CFA
DI AMOND HI LL I NVESTMENT GROUP:
I NVEST I N I NVESTI NG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
BY TI M HANSON
EXPEDI TORS I NTERNATI ONAL OF WASHI NGTON:
SHAPED UP SHI PPI NG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
BY J OE MAGYER
GAP:
FALL BACK I NTO THE GAP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
BY RI CH GREI FNER
LI NI NG:
BRANDI NG MEETS BASKETBALL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
BY BRYAN WHI TE
LORI LLARD:
GET HOOKED ON THI S DI VI DEND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
BY CHARLY TRAVERS
RED ROBI N GOURMET BURGERS:
AN ACTI VI ST I NVESTOR S BLUE PLATE SPECI AL . . . . . . . . . . . . . . . . . . . . . . 21
BY J I M GI LLI ES
SYNAPTI CS:
YOUR FI NGER ON THE PULSE OF TECHNOLOGY . . . . . . . . . . . . . . . . . . . . . . . 23
BY DAVI D MEI ER
WAL MART:
STI LL DELI VERI NG DEEP VALUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
BY J AMES EARLY
P A G E I V | T H E M O T L E Y F O O L | S T O C K S 2 0 1 1 : T H E I N V E S T O R S G U I D E T O T H E Y E A R A H E A D
STOCKS 2011
Introduction
BY BRYAN WHITE
DEAR FELLOW FOOL,
Markets are like rubber bands. Stretch them too far in one
direction, and snap! they eventually pull back. Lets take
bonds. About this time last year, a bond bubble was brewing.
Now, bonds appear on the verge of reverting to the mean, ready
to snap back to their usual slow and steady growth.
But guessing which direction markets will be pulled, and for
how long, is a fools game. We capital-F Fools prefer a more
measured investing approach to make our money. Our secret
weapon: time.
WHY WE GO LONG
Long-term investors like us view the market as a tool to
build wealth over long periods of time. Instead of focusing on
the next three weeks, we fixate on the value of an asset three
years from now maybe more. This discipline allows us to
spend our time researching and analyzing businesses rather
than watching ticker feeds all day.
Well leave that to the professional traders. Those guys have
a completely different motivation (read: financial incentive)
that makes it impossible for them to think beyond a quarter or
two. Their clients are after short-term gains and arent willing
to wait around for a few years for an investment to work out.
But we are. Were not concerned with staying ahead of the
crowd. In fact, well look for opportunities where others have
fled and profit from them.
One of my favorite recent stories about the herd mentality
is Priceline.com (Nasdaq: PCLN). Business at the travel
website was zooming right along when an earthquake in Chile
called the companys short-term growth into question, and the
stock stalled.
About a month later, Europe Pricelines largest and
most profitable market became a cauldron of chaos fueled
by government austerity plans. Traders and investors alike
worried about a slump in travel, and they dumped the stock.
Priceline lost about one-third of its value in a matter of a few
weeks. Soon after, the companys earnings blew away analysts
expectations, and the stock is now at an all-time high.
The moral here is that you lose out when you reflexively try
to trade ahead of others. If Pricelines sellers had slowed down
and given the business some real thought, they would have
realized that travel websites are used to plan the minority of
trips in Europe. Yet the online travel industry is growing almost
10% a year in the region, so Priceline faces a huge growth
opportunity there. Makes that frenzied selloff seem silly,
doesnt it?
Thats why I encourage you to take things slow and profit
from measured, reasoned investing. To help, my fellow Foolish
analysts and I have put together this investors guide for the
year ahead.
YOUR STOCKS FOR 2011 AND BEYOND
Inside, youll find 11 great stock ideas with compelling
growth stories. Weve included buy-below prices and sell
guidance to help you get into and out of these stocks at
the best time.
So take a spin through our best timely stock ideas, which
include opportunities for value, international, and dividend
investing. We even have a special-situation stock for those of
you who dont mind digging through traders trash (with gloves
on, of course).
Some of these stocks have snapped up sharply in the recent
market rally. We still think theyre stellar companies, but you
shouldnt overpay for them. Use your advantage of time to wait
for a price closer to our buy-below guidance.
After all, good things come to investors who wait for
opportune buying prices, for investment theses to play out, and
for the right time to sell at a handsome profit.
Stay patient, long-term investor and happy investing!
Foolish best,
Bryan White
T H E M O T L E Y F O O L | S T O C K S 2 0 1 1 : T H E I N V E S T O R S G U I D E T O T H E Y E A R A H E A D | P A G E V
STOCKS 2011
Stocks 2003 Performance
Company
Recent
Price *
Return **
AllianceBernstein Holding (AB) $24.28 16.3%
WP Stewart & Co. (WPL) $5.95 -96.8%
Activision (ATVI) $11.46 445.7%
Cheesecake Factory (CAKE) $29.12 28.5%
Cognos (COGN) *** $58.00 157.9%
Cemex (CX) $8.77 -2.9%
Hollywood Entertainment *** $13.25 -31.0%
Ligand Pharmaceuticals (LGND) $1.62 -63.8%
Noven Pharmaceuticals (NOVN) *** $16.50 62.7%
Quality Systems (QSII) $64.26 1,203.5%
WPP Group (WPPGY) $58.04 60.9%
Expedia (EXPE) / InterActive (IACI) $28.95 / $27.90 55.8%
Total Return 153.1%
Return vs. S&P 500 127.4%
* As of 10/29/10
** Cumulative as of 10/29/10
*** Last closing price as of corporate event (acquisition,
bankruptcy, spinoff, etc.).
Company
Recent
Price *
Return **
BioMarin Pharmaceutical (BMRN) $26.11 461.5%
Ceradyne (CRDN) $23.81 -27.2%
Deckers Outdoor (DECK) $58.10 320.1%
Walt Disney (DIS) $36.13 41.2%
Deswell Industries (DSWL) $3.20 -71.2%
iShares Russell 1000 Growth Index Fund (IWF) $53.89 20.1%
Lowrance Electronics *** $37.00 20.1%
Palm (PALM) $5.69 -44.2%
Par Pharmaceutical Companies (PRX) $32.51 -21.1%
RH Donnelley (RHD) *** $0 -100.0%
Shimano (SHMDF) $49.50 88.7%
Ultralife Batteries (ULBI) $5.25 -62.7%
Total Return 52.1%
* As of 10/29/10
Company
Recent
Price *
Return **
Alderwoods *** $20.00 139.0%
Bandag *** $50.75 40.6%
Cephalon (CEPH) $66.44 41.4%
Chico's (CHS) $9.72 -47.5%
Point Blank Solutions (DHBT) $0.28 -96.2%
Garmin (GRMN) $32.84 39.3%
Guangshen Railway Co. (GSH) $20.34 94.6%
MIVA (VTRO) $4.19 -95.4%
7-Eleven *** $37.50 132.2%
Lone Star Steakhouse & Saloon *** $27.35 31.4%
UnitedHealth Group (UNH) $36.05 14.1%
Total Return 26.7%
* As of 10/29/10
Company
Recent
Price *
Return **
American Eagle Outfitters (AEOS) $16.02 6.8%
BioMarin Pharmaceutical (BMRN) $26.11 157.8%
Bridgeway Large-Cap Growth (BRLGX) $11.76 -1.8%
Brookfield Asset Management (BAM) $29.72 56.4%
Disney Co. [Pixar] (DIS) **** $36.13 49.2%
Harley-Davidson (HOG) $30.66 -36.8%
Headwaters (HW) $3.40 -90.5%
Markel (MKL) $335.02 5.4%
OSI Restaruant Partners (OSI) *** $41.15 3.5%
Patterson-UTI Energy (PTEN) $19.41 -35.4%
United Natural Foods (UNFI) $35.76 25.0%
Urban Outfitters (URBN) $30.79 -6.2%
Total Return 11.1%
* As of 10/29/10
**** Pixar was acquired by Walt Disney on May 5, 2006, for stock.
Starting from then, the performance tracking indicates holding
Disney shares at the 2.3 share ratio and prices as of that date.
The Motley Fool has published The Investors Guide to the Year Ahead series each November since 2002. What follows is a list
of recommendations and their performance for all years from our Stocks 2003 publication (published in November 2002) through last
years Stocks 2010 (published in November 2009). All dividends are considered reinvested, including for the S&P 500.
P A G E V I | T H E M O T L E Y F O O L | S T O C K S 2 0 1 1 : T H E I N V E S T O R S G U I D E T O T H E Y E A R A H E A D
STOCKS 2011
Company
Recent
Price *
Return **
Abercrombie & Fitch Co. (ANF) $42.86 -33.2%
Braskem S.A. (BAK) $20.85 53.9%
Centene Corp. (CNC) $22.32 -13.1%
Chico's FAS (CHS) $9.72 -57.5%
Coventry Health Care (CVH) $23.42 -50.0%
First Cash Financial Services.(FCFS) $29.07 41.3%
International Business Machines (IBM) $142.96 67.9%
Logitech International (LOGI) $18.80 -32.4%
Marchex (MCHX) $6.42 -50.8%
Paychex (PAYX) $27.74 -17.8%
Pulte Homes (PHM) $7.85 -73.9%
Sprint Nextel (S) $4.13 -78.7%
Oakmark Select (OAKLX) $26.56 -7.2%
Urban Outfitters (URBN) $30.79 38.1%
Total Return -15.3%
Return vs. S&P 500 -7.1%
* As of 10/29/10
Company
Recent
Price *
Return **
Colfax (CFX) $16.07 84.7%
Dolby Labs (DLB) $61.68 109.5%
Domino's Pizza (DPZ) $14.84 181.1%
Guess (GS) $38.92 107.2%
Netflix (NFLX) $173.57 655.0%
Parker Hannifin (PH) $76.28 107.7%
Tenaris (TS) $41.43 102.7%
XTO Energy (XTO) *** $41.81 14.9%
Rydex S&P Equal Weight Materials RTM) $57.38 67.3%
Total Return 158.9%
* As of 10/29/10
Company
Recent
Price *
Return **
Brinker International (EAT) $18.54 -12.0%
Canadian Imperial Bank of Commerce (CM) $76.60 4.4%
Charlotte Russe Holding (CHIC) *** $17.51 15.6%
Faro Tehcnologies (FARO) $24.14 -6.4%
Fomento Economico Mexicano (FMX) $54.91 83.7%
Intuit (INTU) $47.98 64.4%
Marvel Entertainment (MVL) *** $54.08 96.0%
Portfolio Recovery Associates (PRAA) $67.05 73.6%
Spectra Energy (SE) $23.53 11.4%
Starbucks (SBUX) $28.56 27.5%
Thor Industries (THO) $31.49 -2.4%
Janus Contrarian (JSVAX) $14.56 -19.4%
Total Return 28.0%
* As of 10/29/10
Company
Recent
Price *
Return **
BD (BDX) $75.52 5.1%
China Mobile (CHL) $51.37 10.3%
Compass Minerals (CMP) $78.87 25.0%
Devon Energy (DVN) $65.02 -7.5%
Hillenbrand (HI) $21.49 11.0%
Nike (NKE) $81.44 25.1%
Olin Corp. (OLN) $19.79 20.5%
Somanetics (SMTS) *** $24.98 66.8%
Take-Two Interactive (TTWO) $10.67 -10.2%
Yum Brands (YUM) $49.56 41.0%
Total Return 18.7%
* As of 10/29/10
T H E M O T L E Y F O O L | S T O C K S 2 0 1 1 : T H E I N V E S T O R S G U I D E T O T H E Y E A R A H E A D | P A G E 1
STOCKS 2011
Apple:
Its Not Too Late to Take a Bite
BY DAVID GARDNER AND TIM BEYERS
APPLE
Nasdaq: AAPL
Headquarters: Cupertino, Calif.
www.apple.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . $317.13
Market Cap: . . . . . . . . . . . . . . . . . . $291.9 billion
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . . . NA
CAPS Rating:. . . . . . . . . . . . . . . . . . . . . . . . . 3 Stars
Buy Guidance:. . . . . .No recommendation.
Apple is a well-positioned business with
a volatile stock. Buy it with a plan to hold
for years.
Data as of 11/8/10
WHY BUY
Apple is becoming the most powerful
content distributor in history.
Taking its computer and iPad sales
together, Apple is the market leader in
personal computing.
Its hard to believe now, but Apple (Nasdaq: AAPL) is a prototypical two-guys-in-
a-garage success story. (Sound familiar, Fools?) In Apples case, the two guys werent
the brothers Gardner. They were CEO Steve Jobs and future Dancing With the Stars
contestant Steve Wozniak.
Long before he was doing the tango on the telly, The Woz was building the first
few Apple I computers by hand. By 1976, Apple was selling its machines to retail
customers, and in 1984, the companys Macintosh computer splashed onto the scene
during a Super Bowl ad. Thats when Jobs and Wozniaks business efforts really
began to bear fruit.
Since then, Apple has fired and rehired Jobs, teetered on the verge of bankruptcy,
rebuilt its Mac operating system, changed the way we consume music, and reinvented
the cell phone and tablet computer. Effectively, its built an iEmpire. Apple is now
the worlds third-most valuable company behind ExxonMobil (NYSE: XOM) and
PetroChina (NYSE: PTR).
And yet we think the stocks rally is just beginning. Invest in Apple today, and you
can expect to nearly double your money over the next four years.
THE COMPANY
Thats because Apple is no longer simply a leader in the computer business. Its
also become a driving force in the media business, in which there are content creators
and content distributors. Apple is emerging as the most powerful distributor in history
thanks to its means of sharing written, audio, and visual material.
Take Apples iTunes store. In 2009, iTunes accounted for more than 99% of mobile
app sales, according to research firm Gartner. Today, music and apps are about a $5
billion business, and Apple rakes in more than $1 billion of that.
Apple owns this market, and it not only sells music and apps but also books and
articles (through the iPad) and video games (through the iPod Touch, iPhone, and iPad).
As more of this content is produced, sales of Macs and mobile devices that use Apples
operating system should rise.
The increasing use of iPhones in emerging markets, such as India and China, should
boost sales, too, as should Apples forthcoming agreement with Verizon (NYSE: VZ) in
the United States.
WHY INVEST?
Yet its the iPad that has us most excited about Apples future. When you add iPad
and Mac sales together, Apple becomes the market leader in personal computing. Sure,
we know the iPad isnt technically a computer, but we dont think its a stretch to think
that it will be used like one. There are already accessories out there that can transform
an iPad into a laptop equivalent, and Apple could easily beef up the iPads data-storage
capability in future generations of the device.
And consumers already prefer the iPad over alternative e-readers for reading
magazines and newspapers. Theyre also excited about streaming Netflix (Nasdaq:
NFLX) movies to the iPad, a feature neither the Nook nor Kindle offers. (Heck, were
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STOCKS 2011
excited about that, too.) And once the Game Center social-
gaming platform moves from the iPod Touch up to the iPad
which we think will happen in 2011 teens should yearn
less for consoles and more for the portable, widescreen gaming
experience the iPad offers. In short, consumers will keep finding
ways to work and play with the iPad, and Apples stock should
keep rising because of it.
Research company IDC predicts that the overall market for
converged devices like smartphones and tablets will reach
594.4 million devices by the end of 2014 and that Apple will
own just 10.9% of that market. Thats down from an estimated
14.7% this year, which makes sense when you factor in the
increasing popularity of Googles (Nasdaq: GOOG) Android
operating system.
Whats funny is, if you do the math, Apples worst performance
would still generate $30 billion in iPhone and iPad sales in 2014.
We think $40 billion is far more likely. Add in $30 billion more
just from Mac sales, and todays Apple, which generated $65.2
billion in fiscal 2010 revenue, starts to look small.
And remember, this estimate doesnt include the kickers.
Apple TV is starting to gain traction, the iPod is still a must-have
personal accessory, and social additions to Apples App Store
could transform every mobile device that runs Apples operating
system into a gaming platform. This would create billions of
dollars more in high-margin revenue.
FINANCIALS AND VALUATION
Yet investors arent accounting for this huge growth
opportunity. If anything, theyre pricing Apples stock lower than
they did just a few years ago. Check out these multiples:
Average
Multiples
Year to date 2009 2008 2007
Price to
earnings
21.78 25.51 29.40 38.69
EV to EBIT 13.99 15.42 19.02 26.62
Source: Capital IQ, a division of Standard & Poors
If youre not familiar with the EV-to-EBIT ratio, we think its
the most valuable metric to use when assessing Apples relative
value. It measures a companys enterprise value (that is, its
market cap plus debt, minus cash) against its earnings before
interest and taxes.
The advantage of looking at the EV-to-EBIT ratio is that we
can account for Apples $24 billion (yes, thats billion with a b)
cash hoard in pricing the companys pre-tax earnings power:
Balance Sheet Sept. 2010 Sept. 2009 Sept. 2008 Sept. 2007
Cash and
equivalents
$11,261.0 $5,263.0 $11,875.0 $9,352.0
Short-term
investments
$14,359 $18,201 $10,236 $6,034
Operating
leases
($2,168) ($1,848) ($1,656) ($1,208)
Diluted shares
outstanding
924.7 907.0 902.1 889.3
Cash per share $25.36 $23.83 $22.67 $15.94
Numbers in millions, except per share. Source: Capital IQ, a division of Standard & Poors
Historically, investors have been willing to pay 30 times EBIT
for Apple during the Jobs reign, or more than twice the stocks
recent price. Some investors argue that 30 is too high a multiple
to pay given Apples size. Others say Apple will realize just 13%
aggregate growth in EBIT from 2011 to 2014 as volume sales cut
into margins. Apple is fully and fairly priced, they argue.
But we dont buy it. Jobs and his team have so consistently
blown away estimates that were comfortable working with a
multiple of 20 times estimated EBIT, which brings our estimated
2014 enterprise value to $554 billion. Mix in Apples $25 billion
in net cash and dilute the number of shares outstanding by 1.5%
annually, and you get a stock worth $587 per share in 2014.
Thats nearly double todays price in just four years.
RISKS AND WHEN WED SELL
Even though it seems as if Apple has an app to accomplish
anything, the company isnt invincible. Android is winning
a larger share of new smartphone buyers, and Microsofts
(Nasdaq: MSFT) revitalized Windows Phone 7 could shape up
to be a sizable rival. The old standbys Research In Motion
(Nasdaq: RIMM) and Nokia (NYSE: NOK) arent going
away, either.
In terms of computer sales, low-cost Asian manufacturers are
the biggest threat to Apple. Strapped consumers are more likely
to turn to cheaper alternatives in a down economy, though we
also cant count out Dell (Nasdaq: DELL) and Hewlett-Packard
(NYSE: HPQ). Fortunately, our intrinsic value estimate assumes
zero market-share gains in smartphones or computers.
Some say Steve Jobs himself is another risk facing the
company. They worry that too much of the companys success
is wrapped up in the CEO and that an Apple without Jobs would
be an Apple without a core. We strongly disagree. Tim Cooks
successful run as interim CEO proves that Apple has a deeper
bench today than ever before.
If youre thinking theres almost no scenario in which wed
recommending selling your Apple stock, youre right. Apple
is one of the worlds great brands, and were both delighted
to be shareholders. Short of proof of outright fraud or rapidly
deteriorating market share for its Macs and mobile devices, we
recommend holding Apples stock for many years.
THE FOOLISH BOTTOM LINE
Apple has made millions for investors willing to bet against
the establishment. Now, the iEmpire is the establishment. Yet
Apple retains its purpose and the competitive edge its built
through brand loyalty and design pretty great for a company
that began in a garage. Its stock is insanely cheap for a growth
story that still has years to play out so Apples pretty great for
your portfolio, too. Take a bite of this stock today.
David Gardner, co-founder of The Motley Fool, is the advisor
for Motley Fool Rule Breakers and co-advisor for Motley Fool
STOCKS 2011
Stock Advisor with his brother and Fool co-founder, Tom. David
owns shares of Apple and Netflix.
Tim Beyers is a member of Davids Rule Breakers stock-
picking team and a contributor to The Motley Fools online
content and special reports. Tim owns shares of Apple and
Google and has options positions on Apple.
The Motley Fool owns shares of Apple, ExxonMobil, Google,
and Microsoft.
STOCKS 2011
Arris Group:
The Backbone of a Megatrend
BY NICK CROW
ARRIS GROUP
Nasdaq: ARRS
Headquarters: Suwanee, Ga.
www.arrisi.com
FINANCIAL SNAPSHOT
Recent Price: . . . . . . . . . . . . . . . . . . . . . . . $10.13
Market Cap: . . . . . . . . . . . . . . . . . . . . $1.3 billion
CAPS Rating: . . . . . . . . . . . . . . . . . . . . . . . . 5 Stars
Buy Guidance: . . . . . . . . . . . . . . . Below $10
Data as of 11/8/10
WHY BUY
The Comcasts of the world compete to
offer customers the fastest networks and
Arris helps the service providers build them.
The U.S. government is backing faster
connection speeds, and theres a global
push for increased bandwidth.
The stock is cheap relative to the
companys worth.
Do you dig all things digital? Want to invest in a megatrend where consumption
doubles every 18 to 24 months?
Then I present Arris Group (Nasdaq: ARRS), a stock that benefits from our lust
for increasingly more oomph from our cable providers. This thirst goes beyond my
co-workers playing Halo in the game room at Fool HQ: Bandwidth consumption per
user has increased 50% annually since 1982. Given our fanaticism for HD video on
demand, voice over Internet protocol, YouTube, Netflix, Facebook, and online gaming,
this trend shows no signs of abating.
That means multiple systems operators (MSOs), such as Comcast (Nasdaq:
CMCSA), are falling all over themselves to provide you with a triple play of telephone,
high-speed data, and video services. This competition combined with our insatiable
demand for richer, more personalized content and faster download speeds requires cable
companies to continually improve their networks. And Arriss head ends, hubs, nodes,
and other devices are most efficient way for them to do that.
THE COMPANY
Arris designs, engineers, and provides the infrastructure needed to create broadband
networks. That includes selling MSOs the physical equipment that makes up the
backbone of broadband infrastructure as well as helping them with digital advertising.
Accounting for about three-fourths of revenue, the biggest part of Arris business is
its broadband communication systems unit. This part of the business helps send and
receive data at high speeds, and its what enables cable operators to provide voice over
Internet protocol, video over IP, and high-speed data services. All this is made possible
through Arris Cable Modem Termination Systems (CMTS). Cable operators need these
pieces of equipment at their hubs to provide subscribers with broadband services. Arris
has increased its CMTS market share from 18.6% to 42.9% over the past five years,
even as industry giant Ciscos (Nasdaq: CSCO) has dropped from 54.4% to 38.4%.
Arris is also dominant in Embedded Multimedia Terminal Adapters (EMTA) think
broadband cable modems and voice over Internet protocol where its been No. 1
globally for more than five years.
Perhaps most importantly, Arris products conform to the latest international telecom
standard, version 3.0 of the Data over Cable System Interface Specification (DOCSIS).
This keeps Arris products relevant and sought-after as cable operators seek to upgrade
their networks.
In addition to its send-and-receive business, Arris access, transport, and supplies
business offers hybrid fiber-coaxial equipment, such as head ends, hubs, repeaters, and
terminals, that make up much of the networks physical infrastructure. That business
accounts for about 15% of Arriss revenue and has a 24% gross margin. The high-
margin media and communication systems business (6% of revenue) helps MSOs with
ad insertion, digital advertising, and video on demand.
WHY INVEST?
In the race to provide the fastest connection speeds and the most reliable networks,
MSOs have no choice but to continually reinvest in Arriss offerings or risk falling
STOCKS 2011
behind and losing valuable subscribers. Sure, they can delay
major capital expenditures for a while, but eventually they pay
up or risk going the way of dial-up. Because of these dynamics,
they tend to invest at a rate just fast enough to barely leap-frog
their competitors. But theres reason to believe that the rate of
investment will increase in the near future.
Thats because the U.S. ranked 16th in the world in Akamais
(Nasdaq: AKAM) State of the Internet report. U.S. residents have
an embarrassingly slow average connection speed of 4.7 megabits
per second. Thats 60% slower than users in South Korea and
25% slower than Facebook fiends in Latvia and Romania. To
combat this, the Federal Communications Commission is pushing
for substantially increased investment through the National
Broadband Plan (see www.broadband.gov).
Among the plans key goals is the creation of the Connect
America Fund, which would provide nearly $16 billion to support
affordable broadband and voice services with download speeds
of at least 4 Mbps. The primary long-term goal is for at least 100
million U.S. homes to have access to a download speed of 100
Mbps a speed that Arris DOCSIS 3.0-compliant equipment
enables. But right now, only 0.8% of Americans have access to
connections faster than 25 Mbps (even if you include universities
and companies), and about a quarter of the population has speeds
above 5 Mbps. Were a long way from 100 Mbps.
Why should the government (or you) care about our connection
speeds? Well, according to studies from the Brookings Insititution,
Massachusetts Institute of Technology, and World Bank, modest
increases in the use of broadband can create hundreds of thousands
of jobs. FCC Chairman Julius Genachowski says broadband is
akin to the advent of electricity. And were still in the early
stages here; high-speed Internet will continue to reshape our
economy and our lives for decades.
Revolutionary new technologies such as smart grids that cut
power-plant emissions while lowering consumers energy costs
and networks that connect first responders, law enforcement,
and hospitals to help save lives all depend on faster
broadband access. And for cable companies that have invested
in connections to our homes and businesses, upgrading to the
DOCSIS 3.0 specification is the fastest and most cost-effective
way to meet the demand for 100 Mbps speeds.
This need for speed isnt limited to the States. Developed and
emerging countries alike want the economic and social benefits
that come with faster broadband. Its a global trend, and you can
see it in Arris sales. International sales accounted for 26% of
total revenue in 2009, and that proportion has risen to 37% so
far in the first half of 2010. When looking at Arris prospects, the
market is missing this demand shift.
Already, Arris is profiting from the industry move to DOCSIS
3.0. The product shift to selling more DOCSIS 3.0-compliant
CMTS and EMTAs has bumped Arris gross margin to more than
40% in 2009 from about 35% in 2008. The companys EBIDTA
is about $220 million, and its profit margin is nearly 20%.
Its a bit surprising that a company so dominant in its core
businesses has a market cap of just $1.3 billion clearly, Arris
has room to grow. But for now, with more than half its market
cap in cash and short-term investments and just $200 million in
debt, it has an enterprise value of $833 million. That puts Arris
EV/EBITDA ratio at just 4.1, which suggests that this business
is incredibly cheap right now. It might even be an attractive
acquisition target for a larger competitor, such as Cisco, or one
of its primary customers, such as Time Warner Cable (NYSE:
TWC) or Comcast.
Using a free-cash-flow-to-firm model, I value Arris at $12 to
$15 per share, which is 20% to 50% higher than its recent $10
price.
Arris is a good business at a great price, but its not a
superior business. Thats because other companies can and do
provide the products MSOs depend on. Arris has to compete for
business, which is tough because the industry it serves is pretty
concentrated. Think about it: How many choices do you have for
broadband access? (And how many times have you cursed the
answer?) Its frustrating for Arris, too, as it leads to high levels
of customer concentration. In the first half of 2010, Comcast
made up 21% of Arris revenue, and Time Warner accounted
for 17%. Together, they made up 53% of sales in 2009. Losing
one of its major customers to a rival is the most obvious risk
for Arris. As the MSO industry consolidates, each operator
gains bargaining power and could force price concessions,
compressing Arris margins.
Whats more, the operators tend to be highly leveraged, and as
we witnessed during the credit crunch, even good companies can
lose access to capital. If this happens to Arris customers, they
wont make any capital expenditures, and Arris revenue will go
out the window.
Id recommend selling Arris if the company lost either of
its major customers. Id also recommend selling if its top two
customers ever made up more than 70% of sales. Likewise, if
competition forced price concessions without a commensurate
increase in volume, Id also suggest selling.
This isnt a buy-and-hold-forever business. I expect you to
profit because Arris stock is cheap relative to its worth. When
Arris starts to trade in the range of my fair-value estimate, you
should sell and pocket your profit.
Arris gives you a compelling opportunity to invest in the
megatrend of growing broadband consumption. Industry
competition, the National Broadband Plan, and a global push
STOCKS 2011
for increased bandwidth speeds act as a catalysts to unlock the
stocks value.
For now, the stock is cheap relative to its potential. But that
wont be the case for long, so buy into broadband while its still
a bargain.
Nick Crow is a senior analyst for Motley Fool Pro, a real-
money portfolio that uses stocks, ETFs, and options strategies;
and Motley Fool Options, the Fools options ideas service. He
owns shares of Arris Group.
The Motley Fool has options positions on Cisco.
STOCKS 2011
CIT Group:
Not as Naughty as It Seems
BY ALEX SCHERER, CFA
What would you call investing in (1) a specialty finance company thats (2) fresh out
of bankruptcy and (3) has an ugly, high-cost financing structure? Oh, and (4) regulators
are breathing down its neck, and (5) the CEO is infamous for buying a $35,000
commode (no, not that kind of commode this one was a fancy cabinet) on his earlier
companys dime?
Five kinds of crazy? Well, Id call it exhilarating like dating the bad girl. Thats
because what makes CIT Group (NYSE: CIT) seem so naughty is in fact a batch of
low-hanging fruit the market has largely ignored. Special-situation investors, take note.
THE COMPANY
CIT is a commercial finance company that makes loans to small and medium-size
businesses in about 30 industries and 50 countries, though primarily in the U.S. and
Canada. Its historically served smaller, niche lending areas for example, partnering
with an office equipment provider to provide financing for its customers copier and
computer purchases. More than 100 years of experience and millions of bread-and-
butter loans made for a staid yet successful business until rapid expansion from 2005
to 2007 ran smack into the credit crisis. CIT was dealt a liquidity squeeze it wasnt
prepared for.
Like many of its non-bank financial peers at the time, CIT restructured. In December
2008, it became a bank holding company and accepted more than $2 billion in
federal rescue funding in an attempt to outlast the liquidity crisis. But as fear of
credit implosions soared in 2009, CIT was deemed not quite too-big-to-fail, and it
was ultimately denied the kind of federal rescue that kept the biggest companies like
Citigroup and Bank of America out of bankruptcy court. So CITs lenders arranged
a prepackaged bankruptcy that brought the company into and back out of Chapter 11
intact and in only 40 days, a feat unheard of for a complex finance company. The
old stock was wiped out along with more than $10 billion of debt, and CITs lenders
became the new owners of a company in fighting condition.
And then the company cleaned house. Seven of the 13 board members are new,
including Chairman and CEO John Thain. In the cocktail-party crowd, Thain is known
as one of the villains in the Wall Street bailout saga. But he also successfully turned
around the New York Stock Exchange during a time of major turmoil. That experience,
plus his marquee name, made him a natural selection for this high-profile turnaround.
Hes hit the ground running, hiring a new CFO, chief administrative officer, chief risk
officer, and chief credit officer in the past year, and hes focusing on the right issues to
set CITs turnaround in motion. Importantly, many longtime CIT executives have stuck
around at the individual business level, each with many years of experience in their
roles and very knowledgeable about their clients and products.
WHY INVEST?
In large part, CITs woes were caused by overextending itself and using short-term,
finicky lenders to finance its business. Today, the new company is steadily shrinking so
it can pay off the high-cost debt it took on as part of the prepackaged bankruptcy deal.
The net effect will be a smaller company but one that has a more profitable funding
CIT GROUP
NYSE: CIT
Headquarters: New York, N.Y.
www.cit.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $43.46
Buy Guidance:. . . . . . . . . . . . . . . . Below $42
Data as of 11/8/10
WHY BUY
The switch to a new funding model will
make this specialty finance companys stock
more valuable.
CEO John Thain has experience with
corporate turnarounds.
Book value should increase as accounting
adjustments are reversed.
STOCKS 2011
model and is therefore more valuable on a per-share basis.
Much of the shrinkage will come smoothly, through the natural
maturities of its customers loans, and the rest will come in
lumps as CIT sells off parts of its business that are no longer
relevant to its core operations.
Another big boost to the stock price will come when CIT
successfully makes the transition from a lender reliant on
capital markets to fund its lending to one with a bank-centric
model that uses a base of deposits to fund its lending. To get
there, CIT has to extricate itself from a series of regulator-
imposed limitations that are preventing its bank subsidiary from
increasing its deposit base. This will be an important catalyst
for the stock over the next 12 months, as current funding costs
are nearly 6%, compared with the approximately 2.5% CIT
pays out on its deposits.
For a business that makes money simply by borrowing dollars
at one rate and lending them out at another, the cost of those
borrowings is a big deal. Historically, the company could loan at
nearly 4% higher than its borrowing costs, but that spread is now
less than 1% because of its high-cost debt and the anchor of $10
billion in cash on its balance sheet thats earning nearly nothing.
But todays pain is tomorrows gain. Through debt reduction and
a rising deposit base, the spread should approach its historical
3% to 4% level by the end of 2012.
As with all companies in bankruptcy protection, CIT went
through a mind-numbingly complex fresh-start accounting
process, during which its entire balance sheet was reset to then-
prevailing fair market values. This occurred when the credit crisis
was still fresh in everyones minds, so those fair-value figures
were draconian assumptions about the value of CITs assets (the
collectability of the loans it had made) and liabilities (CITs
promises to repay its lenders). Those values were marked down
severely, with about $8 billion of value whacked off of CITs $57
billion in non-cash assets.
But all that has turned out to be a good thing today. CIT now
has one of the industrys cleanest balance sheets, with a legitimate
book value and earnings power baked in. As of Sept. 30, CITs
tangible book value per share was $42, and the remaining
accretable discount per share (the portion of CITs write-downs
that will reverse as loans mature and are paid off) was about $14.
Most of that will flow through earnings into book value over the
next several years, so by the end of 2013, tangible book value
should be more than $52 per share.
The stock now trades right around CITs conservative $42
book value, so the shares potential downside if the U.S. economy
goes south again is substantially lower than at nearly any other
financial company. (Most of them trade at or above their own
less-conservatively stated book values.) This margin of safety is
the first clue that CIT is a tempting special-situation stock.
An additional $4 to $5 per share of book value should accrue
over the next several quarters as CITs fresh-start accounting
adjustments are reversed. More normal earnings should
further enhance book value starting next year, as CIT progresses
back toward its true economic book value of about $53. At that
point, CIT should be able to earn more than $3.75 per share as
a baseline and theres significant upside beyond that after
the bank-centric model takes root. All told, I value the stock
conservatively at $58, or 1.1 times economic book value.
The biggest risk facing CIT is that another major recession
could sink its turnaround effort before it has a chance to flourish.
If a double-dip recession leads to a new round of credit losses,
book-value growth wont materialize, and CIT wont be able to
repay its debt fast enough. Given the current margin of safety
built into the stock, CIT will probably outperform its peers
but it wont give you too much to cheer about, so you might
want to sell your shares.
CITs bank is widely expected to get out of its current
regulatory restrictions in the next year. If that finagling takes
longer, it would weigh on the stock price. And while CIT
should shrink its balance sheet over the next two years, if it
shrinks more than expected because it cant increase its lower-
cost funding from bank deposits, the turnaround effort would
be half-baked, and CIT wont achieve a return to its previous
baseline earning power. In that situation, Id recommend you
sell your stock.
CIT is a show-me investment that requires proof of steady
progress. If management starts waffling about regulatory
clearance or if credit losses rear their ugly heads again, dont
stick around hoping for the best. This isnt a hold-it-forever
stock. After all, CIT is in a highly competitive business that
generally produces mediocre returns on equity.
If CIT stock kisses the $60s without a major change in the
companys business prospects, youd be wise to show this
one the door. How well Thain navigates the turnaround will
determine whether this special situation pays off, but todays $43
price gives you a nice margin of safety, and that makes the date
worth the while.
Alex Scherer is an associate advisor for Stock Advisor, the
Fools flagship general equity newsletter service. He owns shares
of CIT Group.
The Motley Fool owns shares of Bank of America.
STOCKS 2011
Diamond Hill Investment Group:
Invest in Investing
BY TIM HANSON
The past 10 years havent been kind to stocks. In fact, investors dubbed the Aughts
a lost decade because for the first time ever, the S&P 500 closed a calendar decade
in the red. Investors have responded this year by pulling more than $45 billion from
domestic stock funds. Yet the last time investors showed such disdain for stocks was
1979, when BusinessWeek announced The Death of Equities. The start of the next
market rally, of course, soon followed.
The reason for this is that although the stock market can be cyclical, its also one of
the greatest creators of wealth ever known. So even though equities are out of favor
today, I suspect they will move back into favor during the next decade making it a
far better 10 years for investors.
Youll benefit from this, particularly if you invest in other superior investors, such
as the team at Diamond Hill Investment Group (Nasdaq: DHIL). This asset manager
has done an excellent job gathering and managing money during a challenging time for
stocks, and the companys performance should only improve as the market does.
THE COMPANY
Diamond Hill is an asset manager with nearly $7 billion under management. At
the end of October, $2.9 billion of that resided in separate accounts that the company
manages for high-net-worth individuals, and $4.9 billion was invested across the
companys seven retail mutual funds. These include four value-oriented equity funds:
small cap, small-mid cap, large cap, and select; and three alternative funds: long/short,
financial long/short, and strategic income, with the majority of those assets stashed
in the large cap and long/short funds. The company ranks reasonably well as a fund
manager, according to Morningstar data, with five of its seven funds earning 4-star
ratings. And although the companys flagship long/short fund doesnt stack up well
against its peers over the trailing five-year period, the funds 10-year profile is more
favorable: Its 6.24% total return puts it among the top 25% of funds in its category.
Fund
Assets under
management
Morningstar
rating
Five-year annualized
return
% rank in
category
Diamond Hill Small Cap (DHSCX) $714.4 million 3 stars 3.90% 37%
Diamond Hill Small-Mid Cap (DHMAX) $54.5 million 4 stars 2.20%* 2%*
Diamond Hill Large Cap (DHLAX) $949.2 million 4 stars 2.58% 20%
Diamond Hill Select (DHTAX) $35 million 4 stars -3.76%* 6%*
Diamond Hill Long-Short (DIAMX) $1.9 billion 3 stars 2.31% 58%
Diamond Hill Financial Long-Short
(BANCX)
$12 million 4 stars -5.39% 56%
Diamond Hill Strategic Income
(DSIAX)
$150 million 2 stars 6.02% 67%
*Trailing three year results. Fund does not yet have a five-year track record.
The managers of these funds are all either long-tenured, have been with their fund
since inception, or both. Diamond Hill has recently been investing heavily in its
research staff to keep improving returns and to expand its capabilities to open new
funds. CEO Ric Dillon alluded to a potential international fund in his most recent letter
to shareholders.
The company is also regarded for doing well by its investors and its shareholders.
Diamond Hill has received nothing but A stewardship grades from Morningstar, a
proprietary rating that judges funds based on their corporate culture, board, quality,
DIAMOND HILL INVESTMENT GROUP
Nasdaq: DHIL
Headquarters: Columbus, Ohio
www.diamond-hill.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $81.67
Market Cap: . . . . . . . . . . . . . . . . . . . $227 million
Dividend Yield. . . . . . . . . . . . . . . . . . . . . . . . . 16%
(Buy below guidance changed from $55 to $75 on 11/11)
Data as of 11/8/2010
WHY BUY
Although the past decade has been
challenging for investors, Diamond Hill has
bucked the trend and increased its assets
under management at a remarkable rate.
The insider-owned company rewards
investors with sizable special dividends.
It should easily exceed the growth
and profit margin expectations priced into
the stock.
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STOCKS 2011
incentives, fees, and compliance. And the company carries
over that respect for stewardship to the treatment of its owners.
Investors have shared in the companys recent success thanks to
special $10 per-share dividends in 2008 and 2009 and a declared
$13 per-share dividend for 2010. Dillon, a 7% owner of the
company and an admirer of Warren Buffett, regularly emphasizes
that the companys commitment to sustainable growth increases
its per-share intrinsic value. This is truly a company run by
investors for investors.
WHY INVEST?
Despite the tough market over the past decade, Diamond
Hill has had no trouble increasing its business. Assets under
management (AUM) has increased from a scant $524 million
at the end of 2004 to more than $7 billion today thats better
than 57% annual growth. Whats more, while that growth is
slowing, Diamond Hill has continued to be robust even as
investors pull money from other domestic stock funds.
Year 2005 2006 2007 2008 2009 2010 YTD
Year-end
AUM
$1,531 $3,708 $4,403 $4,510 $6,283 $7,080
YOY
Growth
192% 142% 18.7% 2.4% 39.3% 29%
Dollar amounts in millions. Source: Company filings.
Given that the biggest challenge to collecting assets is
its investment performance, Diamond Hill should be able
to maintain this AUM momentum if domestic stocks regain
favor with investors. The company also recently began a new
relationship with Nationwide to sub-advise an additional $800
million portfolio. As a result, Diamond Hill has several new
avenues for growth in addition to its investment performance,
including creating new funds and expanding its relationship with
Nationwide. Put it all together, and Diamond Hill looks like a
compelling long-term opportunity at todays $81 price.
One of the best-known methods to value asset managers is
Marty Whitmans rule: 2% of AUM plus tangible book value. This
is useful as long as the asset manager has substantially more cash
than debt on its balance sheet. Diamond Hill fits that bill, though
its $35 million dividend payout will temporarily alter its balance
sheet profile. That said, as of its last report, the company was
sitting on $18.7 million of cash and $15.5 million of investments
in its own funds. It had no debt and was on track to generate $10
million to $20 million of free cash flow again this year.
If we apply Whitmans method to Diamond Hill, we get a fair
value of almost $70 per share:
AUM $7,965
Nationwide relationship $800
Total estimated AUM $7,880
2% of estimated AUM $158
Cash and investments $34
Shares outstanding 2.8
Fair value $69.11
Dollar amounts in millions, except fail value.
Yes, $70 is below todays stock price, but this valuation is
conservative because it doesnt account for Diamond Hills AUM
growth profile or its attractiveness as an acquisition by a larger
asset manager. Recent buyouts in this industry have been for 3%
to 4% of AUM, which would value Diamond Hill at $98 to $126
per share.
Its also important to note that AUM is not just a product of
marketing and asset-gathering but that it also rises as returns
improve. This is a negligible fact in a flat or down market (like
the one we had over the past decade), but if you believe that
stocks will rise over the next decade, then Diamond Hill will
benefit from an AUM tailwind that wont cost it anything in
the way of additional marketing expenses. Further, although the
company has dramatically increased its AUM in the past five
years, its also paid up to improve its infrastructure:
Year 2005 2006 2007 2008 2009
Compensation $6.9 $18.1 $20.0 $26.1 $24.1
Fund administration $0.8 $1.7 $2.4 $2.3 $2.3
Selling, general and administrative
expense
$0.9 $1.5 $3.3 $3.4 $3.9
Total operating expense $8.6 $21.3 $25.7 $31.8 $30.3
YOY Increase 148% 21% 24% -5%
Dollar amounts in millions.
All told, AUM growth has been proportionally offset by
growth in operating expenses, with the companys operating
margin stable at about 30% each year.
What last years results with AUM up nearly 40% and
expenses down 5% suggest, however, is that the company has
enough people to continue to increase AUM without increasing
expenses. That means investors should begin to see operating
leverage lead to a higher profit margin. As Dillon wrote in this
years letter to shareholders, Diamond Hills staffing levels
are above average for the industry, with that excess capacity
enabling high AUM growth rates. Yet as those numbers revert to
the mean (the companys website currently advertises just one
job opening), operating profitability should improve to about
35% the industry average.
Tweak the model to assume 8% to 10% AUM growth during
the next decade (to reflect a better investing environment) and
35% operating profitability, and Diamond Hill stock is worth
$85 to $95 per share. All told, the upside potential of a $126-per-
share acquisition scenario significantly outweighs the downside
of a $70 Marty Whitman model. Furthermore, Diamond Hill
has shown a propensity for rewarding shareholders with hefty
dividends, so this stock is a solid investment.
Although asset management is an attractive business
because its asset- and capital-light, that also means theres
little to prevent a competitor from setting up shop. That makes
performance and networking critical to a companys continued
success. The most important things to watch at Diamond Hill
are the performance of its funds and the ratings they receive
from Morningstar.
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STOCKS 2011
Deterioration there would suggest that AUM growth could
slow or even revert. If Diamond Hills funds and particularly
the small-cap and long-short funds because they have the most
AUM underperform the market in the next one to two years,
you should think about selling your shares.
Diamond Hill has many of the attributes I look for in a
promising small-cap investment. Its well-run, its owners are
vested in the business, it has a track record for rewarding
shareholders with dividends, and its performed at the top of
its peer group despite a challenging economy. When the stock
market rises, investors in superior investors, such as Diamond
Hill, should be richly rewarded.
Tim Hanson is co-advisor of Motley Fool Global Gains, the
Fools international investing research service. He owns shares
of Diamond Hill.
The Motley Fool owns shares of Morningstar.
STOCKS 2011
Expeditors International of Washington:
Shaped-Up Shipping
BY JOE MAGYER
Eureka! An idea for a revolutionary new device hits you like a thunderbolt while youre
scrubbing in the shower. By the time youve put on your socks, youve already settled on
producing the device in China, lining the walls of your executive office with cedar, and
asking Leonard Nimoy to be your pitchman.
Theres just one problem, and it isnt that Spock is your spokesman. You dont know
the first thing about the nuts and bolts of global trade. You dont speak Mandarin, dont
know a lick about navigating customs, and you will probably get bullied by transporters
because you cant negotiate favorable terms.
But dont bail on your dreams of a woodsy-smelling office just yet. Expeditors
International of Washington (Nasdaq: EXPD), a global logistics solutions provider, has
been helping companies worldwide shape up their shipping for the past three decades
and making a mint for Expeditors investors while doing it. And given its strong balance
sheet, asset-light model, and entrepreneurial culture, Expeditors is poised to profit from
global trade for years to come.
THE COMPANY
Expeditors doesnt own a fleet of boats or planes. Instead, it buys big blocks of
space on other companies vessels and resells that space to its clients. The joy of the
arrangement for clients is that theyre able to get lower shipping costs than if they tried
to buy the space themselves. Expeditors, meanwhile, avoids shelling out the cash it
would cost to buy a fleet.
Founded in 1979 and based in Seattle, Expeditors helps companies seamlessly and
cheaply move goods from Point A to Point B. The company offers services such as air
and ocean freight forwarding to customs brokerage and a host of international shipments-
centric services. From Hong Kong to Hanoi to Houston, Expeditors has a global reach
and positioning in virtually every major city. The company operates 183 full-service
offices, 65 satellite locations, and two international service centers on six continents.
WHY INVEST?
Expeditors capital-light business model allows it to grow without having to
reinvest much in its business. That model allows its profit to grow faster than revenue.
Historically, about 35% of Expeditors net revenue comes from air freight services, 25%
from ocean freight, and 40% from customer brokerage and other services.
Third-party logistics management has fantastic tailwinds, as lower barriers for trade
and many companies desire to outsource amplify the long-term upswing of the global
economy. And with Expeditors good standing in the industry thanks to its results-
oriented culture, the company should continue to benefit handsomely.
Individual Expeditors branches are considered their own profit centers, with most
compensation for branch managers coming through incentives based on that branchs
operating income. That extraordinary focus on branch-level success fosters an
entrepreneurial spirit thats a win-win-win for customers, employees, and investors.
The company is led by a straight-shooting CEO, Peter Rose, whos been in place
since 1988. Rose isnt your typical CEO, eschewing forecasts and Wall Street-style
EXPEDITORS INTERNATIONAL OF
WASHINGTON
Nasdaq: EXPD
Headquarters: Seattle, Wash.
www.expeditors.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $51.78
Market Cap: . . . . . . . . . . . . . . . . . . . . . $11 billion
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . 0.8%
Data as of 11/8/10
WHY BUY
Expeditors is a market leader poised to
profit from outsourcing and global trade.
It has a capital-light business model that
allows the company to grow with minimal
investment.
A pristine, cash-rich balance sheet
enables the business to think and spend for
the long term.
STOCKS 2011
quarterly conference calls. A recent quote from him neatly sums
up Roses style and the culture he has built:
Our philosophy these last several years has been to try to
not do anything stupid. We simply did what weve always done:
focusing on improving customer service, taking market share
by adding new customers, taking care of our people by not
doing lay-offs, and making ourselves more productive through
continued process improvement efforts. Boring consistency is
what we do best.
Expeditors operating profit grew at an impressive 15%
clip during the past five years during a tumultuous economy.
At many companies, that kind of heady growth is fueled by
acquisitions. Not at Expeditors. The companys primary focus is
on organic growth. You wont hear about Expeditors overpaying
for a splashy acquisition. Thats because a large-scale deal
would introduce systems integration risks and water down the
companys entrepreneurial, customer-centric culture. And if it
aint broke, dont fix it.
Expeditors balance sheet, meanwhile, is strong with no debt
and $1 billion in cash. That cash cushion makes for nice padding
if the market takes a spill, though of course it would be nice to
see some of that cash go to shareholders. To Expeditors credit,
though, it has raised its bite-sized, 0.8%-yielding dividend at a
25% clip over the past five years.
2009 2008 2007 2006
Revenue $4,092.3 $5,633.9 $5,235.2 $4,634.0
Net Revenue $1,382.8 $1,603.3 $1,453.0 $1,291.0
Operating Profit $385.0 $473.1 $423.4 $375.1
Dividend Per Share $0.38 $0.32 $0.28 $0.22
All numbers in millions except dividend. Net revenue is determined by deducting freight
consolidation and customs brokerage costs from total revenue.
Expeditors stock isnt cheap by traditional valuation metrics,
trading around 29 times analysts 2011 earnings estimates. The
stock is pricey right now, but Expeditors has always traded at a
premium. Exceptional, well-run businesses with bright futures
always do. That doesnt mean you should pay any price for
Expeditors, but snatching up shares for $45 or less is a safe,
money-making bet. Youll want to take advantage of any short-
term dips in price to get started with this stock.
Expeditors performance is tethered to global trade, meaning
its profit and stock will get hit if the global economy sputters.
Meanwhile, the fragmentation of Expeditors industry is a double-
edged sword. On the plus side, it affords a window for superior
operators such as Expeditors to more easily grab market share. On
the down side, though, competitors are more likely to use price as
a weapon, and theres a chance that aggressive pricing by even just
a few players could crimp profit industrywide.
Finally, while I love Expeditors asset-light model, its lack
of control over the full shipping chain could be a disadvantage
if full-service rivals like United Parcel Service (NYSE: UPS)
get their act together or if shippers and airlines start muscling
Expeditors around.
Id also have second thoughts on the stock if Rose steps
aside or if Expeditors abandons its focus on organic growth
in favor of an acquisition-happy strategy. Expeditors isnt a
classically cheap stock, but thats not an excuse to own it at
nosebleed-section high prices. You should consider selling
Expeditors if its price-to-book ratio nears 7 thats just too
darn expensive.
Expeditors has great growth prospects, a fantastic culture,
and a cash-rich balance sheet. These qualities should check a
lot of boxes for long-term investors you included, so keep a
sharp eye on this outstanding business, Fools. If the stock dips
back below $45, dont hesitate to buy Expeditors in bulk.
Joe Magyer is the advisor of Inside Value, the Fools value-
driven investing service.
The Motley Fool owns shares of United Parcel Service.
STOCKS 2011
Gap:
Fall (Back) Into the Gap
BY RICH GREIFNER
Theres a fascinating phenomenon in the world of fashion, where a style of clothing
can be out of favor for so long that it eventually becomes en vogue. Its called retro
(and its the reason I refuse to part with my Zubaz pants).
A similar phenomenon occurs in the world of investing, where the stocks that Wall
Street shuns tend to produce the most attractive long-term results. Its called value
investing.
Put those two concepts together a fashion retailer thats out of favor with
consumers and investors and you have the makings of market-crushing returns. Its
called Gap (NYSE: GPS).
THE COMPANY
Founded in 1969, Gap sells casual apparel for men, women, and children under
the Gap, Old Navy, and Banana Republic brands. The company operates more than
3,000 stores across the globe and owns two small but growing online apparel sites,
Piperlime and Athleta.
If you bought a pair of khaki pants during the 1990s, theres a good chance youre
already familiar with the Gap story. Theres also a good chance you havent shopped
at the Gap in years, think Bananas styles are bland, wouldnt set foot in Old Navy
if it were giving away clothes, and are strongly considering moving on to the next
recommendation in this report. But before you do that, give me a minute to try to
change your mind.
Although your memory of it might be foggy today, there was a time when Gap was
ubiquitous. Adam Sandler wore Gap on Saturday Night Live. Sharon Stone wore Gap at
the Academy Awards. Monica Lewinskys infamous blue dress? You guessed it Gap.
Under the leadership of merchant prince CEO Mickey Drexler, Gap could do no
wrong. Between fiscal 1994 and 2000, the companys stores more than tripled their
square footage as revenue rose 267%, to $13.7 billion. The greatest surge of all was
in Gaps stock price, which increased six-fold.
But in 2000, Drexlers designs stopped resonating with the companys core
customers, just as the economy took a turn for the worse. Although Gaps
comparable-store sales dropped for 10 consecutive quarters, the company stubbornly
continued expanding. Adding insult to injury, Gap bloated its balance sheet with a
big slug of debt to fund those new stores, as well as an accelerated share buyback
program at what would later prove to be lofty prices. By the time Drexler was forced
out in 2002, Gaps stock had plummeted 70%.
Eight years and two CEOs later, Gap is still out of fashion with consumers and
investors. Sales per square foot have slumped for five straight years (and eight
of the past 10), as nimbler competitors such as H&M, Zara, and Forever 21 have
consistently offered shoppers fresher looks, while Target (NYSE: TGT) and
Aeropostale (NYSE: ARO) haven stolen the cheap-chic crowd away from Old Navy.
GAP
NYSE: GPS
Headquarters: San Francisco, Calif.
www.gap.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $20.81
Market Cap: . . . . . . . . . . . . . . . . . . . $12.9 billion
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . 1.9%
Data as of 11/8/10
WHY BUY
Overseas expansion should spur sales,
while a burgeoning Internet business
should propel margins to new highs.
Management is dedicated to cutting
costs and returning capital to shareholders.
The stock is out of favor, so you can snag
it on the cheap.
STOCKS 2011
Tired of waiting for a turnaround to take hold, Wall Street
has all but abandoned the stock. Everyone has given up on Gap
which means its prime time for value-minded Fools to go
on a shopping spree.
WHY INVEST?
Here are three reasons Gap looks good in your portfolio:
1. Expanding margins
Current CEO Glenn Murphy hasnt been able to boost sales,
but he has done wonders behind the scenes. Gaps gross margin
has swelled by 5.4 percentage points since 2007, largely due
to disciplined inventory management that resulted in fewer
markdowns. Gaps trailing 12-month gross margin of 40.9%
represents a 3.1 percentage-point improvement over last years
level and its within spitting distance of the companys all-
time high.
Gaps operating margin has also risen steadily since Murphy
became CEO. This is partially due to strategic store closures
and a streamlined organizational structure (Gap has 50 fewer
VPs than it did three years ago), but much of the improvement
can be attributed to a sustainable source: the Internet.
Gaps Internet-based revenue has doubled over the past five
years, which is especially encouraging because these sales
come with an operating margin of 22.5%, compared with 12%
for the companys brick-and-mortar stores. In addition to the
Web commerce for Gaps big three brands, this segment also
includes sales at Piperlime, which offers fashionable footwear,
handbags, and accessories, and Athleta, a brand based on
womens athletic apparel and footwear.
Gaps 13.6% operating margin over the past 12 months is
the best performance the company has posted in a decade, but
Murphy thinks that number can be even better.
Fiscal 2006 Fiscal 2007 Fiscal 2008 Fiscal 2009
Trailing 12
months
Gross margin 35.5% 36.1% 37.5% 40.3% 40.9%
Operating
margin
7.8% 8.4% 10.7% 12.9% 13.6%
Data from CapitalIQ, a division of Standard & Poors. Gaps fiscal year ends on the Saturday closest
to Jan. 31.
2. Cash is flowing
Without much need for capital expenditures (Gap is still
trimming down its store count) or inventory replenishment
(theres no need to restock what customers arent buying), free
cash has been flowing straight to shareholders pockets. Over
the past six years, the company has generated about $6 billion
in free cash flow. Over that same period, its paid out $1.25
billion in dividends and bought back $7 billion worth of shares
while simultaneously paying off all of its debt. Due to those
buybacks, Gaps share count has decreased by 30% since 2004.
3. Revenue revival?
Operationally, Gap is now a well-oiled machine. Theres only
one challenge remaining: Can the company produce clothing
that customers actually want to buy?
Last year, Gap took a step in the right direction by retooling
its outdated denim offerings. Its new 1969 line of jeans is a
significant style upgrade, and the $55 to $70 price point is a
fraction of what designer labels like True Religion (Nasdaq:
TRLG) and V.F. Corp.s (NYSE: VFC) Seven For All Mankind
charge. And straight out of the if you cant beat em, hire
em playbook, Gap has lured Sevens vice president of design,
Rosella Giuliani, to lead the 1969 brand.
In addition to denim, Gaps emphasis this year is on its new
black magic line of premium black pants. The company has
also cut its product-development time by a third, so its new
offerings will no longer be so far behind the fashion curve.
These are all smart steps, but with the North American
market largely saturated, Gaps real growth will have to come
from abroad. This year, Gap will open its first locations in Italy
and China, and the online division will start selling in Europe
and Canada. The company expects its international and online
businesses to contribute 27% of total revenue in 2013, up from
18% today.
Still, its no wonder the stock market isnt giving much
credence to Gaps turnaround efforts. After all, this is hardly the
companys first attempt to round a corner and yet sales per
square foot have been in a downward spiral for the better part of
the past decade:
Investors are smart to be skeptical of Gaps latest turnaround
attempt, but theyre missing the bigger picture. The market
is pricing Gap as if its present levels of profitability will be
fleeting, but the current margins are sustainable and theres
even upside. If Gap improves at all on the top line, its stock
Sales Per Square Foot
$325
$375
$425
$475
$525
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STOCKS 2011
should solidly beat the market. And if the company can boost
sales per square foot to pre-recession levels, investors will be
sitting pretty. Check out these potential growth scenarios:
Pessimistic
scenario
Moderate scenario Optimistic scenario
Sales per Square
Foot
325 365 385
Operating Margin 10.8% 12.6% 14%
Estimated Value per
Share
$16.10 $23.00 $27.50
From the stocks current $21 price, the downside of investing
in Gap is limited (and is cushioned by the companys steady
dividend and rock-solid balance sheet) while the upside
is significant.
Gap recently made headlines when it clumsily attempted to
revamp its logo and then even-more-clumsily tried to pass the
episode off as a crowdsourcing project. Although the universal
ridicule of Gaps proposed logo resulted in some bad press, I see
it as an encouraging sign. It suggests that consumers are more
attached to the brand than their shopping habits indicate. But
I would consider selling your shares if Gap continues to make
moves that alienate its core customer base especially if the
company shifts its focus from basics and starts chasing trends.
In a similar vein, Id also consider selling if Gap committed a
significant amount of capital to developing a new concept. With
the failure of its Forth & Towne stores (the companys botched
attempt to reconnect with women who outgrew the Gap brand)
still fresh in managements mind, I doubt this will be an issue.
However, if Gap starts blowing shareholder capital on risky new
concepts or worse, overpriced acquisitions it will be time
to return your shares.
Telling your friends youre buying Gap shares at a cocktail
party is almost as embarrassing as wearing an Old Navy T-shirt
to said cocktail party. But thats the only reason we can buy
shares in this quality company at such a bargain price. Gap has
learned from its mistakes and is ready to reclaim its rightful
position as a respectable brand. This is a stock you should get
into before it becomes expensively en vogue.
Rich Greifner is advisor for Duke Street, the Fools premier
investing-advice service.
The Motley Fool owns shares of Aeropostale.
STOCKS 2011
Li Ning:
Branding Meets Basketball
BY BRYAN WHITE
Ever wonder what Olympic gymnasts do after they give up the pommel horse? Well,
1984 gold medalist and Prince of Gymnastics Li Ning has been busy building an
eponymous Chinese sportswear company, Li Ning (Pink Sheets: LNNGF.PK), for the
past 20 years.
Maybe naming the company after himself was a little over the top, but Mr. Li has
successfully created one of the few homegrown Chinese consumer brands with some
national traction. The company is the leading domestic sportswear brand in China a
country whose economic growth is measured in the double digits and whose residents
are gaga for consumer brands. Theyre also nuts about basketball. A reported 300
million Chinese residents casually play, and 450 million tune into NBA games. Thats a
hodgepodge of trends, to be sure, but by investing in Li Ning, youre getting your foot
in the door on all of them.
THE COMPANY
Li Ning focuses on selling athletic footwear throughout mainland China. Its built
up a broad supply chain, distribution system, and retail network, with more than 130
distributors and 6,800 retail outlets on the mainland. The company has the No. 1 market
share in mid-size and smaller cities and is right on the heels of international brands Nike
(NYSE: NKE) and Adidas (Pink Sheets: ADDYY.PK) in Chinas largest cities.
The company built its following in Chinas mid-size and smaller cities by selling
its shoes at a substantial discount to Nikes and Adidas offerings. Now that Li Ning
is well established, management is ready to move up the value chain and take on its
international rivals. Li Ning recently announced a brand-revitalization strategy that
includes a small change to its Nike-like logo, a shift to higher prices and more
importantly higher-quality products. The plan is a smart one: Brand recognition and
product quality have led the way in Chinas sporting-goods industry, where consumers
have shown they are more than willing to pay up for superior sneakers.
Another important aspect of this strategy is Li Nings entrance into the U.S. market.
Its shoes have already been seen in the States through Li Nings endorsement deals
with NBA players Shaquille ONeal, Baron Davis, Jose Calderon, and last years No.
2 draft pick, Evan Turner. Now the company has established its U.S. headquarters
right in Nike and Adidas backyard, in Portland, Ore., and will sell its shoes through
select retailers, such as Eastbay and Champs. Im not counting on Li Ning becoming
a sought-after shoe brand here, but the more its recognized in the States, the better
chance it has to compete as a premium brand in China.
WHY INVEST?
But of all things, why would Chinese consumers care about owning premium
sneakers? In a word: basketball. More than 350 million Chinese residents play and
watch hoops on a regular basis. Recreational games are played at most factories across
mainland China. So an investment in Li Ning is partly a bet on the continued popularity
of basketball in the worlds most populous country. If this fascination holds, we can
expect the sportswear industry to continue its double-digit growth while the ranks of
Chinas middle class swell in the next decade.And those middle-class consumers are
LI NING
Pink Sheets: LNNGF.PK
Headquarters: Shanghai, China
www.lining.com
FINANCIAL SNAPSHOT
Recent Price: . . . . . . . . . . . . . . . . . . . . . . . . $3.00
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . . . 2%
CAPS Rating: . . . . . . . . . . . . . . . . . . . . . Not rated
Buy Guidance: . . . . . . . . . . . . . Below $3.50
Data as of 11/8/10
WHY BUY
The Chinese sportswear market has a
long runway as the middle class purchasing
power grows.
Li Ning is well established as Chinas
most popular domestic sportswear brand.
It benefits from the growing popularity
of basketball in China.
STOCKS 2011
extremely brand-conscious. Outside the automotive industry,
though, China doesnt have many national brands. Given
Li Nings established name and its recent strategy shift, the
company has a great opportunity to increase its popularity in
Chinas largest cities and become a truly national brand with
all the cachet and aspiring customers that go with it. If Li Ning
plays things right, it could be a shoo-in as one of Chinas biggest
brands for years to come.
Li Ning has been consistently profitable for nearly 10 years
and has doubled its sales and earnings over the past three. The
company also has the best margins among its peers, including
Nike and Adidas. Gross margins are consistently in the mid to
high 40% range, and operating and net margins have grown to
16.5% and 12% in the past 12 months. The profit margin should
remain in this range even as Li Ning charges more for its shoes,
because its also paying more for better raw materials.
A glut of products has reduced the industrys growth over
the past year, and expectations for athletic apparel makers
including Li Ning have been reduced for the next 18 months.
But in Li Nings case, management thinks this has more to do
with its strategic shift and new logo, which could lead to major
discounts or even inventory writedowns. Industry-wide, the glut
has mostly worked its way out of the system, with only Adidas
experiencing lingering inventory problems. Industry growth
should resume its typical 20% rate in 2012, thanks in part to the
summer Olympics. Still, Li Nings inventory turnover has been
steadily improving, as has its average cash-conversion cycle.
McKinsey research estimates that between now and 2015,
50% of Chinas population will be in the middle class, up from
todays 35%. Thats more than 50 million additional households
that could start buying Li Ning shoes so at 20 times trailing
earnings and free cash flow, our hurdle for success with this stock
is low.
Over the next three years, concerns about Li Nings strategic
shift should dissipate, and the stock should revert to more
historical multiples, eventually hitting $5 a share. It could rise
even higher depending on how long the company can grow
and I think it has much longer legs than the market is giving it
credit for.
Whats more, Li Ning knows how to take care of its
shareholders. Its returns on equity are twice as big as Nikes,
at 39%, and management recently raised the stocks dividend
payout ratio to 40% from 30%. That results in a dividend yield
north of 2%.
The sportswear industry in China is highly competitive
and includes well-known Western brands as well as up-and-
coming domestic companies, such as Anta, China Dongxiang,
and 361 Degrees. These discount brands have recently stolen
market share from Li Nings cheaper offerings, though Li Ning
continues to increase market share in more expensive products.
By shifting its focus to these higher-end offerings, Li Ning risks
losing its most loyal cost-conscious customers. If the strategic
shift doesnt pan out and the company sits on the bench for a
few years too long, it might be too late to try to re-establish its
domestic discount dominance. In that case, Id recommend you
sell your shares. Likewise, if the Chinese consumers who prefer
the higher-end Nikes and Adidases stick up their noses at Li
Nings fancier offerings, Id recommend dumping your shares.
Li Ning also faces the short-term challenge of selling its old-
logo products along with its new-logo products. That could lead
to a slowdown in growth and a dip in the stock price. I expect
these short-term concerns will keep the stock attractively priced
for a while, which works in your favor because the stock is
thinly traded. Its best to build out your position over time and
use a limit order when you buy the stock. If you dont, you run
the risk of paying much more than you were expecting to.
The opportunity to invest in what could become Chinas first
major national brand is just too big to pass up. Li Ning does
well over $1 billion in annual sales and has a 20-year history
in its home country. Its laid the groundwork for sustainable
growth, and its recent strategic shift up the value chain could
result in a dominant national brand that rewards shareholders
for years down the road. If youre looking to invest in a brand
before its time, youll want Li Ning on your portfolios team.
Bryan White is an analyst for Stock Advisor, the Fools
flagship general equity newsletter service. He is also the
financial editor for Stocks 2011.
The Motley Fool owns shares of Adidas.
STOCKS 2011
Lorillard:
Get Hooked on This Dividend
BY CHARLY TRAVERS
Interest rates are so low these days that theyd win a limbo contest. Thats great if
youre trying to buy a house but less so if youre relying on bonds to pad your portfolio.
And with the economy showing further signs of weakness, its unlikely that rates will
rise anytime soon.
Fortunately, bonds arent the only way to generate dependable income for your
portfolio. Dividend-paying stocks will also do the trick, especially if the company
has a steady revenue stream and a straightforward business model like Lorillards
(NYSE: LO).
THE COMPANY
This cigarette maker has been around since 1760, back when George Washington
was growing tobacco instead of presiding over the country. Now, its the third-largest
cigarette company in the United States, after Altria Group (NYSE: MO), which owns
No. 1 brand Marlboro, and Reynolds American (NYSE: RAI), which makes Camel.
Lorillard comes in close to the top because it has an exceptionally strong brand, too:
Newport. Newport is the No. 2 cigarette brand in the country after Marlboro, and its
tops in the increasingly popular menthol category, with 36% market share. Menthol
cigarettes have been outselling their non-minty brethren for the past four years and
currently account for 29% of the domestic cigarette market. I dont expect Lorillard to
cede any of that ground to the competition Marlboros Blend No. 54 and Camels
Crush because smokers tend to be brand-loyal, and Newport is already entrenched
with U.S. consumers.
Thats key, because the companys fortune depends entirely on the success of
Newport in the U.S. market. The brand accounts for more than 90% of Lorillards
sales, with smaller brands such as Kent, True, and Maverick contributing the balance.
Lorillard sold the international rights to all its major brands, including Newport,
in 1977, so you dont have to consider foreign smoking trends when evaluating
the company.
WHY INVEST?
My case for Lorillard isnt based on its growth potential. With smoking rates
expected to remain static in the United States, Lorillard should be singularly thought of
as an income-generating investment. The stocks quarterly dividend payout of $1.125
per share (a 5.1% yield) is the primary reason to own the shares not a belief that the
price will rise. But even if the stock price stays static, the dividend could occasionally
grow. In August, Lorillards board increased the payout by a hefty 12.5%.
Based on Newport sales trends and Lorillards cash flow, I expect that dividend to be
sustainable for the foreseeable future. The companys cigarette shipments are holding
up even though industry-wide shipments, especially for non-menthol cigarettes, are
falling. Over the past 12 months, Lorillard generated nearly $1.1 billion of free cash
flow, easily covering the $636 million it paid out in dividends which should be
sustainable as long as Newport sales remain steady.
LORILLARD
NYSE: LO
Headquarters: Greensboro, N.C.
www.lorillard.com
FINANCIAL SNAPSHOT
Recent Price: . . . . . . . . . . . . . . . . . . . . . . . $88.92
Market Cap: . . . . . . . . . . . . . . . . . . . $13.3 billion
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . 5.1%
Data as of 11/8/10
WHY BUY
Lorillard owns the Newport brand,
which is the top-selling cigarette in the
menthol category and the second-best-
selling brand overall after Marlboro.
It pays a generous dividend, currently
yielding 5.1%.
The stock is attractively priced.
STOCKS 2011
I welcome such peace of mind at a time when the Federal
Reserve is signaling that interest rates will stay in the basement
for a while. After all, its tough to be an income-focused investor
these days. There just arent many attractive income-generating
stocks right now, but Lorillard is among them.
I know it seems strange to say that Lorillards balance sheet
is in good shape with $1.8 billion of long-term debt and only
$2.1 billion in cash, but stick with me. The debt load is nothing
to worry about because Lorillards cash flow can easily cover its
interest payments, and its earliest debt doesnt come due until
2019, when it has to pony up $785 million.
As I mentioned earlier, free cash flow over the past 12 months
was nearly $1.1 billion, giving the stock a 8% free-cash-flow
yield. To its credit, the company returns all of this money to
shareholders through its dividend and share buy-backs. Since
July 2008, Lorillard has spent $1.7 billion to buy back 22.6
million of its shares at an average price of $73. It was money
well spent, as the stock is now trading higher.
At $83 a share, Lorillard is priced as if its free cash flow
will grow at a 2% rate in perpetuity. When you consider that
the domestic cigarette industry is contracting, that 2% could
be considered unreasonably high. On the other hand, Lorillard
is outperforming its peers and taking market share. If it can
continue to hold its annual sales steady and successfully
implement regular price increases, free cash flow could grow
well into the future.
Of course, plenty could happen to send Lorillards sales
packing. Higher taxes, restrictions on smoking in public, and a
general decline in smokings popularity have cut into the U.S.
cigarette market at an annual rate of 3% over the past decade,
according to Lorillard. So far, the company has been bucking
the trend. Its unit volume over the past three years, for example,
has been flat, while the industrys as a whole has dropped more
than 11%. But if Lorillard starts to buckle and its sales fall, you
should sell your shares.
The industry is also subject to regulation. The Food and
Drug Administration has the authority to regulate tobacco
products, and in September 2009, it banned flavored cigarettes
(such as fruit and chocolate) because they were thought to
appeal to children. The agency is now reviewing menthol
cigarettes, though industry experts dont expect a ban. More
likely would be a requirement to change cigarette warning
labels or to reduce menthol levels. Still, an outright ban on
menthol cigarettes would be catastrophic for Lorillard and
a cut-and-dried reason to dump your shares. The FDA is
scheduled to make its ruling by March 2011.
Given that the cigarette business is declining and that the
only reason to own Lorillard shares is for the dividend, you
should sell your shares if the board cuts the dividend or if the
stock price rises to a point that the dividend yield dips below
a threshold youre comfortable with. If the yield falls below
4.5%, which would happen at a share price of $100 based on
the current dividend, you should sell and seek out better-priced
dividend-payers.
Even though smoking is waning in the U.S., many people
still do it and theyll most likely keep smoking their
Newports. These brand loyalists should provide Lorillard and its
shareholders with cash for years to come. If youre looking for a
solid income-generating stock for your portfolio, you dont have
to look further than Lorillard.
Charly Travers is an associate advisor for Hidden Gems, the
Fools small-cap investing service, and Million Dollar Portfolio,
the Fools real-money portfolio made up of all of the best ideas
in the Fools universe.
The Motley Fool owns shares of Altria Group.
STOCKS 2011
Red Robin Gourmet Burgers:
An Activist Investors Blue Plate Special
BY JIM GILLIES
RED ROBIN GOURMET BURGERS
Nasdaq: RRGB
Headquarters: Greenwood Village, Colo.
www.redrobin.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $18.65
Data as of 11/8/10
WHY BUY
The company capitulated to activist
investors demands that will improve its
cost structure.
The stock is cheap relative to the
companys cash-generating power.
Industry consolidation and the
attractiveness of its cash flows make Red
Robin a likely target.
Americans love burgers, and plenty of restaurant chains exist to sate this craving for
patty and bun. But while serving satisfying sandwiches is one thing, satiating investors
appetites is quite another. A burger joints cash flow can be drool-worthy if the place
is run right. But sometimes management loses its way, as when executive pay trumps
investor returns or when growth at any price supplants reasoned value creation. When
this happens, the stock price invariably falls. This makes activist investors hungry, and
its here we meat sorry, meet Red Robin Gourmet Burgers (Nasdaq: RRGB)..
THE COMPANY
Red Robin offers gourmet burgers (think toppings like guacamole, sauted onions,
and even fried eggs) and bottomless fries and drinks at its 446 restaurants, 312 of which
are company-owned and operated and the rest franchised. The chain differentiates itself
from the competition by offering sit-down table service, positioning its restaurants more
as a fast-casual dining experience akin to Applebees than a typical fast-food place.
Zagat, the restaurant-rating Bible for foodies, has named Red Robin Best Burger
among full-service restaurants for two years running.
Yet once you get beyond the menu and focus on Red Robins operating and
financial performance, the company looks like just another inefficient, value-
destroying restaurateur. The stock now trades for less than one-third of its all-time
high, hit in 2005, even though its restaurant count is up more than 60% since then.
We can blame managements growth-for-growths sake strategy, with inadequate
attention paid to ballooning operating and corporate costs. Sure, the chain has grown,
but profit has frayed, leverage has increased, and management didnt seem to care.
At least, that is, until someone with deep pockets turned up. After all, an imploding
stock price attracts private-equity folks and activist investors as sure as spilled fries in
the parking lot draw seagulls.
WHY INVEST?
Thats because the labels inefficient and value-destroying, when applied to
restaurants, arent necessarily pejorative. Rather, they can serve as clues for activist
investors hoping to turn around the companies. Cases in point:
y Sonic (Nasdaq: SONC): Disastrous, debt-fueled share repurchases made at all-
time highs hobbled the company as the recession began. Returns on capital and
margins are declining, and the company has attracted activist interest.
y Jack in the Box (Nasdaq: JACK): The companys unfocused, self-interested
management is pushing ahead with an arguably failing refranchising strategy.
At the same time, same-store sales are falling, cash flow is waning, and a giant
sucking sound is emanating from the companys underfunded pension plan.
Also attracting activist investors.
y Steak n Shake pre-2009: Former management pursued growth at any price,
took on debt, and wasted hundreds of millions of dollars on new stores that
delivered declining returns. The company was within months of defaulting on
its debt in 2008, when an activist investor won a proxy fight, ascended to the
STOCKS 2011
board and was subsequently named CEO. The former
growth management is long gone.
And now something similar is happening at Red Robin. As
the companys stock price declined, Clinton Group and Spotlight
Advisors built up a near-8% stake in Red Robin. They aired
their concerns in December 2009, citing the rigidity of Red
Robins corporate strategy given the economy (translation: too
growth-focused during a recession), operational issues, low
returns on invested capital, executive compensation (too high
given performance), and management and board accountability.
The activist group threatened to nominate a competing slate of
directors if its concerns werent met.
Heres the twist. Instead of doing what most companies do
when faced with the activist cudgel ignore it Red Robins
board capitulated and is now warbling the activists tune.
New directors were named to the board, including the former
CEO of Applebees, the former CEO of a large foodservice
distributor, and a former director of Wendys. The chairman
and CEO roles were split, the CEO was ousted, and the new
board members basically chose his successor. Option plans were
re-written to discourage re-pricings. Incentive compensation was
tied more to performance than to just showing up for work.
Despite these positive changes, Red Robins stock price is
now less than it was when the activist group built its stake.
Yet the investors say the stock has substantial upside and
have encouraged the board to listen carefully to buyout offers.
Theyve also not-so-subtly reminded the board that their
standstill agreement, which prevents a hostile takeover, expires
at the end of 2010. This continued pressure should drive Red
Robin into the hands of an acquirer, and I expect someone to buy
it for a stock price in the high $20s within a year.
As Red Robin has grown, its expenses have outpaced revenue.
The previous management didnt seem to care about the
withering operations:
Fiscal
2005
Fiscal
2006
Fiscal
2007
Fiscal
2008
Fiscal
2009
TTM
Q2 2010
Revenue growth 20.5% 27.3% 23.4% 13.8% (3.2%) (3.8%)
Total restaurant
operating cost
plus general and
administrative cost
growth
20.2% 29.4% 25.0% 16.1% (1.2%) 1.6%
Period-end store
count
299 347 384 423 439 443
General and
administrative plus
operating costs per
store
$348,000 $407,000 $470,000 $490,000 $452,000 $463,000
Source: Analyst calculations
But given the changes brought about by the activist group, future
expenses shouldnt reflect trailing costs. Even if Red Robin isnt
bought, the changes should help create value.
To do that, the company needs to cut back on its expansion.
It needs to close underperforming stores and sell the related
assets. It should spend more on marketing but push other
operating costs down. It should keep its prices as low as
possible, sacrificing big checks for more customers. It could tip
the business toward being a royalty collector by refranchising
company-operated stores. It should redirect cash flow to pay debt
and buy back shares. Each of these things is achievable given the
new management.
So whats the company worth? Simply put, more. Red
Robin has a demonstrated ability to generate $90 million
of operating cash a year. Maintenance and corporate capital
spending is less than $15 million, which means Red Robin
could generate $75 million of free cash flow annually.
Discount that by 12% into perpetuity, and you get a value
of $625 million (roughly $30 per share), compared with the
present enterprise value of $424 million. Management is also
committed to paying down debt, which will further tilt the
companys value toward shareholders.
These projections are all well and good, but if Clinton Group
and Spotlight Advisors give up on Red Robin, Id recommend
you sell your shares. I dont expect this to happen, but if the
activist investors arguably the most in-the-know outside
party leave before a big jump in the stock price, theres
probably something really wrong with the business.
Likewise, if the newly appointed CEO restarts Red Robins
empire-building and the board or the activists dont rein him in,
Id recommend you sell.
And despite the changes brought on by the activist investors,
Red Robins nest is still built on a reasonable amount of debt.
The company probably cant pay its obligations in full by the
June 2012 deadline, so I expect it to renegotiate its credit options
in 2011 (if it hasnt been acquired by then). But if these talks
stall, youd be wise to scale back your position.
Red Robin will either perk up after the company acts on the
activists demands, or it will be bought. Either way, its a good
investment right now. Cash flow is attractive, and the stock is
a steal. With the restaurant industry consolidating and activist
investors stirring the pots, Red Robin shareholders could even
get the fun of a proxy fight. All this to say: If you love a good
stock as much as I love a good burger, Red Robin packs some
serious promise for your portfolio.
Jim Gillies is associate advisor of Motley Fool Options
and a senior analyst at Hidden Gems, the Fools small-cap
investing service. He owns shares of Red Robin Gourmet
Burgers and Biglari Holdings (parent company of Steak n
Shake) and has options positions on Red Robin.
STOCKS 2011
Synaptics:
Your Finger on the Pulse of Technology
BY DAVID MEIER
I remember when I thought a computer mouse was the coolest thing ever. That
fascination seems quaint now, in the days of voice-recognition software, touch
pads, and touch screens. But even as far as weve already come, the way we control
electronic devices will keep evolving. Synaptics (Nasdaq: SYNA) has been at the
forefront of this technology, and it will continue to set the standard in the way humans
interact with machines.
THE COMPANY
Synaptics doesnt make laptops or cellphones, but its touch pads and touch screens
make them easier to use. Isnt it amazing how a cursor can come to life as you run your
finger over a touch pad? This isnt magic; the engineers at Synaptics simply understand
the science of capacitive sensors.
In case you skipped physics that one day, Ill briefly explain how capacitance
works. (Dont worry there wont be a quiz.) Capacitance is the ability of an object
to hold an electrical charge. If you put your finger on a touchpad, youre changing the
capacitance of the area around your finger. Those changes can be turned into a signal
thats analyzed by a computer chip and then translated into motion on a screen.
Synaptics founders have used this scientific knowledge to create many types of
interface products, but the companys TouchPad and ClearPad account for most of its
sales. On many laptops, the TouchPad is that little square below the keyboard that has
allowed us to kiss mouse wires and carpal tunnel syndrome goodbye.
Ever innovating, the companys next-generation touch pad is called the ClickPad.
It has a bigger surface area than the TouchPad, and it doesnt have any clickable
buttons underneath. Instead, you can tap the pad or push down on one of its corners
to execute a task.
Software updates for the ClickPad also allow for multifinger control, such as sliding
two fingers down the pad to scroll through the pages of a document, regardless of
where you cursor is. I tried this on my new laptop, and I really like the upgrade.
The companys other big seller is its ClearPad, a touch screen for mobile phones,
GPS units, and portable entertainment devices. Synaptics offers ClearPads in a wide
variety of sizes, with different features depending on the complexity of the device. Its
newest offering, the ClearPad 7200, is a 10.1-inch screen the company plans to sell to
notebook and tablet computer manufacturers.
Synaptics products are in more than 800 million devices, and its TouchPads and
ClickPads have more than 70% market share in the notebook market. Whats more,
the ClickPad, with its multifinger, gesture-enabled capabilities (such as pinching or
expanding to zoom in or out), now accounts for 10% of Synaptics shipments.
WHY INVEST?
Clearly, Synaptics stuff has some traction. But will that last?
You bet. Synaptics technology is at the forefront of customers minds. The company
also has the expertise to improve its current products and the drive to develop new
SYNAPTICS
Nasdaq: SYNA
Headquarters: Santa Clara, Calif.
www.synaptics.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $29.16
Data as of 11/8/10
WHY BUY
The company will benefit from growth in
the notebook and mobile phone markets.
Its strong balance sheet supports
research and development.
Synaptics out-of-favor stock gives you
the opportunity to invest in a technology
leader.
STOCKS 2011
ones. All that puts Synaptics in a great position to capitalize on
the growth in the notebook and mobile phone markets as well
as to try to enter new markets.
In addition to building on its past successes, the company
is working on new projects. Its next generation of control
software, Scrybe, will create new ways for users to control
notebooks and tablets. Synaptics has also helped create a new
concept phone called the Fuse. The Fuse has a touch screen on
the front, a touch pad on the back, and sensors on the sides,
giving users multiple points of control. I recommend you check
out the demo on YouTube.
And not only does Synaptics develop great products, but it
also sells them into growing markets. The mobile computing
device market, which includes notebooks, netbooks, and tablet
computers, is projected to grow an average of 19% annually
until 2014. The worldwide smartphone market (phones that run
applications and have advanced features such as touch screens)
could increase more than fourfold, to more than 800 million
phones, by 2014. Thats a lot of opportunity for Synaptics to sell
TouchPads, ClickPads, and ClearPads.
And as you can see in the table below, sales have grown
steadily over the past five years.
FY2005 FY2006 FY2007 FY2008 FY2009 FY2010
Sales $208.1 $184.6 $266.8 $361.1 $473.3 $514.9
Research and
development/Sales
12% 19% 15% 14% 14% 17%
ROIC 55% 11% 19% 24% 42% 37%
Operating cash flow $42.5 $24.8 $26.3 $76.4 $81.6 $114.0
Dollar amounts in millions. Source: CapitalIQ, authors calculations.
Whats more, the company generates a considerable amount
of cash flow from those sales. Synaptics doesnt manufacture its
products it contracts that work out to third-party suppliers.
So a big chunk of the companys cash goes toward research and
development, a proportion thats averaged a little more than 15%
of sales. Fortunately, the company continues to generate a very
high return on invested capital as the market keeps snapping up
its products.
We can work backward from Synaptics most recent free cash
flow figure ($50 million, adjusted for stock compensation and
normalized working capital) to see how much growth the market
expects here. Accounting for the $210 million of cash on the
balance sheet, the market expects Synaptics cash flow to grow
7% for the next five years, 3% for the following five years, and
at a 1% terminal rate. That seems pretty low for a company
whose product markets are expected to grow much faster than
7%. If the company can increase its cash flow by 15% over
the next five years, 5% for the following five years, and 2%
thereafter, I estimate Synaptics is worth about $40 a share.
Synaptics faces two main risks: competition and
disintermediation.
To keep costs under control, original equipment manufacturers
such as Dell (Nasdaq: DELL) like to work with a number of
suppliers to find the best deal. Synaptics is a supplier, so if it gets
into a price war with its rivals in an attempt to win business, it
might have a hard time earning a high enough margin to generate
an adequate return on capital.
The second risk (and SAT-word contender),
disintermediation, occurs when a company cuts out a middle
man. If a PC maker, for example, decides to manufacture its
own touch pads, it could cut Synaptics off as a supplier and
cut sales off from the company.
If Synaptics were to lose a major customer or become
involved in a price war to protect its market share, Id have to
revisit my valuation model. And if the effects on the financials
are bad enough, Id recommend sell your shares.
With worries about people upgrading their computers less
often and increased competition, Synaptics stock has fallen out
of favor its more popular with the short sellers.
Yet the company is powering ahead, with rising sales and new
products that continue to gain traction in the growing notebook
and mobile phone markets. This disconnect should create some
very tangible assets for your portfolio, so consider investing in
the touch screen titan today.
David Meier is an associate advisor for Million Dollar
Portfolio, the Fools real-money portfolio made up of stocks from
throughout the Foolish universe.
STOCKS 2011
Wal-Mart Stores:
Still Delivering Deep Value
BY JAMES EARLY
A massive parking lot. That long walk. The chance to rub elbows with folks from all
walks of life. Tremendous selection at low, low prices. Youre in Wal-Mart, baby.
And you might want to invest in Wal-Mart Stores (NYSE: WMT), too: Not only
is it 30% undervalued by my model, but it also has a massive 22.5% return on equity
and has raised its dividend more than 17% per year on average for each of the past
five years.
Best of all, though, is that for you to make money with this stock, Wal-Mart just has
to keep on being Wal-Mart. No major catalysts have to fall into place, and no thesis has
to play out. Members of my conservative Income Investor stock-picking service know
that this is my favorite kind of investment and its what you get with Wal-Mart.
THE COMPANY
I already mentioned the gargantuan parking lots, but Wal-Mart is all kinds of big. Its
the worlds largest retailer, the nations leading private employer with 2.1 million
employees and the countrys biggest grocery store. Its also the worlds largest seller
of organic milk and the biggest buyer of organic cotton.
The company has three businesses: Wal-Mart U.S. (64% of revenue), Wal-Mart
International (25%), and Sams Club (just under 12%). All told, the U.S. accounts for
about three-quarters of sales, but if youve been following this stock, you know that
most eyes are on Wal-Marts international business, which is expected to account for
much of the companys growth.
Its fitting, then, that CEO Mike Duke used to be the head of Wal-Mart International.
Duke, who started at Wal-Mart in 1995, has earned a reputation as a disciplined
manager willing to make tough decisions. Notably, he pulled the company out of
Germany and South Korea two countries where the business concept just wasnt
working. Most recently, Duke has been adding items back onto Wal-Marts shelves after
efforts to streamline the companys products reduced revenue.
This good corporate stewardship goes way back to the companys founder, Sam
Walton, who started Wal-Mart in Arkansas after successfully building out a chain of
Ben Franklin five-and-dime stores. It continues to be a family business of sorts, with
the Walton family holding 46% of Wal-Mart shares.
WHY INVEST?
That stake makes Sam Waltons children among the richest people in the United
States. Now, Im not claiming that the same will happen to you if you invest in Wal-
Mart, but the stock will enrich your portfolio. Thats because for the company to
succeed, it simply needs to keep on doing what its doing. After all, it can lean on these
three super-sized advantages:
1. It has a superior retail format: If youve seen the Pixar movie Wall-E, in which
a mega-retailer encourages so much consumption that humans are forced to abandon
a trash-filled Earth for outer space, you know that some people find the mega-store
concept unromantic. But it works. The fact that Wal-Mart can come into town and clean
WALMART STORES
NYSE: WMT
Headquarters: Bentonville, Ark.
www.walmartstores.com
FINANCIAL SNAPSHOT
Recent Price:. . . . . . . . . . . . . . . . . . . . . . . . . $55.20
Market Cap: . . . . . . . . . . . . . . . . . . $200.9 billion
Dividend Yield: . . . . . . . . . . . . . . . . . . . . . . . 2.2%
Data as of 11/8/10
WHY BUY
Wal-Marts superior retail format trounces
the competition, time and time again.
The stores bargain-priced consumer
staples keep customers coming back,
regardless of the economy.
International expansion should drive
growth.
STOCKS 2011
out small businesses is bad if youre a small business, but its
also evidence of evolution favoring a stronger offering. And its
very good if youre an owner of Wal-Mart.
2. Wal-Mart is largely recession-proof: When tough times
hit home, whos giving up toilet paper? Go ahead, raise your
hand. I wont tell. Anybody? I didnt think so. Thats why Wal-
Mart was one of the few retailers that posted at least some same-
store sales gains in the last recession. When the going gets tough,
the tough head to Wal-Mart.
3. The world is Wal-Marts oyster: Remember that
superior retail concept? Wal-Mart has been taking it worldwide,
with more than 4,100 stores outside the U.S. And in a sense,
developing economies take Wal-Mart along with them. Before
the financial crisis, operating profit in Wal-Marts international
business had been growing in the double digits. As growth
resumes in foreign economies, Wal-Marts operating profit
should jump-start once more.
Everyone knows you can find great prices (and falling ones,
too) on Wal-Marts shelves. Lets see if its stock is a similar
bargain.
To value the company, Ill use big breath! an after-
tax operating income discounted cash flow valuation model.
Despite the name, its a straightforward model suitable for
straightforward companies like Wal-Mart.
Now for the numbers: Wall Street analysts expect earnings
to grow at an annualized 10.5% rate over the next five years,
though I forecast a more conservative 6% annual growth for the
same span. This growth should taper off to 2.5% per year, about
the growth rate of U.S. economy. Im discounting the equity cash
flow at 10.5%, which means I think Wal-Mart will be about as
risky as the average blue chip.
One big unknown here is how any increased employee
benefits will affect Wal-Marts earnings. In general, it would
lower them and Im projecting these costs into my model
accordingly but my inner optimist hopes that by bumping up
its benefits, Wal-Mart will benefit from higher productivity and
less turnover.
All told, I value Wal-Mart at $72 per share, which is 30%
above the current price.
If youve surfed around to one of the many anti-Wal-Mart
websites at least the ones whose domains the company didnt
buy up you know that the store has its vocal detractors.
Wal-Mart regularly comes under fire for ruining small-town
businesses, being stingy with suppliers and workers, and building
ugly stores, to name a few. A discrimination lawsuit brought by
women in 2001 is ongoing. All these concerns might cost Wal-
Mart the occasional lawsuit, but they weigh more heavily in the
court of public opinion: No doubt some people refuse to shop at
Wal-Mart, and more may follow suit. But I dont think this poses
a real danger for the company. Wal-Mart has thrown its heft into
managing its image, and it appears to have turned a corner. If
only because its good for business, the company has become
serious about sustainability and organic products, and its leaning
toward improving its employee benefits.
The bigger challenge facing Wal-Mart is growth in the face
of its hugeness. When youre that big, it can be tough to grow.
Yet Wal-Mart keeps doing it, and theres plenty of opportunity
overseas. But figuring out international tastes is a tricky thing,
as the companys missteps in Germany and South Korea attest.
Having an increasing proportion of its growth coming from
abroad means Wal-Mart will need to have good aim. If you
see consistent signs that the company is misfiring abroad, that
could be a cue for you to take cover and sell your shares. But
fortunately, strategic indicators both positive and negative
tend to happen incrementally, which gives you plenty of time to
evaluate the situation.
They say that if you cant beat em, join em. Im the first to
admit that I dont often shop at Wal-Mart, but its retail concept
works and works well. The company will continue to grow,
in terms of store counts, revenue, and dividends, to name just a
few metrics. Yet its stock currently trades for what it did about
10 years ago (excluding dividends). It will take off as foreign
economies become more developed, so now is a smart time to
add these bargain-priced shares to your portfolio.
James Early is the advisor of Income Investor, the Fools
dividend-focused investing service.
The Motley Fool owns shares of Wal-Mart Stores.
STOCKS 2011
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