Special Situation Ideas for the week of 17 July 2017

Those looking into some catalyst might want to ponder over these names for the week. I have done research on few of them, the other I have read online on Barron’s and other publications. If you have questions, feel free to write to me on kedar@kedarcap.com

SHORT: Best Buy (BBY):  Best Buy  is a provider of technology products, services and solutions. It has operations in the United States, Canada and Mexico.
The company reports in 5 distinct segment: Consumer Electronics - home theater, home automation, digital imaging, health and fitness and portable audio (approx. 33% of rev); Computing and Mobile Phones - computing and peripherals, networking, tablets, mobile phones (including related mobile network carrier commissions), wearables (including smart watches) and e-readers (approx.46% of rev); Entertainment - gaming hardware and software, movies, music, technology toys and other software (approx. 5% of rev); Appliances - major appliances, for example, refrigeration, dishwashers, ovens, laundry, etc.) and small appliances for example, coffee makers, blenders, etc. (approx. 11% of rev); and Services - consultation, design, delivery, installation, set-up, protection plans, repair, technical support and educational classes (approx. 5% of rev). The stock has had quite a run-up in its share price in the last year, a run-up which was helped by the rise in the stock markets. The top line has remain largely flat to down, despite this rise. Most of the growth trends impacting BBY are directly correlated to population growth, housing recovery, and health living trends. Aside the top line, even the gross profit and operating profit margins have remained largely flat. So the question is – why a meteoric rise in the stock price? The answer lies in the rise in EPS mostly, from cost cutting and buyback in stock. Since FY15, the company has bought back stock and cut costs, both operating and fixed – a step that has directly impacted its bottom-line. That coupled with steady rise in housing and a positive trend in job markets has positively impacted BBY. The positive cash flow generation has been mostly deployed to keep the dividends and buy back the stock – not the best way to grow the business. The company has historically traded at 10x earnings multiple. Putting 13x earnings multiple and assuming the company earns between $4 - $4.50, the stock can trade as high as $54 a share, which it currently is. This also assumes an EBITDA north of $2.2bn. The recent announcement in another $3bn in share buybacks might keep the momentum going for a bit more. However, the risk to the downside are much higher, given the rise in stock markets, highs in employment rate, tightening of federal reserve policy and a growth in housing which is little long in its tooth. This coupled with the day when the magic of cost cutting and share buyback comes to an end, the stock can tumble more than 25% in the mid 40ies.

SHORT: Verint Systems (VRNT): The Company with a $2.5bn market cap specializes in customer engagement, cybersecurity, fraud, and risk and compliance software and services for some 10,000 customers in 180 countries around the world. The shares have risen nearly 30% over the past 12 months, yet its weakening track record over the past four years suggests that investor enthusiasm is misplaced. Revenue growth has dropped steadily, from 24% in Fy15, which ended Jan. 31, to an 8% decline in FY17. The sales drop happened despite the company having spent $765mn in that period on three major acquisitions designed to increase sales. Over the same period, costs for R&D, among other expenditures, have risen about twice as fast as revenue.  Based on GAAP, the company reported a loss of 47c in FY17 from an income of 99c in FY14. Although non-GAAP EPS is only 15x estimates EPS of $2.71 for FY18, GAAP EPS estimate is just 16c for a P/E of 250x. For a company that has been growing through acquisitions, stock-based compensation; acquisition expenses; restructuring expenses; amortization of acquired technology; and impairment charges are real costs and not extraordinary expenses. The current valuation is priced to perfection. Its customer-engagement business, which is about two thirds of sales, and its cyber intelligence business, which is the other third, compete with the likes of Oracle, Microsoft, and Salesforce.com (CRM). If the company does not get bought by a firm expect the price to drop.

LONG: Hain Celestial Group (HAIN) : The Company deals with organic and natural foods and other products. Most recently, Engaged Capital has submitted seven candidates for election to Hain’s eight-seat board. The fund bought into the company at an average cost of $34.63 per share. The company has a market value of $4bn. Engaged was an investor in Hain 2 yrs ago, and had successful activist engagements at natural/organic companies Boulder Brands and SunOpta. Hain has a great portfolio of organic brands, but suffered some setbacks, including a lengthy accounting issue it rectified on its own and slowing of top-line growth as its retailer mix evolved from natural specialty stores to major grocers. While Hain has done a great job of acquiring brands, its poor integration of them has led to profit margins much lower than peers. So the first opportunity here is operational: A more-efficient supply chain and rationalization of SKUs could double margins. The second opportunity is strategic. Hain is the last pure-play organic food company large enough to move the needle for companies like Pepsi and Kraft. Engaged has had a constructive engagement with management. The investor nominated seven directors not as a power grab, but to address the severe lack of relevant experience on the Hain board. There are also some positive trends that might help HAIN grow. For example, approximate annual growth in consumption of natural/organic foods over the past ten years in the U.S. is approx. 10%. In the US, less than 10% of all foods sold is organic/natural. While Hain has 3,000 SKUs, or stock-keeping units, only about 500 drive 90% of its revenue. If the fund plays its card right, there is a huge opportunity to drive.

I have been busy running money for some families, for over 3 years. Decided to take a break and restart the blog while I decide my next move/job.

I have done research on few ideas here, others I have read online on Barron’s and other publications. If you have questions, feel free to write to me on kedar@kedarcap.com

MACRO: The S&P’s 500 is trading for roughly 18x future earnings. The historical norm is 16x. A price/earnings multiple of that magnitude historically has suggested limited upside.

Corporate performance in the U.S. has been pretty good. Revenues were up 7%ish in 1Q17, and earnings were up 14%. Emerging markets are up about 20%, and even some slow-growing European markets have performed well. There are other things happening: some deal activity, and a lot of activist investing. Leveraged buyout firms are flush with capital and ready to invest. So are private equity firms, which are investing in expensive public equities.  The Federal Reserve will likely raise rates again. It is a little behind the curve, and the equity market is a little ahead of itself. Flat or rising rates will limit multiple expansion, which accounted for two-thirds of the S&P 500’s 98% return in the past 5yrs.There might be some moderation in the second half. Complacency is high and volatility is low, so we are set up for a more rugged market in the second half. Then there is also concern about auto loans, which have climbed to about $1.2Tn from $820bn in ’07, and student loans, which are now $1.3T, up from $410bn.
The biggest risk is that the Federal Reserve continues to raise rates as the economy begins to show signs of slowing. The pace of economic activity is an important thing to watch. So is Washington. The rhetoric coming out of Washington is that a lot of positive things are happening. Investors are overly optimistic about what the Trump administration can accomplish.

Internationally, China is delivering 6.5% economic growth like clockwork, although China is slowing, and that is the key to what will happen in the 2H and beyond. A few months ago, China appointed a new head of the China Banking Regulatory Commission to reform the financial sector. Reform means that China will have to squeeze out excessive leverage and systemic risks, and it can’t do that without doing some damage. Right now, China has a mini credit crunch. It is the only country in the world with an inverted yield curve, and not because the central bank has tightened rates. It is because the system has tightened due to reforms. The shadow banking system has been squeezed, and the banking system is short of deposits, so there is a funding problem.

STOCKS

Bed Bath & Beyond (BBBY): It is based in Union, N.J. The stock is down 12% this year. Amazon.com is going to take share from everyone, but it can’t kill everything. They do a great job of selling dorm equipment that can be picked up at a store near campus. As long as the housing cycle continues, that is good for BBBY. BBBY earned $4.58 a share in the FY17 ending February. They can make FY18 is $4.30 a share. At $35, it is at 8.2x. The company just increased its dividend by 20%, and reduced its share from 245m 5yrs ago, to 145m. BBBY is a better-than-average retailer and can be a good money maker over 5 years.

CyberArk Software [CYBR]: A leader in the small, but growing, area of privileged access management security. Its products take aim at hackers attempting to infiltrate corporate networks. CyberArk has a 25% market share and could grow as enterprises shift their focus from protecting firewalls to protecting against targeted user attacks. Unlike a lot of smaller vendors, it is profitable and keeps expenses low. The company could have strategic value to Check Point Software Technologies [CHKP]. CyberArk could generate $2.25 a share of free cash flow in 2019. At 25x earnings along with their net cash, stock can go to $65 a share.

Johnson Controls [JCI]: JCI provides building products and technology solutions, including air systems, HVAC controls, and fire and security solutions. Following the September 2016 merger of Tyco and Johnson Controls, and the spinoff of the auto-parts business, Johnson became one of the largest multi-industry companies. George Oliver, head of Tyco, will become the combined company’s CEO next year. The company will realize more than $1bn, or $1 a share, of cost synergies in the next 3ys. It could produce about $4 a share of cash earnings in the fiscal year ending in Sep-19 versus $2.80 in FY16. That could propel the stock into the mid-$60s in the next two to three years.

Ichor Holdings [ICHR]: went public in December. It trades for $23.31. The company is based in California. It has 25.6m shares, a $597m market cap, and net cash of $10.3m, or 40 cents a share. It was founded in 1999 and later bought by a private equity firm, which recently sold some stock. Ichor is a leader in the design, engineering, and manufacturing of fluid and gas delivery systems for semiconductor capital equipment. Two major customers: Applied Materials and LAM Research [LRCX. Pro forma revenue can be of $576m this year, which will be up 42%. Gross profit margins can be 16.8%. Fully taxed, the company could earn $2.02 a share, versus $1.32 in FY16. Demand in semiconductor land is being driven by two things: FinFET or Fin Field-Effect Transistor, which involves putting many more layers on a chip, and 3D NAND flash memory. Customer spending on semiconductor capital equipment is expected to rise to $36bn this year, from $33.8bn.

Valvoline [VVV]:  makes automotive lubricants. It was a spin-off from Ashland Global Holdings [ASH]. VVV has 200m shares outstanding. The stock trades at $22. The company could generate $2.1bn in revenue. Earnings could climb from $1.20 to $2 a share by 2021.

The company had $1.3bn in debt and VVV could be debt-free by FY21. The company generates a lot of cash. Stock can double in 5yrs. Dividend is 20 cents a share. Electric cars don’t have pistons, so they don’t need lubricants. But Valvoline also sells industrial lubricants and equipment, and will sell other sorts of products over time. There are 1bn cars in the world, and 250mn in the U.S. Another 100mn will be produced this year. If 8% of cars are electric in 5yrs, that’s not a significant impact.

Cott [COT]: There are 139m shares outstanding, and the stock sells for $13, giving the company a $1.8bn market capitalization. Cott has made a bunch of acquisitions and has $2.15bn of net debt. It has a growing private-label business in sparkling water. In recent years, it also entered the home- and office-delivery market for water and coffee in the U.S., U.K., and Europe. Cott will generate about $450m of Ebitda this year and $550m by 2021. U.K. currency-translation problems have caused a bit of an air pocket in the results, as the pound has fallen to 1.29 to the dollar from 1.60 last year. In the next few years, the stock will overcome that. We have a price target of $21.