Marquette University’s Applied Investment Management (AIM) Program
AIM Fund Investment Advisory Board Meeting AIM Equity Fund Presentations Thursday, May 10, 2007 10:30 AM – 12:30 PM Room DS265
Ticker Company Name Sector Student Presenter AOB American Oriental Bioengineering Healthcare Peter Merkel APKT Acme Packet Software Chris Caparelli DIOD Diodes Hardware Luke Junk EDE Empire District Electric Utilities Katerine Provo FCFS First Cash Financial Services Financial Services Mike Carlson HCSG Healthcare Services Group Business Services Pat Ingber IUSA info USA Business Services Joel Grebenick JRC Journal Register Media Paul Simenauer KSWS K-Swiss Consumer Goods Jason Bednar MPW Medical Properties Trust Financial Services Barrett Willich MRLN Marlin Business Services Consumer Services Greg Sirotek RTSX Radiation Therapy Services Healthcare Katie Koutnik WSO Watsco Industrial Materials Luke Lamanna
CRDN Ceradyne Industrial Materials Andy O'Connell FTBK Frontier Financial Financial Services Stan Zurawski LINC Lincoln Educational Services Consumer Services Nick Ihn SUNH Sun Healthcare Group Healthcare Chris Williams TTMI TTM Technologies Hardware Pat Flaherty Proposed AIM Equity Fund Portfolio Transactions
Share Price # of Shares Market Value at Ticker Company Name YES NO 5_10_2007 to Sell Close KFY Korn/Ferry International $24.60 120 $2,952 MCBC Macatawa Bank $16.15 130 $2,100 ASFI Asta Funding $43.79 300 $13,137 AUDC AudioCodes $5.93 970 $5,752 BSTE Biosite $94.00 200 $18,800 CHTT Chattem $58.50 60 $3,510 LIFC LifeCell Corp $29.85 230 $6,866 ELOS Syneron Medical $25.75 250 $6,438 KONG Kongzhong $6.71 500 $3,355 SAFM Sanderson Farms $40.17 100 $4,017 SSYS Stratasys $46.14 120 $5,537 CWCO Consolidated Water Co. $25.83 150 $3,875 IWM iShares Russell 2000 ETF $82.36 100 $8,236
$84,573
Share Price # of Shares Market Value at Ticker Company Name YES NO 5_10_2007 to Buy Close AOB American Oriental Bioengineering $11.00 560 $6,160 APKT Acme Packet $11.90 250 $2,975 DIOD Diodes $36.27 250 $9,068 EDE Empire District Electric $24.81 160 $3,970 FCFS First Cash Financial Services $22.46 90 $2,021 HCSG Healthcare Services Group $28.00 220 $6,160 IUSA info USA $10.15 600 $6,090 JRC Journal Register $5.93 550 $3,262 KSWS K-Swiss $29.07 200 $5,814 MPW Medical Properties Trust $13.74 950 $13,053 MRLN Marlin Business Services $20.46 300 $6,138 RTSX Radiation Therapy Services $28.32 220 $6,230 WSO Watsco $56.08 220 $12,338
$83,278
AIM Equity Fund - Sector Weightings (May 10, 2007)
Russell 2000 Current AIM Sector Weighting Proposed AIM Sector Weighting
25
20 e u l a 15 V o i l o f t r o P f o
10 %
5
0
2 Table of Contents
Page ACME PACKET, INC.4
AMERICAN ORIENTAL BIOENGINEERING INC...... 7
DIODES INC...... 10
EMPIRE DISTRICT ELECTRIC...... 13
FIRST CASH FINANCIAL SERVICES...... 16
HEALTHCARE SERVICE GROUP, INC...... 19
INFOUSA...... 22
JOURNAL REGISTER...... 24
K-SWISS INC...... 28
MARLIN BUSINESS SERVICES CORP...... 31
MEDICAL PROPERTIES TRUST INC...... 34
RADIATION THERAPY SERVICES INC...... 37
WATSCO INC...... 40
CERADYNE INC...... 43
FRONTIER FINANCIAL CORP...... 46
LINCOLN EDUCATIONAL SERVICES CORPORATION...... 49
SUN HEALTHCARE GROUP INC...... 52
TTM TECHNOLOGIES...... 55
3 Acme Packet, Inc. APKT Price: $12.01 ($11.50-$21.97) Fiscal Year Ends: December 31
Date: May 7, 2007 Christopher Caparelli Russell 2000 Index: 831.87 (668.58 – 835.17) Software Sector
Acme Packet, Inc. is the leading provider of Session Border Controllers (SBC); devices that enable interactive communication service providers to provide high quality and secure communication over Internet Protocol (IP) networks. SBCs, which contain both hardware and software components, play an integral role in the continuing development of the internet as a viable medium for voice, video and other real-time multimedia communication. Acme’s technology, primarily used for Voice over IP (VoIP) transmissions, is sold to over 360 carriers in 75 countries, comprising more than 50% of the SBC market. Founded in 2000, Acme went public in October of 2006 at $14.00 per share. Acme is headquartered in Burlington, Massachusetts and has 250 employees in 20 different countries.
Recommendation
The market for Acme’s products comes primarily Key Statistics May 7, 2007 from internet service providers looking to merge Market Cap $704.36 M their traditional voice networks and next Shares Outstanding 58.7M generation data services onto one network. While Average Volume 345,843 the current Public Switched Telephone Network Beta 1.62 (PSTN) provides flawless voice service, it does not EPS (TTM) $0.43 have the bandwidth capabilities that video and 2007 Estimated EPS $0.34 other real-time multimedia transmissions require. P/E (TTM) 26.88 The internet, while designed for high volume data PEG 1.31 transmission, does not offer the security or WACC 13.23% reliability necessary to successfully transmit voice ROA 21.95% communication. Using SBCs for reliability, ROE 25.24% security and control, VoIP has offered a solution to Gross Margin 34.33% this problem, allowing for the routing of voice Operating Margin 27.58% conversations over the Internet. This allows Target Price $18.50 service providers to deliver voice, video and data service packages over the internet, providing unmatched convenience which has already proven popular with businesses and consumers. Global revenues in the market for SBCs are forecast to grow from $143 billion in 2006 to $571 billion in 2009 by market research firm Infonetics, leaving Acme with fantastic growth prospects. Sales growth for Acme in the coming years is forecast at well over 100%, leaving me to recommend Acme Packet for addition to the AIM portfolio with a target price of $18.50.
Investment Thesis
Technological Evolution. Through the routing of voice conversations over the internet, service providers have experienced a major decrease in the use of traditional wireline services. With the PSTN no longer serving as a viable alternative, service 4 providers will continue to look towards Acme Packet for the SBCs crucial in the VoIP process. Acme will look to maintain its status as the leading provider of SBCs as this technology continues to grow and evolve.
Market Strength. Acme sells its products and services to over 360 different customers in 75 different countries. Their customers include 23 of the 25 largest service providers in the world as well as 72 of the largest 100. Acme controls greater than 50% of the market share for SBCs, dominating the pure-play competition including Nextone (17% market share) and Newport Networks (7%). The overall market for SBCs is one characterized by high switching costs, with providers unlikely to change vendors once their equipment has been integrated into their networks. This places Acme in a dominant position as providers look to aggressively expand their VoIP offerings in the coming years.
Attractive Valuation. Acme’s stock has taken a hit in the last few months after having reached a closing high of $19.64 on January 16, 2007. This tumble has not been caused by any company news as the company has remained relatively inactive since last quarter’s earning report. The market has been bearish as a whole for the space in which Acme operates, but I expect this trend to reverse in 2007. The recent downturn in Acme’s stock has not changed the underlying assumptions in my valuation, but rather, presents an attractive buying opportunity.
Valuation
A five year discounted cash flow model yielded an intrinsic value for Acme Packet of $18.43 with a 30% margin of safety built in, suggesting that the stock is currently undervalued by about 35%. The company is trading at a high earnings multiple because of its strong growth prospects and the expectation that sales growth could exceed 100% for the next year or two. While the financial statements from the last year look optimistic because of a large one time tax credit, Acme appears positioned to continue their strong financial performance.
Risks
Technological Adoption. The biggest risk posed to Acme’s success is the rate at which this new technology is adopted as a mainstream form of communication. Currently the cable industry leads the way in VoIP adoption, integrating this service into their popular “triple play” subscriptions. Traditional companies such as AT&T and Verizon have yet to push for VoIP technologies to be integrated into both their wired and wireless offerings. If the rate at which these traditional telecommunication companies adopt this technology is slower than expected, it will have a negative impact on Acme Packet.
Revenue Lumpiness. While Acme is expected to perform at a high rate on an annual basis, revenue lumpiness on a quarterly basis can cause high price volatility. The nature of Acme’s business leads to a huge influx of revenue whenever a new customer makes a purchase, followed by a period of little revenue as Acme services and supports their products within their customer’s networks. These uneven revenue streams can lead to price volatility, potentially dropping the stock price for extended periods.
5 Increased Competition. While Acme dominates the market of pure play SBC companies, the high margins that Acme earns will undoubtedly attract increased competition. Integrated companies such as Cisco Systems and Juniper Networks have begun to manufacture their own SBCs posing a risk to Acme in the future.
Management
Acme Packet was co-founded by Mr. Andy Ory and Mr. Patrick MeLampy in 2000. These two men along with the rest of Acme’s senior management have an extensive background and thorough knowledge of both the IP networking and telecom industry. Mr. Ory is the current CEO of Acme while Mr. MeLampy is and has been the Chief Technology Officer for the firm.
Ownership
% of Shares Held by All Insider and 5% Owners: N/A
% of Shares Held by Institutional & Mutual Fund Owners: 25%
Top 5 Shareholders Shares Percent of Outstanding Holder Name Held Shares TIAA-CREF Investment Management, LLC 2,088,553 3.56% Tiger Global Management, LLC 1,500,000 2.56% Oberweis Asset Management Inc. 1,388,411 2.37% Next Century Growth Investors, LLC 1,194,140 2.04% Gilder, Gagnon, Howe & Co. 837,580 1.43%
6 American Oriental Bioengineering Inc. AOB Price: $10.52 ($4.55-$14.19) Fiscal Year Ends: December 31
May 4, 2007 Peter Merkel Russell 2000 Index: 832.88 (668.58-835.17) Health Care Sector
American Oriental Bioengineering’s principal activities are to manufacture and formulate supplemental and medicinal products using proprietary processes. They focus on new product research to combine biotechnology and Chinese medical technology to capture the increasing demand for traditional Chinese medicines and health supplements. AOB owns and operates several plants in addition to a large capacity soybean peptide manufacturing plant. Soybean Peptides are used widely in general food and health food products, sports foods, medicines, the fermentation industry and environmental protection applications. These are easily absorbed by the body and can lower blood pressure and blood fat levels, enhance immunity, lower cholesterol, prevent cardiac and brain blood vessel diseases and inhibit the growth of tumors. On 27-Jul-2006, AOB acquired Heilongjiang Qitai Pharmaceutical Limited. AOB is based in Shenzhen, China.
Recommendation
As a company, American Oriental Bioengineering Key Statistics May 04, 2007 Inc. presents itself favorably due to its variety of Market Cap $681.53M organic products in a highly demanded market. As an Shares Outstanding 64.78M investment, AOB should be a profitable addition to the Average Volume(3m) 1.719M AIM portfolio because of its potential upside of 33%. Beta 1.42 Diluted EPS (TTM) $.46 Over the last five years AOB has averaged yearly 2007 Estimated EPS $.61 revenue growth of 82%. This was due to the P/E (TTM) 22.67 acquisition of several companies in the last two years. PEG 0.54 These acquisitions have expanded the company from WACC 12.14% its original northeast China markets to substantially all Debt/Assets 6.00% of China’s 23 provinces. AOB’s distribution network ROE 23.65% increased to 100,000 points throughout China. Based Gross Margin 65.22% on a target price of $14.00, this stock is an attractive Operating Margin 33.02% buy. Target Price $14.00
Investment Thesis
Viable products in a niche market. In January 2007, AOB introduced a new product that targets women in the 15-to-64 year range with its Jinji capsule and Yi Mu Cao.
Adequate cash on hand and access to capital to take advantage of opportunities. With about 2,000 companies active in the traditional medicine market in China and the Chinese government’s push to privatize the companies it owns, AOB is in a good position to make further acquisitions with $88M in cash on hand. In addition, listing on U.S. equity exchanges opens access to capital as part of their growth strategies.
7 Almost zero current R&D expenses. With no drug under the approval process, no product licenses revoked, and no products on the government-issued price-cut list, AOB is in a good position to maintain its growth and be sheltered from the China State and Food and Drug Administration (CSFA) investigations. Contrary to other companies, AOB received a favorable price hike for its Shuang Huang Liang injection powder after a government review.
Valuation
Based on a 10-year discounted cash flow analysis, American Oriental Bioengineering’s intrinsic value is $13.54. According to a relative valuation model based on the forward EPS of firms in the industry, the stock should be valued at $15. This is based on a 25x 2007 EPS multiple. I believe a target value of $14.00 is reasonable. The company pays no dividend.
Risks
AOB’s CEO Tony Liu owns 23% of AOB’s common shares. In addition to ownership of the common shares, Mr. Liu owns 100% of the Series A Preferred Stock which gives him 48% total voting power of all shareholders.
The recent scandal involving the CSFA. Earlier this year, the Chinese government ordered an investigation into CSFA and its drug approval policies. This should not affect AOB because its drugs were approved over a decade ago and the investigation is about recent approvals. However, there is a risk that there will be a general short-term slow down in the industry if consumers shy away from certain products. The strong brand name and image of AOB might not be enough to counter these events.
Additions to AOB’s basic and diluted shares counts will come to an end. AOB’s outstanding warrant count was at 4.0M as of March 2007. With a strike price of $5.51 and expiration in December 2008, it is likely that all of these warrants will be exercised over the next two years.
Management
Led by CEO Tony Li, management has successfully improved operating efficiencies. For example, in 4Q06 days sales in inventory was 75 days (compared to 112 days the previous quarter and 102 days a year earlier.) In addition, accounts receivable turnover has improved from 38 days at the beginning of the year to 23 days by fourth quarter of 2006. These efficiencies reflect management’s commitment and ability to efficiently integrate acquired operations and improve existing operations. In February, management had a short list of two possible targets for acquisitions. Recently in a conference call, no additional guidance on potential acquisitions was provided. This could be a sign that management is being patient about new acquisitions in order to identify acquisitions whose products compliment AOB’s current line.
8 Ownership
% of Shares Held by All Insider and 5% Owners: 28 % % of Shares Held by Institutional & Mutual Fund Owners: 32 % *Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Lui Tony 14,858,871 22.94% MORGAN STANLEY 2,169,900 3.35% TURNER INVESTMENT PARTNERS, INC. 1,615,458 2.49% COLUMBIA PARTNERS, L.L.C, INVESTMENT 1,371,114 2.12% MANAGEMENT INSIGHT CAPITAL RESEARCH & 1,316,255 2.03% MANAGEMENT INC. *Source: Yahoo! Finance
9 Diodes Inc. DIOD Price: $38.00 ($31.65-$47.58) Fiscal Year Ends: December 31
Date: May 4, 2007 Luke Junk, Pat Flaherty Russell 2000 Index: 832.88 (668.58 - 835.17) Hardware Sector
Diodes Incorporated is engaged in the design, sale and manufacturing of discrete semiconductor products, fixed-function devices that are less complicated than integrated circuits. The company maintains a portfolio of over 4,000 products are sold into a diverse group of end-markets, including the consumer electronics, computing, industrial, communications, and automotive sectors. In addition to its US headquarters, Diodes maintains sales, manufacturing and marketing facilities in the US, Taiwan and China. Major competitors include Fairchild Semiconductor, International Rectifier, Vishay Intertechnology, and ON Semiconductor. Diodes has been a public company since 1966 and is headquartered in West Lake Village, California.
Recommendation
Diodes positions itself well in the highly cyclical Key Statistics May 4, 2007 semiconductor industry with its portfolio of over Market Cap $989.37M 4,000 products, limiting exposure to weakness in Shares Outstanding 26.04M individual sectors. Over the last five years Diodes Average Volume 459,098 has averaged yearly revenue growth of over 30%, Beta 1.52 while improving gross margins by 10.2% over that EPS (TTM) $1.74 same time period. We expect the continued rapid 2007 Estimated EPS $2.25 introduction of new products (218 new products P/E (TTM) 21.84 introduced in 2006) and achievement of design wins PEG 0.83 with OEMs (over 100 in 2006) to continue to drive WACC 11.30% revenue growth. This revenue growth should be Debt/Equity 0.821 paired with an improvement in gross margins in ROE 18.53% 2007 as the company completes the integration of its Gross Margin 33.2% Anachip acquisition. We are recommending the Operating Margin 16.8% addition of Diodes to the AIM portfolio with a target Target Price $44.00 price of $44.00. Source: Yahoo! Finance
Investment Thesis
Broad end market exposure. Diodes’ broad end-market exposure reduces the company’s exposure to sector-specific weakness in the semiconductor space. As a manufacturer of discrete semiconductor components, Diodes is able to focus more on the aggregation of new product ramps and design wins rather than relying on a few major products. Diodes estimates that its indirect customer base numbers over 10,000 with no single customer accounting for more than 10% of revenues.
10 Manufacturing flexibility and efficiency. Diodes’ is able to exercise nearly complete control over their manufacturing costs, a key factor in the company’s five year gross margin improvement of 10.2%. The company’s two principal plants in Shanghai each boast utilization rates of over 95%. Additionally, Diodes always has access to the adequate manufacturing capacity, an important factor for a smaller semiconductor company.
New product ramps. Diodes has shown a dedication to the continued development of new products. From 2005 to 2006, R&D spending has increased $4.6 million to $8.3 million while 218 new products were launched in 2006. Moving forward, company management has said that it expects R&D spending to increase to approximately 2-3% of revenues.
M&A Activity. Diodes currently has about $335 million of cash and cash equivalents on their balance sheet, nearly $13 of cash per share. Management continues to look for acquisition targets to enhance revenue and profit growth.
Valuation
A 10-year discounted cash flow analysis indicates that Diodes’ intrinsic value is $43.62. On the basis of basis of the company trading at a PE of 20, the one-year target price assuming the $2.25 FY07 consensus EPS estimate (Thomson) yields a target price of $45.00. Taking into account both of these valuation metrics, my target price for Diodes is $44.00.
Risks
Ability to integrate new acquisitions. As of 4Q06, Diodes’ management indicated that less than 50% of Anachip’s products were integrated into the distribution channels. A drag on the company’s profits could result if the company experiences the same kinds of delays integrating its November acquisition of APD Semiconductor and other acquisitions in the future.
Lite-On Semiconductor’s role as owner and customer. Lite-On Semiconductor (LSC) owns 22.3% of Diode’s common stock as of the year-end in 2006, and is also the company’s largest customer. During 2006, 6.5% of net sales were attributable to LSC. LSC is also Diode’s largest supplier, accounting for 13.0% of net sales in 2006.
Potentially slipping gross margins. For the first time since 2001, Diodes saw their gross margins decrease in 2006 by 140 basis points. Management attributes the slip in margins to the Anachip acquisition and falling ASPs.
Management
Diodes’ management boasts extensive experience in the semiconductor industry. CEO Dr. Keh-Shew Lu worked at Texas Instruments for 28 years, leaving as a senior vice president and general manager. To this date, the company has not been forced to conduct a review of its stock option accounting practices.
11 Ownership % of Shares Held by All Insider and 5% Owners: 23.12% % of Shares Held by Institutional & Mutual Fund Owners: 74.70% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Munder Capital Management 1,595,473 6.13% Rainier Investment Management 1,194,372 4.59% New Amsterdam Partners 1,154,519 4.43% Barclays Global Investors UK Holdings 928,246 3.57% Royce & Associates 776,400 2.98% Source: Yahoo! Finance
12 Empire District Electric EDE Price: $24.89 ($20.25-$26.13) Fiscal Year Ends: December 31
Date: May 4, 2007 Katherine Provo 832.88 (668.58 – 835.17) Utilities Sector
Empire District Electric is an operating public utility engaged in the generation, purchase, transmission, distribution and sale of electricity in parts of Missouri, Kansas, Oklahoma, and Arkansas. Revenues for Empire are predominately generated from the sale of electricity, but they also provide water service to three towns in Missouri, natural gas distribution to communities in Missouri, and have investments in certain non-regulated utilities. Empire serves an area of about 10,000 square miles with a population of over 450,000 with most of their customers residing in southwestern Missouri.
Recommendation Key Statistics May 4, 2007
Empire District Electric operates in a highly regulated Market Cap $748M utilities industry. Over the past five years Empire has Shares Outstanding 30.30M been successful at increasing their rates to substantially Average Volume 140,700 increase their revenue per kilowatt. Management has Beta 0.64 recently sold investments in non-regulated industries EPS (TTM) $1.45 and re-focused on utilities operations. The acquisition 2007 EPS est. $1.51 of their gas operations on June 1st 2006 provides the WACC 6.88% company with growth potential. Investing in Empire P/E (TTM) 18.27% would provide the portfolio an opportunity to diversify PEG 5.97 along with a safe investment with significant growth FCF/Share -$2.21 potential. ROE 9.11% ROA 4.78% Investment Thesis Operating Margin 22.13% Dividend Yield 5.18% Stability of their business. Empire operates in Target Price $28.50 a regulated market and does not face any direct competition. They are able to predict their customer’s demand and enter into long term contracts for the purchase of coal and natural gas along with transportation services. They are able to hedge their risks against the volatile price of natural gas.
Diverse operating area. Empire serves communities in Missouri, Kansas, and Arkansas by selling electricity to incorporated communities through franchises with contracts of twenty years or more. Only 2% of electric revenues from 2006 came from companies with ten years or less remaining on their contract. Empire has never had a community franchise refuse to renew the contract before the term is up. No single retail electric customer made up of more then 2% of electric revenue and no single gas customer for more then 4% of gas revenue in 2006.
13 Renewed focus on their utilities operations. In 2006, Empire focused their capital on what they do best, supply customers electricity, gas, and water. They sold off a majority of their investments in other companies and acquired Aquila gas on June 1 st 2006. With only seven months of operation in 2006, their gas subsidiary contributed negative margins for 2006 which will likely be reversed after operating a full year.
Ability to increase rates. For a regulated utility the process of raising rates is a difficult process where the company must go through state regulatory bodies. Empire was approved an annual rate increase of 9.96% in 2005, which has already been extended for the entire 2007 year. Because they operate in a fairly friendly regulatory environment they are also able to increase their gas rates up to four times a year to recover their costs.
Valuation
Using a discounted cash flow model, an intrinsic value of $29.32 was computed using a WACC of 6.88%. The 2007 EPS estimate multiplied by their historical PE provided a target value of $27.60. Given these two values I would set an intrinsic price of $28.50. Although this value only provides a 15% upside, Empire’s dividend yield of over 5% and their consistency of out performing the Russell 2000 make it a valuable addition to the portfolio.
Risks
Weather. The main demand driver for both gas and electricity is the weather. In months with extreme weather Empire’s revenues are higher than months with milder weather. The downside to this is that extreme weather can also harm equipment which raises operating expenses. In January of 2007, Empire incurred $28 million dollars in damage due to a three day ice storm.
Ability to cover costs. Although Empire has been approved for rate increases, they must resubmit the increase to the state government. Rate increases are not assured. They amount that they are able to recover through their natural gas operations is their direct cost and does not include costs such as increased pension liabilities.
Large capital investments in production plants. To meet the increased demand for electricity in the region Empire is investing large amounts of capital into their production facilities. These investments are not assured to be profitable if demand does not increase at the projected levels or they experience unplanned costs. The large amounts of capital expenditures has resulted in a negative free cash flow for the current year and in the next two years but will then recover in future years.
Management
Mr. William Gipson, has had the role of president and CEO since May of 2002. Mr. Gregory Knapp, vice president and CFO was also elected to his current position in 2002. Both Mr. Gipson and Knapp have been with the company for over 25 years starting in 1981 and 1978 respectively. Six of the nine officers for Empire have been with the company for over twenty years.
14 Ownership % of Shares Held by All Insider and 5% Owners: 3% % of Shares Held by Institutional & Mutual Fund Owners: 39% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Price (T.Rowe) Associates 1,675,660 5.53% Barclays Global Investors UK Holdings 1,416,401 4.68% Dimensional Fund Advisors 1,097,276 3.62% Vanguard Group 832,279 2.75% TIAA-CREF Investment Management 496,544 1.64%
15 First Cash Financial Services FCFS Price: $22.95 ($16.20 - $26.47) Fiscal Year Ends: December 31, 2007
Date: May 7, 2007 Mike Carlson Russell 2000 Index: 833.80 (668.58 - 831.71) Financial Services Sector
First Cash Financial Services, Inc., (FCFS) through its subsidiaries, provides consumer financial services and related specialty retail products through pawn stores in the United States and Mexico. Its pawn stores engages in providing small consumer loans; advancing money against pledged tangible personal property, such as jewelry, electronic equipment, tools, sporting goods, and musical equipment; and retail sale of previously-owned merchandise acquired through collateral forfeitures and over-the-counter purchases from customers; and offer cash advances or a credit services products. The company operates stand-alone cash advance stores that provide a range of consumer financial services products, including cash advances, credit services, check cashing, money orders, money transfers, and prepaid card products. In addition, it operates automobile dealerships that sell used vehicles; and engages in related vehicle financing contracts. Further, the company owns and operates kiosks that offer credit services program and check cashing services. As of December 31, 2006, the company owned 252 pawn stores, and 145 cash advance stores, as well as operated 40 kiosks. First Cash Financial Services was founded in 1988 and is based in Arlington, Texas.
Recommendation
First Cash Financial Services has seen large growth Key Statistics April 26, 07 during the past five years. They have continued to add Market Cap $736.44M new pawn shops, cash advance stores, and auto Shares Outstanding 32.19M dealerships every year. They have focused their pawn Average Volume 259,524 shop and cash advance growth in Mexico, and their Beta 1.41 recent returns on this venture have been substantial. EPS (TTM) $1.05 Revenue has grown 127% from 2002-2006. Through 2007 Estimated EPS* $1.29 their stock price and revenue growth, history has P/E (TTM) 21.81 shown that First Cash performs well during times of PEG .92 economic distress. Increasing the weight on this WACC 12.24% investment could be a hedge maneuver for the AIM Debt/Assets 5.80% portfolio. A target price of $28.50 is reasonable, ROE** 18.30% offering a 24% upside on increased holdings. ROA** 15.40% Gross Margin** 43.60% Investment Thesis Operating Margin** 18.00% Target Price $28.50 Revenue Growth. First Cash has seen Sources: Yahoo! Finance; *Thomson significant revenue growth over the past five years. They have also expanded their business Analytics; **Morningstar; from being solely a pawn shop company. These new ventures in cash advance stores and auto dealerships have increased revenues as well as provided diversification for FCFS. Revenues grew 30% from 2005 to 2006 while the number of locations grew 24%.
16 Expansion in Mexico. First Cash is currently the only publicly traded pawn shop company in Mexico. They first established themselves in this region five years ago and have greatly expanded. Mexican revenues grew 43% from 2005 to 2006 with 25% due to store growth and 18% due to organic growth. The pawn shop market is also less established in Mexico, allowing for First Cash to take a greater market share. Mexican revenue accounts for 28% of total revenue. This proportion will increase in the near future.
Economic Uncertainty. The publicly traded pawn shop industry performed well financially and in market value during the last recession. With many experts predicting an economic downturn, an investment in First Cash would be a hedge for the AIM portfolio. The majority of Mexico has experienced hard economic times historically as well. Without a change of this in sight, First Cash should be able to succeed based upon their past performance during rough economic times.
Valuation
Based on a discounted cash flow model, First Cash should be valued at $28.60 (20% Margin of Safety).After performing a relative valuation model based on the forward P/E of their competitors, First Cash should be valued at $26.50. Because of the small peer group related to the P/E, a price of $28.50 is reasonable.
Risks
Economic Growth. Despite having growing revenues during the strong economy of the late ‘90s, First Cash’s market value declined. First Cash rebounded and has since diversified their business activities. They have performed well during the rebounded economy of late, but if there was another economic boom, their reputation as a pawn shop operator could lead to their decrease in market value.
Expansions in Mexico. First Cash’s success in Mexico has attracted other publicly traded pawn shop companies. This increased competition in the main region of expansion could affect growth rates and revenues.
Regulations. Short term personal loans have come under increased scrutiny over the past years. Increased regulations on these types of transactions could have a negative affect on First Cash’s Revenues. Most laws are governed independently by state. First Cash is at risk of experiencing changes between federal and state legislations.
Management
First Cash Financial has an experienced management that has been with the company for awhile. They see expansion as their main business strategy while maintaining their operating profits. Insiders own 13%% of the shares outstanding.
17 Ownership % of Shares Held by All Insider and 5% Owners: 13% % of Shares Held by Institutional & Mutual Fund Owners: 71% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Richard T. Burke 2,833,000 8.82% Barclays Global Investors UK Holdings Ltd 1,345,155 4.18% Delaware Management Business Trust. 1,159,868 3.60% Prudential Financial 1,146,398 3.56% Munder-Capital Management 1,061,978 3.30%
18 Healthcare Service Group, Inc. HCSG Price: $28.78 ($19.00-$30.91) Fiscal Year Ends: December 31
Date: April 30, 2007 Joel Grebenick and Pat Ingber Russell 2000 Index: 828.86 (668.58 - 831.71) Business Services Sector
Healthcare Service Group, Inc. provides housekeeping, laundry, linen, facility maintenance and food services to the health care industry, including nursing homes, retirement complexes, rehabilitation centers and hospitals located throughout the United States. Based on the nature and similarities of the services provided, its business operations consist of two business segments (Housekeeping and Food). It is believed that Healthcare Service Group is the largest provider of housekeeping and laundry services to the long-term care industry in the United States, rendering such services to approximately 1,950 facilities in 47 states as of December 31, 2006. The company does not directly participate in any government reimbursement programs, but its clients’ reimbursements are subject to government regulation. Therefore, they are directly affected by any legislation relating to Medicare and Medicaid reimbursement programs.
Recommendation Key Statistics April 22, 2007 With the expansion of the services offered by Market Cap $788.00M Healthcare Service Group, Inc. to include dining Shares Outstanding 26.04M services and the integration of Summit Services Average Volume 186,246 Group, Inc. into the company’s offerings, the Beta 1.01 company is expected to build on its steady stream EPS (TTM) $0.93 of revenues. While revenues improve, the 2007 Estimated EPS $1.08 company has also positioned itself to maintain the P/E (TTM) 32.03 quality margins that contribute to its compelling PEG 1.48 ROE. The increase in profit margins that WACC 10.02% Healthcare Services Group, Inc. will experience Debt/Assets 0% from its greater efficiencies will result in more ROE 16.22% funds available for marketing and sales efforts that Gross Margin 14.3% should fuel future organic growth. Operating Margin 7.0% Complimenting the company’s increase in sales Target Price $32.77 efforts, organic growth will most likely be spurred by expected future growth in the aging population.
Investment Thesis
Aging Population leading to Increase in Demand. The market for Healthcare Service Group, Inc.’s offerings is expected to continue to grow as the elderly population increases as a percentage of the United States population. As the largest long term healthcare facility provider of housekeeping and laundry services in the United States, HCSG can expect to benefit from this increase.
19 Expansion of Service Offerings. HCSG has been able to generate high profitability through an ROE averaging 11.86% over the last five years and an ROE of 16.68% in 2006, which is far above the industry average of 9.5%. HCSG has been able to provide this type of return without the financial risk associated with incurring debt. Instead, the company has relied upon decreasing Cost of Service Revenue as a percentage of revenue to increase its margins. We expect that the Cost of Revenue will remain a lower percentage of revenue as a result of further integration of Summit Services Group, Inc. and expanding its range of services to existing customers through its dining service offerings.
Performance Stability despite Weak Economic Conditions. With a large part of the company’s cost of revenue tied to its labor force, HCSG can expect to benefit from any unexpected increases in unemployment due to an economic slowdown, which will result in a decrease in bargaining power of the company’s unionized and non-unionized labor force. However, an economic downturn that results in increase unemployment is not expected to affect the company’s revenue due to a beta that has ranged from 0.50 over the last 60 months to 1.01 over the last 24 months. This is a tribute to the company’s ability to generate stable revenue over the long run despite negative economic conditions. The benefits that HCSG experiences from an increase in unemployment offsets any negative results that AIM holding Korn/Ferry International experiences as a result of increases in the unemployment rate.
Valuation
Based on the intrinsic value calculated from our DCF Model to be 11% higher than the current market price, we believe that it is an opportune time to buy. The factors leading to this conclusion include strong sales, increasing demand for services, and the ability of HCSG to keep its Cost of Service Revenue stable. In addition, the company provides a 1.90% dividend yield.
Risks
Golden Horizon’s Dominate Portion of Revenue. Healthcare Service Group Inc.’s largest client is Golden Horizon, which accounts for 16% and 18% of its Housekeeping and Food Revenues. Golden Horizon was involved in a merger recently but has kept its prior contracts and obligations to Healthcare Service Group Inc. If Horizon were to cut ties with Healthcare Service Group Inc., the break would adversely affect the cash flows of HCGS.
Medicare and Medicaid. HCSG is susceptible to changes in Medicare and Medicaid that may alter government reimbursement for nursing home services. Any decrease in reimbursements provided by the government will decrease the ability of long term healthcare facility residents to pay their bills, which in turn will affect the ability of healthcare service facilities to pay for the services that they contract with HCSG.
Threat of larger companies infiltrating long term healthcare facility maintenance. HCSG is susceptible to larger healthcare facility service providers, who currently focus their efforts on large hospitals, getting involved in servicing long term healthcare 20 facilities. Such large providers would be able to rely on greater financial resources that would make it difficult for HCSG to maintain its position as the leader of long term healthcare facility service offerings. The company also faces pressure from close competitors such as Aramark and Crotholl who may expand their services to compete with HCSG.
Management
Daniel P. McCartney has been the Chief Executive Officer and Chairman of the Board of Directors for more than 5 years. McCartney adds a great deal of experience with Board membership since 1977. The other main officers of HCSG have all been with the company for over 20 years.
Ownership % of Shares Held by All Insider and 5% Owners: 8.00% % of Shares Held by Institutional & Mutual Fund Owners: 91.00% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Advisory Research, Inc 2,434,127 8.81% Wells Fargo & Company 1,927,957 6.98% Daniel P. McCartney 1,825,234 6.61% Pequot Capital Management, Inc. 1,666,800 6.03% Barclays Global Investors UK Holdings 1,342,906 4.86%
21 InfoUSA IUSA Price: ($7.81-$12.70) Fiscal Year Ends: December 31
Date: May 3, 2007 Joel Grebenick Pat Ingber Russell 2000 Index: 828.86 (668.58 - 831.71) Business Services
InfoUSA provides sales leads, mailing lists, direct marketing, database marketing, email marketing, and market research solutions to its clients. The company operates three principle business groups. The data group has 12 proprietary databases of U.S. and International businesses and consumers. The flagship offerings that the data group offers includes Salesgenie.com, which is a subscription to sales representatives and business owners, MarketZone, which offers data storage and updating, and OneSource, which provides in-depth information about the world’s largest companies and their executives. In January of 2007, these database operations were combined into one group, the InfoUSA Data Group. The Services Group provides customer data management, email marketing services, and catalog marketing services. Lastly, the Research Group provides customer surveys and other market research services for companies.
Recommendation Key Statistics May 3, 2007 Over the last 10 years, InfoUSA has not generated Market Cap $547.38M any returns to its investors. We feel that through Shares Outstanding 55.46M the company’s recent acquisitions and forward Average Volume 272,073 growth strategy that the company is in position to Beta 0.88 generate its long awaited returns. Although EPS (TTM) 0.60 InfoUSA has many characteristics of a mature 2007 Estimated EPS 0.62 company through its existing reputation and P/E (TTM) 17.30 annual dividend, we believe that there is a large PEG N/A potential for growth both domestically and WACC 9.40% internationally. Debt/Assets 36.30% ROE 14.74% Investment Thesis Gross Margin 73.2% Operating Margin 14.90% Target Price $18.87 Organic growth fueled by greater internet offerings. The company’s new online subscription offerings with different durations and depth better accommodates its customers’ needs. Ease of Internet access to subscriptions for these databases increases annual revenue per customer and assures greater retention rates. With $4.6 million spent in television advertisements in Q107 and the consolidation of the company’s databases into one group, IUSA is in great position to experience a constant subscription revenue stream with increased brand awareness.
Strong Sales Growth in Marketing Services Industry. The already $59 billion industry is expected to experience strong annual growth due to increased economies of scale and the outsourcing of information at an increased rate.
22 Significant Barriers to Entry. InfoUSA spends $50 million per year in compiling and updating its Database. The company’s ability to change its database by 65% each year makes it difficult for any new entrant to compete. For a new company to compete, they would need to spend over $200 million to compile a database and for advertising expenses. InfoUSA already has over 4 million customers and a brand name that is known in the industry to provide an unprecedented 95% accuracy rate.
International Expansion Opportunities. IUSA has been developing its database of international companies through its center in India in 2005. As of 4Q06, this database included 1.1 million non-US companies in approximately 170 countries. IUSA plans to open sales locations in South America, Europe, and Asia.
Valuation
Based on a five year Discounted Cash Flow model that takes into account growing margins from internet based subscriptions and a greater international presence, an intrinsic value of $18.87 was found. In addition to this 90% margin of safety, the company also boasts a 2.52% dividend yield. Compared to competitors, InfoUSA’s lower P/E ratio also signals that the company may be undervalued and selling for a cheap price.
Risks
Ability to maintain key personnel. The company would be negatively affected by the departure of key personnel that have been with the company throughout its growth. The company is highly dependent on such personnel to direct its research and development and other strategic objectives.
High amount of leverage. At the end of 2006, the company’s debt to equity ratio was 1.11. The company is relying heavily on its ability to generate sufficient cash flow to cover both its operating costs and debt requirements as they come due. Failure to meet covenants of this indebtedness would limit the company’s ability to expand and remain flexible.
Changes in Laws and Regulations. Because the company operates through direct marketing, privacy regulations will negatively affect the company. Such possibilities include the Federal Trade Commission expanding its “Do Not Call” requirements to include marketing research calls and other restrictions that limit the availability of personal and business information.
Vinod Gupta’s Significant Ownership. Vinod Gupta, founder and CEO of the company, has an overwhelming ownership in the company, which may lead to excess control and authority for Gupta.
23 Management
Vinod Gupta is the founder of the company and has been Chief Executive Officer from the inception in 1972. Gupta has extensive education in both the United States and India, including the Indian Institute of Technology and an M.B.A. from the University of Nebraska. Gupta was also appointed to a number of government positions under President Clinton. The majority of the company’s other officers and leaders have been with the company for many years, holding a number of different positions throughout their time.
Ownership % of Shares Held by All Insider and 5% Owners: 46% % of Shares Held by Institutional & Mutual Fund Owners: 55% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Vinod Gupta 18,618M 33.54% Cardinal Capital Management LLC 3,138M 5.65% Paul A Goldner 2,901M 5.23% Barclays Global Investors 2,109M 3.80% Columbia Wanger Asset Management 2,033M 3.66%
24 Journal Register Co. JRC Price: $6.00 ($5.49 - 10.98) Fiscal Year Ends: December 31, 2007
May 9, 2007 Paul Simenauer Russell 2000 Index: $835.42 ($668.58 - $835.17) Media Sector
Journal Register Company is a media company that owns and operated 27 daily newspapers and 368 non-daily publications as of December 31, 2006. The Company also operates 239 individual Websites that are affiliated with the Company’s daily newspapers, non-daily publications and its network of employment Websites. These Websites can be accessed at www.journalregister.com. All of the Company’s operations are clustered in seven geographic areas: Greater Philadelphia, Michigan, Connecticut, Greater Cleveland, New England, and the Capital-Saratoga and Mid-Hudson regions of New York. The Company owns JobsInTheUS, a network of 19 employment Websites and three commercial printing operations. The Company’s total paid circulation is approximately 616,000 daily, 635,000 Sunday and its total non-daily distribution is approximately 6.4 million.
Recommendation Key Statistics May 9 2007 Market Cap $234.74M Journal Register represents a deep value play Shares Outstanding 39.12M with very low downside and significant upside Average Volume 388,887 potential. Market participants have the general Beta v. Russell 2000 .69 perception that no one will ever read a EPS (TTM) $0.80 newspaper again. Nonetheless, I still believe that 2006 Estimated EPS $0.67 some old media companies will be able to P/E (TTM) NA survive, specifically old media companies P/E (Forward) 7.30 involved in the local newspaper business that WACC 4.5% have unique coverage for their local area. People Cash Flow/Share $0.1 will always want to read the local obituaries, Debt/Assets 66% sports, and police reports. In addition, Journal ROE -4.6% Register is also starting integrating electronic Net Profit Margin -1.23% content into its product line, which will be an Operating Margin 17.9% area where future growth will come from. EPS Growth Est (3 Year) 6% Target Price $9.50 Investment Thesis
People will continue to read local newspapers with local coverage. Newspaper with local content will survive because people have read them for their unique local information for the past several hundred years, and will continue to read these newspapers.
Integration of electronic media to accompany newspapers. Over the past year, management has begun to focus on building online content that augments the local print media it sells. Ad revenue from this segment will generate future growth.
Bargain price. Journal register’s stock has been beaten down over the past 2 years because the general opinion about old media stocks is that they have no future. The stock currently 25 trades at 1.5 book value, has a forward P/E ratio of 7, is profitable, and has strong assets generating stable cash flows.
Election year as catalyst. 2008 is an election year, which typically sees rates for ad space in newspapers increased due to rising demand as more people tend to read newspapers during election years to stay aware of what’s going on.
Valuation
Based on my discounted cash flow model, I believe Journal Register is worth $9.50 per share based on a WACC of 4.5% and a growth rate of 6%. Even if the company is unable to grow at a rate of 6%, a growth rate of 3% would give Journal Register a value of $7.50.
Risks
Substantial level of debt. As of December 31, 2006, the total debt load of Journal Register was $730.2 million, which represents a leverage ratio of approximately 5.7 times the Company’s twelve months trailing cash flow. As of December 31, 2006, the Company had net stockholders’ equity of $199.8 million and total capitalization of $930.0 million and, accordingly, the percentage of the Company’s indebtedness to total capitalization was 78.1 percent.
Value Trap. The biggest risk for Journal Register is that its stock will remain at its relatively low price of $6.00 per share. Even though the company is in a stable, mature business and generates strong cash flows, growth initiatives may be ignored by other market participants who have written off Journal Register as an old media stock that is headed no where.
Industry Competition. The Company’s business is concentrated in newspapers, web sites and other print publications located primarily in small metropolitan and suburban areas in the United States. Competition for advertising and paid circulation comes from local, regional and national newspapers, shopping guides, television, radio, direct mail, online services and other forms of communication and advertising media.
Dependence on Local Economies. The Company’s advertising revenues and circulation revenues are dependent on a variety of factors specific to the communities that the company’s newspapers serve. These factors include the size and demographic characteristics of the local population, local economic conditions in general, and the related retail segments in particular, as well as local weather conditions. The Company’s Michigan and Ohio clusters are particularly impacted by the automotive sector.
Management
Robert M. Jelenic, age 56, is Chairman and Chief Executive Officer of the Company. Mr. Jelenic was President and Chief Executive Officer from the inception of the Company to June 2005 and has been Chairman of the Company since 1997. Mr. Jelenic has also been a director of the Company and its predecessors for over ten years. A Chartered Accountant, Mr. Jelenic began his business career with Arthur Andersen in Toronto, Canada. Mr. Jelenic has 30 years of senior management experience in the newspaper industry, including 12 years with the 26 Toronto Sun Publishing Corp. Mr. Jelenic graduated Honors, Bachelor of Commerce from Laurentian University, Sudbury, Ontario. Mr. Jelenic is a director of the Audit Bureau of Circulations ("ABC") and Lamar Advertising Company, where he also serves on its Audit Committee.
Ownership
% of Shares Held by All Insider and 5% Owners: 1% % of Shares Held by Institutional & Mutual Fund Owners: 94% *Source: Yahoo! Finance
Top 5 Holders
Percent of Shares Holder Shares Held Outstanding DIMENSIONAL FUND ADVISORS 3,171,826 8.11% Barclays Global Investors UK 2,878,099 7.36% Holdings Ltd PRICE (T.ROWE) ASSOCIATES 2,755,820 7.04% PRIVATE MANAGEMENT 2,365,261 6.05% GROUP, INC. ROYCE & ASSOCIATES, INC. 1,947,600 4.98% *Source: Yahoo! Finance
27 28 K-Swiss Inc. KSWS Price: $29.07 ($22.54-$37.81) Fiscal Year Ends: December 31
Date: April 27, 2007 Jason Bednar Russell 2000 Index: 825.57 (668.58 – 835.17) Consumer Goods Sector
K-Swiss, Inc. was founded in 1966 and is headquartered in Westlake Village, California. K-Swiss, Inc., together with its subsidiaries, primarily engages in the design, development, and marketing of athletic footwear for sports use, fitness activities, and casual wear. The company offers its footwear products under the brand names, ‘K-Swiss’ and ‘Royal Elastics’. It also markets apparel and accessories under the brand name, ‘K-Swiss’. K-Swiss, Inc. sells its products through sales executives and independent sales representatives to specialty athletic footwear stores, pro shops, sporting good stores, and department stores in the United States. The company also sells its products through its Web site, kswiss.com, as well as through foreign distributors internationally.
Recommendation
K-Swiss has limited downside due to a significant Key Statistics May 8, 2007 amount of cash on hand and an established brand. Market Cap $1.01B The company continues to expand internationally Shares Outstanding 34.61M where its margins prove to be better than domestic Average Volume 428,589 operations. Over the past five years, K-Swiss’ ROE Beta 1.13 has exceeded 20%. Also, gross profit margin has EPS (TTM) $1.98 been on the rise each of the last five years, rising 2007 Estimated EPS $1.38 from 44% to the current level of 47%. We believe P/E (TTM) 14.72 that despite the company’s lowered projections for PEG 1.44 the current fiscal year, they have taken the necessary WACC 10.56% steps to limit sales declines domestically while Dividend Yield 0.70% simultaneously maintaining international growth. ROE 24.75% Revenues, income, and EPS for the year appear to be Gross Margin 47.33% isolated declines in the company’s long history of Operating Margin 19.89% growth and profitability. Based on my DCF, we Target Price $36.00 arrived at an intrinsic value and target price for the stock of $36. Following the earnings release and conference call on April 26th, the stock hit an intraday high of 32.29. The stock has since retreated back to its levels prior to the first quarter earnings release of $29.07 per share.
Investment Thesis
Solid, Established Brand. Few companies can compare to K-Swiss’ ability to maintain a nearly unchanged product for over forty years. K-Swiss and its “Classic” style, first introduced in 1966, still exist today. This key product line accounts for over 70% of sales and has been expanded to include numerous variations.
29 Buyout candidate. K-Swiss is a buyout candidate as it possesses many of the qualities acquiring firms seek. A large amount of cash churns from this business, continually strengthening the debt-free balance sheet. Also, given a lower outlook and slower U.S. sales, much of the bad news can be considered to be priced into the stock price. Essentially, this short-term news undervalues the stock, especially when compared to other footwear firms recently bought out (Converse, Reebok, and Puma). K-Swiss also holds approximately $7.60 per share in cash.
Rapidly increasing international sales. K-Swiss has shifted much of its attention to the fastest growing part of its business, the international segment. Since 2004, the company has grown international revenue by 40-50% per year. In 2004, international sales comprised 17% of total sales, but that figure is expected to exceed 40% this fiscal year. The company also has plans to expand its apparel lines, particularly in the international arena where its brand receives greater recognition.
Avoidance of costs associated with retail stores. K-Swiss does not operate retail stores or outlet stores domestically, which often bring significant costs for similar companies. Instead, they are able to focus on other parts of their business, as well as their online store. The company, however, does foresee opening stores in the United States, ultimately when the apparel portion of the business takes hold (Q108). It currently does have stores that it operates or are operated by its distributors internationally.
Valuation
A 15-year discounted cash flow analysis indicates that K-Swiss’ intrinsic value is $36.03. The growth rates used in the model range from 6%-8% with a terminal growth rate of 3%. The company currently trades at a PE of 14.17 and a forward PE of 17.80. Also, Price/Sales is at 2.02 while the Price/Book sits at 2.93. Both of these metrics lie below the industry averages of 2.3 and 4.2, respectively. The Price/Book is also below K-Swiss’ historic value of approximately 4 for this measure. Other footwear companies that have been acquired recently, Reebok and Puma, have both been valued at 13 and 12.2 Enterprise Value/EBITDA, respectively. K-Swiss currently has a value of 7.27 for this metric. K-Swiss also pays a 20 cent annual dividend, yielding 0.7%.
Risks
Declining domestic sales. Domestic sales declined 18% last year and are expected to drop another 30% this year. This is underscored by the lower future orders year-over- year. The company has forecasted overall lower sales for the year, coming in between $415-$440 million which is below the $500 million originally expected by analysts. Also, for the first time, international backlogs are higher than domestic.
Steve Nichols holds 70% of the voting power. The chairman of the board and president of K-Swiss holds a significant, large majority of the total shareholder voting power. This comes through his substantial holding of Class B common stock (92%).
30 Decrease in backlog orders. K-Swiss has lowered its revenue forecast due in large part to a decrease in backlog orders for the remainder of the year. The company has noted double-digit declines in backlog orders domestically, partially offset by equal percentage increases internationally. The company did announce during their conference call that Foot Locker, its largest customer at 15% of sales, has booked orders 40% below last years levels.
Management
The management of K-Swiss boasts significant experience in the footwear and apparel industries. Chairman of the Board and President Steven Nichols has held these positions since 1987. Prior to working with K-Swiss, he was the Vice President of Merchandise at Stride Rite Corp. George Powlick has been with the company since 1988 and serves various roles including COO, CFO, and Secretary.
Ownership % of Shares Held by All Insider and 5% Owners: 0% % of Shares Held by Institutional & Mutual Fund Owners: 92%* (*This constitutes only Class A shares) Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Barclays Global Investors UK Holdings 2,593,180 7.49% Third Avenue Management 2,305,078 6.66% Allianz Global Investors of America 1,931,957 5.58% The Vanguard Group, Inc. 1,160,414 3.35% FMR Corporation 1,112,909 3.22%
31 Marlin Business Services Corp. MRLN Price: $20.67 ($19.56-24.40) Fiscal Year Ends: December 31
Date: May 7, 2007 Gregory Sirotek Russell 2000 Index: 829.70 (668.58 - 835.17) Consumer Services Sector
Marlin Business Services Corp. provides equipment financing solutions primarily to small and mid-size businesses in the United States. It finances commercial equipment, including copiers, certain commercial and industrial equipment, computers, telecommunications equipment, security systems, restaurant equipment, closed circuit TV security systems, computer software, medical equipment, automotive equipment, water filtration systems, cash registers, and office furniture. The company also offers insurance products; factoring, which provides small business customers working capital funding through the discounted sale of their accounts receivables; and business capital loans that enables small business customers access to credit through term loans. Its products and services are sold through independent equipment dealers and lease brokers. The company was founded in 1997 went public in 2003, and is based in Mount Laurel, New Jersey.
Recommendation
Marlin Business Services Corp. estimates that there Key Statistics May 7, 2007 are up to 75,000 independent equipment dealers who Market Cap $252.01M sell the type of equipment they finance. Their Shares Outstanding 12.11M existing network consists of only 10,900 of these Average Volume 63,393 companies, and leaves considerable room for growth. Beta 0.910 The company also targets the small and mid-size EPS (TTM) $1.53 independent equipment dealers because they believe 2007 Estimated EPS* $1.85 the segment is underserved by the large commercial P/E (TTM) 13.53 finance companies and large commercial banks. PEG 0.78 Often, these larger companies focus on equipment WACC 5.52% manufacturers and larger distributors, and do not Debt/Assets 77.68% have the infrastructure capable of servicing high- ROE** 15.09% volume, low balance transactions of small to mid- ROA** 2.54% size businesses. Gross Margin** 28.39% Marlin is focused on establishing Operating Margin** 49.76% relationships with independent equipment dealers to Target Price $24.72 meet their need for high-quality, convenient point-of- Sources: Yahoo! Finance; *Thomson sale lease financing programs. Also, Marlin’s fully Analytics; **Morningstar; integrated account origination platform enables them to process and service a large number of low-balance financing transactions. The relative youth of the company, the untapped market, and the focused business plan should allow for considerable revenue growth in the near future. These factors combined with the under pricing of the stock provide for what we believe to be an excellent buying opportunity.
32 Investment Thesis
Disciplined Growth Strategy. Marlin’s primary objective is to enhance their current position as a provider of equipment financing solutions primarily to small businesses by pursuing a strategy focused on organic growth initiatives. Also, by establishing offices in strategic locations around the country, the company can expand the reach of its sales force.
Introduction of two new products. In November, 2006, Marlin announced the introduction of two new financial products targeting the small business market; factoring and business capital loans. It is too early to tell if these two product offerings will be successful, however, these products help diversify their product mix. Favorable Valuation. The results of the fundamental analysis suggest that the stock is very much underweighted. The PEG ratio of the 0.71 is below the industry average of 0.80. All data suggests that this stock is undervalued at the moment. Valuation
A 10-year discounted cash flow analysis yields an intrinsic value for MRLN of $23.87, with a 5% margin of safety. The model assumes sales growth of 15% for five years, 8% growth for the next five years, and a terminal growth rate of 5%. Currently, the company is trading at a lower than industry P/E multiple. Given recent news, our FY07E EPS estimate was lowered to $1.67, and, at a multiple of 15x the price target is $25.05. The four year average P/B ratio for MRLN is $2.45, and it is currently trading at $1.82. Although this ratio is consistent with its competitors, MRLN does produce a higher ROE. A P/B ratio of $2.20 yields an intrinsic value of $24.99. A combination of the three valuation methods yields an intrinsic value of $24.72 and a potential upside of 19.61%.
Risks
Inaccurate in assessing the creditworthiness of end user customers. This could result in a higher number of lease defaults, which may restrict Marlin’s ability to obtain additional financing and could reduce earnings. Also, MRLN specializes in leasing equipment to small businesses, which may be at a greater risk than large business to an economic downturn. Furthermore, there is typically only limited publicly available financial and other information about small businesses, and they often do not have audited financial statements.
Highly fragmented and competitive industry. Many competitors are substantially larger and have considerably greater financial, technical, and marketing resources than MRLN. Some competitors may have a lower cost of funds, which could enable them to offer leases with lower yields. This could potentially force MRLN to decrease their yields or lose origination volume. Also, there are few barriers to entry in the small- ticket equipment leasing industry. The companies that typically provide financing for large-ticket or middle-market transactions could begin competing with Marlin on small- ticket leases.
33 Management
Daniel P. Dyer has been Chairman of the Board of Directors, CEO and Treasurer since co- founding the company in 1997. His most notable position prior to Marlin was as Senior Vice President and CFO of Advanta Business Services. It is also worth noting that both the CEO and CFO are Certified Public Accountants.
Ownership % of Shares Held by All Insider and 5% Owners: 29% % of Shares Held by Institutional & Mutual Fund Owners: 68% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Blair (William) & Company, L.L.C 1,016,988 8.40% JP Morgan Chase & Company 1,005,465 8.30% Columbia Wanger Asset Management, L.P. 685,000 5.66% Pequot Capital Management, Inc. 656,448 5.42% Mason Street Advisors, LLC. 630,850 5.21%
34 Medical Properties Trust Inc. MPW Price: $14.06 ($10.25-16.70) Fiscal Year Ends: December 31
Date: May 7, 2007 Barrett Willich Russell 2000 Index: 833.51 (668.58 - 835.17) Financial Services Sector
Medical Properties Trust Inc. (MPW) is a Real Estate Investment Trust (REIT) that acquires, develops, and leases healthcare facilities. They lease their facilities to experienced healthcare operators with long-term leases that require the tenant to bear most of the operating costs. The company focuses on acquiring and developing rehabilitation hospitals, long-term acute care hospitals, regional and community hospitals, women’s and children’s hospitals and ambulatory surgery centers. The company was started in August 2003, and is currently based out of Birmingham, Alabama.
Recommendation
MPW has a different strategy than most Key Statistics May 7, 2007 healthcare REITs, which generally invest in Market Cap $691.68M assisted living facilities and medical offices. Shares Outstanding 49.20M MPW invests in high-tech, up-and-coming areas Average Volume 734,121 of health care. They specifically target hospital Beta 0.61 operators with above average profit margins. EPS (TTM) $0.75 60% of their portfolio is in general acute care 2007 Estimated EPS $1.02 hospitals with the majority of the rest in other P/E (TTM) 18.11 licensed hospitals. They provide an opportunity PEG 2.12 for hospital operators to free up cash and reinvest WACC 7.36% in operations. They advise their tenants’ Debt/Assets 33.49% operations and financing during hard economic ROE 8.62% times. MPW’s management experience in the Operating Margin 55.74% healthcare industry has recently helped them to Target Price $16.50 take over operations of a defaulting tenant and turn an inevitable loss into a $5.0M gain. The stock has recently dropped, because of a new equity issuance of 9.0M shares, priced at $15.20, diluting shareholder’s equity. The target price is $16.50 with a healthy dividend at $1.08 (7.36%).
Investment Thesis
High dividend yield. The current dividend yield is at 7.36%. In 2006, MPW had the highest total shareholder return for all healthcare REITs and the second highest total shareholder return for all REITs.
Excellent management. Although the company is young, MPW’s managers have an average of 25 years experience in healthcare related industries.
35 High, aggressive growth. Management has already completed half of the 2007 acquisition goal ($200M) during the first quarter. 2006 rental revenue increased 48.81%.
Defensive position in REITs. Investments in commercial or residential properties could be exposed to a downturn in the real estate market, along with the sub-prime mortgage blow up. Healthcare real estate is a segment that is not driven as much by changes in the economy and the aging baby boom generation will require more medical attention in the future.
Portfolio allocation. Moving into the non-actively managed part of the year, it is important to have a balanced financial services sector in relation to the Russell 2000. The current portfolio is heavily weighted in financials and insurance companies with no holdings in REITs, which composes 22.13% of the sector.
Valuation
A comparables model based on a peer group of healthcare REITs indicates that MPW’s intrinsic value is $16.50 on the basis of P/E and P/B multiples. This valuation factors in the new placement of 9.0M shares from February 2007 and no forward earnings. A dividend discount model calculated an intrinsic value of $16.32. The expected return for the year end, including both capital appreciation and the next three quarters of dividends, assuming no dividend growth, would yield a 15.71% return.
Risks
Revenues dependent on limited number of investments. The bulk of revenues come from two medical operators, Vibra Healthcare, LLC (55% of 2006 revenues) and Prime Healthcare Services, Inc (19.4% of 2006 revenues). MPW recognizes this problem and is actively searching to add new tenants.
Limited location diversification. Properties in California account for 39.7% of 2006 total revenues. The remaining revenues come from other properties in nine states. These states contribute 2.0% to 13.6% of the company’s total revenue.
Short performance history. The REIT’s taxable status began April 6, 2004. The company has been around for less than four years and does not have much historical data to analyze. The business model has not been tested in different situations and economic environments.
Property values and interest rates. Revenues are composed of 75.6% rents and 24.4% fee income from loans. A decrease in property values could cause a weakened balance sheet and possible impairments. Changes in interest rates could drive down margins and possibly hinder tenants’ ability to pay rents.
36 Management
MPW has extensive experience in the healthcare industry. The managers’ previous positions in other firms include healthcare real estate, investment banking in healthcare, public accounting, and healthcare and transactional law. The CEO and founder, Edward K. Aldag, Jr., previously managed two private real estate companies with similar sizes to MPW. The management team has a long-term focus and do not worry about short-term and seasonal results.
Ownership % of Shares Held by All Insider and 5% Owners: 2.0% % of Shares Held by Institutional & Mutual Fund Owners: 59.0% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Vanguard Group 2,334,034 4.74% AXA 2,082,196 4.23% Heartland Advisor Inc. 1,348,800 2.74% Cohen & Steers Capital Management, Inc. 1,269,900 2.58% Barclays Global Investors UK Holdings Ltd 1,223,729 2.49%
37 Radiation Therapy Services Inc. RTSX Price: $29.66 ($22.01-$34.94) Fiscal Year Ends: December 31
Date: May 4, 2007 Katie Koutnik and Chris Williams Russell 2000 Index: $832.88 (668.58-835.17) Health Care Sector
Radiation Therapy Services, Inc. is the country’s largest operator of radiation-treatment facilities to cancer patients in the United States. It owns, operates, and manages treatment centers that primarily focus on providing radiation treatment alternatives for various cancers, including prostate, breast, lung, and colorectal. The company’s radiation treatment alternatives include conventional external beam radiation therapy, image guided radiation therapy, 3-D conformal treatment planning, respiratory gating, brachytherapy, stereotactic radio-surgery, and intensity modulated radiation therapy. It owns 67 freestanding and 10 hospital-based treatment centers in 16 states. Radiation Therapy Services has been a public company since 2004. The company was founded in 1983 and is headquartered in Fort Myers, Florida, home to one of the nation’s largest per-capita senior populations.
Recommendation
As a company, Radiation Therapy Services, Inc. Key Statistics May 4, 2007 presents itself favorably due to its cutting edge Market Cap $676.81M technological radiation equipment during a time where Shares Outstanding 23.43M cancers as well as aging baby boomers are on the rise. Average Volume 160.502 As an investment, RTSX would be a profitable Beta 1.48 addition to the AIM portfolio. Over the last five years EPS (TTM) $1.26 Radiation Therapy Services has averaged yearly 2007 Estimated EPS $1.58 revenue growth of 26%; this revenue will continue to P/E (TTM) 22.86 rise with the aging population and the number of new PEG 0.91 facilities. Radiation Therapy Services has continually WACC 10.74% been an industry leader in managing their costs and Debt/Assets 51.43% maintaining a high EBITDA and Operating Margin. ROE 26.35% Their successful business plan of entering new Gross Margin 39.6% markets by purchasing existing facilities and practices, Operating Margin 20.38% and expanding them has made Radiation Therapy Target Price $36.00 Services a leader in their industry. Based on a target price of $36.00, this stock is an attractive buy.
Investment Thesis
Increased prevalence of cancer. Cancer is the second leading cause of death in the United States. In 2007, the American Cancer Society estimates there will be 1.5 million new cancer cases diagnosed in the United States and that cancer will account for one in every four deaths. Also, according to the American Society, approximately 50% to 60% of patients diagnosed with cancer receive radiation therapy.
38 Leader in advanced radiation treatment alternatives. Within local markets, Radiation Therapy Services is the leader in providing the most advanced radiation therapy alternatives. The advanced radiation treatment alternatives provided are designed to deliver more effective radiation directly to the tumor while minimizing harm to surrounding tissues and therefore reducing side effects.
High barriers to entry. A key advantage for the company is that the industry is highly fragmented. Most of the country’s 2000 radiation therapy centers are usually operated by small groups of local doctors or hospitals that don’t have the resources to invest millions of dollars in the newest technology or the influence to negotiate lower prices for that technology.
Aging baby boomers. Cancer is predominantly a disease of the elderly and there currently is an influx of baby boomers reaching this age. Radiation Therapy Services is targeting areas where there is a large concentration of the elderly.
Valuation
Based on a 10-year discounted cash flow analysis, Radiation Therapy Service’s intrinsic value is $35.82. According to a relative valuation model based on the forward P/E of firms in the medical practitioner industry, the stock should be valued at $37.50. We believe a target value of $36.00 is reasonable.
Risks
Reimbursement reductions. Any changes that result in reimbursement reductions will decrease their revenue in take. Acting on reimbursements, RTSX retains two lobbyists in Washington D.C. and is active in industry associations that lobby Congress for funding.
Dependence of revenues from Medicare and commercial payers. Payments from government Medicare and Medicaid programs represented approximately 52% of net patient service revenue in 2006. This is due to the high proportion of cancer patients over the age of 65. Approximately 46% of our net patient service revenue in 2006 resulted from commercial payers such as managed care organizations and private health insurance programs. While commercial payer rates are generally higher than government program reimbursement rates, commercial payer rates are based in part on Medicare reimbursement rates and when Medicare rates are lowered, commercial rates are often lowered as well.
Competition among local markets. Entering a new market where a local radiation name is already established provides an increased need for quick cohesion of the Radiation Therapy Services name in the new market.
Insider Ownership. Management owns 47.07% of shares. Additionally, top management also serves on the board of directors. As a result, management collectively is able to determine the outcome of all matters submitted to shareholders for approval regardless of the preferences of our other shareholders.
39 Management
All senior executives have top industry experience. Dr. Daniel E. Dosoretz, M.D. and Dr. Howard Sheridan, M.D., co-founders of the Radiation Therapy Services are pinnacle assets of the company. Dosoretz serving as the CEO, president, and executive director, has taught and served his residency at Harvard Medical School where he was also selected Chief Resident of the department. While Sheridan serves as the chairman of the board, and has practiced interventional radiology and diagnostic radiology in Fort Myers, Florida from 1975 to the present. Together, Dosoretz and Sheridan have penetrated into an industry that used to be solely run by hospitals, and concentrate their services on superb patient care, the newest technology, and physician relations.
Ownership
% of Shares Held by All Insider and 5% Owners: 47.07 % % of Shares Held by Institutional & Mutual Fund Owners: 49.00 % *Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Dosoretz, Daniels 3,457,000 14.757% Rubenstein, James 2,465,000 10.521% Katin, Michael 2,223,000 9.490% Sheridan, Howard 2,211,000 9.438% Copper Rock Capital Partners LLC 1,120,000 4.783% *Source: Bloomberg
40 Watsco Inc. WSO Price: $55.73 ($41.50 - $66.95) Fiscal Year Ends: December 31
Date: May 6, 2007 Luke Lamanna & Andy O’Connell Russell 2000 Index: 832.88 (668.58 - 835.17) Industrial Materials Sector
Watsco Incorporated is the nation’s leading HVAC/R distributor. The company carries a wide variety of heating and cooling products, with the majority of its revenue tied to air conditioning unit replacement sales. Watsco also offers service, parts and supplies to accompany the units that it sells. Founded in 1945, WSO is headquartered in Coconut Grove, FL. The company is a distributor in 32 states, with approximately 380 locations in which it operates. Major competitors include HD Supply, Johnstone Supply, US Airconditioning Distributors, ACR Group, as well as over 1300 local and regional HVAC/R distributors.
Recommendation
Watsco operates as the leader in HVAC distribution Key Statistics April 26, 07 in a highly fragmented industry. With a proven track Market Cap $1.48B record of sound acquisitions, the company has taken Shares Outstanding 27.85M advantage of its position in the market and has Average Volume 432,527 developed a sound growth strategy. The excellent Beta*** 1.38 financial health of the company allows for consistent EPS (TTM) $2.88 growth through acquisition. After a down year due 2007 Estimated EPS* $3.28 to new governmental regulation in 2006, Watsco is P/E (TTM) 19.32 poised to take advantage of its solid and proven PEG 1.13 operating margin. Recent initiatives to consolidate WACC*** 11.78% its operating branches have decreased operating Debt/Assets 4.23% costs. Further consolidation in 2007 is expected to ROE** 17.09% improve its already healthy margins. We are ROA** 11.85% recommending the addition of WSO to the AIM Gross Margin** 25.7% portfolio with a target price of $64.00. In addition, Operating Margin** 7.53% Watsco has a trailing annual dividend yield of Target Price $64.00 1.90%. Sources: Yahoo! Finance; *Thomson;**Morningstar;***Bloomberg
Investment Thesis
Scalable Growth Strategy. Watsco’s primary method for growth has been acquisition. They focus on finding proven companies in the industry with good customer relationships. They also have acquired distressed companies and brought them back to financial prosperity. With the industry being so fragmented, Watsco has many companies to choose from. Watsco has proven to be successful in identifying potential companies for acquisition, having made 51 acquisitions since 1989. Watsco is currently in excellent financial health and has made it well known that they are in the market for additional acquisitions.
41 Favorable Industry and Market Trends. While Watsco does have a portion of revenue tied to new housing starts, the HVAC industry is ultimately driven by repair and replacement. Potential downturns in the economy and housing will not hurt Watsco as much as other companies that serve the housing sector. Also, there are two positive industry trends. First, the percentage of homes equipped with A/C units is increasing. Secondly, the price per unit has been increasing due to government regulation and a trend of increased square footage per home. Larger homes in turn require higher powered cooling units, which are also more expensive.
Leader in a Fragmented Market. Watsco is the industry leader in a market that is extremely fragmented. The company leads the industry in market share with only 7%, leaving a great deal of room for growth in existing and future markets. This room for growth partnered with sound acquisitions could be very beneficial for Watsco. Also, Watsco’s competitors are under capitalized and are not as adaptable to market changes. As the industry leader, Watsco does enjoy some amounts of purchasing power which has helped the increasing margins.
Replacement Driven. Of the revenue from new unit sales, 75% of the sales are driven by replacements of existing units. The average replacement occurs between 8 and 20 years after the unit was installed. Watsco’s exposure to downturn in new housing starts is limited, as a majority of new unit sales is tied to replacement. Valuation
A 10-year discounted cash flow analysis indicates that Watsco’s intrinsic value is $67.82. The model assumes sales growth of 10% for 5 years followed by 5 years of 8% growth, and a terminal rate of 3%. The model also factors in an increasing operating margin due to improved efficiency from branch consolidation. With the company’s P/E ratio at 19.32 and assuming an estimated EPS FY07 of 3.28, the one-year target price, yields a target price of $63.37. Taking into account both of these valuation metrics, our target price for Watsco is $64.00. In addition, Watsco has been paying out dividends at an increasing rate, with the most recent quarterly dividend equaling $0.33 per share.
Risks Ability to execute successful acquisitions. A large portion of Watsco’s growth is generated through acquisitions. The inability to find attractive candidates would slow sales and profitability growth. Other risks related to acquisitions including: new stock issues and successful integration of the acquired company, could negatively affect stockholder returns as well.
Supplier concentration. Over 47% of Watsco’s revenues are generated from seven suppliers, and 17% are generated from their top supplier. Dissolution of any of these supplier relationships would impact Watsco’s performance materially.
Seasonality. Revenues are seasonal. The 2nd and 3rd quarters are traditionally the best revenue quarters for AC products, and the 4th quarter is traditionally the best heating quarter. A warm winter or cool summer, and vice versa, will impact the need for replacement during these seasons, increasing or decreasing revenues. 42 Management
Albert H. Nahmad has been Watsco’s CEO since 1973. He has helped move Watsco from an HVAC manufacturer to the nation’s largest HVAC distributor. With a background in Industrial Administration and Mechanical Engineering, Nahmad has the expertise and a vision of how to continue to grow Watsco. Along with Senior Vice President Barry S. Logan, who has CFO experience, Nahmad has continued to express his goals of growing the company through the “build and buy” growth strategy.
Ownership % of Shares Held by All Insider and 5% Owners: 5% % of Shares Held by Institutional & Mutual Fund Owners: 95% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Barclays Global Investors UK Holdings Ltd 1,244,816 5.16% Basswood Capital Management, L.L.C. 1,204,973 4.99% Mellon Financial Corporation 1,194,689 4.95% Lord Abbett & Co 1,131,689 4.69% Granahan Investment Management Inc. 1,101,595 4.56%
43 Ceradyne Inc. CRDN Price: $63.99 ($38.72 - $64.40) Fiscal Year Ends: December 31
Date: May 6, 2007 Luke Lamanna and Andy O’Connell Russell 2000 Index: 832.88 (668.58 - 835.17) Industrial Materials Sector
Ceradyne Inc. operates in the aerospace and defense industry within the Industrial Materials sector. The company develops and manufactures advanced technical ceramic products and components. Advanced ceramics are more lightweight and durable than alternative materials such as steel, glass and plastic. Additionally, advanced ceramics have a higher temperature durability and resistance to friction, wear, and corrosion. While these products are used for industrial, automotive and consumer applications, the primary use is for military and defense applications. Major competitors of Ceradyne are Armor Holdings, Armor Works, Kyocera and privately held CoorsTek. Founded in 1967, Ceradyne runs its operations out of Costa Mesa, California.
Recommendation Key Statistics April 30, 2007 Ceradyne has established themselves as a niche Market Cap $1.74B player within the highly fragmented advanced Shares Outstanding 27.14M ceramics market. As a niche player, Ceradyne has Average Volume 702,857 concentrated primarily on ceramic body armor, as Beta 1.51 well as other products including ceramics EPS (TTM) 4.70 powders, and orthodontics. Since, 2002, Ceradyne 2007 Estimated EPS 5.27 has been the primary supplier of body armor for P/E (TTM) 13.6 the U.S. military and Allied forces. This has PEG** 1.4 driven their revenue from $61.2 million in 2002, to WACC 14.79% $662.9 million in 2006. Now, with a balance sheet Debt/Assets 4.23% consisting of over $250 million in cash, Ceradyne ROE** 39.69% is pursuing strategic acquisitions, as well as ROA** 24.60% launching new ceramics based products to Gross Margin** 39.4% diversify and grow its business in light of their Operating Margin** 29.1% heavy reliance on body armor sales. The intrinsic Target Price $53.69 value of Ceradyne’s stock is $53.69, which is 19% Sources: Yahoo! Finance; *Thomson lower than its current stock price of $63.99. Based Analytics; **Morningstar on this stock price, Ceradyne is not currently a good buy. So our recommendation is to monitor this stock, looking for either a price drop or better visibility of earnings into the future.
Investment Thesis
Leadership position in niche market. Ceradyne is the leading provider of ceramic body armor to the U.S. military. They have held this leadership role since 2002, when they were awarded the first large volume body armor defense contracts. Ceradyne reestablished this position in 2006 when they were awarded a second generation body armor contract, which is scheduled to last through 2007.
44 Vertical integration from production of raw materials to customer design of ceramics for customer. With complete control of the design and manufacturing process, Ceradyne can ensure quality and timeliness of product delivery to their customers. Trade secrets are more easily safeguarded in this research and development intensive industry as well.
Emerging technologies opportunities. Ceradyne has several recently developed products with large revenue potential. Vehicle armor, materials for nuclear material containment, and ceramic crucibles for the manufacturing of silicon for photovoltaic solar cells have all been developed in an effort to diversify revenues. Vehicle armor has a projected market size larger than body armor, and will begin producing revenues in 2007. The latter two products are also scheduled to being producing sales in late 2007.
Valuation
A 10-year discounted cash flow analysis indicates that Ceradyne’s intrinsic value is $53.69. The model assumes free cash flow growth of 12% for 2007, a -15% decline for 2008, followed by 15% growth until 2016, and a terminal growth rate of 4%. Diversification efforts and strategic acquisitions are assumed to drive the growth in the model. Relative valuation methods were not as appropriate for Ceradyne due to the expected decrease in future EPS.
Risks
Customer Concentration. Over 73% of Ceradyne’s revenues were tied to government spending in 2006. A cut in defense spending will adversely affect Ceradyne’s revenues.
Reduction in gross margin. Ceradyne has been increasing gross margin from 21.4% in 2002, to 39.4% in 2006. A reduction in gross margin due to competitive or legislative pressures will adversely affect Ceradyne’s EPS.
Product development success. Keeping a leading edge in body armor, as well as other product development efforts will be critical to short and long term success.
Management
Joel P. Moskowitz was a co-founder of the company in 1967, and currently serves as the Chairman, President, and CEO of Ceradyne. Except for an eight month gap in 1967 from January to September, Moskowitz has served as the president of Ceradyne for its entire existence. Mr. Moskowitz has a degree in Ceramic Engineering, as well as an M.B.A from the University of Southern California.
45 Ownership % of Shares Held by All Insider and 5% Owners: 6% % of Shares Held by Institutional & Mutual Fund Owners: 92% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Munder Capital Management 1,668,737 6.15% Barclays Global Investors UK Holdings 1,476,390 5.44% Ivory Investment Management L.P. 1,000,000 3.68% Vanguard Group 817,420 3.01% Smith Asset Management Group, L.P. 808,342 2.98%
46 Frontier Financial Corp. FTBK Price: $25.34 ($21.08-$31.33) Fiscal Year Ends: December 31
Date: May 4, 2007 Stan Zurawski Russell 2000 Index: 832.88 (668.58 - 835.71) Financial Services Sector
Frontier Financial Corp. (FTBK) is a regional bank headquartered in Everett, Washington. Founded in 1978, Frontier has grown to more than $3 billion in assets, making it the largest financial institution headquartered in Snohomish County. The bank operates more than 45 branches in eight counties surrounding Seattle. Frontier emphasizes commercial real estate and residential construction lending to customers in its region. In February of 2006, the bank acquired Northstar Financial Corporation. FTBK plans to open two branches in the Puget Sounds area sometime between 2Q07 and 4Q07. Major competitors of Frontier include Washington Mutual, Bank of American, Cascade Financial, and City Bank.
Recommendation
Frontier is an excellent franchise, with a high Key Statistics May 4, 2007 ROA (2.26%) and ROE (18.48%). Management Market Cap $1.13B has excelled in limiting expense growth and Shares Outstanding 44.82M focusing on the franchises’ core competency. The Average Volume 239,729 loan composition is heavily weighted toward Beta 1.30 construction (47% of total loans) which is risky EPS (TTM) $1.55 and the stock could suffer with the downturn in the 2007 Estimated EPS $1.61 real estate sector. Nonetheless, this type of P/E (TTM) 16.22 lending can be quite profitable if management is PEG 1.43 aware of the risks and understands how to WACC 10.03% originate and underwrite the loans. Past records Debt/Assets 11.39% show managements ability to run a profitable ROE 18.48% bank. An extremely low efficiency ratio (37.33%) Efficiency Ratio 37.33% is coupled with low non-performers (.35% of Net Interest Margin 5.72% assets) and minimal net charge offs (.11% of Target Price $29.53 loans). In addition, the reserve for losses is well funded (1.38% of loans). With the recent hit to the residential sector and the continued underperformance through the rest of the year, the stock will be negatively affected and fall to a more attractive buying price.
Investment Thesis
Strong Profitability: Management has constructed a high-quality franchise with industry-leading profitability. ROA and ROE of 2.26% and 18.48% respectively are well above competitor’s average of 1.30% and 14.02%. Frontier has been able to increase its net interest margin the last three years and is now up to 5.72% despite a flat yield curve. Frontier’s efficiency ratio at 37.33% has also shown consistent improvement over the last three years and is much better than the peer average of 55.51%. 47 Strong Asset Quality: Frontier has been able achieve high profitability while maintaining strong asset quality. Nonperforming assets to total assets was a minimal . 27% in 2006. In 1Q07 this number did increase 9bps, however this was due to a single relationship, and management does not anticipate any losses resulting from these well collateralized loans. Net charge offs are also minimal, currently at .11% of average loans. The reserves to loans ratio is 18bps above FTBK’s peers at 1.38%.
Positive Demographics: Frontier’s market area is growing while becoming more affluent. The projected population change for 2006-2011 for the MSA at 6.95% is 60bps above the average for the state of Washington and 30bps above the aggregate national average. In addition, the median household income in 2006 for Frontier’s MSA was $62,937 well above the national average of $51,546 and is expected to grow at a rate 151bps above the national average.
Valuation
A 10-year discounted cash flow analysis indicates that Frontier’s intrinsic value is $28.73. A dividend discount model yields a vale of $25.65. The one-year target price, assuming a $1.61 FY07 EPS estimate and the current PE of 16.7, is $26.89. Taking these three valuation metrics into account, the target price for Frontier is $29.60; or a 16.8% return. The current dividend yield is 2.53%.
Risks
Loan Composition: 94% of loan growth in 1Q07 was construction loans. Currently, construction loans make up 47% of loans, with 80% of that being residential. Due to a slowing in the construction market earnings may be hit in the next few quarters. Strong construction loan growth has driven the strong NIM and profitability. Future deceleration in construction growth may reduce volume for as long as the next 12 months. Commercial lending involves higher average loan balances and loans that are more complex to originate and underwrite.
Dependent on local economy: Frontier is dependent on the Seattle area economy and market for both its source of funds and origination of loans. In the event of a decline in the local economy, profitability could suffer. In particular, Frontier’s large commercial base is inherently dependent on the macroeconomic situation for growth and profitability. A high percentage of loans in construction represents significant concentration risk.
Flat yield curve: A reduction of interest rates by the Fed would adversely impact Frontier’s NIM, given a strong concentration of variable-rate loans. To help offset this risk, Frontier has worked to make approximately 2/3 of borrowings callable/putable advances. The rates on such notes are significantly different from market rates on retail CDs.
48 Management
Frontier’s managers have an average of 30 years of experience in the banking industry. CEO John Dickson joined the bank in 1985 becoming CEO in 2003. Prior to his CEO role, John has spent several years in the finance area of the bank and in credit administration as a loan officer. The CFO, Carol Wheeler, has been with the bank since 1978. In 1983 she established the bank’s audit department and has served as senior vice president and the bank’s internal auditor as it grew from $100 million to $2 billion. President and Chief Banking Officer, Lyle Ryan, has spent more than 25 years with Frontier and 35 years in the industry.
Ownership % of Shares Held by All Insider and 5% Owners: 10.35% % of Shares Held by Institutional & Mutual Fund Owners: 25.40% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Barclays Global Investors UK Holdings 1,831,033 4.09% Vanguard Group, Inc. 1,018,742 2.44% T.Rowe Price Associates 852,599 1.90% Dickson LTD Family 688,432 1.54% Robinson William 648,026 1.45%
49 Lincoln Educational Services Corporation LINC Price: $13.92 ($11.34-$18.45) Fiscal Year Ends: December 31
Date: April 27, 2007 Nick Ihn Russell 2000 Index: 839.70 (668.58 - 831.71) Consumer Service Sector
Lincoln Educational Services provides post-secondary education to working adults and recent high-school graduates. Trainings focus in five areas: automotive technology, health, skilled trades, Business and Information technology, and hospitality services, with automotive being the most popular and profitable. Programs vary from 2 year associate’s degrees, diplomas, and certificate programs. Lincoln currently operates 37 campuses in 17 states, mostly on the east coast. Lincoln’s different programs are branded under six labels: Lincoln Technical Institute, Lincoln College of Technology, Nashville Auto-Diesel College, Southwestern College, Euphoria Institute, and Florida Culinary Institute. The company was founded in 1946, and began being traded in 2003.
Recommendation
Lincoln Educational Services has built a great tradition Key Statistics April 27, 2007 in its over 60 year existence. Very few technical Market Cap $354.57M institutes have their experience or breadth of offerings. Shares Outstanding 25.47M Many opportunities are on the horizon for Lincoln, with Average Volume 37,522.2 plans to continue to expand their physical institutions, Beta 0.76 while already beginning to infiltrate the online education EPS (TTM) $0.60 realm, it is expected that their current growth rate of 2007 Estimated EPS $0.55 20% continues. For these reasons, and other, Lincoln P/E (TTM) 23.36 Educational Services is submitted to be held and PEG 1.51 monitored by the AIM Fund. WACC 10.7 % Debt/Assets 21.39% Investment Thesis ROE 10.81% Gross Margin 17.9% Operating Margin 8.85% Company Reorganization. It was announced in Target Price $16.39 late 2006 Lincoln Educational Services will undergo a dramatic regional reorganization to improve efficiency and student enrollment. All Lincoln services will be branded under two names: Lincoln Tech Group, which will consist of the company's automotive and skilled trades campuses, and Lincoln Education Group, which will comprise the company's services and business campuses and online division. Each will be run independently by their own management groups. This move will now put all services under the Lincoln name thus using their history as an advantage, while lowering costs by allowing managers to specialize.
Online Education. Though physical institutions can be quite profitable, online program provide a very lucrative alternative, with very little cost past installation. By taking advantage of online education, Lincoln can eliminate the infrastructure costs of 50 buildings and supplies, while allowing less staff to account for more students. Also, online programs are more attractive to some students as they allow the student to learn at their own pace from their desired location. Lincoln has already launched the Lincoln Online Institute; however they will begin to market its capabilities in 2007.
Post-Secondary Market is Growing. Post-Secondary enrollments are expected to continue to grow based on population growth. A shift in the U.S. economy from manufacturing to service based, and an increasing wage gap between people with a post-secondary degree and those with only a high school diploma. As students look to balance school with work.
Valuation
A 10-year discounted cash flow analysis, with perspective growth rates of 20% and 10% for the next two five-year periods respectively, indicates that Lincoln Educational Services’ intrinsic value is $15.34. Taking into account the discount rate (10.7%) and future dividend issue, a target price of $16.39 is found.
Risks
Degree Completion Rate. Lincoln targets a younger student base than most for profit higher education companies (66% of students are under the age of 24, 25% recent high school graduates). Younger students tend to drop out more frequently than working adults which could lead to increases in bad debt and decreased student retention.
Online Education Competition. Though Lincoln will play to their reputation strengths, there are other competitors already established in the online education realm (University of Phoenix, Etc.). The success of Lincoln Educational Services depends on there ability to establish themselves as provided a unique online education.
Continued Expansion. Lincoln Educational Services is a very attractive company due to its current expansion plans. Continued success depends on Lincoln’s ability to identify and acquire profitable institutions to increase enrollment and spread the Lincoln name.
Majority Holdings: 77% of outstanding shares are held by Stonington Partners Inc. II. As a result Stonington has a large influence over Lincoln’s management, operations, and overall condition. Also, this limits stock liquidity, which is trading under 49,000 shares per day on average.
Management
Lincoln Educational Services’ management has substantial knowledge of the education industry. David Carney (Chairman/CEO) has 29 years experience in the career-education industry. Also, both managers taking over the new 2 independent lines of Lincoln Education have previously served as presidents for Lincoln.
51 Ownership % of Shares Held by All Insider and 5% Owners: 91.94% % of Shares Held by Institutional & Mutual Fund Owners: 10.40% Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding BLUM CAPITAL PARTNERS, L.P. 1,435,878 5.64% ROYCE & ASSOCIATES, INC. 1,072,679 4.22% FIRST INVESTORS MANAGEMENT 311,900 1.23% COMPANY, INC LaGrange Capital Administration, L.L.C. 225,216 .89% DIMENSIONAL FUND ADVISORS INC 200,393 .79%
52 Sun Healthcare Group Inc. SUNH Price: $13.41 ($7.69-$14.17) Fiscal Year Ends: December 31
Date: May 4, 2007 Katie Koutnik and Chris Williams Russell 2000 Index: $832.88 (668.58-835.17) Health Care Sector
Sun Healthcare Group, Inc. provides long-term and specialty healthcare services primarily to the senior population in the United States. The company operates through three segments: Inpatient Services, Rehabilitation Therapy Services, and Medical Staffing Services. Caregivers provide essential services, including skilled nursing and rehabilitation therapy, for individuals recovering from illness or injury. Specialized care for patients with Alzheimer’s disease and other forms of dementia, along with care for mental health patients is also given. Rehabilitation hospitals offer inpatient and outpatient treatment for patients who need intensive rehabilitation therapy. Sun Healthcare Group Inc. operates 118 skilled nursing facilities, 13 assisted and independent living facilities, 7 mental health facilities, and 3 specialty acute care hospitals in 19 states. The company was founded in 1989 and is based in Irvine, California.
Recommendation
Sun Healthcare Group presents an attractive Key Statistics May 4, 2007 investment at $14.50, with current upside potential of Market Cap $541.57M 8%. With the integration of the recent Harborside Shares Outstanding 42.94M acquisition, revenues as well as debt have risen. Average Volume 360,306 Acquisition costs have decreased their 2007 estimated Beta 1.62 EPS; however the EPS is expected to increase in 2008, EPS (TTM) $0.85 presenting an attractive buying opportunity near the 2007 Estimated EPS $0.56 end of 2007. Sun Healthcare has placed itself in an P/E (TTM) 15.72 advantageous industry – increasing elderly customer PEG 0.79 base among decreasing elderly facilities. We WACC 8.97% recommend watching Sun Healthcare throughout the Debt/Assets 30.2% summer of 2007 with intent for revaluation and ROE 20.80% possible portfolio addition in fall 2007. Gross Margin 38.2% Operating Margin 3.4% Investment Thesis Target Price $14.50
Healthcare portfolio diversification. With no current holdings in the managed care industry, the addition would allow for sector diversification and decreased portfolio risk.
Aging baby boomers, increased life expectancy, and decline in nursing facilities. The Department of Health and Human Services, predicts that spending on nursing homes will grow from $105.7B in 2002 to $210.9B in 2016, representing an annual compounded growth rate of 5.1%. Despite this potential rise in demand for senior healthcare, there has been a noticeable, decreasing trend in the number of certified
53 nursing homes, declining from 17,014 in 1999 to 15,885 in 2006. These demographic trends create notable growth opportunities. Acquisition of Harborside. This recent acquisition presents an opportunity to improve margins and grow revenues. SUNH expects to achieve $12-$14M in annual synergies within two years of the Harborside deal’s closing.
Valuation
Based on a 10-year discounted cash flow analysis, Sun Healthcare Group’s intrinsic value is $14. On the basis of an industry average P/E of 24.7, the one-year target price assuming an EPS of $0.63 for the trailing 12 months (Bloomberg) yields a target price of $15. Taking into account both of these valuation metrics, our target price for Sun Healthcare Group is $14.50.
Risks
Levered balance sheet. The acquisition of Harborside increased the company’s debt load from $174M in 4Q06 to over $700M with an interest rate of roughly 8%. While we expect the combined company’s cash generation power will be sufficient to cover all interest payments and capital expenditure needs, this leverage will prohibit the company from being an active acquirer and/or returning value to shareholders in the form of dividends and share buybacks.
Harborside Integration Risk. There is a risk to the company’s earnings potential if completion of the Harborside deal is delayed or if the combined companies are not able to achieve their goal of $12-$14M in annual synergies.
Dependence of revenues from Medicaid and Medicare. Payments from government Medicaid account for 38.6% of revenues. Medicare represents 26.7% of revenues; however this number is expected to increase with the acquisition of Harborside.
Management
The strong management team has substantial industry knowledge and a proven track-record of operations success in the long-term care industry. A great deal of weight is placed on the management team, led by CEO Rick Matros, to reduce debt. The chief executive officer, chief financial officer, and the chief operating officer have over 75 years of cumulative healthcare experience. Importantly, the management team has successfully acquired and integrated numerous acquisitions, a key to future growth.
54 Ownership
% of Shares Held by All Insider and 5% Owners: 29.0 % % of Shares Held by Institutional & Mutual Fund Owners: 64.0 % *Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding RFE Investment 3,528,000 8.224% Fidelity Management 2,840,000 6.620% Hennessy Management Co. 1,746,000 4.069% Hennessy Advisors 1,746,000 4.069% Friess Associates 1,518,000 3.539% *Source: Bloomberg
55 TTM Technologies TTMI Price: $11.13 ($8.47 - $17.50) Fiscal Year Ends: December 31
May 10, 2007 Patrick Flaherty Russell 2000 Index: $829.70 (668.58-834.89) Hardware Sector
TTM Technologies is an industry leader in the manufacturing of printed circuit boards. TTM Technologies’ PCBs are mainly used in high-end computing markets and for networking, industrial, medical, government and aerospace purposes. The company prides itself as a “quick-turn” company that can rapidly provide their clients with PCBs, working with them from the prototype production phase through mass production. TTM Technologies operates twelve manufacturing facilities in California, Utah, Oregon, Connecticut, and China and employs just over 4000 employees. The company was founded in 1999 as a result of a merger and went public in 2000. TTM Technologies has purchased two large companies through their inception, consisting of Honeywell’s Circuits Operations and Tyco’s Printed Circuit Group. The company trades on the NASDAQ and is headquartered in Santa Ana, California.
Recommendation
TTM Technologies presents itself as a favorable Key Statistics April 26, 2007 company with its market share. To have an edge, Market Cap $469.43M TTM Technologies produces high-quality PCBs Shares Outstanding 42.18M unlike the commodity type circuits used in many Average Volume 596,687 electronic devices. The company works to produce Beta 1.42 the best PCBs with high layer counts, blind and EPS (TTM) $.82 buried vias, microvias, thin cores, and high- 2007 Estimated EPS $.80 frequency, flexible circuits. Where TTM P/E (TTM) 13.61 Technologies really stands out in its quick PEG .88 distribution times, supplying the prototype phase WACC 14.81% between 24 hours and ten days and the mass ROE 12.58% production phase between five and fifteen days. It Gross Margin 22.86% provides inputs to some successful companies, Operating Margin 12.69% including Cisco, Hewlett Packard, IBM, Juniper, Target Price $11.25 Motorola, Celestica, and Flextronics. The most recent acquisition of Tyco’s Printed Circuit Group has broadened the company’s manufacturing and customer list providing more business for TTM. Based on a target price of $11.25, this would be an attractive buy.
Investment Thesis
Industry Leader: With its high-end PCBs, TTM Technologies has established itself as a quality manufacturer. It offers high-end, distinctive circuit boards rather than commodity PCBs. It is considered the largest PCB manufacturer in North America and continues to excel in its products and technologies.
56 Quick-Turn Service: TTM Technologies’ ability to quickly respond to demand makes it attractive for clients who wish to keep the production process quick. Instead of purchasing PCBs from another supplier that can take weeks to arrive, companies can obtain PCBs in as little as 24 hours or ten days.
Strong Financial Health: Sales have been steadily increasing on average 47% for the past five years and margins consistently beat TTMI’s competitors. Net income has risen an average of 11% each year since 2002. The company has a lot of cash on hold, with an average of $54,702 for the past three years. It recently took on $140 million in debt to fund the Tyco acquisition. Cash flow from operations has been healthy for several years, with an average of $34,207 and earnings per share has been increasing an average of about 10% year over year.
Acquisition of Tyco’s PCG: With the purchase of the circuit board segment of Tyco, TTM Technologies was able to broaden its manufacturing facilities and helped add new customers for more business. Sales are likely to increase with more aerospace/defense companies coming to TTM for their products.
Valuation
Based on a 10-year discounted cash flow model with a discount rate of 14.81%, TTM Technologies’ intrinsic value is $13.18. Growth rates of 10% for the first five years, 5% for the next five years, and 3% for the terminal rate were used. The company’s current P/E ratio is 11.41 and taking into account the estimated EPS for 2007 of .82, the target price is $9.35. Considering both methods, I believe a target price of $11.25 is fair.
Risks
Increased Competition from the Asian Market: PCB manufacturers in China and other Asian countries have the ability to produce circuits at lower costs. While these companies do not currently produce high-end PCBs like TTM Technologies, they may enter the market for more sophisticated PCBs and gain market share from the company.
Dependence on Small Number of Customers: A large chunk of TTM Technologies’ sales go to a relatively small number of clients. In 2006, the company’s five largest OEM customers (Cisco, Hewlett Packard, IBM, Juniper, and Motorola) accounted for about 40% of sales. If these companies started purchasing less as a result of financial downturns, TTM Technologies would also suffer.
Change in Customer Relationships: TTM Technologies relies heavily on the ability to build long-lasting customer relationships. The company wants to start this relationship in the prototype phase and continue serving during mass production. An effective sales force team is critical in building these relationships. If customer relationships ever suffered, TTM’s customers could turn to the company’s competitors to meet their needs.
57 Management
TTM Technologies’ management team brings knowledge and experience from the printed circuit board industry. Kenton Alder, Chief Executive Officer, President, and Director of the company, has been working with the company since March 1999. Earlier in his career, Mr. Alder worked with several other PCB companies including Tyco’s Printed Circuit Group, Electrostar, and Lundahl Astro Circuits Inc. Mr. Alder also has background in finance and accounting. The Chief Operating Officer, Shane Whiteside, and Executive Vice President, Douglass Soder, also bring experience with PCBs in long work histories in TTM and other circuit companies.
Ownership
% of Shares Held by All Insider and 5% Owners: 2% % of Shares Held by Institutional & Mutual Fund Owners: 86% *Source: Yahoo! Finance
Top 5 Shareholders
Holder Name Shares Held Percent of Share Outstanding Royce and Associates Inc. 4,104,235 9.73% Barclays Global Investing UK Holdings 3,043,584 7.22% Putnam Investment Management LLC 2,722,898 6.46% Lazard Asset Management 2,421,910 5.74% Vanguard Group Inc. 1,544,131 3.66% *Source: Yahoo! Finance
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