As the US deals with stubbornly high unemployment and relatively low consumer confidence, some new trends are developing in the business of “outsourced services.”  For some time now, large companies have relied on offshore companies to supply services such as technology support, customer service, and even more business critical functions such as R&D and manufacturing.  Efficiencies gained from working with cheaper labor forces and relaxed regulations allowed businesses to post better margins.

But today, many of these trends are shifting as US companies are benefitting from stimulus incentives aimed at encouraging employers to hire the swelling ranks of unemployed.  Currently, employers who hire particular unemployed workers will be allowed to save their share of the Social Security tax (6.2%) for the remainder of 2010.  The monetary benefit along with the PR boost of hiring American workers is causing many reputable companies to consider closing down outsourced solutions and “backsource” these jobs back to the US.

While this is one of the smarter moves that the current administration has made (cutting taxes actually increases productivity and in time should lead to stronger, more stable tax revenue), the news is not exactly positive for outsourcing companies with operations in India, China, and other International centers.

Today, we are going to look at Wipro Ltd. (WIT) which is an Indian provider of outsourced consulting, technology and R&D.  The stock has become a favorite vehicle for swing traders and momentum players who have enjoyed a steady trend higher for the majority of 2009.  During the difficult days of the credit crisis, WIT continued to pull in strong revenues, averaging between $1.3 and $1.4 billion in revenues.  Fundamentally the business survived very well throughout the challenges.

In 2009 as US based companies were desperate to cut costs, WIT’s services became more attractive and investors quickly caught on to the idea that this would once more be a growth story.  By October of 2009 the stock had already hit a new all-time-high and the positive trend continued through the end of the year.

But 2010 looks to be a much more challenging year.  Companies are demanding price concessions and the competitive factor of backsourcing is likely to cut into margins – possibly more than analysts are currently modeling.  As technology solutions become cheaper domestically, Wipro is likely to face a more difficult environment, and engage in tough negotiations in order to land contracts.

In 2010, we expect IT budgets to be flat to marginally positive.  For the quarter ending march 31, 2010, we expect revenues from our IT Services business to be in the range of $1,161 million to $1,183 million. ~Azim Premji, Chairman

When the company reports fourth quarter earnings in the coming weeks, it will be extremely important to determine what demand trends are shifting as a result of global competition both from similar corporations as well as from the “insource” factor.

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Currently, WIT is trading at about 35 times this year’s expected earnings (the company’s fiscal year end is March 31) and earnings are expected to grow by 9% in fiscal 2011.  The multiple is not too excessive for a company with stellar growth, but as earnings trends flatten out the market is more likely to place a lower multiple on the stock – leading to a reduced stock price.

On March 17, WIT broke to a new high after a healthy looking two month base building process.  However, the stock immediately came under distribution and the breakout failed.  This is a dangerous pattern – especially for a stock that appears over-valued relative to its earnings and growth.  Volume has yet to confirm the negative pattern, but if WIT begins to break, it may be a good candidate to short, and long positions should definitely be hedged or trimmed.

Other stocks that may also face challenges from the backsourcing issue include Cognizant Tech Solutions (CTSH) and Infosys Technologies (INFY).  All of these stocks are currently trading with strong positive momentum, but they are worth putting on a radar list for potential breakdowns in the future.

FD: Author does not have a position in WIT

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Medical stocks have received more than their fair share of attention in the past few weeks as congress passed the health care reform bill.  While I see the bill as a major impediment to free commerce – Note AT&T Inc. (T) $1 billion dollar charge related to healthcare – there are still many medical companies which will continue to experience growth and opportunity in the coming years.  Best of all, some of these investments are trading at discounts to a “fair market value” due to concern over what healthcare reform will look like.

Intuitive Surgical (ISRG) has put in a very strong performance with the stock up more than 250% since this time last year.  The company makes robotic equipment for Minimally Invasive Surgery (MIS) procedures and has expanded the number of procedures and the quality of service that physicians can offer patients.  The daVinci Surgical System employs cutting-edge (no pun intended) technology which is assisting surgeons around the world.

According to the company, the technology is changing surgery in three primary ways:

1. The technology simplifies existing MIS procedures
2. The technology makes difficult MIS operations routine
3. The technology allows new MIS procedures to be possible

These changes have led to adoption of the system around the globe, and ISRG recently announced that Japan has approved the da Vinci system for use.  During the fourth quarter the number of procedures completed with the system rose by 44%.

Led by outstanding patient outcomes, robotic surgery adoption with patients and the medical community at large continues to grow. ~Gary Guthart, CEO

The primary case against investing in ISRG is the premium multiple.  Currently the stock is trading near $345 per share, while the company reported earnings of $5.93 in 2009.  This nets out to a historical PE of 58, certainly an expensive proposition.  But with the company expected to grow earnings by 31% this year and another  20% next year, the numbers start looking a bit more reasonable.

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I expect that the current estimates for earnings growth may be light as analysts are rightfully concerned that ISRG will face pricing pressures as a result of the healthcare reform act.  But with growing international exposure and the expanding necessity of the company’s products, volume should more than make up for the potential pressure on margins.

While Intuitive has been successful in expanding its footprint and selling a large number of systems quarter by quarter, it’s even more impressive to see the stable base of renewable revenue the company is creating.  In the fourth quarter, instruments and accessories accounted for $113.3 million in revenue which was up 39% from a year ago.  On top of this, service revenue accounted for $47.8 million in revenue – and the two categories combined make up for roughly 50% of total revenue.

So as the installed base of systems grows, ISRG’s long-term revenue stream should continue to be healthy.  The additional revenue more than cover additional expense items associated with growth such as overhead issues like medical billing employees.

ISRG finished 2009 with cash of $1.172 billion and no debt.  The financial soundness allows for flexibility in pursuing additional growth strategies.  Intuitive could easily purchase an ancillary business with attractive products it could cross-sell to its growing client base of surgeons and facilities.  The capital can be used for R&D to develop a new line of complementary products.  Or the capital could be returned to investors through dividends or stock repurchases (although I would prefer for management not to buy stock at the current high price)

So with the broad equity market still showing strength, it makes sense to buy strong growth companies with the potential to continue to generate improving numbers.  The recent pullback offers a good entry point where traders could set a stop point near $330 or so and risk $15 with the potential for much higher gains.  If stopped out, investors may want to keep this name on their radar as the fundamental strength of the company should eventually lead to another strong run in the stock.

FD: Author does not have a position in ISRG

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Last week two telecom IPOs were offered to the market – each showing strong gains out of the gate.  The transactions were indicative of a healthy IPO market with plenty of liquidity, and while that can change in a heartbeat, for now the environment looks technically strong for these new issues.

Today, I want to take a closer look at MaxLinear Inc. (MXL) which was priced Wednesday at $14.00.  The book was jointly managed by Morgan Stanley (MS) and Deutsche Bank Securities (DB) in a deal which provided underwriting commissions of $6.3 million.  The stock was well accepted by investors who immediately sent the stock up 33% in its first day of trading to close at $18.70.  The positive traction is likely giving private equity companies such as The Blackstone Group (BX) additional confidence as they prepare additional offerings which could quickly hit the US exchanges.

Part of the appeal for the MXL deal is that the majority of shares being sold to the public were primary shares.  This means that the proceeds went directly to the company which should be helpful in providing the financial ability to continue to generate growth.  According to the prospectus, MXL will use the cash for “working capital” and possibly for future acquisitions.  I would prefer to see a bit more information on how this capital could be put to work, but since the company has shown strong historical growth, I’m willing to give them the benefit of the doubt for the time being.

MaxLinear is a “fabless semiconductor company” which designs chips that allow devices to better receive wireless television signals.  The majority of the company’s sales have been in Japan where it appears that MXL has a lock on the mobile handset market.  In the last four quarters, the company has seen sales increase by 49%, 13%, 107% and 96% (using year over year comparisons).

In addition to the handset market, MXL is increasing its product offering to include chips that enable devices to receive wireless signals for more traditional television viewing.  These products are anticipated to go in cable boxes, digital televisions, PC’s and notebooks.  While the handset market continues to provide stable cash-flow, these new markets are expected to drive the growth in future quarters.

When we say that MaxLinear is “fabless” it simply means that the company does not have its own manufacturing facilities.  This can be both a business strength as well as a liability.  During the financial crisis, many firms struggled under the weight of the debt used to build large manufacturing plants.  For several solar companies, the decision to expand manufacturing capacity at the wrong time turned out to be fatal.  So MaxLinear’s decision to outsource the manufacturing process gives the company better financial flexibility to be able to focus on research and development and growing other parts of its business.

But the flip-side of this coin is that if the economy improves to the point where it becomes difficult to negotiate contracts with outside manufacturers, MXL could see its costs rise exponentially.  The laws of supply and demand can easily come back to bite the firm if it is not accurate in its long-term projections of customer demand and its need for manufacturing capacity.

After staging a positive IPO transaction, MXL has largely been biding its time and trading within a relatively close range.  This week we will begin to see some patterns developing and from a trading perspective, it will be interesting to see what opportunities set up.  Due to the success of the IPO transaction, it appears demand is in control at this point and I would recommend trading from the long side initially.  A pullback closer to the IPO price would provide a welcome entry point and risk can be carefully managed by placing a stop slightly below the $14.00 IPO price.

On the other hand, if MXL were to break higher – crossing $19.50 – a higher-risk breakout setup might be in order.  The risk is higher in this type of trade because there is less of a defined floor that would be supported by the underwriting team.  When buying above $19.50, traders should look to use a stop where they would exit the position if MXL trades back into its current range.

Fundamentally, it is very difficult to set a fair valuation for the stock.  This is because MXL is just crossing the line where its revenue overcomes fixed expenses and the company is starting to show a positive profit.  There are many variables which could cause MXL to ramp up its profitability sharply over the next two years, or possibly cause it to over-extend and lose value for investors.

So for today, it is important to determine who is trading this vehicle and what these traders are looking at.  Currently, MXL is being largely held by growth stock investors who currently appear willing to give the global economic rebound the benefit of the doubt.  As long as these investors continue to provide liquidity and are willing to pay speculative prices for future growth, MXL should stay in a positive trend.  But when the tide turns and growth investing falls out of favor, MXL will likely be hit with distribution – and at that time it might make sense for us to set up a short position.  The stock is dynamic – positive for now – and offers swing traders ample opportunity for profits.

FD: Author does not have a position in any stocks mentioned in this article.

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As the market trends higher and investors gain more confidence, business owners and private equity firms are increasingly tapping into the available market liquidity.  The opportunity at this point is for businesses to raise capital through an IPO transaction, selling shares of the company to the general public.  Private equity firms which own and manage individual companies are also cashing in.  A market of willing buyers allows the private equity managers to sell portions of these companies (or the entire company) and often realize healthy profits on their initial investment.

But how exactly does this process work?  As a fund manager who focuses on new issues, I have seen hundreds and participated in dozens of these transactions.  While there are often many moving parts and more than a little “slight of hand,” the IPO transaction is a fairly simple concept to grasp.  And whether you are a business owner or an investor, you should be aware of and understand the basic building blocks of this type of transaction.

The Cast of Participants

In order for a company to start trading on the public exchanges, there are basically three parties who are instrumental in the process.  The seller is the party distributing the shares and receiving the capital.  The underwriter facilitates the transaction much like a broker would facilitate a real estate transaction.  Finally, the buyers actually pay for the newly issued shares for the company.

So let’s look at each of these parties a bit more carefully.

Sellers Seeking to Raise Capital

When I look at an IPO transaction from an investor perspective, one of the most important questions I ask is who is selling the shares?

Usually, I am most excited about participating in the IPO when the shares are primary or being sold by the company.  This means that the capital that I pay for the stock goes largely back into the company which allows for growth.  The capital can be used to expand the sales force and pay their salaries, it can be used to expand a plant or facility that allows for better production, or it can be to pay down debt to make the financial foundation more stable.

The more specific a company can be about what they are doing with the capital, the more confident I can be that the money raised will be put to good work.  Too many times a selling firm will announce that the capital will be used “for general corporate purposes.”  That simply means the management team is asking for a blank check to spend however they see fit.  Not exactly a great way to instill confidence.

Other sellers can include the company’s founders, a private equity firm, or a wealthy individual or trust who has previously owned all or a large portion of the business.  While I understand that these parties need to sell at some point to monetize their investment, I’m instinctively uncomfortable with a current investor selling shares to the public.  Since in this case the seller knows more about the inner-workings of the company than I could hope to learn in a few weeks time, I’m curious whether he or she sees a problem and that is motivating them to liquidate.

Whether a private equity firm or an individual investor is selling shares in the transaction, there are a couple of things that can be done to make the deal a little more appealing.  If the seller retains a large portion of their investment, then I can feel confident that they still believe in the future of the business – but they just want to begin collecting capital from their success in building the company.  I understand this need and if they still stand to benefit or lose from the ongoing success or failure of the company, then I am a more willing buyer.

A second way for sellers to make the deal more appealing would be to issue a mix of primary and secondary shares.  This way the company is still receiving part of the money from the transaction and the sellers are liquidating a portion of their holdings as well.  This way there is still a reason to expect the company to benefit from my investment and the selling parties receive an opportunity to monetize their investment as well.

Underwriters Introduce Buyers and Sellers to Each Other

Underwriting firms are usually well known brokerages such as Goldman Sachs, Merrill Lynch (now a division of Bank of America), Morgan Stanley and similar firms.  In recent years, the number of top tiered underwriting firms have decreased as a result of the financial crisis.  But there are still plenty of niche boutiques which also have the ability to act as underwriters for IPO transactions.

The underwriter is responsible for putting together the prospectus which is an offering document with all of the pertinent information that investors need to make an educated decision as to whether to invest or not.  Typically, underwriters are part of a brokerage firm which will service a number of institutional and retail investment accounts – thus bringing the buyers into the picture.

After performing due diligence on the company, the underwriter will determine a “fair market” price range for the IPO.  This is based on their assessment of the profitability of the business, its risks and growth expectations, and the price at which similar investments are trading for in the open market.

Once an acceptable price range has been established, the underwriters will then turn to the buyers to place the stock with willing investors.

Usually there is more than one underwriter working on a deal.  The LEAD underwriter is usually the firm responsible for performing the due diligence and determining the acceptable price range.  Secondary underwriters are simply brought in to help place the deal.  Since it is important to have a broad number of investors in the stock, underwriters usually work in teams to distribute the stock to a wide assortment of investors.

The underwriting firms are typically paid very well for their assistance in getting the stock distributed to investors.  Typically the underwriting fees are between 6% and 10% of the stock price, so if a company is selling 30 million shares at $14.00 per share, the underwriters could split between $25 million and $38 million.  Underwriting fees can often make up a large portion of revenue for a company like Morgan Stanley.

Buyers Invest In an Unproven Vehicle

You’ve probably heard that the average investment return is highly correlated with the risk taken.  While I don’t think that’s an absolute truth, there is a certain amount of return an IPO investors should expect due to the risk he is taking.  After all, there has never been a market for this stock before and the buyer is being asked to trust the underwriter’s “fair market” valuation of the company.

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Since as a buyer, I am putting my investors capital at risk on an unproven stock, I expect the deal to be profitable immediately.  Underwriters understand this dynamic and so they are constantly trying to please both their buyers and sellers.  After all, they need both parties in order to generate their fees.

So IPO transactions are usually priced with the expectation of being a bit below the expected market price.  That way buyers are pleased with their transaction and are willing to come back the next time the underwriter has a new IPO to pitch.  But if the IPO pricing was TOO low and the stock jumps 50% or 100% from the pricing immediately, the sellers could become angry because they could have received a better price for their stock.  So there is a fine line, but the pricing of the transaction usually favors the buyer.

Buyers of IPOs are typically institutional investors, although it’s not impossible for retail accounts to participate in many of these transactions.  Underwriters typically approach the buyers with information about the stock, the expected price range, and maybe some color as to how much demand there is for the stock.  Buyers will then offer an IOI or Indication of Interest, stating how much stock they would like to buy when the transaction is completed.

When indicating for a particular stock, I am always interested to know how much stock the underwriter believes he can get for me.  There is a bit of reverse psychology at play here because if the underwriter says “this is a great stock and the best news is that I can get you all the shares you want!” then I quickly become nervous that the demand is very low.  However, if the story is “We don’t have much of this one available,” then I am much more interested because it is likely that demand will drive the price higher once the stock begins trading.

After the Process Is Complete

You might think that once the sellers have received their capital, the underwriters have collected their fees, and the buyers begin trading the stock, that the process is over.  However, just like a baby, the newly issued stock still needs some care to survive to maturity.

Underwriters have a definite incentive to make sure IPO transactions work and the stock remains a viable investment vehicle.  After all, they want to make sure that sellers look them up when they have a company to sell to the market, and the only way buyers will stay interested is if the IPO continues to trade in a positive manner.

So it’s a loosely guarded secret that many underwriting firms “support” the stock in the first few months of trading.  That simply means that when and if the stock trades back towards the offering price, the underwriter very well may place large buy orders in the market to keep the stock from falling below the IPO price.  If you look through the charts of a dozen recent IPOs, you will probably see 6 or 8 of these stocks which trade right down to the IPO price and then mysteriously find support.

Another issue is the research process.  Since many investors are hesitant to invest in a stock without receiving a few second opinions from analysts, it is important for these stocks to catch the eye of research departments in various investment firms.  Ironically, the underwriters usually know the most about these companies because of their due diligence process, and yet the underwriters are restricted from offering analysis for a period of time after the offering.

But once that “quiet period” is over, you will often see several underwriting firms issue reports on the newly issued stock.  More often than not, the analysts will have a “buy” rating on the stock which helps to attract more buying interest and once again beef up the stock.

A word of caution here:  If an IPO breaks below the offering price, the risk immediately becomes exponentially higher.  At this point every investor in the IPO transaction is now under water.  There are exceptions, but usually a break below the IPO price leads to massive distribution which can take days, weeks, or even months to run its course.  This is where the risk comes in and while it may be frustrating to sell an IPO at a loss within the first few days, there is a very real risk that the loss will get much worse.

Opportunities and Risk

So IPO transactions offer exceptional opportunities along with material risks.  As a primary buyer, it is important to have a strong relationship with an underwriting firm (or several underwriters if your account size is large enough).

There is opportunity to participate in many of the gains just by investing in IPOs after they have begun trading.  These stocks are usually very dynamic with wide swings and attractive trading opportunities.  But remember to keep your trades sized smaller than a typical established stock because of the large swings associated with unstable supply and demand dynamics.

IPO transactions can be an excellent way for traders to generate returns provided appropriate risk controls are in place.

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In the market today, there is a general aversion to invest in medical companies that could be affected by the healthcare reform recently passed by Congress.  Concerns are certainly valid considering the uncertainty of exactly how companies will be impacted by the measures.  But there are also plenty of opportunities where the market has mis-priced this risk and where healthcare companies actually offer tremendous potential returns.

Tenet Healthcare Corp (THC) is one of those growing companies in an uncertain market.  The firm operates 53 general hospitals and two more specialized hospitals primarily in the Southeast, Texas, and California.  According to the company’s website, the firm focuses on owning and operating acute care hospitals along with ancillary businesses which complement its medical care.

One of the biggest concerns with Tenet (and many other hospital operators) is the tremendous investment these firms must make in order to comply with the American Recovery and Reinvestment Act.  Tenet is guiding investors to expect a $40 million dollar technology expense as it implements the required changes within the hospitals it manages.  The company will focus on a few facilities at a time, rolling out the necessary changes in an attempt to stay ahead of potential regulatory fines.

And while these investments will pressure earnings in the short-run, the efficiency benefits in future periods should actually prove to be accretive to earnings.  Despite the difficult schedule for implementing the technology changes, analysts expect THC to increase earnings by 47% this year bringing the profits to 22 cents per share.

Of particular note is the success management has had in increasing their profit margins.  Adjusted EBITDA margins increased from 8.4% in 2008 to a record 10.9% in 2009.  There are several factors at work here which have led to a more profitable operating platform.

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Lower Employee Turnover – Management has made a concerted effort to increase incentives for employees to remain with the company and to improve productivity.  At the end of 2009, Tenet set aside $16 million to contribute to employee 401(k) accounts.  There were also merit pay increases announced on October 1 that allowed employees to see their pay increase above the general level of inflation.  As a result of these initiatives, Tenet was able to decrease its contract labor which is helpful in keeping costs contained.

Pricing Improvement – Despite the perception that Medicare is driving prices down, Tenet has seen a general improvement in the pricing environment.  This may be a regional phenomenon and certainly warrants some additional analysis, but it is important to note that at this point THC continues to be able to charge a reasonable rate for its services.

Bad Debt Stability – Any hospital which is required to treat patients regardless of their ability to pay is going to have a hefty load of bad debt.  Throw in an economic recession and investors expect bad debt to increase all the more.  But THC has been able to keep this metric at a reasonable level and actually pointed to increased collections as one of the potentially positive driving forces for its 2010 guidance.

Despite pressures from a soft economy and rising levels of unemployment in many of our markets, we achieved another year of solid revenue growth…  Excellent cost control combined with this revenue growth helped us produce the strongest growth in earnings and the highest margin we’ve achieved in seven years. ~Trevor Fetter, CEO

While THC’s stock price is certainly below what you might expect from a top notch hospital management firm, the company actually has a market cap approaching $3 billion and the stock is a very legitimate investment vehicle.  A forward PE of 26 may also scare some investors away as on the surface it appears that THC may be fully valued.

But cautious analysts and conservative guidance by management may be causing this estimate to be a bit too conservative.  After all, the demographic trends in the areas that THC operate combined with the pressure of less-capitalized facilities folding or going out of business will likely lead to higher admission rates.  At the same time, investors willing to look further down the road to when IT investments will add to profitability may quickly increase the amount they are willing to pay for this niche hospital operator.

As a trader, I would watch the $6.00 to $6.50 area very closely.  If the stock is able to break through this level on strong volume, it makes sense to start an initial position.  After a few weeks of holding above this level, I might begin to add to my position at attractive chart points.  My stop would initially be just below $6.00 because if the stock trades back below the breakout range, then something is wrong with the company or the trading dynamics surrounding the stock.

So consider taking advantage of the uncertainty surrounding healthcare by picking up some quality companies before the broad investor population realizes how much value is available.

FD: Author does not have a position in THC

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For the last few months, the market has continued to push to new recovery highs, and the Retail HOLDRS (RTH) have actually been exhibiting leadership and outperformance.  Now a day does not a trend make, but Wednesday’s action was interesting as the RTH declined by 0.92% while the S&P 500 was only down 0.55%.  I understand this is only one data point and may turn out to be insignificant, but today could turn out to be the day the retail sector turned.

While I don’t have extreme confidence in calling a top for retail, I am developing a healthy dislike for the way Blue Nile Inc. (NILE) has been trading.  In early November, ZachStocks covered Blue Nile’s earnings report, noting that international sales were growing more quickly than domestic revenue (although international revenue only represented about 13% of total sales).  Despite the relatively healthy earnings report, we noted that the stock could easily be trading at double its reasonable value – and laid out the case for initiating a short position.

As of the close Wednesday, the stock has dropped about 14%, but the negative outlook is still just as dire as ever.  Analysts are expecting the company’s earnings to grow by 21% this year to reach $1.02 per share, and then in 2011 the expectation is for $1.23 in earnings.  I’m not sure that we can place much confidence in these numbers given the uncertainty due to unemployment and the potential “re-destruction” of wealth as adjustable mortgages reset and US taxpayers foot the bill for the new healthcare plan.

But assuming these analysts are accurate in their assessment, please explain why the stock is trading at roughly 53 times next year’s earnings!  This is a very aggressive price even for a company growing rapidly like Crocs Inc. (CROX) back in 2007.  But for a company like NILE with 20% growth expected over the next two years, the multiple seems absurd.

Over the past week, NILE’s chart has featured a pattern which many technicians call the “death cross.”  This pattern occurs when the 50 day moving average crosses below the 200 day average.  Now I don’t think there is any magic in these moving averages, but they do offer an excellent way to graphically illustrate the pattern that is evolving.  After spending a significant amount of time in a positive trend, the stock has finally begun to falter and at this point the short-term average of its daily closing price is below the long-term average – that simply means the tide is turning and the prevailing trend is negative.

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Now while I said I don’t place too much credence in the actual pattern (I’m looking more carefully at the concept), there are traders who will swear by the patterns and make their trades like clockwork based on special indicators like the “death cross.”  As traders we have to respect this action and understand that a significant amount of selling pressure could quickly hit the stock.  At this point with a series of lower highs and lower lows, we could quickly see momentum pick up and NILE could be in the 30’s or even 20’s by mid-summer.

One thing to be careful of is that Blue Nile has been a big target for other short-sellers.  Currently the published amount of short exposure is 14% of the float.  It would take 15.5 days of trading (using the average daily volume) for these short sellers to exit their position.  The danger in this statistic is that if something positive is announced and the stock begins to move higher, the shorts could quickly hit the exits all at once, driving the price higher in a short period of time.

So fundamentally and technically, this looks like a good short opportunity with the potential for 40% to 50% profits.  However, the risk is certainly present so position sizing should be appropriate and traders should always use a stop-loss when holding short positions.

FD: Author does not have a position in NILE

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With all of the attention on the health care reform passage and the exorbitant costs it will impose on US taxpayers, I want to note that there are a few areas of healthcare that are actually decreasing costs and at the same time providing better care for patients.  The home-health industry has been in stealth rally mode, and ZachStocks has periodically reviewed Amedisys Inc. (AMED) as a growth opportunity in the industry.

Today we’re going to take a look at LHC Group Inc. (LHCG) which operates both home-based and facility-based long-term post-acute health care services.  The company is relatively small with a market cap of about $644 million, but the historic growth has been tremendous with revenues increasing by nearly 40% over the past year and earnings per share up 40% as well.  LHCG has virtually no debt which helps to provide confidence and stability for shareholders, and yet the conservative balance sheet doesn’t mean that the company is shying away from aggressive growth opportunities.

Tuesday morning Forbes featured a healthcare article in which the editor predicted that we will see consolidation in the industry.  Fear of reduced government reimbursements is leading the smaller players to combine with more well established players to take advantage of synergies and economies of scale.

On March 10, LHCG actually announced its own acquisition, purchasing Salem Hospital Home Care in Salem Oregon.  While the buyout was a relatively small transaction (the region covers about 1 million people, and over the last 12 months Salem generated about $5.5 million in revenue), bolt on acquisitions allow LHCG to expand their geographic reach.  On top of that, the company can likely increase profitability because they can cut many of the administrative costs which are redundant with the parent company.

Interestingly, the Salem Oregon region features 12% of the population which is over age 65.  This is a strong market for LHCG as home health users above age 75 comprise a statistically overweight portion of home health users.  As a general rule, more patients who use home health describe their health as fair to poor than the average Medicare beneficiary (see chart).

LHCG is currently trading near the top of its range and a break above $35 would likely attract the interest of more institutional investors.  While the stock is an attractive buy on its own merits (trading at 13 times expected 2010 earnings), there is significant potential for a buyout in the next several months.

Just as LHCG picked up Salem’s business to take advantage of cost savings and an increased geographic footprint, another competitor could easily make a bid for LHCG.  Amedisys is nearly three times the size of LHCG and has shown a willingness and ability to get deals completed.  LHCG would be a large acquisition for the firm but it very well could make sense.

If Amedisys or another competitor were to acquire LHCG, the price would more than likely be at a premium to the current price.  It wouldn’t surprise me to wake up one morning and find LHCG up 15% to 20% due to a bid from one of the other players in the industry.

The health care reform bill will be studied for weeks and months to come to determine what effect it will have on industry.  But for now, LHCG appears to be weathering the uncertainty well and could have a very bright future in front of it.

FD: Author does not have a position in LHCG

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What happens when the leader can’t keep pace with the competition?  Well the obvious answer is that he no longer remains the leader…

For some time, Amazon.com Inc. (AMZN) has been in the good graces of a number of different economic participants.  Investors have been pleased with the exceptional rally which began well before the broad equity market bottomed in March of 2009.  At the same time, consumers have obviously been taken with the firm as revenue growth has continued throughout the financial crisis and has accelerated in recent months.  In fact, the fourth quarter reflected a 42% increase in revenue for the global internet retailer.

One additional group that has been very content with the firm is the number of affiliates who drive traffic and encourage sales on Amazon’s platform.  These affiliates (many of whom actually receive their primary income through this business line) are paid a commission for sales driven by their leads – a process which has been instrumental in the company’s strong growth.

But questions are surfacing in regards to the manner in which these affiliates and the sales that they generate are taxed.  Recently, Amazon actually cut off all affiliates in the state of Colorado after a dispute with how taxation matters will be handled.  This “nuclear option” will certainly be a negative for the company as far as sales growth is considered, but AMZN is willing to make this very public statement in order to pressure Colorado and other states to drop rules which will cause a financial or operational burden on the firm.

It will take some time for the logistics and regulatory issues to work their way through the system, but during an economic time where employment is under pressure, the US does not need additional red tape discouraging individuals from operating home businesses to generate income and promote economic activity.

Relative Weakness

From a trading perspective, AMZN is throwing up a number of red flags that will likely foreshadow weakness in the stock.  To start with, the stock has begun significantly trailing other retail names.  Now I understand that AMZN has some different dynamics than a typical brick and mortar retailer, but at the same time, the company is in the consumer area and has not been keeping pace.  While AMZN peaked in December of ’09, the retail index has continued to make new highs and is in a strongly trending pattern.

The underperformance of Amazon points to decreasing investor confidence and will likely lead to significantly lower prices once the retail sector begins to back off.  It probably makes sense to wait for RTH to break below the 20 day average or even the 50 day average before committing any serious capital to shorting AMZN.

Amazon is currently trading with a premium multiple.  Analysts expect the company to grow earnings by 43% in 2010 – which leaves us with an estimate of $2.91 per share.  Based on today’s price, investors are paying $44 for every dollar that the company earns which is a bit excessive.  I question what will happen if the estimates for 2010 are decreased.

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If Amazon issues guidance that fails to support analyst expectations, the numbers could easily be adjusted down to $2.50 per share which still represents a healthy 22% increase over last year.  But the surprise could cause investors to place a lower multiple on the stock – and a PE of 33 along with estimates of $2.50 per share would lead to a stock price of $82.50.  That’s quite a decline from the current level near $130.

Shorting individual equities is a tricky business.  It takes proper risk control and appropriate timing on both entry and exits.  The newly revised ZachStocks Newsletter is designed to help traders identify timely long and short opportunities and also monitors open trades with risk stop points and levels for taking profits.  For Amazon, the risk is still high that the stock will be carried by bullish retail investors who continue to add exposure.  So while the opportunity is exceptional, we are waiting for the retail sector to show weakness before initiating a short position.

Once the trade has been entered, it makes sense to use a stop point a bit above the most recent swing high (currently $134.20) and then to use a trailing stop as the trade shows a profit.  Along the way, aggressive traders can use days of exceptional weakness to take profits off the table, and retracements higher to add exposure back into the trade.  But I would use moving averages and a picture of the retail sector as tools for determining when the downtrend is in trouble.

In short, Amazon is over-priced and likely to disappoint.  The chart pattern is exhibiting weakness.  Retail should pull back at some point as unemployment continues.  And the combination of these forces will favor a nimble trader willing to sell short.

FD: Author does not have a position in AMZN

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Mastercard Inc. (MA) has had a bumpy ride so far in 2010.  After posting a new recovery high near $270 in early January, the stock lost roughly 20% of its value after the company issued a disappointing fourth quarter report.  While the card issuer’s revenue was up 6% and earnings actually increased by 31%, investors were less than pleased.  Nearly all of the growth in earnings came as a result of cost cutting within the firm and even the 6% increase in revenue was primarily a function of currency fluctuations and not a real growth in business.

Back in 2008, MA became extremely weak as traders (myself included) expected the consumer to rein in spending and transaction volume to decrease.  Not only were we working against a general panic among both professionals and individuals, but spending was also to be affected by tighter credit limits, decreased card issuance, and higher fees charged by banking institutions.  Many consumers had to scramble and find alternate sources of funding such as a direct payday lender or other non-traditional measures.

But as investors regained confidence in 2009, the stock made back a good portion of its losses as Mastercard reported a continually growing chain of quarterly earnings.  The last four quarters featured EPS growth of 9%, 27%, 41% and finally 31% in the fourth quarter.  But a lack of revenue growth points to the fact that Mastercard manufactured the majority of its earnings growth through controlling expenses and not as a result of a material increase in the business.  In fact, the last four quarters of revenue growth have been (2%), 3%, 2%, and 6%.  Not exactly what you would expect out of a stock priced for growth.

It would appear that the future of Mastercard’s success (and the returns its investors will receive) hinges as always on consumer spending levels.  Since MA provides only the credit card transaction portion of the business, it is not on the hook for losses when consumers become unable to make payments on the loans.  But if consumers cut back on the amount of spending due to high unemployment, increases in the savings rate, or as a result of the destruction of household wealth, the fees MA charges will likely be affected.

While consumer spending is difficult to predict on a month-to-month basis, logic tells us that the long-term trend is going to be flat to down.  The US has consumer has been notorious for spending beyond his means, and while Mastercard has a strong international presence, the figures still show that over half of the company’s $28 billion purchase transactions occur within the US.  Bulls will tell you that the expanding international scene will more than make up for the declines in US transactions, but that may turn out to be untrue – especially if we face another global economic recession.

The competition appears to be weathering the environment a bit better than Mastercard with Visa Inc. (V) logging stronger revenue growth even thought the company is already much larger than MA.  Other card companies such as American Express (AXP) and Discover Financial (DFS) are more difficult to compare because these firms actually take on credit risk, collect interest payments, and are subject to write downs for bad loans to consumers and businesses.

Fundamentally, I am worried that Mastercard’s stock price has outpaced the company’s growth.  At the end of the year there were 966 million cards issued which is actually a decline of 1.3% from the number of cards that were issued at the end of 2008.  On top of that, the financial sector is likely not as healthy as many  believe with both commercial and residential mortgage issues hanging over banks.  Sheila Bair, Chairman of the FDIC states that there will be more bank failures this year than we saw during the crisis or as a result in 2009.  These are the banks that issue additional cards to consumers and they are under significant pressure.

Technically speaking, Mastercard has rallied in March but with less vigor than the overall market.  This relative under performance can lead to sharp declines whenever the broad market or specifically the financial sector begins to weaken.  Traders should probably use the 50 day moving average as a good spot to initiate shorts when the stock closes below this level.  Additional exposure could be added when MA crosses below the swing low of $216 logged in late February.  I don’t think it’s unreasonable to expect the stock to trade down to $160 (roughly 12 time 2010 estimates) with the potential for much lower prices if investors become fearful.

The US stock market has been surprisingly strong for the past six weeks, and despite Friday’s breather, it is certainly possible for this trend to continue.  Short positions should be placed carefully with proper risk controls, but in many cases adding short trades to a growth stock portfolio can increase returns while cutting down on the overall risk.  For more information about building a balanced long/short approach to investing subscribe to the newly re-designed ZachStocks Newsletter and take advantage of the free trading and portfolio management tips.

FD: Author does not have a position in any stocks mentioned in this article.

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The healthcare industry seems doomed to be in a constant state of flux and uncertainty.  As the House enters the weekend with an important bill on the table for healthcare reform, many investors are worried about how the bill could affect future profits.

Particularly at risk are prescription drug companies which will likely be required to accept whatever schedule the government deems “fair” when it comes to reimbursing them for patients medications.  And while the long-term effect on our economy and on the freedom of commerce are very serious, I believe that a few pharmaceutical stocks are trading at “worst case scenario” prices and could offer bold investors significant opportunity.  In particular, I am looking at Warner Chilcott (WCRX) as a healthy and growing company likely to trade higher in the coming months.

Warner Chilcott recently made a significant strategic acquisition which puts it in a place where it should be able to grow earnings tremendously.  On October 30, 2009, the company acquired the branded pharmaceutical business of Procter and Gamble.  The spinoff allowed P&G to pick up some much needed capital, while giving WCRX an attractive portfolio of new products to market in North America and Western Europe.  To quote the company’s CEO:

This is a transformational acquisition that extends our presence to include many of the major pharmaceutical markets around the World and significantly enhances the scale and diversity of our business.  Importantly, the increased scale afforded by this deal provides us with the ability to pursue a broader range of R&D projects to fuel our long-term growth. ~Roger Boissonneault, CEO

Not only did the transaction give the company additional products to cross sell to its current stable of clients, but the purchase also included manufacturing facilities in Puerto Rico and Germany.  Now  that WCRX has a diversified suite of manufacturing locations it can increase efficiency which should directly affect profitability.

Is The US Dollar Reversing Again?

The thing that particularly caught my eye in relation to WCRX was the extremely attractive valuation.  After making the acquisition, the company is expected to generate $3.41 in earnings for 2010 and $3.78 for the following year.  Now 2010 earnings will be an increase of 80% over 2009 which is quite impressive.  But investors are right to assume that this growth is a one-time event and will not likely be repeated.

However, despite the strong earnings potential for the company, WCRX is currently trading at 7.4 times the expected earnings for 2010.  That’s a pretty low multiple even if WCRX were to remain stable with no future growth at all!

There are a couple of red flags that investors should be aware of and may be part of what is causing the company to trade at such a discount.  The first is obviously the regulatory environment surrounding healthcare reform.  WCRX could certainly have its average price for branded pharmaceuticals cut which would impact profitability.  Secondly, the company has a large debt load of $3.0 billion.  While cash flow appears to be high enough to easily service this debt, the liability adds another layer of risk to the company.

One way to potentially benefit from a rebound in the share price while still holding an acceptable amount of risk would be to buy out of the money calls.  Specifically, I am looking at the July 30 calls which can be bought for roughly $0.55 per share.  Obviously, WCRX would have to rise more than 20% for these calls to be profitable, but given the cheap valuation and the uncertainty right now, the stock is priced very conservatively and any resolution to outstanding concerns could cause the stock to rally sharply.

When investing, one should always be on the lookout for sectors and industries that are trading at a discount due to unnecessary fear or dislocations in the market.  These opportunities are often very lucrative as long as risk is properly managed.  So consider WCRX as an exciting opportunity, but make sure that you have an exit strategy if the improvement does not turn out to be as expected.

FD: Author does not have a position in WCRX

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