During any market advance, there are stocks that trade higher because they have significant merit, and of course there are those which are just along for the ride.  The axiom “a rising tide floats all boats” certainly applies for at least a time as professional and personal investors alike grasp for exposure to a rising market.  But it has also been said that “a bear market returns capital to its rightful owners.”  This usually applies to markets where speculative buyers have bid up prices to unsustainable levels, and then when the irrefutable laws of fundamental valuation come back into play, the capital invested quickly disappears.  I fear we will soon enter another period where capital is taken away from speculative investors.

One of the areas that seems most prone to a swift decline is the homebuilding industry.  From a business standpoint, the environment is definitely getting better.  After all, it’s not exactly hard to beat the devastating period builders have endured for the last 18 to 24 months.  But while business is beginning to show the signs of a recovery in infancy, the market is pricing in a full-fledged mature recovery and bidding stock prices higher as if they were fully functioning healthy businesses.

Take MDC Holdings Inc. (MDC) for instance.  The stock has no official PE because the “E” part is nonexistant – the company hasn’t earned a dime since sometime in 2006.  And this year analysts expect the company to lose another 44 cents per share.  But of course losing 44 cents is good news considering the fact that the company lost $10.44 per share in 2007, and lost $8.25 per share in 2008.  MDC is trading at roughly 40% of its high logged in 2005, and the value of its stock still appears to be very high.

A Quick Peek at Crude Oil

If you read the company’s fourth quarter earnings report, you will immediately see that the company reported impressive earnings.  But it quickly becomes apparent that the earnings are entirely due to a tax code revision that allows the company to carry forward losses more than 2 years.  This is definitely a positive announcement for the company, but not one that will cause the long-term health of their business to improve.

The revenue picture is one that investors should look at carefully.  Quarter after quarter, the company has seen sales decline when compared to last year.  However the fourth quarter actually saw a pick up in sales – which is good news right?  Well it’s actually not all that impressive considering the fourth quarter of 2008 featured a decline of 62%.  So one would hope that MDC could at least match this dismal performance and even exceed it to a small degree.

MDC is not without signs of improvement.  The company’s new orders for the fourth quarter totaled 637 homes which is much better than the 350 homes ordered during the fourth quarter last year.  Separately, the backlog of homes under contract has risen to 826 compared to 533 homes to end 2008.  Hopefully the majority of these contracts are honored and buyers are able to secure financing (although mortgage standards continue to be relatively stringent).

Investors who decide to buy the company based on the book value of the company’s assets need to realize that property values fluctuate wildly because of the illiquidity in the market.  MDC holds more than a half billion in “housing completed or under construction” and “land  and land under development.”  The value of these properties has been revised lower in the past due to market conditions and if another wave of foreclosures hits the market, this valuation will likely be hit again.  The stock price requires investors to pay 150% of book value to own the company and book value still seems suspect in my opinion.

I wouldn’t be surprised to see MDC trade down to parity with book value (near $22.75) or even lower if management takes another write down on inventory levels.  Sure, the market for real estate may be improving, but with a shadow inventory of foreclosed properties being sold by banks, and many consumers stuck in homes they can’t afford, I believe the environment will be challenging for homebuilders for years to come.

FD: Author does not have a position in MDC

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When Aircastle Ltd. (AYR) reported earnings earlier in the month, the headline numbers didn’t look all that  impressive.  The company reported revenue of $135.8 million which was $22 million below the fourth quarter of 2008, and earnings per share came in at $0.29 (adjusted 0.27) which is significantly below the level of earnings from the same period last year.  However, the details regarding the company’s overall business environment were actually quite encouraging.

Aircastle is an aircraft leasing company which purchases passenger or freight planes and then leases them under long-term contracts to airlines and freight companies.  AYR has taken a very diversified international approach with its fleet of 129 aircraft spread out between 60 different customers in 30 different countries.  The focus appears to be passenger planes with only 29% of the vehicles being used for freight.  Looking at the length of contracts, the weight average remaining lease term is 4.9 years.  This gives investors a fairly stable picture of base revenues for upcoming quarters.

Since owning aircraft can be a very capital intensive business, AYR has a significant debt load of roughly $2.5 billion.  With access to capital curtailed over the last two years, you might think that the company would have struggled to meet its obligations.  However, management has done an incredible job getting the company through the crisis and the Aircastle which has emerged is much stronger than many would have expected if they had foreseen the coming economic struggle.

Near the peak of the market, management had the wisdom to pursue a conservative growth strategy, deciding not to purchase additional aircraft at excessive prices when the economic fundamentals appeared to be peaking.  This allowed the company to continue through the crisis with a stable balance sheet and positive earnings.  While management did decrease the dividend to maintain a healthy cash balance, investors likely understand and appreciate this move which was likely instrumental in causing the stock price to rebound sharply from the March 2009 lows.

Is The US Dollar Reversing Again?

Since the economy has begun to turn, AYR has been able to order and take delivery of new and used aircraft at extremely attractive pricing which should lead to healthy growth in upcoming years.  In the fourth quarter, the company found homes for 11 of 12 new Airbus A330s which it will take delivery of in the coming quarters.  Six of these planes will be leased to South African Airways beginning in 2011 in what management calls “further evidence in the recovery of aircraft leasing.”

Fundamentally, AYR appears to be trading at a very attractive price.  The company is expected to earn $1.12 this year and $1.14 in 2011.  These numbers are likely conservative as AYR has a stable base of customers but could very easily pick up additional aircraft and put them to work in the lease pool which could immediately add to earnings.  With a current stock price of $9.73, investors are paying just 8.5 times forward earnings which is quite conservative considering the long-term nature of the firms leases.  On top of that, investors are being paid 4% annually through the dividend and it would not surprise me to see management increase that dividend now that cash balances are increasing and the global economy is considered to be more stable.

The stock is listed at 0.7 times book value which means that if the company sold all of its assets and repaid its obligations, investors would immediately realize a near 50% return.  The discount is likely due to questions about the book value of the aircraft.  In today’s weak economy, it would be difficult to sell all of the aircraft for a reasonable price – and instead investors are looking at the high debt levels.  But as long as the company is able to maintain payments on the debt and has healthy productive assets to back up any needed refinancing, the picture should remain rosy.

Aircastle might not double in the next six months, but the value of the income producing assets on the balance sheet along with the potential for upcoming growth should support the stock and lead to reasonable growth.  With the market looking a little extended, I prefer to own companies with a strong balance sheet, trading at a discount to book with the potential for increasing business.  Aircastle appears to fit that bill.

FD: Author has long positions in Sound Counsel client portfolios

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Investors in Force Protection Inc. (FRPT) were eagerly awaiting the company’s earnings report when the market closed on Monday.  After trading in a range between $4.00 and $5.00 for eight months, the company was overdue to report some positive news.  The release did not disappoint and by the time the market opened Tuesday morning, buyers were falling all over eachother to get their hands on the stock.

Force Protection is a manufacturer of armored vehicles and other products that increase survival rates on the battle field.  With the United States and a number of allies in a sustained war against terror on several fronts, there is significant demand for FRPT’s products.  This was made clear as the company announced revenue of$ 289 million which represents a 21% increase over the fourth quarter last year.  Management attributed the increase to modernization, spares, and its sustainment business lines.  Offsetting the strength was a lower number of vehicles which were shipped.

Initially, it might seem like a lower number of vehicles shipped would be a negative for the company.  But a transformation is underway in which the company is broadening the number of products it offers which in turn is building a healthier business.

We are transforming our Company into a full-service survivability solutions provider. This effort was rewarded in 2009 with over $450 million in increased modernization, spares and sustainment revenue during the year. We have expanded our operational footprint and significantly improved our capabilities in this business. We are continuing our product development efforts to ensure that we are delivering the best balance of survivability, mobility and readiness to our end-users. We are also continuing to push forward in the area of new vehicle development. ~Michael Moody, CEO

Not only did the company produce higher revenue in the fourth quarter, but profitability increased sharply as well.  The company earned 27 cents per share for the quarter (totaling 61 cents for the year) compared to 17 cents from the fourth quarter last year.  Gross margins were higher as FRPT transitioned to products that offered better profitability, and general and administrative costs were also kept in check.  In short, it was a strong quarter for the firm and investors now have a newfound confidence in the stock.

Gold Catches Traders By Surprise

Supplying military vehicles can be a difficult business.  The revenue trends are unpredictable as governments can increase or decrease contracts almost at will.  Research and development costs can be high and it is not always easy to recoup these expenses.  That is why FRPT’s diversification in business lines will be such a strength for the company.  Replacing parts for existing vehicles, modernizing those vehicles with the most up-to-date equipment, and providing other solutions will create a more stable revenue stream leading to a healthier company.

But that doesn’t mean Force Protection will abandon making vehicles all-together.  Quite the contrary, FRPT has a new vehicle called the Ocelot which is currently being tested by the UK.  As the prototypes are approved, FRPT should receive a good number of orders for new vehicles and it appears that there is a strong possibility that Australia could be a purchaser as well.  New vehicles sent to the field will help to generate additional maintenance and parts business for the firm as well.

Looking at the financial picture, FRPT appears to be in a healthy situation.  The company finished the year with cash reserves of $147.3 million – that’s equivalent to $2.00 per share.  With no debt, this leaves FRPT with plenty of flexibility for developing products, making strategic purchases, or simply riding out the ups and downs of the order cycle.  Management has paired down inventory levels as well which helps to increase the financial stability of the firm.

Whether you look at FRPT from an earnings perspective or a book value frame of reference, it appears the stock is attractively priced.  Analysts appear to have very conservative estimates for earnings this year (pegged at 0.45 per share) and while there may be some bumps in the road, I believe FRPT can easily beat these numbers.  Still as I write, the stock is trading at less than 15 times earnings which appears attractive considering the potential for growth and the financial stability.

Book value per share is roughly $4.44 considering cash, inventory, receivables and the company’s current liabilities.  So the stock is trading at about 1.5 times book value or the price per share investors would receive if they simply liquidated the company.  Since FRPT is actively growing value through positive earnings and a growth strategy, this price appears very conservative.  I would recommend waiting for a bit of the excitement to wear off after the earnings announcement and then try to pick up shares near $6.50 if possible.  The company is relatively small with a market cap of $460 million, but their profitability is proven and the long-term opportunity is exciting.

FD: Author does not have a position in FRPT

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It’s no secret that the Chinese economy has experienced tremendous growth – even during the global financial crisis.  A demographic shift towards the middle class has bolstered demand for goods and services, and we are seeing a wide portion of the population moving towards China’s rapidly growing cities.  However, as with any rapid economic expansion, economists are beginning to wonder just how fast is too fast.   It seems that there is serious potential for China to stumble and lead the globe back into an extended economic slump.

The Chinese equivalent of the Federal Reserve appears to have concern with the situation as they have begun tightening reserve requirements for banks which essentially reduces the amount of capital available for lending purposes.  The moves have been minor in nominal terms, but the banks are getting the message… “Cut back on lending and get your books in order.”  No one wants to see a repeat of the US banking crisis from 2008.

Tightening in China could certainly slow the economic expansion.  Instead of having ready access to capital, business would have to compete for limited financial resources which in turn could drive the price of these resources higher.  When chasing limited opportunities for loans, the interest rate can become the “price” and it seems logical that the cost of financing will rise for businesses.

With this backdrop in mind, I am building my list of China short candidates which will likely trade sharply lower once investment managers begin to trim their exposure to the sector.  One name that has caught my interest and is potentially actionable immediately is Home Inns & Hotels Management Inc. (HMIN).  The Hotel operator currently manages 616 hotels, 390 of which are leased and operated and 226 of which are franchised and managed.  The company has a wide geographic footprint with hotels in 120 cities across China.

Over the past four quarters, the company has continued to grow revenue and earnings although I’m becoming concerned that the rate of revenue growth has begun to decline.  When HMIN was a young company with just a few hotels under management, it was easy to double or triple revenue just by adding a dozen more hotels to the mix.  But now that HMIN has reached critical mass, it will be difficult to maintain the growth trajectory simply because of the law of large numbers.  The last four quarters have seen revenue grow by 53%, 43%, 38%, and finally 29% in the fourth quarter.  That’s still impressive growth but not nearly as exciting as the triple digit revenue gains the company used to put up.

The earnings picture, however, is much better.  Management has been able to manage costs associated with its existing hotels as well as the expenses for opening new locations.  As a result, earnings growth has been 130%, 107%, and 225% over the last three quarters.  That’s an impressive feat – but also one that will be difficult to follow in 2010.  Despite the positive earnings momentum and the hefty multiple, I fear expectations could be tough to live up to in the coming months.

In addition to our improved overall performance, due largely to the reduced impact of new hotel openings, the key metrics of our mature hotels strengthened in the fourth quarter compared to this time last year indicating an improved economic and operational environment. This has allowed us to renew our focus on our core expansion plan, as we remain excited and encouraged regarding the vast opportunity which we believe remains within China’s economy hotel sector. ~David Sun, CEO

Looking at the HMIN chart pattern, there is certainly reason for concern.  The stock peaked in early 2010 and began to lose ground in sync with broad China indices.  After putting in a swing low in early February (just above the 200 day average), the stock has traded higher but on very weak volume.  It appears mutual fund managers are more motivated to dump the stock when the environment is risky than to accumulate shares when we hit the “risk on” periods.

Friday (3/5) the stock traded down sharply on strong volume.  It’s definitely concerning to see a growth stock catching significant volume on negative days – especially when trading below the 50 day average which has been a key support level for the stock.  Today (Tuesday) in early trading, the stock is back below that level as markets are opening mildly negative.  It will be interesting to see if volume comes in with the selling which would be a strong indicator that it is time to begin building a short position.  As always, manage risk carefully and know your stop level.  But in the weeks and months ahead we may find that short opportunities offer the best chance for profits.

FD: Author has a short position in the Sound Counsel Absolute Return Model

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Equity markets continue to rally as economic news appears sanguine and professional managers add risk.  For most professional money managers, there’s nothing worse than under performing their benchmarks, so as the market climbs higher it is becoming more difficult for these institutional investors to resist buying attractive growth stocks.  While I still expect the market to turn lower due to economic weakness, Constant Contact Inc. (CTCT) could at least temporarily benefit from the willingness of institutions to increase their risk exposure.

Constant Contact is primarily an email marketing firm which allows small businesses to build a contact list of prospective clients, and send regular emails to this list in order to generate sales.  The platform is attractive not only to small businesses (who may not have the technical resources to design their own email marketing programs) but is also helpful for non-profit organizations soliciting donations or simply distributing information to interested parties.  With an attractive entry price of just $15 per month, the service is accessible to almost any venture and could easily pay for itself with a minimal level of converted sales.

Investors appear confident in the long-term growth of this company, as the stock is currently trading at more than 50 times expected earnings for 2010.  While this is certainly an excessive multiple for most companies, Constant Contact may actually deserve this vote of confidence as the company has recently crossed over the “profitability threshold” and should be ramping earnings substantially.  Often, growth companies focus on building revenue for years and are willing to operate at a loss in order to capture market share.  When this strategy works, there is a point where revenue growth exceeds expenses and earnings increase at an exponential rate.  This exponential growth almost never lasts for more than a couple of years, but the levels of earnings can often justify what originally was seen as an excessive multiple.

Such is the case right now as Constant Contact turned it’s first profit of 3 cents in 2008, generated 13 cents in 2009 and is expected to post 36 cents in 2010.  With revenue of $129.1 million in 2009 and expected revenue of $169 to $173 million in 2010, much of the additional cash flow should fall directly to the bottom line, increasing earnings per share and generating more confidence in the growing business.

We are pleased that the company’s revenue was ahead of our expectations for the quarter, closing out a highly successful year for Constant Contact. While the economic environment for small businesses was very challenging in 2009, Constant Contact was able to grow revenue by 48% and add over 94,000 net new email marketing subscribers, both of which represent significant accomplishments. ~ Gail Goodman, CEO

The currently high unemployment rate has many individuals considering striking out on their own, or launching a part-time business to help make ends meet.  Since our economy is making increasing use of internet marketing, Constant Contact is in the position to grow its client base and provide a valuable service to these new ventures.  Significant marketing expenses ensure that CTCT is staying in front of its target customer base which is very important as the company continues its exponential revenue growth.

While CTCT is certainly the most well known and aggressively marketed solution for email marketing, it is certainly not the only player in the space.  The ZachStocks Newsletter actually uses  AWeber Communications, a privately held email marketing firm.  Many larger corporations are able to set up their own platforms more efficiently, but for small businesses Constant Contact remains the leader with a very efficient and cost effective platform.

In order to truly get excited about Constant Contact, I would like to first see the stock break above $19.50 on strong volume.  That would help to indicate that institutions are buying the growth story and would provide an attractive entry with limited risk.  Once a trade was initiated, a stop could be placed under the most recent swing low (or for longer-term traders, below the $17 low from early February).  While I am not normally a fan of buying at extreme multiples, the impressive growth rate and inherent leverage in the business makes this an attractive candidate for a rising market.

FD: Author does not have a position in CTCT

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2010 is likely to be one of those years in which traders who participate on both sides of the tape (both long and short) will have a better chance of succeeding.  Investors in the Sound Counsel Investment Advisers absolute return model are currently weighted with significant short exposure due to the high market valuation and the potential for a second bear market in equities.  One of my highest conviction short positions is Salesforce.com (CRM) which reported earnings earlier this week.

Salesforce.com is one of the leaders in cloud computing technology which helps IT administrators make more efficient use of their resources.  In the past, companies would need to own a server for every major function or individual operating system.  The result was often a room full of dozens of servers which were all running at 20% to 30% capacity.  The situation was an incredible waste until cloud computing technology allowed servers to run multiple systems and efficiently allocated resources between the servers.

It’s easy to see how this exciting technology could lead to growing sales.  After all, large and small corporations could save on IT costs by using the technology.  And that’s why Salesforce.com has been able to grow revenues at a steady clip for several years.  Most recently, the fourth quarter revenue was up 22% to 354 million and for the full year the company collected $1.306 billion in revenue which is up 21% year over year.  Earnings were strong with the company posting GAAP earnings per share of 63 cents for the year – an 80% increase over 2008.  But while these figures appear very favorable, it looks like investors have bid the price of shares too high and may be ignoring some of the dramatic risks in the stock.

One of the biggest red flags that I saw when reading the quarterly report was the deferred revenue item.  For companies like CRM which receives 92% of its revenue from subscription and support, much of the revenue is received well ahead of time because of long-term contracts which are paid in advance.  Due to accounting rules, the company is not allowed to record the revenue until service has been rendered – so revenue for future quarters gets allocated to an account called “deferred revenue.”

At the end of the quarter, CRM had deferred revenues of $704 million – which was only up 19% year-over-year.  While positive movement is certainly a good thing, the company will need to attract a significant amount of new business in order to keep up with its recent sales growth.  The company has 73,500 paying customers which is up 4,600 during the quarter and that performance will have to continue to justify the share price.

For 2010, the company is guiding GAAP earnings between 58 and 60 cents per share.  I found it a little disturbing that CRM offered “non-GAAP” guidance of $1.25 to $1.27 in earnings when it appears that this figure simply does not account for stock-based compensation (there are a few smaller items as well).  To the non-suspecting investor, it might look like the company is really generating $1.25 to $1.27 in additional value for shareholders but stock based compensation truly is an expense and should be treated as such.  Although the company does not have to pay cash for this compensation, the additional shares issued has the very real effect of diluting current shareholders.

Finally, if you look at the current price of the stock ($66.75 as I write), and compare it to the earnings expected for this year, you can easily see that investors are paying 111 times earnings to own the company.  Despite the fact that CRM is growing, the multiple is ridiculous and will almost certainly lead to a sharp decline in the stock sometime in the next year.  I am completely astounded at the valuation and hope to profit when the stock trades back to a more reasonable level.

Thursday’s trade offered some mixed signals for short-term traders.  Initially, the stock gapped down well below the 50 day average as investors digested the earnings report.  But by the end of the day, CRM followed the market back higher to recover much of its losses.  Still, the stock was down on the day on volume that was well above average.  My suggestion would be to buy some out of the money puts on this stock (which are actually relatively expensive) or watch for a clear break lower on volume to set up a short position.  Keep your stop levels tight and don’t be afraid to stop out and then try another short trade when the stock breaks down again.

My sense is that eventually this stock will run significantly lower and while the price action will be sharp, it may take several weeks to a few months before CRM finds any significant support.  Damage control remains an important part of investing, but wise and careful shorting of this high-flying Wall Street darling could turn out to be very profitable.

FD: Author has a short position in Sound Counsel Investment Advisers accounts

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Yesterday, the market dealt a disturbing blow to frustrated bulls who were riding the recent rebound in equities.  Before the market opened, futures were a bit weak after a report showed German business sentiment was not as strong as expected.  (Remember, Germany is one of the primary countries which is expected to be responsible for bailing out Greece).  But while the pre-market futures were relatively tame, the market quickly turned lower after the US consumer confidence numbers were released at 10:00 AM EST.

Economists were surprised to see the confidence index drop to 46 which is the lowest reading since 2009.  At issue was the continued absence of employment recovery and a frustratingly lower reading in the “future expectations” category.  It seems that while the market has been pricing in a robust recovery, the average American is not quite assured.  Since consumer spending is a major part of our economy, weakness in consumer confidence is particularly troubling.

Fed laid groundwork for tightening last week

Weak confidence calls into question the stealth rate increase which the Fed undertook late last week.  The Fed is walking a delicate tightrope between loose policy which could quickly lead to excessive inflation, and tight policy which could cut off growth in our fragile economy.  Raising the discount rate last week signaled that the Fed was ready to begin tightening, which could have widespread implications on the economy.  One of the more disturbing results could be an increase in mortgage rates charged by refinance companies which would increase the difficulty of home refinancing for many borrowers.

As adjustable rate mortgages reset (at potentially much higher levels) this could not only reduce the amount of discretionary spending available to many consumers, but it could also cause another wave of losses for banks and mortgage lenders.  Such a crisis could have ripple effects including continued restraint in lending to small businesses which in turn could be unable (or unwilling) to increase hiring in the face of uncertainty.  Not to sound like a broken record, but it appears the dominoes are stacked and the consumer confidence report may have been one of the first to fall – setting off a chain reaction and leading to lower market prices.

Lower prices and a difficult economy does not mean that we as investors need to be resigned to suffer losses.  There are plenty of opportunities to use this scenario to our advantage including purchases of companies that will thrive in this environment as well as owning ETFs that trade inversely to market trends.  One example of an industry that should do well in a poor consumer environment is the payday loan / pawn shop industry.  ZachStocks has discussed a potential investment in First Cash Financial which should see its business pick up as consumers look for non-traditional financing options.

Inverse ETFs are also a helpful tool to offset losses in more traditional growth investments.  New products are quickly being rolled out that allow investors to bet against individual sectors, commodities, or geographic regions.  If you have significant exposure to energy companies, you might consider taking a position in the ProShares Ultrashort Oil and Gas (DUG) which will increase as this sector declines.  The beauty of these instruments is that they can usually be traded in an IRA (which typically would not be able to short securities) and offer an excellent hedging opportunity.

Before investing in any vehicle, make sure you understand the risks and potential rewards.  This is true for both traditional growth stock positions as well as less traditional positions that allow you to hedge your exposure.  If you are worried about potential losses associated with declining consumer confidence and the potential for more economic and market volatility, then please visit Sound Counsel Investment Advisers and allow us to help you navigate the turbulence.  Potential for market losses are significant, but sound investors should be able to use discipline and many available tools to keep their capital intact and even benefit from what may very well be a sustained downtrend.

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

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Investors in Portfolio Recovery Assoc. (PRAA) have to be pretty pleased with the way 2010 has treated them.  The stock is up nearly 20% so far this year despite the fact that the market has been sluggish.  At issue has been both a positive earnings announcement for the fourth quarter, and a successful stock offering last week.  The stock offering allowed the company to raise capital to pay down its debt level and gives the company more flexibility for future strategic purchases.

Portfolio Recovery operates in an industry that doesn’t have too many friends.  The company purchases receivables from financial institutions and other corporations and then attempts to collect enough of these receivables to cover its purchase price and generate a profit.  That’s a nice way of saying the company is a glorified debt collector.  This business has been profitable for quite some time, but in the last decade many market participants have faced competitive challenges.

As you can imagine, the name of the game is to buy these receivables at a steep discount to face value.  PRAA actually focuses on portfolios of defaulted consumer receivables – so they know up front that collecting on these debts will be challenging.  During the fourth quarter, PRAA bought $2 billion worth of loans (measured by the face value of debt owed by consumers).  The pricetag was a mere $75.1 million – or 3.755 cents for every dollar owed.  So with this low price, PRAA could theoretically see 90% of its face value remain in default and still make a nice profit.  There are administrative costs to consider of course, but the low purchase price goes a long way towards creating a strong business model.

A few years ago, there was much more competition for these loans.  Many financial institutions were holding on to debt longer or launching their own collection agencies.  Hedge funds were getting into the game too, buying the portfolios and hiring hourly workers to call and collect the debts.  Prices for these portfolios rose to a place where they were increasingly difficult to generate profits.  But during the financial crisis, many of these competitors went out of business or lost access to capital.  Today, the industry is much healthier and participants are able to generate strong profits.  According to the CFO of PRAA, the future also looks bright and should result in earnings growth:

Looking forward, we believe our strong financial position and continued access to capital will help position us well to take advantage of opportunities for continued portfolio acquisitions as we move further into 2010.” ~Kevin P. Stevenson, CFO

On February 11, PRAA announced strong earnings of 80 cents per share, and finishing the entire year with $2.87 in profits for every share.  Investors celebrated, pushing the stock up 18.3% in a single day.  A week later, the company priced a secondary offering, generating $71.6 million in new capital for the firm.  Before the offering, the stock had closed at $54.03.  The shares were offered at a discount with deal participants paying $52.50.  But during market trading the stock quickly rallied above the deal price and has maintained a stable price.  That’s a good sign considering the dilution effect of the deal.

Raising the capital gives PRAA more flexibility for growth in 2010.  At the end of the fourth quarter, the company had cash of $20.3 million and $319.3 million in borrowings.  With $45.7 million available for new borrowing, PRAA was getting low on options.  But now that an additional $71.6 million has been raised, PRAA has more than $100 million to work with if opportunities for purchases arise.  With continued concern over unemployment and weak consumer balance sheets, it is likely that PRAA will be actively buying debt at distressed prices.

Analysts are estimating 2010 earnings at $3.55 and those assumptions are likely conservative, based on the company’s current assets.  If PRAA makes a strong acquisition or two, these estimates could turn out to be low.  But even if the estimates are right, PRAA is only trading at a multiple of 15 which appears attractive considering the company’s growth.  While I believe caution is the most important trading strategy for the current environment, PRAA could turn out to be one of the better opportunities we have this year.

FD: Author does not have a position in PRAA

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A decade ago, investors were willing to pay any price for a company associated with the internet.  It didn’t matter whether the company made money or not – or even whether they had projections for eventually turning a profit.  Instead of earnings, investors looked at eyeballs, unique users, revenue growth, and plenty of other less important variables.  Analysts who believed that stock prices were too high were ridiculed as a “new age of investing” made old ratios and metrics obsolete.

But as is usually the case, fundamental valuations eventually became important and many of the high-flying internet darlings came crashing back to earth.  Some of the companies that were hit particularly hard (many of which had to declare bankruptcy), were the fiber companies which invested in the infrastructure which carried information across short or long distances.  The investment in these networks was huge and unfortunately, the companies couldn’t stick around long enough to reap profits from their ballooning costs associated with the network buildout.

Today, the picture is a bit different.  ”Dot com” investors who got burned at the turn of the century are leery of making the same mistake twice.  And so legitimate bandwidth companies who are turning a healthy profit are largely snubbed by the investment community as the industry has fallen out of favor.  Such is the case with Abovenet Inc. (ABVT) which provides bandwidth and fiber optic infrastructure to telecom carriers as well as individual corporations.  The stock only trades about 110,000 shares each day so it is widely overlooked by Wall Street, but the company carries a market cap of $1.5 billion and has posted profits for the last 13 consecutive quarters.

ABVT has had a strong run since the panic days of early 2009.  In fact, after trading below $15, the stock is now as high as $62 – more than a 300% return in just over a year’s time.  But despite the strong run the stock has experienced, it looks as if there is a good bit more room for investors to realize a profit.  When the company reports fourth quarter earnings in the coming weeks, it is expected that Abovenet will have generated $3.84 per share in earnings per share.  That’s a gain of 122% over the last year.  And the company’s growth should continue into 2010 although the rate will likely be much slower.  Given the stock price of about $62 and 2010 expectations for $4.12, ABVT is trading at an attractive multiple of just 15 times forward earnings.

Looking at the business, I’m impressed with the wide variety of customers Abovenet deals with.  In a February presentation, the company noted that 28% of its customers were telecom carriers while 72% of its customers were other enterprises.  The broad range of clients include major brokerages and insurance companies, media firms, and other businesses which have high bandwidth needs.  And since ABVT typically engages in long-term contracts, its visibility for revenues and earnings is very appealing.

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An issue that typically plagues infrastructure companies is capital spending.  In order to provide quality service and expand its network, the costs of laying fiber and developing a worldwide network can be prohibitive.  But Abovenet has been disciplined with its roll-out and as of the third quarter 2009, the company had realized earnings that exceeded the capital expenditures for the year.  With these statistics and a low debt level, investors can be confident that ABVT is handling capital decisions responsibly and shareholder value is being protected.

The broad market picture is unclear right now.  Macro issues such as Europe debt, China tensions, and high domestic unemployment continue to hamper recovery.  In 2010, equity markets have been weak, and yet the charts are becoming difficult to read as rebounds cast some doubt on the bearish thesis.  Investors must work through uncertainty and will likely do best with a long/short approach where capital is committed both to solid growth stories such as ABVT as well as to short opportunities where stocks are over-valued and sentiment is likely to fall.

ABVT should be an attractive candidate for the long portion of a growth oriented investment strategy.  A recent pullback offers an attractive entry point and technical traders could set a stop just below $55 where the stock found support earlier this month.  Risk control remains an important skill to develop, but if traded properly ABVT could offer significant profits.

FD: Author does not have a position in ABVT

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As equity markets continue to gyrate and investors fear another financial meltdown, companies with stable earnings and low sensitivity to economic conditions are becoming more attractive.  Healthcare companies may be particularly attractive in the coming year as demand should remain stable and the healthcare reform initiatives from Washington are not likely to be as anti-business as originally feared.  Healthspring Inc. (HS) is one company that offers quality care for Medicare recipients and is making a stable profit in the process.

Healthspring offers health care programs primarily through Medicare in the states of Alabama, Florida, Illinois, Mississippi, Tennessee and Texas.  The company has grown since coming public in 2006 with earnings increasing consistently each year.  However, the stock has not performed very well during the period as the earnings multiple has declined significantly.  Currently the stock is trading at just 7.8 times expected earnings for 2010 – quite a bargain if the company continues to see such consistency in earnings growth.

Part of the reason the stock trades at such a low multiple is the fear that health care reform will reduce the profits available to the firm.  Since Healthspring works closely with Medicare patients, there is a reasonable fear that the company could see its margins squeezed as a result of the anti-business agenda of the current administration.  However, with recent changes in political sentiment and some very clear backlash from voters, it is unlikely that health care reform will have the teeth to curb competitive business.  My personal opinion is that a more competitive environment will result in higher quality care at lower prices.  But regardless of your political view, the news is good for Healthspring and should bolster the company’s stock price in coming months.

On February 8, the company announced strong earnings for the fourth quarter, earning 68 cents per share compared to 51 cents in the fourth quarter of 2008.  For the full year the company grew earnings by 13.7% to $2.41 per share.  Revenue grew at a 25% clip over the quarter and management issued positive guidance for 2010.  According to the CEO, Healthspring should earn $2.25 to $2.50 in 2010 and we should keep in mind that management typically “sandbags” earnings expectations promising low numbers so that they can beat expectations throughout the year.  Analysts weren’t all that impressed as the consensus estimates for 2010 earnings has the company earning $2.27, but the good news for investors is that these estimates are likely to be beaten.

Shortly after the earnings announcement, the company issued another press release stating that Healthspring had been able to refinance its debt with much more attractive terms.  Healthspring entered a $350 million dollar senior secured credit facility which is divided into a $175 million dollar 5 year loan, and a $175 million dollar revolving credit facility.  The company used the proceeds from the loan and cash on hand to pay off its entire existing debt which had been scheduled to mature in October of 2012.  This gives the company more flexibility time-wise, and still leaves Healthspring with a large war-chest of cash.

We believe that we are well positioned to capitalize on potential strategic opportunities created by both the current Medicare Advantage rate environment and healthcare reform. This new facility provides us with greater financial flexibility to, among other things, take advantage of such opportunities. ~Karey L. Witty, CFO

The “strategic opportunities” that Witty speaks about could easily be an acquisition of another provider in a different state.  This would allow the company to increase its footprint and significantly grow its business.  Since many firms are trading at a discounted value (both public companies and private providers), Healthspring would likely be able to make an acquisition that would be immediately accretive to earnings.  So the $2.25 to $2.50 in expectations for 2010 could very well be a conservative number.

So despite a strong run in the stock since the March low from last year, Healthspring is still a very attractive investment trading at a low multiple with significant potential for growth.  I believe investors could see the price more than double over the next 12 months if investor sentiment becomes more amenable to owning health care companies.  With a strong balance sheet, impressive opportunities and a low multiple, this stock appears to have a very attractive risk to reward ratio.

FD: Author does not have a position in HS

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