wall street nuggets

The health insurance stocks recovered rather quickly from Thursday’s overreaction. An interesting observation is an asymmetry in the typical response patterns to good news and bad news. It appears that this phenomenon can even be observed at the sector level and a good example was provided yesterday in the sector rebounds across 7 sectors that appeared to overreact to bad news on Thursday.

Intuitive Surgical [ISRG] was up 23% in heavy trading on Friday following its announcement of first quarter earnings of 38 cents per share, well in excess of the Thomson First Call survey estimate of 20 cents per share, and an upgrade by Piper Jaffray. Other strong performers in the Medical Technology Sector on Friday were Abaxis [ABAX] up 10.7%, American Medical Systems [AMMD] up 10.4%, Angiodynamics [ANGO] up 10.3%, Merit Medical Systems [MMSI] up 9.6%, and Laserscope [LSCP] up 6.5%.

Proquest [PQE] was down 27.7% Friday on very heavy trading. An internal audit led to a restatement of earnings, mostly affecting the Information and Learning business unit, which targets the education market. At this point it appears that the restatements will apply to 2000 through the first 3 quarters of 2005, with major downward revisions to earnings in 2004 and 2005. (The company has yet to file its results for the fourth quarter of 2005.)

Optical Communication Products Inc. [OCPI] reported a quarterly profit in line with analysts’ expectations but provided guidance for next quarter that was below expectations. In reaction, the stock price dropped 24.8%. While a new interim CFO was named, the incumbent remains on board with a new role involving business development. The most recent quarterly result seems to indicate the primary reason for achieving meager profits (2 cents per share for the quarter ending March 31^st) was a cutback in R&D.

Another member of the Network Technology sector, Network Equipment Technologies Inc. [NWK] which announced disappointing results on Wednesday after the close (only one analyst not paying close attention) tanked at the close when someone apparently sold about 3 million shares at $3.05, well below the level of $3.60 per share where it had been trading on relatively low volume before the big sell order. These two stocks explain the dramatic drop in the Daily Sector Performance chart (below). Our most promising stocks in this sector are Emulex [ELX], DIGI International [DGII] and Cisco [CSCO].

Microsoft’s [MSFT] disappointing bottom line, coupled with lackluster earnings projections and a lack of detail on its new R&D efforts led to an 11.4% decline on Friday, and probably cast a shadow over much of the NASDAQ. The real secret sauce at MSFT has always been identifying the next big idea invented somewhere else, and then taking control. We think their focus needs to be outside the company and finding that next big opportunity.

Overstock [OSTK] posted rather disappointing first quarter results and the market responded with a 9.9% drop in price. We should probably expand CEO Patrick Byrne’s eastern proverb this quarter: “Before enlightenment, chop wood, carry water. After enlightenment, chop wood, carry water.” From this reference, we assume he has found enlightenment – presumably that OSTK’s problems are not all due to the short sellers. However, it appears that true enlightenment remains elusive. When we look at the OSTK reach in the online market (see www.alexa.com, for example), the April 2006 reach of about 2 per thousand, compared with 3 per thousand in April 2005 is very ominous, especially given the amount of red ink on the books. Cable TV ads do not seem to be working, and demand is flat at best, depending on your horizon. The company desperately needs a new image, and it needs to find that image well before the fourth quarter seasonal spike.

Aetna [AET] reported Q1 operating earnings of 64 cents per share, up 31% versus last year, 2 cents better than previous guidance. It also increased guidance for FY 2006 to $2.74 to $2.76 per share from $2.71 to $2.74. Despite, the apparent strong quarter, the stock price fell 20.3%. Wow!

So what was the bad news? Apparently its medical cost ratio (MCR), which is roughly the cost of providing coverage as percent of premiums, increased to 79.4% in the first quarter of 2006, versus 74.6% in Q1 of 2005 (Commercial Risk segment). The naïve understanding of MCR would lead one to believe that an increase in MCR would lead to a decrease in earnings, but the MCR is apparently a purer measure of the health of the industry (at least as far as investors are concerned), so the market diagnosis for [AET] is pretty bleak. Given the fact that the MCR tends to increase with the age of the insured (note that the Medicare MCR rose to 87.3% in the first quarter), and given simple demographics (the aging baby boomers), there is obviously upward pressure on the MCR and little capacity in the insured base to tolerate higher premiums. Historically, the MCR has been much higher (over 90%) and healthier living styles should help control future MCR levels, so we are inclined to believe that the long term prognosis is not that bad and that at current P/E levels, the sector undoubtedly will recover and represents a good investment.

Appearing before the congressional Joint Economic Committee on Thursday, Fed Chairman Ben Bernanke indicated that it was likely there would be a pause in the consistent pattern of rate hikes over the past 2 years, while the incoming data was monitored to assess the prospects for inflation and growth. This suggests that while there might not be a rate hike in June, the briskness of the economy in the first quarter should lead to further increases in the yield curve over time, which should benefit the banking sector. Indeed the banking sector did respond well, with an average increase in price of .3% across the entire set of 392 banking stocks. However, the response was much more dramatic for larger banking institutions. The average increase for the largest 5 banks in the universe was a very strong 2.36% increase, and with only one exception (Popular Inc. [BPOP]), the largest 50 banks in the universe (those with market cap greater than 2.5 billion) all saw positive price changes on Thursday! Bernanke also said, “One sector that is showing signs of softening is the residential housing market.” However, he added, “This sector will most likely experience a gradual cooling rather than a sharp slowdown.” Given the average increase in the REIT subset on Thursday was .65% and the average decline in the Construction sector was -1.6%, this was apparently taken as good news for REITs and bad news for Construction.

China’s raising of interest rates on Thursday sent Chinese stocks tumbling and the expectation that this would cool off the global demand for metals, minerals, and chemicals, put a damper on those sectors as well.

Audio chipmaker SigmaTel Inc. [SGTL] dropped 22.6% on Wednesday following a press release by the company indicating that its Q1 revenue was $33 million, down 67% from Q1 revenue of $99.3 million last year. They also reported a pro forma loss for the quarter of $21.8 million (or a loss of 61 cents per share) versus a profit for the same quarter last year of $25.4 million. Since analysts were expecting a loss of 57 cents per share, the stock was probably not punished so much for the dismal Q1 results but rather the new guidance for Q2 losses which are projected to be in the range of 59 to 66 cents per share versus analysts’ expectations of 36 cents per share. Yuck! What is really insane, however, is the decline of $30 million in cash spent to repurchase stock since the end of the year. According to yesterday’s press release, as of March 31^st, the company had only $51.4 million in cash and short term securities, down from $118.9 million at the end of 2005. Good grief!

Research topic:

An interesting question is how to determine when a stock is significantly over or under valued. One common measure of value is the P/E or price/earnings ratio, usually defined as the ratio of the current price to the latest available trailing twelve months earnings per share available, assuming the company has earnings. At this point in time, the majority of the companies in the SigmaInverse universe have reported earnings for the fourth quarter of 2005, so it is a good point to step back and look at the distribution of P/E ratios across the universe of stocks that we monitor.

As of yesterday, there are 3,458 stocks being tracked in the SigmaInverse universe. Of these 2,811 (or 81.3%) have positive earnings for the trailing 12 months, so the P/E ratio is defined. For a few stocks, the earnings are so meager that the P/E ratio is quite large and since we are looking for a measure of central tendency, it is not a good idea to compute a simple average of all the P/E ratios. The simple approach of noting that the distribution peaks between 14 and 18, is probably sufficient. Note that it would be a mistake to label every company with a P/E less than 14 as a bargain, and every company with a P/E greater the 18 as expensive. For example, [SGTL] had a P/E ratio of 7.23. Given their recent performance, we might say even that value is a bit generous.

Other notes:

Travelzoo [TZOO] is finally stabilizing with a soft landing somewhere in the vicinity of $40 per share.

SpatiaLight Inc [HDTV] is not only on track to deliver its LCoS microdisplays, but it announced on Wednesday that it is working with an unnamed global developer of next generation 3-D eyeglass-type displays that can be used with a variety of portable devices. These special “eyeglasses” would use the current HDTV technology. Huge potential here.

Daily Sector Performance (below) shows Oil & Gas down an average of 1.23%, probably in reaction to all the talk of windfall profit taxes in Washington.

As the daily sector performance chart in the previous post indicates, the Railroads did not stay on track Tuesday, with an average loss of 2.4% for the group.  Burlington Northern Santa Fe [BNI] was off 6.2% for the day, following their announcement of Q1 results.  Given the stock gapped down about $4 per share, one might assume that the Q1 results were disappointing.  However, the company reported that earnings had increased 31% to $1.09 per share versus an expected $1.04 per share!  We should also note that Norfolk Southern [NSC] was off 4.3% for the day – with no news at all!  Unlike the Airline industry, Rails have been relatively immune to energy costs, which is to say they have been more successful in passing the energy cost increases on to their customers.  Given the gap down for both [BNI] and [NSC], we need to understand what it was about the [BNI] announcement that triggered the selling.  If the selling came from insiders leaving a blackout period, it would have been limited just to [BNI], so that does not seem plausible.  Noting that Railroads in general are up about 60% over the past year, one can argue that some big players in the market were just trying to lock in the profits in this sector and moving into other areas.  Yesterday saw a very big surge by Thestreet.com [TSCM] which announced some very impressive numbers for both subscriptions and advertising revenue.  Journal Communications [JRN] on the other hand reported little change in revenue or net income (after removing the contribution of the sale of NorthStar Print Group) last year, which was pretty much in line with expectations, and yet had a gain of 6.9% for the day.

The lesson to be learned here is the risk in having a model that is purely fundamentals based.  While there is no doubt that genuine surprises in announcements will affect prices, one cannot assume that, in the absence of surprises in announcements – the market will respond consistently to good or bad fundamentals.

DOV Pharmaceutical [DOVP] stock plummeted 42.1% on Tuesday, when the company announced that Phase III clinical trials of its analgesic drug bicifadine failed to demonstrate any statistically significant improvement over a placebo in the treatment of chronic low back pain. However, it should be noted that a 2003 Phase III clinical trial demonstrated that bicifadine achieved a highly significant reduction in pain when compared with a placebo in the treatment of severe post-surgical dental pain. Furthermore, it was comparable with tramadol in the treatment of pain in that study and, given its relatively low adverse reaction rate and non-narcotic nature, had a clear advantage. A 2005 Phase III clinical trial also demonstrated bicifadine was effective in treating moderate to severe pain following a bunionectomy. Phase III trials involving the treatment of acute pain following vaginal hysterectomies should be completed in Q3. We are apparently dealing with a drug that for some reason failed to achieve the expected response in the case of chronic low back pain at the dosage levels tested. This should actually help shed additional light both on the poorly understood mechanism for how bicifadine actually inhibits pain as well as what the cause of chronic lower back pain might be.

Meanwhile, it does appear that bicifadine should play a role in the $8 billion dollar analgesic market (except for chronic lower back pain), and furthermore, the company has some other strong products for the treatment of insomnia, depression, angina, hypertension and alcoholism.

The company lost $52.97 million in 2005 with revenues of only $8.65 million. Long term debt has increased about $65 million over the past 2 years and equity financing has provided another infusion, but future prospects, with $78.5 million in working capital and current burn rates, pose a serious concern.

Bottom line? I would hold off on this one - NOT because of the Phase III trial results regarding bicifadine - but because there is still too much uncertainty regarding their ability to execute.

A sharp turnaround for the Airlines.  Buoyed by an upgrade by Prudential Equity Group, anticipating positive Q1 earnings for US Airways Group [LCC], the sector was up 2.4% on Monday, while the stocks in the SigmaInverse universe were off an average of .6% on Monday.  LCC was up over 11%.  Other strong performers in the group were Continental Airlines [CAL], AMR Corp [AMR], Airtran Holdings [AAI] and Jet Blue [JBLU] which were all up over 5% on Monday.

Meanwhile, the slight pull-back in oil prices seems to have triggered a sell-off in the Oil & Gas sector which saw an average drop of 1.6% on Monday.  It is interesting to observe that, although one should be able to neutralize the impact of fuel costs on airline profits by adjusting ticket prices, the market reaction will usually translate lower fuel costs into good news for the airlines and vice versa.

Matria Healthcare [MATR] continued to plummet on the resetting of Q2 revenue estimates.  With a P/E ratio of 36.9, this stock still appears very pricey compared to its competitors, so any move to go long in this stock should wait until the price stabilizes.

Travelzoo [TZOO] continues its run unchecked, with a closing price on Friday of $44.35 per share, up 20.9% for the day. For the week, it ended up 126% with a P/E ratio of 98.8. Of course [TZOO] was in this same range about a year ago, as it plummeted down from its all-time high of $106 on Dec. 27, 2004. Of all days, this happened on the same day that crude oil prices hit $75 per barrel and gasoline prices rapidly approached $3 per gallon, taking a toll on the Airline, Travel and Transportation sectors. Having even surpassed Google’s P/E ratio of 87, we are inclined to conclude that [TZOO] is probably over-valued at this level.

Gene Logic Inc. [GLGC] closed down 26% on Friday with a very disappointing first quarter. Sales apparently are down from 19.7 million in the first quarter last year to 12.8 million in the first quarter of this year. All 3 divisions (Genomics, Preclinical and Drug Repositioning) are reporting significant losses and there are apparently no rays of hope anywhere on the horizon. Even the recent partnership with Organon, a unit of Akzo Nobel in the Netherlands, seems to offer little hope at this point.

Matria Healthcare [MATR] managed to hit their Q1 numbers, BUT, in response to certain expected sales not materializing, the company reset expectations for Q2 and as a result the stock closed down 20.4% for the day. This overreaction might suggest an attractive opportunity. The key here is that the company is expecting only a temporary hit on revenue, with a recovery by the end of the year, although the market is reacting as if the decline is permanent.  A metaprinciple in this case is the importance of anticipating which component of the company’s guidance will have the greatest impact and making sure that the model can rationally (or irrationally) respond.

Steven Madden Ltd. [SHOO], which designs, markets and sells trendy footwear primarily targeting teenage girls and women under 30, gave a preview of its Q1 results on Thursday, and its share price soared 29% in response. While full results aren’t expected until May 2^nd, the company indicated that it expects Q1 revenue of $108 million, versus analysts’ expectations of $90.7 million, and 30% higher than last year’s Q1 revenue of $83.3 million. It projects earnings in the range of 72 to 74 cents per share, which is well beyond the range of 18 to 28 cents that analysts had been expecting. This was achieved through smarter inventory control and better than expected wholesale segment sales. Looks like the company is benefiting from having Steven back from prison. (Shades of Martha?)

Broadcom’s [BRCM] Q1 results were very strong with net income of $134.9 million versus $69.2 million last year. EPS came in at 22 cents per share, even including a 14 cent expense related to stock-based compensation. The stock was already up in after hours trading.

Google [GOOG] also posted great Q1 results with a 79% jump in revenue at $2.25 billion, with expectations ranging from $2.05 billion to $2.24 billion, and was also up about 5% in after hours trading.

While EBAY posted a solid first quarter with revenue up 35% over last year, analysts continue to be worried about the apparent lack of growth in reach since October, 2004, and uncertainty, leading to a 9% drop in its price. We think this is likely an overreaction, although EBAY needs to find a mechanism for stimulating demand.