Don’t Let This Dog into Your Portfolio

By Linda McDonough

Roadrunner members know that we like to keep our nose to the ground on any developing news in the pet industry. Imagine how our tails wagged when we saw recently that Blue Buffalo Pet Products (Nasdaq: BUFF) had filed for an IPO. The stock offering is expected to price this week at a price between $16 and $18. Unfortunately, slowing sales growth, flat profits and a St. Bernard sized valuation will leave this stock in the dog house.

Blue Buffalo was founded on honorable principles.  Founder Bill Bishop and his two sons, Billy and Chris, were devastated in 2002 when their young Airedale, named Blue, was diagnosed with cancer at an early age.  Their mission was to develop high quality natural foods for pets to promote and sustain good health.

Bill Bishop, the father, had spent his career perfecting advertising and marketing for consumer product companies Unilever NV (NYSE: UN) and Procter and Gamble (NYSE: PG) before founding SoBe new age beverages in 1995. That company was later sold to PepsiCo (NYSE: PEP) in 2001, setting up a rich source of funding for the development of Blue Buffalo pet foods.

The good news is that Blue, the Bishop’s Airedale, is still chasing tennis balls and feeling healthy.  The bad news is that Blue Buffalo’s revenue, which grew revenue 37% in 2013 and 27% in 2014, put up only 10% growth in the first quarter of 2015.

Slowing growth is not necessarily a problem if profit growth accelerates or if a stock’s valuation is reasonable. Unfortunately neither of these commands is followed by the Blue Buffalo offering.  After growing profits 30% to $0.52 per share in 2014, Blue Buffalo saw earnings per share sag down a penny to $0.15 per share in the first quarter.

At the $17 midpoint of the suggested pricing range, Blue Buffalo will be trading at 37 times 2014 earnings. All of the 29 million shares offered are from selling shareholders which means that the company will not receive any of the proceeds from the deal for future growth spending.  Nevertheless, the selling shareholders are only selling 15% of their holdings and private equity firm Invus will hold a controlling 62% ownership stake after the IPO.

Unless Blue Buffalo starts behaving better with increasing growth rates, investors buying this IPO may leave with their tails between their legs.

Around the Roadrunner Portfolios

MSC Industrial Direct (NYSE: MSM)  is turning lemons into lemonade.  The nationwide distributor of metalworking and industrial supplies continues to be well positioned to gain market share in a weak demand environment.  On the company’s third quarter earnings call, CEO Erik Gershwind spelled out how a cyclical slowdown in the industry could manifest into greater success for MSC:

As I look ahead, longer term dynamics remain favorable for an exciting growth story. First, the MRO marketplace is very large and highly fragmented, with clear signs that we’ve entered the early stages of a consolidation story.

This is starting to play itself out in the large accounts arena, and I expect the trend to build momentum over time. If the recent softness continues, local and regional distributors will be hit disproportionately hard, and that will mean even more opportunity for MSC to execute our growth plan.

Although MSC revenue growth is slowing, investors who have been listening to CEO Gershwind’s honest and direct communication in previous calls were not the least bit upset by this temporary weakness.  Revenue is expected to grow 2% in the fourth quarter.  Management noted that the significant and swift deceleration in demand witnessed earlier in the year has dissipated and orders are leveling off.  The cross selling opportunities envisioned when MSC purchased Barnes Distribution North America are coming to fruition.  Salespeople who previously were primarily selling metal working parts now are able to offer customers a wider range of products.

MSC is set to make $3.79 per share this year and pays a handsome 2.25% dividend yield to investors as they comfortably wait out a cyclical upturn in industrial manufacturing.  MSC joined the Roadrunner Value Portfolio on June 1, 2015 and is up 2.75% since inclusion.

W.R. Berkley (NYSE: WRB), has been a resounding winner in the Roadrunner Value Portfolio since its May 2014 initiation.  The stock is up 42% since inclusion and up a remarkable 9.5% year to date.

The specialty insurer’s combined ratio of 93.9% continues to benefit from strong pricing trends.  In the company’s first quarter earnings release in late April, CEO William R. Berkley noted that rate increases have dwarfed trends in the cost of loss claims.

While investors await the company’s second quarter results, to be announced on July 27th, they are enjoying a boost to the stock due to industry merger activity.

In early June, Japanese insurer Tokio Marine acquired HCC Insurance Holdings for $7.5 billion in cash.  The deal was yet another illustration of broadline insurance companies’ hunger to diversify into specialty lines of insurance.  Tokio was also lured by geographic diversification.  Tokio specifically mentioned the benefit of enjoying the growth in overseas markets, where demographics support higher demand for insurance.

While speculation does not in any way guarantee further stock gains, W.R. Berkley’s fundamentals continue to roll in the right direction.  A 9% increase in the company’s annual dividend and the initiation of a 10 million share repurchase program were announced on June 2nd, offering investors more good news until earnings are released.

One look at the Sanderson Farms’ (Nasdaq: SAFM) chart would leave investors guessing the company’s earnings had laid an egg.  Nothing could be further from the truth.  Second quarter earnings reported at the end of May showcased a 41% increase in earnings per share.  The stock, which is down 27% since our July 2014 inclusion in Roadrunner’s Value Portfolio is down 15% year to date despite delivering robust earnings.

The problem lies in the cyclicality of Sanderson’s business.  Although stronger domestic demand has supported mid-single digit revenue growth, the real propulsion to earnings has been the shriveling cost of corn feed.  Investors are nervous that earnings will plummet when feed costs return to normal levels.

According to data from the Chicago Board of Trade, corn prices have fallen 50% in the past two years.  In that same time period, Sanderson’s earnings have catapulted from $2.35 in 2012 to $10.80 in 2014! Although estimates for 2015 call for an increase to $11.58, 2016 pencils in a 30% drop to $8.00 per share.

Add to that fears that McDonald’s may follow suit of Chick-Fil-A and Chipotle who promise customers antibiotic-free chicken.  In early May competitor Tyson Foods announced that they will phase out the use of all antibiotics for chicken raised for meat by 2017.  CEO Joe Sanderson responded in May that the company is not changing their company policy on antibiotics, which may increase the risk of lower sales in the future.

Yet Sanderson trades at the low end of its historical P/E range.  The company has traditionally traded at 8 times historical earnings and is currently trading at 6.5 times 2014 earnings.  It has almost no debt and a book value of $44, versus its current stock price in the low 70s.  Investors can likely start wading into the chicken coop knowing that this low valuation should insulate them from large future losses.

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