Boom, Boom, Boom

Like it or not, firearms are woven tightly into American history and culture. The founding fathers found gun ownership so important that they protected it in the second amendment to the U.S. constitution. Some of the world's most famous guns and gunmakers, from the Colt Single Action to the Remington 870 to the M16, have come from America. At about 40% personal ownership and over 300 million guns, the U.S. easily has the most armed citizenship in the world.

Recently, the gun industry has enjoyed record demand, with 3 distinct gun "booms" in the U.S. over the past 5 years. The first came in 2008, when the election of Barack Obama sparked fears of increased gun control and even a potential repeal of the second amendment. The second was in 2012, when his re-election became apparent. And the third, ongoing to this day, came after the horrifying school shooting in Newtown, Connecticut, sparked new momentum for gun control laws.

The tangible evidence is staggering. Background checks are up a staggering 4-fold since 1999. Since 2007, Ruger has grown sales 243% while Smith & Wesson is up 127%. Both firms are running flat-out, struggling to produce enough guns to meet demand.

Without a doubt, it has been a good time to be a gun maker.

Dueling Stocks

So we know the industry conditions are good, but which of the two stocks is more attractive?

The companies themselves are very similar. Ruger makes essentially all of its dough from firearms, and although S&W is also a big maker of handcuffs, 96% of sales are from guns. Both firms compete mainly in pistols, revolvers, and rifles. Ruger doesn't compete in black powder guns or "modern sporting rifles", where S&W does with its Thompson Center and M&P Sport lines, respectively.

From a quality standpoint, there is a clear winner - Ruger. While both have enjoyed the boom, Ruger has operated better. We already quoted growth figures, where Ruger has double the revenue growth since 2007. During that period, Ruger has successfully gotten in front of the trends, a notable one being lightweight compact revolvers, something Smith & Wesson was behind the curve on. Ruger has a better balance sheet, with $46 million in cash and zero debt, vs. $62 million cash / $44 million debt for S&W. Ruger's operating margins have been in the 16-23% range during the boom, while S&W's have been about half that. Return on invested capital for Ruger has averaged 63%; for Smith & Wesson, 19%. S&W also went through a debacle of buying security supply company Universal Safety Response in 2009, only to turn around and divest it in 2011! Clearly, Ruger has been a better operator.

From a value standpoint, though, the opposite is true. Smith & Wesson is a much cheaper stock, with a 9.3 P/E ratio and a 19% pre-tax earnings yield, vs. 13.0 and 12.6% for Ruger, respectively. New management at S&W is making real progress in operations, posting a 20.7% operating margin in the past 12 months, only a few points behind Ruger's 23%. One point in Ruger's favor is the dividend - that company pays a substantial 3.8% yield, compared to no dividend for Smith & Wesson.

Pull the Trigger?

If someone held a gun to my head and told me to pick one of the two for investment, my choice would be Smith & Wesson, at least at current prices. Ruger may be the better company, but S&W is the better investment. A cheap valuation is the best determinant of investment success, and SWHC is considerably cheaper. Also, S&W has the longer history (160 years) and better known brands, no small advantages in a market where the collector is a major factor. Finally, S&W simply has more room to improve, and new management is already getting the company back on track and catching up to Ruger's operating standard.

All this said, I'm still not convinced that current gun demand is sustainable over the long term. In coming up with valuations for these stocks, it is prudent to scale back to 2010-11 volumes when estimating future cash flows. Doing this, I come up with a target around $12 for S&W, and about $49 for Ruger, further supporting the case for Smith & Wesson. In any case, a 25% margin-of-safety on SWHC is a bit tight for what seems like a market in a bubble. Neither of these gun stocks looks interesting enough to enter our Top Buys list right now.

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Given the staggering growth in the overweight population, along with the associated health risks, the obesity epidemic is now considered a bigger global health crisis than hunger.

Such is the backdrop behind today's Top Buy pick, Weight Watchers (WTW). Weight Watchers is one of the most known and respected brands in the sometimes shady business of weight-loss solutions. Founded in 1963 by homemaker Jean Nidetch, the company has expanded into almost 30 countries and runs meetings attended by over a million people every week. The core of Weight Watchers is using a "points" system to simplify calorie counting. Members can participate through in-person meetings or through an online-only program utilizing mobile apps and (optionally) wearable activity monitors. Additionally, Weight Watchers licenses its brand to consumer products firms like Kraft (KRFT) and General Mills (GIS) and restaurants like Applebee's (DIN). Last year, meeting fees accounted for 51% of revenues (down 5.6% from 2011), Internet revenues were 27.6% (up 26.2%), in-meeting product sales (foods, points guides, magazines, etc.) accounted for 13.9% of sales (down 10.1%) and licensing and franchise royalties were 7.4% (down 8.9%).

I like Weight Watchers in the low $40's. This is a company that traded at nearly $80 a year ago and at $60 in early January. Recent operating weakness was largely attributed to advertising issues, a major one being the pregnancy of Jessica Simpson derailing a running campaign centered on her 50-pound weight loss on the system! Also, comparisons against 2011 were very difficult. 2011 was a record year, with 25-30% growth throughout.

No one should ever expect Weight Watchers to sustain 20%+ growth rates, and I certainly don't see the stock reaching the $80 point again any time soon. However, I do believe that marketing campaigns can be fixed relatively rapidly, and the tough comparisons will roll off later this year. Management did admit on the Q4 conference call that weak guidance could prove to be too conservative. Even assuming high single-digit declines this year, followed by modest 5% growth after that (driven mainly by Internet, international, and business-to-business growth), I see a 35% margin of safety at current prices.

That is pretty good for such a stable business. Meeting fees are recurring and have a very high rate of renewal. Meetings are the core of Weight Watchers' economic moat - it is a differentiator that few competitors have tried to replicate, and probably couldn't even if they tried. Brand is another - Weight Watchers is still the most well-known and respected brand in weight loss, a powerful advantage over new entrants or the latest fad. Even during the deep recession in 2008-09, Weight Watchers only experienced a 9% revenue decline and still maintained a respectable 25.7% operating margin. Cash flows are stable and reliable, and I categorize Weight Watchers as a "conservative" pick.

That's not to say there are not risks. Weight Watchers' growth is coming solely from Internet revenues, with meeting fees slowly declining for much of the past decade. This is an issue, because as stated before, the core of Weight Watchers' competitive advantage is its meeting infrastructure. There are loads of (often free) mobile apps that users can track calories and exercise with.

Also, the company has a poor balance sheet. At $2.4 billion, debt dwarfs the $70 million on the balance sheet. Fortunately, Weight Watchers' reliable cash flows are more than enough to handle it, and interest obligations are covered more than 5 times over by operating earnings. Banks don't seem too concerned either, as the firm recently refinanced its entire debt load, extending maturities and ultimately reducing interest payments. Still, should operational weakness worsen, the firm could be in danger of violating debt covenants, which would be a major issue, albeit unlikely (particularly within our one-year holding period).

All in all, Weight Watchers looks like a good investment opportunity at present, despite a few warts. The sell early target is $57.

Read MagicDiligence's Weight Watchers (WTW) Research Report

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MagicDiligence likes consumer products businesses like this. Revlon's products are consumable, reasonably non-discretionary, and purchased over and over again. The company has strong brands, with leading market share in mass retail cosmetics and hair color, which provides a sustainable competitive advantage. Measured international expansion (particularly in South America), new products (such as the recent purchase of Pure Ice), and price increases should allow the firm to continue to grow sales in the mid-to-low single digit percentage range. Revlon's margins have reliably been in the 15% range, which is comparable to competitors like L'Oreal. It is just a stable, predictable business.

There are two problems with Revlon as a Magic Formula� Investing (MFI) stock to buy now. The first is poor financial health. Revlon has, and continues to, operate under a mound of debt. The firm's debt burden is nearly $1.2 billion, offset by only $116 million of cash in the bank. Interest rates on that debt have been high - the company's interest coverage ratio (operating earnings / interest cost) is just 2.6, well below my minimum of 5. Considering the company only generates about $90 million in free cash flow per year, it's clear that continuous refinancings are going to be a fact of life here, making another credit crunch a very scary proposition for the firm.

To be fair, this is less of a concern after a recent refinancing. Revlon secured $500 million in senior notes back in February, due in 2021 and carrying a 5.75% coupon. With this cash, they tendered back about $200 million of the $333 million outstanding on previous 2015 notes at 9.75%, and paid down about $100 million on a term loan. In the process, the firm's default risk is lowered, as are interest costs going forward.

The second problem is simply that Revlon isn't quite cheap enough for my liking. A discounted free cash flow calculation, assuming 5-7% growth over the next few years, gives me a fair value of about $24 per share. A multiple-based valuation, using Revlon's long-term earnings yield of about 10%, gives me a similar number. With the stock currently in the low $20's, that's less than a 15% margin of safety. Considering Revlon doesn't (and won't) pay a dividend or buy back shares, and the fact that debt covenants make a buyout of the firm almost impossible, that's not quite enough for me. I might get interested in Revlon around the $17 mark, but until then there are better opportunities in MFI at present.

The second unit is Securities Processing Solutions, or SPS, which was 29% of sales and 27% of earnings in fiscal 2012. SPS consists of an outsourced set of services for trade order execution, confirmation and accounting, as well as tools for aggregating and reporting portfolio data and performance. Using Broadridge allows brokers to avoid building out costly and troublesome infrastructure to support the basic back-end processes of electronic trading.

If I had to pick one word to describe Broadridge, it would be "stable". The company has some very strong competitive advantages. ICS handles proxies for 85% of the outstanding shares in the U.S., and 60% globally, dwarfing any competitors. SPS offerings are involved in $4.5 trillion in trades per *day*! The vast majority of revenues are recurring in nature, and Broadridge sports a nifty 99% client retention ratio. While event-driven communications and trading volumes affect revenues year-to-year, Broadridge rarely sees more than mid-single digit percentage fluctuations in sales. Stability, again, is the word here.

Growth, on the other hand, is more difficult. The securities and brokerage industries are quite mature in the U.S., and with increasing consolidation, there is little in the way of organic growth opportunity for Broadridge. The company has responded by looking for "tuck-in" acquisitions, such as Paladyne and Matrix to build out SPS offerings in 2011. However, Broadridge is not an aggressive acquirer, and as such I don't expect a lot of revenue growth here, perhaps in the 5-7% range annually moving forward.

As a slow growing, cash producing, competitively advantaged company should do, Broadridge rewards its shareholders mainly by returning cash. The firm has reduced shares by a 3.4% annual rate over the past few years, and pays a 3.1% dividend that is well-covered and easily raised, at just a 26% payout of free cash flow. In fact, the company has tripled its dividend since going public in 2007, raising it each year along the way. I expect both share buybacks and dividend hikes to continue.

Broadridge is no doubt a solid company, but as an investment opportunity it comes down to the price. And here is where I feel the investment case comes up short. At just an 8% EBIT/EV earnings yield, Broadridge is not especially cheap. Even assuming Broadridge returns to 13-15% margins after posting a 12% figure last year (largely on short-term transitional issues related to Penson's bankruptcy), the stock isn't that cheap against its historical 9.5% yield average. Even a discounted free cash flow calculation, assuming about 5% long-term growth, gives me a price of about $25. With the stock in the mid-$23 range, that's not enough margin of safety. I'd get interested if Broadridge got under $20. But for now we'll just throw out the "neutral" opinion - it looks about fairly valued. We're looking for better opportunities.

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The Exchanges unit contributed 80% of 2012 revenue, up 22% from 2011. Ebix operates insurance exchanges in the life insurance, annuity, health benefits, workers compensation, and property/casualty (P&C) areas. An exchange is basically a marketplace where clients can compare plans and apply for coverage. Ebix earns revenue from insurance providers that pay monthly subscription fees to list their products, and transaction fees for each transaction processed on their exchanges. Additionally, providers may contract Ebix to build custom interfaces from their systems to the exchanges.

Broker Systems was 9% of revenue, up 3%. This business consists of developing and deploying "back-end" systems for P&C brokers in the U.S., Australia, and elsewhere. Business Process Outsourcing (8%, +8%) creates and tracks certificates of insurance for clients in the U.S. and Australia. Lastly, Carrier Systems (2%, -8%) develops custom systems for P&C providers.

Going strictly by the numbers, Ebix looks like an attractive investment. 5-year compound annual revenue growth rate is 22%, and operating margins have remained very stable around 40%. While debt on the balance sheet does outpace cash ($82 million vs. $37 million), Ebix generates substantial free cash flow, around $70 million each of the past 2 years and growing at a good rate. This allows the firm to execute share repurchases (shares declined 4.5% last year), and pay a decent and safe-looking dividend (1.9% yield at just 10% of free cash flow).

Electronic insurance exchanges have a good growth outlook going forward. The long trend away from paper and towards electronic and online exchanges has been developing for many years. Efficiency is a key differentiator in the industry, where low costs are critical to success. "Obamacare" set the stage for a potentially major uptick in demand for health insurance exchanges, although whether this develops is yet to be seen. Most of Ebix's growth has come from acquisition to expand into new geographies and new lines of products - I see this continuing more or less unabated.

Finally, the stock price seems right. At under $16, Ebix sells 40% below its 52-week high, and at a P/E ratio of just 8.6 - hardly appropriate for a growth company.

So what gives here? Well, it doesn't take much digging to see that Ebix has an alarmingly high short ratio of over 41%, meaning a huge amount of investors are betting the stock price falls even farther. But why?

The latest big drop in the stock price came in late February, when this report on Seeking Alpha drove it down 27% in one day! This followed a 14% drop in early November after Bloomberg said the SEC was investigating accounting practices at the firm - a charge vehemently denied by both management and the company's law firm.

I read over the SA article, which is alleging accounting improprieties. Specifically, it questions the handling of a $70 million loan in Ebix's foreign subsidiaries, while also citing comments from former officers of the firm alleging questionable practices. As far as the SEC probe goes, I can find no new news on it since November and management has not mentioned it in their conference calls or press releases. At this point, it seems like Bloomberg may have been wrong, and it wouldn't be the first time.

All that said, it still feels like there is just too much odor from this stock to consider recommending it. What is absolutely true is that Ebix files a lot of amended quarterly (7 in last 2 years) and annual (5 in the last several months!) SEC reports. But more than anything, Ebix is simply a good ole fashioned battleground stock. And you know what happens when innocents stumble onto a battlefield...

For the brave and intrigued, my quantitative valuation on Ebix is about $26 per share. That's 68% upside from current levels, which may be enough for some folks to take a flyer. But I've seen too many investors get burned by battleground stocks (myself included) to consider recommending this as a Top Buy pick.

The firm can be broken down into 3 segments. The first is the Graphics Processing Unit, or GPU, business. This includes NVIDIA's GeForce graphics chips and cards for PCs, Tesla graphics for super-computing applications, Quadro for workstations (such as computer-aided design or medical imaging), and the GRID cloud gaming platform. GPUs are NVIDIA's legacy and still the firm's bread-and-butter, accounting for 76% of 2012 sales.

The second is the Tegra line of mobile system-on-a-chip (SoC) processors. Tegra integrates a CPU, GPU, and memory controller onto a single chip. It is used in many mobile devices, including smartphones (like the HTC One X), tablets (Microsoft's Surface RT, Google's Nexus 7, and others), automotive infotainment and navigation (including solutions from Audi and Tesla Motor), and will be used in NVIDIA's upcoming Project SHIELD hand-held gaming device. Last year, Tegra accounted for 18% of total revenues.

The final segment is the helpfully named "Other" businesses. "Other" basically refers to revenues from a 2011 patent cross-licensing deal with Intel (INTC). Intel is set to pay Nvidia $1.5 billion over a 5 year period, so this "category" is a short-term one. However, it is generating about 6% of the company's revenue at present, and at presumably very high margins.

I see NVIDIA as a tale of two stories. The outlook for the GPU unit as a whole is mediocre at best. Most of revenues are from high-end PC sales, particularly on the desktop end. Unfortunately for NVIDIA, PC sales have been sinking rapidly, down 3.5% in 2012, and no growth forecast for 2013. This stagnation has been apparent in NVIDIA's GPU unit results. The GPU unit showed just 2% year-over-year revenue growth in 2012, and in fact over the past 3 years sales have declined 3%.

While GeForce and Quadro are suffering from slowing PC sales, there are some isolated positives within GPU. Tesla has been gaining traction in supercomputing applications, including in the world's fastest supercomputer, Titan. Tesla revenue grew 37% last year. Over the long run, I see the GPU unit on whole as a very modest growth business, given the industry headwinds and continuing aggressive competition from AMD's (AMD) ATI unit.

The second story is Tegra, and it is a happier one. Credit NVIDIA for gaining a foothold in the mobile SoC market - without it the company's outlook would be far different. Since 2010, when it was first reported, Tegra has rapidly grown from 6% to 18% of the firm's business. Tegra 4 is set to launch this year, representing a huge spec bump from the current Tegra 3, and NVIDIA recently outlined its aggressive roadmap in mobile SoC's. Tegra grew revenues 29% last year, and given continuing growth in mobile device forecasts, is set to be NVIDIA's growth driver for many years to come.

Let's also quickly run through some other positives on the company. The firm is a financial rock, with $3.7 billion in cash on the balance sheet - and no debt. NVIDIA generates plenty of free cash flow, even in 2008-09 when the firm reported an operating loss. The recently instated dividend yields 2.4% and should come in at a payout ratio of below 30%, very safe. While there is plenty of direct competition, from AMD in PCs and Qualcomm (QCOM) in mobile, NVIDIA is one of just a handful of competitors in its markets, and both have high barriers to entry. Management is outstanding, with founder and CEO Jen-Hsun Huang still in charge and owning about 4% of his company. There is a lot to like here.

NVIDIA does face the same risks as most technology firms. Product cycles are very rapid, and the history of GPUs shows AMD/ATI and NVIDIA leap-frogging one another almost every other generation. While Tegra has had a lot of success in larger, tablet-sized mobile devices, it has not been able to match Qualcomm's success in the more lucrative smartphone space. Embedded PC graphics are getting better all the time, and some day could conceivably offer close enough performance to GeForce dedicated cards. While this still seems far off in the future, if it does happen NVIDIA is at a major disadvantage to Intel and AMD, both of who make PC CPUs as well.

All in all, I like NVIDIA and believe it makes a solid Magic Formula� pick at present. My fair value calculation is $16 a share, offering a 27% margin of safety at current mid-$12 price levels. If the stock should fall down into the $11 range, it would make a prime candidate for a MagicDiligence Top Buy recommendation.