Unpopped Kernels: Our Two Worst Portfolio Stocks ... But Not For Long

Includes: DTLK, KND
by: Stanley Barton

If you ask an investor what his or her favorite portfolio stock is, the answer is usually the one whose price has risen most dramatically. The reality is that the best investment in that portfolio may actually now be one of the laggards: the last kernel to pop may pop the loudest. With the bull market pricing most stocks close to their valuation targets, the non-participants may actually represent the best bets today.

In September, we were charged with creating a portfolio of 30 low-priced stocks, so a client could get adequate diversification with as little as $30,000. This was because typical 401K plans do not invest in this segment of the market. Since the portfolio's inception, 28 of those stocks are selling for more than we paid. This article will revisit the other two and their strengths and headwinds. The goal is to determine if they are candidates for elimination or deserve more patience.

First, we must remember that these stocks were selected for their value, diversification quality and five-year growth prospects. If those characteristics have changed, we should make a change.

Datalink Corporation (DTLK) provides data center solutions and services to mid and large-size companies in the United States. It engages in assessing, designing, deploying, and supporting infrastructures, such as servers, storage, and networks; and reselling hardware and software from original equipment manufacturers. We purchased this stock for $9.34 and it sells today for $8.87, about a 5% loss in a good market for tech stocks.

We originally liked DTLK for technological diversification and its role in data protection, recovery and storage, including cloud computing. In a portfolio of small stocks we wanted to get as much bang for the buck, and DTLK gave us exposure to some of the leading-edge technologies. In creating systems for clients, DTLK resells the components that are made by Cisco Systems (NASDAQ:CSCO), NetApp (NASDAQ:NTAP) and VMWare (NYSE:VMW), for instance. Datalink grew revenues by 29% in 2011 and the average analyst estimate for its revenue growth in 2012 is 26%, which, incidentally, is faster growth than projected for those three big suppliers.

The stock earned $.80 in 2011, so the trailing PE is 11. Sales are double its market cap, and the stock price is only twice the book value. By all measures, this is a value stock. We expected it to carry a PE of at least 15, or a stock price of $12. So what went wrong?

Everyone likes to blame the short-sellers, but we do not think that is the reason that this stock has failed to lift-off. About 2.4% of the float has been shorted, but we think that the effects of a 3.3MM share stock offering in March 2011 may be the primary culprit. For instance, Zacks gave DTLK a top rating after the positive earnings surprise in September. The Zacks theory is that an earnings surprise is the biggest single factor in moving the stock price. Fourth quarter EPS were flat in comparison with the year earlier, due to the 20% additional shares. Surely some Zacks followers bailed out. It should be noted that the first quarter of 2012 will also suffer this comparison problem, so another flat quarter is likely.

Another factor that may be holding back DTLK is that a good portion of the 2012 growth will be from an acquisition in October 2011. Growth though acquisition is not as meaningful as "organic" growth; however, DTLK will have both in 2012. Management states that the acquisition was only "slightly accretive" in the last quarter, but expects more positive impact from the synergies in the last half of 2012.

Finally, DTLK does not fabricate or own the patents on the components it sells, so it does not deserve a PE higher than the original equipment manufacturer. The big three previously mentioned have PEs of 15, 29 and 63, respectively. The lowest is Cisco and perhaps DTLK will be bound by that multiple. However, DTLK does have substantial additional high-margin, recurring service revenue. We think the PE target of 15 and 2012 stock price of $12 is still reasonable.

Verdict on Datalink Corporation. There were factors that contributed to its mediocre performance; specifically, flat EPS comps from the dilution, and low acquisition contribution. We knew of this dilution, and we underestimated the disappointment of the market with the flat EPS comparison, despite real revenue and income growth. We also are aware that we will probably have to wait for mid-2012 to have more exciting year-over-year comparisons. We agree with the management that the acquisition needs a quarter or two to reflect the full impact. The value metrics of the stock and diversification in these technologies are still attractive for this portfolio.

Since DTLK was selected for its appreciation potential over the next five years, we do not see any reason to change our expectations for that growth. We think DTLK is under-priced and will keep this in the portfolio to reevaluate it after the next quarterly report.

Kindred Healthcare (KND) is the largest diversified provider of post-acute care services in the United States. Skilled nursing homes account for 35% of the revenue. We purchased KND for $11.10 and it is now worth $10.22, an 8% loss. We also sold calls in this stock for $1.85 net profit, so actually we are a little ahead technically.

We went into this stock with our eyes open to the fact that rehab centers and nursing homes were hit hard by reduced Medicare reimbursements. Medicare/Medicaid accounts for 57% of KND reimbursement. Frankly, we thought that impact was priced into the stock. At its current price, the forward PE is 7 and its book value is $24 per share. It appears that the fear of further damaging legislation is factored into the stock price.

Despite the reduced reimbursement, KND is profitable and has a habit of surprising to the upside on earnings announcements. We think that was why it was sold particularly hard when it had a negative report in Q4. The company is in discussion with the government agencies to try to adjust the reimbursement. In the meantime, KND is consolidating operation groups in cluster areas for shared overhead and savings, and it is shedding lower-margin rented facilities. With these cost savings, KND is expected to earn $1.45 per share for the next couple years.

We liked KND in our portfolio because of its extraordinary value and the exposure to the aging baby-boomer phenomenon. Many in the rehab and nursing care industry have little strategic vision other than acquire more facilities. KND has experienced and sophisticated management, and they can parlay on the position of leader in this business. It was recently announced that KND was honored as a "Most Admired Company" by Fortune magazine for the fourth straight year.

We think that the worst is behind KND for the reimbursement cuts, although we doubt that they will have any success getting any positive adjustment in appealing the rates. Over the next five years and beyond they will have no trouble finding customers.

Verdict on Kindred Healthcare. To some degree we knew that there existed the possibility that the Medicare cloud would not blow away immediately. The other healthcare stocks in this portfolio have to do with drugs and plan administration, so we do need a hospital/nursing care stock for diversification. Frankly, KND appears to be as good as any other alternative. We looked hard at Five Star Quality Care (FVE) when we selected KND because more of its reimbursement is from private sources. However, the ability of KND to build on its hospital-to-rehab-to-home care-to-nursing-to-hospice arrangements makes it a one-stop solution for many families. As we go forward we think that KND will crowd out much of its competition.

At its current price, we see little downside in KND, and news about reimbursements are as likely to be positive as negative at this point. Kindred is a volatile stock, and that makes it a good option stock. As mentioned before, we will be selling more options on the KND holdings until the stock bounces back. The average analyst target for Kindred is more than $14 for 2012, and that seems reasonable to us. By mid-2012 we think that KND will be back surprising to the upside.

As the bull continues to run, it is more difficult to find real values. There is truth to the sayings "don't fight the tape" and "never catch a falling knife," so some care is warranted when buying stocks that have for some reason missed the market rally. When we know why they did not participate, we can make a better determination if they are poised to burn or pop. In the case of Datalink and Kindred Healthcare, we have companies backed by macro factors that we think will overpower the present headwinds.

Disclosure: I am long DTLK, KND.