Introduction

When it comes to diagnostic imaging, drug eluting stents, and hip replacements, healthcare technology in America is without a doubt the best in the world. Sadly, it’s a recurring nightmare when it comes to information technology within hospitals and small physician practice, where everything from ballooning bad debt expense to illegible prescriptions and 200,000 preventable deaths a year are bleeding our healthcare budget dry, scarring the people who pay too much for too little, and overworking providers of care.

IT investment per worker in the healthcare industry is roughly half of what private industry in America pays and only 1 in 6 physicians have a fully working healthcare technology platform. The US spends $2.2 trillion, or 16% of GDP, on healthcare, yet we rank #46 and #42 when it comes to life expectancy and infant mortality, respectively. Without adjustment, healthcare spending will double to over $4 trillion by 2016.

Last Monday, Johnson & Johnson (JNJ) announced that it had agreed to acquire Mentor (MNT) for $1.07 billion or $31/share, a 92% premium to the prior day’s closing price. While this may sound like a whopping deal for MNT investors, the fact remains that JNJ stole Mentor and likely underpaid for the company. Mentor shares, already down 57% on the year, would have needed to be taken out at a 132% premium simply to match the price level at which they were trading not too long ago. While another 30-40% on top of JNJ's offer would be great for Mentor’s long term shareholder base, don’t expect it -- JNJ has a war chest of cash to outbid anyone, and at a time when elective procedures are off due to the current recession and raising cash is almost impossible, JNJ is destined to take the position of market leader on the cheap.

Let’s take a quick look at what JNJ bought and then we want to throw out two other names to think about as valuations come close to rock bottom among aesthetic stocks.

I am getting incrementally bullish on the investment thesis underlying Allscripts (NASDAQ:MDRX). Allscripts, which is the nation’s leading electronic health records (EHR) and e-prescribing player, recently merged with Misys Healthcare (a unit of UK-based Misys plc), itself a major player in the practice management systems (scheduling/billing) arena. The deal was announced back in March and closed on October 10^th.

On Monday, Allscripts was in New York City presenting their story to the street as well as explaining the rationale behind the deal. Here are some quick notes I put together; as readers will see, the opportunities for this company are many and large in dollar terms,and assuming management can execute operationally on this merger’s proposed synergies, the shares should rebound once the overall market recovers in 2009.

At $22 per share, comScore (NASDAQ:SCOR) trades at a discount to an estimate of discounted free cash flow of $27 per share.

A recent product announcement by competitor Google (NASDAQ: GOOG) has excessively re-priced comScore for risk and given investors a short window to own a high quality growth stock at a discount.

Shares of Johnson & Johnson (JNJ) quietly reached a new 52-week high Friday. This caught our attention, since it at once seemed out of the ordinary, but somewhat comforting, as the recent economic weakness has likely pushed portfolio managers to add to defensive stocks like JNJ, whose vast panorama of business lines likely strips away most of the idiosyncratic risk they would have to take on (assuming no proper hedging) if they invested in a smaller company that was not as diversified and reputable as JNJ.

Nevertheless, we ran some numbers, and ignoring, for the time being, Johnson and Johnson’s fundamentals, we noticed that over the last 3 months, JNJ and the Dow Jones have gone in diametrically different directions. The Dow is down 8% over the last 90 days, whilst JNJ, which is one of the Dow 30 components, is up 8%

In today’s market, it can indeed be tempting to bottom feed and make Vegas-like bets on stocks that have gotten crushed in the weak economy. A poor economy not only slams a company’s earnings, it also compresses the multiple an investor is willing to pay for a stock as market risk heightens and the famous “g” in the PE formula withers down. At that point, many will ask themselves: how much worse can things get? And so they bottom feed the market looking for beaten-up valuations and normalized earnings power in 2009, or whenever you think the business cycle inflects.

We ourselves are guilty of bottom picking – we liked semiconductor equipment maker Varian (VSEA) at $38 – that stock is down a quick 10 after guiding Q4 lower late Thursday; clearly, the memory spending area is still soft and Varian investors will have to sit on the sidelines until the multi- quarter trough shows signs of abating.

We are initiating coverage on Lorillard Group (LO) with a buy/$82 price target based off expected 75% payout ratio, 4% yield, and $4 dividend in 2009. Historical evidence of spin off shareholder wealth creation colors investment case for LO, which remains the best volume story in the domestic tobacco universe.

LO was recently spun off from parent Loews (L) and its merits may not be fully familiar to buy side. Risk appears limited at current price level and would recommend ownership of stock given company’s pricing clout, seasoned management team, and takeover candidacy.  

Pac Crest was out with a note on Varian Semi (VSEA) Monday, raising their price target on the semiconductor equipment name by $6 bucks to $50. That looks like the most aggressive move on the stock from the sell side in recent months, so we thought we’d take a closer look.

Essentially, Pac Crest finds the company's earnings leverage compelling and they are expecting significant earnings growth exiting the current downturn. They kept shares at outperform, which we think makes sense given the degree to which the stock has gotten torched in the last 2 quarters based on cap ex cuts across the board from leading chip makers. We owned VSEA in a student-run fund last Fall and got stopped out after making the mistake of focusing to much on the firm’s attractive technology and market penetration metrics – and not enough on where we stood in the cycle (Varian subsequently missed Q2 by 9c and guided Q3 20c lower than consensus, whose estimates, like ours, were way too high). Now, Pac Crest is suggesting that VSEA has gotten its beating and is picking up share even in today’s tough climate for equipment orders. This implies that VSEA could be one of the first names the buy side warms up to once the cycle peaks.

Leading video game retailer Gamestop has a lot of fans on the buy and sell aside alike. On the back of new console releases and attractive growth story, the stock has been hot. But recently, the stock has seen some technical slippage and we think this is the beginning of a further meltdown, rather than a hiccup that will quickly correct itself.

Resin shoe manufacturer Crocs (CROX) reported so-so earnings on Wednesday afternoon and the stock saw a massive squeeze in Thursday trading, with the stock up 16% as I write this. Results were nowhere near great, contrary to what yesterday’s trading action was telling you. They missed consensus estimate for EPS and came in at the low end of their guidance.

Although CROX came in above expectations for sales, their international revenue growth was nothing to cheer about. They only grew this figure 80% YoY to $106M, compared to last quarter when sales increased 220% YoY. Crocs is having issues growing its international markets, which our buy side contacts say is the only reason one would want to be in this name at all. In addition, gross margins were down to 42%, lower than analyst expectations of 46%. Wednesday’s conference call was essentially a non-event, since all CROX did was reaffirm their previous guidance.

On Thursday night, California-based footwear play Deckers Outdoor (DECK) reported stellar earnings results: Q1 EPS of 86c (20% growth) vs. cons of 76c (DECK, on average, beats by 12c) and revenue of $97.5M (34% increase). The company’s main line – the sheepskin Ugg boot, which accounted for 56% of the Q’s sales – posted sales of $54M, an 86% increase YoY. DECK also increased Q2 guidance for 30% growth on the bottom line and 50% on the top line. Lastly, DECK said 2008 revenues should grow to the tune of 30%, an increase from the 25% rise they expected just a quarter ago.

The only blemish in the quarter was the weak Teva line sales (-2.3% YoY), but that was due to delayed shipments rather than demand impairment. Investors jumped all over the stock Friday, sending it 20% higher on 3x average daily volume. Prior to Friday’s pop, investors in DECK had fled the stock after the company had reduced guidance for the quarter just reported from 92c to 75c.

Just about when everybody was ready to give up on Mexican food purveyor Chipotle (CMG), the Colorado-based company comes out and blows past the Street. Wednesday after the bell, Chipotle reported 52c for Q108 vs. consensus of 48c while revenues came in at $305.3M vs. $298.4M estimates. Chipotle also crushed the low-ball same store sales estimate for the quarter, coming in at 10.1% vs. 7% cons. More importantly, they guided to comps in the mid single digit range for FY08 vs. the low single digit comp guidance they doled out on the Q407 call.

Couple of tidbits from the conference call we thought were worth pointing out:

After the close Monday, shoe manufacturer Crocs, Inc announced drastically lower Q108, Q208, and FY08 guidance, sending shares down ~30% at the time this article was written. With the stock already down 50% before Monday’s nightmare, many on the Street had considered CROX “too cheap” to ignore. The stock was fetching a single digit multiple to forward 12 month earnings and on a first look basis, it looked like things couldn’t get worse. And then the tune changed.

Never heard of The Buckle, Inc (BKE)? Not many people have, even though the Nebraska–based retailer of medium- priced casual apparel, footwear and accessories is crushing same store sale estimates the way kids crack pumpkins on Halloween. The Buckle, which has posted double digit top line growth in a battered economy, operates 371 stores in 38 states and is fetching roughly a market multiple even though it is growing earnings much faster than the overall market, paying a higher yield, and coughing up an 18% return on capital:

Amid increasing cancellations, declining land balances, and shrinking backlogs, something funny is going on among the nation’s homebuilders: their stocks are going up! We view these stocks as "canaries in the coal mine" and just as they first signaled how bad things were going to get last summer, they may be telegraphing an improvement in the broad market. Many homebuilders have "V bottomed" and unless it is a cosmetic relief rally induced by gleeful short covering, the recent sponsorship behind these stocks is impressive.

Fist, a word on the major index: Although the Dow is still well under the 200 moving day average, the MACD reading shows the first climb above zero since right before the Dow topped north of 14,000 in the early Fall. We attribute the latest relief rally to the fact that people simply "feel better" about stocks right now and shorts are winding positions, even as headline after headline continues to evade negativity. A 5.1% unemployment rate, a legion of write offs among financials, and sordid home sale data is not enough to wreak havoc across the tape, apparently.

With the soft-drink market flat, beverage behemoth Coca-Cola (KO) has responded with alternative beverages, like the mid-calorie soda. The Atlanta-based company has been on an acquisition tear to boost holdings in this segment of the market: in 2008 the company acquired a 40% ownership of Honest Tea, following buyouts of NutriJoy, Fuze, and Glacéau. Two things we’re excited about: sell thru data of Vitamin Water looks promising and the weak dollar is helping Coke offset some of the pressure it’s seeing in the states; growth coming from the international business is ripping at ~9% and the addition of high-margin non-carbonated soft drinks into Coke’s portfolio is reinvigorating growth in the flagging North American market.

We are resuming coverage on Corrections Corp (NASDAQ:CXW) with a buy rating and an aggressive 12 month price target of $38, reflecting ~45% upside from the current price of $26. Our investment thesis is based sustainable demand for correction facility beds vis-à-vis an ongoing difficulty at the federal and state level to fund new prison growth. More than 7% of the US prison population is housed in a private detention facility; CXW has approximately 50% of the market and with secular tailwinds at its back, should keep ripping estimates with double digit top line growth for the next few years.

We are initiating coverage on Digital Ally (NASDAQ:DGLY) with a buy rating and a 12 month price target of $10, reflecting ~40% upside from the current price. Our investment thesis is driven on Digital Ally’s explosive top line story that has barely begun to scratch the surface of its market potential. In addition, we expect Digital Ally, which was just listed on the NASDAQ, to capture the attention of boutique research shops as its run rate expands and the company begins to sign higher volume contracts. DGLY is one of our top microcap ideas for 2008. Investors who remember the “out of nowhere” explosive appeal of Taser (NASDAQ:TASR) would be wise to investigate DGLY a bit further.

Business Overview

Kansas-based Digital Ally produces digital video imaging and storage products for use in law enforcement and security applications. The Company’s products are a digital video flashlight and an in-car digital video rear view mirror. These products allow self-contained video and audio recording onto flash memory cards that are incorporated in the body of the flashlight, the digital video rear view mirror or the digital video security camera. These products all incorporate the Company’s own digital compression capability that allows the recording of video over significant time periods on a chip and circuit board that can be designed into a small form. Digital Ally sells its products to law enforcement agencies and other security organizations and for consumer and commercial applications through direct sales and third-party distributors. DGLY was founded in 2003 and was recently listed on the NASDAQ.

Chipotle Mexican Grill (CMG) operates fast-casual fresh Mexican food restaurants in 28 states throughout the US. Its menu includes burritos, burrito bols, tacos, and salads. Customers can choose from 4 types of meats, 2 types of beans, and many different extras, such as guacamole: in total, 65,000 choices available. Founded in 1993 by Steve Ells, Chipotle currently operates 705 units.

We view Chipotle as “best of breed” operator and margin expansion story in the troubled restaurant sector. Shares have taken a beating due to toxic subprime-related headline risk that has tarred the stock even as the fundamental story remains intact. Through a combination of menu prices increases and labor efficiencies, the company is posing phenomenal restaurant level EBIT margins that we think will continue to expand. Given the 5x return in the stock over the last 24 months – and comps deceleration, which is expected of any restaurant looking at unsustainable double digit SSS – a buying opportunity will arise as “first round” investors dump the name, at which point fresh capital should get interested in the longer term 25% EPS growth story CMG is capable of. Net-net, we are midway the 5h inning, there will be some growing pains, but the longer term outlook remains colorful: we’d view pullbacks as rare buying opportunities.  

We are initiating coverage on Dick’s Sporting Goods (NYSE:DKS) with a BUY rating and a $39 price target, reflecting 25% upside from current levels. We believe Dick’s stock price will benefit from strong fundamentals, favorable industry trends, and a discounted valuation. Sharing honors with Costco (NYSE:COST), DKS remains our #1 idea in the specialty retail segment.