Inside Castle Brands

| About: Castle Brands (ROX)
This article is now exclusive for PRO subscribers.


Significant insider buying.

Latest quarters showing new growth trend.

Suitable for investors who can stomach a speculative momentum play.

After moving sideways for five months consolidating previous big gains, shares of Castle Brands (NYSEMKT:ROX) exploded higher again in early March on very impressive volume. Prudent portfolio management practices may dictate that those of us in ROX before its 50% spike take some of our quick winnings off the table, but we're keeping ROX rated Buy on the recommended list of our InsiderInsights Newsletter for investors that can handle a speculative momentum play.

Castle Brands is an international marketer of alcohol, representing such brands as Gosling's, Jefferson's, Knappogue Castle, Clontarf, Pallini, Brady's, Boru, Celtic Honey, and Castello Mio.

ROX garnered a Significantly Bullish +1 InsiderInsights Company Rating on February 3rd, after we noted several insiders buying in the open market and opting into their shares in late January. That insider signal was bolstered in mid-and-late February, when eight insiders exercised options and held onto them instead of flipping them for a risk-free profit. All the insiders accumulating ROX in February increased their holdings significantly with their "opting in" activity (as we term it).

Castle Brands is also among the many companies in the portfolio of Dr. Phillip Frost, a prolific filer of form 4s with an excellent track record trading most his firms, including Opko (NYSEMKT:OPK), Ladenburg Thalmann (NYSEMKT:LTS), and Vector Group (NYSE:VGR), among others. His track record trading ROX is also excellent. Dr. Frost's 26 previous acquisitions that aged a year have a "hit rate" of 69% (meaning ROX was up 69% of the time a year after he purchased), with an average return of 44%. Castle's CEO, Richard Lampen, also has a decent history of trading ROX, and was also a recent accumulator (See our InsiderInsights Profile of ROX for the stats on both these insiders.)

Groggy Growth

Some of us can personally vouch for the quality and attraction of Castle Brands' Gosling's brand of Bermudian black rum: with equally pleasant experiences imbibing the elixir with an ex rum-running St. David's islander accompanying his wife's shark hash, as well as "swizzling" it down at Mid Ocean Club barbecues. Bacardi and Captain Morgan's competing products fall far short, in our opinion.

Putting our personal bias aside, however, we saw that all this bullish insider activity at Castle Brands in February corresponded with signs that revenues at the firm were finally beginning to rise, as per the company's Q2 financial results ended September 30, 2013.

Even so, our serious and quick gains in ROX are a (pleasant) surprise. There was no coincident news behind the stock's spike, and if Castle Brands' Q3 financial results (ended December 31) were the rocket fuel behind the stock's launch, there is no explanation why data released on February 18th should take 12 sessions to spur excitement.

Still, Castle Brands' Q3 was constructive, justifying our addition of this speculative penny stock to our otherwise well-balanced portfolio. Revenues for the quarter jumped 28% year-over-year, to $13.6 million. The increase brought the company within striking distance of an operating profit, and allowed the firm to post positive EBITDA.

It seems that after more than a handful of quarters with revenues stuck between $10-$11 million, Castle's last two periods are finally showing a breakout from that flat line.

With no valuations possible on earnings or cash flow, investors are left to focus on ROX's price-to-sale ratio as a barometer of whether its price is out of whack. Fortunately, that comparison implies a sense of value compared to Castle Brands' immensely larger "peers."

The ratio of trailing 12-month enterprise value/revenue is around 5 for Diego (NYSE:DEO), and closer to six for Brown-Forman (BFA). The same metric for Castle Brands is hovering around 4 - even after its recent surge. It appears Castle Brands may just be entering a higher growth phase than the giants it competes with as well, making the relative price/sales discount on ROX even less logical.

High Beta Bet

So our bet on this penny stock was hardly a crap shoot when we entered before Q3, and it is far less so now after Q3's reported growth. Even so, you won't hear us flogging ROX as a raving value. For our money, this position is still primarily a very high-risk/high-reward momentum play that is not suitable for conservative investors.

A large risk is that Castle Brands' most-recent quarter of growth isn't repeated when Q4 results are released. And though it would be nice to think that ROX's value on a price-to-sales basis could make it an acquisition target for a larger competitor, Castle Brands isn't large enough itself to be of much consequence to many potential acquirers.

Still, momentum investors can look past Castle Brands' sliver of fundamental attraction, and simply focus on the volume behind its recent move as justification for staying with ROX after its surge. The stock spiked a total of 50% on March 5th and 6th, on a combined 2-day volume of 9.7 million shares. Its minor 3.8% pullback on March 7th occurred on just 2.1 million shares. The average daily volume over the past three months has been less than 1 million shares.

ROX remains on a roller coaster during the current tentative week for the indices, and will undoubtedly go lower if the market continues to sell off. It's arguably the most speculative stock we have among the 30-plus longs in our portfolio right now. But taking small bets on speculative stocks is just one way we make sure we have an investment idea in our newsletter for everyone. And we've found that betting on spec plays with significant insider buying increases our odds for success.

Disclosure: I am long ROX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.