It’s time to re-test Electro Optical Engineering (Nasdaq: EXFO)

• BUY EXFO near $6.18

Electro Optical Engineering is still our favorite way to play the competition between cable providers and traditional telcos. In our previous article on Electro Optical Engineering, we explained why Electro Optical is perfectly situated to take advantage of the surge in demand for optical test and measurement equipment.

The optical equipment sector has performed poorly since Ciena’s quarterly results a few weeks ago. At that time we sold our holdings in Electro Optical due to general market volatility and the negative sector sentiment caused by Ciena’s earnings. Since then the market has largely stabilized and Ciena has bounced off its low near $25.

We think this is a good time to get back in Electro Optical Engineering before their earnings report on April 3^rd. Electro Optical has recently been dragged down by the rest of the sector and we think valuation is compelling at this point. Based on analyst estimates, Electro Optical now has a forward P/E of about 17. Considering Electro Optical’s recent surge in revenues and profits, and the strength in demand for test and measurement equipment shown by JDS Uniphase, this looks like a great time to get back into the only pure play optical test and measurement stock.

Full disclosure: Wall Street Mayhem is long EXFO

Has Taser (Nasdaq: TASR) turned the corner?

• BUY TASR near $8.16, set stop loss at $7.00

Taser International, Inc. (Nasdaq: TASR) designs, manufactures, and markets the TASER line of stun guns. The company had a wild ride from 2003-2005. Shares of Taser exploded in 2003 and 2004 due to rapid sales growth and a massive short squeeze. In 2005 shares of Taser cratered as the company tried to deal with a bevy of new problems including product safety lawsuits, shareholder lawsuits, slowing growth, and accounting issues.

Recent results show that Taser is back on track. In the fourth quarter of 2006 Taser posted revenue of $19.3 million and net income of $2.3 million. Revenue was up 53% from the fourth quarter of 2005 and up 5% sequentially from the third quarter of 2006. Profits have grown consistently for four straight quarters.

Taser has a market cap of about $500 million, cash of about $22 million and no significant long term debt. Taser does not have a trailing P/E due to a net loss in fiscal 2006, but based on analyst estimates Taser has a forward P/E near 20.

Taser has sold products to more than 10,000 US law enforcement agencies and 1,700 law enforcement agencies have issued Taser’s to all patrol officers. Analysts expect strong sales growth to continue in the US law enforcement sector. So far sales to the public and the military have been minimal, but Taser hopes to increase sales in these two channels soon. This summer Taser will begin selling a smaller version of its police weapon to the public. Although previous efforts to sell Taser products directly to the public have had disappointing results, the new Taser C2 has a smaller profile and a lower price point ($299 without laser, $349 with laser) which could translate into higher sales.

Taser also plans to expand into a wide range of military applications. Although these technologies are still in the development stage, Taser sees military applications such as their Warfighter and Tasernet programs as significant growth opportunities.

Recently a US district court in New York dismissed a product liability lawsuit against Taser. This marks the 37^th consecutive wrongful death or injury lawsuit against the company that has been either dismissed or decided in favor of Taser.

Although Taser’s sales and profits have rebounded there are still a number of controversial issues surrounding the company. Human rights activists claim that Taser’s stun guns are dangerous and may cause heart attacks. Despite Taser’s excellent court room record, the company will continue to spend money defending these cases for the foreseeable future.

Taser’s fourth quarter results show strong growth in a company that has a near monopoly. Law enforcement sales should continue to be brisk while the new C2 Taser should help jumpstart home defense product sales. Although Taser will continue to have legal expenses, they recently settled the outstanding shareholder lawsuit and they have a growing portfolio of case law in their favor which should limit the number of personal injury suits going forward.

Although sales and profits have turned around, Taser’s stock has been stagnant. We think that shares of Taser represent a compelling value at current prices. Taser has limited competition and previous product safety issues were the main barrier to sales growth. Many of the negative legal issues and product liability claims plaguing Taser have recently been mitigated opening the door for continued growth in revenues and profits.

Full disclosure: Wall Street Mayhem is long TASR

Update on PMI Group and MGIC Investment Corp.

• BUY to COVER PMI near $40.90 (1/2 position)

• BUY to COVER MTG near $55.40 (1/2 position)

Although we still think that the mortgage insurers as a group are in for some tough times going forward, we are buying back half of our short position in each of these trades to lock in profits. We think the markets are somewhat oversold and we are expecting a bounce later today or tomorrow.

Update on Hythiam (Nasdaq: HYTM)

Hythiam had surprisingly low volume at the open this morning which implies that the Business Week article had less of an effect on the stock than we expected. We sold our position in Hythiam at an average of $7.89. The event we were looking for has passed so there is no reason to continue holding the stock.

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Hythiam Inc. (Nasdaq: HYTM) could experience the Business Week Effect

• BUY HYTM near $7.80

• SELL HYTM at or the near the open on Monday

Hythiam is a small company focusing on the research and development of physiological treatment protocols. These treatment protocols include PROMETA which uses a combination of nutritional supplements and medications to help reduce drug and alcohol related cravings.

Hythiam has a market cap of about $320 million, $25 million in cash, and no significant long term debt. Revenues have increased rapidly over the last three quarters, but the company has yet to turn and profit and losses have remained steady despite the increase in revenues.

This week’s Inside Wall Street column in Business Week has a positive article about Hythiam. The article focuses on Hythiam’s PROMETA treatment protocol. According to the article, early results have been “overwhelmingly successful”. The analyst quoted in the story has a buy rating and a 12-month price target of $15.

Recently, some of the small companies that have been featured in Business Week’s Inside Wall Street column have received significant positive moves as a result of these articles. Access Pharmaceuticals was a big beneficiary of the Inside Wall Street column as it soared over 200% after being mentioned in Inside Wall Street.

Previous Wall Street Mayhem trades based on the Business Week effect have performed well including Thermage, American Oil & Gas, Shanda, and Microvision.

This “Business Week effect” does not necessarily last long, but it has recently provided a consistent boost at the start of Monday’s trading to certain small cap stocks. Although the Business Week articles are available on-line on Thursday evening, we believe that the affect a Business Week Inside Wall Street article can have on a stock is often more pronounced on Monday, after the print version of Business Week has been circulated. Certain stocks with small floats and low average trading volumes tend to have a strong open on Monday after readers see the articles in Inside Wall Street over the weekend. We believe that Hythiam is one of these stocks and that Hythiam will open higher on Monday.

Hythiam traded as high as $8.30 this morning before settling down to the current price of $7.80. We think this price is a good entry point for Hythiam considering recent moves of similar small cap companies on Monday after positive mentions in the Business Week Inside Wall Street column.

Double trouble for mortgage insurance companies PMI Group and MGIC Investment Corp.

• SHORT SELL PMI near $45.50

• SHORT SELL MTG near $58.70

The problems faced by subprime lenders like New Century and Novastar continue to take center stage as these stocks were down 68% and 41% respectively yesterday. This new wave of selling started after New Century announced that it was in default with several lenders and that federal regulators have begun an investigation. A Merrill Lynch analyst added that due to the defaults and the new investigation, bankruptcy for New Century was a much stronger possibility than originally anticipated.

Although we expect additional problems related to subprime loans, most of the subprime related companies have already had large percentage declines. However, mortgage insurance companies that may have significant exposure to subprime loans have declined slightly, but these companies have been relatively stable compared to the subprime loan originators. We expect the mortgage insurers to see increased mortgage insurance related losses due to an increased number of claims created by an increasing number of mortgages in default.

While a recent Standard & Poors article took the position that mortgage insurers may have limited exposure to subprime loans, we think that the S&P author may have underestimated the exposure companies like PMI Group (NYSE: PMI) and MGIC Investment Corp. (NYSE: MTG) have to subprime loans. The article cited smaller average loan prices and limited exposure to ARMs in an argument that mortgage insurers should not be sold off in sympathy to problems in the subprime market. The article also mentioned that lenders are increasingly turning to mortgage insurers when trying to sell their loans to Fannie Mae and Freddie Mac. These government sponsored entities require mortgage insurance when the borrower has less than 20% equity in the value of the property. S&P argued that between 2003 and 2005 this requirement was often satisfied by packaging second and third liens with the primary loan, but rising interest rates have made mortgage insurance more cost effective than multiple loan originations. However, the S&P article failed to make the connection that because of this 80/20 rule and the trend away from second and third liens, mortgage insurers may have ended up with more exposure to subprime loans. On average borrowers who cannot afford to put 20% down on a purchase are at a higher risk of default. Although many of these borrowers may still have good credit ratings and are therefore not categorized as subprime, they are still more likely to default than borrowers who put at least 20% down.

There is increasing evidence that the problems with the subprime market are beginning to spread to the so called Alt-A market. Alt-A loans categorize borrowers that are somewhere in between “prime” and “subprime”. Many of the innovative mortgage products such as option ARMs, interest only mortgages, and mortgages given without income documentation, fall into the Alt-A category. The Alt-A group may include many homeowners who have good credit, but mortgage products that create problems with even a small rise in interest rates. Although minimum standards for Alt-A loans have recently been raised by IndyMac Bancorp, the largest US Alt-A lender, an estimated 16% of all 2006 mortgage originations fell into the Alt-A category using the previous standards

The deterioration of the broad real estate market also spells trouble for mortgage insurers. The bull market in real estate was a boon to mortgage insurers and allowed companies like PMI and MGIC to consistently increase revenues and profits. This growth in revenues and profits has already started to decline as PMI’s profits dropped 7% in the forth quarter compared to the year ago period. MGIC has had a decline in profits for three straight quarters.

Although shares in the PMI Group have lost some value since the deterioration of the subprime market started, PMI is still trading within 10% of a 52 week high. Additionally, PMI shares are still about 8% higher than they were in late November before the troubles with the subprimes started.

Shares of MGIC Investment Corp. have dropped slightly more than PMI recently, but MGIC is still trading above its recent low in August before the subprime lenders started experiencing problems.

At Wall Street Mayhem we believe that PMI and MTG are both promising short sell trades at this point due to exposure to subprime and Alt-A mortgages and a deteriorating environment for the growth of mortgage insurance due to the underlying weakness in real estate markets throughout the US. If the fallout from the subprime market hits another related industry, mortgage insurance companies appear to be in danger of substantial near term selling.

Full disclosure: Wall Street Mayhem is short PMI and MTG 

Ciena’s earnings shed light on optical capacity demand

Ciena reported first quarter financial results this morning and on the surface earnings and revenue growth appeared strong. Compared to the year ago period, revenue rose 37% to $165.1 million versus $120.4 million last year. Profits totaled $11.1 million for the quarter or 22 cents per share, reversing a year ago loss of $6.3 million. Despite the seemingly strong quarterly report, shares of Ciena were down over 10% in early trading at $28 a share.

Typically when a company has a relatively good earnings report, but the shares drop, it is due to negative guidance. This does not appear to be the case for Ciena. Ciena projected sequential revenue growth of 5%-10%. This growth percentage translates to second quarter revenue between $173.3 million and $181.6 million. According to Thompson Financial, analysts were expecting $172 million in revenue next quarter. Additionally, CEO Gary Smith projected that full year revenues would rise 27% to 30% in 2007 compared to fiscal year 2006. Analysts had projected revenues to rise about 25% in 2007.

So why did shares of Ciena drop nearly 10%? Expectations, gross margins, and increased spending. Although Ciena’s numbers were strong, they missed analyst expectations by 1 cent per share. A one cent per share miss typically does not lead to an 10% sell off, but in this case we think many investors were expecting Ciena to handily beat analyst expectations. It is no secret that the big telcos and cable companies are spending in an attempt to offer improved bandwidth for voice, internet, and video applications. Investors in Ciena were hoping that Ciena would get a larger portion of this increased spending.

A slight decline in sequential gross margins from 45.5% to 44.6% also contributed to the slide. Considering demand in this sector, investors were probably hoping that margins would improve, not decline. Finally, Ciena projected an increase in spending in order to add manufacturing capacity so that they can keep up with demand. Apparently, investors are focusing on the short term negative of increased spending, but we have trouble understanding how spending due to increased demand could be viewed as a negative as some of the analyst notes have suggested.

Although the market has reacted negatively to Ciena’s earnings, we think that Ciena’s report provides further evidence that demand for increased bandwidth is still strong. Ciena is actually adding manufacturing capacity for the first time in many years. Large telecom and cable companies are continuing to upgrade their networks to handle surging internet bandwidth demands, and the margin issues at Ciena are company specific. Therefore, despite the 10% decline in share price at Ciena, we are still positive about the sector as a whole.

We sold shares of Electro Optical Engineering (Nasdaq: EXFO) and JDS Uniphase (Nasdaq: JDSU) a few days ago due to general market volatility. This move proved fortuitous as both of these stocks have dropped since our sell point. We are looking for another entry point for both of these stocks, but for the time being we are staying on the sidelines. Although we think that Ciena’s report shows that demand in the sector is still strong and growing, we are worried that the 10% drop in Ciena could carry over into shares of JDS Uniphase and Electro Optical Engineering in the short term.

We think that Ciena has sold-off farther than it should have based on this report. Underlying demand is still strong and guidance was better than expected. That being said, we still like Electro Optical Engineering and JDS Uniphase more than Ciena due to increased exposure to optical test and measurement equipment. When Ciena stabilizes, it will be time to buy Electro Optical Engineering and JDS Uniphase.

Update on Orthologic (Nasdaq: OLGC), Novadel (Amex: NVD), and Inhibitex (Nasdaq: INHX)

• SELL OLGC near $1.55

• SELL NVD near $1.40

• SELL INHX near $1.63

Orthologic and Novadel passed our stop losses of $1.55 and $1.40 respectively this morning so we sold our shares and took the losses.

We are also selling Inhibitex this morning. Although we still think Inhibitex represents a solid value trading significantly below cash levels, current market conditions are not favorable for small cash rich biotechs. The mini trend started last week by Icogen and Neopharm is a distant memory for most investors considering the major market moves that have happened this week.

Our timing was terrible with these picks and these are some difficult losses to take, but our stop losses are there for a reason and over the long haul they will help protect the overall performance of our portfolio.