GPS maker sees business moving in the right direction

With global-positioning product specialist Garmin’s (Nasdaq: GRMN) recent earnings report, the company showed some real progress.

First and foremost, it exceeded expectations, with revenues climbing 19 percent, led by a strong 35 percent growth in the firm’s second-largest GPS segment, outdoor/fitness. Meanwhile, the flagship automotive/mobile unit grew by 21 percent.

As expected, however, profit margin pressures continued to squeeze profits on those sales. But here’s the good news about falling margins: by taking the hit, Garmin’s made real progress in working down its inventories. Up 125 percent year over year at the end of the second quarter, they’re now down to a still-too-high but less frightening 42 percent increase for the third quarter. And management is planning further reductions, possibly putting an end to its inventory glut in as little time as three months.

And the story could get even better. Slowing its inventory pileup helped Garmin generate $202 million in free cash flow, bringing the company’s rolling tally up to around $500 million.

That gives it a price-to-free-cash-flow ratio of about 9, versus predicted growth of 14 percent per year. If free cash flow continues to swell through further inventory liquidation in the fourth quarter, its valuation could get more attractive still.

Ask the Fool

Q: What are “naked calls”? – F.J., Keene, N.H.

A: They represent an investing strategy using options. Remember that there are two main kinds of options: “calls” and “puts.” Owning a call gives you the right to buy a set number of shares, at a set price, within a certain period of time (often just a few months). For this right, you pay a price premium. Puts give you the right to sell shares.

You sell (or “write”) naked calls when you don’t own the underlying stock. It’s risky because if the stock soars, you may have to buy it at the new high price in order to deliver it to whomever bought the call you sold. You can potentially lose a lot. Of course, if the stock doesn’t pass the “strike price” before the option expires, you simply pocket the price of the option. That’s why people write naked calls.

With the much more conservative covered-calls strategy, you sell a call only when you own the underlying stock and are willing to part with it, if need be. You can’t lose money on the arrangement.

If the stock soars and someone exercises the option you sold them, you don’t have to buy the shares at the new high price – you already own them and can hand them over, still having pocketed the price of the option. Of course, you may end up wishing you still owned the stock, if it keeps soaring.

Q: What are “basis points”? – T.R., Morganton, N.C.

A: Basis points are 1/100ths of a percentage point. So if you hear, say, that some interest rate is down 50 basis points, that means it’s down half a percentage point.

My dumbest investment

I screened for stocks, looking only for high-yield. I ignored business fundamentals, research and market conditions. Along came a 12 percent yield – woo-hoo! The stock also appeared to be on sale after a price dip. Turns out it was a good company but a horrible time to buy it. (It’s a short-term commercial real estate lender.)

Which sectors have been hard-hit lately? Finance and real estate – and I invested in a company that combined both. The stock has now fallen by some 50 percent. What did I learn? One, yield is only part of the picture. Two, hold a real estate investment trust (REIT) in a tax-protected Roth IRA or traditional IRA, where high-yielders can do so much better. – M.S., Durango, Colo.

The Fool responds: Right you are – you always need to examine many aspects of a company, not just one, such as yield or profit margins or revenue growth. It’s also smart to park investments that pay hefty dividends in tax-advantaged accounts, to delay (or avoid altogether, via the Roth) paying taxes on them.