Archive for the ‘Investment Tips’ Category

October Recap: Four Better Valued Opportunities Than Gold

[Excerpted from Marks Group Wealth Management's Monthly Market Recap]

In less than 48 hours, we should know the outcome of the much-anticipated mid-term elections. Regardless of their political persuasion, there is strong historical evidence that investors prefer gridlock in Washington. Polls indicate that this is the likely outcome, but if not, there may be a short-term selloff in equities. The market doesn’t like surprises.

INDEX OCT 2010 YTD 2010

DJIA + 3.06% + 6.62%

Nasdaq + 5.86% +10.50%

S&P500 + 3.69% + 6.11%

The rally that began on August 31st continued through October, albeit at a slower pace. It is possible that recent gains were in anticipation of the election, and equities could experience some short-term weakness regardless of the election results. In other words, the election results are “baked into the market”. After the event investors will refocus their attention on other matters, including uncertainty about future tax rates, the continued slump in housing prices, or the stubbornly high unemployment rate.

When the Federal Open Market Committee meets this week, Bernanke and company will give us more clues as to how they plan to use their latest gadget, “QE2”, to stimulate the economy. QE2 refers to a second round of quantitative easing, and it is interesting for both how it is being used and how investors are responding to it.

Quantitative easing is one process by which the Federal Reserve increases the money supply, first by crediting its own account (in other words, printing money), then by using those funds to buy long-term Treasury bonds. In theory, this keeps long-term interest rates low, which has a stimulative/stabilizing effect on the economy as a whole (and housing in particular) and could help avoid a double-dip recession.

The first round of quantitative easing began in late-2008, when the Fed tried to prop up the economy by buying $1.25 trillion in mortgage-backed securities. With the Fed “backstopping” these bonds, and the economy, markets began to recover. So it’s no coincidence that soon after Fed Chairman Bernanke hinted at a second round of quantitative easing in a speech on August 27th, markets began their ascent.

But investors may be less enthusiastic about the longer-term implications of a second round of this strategy. Bill Gross, Chief Investment Officer for PIMCO and a powerful figure on Wall Street, recently stated that further quantitative easing would signify the end of the 30-year bull market in bonds.

Others believe that interest rates could remain low for an extended period as central banks, in attempting to keep their currencies from appreciating vs. the dollar, continue to buy dollar-denominated assets. This consistent demand for long-duration Treasuries will keep prices high, and interest rates low.

Regardless of when interest rates rise, we believe that high quality U.S. stocks offer greater value than most bonds at current prices.

Gold is the other asset that has investors’ attention lately. It is one of the best performing assets over the past five years, and the upward trend continues. We question if it is for the right reasons. Gold bullion ETFs, products created by Wall Street to make it easier for investors to buy gold, now represent most of the demand for gold. The fact that Wall Street created a product to exploit an asset class is, to us, a red flag.

Warren Buffett, who has a flare for putting things in perspective, recently described gold in these terms:

You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all of the farmland in the U.S. Plus, you could buy 10 Exxon Mobils, and have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?

No one knows how high gold prices will go, but we do agree with Mr. Buffet that there are other less popular and better valued opportunities.

Stock News

Noble Corporation (NE) – Noble and other deepwater drilling companies continue to trade at historically low levels due to the lingering hangover from last April’s disaster on the Deepwater Horizon Rig. Now that the government imposed moratorium on offshore drilling has been lifted, we believe that could be a positive catalyst for stocks like Noble.

As the second largest company in its field, we believe that Noble stands ahead of its competition. Nearly 85% of its 62 offshore drilling units are outside the U.S., providing insulation from the recent disruptions in the Gulf. The company also has maintained a very solid balance sheet with their debt equaling a modest percentage of total capital.

Noble’s profit margins of about 50% continue to be far greater than its closest competitors such as Transocean’s profit margin of 35%. During the 3rd quarter, the company repurchased 4 million shares of its stock at an average unit cost of $32.67, bringing the total number of shares repurchased in 2010 to 6.1 million as of September 30th. (Credit Suisse 10/21/10)

TCF Financial (TCB) – For much of 2010, TCF has fought an aggressive battle to maintain its fee income that has been threatened by proposed legislative changes. The bank has encouraged customers to sign up for overdraft protection, following new federal rules that went into effect in August that bar banks from automatic enrollment.

In addition to new restrictions on overdraft fees, TCF faces a potential revenue hit from planned new fee limits on debit-card transactions. As part of the financial regulatory overhaul passed this summer, the Federal Reserve is allowed to severely restrict the amount that banks like TCF can collect from retailers in interchange fees each time consumers swipe their debit cards at the register. TCF has responded by taking legal action against the debit-card fee section of the Dodd-Frank financial reform bill, calling it “unconstitutional.”

Despite these head winds, Minnesota’s third-largest bank reported a strong quarter in which profits doubled compared to the same quarter last year. TCF Financial CEO, Bill Cooper stated last week that the bank’s service fee revenue is down just 13% while similar revenue streams fell more than 20% at Wells Fargo (BWF) and US Bank (USB) during the 3rd quarter. (Credit Suisse 10/21/10)

Starbucks (SBUX) – Starbucks jumped more than 3% in October thanks to increasing demand for breakfast snacks and higher-priced coffee. Despite new competition from frappes and smoothies at McDonalds, the company shows strength and proves yet again the potential for coffee category growth.

Starbucks has continued to invest in advertising and innovation throughout the recession, creating compelling reasons for consumers to support their brand. Multiple industry analysts have raised their price target to $30 or greater within the past month, in anticipation of the quarterly earnings report scheduled for November 4th.

Starbucks said last month it would raise some prices to account for some more labor-intensive drinks and the surging prices of green Arabica coffee beans. Third party research provider Credit Suisse believes Starbucks has enough growth momentum to keep raising their earnings estimates over the next 12 months, and maintains its $34 price target on SBUX. (Credit Suisse 10/12/2010)

Johnson Controls Inc. (JCI) – Since we added JCI to our Core Equity Portfolio in August, the stock is up over 4.6%. Double-digit sales growth in its automotive businesses and increased orders for energy efficiency projects in buildings have helped lead the charge. During a time when many companies continue to pad their earnings by cutting costs, JCI posted their 3rd consecutive quarter of top-line revenue growth.

The company has continued to benefit from higher battery sales linked to its role as the exclusive provider of batteries to Wal-Mart (WMT) and its aggressive expansion in emerging battery and automotive markets. During a conference call with analysts, Steve Roell, chairman and chief executive, said the company benefited from cost-cutting and restructuring early in the year and then capitalized on the recovery of the auto industry and growth in international markets.

The company has become more aggressive in accelerating its growth initiatives, boosting its capital spending plan, said Bruce McDonald, chief financial officer. These plans include a recent expansion of production of automotive batteries for carmakers and the aftermarket in China, the only country where Johnson Controls is not the leading supplier of lead-acid batteries. The company now ranks fourth in market share in China. (Credit Suisse 10/27/10)

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Buckle Inc: Growing and Undervalued

The Buckle Inc. (Ticker: BKE) Recommendation: BUY

Key Statistics:

Business Description:

Buckle, Inc. is a retailer of medium to better-priced casual apparel for young men and women. The company’s merchandise is designed to appeal to the fashion conscious 15 to 30-year old. The company markets a wide selection of mostly brand name casual apparel, including denims, other casual bottoms, tops, sportswear, outerwear, accessories, and footwear. They emphasize personalized attention to their customers and provide individual customer services such as free alterations, free gift-wrapping, easy layaways and a frequent shopper program. Most stores are located in regional, high-traffic shopping malls, and this is their strategy for future expansion. As of January 30, 2010, the company operated 401 retail stores in 41 states throughout the continental United States under the names ‘Buckle’ and ‘The Buckle’. (Source Capital IQ)

Financial Highlight 2004-2010:

(In millions, except for EPS)

Financial Analysis:

Profit Margins:

Solvency Ratio:

Efficiency Ratio:

Management Overview:

BKE management is shareholder-orientated, especially when the founder’s son and current Chairman, Daniel Hirschfeld, owns approximately 43% of the company. Dividend payout ratio in 2010 was 95%. Buckle is led by dedicated management; Daniel Hirschfeld has been with the company since 1965, while Dennis Nelson (President and CEO) has been with the company for over 30 years. He has helped lead the company to over 400 stores and is actively involved in all phases of the company’s operations. Executive Vice President, Jim Shada has been with the company 25 years. Kari Smith, Vice-President of Sales, has been with the company for 25 years.

Competition/ Relative Analysis:

In the men’s merchandise area, the company competes primarily with specialty retailers such as Abercrombie & Fitch (ANF), American Eagle Outfitters (AEO), Aeropostale (ARO), Hollister, Gap (GPS), Pacific Sunwear (PSUN), and Metropark. The men’s market also competes with certain department stores, such as Dillard’s (DDS), Macy’s (M), Bon-Ton stores (BONT), Nordstrom (JWN), and other local or regional department stores and specialty retailers.

In the women’s merchandise area, the company competes primarily with specialty retailers such as Abercrombie & Fitch, American Eagle Outfitters, Express (EXPR), Aeropostale, Hollister, Gap, Maurices, Pacific Sunwear, Wet Seal (WTSLA), Forever 21, Vanity, and Metropark. The women’s market also competes with department stores, such as Dillards, Macy’s, Bon-Ton stores, Nordstrom, and certain local or regional department stores and specialty retailers.

The Buckle’s P/E ratio of 9.79X was lower with compared to American Eagle, Gap, Urban Outfitters (URBN) and Abercrombie & Fitch. The company’s P/E ratio was slightly higher than the P/E ratio of Aeropostale (9.11X), but was lower than the industry and BKE’s five year average P/E of 13.9X.

The Company’s Return on Equity (35.10%) and Return on Assets (25.85%) were higher than the most of its competitors.

The Buckle’s had an operating margin and net margin of 13.92% and 19.89% respectively, which were higher than the industry average.

Greenblatt’s Magic Formula Analysis:

For a stable business, the higher the earnings yield, cheaper the stock. The Magic Formula requires an earnings yield greater than 10%. With an Enterprise Value of $1116 and EBIT of $204, earning yield of the company was 18.3% (Earning yield for Guess, Fossil and Urban Outfitters was 12.7%, 9.2% and 7.5% respectively).

Greenblatt recommends using return on assets greater than 25%. The Buckle had ROA of 25.85% in 2010 (ROA for Guess, Fossil and Urban Outfitters was 17.4%, 13.1% and 15.1% respectively). The company’s return on capital (ROC) was 35.9% in 2010.

Valuation/DCF:

DCF valuation of the company under different scenarios of growth rate and discount rate shows that the stock is undervalued and there is a margin of safety.

Conclusion:

I have a ‘BUY’ recommendation on BKE stock. BKE’s long-term growth prospects are bullish due to strong earnings estimates. In addition, the company is planning to open 20 new stores, which will drive sales up. BKE’s steady flow of brand merchandise and store expansion will go a long way to increase brand awareness and attract new customers. Buckle is supported by strong management along with strong financials. Currently they have zero debt, current ratio of 2.9 and a quick ratio of 1.8. The company has a PEG of 1.0, which is a bullish indicator. Adding to this they have strong ROE and ROA of 35% and 26%. Buckle insiders hold 43% of the company showing they believe in its long-term growth potential. This long-term growth will be strengthened now that the Buckle is planning on expanding into the Northeast for the first time. Also, BKE’s same store sales growth and sales per square foot analysis shows that company is growing and has shown a better performance in comparison to its competitors. I like BKE due to their strong brand management, overall sales appeal and low Price/Earnings multiple.

Disclosure: The analyst/author of this report holds no financial interest in the securities of this company. The analyst/author knows of no existence of any conflicts of interest that might bias the content of this report. The analyst/author is not monetarily or financially compensated in any way for writing this report.

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L.S. Starrett: Making Money but Losing Value

L.S. Starrett (SCX), a company we have previously discussed as a potential value investment, recently returned to profitability, having achieved sales and gross margin growth of 65% and 80% respectively in its fiscal fourth quarter. But despite the company’s strong operating performance, the value of the company continued to fall. How can this be?

This occurs because not all company losses are shown on the income statement. Changes in the funded status (i.e. the difference between the pension plan’s assets and the present value of what it owes) of a company’s pension plan, for example, are not required to be immediately recognized as losses on the income statement. But to shareholders, a funding shortfall in a company pension plan is a very real liability that will have to be made up by future cash payments unless positive developments (e.g. strong returns from the plan’s investments) occur that reduce the shortfall. But one cannot count on such positive developments!

For some companies, pension plan shortfalls are a drop in the bucket compared to the size of the company’s operations. This is not the case with Starrett, as post-retirement plan shortfalls represent more than 1/3 of the company’s market cap!

In order to properly estimate the intrinsic value of companies, shareholders should be sure to consider liabilities (such as pension shortfalls) that are not fully reflected on income statements. This requires subtracting funding shortfalls from company valuations based on their balance sheet values, or by following the progress of such shortfalls on the company’s statement of comprehensive income.

Disclosure: Author has a long position in shares of SCX

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Armstrong World Industries Is a Stock to Watch

Flooring maker Armstrong World Industries (AWI) is staging a breakout from a 2 month base…. normally, I’d be all over this but earnings are Friday which means we have a binary event upcoming soon. That said, it is still very tempting as these long bases usually provide excellent breakouts. If I had 3 day time horizon I’d probably buy here and be out by Thursday as this one looks promising. Just passing it along, and I’ll be interested to see what happens with the name Friday.

Armstrong World Industries, Inc. engages in the design, manufacture, and sale of flooring products and ceiling systems

Author’s Disclosure: No position

original article

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L.S. Starrett: Making Money but Losing Value

L.S. Starrett (SCX), a company we have previously discussed as a potential value investment, recently returned to profitability, having achieved sales and gross margin growth of 65% and 80% respectively in its fiscal fourth quarter. But despite the company’s strong operating performance, the value of the company continued to fall. How can this be?

This occurs because not all company losses are shown on the income statement. Changes in the funded status (i.e. the difference between the pension plan’s assets and the present value of what it owes) of a company’s pension plan, for example, are not required to be immediately recognized as losses on the income statement. But to shareholders, a funding shortfall in a company pension plan is a very real liability that will have to be made up by future cash payments unless positive developments (e.g. strong returns from the plan’s investments) occur that reduce the shortfall. But one cannot count on such positive developments!

For some companies, pension plan shortfalls are a drop in the bucket compared to the size of the company’s operations. This is not the case with Starrett, as post-retirement plan shortfalls represent more than 1/3 of the company’s market cap!

In order to properly estimate the intrinsic value of companies, shareholders should be sure to consider liabilities (such as pension shortfalls) that are not fully reflected on income statements. This requires subtracting funding shortfalls from company valuations based on their balance sheet values, or by following the progress of such shortfalls on the company’s statement of comprehensive income.

Disclosure: Author has a long position in shares of SCX

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The QE2 Counter-Balance Plan (Or How to Survive This Week’s Market)

by Mike McDermott

As we kick off another week in the life of a trader, it’s clear that the majority of active participants are focusing on one – and only one – announcement this week.

Sure, there are the token earnings reports along with minutes from the Bank of Japan, and the results of mid-term elections… But as important as these issues may be, the majority of wheelers and dealers are eagerly anticipating details on the Fed’s second round of Quantitative Easing.

The most conservative estimates peg the capital injection at a “paltry several hundred billion” over the next few months. But some whisper numbers have raised expectations for an additional $1 trillion pumped into the economy.

Even the fed doesn’t appear to have the number pegged yet as the Finanical Times reported that the Fed was sending surveys out to various dealers in a thinly veiled attempt to gauge the market’s expectation for the announcement this week.

At this point it seems clear that equities are fully pricing in a significant amount of QE2 stimulus – and as Jack mentioned in this week’s Weekender, the reward / risk dynamics certainly don’t appear to favor a bet that the announcement will continue to drive risk assets higher.

So as we line up our trading book for this week, we are taking a much more balanced approach – leaving some profitable QE2 positions on with tightened stops, while at the same time lining up potential trades that will be triggered on a negative reaction to the QE2 announcement.

So let’s take a look at the balance of opportunity for this week…

Precious Metals

It’s a well-known fact that as the Fed continues to pump liquidity into the system – and investors along with consumers fear currency devaluation – that the price of precious metals will be more likely to rally.

Last week I mentioned that we were seeing more strength in the Market Vectors Junior Gold Miners (GDXJ) compared to the large-cap Market Vectors Gold Miners (GDX). Speculative traders are more excited about the juniors’ leverage to the price of gold as many of these firms will be able to use higher commodity prices to significantly improve their financial position.

In a similar fashion, we are seeing outperformance in silver miners compared to their gold siblings as silver prices have risen more sharply than the robust rise in the spot price for gold. Our silver Strategic Intelligence Report gives a bit more information on the supply / demand dynamics for silver along with our three favorite silver trading vehicles.

On Friday, Silver Wheaton Corp. (SLW) broke to a new high and closed at the top of its range (click on chart to enlarge). It appears the stock is finally ready to hold above resistance which increases our confidence in the trade. The company has a very unique approach to the business of silver mining, purchasing production interests in other miners silver production and thereby sidestepping many of the risks and headaches associated with the traditional business of mining.

Our precious metal positions will likely do very well if the QE2 announcement comes in ahead of expectations. Of course, it appears the market has largely priced in the effects of QE2 but as I mentioned, we are stringing for a balanced book to offset risks on each side.

Risk Off Scenario

If the QE2 announcement comes in at or below the expected level, there could be an asymmetrical opportunity where the magnitude of negative action far exceeds the potential magnitude of a positive reaction. So with this in mind, we’re looking to tighten our stops on the existing precious metal “risk on” positions and add some exposure (or potential exposure) on the risk-off side.

One of the first places that a lighter QE2 announcement could affect is the forex market. We’ve all seen the exceptional weakness in the US dollar as attention has shifted from European troubles to a potential devaluation of the greenback. It’s hard to imagine an immediate scenario that would push the dollar deeper than it’s current QE2 quagmire.

But if we get a risk-off scenario, the magnitude of rebound in the US Dollar could catch a number of large players leaning the wrong way – igniting a bullish scramble in the dollar. Of course there are a number of ways to trade this scenario, but we’ve picked out the PowerShares US Dollar Bull (UUP) ETF as our primary vehicle for this week (click to enlarge).

At this point we don’t have a long position, but keying off the short-term support / resistance points could offer a key inflection point which would likely correlate with the Fed announcement this week.

The potential “risk off” trade will also be more likely to affect small-caps as a group than the large cap companies with more stability and more international exposure. At this point, the environment favors taking a broad approach, shorting vehicles like ETFs or broad indices rather than individual equities. That’s because our primary catalyst is a large macro-event instead of dynamics surrounding any one particular company.

There are a number of different approaches to shorting a small-cap basket. Probably the most straightforward would be a short position in Russell 2000 iShares (IWM). Our current decision has been to short the Direxion Daily Small Cap Bull 3x Shares (TNA) for a couple of reasons:

• The leveraged vehicle gives us more firepower while keeping additional trading powder dry.

• The “volatility decay” could work in our favor as this vehicle resets on a daily basis

A sharp break below $50 could (or a corresponding area on IWM could) help solidify this trade and offer a chance for us to both increase our exposure as well as decrease our risk by adding vertical exposure and simultaneously tightening our stop point (click to enlarge).

One final macro approach to the “risk-off” scenario could be a long position corresponding to the CBOE Volatility Index. This index measures the volatility premium in OEX options and typically the index has a strong negative correlation to broad equity prices.

When I mention that we are interested in trading the iPath S&P 500 VIX Short-Term (VXX), I know that many enthusiasts will jump up with explanations for why this is such a flawed vehicle. Let me say that yes, we KNOW that the vehicle is flawed. And it would be stupid for us to hold this vehicle long-term with the hope of replicating the VIX index.

But from a purely utilitarian perspective, the VXX can be a very attractive short-term trading vehicle. Consider the 50% rise over the course of just a few days in May. Once again, we’re looking for asymmetric opportunities where our potential return far exceeds our position risk.

In this case, a stop / limit buy order could be triggered early if the market begins to panic after a QE2 disappointment. If everything settles down and turns out to be ok, we will likely lose a few basis points on the trade. But if the QE2 announcement sets off a true panic environment, a long VXX position could make a material impact on our 2010 performance (click to enlarge).

Industry Opportunities

As the Q3 earnings season begins to offer more clarity for a number of industries, we have a few bearish lines out in key sectors…

The manufacturing sector has been a particularly hot focus area as the potential for an all-out trade war looms. Steel companies are certainly vulnerable to increased tariffs and trade barriers – regardless of which country is the aggressor. On top of that, a lethargic US consumer along with potential policy brakes in China could put a damper on durable goods orders.

The Market Vectors Steel (SLX) stands out as a reasonable vehicle for gaming a slowdown in manufacturing or global trade. The sector has begun trading lower (triggering a short position in the Mercenary book) and further weakness could offer a chance to add more exposure (click to enlarge). Our approach would likely be to add more vertical exposure (additional shares to the existing position) although we very well could add horizontal exposure (new positions within the same theme) with more clarity on individual steel names.

We have a similar view on oil prices which are affected not only by manufacturing, but also by inventory reports which have shown increases in inventories (a bearish development). On top of the “above ground” inventory, we also have new resources like the giant Brazil Libra Field which call the immediate peak oil expectations into question.

There are a number of different vehicles to use to express a trade in oil. Aside from the extremely liquid futures contracts, ETFs like the ProShares Ultra DJ UBS Crude Oil (UCO), and United States Oil Fund (USO) are relatively efficient vehicles. Some traders have had trouble locating shares of these two ETFs and so at this point we’re using the iPath S&P GSCI Crude Oil ETN (OIL) as our vehicle of choice (click to enlarge).

As we enter the uncertainty of the upcoming week, remember that the volatility is actually a benefit – not a detriment – to the competent trader. When the stakes are higher, that simply gives us the opportunity to manage risk better than our competition, capture profits from the swings, and capture those incremental basis points that add up to a significant advantage.

So with the uncertainty and volatility in mind, size trades carefully and most importantly make sure that your bets are balanced and your risk to reward is asymmetrically skewed in your favor.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

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Bank of America: Worth Watching Ahead of 2011

Recent turbulation related to foreclosure procedures at Countrywide and mortgage repurchase claims from GSEs, the Fed (NY), Blackrock and others have pummeled Bank of America (BAC) over the past several weeks, given the inherent franchise strength and low relative valuation at ‘normal’ earnings levels (~6X projected 2012 earnings).

Third quarter results announced recently (see earnings call transcript here) included a $10.4 billion forward-looking goodwill impairment charge related to limits on debit interchange fees under the financial reform legislation (July 2010 ). Given the book size, this charge is significant, even considering impact on both debit and credit card portfolios. Excluding this, 3Q revenues increased to USD 0.27/share, against analyst consensus of USD 0.16/share. Total revenues also increased slightly to over USD 26.7 billion. Apart from the significant charge related to the card services book, mortgage warranty claims related to securitized pools of the 2004-’08 period also caused significant perceived risk increase and hence, pressure on the stock price. BAC currently has around USD 4.4 bn in repurchase reserves, against outstanding claims of USD 12.9 billion. Considering the average loss impact proportion (22-25%) of prior repurchases in this pool, the current reserves look more than sufficient to cover potential claims. Also, BAC and most other lenders seem to have their act ready to manage through the tussle on the foreclosure front – though the ‘omissions’ and lack of control on the process is quite shameful, across many of the large banks. Given the above, despite open/unknown risk factors, especially on the foreclosure front, it is important to note that BAC has budgeted/provisioned reasonably against the major areas of potential headwinds.

A look at the revenue mix across segments – Card Services (24%), Global Corporate banking (19%), Global Markets (17%), Wealth management (15%), Home loans and insurance (14%) and Deposits (12%) – show a heavy skew towards consunmer/retail banking and wealth management. I personally feel that a good part of onerous regulations in this sector has already seen the light of the day, and potential incremental pressures on consumer credit and mortgages should be relatively low in 2011. Given this, though, interest spreads would remain tight:

• Loan loss provisions should definitely decrease in 2011 as compared to 2010 level of USD 31 bn
• Card services revenues should stablize in 2011 due to lower card delinquency and repayment delays
• Mortgage fees should look up due to continued refinance activity in a low rate environment

The above factors, primarily driven by overall franchise strength and market share, should yield positive revenue and earnings numbers in 2011 as compared to the current year. It should also be noted that BAC’s loan to deposits ratio has significantly reduced over the past 3 years (to less than 1:1) and loan loss reserves are at their highest level (close to 3.8%). Given these factors, and a book value of over USD 11, further downward pressure on the stock price seems unlikely.

Of course, this is against the expected backdrop of a gradual continued improvement in employment and the housing market, which seems justified given general trend shown by leading indicators, and pro-active Fed/gov’t support to any market pressures so far. It’s, however, worth a wait-and-watch towards the end of the year to see how the foreclosure story plays out before building long positions – especially given the high foreclosure pipeline volume (USD 54+ bn) as compared to other large competitors like JPM and C.

Financials on the whole look extremely tricky to take value calls on, as always, given accounting practices and rapidly changing regulatory and legal pressures at multiple ends. However, if you are one who really doesn’t believe in a doomsday scenario, and want to look at fundamental business value and segmental growth/stablization potential, stocks like BAC are worth watching as we head into next year. I personally would consider entering before EOY, especially at any entry opportunity below 11.

Disclosure: No positions in BAC, JPM, C at this time

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Mirant: Many Questions, One Conclusion – This Stock Is Undervalued

Electricity producer/wholesaler Mirant (MIR; $10.61 per share; MV $1.5 billion), which reports 3Q10 earnings this Friday (November 5), is in the process of merging with rival RRI Energy (RRI; $3.76 per share; MV $1.3 billion). Both companies appear materially undervalued on a standalone basis, with each trading at less than half of tangible book value and less than $200K per megawatt of electrical generating capacity, compared to a range of $300-700K for industry participants Dynegy (DYN), NRG Energy (NRG), Calpine (CPN) and AES Corp. (AES):

1 – Based on closing share prices as of October 29, 2010. All balance sheet values are as of June 30, 2010, except for Calpine (as of September 30, 2010). Generating capacity is based on recently available data.
2 – Enterprise value includes net pension liabilities, net derivatives, restricted cash, funds on deposit and investments. AES enterprise value includes $14.6 billion of non-recourse debt.

Lots of questions may be on investors’ minds including the following:

1) Why is Mirant issuing shares to buy RRI when its own stock appears to be materially undervalued?
2) Are Mirant’s assets inferior to its competitors as suggested by the above valuation table?
3) Is there a cross-read from Blackstone’s recent bid for Dynegy? (Blackstone is offering an implied >$300k per MW of Dynegy’s generating capacity – more than twice Mirant’s valuation)
4) Is Mirant "doomed" given historically low natural gas prices (which correlate with electricity prices) and declining "dark spreads," i.e. the narrowing of the spread between electricity prices and the price of coal (major fuel source used by Mirant to produce electricity)?
5) Why is Mirant spending ~$500 million to build 760 MW of gas-fired capacity at Marsh Landing in California ( >$650k per MW), when the company’s implied valuation is ~$150 per MW?

The clue to some of the above questions may be Mirant’s dependence on coal as a fuel source (~80% of total fuel used). But, then again, the acquisition of RRI should change that as the combined company, to be called GenOn Energy, will have nearly 40% of capacity based on natural gas (with another ~30% dual-source).

Be it as it may, Mirant is one of the best-capitalized companies in the industry, and the balance sheet of the combined Mirant/RRI will carry less leverage than either of DYN, NRG, CPN or AES. While Mirant’s trading multiples are negatively affected – and rightfully so, to an extent – by relatively heavy reliance on coal in electricity generation as well as declining benefits of hedging in 2011 and beyond, earnings-based valuation measures can be notoriously misleading. Analysts expect Mirant to earn $1.54 EPS this year but only $0.12 next year as a large portion of hedging benefits goes away. The assumption in analysts’ expectations, of course, is that "dark spreads" will remain depressed in 2011. With the price of electricity correlated with hard-to-predict natural gas prices, we question analysts’ ability to forecast dark spreads with precision. We can envision a scenario in which dark spreads surprise on the upside just as Mirant and RRI are starting to benefit from merger-related cost synergies ($150 million, to be fully realized starting in January 2012) . The result would be financial performance that might necessitate a material upward adjustment in the Street’s valuation of the combined entity, GenOn. The below table provides estimate ranges for the fair value of Mirant as implied by the valuation of its competitors:

1 – See comparable company table. Low value multiple is based on Dynegy’s recent multiple, high value estimate on 25% discount to recent multiple of AES.
2 – Based on shares outstanding of 146 million.
3 – See comparable company table. Low value multiple is based on two times Dynegy’s recent multiple, high value estimate on 25% discount to recent multiple of AES. Note that Dynegy is significantly more leveraged than Mirant and may be considered a distressed equity.

With a strong balance sheet and a market valuation barely in excess of one-third of tangible book value, the current Mirant offers strong downside protection and above-average upside, in our view. The pending merger with RRI has been approved by Mirant and RRI Energy shareholders on October 25. While it remains subject to clearance by the U.S. Department of Justice, Mirant management expects to “complete the merger by the end of the year.” Although Mirant shareholders might be giving away more value than receiving in the 100%-stock merger (based on relative undervaluation of Mirant versus RRI stock and the unfavorable treatment of ~$2.7 billion of Mirant’s federal NOLs), the merger reduces Mirant’s dependence on coal versus natural gas, which may prove beneficial over time.

In summary, the above questions may hint at possible reasons why "Mr. Market" is valuing Mirant at a discount to its peers. While not all answers are favorable to Mirant, our conclusion is that the risk-reward implied by Mirant’s share price is attractive. By the way, this also seems to be the view of John Paulson, whose hedge fund owns more than 12% of the company.

Disclosure: No positions

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How High Can Silver Go?

Legendary commodity investor and hedge fund manager Jim Rogers recently pointed out that silver prices are 50% below all time highs.

He’s talking about the brief momentary highs of nearly $50 an ounce back in 1980. With silver currently selling for less than $24 an ounce, Mr. Rogers is technically correct. But priced in 2010 dollars, the inflation adjusted high for silver would be closer to $124.

So if you believe that silver prices will make new inflation adjusted highs, then you’re expecting to see a five-fold increase in the price of silver.

Silver has already trounced just about every other asset so far this year – it’s up 40% since January 1^st.

I believe that silver is due for a correction. If you’ve read any of my articles this week, you’ve heard me talk about Ben Bernanke and the upcoming Federal Open Market Committee (FOMC) meeting where he will announce the next round of Quantitative Easing.

Ben’s announcement could strengthen the dollar, which would be bearish for all commodities, not just silver. As I said, silver is due for a correction. Bernanke’s announcement could be a catalyst for silver prices to drop 5-10% in the short term.

That would create an excellent buying opportunity for people like me, who are long term bullish on silver.

I’ll be bullish on silver as long as the Federal Government keeps interest rates absurdly low, and as long as huge amounts of government debt is the only realistic option to keep paying for all the bells and whistles that politicians promise voters and constituents.

But there’s an additional wrinkle in the silver story that I think could give silver an additional, long-term boost…

For years and years, silver prognosticators and analysts have talked about silver price manipulation. In short, the long-running conspiracy theory is that a handful of global banks have placed massive short-side bets in order to manipulate the price of silver.

Well, it’s not a conspiracy theory anymore.

According to a recent story in Bloomberg,

At a hearing in Washington on Oct. 27, CFTC Commissioner Bart Chilton said there have been ‘fraudulent efforts to persuade and deviously control’ silver prices and that violators should be prosecuted.

If you’re not familiar with the Commodity Futures Trade Commission, they’re the Federal Government body in charge of regulating and monitoring all commodity futures transactions on exchanges in the United States.

They run a pretty tight ship, so it will be surprising if they let any of the offending parties in this manipulation scandal off the hook easily. So what’s the upside for manipulating silver futures contracts?

It’s a little complicated, but these banks were placing phantom or “spoof” orders on silver contracts with the intention of skewing prices of options contracts.

The effect, allegedly, is that these spoof orders made some options worthless while boosting the value of other options.

In any event, these “spoof” orders had the supposed consequence of keeping silver prices artificially low.

In light of the announcement from the CFTC that they believe the price has been manipulated, I think we can see an additional boost as short-side orders are either cancelled and/or filled by the offending parties.

When you take a short side bet and you’re wrong, when the options contract expires, you have to buy the security at current prices. The additional volume usually spikes the price further to the upside.

Now that the CFTC is on the case, I’ll expect silver to continue to make new highs.

It still has quite a bit further to go before it hits inflation adjusted highs – but as I’ve been saying: wait for Bernanke’s announcement next week to add to or build a position in silver.

Disclosure: Long silver and gold

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DepoMed: Positive Pipeline Should Fuel Share Price

By Patrick Crutcher

We wanted to provide readers with an update on DepoMed Inc.(NASDAQ: DEPO). They have been busy making the rounds at a few investor conferences. CEO, President Carl A. Pelzel recently gave a presentation last week at the BioCentury’s NewsMakers in the Biotech Industry Conference. Below is an overview of some of the topics he addressed.

Right now, DEPO is generating most of it’s revenue from sales of Glumetza. GLUMETZA (metformin hydrochloride extended release tablets) is indicated as an adjunct to diet and exercise to improve glycemic control in adult patients with type 2 diabetes. Currently, DEPO has a royalty ~17% on sales of Glumetza. In the presentation, Pelzel noted that they expect Glumetza 500mg resupply to take place in the 4th quarter. They’ve also done a study which showed that Glumetza can be tolerated at higher dosages and that it has showed lower potential for GI adverse events than those using previous metformin formulations.

This is the most important catalyst in the next 3 months for DEPO: PDUFA date of January 30th, 2011 for DM-1796. DM-1796 is an extended release, once-daily tablet formulation of gabapentin for the management of postherpetic neuralgia (PHN), or pain after shingles. If approved, DEPO expects Abbott to launch in Q2 2011 and Abbott will pay DEPO a milestone payment between $35-60M, depending upon the label. Pelzel said they are projecting somewhere in the middle, so roughly $45-50M. DEPO expects to receive favorable labeling as their Phase 3 study demonstrated a better side-effect profile. Additionally, they will have a 14% royalty each year going up to 20% and up to $300M in milestones.

DEPOMED 4.89 - (0.00%) Intraday | 3 Month | 6 Month | 1 Year Quotes delayed at least 20 mins.

On the subject of the rest-of-world market, DM-1796 will require further studies in Europe and Japan, but not in South America and Asia where after a perfunctory 3 month period, US approval will be enough to support approval in these markets. The postherpetic neuralgia (PHN) market has been growing the past several years(~30%) and has continued uptake in prescriptions. Based on their figures, they have seen decreasing Lyrica sales(-11%) and increasing generic gabapentin sales. They believe DM-1796 has excellent potential to capture a portion of this $7B market. DM-1796 offers patients and doctors added convenience(once-daily vs 2-4 times) and a decreased side effects profile. They are still in discussions for sale of ex-US rights to DM-1796.

This drug was filed under the 505(b)(2) NDA, which means no additional carcinogenicity studies were required for the DM-1796 NDA because it will reference the same toxicology package that formed the basis of the approval of Neurontin® (gabapentin) for epilepsy and postherpetic neuralgia. Gabapentin has been around since 1993 and no toxicology has been seen in post-marketing with approximately 20 million prescriptions annually. If approved, they would be the first company to have an approved extended-release formulation of gabapentin. See Pre-NDA meeting notes for more on this.

DEPO also commented on some other items of interest. They expect Phase 1 results for DM-1992 to be available in Q1 2011. DM-1992 is their novel formulation of Levodopa/carbidopa, which is the gold standard treatment of Parkinson’s Disease but currently has significant limitations with inconsistent efficacy and inconvenient dosing (4-6 times daily). Levodopa/Carbidopa is available as a generic (Sinemet) and had $270 M in sales in the U.S. in 2006. They believe their AcuForm™ technology, could help patients using Levodopa/Carbidopa to achieve more consistent efficacy, as well as reduce dosing frequency. DEPO hopes to out-license this program soon after results are presented.

DEPO expects Merck (MRK) to file the NDA for Janumet-XR sometime Q4 2010. Janumet-XR will be an extended release metformin to co-formulation along with its DPP-IV agent, Januvia (sitagliptin). Janumet tablets contain 2 prescription medicines: sitagliptin (JANUVIA®) and metformin. Depomed will earn an undisclosed milestone payment from Merck when FDA acceptance of the Janumet-XR NDA occurs. Januvia and Janumet posted sales of $1.9 billion and $650 million, in 2009. Janumet-XR would certainly occupy most of the Janumet current sales. Depomed likely has a single digit royalty on sales, which would still add plenty of cash to their operations.

Last week, they also announced a $5 million milestone payment from Janssen Pharmaceutica N.V. following the delivery of a prototype of one of four formulations of a fixed dose combination of canagliflozin, a Sodium Glucose Transporter 2 (SGLT2) inhibitor, and extended-release metformin. Pezel also noted that their gastroesophageal reflux disease (GERD) or acid reflux disease product, DM-3458, will likely be out-licensed in 2011. Again this will utlilize their patented AcuForm technology to develop a controlled-release formulation of omeprazole, a generic proton pump inhibitor (PPI).

On a final note, DEPO will be announcing 3Q 2010 results on Monday, November 1st. Based on Pezel’s comments, Glumetza 1000mg sales have been going well, so you can expect to see good numbers posted on this front. DEPO expects to have roughly $59-65M in cash by year’s end. Again, DEPO has no intentions of raising capital since they have multiple revenue streams and several catalytic events that could increase their cash position by 100%. CEO Carl Pelzel also noted that a very well-know analyst had recently visited the company, so we could be hearing a report from this analyst in the future. We feel that DM-1796 will likely be approved based on the data at hand and their side effect profile should lend itself to very favorable labeling with the FDA. Investors can be assured that DEPO has many forthcoming positive events that will fuel an appreciation in share price.

Disclosure: Long DEPO

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