Have you ever wondered what happens to your stock trade between the time you hit “submit order” and the moment the trade is excuted?  Since most traders see an almost instantaneous fill, many assume that the process is seamless and predictable with the trades either executed on the NASDAQ or NYSE depending on which exchange the stock is listed on.  In actuality, there are many moving parts and most trades only have a 50/50 chance of actually being executed on one of the two major exchanges listed above.

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Trading systems such as Direct Edge and BATS Exchange Inc., are becoming major players in the cut-throat world of equity execution.  Over the past two years, these two exchanges have grown their combined market share of US equity executions to 22.6% from just 6.3% in July of 2007.  At the heart of this growth is the practice of high frequency trading which is run by computers swiftly executing trades in order to capture minuscule mispricings and profit from rapid-fire buying and selling.

While computerized day trading is by no means a novel concept, the most recent evolutionary mutation known as “flash trading” has the major exchanges crying foul and has even caught the attention of Congress and the SEC.  At issue is the practice of previewing some orders to a select group of market participants in hopes of matching a trade, before showing the bid or ask to the entire market.  The process is completely invisible to the naked eye as the trades are shown and executed in milliseconds, but the accusation is that the method freezes some market participants from being able to access these initial trade prices.

Direct Edge is owned by an assortment of public and private entities including Knight Capital Group Inc. (NITE), Citadel Investment Group, and Goldman Sachs (GS).  The company justifies its flash trading by stating that it has a duty to its clients to find the very best executions possible for them and the rapid preview to market participants allows them to get liquidity and price improvement.  If the orders are not immediately matched, they are then posted on major exchanges and become available to all market participants.

Regardless of the competitive issues, the process is certainly a very profitable business.  According to the Wall Street Journal, flash trading only accounts for 5% of Direct Edge’s trading volume, but makes up 25% of profits due to the high margins.  It seems that clients are willing to pay a premium for Direct Edge’s access to dark liquidity pools and other flash trading participants.

Lest you believe that high frequency trading is occurring at the expense of the average retail investor, it is interesting to note that TD Ameritrade (AMTD) among other retail brokerages have access to these high frequency trading operations.  Rebates from Direct Edge who pays for order flow has allowed AMTD to offer low execution costs for customers which is a direct benefit to the individual investor.

Knight Capital Group, Inc. has been building a strong business based on its partial ownership of Direct Edge as well as its expanding domestic and international trading business.  During the second quarter, NITE saw its revenue increase by 65% over last year and has recently divested its hedge fund business which was becoming a burden and a distraction.  Looking forward, the company should benefit from increased trading volumes which will be driven by both an expanding market as high frequency trading causes the number of executions to climb, as well as through market share gains as nimble exchanges take volume from the traditional NYSE and NASDAQ exchanges.

FD: The ZachStocks Growth Model has a long position in NITE as well as NYX

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American Superconductor (AMSC) is in the process of reengineering its business.  Once a money losing electrical equipment firm, the company made a strategic investment in 2007 which transformed the company’s focus and lead to a profitable business in providing components to the alternative energy market.

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The process has been turbulent for investors who saw their investment grow by more than 300% in less than two years, only to give the entire gain back as the market reacted to the global financial crisis.  But continued successful execution by management was quickly reflected in the stock as buyers stepped in to gain exposure to the wind turbine market.  AMSC is one of the only publicly traded companies which offers a near pure play on wind energy as many other players such as General Electric (GE) have so much exposure to other markets that the wind business is simply drowned out.

American Superconductor operates with a fiscal year end of March 31.  So they are currently in the second quarter of fiscal 2010.  The most recent quarterly results drove the stock up sharply as investors were impressed with the positive statements given by management.  During the quarter the company earned $0.04 per share on revenues of $73 million (this was an 83% increase over the same quarter last year).  AMSC’s largest customer, Sinovel, essentially asked the company to speed up an existing contract in order to get more units in the field quickly.  This means that a contract which was expected to last until December of 2011 will now be crammed into a time period ending April of 2011.  So not only did the total value of the contract expand, but AMSC will be able to recognize the revenue and earnings much more quickly.

At the same time, management stated that additional customers who have small contracts with the firm will begin to roll out larger products which should lead to an uptick in revenue and earnings over the next 12 to 18 months.

A solid mix of wind power and power grid business fueled another record quarter at American Superconductor… With Sinovel continuing to gain market share, many of our other wind turbine manufacturers set to commence production over the next 12 months, and power grid demand on the rise worldwide, AMSC’s outlook is stronger than ever.  ~Gregory J. Yurek, Chairman & CEO

The future certainly looks bright for the company which is sitting on no debt and has a cash and marketable securities balance north of $95 million.  It’s no wonder investors are bidding the shares significantly higher and seem willing to pay nearly any price to get exposure to this growth company.

Unfortunately, even strong growth companies like AMSC can see their stock values plummet – especially when investors begin to trade with too much confidence.  Currently the stock price is hovering around $33 compared to earnings this year which are estimated at $0.46 per share.  This means that investors are willing to pay more than $71 for every dollar the company earns this year.

The bullish analysts will tell you that the numbers look much better when compared to future earnings.  But even considering the consensus numbers for 2011 of $0.94, the stock is still trading at a multiple of 35 – and a lot can happen between now and March of 2011.  Not only will the company have to compete with a growing number of businesses flocking to the profitable sector, but the demand side could also see a significant contraction if a double dip recession begins to add pressure to our slowly recovering economy.  In short, the risk at this price is simply to high to justify owning this stock.  It is hard to imagine what additional good news could be offered at this point to push the stock significantly higher.

If a client walked in my door today with a concentrated position in AMSC, I would urge him to slowly work his way down to a smaller position or possibly exit it entirely.  We might start out by selling calls so that he could gain some premium and hold some protection against a possible decline.  Often momentum can carry a stock significantly beyond what appears fundamentally possible.

But if the stock broke and closed below $30 I would become much more aggressive.  At this point holding the stock is no longer an option, and I would even consider initiating a short position.  We could quickly see the stock trade down to a multiple of 15 times next year’s earnings and even that could be cut if analysts became skeptical on the future profits.  Bottom line – the danger in AMSC is not worth the risk.  There may be a more attractive spot to own this company but for today I would steer clear.

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Yesterday ZachStocks took a look at regulations concerning private equity purchases of troubled and failed banks.  Today, that information became all the more pertinent as a report was released showing continued stress for the financial sector.

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The FDIC released a report showing an additional 111 institutions were added to the black list during the second quarter.  This additional constituted a 36% increase in the number of banks being closely monitored.  So despite the optimistic market rally and the euphoric trading in financial equities, it appears that danger still lurks below the surface.

As is always the case, the FDIC did not release the names of individual institutions which were placed on this problem list as the disclosure would immediately cause depositors and business partners to bolt.  However, the sheer magnitude of the increase will likely cause some dislocations in the market as depositors will quickly begin wondering if their bank has made the cut.

Overall asset quality deteriorated in the quarter as evidenced by higher charge offs and increasing non performing loan levels. Losses and risk remain largely concentrated in residential real estate secured portfolios and early stage delinquencies in those categories showed improvement.  I will add that we are seeing increased strain in certain economically sensitive industries within our commercial portfolios. ~James Wells, CEO, SunTrust Banks Inc.

Traditional intra-bank lending to regional banks could quickly become constrained as widespread concern over solvency becomes a major lending factor.  Even healthy banks could feel the sting of this report as liquidity dries up and depositors seek larger more capitalized firms in which to keep their cash.  And as the Fed eventually moves its target rate higher, that  will cause even more strain for smaller regional institutions.

Looking at some of the recent banking failures, there has been an interesting shift from the high profile failures of late 2008.  At the time of Lehman’s demise when large firms such as Citigroup (C) and Bank of America (BAC) were facing extinction, much of the problem was due to the ramifications of esoteric vehicles such as the mortgage backed securities that were sliced and diced into unrecognizable forms.  Since that time it appears the market has gotten at least some clarity on these “toxic assets” but now the failures are following a more traditional route.

Many of the new failures (or potential failures on the trouble list) are seeing weakness due to traditional personal and commercial loans going bad.  While the headlines may not be a blaring as we saw in late 2008, the underlying reason is much more worrisome.  Essentially the slow economy, low employment, reduced consumer spending, and generally poor business environment has caused many business loans to simply be unserviceable.  So on bank balance sheets as they write off these loans as uncollectible, it means that their assets (receivables from borrowers) fall well below their liabilities (balances owed to depositors) which creates insolvency.  The pace of more traditional banks going under (there have been 81 so far this year) points to sustained economic weakness which could quickly choke off the current “green shoot” economy.

So as you in today’s rising tide, keep in mind that many fundamental signs continue to point to weakness.  This does not mean that you avoid participating in the market advance, but please pick your spots wisely, manage risk carefully, and have a plan ready for when the music stops and bulls begin to scramble.

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CME Group Inc. (CME) is not far from the level it was at on May 14th when ZachStocks recommended a purchase.  Since that time, the CFTC has stepped in with proposals to limit position sizes for commodity trading – certainly a negative for companies like CME who rely on active speculators who need CME’s execution and clearing services.  But while the potentially negative news drove the stock lower for a few weeks, it now appears that investors are regaining confidence and supporting the current stock price.

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CME has been very active in launching new products as I count nine different press releases which unveil the new products in this quarter alone.  One of the benefits of having a robust execution and clearing platform is that additional products are able to be rolled out without much in the way of fixed costs – the platform has already been built and funded.  Marginal costs for new products are very low and so the financial risk for the company is minimal even if the new products fail to attract trading volume from market participants.  It only takes one or two successful deals to make many attempts worthwhile.

The last 18 months have proven just how important it is for financial products to be cleared.  The clearance process simply involves a third party (CME in this instance) to act as a guarantor between buyer and seller – so that both parties of the transaction have faith that the terms of the contract will be met.  Lehman Brothers and AIG (AIG) showed the world what can happen when large financial institutions are unable to meet the terms of their agreements with counterparties.

Essentially CME’s clearance arrangement requires both the buyer and seller to put up margin capital which is a buffer to cover any losses for either party as a contract moves within its trading range.  Positions are “marked to market” periodically and the margin is shifted between buyer and seller to represent the unrealized gain or loss on the transaction.  If the margin account drops to a pre-determined low point for the losing party, he will be asked to put up more capital to cover the trade.  If this is not done in a timely manner, CME will close out the position automatically thus covering their own risk in the event that the losing party would not be able to cover the losses.

In this business, the important thing for CME is to accurately measure the risk in each trade which is a function of the volatility of the contracts as well as the correlation between many contracts traded by single customers.  The process is much more complicated than the outline above, but for those who are new to this sector, I thought the explanation would be helpful.  Essentially, as CME is able to properly manage their risk, the profits in this business can be very lucrative.  And as more large trading contracts are required by regulatory bodies to be cleared, there is more business for CME to capture.

Currently the stock is trading at about 21 times expected earnings for this year.  However, this year should represent a trough in earnings with a 15% increase next year.  Analysts are likely offering conservative guidance for the next few quarters as volatility in markets has increased risk assumptions but it appears analysts are skeptical that CME will be able to develop more business through its new contract offerings.  Management, however, appears to have a positive outlook on business trends.

Going forward, we anticipate that gradual economic improvement will provide further opportunities to serve existing and new customers around the world with our product mix, which covers all major asset classes, as well as with our superb clearing services and technological resources.  ~Terry Duffy, CEO

Currently, CME pays a healthy dividend of $1.15 per quarter.  This translates to a dividend yield of 1.67% which is not necessarily a good reason to buy the stock, but it does show financial strength as the company would likely be retaining cash if it were not confident in its long-term profitability.  The balance sheet currently has long-term debt at $2.7 billion which sounds large, but is adequately covered by the company’s assets.  Aggressive cost cutting has allowed the firm to remain lean and profitable and will likely lead to even greater earnings growth once the effect of improving markets and new products kicks in.

I would consider buying CME up to a price of $300.  Technical traders may wish to wait for the stock to break out of its current holding pattern which would mean buying just above $290.  Options traders may want to consider selling the December 300 calls against the position which are currently offered for roughly $15 per share.  Keep in mind that if this contract is close to being in the money when the dividend is paid, you will likely be exercised early so that the call buyer can collect the dividend.  This simply speeds up the trade and allows you to re-invest the proceeds from the exercise in your next opportunity.

FD: Author does not have a position in CME

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The FDIC voted Wednesday to approve guidelines for private equity firms interested in buying failed banks.  You may remember in early July the governing body came up with a proposal to place tighter restrictions on these transactions effectively shutting out some much needed capital for these troubled institutions.

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After the initial announcement, The Blackstone Group LP (BX) traded off sharply as investors worried that the company would be kept from participating in some of these lucrative deals.  Since that time the stock has rebounded as it became clear that private equity firms clearly had the upper hand in this negotiation.  The FDIC needs PE firms to help with the orderly transition for failed banks much more than PE firms need the opportunities (there are plenty of other attractive takeover candidates in many other sectors).

The final ruling showed that the FDIC was willing to give up some ground as private equity investors are now only required to maintain 10% Tier 1 capital instead of the proposed 15%.  This means that as PE firms take on the balance sheet  of a bank and theoretically bring it back to life, the amount of capital required to stick with the bank is a bit less restricting than previously proposed.  This will result in much larger profits for such transactions and while it likely means banks will eventually be sold to the public with more debt on their books, the liquidity need for today will likely lead to more help from the PE community.

New regulation is aimed at Private Equity firms who are seen by many as preying on troubled companies and turning a quick profit by selling these banks into public markets – often before they are truly viable on their own.  The argument seems to miss the vital role Private Equity firms play in taking on risk through these transactions and providing capital that is often cheaper than alternatives – or even not available elsewhere.  The important thing for the overall economy is making sure that the system is truly set up to incentivize buyers of these troubled banks to build new stable institutions that can withstand the difficult environment that is our current economy.

The FDIC recognizes the need for additional capital in the banking system…  We want to maximize investor interest in failed institutions… We do want people who are serious about running banks. ~Sheila Bair, FDIC Chairman

Today’s decision was a step in the right direction as it allows free market transactions to take place, but still requires a reasonable amount of care when dealing with some of the most important institutions in our economic system.  We certainly need to ensure that these failed banks are not resurrected, spun off on their own, and wind up failing again simply because private equity firms were too quick to turn their profit.  At the same time, the FDIC (which is eventually funded by all of us who hold deposit accounts through insurance premiums paid by banks) needs to have access to the deep pools of capital offered by private equity investors.

It’s important for industry and governing bodies to figure out ways to align their interests and offer our economy a more stable foundation from which to grow.

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Investors in Syniverse Holdings Inc. (SVR) woke up to a pleasant surprise Tuesday as the company announced a strategic acquisition.  The agreement with Verisign Inc. (VRSN) has Syniverse purchasing the messaging business for a tidy sum of $175 million.  The news sent SVR up 22% as the acquisition is seen as an opportunistic move which should immediately add to the company’s profitability.

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In a normally functioning market, you would expect to see the stock of a company making an acquisition trade a bit lower as skeptical investors fret about overpaying for the new assets.  But the current economic environment has created opportunity for companies with access to liquidity, as they are often able to make purchases for significantly reduced prices – often from troubled sellers.  Verisign is about 2.5 times the size of Syniverse as measured by market cap, but Syniverse likely had the advantage in this transaction because of the excessive debt levels carried by Verisign.  Syniverse was able to take advantage of its financial strength, and purchase an attractive asset at what will likely be proved to be a discount as Verisign was a “motivated seller” trying to raise much needed cash.

The business outlook for Syniverse is actually quite good despite a difficult economy.  Companies may be laying off a significant portion of the work force, but as they do so they are asking employees who stay to cover a larger workload.  This need for productivity is leading to increasing demand for mobile data and Syniverse is riding the trend which is favoring smart phones and notebooks with an increasing appetite for services provided by this quality technology company.

Mobile messaging transactions, the fastest growing segment in wireless communications, continue to increase in volume and positively impact the bottom lines of organizations in the mobile telecom space.  ~Tony Holcombe, CEO

Back in March, ZachStocks discussed how Syniverse’s focus on interoperability and number portability could drive profit and lead to a higher stock price over the coming quarters.  Since that article, the volatility has been relatively high with 20% and 30% swings not an uncommon trait.  However, the long-term trend appears to be solidly in place with investors looking forward to increasing revenue and earnings as a result of the acquisition.

Syniverse has an attractive list of strong customers including AT&T (T), Telefonica (a dominant player in Spain, Europe and Latin America), as well as China Telecom.  The acquisition strengthens Syniverse both in terms of adding new key customers, and broadening its product lines.  With a new list of clients to sell its existing services to, along with new services to sell to its existing clients, it’s no wonder analysts are increasing their guidance and tacking on buy ratings to this dynamic stock.

One of the most difficult decisions to make when trading dynamic names like Syniverse, is to buy after a sharp move has already taken place.  There is the very real fear of the stock giving back its gains, and its simply uncomfortable to pay $18.80 for a stock that could have been purchased for $15.30 just one day ago.  However, I believe this particular move is one worth chasing because the rally could turn out to be a long-term trend driving the stock much higher over the course of several months.

One appropriate strategy for buying stocks with a significant run like this is “dollar cost averaging.”  Essentially you might want to commit $10,000 to this stock, but you are worried bout buying too high today when the market could pull back before establishing a larger trend.  You don’t necessarily want to wait for the pullback because it could be that the stock does not pause, but you also don’t want to throw all of your capital at the stock today if you can buy at a cheaper price next week.

In this case it may make sense to commit to buying $2,500 worth of the stock each week for the next four weeks.  Discount brokerages make it easy and cost efficient to break up this type of trade where in the past it would have been prohibitively expensive.  If the stock drops over the next two weeks you will be able to pick up more shares at a better price.  But if SVR continues to rocket higher you will at least have some shares bought this week before the rally began in earnest.

As always, keep your risk under control and don’t commit too much to any one trade – especially in these turbulent and unpredictable times.  Syniverse likely has a bright future ahead of it, and it is encouraging to see management taking advantage of their strong fiscal position.

FD: Author does not have a position in SVR

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At some point the numbers simply become too big to comprehend.  I’m not sure that the human brain was meant to be able to contemplate deficit levels rising to the trillions and I’m confident that our founding fathers would barely recognize the enormous consuming government we have built over the last 233 years.

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As the US government attempts to spend its way out of a recession, the newest projections point to astronomical increases in deficit spending.  According to the Congressional Budget Office, we are looking at a 10 year deficit of $7.14 trillion dollars.  This figure is a full $2.7 trillion above the level projected when the prior report was released in March.  One can only imagine what this deficit will look like when we tally up expectations in another three months.

Not to be outdone, the White House has its own projections which include future changes in policy which will be put into place over the coming years.  (The CBO projection is based entirely on current policies as if they would remain static for years to come). The White House expectations push the 10 year deficit to $9.05 trillion and at the same time, the administration expects the US economy to shrink by 2.8% this year.  That’s a far cry from the 1.2% prior estimates.

The Achilles Heel of a Market

Nouriel Roubinin published an interesting article in the Financial Times over the weekend discussing the risk of a double dip recession.  We will be unpacking this article in a bit more detail in the ZachStocks Newsletter this week, but suffice it to say that the potential for a much longer period of contraction is quite sobering.

The budget report is an interesting set of data considering the official GDP revision is due out this week.  Remember the markets were extatic when the original second quarter release showed the economy contracted by “only” 1%.  Now analysts are expecting that number to be revised to negative 1.5% and there is still a third adjustment which will be released in a few weeks.  The strategy appears to be to show the best numbers immediately in order to juice the markets, and then let the details leak out in the less-followed revisions.

A higher market could become a self-fulfilling prophecy for at least some time as we are seeing consumer confidence begin to pick up.  This morning we saw a reading of 54.1% from 47.4% in July which actually indicates consumers are expecting a more positive environment (as opposed to a less negative environment).  As consumers begin to feel more confident, traditionally you would see retail spending begin to pick up and economic recovery could create its own momentum and lead to further strength in the market.

However, I belive the current environment lacks much of the dry powder that would have been available to consumers coming out of prior recessions.  The destruction of wealth in the form of lower real estate prices is one significant damper.  At this point, personal debt is also at an unsustainable level and banks are extremely fearful of lending capital to consumers.  So even if consumers are more confident, there will likely be less of an uptick in spending (if there is any at all) simply because consumers don’t have access to any capital to spend.

It’s a lonely road to be bearish on the current market as more and more colleagues are jumping into invstments.  However, save a few individual situations, I don’t see much in the way of attractive investment opportunities.  While clients have made some significant gains owning stocks during the spring rally, we have spent the last several weeks pulling cash out of the market in order to protect against risk.

As a country, we can’t spend forever without absorbing the cost of this recklessness.  At some point we will either have to raise taxes significantly (and I guess that’s already in progress) in order to pay for these programs, or we will need to print money to offset our liabilities.  Both are dangerous.  Raising taxes and interest rates will likely derail any economic recovery and our administration knows this (whether admitted or not).  The only other option is to monetize the debt (print currency) which can be excessively inflationary.  It may take some time, but I strongly believe this is the direction we are taking.

So buckle up – cut back on risk – and take some defensive measures.  Uncle Sam has pulled out the checkbook and is not likely to put it back anytime soon.

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Lululemon Athletica used to be one of my favorite growth stocks.  Unfortunately, the stock only enjoyed a few months of success after it’s IPO, but the initial returns were tremendous.  On July 30, 2007, the stock was issued for $18 per share in the initial transaction.  Shares were hard to get your hands on because the deal was over-subscribed, but my fund managed to call in a few favors and participate in the deal.  On the first day of trading, the stock closed at $28 for an initial gain of 55%, and then motored higher over the next 12 weeks to reach an eventual high of 60.70 (good for more than 230% in returns).  Since that time, however, shareholders have had a bumpy ride.

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Similar to most economically sensitive stocks, LULU traced a low point during the panicked March trading sessions before mounting an impressive rally off the lows.  Today the stock sits near $20 and just a few ticks off its recovery high set in early August.  Despite flat sales and falling profits over the last two quarters, investors are willing to pay roughly 40 times expected earnings for this year.  In short, the stock looks a bit extended and vulnerable to a sharp correction.

Lululemon operates with a fiscal year ending January 31, so we are currently in the 2010 year.  With the extra month of lag time, we have not yet received second quarter numbers for the company, but they are scheduled to be released on September 10th before the open.  It appears that investors are expecting a surprise to the upside and improving guidance from management based on the optimistic stock price.

Looking back at the most recent quarterly results, it is interesting to note that although revenue increased by a modest 6%, the comparable store measure actually saw sales decrease by 8% on a store-by-store basis.  Additionally, the gross margins were 42.8% compared to 53.4% in the same quarter 2008.  The bottom line is that with relatively flat sales, declining margins, and the costs associated with opening the new stores (which is the only way the company can post positive sales figures), earnings are taking a sharp hit.  And yet while pricing is clearly taking a hit (as seen with the margin contraction), management appears to be overlooking this alarming trend.

We are pleased with the current pace of our business and our ability to continue to bring our customers through our doors to make full price purchases.  ~Christine Day, CEO

As I dug a bit deeper into the fundamentals, I noticed that inventory has decreased from $52.1 million last year to a current level of $44.6 million at the end of the first quarter.  This means that despite a broader store base, the inventory for the entire company is down significantly.  That leads me to believe that management continues to expect a difficult sales environment based on the fact that they don’t have the merchandise available even if sales were to pick up sharply.

About  the only positive data point that  really stuck out was the fact that th company has increased their cash balance to $59.3 million.  When considering the fact that LULU has no debt, this leads to a stable financing environment where further difficulty in the economy won’t likely put the company out of business.

My concern with LULU is not that I believe they will fail.  The retailer operates in an attractive niche and is well respected by customers, suppliers, competitors and investors.  Ten years from now I expect LULU to continue to be a healthy retailer operating as a stand-alone company or possibly as a division of a larger firm after being bought out.  But unfortunately, I believe that ten years from now, we might not see very much in the way of stock appreciation from today’s levels.  The company would have to grow tremendously quickly in order to justify the current PE of 40.

Looking toward the earnings call next month, I believe we are in a typical “buy the rumor, sell the news” type scenario.  Traders often bid up a stock expecting good news and are anxious to sell the shares at a gain once the announcement is made.  Unfortunately, this game can be played by too many participants to the point where the quick exit of many players after the announcement actually leads to a declining stock even if the news is “better than expected.”  High multiple, high momentum stocks are particularly susceptible to this kind of trap.

It may not make a whole lot of sense to short LULU today.  It’s more than possible that the stock will overtake its high before the earnings announcement.  But I do think that wise and nimble traders can begin building positions in front of the earnings announcement.  Risk should be carefully managed as the current market  trend is higher, but the potential gain from a sharp reversal could be large and lead to strong profits in a turbulent market.  A conservative target would be $15 where one could take some profits off the table, but over time, it wouldn’t surprise me to see LULU trading in the low teens and even touch $10 as investors grapple with a over-loved stock with no earnings growth.

FD: Author does not have a position in LULU

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On July 31, investors saw Synaptics stock price (SYNA) lose roughly a third of its value after the company reported earnings for its fourth quarter ending June 30.  The company actually posted strong earnings of 47 cents per share which was 57% higher than the fourth quarter of fiscal 2008.  However, as management issued guidance for the upcoming first quarter, analysts were very disappointed with the outlook.

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Management told investors to expect revenue to fall in the range of $113 to 119 million which is relatively even with the first quarter last year, and significantly below analyst expectations of $127 million.  For the full year, the picture actually looks better with management guiding for revenue of $495 to $525 million compared with 2009 revenue of $473.3 million.  However, it appears that investors have a very short time horizon and are only willing to consider the most current quarter in their pricing of the stock.

A significant change in management certainly didn’t help investor confidence as Francis F. Lee announced that he would step down as CEO and named Thomas J. Tiernan (currently the Chief Operating Officer) as his successor.  Mr. Lee will remain as the firm’s Chairman but expects to turn the day-to-day management and strategic decisions over to Mr. Tiernan.  While management changes can often signal a new direction and better profitability for growth companies, it also can send a negative signal to long-time investors who have grown to trust the existing management team.  It was difficult to absorb both the disappointing quarterly guidance along with the uncertainty of this change in leadership.

Synaptics is stronger and better positioned than at any time in its history and as I am interested in dedicating more of my time to my family, my foundation and other charitable and civic endeavors, I feel this is the right time for me to step down as CEO. Tom and I have worked closely together to spearhead the company’s growth over the past three years, and the Board and I have confidence in Tom’s ability to lead the company through its next stages of growth. ~Francis F. Lee, Chairman and departing CEO

One of the concerns voiced after the earnings announcement is that Synaptics is beginning to see its revenue shift from high margin module products to chip solutions which have lower profitability.  While it certainly is important to keep an eye on profitability, the diversification into different solutions is actually part of the company’s plan to add stability to its revenues.  Management noted a growing pipeline of design opportunities in both PC and non-PC.  The diversification benefits may be slight as most of SYNA’s business will be related to general technology trends, but having a number of different clients in PC, handset, and other technology solution businesses can help to smooth out some of the spending cycle.

At the end of the quarter SYNA was sitting on $192 million in cash and had a backlog of $62.8 million in orders.  This backlog is going to be an important metric to watch as it will have to pick up if the company is going to regain confidence from its investors.  Another interesting item will be what happens with the company’s Auction Rate Securities (ARS) which represent about $28.8 million of “non-current assets”  These are the securities that many companies held with the assumption that the securities were essentially cash alternatives.  The sudden lack of liquidity late last year turned the table on these investments as auctions failed and companies were stuck with no way to liquidate these positions.  It is believed that the principal balance is still secure but it will take some time before SYNA will actually be able to get its hands on this capital.

Currently the stock is trading just above $25 with analysts expecting earnings of $2.00 this year and $2.32 in fiscal 2011.  While the growth rate has declined from the strong growth of the past two years, these expectations are likely overly conservative after the disappointing guidance.  I believe that there is an opportunity to pick up this Wall Street darling at a significant discount and hold it for 9 to 12 months while waiting for investors to regain their optimism.  Even without any revisions to 2011 estimates, the stock could easily rise to $35 with a modest PE of 15.

More conservative investors could consider buying at current prices and selling the December $27.50 calls for about $2.30.  If the calls are not exercised, the premium would give you an 8.9% buffer, helping to offset potential losses in the stock.  However, if the stock trades higher over the next four months to where the calls are exercised, the resulting return for the period would be a 16% return in just four months.  The overall economy may be in a difficult period, and earnings growth is not guaranteed, but Synaptics offers an interesting inexpensive opportunity to participate in any economic recovery.

FD: Author does not have a position in SYNA

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It’s quite fitting that markets are trading sharply higher this morning as Fed Chairman Ben Bernanke speaks to economists and policy makers in Jackson Hole Wyoming.  The text of the Bernanke’s speech has been released and concentrates on explaining just how dire our financial infrastructure has been, and how forcefully policy makers acted to avert a total collapse.

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The Chairman believes that “resulting global downturn could have been extraordinarily deep and protracted.” had the Fed and Treasury not stepped in with aggressive actions.  Ironically, the statement pays very little homage to what got our global economy in this mess in the first place.  Quite honestly, there are plenty of strong arguments pointing to lax Fed policies which encouraged excessive borrowing and risk taking in the first place.

This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington ~Ben Bernanke, Chairman FOMC

While the history of Fed policy rests largely on the shoulders of Alan Greenspan, it is clear by the actions of the current administration that we prefer to use leverage and debt to finance short-term strength instead of allowing the market to wring out excesses in order to set a foundation for solid and lasting economic recovery (albeit at a more constrained pace).  The current policies of holding rates extremely low, injecting capital into private industry, encouraging borrowing by both individuals and businesses in order to finance recovery and growth will likely lead to weakness in the future when these debts must be repaid.

Today’s statement also begs the question: Are we really out of the woods yet?  While the market forges ahead to a new recovery high, and investors celebrate new found paper wealth, some serious questions remain unresolved.  What about the millions who not only find themselves out of work, but also have seen the time elapse to the point where they can no longer collect unemployment benefits.  What about housing values which are still significantly below (admittedly inflated) levels from 18 months ago?  Or the fact that an icy residential real estate market makes it nearly impossible for families to relocate and find new jobs?  While the stock market is a barometer for future expectations for the market, it cannot be used as a thermometer to determine that today the economy is more stable.

I will concede that without the emergency actions by the Fed and Treasury, our economic system could have fallen much harder (although the crash that we endured was by no means pleasant).  But my concern is that as we begin to feel that there is some time separation between today and those dark days of the past year – we are all to willing to pat ourselves on the back and congratulate each other for still being alive.  What we should be doing at this time is to evaluate what could have been done in the decades (not months) leading up to this collapse – and how we can implement policies that will encourage more stable ans sustainable growth in the future.

So Mr. Bernanke, I congratulate you for acting forcefully and creatively to stem the fall and put us back on our economical feet.  But I would also implore you and the current administration to resist the temptation to inflate another bubble by encouraging borrowing and excesses.  Instead, please allow the American people and American businesses to conservatively and deliberately rebuild their balance sheets and live within their means.

No more cash for clunkers or expansions to entitlement programs.  Don’t take money from those who have built successful businesses and give it to those who have proven to be poor allocators of resources.  Instead, let the profitable grow so they can hire many in this vast pool of unemployed.  Give tax incentives to those who offer employment and encourage competition in businesses such as energy, health care, and manufacturing.  Leave interest rates at reasonable levels, but be careful not to encourage borrowing beyond ability to repay.  This is true for Mr. and Mrs. Smith in small town USA as well as for Goldman Sachs in the penthouse over Manhattan.

Let this country grow with the spirit of freedom and competition which made us great.  Yes we CAN rise to that entrepreneurial place of strength.  But only if we are allowed to try… and fail… and get up and try again.  Learning from our failures is the key to success.  And that’s true in Washington, in New York, in Michigan, in Silicon Valley, and across the globe.

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