Chesapeake Energy (CHK) knows the value of a dollar today.  On Wednesday the company announced it had ammended a joint venture agreement with Plains Exploration & Production Company (PXP) in order to receive an up front payment that had previously been scheduled to last over a three year period.  According to the deal, PXP will pay $1.1 billion to Chesapeake on September 29, which represents a 12% reduction in the total drilling obligations, but gives Chesapeake access to the capital right away.

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The announcement came just three days after Chesapeake announced earnings for the second quarter.  Adjusted EPS came in at $0.62 per share as natural gas production ticked up slightly over first quarter production.  More importantly, the company was able to increase their “proved reserves” and show progress in drilling programs during the first half of the year.  The company’s heding program also turned out to be beneficial with a realized gain of $597 million.  But despite the positive operational results, the balance sheet and cash liquidity certainly pose risk to current investors.

At the end of the second quarter, Chesapeake had a cash balance of $554 million which was down from $1.75 billion at the end of 2008.  Whiel the magnitude of the numbers is astounding, $500 million can quickly evaporate with aggressive drilling programs, current liabilities of $2.97 billion, and long-term debt of $13.6 billion – especially considering the volatility in natural gas prices over the past 18 months.  While the company has some very impressive properties it could liquidate in the event they faced a cash crisis, a forced sale never yields attractive valuation, so the proactive step of collecting cash from PXP looks very wise.

This agreement modification provides substantial upfront capital to Chesapeake, reduces PXP’s total investment in the Haynesville and further aligns the incentives between the partners. The Haynesville joint venture has been highly successful to date and we look forward to generating strong reserve and production growth as well as very attractive financial returns for both companies in the years ahead. ~Aubrey K. McClendon, CEO

Chesapeake has done an excellent job of growing its reserve base through organic exploration and development, as well as through strategic acquisitions and joint ventures.  At the end of June, Chesapeake was sitting on 12.5 TCFE (Trillion Cubic Feet Equivalent) and expects to grow this to 14.0 TCFE by the end of the year.  At the end of 2010, the company expects this metric to hit 16.0 which should provide investors with an attractive asset base from which to grow long-term earnings.

There are many different approaches a natural gas producer can take.  While Chesapeake holds a well diversified selection of properties, the company has been careful to invest in locations where production falls within the company’s skill set.  All of its properties are onshore US based properties which allows the company to avoid political turmoil, and miss most of the carnage that has hit off-shore producers in the path of recent hurricanes.  Cutting out these risks may keep the company from pursuing some good opportunities, but the security of its natural resources appears to be working to shareholders’ advantage.

ZachStocks has avoided traditional energy plays for some time as the prices for oil and natural gas offered investors very little return considering the risk being taken.  At this point it now looks like the tables are turning, and some traditional energy names could be in play along with alternative energy names we have been trading.  Commodity prices are likely to catch a bid in coming months – especially if the “recovering economy” story continues to hold.  Limits on position sizes for commodities will not likely have a long-term effect on holding prices lower as supply and demand forces are much stronger.  So adding exposure to traditional energy producers appears to make sense in the coming months and Chesapeake is certainly a leader in the space.

FD: Author does not have a position in CHK

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Traders often follow the “buy the rumor, sell the news” matra during earnings season.  The logic is that you want to own the stock ahead of a market-moving event in the hopes that the news will cause the stock to rally.  But regardless of what the news is, you want to be out of the stock shortly after the release because there is now no catalyst for sending the stock higher.  This trading approach may be partly to blame for the recent weakness in Neutral Tandem, Inc. (TNDM).

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On August 6, the company released figures for the second quarter, showing a healthy 44% increase in revenue, and a very impressive 82% increase in earnings per share.  On top of the historical information, management also upped their guidance for 2009 with revenue expectaions of $162 to 168 million and expected billed minutes of 85-88 billion.  Previously the guidance had been for revenue of $158-165 million and minutes of 38 to 87 billion.  TNDM has now added 18 new markets to its coverage and is serving 118 markets as of the end of the second quarter (compared to 82 markets June 30, 2008).

Neutral Tandem is not a household name, but certainly affects the way many household telephone calls are handled.  The company provides switching between competitive carriers and essentially builds redundancy, security and operational efficiencies into the US telecommunication infrastructure.  According to the latest press release, TNDM has access to 443 million telephone numbers and while it doesn’t necessarily handle every call coming from those numbers, it is clear that the company is competitive in growing the number of call minutes it services.  The company is aggressively expanding its network and pursuing opportunities in new geographic and technological markets.

In addition to focusing on developing interconnections with both our existing and new customers, we are continuing our efforts to diversify our revenue streams by increasing the different types of traffic transited over our network. ~Rian Wren, President and CEO

On May 26, ZachStocks issued a positive note on the telecom company stating that a healthy balance sheet would allow the company to aggressively expand its territory without taking on debt.  Within just five trading days the stock had rallied 23%, but the recent weakness has offered us another chance to buy at a discounted price.  The balance sheet is actually in even better condition with a cash balance of $142 million and no long-term debt.  Management has also issued guidance for just $18 to $20 million in capital expenditures for the year so even with aggressive growth, the company is still retaining cash.

At some point soon, one would expect investors to begin asking management to put that cash to work.  While I personally believe that today’s economic market requires more financial strength than may have been needed just five years ago, it woudl be nice to see management use some of this capital to either make an attractive acquisition, or to repurchase stock.  With a current multiple of roughly 23 times 2009 expectations, the stock isn’t cheap.  However, the long-term growth expectations along with the disciplined fiscal approach makes for a very attractive long-term investment.  In a healthy market, this name could fetch north of 35 or 40 times earnings and while I would not be willing to pay that much for the company, I certainly would love to own the stock and sell it at this inflated multiple.

An uncertain economic environment will certainly lead to volatility in stock prices, but trading these swings successfully can actually increase returns over time.  I would suggest beginning a core position in this health growth company, and then adding to the position on dips, and possibly trading some away when new highs are breached.  However, while trading around the position, be sure to leave a core number of shares in play to benefit from the long-term appreciation.

FD: Author has a long position in TNDM in the ZachStocks Growth Model

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Emergent Biosolutions (EBS) traded sharply higher after releasing earnings Friday morning.  The company reported a 68% increase in sales, leading to earnings of $0.48 per share.  Investors celebrated by driving the stock price up 16% on volume that was more than three times the normal level.  The stock appears to be breaking out of a very attractive pattern and should get the attention of technical traders as they pour through charts over the weekend.

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The fundamental strength for the quarter was largely related to an FDA approval which extends the shelf life of the company’s BioThrax vaccine which is used to treat anthrax.  As part of a contract with Health and Human Services, EBS was entitled to a large lump sum payment which helped to make the quarter.  The longer shelf life gives BioThrax even more of a competitive edge against other possible substitutes for the vaccine.

The Strategic National Stockpile (SNS) has extended its contract with Emergent and will now be continuing to buy vaccines from the company through late 2011.  At this point, EBS has a virtual monopoly on the market as the SNS will buy virtually every dose that Emergent is able to produce.  And investors are not particularly worried that the purchasing contract will be allowed to expire in two years as there is no significant risk of a competing vaccine on the market right now.

Recently, we completed our commitments under the current contract and look forward to seamlessly transitioning into initiating deliveries under a follow on contract that provides sales through late 2011. Beyond the follow on contract, we expect that the U.S. government will continue to procure BioThrax® for the strategic national stockpile. ~R. Don Elsey, CFO

But management is not sitting on its laurels, content to collect payments from the SNS.  Instead, they are aggressively pursuing additional revenue sources as they work to find vaccines for largely unmet medical needs.  In particular the  compoany is working on a cure for tuberculosis and investors will be watching carefully to see how much progress the company can make.

Management has reaffirmed guidance for 2009 and expects revenue of roughly $225 to $240 million.  With current revenues for the last six months of nearly $138 million, it is likely that management is “sandbagging” by keeping guidance at a relatively conservative level in order to ensure that they will be able to beat that guidance when the actual numbers are released.  Most investors seem to have figured this out as the the frantic buying of the stock indicates.

Looking at the financial stability, it appears EBS is in a very solid position.  At the end of the second quarter, the company was sitting on $102.5 million in cash.  That’s a significant increase from the $91 million at the end of 2008, but actually the picture is even better.  On top of the cash balance is accounts receivable of $55.4 million – the bulk of which is the payment due from the HHS for the FDA approval.  There’s no need to be skeptical as to whether that capital will be paid as managment noted the bulk of these payments were received early in the third quarter.  So at this point the cash balance is likely much higher.

The debt load is also relatively conservative.  According to the press release, the company only has $21.2 million in long-term debt, but investors should also look at the $19.3 million classified as “Current portion of long-term debt.”  This $19.3 will need to be repaid in the next 12 months (that’s the definition of current portion), but with an ample cash balance, the payment will not be an issue.

With a stock price currently just above $16, and earnings expected to cross $1.00 per share this year, it looks as if EBS is a good value.  Essentially investors are able to pick up a strong cash-flow positive company with a shot at a wildcard win.  Consider what would happen if the company actually landed a TV or tuburculosis cure.  The chance for sales to skyrocket is quite good.  Yet, buying the stock today doesn’t imply the same risk that is normally inherent with a drug discovery company.  If nothing new is developed, investors still have a strong company with a motivated customer in a healthy financial position.

FD: Author does not have a position in EBS

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The Blackstone Group LP (BX) is having a strong week.  At the close of trading on Thursday, the stock is up 24% in this week alone.  Although investors ended up selling the stock down a bit on Thursday after the earnings announcement, the lower trade did little to take away from the sharp gains on Monday and Wednesday.

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Last time we discussed the private equity firm, the stock had been trading lower based on news that the FDIC was setting tighter limits on companies who would buy distressed banks and turn the investment around for a profit.  The new regulations would have firms like Blackstone putting up more tier 1 capital and also being required to hold the acquisitions for at least three years instead of the current requirement of 18 months.  While investors were disappointed in the restrictions, we noted that the company would still have plenty of opportunities in which to deploy their capital and receive great returns.  The FDIC needed Blackstone much more than the company needed the FDIC’s blessing to acquire banks.

Wednesday, Blackstone shares traded sharply higher due to a very unusual opportunity.  It seems that AIG is likely to be broken up with many financial firms across Wall Street generating fees in the process.  A Wall Street Journal report estimated up to $1 billion in fees generated as firms help to set up initial public offerings of certain portions of AIG’s business while other firms are brought on to manage toxic assets that the insurer is still exposed to.

Regardless of the AIG transaction, Blackstone is in the catbird seat when it comes to this new era of investing.  Institutional capital such as endowments and pension funds are increasingly looking for “non-traditional” opportunities to invest – specifically in programs that are not heavily correlated to equity or traditional debt markets.  This is why Blackstone has a stable level of Assets Under Management (AUM) when many traditional competitors have seen their investor base dwindle.

And then there is the issue of what to do with these assets…  Since Blackstone is often able to lock up funds for a significant period of time, and then use that long-term capital to buy up entire companies, the company is often at an advantage versus a normal mutual fund manager.  Mutual funds usually do not have any significant lockup agreements so when investors get skittish, the managers must liquidate investments and return the capital – often at the worst possible time as prices are depressed.  However, Blackstone currently has an enourmous balance of available cash to put to work in some great opportunities.

We currently have the largest amount of available capital in our history across our investment platforms and we expect our investors will benefit greatly as we deploy that capital over the next several years. ~Stephen Schwarzman, Chairman and CEO

Looking at the last quarter, while GAAP earnings actually posted a loss (you wouldn’t believe how complicated the accounting is for private equity firms), the company actually created economic net income of $173 million.  Management and advisory fees were down slightly from last year’s levels as the Assets Uunder Management were just a bit lower.  Losses in portfolios such as real estate funds have been mostly offset by new capital coming in.  But the real positive news was an increase in performance fees which were $72.2 million.

During the first quarter, performance fees were actually negative $213.8 million.  Performance fees are essentially Blackstone’s take of customer profits.  Most of the real estate and private equity funds are set up so that as the funds increase in value, Blackstone is entitled to a certain portion of the profit.  This portion is recognized as incentive allocations or performance fees.  During the first quarter, losses were big enough that the company actually had to write off some of the fees that had previously been “earned” but not yet collected.  The resurgence of performance fees in the second quarter is good news because this is the largest income generator in normal economic times.  Watch for incentive fees to pick up sharply in future quarters as the company’s strategies should lead to several of the private equity funds turning out profits.

One of the biggest challenges remaining is the issue of debt financing.  In the past if Blackstone were to want to make a $5 billion purchase, it might put up 1 to 2 billion of its own capital and then finance the rest of the transaction.  This made many deals extremely profitable as a 20% increase in the $5 billion investment would actually nearly double the fund’s leveraged investment!  It appears banks are still unwilling to commit to financing such large commitments which may limit the number and profitability margins of new transactions.  But don’t feel too sorry for Blackstone as they still have plenty of their own dry powder to pursue deals.

During the panic stages of the last market collapse, Blackstone suspended its normal dividend in order to conserve cash.  But the suspension only lasted one quarter and as we have stated, the company is currently awash in cash and should have no difficulty paying the dividend for the foreseeable future.  Currently with the stock at $14 and the quarterly dividend of $0.30, investors are receiving an 8.5% yield on top of expected appreciation in the stock.  The deal almost seems too good to be true.  While there will certainly be some volatilty in the shares as market events transpire, Blackstone is managing an incredible amount of capital – employs the most talented deal makers across the globe – and has its pick of distressed situations to invest in.  The ZachStocks Growth Model is currently sitting on a 93% gain in the stock and I expect that to increase exponentially in the coming months.

FD: Author has a long position in the ZachStocks Growth Model

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Although investors have been celebrating the new green shoots of economic growth, the ISM data released Wednesday poured a bit of cold water on the celebration.  The report was essentially a survey of the service sector environment for July.  The index is based on a scale of 1 to 100 with 50 being “neutral” or showing no growth or contraction.  The latest data came in at 46.4 as compared with a 47.0 reading in June.  Analysts had been expecting a jump to 48.2 so the news was fairly disappointing.

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The lower reading was particularly surprising after the ISM manufacturing index actually moved to 48.9 from June’s reading of 44.8.  While both manufacturing and service sectors are showing declines, analysts had been encouraged by Monday’s manufacturing data as the decline was much closer to flat.

In other economic news, the employment index declined to 41.5 from a reading of 43.4 in June.  The number is certainly ominous with the official July non farm payroll on tap for Friday.  It appears there is significant potential for the payroll report to disappoint and with the market up significantly over the last three weeks, we may be overdue for a moderate correction.

Take a look at the US dollar index below:

You can see that the dollar is quickly losing ground against rivals as the US spends recklessly on stimulus plans and other entitlement programs.  In all likelihood, the government will have to print its way out of the excessive debt which is likely to set off an inflationary move that will cause paper dollar savings to rapidly lose purchasing power.  A good example of this trend beginning can be seen in the chart of silver below:

Silver is likely to offer better purchasing power than gold in the coming months because silver doubles as an industrial metal as well as a precious metal.  So while nearly every ounce of gold that has been mined over the past several millenia is still stored in vaults or worn as jewelry, silver is actually being consumed as the metal is used for soldering, in medical supplies, as specialty reflective material, and even as an input for making some synthetic fabrics.

So as we look towards a period that will likely not be as rosy as the market trend would have you believe, it is important to protect the purchasing power of your capital.  That may mean investing in agricultural products or companies, it may mean shorting consumer driven companies trading at high multiples, or it may include precious metals.

My caution is to avoid the two most common mistakes.  The first mistake would be to jump headlong into this bullish trend in equities simply because stocks are going higher.  Following the herd rarely turns out to be profitable and can put you in a place where you are facing significant risk.  The second mistake would be to sit numb with your cash in a safety deposit box (or CD, or other deposit instrument).  Inflation and a falling dollar could quickly erode the purchasing power of that capital leaving you with a stable dollar account, but a poor real (or inflation adjusted) return on your capital.

FD: Author has a long position in Silver futures contracts

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Home Inns & Hotels Management (HMIN) is scheduled to report earnings this evening after the market closes.  Typically you would see excessive volatility after an earnings announcement, but on Tuesday the stock rallied more than 12% with no company specific news.  The move was apparently in sync with an earnings report from Ctrip, the China equivalent of Expedia or Travelocity, which noted strong air travel and hotel bookings.

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HMIN is a leading China lodging economy hotel chain spread throughout the Chinese mainland.  Most of the hotels bearing the HMIN name are leased properties where the company develops and manages each location.  Currently there are 326 hotels in operation under this arrangement with another 54 in development (although I expect these numbers to be updated with the earnings announcement).  A second strategy is for the company to franchise its brand to existing hotel owners and collect royalty fees.  There are currently 145 locations operating under this arrangement and another 60 in development.

It seems that today every stock with the name “China” is being bought hand over fist.  Recent economic reports have shown China as outperforming in what has otherwise been a worldwide recessionary environment.  While China growth has been under pressure, the growing population and some political moves toward a more free economy have certainly stoked the growth.  But unfortunately “growth at any price” can be a dangerous approach when investing.

Looking at the fundamentals for HMIN, the company is expected to earn $0.39 per share this year which represents 11% growth over 2008.  Any growth at all is impressive given a difficult market environment.  In 2010, analysts are expecting a sharp 46% increase to an annual earnings level of $0.57.  Currently the stock is trading near $19 which represents a multiple of 48 times this year’s estimates, and 33 times next year’s numbers.  The price seems a bit dangerous to me – especially considering the long-term prospects for earnings growth.

One of the primary drivers of the optimistic expectations for 2010 is the Shanghai World’s Fair which is expected to draw as many as 70 million visitors.  The surge in travel will certainly bring significant revenue and earnings for 2010, but my concern is that investors are extrapolating the expected 46% increase as a sustainable growth trajectory.  In actuality, it will be very difficult for HMIN to see any growth in 2011 after the one time boost from the world fair.  If investors find themselves holding a stock valued at 33 times earnings next year – and the growth estimates for 2011 and beyond come in flat – we could quickly see shares drop.  In fact, as investors work through this logic in the second half of 2009, I expect a decline in the earnings multiple on the stock.

Shorting stocks during a market rally can be a difficult and dangerous strategy.  But as this advance becomes more overbought, short opportunities are looking more and more attractive.  HMIN is one of those opportunities as I think the stock could quickly trade down to the low teens, offering a significant percentage gain to traders willing to step in.  There are several ways to play this opportunity – some with more risk than others:

• Shorting the stock outright today – This approach is a bit risky as a positive report by management could propel the stock into the $20’s.  Recent history has shown that investors will still buy a good story even at extended prices.  So while shorting the stock today would get you in front of a potential decline, there is risk of getting stopped out quickly
• Buying puts outright today – Currently you can buy the August $20 puts at about $1.90 per share and these puts already have $1.00 of intrinsic value built in.  While your total exposure is capped at the $1.90 price of the puts, the disadvantage is that you have to make up the roughly 90 cents as the stock drops in order to recognize a profit.  That may be difficult in the next two weeks.
• Covered Short Position – If you’re familiar with covered calls, this strategy should be relatively familiar.  Essentially, you could short the stock and then possibly sell the September $20 puts for $2.15 or so.  This strategy caps your potential gain, but also gives you a bit of protection if the stock were to rally and hover a bit above $20.
• Set a “sell stop” entry order – While tyically we consider a “stop” order to be an exit strategy, we can also use stops as an entry point.  The idea is to set up a short that is automatically triggered if the stock drops below a certain point.  This way if the stock begins to give up its recent gains you are quickly involved in the situation and able to participate on the way down.

There are many ways to initiate short exposure on stocks, but the important thing is understanding what your potential returns look like, and what you have at risk.  If you’re new to trading and have questions on how to execute any of these strategies, please send me an email or leave a comment and we can discuss this and similar opportunities.  In summary – HMIN appears to be overpriced and could decline sharply as investors realize that long-term growth is still in question.  Traders can initiate short positions at current levels or after the earnings announcement.  Please use risk control and expect to cover shorts in the low teens.

FD: Author does not have a position in HMIN

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Welcome Back!  I have to admit that seeing the S&P 500 index back in “quadruple digit status” makes me just a bit nostalgic.  So do you remember where you were the last time the S&P closed above 1,000?  For me, the memories are a bit hazy as our twins were born October 21, and since the last time we saw this level occurred on November 4th, I was a good fortnight into sleep deprivation.

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Actually the bigger question might be if you remember where you were the first day this side of 2004 when you saw the S&P close below the 1,000 mark.  The date was October seventh and being a bit of a pack rat, I still have the Wall Street Journal for Oct 8th in which the headline reads:

US, Britain Up Ante in Fight to Stop Crisis

Obviously, that fight had a long way to go as the S&P eventually dropped another 33% before hitting rock bottom just off the illustrious 666 level.  The trip down memory lane is more than just “for old times sake” – it’s important to realize just how far we have come and what issues caused (and prolonged) this financial crisis.  Here are a few additional noteworthy headlines:

Sept 13: Crisis on Wall Street as Lehman Totters, Merrill Seeks Buyer, AIG Hunts for Cash

The article explains that after bailing out Fannie Mae and Freddie Mac just one week prior, the government refused to provide a financial backstop to potential buyers of Lehman

Sept 17: U.S. Plans Rescue of AIG to Halt Crisis; Central Banks Inject Cash as Credit Dries Up

“The Federal Reserve appeared to be motivated in part by worries that Wall Street’s financial crisis could begin to spill over into seemingly safe investments held by small investors such as money-market funds that invest in AIG debt.”  I honestly don’t think that the Fed had any idea of the magnitude of what they were dealing with yet.

Sept 20: U.S. Bailout Plan Calms Markets, But Struggle Looms Over Details

The accompanying picture includes SEC Chairman Cox, Treasury Secretary Paulson and Fed Chairman Bernanke walking solemnly behind President Bush.  The “in process” treasury plan was revealed and was expected to use hundreds of billions to buy illiquid assets from U.S. Financial institutions.  Markets were “soaring” on this news but it would turn out to be just another head fake.

Sept 26: WaMu Fails, Is Sold Off to J.P. Morgan

The “biggest banking collapse in US history” brought the markets to new lows, but we were still well above the 1,000 mark.  In fact, the markets held a relatively stable line as the orderly transition to JPM was viewed as a confidence booster in the financial markets.  That confidence would all too soon be shattered.  On Monday the 29th, the whole world watched with breath held as a bailout plan was voted on by Congress.  When the “nays” took control, the market was rocked and the Dow Jones Industrial Average dropped 777.68 points – the largest drop on record.  Tuesday’s headline is below:

Bailout Plan Rejected, Markets Plunge, Forcing New Scramble to Solve Crisis

The days were dark and getting darker still.  I remember walking to a CFA meeting in Buckhead (the financial district of Atlanta) and noting just how somber everyone was as I walked through the hotel lobby and into the restaurant.  It’s amazing to think that at this point we still were nowhere near the ultimate low in the market.

Oct 10: Market’s 7-Day Rout Leaves U.S. Reeling

The sub-title reads: “Stocks in a Slow-Motion Crash as Dow Drops Another 679 Points; After Year of Declines, Investors Lose $8.4 Trillion of Wealth.”  Another headline on the same day: “As Banking ‘Fairy Tale’ Ends, Iceland Looks Back to the Sea.”  It’s no ordinary recession which sends an entire country into bankruptcy.

There are plenty of additional headlines – all with the same memories – all with the same pictures of traders, executives, world leaders and individual investors with head in hands – wishing for a recovery to begin.

Now that the dust has settled, the market appears to be functioning in a much more normal fashion.  But below the surface there are still major concerns. Unemployment continues to rise, while demand for goods drops – this leads to the familiar death spiral where falling demand causes reduced output thereby making wage and payroll cuts necessary.

But investors appear ready to embrace the positive and look past the economic shortcomings.  The question is whether this 40% plus rally is really the beginning of a new bull run, or simply the retracement of a portion of the losses from the last 18 months.  Bear markets are notorious for their sharp and extensive rallies which last just long enough to pull the most skeptical trader in – before crashing back to earth.

While many of our investments have turned in triple digit gains off the lows (and the ZachStocks Growth Model more than matched the market rebound from March through mid-June), it now seems prudent to at least use caution.  There are still many questions to be answered in regards to how we will engineer a true economic recovery, and the current administrations aversion to free markets will eventually have its price.

Today – just as in decades past – it doesn’t pay to fight the tape.  But at the same time, you can’t be lulled to sleep by a rising tide.  Eventually the fundamentals will dictate price, and the observant flexible traders will reap the greatest profits.  So here’s to 1,000 on the S&P and to your success in navigating the uncertain waters ahead!

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Verso Paper Corp. (VRS) has been to hell and back.  It’s really not an exaggeration.  From the fateful day in May of 2008 where the IPO priced at $12.00 per share, to the ultimate low of 32 cents on March 6th, investors have seen nothing but red ink.  ZachStocks issued a short recommendation on the stock in June of 2008 when the stock was just a bit over $8, and recommended covering the short on March 25 with the stock at $0.71 and for aggressive traders we suggested putting some capital to work on the long side.  Now that the stock is above $2.00, the recommendation appears quite timely (although we had to wait a month or so for the stock to turn higher).

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Today, Verso’s movement points to renewed institutional interest in the stock as the dynamics are quickly improving.  There are two primary forces behind the recovery – one of which is very large in magnitude, but most likely a temporary fix.  The second has much longer-term potential and could eventually carry this stock back to it’s IPO level or higher.

Stimulus Measures Benefit Paper Producers

Part of the Obama administration’s stimulus programs have been geared towards encouraging the use of alternative fuels for energy.  Cutting our dependence on fossil fuels and relying more on renewable sources could decrease our dependence on foreign oil, and also lead to lower carbon emissions.

The paper industry has actually been able to collect millions in tax credits due to these stimulus programs as many factories burn what is known as “black liquor” and is a byproduct of the pulping process.  Currently, Verso is receiving upwards of $50 million per quarter in tax credits which flow directly to the company’s cash balance.  Considering the fact that there are only 52 million shares outstanding, this tax credit is a huge boost to a stock that until recently was valued at less than $2.00.

Unfortunately, these tax credits seem to be overlooked by most investors because although they funnel directly into GAAP earnings per share, the temporary nature of the stimulus program causes the cash flow to be excluded from “normalized” earnings figures.  This is one of the rare instances where GAAP earnings are actually much more attractive than the more visible earnings from ongoing operations.  The tax credit is only expected to extend until December so while there is still more incentive to come, the company will have to eventually work back into a profitable business model if it is to see the share price increase…  And that’s exactly what VRS is expected to do.

Industry Inventory Levels Hit Rock Bottom

It’s no secret that we are in an extremely difficult economic period.  During times like this, companies are looking for every opportunity possible to cut back on costs.  Spending on advertising and marketing have taken a huge hit not only because of budget restraints, but also due to some of the biggest producers of ad papers (ever hear of GM?) going out of business.

As advertisers have quit spending, the printing business has suffered.  In order to survive the downturn (and as a result of the rate of business slowing) printers have cut back on their inventory of paper.  But the inventory cut has been a slow process.  Basically, most printers stopped buying paper alltogether and instead worked through the stocks in warehouses until there was little to nothing left.  You can see from the chart to the right that there is very little room left to cut as far as inventories are concerned.

With no paper orders from printers, the paper producers like Verso have had their hands tied.  The list of mill closings continues to rise as lower demand has required many in the market to either close up shop or declare bankruptcy.  But the silver lining in this cloud is that once much of the capacity has been removed from the market, any upturn in business will go to fewer players – meaning more business for Verso.

Now if you’ve been reading ZachStocks for very long, you know that I am no bull and don’t expect the broad market to continue its climb much longer.  But at the same time, there are some exciting opportunities in names that have been adequately punished and are now facing much better prospects.  Verso just recently issued a five page “key issues” report which listed an expanding number of print projects which could cause orders to pick up and bring normal business back into play.  That list includes:

• A new Food Network magazine which has already been tested and is now primed to hit the broad market this fall
• National Geographic has a special “your shot” issue with more than 100 reader generated photos – the issue should be a strong month considering user content sells more magazines
• Wheaties and Mens Health are partnering up with a joint advertising program which should include a direct mailing.

There are probably another dozen data points but you get the picture.  The print business is seizing the momentary increase in consumer and investor confidence and will have to order paper stocks because they are virtually out of inventory.  The orders will come to the few remaining pulp participants and Verso is set to handle the resurging business.

As we look forward to the remainder of 2009, we anticipate inventory levels, for both producers and customers, to continue to decline. Additionally, there are some positive signs on the horizon, as we see the United Postal Service offering some attractive program postal rates to improve their volume and, secondly, as we move into the traditionally stronger second half of the year the supply/demand situation should be more balanced. ~Mike Jackson, President and CEO

The Debt Issue – An Improving Situation

Verso (and the paper industry in general) has a reputation for being over leveraged.  Excessive use of debt can bring even stable companies to their knees with just a small hiccup in operating trends.  But the huge capital requirement for building paper mills has led to many industry players building a business on borrowed capital.

One of the biggest investor fears in the spring and early summer, was that Verso would have to find alternative financing after falling behind debt covenants.  With liquidity basically non-existent, this would almost surely lead to bankruptcy as the company would not have any financing choices.  However, the company has managed to renegotiate with creditors and now does not have any significant debt repayments due until 2014, and has gotten the debt covenants restructured to allow them to stay in compliance.

The stimulus dollars from the black liquor fuel are now being put to work to pay down debt which is both reducing interest expense as well as increasing the financial stability of the company.

“All Systems Go”

With many of their competitors out of the picture, a customer base that has worked through its inventory, and a more stable financial foundation, Verso is looking like an excellent turnaround candidate.  Of course the stock has rebounded to several times the low seen in March.  But the percentage move was only because the low was so close to zero, making the mathematical headline more pronounced.

Trading back up to the IPO price of $12 will not likely happen this decade.  But improving metrics could certainly take us halfway to that point – and that’s nearly a 200% return from the current stock price.  On Monday, UBS upgraded competitor Sappi Limited (SPP) after a strong earnings report last week.

Verso will report earnings on Thursday and the release could turn out to be another catalyst to move the stock higher.  In particular analysts will be listening for any signs of recovery or new orders from printing companies as well as insights into regulatory changes for the tax credits.  Stocks are often unpredictable and volatile the week of the earnigns release so it may make sense to build a long-term position over time, but in case the stock gaps significantly higher on the earnings announcement, it makes sense to start buying at least part of your position before the announcement.

FD: Author does not have a position in stocks mentioned

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Friday’s GDP release was a sight for sore eyes.  After experiencing sharp declines in the US economy for three consecutive quarters, the data for Q2 showed a decline of only 1% compared to the 1.5% that analysts were expecting.  The news was enough to cause a number of economists to increase their forecasts regarding the “economic recovery” and was helpful in pushing stocks higher throughout most of the trading day.

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A 1% drop is significantly better than the 6.4% drop we had in the first quarter right?  Actually, the answer is NO! A drop is still a drop.  Consider the fact that we had the worst decline in 27 years for the first quarter, and that in the second quarter we were still declining.  It’s tough to find a silver lining with this dark cloud, but that doesn’t keep analysts from spinning it in order to attempt to prop up the equity markets.  As Mark Twain so eloquently said, “There are three kinds of lies: lies, damned lies and statistics.”  The point is that you can make statistics indicate whatever you want to if you spin the data correctly.

Looking at the components which make up GDP, it is clear that we are still in a very stressful time economically.  Consumer spending continued to fall and was down 1.2% more than analyst expectations.  The positive surprise in the headline number came almost entirely from government spending (which is not exactly subject to economic forces – especially with this administration).  While the government can – and most likely will – continue to spend and prop up the economic data, the cost of that spending will ultimately be paid either in the form of higher taxes, or a lower value for the dollar.  Neither of these outcomes will do much good for the real state of our economy.

Business and residential investment continued to be horrific.  While some may consider it positive that business investment only declined by 9% this quarter (compared to 39%) last quarter, I will reiterate that continued decline from the depressed state of Q1 is sobering.  Residential investment fell another 29% after the 38% drop in Q1.  And employment numbers continue to drop with many expecting the unemployment rate to hit 10% this year.  To quote Richard Yamarone from Argus Research:

how do you have a recovery when you’re furloughing half a million jobs a month?

So why are stocks continuing to show strength even while the economy contracts?  Equities are 40% above their lows from five months ago and many stocks have grown by 100%, 200% or even more.  Shouldn’t the weak economy translate into lower stock prices?

Well, unfortunately in the short run, stock prices often deviate significantly from what we might consider “normal” values.  Since the price of a stock is based on what a buyer is willing to pay, or what a seller demands in return, prices are often swayed significantly by the optimism or pessimism associated with the broad investing public.  Currently it appears that investors are buying the notion that the economy is getting better.  Many who have been sitting cautiously with money on the sidelines are now wondering if they have missed the turn in the market.  Fear of under-performing can be a overwhelming motivator for institutional investors as well who could see bonuses cut or even jobs lost as a result of trailing a benchmark.

These forces of greed and fear can often temporarily move markets significantly above or below an “appropriate” economic value.  But irrational moves also give us as traders an opportunity to profit from the swings as emotional trades rarely result in long-term gains.

Today’s market appears to be following one of two possible courses:

1. We are in the middle of a bear market rally (50% rallies are not uncommon within the context of larger bear moves) and the market is vulnerable to a sharp reversal lower.  This scenario would likely see us breaching the March lows sometime in the next year, but could also simply mean that we continue to be range bound below the highs from 2007 for some time.
2. We are experiencing a genuine recovery in which the market accurately recognizes the coming economic improvement, and trades higher ahead of the recovery.  This type of move also has historical precedent as most recessions recover only after the broad market has signaled that things are getting better.

So while the question of which scenario we are in is certainly pertinent, it’s also important to consider the ramifications of each scenario.  If this is indeed a recovery, we have already begun to experience a sharp move in the market and are now waiting for the fundamental data to confirm what the market has already figured out.  It seems that even positive economic news would not move the market significantly higher because we already made the recovery move.  Of course a new bull market could last for years, but if this is a true new bull market, then we will have ample time to pick out individual investments and buy them at attractive times along the way.

The significance of the second scenario is what worries me.  If the market is wrong and investors are chasing performance without economic strength, then the coming losses could be catastrophic.  Consumers who have been pummelled by declining house values, slashed retirement accounts, and employment concerns can not afford to take another hit in the stock market.  So if this rally begins to falter, I am concerned that panic could set in and the market could fall quickly even without a significant catalyst.  Heaven forbid we get another macro issue to deal with such as powerful losses from commercial real estate.

So while the eventual economic outcome is a bit uncertain, the risks seem stacked against investors who may consider committing new capital to the markets at this time.  One must not only consider the likelihood of each scenario, but also the ramifications of each outcome (one of which has much more magnitude than the other).  While a stronger economy is definitely in our best interest and can be hoped for, remember that risk control is what keeps investors in the game for the long haul.  A missed opportunity is ten times easier to make up than lost capital.

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Amedisys Inc. (AMED) released its numbers for the second quarter this morning and the results were certainly impressive.  The company realized EPS of $1.27 for the quarter which was up 67.1% over the same quarter last year.  I must point out that even though earnings are 67% higher than they were at this time last year, the actual stock price is roughly 33% lower than August of 2008 when the stock actually hit its climax.

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Management has three main initiatives which appear to be driving their success

• Superior Clinical Services
• Aggressive Growth
• Operational Efficiency

All three are important in this dynamic period as it relates to health care.  In order to receive favorable treatment from Medicare, the company must provide excellent service.  The focus on acute in-patient care allows Amedisys to differentiate themselves and provide a level of service which is needed and clearly beneficial to both their patients and to Medicare as an institution.

The talented management team has become notorius for making strategic acquisitions during the difficult financial period.  With a disciplined approach to managing debt and balance sheet risk, and a strong eye for accretive purchases, the geographic footprint has expanded while at the same time the financial integrity of the company has remained sound.

Finally, a commitment to cutting costs has led to strong profitability.  Management has been able to take many of its newly acquired offices and cut redundant expenses in order to create better efficiency.  The net result has been strong margins while at the same time providing quality care at a reasonable price.

Perhaps the most exciting part of Friday’s announcement is the increased guidance for 2009.  Management now expects earnings of $4.75 to $4.90 on revenue of $1.475 to $1.50 billion.  That’s well above current expectations and even at the low end it represents a 44% increase in earnings.  And yet the stock is currently trading at just under 10 times this year’s earnings.  So despite a 10% increase in the stock Friday, it appears there is ample room for investors to generate a healthy return with relatively little risk.

The major unknown for many stocks in the health care sector is the legislation currently in process in Washington which could significantly change the way Medicare reimbursements are handled.  But Amedisys actually has put itself in a position of strength by offering quality care at a reduced price compared to many of the more traditional alternatives to home health care.

We continue to believe that the effective use of home health will provide high quality, outcome driven care to the chronically ill Medicare population for the lowest cost. ~William F Borne, CEO

Low cost and high quality are certainly positives when it comes to determining how Medicare will reimburse for services.  Statistically, it appears Amedisys is above the nation when it comes to specific outcomes for patients.  The chart below lists an assortment of goals such as “improvement in pain” or “improvement of surgical wounds” and shows that for the majority of categories, Amedisys patients are seeing more improvement than national norms:

Placing a modest multiple of 12 on the low end of the company’s guidance would yield a stock price of $57 – significantly higher even after Friday’s rally.  I think a more realistic multiple of 15 on next year’s earnings (conservatively valued at $5.25) could be possible in the next few quarters – potentially pushing the stock up above $75.  This company has built an impressive platform and management is talented at growing while still keeping close relationships with health care regulators.  Look for Amedisys to be an industry leader for years to come.

FD: Author has  a long position in the ZachStocks Growth Model

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