Investors in Salesforce.com (CRM) are hitting the panic button today after the company announced an unexpected debt offering.  According to the press release which came out after the close on Monday, CRM will be issuing $500 million worth of convertible senior notes to qualified institutional buyers.  There is an option for purchasers to buy an additional $75 million if the demand is strong, so it is likely the deal will actually be valued at $575 million.

Shareholders are especially concerned because the notes will be convertible – meaning that over some period of time we can expect dilution to shareholders.  Now management stated in the press release that they have entered into an agreement with a counterparty to hedge against the risk of dilution.  Essentially this likely means that CRM will have an option to purchase shares which it will pull out of the market to offset the additional shares issued when the notes are converted to equity.

But the problem with this hedge is that the third party will likely hedge his own exposure.  So if the third party is obligated to deliver CRM shares to the company at some particular price, this counterparty will enter into transactions today to make sure that he is not left with significant risk if CRM stock continues to rise and he is forced to deliver the stock at a discount.  The bottom line is that the transaction certainly initiates downward pressure on the stock.

Right now the terms are not clear as to what the interest rate will be on the notes or what the conversion price will be.  CRM simply says that pricing and conversion metrics will be determined through a negotiation process with the buyers.  The use of proceeds is also sketchy as the company intends to use the cash to pay for the cost of the hedge, and for “general corporate purposes, including funding possible investments in, or acquisitions of, complementary businesses, joint ventures, services or technologies, working capital and capital expenditures.”  In other words, the company can use the cash for whatever they like.

It certainly wouldn’t surprise me to see CRM use the cash to pay for an acquisition in the near future as the cloud computing area is certainly ripe for consolidation.  CRM already had a very attractive balance sheet and ample cash-flow so it doesn’t seem necessary for the company to raise $500 million unless they have a very specific plan for the capital.  It would not be customary for the firm to announce an acquisition before the terms were agreed upon because that would cause the market to bid up the target company and likely result in a higher purchase price.

So I expect CRM has its eye on an acquisition and will be announcing the purchase in the next few months.  The problem is that most of the time when an acquirer announces a purchase agreement, the acquirer’s stock (CRM) will drop significantly as once again the shareholders worry about dilution and overpaying for the target.  So it seems very possible that CRM could see another gap lower in the near future.

CRM operates on a January year end, so their 2011 year is  just about to complete.  Analysts expect the company to earn 63 cents for 2011 giving them a current PE of about 111.  Looking at forward earnings (CRM is expected to grow EPS by 32% to 83 cents per share next year) the forward PE is a tiny bit more reasonable at 84.  Keep in mind that these ratios are calculated after the stock has already dropped more than 5% on the day.  So it’s hard to look at this stock as anything but expensive.

In today’s momentum based market, it has been difficult to make money on the short side as positive trends have persisted regardless of the fundamentals.  However, with a significant break like this, it is likely that the trend has been broken and further downside is likely.   I would recommend shorting the stock today with a tight stop at the most recent high (near $75)  If we are wrong, our losses should be close to 10%.  However, if this stock trades down to a still attractive forward PE of 35, the gains on our short position will be roughly 58%.  This could be a great trade to get the profits rolling in 2010.

FD: Author has a position in the Sound Counsel absolute performance model.

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As Congress prepares to get started on a new calendar year of legislation, it looks like the much anticipated health care bill will fail to live up to its promises.  That’s not necessarily bad news as the original plan for the bill could have been devastating to the American taxpayer due to its cost and the inefficiency of most government programs.  Despite the strong rhetoric and elected officials propensity to pat themselves on the back, the final outcome for this bill will likely lack the teeth its original authors intended.

Investors have been watching healthcare reform developments carefully as regulations could have a strong impact on companies from drug makers, to insurance companies, to hospitals and physician services.  Many of my clients in Sound Counsel Investment Advisers have been invested in Amedisys Inc. (AMED) which is up more than 30% from when it was originally purchased in our aggressive growth model.  As expected, there have been plenty of winners and losers as a result of the expected healthcare reform.

Many healthcare stocks have seen their price fluctuations improve as the healthcare bill has become bogged down and less potent.  This is likely because investors are expecting a free market system to prevail (or at least survive) which is certainly a plus for shareholders.  I could argue that this is good for patients and taxpayers as well because a free market system leads to more efficiencies and better service, but that is a discussion for another day.  Today I want to look at a heath care related stock that has traded in line with the positive trends, but appears to be getting ahead of itself.

Athenahealth Inc. (ATHN) is a billings, collections, and medical record keeping company that stood to benefit from a strong health care reform approach.  The company has some excellent products that allow physicians to manager their practices and allows patients to quickly review and transport their medical records between practices.  The current administration had vowed to make electronic medical records a priority which has caused stocks like ATHN to capture investors attention.

Now I must say that I am extremely impressed with the product suite that ATHN offers its customers.  The Software as a Service (SaaS) model allows practices to keep all records digitally stored and securely available online.  But since there are no paper records necessary, practices do not have to deal with storage and retrieval headaches.  Athenahealth can save many physicians a significant amount of money in overhead expenses so it’s reasonable to expect this company and industry to continue to grow.

The cause for concern comes from two different factors

1. Athenahealth faces mounting competition from technology companies with much broader resources.  Even if Athena offers the very best product, major cloud computing companies can develop a competing product and use their deep marketing budget to outsell Athena’s reps.
2. The stock price is at a valuation that can only be categorized as speculative.  The company is expected to earn 95 cents a share this year and the stock is trading near $47.  So even assuming the optimistic 58% growth expectations for this year are correct, investors are still betting on the company continuing to grow at an astronomical rate.

Now shorting runaway stocks like Athena is a very dangerous proposition.  Athena looked extremely overvalued back in October before running another 18% higher.  It is difficult to just pick a stock that is expensive and short it on principal.

But for traders who are willing to use patience and wait for the right opportunity, ATHN could offer significant rewards.  The best approach for this position is likely to set an alert a few dollars below the current stock price and wait.  Once investors begin to back off health care stocks, Athena will likely be one of the biggest losers.  But until that happens you don’t want to commit your capital short.

Investors could also consider buying longer-term puts which will rise in value once ATHN begins to give up its gains.  The puts allow you to limit your potential losses (you can only lose what you pay for the puts) and could return a much higher return on investment.  But at the same time, puts have a limited time frame and lose value in a process dubbed “time decay.”  If you are trading options, you need to make sure that you understand these concepts before committing your hard earned capital to a trade like this.

At any rate, Athena is a name that I am stalking and will likely add as a short position to our Absolute Return model this year.  If you would like to know how Sound Counsel’s  investment models are performing, sign up to the ZachStocks Newsletter and you will also receive the monthly commentary from Sound Counsel.  In the mean time, keep a close eye on health care stocks as changes in the reform bill could have lasting effects on stock prices.

FD: Author has a long position in AMED in Sound Counsel client portfolios.

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Fertilizer stocks ramped higher to start the new year after China settled on 2010 pricing for importing potash.  The price level is set at $350 per metric ton which is within the range of expectations.  While the $350 price point was largely anticipated, many related stocks traded higher simply due to the stability the decision added to the market.  Now that the largest consumer of potash has settled on an attractive price, North American distributors can begin negotiating with other purchasers both domestically and abroad.

Typically, China receives a discount because of the large volume represented by the country.  As such, most market participants now consider $350 the “floor” for pricing with marginally higher prices for other buyers.  According to Credit Suisse, the economic dynamics favor a continually rising price for the next several years and they expect potash to sell for $550 per metric ton in 2017.

The supply / demand dynamics for fertilizer look especially attractive in North America today.  Most farmers in North America dealt with a late harvest which meant that fertilizer could not be spread in the fall.  This could lead to significant demand in the first and second quarter as farmers prepare the soil for the spring crops.  Most of the potash dealers currently have extremely low levels of inventory which should lead to heavy buying pressure.  Not only do these dealers need to buy enough potash to meet the demands of farmers in the spring, but they also need to replenish their inventory now that pricing visibility is in place.

The $350 per metric ton pricing is especially attractive to North America producers such as Intrepid Potash (IPI) and Potash Corp (POT) because of the low cost of production.  It is estimated that these companies can mine potash at a cost of roughly $100 per metric ton, leading to a gross profit of $250 – an impressive margin.  Normally when businesses have such a hefty multiple we would worry about competition, but global supplies of potash are limited and there are significant barriers to entry in this market.

The selling prices are now high enough to justify an increase in production for firms like POT.  The company is well known for matching production with demand, and in the past year the company has reduced its production as the global recession caused demand to wane.  But farmers cannot continue to grow crops much longer without replenishing the soil and demand for agriculture products is much more inelastic than other goods.  With an aging population in North America (which means more resources used per capita) and a rapidly expanding middle class in developing nations (again – more resources per capita), the demand for agriculture products will likely only continue to grow.

Potash Corp (POT) is probably the most stable investment in this area as the firm holds the rights to a very wide range of potash properties.  Intrepid Potash (IPI) on the other hand is a smaller and more nimble player and could theoretically grow at a more rapid rate than its competitor.  Both companies appear to be trading in a strong trend and could lend significant investment returns.

Aggressive investors may want to own the individual stocks or potentially buy out of the money options on POT or IPI.  A more conservative approach would be to own the stock and sell calls against the position.  Currently the POT June 120’s appear to offer a strong annualized return while at least partially protecting investors from a pullback in the stock.  Alternatively, one could own IPI and sell the March 32 calls for a bit over $2.30 per share.  The option premium would protect against an 8% loss in the stock, and the return over the next three months would still be attractive if the stock was called away.

Regardless of how you play this area, it appears the opportunity is strong.  An improving agricultural picture, visibility with pricing, and the fear of inflation could all help push fertilizer stocks higher to begin this new decade.

FD: Author has a position in Sound Counsel client portfolios

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It’s been a rough last 24 months for Chimera Investment Corp (CIM).  The company is in the business of investing in Residential Mortgage Backed Securities (RMBS) – deemed “toxic assets” by many in the industry.  After coming public at $15 in late 2007, the stock briefly rallied to give investors a temporary gain of 32%.  But then the financial crisis hit and shareholders saw the value of home loans as well as the share price plummet.

In the darkest days of November 2008, the stock briefly traded below $2.00 per share and many believed that the company would not survive the credit crisis.  Chimera had borrowed huge amounts of capital and used the funds to invest in risky Adjustable Rate Mortgages (ARMs) which had often been issued to borrowers without the means to repay the loans.  The underwriters continued to write these admittedly irresponsible loans because they assumed that home values would rise and when the higher mortgage rates set in, borrowers could simply refinance based on the higher home value and net equity in the home.

As it turned out, trees don’t grow to the sky and home prices don’t rise forever.  Chimera’s 4.6:1 leverage rate meant that for every dollar of company equity, an additional $4.60 had been borrowed to invest in these assets.  As the value of the assets fell and the liabilities remained stable, Chimera was in hot water.

But rather than fold, management went to work improving their balance sheet and making wise strategic decisions.  The strategy was to lower exposure to these risky ARM investments and reduce the amount of leverage the company utilized.  Within four quarters, the company had paired down its leverage to a level of 0.9:1 – quite an impressive feat considering the environment.  In April and again in late May, the company issued additional shares to the public raising capital and investing these funds at much more attractive prices.

Today, the company looks much more healthy and the stock price just shy of $4.00 appears to be an attractive value.  The most recent quarter saw the company reporting adjusted earnings of $0.13 per share.  This is down a bit from the 16 cents reported in the third quarter of 2008, but the prior three quarters had earnings of 7 cents, 9 cents and 10 cents in the June quarter.  So it appears momentum has turned and is favoring this much more conservative approach.

After fully investing the proceeds of our capital raises earlier in the year, our team executed two re-securitizations that should enhance our return potential going forward. We continue to monitor evolving market conditions and prepare for a wide range of possible outcomes. ~Matthew J. Lambiase, CEO

Chimera briefly stopped paying a dividend at the height of the crisis, but the firm only missed one quarter and has been increasing its payout ever since.  Looking at the last year, the company has paid out 44 cents per share in dividends and that includes the one quarter when the company did not make a payment.  At this rate, the stock is offering investors a dividend yield of 11.3%.  If you assume that the company will be able to continue to pay 17 cents per share each quarter (which it announced for the fourth quarter) then the yield increases to 17.5%

Currently Chimera is realizing an annualized yield on its assets at 7.71% and has been able to lower its borrowing costs to 1.67%.  The interest rate spread of 6.04% is quite impressive and while that may narrow in a rising interest rate environment, the company should still be able to command a healthy margin.  The current loan portfolio is now made up of 59% fixed rate mortgages which are more stable and likely much less risky than the ARM component.

As far as the Adjustable Rate Mortgages, the company has already written a large portion of these loans down to a fair market value of 52.4 cents on the dollar.  So this means that if three quarters of these mortgages turn out to perform well, the company will recognize a large gain on this investment.  Looking at the entire book, only 0.6% of the loans are delinquent 60 days or more, and 1.37% are in foreclosure.  So the metrics are not particularly bad despite a difficult employment and economic picture.

I wouldn’t be surprised if Chimera were to sell additional stock in the near future to raise capital for more purchases.  If another wave of ARM resets sends mortgage prices lower, Chimara will be in great shape to pick up assets at discounted prices.  But for now, the company seems content to use low levels of leverage and enjoy its attractive interest spread.

FD: Author has long positions in Sound Counsel portfolios

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In today’s uncertain market, investors are looking for a wider variety of tools to help them capture returns and protect their investment capital.  One of the most powerful (and sometimes dangerous) tools is the leveraged ETF.  These investment vehicles have been trading for a few years and have become very popular both with daytraders and investment managers looking for ways to hedge their exposure.

A leveraged ETF is designed to trade at twice (or three times) the velocity of an underlying index.  So if the Russell 2,000 were to trade 3% higher today, the Daily Small Cap Bull 3x Shares (TNA) should rally by a full 9%.  In contrast, the leveraged 3x short vehicle (TZA) should trade down by 9%.  The inverse funds can be very helpful in helping long-only managers to offset their daily risk as a small position in the 3x bear funds can capture significant gains on a negative day which will offset that managers portfolio losses.

But leveraged vehicles have gotten a lot of bad press lately because of a mathematical property I call volatility decay.  Now to be clear, this is not an error in the design of the funds, it is simply a mathematical property that many do not take into account when using these tools.  The tools work exactly the way they were designed to – it’s the investors who need to understand how to use the tools.

Let’s take a volatile week and see how a triple index fund would perform:

• Monday: Down 5%
• Tuesday: Up 3%
• Wednesday: Down 4%
• Thursday: Up 6%
• Friday: Down 2%

Using the returns for the index, you would end up with a 2.42% loss.  So if you were using a triple leveraged inverse fund, you might expect your gains to be 7.26%.  However, the math doesn’t quite work that way.  Here is how a $10,000 position would likely trade if the fund perfectly tracked the market:

• Monday: Up 15% – now holding $11,500
• Tuesday: Down 9% – now holding $10,465
• Wednesday: Up 12% – now holding $11,721
• Thursday: Down 18% – now holding $9,611
• Friday: Up 6% – now holding $10,188

So you see, in a volatile period, the investment would only have returned 1.88% despite the fact that the market was down 2.42% and your investment was supposed to return three times the opposite of the index.  That’s because each day the funds reset to offer 3x exposure the next day.  This daily reset works to our favor in a steadily trending environment (assuming the trader picks the right direction), but works against us in a highly volatile market.

But don’t give up on the idea of using a leveraged investment to help protect your capital (or supercharge your returns).  Direxion Funds has developed a series of mutual funds which are designed to help avoid the volatility decay associated with the daily volatility.  These mutual funds are instead geared to return double the monthly performance of the index they track. So with these funds, if you buy on December 31, you can expect that on January 31, you will receive 200% of the price movement of the underlying index.  The funds do not reset daily and so you don’t have the negative (or positive) compounding effect on a daily basis.  There is still a volatility decay property to the funds, but it occurs on a monthly basis rather than a daily basis.  This is much easier to manage and makes the mutual funds a bit more relevant to long-term investors.

One thing to consider is that if you buy a fund in the middle of the month, you may be getting higher or lower exposure to the market through the end of the month.  This is because the funds do not reset mid-month to account for the price movement that the market has already undertaken.  But Direxion has a good solution for this potential problem.  If you click on this link you can see the “estimated current exposure level” which can serve as a guide for how much of a particular fund you should buy to meet your hedging or speculation target. Mutual funds offer the benefit of more accurately offsetting your losses over a longer period, or making a directional call on the market for a wider time frame.  However, the drawback is that the funds are traded on a daily basis, so you can’t liquidate your position at any point throughout the day.  But don’t worry, there are plenty of leveraged ETFs to help offset your mutual fund exposure throughout the day!

FD: Author does not have a position in any stocks mentioned in this article.

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