After taking some time off to enjoy time with friends and family, I’m back at the desk combing through opportunities for 2010.  ZachStocks market and stock articles will be back up and running shortly, but in the meantime I wanted to post a sample of the free ZachStocks Newsletter.  The newlsetter is sent out twice a week with market commentary early in the week, and some insightful links heading into the weekend.  Sign up to receive your free subscription and I look forward to hearing your thoughts.

Below is a sample of the ZachStocks Newsletter which was sent on December 18th…

Dear Subscribers,

Strength in the US dollar has begun what could be a major market shift.  Up to this point, international stocks and domestic companies with significant international revenue have been the beneficiary of a weak dollar.  But as the economic picture turns “less bad” traders are beginning to price in the probability of a rate hike and the long-term consequences of inflation.  This could cause a major shift away from international exposure at a time when the domestic risks aren’t much better.  It’s unclear exactly where investors will be able to put their capital that offers attractive returns and acceptable risk.  So continue to keep the defense on the field and consider lining up some short ideas for when markets begin to crack.

Below are some of the articles I found most interesting this week:

Zero Hedge: Prepare for the Hyperinflationary Great Depression

While the debate between deflationists and (hyper)inflationists has been a long and painful one, numerous events set off in motion by the Bernanke Fed (as a direct legacy of the Greenspan multi-decade period of cheap and boundless credit) may have well cast America as the unwilling protagonist in the sequel of the failed monetary policy economic experiment better known as Zimbabwe.

Some of the charts showing currency expansion and government debt can be very concerning.  I’m not sure why the US would be any different than numerous other historical cases where printing of fiat currency caused devastation.  While it’s not fun to think about the long-term ramifications of our current policy decisions, I fear that if we can’t learn from history we will be doomed to repeat it.

Sitka Pacific: November Letter to Clients

The US economy has indeed pulled back from the brink this year, as the positive Gross Domestic Product for the third quarter attests.  However, the question now is whether we have truly turned the corner, or whether this rebound has been just a lull in the storm… Unfortunately, the drop-off in mortgage resets seen in 2009 is only a temporary respite… The dollar amount of mortgages scheduled to reset in 2010 and 2011 is going right back up again, until finally dropping off in 2012.  Seen from this perspective, the conditions in 2009 appear to be more like the eye of the hurricane, not the end of it.

As more banks repay the TARP funds, the potential for further mortgage losses looms as an even larger threat.  If these banks which were bailed out by the government and then repaid the loans are forced to once again ask for assistance, you can bet that the public outcry will be fierce.  Many off-balance sheet assets (of the toxic sort) will be required to be put back on balance sheets in 2010 which could cause a weakening of capital ratios and lead to significant weakness.  I hope that these problems will remain contained, but for now I wouldn’t touch most major financial institutions.

Financial Times: Distressed Debt on the wane in US markets

Bonds trading at less than 50 cents on the dollar now account for only 1.1 per cent of the high-yield market, or $8.9bn in securities, down from 27.5 per cent, or $202bn in bonds, a year ago, according to JPMorgan data.  The intense demand for once-distressed bonds is stirring the debate about whether investors are acting wisely or piling into junk bonds because of a lack of opportunities elsewhere in the fixed-income markets.

Investment managers have become so intent on generating returns, that they are once again turning a blind eye to risk.  The quote above may appear to be a positive – after all, more bonds are trading close to their par value – but if the underlying fundamentals continue to be weak, and investors are just paying more for the debt, then we could be grossly mispricing risk.  A positive side to this coin is that small businesses are finding it somewhat easier to issue bonds and raise capital.  But is that really helpful if these bonds go into default in a few years?

WSJ: Spendthrift to Penny Pincher – A Vision of the New Consumer

Their (the consumer) value system is shifting from aspiring to material wealth to aspiring to a life better lived.  Businesses ranging from shoemakers to financial services to luxury hotels don’t expect American consumers to return to their spendthrift ways anytime soon. They see consumers emerging from the punishing downturn with a new mind-set: careful, practical, more socially conscious and embarrassed by flashy shows of wealth.

You can’t live through a decade like we are currently completing without having it affect you in some way.  A return to a grass-roots lifestyle is intuitively refreshing as there is nothing more obnoxious than a wealthy person trying to make sure that everyone knows he is doing well.  But a shift away from luxury goods also has a downside too.  Employees at retailing locations, manufacturing plants, and many other service industries will likely see hours cut and jobs eliminated.  Ultimately, a return to the basics will be good for the country, but in the meantime the pain can be quite difficult.

Sorry to be a Grinch this holiday season.  I truly am not a pessimist and despite the danger I see in the markets, I believe 2010 can be an incredibly profitable period.  We simply need to keep our eyes open and take advantage of the opportunities that present themselves.  This coming year, investors who embrace a conservative approach or who are willing to profit from declining profits will likely see their wealth increase.  But the simple buy and hold crowd will find it difficult to make money, much less outpace inflation.

Wishing you every success,

Zachary Scheidt
Chief Investment Strategist
Sound Counsel Investment Advisers
678-467-7064

Talecris Biotherapeutics (TLCR) is one of the more recent successful IPO stories as the company raised capital and began trading on October 1.  The IPO was priced at $19.00 per share and underwritten by an all-star cast of investment bankers including Morgan Stanley (MS), Goldman Sachs (GS), Citigroup (C) and JPMorgan Chase (JPM).  On the first day of trading, investors were rewarded with an 11% return as the stock bolted out of the gate.

Over the next month, the stock began to cool off as is often the case with new issues.  In early December, TLCR breached the all important IPO price of $19, but within two weeks the stock began to mount a recovery.  This is a perfect example of how underwriters and IPO investors can often be counted on to support a new issue very close to the IPO price.  It’s important for the underwriters to have the issues trade above the offering price, because it makes their job easier when peddling the next IPO to investors.  So often for quality IPOs, it is a good strategy to buy additional shares when the stock tests the initial price point.

The business model for Talecris appears to be very sound, as the company is experiencing strong revenue growth and generating impressive strength in earnings.  The company is a world leader in plasma based therapies and has strong command over its niche of the medical business.  One concern could be that the company receives 70% of its revenue from its two main products (Gamunex IVIG and Prolastin A1PI).  I’m not extremely experienced when it comes to the medical industry, but it appears based on market share and revenue trends that the company is very successful in its product lines. The third quarter was a strong period for TLCR with revenue growth of 12.9% and EPS of $0.38 which represents an increase of 72.7% over last year.  It appears that the company has been able to reduce expenses through vertically integrating its supply chain which has led to stronger gross margins.  The IPO transaction allowed the company to pay down a portion of its debt leading to lower interest expense which further helps to bolster earnings.

Our third quarter results reflect the continued demand for Gamunex, our brand of IGIV, as well our success in building a vertically integrated plasma supply chain to ensure a continual supply of Gamunex. ~Lawrence D. Stern, CEO

As far as debt is concerned, the company still has long-term liabilities north of $1 billion.  The liabilities are offset by $630 million in inventory and a healthy balance of accounts receivables, but the high level of debt could still become a concern should there be any unexpected changes in the revenue stream.  While it is still too soon after the IPO, I would not be surprised if the company issued additional equity in the first few quarters of 2010 in order to pay down debt.  This would dilute current shareholders, but would also lead to a more stable capital structure.

Analysts are expecting the company to earn $1.52 per share in 2010 which is probably reasonable given the strong management team, growing revenue base, and cost cutting initiatives.  At the current price near $21, the stock is trading at a multiple of 14 which seems a bit conservative considering the earnings growth.  Some caution is in order due to the debt level, but a multiple of 20 would not be unreasonable.  If we see medical stocks rebound in the aftermath of health care reform (as I expect we will), TLCR could ride the trend and see a much higher multiple.

So at this point it looks like the risk/reward ratio is very good.  $19.00 remains an important level to watch as a breach of this level would cause me to stop out my position.  On the other hand, the stock has the potential to trade through $30 and yield a 40% plus return.  The next six months should be a positive period for TLCR and its investors and I look forward to seeing what kind of growth management can generate.

FD: Author does not have a position in TLCR

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It’s not easy being a bank these days.  Oh sure, it’s nice to still be alive.  After all, last year at this time it was uncertain exactly how many financial institutions were actually going to stay in business.  But after begging for taxpayer money to keep them alive and kicking, banks are now finding that the strings attached are more like giant anchor chains and regardless of whether an individual firm has paid back the funds or not (and really it doesn’t matter whether the institution received any funds or not), banks are now being held to a standard that requires them to focus on the public good more than the pursuit of profits.

This week, Barack Obama delivered a very pointed address to US banks, declaring that he didn’t run for office to help a bunch of “fat cats” get rich.  With many high profile banks repaying TARP liabilities and removing themselves from the compensation restrictions imposed by the government, Obama is sending the message loud and clear that banks are still required to be good stewards of their capital.  This implies that the president believes that US banks should significantly increase lending in order to supply liquidity to businesses and consumers in need of financing.

Currently, banks are enjoying one of the best rate environments possible due to the low short-term borrowing costs these institutions can take advantage of.  With the Fed Funds target rate at zero to 0.25%, banks can borrow for quite literally no interest expense (or marginal expense at worst) and invest that capital in nearly anything paying a nominal yield.  Of course Bernanke would like to see this capital lent to businesses and individuals for higher rates of return but also to prime the pump for additional economic growth.  But most recently, banks have been taking the capital they can borrow at low rates and investing in treasuries which carry a smaller profit but much more stability.

The process of borrowing cheap and investing “just a bit less cheap” does very little to stimulate our economy.  In fact, the only good it really does is to help the bank report stable profits and show a balance sheet with an improving risk picture.  (Now I’m well aware that most major banks have plenty of legacy risk associated with assets already on their books – but new lending is following the path of zero risk tolerance).  If banks continue on this path, they will likely face even more harsh criticism from an administration who believes that the financial institutions owe it to the taxpayers to be offering more liquidity.

As it turns out, the choices for banks are not pretty regardless of which angle you take.  If banks are more free with their lending, the amount of risk taken could turn out to be devastating.  This is actually a major part of the problem that got us into our difficult position in the first place.  Credit flowing freely to consumers and businesses who are not good credit risks is certainly not a good idea for the banks, or for the taxpayers.  Imagine the public backlash if these new loans turned to losses and the government had to bail out the banks again! You can bet the heads would start to roll.

But on the other hand, if the lending institutions decide not to extend credit to businesses and instead use the low borrowing rates to fortify their balance sheets, they will likely face the ire of an administration desperate to manufacture economic growth.  As it stands now, rates for borrowers are extremely low – definitely an attractive point for businesses.  But the credit standards required are extremely high.  Even showing a rock solid balance sheet, business plan, and collateral does not ensure that a business will be able to raise capital.

My personal fear is that banks are buttressing their capital base because of the off-balance sheet exposure that many still have to weak assets and structured products.  As these products are moved back on the balance sheet due to regulations imposed next year, the capital picture could turn much uglier.  With this in mind, I would recommend steering clear of major banks as an investment in the first half of 2010 while regulation continues to unfold and the picture becomes clearer.

As for the banking industry, the government should certainly continue to monitor the risk associated with these institutions, but should refrain from pushing these companies toward making loans.  Once the risk picture is cleaned up and transparency returns, competition will cause the banks to naturally lend at fair market rates.  But forcing these institutions to lend regardless of credit quality will ultimately lead to higher risk and systemic failure.

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

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For the past several years, investors have only had one choice when it comes to a major technology investment serving the China telecom market.  AsiaInfo Holdings (ASIA) has been the only major technology provider in the sector trading on US markets, and the stock has had a tremendous run over the last several quarters.   Investors are betting that the emerging middle class in China will drive growth in both  land line and mobile telecommunications and in turn increase the business available to ASIA.

AsiaInfo is actually broken into two separate divisions which meet different needs of institutional clients.  The first division is AsiaInfo Technologies which provides software and solutions to voice and data carriers.  The Chinese government recently combined the six major telecom players into three and has implemented measures designed to inspire competition and in turn drive demand for their services.  ASIA stands to benefit from the rapid integration as these three firms consolidate operations and struggle to create an efficient technology framework.

The second division is Lenovo-AsiaInfo which specializes in IT security, antivirus and network protection technologies.  Similar to Mcafee (MFE) or Symantec (SYMC), the division offers subscription based services to protect against malware.  The division has several government contracts which not only provide stable revenue, but also gives the company credibility and helps prove the legitimacy of their products.

But while ASIA has been a strong competitor, there is a new player which will likely issue a US based IPO in the next couple of weeks.  Lincage Technologies is expected to offer shares between $13 and $15 sometime near December 9th.  The ticker, ironically, will be BOSS and the shares will be sold through the underwriting branches of Citigroup and Barclays Capital.  Linkage receives most of its revenue through software development, and the software helps clients properly manage customer accounts, manage network issues, and generate helpful data for future planning.

Unlike many of the technology IPOs in the US over the past decade, Linkage is actually a profitable company with revenue of $66.6 million during the first half of the year and net income of $15.1 million.  Despite hefty competition in the market (including domestic rivals that are not traded on US exchanges), the company appears to be growing rapidly and winning significant contracts from the three major telecom providers.

The IPO transaction is expected to net the company roughly $129 million although this could vary depending on what price is received for the shares.  Linkage will set aside $30 million for research and development and use the remainder for “general corporate purposes.”  It’s encouraging that the company will actually be receiving capital from the transaction instead of the capital going to a private investment firm or directly to previous shareholders.  The additional capital should be able to fund growth and allow the Linkage to compete against rivals in this attractive growth market.

For the time being, ASIA still looks like an attractive investment although possibly a bit pricey.  The company is expected to earn $1.20 per share in 2010 which means that the stock is trading at roughly 20 times forward earnings.  That is a reasonable multiple given the growth assumptions, but does imply a bit of risk as any disappointment would likely cause the stock to drop quite a bit.

Buying BOSS on the IPO could be very profitable but also encompasses a decent amount of risk.  It is too early to tell how the deal is shaping up and whether there is sufficient buying interest to support the share price.  Usually when an IPO begins trading, the first few months are driven much more by perceived value and the supply and demand is centered around how much interest the underwriters are able to generate.  After that time, the stock will settle into a more predictable pattern based on the fundamentals of the company and the opportunities within the sector.

I would be willing to take a small position in BOSS and participate in the IPO unless there is a significant dislocation in the market between now and the actual transaction.  It appears equity markets are shrugging off the Dubai news and liquidity still continues to be strong.  While this can quickly change, under the current environment the prospects for this IPO remain very strong.

FD: Author does not have a position in ASIA

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Today is traditionally known as “Black Friday” in the retail industry for a number of reasons.  Traditionally, it was the day after Thanksgiving when many retailers actually crossed into the black, meaning they became profitable for the year.  More commonly, retailers and shoppers  refer to the day after Thanksgiving as “Black Friday” because of the madness at store locations where door busters, huge crowds, and short tempers make for a chaotic shopping experience.

This year we may face fewer shoppers than we have traditionally seen, due to lingering unemployment, an economy likely to still be in recession (or only recently beginning to show signs of recovery) and a level of wealth that is diminished from last year.  However, we may still end up with a significantly “black” Friday as far as the markets are concerned.

Most US investors were unaware of the carnage that was sweeping world markets yesterday as we all binged on turkey and remembered to be thankful.  However, the European markets along with many other international markets were down more than 2% as Dubai rocked the international sense of economic improvement.  Dubai World is a sovereign wealth fund which has huge liabilities related to its leveraged investment.  On Thursday, the country announced that it would seek arrangements to delay the repayment of a good portion of its debt.  This has caused quite a stir in the international community and brings liquidity questions into play.

As I write, the US pre-market futures are pointing to a negative open of about 3%.   While a drop of that magnitude is not extremely concerning, it should be noted that markets are likely very susceptible to a sustained decline, due to rich valuations in equities, and generally bullish pricing trends on securities across many asset classes.  Sometimes it only takes a small catalyst to shift sentiment enough to completely reverse the trend.  In today’s markets, there is enough dry powder which could lead to a morally bruising market decline, and Dubai’s news could be just the spark to set off the explosion.

US markets will only be open a half day today with the majority of the country still in celebration (or shopping) mode.  That leaves trading desks largely full of rookies whose trading decisions are fairly unpredictable.  If these managers begin to panic with losses mounting, selling could begin in earnest shortly after the 9:30 open.  If this happens, there will be very little liquidity in the market to support prices and the declines could quickly accelerate.  I’m not predicting this to be the most likely outcome, but investors should at least understand that this is a possibility.

With equities largely pricing in a full fledged economic recovery, stocks holding multiples that imply significant growth, and short-term treasuries at levels that are simply unsustainable, there are few safe places to hide.  We have been recommending purchases of precious metals for quite some time, but it now looks like gold may e a bit extended on a short-term basis, and while silver may have a long way to run, it will likely experience a temporary pullback if the markets decline.

So please keep your capital safe and wait patiently for buying opportunities.  I wouldn’t plow any capital into growth positions today or next week, even if the prices drop significantly.  The market will need to take some time to adjust to the declines and buying opportunities should only be pursued after careful thought and deliberation.  So keep the defense on the field and watch out for the dreaded “Black Friday” Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

Black Friday is coming – that dreaded day when consumers look for bargains, and retailers stay open from dawn (or pre-dawn) to dusk in a day that could make or break sales goals for the entire year.  Investors are shopping for bargains as well, and many are looking for quality stocks on sale.  The problem with buying something at a cheap price, is that unless you are careful, you could end up buying poor quality goods.

Whole Foods Market Inc. (WFMI) appears to be one of those “on sale” retail stocks.  Investors can pick up shares for a 22% discount to the high posted in October, and if you look back to the stock’s all-time-high in 2006, investors are now able to buy at a 65% discount.  Since the company sells high quality organic groceries at relatively wide profit margins, it is easy to understand why investors would be willing to pay a premium for the shares.  But at the end of the day, Whole Foods is still simply a grocery store, and one with relatively stagnant growth at that.

Back in August, ZachStocks noted that WFMI stock was as “pricey as it’s wares.”  We stated that the company had cloudy visibility into the year ahead, and that the US consumer would have difficulty rationalizing the higher costs for commodity goods.  While the stock still made new highs along with a strong market in October, the recent weakness has now pulled the stock below the level it traded at when our last article was posted.

On November 4th, the company announced it’s fourth quarter earnings (working off of a September year-end), which came in at $0.20 per share.  That represented an increase of 43% over last year’s fourth quarter earnings which would appear to be positive news on the surface.  However, this was the fifth quarter in a row that the company reported sales levels that represented growth of 0% to 3%.  Not exactly the kind of sales increases that you would expect out of a healthy growing company.

Despite the ugly sales growth numbers, management appears to be optimistic about what the figures represent…

We believe our sales have stabilized and officially turned the corner.  Our comparable store and identical store sales trends improved for the second quarter in a row and, after five quarters of year-over-year declines, so far in the first quarter are up 1.6% and 0.4% respectively.  ~John Mackey, CEO

Same store sales growth of 1.6% may be an improvement, but they hardly warrant the kind of optimism that investors are indicating with the share price.  Currently, WFMI trades between $26 and $27 even after falling 22% from its recent high.  Considering the company is expected to earn $1.10 this year (and I think analysts may have this number too high), the stock is trading at more than 24 times 2010 earnings.  A multiple of 24 may make sense for a rapidly growing technology company, but it certainly seems aggressive for a grocery chain (however swanky they may be) which is forecast to grow by 10% to 13% over the next couple of years.

There are several different ways that traders could profit from a fall in WFMI.  The most obvious would be to short the stock outright, but I would recommend managing risk carefully.  Stocks have been resilient lately and just because something is overpriced doesn’t mean that it will immediately fall.  Long-term puts are a bit expensive, but could turn out to be a risk-averse way to play this trend.  You can buy the May 25 puts for $2.75 right now which means that if the stock dropped to $20, the puts would realize at least an 82% gain.  However, there is a legitimate risk that these puts will expire worthless if WFMI manages to be stable for the next six months.

My suggestion would be to short the stock and then sell puts against the position to help offset risk.  Using this strategy, you cap the level of gains you can receive, but you also lower the volatility.  Shorting the stock today and selling the May $25 puts gives you a potential 18.5% return on capital in six months time.  Compounded (assuming you can find a similar trade for the second half of the year) that would yield roughly 40% annualized.  The best part about this trade is that you only need the stock to trade down to $25 to realize maximum profit, and you break even if the stock rallies to $29.45.

The bottom line is that Whole Foods appears to be a risky investment at the current price.  I expect shareholders to dump this position over the next several quarters as the lack of growth and poor consumer spending causes profits to remain pressured.

FD: Author does not have a position in WFMI

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Green Mountain Coffee Roasters (GMCR) is down sharply this morning after announcing earnings last night.  While the revenue and profit numbers for the fourth quarter (the company operates with a September year end) showed considerable growth, the stock (which is featured in the Retail Fail quarterly sector report) had been priced for perfection and it appears that investors now have some concern with the rosy outlook.

For the quarter, Green Mountain reported earnings per share of $0.34 which beat the 33 cent consensus estimate and represented an increase of 89% above last year’s level.  Revenue was $222.2 million which also beat estimates and represents a 65% increase over last year.  The third quarter was certainly a victory for the company, but looking forward the picture is a bit less optimistic.

Management issued its outlook for the first quarter which includes sales growth of 61 to 66% ($317 million to $327 million) and earnings growth of 11 to 15 cents per share.  Since analysts had been expecting first quarter earnings to approach 19 cents per share, this is obviously a disappointment.  While the sales growth guidance is relatively in line with the market’s perception, operating margins are expected to be between 3.8% and 4.3% which is well below the 11.4% operating margin in the fourth quarter.

There may be a reasonable explanation for such a steep drop in operating margins.  Green Mountain’s business model is to sell its coffee machines at nearly break even in order to get customers hooked on its brand.  Then once the machine is installed, GMCR makes a much higher profit margin on the K-cup coffee servings.  The strategy is similar to HP who invented the model of selling printers for a loss and then making a killing by supplying the ink cartridges.

Overall, the growth story for Green Mountain remains intact and as a stand alone business, they are very attractive.  The distribution deal with Wal-Mart (WMT) continues to drive sales and will likely be a stable source of revenue for the foreseeable future.  Management has a legitimate reason to be proud of their success.

GMCR is executing on its plans and running on all cylinders as the innovative and proprietary Keurig Single-Cup Brewing System continues to transform how consumers in North America prepare and enjoy their beverages. The resulting demand for K-Cups is fueling our growth. This past quarter, Keurig realized the highest ever quarterly year-over-year increase in K-Cup shipments since becoming part of GMCR in the third fiscal quarter of 2006. ~Lawrence J. Blanford, CEO

From an investment standpoint, however, I simply cannot justify the price that GMCR is trading at.  Current investors are buying the growth story with very little regard for the actual fundamental valuation of the company.  Using Wednesday’s closing stock price, and the high end of management’s updated guidance for 2010, investors are paying 41 dollars for every dollar the company is expected to earn.  That’s an exorbitant multiple and as we are seeing this morning, carries quite a bit of risk.

It is always difficult to anticipate the short-term price movement directly after the earnings announcement.  Obviously investors are frustrated with the first quarter guidance and have sent the stock lower to begin the day.  But it wouldn’t surprise me to see a rally over the next few days as bullish investors take advantage of a low price and accumulate more shares.

But over the next several weeks, I expect this news to sink in and cause more suspicion in the stock.  It is quite possible that analysts could assign a multiple of 35 or 30 or even 25 times projected earnings.  This would occur if the long-term growth rate were called into question.  After all, it’s going to be hard for the company to find a repeat event for it’s Wal-Mart contract win from this year.  At a still-aggressive multiple of 30 times 2010 expectations, the stock would trade in the mid 50’s which represents quite a decline from the current levels.

Aggressive traders could consider taking a short position in this name, although tight risk control should be used.  If the stock rebounds and closes above $76, I would become concerned and step away until a better opportunity arises.  Option premiums are very high which may prevent traders from buying puts outright, but may set up a better opportunity.  Consider selling the stock short and then selling the December or January $65 or $70 puts.  This would allow you to collect some attractive premiums which will offset losses if the stock runs higher.  If the stock continues to trade lower, you may sacrifice some of your gains, but your rate of return will still be very attractive.

FD: Author does not have a position in GMCR

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One of the more successful IPOs over the past few weeks has come from Vitamin Shoppe Inc. (VSI).  The stock was offered to investors at $17.00 and began trading on October 28.  Underwriters included JPMorgan Chase (JPM), Bank of America (BAC) / Merrill Lynch, and Barclays Plc. (BCS).  The stock traded sharply higher out of the gate, closing its first day of trading at $17.95 which was good for a 5.6% initial return.

Since the IPO, investors have gained more confidence in the stock, pushing it as high as $21.39 during the day on Tuesday.  That’s a potential 26% increase over the IPO price.  It’s encouraging to see additional strength in the open market for a growth opportunity in its early days of trading.  The positive movement points to liquidity which continues to show up in pockets of the market despite the economic uncertainty.

Investors were particularly pleased with the third quarter earnings release which came out last Wednesday, just a week after the IPO.  During the quarter, VSI reported sales of $168.4 million which represents an 11.3% increase over last year.  The company has opened 60 retail stores over the last year, brining their total locations to 434.  Comparable store sales were up 4.4% which is impressive given weakness in consumer spending.  Of concern was an increase in cost of good sold which were higher due to increased product costs and occupancy costs.

While there are certainly challenges in operating a retail shop in today’s market, VSI used the proceeds from its IPO to pay off debt, giving the company a better financial presence.  Of the $121.2 million received in the transaction, $72.5 million was used to redeem preferred stock, and $45.2  million was used to repurchase senior secured notes.  Now the preferred stock was essentially a way for the early investors in the company to get paid, but the lower value on the senior notes should help with long-term interest expenses.

The dynamics on this IPO are very positive for the time being.  A well managed deal has led to a higher stock price which will likely be supported for the next several months.  Aggressive traders could pick up stock on any dips into the high-teens with an absolute stop below $17.  If the stock breaks below this level, all bets are off and the picture could get ugly very quickly.  But as long as the stock remains above this level, the trading opportunities will be best from the long side.

Down the road, it will be important for the company to demonstrate superior growth characteristics.  Over the last 10 quarters, Sales have grown very steadily by roughly 10 to 12% but that number will need to pick up in order to justify the current stock price.  It appears that the first quarter is typically a strong earnings quarter for the company so that will be the first major data point for investors to analyze.

It is often a major challenge for management teams to transition to publicly traded dynamics.  Transparency is extremely important and the reporting issues can be burdensome.  Currently, the company does not appear to have an extremely transparent setup with balance sheet information less than accessible.  As management becomes more talented at disclosure and keeping the necessary systems and processes in place, they will need to refocus on driving growth in order to create value for shareholders.  I believe the long-term prospects are good, but challenges must be overcome quickly in order to maintain a premium stock price.

FD: Author does not have a position in VSI

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Investors in Blue Nile Inc. (NILE) are cheering the third quarter earnings release.  For the period ending September 30, the company grew revenue by 2.4% and turned in earnings of $0.17 per share.  The profit represented 13% growth over the same period last year as the company noted specific strength in bridal jewelry and international sales.

Any consumer discretionary company growing sales and earnings in this environment deserves a certain degree of respect.  While the third quarter of 2008 was no picnic, retail companies are finding it difficult to convince penny pinching consumers to open their wallets.  Blue Nile is capturing market share from competitors during the difficult economic period with the expectation that the recovery will bring substantial revenue and earnings growth.

The Blue Nile brand is resonating with consumers in the current environment, and we are gaining market share. As we look toward the important holiday season, we are well positioned with a broad selection of diamond engagement rings and fine jewelry and a newly redesigned website to showcase these products. ~Diane Irvine, CEO

The most impressive part of the quarterly report was the fact that the company grew international sales by 27.5%.  While the percentage gain is quite a large number, NILE only received 8.8 million from international customers (roughly 13% of total sales).  In order for international growth to make a significant difference in the company’s growth, it will have to represent a larger portion of the total business.  Volatility in currency rates could cause these numbers to fluctuate, but a generally weaker dollar could be a benefit as it makes merchandise generally cheaper to offshore purchasers.

While I continue to be impressed by the company’s growth, I am very concerned that investors could find themselves trapped in an inflated stock over the next several months.  NILE commands a hefty multiple of 60 times expected earnings for 2010.  Even if the company is able to grow by 26% next year (which is the consensus estimate), the stock still appears to be overvalued at a price that is potentially double an aggressive analytical price.

There are plenty of examples of stocks which have traded at exorbitant multiples for several months, only to disappoint investors with a sharp reversal lower.  In fact, Blue Nile itself lost more than 80% of its value between late 2007 and the beginning of this year.  After making up about half of those losses, it appears the stock could once again be setting up for disappointment.

Currently, I don’t have a short position in the stock due to its strong momentum.  However, some technical chinks are showing up in the armor as NILE recently traded below the 50 day in strong volume as the overall market began to deteriorate.  Today’s earnings announcement and subsequent stock rally will be a good test as to the resolve of investors picking up new shares.

If the stock is able to maintain a price above $60 for the next week, then I would steer clear of committing capital on the short side.  Momentum could certainly carry the stock higher as investors are more excited about the solid company story than they are concerned with valuation.

However, if the stock gives up its gains from this morning and breaks back below the 50 day average, that would be a good short-term indicator that the picture is deteriorating and investors are ready to bail.  Once the positive momentum is broken, analysts could quickly begin calling for a multiple of 25 to 30 which would represent a 50% decline in the stock.

So tread carefully in this over-hyped retail stock.  Using your capital to buy actual gold or a diamond ring will likely be a much better investment than purchasing the shares of this high value growth stock.

FD: Author does not have a position in NILE

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Over the past two months, the IPO market has heated up, allowing companies and private investors to access liquidity by selling new shares to the public.  While the performance of these deals have varied from company to company, Verisk Analytics (VRSK) turned out to be one of the better managed, more profitable transactions for investors.  The stock was offered to the public on October 7th at $22 per share and closed above $28.50 on Tuesday for an attractive gain of nearly 30%

The deal was underwritten by Bank of America (BAC) and Morgan Stanley (MS) along with a syndicate of supporting cast.  Although Bank of America was not considered one of the top tier underwriters for the majority of this decade, their acquisition of Merrill Lynch during the financial meltdown has given them access to a large pool of retail and institutional investors which makes placing IPOs and secondary offerings a bit easier.

It is interesting to watch the trend in underwriting fees which used to be incredibly lucrative for these introducing firms.  While the profit margins are still relatively fat, Verisk Analytics only offered the underwriters 88 cents per share for the offering which represents a 4% haircut.  A few years ago, this underwriting discount could easily have topped 8 to even 10% of the offering price.

Looking at the details of the transaction, it immediately becomes clear that the entire amount of the $1.8 billion raised in the offering goes to selling shareholders with no capital actually flowing to Verisk as a company.  This would usually be considered a black mark against the deal, but Verisk is a different animal.  The company was actually owned by a broad assortment of top tier insurance companies including American International Group (AIG), Berkshire Hathaway (BRK.A), CNA Financial (CNA), Hartford Financial Services Group (HIG) and Travelers.

Verisk was created by these insurance companies as a third party risk analysis and decision support vehicle.  Verisk has built a well-recognized skill base in determining risks associated with a number of different industries, and providing decision support tools allowing clients to properly price, manage, and avoid risks associated with their individual businesses.  The decision to spin off the company appears to be an important liquidity event for these insurance companies, many of which could use some additional stability in their balance sheets.

Earnings have been relatively stable over the past five years with Verisk growing pro-forma EPS from 79 cents per share in 2004 to $1.26 per share in 2008.  The first two quarters of 2009 showed attractive growth with revenue increasing by 14% and 16% respectively and earnings up 9% to 16%.  So far there have been no official consensus estimates for the full year or for 2010 due to the fact that so many underwriters were assisting on the deal and they are barred from issuing an opinion on the stock for about 30 days.  Over the next several weeks we should see these research firms quickly initiate coverage and offer guidance for earnings.

The risk assessment business will likely face significant demand over the next several years as Wall Street and Main Street adjust to the new dynamics of a (hopefully) post recession world.  With VRSK now operating as its own independent business apart from the founding insurance companies, the firm should be able to diversify its client base and expand into promising industries.  In fact, the company recently hired Vince McCarthy who has extensive experience in corporate finance and M&A (Mergers and Acquisitions).  The title of Sr. VP – Corporate Development and Strategy indicates that the company is exploring opportunities to broaden its reach and develop new business lines.

Investors in VRSK are paying a relatively high premium for the potential growth.  Currently, the published PE for VRSK is 21 which is in line with Risk Metrics Group (RMG) which operates in a similar field.  I would expect a bit of a pullback in the stock over the next two weeks as the 30 day restriction on trading is lifted and a few investors cash in on their profitable position.  However, the long-term prospects for this industry are very good and I expect VRSK to begin a steady climb once the IPO trading dynamics have played out.  Investors may want to try to accumulate shares near $24 if they have the opportunity with the intent of holding into the $30’s over the next 12 months.

FD: Author does not have a position in VRSK

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