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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It has become a New Years tradition to combine forces with a few investment bloggers and put together some investment ideas for the coming year.  ZachStocks has bragging rights to the last place slot for 2009 as my recommendations for TBS International, TBSI (a dry bulk shipping company) and China Medical Technologies, CMED both faces significant challenges.  Shipping rates continued to be low throughout much of the year, and China Medical faced a surprise change in management and a heavy debt load.

Looking forward to 2010, I expect the ZachStocks recommendations to perform much more positively, while at the same time I want to caution against buying and simply leaving the positions unmonitored for the year.  We live in dynamic times where policy and economic trends are fluctuating very rapidly.  All investment decisions must be made with imperfect information, and then adjusted as new information comes to light.  Successful investors are able to allocate capital with purpose and confidence, but they are also able to switch gears and make new decisions when the situation warrants.

So with that said, here are my four recommendations for 2010 and as they become available you will see the additional recommendations from my competition at the bottom of the post:

The Blackstone Group LP (BX)

The private equity industry is set for a major rebound in the coming year.  Many of the funds that are managed by Blackstone are nearing their high water mark which means that the company will be able to participate in further gains in the alternative funds managed.  The market is offering ample liquidity which means that many of the companies owned by Blackstone’s private equity funds can be sold to the public in Initial Public Offerings (IPOs).  These transactions will allow the funds to book significant profits and lead to increasing shareholder value.  Finally, Blackstone continues to attract new capital with the most recent figure of $96.3 billion under management.  With these growth situations along with a healthy 9% dividend yield, I expect Blackstone to rally sharply this year.

Assured Guaranty (AGO)

Most financial insurance companies (which insure securities such as municipal bonds and Mortgage Backed Securities) have either gone out of business or are teetering on the edge.  Companies like Ambac Financial (ABK) and MBIA Inc. (MBI) may still be solvent, but they don’t have the capital available to go after new business.  But Assured Guaranty made some very smart, conservative decisions in the mania leading up to the housing crash, and now has the capital to write new business and capture market share.  Assured Guaranty recently made an acquisition that adds a significant amount of new revenue, and should be accretive to shareholders in the coming year.  While the stock has had a tremendous run since April, it still trades at an attractive level compared to its high quality assets and its prospective growth.  I expect the stock to continue to add to its gains as we enter this new decade.

IntercontinentalExchange (ICE)

As Congress works to overhaul the regulatory system for our financial markets, many of the banks and derivative dealers will face a new standard of disclosure and risk control.  OTC contracts which used to be private will be forced onto exchanges and the contracts will have to be cleared by a third party.  The CME Group (CME) and IntercontinentalExchange are the two primary clearinghouses which have the ability to clear derivative products and the additional business should add to profitability for both of these companies.  ICE has made several recent acquisitions to give the company a competitive edge and I expect the company to capitalize on the regulatory opportunities in the next several months.  The stock is not cheap, so there is a bit more risk in this opportunity, but investors should reward the company for its growth, driving the stock price higher.

iShares Silver Trust (SLV)

The fear of inflation could be a major trend for 2010 as most governments continue to utilize an accommodating monetary policy.  Printing presses continue to pump out more currency leaving more dollars (or euros) chasing fewer goods.  When inflation fears mount, the best investment strategy is to own “stuff” or hard assets because supplies are relatively stable (versus an increasing supply of currency).  Silver is unique in that it is both a precious metal (storage of value) as well as an industrial metal (there are real-world uses for it).  December has featured a sharp pullback in the shiny metal and that actually gives us an excellent entry point for silver heading into the new year.  I expect silver to be a solid place to store “real” value, and if inflation fears take off, silver could vault higher with a price that increases many-fold as investors look for an alternative to owning dollars.

Happy New year and I wish you the best of success in the coming year.  If you would like information on how to develop an appropriate investment program for your personal account, please email me and I would be happy to discuss ways to safely grow your capital.

Wishing you every success!

Other Bloggers 2010 Recommendations

The Financial Blogger

My Trader’s Journal

The Wild Investor

Four Pillars

Where Does All My Money Go

Intelligent Speculator

Dividend Growth Investor

Note: This is a recap of performance for the stocks picked at the beginning of 2009.  Picks for 2010 will be posted January first.

To paraphrase a hedge fund manager that I follow closely, “Nothing has happened this year the way I expected it to.”  While this statement does little to instill confidence in this money manager, William posted returns north of 20% for the year in his long-short fund which remains fairly neutral as far as market exposure is concerned.  The point is that although 2009 was a year of major shifts in market direction, policy decisions, and investment risk; it was still possible to adjust trading style along the way to account for the changes and book significant profits.

My four picks for 2009 did not turn out to be very profitable despite a significant market rally from March through December.  Thankfully, portfolios managed for Sound Counsel Investment Advisers were able to trade actively throughout the year and performed much better than the 2009 recommendations.  As I choose growth opportunities for the portfolios I manage, I am careful to use stop points in order to exit losing trades, while letting winners continue to compound gains.  Often we use covered calls to manage some of the risk, and the advent of inverse ETFs has also been helpful in managing downside risks for entire markets as well as individual sectors.

So without further adieu, here is some commentary on the four picks for 2009.  Stay tuned for the 2010 picks which will be posted January 1.

1. JA Solar Holdings (JASO)
   While Alternative certainly received its fair share of headlines this year, the solar industry was plagued with rising inventory levels and falling prices for solar products.  On top of the supply dynamics, many countries which had implemented strong solar energy tax incentives had to pull back on the stimulus measures due to financial strain.  As a result, many solar companies experienced a difficult period and those with excessive leverage were especially hard hit.  At the time of writing, it looks like JASO will finish the year with a gain of 30.5% which is certainly healthy, but the majority of the gains came in the last few weeks of the year.  JASO could continue to post additional gains in the coming year, but there are still significant uncertainties surrounding the alternative energy market.
2. AECOM Technology Corp (ACM)
   AECOM is an international construction management company which is expected to benefit from global stimulus projects aimed at improving infrastructure projects such as bridges, roads, power plants and other developments.  Since AECOM has a well diversified client base, it was expected that the company would grow earnings (which occurred quite nicely) and see its stock price rise as a result (which unfortunately did not occur).  Much of the stimulus spending took longer than expected to reach the market, and investors have placed a lower multiple (paying a smaller price for every dollar that the company earns).  The lower multiple is likely due to a perception that the company will not continue to grow quickly after the stimulus projects are completed.  At this point AECOM still looks like a great investment with little debt and a low earnings multiple, but it has taken longer than expected for the stock to bounce.  Currently it looks like ACM will finish 2009 with a loss of 1.2% – not a very healthy showing considering the strength of the market.
3. TBS International (TBSI)
   At the end of 2008, it looked like shipping companies were primed for a significant rebound.  The financial crisis had sent many of the more leveraged players into the abyss, but companies with longer-term charters and reasonable debt levels were showing signs of improvement.  The wildcard in this industry was whether the day rates for dry bulk shipping would improve over the coming year.  Unfortunately, shipping has continued to be a challenging area for the economy, and since TBSI does not pay a dividend, it has been especially unattractive to investors.  The stock is down 27.2% for the year which is extremely disappointing.  Looking into the coming year, there is little evidence that this company will offer investors much hope of improving profits so I would not recommend an investment in this stock and have kept clients out of this name for some time.
4. China Medical Technologies (CMED)
   China Medical is another disappointing story as the stock is now down 30.2% for the year.  Midway through 2009, CMED had traded higher as the company’s rapid growth caught investor’s attention and the diagnostic company was expanding its base of customers.  However, a management change along with significant debt has caused investors to lose confidence.  At the current price, CMED is looking like a very solid value, but I am not invested right now because I want to know for sure that the business metrics are solid.  If management were to issue healthy guidance for the coming year (ending March 2011), I would consider working back into the stock, but for now it appears to hold excessive risk.

We have many risks and many opportunities in front of us as we enter this new decade.  Flexibility and damage control will be important skills to employ as the markets face the risk of inflation, mounting sovereign debt, and significant fluctuations in currency rates.  I would welcome the chance to help you develop a comprehensive plan for your investments in the coming year.  Please email me if you would like more information on Sound Counsel’s investment strategies.

Wishing you a happy New Year!

Other Bloggers 2009 Results

Intelligent Speculator

The Financial Blogger

My Trader’s Journal

The Wild Investor

Four Pillars

Where Does All My Money Go

Million Dollar Journey

As we wind down 2009 and look forward to the year ahead, I have been taking some time to read a few books relating to the financial crisis and how the events transpired.  The Greatest Trade Ever by Gregory Zuckerman details how John Paulson turned a profit of more than $15 billion by betting against the unrealistic housing and mortgage bubbles.  It’s inspiring to see how careful thought and methodical execution allowed this now legendary trader to vault from an “also ran” mediocre fund manager to one of the most respected investors of our time.

House of Cards by William D. Cohan is a bit of a darker read as it chronicles the collapse of Bear Stearns over a fateful spring week in early 2008.  The Bear Stearns failure is especially interesting to me as I personally worked on the same floor as Bear Stearns’ Atlanta office during the time that the firm went under.  It is quite sobering to see just how vulnerable our major financial institutions were (and many still are) due to the enormous leverage used as these companies aggressively pursued profits.  Many of the derivative tools which were used to drive trading gains (and eventually to bring down companies like Bear, Lehman, and AIG) are still actively traded and could potentially cause market chaos again.

As the political machine moves from emergency bailouts to the much more difficult process of making sure a similar financial catastrophe never happens again, new regulations are being put into practice which are expected to discourage institutions from taking similar excessive risks.  Now I could write a number of pages on why political regulation will likely fail at reigning in human greed and fear, but rather than dive into the intellectual side of that argument, let’s look at some investments which could profit from the additional regulation.

One of the most recent regulatory reform bills which was debated in the House attempted to require all financial derivatives to be traded on exchanges and cleared.  The purpose was to provide both transparency and a sense of risk control.  As exchanges posted data on which derivative contracts were being traded, at what prices, and at what volume; investors would have a better sense of the liquidity of such vehicles and what price the market was willing to pay for exposure to particular investment and trading agreements. The risk control would come into play as the derivative agreements were “cleared” or guaranteed by a third party.  Companies like IntercontinentalExchange (ICE) and the CME Group (CME) act as intermediaries between trading counterparties, guaranteeing that the trades will be settled.  As the clearinghouses are taking on the counterparty risk associated with each trade, the market becomes less vulnerable to the risk that one of the parties will default on a major trade (or basket of trades).  The clearinghouse must manage its own risk and will therefore require each party to put up a certain level of margin or collateral depending on what is at risk with the particular trade. Clearinghouses must carefully manage their own risk, but if the business is handled appropriately the profits can be quite lucrative.  Not only does the clearinghouse get to charge fees for each trade cleared, but the firm holds a large amount of capital which it can invest while counterparties leave the trade on the books.  ICE and CME are both expected to be major beneficiaries of the push to have more derivative trades directed through the clearing function. Of course not everything goes according to plan in Washington (thank goodness), and it is unreasonable to expect that 100% of derivative trades will be forced onto exchanges.  Dealers and other market participants will still transact some business without a third party intermediary.  However, Morgan Stanley (MS) believes that the volume of derivatives cleared could increase from the its current portion of 20% to as high as 60% in 2012.  A tripling of market share could certainly boost the profits of the established players and potentially lead to sharp investment gains in 2010.

One of the benefits of operating a capital intensive business like a clearinghouse is that it is very difficult for new competition to enter the market.  With a clearing business, trust and reputation are the most important assets as traders do not want to clear unless they believe that the clearinghouse has the capital to truly absorb the risk if a counterparty defaults.  This reputation cannot be easily built without a significant amount of time in the business, and it is difficult to manufacture that experience without clearing major trades.  So there truly is a “chicken or egg first” difficulty in starting a new clearing franchise.  Also, large financial institutions are not likely to enter the clearance business because they would rather make their profits on the trading side.  So for now it appears that ICE and CME are the leaders and have a sustainable advantage in collecting profits from clearing derivative trades. Neither CME or ICE are trading at extremely cheap multiples.  That is because the market has begun to realize the strong potential for earnings growth.  However, as the political climate continues to drive banks and dealers toward greater disclosure and stronger risk controls, it is likely the earnings growth will be even greater than expected for CME and ICE.  The result will likely be a sustainable advance in the stock price of both clearinghouses and while there could be moderate volatility the trend should remain intact for months to come. FD: Long position in Sound Counsel Investment Advisers client portfolios Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

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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Shares of Fortress Investment Group (FIG) are trading higher today after comments made at the Goldman Sachs (GS) US Financial Services conference. The private equity company has benefited from the equity market rebound and the return of liquidity to the global investment universe. As I write, the stock is up more than 7% after CEO Daniel Mudd spoke at the conference this morning and told investors that they are seeing more demand for their private investment funds.

Fortress has seen its stock plummet over the past year as funds that the company managed took on losses while at the same time, investors pulled capital out due to the poor returns. This is the nature of private equity – it can often be a boom and bust business model even though funds are usually structured to be absolute return vehicles. When a fund or family of funds are performing well, the company recognizes very attractive incentive allocations (FIG gets to keep a portion of it’s investor’s profits) and at the same time, new capital comes pouring in.

However, when these funds face a few months of poor performance, investors pull capital out resulting in a smaller pool of capital available to generate gains. At the same time, the poor performance puts the funds below their “high water mark” and that level must be reached again before the fund can charge any incentive fees on investors who are simply making their money back. So even in a rebounding market environment, companies like FIG will see their profitability lag because it takes time to make up past losses on their investments.

But we are likely in the early stages of another boom in the private equity market and for Fortress particularly. There are two factors feeding this new wave of profitability which could quickly lead to a sharply higher stock price. First, the company isseeing new investment capital come in the door. Keep in mind that this capital does not have a high water mark. Gains on these new investments will immediately lead to FIG taking a portion of the returns as their own profit. In the past few months, FIG raised $500 million in a portfolio designed to invest in the Japanese real estate market. Other new fund launches will likely allow the company to substantially increase their Assets Under Management (AUM)

The second factor is that existing funds are nearing their high water marks. So while the funds have been struggling to make up past losses, these assets have basically been adding very little to FIG’s profits. But once the magical high water mark is hit, immediately new gains will tie directly to increased profits. As expectations ramp higher, the stock price will likely get a lift and potentially run several hundred percent higher.

Currently, analysts are expecting FIG to earn 28 cents in 2009 and 45 cents in 2010. This means that the stock is currently trading below 10 times next year’s expected earnings. To be fair, these earnings estimates are not very reliable. It’s extremely difficult to handicap exactly how well the company’s funds will do and what type of incentive allocations will be generated. But I do think that the Wall-Street analysts are excessively conservative given the difficulty we have experienced over the last year.

FIG is not an investment that you should make with your “safe” capital. In many ways, this is a risky bet that could go bust, or could pay off big. If the market experiences another decline (which I think is possible) its likely that the funds will be better prepared to handle the turbulence. But there’s no guarantee that they won’t lose money in the funds resulting in much lower revenue. However, there is a good chance that FIG will have some of its funds make wise investment decisions (short or long) which will yield significant profits and push earnings up significantly. A little confidence could go a long way and if FIG realized a multiple of 20 on earnings of 75 cents we would have a return of roughly 275%.

So consider taking a shot at FIG – buy a few speculative shares and tuck them away for 6 to 12 months. The potential is great and you are only risking roughly $4.20 per share.

FD: Author does not have a position in FIG

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The IPO market has become more active as underwriters try to push through deals before we hit the holiday doldrums.  There are only a couple of actionable weeks left until portfolio managers and traders close up shop for the year and liquidity dries up.

One of the most recent companies to take advantage of the liquidity is Archipelago Learning (ARCL) which was offered to investors at $16.50 on November 20.  The Underwriters (Bank of America / Merrill Lynch and William Blair) did a good job of pricing the deal attractively for investors and developing interest in the company.  On the first day of trading, the stock closed at $18.77, good for an initial gain of 13.75%.  Since that time, the stock has pulled back to just above the IPO price, an important level that  BAC will likely defend.

Looking at the company, Archipelago has built a line of subscription based online educational products which are predominantly sold to the Kindergarten through 12th grade schools.  During the 2008/09 school year, the products were used by 8.9 million students through a relationship with 21,000 different schools in all 50 states.  While the company has already penetrated a very large geographical footprint, management estimates that they only represent 17% of the available schools with 94,000 public and 24,000 private schools as potential clients.

As a growth strategy, the company is not only looking to expand into new schools, but also to increase the revenue within its existing client base.  The products used by high-school students typically carries a higher price point and stronger margins than lower grade products, and there is potential to develop new products which could assist with the company’s existing initiatives to expand into the college and post-graduate markets.

According to the terms of the IPO prospectus, the company sold 3.1 million shares with selling stockholders also selling 3.2 million shares.  As it turned out, another 937,500 shares were sold by the selling shareholders to meet the strong demand for the deal.  The primary selling shareholder was Providence Equity Partners which still retains a 54.9% position in the company.  Over the next several months, investors are likely to worry that Providence will liquidate its position.  But for today, there is a lockup on these shares and so the overhang should not play heavily into the price of the stock. The company indicated that it would use the proceeds from the sale for “general corporate purposes” which means very little to us as investors.  Given management’s desire to grow the company and expand its client base, I would expect much of this capital to be used for marketing and promotional initiatives.  The company has $61 million in debt, so the additional capital could theoretically be used to create more financial stability.

Archipelago is at a critical spot where revenues are just barely covering fixed costs and beginning to provide the company with a profit.  The pro-forma model for the year ended 12/31/2008 shows that the company would have earned 3 cents a share, and with the lower interest expense this year, the company was able to clear 17 cents per share in the first three quarters.  If management is successful at integrating its programs in a wider base of schools, the earnings growth could expand exponentially.

Most IPOs are heavily influenced by the underwriters in the first few weeks of their existence.  It’s important to the underwriters that the deals are profitable to investors because that will allow them to efficiently market the next deal and investors will have confidence in the company’s ability to price the IPOs attractively.  With that in mind, ARCL is now trading just above the $16.50 IPO price and is likely being supported by Bank of America.  This offers us as traders a great risk/reward spot to buy on the expectation that the stock will be bid higher by IPO investors and the underwriters.

If we are wrong and the stock breaks below $16.50, we will quickly sell and realize a small loss.  (I would give the stock 20 or 30 cents below the IPO price but not much more room than that).  On the other hand, the potential for the stock to trade back up to $18.50 or even its high at $19.50 is fairly good.  I would welcome a trade that allows me to risk 50 cents with the potential for a 2 dollar or 3 dollar gain.

One caveat is that there is very little volume in this new issue.  That means it is much easier for large blocks of stock to push around the price – and so we will have to endure more volatility.  If the stock breaks $16.50, it could very quickly continue lower before you exit the stock.  But by the same token, if it is bought by a large institutional investor, there is a good chance the order would push the stock significantly higher.  So consider putting a small amount into this position and maintaining a close stop.

FD: Author does not have a position in ARCL

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Emergent Biosolutions (EBS) has seen some disappointments over the last few months.  The company is the only provider of an FDA approved Anthrax vaccine and EBS primarily sells its products to the United States Strategic National Stockpile (SNS).  While EBS enjoys a relative monopoly on its vaccines, the third quarter gave investors a bit of a surprise with revenue actually declining by 24% and earnings nearly flat.  The company had a much lower level of shipments to the SNS which dramatically impacted its financial figures.

This lumpy revenue stream is not without precedent.  In the fourth quarter of 2008, a similar revenue decline took place before shipments resumed and the company recorded a strong first two quarters of 2009.  During quarters where revenue declines, profit margins take a significant hit due to ongoing research and development as well as fixed costs which continue regardless of the number of doses shipped.  The bad news is that this uncertainty causes investors to bail and drive the share price lower.  But the good news is that once the company resumes its strong growth trends, investors will likely be rewarded with a strong rebound in the share price.

Looking at the results of the third quarter, it is obvious that the company is being managed for long-term growth and management is not overly concerned with any one quarter report.  This is encouraging in an age where most investors, management teams, and board of directors micro-manage each quarter at the expense of long-term performance.  The company continues to invest in R&D which will be instrumental in developing new products or improving products already on the market.  For example, the anthrax vaccine was recently improved to handle a longer shelf-life, and the FDA approved the longer expiration date.  As a result, EBS can charge a higher price, enjoy better profit margins, and offer a higher quality product.

During the third quarter, the company added to its cash base and now has $118.8 million in cash and equivalents.  This cash can be used for acquisitions such as additional manufacturing and testing facilities which the company closed on in November, as well as to create new products and market them in a broadening target demographic.

We also continue to make significant investments in our commercial product pipeline, most notably our tuberculosis candidate, which is in a Phase IIb efficacy trial in South Africa. ~ R. Don Elsey, CFO

Most recently the stock price has been hovering between $13 and $15 as investors try to determine whether the third quarter was a change in trend or if earnings growth will return.  Since EBS has a high degree of exclusivity (and management noted that it’s contract with the SNS is scheduled to remain in effect through September 2011), it looks like the revenue base is currently stable.

Analysts are modeling earnings of $0.75 per share next year which puts the stock at a multiple of 20 times expected earnings.  This estimate is likely to be very conservative as it represents a 19% decline from 2009 earnings.  The stable revenue with the SNS as well as potential for new products and new clients should beef earnings higher and likely lead to a higher multiple on the stock.

The company has several projects in place that could result in important new products.  Don Elsey noted the tuberculosis vaccine which could be rolled out in South Africa in the near future, and the anthrax vaccine could eventually be sold to a wider target market as well.  With the high cash balance, EBS could potentially purchase another product line from a competitor and leverage this to its existing client base.

The future is somewhat uncertain, but with the stock price trading at a low level, and potential for growth in place, it makes sense to make initial or add-on purchases to EBS here.  I wouldn’t be surprised to see the stock trading above its recent $20 high in the next few months, and if the company makes a major announcement, EBS could challenge its all-time high of $27.

FD: Author does not have a position in EBS

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