During any market advance, there are stocks that trade higher because they have significant merit, and of course there are those which are just along for the ride.  The axiom “a rising tide floats all boats” certainly applies for at least a time as professional and personal investors alike grasp for exposure to a rising market.  But it has also been said that “a bear market returns capital to its rightful owners.”  This usually applies to markets where speculative buyers have bid up prices to unsustainable levels, and then when the irrefutable laws of fundamental valuation come back into play, the capital invested quickly disappears.  I fear we will soon enter another period where capital is taken away from speculative investors.

One of the areas that seems most prone to a swift decline is the homebuilding industry.  From a business standpoint, the environment is definitely getting better.  After all, it’s not exactly hard to beat the devastating period builders have endured for the last 18 to 24 months.  But while business is beginning to show the signs of a recovery in infancy, the market is pricing in a full-fledged mature recovery and bidding stock prices higher as if they were fully functioning healthy businesses.

Take MDC Holdings Inc. (MDC) for instance.  The stock has no official PE because the “E” part is nonexistant – the company hasn’t earned a dime since sometime in 2006.  And this year analysts expect the company to lose another 44 cents per share.  But of course losing 44 cents is good news considering the fact that the company lost $10.44 per share in 2007, and lost $8.25 per share in 2008.  MDC is trading at roughly 40% of its high logged in 2005, and the value of its stock still appears to be very high.

A Quick Peek at Crude Oil

If you read the company’s fourth quarter earnings report, you will immediately see that the company reported impressive earnings.  But it quickly becomes apparent that the earnings are entirely due to a tax code revision that allows the company to carry forward losses more than 2 years.  This is definitely a positive announcement for the company, but not one that will cause the long-term health of their business to improve.

The revenue picture is one that investors should look at carefully.  Quarter after quarter, the company has seen sales decline when compared to last year.  However the fourth quarter actually saw a pick up in sales – which is good news right?  Well it’s actually not all that impressive considering the fourth quarter of 2008 featured a decline of 62%.  So one would hope that MDC could at least match this dismal performance and even exceed it to a small degree.

MDC is not without signs of improvement.  The company’s new orders for the fourth quarter totaled 637 homes which is much better than the 350 homes ordered during the fourth quarter last year.  Separately, the backlog of homes under contract has risen to 826 compared to 533 homes to end 2008.  Hopefully the majority of these contracts are honored and buyers are able to secure financing (although mortgage standards continue to be relatively stringent).

Investors who decide to buy the company based on the book value of the company’s assets need to realize that property values fluctuate wildly because of the illiquidity in the market.  MDC holds more than a half billion in “housing completed or under construction” and “land  and land under development.”  The value of these properties has been revised lower in the past due to market conditions and if another wave of foreclosures hits the market, this valuation will likely be hit again.  The stock price requires investors to pay 150% of book value to own the company and book value still seems suspect in my opinion.

I wouldn’t be surprised to see MDC trade down to parity with book value (near $22.75) or even lower if management takes another write down on inventory levels.  Sure, the market for real estate may be improving, but with a shadow inventory of foreclosed properties being sold by banks, and many consumers stuck in homes they can’t afford, I believe the environment will be challenging for homebuilders for years to come.

FD: Author does not have a position in MDC

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

It’s no secret that the Chinese economy has experienced tremendous growth – even during the global financial crisis.  A demographic shift towards the middle class has bolstered demand for goods and services, and we are seeing a wide portion of the population moving towards China’s rapidly growing cities.  However, as with any rapid economic expansion, economists are beginning to wonder just how fast is too fast.   It seems that there is serious potential for China to stumble and lead the globe back into an extended economic slump.

The Chinese equivalent of the Federal Reserve appears to have concern with the situation as they have begun tightening reserve requirements for banks which essentially reduces the amount of capital available for lending purposes.  The moves have been minor in nominal terms, but the banks are getting the message… “Cut back on lending and get your books in order.”  No one wants to see a repeat of the US banking crisis from 2008.

Tightening in China could certainly slow the economic expansion.  Instead of having ready access to capital, business would have to compete for limited financial resources which in turn could drive the price of these resources higher.  When chasing limited opportunities for loans, the interest rate can become the “price” and it seems logical that the cost of financing will rise for businesses.

With this backdrop in mind, I am building my list of China short candidates which will likely trade sharply lower once investment managers begin to trim their exposure to the sector.  One name that has caught my interest and is potentially actionable immediately is Home Inns & Hotels Management Inc. (HMIN).  The Hotel operator currently manages 616 hotels, 390 of which are leased and operated and 226 of which are franchised and managed.  The company has a wide geographic footprint with hotels in 120 cities across China.

Over the past four quarters, the company has continued to grow revenue and earnings although I’m becoming concerned that the rate of revenue growth has begun to decline.  When HMIN was a young company with just a few hotels under management, it was easy to double or triple revenue just by adding a dozen more hotels to the mix.  But now that HMIN has reached critical mass, it will be difficult to maintain the growth trajectory simply because of the law of large numbers.  The last four quarters have seen revenue grow by 53%, 43%, 38%, and finally 29% in the fourth quarter.  That’s still impressive growth but not nearly as exciting as the triple digit revenue gains the company used to put up.

The earnings picture, however, is much better.  Management has been able to manage costs associated with its existing hotels as well as the expenses for opening new locations.  As a result, earnings growth has been 130%, 107%, and 225% over the last three quarters.  That’s an impressive feat – but also one that will be difficult to follow in 2010.  Despite the positive earnings momentum and the hefty multiple, I fear expectations could be tough to live up to in the coming months.

In addition to our improved overall performance, due largely to the reduced impact of new hotel openings, the key metrics of our mature hotels strengthened in the fourth quarter compared to this time last year indicating an improved economic and operational environment. This has allowed us to renew our focus on our core expansion plan, as we remain excited and encouraged regarding the vast opportunity which we believe remains within China’s economy hotel sector. ~David Sun, CEO

Looking at the HMIN chart pattern, there is certainly reason for concern.  The stock peaked in early 2010 and began to lose ground in sync with broad China indices.  After putting in a swing low in early February (just above the 200 day average), the stock has traded higher but on very weak volume.  It appears mutual fund managers are more motivated to dump the stock when the environment is risky than to accumulate shares when we hit the “risk on” periods.

Friday (3/5) the stock traded down sharply on strong volume.  It’s definitely concerning to see a growth stock catching significant volume on negative days – especially when trading below the 50 day average which has been a key support level for the stock.  Today (Tuesday) in early trading, the stock is back below that level as markets are opening mildly negative.  It will be interesting to see if volume comes in with the selling which would be a strong indicator that it is time to begin building a short position.  As always, manage risk carefully and know your stop level.  But in the weeks and months ahead we may find that short opportunities offer the best chance for profits.

FD: Author has a short position in the Sound Counsel Absolute Return Model

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

2010 is likely to be one of those years in which traders who participate on both sides of the tape (both long and short) will have a better chance of succeeding.  Investors in the Sound Counsel Investment Advisers absolute return model are currently weighted with significant short exposure due to the high market valuation and the potential for a second bear market in equities.  One of my highest conviction short positions is Salesforce.com (CRM) which reported earnings earlier this week.

Salesforce.com is one of the leaders in cloud computing technology which helps IT administrators make more efficient use of their resources.  In the past, companies would need to own a server for every major function or individual operating system.  The result was often a room full of dozens of servers which were all running at 20% to 30% capacity.  The situation was an incredible waste until cloud computing technology allowed servers to run multiple systems and efficiently allocated resources between the servers.

It’s easy to see how this exciting technology could lead to growing sales.  After all, large and small corporations could save on IT costs by using the technology.  And that’s why Salesforce.com has been able to grow revenues at a steady clip for several years.  Most recently, the fourth quarter revenue was up 22% to 354 million and for the full year the company collected $1.306 billion in revenue which is up 21% year over year.  Earnings were strong with the company posting GAAP earnings per share of 63 cents for the year – an 80% increase over 2008.  But while these figures appear very favorable, it looks like investors have bid the price of shares too high and may be ignoring some of the dramatic risks in the stock.

One of the biggest red flags that I saw when reading the quarterly report was the deferred revenue item.  For companies like CRM which receives 92% of its revenue from subscription and support, much of the revenue is received well ahead of time because of long-term contracts which are paid in advance.  Due to accounting rules, the company is not allowed to record the revenue until service has been rendered – so revenue for future quarters gets allocated to an account called “deferred revenue.”

At the end of the quarter, CRM had deferred revenues of $704 million – which was only up 19% year-over-year.  While positive movement is certainly a good thing, the company will need to attract a significant amount of new business in order to keep up with its recent sales growth.  The company has 73,500 paying customers which is up 4,600 during the quarter and that performance will have to continue to justify the share price.

For 2010, the company is guiding GAAP earnings between 58 and 60 cents per share.  I found it a little disturbing that CRM offered “non-GAAP” guidance of $1.25 to $1.27 in earnings when it appears that this figure simply does not account for stock-based compensation (there are a few smaller items as well).  To the non-suspecting investor, it might look like the company is really generating $1.25 to $1.27 in additional value for shareholders but stock based compensation truly is an expense and should be treated as such.  Although the company does not have to pay cash for this compensation, the additional shares issued has the very real effect of diluting current shareholders.

Finally, if you look at the current price of the stock ($66.75 as I write), and compare it to the earnings expected for this year, you can easily see that investors are paying 111 times earnings to own the company.  Despite the fact that CRM is growing, the multiple is ridiculous and will almost certainly lead to a sharp decline in the stock sometime in the next year.  I am completely astounded at the valuation and hope to profit when the stock trades back to a more reasonable level.

Thursday’s trade offered some mixed signals for short-term traders.  Initially, the stock gapped down well below the 50 day average as investors digested the earnings report.  But by the end of the day, CRM followed the market back higher to recover much of its losses.  Still, the stock was down on the day on volume that was well above average.  My suggestion would be to buy some out of the money puts on this stock (which are actually relatively expensive) or watch for a clear break lower on volume to set up a short position.  Keep your stop levels tight and don’t be afraid to stop out and then try another short trade when the stock breaks down again.

My sense is that eventually this stock will run significantly lower and while the price action will be sharp, it may take several weeks to a few months before CRM finds any significant support.  Damage control remains an important part of investing, but wise and careful shorting of this high-flying Wall Street darling could turn out to be very profitable.

FD: Author has a short position in Sound Counsel Investment Advisers accounts

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

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

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

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

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

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

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

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

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

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

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

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

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

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

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

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

The cause for concern comes from two different factors

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

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

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

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

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

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

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

If you are a musician for the money, it’s likely that your music is less appealing to the majority of your audience.  But what about the companies who make music their business?  The last few years has ushered in dramatic changes for the music industry and at this point most participants are struggling to survive.  Today, we’re going to take a look at Warner Music Group Corp (WMG) as a potential short candidate for the new year.

At first blush, you might think that WMG has a strong business which owns the rights to some very high profile artists.  Warner represents Fleetwood Mac, Linkin Park, Gnarls Barkley, Faith Hill, and many other up and coming stars.  Now my sense of pop culture is a bit deficient so these artists may not be a good representation of the talent Warner represents, but with the company pulling in more than $800 million dollars in revenue each quarter it is clear that they have at least a few products which resonate with the average music buyer.

But the technology changes in how music is distributed along with a sharp decline in the global economy has thrown WMG a one-two punch which has left profitability reeling.  Today, many listeners use free services such as YouTube, or Pandora to listen to music, and the revenue models for these services are primarily based on advertising rather than the purchase of music.  Warner has been scrambling to keep up with the changing world, but it currently appears that the company is falling behind from a business standpoint.

Just before Christmas, Warner announced a new agreement with Hulu in which WMG will offer music videos and concert footage to Hulu viewers.  The agreement could help WMG capture some of the advertising revenue as they will likely operate under a revenue split agreement.  Both companies are already working together to determine what content will be available with Muse being the first artist featured.  Theoretically, as Warner exposes their artists to the broad audience which Hulu has assembled, sales of the artists records will pick up leading to stronger product revenue.  But the success of this model has yet to be proven.

Last month Warner announced results for its fiscal fourth quarter which ended September 30.  The company saw revenue of $861 million which was up 1% from last year.  Management seemed especially proud of the fact that digital revenue was $184 million which represents 21% of total revenue.  It stands to reason that in today’s technological world, media companies should see their digital revenue make up a larger portion of total revenue if they are to stay in business.

WMG had a strong quarter, increasing revenue, growing our cash balance to $384 million and raising digital revenue to 24% of total Recorded Music revenue. Over the fiscal year, even in the midst of difficult economic and industry trends, we grew our market share to 21% in the U.S. and continued progress on our key strategic goals: diversifying our revenue mix, improving our financial flexibility and maintaining our leadership in the industry’s digital transition. ~Edgar Bronfman Jr., CEO

To hear the CEO speak, you would think that this was a positive quarter for the music company.  But in actuality, WMG ended up losing 12 cents per share for the quarter and a full 64 cents per share for the year.  Also, while management may boast about their cash balance being a third of a billion dollars, you should note that long-term debt is stuck at $1.939 billion which dwarfs the company’s cash levels.

Warner’s balance sheet appears to carry a significant amount of risk.  Total assets are listed at $4.07 billion with total liabilities listed at $4.21 billion.  So the company actually has a negative book value.  The asset side of the equation is also a bit disturbing with $1.04 billion in goodwill and another $1.32 billion in “intangible assets subject to amortization.”  While I don’t necessarily doubt that these assets carry value, the math suggests that the company has a tangible book value that is more than $2 billion in the red!  As long as the company can continue to service the large debt load, they will stay in business.  But as we have seen in the past 18 months, there are times when debt service becomes nearly impossible even for strong companies.

Looking to 2010, analysts expect WMG to lose another 59 cents per share.  Now that’s better than the 64 cent loss of 2009, but it still represents losses for shareholders.  After rebounding from below $2.00 per share, the stock is now at $5.70 and appears very vulnerable.  There is a significant amount of volatility, but I wouldn’t be surprised if the stock tested or even broke below it’s March low in the next 12 months.

One caveat is that the company has some relatively easy hurdles to beat in 2010 when compared to 2009.  So it is not outlandish to think that the company could post revenue gains over last year, and profit losses that are less dramatic than we saw in 2009.  News releases will likely be skewed positively so while the company is posting a loss, management assumes that it is good news.  This positive spin could easily sent the stock higher – if only temporarily – which can cause losses if you are short.

So please use caution when trading WMG.  It may make sense to use option strategies that lower risk such as shorting the stock and then selling puts, or buying the puts with the understanding that the time decay could make the trade less profitable than shorting the stock outright.  But despite the volatility I expect the next year to favor short-sellers in this financially challenged stock.

FD: Author does not have a position in WMG

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

As equity markets continue to trade higher, and economists have largely turned into cheerleaders for an unsubstantiated recovery, the junk bond market has begun to reflect a smaller degree of risk.  Not only have prices risen to the point where many poorly rated bonds are trading at levels that mirror their financially sound counterparts, but companies which real financial challenges have been able to issue more debt at attractive interest rates.

One of the largest junk bond issuances occurred last week when Clear Channel Outdoor Holdings (CCO) issued a full $2.5 billion which was significantly higher than the original plan to sell $750 million.  Clear Channel Outdoor is the spinoff child of the larger Clear Channel Communications which is privately held by Thomas H. Lee Partners and Bain Capital.  Investors have been bidding CCO higher as more capital would normally create a healthier company for investors.  However, the picture is a bit more complex and the bond offering may turn out to be little help for the leveraged advertising company.

As it turns out, nearly all of the capital raised will be used to repay the parent company which is privately owned and leveraged 14.4 times.  This means that  for every dollar of equity Clear Channel Communications has created, there is $14.40 in debt – a staggering level.  The heavy debt is largely a risk born by the private equity companies and Clear Channel Outdoor is simply the conduit that the private equity holders are using to borrow capital from public markets to reduce their own exposure.  Since CCO is a healthier entity (and that is a stretch because CCO is leveraged 4.6 to one), it is easier to use this vehicle to raise capital.

Clear Channel Outdoor is the outdoor advertising division of the media conglomerate which was brought public in an IPO in 2005.  While the stock initially traded well, doubling in price during its first year as a public company, the last two years have been difficult for many advertising companies.  CCO has since dropped from a high just above $30 to a low of $2.14 during the financial crisis.   But like many speculative stocks, CCO has rallied sharply, and is now up 416% from the ultimate low.

2009 has been a very difficult year fundamentally for the company.  Revenues have been sharply lower each quarter, and despite the rising stock price, the company has reported a sharp loss for the year.  On June 30, the company announced that it would take a write down of $812 million to account for the lower value of many intangible balance sheet items and even in 2010, the company is expected to lose 17 cents per share.  It’s a bit baffling to see the stock trading with such strength when the actual company is under such duress.

One bullish case for the company is that the parent company – or more accurately the private equity owners – could take CCO private, buying out the public shareholders at a premium.  The parent company already owns 89% of the company and if things got bad enough, the private equity team could simply buy the remainder of the company and wait for a better opportunity to re-issue the company to the market.  However, if the private equity holders were up for this type of transaction, I believe they would have taken advantage of the opportunity when the stock price was much lower.

More likely, the private equity holders will look for an opportunistic time to begin selling their 89% ownership stake and thus reducing their risk.  Liquidating their holding into a market that is now willing to take on risk could be a very wise move – especially if a weakened consumer leads to a continued weak environment for advertising.  A sell of CCO stock would likely cause pressure and drive the price lower, so the private holders will have to be careful how they initiate the transaction.

The bottom line is that there is significant risk in CCO shares at this price.  The firm is under a significant debt burden, and the recent junk bond issuance does little to relieve that burden.  The equity and bond markets may be extremely forgiving today, but if and when the environment turns south, CCO equity holders and debt holders could be left holding a lot of risk and very little in the way of profitable assets.

FD: Author does not have a position in CCO

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

For-Profit schools have been getting a lot of attention over the last few weeks – and not much of it has been good.  While managers of these institutions often argue that the industry offers an efficient and cost effective opportunity for students to better their education, the track record of many of these companies when it comes to the career mobility or the financial improvement of students, does not exactly garner high marks.

This morning, an article buried on page A7 of the Wall Street Journal outlines the results of government data which discloses default rates for students who have enjoyed government loans for various forms of education.  The information appears to point to a much higher default rate for students who were enrolled in for-profit programs versus community college and state funded not-for-profit schools.  Of the 316 schools whose students had default rates above 30%, three quarters of the institutions were for-profit institutions.

The information is likely to cause a serious black eye to these for-profit educators, many of whom rely on government grants and loans to students in order to maintain enrollment levels.  The public backlash could come on two fronts.  First, students will likely think twice about enrolling in a public school if the data points to fewer of their classmates having the ability to repay government loans for the program.  The second source of backlash could come from taxpayers who are disappointed to see their government funding education programs which are failing to provide students with the earnings power necessary to repay the government for the education.

Today, credit availability has tightened and it has become more difficult for students to find financing in order to further their education.  To a large degree, the government has stepped in to fill the gap with an assortment of available plans to students.  Up to this point, there has been plenty of capital available for students to borrow and spend on for-profit education programs, but that trend may be set to decline.  With these schools representing a majority of the defaulting borrowers, the government must take a close, hard look at whether these programs are beneficial or not, and whether public money should be spent to allow students to enroll in these programs.  If public funding is pulled or even just rationed, that could mean slumping profits for many of these schools.

Despite the relatively negative tone of the article, for-profit education stocks are rallying today as it appears investors were expecting the data to be even worse.  Most publicly traded educators are trading with relatively low multiples due to concern which has been growing in the sector.  The stocks have traditionally traded in a volatile pattern with 20% and 30% swings the norm more than the exception.  The Wall Street Journal cited Corinthian Colleges Inc. (COCO), and ITT Educational Services (ESI).  Both of these companies trade at single digit multiples to next year’s earnings (or very close) which may accurately reflect the risk in the industry.

Strayer Education (STRA), however, may be the exception which presents an attractive short opportunity.  The stock is trading at nearly $210 per share while analysts expect earnings of $9.51 per share in 2010.  If funding becomes more difficult for students to obtain, that $9.51 in earnings could quickly be in jeopardy.  While the stock is rallying sharply today and should probably not be shorted until it shows some weakness, shorting STRA could yield hefty profits in the coming year.  Assuming a modest 10% disappointment in earnings, and a still above average multiple of 14, the stock could trade down to $120 – down 43% from current levels.  When shorting, be sure to have proper risk controls in place and know how much you are willing to risk.

FD: Author does not have a position in STRA

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

As equity markets continue to march higher, and investors are still willing to commit capital to growth opportunities, a number of small companies are seizing the opportunity to sell stock and raise permanent capital.  I can’t disagree with the strategy, as the liquidity window may only be open for a short time (at current prices), but a few deals have raised the question as to whether investors are wise in committing this capital.

Two weeks ago, Taleo Corp. (TLEO) was able to raise more than $125 million by offering 6.5 million shares to the public.  Actually the underwriters exercised their option to purchase another 975,000 shares, so the proceeds are closer to $140 million.  While traditionally, small companies will use capital from a secondary offering to pay down debt, or to fund a merger or business investment, Taleo noted that they “intend to use the net proceeds from this offering for general corporate purposes…”  Essentially, investors are giving management a blank check worth up to $140 million with very few documented plans.

To its credit, Taleo is operating a profitable business during a time that is particularly challenging for small businesses.  The company provides “talent management” software for use by human resource departments.  This software helps companies through the recruiting, performance management, compensation management, internal mobility, and other analytics processes.  The software is offered under the Sofware As A Service (or SAAS) model, meaning customers use an internet interface instead of downloading the software on their own machines.  Most customers are set up with a subscription payment plan which allows for lower up-front costs, and also gives TLEO a recurring revenue stream.

Taleo has put together an impressive string of quarterly earnings figures with significant growth in 7 of the last 8 quarters.  However, some questions arise when looking at the company’s revenue trends (growth has been slower in each of the last four quarters) as well as trends in deferred revenue.  With many customers paying for a full year of services ahead of time, Taleo is forced to book the majority of this cash flow as deferred revenue.  In future quarters when the service is performed, the revenue will be recognized based on a pro-rata schedule.  So deferred revenue can actually give us a good picture of what future revenue will look like in the coming quarters.

When the company announced earnings for the September quarter, deferred revenue was basically flat from the level at the end of 2008.  This implies that the company is either having trouble booking new business, or is seeing its retention rate decline.  This is not a deal killer as far as an investment is concerned, but it certainly raises some questions about future growth.

Currently, analysts are expecting the company to earn 82 cents per share in 2010 which would represent a 12% increase over 2009 expected levels.  Expectations may be a bit aggressive given the rising level of unemployment which could very well lead to a decline in demand for Taleo’s services.  But despite the uncertainty in the business, investors are willing to pay more than 25 times earnings for a company expected to grow 12% next year.  That appears to be a bit optimistic and I wouldn’t be surprised to see the stock decline to a more reasonable multiple of 12 to 15.

The secondary offering set up a situation where a large portion of the investment base has a cost basis of $20.25 per share.  For the time being, it looks as if the underwriters are supporting this stock and buying shares to keep it above that level.  This practice won’t continue for long – especially if the market becomes weaker.  If the stock drops below the $20.25, then a good number of investors will be underwater and you could see selling pressure increase very quickly.  So one way to approach this opportunity would be to set an alert at $20.20 or close by so that you can short the stock once it breaks below the secondary offering price.

Speculative prices in growth stocks are likely to lead to losses in the coming months or quarters.  It is difficult to pick the correct timing for entry, but once the selling begins, I fear we could see significant investment losses mount.  So please use caution in today’s market and employ risk management strategies to protect your capital.  If you need help devising a defensive plan for your investments, feel free to contact me and I look forward to serving you as we navigate the market through the end of the year and into 2010.

FD: Author does not have a position in TLEO

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

Over the summer and into the fall, growth stocks have seen their share prices rise sharply as a violent shift from pessimism to optimism encouraged risk taking.  Arguably, many of these growth companies had been unfairly punished as the economic crisis created opportunity for some, and was simply not as bad as expected for others.  However, the unbridled buying of the last few months has pushed quite a number of growth stocks into excessively over-valued territory and many are vulnerable to sharp drops.

Netsuite Inc. (N) could be one of the next victims of the flight to quality.  The stock has recently fallen 22% from it’s recovery high, and that could simply be the start.  While Netsuite came public at a price of $26 in December of 2007, the company has failed to show any meaningful profitability and investors are losing patience as profit projections continue to be extended to later dates.

Management recently bragged that Netsuite logged its fourth consecutive profitable quarter, pointing to the company’s $0.01 earnings for the third quarter.  The earnings were on an “adjusted” basis while true GAAP earnings showed a loss of 13 cents per share for the quarter.  Adjusted earnings are certainly important for investors to consider, since many intangible items are included in the GAAP numbers.  However, even the adjusted earnings show a company that is clinging to marginal profitability instead of growing rapidly.

Earnings are a bit easier to manipulate than revenues.  While management can defer expenses and play around with the adjustments a bit, it is difficult to hide a lack of revenue growth.  So while the press release stated that the company experienced the highest number of Netsute One World (its flagship product) wins, the actual revenue came in at $41.7 million which is only 3% higher than the same level in 2008.  The decline in revenue growth has become a trend as 2008 saw the majority of quarters with 40% plus revenue growth, but the last four quarters have shown 30%, 22%, 10% and 3% growth respectively.

Our customer wins and new SuiteCloud partnerships indicate customers are running from legacy applications like SAP and Microsoft Great Plains to NetSuite’s cloud computing offerings. ~Zach Nelson, CEO

Another concerning statistic is a decline in the deferred revenue.  Companies like Netsuite usually sell annual subscriptions and often collect payment for a full years worth of service.  The company cannot book the full payment as revenue, because the service will actually be delivered in future quarters.  So the payment usually goes into the “deferred revenue” category and is realized as revenue in future quarters when the company performs the service.  If the level of deferred revenue declines, this can be ominous for revenue growth in future quarters.

The cloud computing service is certainly a growth industry, and has helped many companies save resources during a time when it is important to keep expenses low.  However, competition is heating up in this industry and the  majority of publicly traded companies are trading at extraordinary multiples.  It’s easy to see how investors could quickly begin selling shares at the first hint of trouble in the industry.

Most analysts are expecting Netsuite to earn $0.06 in 2009 and $0.14 in 2010.  This is a strong growth rate, but simply represents the huge percentage change from “near zero” to any positive earnings growth.  It is unlikely that the company will experience any significant earnings growth with revenue trends in such dismal shape.

The stock is currently trading north of $13.50, so even if the 2010 estimates are correct, the price/earnings multiple is roughly 98.  Unless the company continues to see its earnings double or more for several years, investors are likely paying too much for the hope of future growth.

To its credit, Netsuite does appear to offer a very attractive product, the company is being run with no debt, and technology advances continue to make it more relevant with new features such as an app for the iPhone.  However, as an investor, I am not willing to pay the current price for this growth story, and would be much more interested in shorting the stock and looking to cover somewhere south of $10.00.  Concern is beginning to creep back into the market, and we are seeing speculative issues get hit the hardest.  For now, Netsuite appears to be a poor place to invest your hard earned capital.

FD: Author does not have a position in N

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies