Credit and Debit card issuers, along with transaction processors were sharply lower on Friday after a Senate vote included restrictions on the fees that can be charged for these transactions.  The vote essentially allowed the measures to be included in the Financial Reform bill and the regulations could have a dramatic impact on the profits for many of the companies involved.

Transaction Processors

The two most important companies affected by this bill are Visa Inc. (V) and Mastercard Inc. (MA).  Both stocks were down sharply on the news – and both traded on heavy volume indicating institutional selling was extreme.

Visa is currently trading at about 20 times expected earnings for the year ending September, 2010 which is not an extremely rich multiple.  But the technical pattern is very sobering with Visa dropping below the 200 day average on huge volume.  Most investors are banking on the fact that Visa will see long-term growth rates near 20% as international expansion generates revenue growth – primarily from emerging markets.  But the US is a significant portion of the company’s established business and if the senate bill cuts down on fees for debit and credit cards in the US, it will likely lead to at least some pricing power in international markets as well.

Mastercard is in a similar position except for the fact that the stock has a much lower multiple.  When it appeared that consumer spending would be constrained as a result of higher unemployment, many analysts argued that Mastercard and Visa would continue to generate large profit increases with little risk.  The fact that these companies do not take on credit risk was a major benefit as opposed to the banks who actually lend to consumers and face the risk of default.  If the transaction fees are more heavily regulated and margins are constrained, that may significantly reduce the appeal of these companies to investors.

Discover Financial Services (DFS) is one of the short positions currently held in the ZachStocks Newsletter Portfolio.  Currently, we have a 4.4% profit in the position and I expect that number to increase over the next few weeks.  Analysts are expecting 309% profit growth in 2011 as the company faces fewer defaults and the economy becomes stronger.  But as the financial reform bill makes its way through the legislative process, there could easily be more unfavorable surprises for lenders like DFS – and the uncertainty abroad doesn’t help matters either.

The pattern on American Express Co. (AXP) looks quite disturbing as the stock has given back all the gains from its breakout in April, and volume was strong on the gap lower Friday (although not nearly as pronounced as Visa and Mastercard).  AXP has a significant debt level which is not a concern when markets are functioning properly, but could become a much bigger issue if liquidity freezes up and delinquencies rise.  A PE of 13.5 is not exceptionally expensive, but if analysts expectations for 2010 turn out to be aggressive, the intensity of selling could pick up.

What’s in YOUR wallet? Capital One Financial Corp (COF) has put together an incredible marketing effort.  But their earnings are just a shadow of what they once were.  With one of the biggest portfolios of consumer loans and credit lines, COF is finding itself square in the cross-hairs of regulators and may very well operate in a confined industry for years to come.  Don’t expect profit to grow significantly after 2010 unless the economy rebounds more strongly than even the most bullish economists expect.  The stock appears vulnerable after giving back gains from its most recent breakout and I wouldn’t be surprised if the current estimates prove too aggressive.

The bottom line is that regulatory uncertainty is a cloud that will continue to hang over companies associated with credit and debit transactions.  Long-term, regulations could eventually backfire on consumers, shutting down the availability of credit lines and inadvertently helping business lines such as payday cash advances.  The financial reform bill could be just as damaging as the healthcare bill when it comes to some of the key financial companies.   Surely, something needs to be done to protect consumers – and many of these companies have lost all sense of decency and ethics when dealing with their customers.

Regardless of what may look like reasonable (or even attractive) multiples, I wouldn’t take long positions in these stocks right now, and any rebound next week could serve as an opportunity to test some small short positions.  Given how far these stocks have rallied in the last several quarters, some profit taking is entirely possible, and significant declines could end up causing panic and additional selling.

Author has a short position in the ZachStocks Newsletter portfolio

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

While the historical numbers should be viewed positively (although analysts have become accustomed to the company actually beating expectations), the forward guidance was concerning.  Management is guiding investors to expect earnings between $2.50 and $2.70 for the second quarter.  This is an important quarter for the company given travelers tendency to book summer vacation trips.  Revenue is expected to increase 18% to 23% which is significantly below the 25.8% average expectation.

Guidance for the second quarter still reflects growth for the company, but challenges are certainly pressuring that growth:

The Iceland volcano caused widespread disruptions in air travel which resulted in a significant increase in hotel room cancellations for our Booking.com business. Civil unrest in Thailand has substantially impacted hotel room reservations in Thailand, which is a key market for Agoda and Booking.com’s Asia business. Lastly, sovereign debt concerns in Europe have resulted in a significant decline in the value of the Euro as compared to the U.S. dollar which adversely impacts our financial results as expressed in U.S. dollars. ~Jeffery H. Boyd, CEO

Priceline’s stock price has been extremely volatile over the last week.  This is in stark contrast to the sustained positive move which investors have enjoyed for well over a year.  After setting a low near $45 in December of 2008, the stock has rallied more than 500% to its recent high above $270.  And despite the sharp increase, the earnings multiple is not overwhelmingly expensive at this time.

Using the forward consensus earnings expectations of $11.21 for this year (which will likely be reduced after the earnings report), the stock is trading at just 18 times forward earnings.  But while that number may appear reasonable, I expect these expectations to be reset lower and potentially continue to be adjusted as we move through the year.

Debt issues in Europe are almost certain to continue to be a problem.  Yesterday (Monday) the Euro made very little progress against the dollar despite the fact that a $1 trillion dollar bailout package was put into play.  If the Euro can’t rally on this type of stimulus, then it is difficult to see what would pull it out of its decline anytime soon.

On top of that, the global consumer’s confidence may quickly be shaken as we deal with sharp volatility in the market again.  For over a year, a rising stock market (both domestically and abroad) has led to consumer confidence, and in turn has helped to propel consumer spending on many luxuries including travel.  Businesses have become more active travelers too as liquidity and corporate spending has become relaxed.

But if those trends are reversed, PCLN could be very vulnerable to a sharp decline.  If earnings for this year turn out to be 10% above 2009 and 2011 experiences the same type of growth, the market could easily use a lower multiple in the neighborhood of 12 which would yield a stock price closer to $112.  And if earnings actually decline in 2010 or 2011 the stock could fall much farther.

At this point it appears that the risks in owning PCLN far outweigh the possible returns.  While shorting outright at this juncture may be difficult (given intense volatility) active traders could consider selling out of the money calls (and possibly puts too) to capture volatility premiums.  Before engaging in this type of trade, make sure you understand the risks of selling options and have a plan in place to offset your losses if the stock moves against you.

If PCLN rallies back towards the 50 day average, aggressive traders could take a shot at shorting the stock with a tight stop.  The environment is changing for this successful travel business and I expect more weakness in the coming quarters.  As an alternative, investors could also consider shorting Ctrip.com International (CTRP) which could be under pressure both from weakening travel as well as less robust growth in the Chinese economy.

FD: Author does not have a position in PCLN

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

First quarter earnings came in roughly in-line with expectations at $0.16 per share.  This was good for a 23% increase over the earnings figure for last year.  Revenue narrowly missed expectations with sales coming in at $347.5 million as opposed to expectations at $348.9 million.  The difference is minuscule, but the failure of NILE to beat expectations is what will catch investors eye and likely cause concern.

Similarly, the guidance issued by management came in roughly in-line with expectations as management expects to generate $1.01 in earnings this year.  At Friday’s close – even after the sharp decline – NILE’s shares were still trading at nearly 50 times the expected earnings for this year.  It appears investors are still expecting great things out of the online jeweler.

Despite the perception of the jewelry industry collecting thick profit margins, Blue Nile appears to make a very small profit relative to its sales levels.  While the company selectively displays a 21.3% gross profit margin for the first quarter, the overhead expenses significantly reduce profits.  Total net income was $2.4 million compared to sales of 74.1 million – so investors realize just a 3.2% profit margin on the company’s sales.

Given the high multiple on the stock, I would expect a much larger return on company revenue.  Despite the luxury image, Blue Nile is basically a commodity retailer – buying diamonds and other jewelry, and turning it around at a small increase in price.  And without a showroom and pushy sales staff that is usually present in brick and mortar distribution networks, NILE can only compete on a price basis.  Basic economics say that this type of business must focus on volume instead of price – and sketchy sales growth over the last two years, the high stock multiple seems unjustified.

There are certainly some positive issues that could eventually help to support the stock.  NILE is sitting on an ample supply of cash with virtually no debt.  The company finished the first quarter with $47.2 million in cash.  Management has been using the cash to repurchase stock – and over the first quarter the company repurchased 292,100 shares at an average price of $52.04.

Usually, I would be a fan of a company using cash to repurchase shares.  The net result is a lower share count which can be accretive to investors.  But with the company also paying $50 for every dollar expected in earnings this year, the purchase price appears steep even for a company buyback.

Today’s broad rally in the market may be a gift for traders interested in shorting NILE but those who missed the break last week.  As I write, shares are up 2.5% on very light volume.  But looking at a larger picture, the stock broke below key support areas near $54 last week and is likely to test the February lows at $45 in the near future.

Ultimately, I believe NILE could trade back in the low twenties with an outside chance at dropping to “teenage” status.  If investors begin to realize that the middle class consumer is having difficulty, and correctly view NILE as a company that caters to normal working people instead of a luxury demographic, shares could begin trading at a multiple that is more akin to a low-margin retailing business.

New short positions should likely place a buy-stop order above $56 as a rally back up to this level would call the timing into question.  When trading short positions, stops are important as capital should be protected and losses managed.  At this point I view the trade as risking roughly $5.00 for the potential to capture $25 on the decline.  The risk appears overwhelmed by the opportunity for this name to trade substantially lower.

FD: Author has a long position in the ZachStocks Newsletter portfolio

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

However, despite the positive outlook and strong execution, I’m concerned that  FSLR could find itself in a trading range – or worse, in a negative trend as investors shy away from growth companies which rely on European customers.

With the financial world’s attention focused on the problems in Greece, and the growing concern that contagion could quickly spread to Spain, Italy, Ireland and Portugal, European commerce could quickly come under pressure.  Germany has been one of the few stalwarts of strength, but even the fiscally conservative country could find itself with serious losses as the government is faced with the task of bailing its neighbors out.

To be sure, the crisis in Europe is nowhere near contained, and it is difficult to handicap the potential danger, and the ways that mounting sovereign debt could affect the broad global economy.

Germany has had one of the most liberal solar stimulus programs, encouraging the use of alternative energy and helping to boost the profits of solar companies that operate across Europe.  My understanding is that stimulus programs were already in the process of being wound down before the crisis truly became big news in Europe.  Now that Germany is more likely to be on the hook for a huge bailout, the stimulus programs are even more likely to be curbed – which could have a material effect on sales levels for solar manufacturers across the board.

As you can see in the chart below, Germany makes up a significant amount of projected demand for solar energy

First Solar is not particularly expensive given its strong profits and past record of growth.  But at 22 times current estimates for 2010 earnings, investors are pricing in robust growth which may be much more of a challenge as the European crisis evolves.  On top of that, FSLR appears to be on the acquisition trail as it announced a purchase of NextLight Renewable Power and could make additional purchases with its leveraged balance sheet.

There are a few positive issues that could help support the price of FSLR.  For starters, the company has little debt which will likely give the firm a competitive advantage if we enter another difficult period for solar.  In this case, acquisitions might be a strong benefit to the long-term value of the company as cash-starved competitors could sell out for attractive discounts as they would be unable to remain solvent under heavy debt loads.

Also, there is the BP oil spill which may add to pressure for more “safe” energy sources.  If oil drilling comes under tougher sanctions, we may see higher demand for solar energy as a result.  Such a move would benefit the entire industry and with FSLR as one of the leaders, it could receive higher levels of new orders.

But today, it appears the safest bet on FSLR is for a lower price.  Speculation is being punished and the solar industry is certainly one with high risks and cloudy visibility.  Investors are likely to bail out of these growth positions until the environment becomes clearer and until that happens FSLR shares could easily lose a third of their value to trade back down to the lows from February.

FD: Author does not have a position in FSLR

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

Pizza and beer are a good combination and BJ’s appears to have perfected the art of offering an exceptional neighborhood “feel” while still expanding the number of locations to 94 at last count.  Over the last four quarters total revenue has increased anywhere from 9% to 19% (year-over-year).  The strength is both due to existing restaurants seeing improving sales, and new restaurants coming online.

In the first quarter, BJRI opened two new locations.  Management is guiding for an additional 2 openings this quarter with expectations of four new stores in the third quarter and another 2-3 in Q4.  So for the full year, there will be 10 to 11 new stores in play and generating revenue for the company.

While management seems pleased with the rate of growth, I am worried that investors are setting themselves up for disappointment when it comes to the future growth of the company (and the stock price).  Expanding by 10 to 11 new stores is hardly a “high-growth” rate of openings – basically an 11% to 12% store base expansion.  This rate would be good for a well-established chain like Applebee’s, but is not very impressive for a small pizza chain with high hopes.

Don’t get me wrong – I believe that in the current retail environment, it makes a lot of sense for a company like BJ’s to be very conservative in how many stores they open.  If consumer spending becomes weaker as a result of high unemployment and the potential for stimulus measures to decline, then BJ’s will want to keep a higher cash balance and be very selective about where it opens new stores.

But investors appear to be much more aggressive in their growth assumptions.  Currently, the stock is trading at 36 times expected earnings for this year.  This during a time when same-store-sales are increasing by just 4.4% and most of the growth should come from new locations, not from better revenue in existing locations.  In fact, management recently unveiled a new menu with smaller items at lower prices.  The decision may help the company keep customers loyal, but will likely result in lower profit margins for the entire firm.

Shorting BJ’s may be a bit of a dangerous game because the float is very small (only 14 million shares are actively traded), which could lead to a “short squeeze.”  This occurs when too many short sellers have negative positions and the stock begins to rise.  At times like this, traders can feel trapped as they are forced to buy back shares which lead to higher prices.  But after a short squeeze in less-than-liquid names like BJRI, the opposite can easily occur with the stock dropping sharply as fundamental metrics lead to a much lower price.

Based on my concern for  the retail sector, along with my respect for the company and the conservative approach management is taking, I believe BJRI could easily command a multiple of 20 times this year’s earnings.  Unfortunately, that metric would bring the stock to about $13.60 which would be a significant decline from current levels.

Aggressive traders might want to consider buying puts on the restaurant chain which would allow for the volatility associated with a smaller-illiquid name, but still give traders an opportunity to capitalize on a potential decline in the stock.  The July 22.5’s look attractive to me, trading at 85 cents.

The environment for today’s retail investor is quite treacherous.  With high expectations for growth and inflated prices, there is plenty of room for disappointment – resulting in lower prices.  I would avoid long positions in the group, but if you must have exposure, be sure to keep close stops or hedge against potential losses.  Once earnings season is over, there is a good chance many of these high-momentum names will back off quickly.

FD: Author does not have a position in BJRI

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

But this week, the retail index has fallen a bit behind the broad market action, which makes me concerned that the sector may be losing its leadership.  Tuesday was a difficult day for nearly every sector as Greek worries led to a sell-off in widely held growth names.  It was completely normal for retail to be hit especially hard because the industry has become a “high beta” or more volatile area for traders.

As stocks rebounded on Wednesday and Thursday, however, retail as a whole had very little strength.  If managers were really putting more capital back into speculative issues, one would expect retail to have been back to it’s Monday highs by the end of the day yesterday.  As it stands, early Friday, the SPDR S&P Retail (XRT) was back down nearly to the lows set at the close on Wednesday.

If retail is weakening as a sector of choice for growth managers, then there will likely be many dynamic stocks which make for good short opportunities within the sector.  Lululemon Athletica (LULU) is one that looks particularly interesting.

The yoga-inspired athletic apparel company has been growing its retail presence from what used to be primarily a Canadian chain – to a well established US presence.  The chain appeals primarily to up-scale athletic women (although the company’s men’s concepts are starting to pick up traction) with high prices that assure fat profit margins and a certain quality premium perceived by clients.

Many of the textiles incorporate seaweed which is supposed to be soothing for skin, and the company prides itself on offering much more than just apparel.  Lululemon typically employs professional trainers to serve customers, ensuring that customers pick out the perfect items for their own workout regimen, and offering training tips and guidelines along the way.  For LULU customers, the shopping experience is just as important as the products they walk out of the store with.

While the concept has been very successful and I have owned the stock for gains shortly after the IPO, LULU is now trading at a multiple that warrants concern.  Investors are expecting strong 30% plus growth for the next two years which will be easy for management to hit if the consumer really is organically stronger.  But if consumer spending is propped up by government stimulus or strategic defaults, the whole house of cards could come crashing down.

At this point it looks like the risks of a softening retail market are too big to ignore.  At the same time, the technical pattern on LULU is also very concerning.  After topping out over two weeks ago near $45, the stock has lost a good bit of value on heavy volume.  And it looks like there could be further weakness in store.

In early February as the market was dealing with the last correction, LULU bottomed at $25.75.  At the time, investors were worried that a weak consumer could crimp growth or even cause retail earnings to contract.  Once those fears were alleviated, the industry traded sharply higher – due in part to temporary effects of stimulus and mortgage defaults.

Once it becomes clearer that the consumer is not as healthy as commonly perceived, analysts will likely ratchet down their estimates – and investors could also cut back the multiples they are willing to pay for equities.  If 2012 estimates for LULU were cut from the current $1.39 to just $1.18 (only a 15% decrease) and investors paid a still robust multiple of 20, the stock price would fall more than 30% to $23.60.

Based on the price action of LULU, and the potential for estimates and multiples to shrink, I would recommend a short position with a tight stop.  Obviously, the bulls could still step back in and support the market and retail stocks particularly.  But it appears the risk of further weakness trumps the optimism we have experienced for so long.

FD: Author has a short position in Client Accounts

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

Since most homebuilders are still operating at losses with huge inventories of homes and land, and stifling levels of debt, the move indicates that institutional investors are very optimistic about the nation’s economic recovery.  It will take a significant increase in wealth, along with a much better employment picture for the lofty prices on most homebuilders to be justified.

But just as the euphoric trading was catching the eye of momentum and breakout traders, Tuesday ushered in a new dynamic for growth and speculative issues.  The catalyst was renewed concern over a default of Greek debt, but the broad effect was a move away from risk by a large number of influential traders.  While the benchmark indices took on water, homebuilders quickly gave up gains from last week’s breakout and now look vulnerable to fall much further.

KB Home (KBH) builds single family homes, condos, and townhomes in 10 states across the US.  The stock had recently broken out above a consolidation area at $18.00 and immediately added more than 10% to top out near $20.  But the “risk off” trading on Tuesday negated the breakout and caused investors to lose nearly the entire gain from the previous week.  Speaking as a trader myself, this kind of volatility would cause me to re-think a long position even if I was confident in the company’s fundamentals.

As it stands, KBH isn’t exactly in great shape fundamentally, and significant risks are still in place.  Quarterly revenue numbers continue to decline although doing so at a decreasing rate.  Still, the company has reported major losses totaling $2.64 per share in the last year alone.  Analysts expect the company to lose “only” 89 cents per share this year which ends November 30, and then a gain of $0.65 is projected for the following year.

Even if the 2011 guestimates turn out to be accurate, the stock is still trading at nearly 30 times forward earnings – a difficult multiple to justify given the losses and risk of a stall in the economic rebound.  During the last quarter management tried to paint a pretty picture of the housing market, but reading between the lines it appears there is still significant concern:

Encouraging data in recent months suggest that a number of housing markets may be stabilizing or starting to rebound, though we do not yet see, in many respects, a sustained nationwide recovery.  While the pace is likely to be uneven in the months ahead, we currently expect housing market conditions to follow a generally positive trajectory throughout this year and into 2011. ~Jeffrey Mezger, CEO

With Europe continuing to be a significant red flag (I don’t think US investors realize how our fortunes could be closely tied to the international events) and US unemployment stubbornly high, I believe a rally in the homebuilding sector is premature.  We have already seen how quickly the homebuilders can give up gains when managers decide to reduce their risk levels.  Imagine what would happen if managers truly kept this mindset for more than just a single day.  In this case, I would expect homebuilders, retail stocks, many China plays, and a few other speculative sectors to take on water.

The ZachStocks Newsletter has a short position in another related homebuilder.  This luxury builder has recently had to write down the value of its land inventory which has a negative effect on book value.  I’m expecting a 20% decline in this stock along with similar negative action for the entire sector.  So if you are long homebuilders, it may be worth lightening exposure on today’s strength.  The temporarily higher prices may provide a decent short entry, and at the very least, investors should have an exit or hedging strategy in place to carefully manage the risk.

FD: Author does not have a position in KBH

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

Despite the “alternative energy” name, Solarwinds is actually a network company which seeks to identify and solve network performance issues.  The company has a broad client base – boasting 93,000 customers at the end of the first quarter and offers a wide assortment of solutions:

• Network Monitoring
• Configuration Management
• Network Traffic Monitoring
• App & Server Monitoring
• IP Address Management
• IP SLA Monitoring
• Virtualization Monitoring
• Wireless Monitoring
• Network Mapping

I’m not a tech guy by any means, but I can tell you that investors were excited about this relatively new stock because of the broad number of services the company offers, and the potential to cross- sell these services to existing clients.  The idea is for the company to get their foot in the door by selling one service, and then quickly explain why the customer needs a full bundle of services to operate efficiently.

Up to this point, it looks like the company has been very effective in growing its revenue base.  The first quarter showed a revenue increase of 43% over the same quarter last year.  The business was nearly evenly split between license revenue and maintenance revenue.  The maintenance business is a bit more valuable to investors because this is largely recurring revenue with stability quarter after quarter.

But looking at management’s projections, it appears the growth rate is likely to contract considerably – which is a major concern for investors.  For the second quarter, management is guiding revenue of $36 to $37.8 million which is at best a 40% increase over the second quarter of 2009.  For the full year, revenue is expected to be $159-165 million.  This indicates that management is expecting a significant pickup in revenue for the third and fourth quarters in what is known as a “back end weighted” year.

Essentially, management is asking investors to take a “leap of faith” stating that revenues will be in the mid 30 million level for the first two quarters – and then the high 40 million range for the third and fourth quarter.  Unless there is a particular contract that management expects to land – and the timing is very specific, it would seem that the back-end weighted guidance is sketchy at best.

Despite the 15% drop in Tuesday trading, the stock still appears to be over-valued based on earnings expectations.  Management is guiding analysts to expect 72 to 75 cents per share this year which only represents an increase of 15%.  But at $20.50, the stock is trading at 27 times the high end of guidance.  This multiple might be reasonable for a stock in the middle of a strong growth period, but with heavy competition, disappointing growth projections, an extended and vulnerable market, and a technically broken stock chart; the risks seem to far outweigh the potential benefits of owning the stock.

Shorting SWI today may be a bit premature.  With the market likely to at least stage a rebound attempt from the sharply negative trade today, I wouldn’t be surprised to see SWI consolidate or even trade back to the $22-23 range.  But with the technical breakdown we have seen today and the potential for more selling as managers become less confident in the recovery, the stock will remain on my short list and could potentially trade back down to the IPO price of $13.

FD: Author does not have a position in SWI

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

One of the three most speculative (and potentially dangerous) areas appears to be investments in Chinese companies showing attractive growth.  With the nation reporting strong GDP growth and the middle-class consumer population expanding rapidly, many investors are willing to pay exorbitant prices to get a piece of the action.

Ctrip.com Intl Ltd. (CTRP) is a healthy, growing China travel company with a business model similar to Expedia.com (EXPE) or Priceline.com (PCLN). The company has seen growth accelerate coming out of the financial crisis as China travel has gotten a healthy boost.  In March, CTRP  broke out to a new high, exciting the bulls – only to be turned back as China stocks fall under pressure.

There is a specific catalyst brewing which could technically become an Achilles heel for the stock on a short-term basis.  On March 4, the company announced that they had sold 5.7 million ADRs to the public at a price of $36.00.  Goldman Sachs (GS) was the book runner on the deal and likely distributed the shares to favored clients.  The deal was well accepted to begin with, and initially investors made a double digit percentage return on the new shares.

But as the stock trades lower, CTRP is once again approaching that break even price where investors picked up the new shares.  There is nothing magical about the $36 price or any other point on the chart, but the interesting thing about markets is that they are dictated in the short-run by human emotions and cycles of fear and greed.

Investors who bought at $36 and were initially shown a strong profit, are much more likely to get discouraged and dump the shares if this price point is broken.  This is just as true for institutional investors as it is for individuals – I know – I’ve been on both sides of the desk…  So if CTRP crosses below this line, it could be a catalyst which would ignite a much more dangerous drop in the stock.

Valuation and Sentiment Add Fuel to the Fire

For quite some time now, CTRP has been trading at a valuation that some consider unsustainable.  At today’s price, investors are paying $40 for every dollar CTRP is expected to earn in 2010, and it’s difficult to have much confidence in the 30% gain projected for 2011.  Such high valuation isn’t necessarily enough reason for investors to immediately sell, but if the pattern changes and the trend becomes negative, investors will have a harder time justifying a position in a stock with a multiple of 40.

Sentiment surrounding China is also a bit of a concern.  From all that I read, it appears that investors are anxious to gain exposure to this vibrant growing economy.  But the political risks, currency issues, fiscal policy disconnects between China and the US, and the mounting evidence of a real estate bubble in China all cause concern.

This week CTRP has had two high volume negative days as the stock broke through the 50 day average and has briefly touched the $36 level.  I would suggest watching this price point carefully as the immediate danger would be for the stock to trade to its February low of $30 – and potentially much farther if broad sentiment begins to shift.

As always, manage your risk carefully.  There are many ways to structure a short play on CTRP – including using options, inverse ETFs or other methodologies to offset risk.  The danger of CTRP breaking to a new high should not be ignored, but the shifting trend appears to favor the bears on this speculative name.

FD: Author has short positions in client accounts Enjoy this article? Sign up for the ZachStocks Newsletter, Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies

We’re in a different world now that the SEC has announced its lawsuit against Goldman.  I mentioned over the weekend that I didn’t expect the market to trade down immediately, but over the next few weeks and months we should see a dramatic change in the leadership on Wall Street – and in the premium prices investors are willing to pay for growth.

Monday’s market action was very interesting in that the blue chip indices (Dow and S&P 500) both traded higher, while more speculative indices (Nasdaq, Russell 2000, Small caps) actually lost more ground.  It looks like managers may still be willing to prop up the bull market, but they certainly want to be owning stocks they can justify from a quality basis rather than spinning a yarn about the future growth prospects.

If this “flight to quality” trend picks up speed, we could see a huge drop in small cap prices – especially the names with large multiples and optimistic but very subjective future earnings growth.  The short opportunities could be tremendous as investors deal with the compounding effect of lower earnings projections and lower price multiples.

Consider a company expected to earn $2.00 per share in 2010 and trading with a forward multiple of 30 (the stock price would fall at $60.00).  If analysts decreased their earnings projections by just 20%, and the market took 20% of the premium multiple off the price, the result would be a decline of 36% ($2.00 estimates would drop to $1.60 and the multiple would drop from 30 to 24).  For more speculative vehicles, the decline could be even more pronounced.

VMWare Reports After the Close

The cloud computing industry is one of the more speculative areas of the market with analysts expecting robust growth, and stock multiples trading at levels that would require excessive growth to justify.  VMWare Inc. (VMW) is currently trading above $55 despite the fact that the company is only expected to earn $1.19 per share in 2010 and $1.39 in 2011.  The company’s technology is tremendous…  But the price on the stock assumes that analysts are dead wrong and the company will grow earnings by a much higher rate.

As with any market or economic call, there is always a chance that an assumption will be proven false.  VMW may in fact grow by leaps and bounds over the coming year.  A technology upgrade cycle could lead to a broader customer base, and even a difficult economic period could cause more customers to use VMW’s services to cut costs and grow efficiency.

But the problem is that the stock price is already pricing these positive outcomes in.  What appears to be missing is the opportunity for competitors to eat into market share, for new technologies to make VMW obsolete (or at least a bit less competitive), for capital expenditures to eat into profit margins and disappoint short-term holders…  When stocks trade at these levels, the risk is tremendous and the chance of outsized positive returns become less likely.

VMWare reports after the close today and the stock is currently up 32% on the year.  Regardless of what the company says in the report, I expect the stock to have a muted or even negative reaction.  Think about it – If management says “everything is great and we’re expecting strong growth in 2010,” the stock has already assumed this is true…  The likelihood of a further advance is modest at best.  However, if management says “We’ve had a great quarter and our backlog is at the same level it was last quarter,” investors will likely be disappointed.  The odds seem stacked against the holder of this stock heading into the report.

Handicapping the Report

Although I have confidence that VMW will not trade significantly higher from the current level, I’m not willing to put too much risk on the table.  Earnings reports can offer a significant amount of volatility and if it takes a few days for the reality to sink in, I don’t want to be left holding a straight short position that continues to rally.  So to play for a sharp drop in the stock, I would consider implementing the following series of options trades:

• Buy the May 50 Puts for $1.00 per share
• Sell the May 60 Calls for $1.40 per share
• Buy the May 70 Calls for $0.30 per share

Putting all of these three trades on simultaneously, allows you to capture profits if VMW trades sharply lower between now and May options expiration.  The total dollar amount for this trade is actually a credit of 10 cents per share – which means you are paid to take this position.  (the credit will likely cover commission costs if you use a decent discount broker)

The risk on this trade is that VMW trades sharply higher from this point.  If VMW closes anywhere between $50 and $60 before expiration, all options will expire with no damage.  However, between $60 and $70, there is risk and the worst case scenario would be losing $10.00 per share on the trade.  The calls at $70 keep us from any further exposure.

A price of $70 is very unlikely given the high multiple and the challenges VMW has had in growing top line revenue or bottom line earnings.  But despite the unlikely nature of this loss, one still has to account for that possibility.  On the other hand, if VMW starts trading for a still aggressive 30 times 2011 expectations, the stock could quickly drop below $42.

So consider using this options strategy ahead of the earnings announcement, but as always, do your homework and understand the risks of trading any vehicle before stepping into a trade.

FD: Author does not have a position in VMW

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

At risk are many of the sectors which have seen the most speculative buying since the most recent January swing low.

Markets have continued to motor higher, and recently the crossing of major points of interest (11,000 on the Dow and 1200 on the S&P 500) has had a major psychological effect on short exposure.  For the most part, short-sellers have picked up stakes and gone home – leaving the market more vulnerable to a significant drop.

When there are enough short participants in a market, that can help to add support.  This is because profit taking occurs when markets fall – and shorts covering profitable positions can sometimes be the majority of buying interest in certain stocks or sectors.  With very little short interest, a significant drop in speculative sectors could go un-checked and lead to more volatility.

So due to high levels of speculation and risk – and with the next inclination likely to be a flight to safety, here are the three areas I think traders should be most interested in shorting.

Consumer Discretionary / Retail

The retail industry has logged some impressive gains since the pullback in January / February.  After hitting a low on February 5, the retail HOLDRS (RTH) made a new recovery high in just 20 days, and has continued to march steadily higher.

Individual retailers have been reporting a pickup in sales levels and with inventories largely low and overhead costs also reduced, the profitability increase has been tremendous in some cases.  For the most part, the profitability increases has been boosted by one time issues (it’s unlikely that companies will continue to cut overhead and inventories are already picking up in anticipation of stronger demand).

The same could be said about the consumer demand for goods.  Especially if you buy into the concept of strategic defaults boosting consumer spending.  Since I have written the article on strategic defaults, I have received what I would consider a bi-polar response with many outraged readers suggesting the concept is ludicrous, while the other half actually know at least one (if not more) friends or neighbors engaged in a strategic default situation.

The ability to spend more through living rent-free in one’s house (by simply not paying the mortgage) cannot continue indefinitely and when this practice is stopped, it is likely consumer spending will once again decline – especially since employment numbers have yet to show much in the way of recovery.  When consumer spending is called into question – or simply when managers start applying the “risk off” portfolio management, retail stocks could take the brunt of the selling.

Shorting the RTH vehicle is one broad way of capitalizing on this movement, but it may be more profitable to focus on some individual stocks which have experienced significant gains and could be due for a pullback.  Stocks that quickly come to mind (for more research later) include Abercrombie and Fitch (ANF), Ann Taylor (ANN) and potentially Lululemon Athletica (LULU).

Domestic China Companies

Strong economic growth in China has attracted significant foreign investment and led to strong price appreciation.  While speculative buying has supported strong price multiples, another issue has been reduced supply of available investment vehicles.  Since the Chinese government restricts the amount of financial assets available to foreigners, mutual fund managers and other institutional investors have found it difficult to secure their desired level of exposure to China.  By nature, a low supply of an asset coupled with strong demand will result in higher prices.

With current prices already reflecting strong long-term growth for the Chinese economy, it would only take some small disappointments for this sector to begin to fall.  The strong GDP reports are likely to cause the government to be more aggressive, tightening regulations on the banking sector which would reduce available capital to industry.  As these measures are enforced, the Chinese economy could continue to grow at a slower pace, but the stock prices could decline sharply to reflect the lower growth rate.

Two easy vehicles for investors to trade are the iShares MSCI Hong Kong (EWH) and the iShares FTSE/Xinhua China 25 (FXI).  The EWH includes a broader section of the Chinese economy, while the FXI has a larger financial concentration.

For a bit more volatility (and potentially larger gains) traders  could consider short positions in individual China companies:

• E-House China (EJ) – A real estate agency whose profitability is closely tied to property transactions in China’s overheated real estate market.
• Baidu Inc. (BIDU) – The well-known Google competitor running online advertising and internet search capabilities.  The stock has a strong trend but investors are paying 63 times this year’s expected earnings.
• Home Inns & Hotel Management (HMIN) – A Chinese hotel manager with a high multiple and declining revenue growth.  The hotel industry is closely tied to a vibrant economy and any hiccup could send the stock sharply lower.

US Regional Banks

During the last financial crisis, many of the largest banking institutions were deemed “too big to fail” and were subsequently bailed out or backstopped by the US government.  While it is certainly not fair, the majority of US regional banks are decidedly NOT too big to fail and face significant risks in today’s environment.

A rising stock market and improving confidence has led many investors to overlook balance sheets with excessive leverage, and the impending danger of write-downs.  Commercial mortgages still comprise a major risk to regional banks and many of these loan portfolios are still being carried at valuations which imply economic health and little risk of default.

If the Goldman news causes a new “risk off” dynamic with lower amounts of liquidity and a focus on what could go wrong instead of only what could go right, the multiple on many of these smaller and more vulnerable banks could decline sharply.

There are two primary ETFs which were designed to track the regional banks – the iShares DJ US Regional Banks (IAT) is comprised of some of the largest regional banks like US Bancorp (USB) and BB&T Corporation (BBT).  While these banks may be vulnerable, they may also still fit into the “too big to fail” bucket and be propped up by the government in some shape or fashion.

For this reason, I’m more interested in the SPDR KBW Regional Bank (KRE).  The ETF is made up of many smaller banks and even its largest holdings only represent a small portion of the total fund.  Shorting this vehicle will give traders more exposure to the general factors that affect the small traditional US bank, and looking through the top 25 holdings for this ETF (which can be found on Morningstar.com) could yield some individual picks that are even more powerful.

Timing is Everything

Timing will be key when laying out shorts in the post Goldman lawsuit period.  My expectation is for bulls to step in early this week and prop up markets.  After such a stunning run for the last 6 weeks (and for the last 12 months for that matter), it is hard to imagine the market rolling over and heading directly south without at least a week or two of wrestling.

Using reflex rallies to lay out shorts may help to cut risk.  At the same time, small positions could be initiated right away so that if the bearish sentiment takes hold immediately, at least we have some exposure taking advantage of the new trend.

For long positions in these three sectors, I would urge caution.  True investors may want to hold these positions long-term for better tax treatments and for fundamental reasons.  If this is the case, it may make sense to sell calls against individual stocks to create some income and reduce the risk, or potentially buy inverse ETFs which can generate gains while the market falls.  This could help offset traditional exposure and lead to better long-term profitability for your portfolio.

The ZachStocks Newsletter will likely begin adding short positions later this week or early next week.  At this point we are waiting to get a better feel for the market reaction, but should be able to use a reflex rally to step into some profitable shorts at appropriate risk / reward ratios.  The important thing for traders to do at this point is to continue building a watch list of appropriate short candidates so that when the decline begins in earnest, we will have a robust list of short candidates.

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

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

While at first blush the prospectus states that the shares are primary (with the shares being distributed to the company) further reading highlights the fact that private equity holders will actually retain the majority of funds from this transaction.  In no more than 60 days, the company is required to make an offer to purchase Payment In Kind (or PIK) notes which are held by the asset manager Apollo Group and some of its subsidiaries.  So while all the information is public, it appears this is a bit of a stealth deal to allow Apollo to cash out.

At this point there is still significant incentive for Apollo Group to support the stock and also provide MUSA with the necessary support to grow its business.  While 11.4 million shares were offered to the public, a full 37 million shares are outstanding with Apollo Group still owning a majority position.  I wouldn’t be surprised to see these additional shares hit the market later in the year – especially if equities markets continue to price in a recovery scenario.

Metals USA is an industrial company which is heavily dependent on sustained economic growth.  In the prospectus, management indicated that they expect demand for steel products to increase alongside improving general economic conditions.  The company believes that its customers are continuing to operate with low inventory levels which could bolster demand if these inventories are rebuilt.

To show how economic conditions affect this company, consider the wide swings of the last three years.  In 2007, the company collected $1.8 billion in revenues and produced 55 cents in earnings per share.  2008 was an even better year with revenues of $2.2 billion and earnings of $2.87 per share.  But 2009 was quite a challenge – revenues were cut in half to $1.1 billion and through cost cutting and managing expenses MUSA was able to generate just 14 cents per share.

Improving trends this year should push earnings higher but we are unlikely to see returns similar to 2008.  It is very difficult to forecast future growth because manufacturing and broad economic conditions are so unpredictable.  But lately the price of steel has been rising and competitors like US Steel (X) are expecting strength in 2010 and a much more profitable year in 2011.

MUSA operates three primary business segments

• Plates and Shapes accounted for 47% of 2009 sales
• Flat Rolled and Non-Ferrous commanded 45% of revenue
• Building Products is much smaller with 8% of revenues.

Looking through the prospectus materials, it is clear that the company has been slowly working both its inventory and its debt level lower.  This should provide a more stable fiscal foundation which is encouraging for shareholders.  But the failure of the IPO deal and the overhead resistance from Apollo’s shares which could eventually be dumped on the market will likely keep this stock lower.

As I write Thursday, the stock is trying to rally a bit and very well make a run back towards the IPO price.  If it reaches $20.50 or even $21, I will be interested in setting up a short position.  The position would not be entered until the stock began to fall again, but using a sell stop to get short and a tight stop above the IPO price, there is a good chance that traders could capture $2 to $3 in profits quickly, while only risking about $1.00.  Timing is critical and it might take more than one trade to get it right, but busted IPOs are some of my favorite short opportunities to pursue.

FD: Author does not have a position in MUSA

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

The retail sector has been particularly strong as it appears that strategic defaults are driving a significant amount of spending.  Optimism may also be increasing which is driving consumers to be more willing to spend – and consequently driving savings levels lower.

While consumer cash flows may be increasing towards discretionary purchases, the value of many discretionary spending stocks appears to show not only the expectations that the consumer will remain strong, but also proves that Wall Street to a large degree buys deeply into the recovery theory.  Take, for instance, the speculative price on OpenTable Inc. (OPEN), a computerized reservation and table management system for restaurants.

The business model is sheer genius for strong economic times.  Restaurants are able to subscribe to Opentable’s software on a monthly basis and gain not only publicity and exposure, but also better manage their flow of guests during busy periods.  Diners also have an advantage as they are able to book reservations quickly and easily, view information about different restaurant choices in their area, and even view a menu before deciding where to eat.

Opentable relies on economies of scale to cover overhead expenses and generate attractive earnings.  At the end of the fourth quarter, there were 10,850 restaurants in North America using opentable’s program as well as an additional 1,501 restaurants internationally.  According to the fourth quarter press release, there were over 12 million diners seated during the period which was up more than 40% from the fourth quarter of 2008.  Tapping into today’s mobile handset market, the company recently announced that it had seated its 2 millionth diner through booking over a mobile device.

Analysts believe that the future is bright for the company as well.  The current estimate is for earnings growth of 45% in 2010 to 45 cents per share.  While it seems almost impossible to predict dining trends in 2011 (given the uncertainty of the current economic climate) analysts are handicapping another 44% increase to $0.69.  The commentary out of the company is positive – to be expected – and management expects a positive year ahead.

We’re energized by the opportunities in front of us and are focused on helping our restaurant partners grow and providing diners with the convenience of online, real-time restaurant reservations.”  Jeff Jordan, CEO

While I’m impressed with the way this business has been built – and will likely use the service myself in the future – from an investor’s standpoint I have some significant concerns.

The first potential issue is that there are basically no barriers to entry for competing firms.  Anyone with a few thousand dollars or some technical know-how could replicate the main components of OPEN’s software.  There doesn’t appear to be anything keeping a copycat entrepreneur from creating a similar business platform which would eat into the niche that Opentable has built.  And as OPEN becomes more successful and generates significant profits, the environment for competitors will become even more tempting.

Secondly, management currently owns 61% of the company.  While I typically like for management to have a significant stake in a growing business, the controlling ownership makes it very difficult for shareholders to implement any changes should they disagree with management over particular business issues.  At the same time, management appears to be slowly liquidating shares through exercising options and selling the stock.  It makes sense for officers to be able to capitalize on the company’s success, but if this trend increases it could become more concerning.

Finally, the stock is trading for an overwhelming 80 times 2010 earnings – much more than most investors should be willing to pay even for a great growth opportunity.  I definitely expect OPEN to trade at a fat premium due to its unique business and the success it has enjoyed so far.  But the market is essentially projecting 40% growth for several years and any disappointment could quickly send shares back down to the $25 area where it was trading in January and February (or potentially even lower).

Trading is a difficult and sometimes counter-intuitive game.  Over the weekend I wrote a piece on the difference between value-based investing and technical trading.  This piece might be helpful in analyzing the potential trend for OPEN over the coming weeks and months.  At this point, OPEN has strong momentum and may very well continue trading higher as investors brush aside risk concerns.  I’m not brave enough to step on this train – I believe the risk is too great at such lofty valuations.

But shorting this stock is a dangerous undertaking if timing is off.  I would keep OPEN on the watch list for now and look to short after a failed breakout attempt (which may be forming now at the $39.00 level) or possibly on a break below $35.  It will be important to confirm that the trend is in fact lower, and that there is an appropriate stop point to minimize risk.  OPEN will likely turn out to be an excellent short sometime this summer, but traders must first have the patience to wait for it to falter.

FD: Author does not have a position in OPEN

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

The ample liquidity has allowed new companies to raise capital to build their businesses, and has also allowed private equity investors to unload positions at a profit as the public market snaps up shares.  Last week Citigroup (C) took the position of a private equity player by selling a large portion of its position in Primerica Inc. (PRI).  The stock was issued to the public at a price of $15.00 and quickly began trading near $20.

Investors are likely very happy with their 30% plus gain in a single day and it looks like Citi may have sold itself short, as it could easily have collected $17 or $18 for the stock and still made investors very happy.  Fortunately for the company, it still owns roughly 40% of the company so it should be able to write up the value of its holdings.

The transaction has certainly benefited Citi as the company was able to raise roughly $300 million.  That number is actually very conservative because as part of the convoluted transaction, Citi issued warrants to Warburg Pincus LLC, and also was the lead underwriter for  the stock – meaning Citi was able to keep a large portion of the underwriting discount usually paid to brokers who place IPO stock.

Primerica could be considered a “low-tier” financial services company whose primary business is selling life insurance.  The target client includes middle income families with $30,000 to $100,000 in annual income.  The prospectus lists these client as:

• Having inadequate or no life insurance coverage
• Needing help saving for retirement
• Needing to reduce consumer debt
• Preferring face-to-face meetings for financial decisions.

While this target market covers a large percentage of households (Citi estimates the demographic at 50% of US households), the margins on this segment of customers is usually relatively low.  That is why Primerica was considered the perfect solution for Citi – allowing middle income households to be served by Primerica while the Citi financial professionals focused on the bigger and more profitable clients.

Why gold will not make new highs or lows this year

The problem that I have with the Primerica business model is that the representatives often take a multi-level marketing approach to building their client base.  In the prospectus, Primerica speaks of “independent entrepreneurs” who are responsible for building and operating their own businesses.  These representatives are classified as independent contractors and are not official employees of Primerica.  Many of these “financial representatives” are part-time workers and Primerica actually encourages this aspect in order to attract more representatives.

The end result is that many of these representatives have little experience, a deficient knowledge base, and may not be giving the best advice to clients who need financial information.  While there are of course exceptions, Primerica has become known as the “Amway” of financial services – a reputation Citi would like to distance itself from.

I must say that I am a bit surprised at how well the IPO has been accepted by the market.  Financials are still a bit sketchy as it is difficult to understand the pro-forma numbers presented in the prospectus and account for the adjustments.  Below is a flowchart of the organizational structure which shows the convoluted state of the offering.

With this much complexity, I would avoid buying the IPO at this point as the market hates uncertainty and once the hype of the IPO wears off the stock could drop quickly.  Farther down the road, I expect Citi to unload the rest of its  shares and Warburg will likely exercise its warrants and liquidate the shares as well.

Aggressive traders might consider shorting below $19.60 but don’t get too greedy.  Citi will defend this stock vigorously as they still have a vested interest in the deal working.  So the stock could drop to $17 or even $16, but the IPO price is important for Citi to defend so I would expect them to start buying aggressively at the $16 level.

Typically an IPO that trades well out of the gate is likely to continue its positive trend.  But Primerica is a different animal and I wouldn’t put too much confidence in the positive initial reaction.

FD: Author does not have a position in PRI

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

But today, many of these trends are shifting as US companies are benefitting from stimulus incentives aimed at encouraging employers to hire the swelling ranks of unemployed.  Currently, employers who hire particular unemployed workers will be allowed to save their share of the Social Security tax (6.2%) for the remainder of 2010.  The monetary benefit along with the PR boost of hiring American workers is causing many reputable companies to consider closing down outsourced solutions and “backsource” these jobs back to the US.

While this is one of the smarter moves that the current administration has made (cutting taxes actually increases productivity and in time should lead to stronger, more stable tax revenue), the news is not exactly positive for outsourcing companies with operations in India, China, and other International centers.

Today, we are going to look at Wipro Ltd. (WIT) which is an Indian provider of outsourced consulting, technology and R&D.  The stock has become a favorite vehicle for swing traders and momentum players who have enjoyed a steady trend higher for the majority of 2009.  During the difficult days of the credit crisis, WIT continued to pull in strong revenues, averaging between $1.3 and $1.4 billion in revenues.  Fundamentally the business survived very well throughout the challenges.

In 2009 as US based companies were desperate to cut costs, WIT’s services became more attractive and investors quickly caught on to the idea that this would once more be a growth story.  By October of 2009 the stock had already hit a new all-time-high and the positive trend continued through the end of the year.

But 2010 looks to be a much more challenging year.  Companies are demanding price concessions and the competitive factor of backsourcing is likely to cut into margins – possibly more than analysts are currently modeling.  As technology solutions become cheaper domestically, Wipro is likely to face a more difficult environment, and engage in tough negotiations in order to land contracts.

In 2010, we expect IT budgets to be flat to marginally positive.  For the quarter ending march 31, 2010, we expect revenues from our IT Services business to be in the range of $1,161 million to $1,183 million. ~Azim Premji, Chairman

When the company reports fourth quarter earnings in the coming weeks, it will be extremely important to determine what demand trends are shifting as a result of global competition both from similar corporations as well as from the “insource” factor.

Why gold will not make new highs or lows this year

Currently, WIT is trading at about 35 times this year’s expected earnings (the company’s fiscal year end is March 31) and earnings are expected to grow by 9% in fiscal 2011.  The multiple is not too excessive for a company with stellar growth, but as earnings trends flatten out the market is more likely to place a lower multiple on the stock – leading to a reduced stock price.

On March 17, WIT broke to a new high after a healthy looking two month base building process.  However, the stock immediately came under distribution and the breakout failed.  This is a dangerous pattern – especially for a stock that appears over-valued relative to its earnings and growth.  Volume has yet to confirm the negative pattern, but if WIT begins to break, it may be a good candidate to short, and long positions should definitely be hedged or trimmed.

Other stocks that may also face challenges from the backsourcing issue include Cognizant Tech Solutions (CTSH) and Infosys Technologies (INFY).  All of these stocks are currently trading with strong positive momentum, but they are worth putting on a radar list for potential breakdowns in the future.

FD: Author does not have a position in WIT

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

For the last few months, the market has continued to push to new recovery highs, and the Retail HOLDRS (RTH) have actually been exhibiting leadership and outperformance.  Now a day does not a trend make, but Wednesday’s action was interesting as the RTH declined by 0.92% while the S&P 500 was only down 0.55%.  I understand this is only one data point and may turn out to be insignificant, but today could turn out to be the day the retail sector turned.

While I don’t have extreme confidence in calling a top for retail, I am developing a healthy dislike for the way Blue Nile Inc. (NILE) has been trading.  In early November, ZachStocks covered Blue Nile’s earnings report, noting that international sales were growing more quickly than domestic revenue (although international revenue only represented about 13% of total sales).  Despite the relatively healthy earnings report, we noted that the stock could easily be trading at double its reasonable value – and laid out the case for initiating a short position.

As of the close Wednesday, the stock has dropped about 14%, but the negative outlook is still just as dire as ever.  Analysts are expecting the company’s earnings to grow by 21% this year to reach $1.02 per share, and then in 2011 the expectation is for $1.23 in earnings.  I’m not sure that we can place much confidence in these numbers given the uncertainty due to unemployment and the potential “re-destruction” of wealth as adjustable mortgages reset and US taxpayers foot the bill for the new healthcare plan.

But assuming these analysts are accurate in their assessment, please explain why the stock is trading at roughly 53 times next year’s earnings!  This is a very aggressive price even for a company growing rapidly like Crocs Inc. (CROX) back in 2007.  But for a company like NILE with 20% growth expected over the next two years, the multiple seems absurd.

Over the past week, NILE’s chart has featured a pattern which many technicians call the “death cross.”  This pattern occurs when the 50 day moving average crosses below the 200 day average.  Now I don’t think there is any magic in these moving averages, but they do offer an excellent way to graphically illustrate the pattern that is evolving.  After spending a significant amount of time in a positive trend, the stock has finally begun to falter and at this point the short-term average of its daily closing price is below the long-term average – that simply means the tide is turning and the prevailing trend is negative.

Is The US Dollar Reversing Again?

Now while I said I don’t place too much credence in the actual pattern (I’m looking more carefully at the concept), there are traders who will swear by the patterns and make their trades like clockwork based on special indicators like the “death cross.”  As traders we have to respect this action and understand that a significant amount of selling pressure could quickly hit the stock.  At this point with a series of lower highs and lower lows, we could quickly see momentum pick up and NILE could be in the 30’s or even 20’s by mid-summer.

One thing to be careful of is that Blue Nile has been a big target for other short-sellers.  Currently the published amount of short exposure is 14% of the float.  It would take 15.5 days of trading (using the average daily volume) for these short sellers to exit their position.  The danger in this statistic is that if something positive is announced and the stock begins to move higher, the shorts could quickly hit the exits all at once, driving the price higher in a short period of time.

So fundamentally and technically, this looks like a good short opportunity with the potential for 40% to 50% profits.  However, the risk is certainly present so position sizing should be appropriate and traders should always use a stop-loss when holding short positions.

FD: Author does not have a position in NILE

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

For some time, Amazon.com Inc. (AMZN) has been in the good graces of a number of different economic participants.  Investors have been pleased with the exceptional rally which began well before the broad equity market bottomed in March of 2009.  At the same time, consumers have obviously been taken with the firm as revenue growth has continued throughout the financial crisis and has accelerated in recent months.  In fact, the fourth quarter reflected a 42% increase in revenue for the global internet retailer.

One additional group that has been very content with the firm is the number of affiliates who drive traffic and encourage sales on Amazon’s platform.  These affiliates (many of whom actually receive their primary income through this business line) are paid a commission for sales driven by their leads – a process which has been instrumental in the company’s strong growth.

But questions are surfacing in regards to the manner in which these affiliates and the sales that they generate are taxed.  Recently, Amazon actually cut off all affiliates in the state of Colorado after a dispute with how taxation matters will be handled.  This “nuclear option” will certainly be a negative for the company as far as sales growth is considered, but AMZN is willing to make this very public statement in order to pressure Colorado and other states to drop rules which will cause a financial or operational burden on the firm.

It will take some time for the logistics and regulatory issues to work their way through the system, but during an economic time where employment is under pressure, the US does not need additional red tape discouraging individuals from operating home businesses to generate income and promote economic activity.

Relative Weakness

From a trading perspective, AMZN is throwing up a number of red flags that will likely foreshadow weakness in the stock.  To start with, the stock has begun significantly trailing other retail names.  Now I understand that AMZN has some different dynamics than a typical brick and mortar retailer, but at the same time, the company is in the consumer area and has not been keeping pace.  While AMZN peaked in December of ’09, the retail index has continued to make new highs and is in a strongly trending pattern.

The underperformance of Amazon points to decreasing investor confidence and will likely lead to significantly lower prices once the retail sector begins to back off.  It probably makes sense to wait for RTH to break below the 20 day average or even the 50 day average before committing any serious capital to shorting AMZN.

Amazon is currently trading with a premium multiple.  Analysts expect the company to grow earnings by 43% in 2010 – which leaves us with an estimate of $2.91 per share.  Based on today’s price, investors are paying $44 for every dollar that the company earns which is a bit excessive.  I question what will happen if the estimates for 2010 are decreased.

Free Email Trading Course

If Amazon issues guidance that fails to support analyst expectations, the numbers could easily be adjusted down to $2.50 per share which still represents a healthy 22% increase over last year.  But the surprise could cause investors to place a lower multiple on the stock – and a PE of 33 along with estimates of $2.50 per share would lead to a stock price of $82.50.  That’s quite a decline from the current level near $130.

Shorting individual equities is a tricky business.  It takes proper risk control and appropriate timing on both entry and exits.  The newly revised ZachStocks Newsletter is designed to help traders identify timely long and short opportunities and also monitors open trades with risk stop points and levels for taking profits.  For Amazon, the risk is still high that the stock will be carried by bullish retail investors who continue to add exposure.  So while the opportunity is exceptional, we are waiting for the retail sector to show weakness before initiating a short position.

Once the trade has been entered, it makes sense to use a stop point a bit above the most recent swing high (currently $134.20) and then to use a trailing stop as the trade shows a profit.  Along the way, aggressive traders can use days of exceptional weakness to take profits off the table, and retracements higher to add exposure back into the trade.  But I would use moving averages and a picture of the retail sector as tools for determining when the downtrend is in trouble.

In short, Amazon is over-priced and likely to disappoint.  The chart pattern is exhibiting weakness.  Retail should pull back at some point as unemployment continues.  And the combination of these forces will favor a nimble trader willing to sell short.

FD: Author does not have a position in AMZN

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

Mastercard Inc. (MA

Back in 2008, MA became extremely weak as traders (myself included) expected the consumer to rein in spending and transaction volume to decrease.  Not only were we working against a general panic among both professionals and individuals, but spending was also to be affected by tighter credit limits, decreased card issuance, and higher fees charged by banking institutions.  Many consumers had to scramble and find alternate sources of funding such as a direct payday lender or other non-traditional measures.

But as investors regained confidence in 2009, the stock made back a good portion of its losses as Mastercard reported a continually growing chain of quarterly earnings.  The last four quarters featured EPS growth of 9%, 27%, 41% and finally 31% in the fourth quarter.  But a lack of revenue growth points to the fact that Mastercard manufactured the majority of its earnings growth through controlling expenses and not as a result of a material increase in the business.  In fact, the last four quarters of revenue growth have been (2%), 3%, 2%, and 6%.  Not exactly what you would expect out of a stock priced for growth.

It would appear that the future of Mastercard’s success (and the returns its investors will receive) hinges as always on consumer spending levels.  Since MA provides only the credit card transaction portion of the business, it is not on the hook for losses when consumers become unable to make payments on the loans.  But if consumers cut back on the amount of spending due to high unemployment, increases in the savings rate, or as a result of the destruction of household wealth, the fees MA charges will likely be affected.

While consumer spending is difficult to predict on a month-to-month basis, logic tells us that the long-term trend is going to be flat to down.  The US has consumer has been notorious for spending beyond his means, and while Mastercard has a strong international presence, the figures still show that over half of the company’s $28 billion purchase transactions occur within the US.  Bulls will tell you that the expanding international scene will more than make up for the declines in US transactions, but that may turn out to be untrue – especially if we face another global economic recession.

The competition appears to be weathering the environment a bit better than Mastercard with Visa Inc. (V) logging stronger revenue growth even thought the company is already much larger than MA.  Other card companies such as American Express (AXP) and Discover Financial (DFS) are more difficult to compare because these firms actually take on credit risk, collect interest payments, and are subject to write downs for bad loans to consumers and businesses.

Fundamentally, I am worried that Mastercard’s stock price has outpaced the company’s growth.  At the end of the year there were 966 million cards issued which is actually a decline of 1.3% from the number of cards that were issued at the end of 2008.  On top of that, the financial sector is likely not as healthy as many  believe with both commercial and residential mortgage issues hanging over banks.  Sheila Bair, Chairman of the FDIC states that there will be more bank failures this year than we saw during the crisis or as a result in 2009.  These are the banks that issue additional cards to consumers and they are under significant pressure.

Technically speaking, Mastercard has rallied in March but with less vigor than the overall market.  This relative under performance can lead to sharp declines whenever the broad market or specifically the financial sector begins to weaken.  Traders should probably use the 50 day moving average as a good spot to initiate shorts when the stock closes below this level.  Additional exposure could be added when MA crosses below the swing low of $216 logged in late February.  I don’t think it’s unreasonable to expect the stock to trade down to $160 (roughly 12 time 2010 estimates) with the potential for much lower prices if investors become fearful.

The US stock market has been surprisingly strong for the past six weeks, and despite Friday’s breather, it is certainly possible for this trend to continue.  Short positions should be placed carefully with proper risk controls, but in many cases adding short trades to a growth stock portfolio can increase returns while cutting down on the overall risk.  For more information about building a balanced long/short approach to investing subscribe to the newly re-designed ZachStocks Newsletter and take advantage of the free trading and portfolio management tips.

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

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

In a financial jam? Instant Payday Advances from MyPaydayLoanCash.com can help out today with direct deposit into your bank account in just 60 minutes.

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

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

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

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

Need cash fast? Instant Online Cash Advances from MyPaydayLoanCash.com can help out today with direct deposit into your bank account in just 60 minutes.

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

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

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