Random Thoughts: Toll's Bias; Housing Market; Russian Oil Production

August 25-26th, 2006 - Minyanville.com

Toll's Bias

There was an interesting article in the NY Times on the housing market. But what really struck me is Robert Toll’s (CEO of Toll Brothers (TOL)) denial of what is taking place in the housing industry until recently:

Here is a sample of his comments from a year ago: “We’ve got the supply, and the market has got the demand. So it’s a match made in heaven.” This is from last October: “Why can’t real estate just have a boom like every other industry?” he asked. “Why do we have to have a bubble and then a pop?”

Now, after the market turned ugly: “... is unlike anything he’s seen: sales are slumping despite the absence of any 'macroeconomic nasty condition' taking housing down along with the rest of the economy." He suggests that "unease about the direction of the country and the war in Iraq is undermining confidence. All I have to say is: pop!”

What bothers me about this is that I am sure Mr. Toll is a very smart person, he has built a multibillion dollar company after all – he's not a dummy. I have two theories on why he made the previous comments:

He convinced himself that the housing market is going through a normal boom and rejected every other rational argument that almost any other rational person would see without a magnifying glass. He had so much at stake for this to be true that he had an inherent interest to reject the bubble argument. The sad part about it is that he may not have been lying when he made his “not a bubble” argument, as he truly convinced himself to believe it.

The second theory: He just lied. His whole sales organization’s job was to convince potential buyers to buy bigger, better houses. Toll Brothers sales people had to answer the “are we in the housing bubble?” question from potential buyers on a constant basis. You don’t sell houses by telling buyers that they are purchasing a bubbly asset. Also, even if his sales people would never read his comments in the Wall Street Journal, these comments for sure would send the stock down and thus his net worth.

I tend buy into the second theory for one reason: Mr. Toll was selling Toll Brothers stock as it was going out of fashion. This is a very transparent and important lesson to learn: management’s comments always have to be looked at with a healthy dose of skepticism. The car salesman may be telling you the truth about the car, but you still don’t take him at his word as he has an inherent bias to sell you a car. He is not a bad person, but he has a nagging wife, his kids need to go to “better” schools and they need braces. What would you expect? Corporate executives arguably have a higher standard on “truth” than a car salesman, but they still have a bias as they need to sell stock. More thoughts on the housing market:

I don't know if other states have "charity programs" that help consumers to buy houses, but I think in part these "charity programs" were in part (emphasize: in part) responsible for what is taking place in Colorado. As I understand it, according to law, a seller cannot provide a down payment to help a buyer to buy a house. But there is a loophole in the law - the charity can "help" a buyer with a down payment. The game that was very often played in Denver was as follows: Let's say a house is on the market for $300,000. A buyer needs to bring $15,000 down payment to the closing, the buyer doesn't have it. So the following would take place: The seller agrees to donate $16,000 to a "charity." The "charity" in turn would "donate" $15,000 to the buyer for the down payment. The seller in turn would raise the price of the house from $300,000 to $316,000 and charity would keep $1,000 as a processing fee. Everybody happy? Well, yes, with exception that the entity that has arguably created zero economic value, just increased the transaction cost by $1,000 and comparative housing prices just registered a 5.3% ($16,000) jump.

Russian oil production:

Paint me a skeptic or perhaps it's just from being born in Russia, but I think Russian oil production is very likely to decline in the future. Why? Simple, over last couple of years Russian Government has de-privatized a big chunk of oil companies.As we know government is not as effective at managing resources as private enterprise. Don't believe me? Just take a look how Fed Ex (FDX) and UPS have taken share from the US Postal Service - a government run legal monopoly.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Random Thoughts

Minyanville - August 16th, 2006

I'll pose these questions for readers:

Let's say the scenario that I described in this article plays out, the Chinese economy slows down, its massive operational and financial leverages create deflationary pressure on the companies forcing them to lower prices in an attempt to stimulate sales growth, starting a price war which would in turn lead to even lower profitability, driving many companies into red. A sudden loss of profitability would lead the bad loans, which are estimated to be around $900 billion (40% of GDP), to become a real problem.

Let's say government decides to take a hands off approach and not take the Japanese route by creating a zombie economy and would let the market forces play out (I know I am stretching here). If (actually in my mind it is a question of when, not if) all that takes place, what would happen to:

1. The U.S. dollar reserves, would Chinese companies have to pull the money out of U.S. Treasuries? What would happen to the U.S. interest rates? Long term and short term?

2. What would happen to the Chinese/U.S. Exchange rate?

3. Would the Chinese exported deflation throughout the world be a net positive? Or we may see an Asian contagion spreading throughout the world?

We have nothing to fear but Google itself

Let's say written in the past, though Dell (DELL) appears to be cheap relative to its past valuations, I believe it is not cheap on an absolute basis, which is more important for range bound markets.If Dell decides to take a recommendation from Barron's and start opening new stores, it will be a kiss of death as it will give up on its last competitive advantage. Just take a look at Gateway (GTW).

I believe Microsoft (MSFT) is a much easier play on the computer sector. Its valuation is very attractive, 14x earnings (excluding cash that is going back to shareholders through stock buy backs and rising dividends). It also has a Google-will-take-over-the-world discount built into it, which I believe will dissapear a lot sooner than later.

Another stock that becoming more and more appealing through valuation (though not there yet) due to Google (GOOG) fears is Ebay (EBAY).

More on Dell, Intel, HP and AMD

Professor Gilmartin and I were exchanging thoughts on Dell's (DELL) valuations. Trying to figure out what is the appropriate buy valuation for the stock that would have an appropriate margin of safety.One thing I have found is that relative valuation (i.e. today's P/E vs. where it was in the past) is skewing many fundamental folks' view on Dell's attractiveness. But I believe it is very important to attempt to come up with the appropriate absolute valuation for the company first and only then look at the past valuations. If one does that, then today's P/E or P/CF may not appear to be as attractive. I am not in love with Dell (DELL) at today's price, falling in love with Hewlett-Packard (HPQ) looks like a mistake to me. Just scanning through Dell's conference call (albeit between the lines) it is fairly clear that Dell will not let HP prosper at Dell's expense.

Also, aside from offering customers "variety," I gather from reading the transcript that Advanced Micro Devices (AMD) is likely to be undercutting Intel (INTC) on price. Maybe that is their way to get into Dell's computers and get the scale needed to compete with Intel? But that is a risker strategy. Just compare Intel and AMD's operating margins.

Vitaliy N. Katsenelson, CFA This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Random Thoughts

I wrote these short comments on Minyanville.com between August 14-16.

It's what good managers do to win ball games

At MIM2 (Minyanville in the Mountains 2) Jeff Macke and I discussed how being a public company impacts management's decisions, where management may do things that are not necessarily good for the long run of the business to please the short-term, result hungry Wall Street.

This excerpt from Lion's Gate Entertainment (LGF) is a good example of that.

Analyst: There does appear to be a move towards really squeezing those windows closer together. I am wondering what the pros and cons of that are.

Jon Feltheimer (CEO): We think 16 weeks is still about the right amount between windows. I do not think we see really compressing them much more than that. I think there are times, particularly as a public company, when you are trying to get certain revenues within your fiscal year, and you move a movie a couple of weeks, so maybe the window changes a little. Life Sentence

A WSJ article highlights how dysfunctional French labor laws are. Two-thirds of France Telecom's employees, for instance, have civil-servant status - a job for life guarantee. This is shocking, since this is a company that is fighting for its existence in the fast changing world of telecommunications. The majority of its workforce have little incentive to work. The article highlights the hoops the company has to jump through to convince its workers to voluntarily retire.

The employment for life mentality only works when there is no competition or when you compete with other employment for life entities. Meanwhile, employment-for-life Europe is competing with the rest of the world which operates under capitalistic conditions (employed until you create value), or even worse - sweatshop-like conditions, 20 hours a day, no-lunch labor laws.I don't know how Europe can remain competitive when it is still stuck in the 20th Century pre-flat world.

Danger of Cheap Stocks

By definition, a value investor is enticed by “cheap” stocks. However, quite often “cheap” stocks are cheap for the right reasons: fundamentals deteriorate or expected growth rates don’t materialize - welcome to the value trap, the value investor’s hell. I wish there was a silver bullet that would keep the investor out of value traps, but there isn't. Investors might want to do an un-American thing – assume a cheap stock is guilty of been cheap for the right reason until proven otherwise. The burden of proof should be on NOT buying the stock.

Though I don't short stocks – I run long only accounts, I believe an ability to short stocks may make investor more objective. A long only manager often lacks the dark (short) side’s perspective. The ability to walk on the dark side forces investors to look at the negative more objectively.

I’d love to spend as much time in value investor’s hell as the next guy. I’ve stepped in my fair share of value traps and (publically) avoided a few (here and here).

Recently I looked at Cedar Fair (FUN) which attracted me with its 7.6% dividend yield, however, as you’ll see from this article, I found that the risk profile of the company has increased exponentially after it bought Paramount Parks from CBS and dramatically leveraged its balance sheet. Though Cedar Fair may be able to maintain its dividend over the years (it will unlikely be able to raise it by meaningful amount), an economic slowdown or bad weather or any other unforeseen event (earthquake, hurricane, flood etc...) will put the company’s ability to pay its dividend in jeopardy.

Large and In Charge

A couple of weeks ago I wrote an article for the FT which also FT, making a case that quite a few large cap growth stocks like Microsoft (MSFT), Wal-Mart (WMT), Johnson & Johnson (JNJ) are trading at very attractive valuations. Their earnings more than doubled or tripled since the late 90s but the stocks have not gone anywhere, for the right reasons I might add - they were overpriced.

I believe the investors in these stocks that bought them in the early 2000s fell into what I call a "relative valuation trap" as they appeared cheap relative to the end of the bull market valuation. I believe today they are cheap on a more important absolute basis. However, after I wrote the article, I received several dozen "right on" emails and only one "you are out of you mind emails," this tells me I am probably too early as too many people agree with me.

Vitaliy N. Katsenelson, CFA

Dividends on the Ride Down

August 11, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

As I began analyzing amusement-park operator Cedar Fair (NYSE: FUN), it reminded me of a computer game that I used to play called Rollercoaster Tycoon, because I felt like I was on a roller coaster when debating whether to open a position in this company.

Cedar Fair is known as a pure-play, profitable, well-managed company that has paid and raised dividends every year for the past 19 years. Though competitor Six Flags (NYSE: SIX) is a pure-play amusement-park operator as well, it lacks all of the other qualities that Cedar Fair brings to the table -- it is buried in debt, and its cash flow reminds me of its wilder coaster rides.

Then, several months ago, Cedar Fair revealed its plans to purchase all six Paramount Parks from CBS for a tidy $1.25 billion. That announcement shocked investors, who were attracted to Cedar Fair for its reputation as a relatively low-risk and stable dividend-payer. The stock fell from the low $30s to the mid-$20s, while the dividend yield rose from 6% to 7.6%. Being a sucker for a dividend, I decided to take a peek at the stock. I wanted to find out whether the sell-off was warranted.

The upside of the roller coasterI also knew that Cedar Fair is run by a good, seasoned management team, and that its EBITDA (earnings before interest, taxes, depreciation, and amortization) margins and return on capital are the best in the industry, even exceeding those of the almighty Disney (NYSE: DIS) theme parks.

I like the general stability of the theme-park business. It's not immune to economic downturns, but a trip to a theme park is still one of the cheaper ways for a family to spend time together in the summer, which makes the industry somewhat resistant to rough patches. At the same time, a weaker dollar makes international travel more expensive, so U.S. citizens are more likely to vacation stateside in the first place. Cedar Fair's theme parks usually serve customers who live within a 150-mile radius, so high gasoline prices are unlikely to have a significant impact.

The Paramount purchase has doubled Cedar Fair's revenues and diversified the company's revenue base. It exposed the company to more robust local U.S. economies and even provided foreign exposure, since one of the largest Paramount theme parks is located in Canada. The steep descentAnd then there's the downside. At the right price, the Paramount acquisition would have made sense. But at the price Cedar Fair paid -- 10.7 times EBITDA -- the company's risk profile increased substantially, and the steep price may have limited its ability to further raise dividends for a while. Let's look more closely at why I think Cedar Fair paid too much.

1. Increased debtRight around the time of the purchase, Cedar Fair's $470 million in debt came due for refinancing. Banks, being aware of the company's increased risk profile after the acquisition, required a higher interest rate from the company for both old and new debt, which significantly raised Cedar Fair's borrowing costs. The company says it would like to raise $250 million in equity to pay for the acquisition, but it's not willing to do so at today's stock price. It may not have a choice, however.

Management said that it can increase merchandise and food sales at the existing parks. If so, that should help increase spending per visitor and raise the new parks' margins by about 3%-4% over the next several years. If anybody can do it, this management team can, but doing so could prove more difficult than expected.

Assuming the company will be able to refinance a $1.25 billion bridge loan from Bear Stearns and $470 million of its existing debt at 8% -- a rate the company says it can get -- management will still need to grow food and merchandise sales in Paramount Parks in the low-teen percentages for the acquisition to become accretive in three to four years. It will barely swing by in making its dividend payments, and it will have to make a heroic improvement in the Paramount parks' performance to be able to raise that dividend.

2. Potential for underinvestment in the parksIn the past, Cedar Fair prided itself for spending about $55 million a year on capital expenditures -- maintaining the parks, improving the rides, and so on. Paramount Parks, meanwhile, spent around $45 million a year. Next year, the company expects to spend $80 million on capital expenditures for Paramount and Cedar Fair parks combined. Part of that expense will go toward adding amenities such as restaurants and shops for the Paramount parks.

Is the new, much higher debt constraining Cedar Fair's capital expenditures? It's hard to say. But if so, underinvestment in its theme parks may increase the risk that it will share Six Flags' financial fate.

Although the Paramount parks are in better shape than Cedar Fair's previous acquisitions were, management was also very shrewd with its past purchases. They were much smaller and cheaper, and the management team focused on turning around mismanaged theme parks. That's arguably less difficult than converting a good, above-average group of theme parks like Paramount's into a great one.

3. Limited financial flexibilityBefore the acquisition -- with the exception of the past two years, when it built a water park and converted a Sea World into a water park -- Cedar Fair had a nice margin between its free cash flow and the dividend it paid. But the Paramount acquisition has put the company's ability to pay a dividend, much less raise one, at grave risk. If management is successful at improving the Paramount parks, this acquisition will become accretive in a few years. But if it fails, or if anything really unexpected happens, the company may become forced to do one of three things:

• Borrow money to pay the dividend, which would further increase its future financial burden.
• Cut capital expenditures, which it would pay for in years to come by way of lower attendance.
• Lower the dividend, which investors would not welcome.

The debt Cedar Fair amassed from the Paramount acquisition has made the potential cost of being wrong tremendous. There is little room among the operating cash flows, interest expense, and the dividend payment to soften the blow. The future ain't what it used to beIt's easy to say this management team has created a lot of shareholder value, made successful acquisitions in the past, and increased dividends for almost two decades. But investing is a forward-looking activity. Though I'd give the management team the benefit of the doubt, the recent numbers speak for themselves. Cedar Fair's interest coverage ratio for 2006 (in this case, computed EBITDA divided by interest expense) will have declined from about 7 before the Paramount acquisition to a meager 2.5 or so, assuming the company can obtain the 8% debt financing it says it can. With its 7.7% dividend yield, the stock looks very attractive on the surface. But there's no such thing as a free lunch. An increased dividend yield (caused by the price decline) has come at a much higher risk. Put simply, Cedar Fair is not the company it was three months ago. I believe that management made a mistake when it hurried to buy Paramount. I suppose I have an excuse now to play Rollercoaster Tycoon, but because of the Paramount acquisition, I won't be buying Cedar Fair's stock anytime soon. Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates. He and his company have no positions in the companies mentioned. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Fall in love again with a bellwether friend

August 4th, 2006 - Financial Times By Vitaliy Katsenelson

Published: August 4 2006 19:42 Last updated: August 4 2006 19:42

Love was in the air, birds were singing, price/earnings ratios were growing and the stock prices of large-cap, bellwether companies such as Microsoft, Wal-Mart and Johnson & Johnson were rising as if dotcom had become their middle name. Investors could not get enough of these great companies that had created substantial wealth for shareholders in the preceding decades. But they were in for a surprise.

Late 1999 and early 2000 marked the end of the renaissance era for large-cap growth stocks. Most of them either have gone down or drifted sideways since. And this should not have been surprising. In the ecstasy of market excitement, investors had confused great companies with great stocks. And those great companies stopped being great stocks once their p/es reached unprecedented highs.

The birds stopped singing. Seeing their money going nowhere during the past six years, investors’ excitement has gradually turned into indifference and then disappointment. The cold reality of miserable stock performance leaves no room for argument: these stocks were grossly overpriced.

But time is the great healer, especially when earnings are growing. These companies have more than doubled their earnings since the late 1990s. Those higher earnings have combined with lacklustre stock performance to create very attractive valuations.

Microsoft stock has declined substantially from its 1999 highs when it traded at more than 50 times earnings. Since then its profits have doubled. Adjusting its price for a cash pile (that is soon to make its way back to shareholders’ pockets through a $20bn share buyback and constantly rising dividends) it trades at an unbelievable 13 times earnings. Yes, this is not a typo. One of the few legal monopolies – which has a return on capital of 28 per cent, scores profit margins of 30 per cent and is increasing revenues at a double-digit rate – is trading at a below-market p/e. To top all of that, this downward valuation has taken place when it is about to come out with two huge new product releases, Windows Vista and Office 2007.

Wal-Mart in 1999 sported a p/e of 39 and earned $1.28 a share. Six years later it is expected to earn $2.95 for 2006. Yet its stock price is at the same level as it was in 1999. Its p/e is at a level that has not been seen in more than 20 years: 15 times forward earnings. That is very cheap for a company that is likely consistently to increase earnings in the low teens for years to come, and has a moat the size of Lake Michigan around its business.

Johnson & Johnson is trading several dollars above its 1999 level in spite of its large size. Its earnings have grown at a very impressive 15 per cent a year at the same time as its p/e has been cut in half from 32 times in 1999 to 16 times 2006 earnings today. How often do we get an opportunity to buy one of the best and most diversified pharmaceutical and consumer companies that pays a 2.5 per cent dividend yield at this valuation? It happened a couple of times in the early 1990s, and Johnson & Johnson’s stock has more than quadrupled since then (although I am not saying I expect it to do that this time around). Did I mention it has $15bn of net cash (cash less debt) in the bank?

Six years of subpar stock performance for large-cap growth stocks has led many to believe there is something wrong with the underlying companies. That assumption could not be more wrong. The stocks have disappointed investors’ linear expectations because they were overpriced in the late 1990s and it took six long and dreadful years for the valuations – the p/es – to catch up with fundamentals. They have finally done so. What these companies usually share is that they have strong moats around their business, a long track record of success, above average dividend yields, strong brands, great return on capital, a bright future of growth ahead and very attractive valuations. They are considered to be bellwethers for a reason. Their defensive qualities make them less risky stocks, performing better than the rest of the market at times of uncertainty – and we have plenty of uncertainty to go round.

The laundry list of the large-cap growth stocks that have not gone anywhere in a long time and are hitting attractive valuations is very long. Also look at McDonald’s, Abbot Labs, Berkshire Hathaway and General Electric. They have not been this cheap in a very long time. When quality, defensive growth becomes value who can say no to that?

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in DenverVitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Being Contrarian With Jos. A. Bank

August 3th, 2006 - Minyanville.com Vitaliy Katsenelson, CFA Jos. A. Bank (JOSB) is up close to 6% after reporting truly unbelievable sales numbers for July: same store sales were up 16% and total sales were up 28%. July's performance has validated my view on the stock that you are about to read.

What does it really mean “being contrarian?” Doing the opposite of what everybody else is doing, all the time? What if you agree with what everybody else is doing? Should you disagree for the sake of being contrarian?

“Being contrarian” means being able to think and act independently of the crowd and not be swayed by the crowd thinking. It means to stay on your own autonomous thinking track, independently of the direction the crowd is taking, even if it requires going against the crowd. It means not accepting (though respecting) the market’s wisdom unconditionally, but attempting to develop an opinion of your own.

Yogi Berra’s saying “In theory there is no difference between theory and practice. In practice there is,” could not be more true when it comes to contrarian investing. In theory it is easy to be able to think and act independently; however, in practice it becomes a very lonely and trying experience. Emotions that we don’t experience in the theoretical state overcome us in "the in-the-practice-state."

Investing in Jos. A. Banks requires the investor to be a contrarian. Wall Street hates the stock for sending share price from the mid 40s in April 2006 to the mid 20s. The stock is trading at a pitiful 12 times forward earnings. The stock has been slaughtered as Wall Street did not care for the earnings miss in the first quarter coupled with higher inventories.

At this price, the market expects no growth from the company, but the market could not be more wrong. Here is why:

In December of 2005, JOSB delivered 20% same store sales; management has likely expected this trend to continue and has built up a significant amount of fall inventory. However, weather was not on the company’s side, the spring ended up being warmer. The 20% same store sales comps of December did not come through in the following months and that, coupled with warmer springs, sent management on a fall close discounting spree. Management admitted that it was too aggressive in discounting fall merchandise, with the benefit of hindsight it did not have to do that.

It is hard to tell what the next quarter will look like, but that would be focusing on the trees in the forest and not on the forest. However, the future (the forest) appears to be bright for this company. I recognize that managing business involves making decisions under uncertainty. In the first quarter, management made a mistake, I believe that mistake will have little consequence in the long-term fundamental picture of JOSB.

Inventory is Not An Issue Retailers live and die by their inventory; it is the lifeblood of their retailing business. Too little inventory means the company doesn’t have enough goods to sell, too much inventory means the company has to heavily discount merchandise in order to clear the inventory. So here is the perceived bad news about JOSB – its inventory days have almost doubled over the last six years from 173 days to 334 days. It is twice the amount of its most comparable competitor, Men’s Warehouse (MW) whose inventory days have stayed in a very stable range of 153-169 days over the same time frame. That is just bad, isn’t it? On the surface, inventory numbers look terrible.

Over the last six years since the new management team has taken the reins of Joseph A. Banks, it has intentionally increased inventories per store. Why am I not worried about high inventory levels? Not all inventories are created equal. Inventory increases at a grocery retailer, like Kroger (KG) may lead to higher spoilage and thus lower profitability. Teen apparel retailers, like American Eagle Outfitters (AEOS) and Abercrombie and Fitch (ANF) need to have a fairly high inventory turnover, as teen preferences for the size and location of holes in their jeans could change with Britney Spears' new CD. However, when it comes to men’s apparel, the men’s tastes rivals the speed of the ice age. Blue shirts and stripe suits have been in fashion as long as...well, forever.

Instead of looking at JOSB's inventory as a risky, unstable assets which may have to be discounted by the retailer to clear the shelves (which is usually is the case for other retailers), one should look at it as an investment in long term assets, not unlike investment in store improvements. Though increasing inventory per store is counter intuitive for retailers that strive to achieve Wal-Mart (WMT)-like inventory efficiency, JOSB customers come to the stores only once or twice a year. The company wants to make sure that the customer finds everything he desires in the right sizes, knowing they won’t be back for a long time. The inventory increase was mostly done on the availability of more sizes, not in greater variety. As customers found the merchandise they liked and the sizes that fit – they bought more, driving same store sales and operating margins at the same time. Also, reading the transcripts of the conference calls from 2004, management has been constantly saying that raising inventory is a part of the company’s strategy.

This strategy has paid off handsomely since it has been implemented; earnings and sales have grown in double digits, margins expanded due to increased same store sales and most importantly, returns on assets (despite higher asset base due to increased inventories) have more than doubled. JOSB has beat Men’s Warehouse hands down on every aforementioned measure! Despite substantial increases of inventories per store, JOSB more than doubled its store base and achieved that mostly from its free cash flows.

The good news is that JOSB is in the last inning of inventory increases. Although the inventory of new stores will still be climbing as they will be brought to company’s average level, management indicated that they are happy with the inventory levels at the matured stores.

Pristine Balance Sheet JOSB is allergic to interest bearing debt as it was a byproduct of a leveraged buyout, though it does compare to most retailers' operating leases. The company has almost no interest bearing debt and has an available credit line of $125 million that is used to finance seasonal capital needs. Growth Management has stated that they plan to bring the store count from 329 today to 500 in 2009, which will be financed by internal free cash flows. But it has been mute about the plans beyond that. Logically, the United States should be able to support more than 500 stores, which are only about 4,500 square feet. There is also life beyond the United States, though it's riddled with more unknowns.

Economic Uncertainty This is probably the biggest risk facing this stock. Economic slowdown, deflation of the housing bubble and a weaker stock market are all risks that could create the headwinds for consumer spending and thus for the stock.

Though not immune to economic slowdown, the majority of JOSB customers make over $100-125 thousand a year and are less sensitive to an economic slowdown. Business suit or slacks purchase decisions could be postponed if one is not certain of what the future holds, however, clothes rip, coffee gets spilled and new ones need to be bought.

One way to gauge how the JOSB customers will behave during a recession is to look at their behavior in the last recession – average same store sales in 2002 were 6.6%, not bad for any environment.

The Hidden Asset JOSB has a hidden asset which is not apparent to most investors looking at the company’s operations on the surface, half of JOSB stores are less than three years old. “So what?” - You’d ask. It takes close to five years for a store to reach companywide average sales and operating margins of 23%. A store that is less than three years old has a profitability of 10% below company average. This makes sense, as a very large portion of the costs of running a store (rent, salaries, utilities etc...) are fixed. These costs are more or less the same, either sales are at $0.9 million approximate average sales of a new store, or they are at $1.6 million approximate average sales of a relatively mature store. As new stores mature, sharply rising same store sales arrive with much higher margins. Today, company’s margins are depressed with half of its stores being relatively new, but as they mature, margins will rise and earnings and free cash flows will go through the roof.

I estimate the company’s net margins will rise by about 3-4% and the company will earn somewhere around $5 in 2009. Slapping a 10 times P/E (no growth) multiple we get a $50 stock. There is plenty margin of safety in this stock.

Vitaliy N. Katsenelson, CFA

Positions WMT, JOSB

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.