Need I say more?

Walgreens (WAG) comments on Wal-Mart (WMT) "will put them out of business strategy" on the company conference call:

• For the 291 drugs that Wal-Mart will sell for $4, the average co-pay at Walgreens is $5.30 and for Medicare Part D patients it’s only $3.18.
• Wal-Mart’s program covers less than 300 generic medications while Walgreens pharmacies’ stock has about 1800 different generics.
• Over the years, WAG's convenience, locations, and services have proven to be bigger factors for its patients than a few dollars in price difference - the point I argued in this article.

Need I say more?

Vitaliy Katsenelson : Oil, diapers and US economy

By Vitaliy Katsenelson September 22, 2006 - Financial Times Are low oil prices good for the US economy? Of course. But are they good for retail stocks? That depends on the retailer, and on the mental account that consumer spending is coming from.

A “mental account” is not a new form of a cheque or savings account. Rather, the term comes from behavioural finance – a relatively new science that tries to explain our financial decisions. Our brain uses shortcuts to process information. And it creates “mental accounts” for different financial decisions.

We will buy a nice entertainment centre with a windfall from a risky gambling excursion – it was “found” money after all. With an inheritance from a grandmother, the money goes to a more conservative type of mental account, maybe even making it into our retirement fund.

Money is a fungible commodity – $5,000 inherited from grandma buys as many Britney Spears compact discs as $5,000 won in casino gambling. But we treat this money differently, placing them into different mental accounts. We just do.

The same type of thinking applies to other aspects of life. We put a different value on money depending on the source of funds. Borrowed money usually carries less weight when it comes to spending decisions than hard-earned cash, though it should carry a higher value since we have to pay interest on it.

Almost unprecedented low interest rates created cheap money in the eyes of US consumers and fuelled the economy. After 9/11, they went on a prolonged shopping spree taking out equity from their appreciating house and buying newer, bigger, shinier must-haves.

Home equity loans are considered to be “found” money and thus put in a less valuable mental account. What many neglected to notice:

• Home equity loans do not come free – they carry an interest rate often linked to short-term rates, which have risen substantially. That chips away at discretionary spending.
• Home equity loans have to be repaid.

• Housing prices rose nationwide, thus creating no wealth. Consumer debt – the liability side of the balance sheet – has risen over the years, but so has the asset side. Unless a homeowner decided to move to Antarctica or into a smaller house, the new wealth did not increase their house buying power.

I would argue that rising housing prices have not increased homeowner’s wealth. Instead, they have increased property taxes – as our houses appraise at a higher value. They have increased the transaction cost of buying and selling houses (because agents take a percentage of the price).

And they have encouraged consumers to spend more as they counted on housing prices to rise forever.

This leads to another problem, as housing prices may face a first nationwide decline. The asset side of consumer balance sheets will be lower but the liability side, the debt, will remain the same or even rise as interest rates increase and negative amortisation loans keep adding to mortgage balances.

How does this relate to oil prices and retailers? Very simply, our spending on gasoline comes from wages – a mental account many call a pay cheque. We spend our pay cheque mental account on staples such as groceries, clothes and diapers – lower-price items. A new kitchen countertop from Home Depot or a flat-screen television from Best Buy comes from the home equity loan mental account. This account will shrink as housing prices decline.

Wal-Mart (WMT) and Target (TGT) , which sell must-haves, should benefit as the amount in their mental account will rise with lower oil prices. Companies that sell big-ticket discretionary items will not benefit much.

Lower oil prices will most help companies that make “stuff”. Take Kimberly Clark (KMB): it takes polymer (an oil byproduct) to make diapers, and it requires energy (oil) to convert plastic and paper into a Huggies diaper. Diapers do not wheel themselves into store shelves and transport costs will come down with oil prices. Kimberly Clark spent hundreds of millions of dollars on becoming more efficient, but its cost cuts could not offset increased oil costs. At least for a while, lower oil prices will let the company enjoy the fruits of its labour.

Vitaliy Katsenelson is a manager at Investment Management Associates and teaches at the University of Colorado in Denver.

Vitaliy has a position in WMT, KMB

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.

Don't Hit the Panic Button Just Yet

By Vitaliy Katsenelson, CFA

September 21, 2006 - The Motley Fool

This morning, Walgreen(NYSE: WAG) and CVS(NYSE: CVS) investors found their stocks chopped up by a bit of news from Wal-Mart(NYSE: WMT). It seems the retail giant will introduce a pilot program next year to sell generic drugs for $4 a month in its Florida stores. This is opposed to the $30 a month that CVS and Walgreen charge. Should investors hit the panic sell button?

I own all three stocks. So when I turned on the TV and heard comments like "WMT will drive CVS and Walgreen out of business!" I walked to the water cooler, got a drink, sat down, and put on some opera music (loud -- it helps me think). I came to the conclusion that it's a brilliant move for Wal-Mart (way to go, Wal-Mart!) and almost a non-event for Walgreen and CVS.

Here's why:

Wal-Mart's program has the biggest impact on consumers who are paying for prescriptions out of their own pocket, which accounts for a very small portion of CVS's and Walgreen's sales. In fact, only 5.9% and 7.1% of CVS and Walgreen pharmacy sales are paid by consumers directly; the bulk is paid by third parties (insurance companies, government, and states). Out of this 5.9% and 7.1%, a portion goes to branded drugs and the rest goes to vitamins and generics. I think the impact on Walgreen's and CVS' future sales should be negligible.

The only way the news would have a meaningful impact on CVS or Walgreen is if the insurance companies and government suddenly decided that $4 is a fair price for a generic drug -- a very unlikely scenario. Both companies operate on razor-thin margins as it is. They have very large store bases and armies of loyal customers, and they're likely to join forces to fight insurances companies that would lower their compensation for generic drugs.

Wal-Mart will probably not be making money on generics, but it doesn't have to. Where pharmaceuticals represent greater than two-thirds of sales for stand-alone pharmacies, pharmacy sales are a mere rounding error on Wal-Mart's electric bill.

Wal-Mart will be subsidizing pharmacy sales by (hopefully) getting old customers into their stores more often and bringing new customers through the doors. Have you ever tried to buy just one thing at a Wal-Mart? I think it's physically and psychologically impossible -- at least, it's never happened to me. If this pilot is successful, it should offset the loss of profitability in the pharmacy by generating sales of other general merchandise and groceries. Also, Florida is a perfect testing ground for this program, as it has more "blue hair" -- the main consumers of drugs -- per capita than any other state.

This move may also help to cool off the criticism against Wal-Mart on the PR front -- the company is working to lower medical costs to U.S. consumers, after all. The brilliance of this move lies in trying to bring market forces into the fight.

I think the Wall Street reaction to the news is overblown. But the news added a level of uncertainty to pharmacy stocks, and Wall Street doesn't like uncertainty. It also raises the question, "What else does Wal-Mart have up its sleeve?" But while Wal-Mart has a competitive advantage over many other retailers, its competitive advantage against Walgreen and CVS is very limited. These companies don't try to compete on price because insurance companies are the ones most often footing the bill; insured consumer out-of-pocket expense (the copayment) for drugs is the same at any store. One doesn't go to Walgreens or CVS because they have the best prices. People shop there because of convenience -- smaller stores, quick in-and-out trips, proximity of location -- not something Wal-Mart is going, or wants, to replicate.

Before this news, Walgreen and CVS stocks were pushing all-time highs. In my estimate, CVS was approaching a fair price valuation -- it was a couple of dollars from our target sale price -- and Walgreen was trading with little margin of safety, if any. (My firm sold shares of Walgreen a couple of weeks ago on the valuation concern.)

These stocks have big tailwinds behind them. High predictable growth rates are likely to persist in the future. On top of all this, baby boomers are not getting any younger and are consuming drugs by the pound. If you loved those stocks when they were 10% higher, you must love them today; their businesses haven't changed as much as you may think.

I have position in CVS and WMT

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.

Brilliant!

By Vitaliy N. Katsenelson, CFA

I wrote this article on the impact that Wal-Mart's (WMT) brilliant (I think it's a stroke of genius) actions will have on CVS (CVS) and Walgreens (WAG) - which is not much, unless grocery stores will follow WMT's lead, possibly diminishing my "convenience" argument.

I failed to mention in the article that at times insurance co-pay for generic drugs will exceed $4 that Wal-Mart is offering. In my experience most copays for generic run at about $5-$10. So will consumers want to go to Wal-Mart to save from $1 to $6 on generic copay. I'd bet that a very small minority would. The brilliance of WMT's action is that neither WAG or CVS can follow its strategy otherwise they'll jeopardize reimbursement rates from the insurance companies.

Wal-Mart actions were not really focused on WAG or CVS since most of their customers have insurance, they were directed towards the uninsured consumers. A bigger question, will insurance companies try to exert pressure on pharmacy retailers to follow WMT’s pricing – they may try but I don’t believe they’ll be successful.

(see original article for position disclosure)

Russian Thievery

by Vitaliy N. Katsenelson, CFA

September 20th, 2006 - Minyanville.com

The Russian government's threat to suspend licenses for two giga-billion projects by TNK-BP, in part owned by BP (BP) and Royal Dutch Shell (RDS-A), is not uncharacteristic of Russia and its very short term thinking. The Russian government argues that it is based on environmental concerns. Nothing, I repeat nothing, in Russia gets done based on environmental concerns. The government simply wants to muscle in on a larger stake in the projects.

Russia feels like it has an upper hand in any negotiation as commodity prices and demand are on its side, plus it is becoming less dependent on the rest of the world as it is swimming in cash. This arrogance raises a political risk premium that foreign companies have to factor into their models by raising the risk premium when deciding to invest or not to invest in Russia.Since commodity prices are very high, rates of returns are high enough to cover the increased cost of capital. But commodity prices will not be scratching the sky forever.

Maybe I am just too cynical and TNK-BP really is trying to pollute poor mother-Russia... nah, if Gasprom was doing this the government would be laying a red carpet under its pipelines to make sure that its executives don't get their feet wet.

Reaction to Toll

by Vitaliy N. Katsenelson, CFA September 18th, 2006 - Minyanville.com After reading my comments on Toll Brothers (TOL), I got the following argument from a reader that I thought was interesting:

Toll builds to suit in most of its communities, thus putting itself in a position of carrying low amounts of inventory unlike virtually all other national builders. You don't have to give huge incentives to move a house that hasn't been built yet because you are giving the buyer choice!

This is an interesting observation. Let’s say the reader is right and Toll Brothers doesn’t build spec houses; all the houses are custom built to order and it faces very few cancellations. Would this practice put breaks on price declines? No! Toll Brothers competes against a small army of homebuilders that are facing cancellations of already built houses. A flood of new homes and a drop of demand caused by a cooling down of the housing market created a significant pressure on house prices. And though Toll Brothers did not cause the price declines (as the reader argues) its future to-be-built houses will be facing competition from lower priced, already built and/or to-be-built houses from struggling competitors. If other builders give incentives or lower prices to keep selling their houses, unless Toll Brothers have something very unique about their houses (i.e. premium waterfront lots, much better quality etc..) it will have to lower the prices to be competitive.

Toll Brothers may decide to abstain from selling houses at lower prices. It then will sell a lot fewer houses and its earning will still suffer. Unfortunately for Toll Brothers, industry structure is a function of actions of all competitors, not just the stronger, wiser ones (as the reader argues). Weaker, less disciplined competitors can destroy value for the whole industry, they’ve done it many times in the past and will do it again.

Mr. Toll at "It" Again

by Vitaliy N. Katsenelson, CFA September 7th, 2006 - Minyanville.com I wrote about Mr. Toll, CEO of Toll Brothers (NYSE: TOL) before. But Mr. Toll still keeps amazing me. Reader sent me the following link to Mr. Toll's latest interview.

I just love when a person who made hundreds of millions on building houses pleads ignorance. This comment insults everybody’s intelligence: “The current slowdown is 'strange' because it cannot be explained by macroeconomic factors such as interest rates or unemployment that traditionally reduce demand for houses," Toll said. "We have an apparently decent economy."

Why? Because he just told us in a previous statement: “The current downturn is mostly the result of a 'severe overhang' in supply that Toll estimated at 15 percent to 20 percent more than the market can easily absorb. That was driven by 'tremendous speculation' by home buyers who never intended to occupy seeking a quick profit from a rising market, and by builders who constructed homes before securing buyers, he said.”

I don’t have anything against Mr. Toll, in fact I don’t even follow the stock. But I find his comments are very insulting. You did not have to be a braniac to know that the housing market was going through a bubble. I am waiting until he’ll take Mr. Byrne' (from Overstock.com (Nasdaq: OSTK) tactic and will start blaming the decline in housing prices on short sellers – he is already blaming other builders. There is a unique element to the housing industry – once you build and sell a house, it starts competing with your future houses because at some point that house will make it back on the market. Mr. Toll knows about it but he pleads ignorance.

I don’t know if housing stocks are cheap enough. I am aware that one has to be able to differentiate between a good company and a good stock. There is a possibility that despite the housing market going through some very tough times, the housing stocks’ valuations reflect a scenario that is a lot worse that could possibly transpire. I know some very smart investors for whom I have a tremendous respect that made that case. I have an un-quantified hunch that they probably are not cheap enough – Toll Brothers (TOL) is still trading at above 2004 levels. I am not sure that 2004 earnings will be coming back. Looking at past earnings is a fruitless exercise as they are meaningless for the forward looking analysis – the past is unlikely to repeat for quite awhile.

China Redux

by Vitaliy N. Katsenelson, CFA

Sep 15, 2006 - Minyanville.com

Some interesting feedback... I wrote an article in July 2005 titled “China Speed -- Running Into the Great Wall”, making a case that Chinese economic slowdown will send that great country into a severe recession. Last month I updated that article adding some minor twists. I found an interesting counter point to my article on this website that I thought I should share with readers:

The post, written by Vitaliy Katsenelson, VP with Investment Management Associates and a teacher of equity analysis at the University of Colorado, entitled, "The Great Bubble of China?" posts China is "living through one of the greatest historical bubbles." Katsenelson sees China as a manufacturing country built with high interest debt. He sees China's fall occurring due to factory overcapacity, a rise in the cost of money, and/or a slowing U.S. economy.

Katsenelson even has titles for the books he sees being written after the fall: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2.” The author's investment advice is to take your money out of commodities and to forget about investing in Chevron (CVX), Exxon Mobil (XOM), or Conoco Phillips (COP). Katsenelson equates the idea that all companies need a China strategy to the idea in the late 90s that all companies needed an internet strategy.

Call me part of the bubble, but I disagree with Katsenelson on all points. China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising and even if they were not, I could see manufacturing tailing off and stabilizing, but I cannot see it crashing. If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising. On top of this, China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers.

I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China. Secondly, the U.S., though obviously of huge importance to China, is not everything. Thirdly, though I do believe there will be a slowdown at some point (there has to be!), a slowdown is not a crash. It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

I was glad to see interest in the article and it got me thinking more about the discussion. Let me try to reply to every point made:

"China is a manufacturing country now, but it is rapidly diversifying from that. Its consumer and service sectors are rapidly rising... "

I actually agree with this statement, at least in part. China is likely to transform to a broader economy over the years, but it will take time. And with manufacturing making up such a large sector of the economy, it will take awhile (decades) before the services sector will be able to make meaningful contributions to the economy.

"I could see manufacturing tailing off and stabilizing, but I cannot see it crashing."

The operational and financial leverages are likely to prevent a normal slowdown, as revenues fall the costs will not fall as fast (by definition of leverage) and thus profitability will suffer.

"If labor costs in China rise such that companies take their manufacturing elsewhere (Vietnam, Indonesia, and the Philippines come to mind), and China has no industries to replace it, labor costs will stop rising."

Business Week had a small article last year making the case that China saw some double digit wages in inflation, but I think this is not true for the whole economy, but more common in specific industries. If the Chinese economy implodes, I don’t think the wages will be rising, the implosion will be deflationary for China and the rest of the world. I agree that if labor costs in China become high enough, companies will start looking for a cheaper alternative.

"China's advanced physical and legal (yes, legal, at least as compared to lower cost countries like Vietnam, Indonesia and the Philippines) infrastructure creates real value for manufacturers."

I agree.

"I also find fault with the view that a U.S. slowdown will crush China. Firstly, there has to be a U.S. slowdown on trade with China."

This comes back to my point of leverage - China has plenty of that. A U.S. slowdown will decrease incremental demand and depending on the amount of the U.S. slowdown it may be enough to decrease incremental demand to send many Chinese producers into red. Also, something I did not mention in the article is the bad loans are a real issue in China, a number I saw was 40% of GDP. Once the economy slows down they’ll come to the surface.

"It is interesting to note that in this post from June, 2005, entitled, China Speed -- Running Into the Great Wall," Mr. Katsenelson said pretty much the same thing he is saying now. So when is this bubble going to pop and why did it not pop in the last year when all of these same bubble poppers were purportedly in place?"

As I mentioned in my article “But, as with any bubble timing, the pop is very difficult, Bears are usually too early to call it and Bulls are usually too late to see it.” I really have no idea when it will take place. The Chinese government plays a very large and important role in China's economy, thus it may postpone the crash by intervening. But the longer it intervenes the great the decline will be. I have no idea when it will happen, but I am aware of the risk and thus we structure our firms portfolios accordingly, trying to minimize our exposure to a slow down in the Chinese economy.

The Best of: Dell, Not Yet?

Since there are lot of new visitors to this site, I am reposting some of my older articles that I believe are still relevant today.

July 14, 2006 - The Motley Fool By Vitaliy Katsenelson, CFA

Dell (Nasdaq: DELL) is hitting multi-year lows and, at 16 times trailing earnings, is attracting value investors that have coveted the stock from afar for years. Some of this latest decline can be traced to the company's recent downward revision of earnings estimates. And this is precisely the noise that a contrarian investor looks to capitalize on.

But are Dell's problems short-term in nature? Though the valuation appears alluring on the surface, I don't yet own the stock. Here's why.

Almost no recurring revenues With the exception of small service and printer cartridges businesses, Dell has no recurring revenues -- none! To grow a computer business 10% year over year, it has to sell as many computers as it sold last year, plus 10% more -- not an easy task with computer prices on a steady decline.

The upgrade cycle It is the last inning of the usual four-year PC upgrade cycle, and that's not great news. However, Microsoft's (Nasdaq: MSFT) Vista is likely to provide a new engine of growth for computer makers. It shifts a lot of processing from the CPU to the video and network cards, which will -- in theory -- improve the computer's performance. To reap the benefits of improved functionality, users will need to upgrade to brand new, redesigned computers -- great news for Dell. But will consumers and corporations looking to upgrade take a wait-and-see approach to Vista? Or will they install Vista on top of their existing, relatively new PC?

Laptops are still hot Laptops are a bright light in the Dell story for several reasons. First of all, as more and more people switch to laptops from PCs, the upgrade cycle will get shorter -- since a laptop's useful life is about half that of a PC's -- good news for all PC manufacturers. Second, laptops are a less commoditized product. While PCs have been mostly impersonal commodities bought mainly on price or availability, laptops are a more personal product, with features that vary from one manufacturer to another. Dell got the laptops right. And as Wi-Fi becomes more of an everyday staple throughout the world (I assume), laptops could overtake PCs.

Eroding advantage? Dell's competitive advantage as a low-cost producer, which helped the company become what it is today, has been shrinking. But it is still there; Hewlett-Packard(NYSE: HPQ) and its competitors have been squeezing suppliers, becoming much more competitive on price. In Dell's defense, it still has a distribution advantage, since it sells its computers directly to customers, allowing the company to capture extra margin instead of sharing it with distributors and retailers. And it maintains much lower inventories, a very important competitive advantage. Dell is still the only manufacturer with a negative cash conversion cycle -- it sells a computer and doesn't need to pay for the components for more than a month, resulting in great free cash flows.

Converging prices Back when a decent computer would cost a couple thousand dollars (seems like decades ago, doesn't it?), price was a very important factor. But the prices of computers have declined so much that a $30-$50 price difference is not a very persuasive argument to go with Dell versus HP or another respected manufacturer. However, this may be a very U.S.-centric perspective. For consumers and corporations in developing countries -- Dell's source of future growth -- $40-$50 is still a meaningful amount.

New products Life beyond computers is uncertain. Dell has done a decent job of expanding beyond computers to printers and ... really nothing else, at least not yet. It is an extremely efficient manufacturer, but not an innovator. It is too early in the game to determine if Dell will succeed or not, but the deck is stacked against it, insofar as it is competing against a new breed of innovative companies like Sony(NYSE: SNE) and Toshiba.

Poor customer service To cut costs, Dell has dropped the ball on customer service. I've talked to many people who've had a terrible customer service experience. While I give management credit for realizing the problem and announcing plans to hire more customer service people in the United States, I wonder how this will affect the company's margins. Is the damage irreparable? Not likely. Will it have to spend more money on advertising (further affecting thin margins) to convince consumers that things have changed? We'll see.

Financials are still strong Dell has a 58% return on capital, about 15% of its market capitalization is in cash, and its free cash flows are to die for. However, its core earnings, as calculated by Standard & Poor's, stand about 30% lower than reported, thanks to significant stock option expenses.

Tempting, but will you regret it in the morning? After reading this, the reader may find that the positives and negatives are pretty close. But two negatives in particular prevent me from buying Dell (at least at this price): lack of reoccurring revenues and a good possibility that the growth of PCs will slow down and laptop growth will not be able to make up the difference.

Glancing at the P/E, the stock appears to be inexpensive, especially in relation to its historical P/E. However, based on my discounted cash flow model, a GDP-like 4%-5% sales growth is priced into the stock. And at today's price, I think that provides little margin of safety if the above scenario plays out for at least couple years. 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.

Jos. A. Bank: You Betcha!

By Vitaliy Katsenelson, CFA September 12, 2006 - The Motley Fool Jos. A. Bank (Nasdaq: JOSB) has reported its second-quarter numbers, and they aren't good -- they're great! To start with, sales were up 20.8%, and gross and operating margins improved, mainly driven by maturation of the company's fairly new store base. But the Jos. A. Bank story is not about growth -- it always had plenty of that. It is about inventories, and they were the bright, shining star of this quarter. Specifically, inventories increased only 11.7% over the second quarter last year. So why is that great news? To answer that question, it's necessary to understand the issues surrounding Jos. A. Bank. First, it has double the inventory days (a measure of how long it takes to convert inventory into sales) of its closest competitor, Men's Wearhouse (NYSE: MW), and second, it had a terrible first quarter due to too much seasonal inventory. I have written two long articles on the first issue, so let me address the second issue here. At the end of last year, Jos. A. Bank had some incredible, blockbuster same-store sales numbers. As the company prepared for future sales growth, it continued to stock up on winter inventory. However, the winter was warmer than expected, and demand did not materialize. The company launched an aggressive fire-sale campaign to move that entire seasonal inventory, and the stock was slaughtered as margins crashed and earnings estimates were missed. Wall Street was concerned that Jos. A. Bank's "let's have a year of inventory" strategy was falling on its face. Last quarter, the company's management said it had been too aggressive with price cutting -- the benefit of hindsight showed that prices didn't need to be cut so much. Management also said it will not be cutting prices for winter merchandise in the second quarter. Declined inventory on a per-store basis and improved margins suggest that management kept its word. In fact, margins improved on an overall basis. The only cost that was rising (slightly) faster than sales was sales and marketing, which makes sense as the company has been spending more money on TV advertising. Though inventories increased, they have grown at a much slower pace than sales -- a very important nugget of information. I expect inventories will still be growing in the future, but probably slower than sales, as inventories in established stores will not be rising. This is great news on many fronts. First, the company's free cash flows will start outpacing net income growth, and second, the management that took an unorthodox strategy will gain credibility with the Street -- and the company's stock will reflect that. Let's quickly take a look at three important components of any investment: quality, valuation, and growth. Quality:

• Balance sheet: With the exception of leases, the company has almost no debt.
• Return on capital: This number has improved on a consistent basis since 2000 (despite rising inventories per store).
• Sustainable competitive advantage: JOSB is not a Wal-Mart (NYSE: WMT), but it has a product and a distinct brand that men want and it provides a better, more personal shopping experience than Men's Wearhouse.
• Free cash flow: On average, operating cash flows have consistently grown in line with net income -- a good sign in itself. As inventory growth decelerates, free cash flows will follow.
• Management: So far, it's done everything it said it would do. It made mistakes along the way (i.e., the first-quarter mishap), but nothing that would make me doubt its unorthodox strategy.

Valuation: The stock is cheap! It is trading at 13 times next-year numbers and at 5.4 times my $5 estimates for 2009 (yes, I do look that far). Growth: The company is set to open about 150 stores over the next three years to bring its total store count to 500 by 2009. As its fairly young store base (more than half of its stores are less than three years old) matures, its margins will increase, driving earnings growth in excess of sales growth.

Owning Jos. A. Bank requires one to think independently from the rest of the pack. Analysts don't get fired for owning conventional stocks like IBM or Colgate, but they do get fired for owning a company that has double the inventory days of a close competitor. Investing in JOSB requires a strong stomach for high short-term volatility and a conviction that can only be achieved from one's own in-depth research.

Vitaliy N. Katsenelson, CFA

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Jos. A. Bank and Wal-Mart. The Motley Fool has a disclosure policy.

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.

China stuck in overdrive

By Vitaliy N. Katsenelson

Denver Post Al Lewis's Blog - August 16th, 2006

The Chinese economy reminds me of the movie “Speed”, where Dennis Hopper wires a bus with explosives and sets them to blow if the bus goes slower than 50 miles per hour.

• The Chinese economy has 1.2 billion unsuspecting people on board. It could all blow if economic growth drops below its current pace of more than 8 percent. Even a small, otherwise harmless speed bump is likely to send this gigantic economy into a severe recession. Here are the reasons why: China has become a de facto manufacturer for the world. With exception of food products, it is difficult finding a product that was not, at least in part, manufactured in China. Industrial production accounts for 53 percent of its Gross National Product (according to CIA Handbook), double the rate of most developed nations. Industrial production for the United States is 19.7 percent of GDP, UK 26.3 percent, Japan 24.7 percent. Chinese economic growth is largely driven by the manufacturing sector, as its industrial production growing at the double rate of GDP.
• The manufacturing industry is very capital intensive. Building factories requires a large upfront investment. To make things worse, with commodity costs rising, the required investment has increased. Once it’s built there is a fixed cost associated with running a factory that is to some degree independent of utilization level – a classical definition of operational leverage. Laying-off workers is a politically sensitive process thus creating another layer of fixed costs.
• Debt is an instrument of choice in China. Due to a lack of equity-fund- raising alternatives, bank debt and underground finance companies that charge very high interest rates are the predominate sources of capital in China – financial leverage. Large piles of debt (financial leverage) combined with high fixed costs (operational leverage) create a very high total operational leverage. Total operational leverage in China is elevated further as factories are built to accommodate a future demand, and since it has been rising in the past automatically projected to climb in the future. This greatly leveraged growth works fine as long as the economy continues to grow at fast pace. As sales are growing, costs are not growing as fast as they are largely fixed (thanks to operational leverage) leading to operating margins expansion - the beauty of leverage. Unfortunately leverage works both ways, as sales growth slows down the opposite takes place.

There are many factors that could cause the fatal slow down in Chinese economic growth:

• Slow down of China’s largest trading ‘partner’ - the U.S. economy: China is financing its biggest customer – the U.S. consumer. Similar to Lucent Technologies trying to induce sales growth by financing its dot.com customers, China is in part financing U.S. consumers by buying U.S. Treasuries, thus keeping the U.S. interest rates at very low levels and creating what Mr. Greenspan called a ‘conundrum’.
• Higher short-term rates coupled with debt levered balance sheets, doubling of credit card minimum payments (coming to consumer door steps in January 2006), high gasoline prices topped with a sprinkle of significantly higher heating costs may push consumer off the shopping train - lowering demand for Chinese produced goods.
• An ever rising pile of politically motivated bad loans may bring the Chinese banking system to a halt (similar to Japan’s of late 80s). Though China is trying to Westernize its lending practices, a dangerous combination of semi-market economy and a in most part government controlled banks is very dangerous. In this environment loans are often made not on the merit of investment but based on political connection – a recipe for disaster.
• Overcapacity - It is a human tendency to draw straight lines and thus making linear projections from past into the future. During the fast growth period the angle of the straight lines is usually tilted upward, causing over investment in fixed assets, as inability to keep up with demand may cause manufacturers to lose valuable customers. However, overcapacity is a death sentence in the manufacturing (fixed costs) world. As companies face overcapacity or slowdown in demand, they try to stimulate sales by cutting prices, which in part lead to price wars (similar to what we observed in the U.S. between Sprint, MCI and AT&T (NYSE: T) in long distance business in mid 90s) and to a fatal deflation.

Currently companies emphasize their China strategy on their conference calls, in a similar fashion as companies were emphasizing their internet strategies in the late 90s. Though did not start re-naming themselves to incorporate China into their names -a common practice in late stages of internet bubble; It is very apparent that many are making large investments in China. As it usually happens after the bubble pops, the past assets turn into today’s liabilities. Thus, a highly touted exposure to China that was looked upon as an important asset lead to a written-off investment, leaving nothing but a trail of liabilities behind.

Though a pop in Chinese bubble is unimaginable to many, the same way as collapse of Japan and fifteen year recession that followed was unimaginable in late 80s. It is not a question of ‘if’ but more of a question of ‘when’ the Chinese economy will cross that metaphorical 50 miles per hour mark and falling into the deep abyss of prolonged recession and very possible deflation.

China is living through one of the greatest historical bubbles. Books will likely be written to describing its ‘ridiculousness’, but as always, they’ll be written after the fact. Here are some suggestions for the book titles: “The Chinese Conundrum” or “The Great Chinese Bubble” or “Irrational Exuberance 2”.

But, as with any bubble timing, the pop is very difficult. Bears are usually too early to call it and bulls are usually too late to see it.

As government published numbers of economic growth cannot be trusted, investors should look for anecdotal clues for the inflection point. Conference calls of U.S. companies doing business in China are probably the best source of information.

The risk of the Chinese bubble is real, thus it may be wise to prepare by immunizing portfolios from that risk. Though being completely rid of the China risk is impossible and impractical, it is very important to stress-test a portfolio against that risk, one stock at a time. Industrial commodities and companies that produce them are likely to be the first casualties of the bubble bursting. Oil stocks like Chevron (CVX), Exxon Mobil (XOM), Conoco Phillips (COP) and many others were great performers in 2005, up in double digits. Their run is likely to end when Chinese economy goes into a tail spin.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches equity analysis at the University of Colorado at Denver’s Graduate School of Business. He also writes for the Financial Times, The Motley Fool and Minyanville.com. More of Vitaliy’s articles could be found at www.ContrarianEdge.com

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.

Jos. A Bank Is a Patient Joe

By Vitaliy Katsenelson, CFA

August 31st, 2006 - The Motley Fool

Investing isn't for the faint of heart. A Foolish investor must be strong enough to change his or her mind when a stock's underlying facts change -- or hang on tight, even in the face of a share-price decline, when they don't. I wrote a very favorable article about Jos. A. Bank (Nasdaq: JOSB) about a month ago, and I wouldn't change a single line in that article, despite news that the retailer's same-store sales for August fell 6.1%.

Monthly same-store sales numbers are just too random to make good predictors of future results. And Jos. A Bank's most recent sales faced numerous obstacles:

• They had to top last month's 15.9% same-store sales increase. The company's average July/August sales are still up 4.9%, and year-to-date same-store sales are still running at a very impressive 5.7% clip. Note that catalog and Internet sales (about 10% of total sales ) were up 17.4% in August.
• They faced similarly tough comparisons with the year-ago quarter's 12.9% same-store sales increase.
• Finally, they relied upon uneven promotional activity. Jos. A. Bank's same-store sales were always volatile, largely because of its legacy marketing positioning. Under previous management, the company mailed promotional coupons to target male shoppers; store prices were inflated to compensate for these coupons. This kind of of promotion-driven marketing causes same-store sales to ebb and flow.

The current management team is gradually trying to steer the company away from coupons and toward brand-building via TV advertising instead. But old habits die hard; male shoppers in established Jos. A. Bank markets have grown accustomed to waiting for coupons before shopping at the store, so the company must still rely heavily upon coupons to bring them in.

Invasion of the increasing inventoryWhile all these points may help explain Jos. A. Bank's recent difficulty with same-store sales, they're irrelevant to any analysis of the overall company. This is not a sales story; the company has demonstrated a healthy ability to grow sales. This isn't even really a profit-margin story; with the exception of last quarter, the company's profit margins have been rising since 2001.

No, Jos. A. Bank is an inventory story. The stock has fallen from its mid-$40s highs because Wall Street doesn't trust a retailer whose inventory has been on the rise for the last five years. The distrust makes a lot of sense to me, since retailers live and die by inventory -- but not all inventory increases are created equal. If inventory days were to rise for American Eagle Outfitters (Nasdaq: AEOS) or Abercrombie & Fitch (NYSE: ANF), I'd be very concerned, since teenagers' love affair with hole-filled jeans fluctuates as quickly as the fashion trends spotted on YouTube or MTV. But casual and not-so-casual men's fashions move at a more glacial pace. White and pinstripe shirts have been in fashion since ... frankly, I can't count that far back.

Out-of-control inventory increases are simply scary, an indication that customers don't want to buy the company's merchandise. But again, that's not the case here. In conference call after conference call, Jos. A. Bank management has stated its intent to increase inventories at its stores. Why? The company found it was turning customers away because it didn't have enough of the right sizes. By increasing size selection in its stores, Jos. A. Bank was able to generate higher sales. It's just that simple.

Rising inventories are a cash flow hog, but Jos. A. Bank still has enough cash left over to fully cover its explosive growth. Despite rising inventories, its return on capital has been increasing since 2001, exceeding the return on capital of Men's Warehouse (NYSE: MW). The higher-inventory strategy has worked for Jos. A. Bank, and I believe it will keep working.

Tailored for successHow much inventory is enough? Management has indicated that the end of inventory increases is in sight. Once the market becomes comfortable with Jos. A. Bank's inventories once more, the stock should find a renewed Wall Street following. In my analysis, Jos. A. Bank should earn about $5 a share in 2009 -- perhaps a dollar or so less if the economy slows down. At today's price, I've got more than enough of a margin of safety to remain patient about this stock.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of Jos. A. Bank. 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.