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US Bancorp’s Glass Is Half Full

By Vitaliy Katsenelson, CFA

October 19, 2006 - The Motley Fool.com

One nice thing about owning US Bancorp (NYSE: USB) is that you know you won't blow up when it reports earnings. Unlike other money-center banks such as JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C), it won't make dumb loans to a risky country, nor will it be involved in a hedge-fund trade that went bad, nor will it grow through making large acquisitions. It is not that kind of company.

As expected, the third quarter was not exciting. It's hard to analyze the company's performance without diving into a series of glass-half-empty and glass-half-full arguments. So I'll do just that.

Half full: Earnings per share rose 6.5% over the third quarter of 2005 -- not bad, considering the stock is yielding 3.8%.

Half empty: Half of the EPS growth came from stock buybacks.

Half full: The rate of decline in net interest margin has been decelerating and likely will come to a halt if or when the Federal Reserve stops raising short-term rates.

Half empty: The net interest margin declined further, from 3.95% last year to 3.56% in the current quarter. Though loans have grown by 5.6%, average deposits shrank by 0.8%. To make things worse, non-interest-bearing deposits declined 4.8% as customers fled to accounts that paid higher interest. That further contributed to an increase in cost of capital.

Half full: This quarter demonstrated the tremendous value of the fee side of the business, which accounts for about half of the company's profitability. Fee revenues grew 15% on an organic basis -- very impressive!

So which is it?

The fee business is firing on all cylinders. But in the lending business, half is working (i.e., assets are growing) but the other half is temporarily broken (i.e., deposits are shrinking and the net interest margin is contracting).

This is where my "half-full" personality takes over. I'm not sure what could stop the deposit shrinkage, but stabilizing short-term rates should definitely help to stop the bleeding in the net interest margin. Once the contraction there stops, the net income will start growing nicely because the loan portfolio is growing. Banks have a tremendous operational leverage in that costs grow at a slower rate than revenues. Even a mild resumption of net interest income growth should help the company to substantially accelerate EPS growth.

US Bancorp is trading at about 13 times earnings, so it's not screaming "cheap." But it's not expensive, either. However, any expansion in margins, if achieved on top of growing loans, should send earnings growth into the double digits, and earnings estimates should face upward revisions.

This is one of the best-managed large-size banks, it has one of the lowest cost structures in the industry, and it has been very conservative with its lending practices. Though it does have an exposure to home equity loans -- which I believe is a riskier business than most people believe -- it is a relatively small part of its overall loan book.

One final word from the half-empty side: A significant slowdown in the economy is not good for any bank, including US Bancorp, as loan growth declines or turns negative and bad debts increase. Though I expect US Bancorp to fare better than most banks, it is not immune from troubles.

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.

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.

Dell? Not Yet

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.