How quickly value can evaporate these days. Bear Stearns (BSC) closed on Friday at $30, down from $57 the night before. I spent the weekend working up an article on why investors should still avoid it despite an apparently low price relative to book value. Before I could publish it (not that it would have done any good), JPMorgan says it will buy Bear Stearns.

JPMorgan Chase & Co (JPM - Annual Report) said on Sunday it would buy stricken rival Bear Stearns for just $2 a share in an all-stock deal valuing the fifth largest investment bank at about $236 million.

How could a stock go from $57 to $2 in two trading days, all the while having a book value above $80? I can’t say, exactly. But here’s what I was planning to say on the assumption that the stock would still be $30:

Many value investors look for stocks trading at prices below the company’s book value per share. Such stocks are often undervalued.

After Bear Stearns’ shellacking on Friday, the stock closed at $30. Yet on the conference call, Bear Stearns CEO said its book value “fundamentally” is still in the mid-$80 range. Does that mean value investors should step in?

I don’t think so. Taking a look at the 10K the company filed in January, I found it quite easy to make most of that $11.8 billion book value disappear.

To start with, there is $950 million recorded as “goodwill & intangible assets.” Subtracting this out leaves a tangible book value of $10.8 billion, or $82 per share.

Next, Bear’s balance sheet includes, in “other assets,” $5.2 billion in “financial instruments that are valued using models or other valuation methodologies.” Most of the total is “comprised of financial instruments whose fair value is estimated based on internally developed models or methodologies utilizing significant inputs that are generally less readily observable.”

Given that the credit issues have really just started to flow through the system, I’d want to be conservative about the value of these instruments. For the sake of argument, I’m assuming they are really only worth half their book value. Admittedly, I’m just making a guess. But then again, so is Bear Stearns.

If I take $2.6 billion off the value of these instruments, the tangible book value is reduced to $8.2 billion, or $60.22 per share.

Bear also reported $33.5 billion in “assets of variable interest entities and mortgage loan special purpose entities.” These were the loans it was unable to move off of its balance sheet. Of this amount, Bear says its maximum loss is nearly $3 billion. For conservatism, I’ll assume that maximum loss gets realized. That cuts the tangible book value to $38.

Finally, As of November 30, 2007, the Company had notional/contract amounts of approximately $13.40 trillion of derivative financial instruments, of which $1.85 trillion and $1.25 trillion, respectively, were listed futures and option contracts. These amounts are not fully reflected on the balance sheet.

It’s likely that many of these derivative instruments offset each other, reducing the total exposure Bear faces. But without being able to see the underlying contracts, investors are unable to make that judgment. Since the tangible book value is less than a tenth of one percent of the notional value of these contracts, it isn’t hard to imagine the contracts changing in value sufficiently to wipe out the remaining tangible book value.

While there may be a buyout of Bear Stearns, it would be made by sophisticated investors with full access to the company’s financial information. These investors are in a position to determine a value for Bear Stearns.

I, on the other hand, am not. And if I can’t make a reasonable estimate of the company’s value, I’m going to stay away.

Disclosures: William Trent has no positions in the companies mentioned

Starbucks launches chocolate line:

Starbucks Coffee Co. (SBUX) has launched a line of chocolates laced with the flavors of its coffees and teas, such as Milk Chocolate Caramel Macchiato Truffles, and milk and dark chocolate infused with Tazo brand teas.The chocolates, which are made by The Hershey Company (HSY), were launched this month at grocers and other retailers nationwide. For now, however, the chocolates are not available at Starbucks coffee shops.

When I wrote about Hershey’s, I said “at this point, even if Hershey’s problems don’t go away, merely not getting worse should be enough to get the shares back on track.”

One of Hershey’s problems has been market share loss to premium chocolates. A difficulty in fighting this is that Hershey’s own brand will not attract premium customers. Enter Starbucks, who has exactly the right kind of brand for the task at hand.

I’ve also said that the problem for Starbucks is in the licensed stores, which are typically located inside other retailers such as Safewa. These stores dilute the brand by failing to provide the “Starbucks experience.” Licensed products, on the other hand, can fit into the premium brand (if done right.)

That said, it seems clear to me that this partnership offers more to Hershey’s, whose $5 billion in annual sales come from chocolate products sold primarily at grocers and other retailers, than to Starbucks, whose $10 billion in annual sales come primarily through coffee products sold in its own coffee shops.

Disclosure: At time of publication, William Trent owns shares of Starbucks (SBUX)

Disclosure: Author is long Starbucks (SBUX) at time of publication.

My latest column is up at RealMoney. It is about Websense (WBSN), which provides companies with Internet security tools. In brief, I like the company, but I’d like it more at a different price.

The $48 million in free cash flow Websense generated last year equates to a 5.1% free-cash-flow yield, about double the yield on five-year Treasuries. Analysts are projecting a 13% growth rate over the next five years, but 28.4% for this year. Given the growth in deferred revenue, I think this year’s growth number will be easily met. That means that the 13% five-year rate only requires 9.5% growth in the remaining four years.

With estimates rising, the growth estimates appearing conservative, and a solid free-cash-flow yield, I like the prospects for Websense over the longer term. However, I’ll be approaching an investment cautiously. On the fundamental side, I’d like to see the earnings quality and cash-flow improvements start to show up. Absent that, the chart could look a bit stronger — especially given the whipsaw market we’ve been in lately.

I’d normally look at writing put options here, but the price is too far from any strike price to make the premium sufficiently attractive to me. Whether higher or lower, I’d prefer a different entry point. A pullback to recent lows would boost the free-cash-flow yield above 6%. Alternatively, better price action would give me more confidence that the bottom is really in place.

The full article is available at RealMoney.

Last September I was bearish on Delta Airlines (DAL), saying “How quickly we get from something that looks enticing to something that looks like it came out of bankruptcy five months ago. Which, of course, it did. Bottom line, if you want to take a flier on an airline, I’d stick with one of the short squeeze plays. The majors still look like they can cause a major league stomachache.”

Earlier this month, I noted that I should learn to take the money and run, as three of my previously correct bearish calls had been bolstered by takeover rumors.  With Delta now solidly back in the column of not making me look stupid, it’s time to call it quits on this call.

U.S airlines plunge on recession worries | Markets | Markets News | Reuters

Shares in U.S. airlines plunged on Wednesday, with Northwest Airlines (NWA) and Alaska Air Group (ALK) dropping more than 10 percent, after JP Morgan cut its ratings on those carriers and several others due to recession concerns.

Since my original bearish article, Delta is now down 37.3%, compared to a 10.3% decline in the S&P 500 (SPY) over the same period. Although I didn’t take a financial position in the stock, I am figuratively closing the position. Before another greater fool comes along and tries to buy them out, I’m taking the money and running.

Disclosure: At the time of publication, William Trent has no financial position in the companies mentioned. 

When I said it was too early to buy NBTY (NTY), unfortunately I didn’t mean a day or two early. The stock was up nicely this morning after an analyst upgrade.

Analyst Upgrades NBTY, Stock Surges: Financial News – Yahoo! Finance

Shares of NBTY Inc. surged Wednesday as an analyst upgraded the nutritional supplement maker, citing its solid sales and an attractive stock price.Edward Aaron of RBC Capital Markets said he is more comfortable with his NBTY estimates now partly because the Bohemia, N.Y.-based company recently reported improved sales. Last month NBTY said its January sales rose 6 percent, as strong wholesale results offset a weak retail environment.

As I said in the original article, though NTY looks fairly cheap so do most retailers and consumer companies. Unless we can get through another quarter without a significant earnings miss or downward revision it just seems too early to call a bottom here.

I still think there is better opportunity in names like Tupperware (TUP) or Coach (COH).

Disclosure: At time of publication, William Trent has no position in the companies mentioned.

photo credit: lemoncat1

This article is a reprint of my March 5, 2008 RealMoney column

Although MGM Mirage operates casinos across the United States and recently expanded to Asia with its MGM Grand Macau joint venture, more than half its assets are on the Las Vegas Strip. Both the number of visitors to Las Vegas and the number of total rooms in Las Vegas increased by less than 1% in 2007.

After a few years of limited new development in Las Vegas, MGM is looking to kick things up a notch or two. Capital expenditures more than quadrupled from $719 million in 2005 to $2.9 billion in 2007. The total capital costs for two Las Vegas strip development projects are expected to approach $13 billion. Another $1 billion is expected to be spent on upgrading non-casino areas at the Strip resorts and $5 billion more for the MGM Grand Atlantic City.

The situation reminds me of late 1998, when the Asian financial crisis and a slew of new Las Vegas developments (many of which are now owned by MGM Mirage) depressed share prices for the gaming stocks and proved to be an ideal buying opportunity. As happened then, majority owner Kirk Kerkorian has been buying shares recently at prices well above the current levels. Last time, he cashed in handsomely on those bets. Will 2008 be a repeat?

According to the latest 10K, the investments are paying off. “For instance, between 2003 and 2006 we invested a significant amount of capital at MGM Grand Las Vegas…. That resort earned $290 million of operating income in 2007, a dramatic increase from the $127 million earned in 2002. Similarly, we transformed The Mirage…. The Mirage earned $108 million of operating income in 2003; in 2007, The Mirage earned $173 million of operating income.”

Perhaps it is because I just read Warren Buffett’s letter to Berkshire Hathaway (BRK) shareholders, but I thought I should check whether this improvement in operating income was actually a good return on the investments being made. Buffett evaluated two of his business on the basis of pre-tax operating income divided by the total capital required to run the business.

Unfortunately, MGM has a bunch of non-operating items to contend with, and I didn’t like the way the database I use broke out the data. So I decided to use cash flow from operating activities as a proxy for operating income (in this case, after-tax.)

Source: Zack’s Research Wizard, compiled by William A. Trent

I don’t think Buffett would be impressed. In 1997, average net operating assets (NOA) for the year were $1,055 million, while cash flow from operations was $184 – a cash return on NOA approaching 18%. By 2007, average NOA were $16.6 billion and cash flow from operations was $994 million – a cash return on NOA of just 6%.

While it’s true that the current NOA includes substantial investments in long-term projects that aren’t yet contributing to operating cash flow, the trend was heading down even before these got underway. Even if the projects do boost returns on invested capital to prior levels, it will be some time before that happens. CityCenter is not expected to open until November 2009, the other Las Vegas strip development is expected to finish in 2011, and MGM Grand Atlantic City in 2012.

At an enterprise value of 3.8 times 2007 revenue and 21 times 2007 income from continuing operations, MGM looks about as fully valued as one can imagine. The acquisition of Harrah’s, which recently closed after a year-long process, valued that company at 2.6 times 2007 revenue, and 17 times 2007 operating income. And that deal was launched at the height of the private equity boom. It seems wishful thinking to expect a similar valuation in today’s environment.

So I am not optimistic that the 1998 thesis will pan out this time. But while I would sell any existing long position and sit on the sidelines (at least until CityCenter opens), I don’t have the guts to short this name. Kirk Kerkorian’s Tracinda Corporation has the resources to continue funding the developments and possibly to take on a larger ownership stake. Bringing on joint venture partners to co-finance the project has also become a key strategy, with deep-pocketed Dubai World being more than capable of taking up any slack. In fact, taking on Dubai World as a joint venture partner on CityCenter resulted in a $1 billion gain on the investments made to date.

Disclosures: William Trent has no positions in the companies mentioned

This article is a reprint of my March 4, 2008 RealMoney column

When I started looking at NBTY (NTY) when it showed up on one of my screens recently, I realized a good chunk of my typical Whole Foods (WFMI - Annual Report) bill was going to their products. NBTY makes vitamins, sport supplements and other products under the brand names Nature’s Bounty, Vitamin World, Puritan’s Pride, Holland & Barrett, Rexall, Osteo-Bi-Flex, Flex-a-min, Knox, Sundown, MET-Rx, WORLDWIDE Sport Nutrition, American Health, DeTuinen, Le Naturiste, SISU, Solgar, and Ester-C.

The health food shops where I pick up my supplements (which are served through NBTY’s wholesale segment) account for nearly half the company’s total sales. The North American Retail segment (457 Vitamin World and 80 Le Naturiste shops) provided 11% of 2007 sales, European Retail (626 stores under a variety of brand names) was 31% of company revenues and the Direct Response/e-commerce segment provided 10%.

These are clearly consumer products, clearly discretionary, and clearly at risk to a consumer slowdown. Given a price of just over ten times earnings and a 10% free cash flow yield, it is also clear investors are aware of this. However, there could still be some downside given that in 2000 valuations troughed at 8.8 times earnings and 0.6 times sales.

For NBTY, the slowdown hit hard in the December 2007 quarter with flat sales and falling margins. That said, the company appears well prepared to weather a slowdown, having cut its debt load from $500 million to $210 million over the last two years. Moody’s recently upgraded its outlook to positive, which is nice for a company with high yield debt in a time of extreme credit market jitters.

The wholesale division has been the company’s strong point, with improving gross margins over the last year. The other half of the business has been poor, requiring store closings in North America. Although European retail performed relatively well in 2007, it was primarily due to currency related issues. In the first quarter, European retail sales declined 4% in local currency.

NBTY is trying to right the retail ship through its store closings and other cost saving moves. The company ended 2007 with 35 fewer stores than it started with. 71 leases are due for renewal in 2008, and the company expects to close 23 more in 2008. NBTY also plans 10 to 12 new store openings this year. In the first quarter, five stores were closed and two opened. These efforts will only be made more difficult if a recession materializes.

I have a few concerns over earnings quality. For example, in each of the last two years the company has reserved less than the actual amount charged for sales returns, bad debt and promotional incentives (an under-reserving trifecta.) However, overall earnings quality measured using the accrual ratio appears strong.

Source: Zacks Research Wizard, compiled by William A. Trent

I’m also nervous about a stock that has had such a big run over the last few weeks. But then again, I had the same concerns about Tupperware (TUP) and it has continued to outperform after rebounding from the same January low. (As a side note, American Oriental Bioengineering (AOB) could represent a catch-up play here.)

The options aren’t generating a particularly good premium right now, so there doesn’t seem much point to a put-write strategy. On the other hand, buying the March $25 puts for $0.15 (as I am writing this) seems like fairly cheap insurance on a long position, given my concerns about the recent run-up.

All in all, though NTY looks fairly cheap so do most retailers and consumer companies. Unless we can get through another quarter without a significant earnings miss or downward revision it just seems too early to call a bottom here.

Disclosures: William Trent has no positions in the stocks mentioned.

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

When I first became an analyst, my boss was fond of saying he’d rather have luck than brains. There are so many times, as an investor, when I have considered the understated wisdom of those words. The whole field of behavioral finance is devoted to the tricks our brains like to play on us, and there are certainly plenty of examples of cases where investors simply became too smart for their own good.

I had a little case of luck last week, when I was going to write puts on either Ceradyne (CRDN) or Verizon (VZ - Annual Report), having the capital available for only one of the trades. I chose Verizon primarily out of luck, and it has rallied nicely from the intra-day lows near which I wrote my puts, making it quite unlikely that they will be exercised against me. Meanwhile, Ceradyne lowered guidance Tuesday and lost more than 25% of its market value.

Although I have often expressed the benefits of a put-write strategy (lowering the effective price of stocks you were willing to buy anyway, or collecting a more generous yield if the stock doesn’t fall below the strike price) I thought an analysis of the Ceradyne case would offer a good illustration of the risks – and why I like the strategy even when those risks are considered.

First of all, the 25% decline in Ceradyne was going to knock put sellers or long investors regardless of any stop-loss or other strategies commonly described as “risk reduction” tools. In fact, it nicely illustrates the criticisms of the Black-Scholes option pricing model so recently discussed in Conde Nast Portfolio. Namely, the big event risks are underestimated. Only having bought puts at a lower exercise price (and thus eroding the potential returns) would have offered some protection against the sudden price drop. 

That said, does the exposure to sudden price drops invalidate the strategy? I don’t think it does, provided investors focus on the stocks that they understand and are willing to be long anyway. In fact, when I looked at the put-write on Ceradyne in December I pretty much nailed the potential risks.

“Let’s say you write a January $45 put and get your $1.60 premium. In January, the stock trades at $44 and you end up with it, at a net cost of $43.40. You immediately sell a February $45 call option for something like $1.25, bringing your net investment down to $42.15.

“Then the company announces that earnings will only be $3 a share in 2008, and the stock drops to $30. You’re down $12.15, or 27% of the money you put at risk. So much for low risk.

“On the other hand, if you compare the same transactions to buying the stocks today for $48.30 you would be $6.15 ahead of the game if you used the option strategy. So, while the risks are real, I still consider the strategy to have less risk than either owning or shorting Ceradyne outright.”

Whether simply buying a stock, or using a put-write strategy, knowing the risks is imperative. I always try to look at a disaster scenario (like the one I illustrated for Ceradyne) that is outside the limits of what most investors consider. Usually these disasters don’t occur, but they happen more often than investors like to admit. Planning for them – and mitigating them when possible – should pay off over time.

Disclosures: William Trent has written put options against the shares of Verizon (VZ - Annual Report).

photo credit: atennies94

The following article is a reprint of my February 27, 2008 RealMoney column.

A long UPS/short FDX paired trade could work, but I’d wait for a pullback to $65 before UPS would tempt me as a long-only play.

My bullish November 2007 Landstar (LSTR - Annual Report) column represents my most successful pick for RealMoney to date. The stock is up 20%, compared to a 6% decline in the S&P 500. Landstar has also outperformed CH Robinson (CHRW - Annual Report) by 9% since I predicted as much in December, and YRC Worldwide (YRCW) has underperformed the S&P by 10% since I advised looking elsewhere.

Given that my transportation picks seem to be working out better than my others, I decided to push my luck with another long-short idea. This time, I think United Parcel Service (UPS) can continue its recent outperformance relative to FedEx (FDX - Annual Report).

Two years ago, I wrote briefly about the relationship on my blog, saying:

FDX has greater operating leverage and will continue to outperform as long as the economy continues to expand and trucking capacity remains tight…. Timing this switch is the difficult part.

Over those two years, the timing has clearly happened. UPS has outperformed FedEx by about 10% since then, and by 25% in the last 12 months.

Other than the operating leverage, I think the stocks are similar enough that a long-short trade would truly offset much of the risks. Clearly the macroeconomic and industry exposures are similar.

FedEx is expected to grow slightly faster (15% compared to 13% for UPS) over the next five years and has a lower P/E multiple. But UPS generates far more free cash flow. The free cash flow yield at UPS is 5.3%, compared to just 2% at FedEx. The cash flows can be used to buy back shares, pay dividends, or make acquisitions. All of these could boost the EPS growth rate for UPS. Because of the higher yield, I think there is much less downside for UPS.

UPS also tends to have slightly higher earnings quality, on average, than FedEx. I use the accrual ratio, which measures the difference between cash earnings and accounting earnings, as a proxy for earnings quality. This ratio is less volatile for UPS and tends to be closer to zero in most periods, both of which give me more confidence in the earnings reported by UPS (though earnings quality at FedEx is by no means poor.)

Source: Zacks Research Wizard, compiled by William Trent

The differences in performance, however, are only relative. Long-only investors have been disappointed by UPS over time, with the shares trading within 10% of the current price for the last two years, and within 20% for the last five. In fact, UPS is almost exactly in the middle of its long-term trading range.

I think the future performance will remain uninspiring. The 5.3% free cash flow yield is reasonable and offers some downside protection, but is not enough to juice returns. At roughly five times book value and 16 times earnings, I don’t see a huge opportunity for expanding valuation. The tight trading range has also means there is little advantage to a put-write strategy. Low stock volatility means the March $70 puts offer just over a 1% premium. That isn’t enough for taking the risk that the stock falls to the low end of its trading range – though I’d be much more favorably disposed toward UPS if the stock pulled back to $65 or so.

For the reasons outlined above, I think a paired trade going long UPS and short FedEx could continue to work over the next few months.

Disclosures: William Trent is long Landstar (LSTR - Annual Report)

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

US News & World Report – Breaking News, World News, Business News, and America’s Best Colleges – USNews.com
The Housing Nightmare: Will Uncle Sam help distressed homeowners—and a hard-hit economy?

I don’t know if this article will prove to be the contrary indicator on housing, but it has many of the right hallmarks: mainstream media, cover story, major yellow journalism style headline. Will we look back and mark this as the bottom in the housing market?

I’m inclined not to think so… but it definitely gives me pause for thought.