Monday, May 13, 2013

Election 2012: Hot Stocks to Trade After the Election- Follow Up

Election 2012: Hot Stocks to Trade After the Election

By: David Emami

(Original article available here)

On November 5, the Monday before the election I wrote this article with a few suggestions of stocks which should outperform the S&P 500 in the short to intermediate term depending on who won the election. I wrote "Stocks to consider if Obama wins: TSLA, FSLR, PZD, NVS, SNY, TEVA" Below, I will review the performance of my picks in the event of an Obama victory.

1) TSLA- Tesla Motors Inc.

In the month immediately following the election, TSLA was up 17.92% compared to only 0.6% for the S&P 500. In the last 6 months since the election, TSLA is up 175%, compared to 17% for the S&P 500.


Below is an interactive chart comparing the performance of TSLA to the S&P 500.



2) FSLR, or First Solar is up 117% in the 6 months since the election. Compared to 17% for the S&P 500



In the month immediately after the election, FSLR returned 31.7% compared to .6% for the S&P 500.


3) PZD, the Cleantech ETF, returned 21% in the 6 months since the election. In the month immediately after the election, PZD returned a modest 1.25%, still outperforming the general market.



4) Of the three Pharmaceutical companies, Novartis (NVS), Sanofi (SNY), and Teva Pharmaceuticals (TEVA); two (NVS) and (SNY) performed extremely well while the other, (TEVA) was a disappointment.




In the month immediately following the election, all 3 outperformed the S&P 500,with TEVA up 2%, SNY up 5.6% and NVS up 3.8%. In the 6 months since the election, TEVA is down 3.5%, SNY is up 26.48% and NVS is up 24.21%.


So ultimately, of my six recommendations, five of them outperformed the S&P 500, and two (TSLA and FSLR) turned into real home runs. TEVA underperformed due to company specific issues. That is the purpose of a portfolio however, to diversify idiosyncratic risk. 





THANKS OBAMA!




Friday, December 7, 2012

Election 2012: Hot Stocks to Trade After the Election



By: David Emami

Most Americans have spent the last year trying to figure out what an Obama or a Romney victory would mean to their lives for the next four years. Due to differing political agendas, some people will benefit more from the election of one candidate than from the election of the other. Policy differences between Obama and Romney also mean that different sectors of the economy will outperform others. This trend can be capitalized on by purchasing market leaders in sectors that should benefit, or by purchasing an Exchange Traded Fund for that particular industry. Here is a brief walk-through:
If President Obama is re-elected:
Sectors that will benefit: Generic Drug Companies, Clean Energy, Technology
If President Obama is reelected this will remove any lingering uncertainty about his universal health care plan taking full effect. This will likely aid companies which manufacture generic drugs, while harming insurers and managed health care providers... (To read more, view original article here)


Update: The Future of this blog

Hi Everyone!

About a month ago, I began writing for Kapitall Wire as a contributor. This has consumed much of my time and I have wondered how I could integrate my work for Kapitall with this blog. I have decided to post all my articles I write for Kapitall here. I will also use this blog to track the performance of my stock picks

Monday, August 20, 2012

Do You Know Your Stocks? Questions to Consider Before Investing


     What makes a company a good play for a value investor? There are some quantitative metrics, such as a low P/E ratio, a low price-to-book ratio or a higher than average Return on Invested Capital which can help one evaluate a prospective company. Value investing is largely based on qualitative, subjective judgments such as quality of management however. In light of this absence of hard metrics, I have compiled a few questions that one should be able to answer before investing in a company. There is not a "right" answer to many of these questions; however a prospective investor who can answer all of these questions will have a pretty decent grasp on the operations of the target investment. 

General: 

What drives the company's revenues? For example are their revenues driven by domestic sales? Do they have one key product that drives sales? Try performing a SWOT analysis on their main driver of revenue. (SWOT= Strength, Weakness, Opportunities, Threats) 

What is the company's market share? Is the company the industry leader? What is the company's competitive advantage? Where is their industry headed? Think long term. Value investors think in terms of decades, not in terms of quarters. Will this industry still be viable in 10 years? 

How did this company handle the financial crisis of 2008? How did they handle the crash of 2002? Has the stock price recovered? Is this company's business counter-cyclical? (Their business picks up when the economy slumps i.e- McDonald's, Walmart, Dollar Tree, Advance Autoparts) 

What is their business plan? How forthright is management with shareholders? Look at transcripts of past earnings calls- especially from quarters before disappointing earnings. What guidance did management provide? Are they honest and realistic in their reports on the business? 

Efficiency: 
There are some quantitative metrics which can assist an investor for evaluating efficiency, such as: Return on Investment, Return on Equity, Return on Assets and Operating Margins. How do these compare to the industry average? A company that efficiently allocates its capital and has comfortable operating and profit margins can better whether tough times. 

Value: 
Does the company trade at a discount or premium compared to the industry average? Look at the P/E ratio and compare it to the industry average. Why do they trade at a discount/premium? Is this fair? 

Solvency: 
There are also quantitative metrics for comparing a company's solvency. 

What is their interest coverage? Current ratio? Debt-to-equity ratio? How do these compare to the industry average? 

Direction: 
What is the company's core competency? What percent of revenues are derived from this? Is this percentage an increase or decrease from 5 years ago? Have they moved to diversify their business? Why or Why not? What are the revenues/costs for each department? Is any group an outlier? 

Again- When examining the direction of the company, look at long term trends, not quarterly trends. 

Misc.
Does the company have global exposure? What percent of operations/sales are in Europe? Emerging markets? Depending on the economy, global exposure could be a positive or a negative. 

Value investing is simple, but it cannot be simplified to a check list. Nevertheless, I hope you guys find this list helpful. Warren Buffet always says that he invests only in companies that he understands, trusts their management, and believes in their long term prospects. These questions will help you understand a company and their management and long term prospects, thus simplifying your investment process. 


-DE

Wednesday, August 8, 2012

Not Sweet on NetSuite: Misleading Accounting Explored



     I intended to write a detailed analysis of Applied Materials Semiconductors (AMAT) and share with you guys the value I found hidden on their balance sheets and in their quarterly conference calls; however, I have a curious mind and in the last few hours I have become obsessed with NetSuite and the enigma posed by their quarterly financial statements. 




     Overview: NetSuite (N) is a cloud computing financial solutions provider founded in the late 1990s by Oracle alumnus Evan Goldberg. They went public in 2007 and the stock is currently trading for $57.95 per share as of Tuesday's close. NetSuite is up 42.91% YTD.  

     Intro: NetSuite posted their worst quarterly earnings in the last year, losing .14 cents per diluted share for Q2 2012, yet since the announcement; their stock is UP 18.29%! Why is their stock on a tear if NetSuite has yet to post a profit since becoming a public company? The headlines on their press release provide a clue: 

"NETSUITE ANNOUNCES SECOND QUARTER 2012 FINANCIAL RESULTS
    •  Q2 REVENUE OF $74.7 MILLION, A 29% Year Over Year Increase
    • Non-GAAP Net Income grows 192% Year-Over-Year
    • Operating Cash Flow Grows 80% Year-Over-Year to $15.2 Million"     
That sounds great! (Although the Investment Relations team should refrain from overcapitalization for emphasis as if they were middle schoolers) Listening to their conference call, the CEO and CFO both declared that Q2 2012 was NetSuite's greatest quarter ever. The discrepancy between the company's claims and their income statement, which shows their largest quarterly loss were troublesome. I poured over the transcript from their earnings call, expecting an analyst to ask the inevitable tough question: Why has NetSuite posted a GAAP loss every quarter, yet for the last 5 quarters has posted steadily rising positive Non-GAAP earnings per share, smashing Wall Street expectations? That question never came however. For those who do not know, GAAP stands for Generally Accepted Accounting Principles. All companies must use these standardized methods of accounting for reporting to the SEC. Companies are permitted to occasionally use non-GAAP accounting in order to communicate a more accurate picture of the health of the company's core operations to shareholders. The only caveat is they need to reconcile the GAAP numbers with the non-GAAP numbers in the press release. This is a rather vague allowance and some unscrupulous companies take advantage of that. I believe that NetSuite is one of them. 

     Financials: NetSuite does not have a P/E ratio as they have negative earnings. They also do not have a PEG (Price/Earning's Growth) ratio since their earnings growth is negative! This makes Comps valuation very difficult. As a value investor, I always look first to financial metrics and the financial statements when appraising a potential investment. There are not many significant ratios for N. They trade at a price to book ratio of 28.3, which is obscene. This means that the market value of NetSuite is currently 28x the book value of all of NetSuite's assets. This is in the highest 1% of all publicly traded companies, and is significantly higher than the Price-to-book ratio of Oracle (3.54) and SAP (4.9), the two companies NetSuite named as their biggest competitors. The book value per share is slightly greater than $2.02 per share. If NetSuite would trade at twice the Price-to-book value as SAP, then NetSuite would be worth 19.78 a share. To justify a multiple twice as large as their nearest competitor, one would have to project very optimistic revenue growth for NetSuite. Some companies that do not yet have earnings or earnings growth are compared using the metric price-to-sales ratio. (N) trades at a LTM (Last Twelve Months) price-to-sales multiple of 17.39. To put this in perspective, after running a Google Finance stock screener for companies with price-to-sales multiples greater than 15, the vast majority of results were ETFs and mutual funds. There were also a few lightly traded small biopharmaceuticals and Palo Alto Networks, the summer's hot new IPO which has yet to post a profit but boasts incredible revenue growth. No other cloud computing company trades at such an elevated multiple. NetSuite has a decent current ratio of 1.5 and virtually no long term debt, posting a debt to equity ratio of .03125. NetSuite has an unsatisfactory Return On Investment of -24.93% and a decent gross margin of 70%, but an poor operating margin of -12.77%. 

     By looking at valuation metrics, we have determined that NetSuite is overvalued relative to their revenue and relative to their assets. The seemingly incredible 192% non-GAAP net income growth will be covered later. This brings us to the one metric they cannot manipulate. Operating Cash Flow. Right? Wrong. A closer inspection of the Cash Flow Statement reveals that this too was the result of manipulation.  Look at their operating cash flow for the last two calendar years. If one simply looks at the bottom line, Operating Cash Flow growth looks incredible! However, a closer inspection reveals that non cash items account for 203% of Cash from Operating Activities in 2010 and 102% of Cash from Operating Activities in 2011. If one looks at the middle column depicting the percentage change year to year, it is clear that the increase in Non-Cash Items is driving their nearly 100% increase in operating cash flow. To put this figure in context, Oracle and SAP AG, their two largest competitors have Non-Cash Items as a percent of Cash from Operating Activities of 6.7% and 36.1% respectively. Facebook, a young internet company with questions about revenue generation and aggressive utilization of stock based compensation for employees has Non-Cash Items as a percent of Cash from Operating Activities of 14.3% for the 2011. Lest one think that these relatively low percentages are explained solely because all of those companies had positive net income, I also examined the financials of salesforce.com. Salesforce.com (CRM) is another growth company that posted an operating loss for the last calendar year and specializes in commercial cloud based enterprise solutions, like NetSuite. Salesforce.com had Non-Cash Items as a percent of Cash from Operating Activities of 57.6% for the 12-month period ending Jan-31 2012, despite having negative net income. While that is significantly higher than the other comparable companies, it still pales in comparison to the whopping 102% of Non-Cash Items as a percent of Cash from Operating Activities of NetSuite in 2011. 


Operating Cash Flow




12 months ending 2011-12-31
% change
12 months ending 2010-12-31
In Millions of USD (except for per share items)
Year to   Year
Net Income/Starting Line
-32.01
-16.5%
-27.47
Depreciation/Depletion
9.18
18%
7.75
Amortization
3.79
-17%
4.62
Deferred Taxes
-

-
Non-Cash Items
73.31
32%
55.38
Changes in Working Capital
-17.99
-18.4%
-22.06
Cash from Operating Activities
36.27
99%
18.23


     This brings us to the simpler and more important question. What does NetSuite consider to be Non-Cash Items? The accounting definition of Non-Cash Operating Items is all non-cash items outside of working capital, deferred taxes, depreciation and amortization. Non-Cash Items are one of the ways in which cash flow can differ from Net Income. It accounts for activities such as stock-based compensation and barter. This is because if a company compensates employees with stock options, they are required to report this compensation as an expense on their income statement which subtracts from Net Income; however, since the compensation did not require cash, on the cash flow statement, stock based compensation is added back to Cash from Operating Activities under the generic tag "Non-Cash Items".  Later on, I will break down how this NetSuite is manipulating this figure to fabricate earnings. First I will discuss the significance of including sizable stock based compensation in Cash from Operating Activities. 

      NetSuite reported stock-based compensation of $38,315,000 in 2011 compared with a reported operating loss of $30,188,000. This means that of the $73.31 million of Non-Cash Items added back to Cash from Operating Activities, $38.3 million came from stock based compensation. If Cash from Operating Activities were adjusted to not include stock-based compensation, Cash flow from Operating Activities would negative $2.03 million. If the operating cash flow from 2010 would be adjusted without the $35,937,000 in stock based compensation, they would have generated a negative $17.71 million. While this represents a still impressive 88.5% year over year growth in Cash Flow from Operations, it misrepresents the cash situation of the company by masking the fact that cash flow from operations was negative. 

     EBITDA and OCF (Operating Cash Flow) are closely related. The difference between OCF and EBITDA provides a clue as to how the company is financing itself, since Operating Cash Flow can be reinvested into ongoing operations, and EBITDA indicates the amount of debt a company can assume. (EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization can be used to calculate interest coverage and how much interest a company can afford to pay on debt. For example, if a company has EBITDA of $10 million and can borrow money at interest rates of 6%, then the company can assume a debt of $166 million ((6% of 166 million is 10 million))). Originally, I was impressed by the fact that NetSuite carried such little long-term debt. Looking at their EBITDA of -17.22 million however, it is obvious that NetSuite has very little debt because they cannot pay interest on debt since they are losing money every quarter. In the earnings call, management continuously heralded their decades of investment in the business and declared themselves "content with their cash position" and promised to continue reinvesting in growth. However, they have no retained earnings to reinvest and they cannot use debt financing since they have a negative EBITDA. This forces them to fund growth through the issuance of equity. In 2011, NetSuite raised $14 million through the issuance of equity. 189% (almost $10 million) more than in 2010. These additional equity offerings dilute the current shareholders' stake. In addition to this $14 million in new equity is 2011, NetSuite issued $38.3 Million worth of stock-based compensation. Employee options normally take about four years to vest, and predicting their value is not an exact science. It is troubling however, that NetSuite offers this large stock-based compensation every year. In 2008, NetSuite reported stock-based employee compensation of $13,378,000. These options should vest in 2012, further diluting shareholder equity. Some academics blame the lack of regulation regarding the reporting of stock-based compensation for the 2002 stock market crash. A study by a trio of Harvard Economics professors concluded that 

"in a dynamic rational expectations model with asymmetric information, stock-based compensation not only induces managers to exert costly effort, but also induces them to conceal bad news about future growth options and to choose suboptimal investment policies to support the pretense. This leads to a severe overvaluation and a subsequent crash in the stock price." 

This is why GAAP now requires companies to disclose information regarding stock-based compensation. 

This research was necessary and sufficient to prove to me that NetSuite is most definitely not a buy as a value play; however I was very curious so I decided to dig further. 

GAAP and non-GAAP reconciliation: 

When a company uses non-GAAP accounting in their earnings conference call, they are required to release a GAAP and non-GAAP reconciliation showing what the difference is and explaining why they chose to use non-GAAP accounting. NetSuite's justification for non-GAAP treatment of its stock-based compensation is fairly typical for companies that exclude stock-based compensation from non-GAAP net income and earnings. The company press release states: 

" [One time expenses and Stock-based Compensation are] often excluded by other companies to help investors understand the operational performance of their business, and in the case of stock-based compensation, can be difficult to predict. Stock-based compensation is a non-cash expense accounted for in accordance with FASB ASC Topic 718."

- NetSuite 4Q and Fiscal Year 2011 Press Release and Financial Statements (http://www.netsuite.com/portal/investors/quarterly-results.shtml)  


While it is true that many companies also give non-GAAP earnings that are adjusted to exclude stock-based compensation, and predicting the future value of stock options is difficult; quarter-to-quarter, the change in the reported value of stock -based compensation was remarkably stagnant. The change quarter to quarter for each quarter in the last calendar year was 2.08%, 1.02%, .93% and 15.4%. Running a linear regression, I found there was an r-value of .148 and an r² value of .022. Put simply, there is not a statistically significant correlation between stock price and stock-based compensation. This leads me to believe that regardless of stock price performance, key executives are receiving a fixed dollar value of stock compensation per quarter. This seems to be supported by information obtained from Morningstar, which shows total executive compensation declining 17% in 2011 while the stock price rose 62% and revenue grew 22%, despite an 18% fall in Net Income. 


 According to an S-1 filing from shortly before the 2007 IPO, in 1999, the board of directors approved a stock option plan which authorized NetSuite to issue up to 277,715,000 options to employees, directors and consultants, as incentive or non-statutory options. This is massive compared to the current amount of currently outstanding shares of common stock of slightly more than 70 million shares. At the end of 2006, NetSuite reports that there were 117,719,409 outstanding options with a weighted average exercise price of .09 cents. That is not a typo- these are not options issued with a strike price of the current share value, meaning that in order for employees to exercise the option, the stock price must appreciate. These are restricted share, stock option grants that will almost definitely be exercised when they vest or at least converted into common stock, regardless of stock price performance. Over 81 million of these options were exercisable immediately once the IPO lockup expired. The S-1 predicts that the average term life of these options, which were exercisable on December 31, 2006 to be 7.3 years. This means that these options can be converted into common stock and dilute the share base anytime between 2007 and 2014. Another 36 million options were not yet exercisable for another four years, after which they would have ten years to be converted into common stock. Under terms of the 1999 plan, at the end of 2006, the board still had 5,274,230 options it was permitted to grant. Any options that are cancelled due to employees leaving the company are allowed to be reissued to other employees in the future. 

This information, all found on the publicly available S-1 filed with the SEC by NetSuite on July 2, 2007 (http://sec.edgar-online.com/netsuite-inc/s-1-securities-registration statement/2007/07/02/section50.aspx) should frighten any investor who holds NetSuite common stock. The aggressive stock option plan approved in 1999 still is exposing NetSuite common stockholders to the risk of massive share dilution. 

In addition to the potential of share dilution due to stock-based compensation, the company's reliance on issuance of new equity to finance growth is troubling. Adding to this, I think the numbers on the Reconciliation of GAAP to non-GAAP Net Income per share for Second Quarter 2012 for "Effect of dilutive securities (stock options and restricted stock awards)" are grossly underestimated. The effect in the number of shares of common stock for the dilutive securities decreased between all of the last four quarters except between the 3rd Q of 2011 and the 4th Q of 2011. This is despite the value of stock-based compensation increasing in every quarter. The total value of stock based compensation for the second quarter (12,566,000) divided by the number of shares added to the denominator in calculating net income (effect of dilutive securities on number of shares) (3,152,000) equals a value of stock-based compensation per share of $3.98. This number does not make sense in light of the share price at the time (about $49.50) nor the strike price (.09). I have been unable to explain this discrepancy and have not found any supplemental SEC filings explaining it. One possibility is that the value of stock-based compensation is overstated to cover the loss in net income and still report a non-GAAP operating profit. According to Morningstar, the total compensation for the CEO, CFO and three highest paid executives for 2011 was $10.65 million. According to NetSuite's year end financials, in 2011, they booked an expense of $38.3 million for stock-based compensation. In their S-1, NetSuite says that the options generally vest in four years. Four years ago, in 2008, NetSuite reported a mere $13.4 million in stock-based compensation. In 2008, NetSuite reported 13.29 million for their 5 highest paid executives with approximately $12 million coming from stock options, stock grants and other non-equity compensation (forgivable loans). I am not sure whether NetSuite records options as employee compensation in the year they are exercised, in the year that they vest, or in the year they are granted. I would assume they would be recorded in the year they are granted because that is the year the company is required to list them as an expense in their SEC filings. If Morningstar records options the year they are granted, then in 2011, in order to meet the 38.3 million in stock-based compensation reported by NetSuite, approximately $30 million in stock-based compensation was split between 1000 employees, and none of them were in the top 5 best compensated for NetSuite. That would mean that all employees average $30K a year in stock-based compensation. Glassdoor.com lists the entry-level compensation at NetSuite as $67K. It is possible that almost $30K of this is paid in stock grants, however in my opinion, doubtful. $30K per employee in yearly stock-based compensation is certainly plausible, yet doubtful. Regardless of the year options are recorded, something does not quite add up in their Reconciliation of Net Loss Per Share to Non-GAAP Net Income Per Share. I encourage all of you to look at this for yourselves. It is found within the press release titled NetSuite Announces Second Quarter 2012 Results, available online at http://www.netsuite.com/portal/investors/quarterly-results.shtml 

Fraud is a very serious allegation, and I do not think that I have uncovered any evidence of accounting fraud. All of these disclosures are public record and easy to access if one knows where to look. I am surprised however that although analysts point out the suspect valuation metrics of NetSuite, no one seems concerned over the potential share dilution. While many companies offer stock-based compensation and the inclusion of non-GAAP net income excluding stock based compensation is not unusual; the extremely high percent of Operating Cash Flow derived from adding back in stock-based compensation, the large discrepancy between EBITDA and OCF caused by stock-based compensation, the dramatic difference between GAAP and non-GAAP net income due to stock-based compensation and the discrepancy between the compensation numbers reported by Morningstar and the numbers listed in NetSuite's SEC filings are cause for concern and further investigation. 

This case demonstrates the importance of understanding financial statements. Financial statement analysis is one of the principles upon which Value Investing is based. Successful interpretation of SEC filings can help an investor find an undervalued company that possesses a "margin of safety" and it can help an investor avoid companies with complicated and questionable financials. 

-DE


Disclosure: I do not have a position in any company mentioned nor do I have plans of initiating a position in any of these companies in the next 72 hours. 

Thursday, August 2, 2012

Chipotle's High Priced Burritos Will Burn Investors



     I am by nature an optimistic person. This inclines me to be a bull. I find great joy in pouring over financial statements and finding hidden intrinsic value in companies that are under valued. Unfortunately however, during the course of my research, sometimes I come across a stock that is grossly overvalued. This was the case with Chipotle. I first looked at CMG when it was trading at 430. I looked at its financials not as a prospective short, but as a prospective buy. After some initial analysis, I realized that CMG was significantly overbought. I did not short CMG at the time however. It was in the middle of a tremendous stretch. Rich Hogan, a Merrill Lynch money manager once told me "You're dead right", regarding one of my value investment ideas. "You are right, "He clarified. "But by the time the market realizes you are right, you will be dead broke." With his words of wisdom etched into my brain, I remained an interested observer on the sideline. After CMG's disappointing earnings, the time to short is now. The momentum is broken and the hedge funds are dumping CMG in droves. Now CMG should retreat to levels supported by the fundamentals. What levels are these you may ask? I answered this very question in an internal company memo about a week ago when we were discussing shorting CMG. Below, you guys can see a rare glimpse of part of our Due Diligence process. This position and strategy is designed to be maintained for a few months, so despite the fact that we started this trade last week, the method can still be used at current prices.


Memo: RE: Short strategy for CMG

Intro:  Chipotle Mexican Grill (CMG) is a chic quick service restaurant chain specializing in Burritos. Their ethos is all about treating their animals, customers and employees right. CMG operates 1316 restaurants (all but 5 in the USA). In the last quarter, CMG opened 55 new restaurants including their first in Paris.  For the 2nd Quarter of 2012 (ending June 30), CMG reported earnings of 8.32 per share. CMG currently trades at 298 a share, and has a 52 week range of (271-442) per share.

Brief call and why: I thought this was a short at 430 and I think it’s a short at 300. CMG is a food company trading at multiples of a growth company. As evidenced when they disappointed the Street by missing revenue targets by 16%, growth stocks are punished severely if there are any signs that growth is stagnating. CMG also reported the growth in same store sales slowed to only 8%, their slowest growth since 2010. In the earnings call the CFO said that “we are seeing a slowdown. Not a significant slowdown but there is no other way to put it.” For his candor, Wall Street dropped CMG by over 20%. Due to macroeconomic pressures – most notably the drought that is projected to raise food costs by 3-4% in 2013, and a stagnant economy that is making consumers unwilling to accept the higher costs, I believe CMG will experience slower than expected growth, which will prove catastrophic on the stock.

Recent News: CMG reported revenue growth of 21%, Net Income growth of 61% and same store sales growth of 8%. In the facing of rising food costs, CMG raised prices last quarter and that is being blamed in part for the slower growth. This will prevent CMG from raising prices again and force them to absorb the higher costs.  Analysts in the recent conference call raised questions on whether management could be trained or hired fast enough to keep pace with the expansion of stores and whether the opening of new stores would continue to be as profitable as it had been in the past in light of the current economic situation.


SWOT ANALYSIS

Strengths: Posted Earnings of 6.76 per share, 2011- just had strongest Earnings per quarter $2.56 (still growing but slowing) revenue growth, plans to open even more stores and spread to emerging markets
-limited exposure to Europe

Summary: their strengths? – recent success. What fwd looking strength do they have? They were first to the healthy/hip burrito market, they have growing brand name recognition, strong company culture. Low debt .35 debt to equity ratio gives them the capital needed for aggressive expansion
+6

Weaknesses: priced higher than other quick order competitors.
-1
Opportunities: will open many new stores and are exploring emerging markets such as Peru
+1

Threats: Rising food costs due to a record drought will cut profit margins by around 3%.  Slowing same sales growth will force the company to seek growth thru capital-intensive expansion. In the past quarter there were some signs that newly opened stores were not doing as well as in the past. CEO admitted that expanding into emerging markets where they are less established may cause new restaurants there to have slower launches. Company’s stock price is vulnerable due to high P/E multiple and classification as a growth/momentum stock.  Company is owned by many institutional investors (most who have already made large profits) who will dump the company if it is no longer considered a growth stock. CMG must continue to wow Wall Street with earnings growth to justify their high multiple.
-6

SWOT total= 0
Bearish/neutral.


Financials:
Income Statement highlights
2007
2008
2009
2010
2011
Q1 2012
Q2 2012
Revenue
1009
1330
1520
1840
2270
640.6
690.3
Sales Growth
-
22.67%
14.00%
20.91%
23.62%
7.35%
7.86%
389.9
484.27
527.34
630.03
1360
378.66
401.96
COGS as a % of Sales
39%
36%
35%
34%
60%
59%
58%
COGS excluding D&A
346.39M
431.95M
466.03M
561.11M
1.28B
Depreciation & Amortization Expense
43.6M
52.77M
61.31M
68.92M
74.94M
COGS Growth
-
24.29%
8.79%
19.47%
115.35%
79.38%
6.15%
695.79
847.25
991.08
1210
912.77
261.94
288.98
Gross Income Growth
-
21.77%
16.98%
21.67%
-24.31%
-32.08%
10.32%
Gross Profit Margin
69%
64%
65%
66%
40%
41%
42%

2007
2008
2009
2010
2011
Q1 2012
Q2 2012
Net Income
70.56
78.2
126.8
178.98
214.95
62.66
81.68
Net Income Growth
11%
62%
41%
20%
9.03%
30.35
EPS
2.16
2.39
3.99
5.73
6.89
2
2.58
EPS Growth
11%
67%
44%
20%
8.00%
29%




Motley Fool Value+Growth Buffett test:
Factor
What We Want to See
Actual
Pass or Fail?
Growth
5-year annual revenue growth > 15%
 20.25%
Pass
   
1-year revenue growth > 12%
23.62%
Pass
Margins
Gross margin > 35%
38%
Pass

Net margin > 15%
9.5%
Fail
Balance sheet
Debt to equity < 50%
35%
Pass

Current ratio > 1.3
3.19
Pass
Opportunities
Return on equity > 15%
23.2%
Pass
Valuation
Normalized P/E < 20
35.2
Fail
Dividends
Current yield > 2%
0
Fail

5-year dividend growth > 10%
0
Fail





Total score

5 out of 9



Comments: There is no question CMG is a growth stock. It has the revenue growth to justify its high valuation but it is still a food company trading with a technology company's P/E multiple. As demonstrated this quarter, 21% revenue growth with rising costs is not sufficient to remain a growth company and continuing to justify its high valuation.


Growth Model:


I raised total COGS as a % of sales from current levels- 73.5% to 75% as a result of the drought and every single valuation model predicted negative long term returns. I allowed the company to still grow at a similar pace (albeit declining) and reach mature company status in 2019.  These models show company value and don’t reflect the temporary effect of price shocks (i.e Earnings beats/misses). This shows that true to a value play, we have a margin of safety by shorting a company that is over valued. My expectation that CMG misses earnings next quarter and the ensuing negative price shock will present an opportunity to make an outsize profit with limited risk.

Trading Strategy:


Current Share price: $298

Bearish Risk Reversal Option:
Buy X CMG 295 Jan 14 Puts for $52.00 a contract
Sell X CMG 300 Jan 14 Calls for $52.30 a contract

Trade results in a $30 debit per 100 share contract.

Exit points: Stop loss will be set at 5% above Call Strike Price ($315.00)
The greater stop loss is set because CMG is heavily traded and may get days of heavy volume where it rallies. A tight stop loss leaves us at risk of being stopped out.

Target Price= $202.80 March 2013.
Although CMG should continue to grow EPS. Growth at 20% year over year would give them earnings of 8.11 a year for 2012 but would again disappoint Wall Street, which has come to expect yearly growth over 20%. With earnings growth at 20%, it will be difficult to justify CMG’s P/E of 35 and it will be brought to a more reasonable multiple like 25x earnings. 25x earnings of 8.11 would give CMG a valuation of $202.80. Earnings for first half of 2012 are 4.53 (historically CMGs strongest 6 months. Expected stagnation coupled with rising costs could conceivably see earnings for the 2nd half of 2012 fall to the 3.6-4 range.  

Consensus analyst estimate for 2012 is 9.02 according to NASDAQ.com. However, the consensus yearly growth rate for EPS 2012 is 33%. I think that CMG falls close to or under the EPS number, but misses growth projections. For a growth company, it is more important to be seen as growing than current profits.

Risk Profile of Trade:

Behaves as a synthetic short – Break even is between 295 and 300.         

We profit as the price of the underlying security declines

We are exposed to Primary market risk- if the stock goes up, we lose money
We have limited climate risk- the drought has done its damage to this years crops for the most part
We have very slight dividend risk- it is unlikely CMG announced a dividend as it is a growth company
We have some economic risk- QE3 could lower interest rates and flood the market with easy money bringing up the market in general

We also have sector risk- if restaurant stocks are up during the course of the trade, while CMG will under perform, it may not fall. A strong market or strong sector can mask the weaker fundamentals.