Helen of Troy and Select Comfort

Introduction

This investment report addresses whether Select Comfort or Helen of Troy should be added as small positions, of up to 50 million between them, to the Aikens small/mid cap core portfolio. Both stocks are attractive, with more certainty behind Helen of Troy.HHH Thus, the recommendation is to buy 30 million of Helen of Troy and 20 million of Select Comfort. Should, the next few data points continue to indicate a turnaround at Helen of Troy and that the 2^nd half of 2006 was an outlier for Select Comfort, the positions should be increased as there would still be considerable upside.

Conclusions + Recommendations

Both Helen of Troy, a value stock which is cheap given potentially improving fundamentals, and Select Comfort, a growth stock that is discounting rapidly declining growth, sit at different kinds of crossroads. Helen of Troy, after 2 years of declining profitability and slowing revenue growth had a very strong 3^rd quarter that suggests it may be turning around, sending the stock up 20%. Conversely, Select Comfort, after years of impressive revenue and earnings growth had a bad 3^rd quarter. Further, preannounced that the 4^th quarter is likely to be much lower than expected with negative sales comps and since October is down 30%. Despite these big moves resulting from dramatic data points, if Helen of Troy’s recent quarter is an indication of a turnaround, it is still cheap, whereas if Select comforts downside surprises are an indication of declining growth and pricing power, then it is still too expensive.

Both of these stocks appear to have attractive risk rewards, of roughly 30% downside to 100% upside in both, and it appears both the unattractive industry for Helen of Troy and the declining competitive advantage of Select Comfort are priced in. Both of these stocks appear worth buying, though there is more uncertainty in the forecast for Select Comfort as there are many more variables in play. Thus, the modeling and valuation behind this analysis is more suspect for Select Comfort. However, it seems if the model is incorrect with Select Comfort and things do get worse because of the high short position, it is likely the downside would be cushioned.

Select Comfort

Business Analysis

Select Comfort operates in the mattress industry, a 6 billion dollar industry, growing at roughly 6% annually (2% unit, 4% revenues). Four players, Sealy, Simmons, Serta and Spring Air, who sell primarily traditional spring mattresses, largely dominate the industry, accounting for 55% of sales. The retail industry is highly fragmented with Select Comfort being the largest player at just over 5% market share. There is a shifting trend to customers buying more expensive beds from specialty stores like Select Comfort. This trend bodes well for them. However, there are concerns for the mattress industry given macroeconomic and the weak housing market.

Select Comfort sells premium air mattresses, marketing them under the sleep number brand. Select Comfort recognized that other mattress companies didn’t use marketing budgets on building their brand, so they built their brand by heavily marketing the “sleep number” concept. Select Comfort, differs from competitors in that it is fully vertically integrated, producing, distributing and selling its mattresses, thus capturing both the manufacturing and selling margins. It owns 440 retail stores, which account for 78% of sales, and has one of the highest sales per square foot in the business at approximately 1333. They also signed an agreement to put mattresses in all Radisson Hotels, which also serves as a marketing initiative. Select Comfort also sells ancillary non-mattress items, accounting for roughly 20% of sales. Select Comfort also differs from competition in that they ship all mattresses from their two distribution centers (in Utah and South Carolina) giving them better inventory management.

Porter Analysis of Mattress Industry and Select Comfort’s Position

Bargaining Power of Customers-The bargaining power of mattress buyers, for traditional mattress companies, is relatively weak. Mattress retailers are highly fragmented, without substitutes, more concerned about quality and lack the ability to backwardly integrate. However, the retailers are consolidating and in the process gaining more power. Select Comfort has already integrated forward with their own retail stores and has especially strong pricing power because of their differentiated product.

Bargaining Power of Suppliers- The bargaining power of the suppliers to mattress companies is also relatively weak. Their products are commodities and they are highly fragmented without the ability to forward integrate.

Threat of New Entrants- There is a risk of new entrants to Select Comfort’s dominant position in the specialty mattress segment. Competitor’s such as Sealy are looking to enter this segment of the mattress market because of its especially high margins. This fear is largely the reason for the high short interest. However, Select Comfort’s main differentiation is not their patents but their brand name and marketing, which does create some barriers to entry.

Threat of Substitutes- There is a threat of substitutes to Select Comfort’s air mattresses from Tempur Pedic’s visco-elastic mattresses (which themselves are facing increasing competition in their type of mattress).

Intensity of competitive rivalry-The mattress industry is becoming increasingly competitive. Sealy and perhaps some of the other big four traditional mattress manufacturers (Simmons has an insignificant current foray into the air mattress sector) could enter into Select Comforts segment of the industry, attracted by the very high gross margins.

Overall this is a decently attractive industry, where Select Comfort has a good competitive edge as a result of their vertical integration and brand differentiation, achieved largely through their strong marketing efforts. However, the attractiveness of this industry, particularly for Select Comfort is declining with the increasing competition, and is the key reason it is so heavily shorted.

Management

Select Comfort’s management is headed by William McLaughlin, who was formerly the president of Frito-Lay Europe. James Raabe is the CFO and has been with the company since 1992. This is a fairly experienced management team for a small company and they have so far done a good job leading the turnaround of Select Comfort since 2001. Management is expanding into a larger headquarters, which is never a good sign, but it seems like a modest and thus likely a necessary expansion.

Financials

Select Comfort has been consistently growing revenues at a rate of 25% since the Mclaughlin led turnaround started in 2001. Revenue growth has slowed slightly from 30% annualized in 2001 to 2003 to 23% annualized from 2003 to 2005. Operating income (as 2002 benefited from a tax loss carry) became positive in 2002, and after doubling in 2003, has grown 20% in 2004 and 33% in 2005. Operating margins, after increasing from 6% in 2002 to 9% in 2003, have remained constant. ROA has remained constant at 18% over the last 3 years, while ROE has increased from 29% in 2003 to 36% in 2005.

Likely as a result of their shipping from their distribution centers, Select Comfort’s days to sell is very low and decreased to 32 in 2005 from 42 in 2003. Days to collect is also extremely low at 5 in 2005, likely because they control their distribution channels. Days payable was 38 in 2005, having been constant since 2003. The efficiency of operations can be seen in the cash conversion cycle of 0 days in 2005, showing the benefits they realize from being vertically integrated.

On Nov 30, Select Comfort reported that 4^th quarter revenues would be much lower, as same store sales declined 9% (though some of this was because of price increases in 2005). Earnings guidance was lowered to 80 to 87 cents, when street estimates had been 96 cents. This came on top of a weak 3^rd quarter. Management continued to reiterate 15 to 20% revenue growth and 20 to 25% earnings growth. However, this indicates that Select Comfort is suffering from the increased competition (it is unlikely the whole decline is from the real estate market), and possibly also that their unique marketing campaign has tired.

Competitors

Many of Select Comforts competitors (Simmons, Serta, and Spring Air) are private, with only Sealy and Tempur-Pedic being public. Tempur -Pedic is a very similar company to Select Comfort, both being high margin specialty mattress manufacturers. Both are over 20% shorted. Select Comfort has better gross margins by 8% but with Select Comfort’s heavy reliance on marketing, Tempur-Pedic has 10% higher operating margins. They have also rather equal revenue and growth rates as well as total revenue. Despite the much lower margins and thus a lower ROE, Tempur-Pedic trades at a discount to Select Comfort, with a 13 forward PE and 1.06 PEG compared to a 15 forward PE and .91 PEG. This may be a result of concerns about the sustainability of Tempur-Pedic’s competitive advantage, and while this is the same concern that has Select Comfort heavily shorted, Select Comfort maintains a better brand moat due to advertising.

Valuation- FCFE using growth sensitivity

There is a lot of uncertainty surrounding Select Comfort’s valuation at the moment, largely dependent on whether the mid quarter update was a blip or signifying a slower rate of growth, and a shorter period of higher growth. Therefore two scenarios have been modeled for the different growth trajectories using a two stage FCFE growth model.

The first scenario assumes a 3 year period of higher growth at 15%, with revenue growth at 12%. This scenario is possible particularly if there quickly becomes more competition, slowing revenues and growth. At a stable growth level, a 6% growth rate was assumed with a ROE of 15%, which would imply a revenue growth rate equal to the industry average and stable margins. These assumptions gave Select Comfort a valuation of 14, or roughly 20% below the current market value.

The second scenario assumes a 4 year period of higher growth of 20% (still below the last few years) with 15% revenue growth, which is roughly what company guidance is. The stable growth rate is key here as if it Select Comfort can maintain a sustainable advantage keeping the growth rate at 8% (above industry growth), it would give Select Comfort a valuation of 40, which is considerable upside. With a growth rate of 6%, the valuation is 30, which is still roughly 80% above the current price.

However, there are no guarantees that either of these scenarios is realistic. It is entirely possible that the competitiveness of the specialty retail industry accelerates such that the long term growth rate is 2% for example, leaving the pessimistic scenario at a value of 13 and the optimistic scenario at a value of 22. It is also possible that both scenarios are too positive on the length of higher growth, which could be the case if competition is increasing and their message and penetration is slowing as the warning showed. If the both models only assume 2 years of growth and 4% sustainable growth, the values fall to 12 and 20 respectively.

Investment Conclusions

Select Comfort is clearly at an inflection point. It is heavily shorted, and as recently was proven, there was at least some validity for this. If it can maintain a reasonably high level of growth, by maintaining margins, growing revenues in the high teens, and keeping new entrants from penetrating its high share of the air mattress market, it will prove the shorts wrong and double or triple from current levels. However, should larger players like Sealy successfully enter and competitors in the specialty space impede on Select Comfort, the decline in margins and revenue growth will severely impact the short term and sustainable growth rate.

The market is more heavily discounting the negative scenario, particularly after the recent preannouncement. There is significant risk that Select Comfort will not perform well but the risk reward makes this a compelling situation. A lot can continue to go wrong here without the stock losing more than 20% of its value. Thus while the miss was very bad, it did not guarantee that high levels of top and bottom level growth were necessarily over. Therefore, Select Comfort is an attractive but risky stock.

Helen of Troy

Business Analysis

Helen of Troy operates in the personal care and appliances industry; with a relatively unique business model (a few smaller companies such as Applica and Salton have similar models). Some of their competitors are Nu Skin, Playtex and Spectrum Brands. Helen of Troy markets and sells a wide range of products; many of them licensed brand names. Its own trademarks include, OXO, Brut, Vitalis, Final Net and Helen of Troy, while it licensed trademarks include Vidal Sasson, Revlon, Sunbeam and Dr. Scholl’s. They leverage their strong cash flow, established far east suppliers and broad distribution system to acquire new products and brands. One problem they have is that because they outsource all production to the far east, they have to anticipate inventory 90-120 days in advance.

Porter Analysis of Helen of Troy

Bargaining Power of Customers- Helen of Troy customers are powerful as they have a wide range products to choose from, though products are differentiated which somewhat limits their leverage. Additionally, their top 5 customers including Wal-Mart and Target account for 45% of total sales, weakening their position. This is an area of large concern.

Bargaining Power of Suppliers- Helen of Troy suppliers, Chinese manufacturers, have very little bargaining power because Helen of Troy could switch to new suppliers and they cannot integrate forward as Helen of Troy owns the brands.

Threat of New Entrants- There is a high threat of new entrants to most of their markets as they do not have any barriers to entry beyond the strength of their brands. Many small companies are introducing new products, sometimes marketing them through infomercials.

Threat of Substitutes- There are a lot of substitutes to most of Helen of Troy’s products (OXO being one of the few without many substitutes), as they are only differentiated by brand.

Intensity of competitive rivalry- The personal care and small appliances business is highly competitive, with relatively good margins and a number of competitors leaving it a very competitive industry.

Helen of Troy is in an unattractive industry that is highly competitive, without much bargaining power and not too many barriers to entry. The reliance on sales from Wal-mart and Target is an area of particular concern.

Management

Helen of Troy management is very entrenched, lead by Gerald Rubin, who founded the company in 1968 and owns approximately 20% of the stock (although the rest of management and directors own less than 1%). Alan Lee, the former president of Oxo, who has been there since 1994, still leads the division and has won many business design awards. However, management has made mistake after mistake, most recently over paying for Oxo and has had great difficulty integrating it into the company. Helen of Troy would likely be worth more and create more value with new management.

Financials

Helen of Troy’s revenue growth slowed to just 1.5% in 2005 after growing at 25% in both 2003 and 2004. Similarly earnings fell 35% in 2005 after growing from 2000 to 2004 at an annualized rate of 45%, as profit margins fell from 13.1% in 2004 to 8.4% in 2005. The dramatic decline in profit margins came from a 2% increase in COGS, a 3.5% increase in SG&A and a 1% increase in interest expense. Helen of Troy’s ROA has declined to 5.7 in 2005 from roughly 10% in previous years, where ROE declined to 10.7% from the high teens in previous years. Helen of Troy has also benefited from a decline in its tax rate from 24% in 2001 to just 12% in 2005.

This worrying trend continued through the first half of 2006, with a profit margin of 5% vs. 7.5% in 2005. In Q3, this trend was reversed and the profit margin of 7.4 was comparable with the previous year. Revenue growth was up 13% year over year, the first quarter of double digit revenue growth since Q2 2005, and earnings were up 15%, the first increase since Q1 2005. It’s unclear whether this was just an outlying quarter. The market perceived it very positively sending the stock price up 18% also on the backs of raised guidance.

One of Helen of Troy’s problems, likely a result of their outsourced manufacturing, is a poor days to sell, which eroded to 95 in 2005 from an already poor mid 70’s in both 2003 and 2004. Days to collect is also a poor 68, up from 50 in 2003. This is likely from their lack of power over their buyers. Days payable has also declined to 35 from 23 in 2003, although this is still acceptable, and still being ok for creditors is good for Helen of Troy. However, they have a cash to conversion cycle of 206, which underscores some of their inefficiencies seen in their poor ROA and asset turnover.

However, if the trend of no revenue growth and declining margins reverts to the growth of 2003 and 2004, Helen of Troy is still very cheap

Industry- Ratio Valuation

Helen of Troy competes with personal care and small appliance companies such as Alberto Culver, Nu Skin and Spectrum Brands. Compared to industry average Helen of Troy trades at a significant forward PE discount of 10.5 vs 15 and forward PEG discount at .80 vs 1.2. However, on an Ev/Sales of 1.4 and EV/EBITDA of 9, Helen of Troy trades in line with the industry average. This is largely a result of Helen of Troy’s very low tax structure.

Valuation- Constant FCFF Model

Helen of Troy should be valued using a simple constant growth DCF, assuming a trailing 12 month FCF of 47 million, a WACC of 11% (13.6% cost of equity, 5.7% cost of debt), and a growth rate of 5% (as this industry grows a little faster than GDP, particularly with the expanded baby boomer demographic). This gave Helen of Troy a valuation of 820 million that has a high sensitivity to the growth rate. With a growth rate of 8% Helen of Troy would be worth 1.6 billion, with a growth rate of 2% it would be worth 531 million. The growth rate here has tremendous implications. Attached is a table of growth rate sensitivity.

Investment Conclusions

Helen of Troy is in a mature, low growth industry that is highly competitive. It has been facing declining margins and slowing revenue growth and it incurred a lot of debt in buying OXO. It lacks any competitive advantage to achieve sustainable growth higher than the industry (it only grows through acquisitions) and is not run very efficiently with a high cash conversion cycle. Helen of Troy’s success is in a large degree tied to economic strength which appears to be at least solid. However, it is generating a high level of cash flow, and the risk reward considering the level of growth necessary to generate alpha seems to make Helen of Troy an attractive investment. It might be prudent to wait for more data to show that margins have stabilized and revenue is growing again, but considering the value in Helen of Troy, waiting could make the stock more expensive.

HELE Growth Rate Sensitivity

Growth rate	Value
9.00%	$2,530,126.43
8.00%	$1,678,127.48
7.00%	$1,249,503.08
6.00%	$991,482.25
5.00%	$819,114.33
4.00%	$695,820.52
3.00%	$603,254.91
2.00%	$531,202.91
1.00%	$473,525.66
0.00%	$426,311.59
-1.00%	$386,950.30
-2.00%	$353,633.07

J Crew

Executive Summary

J Crew, a high end specialty retailer, is a buy. It continues to be an early stage turnaround story. The key to this stock is management, led by retailing legend Mickey Drexler, who successfully revitalized both Ann Taylor and The Gap. He is expanding the J Crew brand into new market segments, with both the Crewcuts and Madewell concepts, and is trying to reinvent and differentiate the brand as he successfully did with The Gap. He is improving efficiency and focus, creating improved margins and future cash flows. The stock has nearly doubled since the IPO in late June and thus the near term valuation, with a forward PE of 30 the street’s estimates, is pricing in much of these positives. Nevertheless, given Mickey’s track record and the many areas of growth, J Crew earnings growth should accelerate beyond current street estimates.

Business and Strategy

J Crew is positioned in the low high end segment of the specialty stores, targeting the 25-45 year old group. They have not fully saturated their market, currently operating only 170 retail stores, and 50 factory stores. Factory stores are not limited to liquidate inventory and are more profitable because of higher volume. Sales are 68% women, 18% men and 14% accessories, with 70% sold in stores and 30% directly. Direct sales are split 63% internet, 37% catalogue; thus as internet becomes a larger percentage of direct sales operating margins should improve, as catalog distribution is a large part of the SG&A. While none of their competitors are quite their style or targeting the same audience, their closest competitors are Banana Republic, Ann Taylor, Polo Ralph Lauren, Rhuel and Martin + Osa. While not in their space, Coldwater Creek is a good comparable with the similar seamless multi-channel approach.

Mickey Drexler’s strategy has been to close underperforming stores and downsize larger ones. His goal is maximizing revenue vs. floor space by opening smaller more profitable stores, showing he is focused on the bottom line, not just growing revenues or sales by opening too many, larger stores (the mistake he made in his finals years at The Gap). In clothing he is trying to compete on quality instead of price, branding the clothing “guilt free luxury”, which gives them better pricing power. J Crew is going for clothes that are classics and consistent, thus there is much less risk that the clothes are a fad and will go out of style. He is exiting areas of clothing that J Crew could not compete well in such as suits. All of this shows a focus and drive to maximize and grow profits, consistent with the numbers.

Management

Mickey Drexler is widely respected in the retail industry, most importantly for making Gap into a retail giant. He still has something to prove, having made mistakes at the end of his time at The Gap, and has learned from them. He has a large equity stake, owning 13% of the stock, is meticulous and understands how to build and cultivate a brand. He is attempting to expand J Crew’s market segment as he did with The Gap. He has brought with him a deep management team with over a century of experience, all who worked with him at The Gap (except the CFO).

Growth

Growth forecasts of 20% over the next several years are likely conservative given continued margin expansion and new opportunities which will come from three main sources. After fixing existing stores and closing unprofitable ones, J Crew is ready to expand its stores initially with a target of 300 stores at about 25 stores a year. The second source is their new concept, Crewcuts, which represent smaller, “mini me”, versions of the adult clothes, for 2-8 year old kids. It will be virtually all incremental growth, with very little capex. This is because Crewcuts shelf space replaces men’s clothing space and management has noticed no drop off in men’s sales and there are no extra fashion design costs. The third source is their new concept; Madewell which is a “cooler more hip” all women clothing line meant to bridge the gap between the teen clothing market and J Crew, priced 20-30% lower. So long as it doesn’t cannibalize J Crew, it should be a good growth opportunity as it goes with Mickey’s track record.

Financials

J Crew’s financials have seen a dramatic improvement since Mickey took over the company. He has returned it to profitability, and generated 11 straight quarters of same store sales growth (16% in 2004, 13% in 2005). Debt has been paid down and free cash flow is expected to be used to continue to de-leveraging the capital structure, which will reduce risk and improve profit margins. Gross margins also have improved to 41.8% in 2005 The efficiency of his turnaround efforts can be seen both in sales/sq foot which have increased from 338 in 2003 to 457 in 2005 and operating margins which have increased from -4.3% in 2003 to 8.3% in 2005, 2006 margins around 10.5%. With a forward PE of 30, given street estimates of 1.21, and a PEG of 1.25 J Crew is expensive relative to peers trading mostly at PE ratios of 20-25. However, what is not being priced in by the street is meaningful continued margin expansion with most of the street looking for no more than 100bps. Thus, there is room for EPS upside given gross margin growth and SG&A leverage.

Risks

The main risk is that all of these positives are fully priced in. A great company or great turnaround story does not always make a great buying opportunity and J Crew is definitely expensive at 30 times forward earnings. The loss of Mickey Drexler would be a devastating blow, as he has engineered the turnaround. His importance is further exemplified by the 15% overnight drop in The Gap’s market value when he was fired. Further, J Crew does have a much higher level of debt than competitors, potentially effecting cash flows needed for expansion or competing with rivals like the Gap, who while mismanaged, have a stronger balance sheet. It is also too early to tell whether Madewell is a good investment and if it will generate much growth. Additionally, the expansion may cannibalize some of the direct sales as geographical areas without access to stores gain them. Finally, J Crew is potentially a company caught between other brands without a sustainable competitive edge and once Mickey improves efficiency and operations, further growth may be limited by rivals.

Conclusion

J Crew’s execution, strategic vision and focus on profitability, as shown by the current success of the turnaround, should create long term earnings power and great upside potential over the next few years. Any weakness off of a soft holiday season for retail or selling pressure from the lockup expiration of Texas Pacific’s 38% holding should be viewed as a buying opportunity

Brandeis Capital Newsletter (Market Recap and Research on Costco)

Stock Market Summary

As the 3^rd quarter comes to a close, it is a good time to look at the bigger picture, especially considering the lack of significant news last week. Year to date, the S&P is up about 5%, the Dow 8%, and the NASDAQ is essentially flat. All the indices have recovered since the May correction and have performed extremely well in what is typically the weakest period of the year. This year’s 3^rd quarter was the strongest for the markets in 9 years. Most important, and lost in all the Dow noise, was that the S&P made a higher yearly high, and the Wilshire 5000 total return index has reached all time highs.

The key question at this juncture is whether there is still buying power left to start a new leg up on the proverbial wall of worry. There is reason to believe there may be, as the AAII (a sentiment indicator) % bearish is still at above average levels of 32.9% and the 10 moving average of % bearish is still a very high 39.1% (at the last market bottom in 2002 it was 43%). Short interest is also at all time highs, though this may be more indicative of absolute return strategies. Therefore, should the bullish outcome continue to unfold, a longer rally is possible.

The Transportation sector remains an interesting battleground for the bullish and bearish cases. After a summer technical breakdown, the DJ transportation average has been recovering. It remains unclear whether the recovery is a trend reversal and a signal the economy remains strong, or if it is simply benefiting from perceptions of much lower oil prices.

While BCM continues to feel cash is king because of issues such as a private equity bubble (to be discussed in future newsletters), housing and inflation, it is important to be cognizant of things that could prove this thesis wrong. If 3Q earnings live up to expectations and housing declines moderate, it may be time to reconsider our intermediate time frame outlook in November after midterm elections.

Stock Pitch of the Week- Costco Wholesale Corporation (COST) - Charts (long term, comparison)

Costco is a membership wholesale retailer that operates about 500 warehouses mostly in North America. They sell everything from staples such as groceries, apparel, alcohol, prescription drugs and automotive supplies to luxury goods such as jewelry and electronics. Their average markup is 15%. While, costs are kept down through a simplistic store layout, Costco pays workers better than competitors, so as to minimize turnover and shirking. They offer free samples to give customers a more premium experience. Customers buy membership cards, ranging from $50 for individuals and $100 for businesses as well as an “executive” version that offers 2% cash back to drive turnover.

Costco uses its market power to push accounts payable for up to 30 days from the sale of goods, while receiving cash for the goods on the spot. This generates a float, and with their $3.30 billion in cash ($4.77/share) they generate roughly $140 million in interest income, which has helped to finance consistent growth. Costco also carries very little long term debt.

We believe these factors will help insulate the impact of a recession on Costco’s profitability relative to other retailers. Membership revenue is likely to remain constant in a downturn as people are unlikely to not renew memberships even if they shop less. It also makes earnings less volatile. Costco’s bottom line shouldn’t be affected exponentially like other wholesalers and retailers who finance the goods upfront and don’t receive cash until the customer or credit card company pays them. Furthermore, while the lack of debt may lower maximized value in good years, Costco’s impeccable balance sheet would give them added flexibility in a recession.

A negative we see impacting Costco is that the street is already giving them a premium multiple of 22 versus competitors at 19. This premium is deserved because of the company’s future prospects, excellent management, and the additional advantages outlined above. However, since Costco has some of the lowest margins in the industry and is a company that competes on cost, it has added risk of margin erosion. Costco pays its employees a 42% premium over its closest competitors and pays 92% its employee healthcare costs versus about 75% at other retailers. The concern is that as competitors like Wal-Mart bridge the quality gap Costco enjoys, Costco will be competing solely on price with a higher cost base. There is also concern over whether growth is slowing at Costco, particularly whether membership of 47 million households is near saturation.

The club’s conclusion was that while we like Costco’s long-term prospects, we have concerns that growth may be slowing. However, Costco does retain the ability to maximize shareholder value in the future through increased debt and cutting labor costs. We are concerned about the US economy, and thus the retail sector. However, we feel Costco is well insulated from an economic downturn because of its focus on selling staples to middle and upper class consumers. We feel Costco should outperform the retail industry, particularly in an economic slowdown or recession. Thus, we will look to build a position in the next few weeks.

Stories/Links

Dow 1000 or 100,000? Ok, ok, how about Dow 36,000?

It is important to keep a few things in mind about the Dow. First, the breadth of the performance since the last high is very poor, with the median Dow stock down 39%. This doesn’t get into the point that adjusted for inflation, the Dow is still well off its highs. Most importantly, as this Graham and Dodd investor points out, the Dow is by nature a selected index, so it is more representative of crowd psychology, than the overall economy.

The Tickersense sentiment indicator from Birinyi Associates hit an all-time bearish high. It’s unclear if this should be seen as a contrary indicator, as the indicator is relatively new.

Quantitative Theory + Psychology= A Master Trader

An expert technician sees potential trouble in the madcaps that could have more broad market implications.

Bill Cara suggests that Oct 17-18 could be a bull bear market inflection point, with so many data points coming out.

If its midnight and you’re still at work, bring in the bullpen.

Meetings

We are going try a new meeting time this week, because feedback reflects that by night time no one wants to hike back to Sachar. We likely are just going to have an official meeting Thursday afternoon. This should work well because there is often a speaker in the late afternoon on Thursdays, so people interested could go to that afterward. There are also no econ or finance classes then, so professors can drop by. When we decide on a room and time, we will send out an announcement.

Equity Research on Citigroup April 2006

Citigroup

Recommendation Sector Perform Sector Overweight Price Target 52

Overview

At this time Citigroup is rated sector perform in the financial sector, which is rated Overweight. It is an attractive buy only to those seeking steady income strategies or S&P index performance. Without many company specific catalysts or risks and because of its large size, Citigroup is likely to produce returns near the S&P and a financial composite of its divisions. Other investors looking for financial sector exposure are advised to look at mid cap growth commercial banks or investment banks. Currently a financial conglomerate such as Citigroup captures neither of these attractive trends comparably.

Sector Analysis

Commercial Banking (54%)- Commercial banks have been under margin pressure in recent months as a result of the small lending spread due to a nearly flat yield curve. Those banks such as Commerce Bancorp that are growing through retail have been able to minimize the effects of a small lending spread. This is likely to be ending soon as the fed is likely to stop raising rate at either 5% or 5.25%. However, if fed funds increase more than 5.25%, this will be a strong negative. Commercial Banks have been rising despite the margin squeeze likely in anticipation of the end of fed tightening. This trend is likely to continue and is supported by the strong technical break out of the Philadelphia bank sector trust (BKX) to multi-year highs.

Investment Banking (Solomon Smith Barney) (30%)-Investment banks, in a market flush with cash, have been producing record earnings particularly from strong M&A and high trading volume. Nearly all investment banks are on 52 week highs and the banks of comparable size to Citigroup’s investment bank division (GS, MER, LEH, MS) are up approximately 50% from June lows with the exception of Morgan Stanley which is only up 30%. Multiple expansion has contributed to the rise in stock prices, which are currently compressed from historical averages. As investment banks are less affected by a flat yield curve and raising interest rates, so long as equities continue to perform well, they are likely to continue their out performance. While Citigroup’s investment bank has also had a very successful year and is the most attractive part of the company, the overall size of Citigroup makes it hard for the investment banking division to have a very large impact on valuation and particularly multiple expansion.

Company Specific

Citigroup is the second largest financial conglomerate in the world. It is historically undervalued on a PE basis, with a forward PE based on 2006 EPS estimates of 4.75 of 10.2 compared to a 14 PE over the last 5 years. Assuming a slight multiple expansion to 11 on the expectation of the end of fed rate increases by 5.25% gives a price target for the next 12 months is 52. Citigroup has a very high level of institutional investment at 65%, reflecting that there is a lot of smart money in Citigroup and the stock is rather efficiently priced. Thus even if Citigroup appears to be undervalued in the long term, it seems unlikely that it will generate outsized returns under current market conditions in the next year.

Silver Wheaton- A Premier Silver Company

Silver Wheaton
Current Price-10.51
Recommendation- Strong Buy
12 Month Price Target- 16.25



Summary
Silver Wheaton should continue to outperform both silver and all other silver stocks based on its unique, low risk, leveraged model of buying forward by product silver production. This model makes Silver Wheaton the only unhedged pure play on the expected rise in silver. Since they are not a mine operator they do not carry the operational risk of conventional silver miners. Its unique advantages to traditional silver producers should give it a premium while giving investors the best exposure to silver, an asset likely to outperform gold and other metals going forward.

Price Target
The 12 month price target of 16.25 is based on a 2007 earnings estimate of $.65 assuming an average silver price in 2007 of $15. This price target assumes Silver Wheaton will command a premium over its current forward PE of 16 to 25 based on its attractiveness to funds and investors looking for low risk exposure to silver. If retail investors become more interested in silver stocks and the price of silver spikes, Silver Wheaton could briefly or permanently, depending on the nature of the silver movement, rise above $20 within the next 12 months.

Company Overview
Silver Wheaton is a Canadian company that was created in its present form 18 months ago as an offshoot of the gold company Goldcorp. It is not a silver producer. Instead it helps mines with their financing by purchasing the mine’s forward byproduct silver production. Silver Wheaton looks to add value by purchasing these contracts at advantageous times in the price of silver, getting a good value for these contracts because of the financing needs of producers and by creating leverage that still retains limited downside.
Silver Wheaton plans to sell 15 million oz of silver in 2006 increasing to 16 million oz in 2007 and 2008 and to 20 million oz afterwards as a result of expected increases in production in their Lusimin mine and their new Glencore transaction. The company creates 20 to 25 year contracts by which they agree to purchase byproduct silver from long-lived mines. The contracts are structured such that the cost basis for the silver purchased is the lower of $3.90/oz or the market price. The cost basis only rises to adjust for inflation. The low cost basis is possible even at much higher silver levels because of offsetting upfront cash payments. The cost basis is structured to cover operational costs and ensure Silver Wheaton’s profitability even if prices were to fall dramatically.

Viability of Unique Business Model
The concept of Silver Wheaton works because silver is often a byproduct in most mines, such as gold or copper-zinc mines. Rather than using dilutions or other less desirable financing, mining companies can sell their silver for cash upfront to Silver Wheaton to help cover the very large startup costs of the mine. The mining company can then focus on making a profit from the primary metal(s) in the mine. Thus, this model will remain a good deal for both parties even if prices continue to rise. Therefore, Silver Wheaton can continue to purchase more silver production even as mining for the silver itself becomes profitable. It is not the case that they bought silver forward at a low price in the past and now cannot do this anymore to add value. Thus, Silver Wheaton can continue to use this model as new projects are brought online that need capital to start.

Management
Silver Wheaton has some of the best management in the sector. The company is the brainchild of CEO Ian Telfer of Goldcorp, one of the best-managed and most successful gold companies in the last 5 years. Goldcorp currently owns 62% of Silver Wheaton and much of Silver Wheaton’s silver production comes from Goldcorp mines, as Goldcorp gave them a "sweetheart" deal to get the company started and gave Silver Wheaton instant legitimacy. Thus, Silver Wheaton can be trusted to manage the mining cycle well. They refinanced near the top on March 27th and purchased silver at good prices. Further, the company is just now maturing in its organization as Ian Telfer severed direct ties to Silver Wheaton by stepping down as a director. The ex-Goldcorp executives who have been running Silver Wheaton recently severed their direct ties to Goldcorp to focus on running Silver Wheaton. They have just last week appointed the permanent CEO, Peter Barnes who previously was serving as CFO of both Goldcorp and Silver Wheaton, replacing interim CEO Eduardo Luna, who is now the chairman. While these organizational changes do little to change the actual decision makers at Silver Wheaton, they show the company is leaving Goldcorp’s shadow and becoming more of a standalone company.

Business Risk
A key and potentially significant risk to Silver Wheaton, besides the price of silver, is the legal strength of Silver Wheaton’s contacts and the likelihood that they would be challenged. A linked risk is how guaranteed such production is and the safeguards to protect them are met. Silver Wheaton has this to say about contractual and mine risk.

“The Company has agreed to purchase all of the silver produced by the Luismin and Zinkgruvan mines. Other than the security interests which have been granted to Silver Wheaton, the Company has no contractual rights relating to the operations of Luismin or Zinkgruvan nor does it have any ownership interest in the mines. Other than the penalties payable by Goldcorp and Zinkgruvan to Silver Wheaton if, at the end of the Luismin or Zinkgruvan Guarantee Period, as applicable, the total number of ounces of silver sold to Silver Wheaton is less than the applicable minimum amount, the Company will not be entitled to any compensation if Luismin or Zinkgruvan does not meet its forecasted silver production targets in any specified period or if Luismin or Zinkgruvan shut down or discontinue their mining operations in Mexico and Sweden, respectively, on a temporary or permanent basis.”

However, it is important to note that a significant risk to traditional miners, country risk does not apply to Silver Wheaton. Even though they get silver from a Peruvian mine as a result of their new contract with Glencore, Peter Barnes has stated there is no country risk. They have diversified it away in the terms of the contract and receive the silver offshore. They get the amount of silver that is matched by the mine production as long as it is operating.
A small risk is a change in tax policies in either Canada or the Cayman Islands (where all operations are run) could change their current situation of not having to pay taxes. However, the Cayman Islands are traditionally a tax haven, and such risk seems very small.

Hedging
As previously stated, Silver Wheaton does not use hedging. Even though hedging near recent silver highs of $14.70 would lock in much higher earnings, this is not advantageous for them to do for two key reasons. First, nobody knows where silver is headed short term and it could have gone to $16 that week. Hindsight is 20/20 and this is certainly no exception. More importantly, Silver Wheaton is looking forward to the silver prices for the next two decades, where they see prices going substantially higher then $15. Thus, to become too short sighted and try to trade around the price is not their objective. Secondly, the shareholder base of Silver Wheaton is investing in the company as a pure play in silver and wants to capture all of the potential upside. Even though a hedge at $14 would lock in much higher earnings, it would cause investors to dump the stock, drastically lowering the multiple, as it would create a very negative signal about management. Therefore it is only in Silver Wheaton's interest to hedge if they felt the primary trend in silver had turned, something unlikely for many years.

Competition and Alternatives
The rest of the silver sector is also looking very attractive. The stocks of traditional silver miners are attractive because they have not moved up on the scale of Silver Wheaton and still have decent exposure to silver. Thus these companies will rise significantly as higher silver prices finally make them profitable. Currently these companies, which include Coure d’Alene, Hecla (HL), Apex (Sil), Pan American (PAAS) and Silver Standard (SSRI) remain depressed by their past history, the stock’s overhead resistance and their lack of significant profitability. Once silver starts significantly rising, such short term non-fundamental pressures will become meaningless, and they will correct to their true and significantly higher value.
However, they all still suffer from the traditional risks that go with mining companies, which is a significant amount of operating risk that Silver Wheaton does not have. On May 2nd, Bolivia nationalized gas fields and on fears that mine nationalization will be next, intraday Coure d’Alene was down 12% and Apex was down 30%. These fears have since been reduced. However, this is just the most recent example of the added risk traditional silver miners have. Further, most of the silver mines these companies operate yield significant amounts of gold. Thus, these companies are actually bimetal producers with no more than half of their revenue from silver sales. Therefore, Silver Wheaton remains the only equity pure play on silver. Also, many traditional silver miners are to some degree hedged. While hedging was a means of survival in the downturn, it is now a liability, causing losses and limiting the upside that precious metal investors seek. Therefore even as these undervalued traditional miners realize their value, Silver Wheaton should command a premium in a market looking for low operational risk and leverage to higher silver prices.

Financials
Balance Sheet and Solvency (refers to 2005 fiscal numbers as q1 2006 was reported during the closing of a silver purchase, temporarily changing the balance sheet makeup)
Silver Wheaton has an impeccable balance sheet. It has no long term debt and historically retains large amounts of cash. It also has very low accounts receivable and payable at all times, reducing most financial and operating risk. At the end of the 2005 fiscal year Silver Wheaton had 44% of assets in cash, or $117.7 million. This is partially for defensive purposes, but Silver Wheaton’s cost basis would keep them solvent long after most silver companies would be near bankruptcy if silver prices collapse. The large cash reserves mainly show Silver Wheaton can be opportunistic in purchasing new silver, as shown last month.

Income Statement and Profitability
Silver Wheaton is very profitable with extremely high profit margins for any company and particularly for a precious metal company. Silver Wheaton sold its silver in the first quarter for an average price of $9.62 with a cost basis of $3.90. Current gross margins were 60%. Accounting for depreciation, operating and profit margins were both 53% because the small operating costs were offset by interest earned on cash. No taxes were paid because the company operations are run by a subsidiary based in the Cayman Islands. Silver Wheaton should remain increasingly profitable as silver prices rise and will remain profitable even if silver prices were to fall below $5.

Earnings and Sensitivity Analysis
Silver Wheaton earned $.15 last year on an average silver price of $7.31. In absence of new value added contracts, earnings growth is directly related to the rise in silver prices. This year’s first quarter earnings were $.07, beating consensus estimates of $.06. Analysts will have to revise their earnings of $.28 for 2006 and $.20 for 2007 as silver has gone significantly higher. However this is partially priced in as few precious metal investors listen to analysts in this undercovered sector. Since Silver Wheaton is such a transparent company, analysts in determining earnings are mainly forecasting silver prices. As no one knows what silver prices will be, it is best to perform an earnings sensitivity analysis to determine what earnings will be given a certain silver price.


See Appendix for Earnings Calculation and Assumptions

As evidenced in the table above, as long as silver remains above 9 dollars for the rest of the year, estimates are too low.

PE Valuation
Under street estimates, the PE is 40, which is acceptable for a company with earnings growth that could easily be over 30% for the next few years. Yet, forecasting a reasonably and possibly still conservative average silver price of $12 for 2006, earnings for Silver Wheaton rise to $.44, making the PE 24. At an average price of $15 in 2007 with earnings at $.65, forward PE is 16. This is very low given the room for higher earnings growth and the growth of production in 2009. The premium Silver Wheaton should command given its low risk and pure play on silver makes Silver Wheaton very cheap on a PE basis.

Silver Outlook
Silver has been outperforming gold by a wide margin. This trend is likely to continue.

Fundamentals
Silver trades with a high correlation to gold given that both are commodities that have a role as alternative monetary instruments whose price is linked to the value of the dollar. However, the key difference between gold and silver is silver is both a base and precious metal. Since silver is used up in many industrial uses, supply available is often very tight.
There are many uses for silver, and they are increasing. New uses include many diverse and growing medical and anti-bacterial applications, already approximately 40% of the market. Additionally, perception that photography demands for silver, which constitute approximately 22% of demand, will fall have been overstated. This is because the growth of digital camera use have been overstated as most of the world still uses traditional cameras and digital cameras create more demand for photographic paper. However, the fall in photography use will also lead to a drop in the scrap silver recycling supply. These growing demands put the silver market which is already very tight, into a major supply/demand imbalance.
Finally, supply has become tight in all commodities, as years of very low prices meant low capital expenditures where it takes years to open new production. However, the situation with silver makes supply particularly tight. There are few mines in the world where silver is the primary revenue source because such locations are not as common and it has not been economical to operate one in decades. Thus most silver production is a byproduct of production at other mines, primarily those that produce gold or copper-zinc. Therefore, increasing production specifically of silver is going to be especially difficult as few mines focus on it.
Therefore, silver is unique because a combination of factors lead to a uniquely tight market which in periods of high demand, such as the recent introduction of the ETF, silver is prone to incredible spikes. Further, it has more diversified demand factors as a result of its dual role of significant industrial and monetary uses.

Precious Metal Long Term Forecast
The main catalyst for the major oncoming rally and cushion to prevent any meaningful correction is the very large commercial short position in precious metals. As of April 25th, the commercial traders were long 24,842 and short 84,940 silver contracts, making them net short 60098 contracts with overall open interest at 127,250 contracts. The smartest traders like those at Goldman Sachs, have been very net short precious metals for the last five years. Regardless of why they are, Goldman and other commercial shorts are on the wrong side the trend. This is not a signal that prices are overvalued because there are too many long term bullish forces. This leads to the possibility that the commercial shorts have another agenda than just making money paper trading commodities. The most logical explanation for why this has been happening is that the commercials have been manipulating the market. Whether such a possibility is the reason or not, the heavy short position remains regardless of what the explanation of it is.
The commercial short manipulation of the markets downward can only be a short term effect. Even the most powerful forces cannot stop physical buying and the forces of supply and demand that have been exacerbated by downward price manipulation. The consequence of this is that any large correction considering how high the prices have been going is going to lead to massive covering and any upside surge could lead to a major squeeze.
This squeeze, which has become very likely because long term forces outweigh manipulation, will be more powerful the longer it is delayed. When it does happen it will finally attract the interest of the retail investor and only then will the bubble begin. The formation of the precious metals bubble is likely still years away, and even after that prices will remain at levels much higher than current levels.

Conclusion
Based on the long term outlook on silver and other correlated precious metals, exposure to the silver is advisable. Of the ways to gain silver exposure, equities will outperform metal exposure over the long run based on leverage. Silver Wheaton is a hybrid of a producer and a managed precious metal fund. It is unique in the precious metal space in offering both leveraged exposure without added operational risk. It is also unique in the precious metal fund space as it has no fees. Silver Wheaton is therefore the most attractive way to participate in any further silver upside.

Note: All financial data comes from the 2006 Q1 quarterly report unless otherwise noted

Appendix

Earnings Forecast
Assumptions for this model are that Silver Wheaton is selling 15 million oz of silver in 2006, 16 million in 2007-2008 and 20 million in 2009. Outstanding shares are 263.3 million. Depreciation is assumed to be fixed and increases with the growth of the amount of silver sold. No taxes are paid. Operating costs are assumed to remain constant and negligible, at around two million dollars (roughly .007 EPS), and will be offset by interest revenue.

Modeling Uncertain Variables

The Use of Modeling Inherently Uncertain Variables

I agree with David Babson’s idea of the unpredictable of investing in that some variables are much more predictable than others. The focus of investing should be bottoms up at a company specific level that should especially take into account predictable trends. However, I disagree that the so called unpredictable variables are thus of little importance and are not worth focusing on. What makes a market is that some parts of the valuation equation are either unknown or difficult to predict. It does not make them either useless or unimportant, especially since these unknowns are the unexpected variables that will move the stocks. Therefore, it is possible the unpredictable variables become the most important factors because they are unknown.

The main reason unpredictable variables are important is it is always crucial to know what expectations are regardless of whether you can handicap outcomes. It may be difficult to know what variables such as GDP or interest rates will be, yet to know what the market is pricing in can often give an indication of whether there is more upside or downside already priced in. If these variables are impossible to predict it would be advantageous to take a contrarian approach to what the market is expecting if the expectation is outside of the variable mean. Thus, it is important to accept that some variables are unpredictable but at the same time useful to try to predict whether what people expect is too extreme given that no one really knows.

Further, by knowing what potential outcomes are possible from unpredictable variables, investors can be surer of what will happen when different events either happen or become expected. Regardless of how predictable any variables are, there is still a lot of uncertainty in investing. This is why investing becomes in essence, a numbers game of risk and return. Thus, by developing different scenarios and the outcomes of them, one can attempt to create a forecast for whether the return outweighs risk and in such a way whether something is or remains a good investment.

It doesn’t really matter whether or not effectively we can solve for a certain variable to value a stock. Even if we cannot this missing link in the valuation is important. Those who wish to beat the market do not want people to be able to solve for it because then the market would be efficient and the need for asset managers or ability to be an active investor would be gone. David Babson is arguing for stocks over the long run, and in such a multi-decade outlook, things like GDP or politics become effectively just noise in the scope of very long term company specific trends. Yet, such investing is not as normal today with people demanding short term returns, and does not work as well in a more efficient market than existed when people like Babson and Buffet were highly successful. In today’s market, there is no such thing as too much information, especially the information that is contested and uncertain.

The Loser's Game

I wrote this essay about a month ago for my equity portfolio management class. I thought it addresses some key issues in this business so I thought I'd share it here.

“The Loser’s Game” by Charles Ellis, is a provoking explanation of the seemingly puzzling fact that active mutual funds on average have lower returns than market benchmarks. While Ellis is correct that the market has become more efficient over time to a point where fees on average outweigh alpha, this premise inaccurately implies fund mangers are failing and misses the real goal of fund mangers. Further, he is taking this unique situation to a specific investment strategy, long only large equity funds, and then applying it beyond its implications. So while the concept of a loser’s game and its implications for active investing performance are important, they are overstated and applied too broadly.

To justify the existence of investment management, it is always relative performance that matters. Thus while it may seem important for a manger to beat the S&P, he will really only fail if he underperforms his peer funds. The misconception is that measuring him against his competition is the same as measuring him against the S&P. However, this is not the case if this class of funds does not perform to the S&P in the first place. This is the root of the fallacy since in reality mutual funds can not under perform themselves. It is true that other forms of investment compete for the capital invested in simple equity funds. Yet this becomes irrelevant as well since the individuals and institutions that choose these investment vehicles that consistently under perform market benchmarks are willing to effectively pay the prices of the fees for reasons other than an attempt at outsized gains. Much of the rational for active equity management is the comfort and knowledge that the investments and risk are being actively monitored, even if over the long run this is not productive. Thus much of the capital in this investment universe is content with such “underperformance”, which therefore is really not underperformance because it is both expected and accepted.

Ellis’s argument also overemphasizes the extent of market efficiency. There are many parts of the market, such as small caps as well as new strategies that are by nature of the lack of attention paid to them less efficient. Thus, they are less subject to Ellis’s key point that investors and mangers can no longer succeed through their own positive accomplishments. It is particularly the big caps that are so dominated by large mutual funds that exhibit the over coverage and competition that creates a loser’s game. Therefore, while still significant, like everything about there market, the concept of the loser’s game is less applicable where market efficiency breaks down.

While it is very important to consider the possibility that investor actions in the market can only hurt returns, in the end it is only one part to consider. Nothing in the market is that simple or concrete. Therefore it is more accurate to consider the loser’s game as much harder than the consensus thinks to actually deliver outsized returns that are the result of the investor’s correct decisions. Under this more realistic but still humbling perspective, the concept of a loser’s game can help small investors better understand the dynamics they are up against. Yet such an understanding may matter less to the mutual fund mangers themselves since their goals are still very different then many more speculative smaller investors and hedge funds. In effect the loser’s game is a loser’s game because those mangers who specifically are playing it are trying more to not lose than to win as that is the nature of their incentives. Thus, the loser’s game is more of a subset of the investing world then an overarching principle.