Investing in A Working Class Recession

The recession has already bitten for the working class. That's a bold statement and I have to defend it.
First, let me say that when I say 'recession', I mean a contraction in spending accompanied by rising unemployment.
Second, by 'working class' I mean wage earners, people who depend on a weekly or bi-weekly paycheck: blue collar workers (manual laborers) and service industry workers (retail services, sales people, restaurants, real estate brokers/agents, etc).

The exceptions will be in anything tied to the global boom: oil, mining, plane manufacturing, farming.

The symptoms of a recession are rising unemployment and reductions in spending.
Let's review the Unemployment trends first.
1. For the past 5 months:
Agricultural Employment: Up ~7.5%
Non-Agricultural Employment: Flat
2. Unemployment is up since last year. It is up most for folks 25 years and older: from 3.5% to 3.8%
3. Breakdown of the 138M Employed non-farm workers (Nov 2006 vs Nov 2007):
http://www.bls.gov/news.release/empsit.t14.htm
Natural resources (0.5% of total employed): Up 5%
Construction (5% of total employed): Down 3%
Manufacturing (10% of total employed): Down 1.5%
Biggest drop: Cars
Retail (11% of total employed): flat
Biggest winner: Food and beverage
Biggest loser: Building material and garden supply
Financial including real estate (6% of total employed)): Flat
Professional services (14% of total employed) Up 4%
Education & Healthcare (14% of total employed): Up 3%
Biggest winner: Healthcare, up 400K jobs
Leisure & Hospitality (10% of total employed) Up 3%

CONCLUSION: Unemployment is trickling up but the wave of layoffs in real estate, banking, retail and so forth are not showing up yet.
Am I wrong? Nope.
1. Timing: it's the holidays and most companies will wait a bit
2. Announce layoffs when it matters: most companies will use the earnings release to trigger layoffs.
3. Delays in reporting: most companies give a few weeks and months of severance pay. So folks don't apply for unemployment immediately.

The increase in hiring in leisure is very telling: that's a place where wage costs are rising at a time when I am forecasting a stalling in spending.
That means, from an investing point of view, bad news is coming and it will 'surprise' the experts.

Next, let's consider the status of consumer spending
1. Holiday spending weak.
There are a lot of folks spinning the numbers. The most popular way is a month by month comparison. The big problem with that is that this year's November included 1 week post Thanksgiving - and that's prime shopping season.

My preferred way to monitor sales is to use the Mastercard retail sales figures which measure sales from Thanksgiving to Christmas. Not only does this neutralize the November phenomenon, it also includes gift cards. That's important because gift cards are 5% of total spendingthese days and a lot of 'experts' like to suggest sales are better because of rising gift card purchases. (Retailers can't count gift cards as a sale, so it delays the actual sale).
In any case, Mastercard reported sales are up 3.6%.

But that includes inflation and things like surging gas prices. Adjust for that and you find that sales are actually flat or down.

And that's after major sales and promotions. The margins will be hurting

2. Falling consumer confidence
Expectations are that consumer confidence will again drop, this time to 86.5. That will be the 5th straight month of decline.

If anything, the most positive thing that can be said is that spending and employment have peaked and are showing signs of slowdown.

So I've been thinking that this is a good time to short a few companies because they haven't reported yet. So I had some basic sectors in mind, and this week I want to do some due diligence. But I start with where the paycheck goes
1. Food - I think folks will cook more. So general Foods and Krafts are in a good place. Restaurants that are like TGI FRidays and Applebees will suffer. I figure McDs and other fast food chains may face problems as well. I wonder if Starbucks will get hit.
2. Leisure & Entertainment - Cable will get hit - a few unpaid bills ($100 a month will matter) and at the very least no rise. Non-vegas casinos will get crushed. Even Vegas will get hit, although they have a multinational crowd. Vacation destinations, cruises, hotels and airlines will struggle. (A lot of conferences will start to get canceled.)
3. Big ticket items like Cars and Boats - Nobody will be buying these for a while. I want to short whoever makes jacuzzi tubs. Goodbye harley Davidson. A lot of vehicles will get sold, not bought, as folks try an dcut back expenses. Car sales will be down.
4. Luxury items - Any jewelry seller that caters to blue collar workers.
5. Services - Gardening, pest control, security, insurance, banking. You name it and folks will be cutting back. I especially see insurance getting hit: reduced coverage, fewer vehicles & houses covered, and so on. banking has been hit but it still has aways to go.

So, I need to do some research on specific companies, but there are plenty. If you have any suggestions, please share

Time to Short AAPL Again?

It's almost an annual thing - short AAPL in Janary/February when they peak after holiday excitement. I did this in 2006 - bought PUTs in late January when they were in the 80s and cashed out when they slid to the 50s.

I did it again in 2007 and only broke even: the iPhone announcement really moved them up. Don't believe me? AAPL has doubled in value since the iPhone was released.

But the iPhone has not taken the world by storm. It has flopped in Europe. The Asia rollout is also undergoing some questions. I assume that the US market continues to do well, although I am not seeing the iPhone in use as much as I would expect.

But here's the thing: AAPL is actually showing signs of problems. Here are the key trends that matter:

1. Global sales - Ability to move overseas into Asia is THE issue

2. iPod slowdown - Unit sales are still growing, but at a slower rate. And that growth was really driven by lower end models

3. Semiconductor costs - The chip market is the biggest profit driver for AAPL. As costs have plummeted on flash memory, AAPL has kept prices flat. It's free profit. That gravy train will end in 3 quarters.

4. Mac sales - Continuing to grow steadily.

When you review AAPL's performance, you will notice that even with booming sales, the key ratios are falling not rising. Comparing overall fiscal year 2007 (Oct 2006~Sept 2007) to the most recent quarter:

Net profit DOWN: from 14.56% to 14.54%

Operating Margins DOWN: from 18.37% to 17.05%

Return on Assets DOWN: from 16.43% to 15.43%

Return on Equity DOWN: from 28.52% to 25.96%

AAPL trades at a whopping premium to its peers. It has a P/E of 50 vs 40 for other tech companies. Price to sales is 7+ vs 5 for tech hardware. Price to cash flow of 45 vs 35. And on, and on, and on.

Which makes sense for a growing company.

Is AAPL a growing company? As we look at year-over-year growth, keep in mind that the quarter last year was a 14 week quarter, not 13 weeks this year. Meaning that AAPL's sales and EPS would be ~7% higher.

Sales Growth most recent quarter: 25% (or 32% if comparing 14 week quarters)

Expected Sales growth for FY2008: 32% or another $7.5B.

So that's predicting a flat sales growth. Which is strange considering the explosive empahsis on iPhone sales in that quarter.

Can they churn out another $7.5B in growth?
Assume that the pressure of new business is split between existing products and the new iPhone. Let's say 20% growth from Mac and iPhones (remember iPhone growth will be single digit this year), the remaining 12% growth or $3B is iPhones. They need to sell 10M iPhones this year - and that's doable. Unless sales fizzle overseas (they have) and the US market stops sizzling (it will).

But growth in EPS is not being forecast. EPS is actually set to reverse! This is very, very interesting.
Last year sales rose 26% and EPS rose 30%
Next year, the forecast is Sales to grow 32% but EPS only 28%. When EPS grows slower than Sales, that says margins are expected to drop.

EPS Growth last quarter: 67% (or 74% adjusted for 14 week quarter)
Expected EPS growth FY2008: 28%
Yikes. Expectations about EPS growth seem to be falling.

Now think in terms of what makes a stock price sing: upside surprises and growth.
Growth is now becoming hard to come by as reflected in falling EPS growth rates and slipping margins.
Upside surprises also seem challenging. EPS surprises have fallen from 43% to 17% - and those were driven by chip costs.


And what if the US slips into a consumer recession this year? Will global growth pick up the slack?

Bottom line: at $200 per share, AAPL is trading at a forward P/E of 30, which is their expected growth. So where is the upside? I can see plenty of downside pressures, but I struggle to see upside.

I would expect them to hit $210 or even $220 over the next 3 weeks. And then it's time to short. At $160 I would get out. Right now, the July $180 Puts are $16.40 (almost a 10% cost of the underlying asset). A move to $210 would bring them closer to $13. At $220, maybe $8.

What are the odds of a big pullback? AAPL has doubled in 6 months on the back of a 10% sales growth. It needs to consolidate and drop.

Liverocket Performance Week 51 - Up 5.4%

This was a good week - I think we re-entered at a good point and with the right stocks for the next few months.

Yes we are clobbering all the markets at the moment, especially the Dow and S&P. But a lot of that comes from the way we avoided financial and home stocks (including tools, materials, etc).

EXPECTING VOLATILITY

As you will note, I am including Sell prices but not STOP prices. I expect some exuberance as earnings come out.

At the same time, I see everything unfolding against a background of overall market volatility as evidence mounts of US stagflation. These stocks should be immune from consumer demand slowdowns, but a broad market sell-off will happen a few times. I'd rather not get caught in that volatility until I have a solid strategy. Normally, I'd manage via a put/call coverage but my commitment to LiveRocket wsa to show that simple equity trading could beat the market. Which means we don't do options in this model.

If you are interested in doing something defensive consider either of these 2 approaches:

1. A trailing 5% STOP. The concept is that you may get stopped out and then buy back at a lower price - essentially adding more shares overall. This requires you to:

* Move your STOP price up as the Stock price trends up

* Be prepared to react quickly if you get STOPped out

2. Take 5% of your portfolio value and use on options. Use WFR as an example. It's now at $91. Let's say it will jump another 10% next month OR fall 10%: $82~$100

* The January $85 puts are $2.60. If WFR drops to $85, your stock loses $6 per share but the puts gain in value. The $6 loss is ~7% loss but a $1 gain in Put value is a 40% gain. Do the math to see what the breakeven point would be (how many contracts to cover the WFR asset value)

* Write covered calls. The January $100 calls are going for $2.20. That $2.20 is ~3% downside coverage. And you get the money today. Meanwhile, if the stock reaches $100, you lose the shares, but after adding 10%.

OVERBOUGHT OR BREAKOUT?

Many of these stocks have raced up recently. This is partly a correction to the recent overselling. Also, these stocks do seem headed for pre-earnings excitement. I think WFR and ATW in particular look to be trading high. But I also think that both are incredibly undervalued.

As an FYI, I am not looking to stay very long in AG, IMA or IO.

SPECIFIC COMMENTS

AG - This company continues to grow but exchange rates are squeezing margins. I expect price hikes shortly to offset the pressures.

ATW - All drillers are up recently. Bank of America raised the target to $112. Even at this price, ATW has a Forward P/E of 8. Well, considering the 60% growth trajectory they are on, that's crazy low. I continue to favor ATW because, as a smaller player, they should be the #1 acquisition target.

FWLT - Won a liquid natural gas contract in Australia.

IMA - Another week, another acquisition. They are assembling what has become a diagnostics powerhouse. They are on target for a billion dollar sales, but you have to consider the earnings impact of an acquisition binge: $1B in debt and dilution by adding 20% more shares in just 1 year. But the gross profits have moved up from 39.5% to 42.6%. As they digest recent acquisitions, I expect more write-downs as well as operational gains. But the EPS will continue to be poor because they now spend $100M+ annually on debt servicing.

Once IMA exceeds $1B in sales, I expect more funds to show interest. In the meantime, the stock price is stalling.

IO - Looking at the chart, you will notice that they are showing a steady move up. I don't like how they have set EPS expectations so broadly: $0.45~$0.60. That's a 30% swing. But when you look at 2008, you see 60% growth, so why quibble. That means the growth continues to outstrip the P/E.

MICC - we entered when they were beaten down hard, so is it worth stocking around? They just closed out $200M in bonds, saving ~$15M in interest costs, and that drove up the stock price.

My worries are:

* Accounts payable are surging faster than receivables

* The Year-over-year growth will be lower this quarter. This is driven by math: lastyear, MICC added 27% revenue sequentially. They would have to add $150M this quarter to stay consistent. That would double the rate they have been on for the last 3 quarters.

BUT, they added a few million more subscribers last quarter. ~10M subscriber months above last year's quarter should add ~$100M extra revenue. That's what they need. Add in more new subscribers and things are looking up.

MVL - They are exposed to Xmas holiday sales and I wonder how strong/weak those will be. But I am more focused on the IRON MAN movie. I watched trailers and it looks good. Additionally, the move into India follows recent testing of the waters with some Indian versions of Spiderman comic books, among others. These moves are nice, but I am in for the new movie business model.

NOV - This is worth reading

http://www.forbes.com/business/2007/12/20/best-managed-oil-biz-cz_ch_08platinum_1220varco.html

"Demand is soaring; two-thirds of drilling rigs worldwide were built more than 25 years ago and aren't up to the vital task of drilling into deeper and more complicated oil fields. In recent months, NOV has seen orders for five new floating rigs, at $300 million a pop--the kind that can drill five miles into the earth while floating in 5,000 feet of water. NOV can't build them fast enough. Its order backlog is a record $8 billion."

PCP - The stock has been in a trading range of sorts: hovering around $140. But look at the chart below: even though the highs are still stopping at $150, the lows keep moving higher. This spells breakout to me.

VIP - With a final commitment to buy GLDN, VIP is now the dominant mobile phone company for Russia and nearby CIS countries.

WFR - I think these guys are belatedly enjoying the solar panel sector's run up. That being said, I also suspect them of being heading for a pullback.