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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Wednesday, June 18, 2008

Regions Financial (RF): Due for a Bounce?

Regions Financial (nyse:RF) has plummeted to $11.40 from its July 2007 levels of $32. For most of 2008, RF traded in the $18-22 range, but since May, RF has been on a pronounced downtrend. It’s also important to note, that the regional banking group as a whole, has been extremely weak for the past several weeks. Regions fell 7.4% on Tuesday, June 17th, and then fell 10.4% on Wednesday. In the last 30 days, RF has plummeted 45%. Also under pressure are Suntrust (STI), Key Corp (KEY), Fifth Third (FITB), BB&T (BBT), and Wachovia (WB). Looking at the table, most of the 3 & 6 month cumulative losses occurred just in the last month.

The obvious question- is the selling overdone? Regions may be due for a bounce. The two key possibilities that must be examined are 1) Has indiscriminate selling of the regional bank industry unfairly punished RF shares? 2) Does the market know that disappointing news from RF is imminent- or consensus EPS estimate revisions?

Regarding the first possibility- if shares have been unfairly crushed, then answer is simple: RF should be bought. In order to ascertain if RF’s situation differs from the rest of its peers, the second possibility needs to be examined.

It’s tough to predict negative news announcements and earnings misses. However, it’s rather apparent that investors have been pricing in these events. Thus, the balance of risks appears favorable. If earnings come in below the consensus, or if the dividend is cut etc., it’s likely that much, if not all, are already reflected in the share price. Therefore, disappointing news wouldn’t adversely affect RF’s stock price. If news turns out to be better than expected, then RF should rally. Hence, the potential upside exceeds the risk to the downside; this creates a favorable risk-return tradeoff

Asset Quality:
Regions Financial doesn’t have any sub-prime exposure. It did have a sub-prime origination business- EquiFirst, but those mortgages were sold servicing-released and not retained on the books. Regions sold EquiFirst to Barclays back in 2007. In addition, Regions isn’t exposed to non-traditional mortgages such as option ARMs or loans with teaser rates. Regions primary concern is its $11.5 billion construction loan portfolio with $447 million in non-performing loans. Regions hasn’t had to take any major write-downs, and earnings have held up in the past several quarters relative to peers.

Earnings Expectations:
Analysts are forecasting EPS of 48 cents for the June quarter, which is down from 54 cents 90 days ago. For FY08, the consensus estimate is $1.95, down from $2.14 three months ago, but has been steady for the past month. Regions is trading 5.8x this year’s EPS estimate. This is quite low given RF’s 12.8x 5-year average and industry average of 13.5x. This might suggest that investors expect Regions to earn half of the current consensus, or 97 cents for FY08.

The trailing 12m dividend is $1.50, a yield of 13.2%. The stock price definitely reflects a cut or elimination. A 5% dividend yield at the current share price would be 57 cents. Assuming a 60% payout ratio, EPS would need to total at least 95 cents over the next 4 quarters.

It appears that analysts haven’t revised RF estimates down to reflect current market expectations. Why do investors think estimates are too high? It’s likely concerns center on Regions construction lending portfolio as it has been deteriorating. 3.5B of the 6.2B residential homebuilder segment consists of vacant lot and land, which could experience high losses. Regions management states that they are moving aggressively to manage losses in this portfolio.

Regions recorded a loan loss provision of 181 million for 1Q08, down from 358 million in 4Q07. It’s likely that Q2’s provision will have to return to at least 400 million. Even so, RF has been reducing costs through last year’s merger with AmSouth. In the march quarter, merger cost saves totaled 127 million, and management expects total cost saves of 700 million by year-end 2008. In addition, Regions Financial also owns Morgan Keegan, a strong brokerage firm, which will help diversify revenue streams during this downturn.

Short Interest:
RF’s short interest surged 13.1 million shares (27%) during the last period reported (May 15-30). This represents about 9% of the outstanding share float with cover ratio of 6.3 days. Since the last report, short interest has likely increased further given the declining share price. Short interest represents future share demand as shorts must buy shares to cover their positions.

Option investors are betting on further share declines in RF shares. On Wednesday, trading in Regions Financial's options surges to eight times the normal daily volume, as investors bought 48,000 puts and 8,000 calls. Activity was heavy in the July $10 puts, trading at 95 cents and will be in the money if RF slides below $9.05 before July 18.

It’s quite evident that investors are negative on RF. This positive aspect is that weak sellers are folding there hands and negative expectations are being priced-in. With so many investors negative, the supply of sellers begins to dry up, as the supply of future buyers increases. If future developments are not a dire as expected, then RF should see a nice bounce as short-sellers scramble to cover positions.

Capital ratios are decent- Tier 1 capital ratio is 7.3% and Total capital ratio is 11.1%. These are well above the minimum requirements of 4% and 8%. Regions book value / share is $28.82 resulting in a P/BV of 0.4x.

Thus, the selling of RF shares has been warranted, but has it been overdone? Or, is there more selling to come? Regions revenue streams are diversified with its banking, brokerage, and insurance businesses. Regions is also aggressively improving its cost structure through its merger cost reduction plan. The combination of these factors should help offset, to a degree, future write-downs and loan losses. RF has adequate capital ratios, thus I don’t foresee a major equity capital raising.

I believe current share prices can withstand a 50% reduction to earnings and the dividend, as these possibilities are priced-in. Thus, I think, with a considerable amount of negative news already discounted, there is significant upside potential. Hence, the balance of risks is favorable possibly making RF due for a bounce.

Wednesday, June 11, 2008

What Can Push Apple's Shares Higher?

Apple Inc (nasd:AAPL)- Apple has surged to $180 from $120 where it was trading back in February. Of course, Apple was trading near $200 at the end of December 2007, but sentiment turned and Apple’s shares plummeted January through March before reversing, and staging a rally in April. Shares have been stuck in the $180’s since May. The pivotal question becomes: “what can/will push shares higher?”

Apple’s stock may have gotten ahead of itself at the end of last year (2007), when it hit $200. Analysts were bullish and nearly all had a price target above $200. Then January arrived, Apple provided weak guidance and the Street flipped out. Sentiment quickly turned negative, and heavy selling drove Apple lower. A couple analyst downgraded the stock, and most revised their price targets lower to the $150-175 range. As industry data reports showing potential robust Mac sales became available in March, Apple shares began to recover. Apple announced earnings in April that showed strong Mac sales. This further quelled apprehension and eliminated the overly pessimistic attitude on Wall Street. As the chart illustrates, price targets were revised upward. In short, I believe Apple shares collapsed due to worries that they were overvalued, then information subsequently supported those high share prices, thus Apple’s stock returned to that level.

Apple has been stuck in the $180s since the beginning of May. Nothing has been able to power shares beyond the current range. There have been several analysts raising price targets. However, the effect on Apple’s share price has been insignificant. Apple announced the July arrival of its new 3G iPhone, yet Apple shares were still unsuccessful in breaking out into the $190s.

Apple has announced the expansion of iPhone countries from 5 to 70, as well as a much lower price point of $199. However, EPS estimates for FY09 have only slightly budged.

According to the EPS revisions table, most recent changes to the consensus estimates have been downward.

In my opinion, I think the catalyst for a move higher will be upward revisions to EPS estimates. I don’t think they currently account for the immense sales potential of the new iPhone, as well as the momentum in the demand for Macs. Albeit, Apple is giving up the monthly subscription revenue payments from AT&T, thus the increase in volume will becoming at a lower margin. This might possibly be why Apple’s shares have failed to respond more positively. There are a couple things to consider. First, there have been estimates that the new phone’s manufacturing cost is half of the current iPhone. Second, the MobileMe service at $100 per year adds revenue potential associated with the new iPhone. Sales of iPhone applications from Apple’s App store is another avenue to boost revenue. Most importantly, iPhone sales will expose the Apple brand to many who lack experience, and ultimately boost Mac sales.

I think we will gain more clarity in July, when the new iPhone hits stores and Apple releases Q3 results. It’s likely, until then, there won’t be many developments capable of really moving the stock, other than possible EPS estimate revisions.

Apple isn’t cheap trading at 35x FY08 consensus EPS estimates and 28x FY09. Apple may actually be cheaper if you believe those estimates are too low. I think the estimates are likely too low, thus Apple would be trading at slightly lower multiples. I think Apple could be bought on any weakness or pullbacks, since Apple’s share price reflects the fundamentals as opposed to pure sentiment, as it did last fall and this winter.

Disclosure: none

Monday, June 9, 2008

Consumer Spending Outlook

Current economic conditions are challenging, especially for the consumer. Given a multitude of factors, I am skeptical of the popular belief that GDP growth will pick up significantly in the second half. I expect GDP growth will remain flat to sluggish well into 2009. I can’t foresee significant economic growth returning until the consumer regains strength. Historically, roughly three-quarters of GDP is related to consumer consumption, thus economic growth hinges on the health of the consumer. I have highlighted the primary elements affecting consumption.

Consumption is a function of monetary inflows (spending capacity) minus compulsory monetary outflows with respect to the level of willingness to spend net inflows. A consumer’s spending capacity is a combination of wages, investment income and access to borrowed funds. Compulsory expenditures are basic necessities, such as food, housing, energy, clothing, health & education, and taxes. After purchases for non-discretionary goods and services are satisfied, a consumer can choose to either spend or save the remaining money. The decision to save vs. spend depends on consumer sentiment and outlook on the economy.

Since we are focusing on GDP growth, we must evaluate at the margin, how current conditions have changed from those previous. There are multiple factors responsible for overall consumption. I can’t think of any major factors positively affecting spending other than the tax rebates. Most factors are neutral or unfavorable, with a major factor- home equity borrowing, being very negative. In this decade, GDP growth was largely dependant on equity withdrawals, which significantly boosted consumption. This is my key concern- the demise of the housing market and the evaporation of home equity. Since 2000, GDP without equity withdrawals would have never surpassed 1.25%.

Consumers have a reduced capacity to spend and face higher costs for essential goods/services, which leaves less money available for discretionary spending. Due to weak consumer confidence, disposable income will likely go more towards saving and debt reduction than being spent.

Wages + Investment Income + Borrowed Funds + Sentiment
- Taxes
- Mortgage/rent payment
- Compulsory Spending
= Disposable Income

I expect slow consumer wage growth due to the increasing supply of labor. Labor demand is weak as evidenced by the monthly decreases in payrolls we have been witnessing this year. When the economy is shedding jobs, then the unemployment rate rises (all else equal). Wage growth primary occurs when employers have to compete for labor in a tight market. When labor is abundant, there is less need to offer higher wages to attract and retain labor. In addition, corporations are trying to preserve earnings by controlling costs, thus there is less impetus to increase workers’ wages. Instead, companies will be looking to boost productivity. This is likely a reason we have been seeing strength in the technology sector.

In aggregate, job losses means there is lost income that otherwise would be spent, adding to total consumption.

Investment Income:
Investment income should continue to be soft. Financial firms, such a banks, generally pay large dividends. A large number have recently reduced or cut their dividend. Interest income from savings accounts and bonds has decreased due to falling interest rates. Income can also come from capital gains on investments and real estate. The stock market has been volatile, and one would have to go back to 2006 levels for gains on S&P500. Thus, in general, there are probably less profits that can be taken from an investor’s stock holdings. The second half of the ‘90s GDP growth was bolstered by a surging stock market.

Falling home values mean potential capital gains have fallen as well. Unless the house was purchased more than several years ago, there will not likely be any gain on sale.

Available Credit:
The most crucial aspect of consumer spending is ability to borrow funds. The major sources of borrowing are mortgage cash-outs, home equity lines of credit, and credit cards. In this decade, consumer spending was driven by home equity withdrawals. At the beginning, rates fell to historic lows resulting in mortgage refinances. Monthly payments were reduced along with equity withdrawals. During the middle years, home values appreciated significantly causing home equity levels to rise contemporaneously. The robust gains in home equity, coupled with easy credit that allowed high LTV, enabled consumers to use their homes as a major source of funds.

Recently home values have been plummeting which is causing reductions in home equity levels. 16% of homeowners with a mortgage have zero or negative equity. Moody’s expects that number to increase to 25% by June 2009. Average level of equity for a US home is 46%, which is the lowest level since the 40’s. At the beginning of the decade, home equity was nearly 60%, and hovered in the mid to low 50’s until 2007 when in broke below 50% as home values began to decline. Considering inflation-adjusted home values rose 70% from 2000 to 2006, one would expect equity levels to rise as well. Of course, cash-out equity refinancing must be considered. Thus, value created from home appreciation was withdrawn and consumed. Lax credit standards and loans allowing higher LTV (loan to value) also contributed.

With equity levels at historic lows, the amount of equity available to be withdrawn and spent is relatively minimal. This is compounded by the reduction of LTV ratio that banks will lend.

Foreclosures will add to the already bloated housing supply, which stands at 11 months. Demand for housing is weak due to tightened credit and reduced investor appetite for mortgages. These factors will continue to pressure home prices, and without appreciation, equity withdrawals will not increase.

Consumers pulled back on their borrowing during the first quarter, slowing the growth in their new debt to a 3.5% annual rate, less than a third of the growth rate seen two years ago and the slowest growth since 1992. New mortgage debt was particularly weak, growing just 3%, the slowest increase since 1970. Home-equity loans fell by $7.3 billion, the first decline since 2001.

With rising inflation, essential goods are becoming more expensive which leaves less funds available to spend on other goods and services. Even though spending on essential goods/services contributes to GDP, it can reduce discretionary spending leading to weakness and job loss in those areas. Inflation is rising in areas where demand is inelastic, such as food and energy. The dollar has been declining making imported goods more expensive. Not only does this reduce spending in other areas, it takes money from the domestic economy to be recycled in foreign markets.

Food Inflation:
Food prices have been rising to very high levels. The primary reason is due to a significant increase in demand coming from emerging markets where standards of living have drastically improved. Since nutrition is a top priority, consumers spend will first spend on food until satisfying that requirement, before challenging expenditures to other areas. Thus, huge demand increases will occur from those with the highest propensity to purchase food, which are those who are undernourished. In many countries, people are able to eat 2 to 3 meals a day instead of just 1 or 2.

The cost of food production has risen due to higher fuel and fertilizer costs. In order for farmers to produce a crop, the price must be high enough to cover costs or they will choose not to supply it. Essentially costs are passed on to the consumer if producers don’t incorrectly forecast demand resulting in excess supply.

Ethanol production has led to increased corn acreage, which has affected other food prices. Since more land has been devoted to corn, land available for producing other grains has decreased, hence reduced supply. Higher grain prices have translated into higher feed costs for livestock farmers, which drives up prices of meats.

Higher Energy Costs:
The price of oil has skyrocketed over the past two years. Price of gas has about doubled. Heating oil and natural gas prices have risen too. Transportation costs generally spread throughout all areas of the economy causing rising prices. Transportation for an individual, such as driving, has become much more expensive and there isn’t much that can be done to significantly alleviate the increased costs. Heating a home has become more costly as it’s another area where demand can’t be reduced much to offset rising costs.

Rising Cost of Imports:
Americans import many of their goods. The weakening of the dollar means that foreign goods become more expensive. China has been a major source for inexpensive goods, especially since its currency has been very undervalued for a longtime. With inflation is China skyrocketing and pressure to revalue the Yuan, the dollar has been weakening against the Chinese currency and will likely continue for some time. A significant factor in keeping inflation low has been cheap Chinese imports.

The mood of the consumer is important in determining whether they will spend or save/pay down debt. The current economic landscape plays an important role. If consumers are optimistic about the economy, then they will save less, increase debt levels, and spend more. The wealth effect is equally important. Rising asset values make the consumer feel more wealthy, thus increasing discretionary spending budgets.

The net worth of U.S. households and nonprofits dropped at an annual rate of 11.3% in the first quarter to $55.97 trillion. It was the biggest drop in wealth since late 2002. Net worth had grown by more than $20 trillion from 2002 through the end of 2007, as home values and the stock market boomed.

Consumer confidence has plummeted. Home values, the consumer’s largest asset, are dropping. Consumer debt levels are high (nothing new). With these factors, consumers are less sanguine about spending and will be more reserved. They will likely take on less debt and save more.

As I outlined above, there are multiple challenges facing the American consumer. The pivotal question is: “what will energize the consumer?” Historically, home equity borrowing has been the primary source, yet it will be some time before this is a material source for consumer funds. The consumer is also facing higher costs on staple goods and bleak employment outlook. Consumption has been by far, the largest component of GDP. Thus, I expect GDP growth to be tepid and consumer discretionary stocks to struggle. There is a bright spot- exports, the weak dollar is causing exports to surge. This is especially important because foreign funds pour into the American economy and are recycled domestically.

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