Friday, March 30, 2012

Netflix - Can They Pay Their Off Balance Sheet Liabilities?

Caleb Tommasini


Netflix: Can They Pay Their Off Balance Sheet Liabilities?

I have been watching Netflix for some time playing both stock and option strategies. I was a large proponent of the company being "over-valued" when they traded around $300/share at astronomical multiples.  I even chuckled at the dialogue between Whitney Tilson and Reed Hastings over Seeking Alpha.  Ironically, both the men were ultimately wrong, and now Whitney is long the stock.  The interesting thing is that he compares the company to Green Mountain Coffee in going long for who knows what reason, but hey, made for some good reading.  Personally, I made some money on the way down, but lost repeatedly on long put positions as I thought the market was expecting too much in terms of growth prior to earnings releases.  I actually had puts at $250 and literally missed the collapse by a week due to option expiration.  Now that the stock has crashed heavily, experts, such as Whitney, are now signaling its time to buy as the valuation is much lower and the growth is still in full force.  I am going to present one issue in their accounting that may significantly hurt the company over the next 1-3 years.  I found something that I thought was interesting on pages 35-36 of their 10-K.  They disclose the following chart and descriptions:

Contractual Obligations
For the purposes of this table, contractual obligations for purchases of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The expected timing of payment of the obligations discussed above is estimated based on information available to us as of December 31, 2011. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations. The following table summarizes our contractual obligations at December 31, 2011:



that include renewal provisions that are solely at the option of the content provider, we include the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified. For these reasons, the amounts presented in the table may not provide a reliable indicator of our expected future cash outflows.

We have entered into certain streaming content license agreements that include an unspecified or a maximum number of titles that we may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether we will receive access to these titles or what the ultimate price per title will be. Accordingly such amounts are not reflected in the above contractual obligations table. However, such amounts are expected to be significant and the expected timing of payment for these commitments could range from less than one year to more than five years."

Note 3:
"For purposes of this table, less than one year does not include liabilities which are reflected on the Consolidated Balance Sheets as current liabilities. Content accounts payables for instance includes $905.8 million in streaming content obligations not reflected in the above table."

The first thing I did was check the numbers, my eyes may be going bad as I have been reading extensively, after checking again it was true, nearly $1 billion in 1 year and over $2.5 billion in 1-3 years.  Add in note 3 above, and this number increases by another $906 million for content alone.  So NFLX will owe $1.9 billion in this year alone for content! Yes, those numbers are in thousands up above, they are going to owe nearly $3.5 billion in the next 1-3 years in off balance sheet liabilities (plus the $.9 billion).  To put this in perspective (% of $1.9 billion owed this year displayed next to actual number for comparison purposes):

·         Market cap is around $6 billion (31.7%)
·         Book Assets are $3 billion (63%)
·         Revenues $3.2 billion (59%)
·         Net income is $226 million (841%)
·         EBITDA is $428 million (475%)
·         Book Equity is $642 million (296%)
·         Short Term Investments are $290 million (655%)
·         Cash balance is $508 million (374%)

They additionally have these major liabilities:

·         Short Term Liabilities are $1.23 billion (including the $.9 billion)
·         Debt is $400 billion
·         Other Long Term Liabilities are $770 million

Note of Off Balance Sheet Liabilities
First, before I get too crazy on the numbers, I want to discuss why these are Off Balance Sheet Liabilities.  Generally, when investors want to check future operating lease liabilities, they look at this section. This holds for NFLX as they have $21.7 in operating leases due in one year and $79.2 million in total.  Based on NFLX's cash and balance sheet, I am not concerned with these being paid off.  The major question I have is how the company can call these "off balance sheet" if it's clear they have a contract to pay up and can place a minimum value on the portion they estimate and they have to 100% for sure pay this portion at set agreed upon times? Maybe they should put this on the balance sheet as "Other Liabilities" and put in the notes that they may owe more depending and add an offsetting "prepaid other assets".  They specifically state that they are legally bound to make, at minimum, these payments. They have the minimum they will owe, the minimum price they will pay, and the time when they will pay, so why is this not on the balance sheet?  They state in their "Streaming Content" note:

"The Company had $3.91 billion and $1.12 billion of obligations at December 31, 2011 and December 31, 2010, respectively, including agreements to acquire and license streaming content that represent long-term liabilities or that are not reflected on the Consolidated Balance Sheets because they do not meet content library asset recognition criteria. The license agreements do not meet content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to subscribers. For those agreements with variable terms, the Company does not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date. For those agreements that include renewal provisions that are solely at the option of the content provider, the Company includes the commitments associated with the renewal period to the extent such commitments are fixed or a minimum amount is specified."

Notice they give reason as to why they do not reflect these liabilities in the accounting statement.  They claim because they don't know the fees or the timing of the fees generated from the assets (not from the liabilities, which they do), they do not have to reflect the content as an asset, and thus do not have to reflect a liability!  Almost like magic! Amazing, so because they can't reasonable estimate the value of the asset, the liability also do not exist, but they all will soon, very soon.  This is a definite loophole in FASB for Netflix as their leverage is reduced significantly based on balance sheet multiples.  Just viewing the statements would show a relatively healthy, fast growing company, but buried you find this, turning their Balance Sheet sour in a hurry.  They further state that they are claiming the absolute bare minimum that they will be required to pay.  They then go on and explain that  costs above the stated amounts could be "significant".  I wonder by significant if they mean $100 million, or $10 billion?  Your guess is as good as mine.

Note, someone is already suing them for these "off balance sheet" liabilities according to page 63 of their most recent 10-k, and NFLX is already stating they will "reasonably possible" lose money as a result of the suit, "based its current knowledge".  However, NFLX cannot estimate the liability once again and thus will not record anything on the Balance Sheet. The excerpt in the 10-K:

"On January 27, 2012, a purported shareholder class action suit was filed in the United States District Court for the Northern District of California against the Company and certain of its officers and directors. The complaint alleges that the Company issued materially false and misleading statements regarding the Company’s business practices and its contracts with content providers, which lead to artificially inflated stock prices. The complaint alleges violation of the federal securities laws and seeks unspecified compensatory damages and other relief. A second suit was filed on January 27, 2012, alleging virtually identical claims. Management has determined a potential loss is reasonably possible however, based on its current knowledge, management does not believe that the amount of such possible loss or a range of potential loss is reasonably estimable."

Most troubling is that Netflix also agrees with me on their short comings in the future.  In the section titled "Liquidity", they have this excerpt:

"As a result of the significant increase in subscriber cancellations negatively impacting domestic and consolidated revenues, coupled with increased investments in our International streaming segment, and in international content in particular, we expect consolidated net losses and negative operating cash flows for 2012. Although we currently anticipate that our available funds will be sufficient to meet our cash needs for the foreseeable future, we may be required or choose to obtain additional financing. Our ability to obtain additional financing will depend on, among other things, our development efforts, business plans, operating performance, current and projected compliance with our debt covenants, and the condition of the capital markets at the time we seek financing. We may not be able to obtain such financing on terms acceptable to us or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution."

The scary thing is that they flat say they will burn more cash, have losses, and explain they "may be required or choose to obtain additional financing," and further state at the end, "our stockholders may experience dilution."  Even Netflix management openly agrees with me that they need to raise money and explain that current shareholders will be diluted to do so.  They further state beyond this in the next paragraph, " As we expect to have negative operating cash flows in future periods, we do not expect to make further stock repurchases for the foreseeable future." They buy shares when the stock is above $200, and stop when it trades at $100? This is signaling cash flow concerns, most certainly as why would they buy expensive shares and stop when they become cheap unless they can no longer afford to buy them.  At this point, this does not sound like a company I would want to own, in fact, this sounds like a company that is screaming SHORT ME!  Negative cash flows, slowing growth, lofty valuations, margin pressure, competitors with deep pockets and changing business model all lead me to believe that NFLX will be under some pressure.  The interesting part is that they mention content last as the reason and specifically mention international content with no mention of domestic content.
Just to reiterate my point, I want to show the recent increase in content liabilities due to the switch of focus from mail DVD to streaming content, NFLX presents on Page 59:



The main purpose in posting this excerpt is to view the content liabilities from 2010 and 2011.  In 2010, they post $185 million, in 2011, they post $1.6 billion!  That's roughly a 789% gain in one year and as I mentioned above, this number is continuing to swell.  The reason they have these new content costs where they did not before is due to something called, "First Doctrine Sale."  Under the mail order model, Netflix would buy the  DVD once, that was it, and occur no further costs.  NFLX could then rent the DVD as many times as they wanted to free of charge.  With streaming, they are no longer protected by this clause as they never actually buy a physical product.  They now need to sign contracts to stream content.  This is changing their business model and adding significant costs.  Also note, Netflix does now own the pipes where they stream this content, and essentially is a middle man providing a replicable service.  Further, of the competition entering to compete directly, Apple, Amazon, and Comcast among others, Netflix controls the low end of the spectrum in terms of content and hence the massive costs to catch up.  If you look at it from the content providers side, they basically have deep pockets bidding for their goods and will give rights to the highest bidder, but only lock in short term contracts enabling them to re-evaluate who has the most money to pay them the next time contracts are signed.  Netflix acknowledges that they are lengthening their contracts to yearly terms from the shorter contracts they used to use, but this does little in terms of sustainable competitive advantage especially given the liquidity concerns they are facing compared to the deep pockets competing in the bidding process.

I am no mathematician, but I can do basic addition. Let's look roughly at their cash situation in 2012 just from what we have viewed in a high level setting. This is going to be by no means a perfect analysis, but should provide a "rough" estimate of where liquidity concerns may pop up for 2012.  Assuming NFLX owes $1.9 billion in content this year as described above and they have another $325 million in short term liabilities (deferred revenue is $150 million, not a true cash outflow, but will be deducted from CFO as its being added to Net Income so important).  This brings the current liabilities to roughly $2.25 billion.  They currently have $1.8 billion in short term assets, and a net loss.  I do take note that they have a bunch of other cash adjustments, but for argument sake, these are the large ones.  Note that this does not include any further additions to their content library, which certainly Netflix will want to do to stay competitive or cash flow from investing.  Just with those numbers, they need to raise at least $425+ million without an investing from cash flows assumed in the numbers.  As you can see, realistically the math does not work and NFLX will have to raise money.  They probably will not have great access to the debt markets again (they are already paying 8.5% on notes, a massive credit spread given rates are so low), so they will more than likely have a large equity offering or pay an interest rate that is well above what they could under normal conditions.  A raise of this magnitude would be worth at least 5% the company and with Netflix against the wall with the recent "Qwickster" fiasco and a couple lawsuits, I doubt shareholders will be pleased and will punish the shares.   

Conclusions
Netflix's shareholders are are going to be in trouble for the short term.   They already claim they expect negative CFO and earnings in 2012.  Capital IQ has NFLX losing ($0.23) / share this year, but recovering to earn $2.60 / share in 2013 and $4.47 / share in 2014.  This places the stock at $110 today trading at a 1.7 forward P/E of 42x and 2.7 forward P/E of 25x, hardly cheap by any metric.  I think the upcoming equity raise or massive leveraging of the balance sheet (this time on the balance sheet) that is most certainly going to occur will be the catalyst to make this trade a success.  

Thursday, February 16, 2012

Market Summary 2/16/2012


Highlights
The S&P500 made it biggest move of the year rising 1.1% ongreat news all around.  Starting with theUS, Housing starts came in above the consensus showing that there may be lifein the housing market after all.  Joblessclaims also came in at a much better than expected 348k compared to a consensus365k showing that the labor market it also heating up.  The PPI numbers less food and energy also roseabove the expectations showing that inflation is starting to potential creep inon the supply side.  Lastly from the US,the Philadelphia Fed Survey blew out the estimates following the Empire Statenumber yesterday showing that this market may have much more room to run. 

I think the most important news on the day came on rumor that theEU will give approval to start the Greek debt swap by Monday.  The Euro, which dropped in the high 1.29sfinished the day at 1.313.  There stillis some debate on how an escrow account will collect revenues to make sure thedebt gets paid, but all in all the market loves certainty and as soon as theGreeks "fix" their problems, the better off we will be. 

Equities
Markets rose on the day on good news from around the world.  NASDAQ took the biggest leap of the large indiceswith a 1.5% pop.  In individual names, GMposted its highest profit ever and even though they missed profit estimates,they finished the day up 9% at $27.17. I still think GM is a great buy at theselevels moving forward. Nordstrom's (JWN) profits rose 1.7% as the affluentcustomer continues to spend. This was in line with wall street estimates,however the company issued cautious guidance dropping the shares heavily inafter hours before a recovery in the stock.  
Cabela's (CAB) finished the day up nearly 14% on better thanexpected earnings, revenues and expectations moving forward. Advanced AutoParts (AAP) was another name I would follow as they rose over 8% on the day onpositive earnings results.  I am stillvery bullish on my Ford (F) pick moving forward and the auto sector in general.  In terms of volume, Bank of America was themost active stock with a 4% gain followed by Sprint, Citigroup, and Ford. 

Rates and Fx
In FX news, the Euro finished the day off strong on the Greek news.  I feel the move will continue until at least1.33 on continued progress.  The Yencontinued its decline against the dollar moving towards 78.93.  Other than that, the Dollar finished down tothe majority of currencies on the day. Most notable were the AUD at 1.0755/$, CHF at .9191/$, and the GBP at1.5801. 

In fixed income news, rates sold off across the curve.  The 30 year was off 5.8bp moving to 3.15% andthe 10 year sold off 6.4bp finished at 1.99, still under the 2% mark. I wouldlook at shorting rates especially on news of a Greek resolution as a risk ontrade should push yields higher. 

Commodities
As a potential conflict with Iran becomes closer and closer andthe economy continues to heat up, I would pay close attention to oil.  WTI finished at $102.44 and natural gasfinished at $2.55.  I still in bullishNG, but if a war with Iran sparks, there are predictions of oil crossing the $200mark until we can clear the Strait of Hormuz where some 20% of the world's oilpasses through. Gold rose slightly to finish at $1,733. 

Tomorrow
Major economic news tomorrow includesthe CPI data and a leading indicators number. The CPI should be telling on how the fed will monitor its ratesexpectations.  I think rates will risesooner than we think on continued strength in the US economy and the inevitableinflation on the horizon.  In terms ofmarkets, I am bullish into the weekend as a lot of people missed out on therally and will want to put money to work in hopes that the Greek situation isgetting better.    

After an earnings miss, I still believeCLF is a great buy as they finished the day flat.  At these levels the stock trades at 6xtrailing earnings.  Most importantly,most of the management team bought large amounts of shares showing thatmanagement believes the company has strong prospects moving forward.

Wednesday, February 15, 2012

Market Summary - 2/14/2012



Highlights
Another day, another Greece headline! I am personally starting to get sick of Greece having such an impact on market prices.  Troubling news on the day was that the Germans seem to be signaling that they wouldn't be all that upset if Greece defaulted and left the Eurozone.  This is apparent in the demands they are insisting as well as the harsh stance they are taking.  However, this evening, the Chinese said that they are going to invest heavily in the Euro and are supportive of a strong Eurozone.  I imagine this plea is due to the reliance upon the US and dollars.  China, wants to diversify its assets and they rely upon the Eurozone heavily for international trade. Part of the drama in the markets today was the rescheduling of the Greece meeting from tomorrow to a phone call and the official meeting has been postponed yet again until Friday.  There was rumor at the end of the day that the Greeks are going to sign a commitment to honor their austerity and the markets rallied.  As cynical as this sounds, what is signing a paper going to do for the Greeks?  Time will tell. 

US markets finished relatively unchanged on the day, but bonds rallied as the flight to safety measure kicked in and inflation expectations were kept at bay.  Retail sales numbers were released and they grew less than expected, but still showed growth of .4% and an even better .6% excluding autos.  Business inventories, a measure of the inventory in dollar amount held by manufacturers, came in at .4%, less than the .5% expected.  This bodes well for the economy moving forward as businesses are managing with very lean levels of inventory and will probably have to restock moving forward.  The last major data point released on the day were the import and export prices.  Import prices dropped .1% and export prices rose .2%, greater than the .1% expected.  However, these numbers are still very low and helped explain the rally in rates today as inflation expectations are being kept at bay.

Equities
Due to time constraints, I wanted to focus on one stock today.  Zynga reported $311.2 million in revenue but still managed to lose money on the quarter.  This represents a 59% increase YoY in revenue, tremendous growth.  Earnings, however, were a different story.  The company reported a net loss on the quarter of $1.22 / share.  Excluding stock based compensation, the company managed to earn $.05 a share.  More troubling is that this number represents a 24% decline in profits from 2010 even with the stock based compensation removed.  I fear this company could be on my short list within a year if they don't manage to turn profits around.  After hours quotes had the stock down 9% on the report but the stock moved back to even by the close.  

Monday, February 13, 2012

Market Summary - 2/13/2012


Highlights
Finally, at long last, the Greeks decided to pass austerity measures in a 199-70 vote in favor of the cuts.  They lowered minimum wage, cut government labor, and proposed to remove benefits in a sweeping reform that sent markets higher.  I imagined such a day would bring a 2-3% shot up in markets given the down days we have recently experienced.  Instead, the DOW rose a measly 0.57% with the S&P and NASDAQ posting similar gains.  What caused such a muted reaction?  Well, for the Greeks to actually get the €14.5 billion of the €130 billion bailout from the EU and IMF, the Greeks must specify the a portion of the exact cuts to be taken as well as send the EU a written commitment to actually follow the terms of the proposal.  It seems that the Euro zone is finally realizing that money thrown at Greece is likely not to be recovered and it may make better sense to let them default and exit the Euro.  The question remains, is what happens under a defaulting scenario?  Surely people will try and run the banks in fear of their bank being the Lehman of a potential Euro crisis.  The Greek economy will face much more severe contractions and the people will probably revolt, but this time full fledge. It will be interesting to see what the EU and IMF decide come Wednesday.  Beyond this, 100,000 Greeks set Athens ablaze in violent and disruptive protests.  Yes, 100,000, and given that Greece has around 11,000,000 people, this would represent nearly 1% of their population.  This is a staggering number and makes you wonder if the government did all they could if Greece is even able to be saved.  Don't even get me started on Portugal.  They may be the next domino to fall in the chain.  After being pro the Euro recovering as little as a day ago, I now realize that the people may make this not even a possibility.  Here is a nice picture of Athens ablaze last night:



Beyond Greece,  there was little action in the US markets.  There were a few t-bill auctions, but nothing special.  Crude was halted midday on what was labeled a "technical glitch" by the CME.  There is speculation that an algo went wrong and the CME caught this one before we experienced an oil flash crash.  There weren't any crazy earnings reports to note.  Apple did break $500 on the day as there is speculation of a dividend and the iPad 3. 

Equities
Stock markets were relatively boring on the day. Nearly all markets finished close to where they started.  The S&P 500 did close above the psychological barrier of 1350.  The main wonder is whether it can hold it this time as last year the market hit over 1370 before crashing hard over 300 points in all.  The VIX was down and finished at 19, low given the risks in the market.  Priceline (PCLN) was the biggest gainer on the S&P with a 4.8% pop followed by International Paper (IP) and Fastenal (FAST).  Biggest losers on the S&P were First Solar (FSLR) with a -5.0% drop followed by TripAdvisor (TRIP) and Netflix (NFLX).  On the DOW, Bank of America (BAC) continued its hot year with the largest pop at 2.2%. 

Rates and Fx
I am still a treasury bear long term, but short term, risk remains.  Bill Gross added to his position in treasuries as well.  I will be especially curious as to what happens after tomorrow's import/export prices report.  The 30 year finished down 1 bp at 3.11%, same with the 10 year (1.96%), and the 7 year (1.36%).  Somewhat related to rates, but I think extremely telling, individual central banks in the Euro zone are expanding the types of assets they can take as collateral.  This is English for the banks do not have collateral to meet their needs and the Central Banks are helping them out.  I was amazed that the European banks were not just absolutely punished on the news.  If I was long a European bank, I would suggest an exit as the upside does not compensate a 0 on the downside.  In FX news. the Euro was down on the day settling most recently at 1.3161 $/Euro.  The Yen actually sold off heavily as the BOJ announced a surprise asset purchase program enlargement.  Most recently the Yen was quoted at 77.88 Yen/$.  The pound also finished down on the day to settle at 1.5707.

Commodities
As mentioned before, Crude was halted on the day.  WTI Crude finished at $100.53 down $0.38 on the day with Brent at $117.20.  Spot gold finished at $1,716.39, down $6.10. Natural gas continued its descent finishing at $2.44.  This price continues to be unsustainable, but with supply and production well above demand, it's hard to see a short term recovery in prices.  I am still very bullish NG's longer term prospects as the US starts to make use of this energy source in greater quantities.  Coffee futures dropped to $214.60, down 1.29% on the day. 

Tomorrow
Should be a much more interesting day.  First, Zynga(ZNGA) reports its first earnings since filing for public status.  This should provide light on the health of Facebook before its IPO as Zynga accounts for a large portion of revenues.  Regal (RGC) is another name I would watch for earnings.  In economic news, Retail Sales are going to be a metric for the health of the consumer as well as inventories and import and export prices.  Import and export prices will be one I will especially be watching as the argument for QE3 continues to be brought up.  The only thing I feel that stops this initiative is the potential for inflation picking up.

Friday, February 10, 2012

2/10/2012

I wanted to start today off with a little disclaimer. I am not licensed and not currently a professional in the field. I am a business school student who loves the markets and wants to voice my opinion and track my ideas and investments. I would recommend going to an expert before taking on any of these investments. With that out of the way, here goes:

Highlights
The markets finally slowed down after 5 weeks of gains, finished lower both on Friday and on the week. The major data points released in the US were the University of Michigan Consumer Confidence number and the Trade Deficit. Expectations for the consumer sentiment reading called for 74.3 and the number came in far below at 72.5. The markets obviously took a hit on this announcement, but for all that was going on today, it really wasn't so bad. The S&P 500 finished down 9.3 points to 1,342 (-0.69%), NASDAQ was down 23.35 to 2904 (-0.8%), and the DOW finished down 89 points to finish at 12,801 (-0.69%). Compare this to some 3-4 months ago when a bad data point moved the market some 3-4%. The main figure that exhibits this low volatility environment is the VIX, which today jumped to 21 points. Contrast this to a reading above 45 in October. Here is the chart:
The US trade deficit also widened to -$48.8 B, a billion wider than expected. On top of all of this, remember that Greece was having issues all day hashing out a deal and the Euro tapered down slowly throughout the day finishing at 1.3197 (-0.69%). At the close Papademos announced approval for deeper budget cuts set forth by the EU and IMF to help obtain the much needed bailout funds before a default. This agreement did not come without a price as 5 ministers resigned within 2 hours and protests ran rampart in Athens. Papademos made it clear that people not for the cuts would not fit in with his government.

Equities
Equities finished down on the day with the major averages down 0.7-08%. Alcoa (AA) led the DOW down with a -3.29% move. The only DOW stock up was HD with +.13% gain. One interesting major mover was LinkedIn (LNKD) with a 17.8% gain after a beat and raise performance. The company experienced its 6th quarter of triple digit revenue growth, a feat very hard to accomplish in this low growth market. Barclays (BCS) joined other financials with poor earnings, however, the stock managed to rally some 1.5% throughout the day after starting down. Credit Suisse (CS) also took a surprise loss on a restructuring charge. The stock finished down some 3.7% and announced a large cut in its dividend to help the firm reach its capital requirements moving forward. Alcatel-Lucent (ALU) finished the day up 12.9% on news of a 20% drop in profit. True Religion jeans (TRLG) got hammered some 27.7% on the day.

Today was actually a big sentiment change for many experts. Many are now calling for a correction on the horizon as the recent market rally is at some 20% on the upside and people feel a pullback is in the cards. I disagree if Greece gets a deal done. I also feel that stocks are cheap with the trailing P/E at 15 and the forward estimate at some 12.7. The forward P/E is especially low on a historical standard, but the large risks are keeping markets at bay.

Rates and FX
Rates rallied slightly on the day with the 30 year yield falling 5 bp to 3.14%, the year yield falling 5 bp to 1.99%, and the 7 year yield falling 4.5bp to 1.38%. I am still very much in the camp that the bond market will sell off. I am bearish and reflect this with short call options on the bond futures and outright short future positions. In FX world, the EUR/USD finished down -.67% to 1.3197, the GBP finished down -0.39% to 1.5756, and the Yen finished down -0.06% to 77.61. I am also still a believer in a Euro relief rally on a debt deal. If you have access watch the FX markets on Sunday and be prepared to short the dollar with the Euro on an announcement. This will not be the end of the drama, but a major step forward.

Commodities
Gold finished down on the day at 1725 (-0.91%) as well as silver at 33.604 (-0.92%). Copper was one of the large losers with a -2.93% drop. Copper is largely driven by projected growth as its used in many infrastructure projects. Oil also sold off slightly on the day to $98.67 (-1.17%). Natural Gas finished flat at 2.477, but I still suspect an increase and hold mini contracts for February. Bloomberg reported that a snow storm should hit the Northeast over the weekend bringing in some 2-4 inches of snow. This should cause a spike in the current active NG contract.

As promised, I wanted to mention some other commodities. In particular I want to focus on Orange Juice (OJ) and Feeder Cattle. OJ hit a low in 2009 of $64.6 and rumbled its way up to $226.95. Recent price movement was caused by a Brazilian fungus found in both Pepsi and Coke brands of OJ. This put major pressure on the prices and a large portion of OJ actually is imported from Brazil, not California or Florida as one might suspect.

Feeder Cattle finished the day at 153.625 or down -0.98%. You may ask, what is Feeder Cattle? The CME identifies the contract on Feeder Cattle as 50,000 pounds of 650-849 pound grade medium-large #1 and medium-large #1-2. Essentially, younger cattle that still need to be fed before the slaughter, which differentiates them from Live Cattle futures. The Slaughter price forward expectations is the primary driver of the Feeder Cattle prices. Currently, Feeder cattle is well above its 3 year trailing average and has since peaked at a high of $156.20. Current chart technical patterns are very bullish, but the contrarian in me wants to place a short on the contract. the interesting information I found online is that the drive up in price is due to lower input costs of corn. I am not fully aware of why this would happen, but have found this as a causation online in multiple instances. If anyone knows why this is, please comment below as new information is always encouraged.

Next Week
Next week should be interesting as the Greek Parliament should solidify a deal on Sunday. I wouldn't take this as a certainty as Greece has been all over the place as of recent. Also on board are retail sales and inflation data. The Fed is also hosting a series of speakers which could give a better idea of what to expect in terms of rates moving forward. An announcement for further quantitative easing is become more of an expectation as inflation has remained somewhat at bay. Also on the tape is the January jobs reports, jobless claims, and Obama should submit his budget proposal which is expected to show a deficit of $1.33 trillion. Yes, you read that correctly, we are going to spend $1.33 trillion more than the revenue we collect if all goes as planned. After Greece, I feel it's only a matter of time before the US and Japan get found out with our debt problems.

Stock Picks
F - Ford Motors. I already gave an auto dealership in LAD, now I want to recommend one of LAD's drivers. Ford has been on a tear in terms of auto sales and the company has reported profits to prove it. The stock currently trades at a measly 6.6x P/E ratio with an 8.6x forward P/E (they had an unusual circumstance to make their earnings bump in Q4). Most analysts predict an average of 27% growth in EPS over the next 3-5 years, which is astounding. On the soft side, Ford has done an excellent job of ridding underperforming models and reducing the number of models it offers. They now offer the leftover models better and at a lower cost due to some of the strategic moves in the auto construction manufacturing process.

Next, jump on a Bloomberg (I may have told you to do this already) and check the SAAR for auto sales and tell me from 1950- now that you don't see a very distinct and cyclical pattern?! This seems to be a pretty easy buy and a buy that should reap you some handsome rewards.

Market Highlights - 2/09/2012


Highlights
So you should not be surprised at this point at what drove markets on the day, Greece.  They actually reached a deal on something so great news!  Right!?  Well, not really. Luxembourg Prime Minister Jeane-Claude Juncker said, "In short, no disbursement without implementation."  He then went on to set another date for Greece at February 15th.  In plain English, the European finance ministers held back an aid package of some 130 billion Euros in bailout funds as they don't believe what the Greeks say.  Pretty harsh if you ask me, but history agrees with them as Greece has continually failed to meet expectations and basically why will this time be different.  So what next?  Greece really has 2 options.  First, they can draft a new plan by the 15th and receive the money they are expecting.  Second, they can exit the Euro.  Not great options for the Greeks and this issue should be interesting for the markets going forward.  I expect the markets will sell off to some degree on the news.  I am still bullish on the Greeks reaching a deal, but the odds deteriorate every day.  In other news, the markets were basically flat on the news. The S&P 500 rallied 0.15%, the DOW.05%, and NASDAQ was flat. 

When Warren Buffet speaks, people generally listen.  Well today he spoke in his annual letter to shareholders about his views on the markets, gold, and other insights that he had to share.  In general summation, he claims that any "productive asset will prove to be the runaway winner over bonds or gold over any extended period of time."  These are pretty bold statements but he backed them up with some excellent logic.  He said in his letter that bonds should "come with a warning label" as they do not compensate investors enough to deal with inflation and taxes.  He was even more critical of gold calling it a "non-productive asset."  In particular he noted "owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future." He went on to state that bubbles "ultimately pop."  I generally agree and feel that gold, although a great trading asset, is not something to hold much of for the long term. 

Another interesting story on the tape, a deal was reached with big banks and state governments and the terms are going to hurt homeowners who have actually been making the payments on their mortgages instead of "strategically defaulting".  The agreement should be worth some $26 billion will pay those who were involved in fraudulent lending and those whose homes are worth less than the debt they owe (underwater).  In reality, this deal helps those who put little money down and those who decided to stick it to the banks rather than the people who did the right thing.  This deal should help some 1 million of the 75 million homeowners or about 1.3% of homeowners.  Most troubling is that the people who put 40% down and lost a similar amount in their house will get no aid. In other news included that jobless claims came in below the consensus at 358k, but the last month revised number went up by 6k.

Equities
The stock market sold off hard in the morning on the rejecting of the Greek bailout loans.  The markets eventually changed their tones and finished flat to slightly up on the day with the S&P 500 up 0.15%, the DOW up .05%, and NASDAQ flat.  In individual names, DMND finished down big at 37% on the accounting issues mentioned yesterday, Akamai (AKAM) was up 10.51% on a beat in both revenues and earnings.  First Solar (FSLR) rose 7% on increasing demand expectations, and Whole Foods(WFM) was up over 5% on an earnings beat, and Pepsi (PEP) fell some 4% on in Europe.

Rates and FX
Watch out for the AUD/USD as the RBA lowered both its growth and inflation on the year.  The AUD/USD sold off to 1.0709 at 11:00 PM Pacific time.  The lowered forecasts came in at 3.5% growth and 3% inflation.  This increased concerns that the RBA would cut rates moving forward and pressured the AUD.  The EUR/USD sold off on the news Greece had preliminarily agreed on terms as the market does not believe Greece will be able to fulfill its promises.  The EUR will continue to be under pressure as uncertainly continues to mount.  The Yuan reached an 18 month high on news that China had imports fall over 15% with a decrease in exports.  This obviously fueled concerns of a global slowdown in growth. The BOE injected some $79.3 billion into the economy to support the recovery.  Another move of quantitative easing in the UK.  The bank left interest rates at a record low of .5%.  The UK economy shrunk at the end of 2011 and the unemployment rate rose to a 17 year high. 

Bonds continued to fall, supporting my recent call of a sell off especially with the longer duration names. The 30 year moved to 3.16%, the ten year settled at 2%, the 7 year moved to 1.38%, and the 5 year settled at 0.82%.  I recommend a long 5s10s30s butterfly (my definition is longing the 10, shorting the 5s and 30s).  

Commodities
Natural Gas storage fell 78 bcf, less than the expected 90 bcf.  This was still semi bullish for NG as the gas has been under pressure due to over supply in the industry.  Gold moved to 1,722 and Oil settled at $99.13.

Monday, I plan on entertaining some less prevalent commodities such as OJ and Cattle Feeder to spice up the report so be prepared!


Tomorrow
Leading US news include the consumer sentiment number at 9:55 ET and Ben Bernanke speaking at 12:50 ET.   China reported that their exports fell .5% and imports fell 15.3% in comparison to last year at this time.  This moved the Chinese trade surplus to a 6 month high of $27.3 billion.  Most economists blame this on the timing of holidays in the country in the data. 

Stock Picks
Bank of America (BAC) - With the good news on a mortgage deal being settled with the big banks, BAC should be a major beneficiary as one of the biggest concern for the bank was the potential litigation and write downs that existed in the future.  From a valuation perspective, the bank trades at a 7.4x forward P/E with very low expectations built in.  In terms of book value, the bank trades at just .39 Price to book.  A large part of this is due to the esoteric nature of the assets on the books and what they are actually worth.  At this point, if you plan to hold BAC for the long term, I feel the bank will come out well positioned in the long run.

Wednesday, February 8, 2012

I apologize up front for some of the short answers today.  It was both my sister and girlfriend’s birthdays and I wanted to get something down.

Highlights
The markets were again on Greece watch throughout the day. I didn't sleep at all last night waiting to put on an FX position in the EUR/USD. The plan was, and still is, to purchase the Euro on a deal or to short the Euro on a default. Now tread carefully as a "default" is in the cards in both situations, the terms of the deal are going to be important. Favorable terms include very little collateral damage to financial institutions and steps toward less sovereignty in terms of aligning fiscal and monetary policy of the union. Unfortunately, the Greeks managed to push the deadline back once again, thus I will probably lack sleep once again. They did, at least what was "reported", make great strides to hammering out preliminary terms. MITK, my pick (Jim Edwards did the dirty work) from February 3rd, roared over 22% on 151% revenue growth and 90% gross margins. I would take profits on this position and keep a small position moving forward. Currently, I don't feel the valuation justifies the position although I still feel strongly about the company. The 10 year was auctioned today and had mixed to poor results as the yield increased to 2.02% with a 3.05 bid to cover in comparison to a 3.11 average over the last four auctions. This aligns well with my short futures of both the 30 year and 10 year and selling naked calls far out of the money on top.

Equities
The equity markets were flat to slightly up with the S&P up 0.22%, and the DOW up 5 points. In after market headlines, Diamond Foods plunged 41% on news that the company had misrepresented its financial statements. The company reported that it is replacing both its CFO and CEO and restating 2 years of past financial data. Should be interesting to hear how this plays out. If the company can manage, this may be a gem to pick up at a massive discount. Other movers were Apple (AAPL) hitting a $476.68, an all time high, OPEN sold off 12% due to slower growth. Cisco (CSCO) beat earnings and trickled up 1.1%. Sprint (S) beat revenue, but posted another loss due to the iPhone compressing gross margins, deepening the firms concerns moving forward. Groupon posted worse than expected earnings of $.02 (missing by $.01) and sold off 16% in the after hours. Visa (V) was up over 3% in the After Hours as it reported better than expected use driven by an increase in card use. Caesers (CZR) IPO'ed today and from an outsider it seemed to be a great stock to buy. Actually, it was a great stock to buy with a 71% gain. However, the company only floated 1.8 million shares. They are still on deck to issue an additional 120 million+ shares in the coming months making this as close to market manipulation as possible. I am actually not sure how they are managing to get away with this except that I think the people buying have no idea. Interesting results are that the company had $2.25 billion in revenue and a LOSS of $164 million. I would short this stock in about 6 months as supply floods the markets. I am still a believer in the bull moving forward.

Rates and FX
The JPY is currently sitting at 77.20/$ and I continue to believe the Yen will sell off.  The AUD is still a currency I am targeting to strengthen to 1.10 as the country continues to export massive amounts of natural resources.  The 30 year yield finished the day at 3.15.  CNBC posted an article on the 10 year auction - http://www.cnbc.com/id/46301729 which yielded 2.02% and a bid to cover of 3.05 compared to 3.11 showing less demand than expected. The Fed was in full force today and bought $1.8 billion in bonds in its “Operation Twist”. 

Other good news on the rates side showed that the index for mortgage purchase application came in at 7.5% vs. a projected drop of 2.9%.  This is pro bullish housing.

Tomorrow
Jobless claims are on the ticker for tomorrow.  Traders will be glued to this number as it is probably the most relevant.  The treasury is also issuing a 30 year bond auction tomorrow. On the commodities side, the EIA is releasing their regular natural gas report. Of course Greece is the headline to look out for.

Stock Picks
Long ARW – Arrow Electronics is a value play.  The company specializes in technology more specifically competitive services and supply chain management.  Their primary line of business has very tight margins and they compete with the likes of Avnet.  However, Arrow has acquired a ton of small high growth service companies, companies that are generating much greater margins and growth than Arrow currently has.  The company trades at 8x trailing and a 5.8 EV/EBITDA multiple.  I feel this is a classic LBO pick as the company has the ability to manipulate their cash flows to best benefit themselves.

Short GRPN – Groupon showed today that the company cannot both grow revenue and even somewhat profitable.  I feel that the business of discounting is just too competitive and easy to enter.  They trade at some $15 billion market cap but hardly make any money and I don’t see how they can grow enough to justify the multiple or create the proper margins.  Ask Amazon.com how that business is going for them…