SINLetter - September 2008

Welcome to edition 37 of Suria Investment Newsletter (SINLetter), a free monthly investment newsletter. The objective of this newsletter is to provide you with unbiased initial research and basic facts about individual stocks and other financial instruments so that you can research them further before deciding to add them to your portfolio or not. If you are reading this and are not a subscriber, you can subscribe by going to www.sinletter.com/subscribe.aspx and you will start receiving this newsletter from next month. I have provided relevant links throughout this newsletter, but if you have any questions or comments, feel free to write to me.


Portfolio Performance:

Additional gains in our July picks Umpqua Holdings (UMPQ) and Towerstream (TWER) combined with spectacular gains in our long-term holdings Medifast (MED) and Suntech Power (STP) helped offset weakness in Blockbuster (BBI), Companhia Siderurgica Nacional (SID) and Diamond Offshore Drilling (DO), helping the model portfolio outperform the major market indices with a gain of 3.14% for the month of August as seen in the table below.

Performance Metric Dow S&P 500 Nasdaq SINLetter
August 2008 1.45% 1.22% 1.8% 3.14%
Since Inception (Aug 2005) 8.66% 3.84% 7.84% 103.01%


SINLetter August 2008 Portfolio Performance

Weight management company Medifast (MED) posted a gain of 52.67% for the month of August, rising from $5.43 to $8.29 per share. We have had a long history with Medifast from the time we first picked up the stock for $5.39 in December 2005, taking profits of over 230% on 3/4th of our position when the stock touched $18 in mid-2006 and then once again adding to our position when the stock had pulled back to $8.52. Unfortunately since then this highly volatile stock which exhibits long periods of detachment from fundamental reality both on upswings and downswings has trended lower after disappointing earnings in 2007 as the company increased its advertising spend, implemented an ERP solution and moved its call center in-house.

The company reported a 73% increase in second quarter earnings to $1.6 million and a 25% increase in revenue to $27.5 million. On a diluted earnings per share basis, earnings increased 57% to 11 cents from 7 cents last year. Gross margins improved by 20 basis points to 75.8% when compared to 75.6% in the same quarter last year. The company expects to meet or exceed its full year expectations of 8 to 10% revenue growth and 30 to 35% EPS growth. Medifast seems to be back on track now in terms of earnings growth and while revenue is also growing, it is nowhere near the levels the company experienced in 2006. As investors in bigger competitor Nutrisystem (NTRI) will tell you, any growth in this industry at this point in the economic cycle is remarkable. Nutrisystem lost more than 60% of its value over the last year due to falling revenue and earnings. The company now trades at a forward P/E of 8.75 compared to Medifast's forward P/E of 15.94, which is based on analyst expectations of 39% earnings growth. Medifast appears to be fairly valued at these levels but momentum traders, a potential acquisition by Nutrisystem or continued growth from their indirect sales channel Take Shape For Life could take the stock much higher. However based on recent gains I am going to close out our position at this point and move the stock to our watchlist for a better point of reentry.

Umpqua Holdings (UMPQ) managed to post additional gains in August, helping the stock register a gain of 15.09% since we added it to our portfolio two months ago. I got a chance to interview Ray Davis, the CEO of Umpqua Holdings on August 19th and wanted to post the interview on the blog but did not get a chance to do so. I figured I would instead touch upon the highlights of our conversation in this newsletter. Just like countless other investors, I asked him if they had any plans to cut the dividend or raise additional capital. He told me that as of right now there were no plans to cut the dividend and they also did not see any necessity to raise additional capital unless certain opportunities presented themselves. Given how the company has grown through acquisitions, I asked him if "opportunities" meant additional acquisitions and understandably he said he could not elaborate on it. I then asked him about what he was seeing in terms of the real estate market in the Pacific Northwest when compared to Northern California and he told me that they were "not in the same class". He said that the Pacific Northwest with the exception of the Bend, Oregon region was holding up much better than California. He also told me that commercial real estate, which represents nearly 50% of Umpqua's portfolio was "doing fine" and most of the weakness was in the residential development area.

I then asked him about their Strand, Atkinson, Williams & York brokerage division and if there were any plans to spin-off this division. He told me that the division remained profitable, contributes a small dollar amount to earnings and they have no current plans to spin-off this division. I finally asked him about Cascade Bancorp (CACB), another regional Oregon bank based out of the troubled Bend region that had a very high short ratio of 54.29 as of mid August. He told me that the bank was not as geographically concentrated around Bend as I had thought but was also spread out across other parts of Central Oregon all the way to Boise, Idaho. When I decided to check out the locations Cascade Bancorp was operating in, it was interesting to find the following statement on their website, "We're based in the Northwest. So rest assured, we know how to handle the peaks and valleys."

As of mid August, the short ratio for Umpqua increased to 21.33, even though the number of shares short remained roughly the same as the end of July. The increase in short ratio was primarily on account of a drop in average daily volume of shares traded. Maybe the shorts know something I don't but overall I am confident that Umpqua Holdings will weather this storm. Just as storms are unpredictable it may be a good idea to take profits periodically or hedge your position through put options or maybe even a short position in the KBW Regional Banking ETF (KRE).

Suntech Power (STP) was another bright star in the model portfolio with the stock posting a gain of 42.89% in August and registering a gain of 84.38% since we picked up Suntech over two years ago. The company reported a 58% jump in quarterly earnings, beat the top end of its revenue guidance with a 51% year-over-year increase to $480.2 million, increased its 2008 revenue guidance to a range of $2.05 billion to $2.15 billion and increased the conversion efficiency of its panels. Despite the recent run-up, I am going to retain our position in Suntech as the long-term prospects of the company continue to look promising. As you can see from the historical trades section we did sell part of our original position for a gain of 151% on 11/8/2007.

After a spike in early August that saw the stock jump to $3.19, Blockbuster (BBI) continued dropping to close the month at $2.40, registering a loss of 38.85% in the model portfolio. Just as the company gave up its pursuit of Circuit City (CC) and the stock started recovering, the company reported a second quarter loss of $44.7 million or 23 cents per share. On the positive side overall revenue ticked up 3% to $1.3 billion, the all important same store sales number grew by 9% and the company has now started offering movie downloads through its website. However a Moody's downgrade of Blockbuster's debt citing a challenging credit environment for refinancing pushed the stock lower through the second half of August. The two near-term debt maturities of concern are a $40 million term loan A and its revolving credit line, both of which expire in August 2009. It should also be noted that beyond operating improvements, Blockbuster also repaid approximately $134 million of senior secured debt during 2007 by liquidating certain assets.

Gold lost some of its luster in August as the precious metal dropped $83.4 or 10.05%, closing the month of August at $829.90 per troy ounce.

Portfolio Readjustment:

As discussed above, I am going to close our position in Medifast by selling 1,000 shares for an average gain of 19.19%. To hedge the portfolio against further market weakness I am also increasing our position in the Ultrashort Russell 2000 ProShares ETF (TWM) by an additional 50 shares. Finally I am starting a new position in Activision Blizzard (ATVI) by adding 300 shares as discussed below.


Activision Blizzard (ATVI) $32.82

The Story:

Have you ever played a computer game that is so addictive and all consuming that you could actually die playing it? I know the question sounds very odd but this is neither a figment of my imagination nor the script of a terrible horror movie with that basic premise. In August 2005, a 28 year old South Korean man died of heart failure after playing a game called StarCraft for nearly 50 hours. I was introduced to StarCraft in 2000 when I joined a start-up in San Francisco and can personally attest to just how addictive and brilliant the game is. Developed by Irvine, California based game studio Blizzard Entertainment, StarCraft is a real-time strategy game. Unlike other Massively Multiplayer Online Role-Playing Games (MMORPG) like World Of Warcraft (another Blizzard product) and Everquest, which charge you every month to play the game, one could play StarCraft on Blizzard's free online platform called Battlenet and the game became very popular in broadband connected South Korea. StarCraft became a televised sport for the country with teams training intensively in apartments, as the game requires both speed and strategic thinking. Prizes for Starcraft tournaments were often in the tens of thousands of dollars. I often tend to describe the game as "chess on crack".

Following the release of StarCraft in 1998, the company came out with a critically acclaimed expansion pack (sort of like a short sequel) later the same year. The original game sold 1.5 million copies in 1998 making it the best selling game that year. In the decade that followed the release of the game, Blizzard sold 9.5 million copies of StarCraft worldwide, making it one of the best selling games of all time. I was so impressed by the quality of games Blizzard was producing, I sent the company a code sample but my linear application code probably did not hold a candle to the multi-threaded code that the hackers at Blizzard were writing. I also checked out the company as a potential investment but decided to hold back for two reasons. Blizzard is notoriously slow at coming out with new games and the game studio was part of French media giant Vivendi that also owns NBC Universal and the Universal Music Group (UMG). Moreover after purchasing a copy of Starcraft and another popular game called Warcraft III that was released in July 2002, gamers could play online for free through Battlenet. Warcraft III was named "game of the year" by several magazines and sold more than 1 million copies within a month after release.

Blizzard or the folks at Vivendi must have realized that a subscription model like Sony's Everquest game that charges players each month or through prepaid game cards is a much more profitable model and in November 2004 the company released what would eventually become the largest MMORPG called World of Warcraft. According to Blizzard, as of January 2008 there were more than 10 million active World of Warcraft players.

Two recent events piqued my interest in Blizzard again. The release of a full fledged sequel for StarCraft called StarCraft II is expected to happen just ahead of the holiday season in early December 2008 and Vivendi merged its interactive entertainment division (which includes Blizzard) with Activision to create a separate public company called Activision Blizzard. I would take the early December release date of Starcraft II with a pinch of salt even though Best Buy and Circuit City have 12/3/2008 listed on their pre-order pages. Blizzard is famous for delaying the release of its games (does software of any kind ever ship on time?) and has at times suspended development altogether. Activision is another game company that holds its own in the game industry with popular releases like Guitar Hero, Call of Duty and the Spider-Man games just to name a few. Not only are the two companies respected leaders in the video game industry, Blizzard will benefit from Activision's expertise in the console area. Blizzard primarily makes games that are played on computers and its attempt at hiring a couple of external studios including one called Swingin' Ape Studios to develop a game called StarCraft Ghost for consoles such as the Playstation 2 and XBox did not come to fruition. Starcraft Ghost was highly anticipated by Blizzard followers including yours truly but after numerous delays and the acquisition of Swingin' Ape Studios, Blizzard decided to postpone the game indefinitely. With this new partnership with Activision, there is a chance we might see Blizzard franchises like Diablo, StarCraft and Warcraft on the new generation consoles.

Vivendi still owns a majority stake (52%) in the newly created Activision Blizzard but for investors it does not get more pure play than this. It is estimated that Electronic Arts (EA) and Activision combined will account for nearly half of all video game sales. StarCraft prompted the publication of not just the standard strategy guides that accompany many games but also full fledged novels. It appears that the movie studio Legendary Pictures is slated to release a big budget movie based on the World of Warcraft in 2009. The stock is supposed to split 2:1 on September 5th and while a stock split in itself is a financial non-event, academic research has shown that the mean return of stocks that split is 9% higher in the first year after the split and this is primarily on account of higher earnings growth in the ensuing years. We discussed the effect of stock splits while featuring Logitech (LOGI) in the June 2006 edition of SINLetter and you can check it out here.

Numbers:

For the full year ended March 2008, Activision had revenue of $2.8 billion, operating margins of 16.55% and operating income of $479.61 million. For the calendar year 2007, Blizzard's revenue was $1.2 billion, up 58% year-over-year. Operating margins at Blizzard were estimated at 40% in the Vivendi press release announcing the spin-off. The combined company reported revenue of over $1 billion in the June quarter and according to this BusinessWeek article, Activision Blizzard is projected to have annual revenues of nearly $4.5 billion.

Unlike certain private equity transactions that burden the balance sheets of the companies they are acquiring with debt, Vivendi is actually putting in $1.7 billion in cash into the newly formed company, part of which would be used to acquire shares of Activision Blizzard through a tender offer. Vivendi estimates that the company will earn $1.20 per share in calendar year 2009, giving Activision Blizzard a 2009 P/E of 27.35 but analyst estimates are higher at $1.29 for fiscal 2009, which ends in March 2009. Even a P/E of 27.35 is not very expensive for a leader in a high growth recession resistant industry and I plan to initiate a position in the company both in the SINLetter model portfolio and my personal portfolio.

ATVI 1 year chart


Conclusion:

With the entertainment cost of video games at just $0.60/hour when compared to $2/hour for DVD rentals according to this very interesting article, investing in the video game industry to ride out a recession or a slowdown may turn out to be a wise bet.


Every month we add featured stocks into a model portfolio started with a cash position of $100,000 on August 2, 2005. To keep calculations simple, trading costs and regular dividends are not included. Prices reflect the closing price as of the last trading day of the previous month (August 29, 2008 for the September 2008 newsletter).

Model Portfolio - August 29, 2008

Long Stocks

Stock Symbol Number of Shares Cost Current Value Diff ($) Diff (%) Date Added
Activision ATVI 300@$32.82 $9,846 $9,846 $0 0% 8/29/2008
Towerstream TWER 10,000@$1.27 $12,700 $13,500 $800 6.3% 6/0/2008
Umpqua UMPQ 500@12.13/share $6,065 $6,980 $915 15.09% 6/30/2008
Textron TXT 150@62.55/share $9,382.5 $6,165 $-3,218 -34.29% 5/31/2008
Companhia Siderurgica Nacional SID 200@43.15/share $8,630 $6,942 -$1,688 -19.56% 4/30/2008
Lionsgate Entertainment LGF 1,000@9.41/share $9,410 $10,060 $650 6.91% 2/29/2008
Tata Motors TTM 500@17.52/share $8,760 $4,930 $-3,830 -43.72% 2/29/2008
Barclays PLC BCS 200@42.27/share $8,454 $5,140 $-3,314 -39.2% 11/20/2007
Powershares Water Resources PHO 400@22.10/share $8,840 $8,780 $-60 -0.68% 10/31/2007
Marcus MCS 500@19.94/share $9,970 $8,590 $-1,380 -13.84% 9/14/2007
Ultrashort Russell 2000 TWM 100@68.56/share $6,856 $6,612 $-244 -3.56% 9/7/2007
Blockbuster BBI 3,000@3.925/share $11,775 $7,200 $-4,575 -38.85% 7/9/2007
Unilever Plc UL 200@32.53/share $6,506 $5,364 $-1,142 -17.55% 5/11/2007
EMC Corp EMC 600@13.85/share $8,310 $9,168 $858 10.32% 3/31/2007
ICON Plc ICLR 300@18.65/share $5,595 $12,051 $6,624 118.39% 1/31/2007
Diamond Offshore Drilling DO 80@76.65/share $6,132 $9,544 $2,661 43.39% 1/3/2007
Alvarion ALVR 1000@6.87/share $6,870 $6,480 $-390 -5.68% 1/3/2007
WisdomTree Investments WSDT.PK 1000@7.40/share $7,400 $2,100 $-5,300 -71.62% 11/30/2006
Teva Pharmaceutical TEVA 300@35.05/share $10,515 $14,202 $3,687 35.06% 9/1/2006
Suntech Power STP 250@25.93/share $6,483 $11,952 $5,470 84.38% 7/31/2006
Procter & Gamble PG 180@55.60/share $10,008 $12,559 $2,551 25.49% 6/30/2006
Johnson & Johnson JNJ 200@57.65/share $11,530 $14,086 $2,556 22.17% 2/28/2006
  Cash     $11,344.5      
  Total     $203,012 $103,012 103.01%  

 

Voluntary Disclosure: From the stocks that are currently in the model portfolio, I own shares of Towerstream (TWER), Umpqua (UMPQ), Lionsgate Entertainment (LGF), Tata Motors (TTM), PowerShares Water Resources (PHO), Barclays (BCS), Medifast (MED), Suntech Power (STP), Teva (TEVA), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), BlockBuster (BBI) and Marcus (MCS). I also own October 2008 $35 put options on Lamar (LAMR).


 


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