SINLetter - August 2007

Welcome to the second anniversary edition 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.

 

July Blog Entries:

If you do not subscribe to blog entries by email or in case you missed them, here are the blog entries for July. Some of the comments following a couple of these blog entries add a lot of interesting information.

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Portfolio Performance:

A nearly 20% gain over the last two days in our June 2007 pick Gymboree (GYMB) combined with the protection offered by our put options helped the SINLetter model portfolio close at a record high of 103.64% since inception and a gain of 3.14% for the month of July. Jitters from the subprime mortgage mess spreading into the prime area pushed most of the major indices into negative territory in July as you can see below.

Performance Metric Dow S&P 500 Nasdaq SINLetter
July 2007 -1.47% -3.2% -2.19% 3.14%
Since Inception (Aug 2005) 24.37% 17.8% 15.98% 103.64%


SINLetter August 2007 Portfolio Performance

The sudden drop in the market that we experienced last week left a lot of investors unnerved and especially those who did not experience the grueling bear market of 2000 to 2003 first hand. The second ripple of the deflating housing bubble combined with a perception that the private equity fueled acquisition mania is finally coming to an end is likely to lead to further market weakness and higher volatility. With both core and overall inflation hovering around the tame 2% level and GDP growth for the second quarter of 2007 coming in at a stronger than expected 3.4%, it appears that the Federal Reserve is going to leave interest rates untouched and not heed calls from the housing/mortgage sector for a drop in interest rates. In this environment I am staying away from bonds, hedging risks through options and anchoring my portfolio with consumer staples and dividend paying stocks.

After giving up a lot of ground in recent weeks, shares of Gymboree rallied on news that the company has raised earnings expectations from a range of 10 to 12 cents to a range of 13 to 15 cents a share. The company also initiated a new $50 million share buyback program upon completion of its previous $50 million buyback. These buybacks account for almost 8% of the company's market cap and is an excellent tax-free method for management to return value to shareholders. The recent performance of Gymboree is all the more remarkable when you consider the performance of competitors Carter's (CRI) and Children's Place (PLCE) who lost 18.39% and 33.95% of their value in July. As some of you may recollect, I decided to stay away from Carter's because of lackluster sales at its OshKosh division. Carter's swung to a loss of $2.48 per share in the second quarter largely because of hefty charges related to the value of its OshKosh division and same store sales declining as much as 10% at OshKosh. The company also lowered its outlook for the rest of the year. Children's Place suffered after it reported June same store sales fell 3% at its Disney stores and 4% at its Children's Place stores. The company is now predicting huge second quarter losses.



Gymboree, Carter's and Children's Place Performance
Source: Yahoo Finance

It appears that our July pick BlockBuster (BBI) has gained an upper hand in its war with rival Netflix (NFLX). The company reported adding 600,000 subscribers for its DVD subscription service in the second quarter when compared to a drop of 55,000 subscribers at Netflix. Netflix lowered its subscription rates in response and as this article points out, the clear winner in this battle is the consumer. BlockBuster has been volatile oscillating up and down before ending the month with a loss of 6.54% in our portfolio. The turnaround at BlockBuster is going to take a while but I like the growth in subscribers, the closing of underperforming stores and the potential of the small store concept that the company is considering. The company is also considering kiosks and hence attempting to address competition at all levels. Instead of building its own kiosks, the company should look closely into California based DVDPlay, which already has a footprint of well over 1,000 kiosks in grocery stores and other locations.



Netflix and BlockBuster Subscriber Growth

Specialty travel company Ambassadors Group (EPAX), which made the cut in March 2007 reported impressive results when it posted second quarter revenue growth of 22% to $42.9 million (the company refers to revenues as gross margins) and earnings growth of 22% to $20.9 million or $1.05 per share, above analyst estimates of $1.00 per share in earnings and $40.2 million in revenue. Available cash on hand is $33.7 million and the company has no debt. The stock reacted favorably to these results and was up 13.73% in the week following the results and is up over 30% since we added it to our portfolio in March. Ambassadors Group has been an amazing story since it was spun off from its parent Ambassadors International (AMIE) back in 2002 and has gained over 600% in the last five years.

Gold reversed course by gaining $19.7 or 3.04% to close the month of July at $667.20 per troy ounce. Contrary to what you might expect, most of these gains came in the first three weeks of July and the glittering metal barely reacted when the stock market dropped last week.

Portfolio Readjustment:

The financial sector has been a DOG this year falling 6.6% year-to-date (as of last week) when compared to a gain of 9.6% for the S&P 500 over the same time period as you can see from this post on Bespoke. While there have been a lot of factors that caused this underperformance, the key risk that has been on everyone's mind is the exposure the sector has to the falling housing market. After 17 consecutive interest rate hikes, spreads on loans (the bread and butter of banks) are also lower. Despite very attractive valuations and equally attractive dividend yields, I have tried to steer clear of the sector with the exception of Barclays (BCS) and WisdomTree (WSDT.PK). I picked both these companies back in December 2006 because of their focus on exchange traded funds (ETFs).

A lot has changed with Barclays since then. The company launched a bid to acquire Dutch bank ABN Amro (ABN), which appeared to be a great idea at the time until the Royal Bank of Scotland decided to spoil the party by launching a rival bid. Beyond this costly acquisition battle, Barclays also had exposure to now bankrupt mortgage lender New Century Financial (NEW) through $900 million in loans. The company was unfortunate enough to lose $400 million through its investment in the two Bear Sterns hedge funds that nearly went bust last month. To make things worse, Barclays even has exposure to American Home Mortgage (AHM), which lost 90% of its market value on Tuesday after reporting that it may have to sell off its assets and will no longer be able to make new loans. Based on these developments, I am going to sell our position in Barclays for a small gain of 3.22%. Subscribers probably made a little more on Barclays over the same time period thanks to its high dividend yield. I am glad we did not suffer the same loss with Barclays as the rest of the financial sector.


Embraer (ERJ) $43.53

The Story:

One of the most successful investors and the second (now third?) richest man in the world Warren Buffett did not mince words when expressing his thoughts about investing in airlines companies and had this to say,

If a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.

You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: “My name is Warren and I'm an aeroholic.” And then they talk me down.”

Sure there are exceptions to this rule such as Southwest Airlines (LUV), SkyWest (SKYW) and British Airways (BAIRY.PK) but this general rule of thumb has been pretty much accurate. Have the companies that actually supply aircraft to airlines companies fared any better? When you look at a 5 year chart of Boeing and Airbus parent EADS, you realize that the very competition that hurts the airlines proves highly beneficial to the aircraft makers as it translates into new orders. Despite being plagued by delays in releasing its A380 "super jumbo" plane, the stock of EADS is still up over the last five years, a period of time defined by bankruptcies of many US airline companies. The only airline companies that have done well recently are small domestic airlines in emerging countries or large ones that cater to international long haul traffic.

Instead of investing in risky, capital intensive and often difficult to obtain small international airline stocks, investors could instead choose to invest in aircraft companies like Brazil based Embraer that happens to be in one of the BRIC (Brazil, Russia, India and China) nations and primarily satisfies the need for small and regional jets with 30 to 120 seats. The kind that I tend to fly a lot. Embraer also makes executive jets such as the Legacy 600 and has recently started moving into the red-hot ultra-light jet market with its Phenom series, the smallest of which the Phenom 100 is priced at just $2.98 million.
Embraer Phenom 100 Jet

Embraer does not appear to be content by catering to these two segments and has bigger plans for the future by building larger planes that can compete with offerings from Boeing and Airbus. There is certainly a lot of execution risk in this strategy but I do not expect the company to attempt anything on the scale of the Boeing 787 Dreamliner or the Airbus A380. I would expect Embraer to focus on the small end of the large airplane segment like the highly popular Boeing 737. To get a glimpse into just how hot this segment of the market is, check out this story titled Stocks, bonds... or jets in Fortune magazine that details how difficult it is to get hold of a 737 and how hedge funds and private equity firms are getting in on the action.

Embraer currently gets a majority of its business from North America but is looking Eastward for growth from countries like India and China. In addition to the incumbent state-owned airlines like Air India and Indian Airlines, the airline industry in India has been booming over the last few years with various new entrants such as Damania (now defunct), Kingfisher, Jet Airways and Air Deccan. This increased competition has led to a wave of mergers recently with Air India merging with Indian Airlines, Jet Airways acquiring Air Sahara for $300 million and Kingfisher Airlines attempting to acquire Air Deccan. However as many observers have noted, this consolidation may be a little premature as the airline industry in India is expected to experience tremendous growth in the future. A burgeoning middle class and rising salaries will shift some traffic from Indian Railways, which is currently the primary means of domestic travel to airlines, which have reduced fares to a point where they are within the reach of the middle class. Embraer is slowly beginning to make inroads into the Indian market though regional discount carriers like Paramount Airways.

The story is similar in countries such as China that are experiencing similar trends. Embraer and China Aviation Industry Corporation (AVIC) created a joint venture called Harbin Embraer Aircraft Industry (HEAI) in 2002 to manufacture Embraer jets locally in China to meet domestic demand. Embraer received a large order of 100 regional jets in September 2006 from China’s Hainan Airlines for $2.7 billion.

Embraer did see some shifting in its order backlog recently when JetBlue decided to delay delivery of 16 Embraer 190 jets from 2013 to 2015. However the pipeline for the company look very strong with an order backlog of $15.6 billion as of the second quarter of 2007. Embraer has been lagging the Brazilian Bovespa index year-to-date but as you can see from this glimpse into the future the company provided in November 2006, the company expects to fly high for years to come.

Note: If you adhere to the principles of socially responsible investing, please note that Embraer derives 5.9% of its revenue from defense aviation.

Competitors:

As the third largest aircraft maker in the world, Embraer faces competition from industry behemoths Boeing (BA) and Airbus as it attempts to build higher capacity planes. Embraer also faces direct competition from the CRJ line of commercial jets from Bombardier as well as the plethora of companies like General Dynamics (GD) (maker of the popular Gulfstream jets), Textron (TXT) (maker of the Cessna Mustang) and privately held Eclipse that are active in the light jet sector.

The Numbers:

At 32 times earnings, Embraer may appear to be pricey until your consider the order pipeline and the fact that this company is selling for less than 12 times 2008 earnings. The PEG (Price/Earnings/Growth) ratio is a low 1.02. The company has over $2 billion in cash and short term investments on its balance sheet and $893.8 million in current/short term debt.

After posting double digit sales and earnings growth from 2003 to 2005, both sales and earnings declined in 2006. This drop was on account of production issues related to wing assemblies that lead to a delay in the delivery of 15 airplanes that were originally slated to be delivered in 2006. For further details, including a month to month breakout of events, check out the very well put together and easy to navigate 2006 annual report.


P/S 2.04 Cash and Investments $3.44 billion
P/E 32.17 Short and Long Term Debt $2.185 billion


Instead of featuring a second stock in the newsletter, I plan to monitor the market and if anything interesting shows up, I will post a portfolio update on the blog just like I did for the Apple strangle in July.

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. However as this newsletter was delayed by a day, it represents the closing price as of August 1, 2007.

Model Portfolio - August 1, 2007

Stocks

Stock Number of Shares Cost Current Value Diff ($) Diff (%) Date Added
ERJ 200@43.53/share $8,706 $8,706 $0 0% 8/1/2007
BBI 1,500@4.59/share $6,885 $6,570 $-315 -4.58% 7/9/2007
GYMB 200@42.02/share $8,404 $8,636 $232 2.76% 6/14/2007
UL 200@32.53/share $6,506 $6,182 $-324 -4.98% 5/11/2007
EMC 600@13.85/share $8,310 $11,454 $3,144 37.83% 3/31/2007
EPAX 300@29.70/share $8,910 $11,682 $2,772 31.11% 2/28/2007
ICLR 250@37.30/share $9,325 $11,752 $2,428 26.03% 1/31/2007
DO 80@76.65/share $6,132 $8,133 $2,001 32.63% 1/3/2007
ALVR 1000@6.87/share $6,870 $10,820 $3,950 57.5% 1/3/2007
WSDT.PK 1000@7.40/share $7,400 $4,700 $-2,700 -36.49% 11/30/2006
SNDK 200@48.10/share $9,620 $10,638 $1,018 10.58% 10/31/2006
TEVA 300@35.05/share $10,515 $12,780 $2,265 21.54% 9/1/2006
STP 400@25.93/share $10,372 $16,064 $5,692 54.88% 7/31/2006
PG 180@55.60/share $10,008 $11,369 $1,361 13.6% 6/30/2006
LOGI 240@20.385/share $4,894 $6,511 $1,618 33.06% 5/31/2006
JNJ 200@57.65/share $11,530 $12,192 $662 5.74% 2/28/2006
MED 1000@6.955/share $6,955 $7,320 $365 5.25% 11/30/2005
TTM 900@11.94/share $10,746 $15,273 $4,527 42.13% 11/30/2005
AIRN 1700@5.62/share $9,554 $5,491 $-4,063 -42.53% 8/1/2005


Options

Option Number of Units Cost Current Value Diff ($) Diff (%) Date Added
JOEMJ.X 3@7.00/contract $2,100 $3,300 $1,200 57.14% 10/31/2006
YUXMG.X 8@2.60/contract $2,080 $3,712 $1,632 78.46% 10/31/2006
Cash     $12,394      
Total     $205,680 $105,680 105.68%  

 

Voluntary Disclosure: I currently own shares of Airspan Networks (AIRN), Medifast (MED), Tata Motors (TTM), Logitech (LOGI), Suntech Power (STP), Teva (TEVA), Mattel (MAT), SanDisk (SNDK), Alvarion (ALVR), WisdomTree (WSDT.PK), Unilever (UL), Gymboree (GYMB) and BlockBuster (BBI).

 


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