AB Analytical Services

Natural Gas: Extreme Contango Suggests Caution for E&P Companies

The price of Natural Gas is hovering just below $3, which is about the median price over the past two decades.  Or is it?  While the spot price has garnered lots of headlines recently for its collapse, the future price has declined much much less so.  The quoted price for a year from now is above $5.  Here is the history since 1990:

Clearly the spot price is very depressed relative to the future price.  In fact, it is at a record percentage differential.  In the chart below, I have divided the one-year forward price by the 1-month forward price.  The mean spread has been 6%.  You will see I included lines for +/- 2 standard deviations as well.  The current relationship is more than 4 standard deviations from the mean:

At this point, I need to alert the reader that I am approaching this from the view of a generalist.  Embarassingly, given that I am both a native Texan for my first 18 years as well as a resident for the past 15, I have never evolved into much of an expert on oil or gas despite my increased efforts over the past several years.  I do know enough to get myself into trouble! 

Kidding aside, though, I think that the "consensus" thinking is that the spot price is depressed and the future price is more reflective of reality, and I have been questioning that notion.  A client of mine came back from EnerCom's Conference last month and shared his views.  It was then that I realized that the leading E&P companies are all telling a pretty similar story, and it doesn't bode well for the price of gas (and the value of their reserves).  Perhaps I am paying too much attention to the big Shale plays, but it appears that despite the plunge in gas prices, companies are cranking out the gas.  Natural gas is more plentiful than we have imagined, and technology makes it more accessible apparently.  If that's not enough, I read this week that Cheniere's (LNG) facility is importing gas despite the very low spot prices.  Demand is muted, and it could return, but the real story to me is supply.  Most commentary points to the large decline in drilling, citing the Baker Huges Rig Count data.  Below, you can see the plunge in North American Gas Rigs in operation:

 

This data can lead one to conclude that production must be plunging, but I wonder if a lot of the rigs are not the marginal ones.  Further, with horizontal drilling, I believe that the output per rig increases.  The plunge in spot prices is attributed to a short-term decline in demand and storage at capacity.  All we need is a hurricane or a cold winter or hot summer and everything will be fine!  In any event, I checked some data published by the Department of Energy and found that production in total has been rather flat.  For the first six months of the year, this is what it looks like:

• 2009:   10.515 TCF
• 2008:   10.213 TCF
• 2007:    9.328 TCF 

I also believe that we have a situation where reserves are growing rapidly.  I reviewed several conference calls from Q2 for the leading gas companies and find an alarming uniformity in what they had to say.  While spot prices are quite low and would seem to suggest lower production, they are cranking it out.  First, they need to crank it out.  All of these companies have significant financial leverage.  Second, due to hedging, they are actually very profitable.  This begs the question:  Who is paying $5 for gas a year out, and how long will they continue to do so?

Here are some quotes, all of which are from transcripts provided by Seeking Alpha.  I have included the link to the transcript in each case (click on company name):

Chesapeake Energy (CHK):  "...we expect to deliver 4% to 5% production growth in 2009, and 7% to 8% production growth in 2010, plus, increase Chesapeake's proved reserve, during '09 and '10, from 12 Tcfe to 16 Tcfe..." (CEO McClendon) and "...Finally, one note on cost trends. As you can see from our release, just about all of our production and other cash cost are down or at worst to flat from quarter-to-quarter. We continue to see some downward trend in drilling and completion costs as well..." (CFO Rowland)

Petrohawk Energy (HK):  "...our priorities are significant production growth and reserve growth..." (CEO Wilson) and "... Our production came in significantly over the high-end of guidance to 483 million a day..." (CFO Mize)

Southwestern Energy (SWN):  "...we will expect to have production growth of approximately 45% over the 2008 levels... During the second quarter of 2009 our horizontal wells had an average completed well cost of $2.9 million per well, average horizontal lateral length of 4,123 feet, and average time to drill to total dept of 11 days from reentry to reentry. This compares to an average completed well cost of $3.1 million per well, average horizontal lateral length of 3,874 feet, and average time to drill to total depth of 12 days from reentry to reentry in the first quarter of 2009." (COO Mueller) 

Ultra Petroleum (UPL):  "...Second quarter of 2009 was a difficult period for the industry, but Ultra delivered strong results. We established a new quarterly record for production of 44.5 Bcfe, an increase of 30% from second quarter 2008. At the same time we decreased our all-in-cost by 29% to $2.43 per Mcfe, and our cash costs also decreased to $1.42 per Mcfe... We ask Netherland Sewell to provide us with a mid-year proved reserve update using the more logical 2009 rules and unrestricted by us. The result is an answer almost twice what we reported at year end 2008... It is clear to us that we can grow annual production by 10% to 15% over our three-year planning period 2010 to 2012..." (CEO Watford)

XTO Energy (XTO):   "...natural gas production averaged 2.352 Bcf per day, 31% increase... Of this growth, 19% comes from acquisitions and 13% comes from development...If we look at our unit cost analysis and guidance importantly, and Keith will talk about this a little later, production expense was $0.94. That compares, per Mcfe, to $1.00 to $1.05 guidance, so a substantial improvement there, and we've lowered our guidance to $0.95 to $1.00 going for the remainder of the year..." (CFO Baldwin)

So, we have increasing reserves, increasing production, and decreasing costs from these leading developers of the Shale reserves.  None of this bodes well for future gas prices, though EOG Resources (EOG) CEO Mark Papa believes that the decline in Texas vertical wells will more than offset this dynamic, calling Texas "the 800 pound gorilla in the room ."  Absent a major change in our national energy policy that results in a massive effort to build gas-fired electrical power plants, I believe that supply will continue to dwarf demand.  Investors in the leading gas-focused E&P companies may want to keep an eye on that forward price that is enabling the companies to generate strong profits through their hedging activities.

Disclosure:  None

Restaurant Investing: Indigestion Ahead

A year ago, I highlighted the fast casual restaurant segment favorably, suggesting these chains would benefit from falling input costs and a slowdown in expansion.  Most of the stocks mentioned are higher today despite the overall market being down.  I followed that article up a few days later with a explanation of why I bought BJ's Restaurants (BJRI), which turned out to be a real winner. 

While most of the stocks mentioned are up, the path wasn't so straight, as all of these stocks were hammered in the October massacre.  I had alluded to the too-high debt levels of many of these companies, and those were the ones that fared the worst.  Several, in fact, suffered losses over the ensuing months of 80-90%.

I certainly have been impressed with the resurgence in these stocks.  In addition to the headwinds of rising input costs for the restaurants and gasoline and other expenses for their consumers abating and reversing, several other factors have helped the sector to do relatively well despite the overall weaker economy.  First, the expansions have pretty much halted.  I had mentioned in the article a year ago that P.F. Chang's (PFCB) had already strategically decided to focus on its existing portfolio rather than opening more restaurants.  I will give an example below of how the math works, but these companies have cut expenses by slowing or halting expansion.  A second reason for stabilization is likely share gains.  I don't have hard data, but the credit crunch buried some weak players like Bennigan's and countless other smaller competitors.  Finally, the "comps" were pretty easy, as the industry has been struggling for a while.

Let's take a look at the data.  The table below is pretty similar to the one I shared a year ago, though there is one additional company, the tiny Mexican chain Rubio's (RUBO).  Here is the universe of fast casual chains sorted by how they have performed over the past year:

 

A few observations:

• The key information is that earnings for the group this year are projected to rise a median 11% - this is why the group has performed well
• Over the past year, the median return for the group is over 6%, while the S&P 500 is down about 20%
• The biggest change in the data is the FCF yield - as CapEx has halted, it has shot up
• Debt levels are still quite high typically
• While some of the YTD returns are spectacular, they represent escape from near-death (I highlighted 4 that are more than 4X off the lows that, on average, have still lagged the group)

As I look out, I am not that optimistic for the group to continue beating the market.  I believe that the strong performance came from very pessimistic assumptions a year ago followed by non-recurring cost improvements.  In the coming year, traffic is unlikely to escalate, as the economy remains sluggish with continuing labor market woes.  Unlike other companies, these derive all of their business from the domestic economy.  But my biggest concern is that investors are not understanding the real source of earnings growth and that it isn't sustainable:  slowing down store openings.

I listened to two calls recently, BJ's and Texas Roadhouse (TXRH).  In both cases, earnings growth for the quarter was quite strong.  For BJRI, which showed 45% EPS growth y-o-y, new restaurant opening expenses declined year-over-year.  Were it not for this dynamic, growth would have been 15% or so (still quite strong).  This remains, by the way, one of my favorites in the group, though I find it a bit expensive.  For TXRH, which reported EBIT growth of 20%, over half came from this same phenomenon.  SG&A fell 9% while sales rose 12% (all from openings over the past year, as s-s-s were slightly negative).  The strong growth historically for these chains and their peers has come from expansion.  I don't believe that investors are going to pay high multiples for restaurants that aren't going to expand.  I wrote about TXRH two years ago when it operated or franchised 270 restaurants.  Now it operates 325.  Q3 earnings calls should be quite interesting, as analysts are anxious to learn about plans for 2010. 

For restaurants to do well in the next year, they will need to see better same-store sales.  Traffic figures have been, not surprisingly, weak all year, and some chains reported a fall-off in July.  Pricing has become much more aggressive as well, with companies acting extremely promotional to keep market share.  If these companies begin expanding again, the cost pressures of openings will be a big drag on earnings.  So, the way I look at it is that in a weak economy, pressure will most likely remain on the revenue line, and the companies won't be enjoying input price declines to the extent that they have this year or the strong improvement in opening costs.  This bodes for flat or even negative earnings growth, depending upon how weak the top-line might be.  On the other hand, if business picks up, the restaurants are likely to depress their earnings by reinvesting in long-term growth.  In either case, I expect a year from now to find most of these stocks trading at levels near or below the current prices.

As far as particular stories, BJRI is a gem.  I continue to think that their strong balance sheet, high perceived value and their relatively small size gives investors potentially a good shot at going along for the ride from 85 to 300 locations.  Most impressively, the company has had higher comps than other chains despite its very strong presence in the economically challenged California. 

TXRH, which I visited last month, should face continuing challenges.  My thesis on the company is that they cater to a lot of families, and this segment is under pressure.  There are just too many cheaper alternatives despite the high value that they do offer.  When both parents are working, the concept works well.  My concerns are that they are hurt worse than average by the economy.  Their comps dipped dramatically in July, and they are changing their store-opening philosophy (end-caps), which could result in problems down the road. 

I wrote negatively recently about DineEquity (DIN), and worry about their high level of debt and the fact that they grabbed a lot of low-hanging fruit as they sold off Applebee's franchises.  They are probably going to issue stock shortly, and the filing along with disappointment regarding their near-term franchising outlook knocked 1/4 off the stock.  I actually ate at an IHOP last week and found it to be surprisingly "refeshed" - they actually had healthy items on the menu.  I don't know about Applebee's, but the IHOP value proposition is extremely high.  My best guess at this point it that the stock will struggle due to the high debt burden.  I plan to reassess it after the equity offering.

I don't know the Cracker Barrel (CBRL) story, but it looks very unattractive on the surface.  They have a ton of debt.  They have slowed their CapEx, but it is still higher than D&A.  At the rate they generate FCF, it would take at least 10 years to pay off their debt.  Further, their dividend might be at risk.  Their fiscal year just ended, and the summer is their big season, so the call in September will be interesting.

My caution on the group has a lot to do with my negative view on the consumer, but it also reflects my concern that investors don't quite understand the dynamics that have led to rising earnings on negative same-store sales.  The top-line growth next year will be negatively impacted by the lack of openings this year, while the bottom-line won't likely be helped by improved pricing, lower input costs or a further slow-down in store openings.  In a best-case environment, consumers start spending more freely, costs don't rise and the restaurants decide to continue their slowdown in new openings, as this will result in earnings growth.  I wouldn't count on that scenario.

Disclosure:  No positions in any stocks mentioned

Dorman won't be Dormant Much Longer

The vastly altered landscape in the automobile retail industry, including the collapse in available credit last fall, concerns over the viability of the manufacturers and now the implosion of the dealer networks for Chrysler and General Motors (GM), is creating several opportunities.  While it took a while for some of my ideas that I shared in the Fall regarding taking advantage of these massive changes to play out, several of them have:

		PX 10/17/08	PX 05/15/09	Change
Auto Parts	AAP	27.58	40.66	47.4%
	AZO	106.60	158.01	48.2%
	ORLY	22.47	36.17	61.0%
	PBY	4.12	6.15	49.3%
Salvage	CPRT	32.09	29.19	-9.0%
	LKQX	14.66	15.25	4.0%
Finance	ACF	8.67	10.24	18.1%
Pawn	CSH	36.09	20.03	-44.5%
	EZPW	13.52	11.68	-13.6%
	S&P 500	940.55	882.88	-6.1%

So, while the market has been down, the four ideas produced a monster of a return from the first idea, a mixed return from the second, an excellent return from the third and a dud from the final area.  At the time, I disclosed that I was long ACF and EZPW.  I failed to pull the trigger on the auto parts players.

I followed up in February with a suggestion to buy Dorman Products (DORM), when it was trading below 9.  Well, egg in my face, as it traded as low as 6.12 a couple of weeks later, but I am happy to report that it has participated in the rally, trading as high as 12.50 in April and settling in a bit lower subsequently.  

The company makes replacement auto parts that are cheaper than the OEM replacement parts, and I expect that the aging of our cars due to the economic crisis should help the company to actually grow through the recession.  In that original article, I concluded:

My own expectation is that the stock may trade as high as 16 later this year, though it will require a couple of things to happen.  First, the margin erosion must stop by mid-year.  Despite the higher inventory than the company should be holding, I am optimistic that the improved sell-through should help clear that overhang.  The company reports on 2/27, so we may learn more about the outlook for margins then and perhaps see signs of inventory improvement.  Second, someone will have to notice!  I think that the fact that the stock trades at tangible book value but should continue to offer a decent free cash flow yield (once it works through the inventory), that it has little debt, that its growth outlook isn't nearly as bad as for companies in general due to the secular theme of cars being on the road longer, and that its margins have plenty of room to expand as input prices have now corrected and the pressure is lifting off of its customer base could be the catalysts.  I base my 16 target on a couple of different assumptions:

• 1.5X projected 2009 ending book value
• 13.3X my projected 2010 EPS of 1.20 (sales growth, margin improvement)

I had noted as well that it had an impressive list of institutional rosters but that I was concerned about a build-up in inventory.

I am happy to report that the company dramatically reduced inventory without sacrificing margin in the most recent quarter.  Also, with 3/31 filings now complete, all 4 of their major holders maintained or even expanded their positions during Q1.  I had added it to my Top 20 Model Portfolio (and have owned it myself), but I increased the size of the position in the model after their recent report.

While the stock is higher than when I first suggested it, so is the market.  Further, it remains cheap, as my original year-end target was 16.  I think that 15 should be pretty easy, and 18 is possible.  The main reason, though, that I am more excited at an even higher price is that I expect the dealer network collapse to benefit the company in the long-term.  As dealerships close, customers will either have to drive further or go to an independent repair shop, where they can get serviced for less money and with Dorman Products parts.  Finally, the chart looks great:

The stock has outperformed the overall market over the past 16 months (and longer).  It has an excellent balance sheet and trades at just 1.1X book value (1.2X tangible book value), affording it downside protection (absent crazy markets like March!).  The PE is just 10X one-year forward expectations (single analyst), which is very cheap considering the strength of the balance sheet and the likelihood of actually growing.  It seems as if the stars are aligning in the firm's favor, including the better times for the three companies that comprise 1/2 its sales:  AAP, AZO and ORLY.  As I said last time, if you like this one, be very careful buying it as it is EXTREMELY thin.

Disclosure:  Long DORM

Conquering the Market with Conservative Growth

Last summer, I launched my second model portfolio, the Conservative Growth/Balanced Model Portfolio.  At the time, I thanked the Seeking Alpha readers for their very thoughtful responses to several of my articles indicating to me that there was great interest in "conservative stocks" and shared a "kick-off" preview, "Investing for Conservative Growth". I followed that piece up with very detailed analysis of all of the stocks I was including in that initial portfolio (Energy, Industrials, Consumer Discretionary, Consumer Staples & Health,  Financials and Technology).  41 long and harrowing weeks later, I am very proud to share that the model portfolio, which is measured against the S&P 500 (60%) and the Barclay's Aggregate Bond Index (40%), has returned over 1%, besting its benchmark by almost 15%.

How did I do it?  It wasn't buy and hold, as here is the initial portfolio and its members' returns:

AGG	99.32	100.96	1.7%
ASF	26.85	30.49	13.6%
BBBY	29.10	29.99	3.1%
CFR	52.21	50.69	-2.9%
COLM	38.35	31.32	-18.3%
CSCO	22.38	19.50	-12.9%
CSL	26.88	24.10	-10.3%
CVX	86.22	66.87	-22.4%
FII	33.58	23.40	-30.3%
ITW	46.55	34.30	-26.3%
JNJ	67.49	53.85	-20.2%
LOW	19.86	21.02	5.8%
NATI	27.97	22.14	-20.8%
WAG	33.97	31.56	-7.1%
			-11.5%

The iShares Barclays Bond Index Fund (AGG) is a big chunk of the portfolio, and it has increased slightly.  The stock holdings, though, have declined about 11.5% since the inception.  A blend of 40% bonds and 60% stocks has declined almost 15%, but 40% of AGG and 60% of the average of our initial stocks would have declined about 6.2%.  Not too bad, but I stated that we are actually up over 1%.

Again, how did we do it?

1. Conservative Growth stocks did better than the market
2. We traded aggressively

Allow me to elaborate.  I already showed that our average stock did better than the market.  With respect to the bonds, we have generally been underweight the 40% benchmark, but we took it way up when the ETF was mispriced in October.  I actually shared this extreme opportunity.  My back-of-the-envelope calculation is that trading around the bond ETF exposure may have added as much as 4%.  The balance came from trading around the stocks.  Allow me to elaborate.

As you are probably painfully aware, we have had one of the greatest rallies ever (now) as well as a very strong one in November and two of the worst bear markets ever (9/08-11/08 and 1/09 to 3/09).  The model portfolio allows me to vary exposure to stocks by neutral +/-25%.  In other words, our 60% neutral exposure can be as low as 45% or as high as 75%.  On balance, I believe I had those exposures relatively helpful to the model, though I confess to having been underweight since late March.  I keep a running blog, and you can get a feel for it by visiting.  So, some of the return was pure beta.  But, that only explains part.  We have also sold several securities and added others.  We sold, for instance, CFR and LOW at higher prices than they currently trade.  We recently sold NATI and CSCO, and we sold ASF in April (well below today's quote!), FII in March, ITW in January and BBBY in December.  We have added BCR very recently, CRR  at 30 in April, HRL at 27.24 in November, MPR at 6.33 in March (hard to believe), RAVN at a much higher price, SYY at 22.23 in April and TDW at 33.23 in March.  We also used the volatility to add to our original positions at much lower prices. 

The bottom line is that we have focused exclusively on companies with strong balance sheets and reasonable valuations.  Some of our excess performance can be attributed to good timing, but a great deal is simply being in the right stocks relative to the market.

We have written on many occasions that trading is essential in this volatile market.  One can't buy and hold one's way to success in a bear market.  Whether it is at the security level or the sector level, one must allow the poor liquidity in the market to be one's friend.

Here is how we are currently positioned:

• Bonds 33.5% vs 40% benchmark (all in AGG)
• Stocks 46% (above the 45% minimum but well below the 60% neutral weight)
• Cash 20.5%

Our stocks by sector:

• Energy:  CRR 5.1%, CVX 5.6%, TDW 2.5% (total of 14.2% or 23.7% of 60% equity benchmark compared to 12.8% in S&P 500)
• Materials:  0% compared to 3% in S&P 500
• Industrials:  CSL 1.5%, MPR 1.6%, RAVN 3.9% (total of 7% or 11.7% of 60% equity benchmark compared to 10% in S&P 500
• Consumer Discretionary:  COLM 4.4% (compared to 9% or 7.3% of equity benchmark compared to 9% in S&P 500
• Consumer Staples:  HRL 6.3%, SYY 4.1% and WAG 1.9% (total 12.2%  or 20.3% of  equity benchmark compared to 12% in S&P 500
• Health:  BCR 2.1% and JNJ 7.5% (total 9.6%  or 16% of equity benchmark compared to 14% in S&P 500
• Financials: 0% compared to 13% in S&P 500
• Tech:  0% compared to 18% in S&P 500
• Telecomm: 0% compared to 4% in S&P 500
• Utilities:  0% compared to 4% in S&P 500

Thus, we are currently very overweight Energy and Staples and underweight Financials and Tech, with about 25% of our potential equity exposure in cash.  The overall portfolio has a forward PE of about 13.7X and a 2.8X Px/Tangible book value.  The median and average net cash is slightly positive.  The equities have a weighted dividend yield of 2.65%, which is slightly higher than the S&P 500 despite the superior balance sheet profile.

I expect this type of portfolio, which is focused on strong balance sheets and modest valuations, to continue to do well in this economic environment. The model is up over 7% YTD.  While my outlook is for falling stock prices in the back half of the year, I am hopeful that we can stay green.

Disclosure:  Long COLM, CRR, CVX, HRL, JNJ, SYY

Goodwill Hunting: Stay Alert for Asset Impairment Charges

Download Goodwill Writedown Candidates

I was listening to the Vulcan Materials (VMC) call yesterday wondering when someone might ask the question I wanted answered.  The company executed a massive acquisition last year, piling goodwill onto its balance sheet.  With business down so much, the company, in conducting its annual "impairment test", might find that it needs to write down the carrying cost.  The company stated that it didn't need to make an adjustment this year, though clearly this is purely management discretion.  This is important, because a writedown can trigger a violation of bank covenants (as debt to equity rises after the equity is reduced).  Further, it can hurt valuation ratios such as price to book value.

I described my major theme of "big bad balance sheets" in December.  As I have been addressing frequently my concerns that many companies outside of the Financial sector will struggle immensely this year with balance sheet concerns, I want to continue the dialogue by identifying companies with high debt loads, high goodwill and deteriorating fundamentals.  If you own these stocks, you should attempt to better understand how a potential writedown might impact its ability to borrow, its cost to borrow and its likelihood to continue paying dividends.  Here are the parameters I employed:

• Intangibles/Equity > 70%
• Debt/Cap > 40% (Net > 25%)
• EPS decline for 2009 >15%
• Market Cap > $600mm

The list yielded 74 names, but several are from different shares of stock for the same company.  Also, I would point out that good things can happen to bad companies, as one of the stocks, Advanced Medical Optics (EYE), recently received an acquisition offer. 

The list encompasses candidates from many sectors and across all market capitalizations.  I included a couple of columns on dividends to help highlight one of the risks (a dividend reduction).  Note that many of these are high-yielding stocks, with several of them having very high payout ratios.  Remember, there is no FDIC insurance on those dividends!

As I stated before, this list is a good starting place to identify companies that may be at risk of an impairment to their goodwill.  The deal looked so good back when it was done, but the current economics might not support the original purchase price.  The consequences of a write-down may not be signficant, but if the company has substantial debt it can lead to violations of its agreements with its lenders and require repayment of debt or higher borrowing costs.  Additionally, companies may be restricted in their ability to pay dividends.  I believe that my thresholds are actually not low enough and would be concerned with companies that have goodwill representing 50% instead of the 70% I employed in order to keep the number of companies hitting the screen to below 75.  Also, there are many companies that haven't reported and have stale earnings forecasts that kept them from meeting the "-15% EPS" parameter.  One that comes to mind is Weight Watchers (WTW), which I recommended as a sale in Mid-January.  Another caveat is that I was unable to include stocks with negative equity, but there are several of those that would meet the criteria otherwise.  If I remove the down EPS parameter and change the goodwill ratio to 50%, the number of stocks rises to a stunning 294.  While companies may avoid it for now, many of them will be taking the charges in early 2010 if this economic crisis persists.  Don't get caught holding the bag!

Disclosure:  No position in any stock mentioned or in the graphic.

Four Ways to Profit from Tight Auto Lending

While everyone is painfully aware of the credit crunch, especially with respect to the housing market, investors are perhaps less familiar with another spigot run dry: Automobile lending.  Leasing has died, the auto manufacturers have shut down or curtailed lending and most third-party providers of capital to the market have retrenched.  Automobiles are big ticket items that are generally bought on credit. Borrowers are strapped, and lenders are in retreat.  It's no wonder that the outlook for the auto industry is so bleak even after such a disastrous year.  Investors who, like me, believe that the recovery will be slow are well served to think through how these dynamics will play out.  I believe that there are four areas that could benefit:  Auto-parts stores, salvage/recyclers, lenders and pawn shops.

I was negative on my favorite automobile parts store, O'Reilly (ORLY), last year.  I covered my short in January, but I am now considering buying this member of my watchlist.  One of my observations at the time was saturation, which could become less of a problem given consolidation.  In fact, ORLY played the role of consolidator by purchasing CSK Auto.  While ORLY took on some debt as part of that deal, it still has one of the better balance sheets in the industry along with above-average margins.  In any event, whether its ORLY or one of its peers, including Advance Auto Parts (AAP), Autozone (AZO) or Pep Boys (PBY), the overall industry should benefit from a slowdown in new car purchases due to the lack of available financing.  Why?  As people keep their cars longer, they will need to maintain them.  While these stores cater to the do-it-yourself repair person (not me!), they also act as just-in-time inventory hubs for repair shops.  An aging fleet of vehicles implies more repairs. 

 

Download AutoLendingCrunchORLY.jpg

The salvage/recycling industry is an interesting angle.  As the economy remains challenging and credit availability for new purchases is constrained, the "repair versus replace" argument swings in favor of repair.  To that extent, components from totaled vehicles become even more valuable than typically.  Copart (CPRT) is a pure-play on the resale of used vehicles via auction.  The company has a very high return on capital, no debt and a PE multiple of just 15X.  LKQ (LKQX) recycles components for resale.  While it trades at a lower PE, it does have some debt on the balance sheet.

If you want to see the LKQK chart, click here:

Download AutoLendingCrunchLKQX.jpg

The next group of stocks makes sense:  The survivors.  For investors, there aren't that many pure-plays.  I own the only one, AmeriCredit (ACF).  I wrote bullishly about it in June.  Like almost any stock since then, it is down a lot, though less than one might suspect ("just" 26%, with the S&P 500 down 31%).  I pointed out in that article that "ACF is potentially dead meat, as it historically has relied upon the capital markets to finance its lending (securitization).  I believe, though, that they will survive."  That the stock has held up better than the broad market despite its very high risk could suggest what I believe to be the case:  Despite the risks, the company is in a great position.  Access to capital and the losses on the existing portfolio have to be weighed against the opportunities to lend at fantastic margins in a favorable competitive environment.  Again, this one isn't for the timid.  The stock trades at a substantial discount to book value, not surprisingly.  I view the company as having massive scale and infrastructure that should appeal to anyone who wants to earn high returns in the future in the business and is willing to absorb near-term losses on the existing portfolio.

The final area is perhaps too far "out of the box" for many, but I firmly believe that the dynamic I am describing could positively impact pawn shops.  EZCORP (EZPW) is one of my largest positions, and I own it for reasons that extend well beyond this argument.  I prefer it to CashAmerica (CSH) due to its better balance sheet and a few other reasons, but both should benefit.  For those who do purchase a new or used car, the days of "no money down" are gone.  I believe that the higher down payments required could lead to people pawning items at the margin.  A car is a necessity for many, not something with which they can do without.  Unlike a home, a car can actually help its owner to make money, whether directly (sales, for example) or indirectly (commuting where public transportation isn't a viable alternative).  To the extent that someone needs a car and can't buy one with the type of easy credit to which we have become accustomed, I believe that they will need to turn to alternative sources of credit/cash.  I realize that most readers of this article don't fall into this category, but I estimate that many of lower means certainly do.  I first wrote about EZPW in February, and, remarkably, the stock has gone up.  I think that it has a lot more to go.  Minimal debt, huge return on capital, a focused and methodical expansion and a stunningly low valuation for an "unFinancial" (no leverage) all suggest to me a possible gain of 80% or more over the next year.

  

We are probably going to face tight credit in automobile lending for quite some time.  In the following table, I have included a few metrics for all of the companies mentioned.  I am sure I left off some other potential beneficiaries and would appreciate anyone sharing their ideas with me.  This phenomenon, unfortunately, extends well beyond housing and automobiles.  We should expect credit card standards to tighten immensely, and we are already seeing a massive constriction in lending for education.  While it is easy to focus on the impact on consumer spending, a more interesting exercise is to think about what changes might occur in the way people go about paying for big ticket items.  I believe that the absence of credit will lead to material pressure on all goods that can be converted to cash as long as credit remains constrained.  I mentioned gold as a short last week, and I have never seen such a furor created by one of my articles.  We know that people are selling their stocks en masse, but what's next?  Art, antiques, coins and stamps all stand out to me.  Pawn lending appears to be an obvious beneficiary, but I am sure that there are others.  I am not yet comfortable enough to even suggest a publicly traded company that has been performing quite well that could benefit from the need for cash, but I will say that it is in the "life settlements" business (formerly known as viatical settlements industry).  Yes, the business for selling one's life insurance pay-off at a discount today is booming. 

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Disclosure:  Long EZPW and ACF

Time to Attach a RV to Your Portfolio

One of the most beaten down industries, not surprisingly, is the Recreational Vehicle manufacturers.  They have declined an average of 50% after falling over 25% last year.  While the longer-term trend of baby boomers retiring and choosing to pursue leisure in this fashion is most likely intact, it has come under severe pressure due to the explosion in gasoline prices and the implosion of the housing market and consumer confidence.  Rising input costs haven't helped the manufacturers either. With gasoline prices reversing, sentiment perhaps bottoming and the stocks still severely oversold and undervalued, perhaps the time is right to consider investment and bet on some pent-up demand being released.  I recently purchased Thor Industries (THO), which I have followed for many years, but there are some smaller companies that probably make sense as well.  This is an industry that Warren Buffet has historically liked, as his Forest River is one of the larger players in the industry.  Here are the 7 publicly traded companies that I have identified:

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As I mentioned, THO is the company I know best.  I have been impressed by their high inside ownership, decentralized management process, strong balance sheet and now valuation.  The company is an industry leader.  While it derives 84% of its sales from RVs (the balance from small and medium sized buses), the vast majority is from "towables" as opposed to "motorized".  I would expect towables to do much better in coming years due to their lower cost, lower fuel consumption and lower reliance upon financing.  While every analyst would say THO is a great company, the chart below indicates they don't say it's a great investment.  This is one of my favorite contrarian indicators!

 

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As far as THO, I believe that they are using their industry strength as the lowest-cost and best capitalized participant to take share and potentially eliminate some competition.  Their inventory remains a bit higher than I would like to see, but I believe that is consistent with their strategy.  As they come out of the downturn and restore margins towards their norms, the stock could rapidly advance.  I have set a target of 32 over the next year.  My comments on the rest of the smaller companies will be briefer due to my lack of familiarity.

Drew Industries (DW) actually looks as compelling if not more so than THO.  DW is a supplier of components to the industry, with direct exposure to THO and high exposure to the towable segment as well.  74% of sales come from its RV segment, with the balance from manufactured housing.  The valuation is quite low off of depressed earnings and the company appears to maintain reasonably high gross margins over time of 24% or so.  It also has a strong balance sheet.  This is one I intend to investigate further.

Winnebago (WGO) is poorly positioned and bleeding badly.  They are pure RV, but they are in the motorized  segment.  Their balance sheet is debt-free, but stuffed with inventory, which, in the recent quarter, rose 22% from a year ago while sales plunged 40%.  I will leave this one for the deep value experts!

Skyline (SKY) has just 29% exposure to RVs, with the balance in manufactured housing.  The balance sheet is very strong and it trades at book value (which is half cash).  They focus on the towable segment.

Fleetwood (FLE) is troubled.  The company has 70% exposure to RVs (mix of towable and motor), with the balance in manufactured housing.  The balance sheet is quite stretched.

Monaco (MNC) is a pure-play, with a large emphasis on motorized.  The balance sheet is stuffed with inventory and lacking much cash.  Additionally, short-term debt has been rising.  The situation looks quite precarious.

Finally, Coachmen (COA), has 75% exposure to RVs (mix of motorized/towable), with the balance in manufactured housing.  Like MNC, the balance sheet looks rather weak, with inventories growing, though not to the same extent.  Debt levels are high relative to non-inventory assets. 

THO and DW look to have the most promise, especially in the near term, though SKY probably merits further investigation as well.  One of the greatest challenges to being contrarian is to get the timing right, as being way too early rather than a little early or a little late can be very costly.  In the case of these stocks, the leaders have bounced nicely thus far this quarter, yet aren't too terribly far from multi-year lows.  The three stocks that I have highlighted as perhaps the best near-term all share the traits of a strong balance sheet with significant cash, though SKY is definitely burning some of its massive cash horde.  These survivors should emerge from the downturn stronger than the rest of the industry.