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Weekly Newsletter, Saturday, 01/14/2006

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Table of Contents

  1. Commentary
  2. Changes in Portfolio
  3. Portfolio Listing
  4. New Plays
  5. Existing Plays
  6. Watch List

Leaps Trader Commentary

Oil Levitation

Oil prices are showing a very good example of levitation by artificial means. While supplies of gasoline and distillates, jet fuel, heating oil and diesel, are continuing to build the price of oil refuses to fall. The culprit is growing political instability in several areas of the globe. Had I foreseen the future we would have a couple more energy positions but these types of events arise suddenly.

The Iran refusal to halt its nuclear ambitions even when several countries offered to give them enriched uranium to produce electricity has catapulted them onto the world stage. Like Saddam the rulers say one thing and then do another and the potential for an eventual conflict appears very strong. That conflict could be more than a year away as the process winds its way through the U.N. committees but the immediate impact was felt in oil prices. Speculators cornered futures contracts and those 330 refineries that actually buy crude were forced to hedge against future needs at higher prices.

Bolivia announced this week that it was going to seize oil and gas reserves owned by international companies but leave other assets like pipelines and refineries in the hands of foreign operators. The president, Evo Morales, said the country would decide the use of reserves and foreign corporations could be partners with the state. This page was right out of the playbook of Higo Chavez in Venezuela. This nationalism of foreign oil is the kiss of death for oil exploration in Bolivia just like we have seen in other countries over the last 60 years. Foreign companies like XOM, COP and CVX hesitate to invest large sums in exploration in countries where those investments can disappear overnight. Investments will go somewhere else instead where companies can control their own fate. Morales said he would not confiscate assets of foreign companies but would take ownership of reserves. This was an olive branch to those firms in hopes some would remain producers under whatever new plan Morales decides to implement. I doubt those companies will be able to remove the assets so the offer is really only a token gesture.

Companies impacted will be Spain's Repsol YPF SA, which holds 35% of Bolivia's 55tcf of natural gas and Petrobras of Brazil, which holds 17%. France-based Total SA, Britain's BG Group PLC, Occidental and Vintage Petroleum also had oil/gas assets in Bolivia. Morales was elected on a platform where he pledged to challenge U.S. interests in his country and forge alliances with Castro. Guess we should not expect anything from Bolivia in the near future or South America in general. With Morales and Chavez leading the revolt the outlook for South American energy exploration looks grim.

In Nigeria being an oil worker is like having a target painted on your forehead. Four oil workers were taken hostage last week in the latest round of rebel violence. Oil production was halted at several facilities and Shell declared Force Majeure on oil deliveries from Nigeria and announced production delays until the situation was resolved. This is especially critical to prices since Nigeria produces the light sweet crude demanded by the majority of global refiners.

The current run in oil prices is begging for a pullback but as we saw last year prices tended to get ahead of reality. In reality Saudi is still producing about 1 mbpd more than current demand and that will eventually push prices lower. You may have noticed that OPEC has been quite this week about production cuts at the end of January. As long as oil is over $60 they will keep the spigots wide open and keep their mouth shut to stay out of the papers. If I had any guts I would be shorting oil today but I learned that lesson several times over the last couple years. Never bet against global politics.

The only forced exit from the portfolio this week was the DJX puts. I had placed the stop at 11025 thinking we could get a little spike over a touch of 11000 before the sellers appeared. Unfortunately that spike took us to 11048 and officially stopped us out of the play. Unofficially I am still maintaining a short bias personally.

I missed an opportunity to add a LEAP put on GM this week when it hit $22.78 on Tuesday. It had been on my target list but the timing was questionable. Last weekend it was climbing sharply on favorable news and I decided to wait another week. That gain has now reversed and a 2007 $20 LEAP Put is now over $6 and nearly 1/3 the stock price. Pass, thank you!

The same was true of MGIC Investment Corp (MTG). I wanted to get a LEAP put with MTG over $70 to go with our LEND position but wanted to get LEND established first and get past MTG earnings on Thursday. Unfortunately MTG fell -$6 from its midweek high at $72.75 after they missed earnings on Thursday and announced an acquisition. I am still going to add it despite the drop.

While I would like to add some additional oil positions it is simply not practical over $64. Oil prices have been moving mostly sideways for a week and the slightest resolution of any of the geopolitical concerns and it could plummet back to earth. Hedge funds may have pushed it to these levels but from the midweek volatility levels they may be having a hard time holding it here. We will be patient and wait.

Patience is a virtue I find difficult to practice!


Dow Transports Chart - Daily


Natural Gas Chart - Daily


Crude Oil futures Chart - Weekly


Changes in Portfolio

New Plays
MTG $67.22 M.G.I.C. Investment Corp

Dropped Plays
DJX $109.61 Dow Jones Average ** Stopped 110.25 **
CSC $53.78 Computer Sciences Corp ** Closed **
ESLR $12.27 Evergreen Solar ** Closed **

New Watch List Plays Triggered

None


Portfolio Listing & Top Picks


New Plays

Most Recent Plays

MTG - $67.22 - M.G.I.C. Investment Corp ** Stop $72.50 **

MGIC provides mortgage insurance to lenders for borrowers with high loan to value ratios. The borrower pays the mortgage protection insurance premiums with their monthly payment. With the very high loan to value mortgages of the last couple years MGIC has a rising risk of default. Earnings were on Thursday and revenue fell -8% along with a net decrease in premiums received of -8.2%. New insurance written also fell. The percentage of delinquent loans at year-end rose to 4.52% from 3.99%.

I know several homeowners, three in the same block, that are only days/weeks away from foreclosure and everyone had taken advantage of the accelerating home values to refi, some more than once. Home values have fallen nearly -20% in this Colorado area despite what you read in the papers. The foreclosure boom is coming and MGIC will suffer.


Company Info:

MGIC Investment Corporation is a holding company that, through its wholly owned subsidiary, Mortgage Guaranty Insurance Corporation (MGIC), provides private mortgage insurance in the United States to the home mortgage lending industry. Its principal products are primary mortgage insurance and pool mortgage insurance. Primary mortgage insurance may be written on a flow basis, in which loans are insured in individual, loan-by-loan transactions, or may be written on a bulk basis, in which a portfolio of loans is individually insured in a single, bulk transaction. It is licensed in all 50 states of the United States, the District of Columbia and Puerto Rico. In addition to mortgage insurance on first liens, the Company provides lenders with various underwriting and other services and products related to home mortgage lending through other subsidiaries.

Buy 2008 $65 LEAP Put YHM-MM currently $6.50
(No 2007 $65 put exists)

Insurance Call: None

Entry $67.22 (01/15)


Play Updates

Existing Plays

LEND - $49.52 - Accredited Home Lenders ** Stop Loss $52 **

No real movement on LEND this week with the $48-$51 range still in control. This was actually a slight improvement over the negative trend the prior week but the markets were bullish. I am still negative on the long term outlook for LEND and the housing market in general.

Original play description:

LEND is a sub-prime mortgage lender. Another way to put that would be to say they lend money to those with weak credit. If the housing market is really slowing and housing values declining then sub-prime lenders could be in trouble.

We have already seen mortgage application rates sink to levels not seen since 2004. The Mortgage Application Index decreased to 545.9 last week, -17% below the level from just four weeks ago and more than 10% below the same period in 2004. Refinancing has fallen to levels -20% below 2004 levels.

The days of the mortgage-refi to get out of debt are gone. Tighter loan restrictions and higher default rates are commonplace across the country. I have a son in the mortgage business and he claims applications have fallen through the floor and restrictions are rising. Borrowers who refied a year ago can't get an approval today despite substantial equity left in their homes.

Option loans, where the lender gives the borrower a smaller payment for the first 2-3 years have evaporated. Even ARM loans are falling, down -4% in the latest numbers.

Ironically Fannie Mae and Freddie Mac raised the limits for conforming loans by +16% as of Jan-1st. This means the conforming loan limit for a single-family property rose from $359,650 in 2005 to $417,000 as of Jan-1st. This should increase the level of loans except that property values are slowing and credit criteria is rising.

The Mortgage Bankers Association expects loan originations to fall by -18.6% in 2006.

In October National City said loan profits fell -91% over the same period a year earlier. H&R Block blamed a $86 million loss on a drop in income from its mortgage unit.

If this trend continues sub-prime lenders may have to set aside more money as reserves to cover defaults at a time when loan initiation profits are also shrinking. The smaller pie available to all lenders is making competition for loans even more cutthroat. Many lenders MUST do loans to survive and they will be forced to take lesser credits, greater risks and receive less income for those risks.

Lenders are already slashing staff in an effort to maintain profitability.

LEND published an earnings outlook on Dec-19th for Q4. They said they expected to earn $7.70 to $8 per share compared to analysts estimates of $7.74. HOWEVER, Accredited Chairman and Chief Executive James Konrath said that the projected earnings target depends largely on pricing in the nonprime mortgage market and assumes growth in loan originations but lower costs of origination. That is a very big IF. I could make a million dollars next month if I could pick the exact top in January and then short 1000 SPX futures contracts. That is not going to happen. LEND may reach its targets but there is still trouble ahead.

I am only using a June Put option on this play despite LEAPS being available. All lenders will see a spike in loans in April/May as the summer selling season arrives. I would like to be out by then.


Company Info:

Accredited Home Lenders Holding Co. (Accredited) engages in the business of originating, financing, securitizing, selling and servicing non-prime mortgage loans secured by residential real estate in the United States. Accredited focuses on borrowers who may not meet conforming underwriting guidelines because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, or past credit difficulties. The Company originates loans primarily based upon the borrower's willingness and ability to repay the loan and the adequacy of the collateral. Accredited originates its loans primarily through independent mortgage brokers across the United States and, to a lesser extent, through its direct sales force in its retail offices.

Buy June $45 Put QFW-RI currently $4.70

No Insurance: LEND hit an all time high in December at $51.70. I put the stop just over that high.

Entry $47.45 (01/08)

DJX -$109.56 Dow Jones Industrial Average ** Stopped 110.25 **

Stopped by the spike to 11048. It appears I was too cautious. I thought 11000 would attract sellers in droves. Fortunately the loss was small at -52 cents.

I am personally still short the market from that level and plan on staying short at least until after Intel/IBM/YHOO report on Tuesday.


Original play description.

The Dow has struggled to touch 11000 for the last month and has failed to pass even the 10984 we saw back in March. It has found resistance to be strong and the clock is running out on 2005.

The analysts seem split on which will come first, 9,000 or 12,000. We really don't care because this play is strictly a timing play based on the historical January weakness of late.

We are going to use the DJX because options are cheap and there are plenty of strikes.

This is going to be a short-term play, probably less than 60 days. It will be target driven for both entry and exit. There will be no insurance but we will establish stops once in the position.

We are going to add to the position on any Dow gains through Jan-6th. Add one contract, two, ten or a dozen at each trigger point. It is up to you. Since we cannot know what the Dow will do we want to average cost ourselves into a put position at Dow 11000. If it only reaches 10950 we will only have 2/3 of our target position.


Breakout target: $109.00 (Dow 10900)
Bought March $108 Put DJV-OD @ $1.65 on 12/27

Breakout target: $109.50 (Dow 10950)
Cancelled - March $108 Put DJV-OD - not triggered

Breakout target: $110.00 (Dow 11000)
Cancelled - March $108 Put DJV-OD - not triggered

If the Dow hits 10900 but does not reach 10950 then add to your position on any breakdown to 10800. ** Added @ $1.90 ** 12/27

Added @ $1.30 on 01/08 at 10956.

Average cost now $1.62, exit $1.10, -0.52 cents (1/11)

FCX - $60.59 - Freeport McMoran ** No Stop **

FCX continued to follow gold higher and there appears to be no indications of weakness ahead. Those trying to short each new high are being met with a strong flow of petro-dollars pushing it even higher.

Company Info:

Freeport-McMoran Copper & Gold Inc. is a copper and gold mining and production company. The Company's principal asset is the Grasberg mine. Grasberg contains gold reserve and copper reserves. Its principal operating subsidiary is PT Freeport Indonesia. The Company owns approximately 90.64% of PT Freeport Indonesia, and the Government of Indonesia owns the remaining approximate 9.36%. PT Freeport Indonesia mines, processes and explores for ore containing copper, gold and silver. It operates in the remote highlands of the Sudirman Mountain Range in the province of Papua, Indonesia, which is on the western half of the island of New Guinea. PT Freeport Indonesia markets its concentrates containing copper, gold and silver worldwide. The Company also smelts and refines copper concentrates in Spain, and markets the refined copper products through Atlantic Copper, S.A., the wholly owned subsidiary of the Company among others, such as PT Irja Eastern Minerals and FM Services Company


2007 $55 LEAP Call OMT-AK @ $6.00

Insurance put: Feb $50 FCX-MK if FCX trades @ $53.

Entry $52.00 (12/21)

DTX - $414.71 - Dow Jones Trans Index ** Stop 430 **

No change to this play. The transports were the weakest link in a very strong market. If the broader market weakens I believe the transports will lead it down. High oil prices are keeping the pressure on and a break of 400-410 could see a sharp drop appear.


Original play description:

The Dow Transports have been in vertical mode since the October lows. The decline in oil/gas/diesel prices has given them wings and the strong growth in Q4 shipping sent them to new highs.

January has not been kind to the transports for the last five years. In 2005 the first three weeks of January saw a drop of nearly -400 points in the transportation average. In 2004 the decline did not begin until the 3rd week of January but continued for nearly -400 points. The decline in 2003 begin with the opening of trading for 2003 and continued for nearly -500 points to bottom on the week of March 9th. 2002 losses were somewhat moderate compared to 2003-2005 with only a decline of around -250 points but it did start with the opening of trading for 2002. 2001 was ugly with more than -575 points lost from the end of December high at 3157 to the March low at 2578. In 2000 the index fell from 3017 to 2260 for a whopping -757 point drop.

While nobody can forecast a repeat the combination of a new all time high just before a potentially weak January seems to be a match made in heaven.

The only fly in this ointment is the thin trading in the options. There are no leaps and future months don't even have put strikes near the current index level.

I am going to take the trade anyway and hope that new strikes are added before we get an entry. If not we will play what the dealer gives us.

I add EXPD as a put candidate for those who don't want to play in the thin DTX market.

I am not going to use insurance on this play as options are expensive. We are going to roll the dice and take our chances. If this is too risky for you please take the EXPD play instead. The difference between the two is a potentially large index move of 40+ points compared to a 10-point move in EXPD. Both could be very profitable.

We could have a new transport high next week but anyone that can do basic math should be very afraid of buying at the top ahead of January given the history for the last five years. I toyed with putting in a breakout/breakdown entry scheme but with the spike last week I was afraid it would collapse before we could get a decent entry. Option premiums could accelerate quickly.

This will be a hard entry for record keeping purposes at $426 but I strongly advise everyone to wait for weakness if we open with a spike on Tuesday. I would love to see a continued run to $450 on short covering into year-end.

We could easily see a dip to $370 over the next 90 days so buying a March put option at $400 is not unreasonable despite the index trading at $426 today. Since the $400 strike is the highest put strike listed for March and June that would be your best entry if none show up on Tuesday. Hopefully the market maker will add some on Tuesday with a new spike on the Transports.

The alternate strike would be the Feb $420 put just out of the money. A -40 point drop in the index would be a fat premium if it occurred before expiration in February. It is definitely possible.

Personally I am probably going to trade both strikes and roll out to a higher March strike when/if they become available.


Feb-$420 Put DTX-NB @ $7.80
Or
Mar-$400 Put DTX-OA @ $5.30

No insurance

Entry $426 (12/27)

EXPD - $66.87 - Expeditors International ** Stop Loss $71 **

EXPD tried to recover lost ground but gave it back once again as it neared a support break at $66. Next week should be pivotal for the transports and EXPD.

Target $60 as a profit exit.


Original Play Description:

EXPD is another way to play the anticipated roll over of the transportation sector. Unlike the DTX the options are liquid and cheap. EXPD spiked higher with the sector from $55 to over $72 on very little change in fundamentals. As you can see on the chart the spike is very unsupported. On a shorter term chart EXPD failed to near its highs on last weeks transport bounce and looks very likely to give back a majority of its gains should the transports in general suffer another January disaster.

This is not a negative indication of EXPD in general rather than just another way to play the potential transport weakness.


Company Info:

Expeditors International of Washington, Inc. (Expeditors International) is engaged in the business of providing global logistics services. The Company offers its customers a seamless international network supporting the movement and strategic positioning of goods. Its services include the consolidation or forwarding of air and ocean freight. In each United States office and in many overseas offices, the Company acts as a customs broker. It also provides additional services, including distribution management, vendor consolidation, cargo insurance, purchase order management and customized logistics information.


May $65 Put URP-QM @ $2.70

No insurance due to cheap options

Entry $69.54 (12/27)

CSC - $53.78 - Computer Sciences Corp ** Closed **

This was looking very positive on Thursday as CSC neared $56 but a downgrade on Friday sent it sharply lower. Prudential said their checks with potential suitors showed falling interest in a deal at much over the current price. They also said they expected CSC to post a -5% drop in revenue with earnings on Feb-7th. Given the gain on last weeks rumor I would rather take a profit here than risk holding for some offer marginally over the current level.

Original Play Description:

Computer Sciences was the target of a takeover back in October and the takeover failed because CSC wanted $65 and while the acquirers agreed in principle to that amount they could not structure a deal that made everyone happy. The parties agreed to disagree and discontinued talks. All parties said they could begin again at any time.

CSC spiked from $46 to $60 on the initial news but quickly fell back again as no further news was forthcoming.

I heard Crammer talking about it on Friday and his presentation made perfect sense. Since the acquisition talks CSC has signed several more contracts for nearly $5 billion dollars and more are in the wings. CSC is more valuable today than they were back in October. If you look at the news for CSC they are signing monster deals almost every day.

Since the talks were dropped General Dynamics paid $2.1 billion for Anteon, which valued them at 13 times earnings. At the $12 billion number discussed for CSC it values them at something less than 17 times forward earnings. CSC says they have more than $30 billion of projected deals in their defense Dept pipeline along with another $10 billion in non-defense bids.

The stock has been dormant at just under $50 since the talks ceased and the opportunity for the same buyout team or someone else to appear over the next year is very strong. As Cramer was saying on Friday there is little or no downside and only upside for CSC. After doing the research I believe him on this one.

Company Info:

Computer Sciences Corporation (CSC) is a provider of information technology (I/T) and professional services. Outsourcing activities include operating all or a portion of a customer's technology infrastructure and applications, and business process outsourcing. I/T and professional services include systems integration, consulting and other professional services and software systems sales and related services. CSC provides these services to customers in the Global Commercial and United States federal government markets. On a geographic basis, CSC provides services to Global Commercial customers in the United States, Europe and other international locations. Operations in Australia, Asia and Canada generate all revenue within Other International.


2007 $50 LEAP Call OSC-AJ @ $7.00, exit $8.70, +1.70
Or
2007 $55 LEAP Call OSC-AK @ $4.50, exit $5.90, +1.40

I chose the $50 call instead of a higher call because any buyout offer caps the upside and time premium will evaporate instantly. We want to be as close as possible to the money on this one. A new $65 buyout number would turn the $50 LEAP into $15 overnight. The cheaper $55 LEAP would go from $4 to $10 so it is not a loser just a different way of looking at it. Both would represent about a +130% to +150% return. The difference would be in the buyout offer. Say they decided to take a $62 offer instead of $65. The lower strike would benefit most.

Insurance Put: June $45 Put CSC-OI only if CSC trades at $47.75.

Entry $49.62 (12/27)

VLO - $58.24 Valero ** No Stop **

VLO set another new all time high on Thursday and we are in very good shape to see VLO continue higher even if oil prices slip. The summer refining season is approaching and VLO profits will continue to flow.

VLO should be a strong performer in 2006 with refining margins better than anyone else in the game. VLO has already made its low sulfur conversion in preparation for the new 2006 rules. According to VLO the new rules will remove 500,000 bpd of diesel from the market at a time when diesel usage is increasing. The effective date for Diesel is June-2006. This will make the price for sweet crude rise while VLO is profiting from processing sour crude. We could easily see the price return to the $100 range if oil demand continues to rise.


Company Info:

Valero Energy Corporation (Valero) owns and operates 18 refineries having a combined throughput capacity, including crude oil and other feedstocks, of approximately 3.3 million barrels per day. Valero produces environmentally clean refined products, such as reformulated gasoline (RFG), gasoline meeting the specifications of the California Air Resources Board (CARB), CARB diesel fuel, low-sulfur diesel fuel and oxygenates (liquid hydrocarbon compounds containing oxygen). It also produces conventional gasoline, distillates, jet fuel, asphalt and petrochemicals. Valero markets branded and unbranded refined products on a wholesale basis in the United States and Canada through a bulk and rack marketing network. It sells refined products through a network of more than 4,700 retail and wholesale branded outlets in the United States, Canada and Aruba. Valero's retail operations include approximately 1,500 company-operated sites that sell transportation fuels and convenience store merchandise.

2007 $60 LEAP Call VHB-AL @ $6.60

Insurance Put: March $45 Put VLO-OI @ $1.20
Put entered on 12/27 when VLO traded at $51

Entry $52.30 (12/16)

ESLR $12.27 - Evergreen Solar ** Closed **

California approved the solar initiative and ESLR promptly soared to $13.75 where it along with the other solar companies were met with a flood of sell the news trades. The 11-year, $3.2 billion initiative will provide a significant business boost to ESLR and SPWR but analysts were quick to point out that the initial installation wave could be 12-18 months away.

The spike to $13.75 was short lived and after spending much of this plays history underwater I elected to close it today for a breakeven rather than wait for a new trend to develop.


Original Play Description:

Evergreen Solar is a leader in the struggling solar space with installations all over the world. The key to any solar technology is volume and the California initiative officially announced on Tuesday would install one million solar assisted homes could be the push that makes solar finally affordable.

The California P.U.C. approval is the only roadblock and it is expected to be approved sometime in January after a 30-day comment period. ESLR is a competitor with improving technology and a real business model. They are yet to be profitable but are closing in on that goal. A true volume spurt as they would get from the million home project should assure that profitability through scale. Solar is the way of the future and the million roof project could be the key. The California initiative would also require home builders in CA to offer a solar component to any buyer by 2010. That would cover 150,000 homes a year.

California would subsidize up to $3.2 billion in solar roofing at the rate of $2.80 per watt over the next ten years starting in 2006.

Description of the plan:
http://www.cpuc.ca.gov/static/energy/051215_solaroverview.htm

http://www.latimes.com/business/la-fi-solar14dec14,1,1642908.story?coll=la-headlines-business

There is no guarantee this will be approved but the odds are very good. I believe in solar enough that I am willing to take the risk on ESLR even without the California initiative. Options are cheap and there is a strong upside if this catches on. Unfortunately there are no leaps. We will buy the June calls and move up to a farther date later if the play progresses successfully.

The Dept of Energy also has a million roof program in progress. http://www.millionsolarroofs.org/

Other companies in the sector are GE, Shell Solar, BP Solar, Kyocera Solar, PowerLight and SunPower (SPWR).

Company Info:

Evergreen Solar, Inc. develops, manufactures and markets solar power products enabled by its String Ribbon technology that provides reliable and environmentally clean electric power throughout the world. Its products are targeted at on grid and off-grid applications. The Company is developing technology at the wafer, cell and module stages of manufacturing, and it holds patents and other intellectual property in all three areas. In the String Ribbon technique, strings are pulled vertically through a shallow pool of molten silicon and the silicon solidifies between the strings to form a continuous ribbon of crystalline silicon. The ribbon is then cut and prepared for cell fabrication.

Buy June $12.50 Call QLU-FV @ $2.35, exit $2.35, breakeven

No insurance

Entry $11.71 (12/12)

OSTK $27.12 - Overstock.com ** Stop Loss $36 **

** Target $20 for a profit exit **

The CEO of Overstock stirred the pot again this week by responding in print in the form of web postings after being questioned by Business Week and New York Post reporters. He said the postings were in order to make sure the truth was in print. Patrick Byrne has had a tough time getting his truth out after several highly publicized rantings in the past.

He did disclose that he had planned to resign after his rantings about the "Sith lord" attacking his company. Unfortunately the job he was interested in evaporated after the Sith lord comments made the talk show circuit. Since he and his father, currently the Chairman, own close to 40% of the stock it would pose an interesting question about Patrick's planned departure to a job that "would have been a lot more fun" according to him.

OSTK has failed to participate in the market rally and continues to languish on support at $27.

We will tighten the stop ahead of earnings but they are not until late January.

Play Description:

Probably the worst managed retail site on the Internet. The President, Patrick Byrne, blamed the poor performance of his stock on an evil "Sith Lord." (A Star Wars Character) Patrick continually ranks in the top five worst performing executives of a public company as rated by the Motley Fool. His latest claim to poor stock performance is the possible existence of "millions of counterfeit shares of OSTK trading on the Nasdaq." I am not kidding. He blames the SEC with being in collusion with the Nasdaq for refusing to disclose the number of counterfeit shares in the system. He warned "shareholders that their only prophylactic against hedge fund counterfeiting was to obtain the actual certificates from your broker and store them in a safe place." This would of course prohibit your shares from being traded. This was in response to a "Get Shorty" article in the WSJ.

Overstock has filed suit against several research firms claiming a conspiracy to drive its stock price down. Patrick claims research firm Gradient Analytics and Rocker Partners were at the center of a vast conspiracy aligned against Overstock. He warned that the criticism of Overstock.com will not go unpunished.

Patrick was forced to give up his role as Chairman in October with his father John Byrne taking back control. Patrick remains the president but that has not diminished his wild accusations.

The company has a good business model but has failed to execute on so many levels that it should be criminal. They have the worst customer service of any E-Commerce site I have every visited. I have made several purchases in the past from OSTK and all but one were botched terribly. The products come in an unlabeled box with no return address label and no invoice. You can't return them without some serious effort. Consumers will not put up with this when other companies like Amazon.com, NewEgg.com and Ecost.com are models for the industry.

Sales at OSTK have slowed and operating expenses are growing faster than revenue and marketing costs nearly doubled in Q3. Cost of acquisition for new customers rose +30% over the prior quarter. This is a signal that competition is winning the battle and prior customers are not returning. OSTK has a huge debt load and slowing sales will not help. Morningstar gives them a D+ for financial health and an F for profitability. Analysts are dropping estimates for the stock into the high $20 range and well below current prices.

In August, Patrick Byrne held a conference call in which he basically said that everyone from hedge funds to journalists to regulators had all been scheming to destroy his company. He said the plan was being orchestrated by someone he identified only as the "Sith Lord." He really said that. Rob Plaza at Zachs Investment Research said when a CEO is putting the focus on things he can't control like short interest there could be a bigger problem he does not want you to see. He said an even bigger problem is when management blames regulators for stock manipulation you have a real problem.

The last really dumb statement, or was it, came from Patrick on Nov-10th. He said "I don't give stock advice but the average investor should probably steer clear of Overstock." That advice I will follow.

Company Info:

Overstock.com, Inc. is an online closeout retailer, offering discount, brand-name merchandise for sale primarily over the Internet. The Company's merchandise offerings include bed-and-bath goods, home decor, furniture, kitchenware, watches, jewelry, computers and electronics, sporting goods and apparel and designer accessories. It also sells books, magazines, compact discs (CDs), digital versatile discs (DVDs), videocassettes and video games (BMV). The Company also offers limited travel services. Overstock.com offers approximately 50,000 non-BMV products and approximately 500,000 BMV products in eight departments on its main Website, www.overstock.com. Overstock.com has a direct business in which it buys and takes possession of excess inventory for resale. It also has another worldstock Website, www.worldstock.com, through which artisans in the United States and around the world can sell their products.

No LEAPS

June $35 Put QKT-RG @ $5.00

No insurance.

Entry $38.51 (12/12)

KKD $ 5.71 - Krispy Kreme Doughnuts ** Stop Loss $6.25 **

Somebody is sitting on KKD once again and $5.75 was the pain threshold on Thr/Fri. No excitement here but their clock is ticking.

The NYSE has given them until mid January to file their reports or be booted from the exchange. However, the creditor deadline for financials of Dec-15th was suddenly extended to April 30th. Despite a resignation from the board and an admission on Tuesday that losses were going to be higher than previously expected the stock refuses to fall. Every dip is quickly bought but we are seeing increasing selling pressure as well. On Friday the stock traded in only a one-cent range for nearly all the day. Very strange behavior. This stock could either break or spike very soon and for reasons not readily apparent.

I lowered the stop loss to $6.25 but with a $1.25 option it is not going to matter much other than ending the play. The difference in option price will be negligible.


Play Description:

Trouble is mounting for KKD. They have not filed financials since November 2004 and they are probably going to miss the Dec-15th deadline imposed by creditors. They warned this would happen about 10 days ago. They have to restate financials for several years due to errors in accounting for expenses, loans and franchisee info.

The CEO Scott Livengood and other top executives were ousted earlier this year on allegations of financial misdealing and securities fraud. Suits are mounting from numerous groups, debtors, employees, franchisees and vendors over all types of non payment, fraud and failure to follow through with agreements.

Stephen Cooper, a turnaround specialist, took over the reins when the officers were evicted. So far the news has only gotten worse. Stores are closing rapidly including prior showplace stores and once leading producers. Cooper has worked on prior disasters including Polaroid, TWA, Enron and Boston Chicken. That list should give you a clue what is ahead for KKD.

Cooper said the chain cannot operate 4,000 square foot stores profitably and will try to reinvent itself as a smaller, leaner company. They are closing unproductive stores in a reasonable and rational fashion according to Cooper. He wants to focus on increasing sales of coffee and other beverages.

I have written about the similarity between KKD and Boston Chicken for several years and warned numerous times at much higher levels that KKD would end badly just like Boston Chicken. Now the Boston Chicken CEO is running KKD. Amazing prediction.

Yes, Boston Chicken was turned into a profitable entity once again. However it was done at the expense of shareholders. The common stock was cancelled the ownership of the stores was turned over to the debt holders. Boston Chicken wins, investors lose.

I believe that the NYSE will eventually tire of the endless deadlines for financials and will delist them. If that happens it will be the kiss of death for funds still holding the stock and hoping for a miracle return to the $105 levels of yesteryear.

Options are cheap and the KKD story is just waiting for Cooper to write the last chapter. KKD wins, shareholders lose.


Company Info:

Krispy Kreme Doughnuts, Inc. is a specialty retailer of doughnuts. It owns and franchises Krispy Kreme doughnut stores where the Company makes and sells over 20 varieties of doughnuts, including its Hot Original Glazed variety. Each of its traditional stores is a doughnut factory with the capacity to produce from 4,000 dozen to over 10,000 dozen doughnuts daily. Its sales channels consist of on-premises sales and off-premises sales. The Company has two complementary business units: its company and franchised stores, which Krispy Kreme refers to, collectively, as Store Operations and Krispy Kreme Manufacturing and Distribution (KKM&D). At February 1, 2004, there were 357 Krispy Kreme factory stores in operation, of which 338 are located in the United States. During the fiscal year ended February 1, 2004 (fiscal 2003), it acquired the remaining 33% interest in Golden Gate Doughnuts, LLC that it did not already own.

2007 $5.00 LEAP Put OKK-MA @ $1.35

No insurance

Entry $6.01 (12/12)

HW - $37.28 - Headwaters ** No Stop **

A new three-month high for HW at $38.34 but it was quickly erased by the drop in gas prices. Cheap gas means less coal is burned.

We are protected against any drop due to the insurance we took out on Dec-27th.

Dec 27th insurance plan:

We currently have no insurance on this play. Looking at the option chain I see that the May $40 call ($2.05) is approximately the same price as the May $35 put ($2.15). I don't believe HW will exceed $40 by May if we get any downdraft in January. By selling the May $40 call against our $40 LEAP and use the proceeds to buy the put we have free insurance at $35 until May. If HW does catch fire we can stop out on the May $40 call for a minor loss that will be offset by our gain in the $40 LEAP. That is my recommendation for Tuesday.

********

Headwaters (HW) has a compound annual growth rate of more than +120% mainly because it deals with the ash left over from burned coal. Coal generates a lot of ash and it is a problem the electric generating plants have to deal with when these cold fronts really suck up their coal supplies. Headwaters has three separate businesses from that ash. They have a business that buys and sells it for various purposes. Second they have produced a bonding agent to that makes it easy to transport without blowing out of the rail cars. They sell this to others for profit. Third they have a patented process for converting this ash into a synthetic fuel, which is licensed to plants that actually do the conversion.

They also make building materials and a cement substitute that uses this ash to make concrete more durable. Considering the thousands of tons of ash generated each week this appears to be a gold mine for Headwaters. When electric plants fight the tons of daily ash Headwaters is there to help and converts that ash back to dollars. This sounds too good to be true and I think that was the real problem with the decline from $46 in August to the $30 level in October. The ramp from IPO in April from $30 to $46 and decline back to $30 is complete. Those that got in on the good IPO story took their profits as energy prices declined. Now may be the time to jump back on the coal train with Headwaters rather than Peabody.

Company Info:

Headwaters Incorporated is a diversified company providing products, technologies and services to the energy, construction and home improvement industries. Headwaters conduct its business primarily through four business units, including Headwaters Resources, Headwaters Technology Innovation Group (HTI), Headwaters Construction Materials and Headwaters Technology Innovation Group. In September 2004, the Company acquired Tapco Holdings Inc., a manufacturer of building products and professional tools used in residential remodeling and construction. In June 2004, the Company acquired Eldorado Stone, LLC, a manufacturer of architectural manufactured stone based in San Marcos, California. Eldorado Stone is being purchased from Graham Partners, a middle-market private equity firm. Eldorado Stone will be integrated into Headwaters' coal-based construction materials operations.


2007 $40 LEAP Call ZPP-AH @ $4.30

Dec-27th Insurance Combo:
Sell May $40 Call HW-EH currently $2.05, set stop at $39.95
Buy May $35 Put HW-QG currently $2.15

Entry $35.50 (11/22)

CHK - $32.54 Chesapeake Energy ** No Stop **

The drop in gas prices should have knocked a significant chunk out of CHK but low and behold it is still holding in the $32-$33 range. While this is not exciting the arrival of cold weather could give us a boost. Surely winter is not going to be confined to the two weeks of subzero weather we saw in December. Surely there is a lasting cold front somewhere in our future. Since we sold the April $35 call against our leap we should be perfectly happy to watch and wait as long as $35 is not broken. With our downside put in place there is little risk and gas prices will end 2006 higher than 2005. Be patient.

The Chairman and CEO, Aubrey McClendon, bought another 100,000 shares on the open market for $3.2 million since Jan-5th.

Keep that stop loss on the covered call at $34.95 just in case we get a sudden surprise.

Insider Trading:

A reader alerted me to the insider buying on CHK, (thanks Joe!) and I must say it is amazing. The Chairman and the President made a total of 14 market buys between Dec-14th and Dec-27th totaling over $73 million. That is an obscene amount of confidence and suggests to me that something is going on at CHK and their outlook is extremely positive. With a market cap of $11 billion they could be a takeover candidate made much more possible by being the third largest holder of gas reserved in the U.S.


Dec-27th Call Insurance:

The April $35 call is $2.15 today and would offset 50% of the cost of our LEAP. We could then afford to watch the fireworks from the sidelines comfortable in the knowledge that we have downside protection in the form of additional income and from the distant put.

Sell the April $35 Call CHK-DG currently $2.15
Set a stop loss on the call at $34.95

That protects us until April against any unforeseen changes.


Company Info:

Chesapeake Energy Corporation is an oil and natural gas exploration and production company engaged in the acquisition, exploration and development of properties for the production of crude oil and natural gas from underground reservoirs and the marketing of natural gas and oil for other working interest owners in properties that it operates. The Company's properties are located in Oklahoma, Texas, Arkansas, Louisiana, Kansas, Montana, Colorado, North Dakota and New Mexico. The proved oil and natural gas reserves as of December 31, 2004 were approximately 4.9 trillion cubic feet of gas equivalent (tcfe). At December 31, 2004, approximately 89% of the Company's proved reserves (by volume) were natural gas, and approximately 70% of its proved oil and natural gas reserves were located in the primary operating area, the Mid-Continent region of the United States, which includes Oklahoma, western Arkansas, southwestern Kansas and the Texas Panhandle.

2007 $35 LEAP VEC-AG @ $4.00

Insurance Put:
April $25 CHK-PE when CHK traded at $28 on 11/07 @ $2.30
Covered Call 12/27:
Sell the April $35 Call CHK-DG currently $2.15
Set a stop loss on the call at $34.95


Entry $29 (11/04)


Leaps Trader Watch List

Being Patient

I am impatiently waiting for this January rally to implode or at least for oil prices to implode so we can start targeting some oil positions for March. The various political tensions I outlined in the commentary above seem never ending and while oil prices are not going higher they are not going lower either.

Entering positions in non-energy sectors ahead of earnings could be catastrophic. We have never held over earnings at Option Investor and I really do not want to start now.

I don't want to hold over energy earnings either unless I have a substantial cushion. Energy earnings for Q4 are expected to be in the +46% range despite the price fluctuations we experienced. I am wondering if we could see something less than that given the various factors at work. That could produce a negative surprise if everyone is expecting energy to pull the S&P out of the fire once again.

Unfortunately, January is simply not a good time to be going long anything and we are already short the transports and housing sector. I know everyone gets bored with no new plays on the watch list but putting a play on the list with a target $15 away from the current price is also a stretch of the imagination. I have a couple like that but I don't want to embarrass myself putting them on the list until they get a little closer to reality.

Keep the faith and lets see how the first week of earnings plays out.
 

Dropped Entries

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New Watch List Entries

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Current Watch List

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