Hello world!

Hi all. My name is Adam Gefvert and I’m a recently retired poker player after making my living playing poker, mainly online, for the past 5 years.  I’m excited that I can now spend my working days scouring the financial world in search of sound investments. I’m a professional contributor to seekingalpha.com, the investment advice website. You can go there and search for “primostocks” to see my posts there. I’m posting my articles on my blog here too, as well as updates of my thoughts and actions regarding the market and my portfolio.

I actively trade and invest in securities, mainly United States equities. I’m very cautious, and only buy or short securities that I feel have the highest probability of profitability. I learn all that I can, and am preparing myself for a future job at an investment fund. Most of the posts here are research reports and I’m a professional contributor to the investing site: seekingalpha.com. I have finished the Chartered Financial Analyst (CFA) program. Feel free to use any information on this blog to help you in your financial decisions. Comments and questions are welcome!

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Technical Trades

Although this blog is mostly about fundamental trading, I believe technical trading is also important with capitalizing on opportunities. The following are times to make a technical trade, just based on stock price movements.

1. When a stock has trended in one direction for awhile, and looks to be set to burst through its 20,50,100, or 200 day moving average on the upside if it’s has been trending hire, or to the downside if it has been trending lower. The volume has to be well above average, as the stock needs to BURST through this moving average for the trade to have a high success rate.

2. When a stock makes an OMG! movement, and goes far beyond what is expected from the news. I’m not talking about a stock going so far as the remark is: “Interesting, it has gone much higher than I expected.” But the reaction should be more like “WTF is going on? This is amazing! The stock just won’t quit! I gotta tell my friends about this.”

When that happens, then the stock price will likely reverse because other traders are thinking the same thing you are.

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I’m writing for Seeking Alpha now

Since I already have a small following on Seeking Alpha and know that thousands of people read my articles, I’m going to stop posting on this blog for now. I may post on here again eventually, but for now I’m focusing on Seeking Alpha. Seeking Alpha also pays me to exclusively write for them.

If you want to check out my articles and Stock Talk posts on there, go to: seekingalpha.com/author/primostocks. Then hit “follow”, that way you will be notified whenever I write a new article.

Thanks for reading my stuff!

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Verizon’s business overview and growth potential

Author’s note: This is a long article because there are so many facets to the Verizon business. Overall, however, the info is pretty simple and has easily explained projected numbers.

In the gangster movie Casino, Ace Rothstein describes Nicky Santoro’s method of strong arming the bookies. He says: “I mean, what were they going to do, muscle Nicky? Nicky was the muscle.”

I compare that to Verizon in the communications industry. Who’s going to threaten Verizon? Verizon IS the threat.

For you conservative investors out there, VZ is a very safe place to park your cash. Verizon has had a pretty steady share price for the last 7 years. From January 2004 to today, it has hovered between 27-37. This is a good sign for conservative investors who are looking for low beta stocks, Verizon is a great investment if one is primarily concerned about preservation of capital. The company offers a dividend which is currently at a 5.4% yield.

Verizon has invested a lot in its wireless and wireline networks in the US and internationally. It invested $17 billion on infrastructure in 2009. In 2010, $19 billion was invested.

Infonetics Research co-founder Michael Howard says AT&T is more conservative with its network investments and took longer to upgrade from copper wires to fiber-optic cables and other cutting-edge gear.

Recon Analytics ­analyst Roger Entner said: “Verizon planned its network with greater foresight than anyone else. They have a very well-built network, and they don’t cut corners.”

Verizon is also spending a lot on patents for 4G licenses. 4G networks are more than 5 times faster than 3G. Verizon’s 4G networks are already available in 40 cities. AT&T is just getting started building their 4G networks and should have them ready later this year. It seems like AT&T is always playing “catchup” to Verizon’s prompt integration of the newest technology.

I see parallels between the battle of AT&T and Verizon and that of MySpace and Facebook. MySpace was acquired by News Corp. in 2005 and their focus was to maximize income from it. Facebook’s focus has always been to expand their userbase and make it more user friendly – immediately raking in the dough wasn’t on its mind. Now Facebook has blown way past MySpace to the point where hardly anyone uses MySpace anymore. Facebook has been appraised at $50 billion.

From this analogy, Verizon could easily surpass AT&T in market cap within the next five years.

To figure out Verizon’s value, it’s important to project its future revenues, net income, and cash flow. It’s also important to know that Vodafone (VOD) has a non-controlling interest in Verizon Wireless of 45%. This means that 45% of VZ net income is attributed to VOD. If one doesn’t remember this, VZ valuations can be misleading.


Verizon revenues mainly consist of wireless and wireline segments. Let’s start with the wireless segment.

Wireless segment revenues: For 2010:  $63,407M  For 2009 $60,325M

Verizon Wireless revenue comes from subscriptions to its large network for cell phones, tablets, netbooks, and MiFi hotspots, and cloud computing. The vast majority of Verizon Wireless revenue is from cell phone subscribers. According to the Nielsen Company, by the end of 2011 50% of cell phone users in the US will use smart phones. Right now, 26% of Verizon’s wireless customers use smart phones. In Q4 2010, more than 75% of new Verizon postpaid wireless subscriptions were for smartphones. For AT&T, 80% of new users got a smart phone in Q4 2010, a larger percentage than Verizon because of the iPhone. But guess what? AT&T’s iPhone advantage has now been rendered null and void.

Impact of the Verizon iPhone

Piper Jaffray analyst Gene Munster said at the beginning of January that Verizon will likely sell 2.5 million CDMA iPhones total during the handheld’s first release wave, and 9 million iPhones across 2011. He also cautioned that those sales may not translate to as big an influx of new subscribers as possible because 6.5 million of those total sales would be existing AT&T iPhone users switching to Verizon. Munster also advised that his estimates might be “conservative.” Even before January’s impressive preorders, other groups were predicting higher numbers than Munster. Research group iSuppli estimated 12.5 million iPhone sales for Verizon in 2011, a number echoed by Kaufman Bros. analyst Shaw Wu following the official announcement of the CDMA iPhone in mid-January.

I predict Verizon will claim 11 million iPhone users by December 31, 2011. This includes 7 million who will have left AT&T to go to Verizon, 3 million will already be Verizon customers, and 1 million will be new Verizon customers switching from a carrier other than AT&T.

The plans and costs are very similar between AT&T and Verizon. Now that Verizon also offers the iPhone there’s little reason to go with AT&T. The connection is much better with Verizon. The only advantage with getting the iPhone with AT&T is that you can surf the net while you talk. I think this advantage is overrated. I have owned an iPhone for over 2 years, and I have never used it for surfing the web while talking on it. I may surf the web on my computer while talking, but never on the phone, that would be difficult. One should focus on their conversation anyways besides surfing the web.

Verizon was ranked as the top major carrier in a 2010 Consumer Reports reader survey of 58,000 readers comparing cell phone services. Here are the results:

In the Tri-State area, Verizon is known to be king. It is known to work the best in packed cities all over the country like San Francisco and Chicago.

AT&T, the largest cell phone carrier in the US, was ranked the worst carrier in the country in this survey. It is known to have overextended itself in cities and hasn’t built enough towers to handle the overload of customers.

In 2010, the percentage of dropped calls on AT&T’s network had risen to 5.8 percent, compared with 2 percent for Verizon, according to a survey by Changewave Research.

On January 13, 2011, Changewave did a survey on cell phone users who are going to switch providers. “Importantly, when we compared the churn rates for the top wireless providers, we found major differences,” ChangeWave noted. “Only four percent of Verizon’s customers plan to switch wireless providers in the next 90 days. In comparison, 10 percent of Sprint/Nextel’s customers say they plan to switch, as do 15 percent of both T-Mobile’s and AT&T’s.”

At December 31, 2010 Verizon had 94.1 million customers, up from 91.2 million on Dec 31, 2009, for a gain of 2.9 million customers. That’s 3.1% of additional cell phone subscribers, and wireless revenues increased by 5.1%. Right now, 26% of Verizon wireless subscribers use smartphones. According to Nielsen, by the end of 2011 50% of cell phone users in the US will use smart phones. In 2011, I project that 80-85% of new wireless Verizon subscribers will get a smart phone now that they have the option to get an iPhone. Smart phone users spend about double what feature phone users spend. For 2011, my projection is there will be an 8% increase in wireless customers, which will add 10% to wireless revenues. Verizon’s other wireless businesses will add an extra 2% gain in revenues, for a whopping 12% gain this year. For 2012 projections, customers will still be moving to Verizon from the other networks, but most of them who were going to join already did in 2011. I project 2012 wireless revenues will increase by 7%.

Cloud Computing

The enterprise cloud industry is growing fast, it’s 15 times as big as it was six quarters ago.  Companies are adopting cloud service for several reasons. A simple explanation of what makes cloud computing so popular is in this article: http://www.serverschool.com/cloud-computing/what-makes-cloud-computing-so-popular/

Verizon has big plans for cloud computing service. Security has always been an issue with companies thinking about hiring cloud services, and with a company as respected and accomplished as Verizon, companies can be confident that their information is secure. Verizon’s acquisition of Terremark was a very good move. It catapulted Verizon into becoming a major player in the cloud computing industry. Terremark has to expand ahead of its revenues. That’s why it has never shown a profit. Because of its huge debt load and inability to show a profit, Verizon was able to buy it for peanuts, or $1.4B, which is chump change for Verizon.

Terremark was founded in 1980 by Manuel Medina in Miami, Florida. . In fiscal 2010 (ended in March)  Terremark boosted its data center capacity to 504,000 square feet, its customer count to 1,350, and its utilization to 29 per cent, pushing revenues up to $292.3m. However, in the past 5 fiscal years Terremark has booked 136.6m in losses on $893.7m in aggregate revenues. Terremark has had revenues increase at an average of 20% per year. With Verizon’s connections and ability to bundle services together, it will be able to market customers faster for Terremark and have its revenues increase even faster. With Verizon’s help, Terremark revenues should grow 25% in 2011 and 30% in 2012 which is $365.3M and $475M, respectively.

Verizon Business, the IP network and server hosting unit, has over 180,000 customers in 75 countries and a total of 200 data centers scattered around the globe.  Verizon is keeping the management of Terremark in place, and a bunch of Verizon data centers will be immediately transferred to Terremark to operate as soon as the deal closes, within 90 days or so, because Lowell McAdam, Verizon’s president,  said that building and running data centers was not Verizon’s “core competency.” Eventually, all of Verizon’s data centers may be run by Terremark.

Verizon management expects Terremark earnings to break even in 2011 and not become profitable until 2012.

Projected wireless segment revenues: 2011: $71,016M 2012: $75,987M


Verizon’s wireline segment consists of fixed phone lines, fiber based services, and enterprise.

Wireline revenues: 2010: $41,227M 2009: $42,451M

Wireline revenues dropped by 3% from year end 2009 to year end 2010. This drop in revenues is because of a decrease in its fixed line subscriber base of 9.5% from December 31, 2009 to December 31, 2010. This decline occurred because customers are looking for cheaper solutions for their phone landlines like VOIP (voice over internet protocol) Vonage and Skype, and some just use their cell phone instead of a landline. DSL is also included in the fixed line segment and customers are ditching that for the much better FiOS internet. Every other aspect of Verizon’s wireline segment increased in revenues. Verizon sold a huge chunk of its landline business to Frontier Communications for $5.3B in mid 2010 so it could focus on its wireless service instead of trying to grow its fixed line business.

Although fixed line revenues will continue to fall, the worst is behind Verizon. The Company laid off about 16,000 workers last year in the fixed line segment. Some of those workers went to work for Frontier Communications as part of the deal.

“While it’s unlikely that our workforce reductions in 2011 will come close to what we experienced last year, our focus on continued — to reduce the Wireline cost structure will be just as vigilant.” Said Verizon CFO Francis Shammo in the Q4 2010 earnings call. Verizon will take many more cost-cutting strategies in 2011. The company cut $1 billion in expenses in 2010 mostly due to better logistics and plans to cut another $1 billion in 2011.”

As the fixed phone line revenue declines in the next couple years, all the other service revenues will increase, especially the fiber based services – FiOS.

Total FiOS revenues which includes FiOS Internet, FiOS TV and HSI (DSL-based high-speed Internet) was $1.8B in Q4 2010, up 18.4% from fourth quarter 2009.  FiOS revenues will grow an additional 20% by Q4 2011 to $2.16B. Growth will slow a bit in 2012 but customers will still flock to FiOS as it’s the best broadband service, by Q4 2012 it will have grown another 15% to $2.48B. This comes out to about $8B total revenue in 2011 and $9.2B in 2012.

Verizon FiOS is rated among the best residential internet service providers by JDpower.com, Consumerreports.org, and pcmag.com.

All the experts agree, FiOS is the best, much better than cable. With cable, like Time Warner Cable for example, you share the network with everyone in your neighborhood. So during peak hours, like from 5pm to 10pm on the weekdays and all day on the weekends, the server can get overloaded and surfing the net becomes painfully slow. This is not the case with FiOS. With FiOS, you have your own box that nobody else uses so it doesn’t get overloaded.

FiOS also uses fiber optic cables that go straight into your home. This is the fast and most efficient kind of cable. Cablevision, Cox, and Time Warner Cable all claimed in their ads that they use fiber cables, but that’s only a partial truth. They use fiber in their own network, but they use the second rate cables to connect to your home. Verizon reported all three companies to the National Advertising Division of the Better Business Bureau (NAD), and action was taken. The National Advertising Review Board (NARB) required them to stop advertising that they use fiber optic networks, and all three companies agreed to stop. Verizon on the other hand, can and does advertise that it uses fiber optic networks for faster internet speeds. People have been increasingly finicky about internet speeds and want the web to be more like “flipping through the pages of a magazine” as former Google CEO Eric Schmidt said the internet will eventually be that fast. When prospective customers hear that Verizon uses top of the line technology for their internet connection with fiber optic cables, then they’re more likely to switch over to Verizon FiOS internet. TV, on the other hand, doesn’t lag or need to load up when changing the channel, so there is no big advantage in switching to Verizon for TV. Verizon’s FiOS TV is pretty much the same as its competitors. However, the advantages and cost savings of bundling FiOS TV with FiOS internet will still move customers to switch to FiOS TV.


Verizon’s enterprise business consists of software developing and IT support for companies all over the world. Enterprise revenues totaled $4B for the quarter, up 1.3% from Q4 2009.

Projected wireline revenues:

2011: 40815M (down 1% from 2010) 2012: 41631 (up 2%)

As Verizon’s fixed line segment continues to contract in 2011 and 2012, the other segments will expand. I predict the Company will have a small decrease in wireline revenues this year but will increase in 2012.


Other revenues are the Company’s revenues that don’t fall under the wireless and wireline categories. Other revenues grows proportionately as the company grows.

Other revenues: 2010: $1.91

Projected other revenues:

2011: $1.98B 2012: $2.14B

Verizon total projected revenues: 2011: $113.80B 2012: 119.76B

% of total projected revenues going to wireless:

2011: 71.016B/113.8B = 62.4% 2012: 75.987B/119.76B = 63.4%

% of total projected revenues attributed to Vodafone (VOD):

2011: 62.4% (.45) = 28.1% 2012: 63.4% (.45) = 28.5%


Now that we have projected revenues, net income can be figured out by projecting what the expenses will be. Higher revenues usually require higher expenses, especially for the cost of services and sales.

2011                                         2012

(dollars in millions except per share amounts)

Operating Revenues:                             $113,800                                  $119,760

Cost of services and sales:                        45,520                                         47,904

SG&A:                                                        34,140                                      35,928

Depreciation and amortization:                17,070                                       17,964


Total Operating Expenses:                      96,730                                       101,796


Operating Income:                                  17,070                                         17,964

Other income/expenses                               550                                            550

Interest expense:                                       2,116                                        1,783


Income before taxes                                 15,504                                     16,731

Income taxes                                                2,636                                      2,844


Net Income                                             $12,868                                    $13,887

Minus VOD’s share: 2011: $12,868 (1-.28) = $9,265

2012: $13,887 (1-.28) = $9,999

Weighted average number

of common shares (in millions)                2,803                                        2,773

Earnings per common share                    $4.59                                       $5.01

Share price with a PE of 13                       $43.03                                      $46.91

Explanation of Income Statement numbers:

From 2007-2010 Cost of services and sales has been around 40% of revenues, so I went with that percentage. The $1B in cost cutting for 2011 will even out with the increase in expenses from expansions like its 4G network and from acquisitions like Terremark.

SG&A expense has been around 28-30% of revenues, so we’ll conservatively go with 30% for 2011 and 2012.

As the company expands it gathers more assets so its depreciation and amortization expense increases. From 2006-2010, it has been around 15% of revenues, so I went with that percentage.

Other income/expenses was about 550 for 2009 and 2010, so that’s what I used going forward.

While most of Verizon’s expenses have been a consistent percentage of revenues, interest expense is different. Verizon is using much of its free cash flow to pay down its massive debt load. In 2010, the company paid off net $9.8B worth of debt, to go from $55.05B in debt as of 12/31/09 to $45.03B as of 12/31/10. This is a major step in the right direction and Verizon will continue to pay off its massive debt load. Verizon paid off 18% of its long term debt in 2010. AT&T, which also has a huge debt load, only paid off 9% of its debt in 2010. As Francis Shammo, Verizon’s CFO, said in the Q4 2010 earnings call: “reducing leverage is our top priority.” One can expect the company to continue to pay down debt with cash flow in the next two years. Although with the purchase of Terremark and more investments related to it, probably less debt will be paid off in 2011 compared to 2012. My prediction is the company will pay off 12% of long term debt this year and 20% in 2012. Interest expense is about 5% of long term debt.

Taxes: As of 2010 the Company’s effective tax rate was 17%, so I went with that for 2011 and 2012.

Number of shares: At the beginning of 2011 Verizon announced it plans to buy back 100M shares over three years. Since Verizon’s top priority is to pay down debt, it isn’t going to buyback the shares immediately. A buyback of 30 million shares for each year 2011 and 2012 is an accurate estimate.


Cash from operations: 2010: 33.4B 2009: 31.4B 2008: 27.6B

From net income, we can figure out projected cash from operations.

Projected cash from operations:

Cash Flows from Operating activities:                       2011                       2012

(in millions)

Net Income                                                             $12,868                   $13,887

Adjustments :

Depreciation and Amortization expense                17,070                        17,964

Employee retirement benefits                                 4,000                        4,000

Deferred income taxes                                             3,500                        3,500

Provision for uncollectible accounts                         1,544                         1,666

Other, net                                                                (2,000)                       (2000)

Net Cash from operating activities                         $36,982                      $39,017

Minus VOD’s share: 2011: $36,982 (1-.28) = $26,627

2012: $39017 (1-.28) = $28,092

Total dividends paid: 2011: 2803($1.95) =$5,519

2012: 2773($1.95) = $5,407

Excess Net Cash: 2011: $26,627 – $5,519 = $21,108M

2012: $28,092 – $5,407 = $22,685M

Explanation of Cash Flow numbers:

Employee retirement benefits and deferred income taxes have been pretty consistent so I just made them close to the same as 2010. Provision for uncollectible accounts has historically been 12% of net income. Other, net, is another unknown, but it seems to usually be negative from looking at past cash flow statements, so I just made it similar to 2010.

The great thing for investors about Verizon is it doesn’t sit on its cash. Many other companies like Apple and Google are sitting on tens of billions in cash that’s not doing anything. Verizon makes sure all of it is utilized for increased shareholder value. Verizon will do four things with the net cash flow from operations. In order of priority, the Company will: pay down debt, spend on investment opportunities, do share buybacks, and pay, and possibly increase, dividends. When a company generates lots of cash flow, investors often fear that it will be spent on worthless acquisitions. I have no fear that Verizon will only spend the cash on acquisitions that are a better deal than it would get from decreasing its leverage. As stated before, the Terremark deal is great for Verizon, and Verizon doesn’t skimp on investing in the most up to date networks in the industry for maximum customer satisfaction.

I believe 2011 and 2012 are the years that things are going to start falling into place for Verizon. It will slowly gain market share as its investments and vision come to fruition. It isn’t focusing on short term gains, it has always had the long term big picture in mind. That is what a long term value investor should look for in management, and VZ is also a good stock for one’s retirement portfolio.

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Apple: A Baby-Boomer Stock

My new Seeking Alpha article, you can read it on SA here.

If you were waiting for a good time to invest in Apple (AAPL), now may be your chance. It’s down 4.5% in the last two days on Steve Jobs health rumors. We’ve been down this road before: the stock pulls back briefly and then goes back up with a vengeance. We may not see Apple under $350 again.

Apple is expanding domestically and internationally and has lots of further growth potential. A P/E of under 20 doesn’t give this growth stock justice. For these reasons, I am comfortable having Apple as my largest long holding. But a big factor that allows me to sleep comfortably at night holding such a big position is because Apple’s products have a near monopoly over the technology buying senior citizen demographic.

There are 65 million people over the age of 55 living in the U.S., about 21% of the population. Most are retired, have lots more money than they’ll ever spend, and are living a more relaxed life. Most don’t furiously keep up with technology like young professionals do, but they still like and are intrigued by it. Many seniors also fear technology. It’s largely new and unknown to them, they fear not being able to understand it or that it will require a lot of work and frustration to learn how to use it. Many seniors feel it’s easier to just avoid new technology altogether; they’ve done fine for decades without smart phones and tablets, why do they need one now?

There are many reasons why seniors buy Apple products. Although many are shy about getting their feet wet with technology, many like the idea of technology and realize the practical usefulness of it. The iPhone is the perfect opportunity for the baby boomer generation to stay hip and current. Apple has closed the gap and allowed seniors to be comfortable with their easy to use technology and reap the benefits of it. The iPhone is the established, solid, trusted, state-of-the-art smart phone. If someone tried to sell a senior an Android, he would have a tough time, because the senior can be confused by all the different Androids, how they work, what they look like and if it is a good fit for them. The iPhone is the “one size fits all” smartphone that seniors can be confident getting for themselves. It’s amusing to me how some seniors go from an old, outdated cell phone from a decade ago straight to the iPhone. The iPhone is also genuinely the best smart phone for seniors to use for simplicity and usefulness, as is described in this article by baby boomer writer and technology enthusiast Sandy Berger.

Another reason seniors buy Apple products is they want to be hip! Many want to believe they are savvy enough to keep up with technology, and the iPhone is the perfect medium for this. By using and showing his friends his new iPhone, a senior accomplishes this, but doesn’t go overboard with technology. Everyone knows and is familiar with the iPhone; you see it everywhere on advertisements It’s a piece of technology people know well and are comforted by, even if they have never held one.

If one’s parents are senior citizens, it’s common to buy or recommend them the iPhone and help them get acquainted with it. The iPhone and iPad have apps that appeal to anyone with a wide range of interests, and they can open doors of enjoyment for a senior. They can be a nice bonding tool for a family of any age.

The iPhone is so mainstream it doesn’t even require that someone know how to use its many features and apps in order to own one. Many seniors I know use the iPhone’s extra features minimally; they are content using the basic features, which still gives it an advantage over a regular phone, and are happy to be part of something new and know that they aren’t being left behind by the world’s rapidly changing innovation. If you see a senior with an Android, on the other hand, you know that she is a geek. Android also markets itself more to young adults, while the iPhone markets itself as the ideal choice for every age and lifestyle.

My Mom has an iPhone. She has it around so much that my Dad teases her and calls it “My Precious.” She enjoys using a few different apps like the “Mobile Dictionary” and “Words with Friends.” She also loves the high-quality camera. She works at an antique store, and many of her senior coworkers also have iPhones to help price antiques or to look something up on eBay. My uncle, who’s retired in Palm Springs, has an iPhone – as well as his partner and all their friends. If a senior citizen is thinking about getting a new cell phone, and his friend has an iPhone, it’s much more likely he’ll also buy one because then he can share advice with his friend about the apps and help learn the different features.

Apple products that appeal to seniors go beyond the iPhone. Often when I’m in Best Buy (BBY) to buy a new gadget, I see a senior lady trying to get a rep to help her play with the Macbooks on display. I often see older women buy an iPad. The iPad is to tablets what an iPhone is to smart phones in that it’s the established standard. Even if a senior hardly ever uses the iPad, many seniors are retired with lots of money they’ll never spend – $600 for an iPad is nothing to them, and it’s a cool toy for them to buy and have around the house. The only other tablet a tech-noob senior might buy is a Kindle (AMZN), also an established standard for reading tablets. But someone who is largely ignorant of technology isn’t going to go out and buy a Samsung Galaxy Tab, for example. Tablets are just too new and mysterious for them to take a risk and not buy the established, industry standard. Then there’s also the reason to purchase an iPad because their senior friend also has one and it’s enjoyable for them to experiment with and use together.

If you have any doubts about whether Apple’s amazing growth will continue or not, think about the baby boomers. When it comes to technology consumption, they’re just getting started in the United States – and beyond.

Disclosure: I am long AAPL.

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My TSTY short is my biggest position

I have 25,000 shares short at an average price of 3.04. After TSTY, my biggest holding is AAPL, which is long of course. What I like about my TSTY short, is it’s probably short term. On June 30th, the banks will make their decision about whether to keep letting TSTY slide on its debt payments, or lower the boom and send it into bankruptcy. Kind of exciting to wait and see how the story plays out.

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TSTY’s valuation is $1.13 based on scenario probabilities

Also posted on Seeking Alpha here.

What’s really important for Tasty Baking (TSTY) to survive is consistent high demand and consumption of its products. Its debtload is very ugly, but that can eventually be overcome if EBITDA is consistently positive. If revenues are growing and EBITDA is positive, it can find a way to restructure its debt, pay off principle inch by inch, and, possibly over decades, gradually pay down its debt. It could also be acquired or merge with another company that sees the potential in the product and willing to take over the enormous debtload.

From looking at the quarters 1-3 of 2010 (see conference call transcript here, here and here), we can assume that TSTY’s revenues did NOT increase in Q4 2010.

TSTY won’t report its financial results for Q4 2010, ending in December 26, 2010, until March, so to figure out the value of the stock it helps to predict what TSTY’s financial results roughly will be. From the previous quarter, Q3 2010, gross revenue had dropped from $73,859,000 to $68,234,000. That’s $5.5 million of less cakes being consumed. TSTY produced an EBITDA of around -$3.8M.

Q4 2010 was the holiday season so theoretically more cakes should have been sold. However I don’t think that happened. Looking at previous years, gross sales for Q4 was never much different than the previous or following quarter. After Charles Pizzi, TSTY’s CEO, saw Q4 2010 results, he immediately said they couldn’t make January’s debt payments. He says it’s because the factory produced less cost savings than was expected. Not only could they not make their debt payments, which now get tacked onto next quarter’s debt payments in addition to the extra interest expense, but they also had to borrow an extra $6.5M.

TSTY’s management has clearly shown they tend to sweep their problems under the rug. They continued to pay dividends after posting losses up until their creditors ordered them to stop. They also have failed to look ahead by not hedging against commodity price increases. Higher oil prices impact cost of sales as well as sugar and cocoa, all at multi-year highs.

Because of their behaviors, it’s safe to say that TSTY is completely tapped out. They have no money whatsoever in reserves. If they did, they wouldn’t have taken the trouble to seek out the extra $6.5M of financing, they would’ve just asked for a delay in paying the debt for a quarter and ended their dividend payments. The new financing came at a high cost: the $3M from the government probably doesn’t have a high interest charge, but the $3.5M from the group of accredited investors is a 12% interest charge, principle and interest all due by December 31, 2011.

These investors aren’t loaning TSTY money out of the goodness of their hearts. Would TSTY have taken this extra $3.5M if they hadn’t completely squeezed money out of every nook and cranny in their establishment? I don’t think so. Come to think of it, it’s very optimistic of TSTY to expect to pay back the $3.5M*1.12 = $3.92M in a lump sum at the end of the year, when TSTY can’t even pay its regular debt payments now.

From this I predict that TSTY experienced another EBITDA loss in the quarter ended December 26, 2010. Keep in mind this is before their mounting interest expense payments, which by now is likely over $2M a quarter.

That said, there is evidence that the company has been getting an increase in sales since they reported their troubles and risk of going under in early January. I believe people have been buying more of the cakes lately because of all the press and spotlight that has been on TSTY, and also because the people of Philadelphia would be sad to see it go, so they’re buying more cakes. I’m guessing this by my own logic and from what an independent TSTY representative, who goes by “tastysd”, said on the Yahoo message boards here. Even if sales do remain higher, TSTY has such liquidity problems it will most likely not be good enough. The closing of some of the A&P grocery stores puts a further damper on current sales. What will generate TSTY’s much needed high sales is loyal customers which requires a great product.

As I have a vested interest in the company’s downfall (I’m short TSTY), part of my research was to taste their product. If I felt they were addictingly good, then I would have a hard time shorting it because I’d really believe in the product. If you, my fellow investor, are considering a long or short position in the stock, it’s worth the small investment to try their product. You can order a box here.

After trying 4 different kinds, I felt they tasted low quality and a little stale. I was surprised being how the company started based on the idea of higher quality ingredients. Now this alone isn’t conclusive evidence that the cakes aren’t very good, maybe it’s just my particular taste buds that don’t mesh well with it. I know there are plenty of big fans who eat a Tastykake after every lunch meal. However, I have a theory as to why Tastykakes don’t taste as good as they used to.

Ask any cook or bakery chef and they will tell you passion and thoroughness needs to be put into the making of a dish or else the food tastes like crap. Desserts I understand are more of a science than an art compared to main courses, but I digress. Pizzi is trying to do all he can to make the new factory profitable. He is trying very hard to max out its cost savings which ended up below his expectations. Also, this factory is built with the latest technology for making cakes efficiently. Lots of the company’s factory workers got laid off because the machines are supposed to do more of the cake baking labor. Because of this there are lots of kinks that need to be worked out to make sure the machines are making the cakes correctly and the balance of ingredients are just right. To this day, TSTY is having a lot of trouble making cream filled cakes and they are often not able to deliver them when ordered.

Kinks in the new cake makers + desperate striving for minimum costs per cake = cakes that don’t taste so great.

For TSTY to survive now, it needs to have cakes that are addictively good. So good that when people see one on the shelf of the grocery store, their mouth waters and they compulsively reach out and put it in their cart. I don’t believe Tastykakes evoke this response.

Several of TSTY’s management have left the company or have been fired. David Marberger, the former CFO, began working for TSTY in 2003 and left to work for Godiva Chocolates in 2008. Ironically, Joe Carboy, the former plant manager of both TSTY’s old and new bakery, and a 25 year veteran of Tasty Baking, got let go sometime in mid to late 2010 because of continual problems with the machines and now also works for Godiva Chocolates. MikeyZman, a regular poster for the TSTY Yahoo message board, said that Marberger saw the writing on the wall and left before things got bad. MikeyZman worked for Tasty Baking for 23 years before leaving seven years ago. He says right now there is a shortage of cream filled cakes from TSTY because the machines have trouble making them, and this is confirmed by tastysd. This is part of the machinery incompetence that led to Carboy leaving the company.

Right now, it’s do or die for TSTY. The banks are giving it this one reprieve until June 2011, and that’s it. TSTY will either have to show considerable improvement by then in revenues and EBITDA, or it restructures its debt or finds a buyer. If none of these events happen, the banks will force TSTY into bankruptcy. Unfortunately for TSTY, fortunately for me, I believe this is the likely scenario.

The banks are not messing around, and have no sympathy for the company and its iconic history, they are only thinking about what’s the best financial decision for them. From reading this SEC filing, you can see that the banks are ready to put TSTY out of its misery and not let them dig themselves a deeper hole.

To value TSTY, it’s important to calculate the risks of each of these events happening, evaluate what the stock price would be based on those events, and get the average.

Lets start with the best case scenario for TSTY: My thesis is wrong and TSTY just needed a little more time to get everything running smoothly with the new factory and have all it’s ducks in a row. It’s somehow able to reach all of the banks’ performance requirement covenants by the June deadline which you can find at that same SEC link here.

If this feat is accomplished and those high demands are met, then TSTY is back to profitability and blue skies are ahead. As these covenant requirements are very high, I’d give it a 3% chance for this outcome. The stock should rise to about $5 in this scenario.

The second outcome is if TSTY fulfills a little bit to most of the performance covenants, shows some hope, and can either pay off its debt owed so far or successfully negotiates with the banks for more reprieves. The stock will go to anywhere from $2.1 – $4.3 dollars, average $3.2. There’s an 11% chance for this outcome.

The third outcome is if TSTY gets a major financing or raises capital in some way, possibly a share dilution. Stock should go to between $1.4-$3 a share, average $2.2. There’s about a 7% chance of this happening.

The fourth outcome is if TSTY finds a buyer or merges with another company. This is what TSTY’s management is really hoping for to save the share price. They are going to have a hard time finding a suitor. Companies are very careful in how they spend their cash in this market, and only want to make an acquisition if the upside is really big.

With TSTY, there’s just too much risk and not enough upside. The new buyer would have a tough road ahead with TSTY’s massive debt and needed factory improvements, so if there is a buyout, it would pay much less than the current share price. The debt for TSTY, based on 9/30/10 numbers and current estimates, is $112M, and the accrued pension liability is $23M. Add to this another $10M (my guesstimate) for company restructuring and changing/fixing of machines. That’s $145M of debt an acquirer would have to take on.

Fellow Seeking Alpha reader Tiger01 alerted me to FLO, which is looking to expand to the PA and NJ area. FLO has an EBITDA margin of 11%, this isn’t realistic for TSTY given the current high commodity prices and other challenges. TSTY’s EBITDA margin has historically been around 8-10% in better times, so we can go with 8%.

Generously giving TSTY gross revenues of $180M a year, that’s an EBITDA of: 180M*.08 = $14.4M.. FLO trades at a multiple of around 8x EBITDA so 8 x 14.4M = $115.2M EBITDA. From this TSTY’s total valuation comes to: $115.2M – $145M = $-29.8M. Adding about $10M of debt that should be allowed for TSTY in this multiple (FLO’s debt is about half its EBITDA) we come to: -$29.8M + $10M = $-19.8M, still a negative number. A buyer would have to be very optimistic that they could get TSTY’s revenues way up to make any kind of acquisition worth it. Futhermore, if a potential buyer waits a little while and lets TSTY suffer more before making an offer, they may get a better deal. If TSTY does get bought out by an optimistic buyer, the stock will go to between $1.4 – $4 a share, average $2.6. 7% chance of this outcome.

The fifth outcome is if TSTY can’t find a buyer or more financing, its performance isn’t good enough for the banks to give it more reprieves, it can’t make its payments, and is forced into bankruptcy. The stock goes to $0.2-$0.6, average $0.4. There’s a 72% chance of this happening.

Current intrinsic value of TSTY based on the probabilities of these outcomes: .03*$5 + .11*$3.2 + .07*$2.2 + .07*$2.6 + .72*$0.4 = $1.126

I admit I have limited knowledge of chances of scenarios in a bankruptcy situation. After mulling over the different scenarios, likelihoods, and calculations, I came upon these numbers. If anyone thinks my reasoning is off in some way, (the market certainly does), please let me know in the comments or send me a private message. Thanks!

Disclosure: I am short TSTY.

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Tasty Baking is a Tasty Short

Note: This article was also published on Seeking Alpha here.

Although this is a great shorting opportunity, what’s happening to Tasty Baking (TSTY) is actually a sad story. It’s an iconic brand in Philadelphia that makes small cakes pre-wrapped at the bakery and sold at local grocery stores.

People around Philadelphia have grown up eating these delicious cakes. The business started with a couple guys in 1914 who went into business making baked pastries with quality ingredients. The cakes became so popular that the company began to expand and eventually became a huge corporation with over $180 million in annual revenues today. Now, Tasty Baking might be baking itself into oblivion.

TSTY has been losing money quarter after quarter, and has consistently paid dividends. This happened to the point where it has been carrying almost zero cash on its balance sheet, or just $5,000, since the fourth quarter of 2009. Below are numbers I picked from its quarterly SEC filings that illustrate the company’s downward spiral. Note I didn’t include Q4 because these are enough numbers to tell the story.

(in thousands $)

Quarter Net Income (loss) / Long Term Debt / SHE / Interest Exp

Q1 2008 / (959) / 36,778 / 45,442 / 456

Q2 2008 / 75 / 37,398 / 45,529 / 508

Q3 2008 / (1352) / 53,364 / 43,408 / 545

Q1 2009 / (70) / 67,561 / 32,300 / 604

Q2 2009 / 2345 / 80,093 / 33,368 / 545

Q3 2009 / (531) / 88,403 / 32,426 / 720

Q1 2010 / (3920) / 96,441 / 24,557 / 1319

Q2 2010 / (3334) / 98,580 / 20,962 / 1579

Q3 2010 / (4940) / 96,738 / 15,761 / 1823

Q4 2010 (We’ll find out how bad in March)

Notice how debt has continually risen since Q1 2008, even when the company had a good quarter now and then, like in Q2 2009. Even though its long term debt stayed somewhat steady through 2010, the vast increases of its interest expense through that period shows that it’s also piling up short term debt that it needs to pay interest on.

TSTY’s management has a hard time earning more than it spends. Keep in mind it also has added to the slow crushing of the company by continuing to pay out $425,000 in dividends every single quarter. Since it didn’t have cash flow to pay it, it borrowed from its credit facility. It’s very irresponsible for a company to add to its already heavy debt load in order to pay dividends. Through 2010, shareholders’ equity was dropping at an enormous pace.

Now TSTY is at the point where it can’t pay off its debt at all without an extension. At the beginning of January, the stock dropped 40% when the company announced its debt problems and the stock has been gradually declining since then. On January 14 it got a reprieve, largely from a great show of support from the citizens in Philadelphia who show a lot of love for the brand. It got $6.5 million in loans to continue operating, $3.5 million from private investors and $3 million from the local government, secured by its assets.

TSTY also negotiated so it doesn’t have to pay off any debt principle until the end of June. The banks stipulated some covenants, including that TSTY must not pay dividends. Unfortunately, TSTY still has to pay interest on the debt, which is a huge expense — over $2 million this quarter.

It seems like TSTY’s problems first developed from an ambitious building of a huge new “green” factory and closing down its old one. Like most ambitious development projects people undertake, there are often unpredicted problems and expenses that constantly come up. This management seems to look through glasses that are too rosy to realize this, and has a habit of sweeping its problems under the rug. Then, with the now-higher commodity prices for ingredients like sugar and cocoa, its cost of goods sold has increased. It was inevitable that the cookie batter would hit the fan.

As if things couldn’t get any worse for TSTY, the UN’s food and agriculture organization said food prices reached an all-time high in January. This is another reason why it’s a safe short. TSTY has more of a chance of going bankrupt now than it did when food prices were lower. Sugar reached its 29-year high in November 2010 and has stayed consistently at those levels. Cocoa is also reaching similar highs, partially due to political unrest in West Africa, where they export cocoa. We haven’t seen the effects on the income statement of November peak level commodity prices, but we will on TSTY’s next income statement — and it won’t be pretty.

But the Tasty Baking tragedy is probably better explained by the management, which knows its company and business better than I do. Below are excerpts from TSTY’s Q3 2010 earnings call on November 1, 2010. Charles Pizzi is the company’s CEO, and Paul Ridder is its CFO. From this call it’s clear to me that these guys are incompetent and dug the company in a hole too deep to dig themselves out of.

“We understand the stress that the challenges and significant complexity of the new bakery project has placed on our shareholders, our company, our independent sales distributors, and our retail partners. As with most things, great rewards require sacrifice. We have made great progress since the beginning of the third quarter. But there is work to be done to fully complete the transformation.” — Charles Pizzi

Not finished yet? Well, I think you’re tapped out of things to sacrifice!

“For the quarter ended September 25, 2010, depreciation expense declined by more than $800,000 as compared to the third quarter of 2009 to $2.7 million, as the accelerated depreciation associated with the move from the company’s former facilities was completed.” — Paul Ridder

Okay, so the income losses are less about depreciation and more about losing cash.

“We expect the commodity costs in the near-term are going to continue to be a headwind. We’ll evaluate pricing action, promotional action that’s necessary to offset that.” — Ridder

Great. So to offset increasing costs, you’re going to increase the price of your product and spend more money on advertising. TSTY’s management hadn’t thought to hedge at all for rising commodity prices. Ridder had mentioned that commodity costs are a “headwind” about three times in the earnings call. I think a 2×4 to the face is a better portrayal.

“For the third quarter of 2010, the company had capital expenditures of approximately $1.7 million, which included $800,000 in expenditures related to the new bakery project. As we move forward through 2011, we anticipate that capital expenditures will be less than $7 million and would primarily be used for a combination of future cost improvements and revenue enhancement projects.” — Ridder

So you’re expecting capital expenditures in 2011 to be less than $7 million. $1.7 spent in Q3 2010 comes to $6.8 million, so it’s safe to say capital expenditures aren’t going to decrease. Like the CEO said, there’s more work to be done …

“We’re evaluating those options to ensure that we have the complete ability to repay and satisfy all our obligations as they come due. I don’t think we want to discuss particulars, but we are evaluating all of our options, including debt.” — Ridder

Guess you’re gonna wait to discuss the particulars when you can no longer make your debt payments. Way to think ahead!

“$4 million annually is usually our true marketing number.” — Ridder

Doesn’t seem like a lot for a company that has $180M a year in revenue.

What a mess. It’s very unlikely TSTY will be able to make a comeback. Pizzi mentioned in the earnings call that TSTY hired an online marketing team to increase online sales. I checked it out and noticed you can buy the treats on the website and on various other sites like Amazon.com (AMZN). On Amazon, there’s only a few comments about the treats, and 90% of them are from 2008 and 2009. That makes me think online sales aren’t increasing too much, if at all.

As far as trying to save costs by laying off workers, the management has done that already. The technology of the new plant can supposedly do the work that factory workers used to do, so it laid off hundreds of employees in the transition.

Now assuming TSTY won’t make a comeback, the only option is to sell itself. The fact that it’s in such a desperate position means it will have to offer itself cheap. It’s definitely not worth more than its book value. It’s currently trading at $3.10, and the book value is $1.84.

The brand is a popular brand, so it can get a few million for the name. The plant is having trouble generating a profit and has some kinks to work through, so it will be sold at a steep discount. If the company is sold quickly, the bondholders will be paid off and the shareholders will get at best $1 a share. The longer it takes TSTY to make a deal, the more frosting will leak, and the less it will be worth.

Disclosure: I am short TSTY.

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