Trouble ahead for Assurant

• Short Sell Assurant (NYSE: AIZ) over $67 (currently $68.30)

• Buy to Cover Assurant at $50

Over the past 6 months Assurant has so far managed to get through the credit crisis unscathed. A few weeks ago a Barron’s article even suggested that Assurant will ultimately benefit from a continually weakening housing market. Although Assurant will continue to write more creditor placed homeowners policies, the company still has significant exposure to the credit crunch and a weakening economy.

First, let’s take a look at mortgage exposure. In the latest 10-Q Assurant showed $1,470,477,000 in assets listed as mortgage loans on real estate. Although Assurant’s investment portfolio declined slightly from the previous quarter, the write downs associated with Assurant’s mortgage loans and mortgage-backed securities were only $37,875,000. This write down seems small considering what has happened to the mortgage market in this time frame. Assurant is essentially saying that the value of the mortgages and mortgage-backed securities portfolio declined by about 2.5% for the 3 months ended March 31, 2008. We expect a much larger write down in the next 10-Q.

The latest 10-K breaks out sub-prime exposure for the mortgage-backed security portfolio at about 8%. However, Assurant does not breakdown the rest of the mortgage-backed securities portfolio. Although the precise makeup of the rest of the mortgage-backed securities portfolio is unclear, Assurant mentions in the 10-K that the sub-prime crisis has created volatility in other high risk products such as alternative documentation loans (high credit scores, lack of income documentation). This implies that the rest of mortgage-backed portfolio has exposure to alternative documentation loans, but the extent of this exposure is not quantified in the 10-K. Interestingly, Assurant goes out of its way to break down the level of assets (1,2, or 3) in its fixed maturity portfolio, but they fail to provide this analysis for the mortgage portfolio. Presumably, the majority of the mortgage portfolio consists of level 3 assets (illiquid assets that require qualitative judgments by management to obtain fair value prices).

The Assurant Solutions group provides credit insurance both internationally and domestically. This group also provides extended warranty policies. The credit insurance division faces obvious problems as the economy weakens, but the extended warranty business could also face tough comparables considering that extended warranties are about as discretionary as it gets in the insurance business. We expect consumers to cut back on extended warranties as the economy weakens and gas prices continue to climb.

Perhaps the biggest problem that Assurant faces lies with the Assurant Health division. It is no secret that stocks for most publically traded health insurance companies have traded down sharply over the last 6 months. Industry wide issues including increasing costs, shrinking margins, and increased competition have taken heavy tolls on most health insurance stocks including United Health (NYSE: UNH), Cigna (NYSE: CI), Coventry Health Care (NYSE: CVH), and WellPoint (NYSE: WLP). This group of stocks is down an average of just over 45% since the beginning of March.

Yesterday United Health issued a revenue and profit warning following a warning from Coventry Health Care a few weeks ago. Both companies cited increased competition, escalating inpatient costs, and high outpatient utilization as reasons for lowering profit forecasts. Assurant Health has exposure to the same market forces that have already led to big declines in the pure play health insurance stocks.

An increase in unemployment related to the current economic downturn could have a significant negative effect on Assurant. As unemployment rises, Assurant gets hit with the double whammy of increased credit insurance loss ratios and fewer employees requiring health insurance coverage.

Overall, Assurant is not immune to the problems facing the health insurance industry, the company has exposure to illiquid mortgage-backed securities, and competition for creditor placed homeowners insurance is likely to increase as troubled insurance giants try to replace lost revenue. Although the concept of finding a stock that benefits from the credit crisis is intriguing, Assurant is not that stock. The Barron’s analysis is short sighted and does not reflect Assurant’s total exposure to a weakening economy. We think that Assurant’s stock has been inflated by the inaccurate Barron’s article and Assurant represents a compelling short sell opportunity at current prices.

Growth Prospects at Global Sources are Sill Promising

• Buy GSOL under $14

Global Sources is a business-to-business media and ecommerce company largely focused on China export markets.

Recently, shares of Global Sources have been in free fall. After hitting a 52 week high of $35 in late October, Global Sources shares have dropped all the way down to yesterday’s close of $13.25. The final blow to the stock’s decline came yesterday when Global Sources lowered its fourth quarter earnings and revenue estimates.

The core B2B business at Global Sources is still strong. Even after the recent downside revision on 2007 revenue estimates, revenue for 2007 is now expected to be $182 million compared to $156 million in 2006 and $112 million in 2005. Fourth quarter growth in on-line revenue and revenues from mainland China were up 20% and 28% respectively from the fourth quarter of 2006. The revenues for print media were lower than expected, but at Wall Street Mayhem we don’t see that as a problem going forward. Did any of the investors that were buying the stock back at $35 a share hope that print media revenues would take off? Nope, there were interested in the on-line revenue and sources fairs which are still on track. Global Sources also plans to add several new Chinese-language online initiatives under the Global Sources brand name in 2008 which could further accelerate online growth in Chinese markets. On the sourcing fairs side Global Sources plans to nearly double the size of its two China sourcing fairs in Dubai and Shanghai this year. In addition to the increased number of booths the average selling price for each booth should be up substantially in 2008 as well.

Although we typically stay away from stocks that have recently lowered estimates, the Global Sources long-term growth story is still intact and now the valuation of Global Sources shares is compelling. A trailing P/E of just under 20 seems very reasonably for a company with a strong growth story and a proven long term record in Asian export markets and B2B sales. Additionally, Global Sources has a strong balance sheet with $185 million in cash and no significant long-term debt.

The pre-announced top line for the first quarter was slightly lower than expected coming in at $60.8 million compared to a previous estimate of $61 to $62 million. However, the bottom line is now expected to come in at 16 cents compared to the previous estimates between 25 and 28 cents. Much of the bottom line shortfall is a result of a $3.1 million write-down on Global Source’s investment in Blue Bamboo. This is a puzzling write-down considering that the Blue Bamboo investment was very recent, but the company has now written down the entire amount of the Blue Bamboo investment so Blue Bamboo will have no effect on earnings going forward.

Back in November, Citigroup put a buy rating on Global Sources and they said that $45 a share was a fair value based on solid growth, good visibility, and a large and loyal community of active buyers. Although it appears that revenue and earnings visibility was not as good as Citigroup thought, the revenue is still close to previous estimates and the EPS took a big hit due to the Blue Bamboo write-down.

The Low Risk Trade on Dendreon

• Buy DNDN January 2009 $2.50 call options (ORGAZ)

• Sell DNDN January 2009 $5.00 call optoins (ORGAA)

• Conditions: Spread between ORGAZ buy and ORGAA sell should be less than $0.65, DNDN stock should be over $6.50 at time of trade.

Dendreon was back in the news Thursday and shares were up 24% to $6.98 after three members of Congress asked for an investigation into the Food and Drug Administration panel’s vote against approving Provenge. The letter sent to the House Energy and Commerce Committee requesting a probe into the FDA alleges conflicts of interest and ethical violations for at least two FDA advisory committee members who opposed the approval of Provenge.

In March, the FDA advisory panel recommended the approval of Provenge with a 13-4 vote. Then a few months later, instead of approving Provenge, the FDA asked for more patient data. Such a request could delay the drug for years.

The new letter authored by Mike Michaud of Main, points out that the FDA should not have had members of the advisory committee evaluating Provenge who had financial ties to rival companies. A similar allegation was made in an ongoing lawsuit against the FDA filed by the Care to Live group.

Although we don’t know how the Dendreon story will ultimately play out, the new Provenge news created an excellent options trade for those who are even mildly positive on Dendreon’s prospects. On Thursday the January 2009 $2.50 call options (ORGAZ, don’t laugh, this really is the call symbol) closed at $4.55. The January 2009 $5 call options (ORGAA) closed at $4.00. By buying the January 2009 $2.50 calls and selling the January 2009 $5 calls the risk/reward comes in at a healthy 1:4 ratio. For example, buying 10 contracts of ORGAZ and selling 10 contracts of ORGAA results in a maximum gain of $1,950 (exercise gain minus initial spread) and a maximum loss of $550.

For this options strategy to become a four bagger, Dendreon’s stock simply has to finish over $5 by option expiration in January of 2009. This position is also protected down to $3.05, if the stock closed at $3.05 at option expiration this trade would be flat. A stock close anywhere between $3.05 and $5 would result in a positive return for this trade. If Dendreon closes below $2.50 at option expiration the maximum loss (the spread between buying ORGAZ and selling ORGAA) would be realized.

However, the maximum loss is unlikely to be realized for this position even if terrible news comes out for Dendreon. This can be partially explained by taking a look at the Black-Scholes valuation for each of the options in this trade. The January 2009 $2.50 call option (ORGAZ) closed at $4.55 and had a Black-Scholes valuation of $4.40. The January 2009 $5 call option (ORGAA) closed at $4 and had a Black-Scholes valuation of $2.29. Therefore, even if Dendreon announced tomorrow that they are completely giving up on Provenge (a very unlikely announcement); the high priced ORGAA options will lose value faster than the reasonably priced ORGAZ options.

This trade keys on the spread between buying ORGAZ and selling ORGAA. We like this trade with a spread less than $0.65. Yesterday afternoon this trade was available with a spread between $0.40 and $0.75. With a spread less than $0.65 ($0.55 spread used in the above calculations), this trade has an excellent risk/reward ratio. If positive news comes out for Dendreon, the maximum gain will likely be realized. If the lawsuits and Congressional hearing drag out past January of 2009, then there will likely still be some positive sentiment for Dendreon, and the stock has a good chance of closing over $5 resulting in the maximum gain for this trade. If the stock drops almost 50% by next January to about $3.50, this trade still has a healthy positive return.

At Wall Street Mayhem we really have no idea how the Provenge saga will ultimately play out. However, we think there is a good chance that either positive news comes out or the matter is still unresolved by January of 2009. This trade has a good base risk/reward profile, but risk is further mitigated for this trade by buying the reasonable priced option (from a Black-Scholes perspective) and selling the expensive option.

Full disclosure: Wall Street Mayhem has a neutral to long position on DNDN options

Taking profits on Ninetowns (Nasdaq: NINE)

• Sell NINE near $6.50
• Buy QIIJU.xx near $0.35 (quantity equal to 10% of profit from NINE trade)

In the last 2 weeks the enterprise value of Ninetowns has moved from -$30 million to +$120 million. This trade took longer than expected to materialize, but the market finally appears to be recognizing the value of Ninetowns. Normally we would hold onto Ninetowns a little longer as a $120 million enterprise value is still reasonable, but we are increasingly worried about the valuations of all Chinese stocks so we are taking this opportunity to lock in a 65% profit. However, we decided to buy some October $7.50 calls with 10% of the profit from this trade. Just in case Ninetowns doubles again (as has happened with more than few small cap China stocks over the last week) we will still be well positioned. If the Ninetowns run is over then we will still net 55% on the trade.

Ninetowns could still receive a nice move when the Alibaba IPO comes out in early November so it is still on our radar, but for now we think this is a good time to take profits and buy a small number of October calls.

March into local Internet advertising with Marchex (Nasdaq:MCHX)

• Buy MCHX under $13

Marchex Inc. is an Internet search and media company focused on local search, local content, and direct navigation. Marchex owns and operates a portfolio of over 200,000 Internet domains.

Marchex has a market cap of about $485 million, $54 million in cash and no significant long term debt. The trailing P/E is about 500 (the company is just barely profitable) and the forward P/E is estimated at about 24.

Although Marchex has a promising portfolio of domain names and the company has consistently grown revenues year over year, profits have failed to impress and the stock has dropped from its post IPO high of $24 to its current price near $11.50.

Until recently, most of Marchex’s domains have been “parked” with the pages serving up pay per click ad pages with little or no content. Last spring Marchex re-launched over 100,000 new websites with local content. Although most of these websites still lack individuality, the creation of value added local websites is certainly a step in the right direction.

In May of 2006, Marchex acquired OpenList, a local information service designed to help consumers find, rate, and review local businesses. Marchex plans on using OpenList content combined with content from partner sites such as opentable.com, contractors.com, healthgrades.com, and judysbook.com to populate its network of local sites. Marchex recently announced that organic traffic growth at the 100,000 local sites integrated into the OpenList network has increased 20% in the last 3 months.

Although operating profits have failed to impress investors, Marchex generates a healthy amount of cash with 2006 operating cash flow of nearly $32 million. Most of this cash has been used to create and improve the Marchex network of local websites and to make strategic acquisitions. As seen by the recent traffic growth for the Marchex network of sites, these investments are starting to pay off. Although the initial surge in traffic is promising, the Marchex sites could really start to shine as user created content increases. The local sites operated by Marchex will become more useful and traffic will increase as user created content in the form of reviews and message boards starts to grow.

Although Marchex’s stock has performed poorly since its IPO, at Wall Street Mayhem we think Marchex shares are currently undervalued. As the value of domain names continues to appreciate, Marchex’s portfolio of 200,000+ domains could already be worth more than the companies’ market cap of $485 million. However, the real potential for Marchex is in the growth and development of its local network of websites. Local on-line ad spending is expected to reach $25 billion over the next decade. If Marchex can continue to improve its network of local websites, the company is well positioned to become the market leader in local on-line advertising.

The shear number of websites operated by Marchex makes the creation of value added websites a difficult task. In order to obtain sustainable traffic growth, Marchex must create sites that draw repeat users instead of relying on traffic from direct navigation. However, considering the current market cap, we think Marchex is a relatively low risk stock considering the underlying value of the Marchex domain portfolio. If Marchex succeeds in creating a large network of value added user friendly local websites, the stock could soar. If Marchex fails, the break up or buyout value of Marchex would still be close to the current market cap due to the value of the domain portfolio.

Full disclosure: Wall Street Mayhem is long MCHX

PrimeWest Energy (NYSE: PWI) agrees to a $2.4 billion buyout, highlighting the value of Candian oil and gas trusts.

• Sell PWI Near $26.35

• Buy CNE Near $14.82

Today PrimeWest Energy agreed to be acquired by Abu Dhabi National Energy. Under the terms of the agreement Abu Dhabi agreed to buy all of the outstanding shares of PrimeWest for $26.75 per share.

We decided to sell our shares of PrimeWest near $26.35 and roll the proceeds into Canetic Resources (NYSE: CNE). Canetic is another Canadian oil and gas trust that pays a dividend of 15%. Despite record oil prices, the Canadian oil and gas trusts have largely failed to rally in the last year. During this time, output has remained steady and the dividend yield has been on the rise.

We think that the purchase of PrimeWest for a 33% premium shows the underlying value of Canadian oil and gas trusts. Canetic will likely receive more investor interest as the result of the PrimeWest buyout and Canetic could also be a compelling takeover target.

Gmarket (Nasdaq: GMKT), the best value in Asian e-commerce

• BUY GMKT near $20.05 (long term portfolio)

It’s no secret that e-commerce is on fire once again. This week Amazon (Nasdaq: AMZN) impressed investors with a second consecutive blow out quarter. It appears that the long awaited promise of e-commerce has finally materialized. Gmarket appears to be poised to benefit from the same e-commerce trends that sent shares of Amazon flying this week.

Gmarket has performed well since we first profiled the company in late April, but the recent strength in Asian internet stocks and e-commerce stocks combined with improving fundamentals, should help push shares of Gmarket considerably higher. Previously, we held Gmarket as a short term pick, but now we have decided to add Gmarket to our long term portfolio ahead of the second quarter earnings report next week.

Gmarket reports gross merchandise value (GMV) a few weeks before reporting earnings so we have some numbers to work with heading into next week. GMV represents the total value of all items sold on Gmarket’s website. For the second quarter of 2007, Gmarket reported a GMV of 780 billion won. This GMV represents an 8% sequential increase in revenue. Last quarter revenue from transaction fees came in at 30.2 billion won. Using the same ratio, transaction revenue should come in at 32.58 billion won for the second quarter of 2007.

Recently, advertising and other non-transaction revenues have been growing faster than transaction related revenues at Gmarket. Last quarter advertising and non-transaction fee related revenue came in at 17.8 billion won, an increase of 114% compared to Q1 2006. If we assume that non-transaction revenue will increase by 50% in Q2 2007 compared to Q2 2006, then non-transaction revenue will come in at about 19.28 billion won. Therefore, after making the preceding growth assumptions, total revenue would come in at 52.4 billion won.

The current won to US dollar exchange rate is 915 won for $1 US dollar. Last quarter the rate was 937 won for $1 US dollar. The weakening US dollar should help Gmarket’s numbers when reported in US dollars. Four US analysts follow Gmarket and all of them report estimates in US dollars. None of these analysts have updated their numbers in the last 90 days despite a weakening US dollar that should help Gmarket’s numbers compared to estimates when the company reports.

Second quarter revenue in US dollars would come in at $57.26 million if we assume a 50% increase in non-transaction revenues compared to Q2 2006 and an 8% sequential increase in transaction related revenues. We think a 50% increase in non-transaction related revenue is a conservative estimate, but even with this estimate, Gmarket would handily beat the consensus analyst estimate of $56.85 million. If Gmarket can increase non-transaction revenues by more than 50%, investors could be in for a Bidu or Amazon type surge in Gmarket shares.

Bidu (Nasdaq: BIDU) reported a great quarter yesterday with revenue coming in at 401.3 million Yuan ($52.7 million). Just like Gmarket, Bidu’s numbers were helped by the weakening US dollar. Last quarter $1 was worth 7.73 Yuan; today $1 is worth 7.56 Yuan.

For Bidu, $52.7 million in revenue was enough to send the stock flying higher, up 19% in the after hours alone. This move propelled Bidu’s market cap to a lofty $7.35 billion. Analysts expect Gmarket to have second quarter revenues of $56.85 million (we think it will be closer to $58 million) and Gmarket has a market cap of $1 billion. Let’s review, Bidu has a market cap that is seven times larger than Gmarket, but it has lower revenues. We all know that the market pays a big premium for growth stocks. Therefore, does Bidu have projected growth numbers that justify the divergence in market cap from Gmarket? Not according to the analysts. The analysts that cover Bidu expect 68.5% revenue growth this year and 48.3% per year growth for the next five years. The analysts covering Gmarket expect 78.4% growth this year and 42% growth per year for the next five years.

For this quarter, Gmarket is poised to benefit from strong demand for e-commerce and a favorable exchange rate. For the long run, Gmarket will benefit from a dominant position in Korean e-commerce and a planned expansion into other Asian markets. Gmarket’s valuation is favorable when compared to other e-commerce stocks and Asian internet stocks. In short, this looks like a great time to buy Gmarket.

Wall Street Mayhem is long Gmarket

Update on Taser International Inc. (Nasdaq: TASR)

• Sell TASR near $18.40

Shares of Taser have been on an incredible run for the last three months. We entered a position in Taser back in late March and since then shares of Taser are up over 120%. In that time frame Taser has successfully released the C2 and they have started to gain traction in foreign markets.

Although the fundamentals at Taser have certainly improved and the concern about wrongful death lawsuits has been largely mitigated, we think shares of Taser have outpaced the underlying business fundamentals. In the most recent quarter announced this morning, Taser posted earnings of $3.7 million on sales of $25.9 million. These numbers handily beat analyst estimates, but with a forward P/E that is still over 50, we think this is a good time to take profits in Taser.

Taser bulls will argue that the big French order promised by Nicolas Sarkozy before the French election has yet to materialize. Although a large order from France will likely produce yet another jump in Taser shares, we prefer not to wait around for a slow moving French government.

Electro Optical Engineering (Nasdaq: EXFO) should benefit from increased bandwidth demand

• BUY EXFO near $7.06

Electro Optical Engineering provides test and measurement equipment for telecommunication carriers and cable operators to test and monitor fiber optic networks.

Electro Optical Engineering has a market cap of about $483 million, $115 million in cash and no significant long term debt. The trailing P/E is about 38.

Electro Optical reported third quarter 2007 earnings a few days ago. Sales came in at $39.2 million and GAAP net earnings totaled $2.6 million or $0.04 per share. Sales increased 10.7% year over year and 11.4% sequentially from the second quarter. Gross margins were 57.1% compared to 56.4% in the third quarter of 2006 and 57.5% in the second quarter of 2007.

Demand in the optical test and measurement sector remains strong as seen by Electro Optical’s raised forward guidance. The company said it expects “significant growth in the fourth quarter” and raised guidance by about $5 million by forecasting fourth quarter revenues between $41 and $44 million.

Shares of Ciena (Nasdaq: CIEN) have been on tear lately as Ciena has raised guidance and beat estimates for two straight quarters. Back in early March Wall Street Mayhem commented that shares of Ciena appeared to be undervalued after the company reported a strong quarter, but the stock dropped. Since then Ciena has turned in another great quarter and this time the street took notice. More importantly, Ciena’s strong results show that demand for the optical sector as a whole is continuing to grow.

JDSU Uniphase (Nasdaq: JDSU) has reported mixed results lately. However, JDSU has shown strong demand and growth in optical test and measurement equipment. Strength in test and measurement at JDSU is a good sign for Electro Optical because Electro Optical derives nearly 80% of total company revenues from the optical test and measurement division.

Demand for increased bandwidth is showing no signs of slowing down. Bandwidth intensive applications using video continue to gain consumer adoption. A recent article in the Financial Times suggests that Apple (Nasdaq: AAPL) will soon begin renting movies online. Although Apple already sells movies online, the addition of low cost movie rental downloads could have a major effect on the movie rental industry. If downloadable movie rentals from Apple take off like Itunes did, bandwidth usage and demand will skyrocket.

In addition to movie downloads, video applications such as Internet TV should also create a surge in bandwidth demand. The research firm iSuppli recently released a report predicting Internet TV revenues to grow 14 fold by 2011. The report went on to say that bandwidth required for Internet TV will grow by more than 44 times to about seven Tebibytes (TiBs) by 2011.

It seems clear that demand for increased bandwidth will continue to grow for the foreseeable future and shares of Electro Optical Engineering represent a great way to profit from the macro trend in bandwidth demand.

Full disclosure: Wall Street Mayhem is long EXFO 

Taking profits in Cree (Nasdaq: CREE) and Nexxus (Nasdaq: NEXS)

• SELL ½ position NEXS near $6.28

• SELL remaining ½ position CREE near $26.05

The LED sector has had a tremendous run over the last month. Considering the recent market volatility we think this is good time to take some profits in this sector. This trade closes out our position in CREE and reduces NEXS to a half weight position. We will continue to follow CREE and will likely be buyers on any significant pullback.