Stocks "On Sale"

Add AKS Calls and V Puts

“Card issuers are struggling to defuse a consumer-debt bomb that could blow an estimated $41 billion hole in their businesses this year — and even more in 2009.”

- MSN Money, October 28^th 2008

PLAY: Buy the Visa January 55 Puts (V MK) at market, good for the day. Place a protective stop limit at $2.20 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

PLAY: Buy the AKS January 2010 15 Calls (YDF AC) at market, good for the day. Place a protective stop limit at $1.50 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

Dear Bottarelli Research Member,

When it comes to the housing market, you know the story…

Borrowers are falling behind on their payments, defaults are rising, loans are soaring, real estate values are falling, and homeowners are getting burned. Amazingly, a new study shows that one in six American households owe more money on their house than it is actually worth.

As you know, this has caused an unprecedented strain on our financial system. But now, there’s mounting evidence that the same reckless spending has also occurred in the credit card markets. As you read this, there’s $950 billion worth of outstanding credit card debt, and much of it is toxic.

As you can imagine, that’s bad news for credit card companies — and it could be the next shoe to drop in our financial credit mess. As you can see from the headline quote above, some have already called it the “consumer-debt bomb.” And unfortunately, this one won’t come with a federal bailout. In fact, the Treasury Department’s $700 billion mortgage bailout offers no lifeline for credit card issuers.

Now, if you listen to big credit card companies, they’ll assure you that they’re fully prepared to weather the storm. But we’ve heard this song and dance before. Remember when Countrywide Financial (or any other mortgage lender) publicly announced that they wouldn’t be affected by the sub-prime crisis? Wrong.

Here’s the sobering truth…

According to the latest estimates, credit card issuers will take a $41 billion hit from rotten debt this year and a $96 billion hit from rotten debt in 2009. Why? Well, just like mortgages, banks bundle groups of credit card receivables (consumers’ outstanding balances) and sell them to hedge funds and pension funds. Sounds just like the sub-prime crisis, right? But here’s the biggest difference…

You see, unlike mortgage debt, credit card debt is unsecured. After all, any consumer can apply for a credit card at no cost. No down payments are needed. What’s worse, if a consumer stopped making monthly payments, there are no underlying assets for credit card companies to recoup. In other words, credit card lending has no collateral. They can’t re-posses any real estate, nor do they have the cushion of a down-payment. As a result, it’s getting harder for credit card companies to find buyers for their ever-mounting debt. And here’s the worst news of all…

Risky borrowers (defined as those with low credit scores) account for 30% of outstanding credit card debt. In comparison, 11% of the nation’s mortgage debt was carried by risky borrowers, and we all know what effect they had on the financial markets. Right now, credit cards have three times more risky debt on their books! Ouch.

When you add it all up, I can’t see this ending positively for credit card companies. Going forward, you’ll probably see them starting to cut their dividends and raise fresh capital. Investors hate this. For example, when Bank of America tried such a maneuver, BAC stock dropped more than 25% in a single day. The other option is to settle the debt by accepting lower price deals (such as $0.30 on the dollar). In each case, the news is not good. And remember, this is all coming during a recession. When you throw reduced consumer spending into the equation, it’s clear that the next six months look very difficult. Therefore, as the first order of business, I’d like to add puts on Visa (V – NYSE).

PLAY: Buy the Visa January 55 Puts (V MK) at market, good for the day. Place a protective stop limit at $2.20 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

As the second order of business, I’d like to continue our tactical strategy of adding longer-term calls on stocks that are currently “on sale.” You see, after reviewing the current trading patterns of many high-quality companies, I’m now finding that some of the best companies in the world are trading below their book value.

“Book value” is an accounting value that calculates the total value of a company’s assets that shareholders would theoretically receive if the company was liquidated. As you’ll see below, shares of AK Steel Holding (AKS – NYSE) have gotten so bludgeoned, you can now own the stock for below their book value. Therefore, I consider shares of AKS “on sale” right now.

AK Steel is a leading producer of flat-rolled carbon, stainless, electrical steel, and tubular products. I consider their current valuation an incredible deal because recent earnings reports out of the steel industry have shown incredible strength. On Wednesday October 22^nd, for example, AK Steel reported a 70% increase in profits. Earnings reached $1.67 per share (compared to $0.97 in the third quarter of 2007) and net sales reached $2,157.6 million (compared to $1,721.7 million in the third quarter of 2007). These are incredible numbers, especially in today’s recessionary environment.

And it’s not only AKS reporting strong earnings. On Tuesday October 28^th, U.S. Steel (X – NYSE) reported that their Q3 profits more than tripled. U.S. Steel’s Chief Executive, John P. Surma, said it was their most profitable quarter in history, as net income reached $919 million ($7.79 per share) versus $269 million ($2.27 per share) one year earlier. This shows you that steel demand will remain in place for years to come. And more importantly, it makes adding longer-dated calls on steel stocks a remarkable buying opportunity.

Just consider the numbers of AKS…

The stock hit a new 52-week high of $73.07 on May 21^st 2008, but it just recently hit a new 52-week low of $9.39 on October 10^th 2008. That’s a $60.00 price swing in five months! Now get this. At current levels, their balance sheet shows that they carry a book value of $12.78 per share. That means you’re buying AKS below book value, which officially makes them a high-quality stock that’s currently “on sale.”

What’s more, they currently have a forward P/E ratio of 3.37, a PEG ratio of 0.26, and a Price/Sales ratio of 0.17. These valuation metrics are truly eye-popping. Remember, Warren Buffett considers any stock with P/E ratio below 10 a good buy. AKS is currently trading at a P/E ratio of 3.37 even after reporting a 70% increase in Q3 profits! Unreal. Based on strong earnings from the steel sector combined with unprecedented low levels for steel shares, let’s go ahead and add longer-dated calls on AKS now.

PLAY: Buy the AKS January 2010 15 Calls (YDF AC) at market, good for the day. Place a protective stop limit at $1.50 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

POTENTIAL FUTURE PLAYS: Leading into next week’s election, I think that a Democratic victory could translate into fear-based selling in defense stocks like Alliant Techsystems (ATK – NYSE) and L-3 Communications Holdings (LLL – NYSE).If either of these stocks falls due to political cut-backs in the defense budget, we’ll profit by adding puts.

UPDATES

Ultra Financials June 8 Calls (UUF FH): The market’s powerful advance this week set a nice tone for this position, as the calls that we entered for $3.00 traded as high as $4.10, good for a nice 37% return. Be sure to lock in half of your profits at the 50% level and hold the remainder for more upside.

Wynn Resorts January 35 Puts (UWY MG): Shares of casino operators experienced a freakish upside pop this week. But if you look at the news, it’s pretty clear that the rally was based purely off short covering. For example, MGM Mirage reported a 67% drop in third-quarter profits Wednesday. They also said they would postpone some of their big-ticket projects. But on this news, shares of MGM shot up 22%, which was a direct result of short positions covering on the bad news. WYNN rallied right alongside MGM. I think this is nothing more than a short-term reaction. The next 6 to 12 months look absolutely dismal for both Las Vegas and Macau, so I’d like to use this abnormal jump in the stock price to add to our put position.

PLAY: Buy more Wynn Resorts January 35 Puts (UWY MG) at market, good for the week.

Auto Zone January 100 Puts (AZO MT): This is another position that’s full of hot air. The month of October was the worst market month since 1987, as the Dow dropped 18%. But stuck within this bad month was a strong market week. Over the last five trading days, the markets moved over 900 points higher, and this helped to push AZO shares up. But I feel this rally will be short-lived. I continue to feel that AZO will follow the same path as Sears, and that means shares are headed to $60.00. Hold.

Tesoro January 2011 5 Calls (ZGC AA): The more oil prices fall, the better it’ll be for refiners like TSO. Over a 24-month time horizon, this could be an explosive winner. Hold.

Zale February 20 Puts (ZLC ND): The market strength helped Zale move up a little bit, but not much. I feel we’ll soon achieve the 50% profit level on our puts, so be sure to sell half once they achieve the $8.10 price target. Sell half at 50%.

Toyota Motors January 65 Puts (TM MM): The news remains bad for Toyota, so I’m maintaining our downside position. Hold.

American Capital May 25 Calls (DQS EE): Shares of ACAS bounced from $10.00 up to $14.00 this week, which could set a positive tone over the next two months. As a more speculative play, I will continue to monitor this position. Hold.

Excel Maritime March 15 Calls (EKN CC): EXM is another stock trying to establish a bottom right at the $10.00 level. Once a bottom has been set, EXM could pop rather aggressively. When it does, I want to be holding calls! Hold.

Apex Silver Mines January 2010 2.5 Calls (YSB AZ): Silver had a powerful mid-week rally, and hopefully this strength carries forward into shares of SIL. Hold.

Southern Peru Copper January 2010 25 Calls (YPV AE) & Barrick Gold January 2010 40 Calls (WRX AH): We witnessed nice comebacks on both positions, as copper and gold spiked on an intra-week basis. I think we could have established a floor in both metals, and this would create a strong base for both PCU and ABX over the next 12 months. Hold.

America Movil January 2009 70 Calls (AMX AN), Petroleo Brasileiro January 90 Calls (PMJ AR), & Entergy January 140 Calls (ODF AH): Still no signs of life for these three. Since they’re at such nominal values, we might as well hold for a miracle. Hold.

Sincerely,