This current website will continue to provide general information as it relates to my equity research and financial modeling consulting business, but I will be writing general commentary on stock ideas on my new blog:  http://jstephencastellano.com/

So many want to find a way to disbelieve the outstanding numbers this company is putting up.  Why is that?  It’s as if FOSL is the learning disabled wimpy kid you grew up with which turns out to be a once-in-a-century genius.  You hear the words, but you just cannot believe it.

In fact, FOSL is one of our favorite long ideas and is held in our model portfolio based on real trade data.

You are only paying 1x PE/G for a stock that can potentially put five wristwatches on every single arm in America.  Admittedly that may be an exaggeration, but take a look at the numbers — there is nothing extended here.  In fact, just the opposite.  In our opinion, FOSL may be preparing itself for a big holiday season, given the large bump in inventory last quarter.

Apparently a big part of the “new” thesis for Starbucks is expansion in China, a theme we highlighted earlier in the year which has tremendous potential but is not going to be generating massive amounts of free cash flow overnight.

12/15/2010 — T. Rowe Price Group (TROW) — Goldman Sachs added the stock to its Conviction Buy List, raised its rating to Buy from Neutral, and raised its stock price target to $80.

12/15/2010 — Freeport McMoRan (FCX) — Argus raised its target price to $139 from $113 while maintaining a Buy rating.

12/15/2010 — Parker-Hannifin’s (PH) — Argus raised its price target to $100 from $86.

12/14/2010 — TRW Automotive (TRW) – KeyBanc upgraded the stock to Buy from Hold with a $69 price target.

12/9/2010 — United Continental Holdings (UAL) — Morgan Stanley named the stock a long Research Tactical Idea.

12/9/2010 — Freeport McMoRan (FCX) — Credit Suisse raised its price target to $130 from $110, making it the highest price target on the Street. In our opinion, that 12-month target is easily attainable.

12/9/2010 — Waddell & Reed (WDR) — Barclays upgraded the stock to Overweight from Equal Weight, and raised its price target to $41 from $30.

12/7/2010 — Fossil, Inc. (FOSL) — J.P. Morgan raised its price target to $77 from $68 while maintaining a neutral rating.

12/6/2010 — Lyondellbasell (LYB) — Jefferies raised its price target to $36 from $33 while maintaining a buy rating.

12/3/2010 — RPC, Inc. (RES) –  Canaccord Genuity raised its price target to $37 from $30 (that is roughly a change to $25 from $20 post the 12/10 3-for-2 stock split).

12/2/2010 — Ares Capital Corporation (ARCC)– UBS initiated with a buy rating and $18 price target.

What catches our attention about this company is [emember_protected] not only its solid rankings in four key factors, scoring 4 out of 5 for 1) Relative Value; 2) Operating Mometnum; 3) Analyst Revision Momentum; and 4) Fundamental Quality, but also due to the fact that it appointed a new CEO this past July that is “evaluating the company’s strategic priorities and examining additional means to maximize shareholder value.”  New management teams are usually looked upon favorably by investors since they can breathe new life into an enterprise.

The new CEO, George Scangos Ph.D., was previously the CEO of Exelixis, Inc. (EXEL), a $720m market cap biotech company involved in the treatment of cancer, metabolic and cardiovascular disorders.  Scangos was the CEO at Exelixis from October 1996 to June 2010, and was the President of Biotechnology at Bayer for the three years prior to that.  Unfortunately, taking a look at the stock price chart for EXEL is not at all that inspiring, however.

The company just completed a $1.5b buyback of stock which was first announced in April 2010; in all, the company repurchased approximately 29.8m shares of common stock which reduced the number of common shares by 15% through September 2010.  It does not pay any dividend but does generate a very attractive level of free cash flow, estimated to increase from $1.2b on a trailing 12-month basis in the latest quarter to $1.6b by December 2011.  Economic profit and ROIC are also forecast to improve.  Not being experts in biotech, we can only imagine that the board wants a more creative use of its cash flow than another 15% buy back of stock.  Biogen already looks quite attractive, and Exelixis does not appear the paramount example of operational success, so we assume Scangos was brought in to use all of that excess cash flow to make a smart acquisition.  In any case, BIIB looks like it might be a nice addition down the road to a high turnover portfolio such as our long-only model, and deserves further study as a longer-term holding.

We have optimized part of our systematic portfolio management approach based on backtests to 12/31/2004, using monthly updates to fundamental data and daily updates to stock price data.  The backtest includes 18 months of data collected in real time.  We frequently backtest new ideas with small refinements, so any backtested “returns” that we may write about could change frequently as well.

We rank stocks on scores of fundamental data points, which can be summarized into four key factors, with a score of 5 being the best and 1 the worst:

1. Relative Value.
2. Operating Momentum.
3. Analyst Revision Momentum.
4. Fundamental Quality.

Note that cash and debt in this particular table do not reflect the Nov 30 acquisitions of Seadrift Coke L.P and C/G Electrodes LLC, or any estimated impact of its 4m shelf registration on Nov 30 related to its equity incentive program.

GrafTech has good relative value and ranks highly for quality (working capital management, asset turnover, margin expansion and other data points), but scores weakly for operating momentum and analyst revision momentum.  This indicates that on a relative basis and by our measures, there are other stocks in the Industrial sector that have stronger fundamentals than GTI at the current moment.

As you can see in the table above, there are six other Industrial stocks that look particularly stronger in our rankings.  We own five of these stocks in our portfolios.  During our holding period Avery Dennison Corp (AVY) has performed well and United Airlines (UAL) poorly.  One could argue about whether these stocks are fundamentally comparable or not or even belong in the same sector, but as far as we are concerned as it relates to our systematic approach to portfolio management and long-term idea generation it is an irrelevant discussion.

Incidentally, United Airlines (UAL) was named as a long Research Tactical Idea at Morgan Stanley today — more than 5 weeks after we mentioned it as a buy in our newsletter and we purchased it for ourselves.  This is the fifth occasion this month in which our model portfolio ideas have presaged major ratings actions by major sell side institutions, and compares to more than 16 sell side actions we presaged in November (see our report, “Getting in Before Sell Side Institutions Follow“).

Take a look at the next two tables, which provides some fundamental details about GrafTech and our best performing Industrial holding, Avery Dennison.  We have adjusted the GrafTech’s forecasts in the table below to take into account lower cash, higher debt and higher operating assets following the November 30 close of two acquisitions.

Potential Integration Issues, ROIC Stagnation and Selling Pressure May Hold GTI Back in the Short-term
On the preceding two tables, notice that the historical sequential improvement in margin expansion and ROIC for GrafTech is better than Avery Dennison, but the forecast margin and ROIC expansion is better for Avery Dennison.  This is because margin expansion may flatten and ROIC is likely to fall off in the near term as GTI integrates its recently closed Seadrift Coke and C/G Electrodes acquisitions.

On November 30, 2010, GrafTech completed the acquisition of its remaining 81.1% stake in Seadrift Coke L.P. and 100% stake in C/G Electrodes LLC by issuing 24m shares, $86m cash, drawing $165m from its revolving credit facility and issuing $200m in non-interest bearing five-year Senior Subordinated Notes (current discounted fair market value of $144 million).  Also on November 30, GrafTech filed to sell 30m shares in three separate shelf registrations, including 26m shares from existing shareholders and 4m shares related to its equity incentive program.  There are only 2m shares remaining in its existing share repurchase program.  Our data source has current shares outstanding at 121m.

The recent acquisitions will raise operating assets and operating capital, with risk of a disproportional rise in cash flow.  In addition, share dilution will be minimal at about 4m, but likely pressure from selling shareholders of the 26m shares may hold the stock down in the near term.  Analysts will likely be cautious in raising estimates for GTI until the company has convincingly shown it has integrated the acquisitions.  The forecasts for GTI in the above table could prove to be optimistic if it has any trouble integrating the acquisitions.

On the positive side, GTI currently has net cash on its balance sheet, having finished paying down an enormous amount of debt over the last few years.  It will probably use its free cash flow to do the same going forward as quickly as possible.  A dividend issue would be a nice addition as well because that would attract a new group of investors while it took the time to integrate its acquisitions, but that seems unlikely to occur for at least the next 12 months or so.

Conclusion
In summary, GTI has solid relative value relative to its fundamentals and relative to other stocks in the Industrial sector.  However, operating momentum and analyst revision momentum has stalled.  For investors that rebalance their portfolios on a monthly basis, it makes sense to sell GTI and purchase an alternative and revisit the story again in one or two quarters.  Long-term investors should probably hold the stock because of its proven management team and its strong strategic position in the graphite electrode industry, made stronger by these recent acquisitions.

About this report
This company report is a supplement to a monthly report dated November 30, 2010 that details the model portfolio strategies of Ascendere Associates LLC (“Ascendere”).

For more information, please see our list of frequently asked questions, suggested tips on using our newsletter or an interview with us on Covestor Live.

See also our long-only portfolio model based on actual trade data.

Please review our disclosures and disclaimers.

On a trailing 12-month basis over at least the last six quarters, gross margins have been expanding with SG&A growing less, helping EBITDA margins expand.  With trailing 12-month sales growth hitting 13.9% for the quarter ended September 30 after six consecutive quarters of declines, ROIC and cash flow growth is poised to accelerate.  The company is trading at 16.4x the calendar 2011 EPS estimate of $4.66, has net cash on its balance sheet and pays a $1.60/share dividend for a current yield of 2.1%.

Operating assets have stayed relatively steady as EBITDA and operating cash flow have been steadily increasing driving superbly high and expanding operating asset turnover, and it is managing working capital extremely well.  Revenue and earnings estimates for the calendar 2011 have surged more than 7% over the last three months.  The company is targeting a nearly doubling in sales to $3b in 2014 with net income expansion to 8% from 6.5% from 2009.

The stock has already moved up more than 5x its March 9, 2009 low of $14.59 to $76.40 this past Friday, December 3, 2010, yet for the aforementioned data points there is still room for appreciation.  The company is currently trading at 16.6x consensus NTM EPS of $4.60; if earnings estimates expand to the high end of the range to $5.05 and its NTM PE hits its 1yr peak of 17.3x, we could see an $87 stock price.  Using the same methodology, risk NTM risk could be $56.  But we think it is more likely than not that estimates keep rising for the company due to renewed sales growth and steps to minimize operating assets.  Recent volatility has been running roughly 8%/month, so some up/down ratio applied to this figure would be useful for setting shorter-term price and stop loss targets.  In our opinion, this company shows solid growth prospects at a reasonable price and has plenty of upside potential before it hit pure growth stock status.  Please review our Disclosures and Disclaimers.

11/19/2010:  Albemarle Corp. (ALB) — Jefferies raises price target to $61 from $56, keeping rating at buy.

11/18/2010:  LyondellBasell (LYB) was named a long Research Tactical Idea at Morgan Stanley. –theflyonthewall.com

11/16/2010:  TRW Automotive Holdings Corp. (TRW) — “Soleil raised its earnings estimates for TRW Automotive to reflect improving industry volume and the company’s better than expected results. The firm upped its target for shares to $59 from $54 and maintains a Buy rating.” – theflyonthewall.com

11/15/2010:  Rockwood Holdings Inc (ROC) Credit Suisse raises target price to $47 from $40.

11/15/2010:  Macy’s (M) — The stock was added to Bank of America’s / Merrill Lynch’s “US 1 List.”

11/15/2010:  Union Pacific (UNP) –  RW Baird upgraded Union Pacific to Outperform from Neutral, and raised its price target to $120 from $100.

11/12/2010:  American Express (AXP) and Freeport McMoran (FCX) were added Ken Heebner’s Capital Growth Management Fund, and Micron Technology (MU) and SanDisk (SNDK) were removed.  Heebner does not get a copy of our newsletter that we are aware of, but we are glad he sees the wisdom of our moves.

11/12/2010:  Williams Sonoma (WSM) –RW initiated with an Outperform rating and $42 price target.

11/11/2010:  Williams-Sonoma (WSM) — “Wells Fargo raised its Q3 estimates for Williams-Sonoma above consensus levels ahead of the company’s Q3 results. The firm thinks the company will also beat Q4 consensus estimates and it believes the stock’s valuation is favorable. The firm maintains an Outperform rating on the stock.”  — theflyonthewall.com

11/10/2010:  Williams-Sonoma (WSM) — ThinkEquity upgraded the stock based on a recovery in home-related purchases and raised price target to $40 from $33.  Oppenheimer identified WSM as a top pick in the hardlines retail sector.

11/8/2010:  Albemarle Corp. (ALB) –Zacks upgrades to a Strong Buy.

11/5/2010:  American Express Corp. (AXP) — Argus upgraded the stock and raised price target to $50 due to reduced loan losses and volume growth.  See also our 10/25/10 article on Seeking Alpha, “Why American Express is Finally Worth a Look.”

11/5/2010:  TRW Automotive Holdings Corp. (TRW) — Deutsche Bank raised its target to $57 from $52.

11/3/2010:  TRW Automotive Holdings Corp. (TRW) — S&P Equity raised its price target raised to $62 from $50.

11/3/2010:  Union Pacific Corp (UNP) — Deutsche Bank raised price target raised to $102 from $92.

11/2/2010:  Fossil Inc. (FOSL) — BB&T Capital Markets initiated with a Buy rating.

Moving Off the “High-Quality” List

Williams-Sonoma (WSM) is one company moving off the “high-quality” list, but for reasons different and less relevant than we initially thought.  WSM is not moving off the list not due to lower analyst revisions (revisions did in fact move slightly higher following its November 18 report), but is moving off due to lower relative rankings for working capital accruals.  Since the higher working capital is likely more a function of seasonality as opposed to core quality, and operating momentum remains very strong, there are still good reasons to own the stock.  We think fears of a slow-down in the home furnishing space is overblown, especially as management seems to be paying particularly close attention to the efficient use of its fixed assets.  Consensus estimates imply flat to slightly up ROIC in the quarters ahead, but we think as management continues to shut-down stores and leverage opportunities in the online space, that ROIC could continue to improve at a good pace.  Even so, portfolios with high turnover may still find a reason to replace this idea for the time being.

Examples of stocks that appeared in our reports several days or weeks prior to major sell side actions:

• 11/19/2010: Albemarle Corp. (ALB) — Jefferies raises price target to $61 from $56, keeping rating at buy.
• 11/18/2010: LyondellBasell (LYB) was named a long Research Tactical Idea at Morgan Stanley. –theflyonthewall.com
• 11/16/2010: TRW Automotive Holdings Corp. (TRW) — Soleil raised its earnings estimates and price target to $59 from $54.
• 11/15/2010: Rockwood Holdings Inc (ROC) Credit Suisse raises target price to $47 from $40.
• 11/15/2010: Macy’s (M) — The stock was added to Bank of America’s / Merrill Lynch’s “US 1 List.”
• 11/15/2010: Union Pacific (UNP) — RW Baird upgraded Union Pacific to Outperform from Neutral, and raised its price target to $120 from $100.

Please see our disclosures and disclaimers.

Quarterly Report Below Blow-out Expectations
Investors were obviously looking for blow-out results, but the sequential change in headline numbers and the estimate beats were mediocre relative to heightened expectations.  For example, revenue for the quarter was $816m, or 2.1% ahead of consensus of $799m, and EBIT was reported at $56m or 1.4% above consensus of $55m. Compare that to Fossil, Inc. (FOSL), a Discretionary company (different industry) which reported revenue 8% above consensus and EBIT 39% above consensus.   Over the last few weeks, sell side analysts have been scrambling with upgrades and new coverage initiations of this stock, and higher-end retail has been doing very well, so expectations were very high for WSM.  Coupled with a cautionary outlook by management WSM is now selling off back to early November levels.

Furthermore, given management’s cautious outlook regarding the macro environment, it is likely that analysts are going come out with estimates at the low end of guidance.  F4Q2011 revenue is now estimated at $1120-1160m versus $1100-1140m following the prior quarter, and GAAP EPS is now expected at $0.83-0.88 versus $0.80-0.85 previously.  However, the consensus revenue estimate for 4Q is $1143m and the consensus GAAP estimate is $0.90.  In addition, gross margins for the fiscal year ended January are now estimated at 38.8%-38.9% versus 38.0-38.2% previously, and management indicated there is some cushion to these gross margin figures.  While management has increased guidance, it looks like consensus estimates are going to be taken down.  This is what is probably driving the sell-off today.

Company Still Very Attractive when Focusing on Metrics that Matter Most
The company is in the middle of a transition, intending to close down 10 out of 11 Williams-Sonoma Home stores in 4Q, while focusing more on online sales.  Meanwhile, prices are at a more promotional level than they would like. However, the company seems to be managing this transition extremely well, with other store concepts like Pottery Barn, Pottery Barn Kids and outlets doing extremely well while taking market share from competitors.

The best way to illustrate how well management is running its business is to look at the key drivers of value, which is ROIC, economic profit and cash flow growth.  ROIC in the quarter improved to 15.3% (NOPLAT of $338m / Operating Capital of $2181m) versus 14.0% in the previous quarter and negative 2.1% in the same quarter last year.  Economic profit for the quarter came in at an $93m (NOPLAT of $338m – Economic Charge of $245m) versus negative $354m last year.  (See our tables below.)

Even assuming the currently lowest consensus estimates going forward, which appears to be below current guidance and therefore representing worst-case estimated data points in our opinion, our models indicate the company should be able to maintain ROIC between 14.2% and 15.2% for the next several quarters.  This level of ROIC is well above its estimated cost of capital (back of the envelope) of about 11%.

We calculate free cash flow in the quarter of $36m compared to $66m last year, lower because of higher cash taxes paid and investment in working capital.  LTM free cash flow is calculated at $315m versus $207m last year, moving to a normalized level of $240-$250m in the quarters ahead (adjust for what appears to be a liquidation and subsequent investment last year).  Free-cash-flow relative to market value currently stands at about 6.3%, and at about 6.9% relative to estimated Q+1 trailing 12-month revenue.

Momentum Strategy Sell-Off Opens Door for Buy and Hold Investors
Williams-Sonoma reported a good quarter above consensus and raised guidance, but management’s cautionary language regarding the home furnishings industry is likely to cause analyst’s to reset estimates at the low-end of a guided range, which could be below current consensus on an EPS basis.  Despite solid value and improving  returns on capital, this momentum driven investors are selling the stock.  In our opinion, the sell off is overdone and offers excellent value.  However, WSM has to be put in a context relative to other Discretionary sector companies that not only offer great value but accelerating momentum (e.g., Fossil, Inc. FOSL, Limited Brands LTD, etc).  We will have more details on our relative ranking model over the weekend, but it appears that rankings for relative value will be moving higher, while relative operating momentum and relative analyst revision momentum will decline.

At the current price of $32.43, or 17.2x NTM consensus EPS of $1.88 (which may decline a few pennies over the next few days), it is difficult to see the price declining much more. We are not in a situation where the company missed estimates prompting a sustained inexplicable sell-off like we saw with Gilead (GILD) earlier in the year; WSM simply has lost some momentum, which in our opinion is a meaningful difference.  In our opinion, investors with 12-month holding periods or longer will probably  feel comfortable purchasing the stock at the current level.  This is because management seems to be taking all the right steps to manage its capital structure and maximize ROIC by closing unprofitable stores, focusing more on online sales and taking share from weaker players in this fragmented industry.  It is also likely that systematic short-term momentum strategies (such as our long-only model based on real trade data) will be moving out of this stock and not revisit it for some time.  At the same time, it seems equally possible to us that if the home furnishing industry does not experience further weakness F4Q could results could be very favorable compared to apparently just-lowered market expectations.