Time to Short Santa

Email – #132

** Time to Short Santa

So the massive government intervention plan failed. Now what?

Get short retail. Here’s why…

Even before the markets nasty dip, dire outlooks abounded.

For instance, just last Wednesday, the National Retail Federation warned retailers should brace for the worst holiday in six years. And a week earlier, consulting firm TNS Retail Forward predicted it would be the worst in 17 years.

Whether it’s the worst in six or seventeen years matters little. Things were going to be ugly anyways. And yesterday’s jaw-dropper only made matters worse.

As the Conference Board acknowledged today, such shocks “generally tend to have a temporary adverse effect on confidence, lasting on average two to four months .” Or essentially, through the holiday season.

And that spells disaster for Leapfrog Enterprises (NYSE: LF) – a manufacturer of technology-based educational toys.

You see, the company’s failed to turn a quarterly profit since 2005. Yet, it spent heavily on research and development and advertising in the last 12 months to put an end to the drought. And it’s relying 100% on holiday sales to pull off the turnaround.

As management acknowledges, “We continue to expect the majority of our 2008 shipments and consumer purchases will occur in the second half of the year.” Moreover, it’s counting on its newest products – the TAG Reading System, the Leapster 2 and the Didj – the most.

But they’re not cheap. They retail for $49 to $89, with additional games and storybooks costing up to $29 each. During times of economic uncertainty such higher-priced items will be a tough sell. Especially since no kid wants a video game system with only one game.

And that means one of two things will happen…

Leapfrog will either advertise more heavily to drum up demand. Or slash prices. Neither guarantees strong sales. But both ensure margins will take a hit.

Now, I’m aware that the company reported narrower losses than expected last quarter, and stood by its full-year outlook, suggesting its turnaround efforts were on track. But that was before the markets came unglued.

The fact that shares still rest near a 52-week high and at a very frothy forward price-to-earnings ratio of 24.2 (roughly double the industry average) reveals investors are clinging to false hope.

What about the CEO’s rather optimistic tone in the latest quarterly report?
I’m suspect. He’s got a track record of such statements… and for running unprofitable businesses, for extended periods of time.

Before Leapfrog, he ran Orbitz – a company spun-off from Cendant that failed to turn a profit during his four-year tenure, despite the fact that every other public Web travel company did. What’s more, his most extensive experience is in another notoriously unprofitable industry – airlines. So yes, he’s got experience – in losing money!

The fact that no insiders are buying convinces me we should expect much of the same. And even if a bailout gets hammered out in the next week – and the markets rally – I’m convinced the damage is done.

I predict losses will come up much higher than expected for Leapfrog. And share prices will quickly correct to reflect the same.

Action to Take:

Sell short Leapfrog Enterprises (NYSE: LF) at market and place a buy stop at $12.50 for protection. Speculators might want to consider the March 2009 $10 puts (LF-OB). But don’t pay more than $2.

Elsewhere, after locking in a 22% gain yesterday on our Dow Diamonds December $110 puts, it’s time we take out another catastrophe insurance policy. Go ahead and reinvest a portion of the proceeds in the Dow Diamonds January $2009 $100 pu ts (DIA-MV) for $4.75 or better.

Good investing,

Louis Basenese

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Current Portfolio

Long Positions:

Stock

Rec
Date

Rec
Price

Current Price

Comments

Ultra Petroleum Corp. (NYSE: UPL)
09/08/2008
$55.52
$56.47
Buy. Sell stop is $42.

Pilgrim’s Pride (NYSE: PPC) March 2009 $15.00 calls (PPC-CC)
08/26/2008
$3.10
$.18
Buy at $4.00 or better.

Financial Select Sector SPDR (AMEX: XLF)
01/22/2008
$25.47
$19.65
Hold.

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Short Positions:

Stock

Rec
Date

Rec
Price

Current Price

Comments

Diamonds January 2009 $100 puts (AMEX: DIA-MV)
09/30/2009

New

New

Buy at $4.75 or better.

Leapfrog Enterprises (NYSE: LF)
09/30/2008

New

New

Sell short at market. Set buy stop at $12.50

Buffalo Wild Wings (Nasdaq: BWLD) March 2009 $30 puts (BQU-OF)
08/26/2008
$4.70
$3.90
Buy at $5.00 or better.

Diamonds December 2008 $110 puts (AMEX: DIA-XF)
07/15/2008
$7.25

Sold

Closed position and took profits on 09/29/2008

Currency Shares Euro Trust (NYSE: FXE)
03/26/2008
$157.90
$141.17
Sell short.