So what exactly does a high short interest mean, and does it always signal that a stock is about to fall because people are betting against it?

In this post, I’m going to go over all the ins and outs of what shorting a stock means, and more importantly for us, how sometimes this high short count is not caused by those necessarily betting against a stock, but rather from the financial institutions that have lent the company money and have received convertible bonds or warrants in return.

Why would a financial institution that is lending money bet AGAINST the stock of the company that they just lent money to?

Good question!

This is one of those small little nuances on Wall Street that often confused me, and left me scratching my head wondering why a seemingly “great” stock had so many people betting against it.

I’ll break down this post into 4 parts:

• What Does Shorting Mean?: Essentially you’re betting a stock will go down
• What Are the Risks?: There are many, shorting is risky!
• Why Do Financial Institutions Short?: A strategy to hedge risk, and lock in profits
• Bottom Line: Shorting is a risky, but necessary part of the market

A Quick Review of Shorting a Stock

Essentially, you are betting that it’s going down

Before I get into the nitty-gritty of why financial institutions would bet against a company that they just lent money to, let’s first go over exactly what the term “shorting” means, and what it entails.

Here’s a common definition of shorting a stock, or being “short”:

The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value.

Opposite of “long (or long position)”.

For example, an investor who borrows shares of stock from a broker and sells them on the open market is said to have a short position in the stock.

The investor must eventually return the borrowed stock by buying it back from the open market.

If the stock falls in price, the investor buys it for less than he or she sold it, thus making a profit. (Taken from Investopedia.com)

Taken further, shorting a stock essentially means that you are taking the opposite side of the trade than when you traditionally purchase shares in a company to hold for long term investment.

If, for instance you think a stock is way overvalued, or is going to run into rough times ahead, you would then “borrow” the shares at the price where the stock sits today, and then sell them on the open market hoping to purchase them back later at a lower price.

Let’s use a quick example: XYZ is trading at $30 per share, but you think that because of high insider selling, a faddish product, and deteriorating fundamentals at the company, this sucker’s headed to $0 in a heartbeat.

So you enter a trade in your brokerage account to “sell short” 100 shares of XYZ at $30 per share.

This costs you $3,000 plus commissions.

You are now “short” the stock, and are betting that it will DECLINE in value.

In a few months, XYZ indeed falters, and the stock trades down to $20 per share.

Sensing a possible turn in the business, or just wanting to take your profits off the table, you “cover” your short position.

What this means is that you buy back the shares at the current stock price, in this case $20 per share.

So, what you have essentially done is make $10 per share in profit on XYZ’s stock decline, or $1000 excluding commissions.

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Sounds Simple Enough, What Can Go Wrong?

Shorting stocks is extremely risky!

It all sounds pretty glamorous, but shorting stocks is not for the faint of heart, nor those that are not watching their investments on a daily basis.

You see, there are many risks associated with shorting stocks that you don’t get with “going long” or buying shares in a traditional manner.

Some of these risks include:

• Unlimited Potential for Losses: This is a nasty potential risk. If a stock RISES instead of falls when you have sold the shares short, you could essentially lose an infinite amount of money.

In reality, what is most likely to happen is that you would get your shares called back by your brokerage firm before your losses swallowed you alive, but by then you are already sunk.

Let’s take our example from above.

Say XYZ goes from $30 to $60 and you are still short. If you then bought back your shares to “cover” your position, you would lose DOUBLE your initial investment!

It would cost you $6000 to cover your position, while it only cost you $3000 to start the short position in the first place.

So you can see how your losses can keep accelerating as the price of the stock increases instead of decreases!

• Limited Upside: Along those same lines, your potential for profit is limited. The most you can make shorting a stock is 100% of your investment, and this only occurs if the stock goes to $0, which will hardly ever happen even with the worst companies.
• Margin Calls: When you short a stock, you must have what is called a “margin account” which means you are preapproved by your broker to have a sort of revolving line of credit to buy more stock than you have money to buy. Think of this as money you have access to if you want to go above and beyond the cash in your account.

For shorting stock, it is a requirement to have a margin account in order to “borrow” against the sold shares that you are now short.

Here’s where it gets even more potentially risky however.

If you are using this margin to purchase more stock, either long or short, brokers have certain thresholds that they use when monitoring their risk, and assessing your ability to pay back that loan with the current value of the stocks in your portfolio.

If you use too much margin, and your stocks that you have bought long go down in value or vice versa, the broker institutes what is known as a margin call.

What this essentially means is that the broker feels that your risk to the market is too high, and the stock value in your portfolio is insufficient to cover your margin requirements which are typically 50% of your total cash value.

So what happens?

Well, the broker forces you to either deposit more money into your account, or, and this one hurts, sell the stock you have for what usually is a large loss to bring the account back to within certain requirements.

The danger of a margin call is that you will lose more money on a absolute basis, than you invested initially.

For example if you only had $1000 in your account and used margin to buy $2000 worth of stock on a long position (you borrowed a matching $1000), if the stock’s value is cut in half and you are forced to liquidate your position, you would be left with nothing!

Why?

Because when you sold your stock, it went from $2000 ($1000 of your own cash, and $1000 that you borrowed from your margin account), to $1000.

When you sold the stock, that $1000 goes straight to the broker to pay off your debt, essentially leaving you with $0!

You leveraged your money in your account to buy more stock, but because of the decline in the stock price and the margin call, you lose all your money!

Of course, the same works on the upside.

If the stock doubled in price, you would sell for $4000, pay back the $1000 that you borrowed, and pocket $2000 in profit, essentially TRIPLING your money with only a double in the stock price.

This is both the power and the pitfalls of using margin.

In the case of shorting a stock, when the broker gets nervous, or you set off predetermined caps or set points in very sophisticated risk models that brokers use, you’ll get a margin call, and you usually have 1-3 days to make a decision.

You either add more money to your account, or sell off some of your shares to meet your margin requirement.

What happens if you don’t do anything? Oh that’s easy…the broker will do it for you!

Ouch!

• Short Squeezes: This one is also potentially very damaging.

Let’s say you short a company’s stock and there is also a high short interest in the stock, meaning that there are lots of others that also think the stock is poised to fall.

Short interest is defined as the total number of shares held short, divided by the total float.

This gives us a percentage.

It depends on the stock, industry, and business, but usually anything above 10-20% is considered high short interest.

This means that 10-20% of the stock’s total float is held short, or those that are short are betting that the stock will fall.

In a short squeeze, a stock price rise forces those that were short to cover their position, lest they lose even more money.

Most investors that short stocks have a low tolerance for price swings in the wrong direction.

So if a stock with a high short interest goes up, and continues upwards, on earnings, good news, or for whatever reason, you can bet that those that are short are going to be heading for the exits.

This “squeeze” as it is known, is when everyone that was short, trip over themselves to buy back the shares before they get further buried under increasing losses.

So, more buying ensues and the stock price goes higher, which scares more shorts into buying back their shares which, yep you guessed it, makes the stock price race even higher.

If you are long a stock, this is a thing of beauty.

If you are short, it’s another potential risk that you have to watch out for.

• Overall Market Trends: Over time, most stocks rise, not fall.

The most difficult part of shorting a stock is knowing, or getting lucky enough, to time its potential decline.

Even crappy companies and stocks will rise in a bull market, and trying to time a decline in stocks, or the market is an exercise in futility.

Therefore, those that short stocks need to have a quick trigger finger and institute tight stops on their trades to protect themselves from the downside risk.

The worse part about this risk factor, and what often happens to short sellers, is that over time you are going to probably be right that XYZ corp. is a bad company with shady management that’s eventually going to trade for $0.

The problem is knowing when that will happen. It could take years, months, or the price of the stock could trade up for a time before the fundamentals eventually catch up to the stock price.

Fortitude and temerity are required to short stocks.

Oh and a quick trigger finger if you are wrong!

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So Why Do Financial Institutions Short Stocks of Companies They Lend Money To?

Learn to look beyond the obvious reasons for a high short interest

High short interest in a stock isn’t always what it seems.

Many of the companies that I research have a considerable or high short interest.

Some of them are for obvious reasons, for instance GeoEye (NASDAQ: GEOY) has a relatively high short interest due to the possible launch failure of GeoEye-1.

But there is another reason why GeoEye has a high short interest.

It’s the same reason AAR Corp. (NYSE: AIR) has a high short interest.

Let’s use AAR Corp. for our example.

Surprisingly, about 20% (7.4 million shares out of 35.4 million total in the float) of AAR Corp. is held short, but there is a simple explanation for this aside from the mere fact of people betting against the company that is heavily tied to the airline industry.

So why are so many shares held short?

Well, the primary reason for this many shares being held short is a function of AAR’s convertible notes/debt that they had to sell to raise capital for their acquisitions and cash flow initiatives last year.

You see, when a company needs capital to make acquisitions, fund operations or grow their business, they have several choices:

• Straight debt: The company simply borrows money from a bank. This is usually attached with certain conditions, and a high interest rate, depending on the company’s financial situation. This option has not been available to most companies because of the current credit crunch, and if they were able to get money this way, it was at undesirable terms.
• Issue more stock: A company could simply issue more shares of stock on the open market, and raise money this way. The downside with this option is shareholder dilution. You and I certainly won’t like it when our 100 shares is worth less because all of a sudden, the company has flooded the market with more shares of their stock. Think of this as similar to inflation whereby the same dollar buys less milk. You still own a dollar, but it’s worth less.
• Convertible debt: The last way that a company usually raises money is through what is known as convertible debt. Convertible debt is a security that a company issues that gives the holder the right to purchase that particular company’s securities from the issuer at a specific price within a certain timeframe. Warrants are often included in a new debt issue as a “sweetener” to entice investors.

So in the case of AAR Corp., straight debt had a higher interest rate than convertible bonds, so companies like AAR prefer convertible bonds to tapping the equity markets and diluting shares, or taking on straight debt

With convertible bonds there is an option to collect interest and the owner of the bond can convert the bonds to shares in company stock if the stock hits a certain strike price, which in this case is much higher than where AAR sits today.

For AAR’s convertible bonds, one of the lots that AAR sold, for example, has a strike price of $35.57, and then the bonds can be converted into shares of stock.

Once AAR’s stock crosses that price then AAR has to account for the additional share dilution when they compute their earnings per share, and total share count.

When the shares are exercised, AAR pays up to the par value (face value of the bond) in cash, and anything above that they can pay in cash or shares of their stock.

So for an example, it works something like this:

Share price - $35.57/ current price x total underlying shares = total.

Or for an example, using a $40 stock price:

$40 -$35.57 = $4.43/ $40 = .11075 x 7.023 million shares outstanding = 723,000 shares that would be added to the total pool of shares outstanding.

In essence, the higher AAR’s stock price goes, the more diluted their stock becomes because more bonds are being converted into shares of stock.

AAR also has the option to pay them all off in cash and have no dilution, or some mix of shares and cash.

Typically, a bond vs. straight debt is more dilutive, but longer term it’s better for shareholders because it allows the company to borrow money, while giving them lots of time to pay the loan back, all the while giving them favorable terms on that debt that are above and beyond what they would get by using straight debt financing.

In order to continue to grow, AAR needed access to capital, and the high yield markets were closed for new debt with the current credit crunch.

On the same token, if they did get a loan, the interest rates are really high right now, so in the end, the convertible debt is much more attractive.

In addition, straight equity also didn’t work because of the dilutive aspects of it (no one wants to be diluted as a shareholder!), so convertible debt was a great cross between the two.

So what does that have to do with short interest?

Great question!

Now that that’s all out of the way, I can now explain what the heck this all has to do with what typically looks like a high short interest in a company’s shares.

As a result of issuing these bonds, the financial institutions that bought them institute what is known as “hedging” strategies whereby they buy AAR’s convertible debt, and then “sell short” the stock to lock in the difference.

This is what’s known as arbitraging or hedging.

It allows the financial institutions that lent money to AAR to lock in gains, but in order to do so, they have to short the stock, or bet AGAINST it, since they already hold the note worth more than the current stock price.

This way, they are guaranteed a certain percentage return on their investment, but in the mean time, it makes it look like AAR’s shares are disproportionately shorted and that there is more negative sentiment on the stock than there really is.

This is the predominant reason for the high short count in shares of AAR, and GeoEye, but not the only reason.

Some of the other reasons include overall market malaise, uncertainty in the airline industry, high oil prices affecting AAR’s customers, a declining U.S economy leading to less demand for flying, higher prices by the airline industry leading to higher costs, and also the airline industry deciding to cut back on flights, and decommission certain gas guzzling aircrafts.

Any or all of these factors are also contributing to the short interest in AAR being so high.

But with all that being said, the disproportional amount of short interest in AAR and GeoEye is as a direct result of their debt financing and the issuance of warrants or bonds, instead of borrowing money or issuing more stock.

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Bottom Line

Shorting stocks is risky, but necessary

Many traders are very fearful of shorting stocks, and for good reason.

By extension, many traders and Wall Street analysts also look at the short interest of a company they are following as a gauge as to the future prospects of that company.

A high short interest usually means there is trouble afoot, or at least there are many out there who feel that the stock should be much lower than where it sits today.

They could be right, or they could be wrong.

What’s more important than the total short interest in a stock, is where that short interest is coming from, or more importantly, why it’s so high.

Wall Street doesn’t work in a vacuum and neither do the stocks that we invest in.

There are usually good reasons for a stock that has high short interest, and it isn’t always necessarily a reason based on the company’s fundamentals.

Oftentimes a company has taken on so much debt and issues so many warrants or convertible bonds, that the hedging strategies employed by the firms and banks that lent them the money, makes the stock’s short interest appear disproportionately high.

Learn to spot when this is occurring when you are doing your due diligence on a stock or company that you are thinking of either buying for the long term, or shorting for a quick trade.

I believe that every balanced portfolio, and every active trader, should include some short exposure in their balanced and diversified portfolio, but make sure you know the ins and outs well before ever attempt this strategy.

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View original at: PeakStocks.com

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(GEOY) Why Does My Stock Have a High Short Interest? Look at the Debt

GeoEye, Inc. (NASDAQ: GEOY), a provider of space-based and aerial imagery and geospatial information, confirmed on Friday August 15, 2008 that they have received the go-ahead from the government to finally launch GeoEye-1, which will be the most advanced commercial imagery satellite available today.

The launch has been confirmed for September 4th, 2008, which was slightly delayed from August 22nd, 2008, which was delayed from March, 2008, which was delayed…well, you get the picture.

New to the GeoEye story?

• Read my initial buy recommendation here.
• or listen to my EXCLUSIVE interview with GeoEye’s management team here.

GeoEye-1 Ready to Fly…Probably

Company Crosses Its Fingers as Final Preparations Being Made

GeoEye-1

As you’ll recall last week, before their earnings release, GeoEye stated that the launch of GeoEye-1 would further be delayed as a result of a problem with one of the pieces of equipment that is necessary to track and help deliver the satellite to space.

This delay and problems with equipment was not related in any way to GeoEye, or GeoEye-1, but rather to United Launch Alliance (”ULA”, a joint venture between Boeing (NYSE:BA) and Lockheed Martin (NYSE:), which is handling the launch.

You can read more about this delay and why it occurred here.

Once launched, GeoEye-1 will be the world’s highest resolution commercial earth-imaging satellite and propel GeoEye to higher revenues, earnings and exposure as GeoEye-1’s imagery will be used in all sorts of applications, not the least of which is by Google (NASDAQ: GOOG) on Google Earth and Maps, Yahoo (NASDAQ: YHOO) and other online portals.

According to GeoEye, the previously reported retest of a booster range safety antenna was successfully completed on Aug. 14.

GeoEye-1 on Delta II Rocket Booster

The next step in the pre-launch sequence is the mating of the GeoEye-1 spacecraft with the Delta II booster, which will occur early next week.

Bill Schuster, GeoEye’s chief operating officer stated in a statement:

“We are good to go for launch on September 4. We look forward to soon providing the National Geospatial-Intelligence Agency and our other customers around the globe with the highest resolution and best quality commercial satellite imagery available on the market.”

GeoEye-1 will have the highest resolution of any commercial imaging system, 0.41-meters or 16 inches for panchromatic (black and white) imagery and multispectral (color) imagery at 1.65-meter resolution.

However, due to U.S. Government licensing restrictions, commercial customers will have access to imagery at half-meter ground resolution.

In addition, GeoEye-1 is designed to offer three-meter accuracy, which means that end users can map natural and man-made features to within three meters of their actual locations on the surface of the Earth without ground control points.

Here’s an example of the type of imagery that will be taken with GeoEye-1, but even more robust and detailed:

Bottom Line

I’m Crossing My Fingers Too!

The bottom line is that it took GeoEye 4+ years and $500 million to build, insure and finally, launch GeoEye-1.

This is a huge time and money intensive commitment, and the successful launch of GeoEye-1 is a huge part of GeoEye’s future success or failure.

There is risk involved and GeoEye’s share price has reflected that for quite some time, but ultimately, these types of launches are more often than not very successful.

In fact, GeoEye-1 will be launched from a Delta II rocket, which has a success rate of over 98.5%, out of 137 launches overall, with the last 82 in a row being successful.

I think what the market was discounting was the delay in the launch rather than the risk of the launch, but either way, it allowed us, and still allows you, to pick up shares of GeoEye at a nice discounted price from where they were earlier this year, with a huge upside potential in business fundamentals once the launch and check-out of the satellite are successful, and GeoEye finally realizes the revenue and earnings potential of GeoEye-1.

I have written extensively about how this launch is critical to GeoEye’s success going forward and how once launched, will allow GeoEye to service their customers in ways that their competitor DigitalGlobe (NYSE: DGI), will not.

As I had mentioned previously, GeoEye’s imagery is already showing up on Google and other online portals, but the entry of their newest satellite will cement their leadership position as these and other sources, including the U.S. government and foreign governments, constantly need better and better imagery updated on a regular basis.

Let’s hope that this is the last delay we’ll ever have to endure for GeoEye-1, and we can instead start to focus on the benefits of the satellite’s imagery, rather than GeoEye’s efforts in trying to actually launch GeoEye-1 into space!

Stay tuned for more updates as they occur.

• If you are interested in learning more about the launch and tracking the launch of GeoEye-1, GeoEye provided a web page dedicated to constant updates and real-time streaming video of the launch.

You can visit that here:

http://launch.geoeye.com

New to the GeoEye story?

• Read my initial buy recommendation here.
• or listen to my EXCLUSIVE interview with GeoEye’s management team here.

*As of 8-15-08. Except share price, all values in millions.

View original at: PeakStocks.com

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(GEOY) GeoEye-1 Launch Date Set…Probably

Not only is the company going to announce its 2nd quarter 2008 earnings on Wednesday morning, but more importantly, on August 22nd, GeoEye will be launching the most advanced commercial imaging satellite currently available.

The launch of GeoEye-1, which took four years in the making, represents a seminal moment for the PeakStocks.com portfolio recommendation.

The company will either push through to new heights, literally, or fail miserably if the launch proves unsuccessful for any reason whatsoever.

In this post I’ll go over the important aspects that we need to be aware of before GeoEye announces earnings and before the launch of GeoEye-1 and then break them down into the following parameters:

• What went right in the quarter: What were some of the positive developments that occurred within the company in the last 3 months.
• What went wrong in the quarter: What were some of the negative developments that occurred within the company in the last 3 months.
• What I want to see: All things considered, what I realistically want to see from the company as it relates to their business.
• What we need to see: At the minimum, what we need to see for our investing thesis to still hold and an investment in this company to be prudent.
• What we’ll probably see: After weighing what’s been going on for the last 3 months, what we can realistically expect when they do announce their earnings.
• Bottom Line: What it all means, and what you should do.

It’s Make or Break Time for GeoEye

Next 10 Days Will Dictate the Fate of the Company

GeoEye is a provider of space-based and aerial imagery and geospatial information.

GeoEye’s imagery information products enable customers to map, measure, and monitor the earth for intelligence gathering, precision mapping, construction planning, and environmental monitoring applications, among others.

New to the GeoEye story?

• Read my initial buy recommendation here.
• or listen to my EXCLUSIVE interview with GeoEye’s management team here.

GeoEye-1

I can tell you right now that Wall Street is not going to be too interested in GeoEye’s Q2 earnings release, but are going to be carefully listening on the call for updates on the status of their launch, and if they expect any additional delays.

Remember that the launch of GeoEye-1 was delayed several times this year, and was initially expected to launch in early 2008, and has now been scheduled for its August 22nd time slot.

Because of these continued delays, through no fault of GeoEye’s, the amount of revenue and GeoEye’s ability to service their customers with the highest possible resolution imagery allowed by the U.S. government, was severely hampered, and with it, GeoEye’s stock price.

So, with that being said, GeoEye’s Q2 earnings release most likely won’t be very surprising either on the upside or downside because of the delays with servicing contracts related to GeoEye-1, as well as the current backlog that is associated with the wait-and-see approach by GeoEye’s customers that aren’t going to commit to long term contracts before they know they are going to be getting that imagery from the best available commercial satellite on the planet.

What Went Right In the Quarter

Continued Image Utilization, Launch Status Execution

There were several positive developments in the quarter as far as GeoEye was concerned, with continued execution within the company, as well as forward progress and positive developments concerning the launch of GeoEye-1.

One of those developments was a confirmation that GeoEye’s imagery is now being used by Google (NASDAQ: GOOG) on Google Earth and Maps, Yahoo (NASDAQ: YHOO) and other online portals for their online imagery needs.

In addition, GeoEye’s imagery was also being used in other applications such as those of navigational GPS providers, as well as video game manufacturers that are using GeoEye’s imagery, both current and future, in their applications.

Here’s a screenshot of one of GeoEye’s images found on Google Maps:

Screenshot of Google Maps now showing GeoEye as an image provider.

Notice the little copyright at the bottom of the image with DigitalGlobe (NYSE: DGI), GeoEye’s only US competitor, and GeoEye.

On the same token, once GeoEye launches their next generation satellite, GeoEye-1, it will be the highest resolution satellite available today, and thus will garner a larger market share in the competitive online marketplace.

Another positive development for GeoEye occurred on June 4th, when GeoEye announced new awards totaling $22 million to supply geospatial products and related services to the National Geospatial-Intelligence Agency (NGA), GeoEye’s largest customer that accounts for about 50% of GeoEye’s sales.

These products and services include a significant amount of value-added, imagery-based geospatial-intelligence products including the company’s airport mapping product line.

I contacted management and they confirmed that this imagery will be delivered most likely within the next 12 months, so while this won’t vastly improve GeoEye’s finances in the upcoming quarter, it will add incremental revenue that will allow GeoEye to really execute their business strategy towards revenue diversification.

This order from the NGA is in addition to the previously reported backlog that NGA has instituted in anticipation of the launch of GeoEye’s next generation satellite, GeoEye-1.

Also in the quarter, GeoEye began the design, parts acquisition and construction of their next generation satellite, GeoEye-2.

Since these things take 4 years or so to build, test, develop and launch, GeoEye is already looking ahead to when they will need to replace their IKONOS and GeoEye-1 satellite with yet another high resolution next-generation satellite.

In this quarter GeoEye secured the cameras and mirror assemblies that will be used in GeoEye-2, and began work on integrating them.

This is a long process, and securing these types of in-demand parts early in the design schedule is critical for GeoEye.

Finally, and most importantly for us, GeoEye continued to progress towards a smooth launch of GeoEye-1, with their latest update confirming that GeoEye-1 has arrived safe and sound at Vandenberg Air Force Base, California, from where it was manufactured in Gilbert, Arizona.

Remember that GeoEye-1 will be launched from a Delta II rocket, which has a success rate of over 98%, out of 137 launches overall.

What Went Wrong in the Quarter

Miscommunication With Wall Street, Possible Government Contract Losses

Although nothing huge went wrong for GeoEye in the quarter, there were some potential problems on the horizon that we need to be aware of going forward.

First off I’ll touch on the fact that GeoEye missed, what was at the time, the only (there are now 3) analyst’s earnings estimates available on the company last quarter, and the stock was severely punished.

Even though there were very reasonable explanations as to why this occurred, the fact remained that management’s inability to effectively communicate with with Wall Street before and after earnings to explain what was going on regarding the delayed launch of GeoEye-1 adversely affecting revenues and profits, hampered investor’s ability to understand what was going on, and dumping of the shares ensued.

GeoEye has pledged to do a better job of this, and I talked at length with GeoEye’s management team about their communication strategy going forward in my exclusive interview with them.

You can listen to the interview in its entirety here.

The second bit of potential bad news came from a recent government pronouncement that the U.S. government might be launching their own satellite fleet in the future, which would curtail their spending in support of companies like GeoEye and its rival DigitalGlobe.

There has been nothing firmly decided yet, and the report was rather nebulous with dates for the government to start building its own commercial satellites starting in 2014, but this is nonetheless something to worry about.

I talked to GeoEye’s management about this in my exclusive interview with them, and they said that again, nothing has been determined, and they might not know anything until the current U.S. elections have been completed and new budgets are drawn up.

For the time being, things are status quo, with companies like GeoEye and DigitalGlobe putting their weight into the discussion to make sure that they are being properly supported by the NGA and the U.S. government, especially in light of the fact that the NGA helps to pay 50% of the cost of building and launching a satellite.

Also, under these mandates as reported, for now anyway, the government will step up their efforts to buy more imagery from these two companies to the tune of $1 billion under their current agreement.

The Pentagon’s plan to both buy commercial satellite imagery and operate similar satellites of its own is an attempt to balance two competing goals.

National space policy requires the Pentagon to buy as much commercial imagery as possible to help companies like GeoEye withstand competition from subsidized foreign satellite companies.

But, at the same time the Pentagon does not want to give these companies so much business that they tailor their services to government needs and ignore the private sector they need to make them self-supporting.

The Pentagon satellites will also be a back-up capability in case future commercial satellites malfunction.

I don’t think that GeoEye is relying on the government to the detriment of their commercial business, especially in light of their recent purchase of aerial imagery company MJ Harden, and their expansion into other commercial fields such as online portals, and other applications that take GeoEye away from purely governmental business.

However, these are things we need to watch out for, and get more clarity on as time moves forward.

What I want to see

Decent Quarterly Results, Obvious Successful Launch

Most likely, GeoEye’s Q2 results won’t be anything spectacular as a result of the delays in launching GeoEye-1 and the deferred revenue associated with that delay.

So, as long as GeoEye reports a quarter that is in-line with last quarter, that’s about all I want to see this time around.

I also want to get some color on the conference call about GeoEye’s business prospects, any updates on the U.S. government’s spending/contracts, and of course an update on the launch of GeoEye-1.

To be honest, almost nothing else matters on this call, aside from absolutely devastating news, except the status of the launch of GeoEye-1.

Any further delay and the stock will take a big hit.

What We Need To See

Continued Execution, Calm Words

What we need to have happen on the conference call and associated press release, assuming GeoEye finally puts one out, is calming words to the ears of Wall Street.

GeoEye basically needs to explain themselves much better than they have in the past, whether that’s in their earnings press release, their analyst conference call, or preferably, both.

Like I said, I don’t expect GeoEye’s earnings to be anything special, but that’s not what we’ll be listening for.

The devil will be in the details, and we’ll be scanning the press release, and listening to management’s words carefully to make sure all is on track with that all-important August 22nd launch.

What We’ll Probably See

Continued Execution, Explanation

I expect GeoEye’s management team to deliver on their promises of better communication with Wall Street and the few analysts that cover their stock, as well as give a nice reassuring report on GeoEye-1 and the launch status.

Anything else on the plus side, including better than expected earnings and revenue, will be a bonus.

Bottom Line

GeoEye Still Best-In-Breed

There are only two companies that operate in this space: GeoEye and DigitalGlobe.

Out of those two, GeoEye is the superior company both in terms of future business prospects and diversity, the GeoEye-1 launch notwithstanding, as well as current execution, and management.

Owning shares of GeoEye into the launch is somewhat risky, even with the stellar track record of the Delta II rocket and all associated companies involved with the launch.
The problem is, owning shares afterwards would most likely significantly reduce some of your potential share price appreciation since most of the risk would be taken out of the stock, and more buyers would jump in with the knowledge that the spigot is now turned on with GeoEye’s business model, and higher revenue and profits are right around the corner.

My talks with management, as well as my thorough research on this company lead me to believe that everything that is within GeoEye’s power to do, has and will be done, to not only ensure a more successful relationship with Wall Street, but also see to continued execution of new commercial contracts to expand GeoEye’s business, and the successful launch of GeoEye-1.

For those that are more risk averse but still want to own a piece of such a dynamic and undervalued company, you can simply wait until after earnings are released and GeoEye-1 successfully launches, or purchase a small position now at these levels and see what happens.

If you are more of a risk taker, then purchasing shares at these levels still represents a good bargain, even though the stock has appreciated from where I initially recommended it.

GeoEye is still a STRONG BUY either going into, or coming out of their next earnings release, and/or the launch of GeoEye-1.

Short of an absolute disaster, we’ll look back on the share price of GeoEye at today’s prices as an absolute bargain.

I recommend you get in now.

Oh, and if you are interested in learning more about the launch, and tracking the launch, of GeoEye-1, GeoEye has provided a web page dedicated to constant updates and real-time streaming video of the launch.

You can visit that here:

http://launch.geoeye.com

New to the GeoEye story?

• Read my initial buy recommendation here.
• or listen to my EXCLUSIVE interview with GeoEye’s management team here.

*As of 8-8-08. Except share price, all values in millions.

View original at: PeakStocks.com

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(GEOY) GeoEye: It’s Make or Break Time, Literally

AuthenTec (NASDAQ: AUTH), the world’s leading provider of fingerprint sensors and solutions to the PC, Wireless and Access Control markets, released their Q2/2008 earnings and held their analyst conference call Monday, July 28th after the market closed.

AuthenTec’s ability to consistently deliver results and beat analyst’s expectations both on the top and bottom line continue to bolster my faith in the company, their management team, and continued execution.

An investment in shares of AuthenTec, especially at today’s prices, are warranted, and their latest conference call and earnings announcement do nothing but crystallize my investment thesis.

What follows is a summary of AuthenTec’s earnings announcement, conference call highlights, and my take on the company’s latest quarter and results.

Click here to read my complete AuthenTec research report and buy recommendation

I’ll break down this report into 4 parts:

• Hit Me With The Numbers: Sales, Earnings, Margins: All Up
• Other Business Highlights: Slightly Lower Guidance, Higher Operating Margins
• Conference Call Highlights: Litigation Update, New Design Wins, Economic Impact
• Bottom Line: Nothing’s Changed: AuthenTec Still a Strong Buy

Hit Me With Some Numbers

AuthenTec Beats Estimates Once Again

Here are some of AuthenTec’s earnings highlights (growth from previous year’s Q2/analyst’s estimates where applicable):

• Record quarterly sales of $18.4 million (up 49.6% from prior year/vs. $17.37 million projected by analysts)
• Non-GAAP quarterly income of $1.2 million (up from a -$.57 million loss in the prior year)
• GAAP quarterly income of $.65 million, or $0.02 per diluted share (up from a -$6.7 million, or $7.37 per diluted share, loss in the prior year)
• Non-GAAP $0.04 earnings per share (up from a -$.03 loss in the prior year/vs. $.03 projected by analysts)
• Gross margin improves to 48.5% (up from 45.0% from prior year, but down sequentially from 49.6% in Q1/2008)

My Take: Another solid quarter for AuthenTec in every sense of the word. I would never dare say this is old hat because in this market environment, a company the keeps delivering results like this quarter after quarter is hard to find, and never gets old!

Revenues came in much higher that what AuthenTec had guided last quarter and clocked in about 6% higher than analyst’s estimates, which is a solid top line number.

Earnings per share also beat estimates, and the improvement in gross margin year over year was a huge bonus.

One small downside was the slight decline in gross margin from the first quarter.

This was simply the result of new product introductions (of which AuthenTec has had many in the last few months) that always lower margins initially before they scale, and more and more efficiencies are squeezed out of the manufacturing process and volume, thus increasing margins in later quarters.

Other than that, everything looks very nice, and I have no complaints at all, even with AuthenTec’s slightly lowered guidance for next quarter and in-line guidance for the year, I’ll explain more below.

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Other Business Highlights

Slightly Lower Guidance, Otherwise Solid Business Trends

• For the 3rd quarter of 2008, AuthenTec is projecting sales of between $19.0-$20.0 million ($19.5 mid-line) vs. analyst’s estimates of $20.22 million.
• For the 3rd quarter of 2008, AuthenTec expects non-GAAP earnings per share to range between $0.04 to $0.05 per share, compared to a profit of $0.03 per share in the 3rd quarter of 2007, vs. analyst’s estimates of $.05 per share.
• For the entire fiscal year of 2008, AuthenTec is projecting sales of between $72 million-$78 million ($75 million mid-line), which is in line with previous projections, vs. analyst’s estimates of $77.1 million.
• The 50% year-over-year revenue growth primarily reflects growth in the PC segment of AuthenTec’s business driven by increasing attach rates and the initial ramp of the new AES2810 sensor.
• Operating expenses as a percent of revenue decreased to 45% from 49.6% in the year-ago quarter.
• Margins expected to range from 47-49% for the rest of 2008 because of the ramp-up of new chips with lower yields and inefficiencies typical of new product introductions and scaling.
• $66.6 million in cash and investments vs. $67 million in Q1/2008.
• Operating cash flow was $545,000 in the quarter
• Capital Expenditures (CAPEX) were $779,000 in Q2, which was an increase from the $190,000 reported in Q1. The increase is primarily related to equipment purchases supporting the manufacturing and test of AuthenTec’s new products.
• Cash Flow: about $400,000
• Inventory increased to $7 million which represented 68 days on hand, compared to Q1/2008 which was $4.1 million or 48 days on hand. AuthenTec says that this increase is primarily due to the build up of inventory to support their customers ramp up for the third quarter of this year.
• Sales breakdown was as follows: PC segment about 85% of total sales, Wireless segment about 13.5% of total sales, and Access Control was about 1.5% of total sales.
• Top five customers in Q2/2008 accounted for 70% of revenue vs. 87% in Q2/2007.

My Take: Everything checked out just fine this quarter in AuthenTec’s business segments and other business trends.

Some of the good: 50% year-over-year revenue growth, continued margin expansion, continued penetration into the PC market (more below), reiterating guidance.

Some of the not-so-good: At least in the market’s eyes, is that AuthenTec slightly lowered guidance for Q3, and the mid-line of their previous guidance for all of 2008 was slightly lower than what Wall Street was expecting, also there was increased inventory and capital expenditures.

So, overall, I am quite pleased with the quarter’s more finite details.

AuthenTec’s guidance was in line with their previous guidance, especially for the entire year, but slightly less than what Wall Street was looking for, but that’s nothing at all to be alarmed about, and one of the reasons I hate when companies give guidance at all.

At one time or another, you are going to “miss” guidance, whether real or perceived, and it looks like analyst’s got a little carried away for the entire year forecast and AuthenTec is just managing those expectations in light of possible economic factors (more below).

I was a little bit alarmed by the greatly increased inventory, but because AuthenTec had introduced 3 new products, they obviously had to ramp up production to make sure they had enough of the sensors on hand that were going to be the most popular with the highest attach rates.

In fact, this bears itself out by the mere fact that AuthenTec ’s revenues were even higher this quarter than they had previously guided, which was also increased significantly from the quarter before!

It’s obvious they are gaining massive traction in the PC market with several wonderful design wins (more below), and their products are being incorporated in about 55-60% of all PC laptop models shipping with fingerprint sensors and they are taking more and more market share from their competitors.

I’m ok with the increased inventory, and higher CAPEX, as AuthenTec is taking advantage of improved business trends and demand for their sensors to increase production, and be ready when their customers come calling for more sensors.

There is nothing in these numbers that alarm me at all at this time.

Finally, as for operating margins, it’s obvious that AuthenTec is really starting to leverage more of their top line to the bottom line.

They are managing their expenses and Research and Development (R&D) spending wisely so that whenever they do get a bump in orders, instead of just keeping that money in the form of profits and cash flow, they are smartly reinvesting it into more R&D and their sales team.

It could be that Wall Street might get impatient for the “big payoff” down the road, but I am more than happy with the way AuthenTec is handling their extra cash, and sales to further distance themselves from the competition, and increase their product offerings, improve the products they already have, and take the opportunity to increase their sales force to get more of their fingerprint sensors into more and more PC’s and wireless devices.

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Conference Call Highlights

CEO Talks About How Economy Might Impact AuthenTec Going Forward, New Design Wins and Product Expansion

The following are the highlights from AuthenTec’s analyst conference call:

• The Economy and its Affect on AuthenTec: Speaking of the economy, an analyst asked if AuthenTec was still seeing things remain strong for them in light of what is going on in the consumer market and the overall economy, and the CEO stated that even though every day we hear more horror stories about things being bad, they are seeing continued strong interest as well as demand in their products and future products and are even seeing more traction in the cell phone market.

He finally stated that as they went into the year they were relatively pessimistic about the overall economy, and he was pleased that they have been able to attain or retain the guidance they have provided.

Another analyst then came straight out and asked why, with the slowdown of the economy, it does not seem to be slowing AuthenTec down.

The CEO then answered that one of the reasons is because they are in many of the higher end laptops, which are more immune to downturns, and although they are not in some of the more cyclical consumer laptops, that frankly over time, they would like to be, regardless of their potential to be affected by slowing economic times because of the large market opportunity.

Along those same lines, he also mentioned that AuthenTec has introduced new customers to new products, which in turn means that they are in more laptops than they were last year, so the attach rate is up.

The CEO then admitted that the slowing economy probably has to be having some effect on them. He stated that if the economy was better, their numbers in Q2 could have been higher, in addition to being higher for the year.

So, that being said, he stated that one of the big reasons why they haven’t appeared to be affected yet by the slowing economy is because they did a reasonable job going into the year with lowered expectations of the economic outlook.

Then the second factor the CEO stated to AuthenTec remaining strong in this environment is that whatever effects the economy or the markets are producing overall, AuthenTec is making that up with new customers and a higher attach rate.

An analyst also asked if the CEO could give some insight into how AuthenTec was able to win those new design integrations and what those customers saw from AuthenTec that made them make the change from a previous supplier.

The CEO stated that AuthenTec basically took what had previously been a two-chip solution (where the fingerprint sensor would have to interact with another chip either within the computer or attached to the fingerprint sensor to verify the user’s identity), and made it a one chip solution which made the process much more secure and attractive to those PC manufacturers.

My Take: Finally after about a year or so of asking the same question, CEO Scott Moody finally gave analysts what they were looking for.

Namely, a straight answer as to how AuthenTec is able to keep kicking butt and raising guidance and growing sales astronomically, when it looks like every other business, and especially those in the semiconductor industry, are getting crushed right now by the declines in the economy and consumer spending.

It’s obvious to anyone that pays attention to these things that if PC sales or cell phone sales decline, then it tends to follow that PCs and cell phones with fingerprint sensors in them would also not sell as well.

But here’s the important thing to remember: Even with this slowdown, AuthenTec just reported a quarter where they increased sales 50% year over year!

Not only that, but management was able to have the visibility and foresight to manage their guidance to Wall Street such that they have NEVER missed earnings expectations in every single quarter as a public company, and have usually always guided revenues in line to higher as well.

In this environment where Wall Street is always waiting for the other shoe to drop, a smartly run company like AuthenTec is uniquely positioned to take advantage of growing consumer trends towards higher levels of security in their PC’s, laptops and cell phones, while at the same time managing sales and profit expectations.

As you can see from analyst’s comments on the call, they were completely perplexed as to how the heck AuthenTec keeps increasing sales, margins and profits while other semiconductor manufacturers are getting hammered.

It’s obvious that AuthenTec is doing things right in this department, and are running a tight ship, with good visibility in their business.

• Patent Infringement Suit Update: AuthenTec briefly updated their patent infringement suits that were pending with Atmel Corp. (NASDAQ: ATML) and Atrua Technologies, one of which has been ruled in favor of AuthenTec.

The CEO ended his prepared remarks be stating that:

“…while patent litigation can be expensive, I see it is something more akin to an investment than simply a tactical exercise.”

While AuthenTec didn’t go into great deal about the pending litigation, they gave a little color on the suits that were being filed.

First off, as I previously reported, AuthenTec’s patent litigation that was brought about against them by Atmel Corp. has since been dismissed and AuthenTec has won the summary judgment.

You can read all about that verdict here.

The CEO went on to explain AuthenTec’s latest summary judgment win against Atmel, and their most recent case against Atrua Technologies in which they have now modified their original suit by adding two additional AuthenTec patents to the original three patents cited in the March 2008 lawsuit, which brings to 5 the total number of patents that AuthenTec is alleging Atrua infringes upon.

He also noted that AuthenTec is also considering further additional modifications to this suit.

You can read the whole background on AuthenTec’s latest suit by and against Atrua Technologies here.

My Take: Well, here we go again I guess. Just when AuthenTec lifted a burden off their back by winning their suit that was brought against them by Atmel, now they are suing, and being sued by, Atrua Technologies.

Hey, might as well go for it right? If you are going to be brining all these infringement suits against a company, you might as well list all of them at once and see which ones stick.

Patent litigation is messy and oftentimes expensive. While it is clear that AuthenTec should defend their intellectual assets, characterizing these lawsuits as “investments” is probably not quite the right terminology.

We’ll have to stay tuned to see where these latest infringement suits lead AuthenTec and how they turn out.

As it stands, look for AuthenTec to spend about $150,000 in legal fees this quarter, rising to potentially $.5 million in the back half of 2008.

• New Product Design Wins: AuthenTec stated that two sensors, the AES2810, and the AES1610, have now been designed into a number of Centrino 2 models being introduced by their OEM customers in the second half of this year.

You can read about AuthenTec’s three newest sensors and sensor packaging technology called TouchStone, here.

AuthenTec also stated that the three newest PC sensors that were introduced recently, are now being designed into new PC models from eight of the world’s top 10 notebook PC OEM’s.

The CEO also stated that within the PC market, their AES2810 sensor has been integrated into actual products from manufacturers that they previously couldn’t mention, but have turned out to be: HP (NYSE: HPQ), who introduced five business notebook PC models featuring the AES2810 sensor, Dell (NASDAQ: DELL), which announced the first of their new laptops featuring the AES2810 sensor which included the new Studio 15 and Studio 17 notebooks, and Lenovo’s ThinkPad series of laptops.

Also noted on the integration front was AuthenTec’s sensors being integrated into many laptops now offering the AES1610 sensor such as Toshiba’s new Protege R550, reportedly the world’s lightest laptop, as well as two new ASUS ultra-mobile portable PC’s, the R2 and the R50.

There were several other product wins and integrations including new integration into more tablet PC’s among others.

As far as the wireless market, AuthenTec spoke about their product wins in the Japanese wireless market and the continued interest outside of Asia. The CEO didn’t announce any new wins outside of Japan, but he said they were cautiously optimistic that they would see continued expansion in this market in the coming quarters.

AuthenTec also reiterated that their newly opened offices in Japan were created and staffed with the sole purpose of supporting their customers in the wireless and PC markets there that included: Fujitsu, Toshiba, Lenovo Japan, Hitachi, JRC, Sony, along with several others.

My Take: These are some huge PC wins, and as I’ve stated before, once AuthenTec’s sensors are integrated into a client’s products they are likely to stay there for a long time to come.

With this added traction, notoriety and design wins, AuthenTec is further positioning themselves to take more market share in the PC segment, and get their chips into more and more large, high vol