Thursday, March 10, 2011

Why Nintendo is in no hurry for Wii2

Nintendo has three functions in the video game business of which most journalists and analysts seem to focus on just one. Today I'd like to look at the health of the Wii platform in reference to those three areas.

Hardware manufacture

Most Nintendo observers focus on it's hardware business. While Nintendo hardware has blown away the competition in recent years, so far this year the Wii platform seems to be falling behind.
Worldwide Hardware 2011 (YTD)
Console Yearly    Total
------- ------    -----
PS3     1,817,179  48,163,035
DS      1,743,582 145,707,365
X360    1,677,025  52,065,666
Wii     1,676,899  85,336,683
PSP     1,046,947  66,433,522
PS2       474,050 142,132,409
3DS       374,164     374,164
Total   8,809,846  
(All charts taken from VGChartz.)

Considering that the DS, in its various forms, has been the best selling game machine since 2006, Nintendo did well to shift to the 3DS, which seems to be off to a fast start. Meanwhile, the Wii maintains a large lead in total consoles sold among current systems, but is clearly losing momentum at an alarming rate. Since this is the number most people focus on, Nintendo seems to be in trouble. By 2010 the handwriting was on the wall for both of Nintendo's platforms:

Worldwide Hardware 2010
Console Yearly     (change) Total
------- ------     -------- -----
DS      21,445,632 (-25%)  143,963,783
Wii     18,345,329 (-15%)   83,659,784
PS3     14,443,529 (+11%)   46,345,856
X360    13,606,638 (+34%)   50,388,641
PSP      9,298,210 (-11%)   65,386,575
PS2      4,591,780 (-24%)  141,942,000
Total   81,731,118 (-9%)  

It's important to know that historically Sony and Microsoft lose money on each console sold and Nintendo makes a moderate profit. This late in the console cycle, it's likely that all three consoles are making money, but Nintendo has always profited from Wii sales. In addition, the Wii's already large install base makes selling new consoles harder.

Software publishing

Nintendo's second role in the industry is as game publisher. In this case, Nintendo's DS and Wii game sales far exceed all competitors with the possible exception of EA.
Worldwide Publisher Totals 2011 (YTD)
Pos     Publisher                    Yearly
---     ---------                    ------
1       Nintendo                    10,901,624
2       Electronic Arts              9,019,470
3       Activision                   6,813,847
4       Ubisoft                      6,694,007
5       Sony Computer Entertainment  4,922,930
6       Microsoft                    3,724,148
7       THQ                          3,303,488
8       Sega                         2,674,190
9       Capcom                       2,568,090
10      Namco Bandai                 2,540,164
While Nintendo has a big lead over EA in terms of unit sales, that seems to include games packed with hardware and does not include downloadable content. So while it's conceivable that EA and Activision have been more successful, by no means is Nintendo failing as a publisher.

Most publishers rely on a hit game system which results in huge sales in the months following a game's launch after which they move to the next title. Nintendo, which has been the leading publisher for years, has been able to create and market "evergreen" titles that sell well for several years. Along with Microsoft and Sony, Nintendo has the advantage that each software release increases the value of their hardware business. Nintendo re-releases titles from their back catalog more successfully than any other competitor. Each of these strategies minimize development costs and increase profits both for DS and Wii games.

Platform licencing

Finally, Nintendo takes a cut of every title sold for one of its platforms. When it comes to evaluating launching a new platform, total software sales has to be a primary consideration. A new console is a huge expense and risk for the manufacturer, consumer and game publishers. The only people who benefit with certainty from a console launch are the journalists who cover the story. As long as games are still selling on a hardware system, there's just no reason to replace it.
Worldwide Software Totals 2011 (YTD)
Console Yearly     Total       (tie ratio)
------- ------     -----       -----------
Wii     22,696,263 637,024,525 (7.46)
PS3     18,246,636 349,149,161 (7.25)
X360    18,227,812 476,688,453 (9.16)
DS      13,323,937 650,342,875 (4.46)
PSP      6,130,249 195,271,066 (2.94)
PS2      1,773,060     n/a
PC       1,349,242     n/a
3DS        344,446     n/a
Total 82,091,645
By game sales, the Wii is still the most successful console due in part to its massive install base. Notice that a console, such as the PS2, can enjoy a very long software life after production ends. A critical statistic for a console is the tie ratio, which compares the total games per console sold. The average Xbox owner has a library of 9 or so games while average Wii and PS libraries hold just over 7 titles. Since people continue to buy software after they buy the console, the number will tend to increase over the life of a system, which is why the oldest system has the highest number. Handheld tie ratios will naturally be lower if only because some households will buy multiple systems and share a software library. Tie ratios matter to the consumer because the more games they own and enjoy, the better value they wring from the console. They matter just as much to a hardware manufacturer because they represent incremental profit on top of the original hardware sale.

Worldwide Software Totals 2010
Console Yearly      (change) Total       (tie ratio)
------- ------      -------- -----       -----------
Wii     182,616,765 (+2%)    614,328,262 (7.34)
X360    141,041,533 (+24%)   458,460,641 (9.10)
PS3     126,996,359 (+38%)   330,902,525 (7.14)
DS      119,157,411 (-17%)   637,018,938 (4.42)
PSP      40,577,954 (+9%)    189,140,817 (2.89)
PS2      15,938,237 (-42%)       n/a
PC       10,153,009 (-)          n/a
Total   636,481,268 (+7%) 
This chart shows the 2010 sales by platform and reveals that Wii software actually increased year-over-year, though not nearly as much as its rivals. The DS, meanwhile, entered the decline portion of its life-cycle, which pushed the introduction of the 3DS. Since the company will not be able to support two simultaneous console launches, a Wii sequel wasn't in the cards for 2011. But if Wii sales slow this year, Nintendo may need to announce its next console soon.

Wednesday, October 20, 2010

Nintendo's next console

David Radd wrote an article titled Why 'Wii HD' Just Won't Happen, which argues that

At the end of the day, I think there will be a successor to the Wii console, and yes it will have HD capabilities, but it probably won't come for at least a couple more years, and it will add far more than a simple bump in processing power and resolution.
I couldn't agree more. While it's far too early to make any solid guesses about what Nintendo will imagine for a Wii successor (the very ambitious 3DS will command their limited attention for the next year or so), we can speculate about it's incremental and sustaining improvements.

Judging from the 3DS rollout, the next Nintendo console will:

  1. Drop hardware GameCube compatibility
  2. Retain Wii compatibility
  3. Retain Virtual Console and WiiWare compatibility
  4. Support HD output
  5. Incrementally improve online functionality
  6. Incrementally improve anit-piracy measures
  7. Do something completely unexpected
Given those postulates, we can infer the new system will:
  1. Support the Wiimote and have a sensor bar
  2. Include a disk drive
  3. Support transfer of Virtual Console and WiiWare titles from the Wii
  4. Include HDMI and adequate processing power for HD graphics
  5. Continue to include built-in WiFi support
  6. Be a shock when first announced

What strikes me about the above conclusions is that the physical proximity between the system and the TV will be more important than the proximity between the system and the player. In fact, if there were no need for a disk drive and a sensor bar, the console could be completely hidden from the user. I could easily imagine digital distribution could allow Nintendo to eliminate the disk drive as Sony attempted with the PSP Go, though properly managing game transfers would be a challenge. With care, such a system could dramatically reduce piracy while also eliminating the annoyance of changing physical media.

Another clue about how the company operates comes from an interview with Miyamoto:

Miyamoto: If you think for yourself about what's wrong with your idea, and you understand the reasons why it's no good and get a handle on the problem, then you're sure to be able to use that idea sometime.

Itoi: That's right. It's a waste if you just say, "Oh, that idea's no good," and forget about it.

Miyamoto: That doesn't lead to anything. That's why, while I used to tell people to store up ideas in a drawer, I recently suggest putting ideas that were no good into a draw[sic] with the reason why they were no good affixed to them. Like writing the reason on a label.


Itoi: So you can toss an idea in storage, but it stays alive.

Miyamoto: Yes, while I stay hung up on the reason it won't work. Then one day I realize I can take off the label. When there's momentum to take off that label, I suddenly get so excited that I can take off other labels too. Things that used to appear little negative were offset and showed no real bad effect.

Among the ideas that Nintendo has resurrected are the Power Glove (the Wiimote captures the basic premise of the controller), the Power Pad (neatly replaced by the Wii Balance Board), and the Virtual Boy (the 3DS promises to correct most problems with stereoscopic 3D). But there are dozens of ideas that have either failed in the marketplace or could be updated for the modern gaming environment. For your consideration, I propose the next console will include an update to R.O.B.. I know it's crazy. We don't need another piece of plastic cluttering up our living rooms. On the other hand, it's just the sort of out-of-left-field idea that Nintendo has made to work over the last few years.

Wednesday, September 29, 2010

Why I bought Nintendo

I recently bought ADR shares of Nintendo at $35 a share. To be completely honest, I did almost no upfront valuation or analysis of the company. I just like their products. But looking back at the decision, it actually makes sense.

For starters, if you take the most recent annual dividend ($1.25 per ADR) and discount it at the current 2% you could get from a Japanese government 30-year bond, you get a fair value of $62.50. Against the more reasonable US Treasury 30-year (3.875%) the fair value is $32.26 assuming no growth. Given Nintendo closely ties it's dividends to earnings based on a formula and that Nintendo's earnings are likely to increase in the next 5 or so years, the dividend discount model suggests buying the stock. (As I write this, Nintendo has announced that earnings and therefore the dividend will be reduced for the fiscal year ending March 2011, but that could not have factored into my decision. I also think the announcement will prove irrelevant to long term value. More on this below.)

Understanding the company's past might help us glimpse the company's future. 92 years before Donkey Kong (1981) was released, Nintendo made traditional Japanese cards called Hanafuda. Until, 1963 the company manufactured playing cards (including western-style decks) at which time Nintendo branched out into other games, toys and novelties. It was a seminal moment that shifted the focus from pure industrial design and manufacturing to considerations of experience design. Having great looking and well-built decks enhances the experience of playing a card game, but the enjoyment of the game comes from the rules used to play it. A puzzle, like Ten Billion Barrel (1980), must be designed with the whole experience in mind: puzzle conception, design, manufacturing, packaging, cost, instructions, marketing and so on. Before 1963, Nintendo was a pure hardware company and afterward became a hybrid software/hardware company.

All early video game companies (Atari, Magnavox, Philips, RCA, Coleco, Midway, Milton Bradley, Mattel, VTech, Commodore, etc.) were hybrid companies out of necessity—true game platforms had not yet been created. Most of these companies either dropped out of the video game industry or shifted focus to either hardware or software. Nintendo alone survived the primordial era with a complete gaming ecosystem under it's control. In fact, Nintendo is the only company that manages two major platforms outside of Japan with it's handheld and home console lines. Much of their early success must be attributed to designers such as Gumpei Yokoi and his protégé Shigeru Miyamoto who began their careers designing physical toys and games.

Nintendo has always taken advantage of Moore's Law by releasing electronics that are behind the leading edge of technology. For instance, the Game Boy handheld was less capable that either the Atari Lynx or the Sega Game Gear, but was also both cheaper and more profitable. Since the chips became less expensive over the life of the system, the retail price dropped further and Nintendo continued to make a good profit on the device. As it became clear to game developers that the platform was the most popular handheld system on the market, they produced more games which increased the hardware's value to the consumer. This same virtuous pattern has cropped up in the DS and the various consoles Nintendo has released.

Along the way, Nintendo has also excelled at producing high quality game franchises. Mario, Metroid and Zelda games are among the highest-rated games of all time. Not coincidently, Nintendo also boasts many of the best-selling franchises in video games, including Pokémon. Since the Philips CD-i debacle, Nintendo franchises are available exclusively on Nintendo hardware creating a sort of killer app for each hardware generation. Software, as always, sells hardware and not the other way around.

Nintendo's future path is fairly well laid out at this point: release new games, new hardware to facilitate those games and further exploit licencing opportunities. Recent history shows that more and more people take up gaming as time goes on, so Nintendo must continue to find new ways to get people into their games. Which is to say, they must continue doing what they are doing.

No game platform lasts forever as players need constant new experiences to stay interested and engaged. Both the DS and Wii platforms have also sold into nearly their entire market at this point. Therefore, Nintendo has already announced their next handheld device called the 3DS. A replacement for the Wii is certainly in the works and ought to be released in the next few years. In my opinion, there are a number of keys to a successful launch:

  1. Backward comparability—Allowing new platforms to play games designed for current systems both gives consumers a better value (at minimal cost) when they upgrade and extends the current system's viability for developers. Given Nintendo's massive current install base, there will likely a market for Wii and DS games for years after replacement machines go on sale. We've seen this happen for Game Boy Advance and PS2 software.
  2. Improved functionality—On the other hand, a new system must offer something substantially different than what is already available for consumers to risk an upgrade. More than any other company, Nintendo stakes it's reputation on delivering novel gaming hardware. From the D-pad to 3D technology, new hardware always adds some significant gameplay improvement over the previous platform. (As an aside, simply upgrading the Wii's visuals to HD would do little to change gameplay. A more radical update will be required.)
  3. Strong first-party launch titles—A critical factor for Nintendo especially. A single Mario or Zelda title can make the difference between buy and wait for many consumers. The Wii broke sales records last holiday season on the back of a throwback Super Mario Bros. sequel.
  4. Third-party developer buy-in—Conversely, Nintendo rarely needs third parties to help sell hardware. Still, third party games at launch suggest to the consumer that there will be plenty of new experiences to be had once you've beaten Bowser for the umpteenth time. For the 3DS, which carries the stigma of Nintendo's previous foray into stereoscopic 3D (the Virtual Boy), having so many developers building software for the system could make all the difference.
  5. Priced to give better value than competitors—For much of Nintendo's history, it's hardware sold for less than all competitors. A massive exception to the rule has to be the North American release of the original Nintendo Entertainment System bundle in 1985. But given the incredible value of the NES throughout its life in terms of better games, graphics, sound and peripherals, the machine was priced to be the best selling system of its era. Ultimately, the better Nintendo does on the first four points, the higher price they can set on hardware while remaining competitive.
  6. Available—Sometimes you hear that Nintendo purposely held back supplies of the Wii or DS to whip up demand with artificial scarcity. But while companies (especially hardware manufacturers) love to see inventory flying off the shelves, they don't like seeing their products resold for twice or thrice the retail price on eBay the week following a system launch. Frothy demand on day one that leads early adopters to sleep over night on the street turns into mocking dismissal a year later. Worse, a successful long-term platform requires those early adopters to evangelize their friends and relatives, but not having enough systems to sell cripples the process.
Technology adoption life cycle

From the above list, Nintendo seems to be handling the 3DS perfectly. Delaying the launch in Japan, while missing an important buying season, will not hurt the system in the long run if it improves availability and eliminates bugs. It's not hard to picture Mario fan-boys and tech-nerds rushing out to get their hands on the world's first stereoscopic 3D device that doesn't make you look like a dweeb, but the public at large will need to be sold on the system's value before it will shell out console cash for a handheld. That remains true whether the system is released before or after Christmas.

Tuesday, November 25, 2008

The benefit of a concentrated portfolio

Today is my portfolio's biggest one day change: 16.33%. The S&P 500 barely moved up 0.66%, so my gain came from the stocks I happen to hold. First Marblehead shot up 64.71% because, I suppose, of news that Leslie Alexander (the company's largest investor) bought more shares. Random fluctuation sent Select Comfort up 28.57%. (When a company costs a quarter a share, a few pennies change in price makes a big relative difference.) Berkshire Hathaway is up 8.95% as investors figured out the company is not going to fail after all. So just a few big moves in companies I happen to own make a huge difference.

Of course, there's a cost as well. On the year, my IRA has lost more than half it's value due almost entirely to awful results from First Marblehead (down 91%) and Select Comfort (down 96%). Digging out of a hole like that will be very tough even with days like today. Both these stocks represent value traps that should have been sold long ago. I'd sell Select Comfort today except it will cost too much in commission. (I am shopping some December call options, but my limit price won't be filled any time soon, I think.)

Friday, November 21, 2008

Best one-day return ever

My IRA shot up 10.93% today. Of course, it's still down 62% this year compared to 45% for the S&P 500. So no celebrating yet. My 401(k) is only down 40%.

Thursday, October 23, 2008

Why I bought even more First Marblehead (or why I'm a glutton for punishement)

After I sold my Canon shares and put money down for a house, I had some cash left over. Today, I used that cash to buy First Marblehead at $1.42 a share. That is less then 10% of what I paid for shares way back in February. In the meantime, the credit markets have fallen apart, TERI has filed bankruptcy and First Marblehead has slashed the accounting value of its trusts.

Even so, I think the company is an even better buy than it was nine months ago. The liquidation value has fallen to about $4 a share, so the market has priced in a considerable chance of complete failure. Further, the residuals are priced as if they are extremely risky—they must be discounted at 25% yield in order to get a $1.42 price. I've been greedy all the way down, so I'm not the best person to ask. On the other hand, there just don't seem to be any more shoes to drop.

One thing I know, this market makes me feel really dumb.

Tuesday, October 14, 2008

Why I sold Canon

I'm pretty far behind in updating my transaction diary. Partially that's because I don't want to think about the carnage done to my portfolio in recent weeks and partially because I got busy with other things (i.e. buying a house). Because I need some cash to use as a down payment, I sold off my Canon shares at a price less than what I consider to be their value. On August 6, I got $46.49 a share. The first lot (bought in December, 2003) returned 62% compared to 6% for the S&P 500. The second lot (bought in December, 2004) returned 47% compared to 7%. The annualized return was about 11% for both lots. Needless to say, both lots were excellent investments.

Canon has lost a lot of market cap since I sold, so I lucked out there. Since Berkshire had about the same price to value ratio, I was tempted to sell it instead. But I resisted in part because I assumed consumer electronics will be harder to sell in the next few years and Berkshire will be able to pick up some good deals over the same time period. Like Oracle, I suspect Canon will be a compelling value and on my investment radar in the future.

Friday, October 10, 2008

Shifting to stocks

Because the markets are free-falling and the yield curve has become more favorable, I've shifted my market-timing position from bonds to stocks.

Updated October 23, 2008

I didn't actually publish this on October 10, but I did make the shift on that date in my 401(k) plan. The markets have been choppy since then, but all indications (besides stock prices themselves) say I did the right thing.

Monday, October 06, 2008

Wait 'til next year!

A little over year ago, I posted a list of mutual funds in my portfolio as if they were a baseball team. In that time, the markets have been rocked and it seemed like a good time to review their performances. The statistics (5-year return/expense ratio/turnover ratio) have been updated to include the most recent numbers I can find for them. I'm also commenting on "last-year's season", which I define as 1-year return from October 3. Today's market was way down, so I expect performance to be a bit worse for these funds. My benchmark is -27%, which about what the market has lost over the same period. Brutal.

  1. First Eagle Overseas - 11.59/0.88/34 (CF)
  2. -18.82% — For a fund that has been heavily invested in gold, losing double digits seems pretty bad. Maybe Jean-Marie Eveillard inherited some bad positions. Maybe, like most of us these days, he had a few positions blow up. In any case, the fund deserved its lead-off spot as it beat the S&P 500 and all but one of its teammates.
  3. T. Rowe Price Small-Cap Stock - 4.61/0.71/40 (SS)
  4. -26.46% — At almost exactly league average, OTCFX does not look good and hasn't for a long time. On the other hand, I suspect the environment will turn around as more good companies get beaten down with the bad. For the moment, I'm hanging on, but a lineup change may be coming soon.
  5. Vanguard PRIMECAP - 7.27/0.31/11 (1B)
  6. -20.04% — At 7% better than average, PRIMECAP continues to be a solid performer.
  7. Dodge & Cox International Stock - 10.94/0.65/16 (RF)
  8. -32.89% — At 6% less than the market, my prediction that the fund might be too big for its britches seems to have been correct. As a result, I'm demoting it to a 5% position and considering cutting it altogether.
  9. Oakmark Global - 8.26/1.13/35 (LF)
  10. -26.94% — Oakmark Global has held its own with almost exactly market returns over the last 12 months. Since the US has done better than other countries in this market(!), that's good for a global fund. If the fee were lower, it might well be a 10% position for me.
  11. Raytheon - 16.10/0.00/0 (DH)
  12. -14.4% — Raytheon has done well recently as it collects more government contracts. I continue to pay only slight attention to this position, but I suspect government spending will shift away from defense in the coming years. Hopefully, Raytheon will find a way to follow the money or build more civilian products.
  13. S&P 500 Index - 3.24/0.01/4 & PIMCO Total Return - 4.66/0.43/226 (C)
  14. -27.07% —
    4.49% — Thankfully, the PIMCO fund has been in the lineup this year so I get a modest positive return rather than the dreadful negative return. Fortunately, I've allowed this position to grow to 25% of my account. As of tomorrow after the close, I will have sold some of this portion to rebalance the lineup. I'll be favoring funds that have performed well over the last 12 months and that I have confidence in.

    The next question is: has the market fallen far enough to shift from bonds back to stocks? As I noted when I originally bought the fund, the inverted yield curve was my primary reason for switching to bonds. Conditions have been turning to start favoring stocks, but it's taken most of the year. I anticipate switching shortly after the Federal Reserve meets again to lower rates at the end of the month.

  15. Turner Emerging Growth - 8.54/1.55/88 (2B)
  16. -25.81% — I haven't expected much from this fund and I haven't been disappointed. The return has been only a little better than average, but that makes it one of my better positions this year.
  17. Fidelity Equity-Income - 2.57/0.67/24 (3B)
  18. -33.40% — I don't plan to add money to Fidelity Equity-Income unless and until there is some compelling reason to do so. Underperforming by 6% or so, is not compelling.
  19. Columbia Value & Restructuring - 5.36/0.94/11 (P)
  20. -34.37% — Excelsior Value & Restructuring has been renamed to Columbia Value & Restructuring, but it has the same management and structure. In a recent interview manager Dave Williams suggested that some restructuring situations take five or more years to develop. I'd hoped that this fund would be counter-cyclical, but it seems to have suffered from fewer buy-outs and mergers in the last 6 months or so.

-19.9% — My fund team has not performed as well as I'd hoped during the downturn in the market, but better than the market as a whole. PIMCO Total Return was the hero of the group as might be expected. Among the stock funds, First Eagle Overseas and Vanguard PRIMECAP earned their high spots in the batting order. Next year, I hope to report the S&P 500 anchoring a strong lineup of stock funds to make back some of this year's losses.

Thursday, August 21, 2008

Why I bought a house

On August 12, 2008, one day after our sixth wedding anniversary, Joy and I bought our first house. Technically, it's a condominium, but architecturally, I'd call it a townhouse. I've linked to, which shows our sales price of $379,045. That works out to $276.47 a square foot.

I mentioned the price per square foot, but we most certainly did not buy our house as an investment. Rather we bought our house to be a place to live. We'd been living in a run-down 2 bedroom 900 sq/ft rental house in Pasadena since we got married. Since then, we've:

  1. Added a son to the family.
  2. Become active in a church in Burbank.
  3. Added a second job in Glendale (Joy's job).
  4. Become Costco members. (The nearest location is in Burbank.)
Those changes prompted us to look for a three bedroom house in Burbank. So we didn't buy with the idea of making a profit.

Now that doesn't mean we aren't hoping to come out ahead on the purchase. Rather we bought what we could afford when it made sense and we'll probably sell when it makes sense.

Friday, June 13, 2008

USAA love

Joy and I are starting to be serious about buying a house(!), which has added to stress lately. We probably aren't going to get a great deal, but I think we are close to finding a fair deal on a townhouse. Now, most of our liquid assets are tied up in retirement accounts, including the IRA that I use for investing in individual stocks mentioned here. So I called USAA to see what the rules are for withdrawing money for buying a house. The representative cleared up the questions I had, but also suggested several other products in the softest possible way. It was like having a conversation with a very knowledgeable friend. I didn't actually buy anything at that point, but I will in the very near future. I'd like to see another bank steal my business from USAA. Good luck!

Wednesday, May 28, 2008

Price/Value ratio

Reading the latest Longleaf Partners Funds report, I was inspired to calculate the Price/Value ratio for my holdings:

Company          P/V
-------          ---
Canon            86¢ 
Select Comfort   36¢ 
Berkshire        82¢ 
Sally Beauty     59¢ 
First Marblehead 23¢ 
I recently sold Oracle for somewhere between 90¢ and $1 to the dollar. Cash is always worth $1 to the dollar and I used the same rate for Alberto-Culver, since I haven't put a value on that company. My composite P/V for the portfolio is roughly 66¢ to the dollar.

Select Comfort and First Marblehead still seem insanely cheap to me even after slashing my value estimate. I expect these will be truly outstanding investments for those who purchase today, but both have been classic value traps for me. (A value trap is an investment that looks cheap, but whose value falls as fast or faster than the price.) First Marblehead in particular has been a head-scratcher, since it operates in a great business that has been abandoned by other companies due to short-term problems. Both companies now include a free option on any future growth.

Of course, the value portion of the ratio is my conservative estimate of the present value of all future earnings. Further, there's no way to know when or if the price will converge on the value, assuming I estimated it correctly.

Thursday, May 22, 2008

First Marblehead's good day

So the analyst who has been talking down First Marblehead for months has upgraded the company because the negative news is now baked into the stock price. As a result, the stock price has jumped 30+% today.

Of course, nothing has really changed except that one influential analyst has become a little less negative on some deeply discounted shares.

Wednesday, May 14, 2008

Luxury Goods

So here are three things I read today:

Of my investments, I'd say three and a half of them less luxury goods to consumers. Canon sells top of the line cameras (as well as high-quality point-and-shoots), Sally Beauty sells salon-quality supplies, and Select Comfort sells premium mattresses. Alberto-Culver has mass market products that are more upscale than average in drug stores and Wal-Mart. The advantage these companies share is pricing power. Basically in hard times, like now, they can decide to drop prices a bit to keep up sales volume, or they can wait around until times get better and raise prices. I have to be honest: I'll probably pay 10% more to get a Canon product over any of the competitors. It might seem irrational, but I think it's justifiable because I know what I'm going to get and I know I'll be happy. I'm sure the same is true of women who buy certain brands of shampoo or soap.

Thursday, April 24, 2008

Biggest losers

I'm constantly amazed by the irrationality of the stock market. (Of course, the market seems irrational when my stocks are going down and I'm a genius when they go up!) My two biggest losers are priced far below what my DCF models predict they are worth. First Marblehead is fairly easy to figure, since the company publishes projected cash flows from its residuals. If you discount those residuals at 15%, which is greater than the rate management uses to value any of the residual tiers, the stock ought to be trading no less than $6 a share. That would imply no future business, which is a safe assumption at the moment. The current price ($3.62) implies a discount rate of 23%, which is what you might be charged for credit card debt if you had a really bad credit score. Remember, these loans can not be discharged in bankruptcy and were originally made to people with relatively good credit scores. First Marblehead will almost certainly double in price when the cash from residuals begins rolling in during 2009. Also, the shares have a built in call option on the possibility business will resume in the future.

Select Comfort, as a consumer products company that is currently out of favor with consumers, represents a tougher challenge to value. There's no way to know if the Sleep Number concept has run its course and sales will whither and die. But if we assume that the company will earn 22¢ in the next 12 months as it did the last 12 months and that earnings will increase a modest 3% forever, you get the current market value. But there are reasons to expect these assumptions are too modest. First, the company has finally stopped building new stores and buying back shares, and has cut advertising, staff and other expenses. Earnings in the future figure to be higher even if sales remain flat. Second, if the market ever turns Select Comfort would seem poised to capture quite a bit of market share. It's severely cut back advertising, which has hurt the wholesale and online portions of the business. When people start buying mattresses again, it should face fewer competitors with less capacity.

Now these companies have very little risk of becoming worthless and if things go right ought to do very well. At these prices, simply returning to profitability will provide new investors with great returns. I've already lost most of my investment in these companies and I can't afford to put more cash into them. But I will continue to hold them, which is functionally the same as considering them good buys, because the upside remains more likely and more profitable than the downside. As Mohnish Pabrai says, "Heads, I win; tails, I don’t lose that much."

Monday, April 21, 2008

Why I sold off my Oracle position

For the first time since I began buying individual stocks, I do not own Oracle outright. The call option I sold last month was exercised at expiry and was worth 80¢ since Oracle ended the week at $21.80. Although I lost a little bit on this option, my combined ratio stands at 68.04% for all options written.

The position I sold over the weekend was purchased a little over a year ago for $16.50, which works out to a 29.32% annualized gain. The S&P 500 has lost about 1% over the same time. So that particular trade has been very profitable, as has my Oracle trades in general. I still believe Oracle is misunderstood, but I believe it is trading near its fair value and I don't think its prospects look particularly good in the next few months. Eventually, companies will respond to slowing consumer demand by cutting capital spending. And we have not yet seen the end of bankruptcies even within the financial sector. Perhaps I will be able to buy back into the company if it misses earnings in the next year or two. I hope so, because I'm already starting to miss it.

Wednesday, April 09, 2008

More good news and bad news

This week, my portfolio had good news and bad news. The good news is that Canon paid their year end dividend. Since the exchange rate has fallen to about ¥100 to the dollar, the ¥60 dividend worked out to be 60¢ a share. Canon's dividend yield is about 2%, but based on my original cost basis, I'm earning closer to 3%. As long as Canon continues to raise its dividend, I will be happy to hold my shares.

The bad news was that TERI, the non-profit that First Marblehead uses to insure its loans, declared bankruptcy. Now I believe the bankruptcy is for technical, not fundamental reasons, and I think the effect on First Marblehead will be very little in the long run. But my position has been battered to a considerable degree and perhaps permanently. At the very least, the news makes an immediate recovery very difficult.

At no time have a felt that First Marblehead was a bad risk/reward proposition at the current price, so in one sense I don't feel I made a mistake. But I did ignore one of my fundamental sell signals: to get out when a dividend is cut or lowered. If I'd done that, I would have saved myself a lot of money and aggravation. Further, there will often be an opportunity to buy the shares back at a later date when I've had a chance to analyze the company independent of the dividend.

At the moment, this sell signal only applies to Canon and my token position in Alberto-Culver. Which reminds me: selling Alberto has easily been my most costly decision to date since it freed up cash to buy First Marblehead.

Thursday, March 27, 2008

Good and bad news for Oracle

Oracle had a pretty good third quarter, but not good enough for Wall Street's standards. Earnings came in at 26¢, which was 6¢ better than the previous year, but 4¢ less than the average analyst prediction. I don't see anything too surprising about the numbers on first inspection—there aren't as many companies buying new licenses, but current customers still seem to be paying. But Oracle's shares fell $1.50 or so this morning.

Meanwhile, my short call position gained about 75¢ over the same time period, which effectively cushioned half of the loss for me. Further, the news does not substantially lower my long-term opinion of Oracle's value, though it did reduce the odds I'd get $21 for my shares. So selling the call option has served my purpose. Interestingly, the call ought to have served the purpose of whoever bought it as well. Rather than buying shares and losing $1.50 overnight, the buyer would have lost only 75¢. And the insurance would have required less cash be tied up than if the shares were bought outright. Altogether, it was a fair exchange.

With 22 days remaining before expiration, there the odds the option will be exercised are less than 30%

Wednesday, March 19, 2008

Why I sold another call option on Oracle

I sold a call option on Oracle with a strike price of $21 that expires in April. I think $21 is near the bottom of Oracle's fair value range and I'm willing to be paid 75¢ for the risk it will be worth more than $21 in a month. Oracle took a little dive today after I sold the call and the odds that it will be exercised are about 2 in 5 as of right now. I'll also be happy to get the cash if I need to sell—Oracle is most nearly fully valued of my positions.

Monday, March 10, 2008

Here comes the activist

Last night on 60 Minutes, there was a story on Carl Icahn, activist shareholder/corporate raider. I caught myself wondering if he would be interested in a small, unconventional mattress company based in Minneapolis. Of course, the entire company is far too small for him to bother with, but as luck would have it, the George Hall (another activist shareholder) has targeted Select Comfort.

The letter to Select Comfort lists a number of proposals, which are not terribly radical, but do highlight several management failures. Most troubling to me are comments about CEO William R. McLaughlin's recent announcement about his salary:

Further, the Chief Executive Officer's agreement to forgo his base salary until same store sales increase by at least 1% for four consecutive weeks, while good for public relations, is inconsistent with shareholder interests, since improvement of the Company's financial performance requires a greater length of same store sales improvement than four weeks. Further, this limited, short test allows for alteration of marketing spending in order for the Chief Executive Officer to achieve his limited performance goals, which may have nothing to do with appropriate marketing spending for the Company and inconsistent with the Company improving its annual financial performance.
Looking at the text of Mr. McLaughlin's letter, I'm forced to agree with his critics—he seems to be an untrustworthy manager. At this point, he has set the bar so low that practically anyone with some business experience can clear it. I'm afraid I now agree with those who have called for him to resign.

Reading between lines, implementing SAP seems to have become a death march. More money will not solve the problem, so shareholders ought to consider the cost so far to be sunk. Also, as the letter spells out, the SAP installation is probably overly ambitious for a company like Select Comfort, which may never recoup the savings needed to pay for the system.

I don't know if I agree with the idea that the company should close low performing stores. The letter suggests returning to the company's direct marketing roots and eliminating the wholesale business. I think the key to the problem is understanding why some stores are failing. For instance, it does not seem like stores are getting the advertising coverage they need. If that's the case, closing the stores might not be the most productive idea.

Overall, I welcome Mr. Hall's investment and I hope management will open up their operation to his input. An outside pair of eyes can only help.

Friday, March 07, 2008

Portfolio volatility

Thanks in part to abysmal performances by First Marblehead and Select Comfort, my portfolio is sinking like a rock. It has now dropped decisively below two of my favorite benchmarks: Berkshire Hathaway and inflation + 10%. Worse, I think the official measure of inflation I use is understated and Berkshire is undervalued. Meanwhile, the S&P 500 index is "gaining" ground (by dropping less quickly than my IRA), so the recent past has been harsh.

Nobody likes to be wrong and the standard response to a situation like this would be to say that luck turned against me. Owning two companies that have been particularly hard hit by the housing and securitization busts might seem like unfortunate timing except that I've bought both companies on the way down knowing the strikes against them. It's ugly and I can't blame luck.

The good news would be that I haven't actually lost money on these shares. Both companies will see their fortunes reverse in a few years. I expect current prices will seem unimaginable. Further, there is no particular reason for me to sell these companies until their fair value is reached. So I need to ignore the stock charts wiggling up and down for the moment.

Wednesday, February 20, 2008

2007 Look-through earnings

As usual, I have to wait for Warren Buffett to release Berkshire's earnings before I can tabulate mine:

EPS              2008* 2007  2006  2005  2004  2003  2002
Oracle           0.15  0.27  0.13  0.21  0.30  0.44  0.34
Canon            0.37  0.31  0.28  0.49  0.34  0.08 
Select Comfort   0.18  0.19  0.19  0.27   
Berkshire        0.22  0.30  0.25    
Alberto-Culver   0.02  0.02  0.08    
Sally Beauty     0.05  0.04  0.00    
First Marblehead 0.41  0.14     
Look-through     1.00  1.13  0.93  0.97  0.64  0.52  0.34

* 2008 numbers are consensus analyst estimates.

I keep track of my IRA like an open-ended mutual fund and this is the look-through earnings per "share" of my IRA "fund". As I buy and sell stocks, my portion of their earnings fluctuates and when I add cash, it alters the percentage of portfolio's total value comes from look-through earnings. So when I sold Oracle shares over the year, I reduced the earnings I give myself credit for and when I bought Select Comfort, I increased my share of earnings.

Thanks in very large part to Oracle, my look-through results actually improved. When you add in call option premiums and capital gains on selling shares, my results are even better. But my relative share of the company has been reduced and I won't get anywhere near those returns in 2008.

My two troubled positions look ok in this table, but that is mostly an illusion because I've increased my holdings to a large degree. In his just released letter, Mr. Buffett lays out four criteria he looks for in buying a business: "a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag." The CEOs First Marblehead and Select Comfort have earned my respect anew by taking voluntary pay cuts for poor results that are largely out of their control. Also, the stock market has cut share price of these companies from cheap to practically free, in my opinion. The reason in both cases is largely a result of worsening economic conditions. In both cases, there are internal changes that need to be made if the companies are going to thrive, but they continue to have advantages compared to competitors that are not likely to disappear. If I weren't already up to my ears in these companies, I'd be buying at these prices.

Canon and Berkshire continue to earn about what is to be expected. They are both too large to grow quickly, but have very wide and clear moats that ought to preserve the businesses for decades to come. Unlike Oracle, the market has not come close to recognizing these company's intrinsic values, so I have not been tempted to sell.

Sally Beauty earned very little this year because it has needed to pay so much in interest expenses since splitting with Alberto-Culver. This year and next ought to be pivotal for the company, so it's very encouraging that directors have bought $3 million of shares to the $1 million worth they purchased with their own money last year. When the restrictions on selling agreed to by the principals of the spin-off transaction expire at the end of the year, I expect management will begin to trumpet business growth instead of underplaying it. I've noticed there are plenty of mom-and-pop beauty supply shops here in Southern California, and I expect there will be plenty of opportunities to consolidate the industry while paying down the debt.

Interestingly, 2007 looks similar to what analysts predicted last year, but that result is misleading because I'm more invested in these stocks than I was at that time. Looking at operating earnings, which includes various cash returns and costs, shows a fuller picture of my results:

Interest    0.01    0.03    0.16    0.01    0.03    0.02    0.00
Dividends   0.00    0.08    0.06    0.08    0.03  
Costs      (0.01)  (0.14)  (0.19)  (0.04)  (0.06)  (0.22)  (0.12)
Arbitrage   0.00    0.50    0.41    
Options     0.07    0.14     
Operating   1.07    1.79    1.37    1.01    0.65    0.32    0.23
Gain      -38.18%  25.76%  35.66%  56.70% 100.59%  41.50% 

I'm fairly pleased with these results, but I can't expect them to continue into the future. In particular, I likely will not have any arbitrage earnings this year, since I've invested most of my cash into businesses that I feel are too cheap to pass up and which might not pan out for a few years. Finally, here are my net results juiced by large realized gains that will not be repeated this year:

Realized Gain           2.88                            1.79 
Special dividend                2.99    
Net              1.07   4.60    4.37    1.01    0.65    2.11  0.23
Gain           -76.79%  5.41% 331.08%  56.70% -69.39% 827.21% 

Friday, February 08, 2008

Portfolio news

First, has some details on the Oracle/BEA merger and gave First Marblehead a gold star.

In worse news, Select Comfort has again disappointed shareholders, though it seems the market is overreacting a bit. Now that it's clear air beds are not immune from recession the way Tempur-Pedic memory foam beds seem to be, no one should be surprised by slowing sales in the quarters ahead. There is no reason the company can't survive and come back much stronger. At these prices the risk is minimal and I suspect that recent price drops have more to do with institutions dropping losers and "penny stocks" than real analysis of the business.

That said, there are some huge opportunities that the company has missed. Having established their brand and product as legitimate, they should have addressed the question of why buy from them. The competition, in my opinion, is regional mattress stores and traditional mattresses, not other premium mattresses like Tempur-Pedic. Now that Select Comfort has established stores all over the country, the network needs to be leveraged.

Here's my idea for a new ad campaign:

A sleazy looking salesman in a wrinkled suit is standing in front of a mile of mattresses next to a guy in a bear costume.

Salesman: Come on down to Miles of Mattresses! If we can't get you the cheapest bed, I'll wrassle this bear!

The picture jumps and slows down as if it were on a film projector that is starting to die. The scene fades to a clean Select Comfort store with three beds or so and a clean-cut salesman in a polo shirt and slacks. There might be another salesman helping a couple try out the bed in the background, but the store should not look cluttered.

Spokesman: Why buy an outdated spring mattress that needs to be flipped every year? Springs start to sag after a while in cheap mattresses and become uncomfortable. Select Comfort sells only modern Sleep Number beds that support sleepers with their exclusive adjustable air chambers. And unlike foam or water beds that are difficult to move, the a Sleep Number bed can be emptied and packed in a matter of minutes. Why buy from this guy, when you can sleep on a layer of air for a lot less than you might think. Come to one of our X locations in Y.

As the spokesman talks, cut to the standard "pressure point and support" image or, if there are customers in the store, show them adjusting the bed to minimize pressure. When the spokesman says, "this guy", cut to the salesman and bear wrestling or cycling each other. Finally cut to a map of the Y region with X stores clearly marked.

These ads should be short, well produced and run constantly. They need to be shown in the cheaper time-slots at night, during the day, and on weekends so that they get seen by people who are ready to buy a new bed. Hopefully everyone who has a TV will see them at least occasionally. I think retail partners are a mistake unless Select Comfort has no locations in a region, and even then, they should make sure the retailer's ads put Sleep Number beds in a good light.

I don't think the financials are nearly as bad as they appear, especially if you allow for a recession. I also don't think it will be too hard to turn this ship around. In fact, I think they are one good TV spot away from returning to high growth, since they have cultivated a number of advantages over regular beds.

Tuesday, February 05, 2008

Why I bought yet more First Marblehead

After the most recent First Marblehead release, the market gave me an offer I couldn't refuse. According to my calculations, the current liquidation or run-off value of the company is $9.80 a share. That number assumes shares will be diluted 20% according to the Goldman Sachs deal. Then I calculated a conservative guess of the company's value assuming it is able to return to some sort of stable business. I'm guessing the company is worth $38 or more if they are able to convert some of their loans on the balance sheet into earnings. Note that I'm not assuming they will get the same sort of securitization deals they received a year ago—just that they find buyers or financing to turn their loans into earnings at some point.

Personally, I think this whole crisis will blow over in a year or two and Marblehead and Sallie Mae will survive as a bunch of competitors will disappear. As survivors, their earnings power will dramatically increase and $38 will seem laughably cheap. But for the sake of argument, let's use that number. I also expect survival has a better than 90% chance, since Goldman Sachs has a stake in the company. But to prove the point, I'll assume the survival odds are 50%. My expected price, therefor, is $24 and my Kelly ratio is 39%. So I bought more shares at $14.95 to boost my First Marblehead position and reduce it's cost basis.

In my opinion, First Marblehead will be able to continue as a going concern whether or not it is able to securitize loans. Those loans will provide consistent, high-return cash flow to someone over the next few decades, so someone will buy them or finance Marblehead to keep them. It's not dissimilar from Microsoft shifting from selling shrink-wrap software to collecting service reviews. Either way they are selling something valuable and it's just a matter of how to collect profits. So this purchase is not a bet on the securitization market, but a bet on First Marblehead's business.

Monday, January 28, 2008

Four types of moats

Recently on the Motley Fool, there was an article highlighting four different moat types:

  1. Economies of scale
  2. The network effect
  3. Intellectual-property rights
  4. High switching costs
Personally, I'd divide IP rights into: patents/secrets and brands, which is to say: what you know and what your customers know. Also, economies of scale and network effect are really two sides of the same coin. Size can give a company advantages or it can give customers advantages or both. I think high switching cost has an analogue as well: monopoly. Regulated monopolies are especially impervious to assault.

  1. Size
    1. Economies of scale
    2. The network effect
  2. Knowledge
    1. Intellectual-property rights
    2. Brand
  3. Stickiness
    1. Monopoly
    2. High switching costs
In each case, the moat is developed by created an advantage that other companies can't steal. Bigger companies, like bigger ancient cities, are more likely to have established moats. For instance Oracle, Canon and Berkshire Hathaway have multiple and deep moats in nearly every category. First Marblehead mostly fends off competition with intellectual property. I'm worried that Select Comfort might have lost their primary moat—their brand. Those are much smaller companies that have not completely staked out their territory.

So for smaller, fast-growing companies, the question is what moats can they develop?

Tuesday, January 22, 2008

Yield curve strategy nears turning point

When the Federal Reserve knocked short-term rates down 3/4%, I took at look at the current yield curve to see if it has become attractive. It still looks flat to me, so I'll stick to the PIMCO Total Return fund for now.

The Total Return fund returned 9.07% last year compared to 5.49% for the S&P 500 with dividends invested. That's pretty good, but I made the call about a year too early. The S&P 500 was up 15.80% in 2006 compared to just 4.0% for PIMCO. So far this year, the index is down 9.67% and the bond fund is up 2.66%, so I'm not complaining about being early. In fact, I think the nature of the yield curve signal requires an early switch when the curve becomes inverted.

As we saw today, the Federal Reserve controls the short end of the yield curve. When it wants to stimulate the economy, it pushes down rates and tries to raise them when the economy seems to be functioning well. Market forces controls the long end of the curve. Since there is little default risk in US bonds, the market mostly concerns itself with beating inflation over the life of the bond. In general, the longer the bond the more yield investors demand to compensate for inflation risk over the life of the bond. Since inflation and economic activity are closely related, you could rephrase those goals so that the Federal Reserve is fighting inflation and the bond market is predicting future economic activity, but I think that's overly complicated.

Under normal circumstances, the curve slopes up as the term of the bond increases. When the short-term rates go up because the economy is functioning well, the long-term rates go up too because of an increased expectation of inflation. On the other hand, when the economy is in trouble, there isn't as much inflation to fear in the future. So there is something strange going on when the curve is inverted. Specifically, the Federal Reserve thinks the economy is doing fine and the bond market isn't worried about inflation, which seems like the best of all worlds—the so-called Goldilocks economy.

And for a while, it is the best of all worlds as the economy hums along with no sign of rising prices. But it also means that most people let down their guard against "bad things". There is also an inherent risk that people will borrow long and loan short to profit off of the inversion. When the curve snaps back to normal, the profit vanishes and the position becomes an expensive liability. Leverage will increases the pain. You might think this only happens to hedge funds and Wall Street types, but how many stories have you heard recently about people taking money out of their home's equity to buy cars or go on vacation? One of the reasons people were willing to do that sort of thing was that borrowing against home equity was so cheap and easy.

So an inverted yield curve marks the moment when everything is working about as well as can be expected and conventional wisdom says there is nothing to be worried about. And there isn't until suddenly, there is a lot to worry about. The Federal Reserve responds to economic trouble by pushing down the short end while the market responds to future inflation by demanding more yield on the long end. When we see a normal to steep curve, the fear permeates the economy and it's time to switch from bonds to stocks.

Friday, January 11, 2008

Long-term results

I go to the mound in the 1st inning planning to pitch a perfect game. If they get a hit, then I am throwing a one-hitter. If they get a walk, it's my last walk. I deal with perfection to the point that it's logical to conceive it. History is history, the future is perfect. — Orel Hershiser

Having become throughly depressed by my IRA's 2007 results, I thought it would be a good idea to look at the long-term results again:

Date      S&P 500   Delta     IRA   Delta   BRK A
12/31/02  -11.37%  42.32%  30.95%  30.18%   0.76%
12/31/03   26.38%  -1.49%  24.89%   9.08%  15.81%
12/31/04    8.99%  -2.16%   6.84%   2.49%   4.34%
12/31/05    3.00%   3.23%   6.23%   5.42%   0.81%
12/31/06   13.62%  14.88%  28.50%   4.39%  24.11%
12/31/07    3.53% -16.83% -13.30% -42.04%  28.74%
01/11/08   -4.59%  -0.66%  -5.24%   1.47%  -6.71%
Total Gain 41.13%  54.81%  95.94%  12.98%  82.96%
Annualized  6.40%   6.47%  12.87%   1.38%  11.49%
While 2007 was a very rough year and 2008 is not looking much better so far, my 5 1/2 year performance is still 6%+ better than the S&P 500 and 1%+ better than if I'd just bought Berkshire Hathaway shares. Big years early on have saved my IRA from under-performance. The current bear market will be a test on my portfolio and my willingness to deal with loss.

To tie in the Oral Hershiser quote: mistakes (and successes) in the past are no longer important to what must be done in the future. Rather than beat myself up over past mistakes, I need to focus on what I can do to maximize my future success. If that means selling some investments at a loss to buy another investment with better potential returns, so be it. As it happens, I still believe in my current investments, so I don't plan on doing anything drastic. Over the long run, I hope my decisions to be shown correct.

Monday, January 07, 2008

I think I understand the Goldman deal

After listening to the conference call and reading the press release and SEC documents, I think I understand the logic of First Marblehead's deal with Goldman Sachs. Recall that when I bought the company, it needed to securitize the loans it helped originate in order to make money. The banks that originally fund the loans only paid the cost of the loan processing in exchange for agreeing to securitize through First Marblehead. As a result, the business model was heavily backloaded and dependent on investors to buy asset-backed securities.

By the end of 2007, the market for all sorts of asset-backed securities had dried up to the point where First Marblehead was not able to sell the loans it helped originate. As a consequence, the banks originating the loans were able to start charging a penalty to Marblehead (a risk I did not fully understand). This left the company in a bind. It could stop originating loans until the market for them cleared up, losing ground to better capitalized companies. Or it could keep making loans hoping they could be sold before running out of capital. Neither choice was very palatable, though curtailing originations was clearly less risky.

Apparently, GS Capital Partners VI Fund, L.P. and First Marblehead "executed a confidentiality agreement, dated as of July 13, 2007", which means they had been considering some sort of deal for half a year. We can't know what the deal would have looked like at that point, but since the confidentiality agreement was signed by a "global, diversified fund dedicated to making privately negotiated equity investments" (according to its press release), we can be pretty sure it would have been a privately negotiated equity investments similar to the one that was finally agreed upon. Of course the terms would have been more favorable in July than they were in December.

It's possible First Marblehead saw the writing on the wall last summer and was ready to sell an equity share in order to get access to a warehouse facility like it got in December. That would open up options in the event secuitization stalled for a quarter or two. Alternatively, it might have facilitated keeping a portion of loans on the books for one reason or another. But there can be no doubt that what First Marblehead wanted, and what the Goldman Sachs fund could provide, was access to capital. So the plan was to begin shifting from the nearly capital-free business model to one that was more capital intensive.

I think the reason the Goldman deal did not go through during the summer is that it wouldn't have looked good to investors or to clients. Low capital requirements made the company a very attractive investment since cash flows could be diverted to dividends and buybacks. It also created an opportunities for First Marblehead's banking clients, who provided capital to originate the loans. So it would have been difficult to sell this deal in July when business looked pretty good.

By December, when it was clear the business was in trouble, the deal could be seen as a baleout, not a sellout. Whether or not it would have been better to just do the deal over the summer is water under the bridge—the real question is was it worth doing in the winter. And given the choice between stepping out of the student loan business or selling an equity share of the company to keep going, there is a strong case to be made for the later, especially if the plan was in the works already.

To make the case, let's look at First Marblehead's growth history:

Fiscal     2007    2006    2005    2004    2003    2002    2001    2000
Revenues  54.61%  34.83% 109.76% 118.11% 121.42% 511.06%  70.08%  72.38%
Earnings  57.37%  47.78% 112.12% 138.96% 157.58% 487.37%  
Now for the sake of argument, assume that without the deal, First Marblehead will lose money for a quarter or two (their Q2 and Q3), and then make enough in the final quarter to be flat on the year. Q1 revenue, which traditionally accounts for a third of the annual total, was up 24% and earnings were up almost 20% from the previous year, so this scenario seems possible. In 2009, we'll assume growth jumps back to 35%, so that earnings are up a total of 35% over two years. I made this scenario as aggressive as seemed reasonable, since it's the one I'm arguing against.

With the deal, we can assume loan volume growth will be close to the 35% we saw in 2006 because there's no evidence student borrowing is slowing down. Q2 will still be a losing quarter and depending on how the accounting works Q3 might be too. But when the market for ABS opens, First Marblehead will have a lot of inventory saved up. We don't know exactly when securitization might start up again, but let's suppose it takes through the end of 2009 to work through the backlog. Two years of 35% growth works out to about 82% total growth compared to 35% without the deal.

Presumably, the securitizations will be less profitable with the deal, because warehousing the loans racks up interest charges. And of course, you have to factor in the 20% share of the company First Marblehead needed to give up. Obviously, there are risks added as well. But its hard to argue against diluting shares 20% over two years to get 47% better growth over the same period.

Wednesday, January 02, 2008

2007 Year in review

On the last day of 2007, my IRA ended the year down 13.3%, which was the first down year I've had and substantially worse than my benchmarks, the S&P 500 and Berkshire Hathaway. These things happen and especially with an ultra-concentrated portfolio. Here are my core positions:

Stock               2007 Return
-----               -----------
Alberto-Culver      20.83%
Berkshire Hathaway  29.19%
Canon              -17.74%
First Marblehead   -87.43%
Oracle              34.23%
Sally Beauty        16.03%
Select Comfort     -57.70%

Select Comfort has been the biggest disappointment of my short investment career. I certainly misjudged the business though I still think my initial purchase was a good decision. I now believe my follow-on purchase last year was a mistake, because I did not recognize the danger of air mattresses becoming a commodity. Select Comfort is built from the ground up to be a specialty bedding company, so if it ever needs to compete on price, quality and service alone, it must be revalued. That said, I think the current price is actually less than what the company would be worth as a commodity manufacturer. So any future turn-around comes as a free option at prices less than about $7 a share. As I mentioned when I made my third purchase, I plan to aggressively sell covered call options until the future becomes more clear.

First Marblehead has always looked stunningly cheap to me. Incredibly, the price has dropped to just over book value because of worsening conditions in the student loan paper market. Basically the market assumed for a while that the company would just close up shop. Since the supply (or from the perspective of students, the demand) of private student loans is growing at breakneck speed, walking away from the business would be crazy. Instead, First Marblehead has entered into an agreement with Goldman Sachs that will allow it to hold the loans it currently sells off in exchange for nearly 17% of the company's equity. I haven't had time to dig into the details of the deal yet, but it does seem like First Marblehead simultaneously removed short-term risk, reshaped its business model, and bought a powerful ally with a vested interest in its success. Buying more shares is a definite possibility, though I don't like the message sent by the dividend cut.

Canon became cheaper in part because of a delayed entry into the TV business due to patent problems. In the meantime, the company's core camera and printer products have sold well and profitably, and it is working on other entries into the display business. The dividend for 2007 was raised another 10% without seriously eating into cash flows. Canon's dividend is important because it is a signal from management that the business is doing well and it provides me with another reason to keep holding. Based solely on the dividend, Canon is trading below its fair value.

Outside of these three stocks, my investments performed quite well. Unfortunately, my losers made up a larger portion of the portfolio than the winners did. Options and arbitrage transactions worked extremely well for me on the whole, but I'd have to dramatically increase my trading activity to come close to making up for any one of the losing positions. On the other hand, my returns would undeniably be worse without these small, short-term, trading successes. Along the same lines, Alberto-Culver helped, but is a portion of my portfolio too tiny to profitably sell. Its performance barely matters.

Sally Beauty meets my current expectations. Everything seems quiet at the moment, but that will change as the company pays down debt and the restrictions on insider sales expire over the next year or so. I'm contemplating increasing my exposure in what amounts to a publicly-traded, private-equity investment (if you can imagine).

I'm in the process of wishing Oracle, my first and most successful investment, a fond farewell. On an annualized basis, my return on shares sold in 2007 has been over 20%. I've decided to end this investment because I believe the company is trading at a fair value. For the last few months it seems that Larry Ellison agrees with me as he has been exercising options for and selling a million shares a day. He has plenty of shares left to keep his financial future firmly tied to the company he founded, but I'm guessing he is more excited about other investments such as NetSuite. I'll keep my eye on the price in case it falls below its fair value again, however.

Berkshire Hathaway remains the anchor of my portfolio for the foreseeable future. This year will almost certainly be the moment when the company can finally use its dry powder. There are certainly plenty of quality assets available for pennies on the dollar due to "lack of liquidity" (i.e., over-leveraged entities that can no longer refinance). No doubt we will see some buys in the months to come.

Perhaps I'm foolish, but I feel fairly optimistic about 2008. Besides Select Comfort, the portfolio has improved financially and the businesses are stronger than ever. I have no urgency to sell until the future becomes clear, so the market price isn't all that important in the short run. Further, lower prices for stocks in general ought to present me with better opportunities for future purchases.

Friday, December 14, 2007

Why I bought yet more Select Comfort

This might be a mistake. Yesterday, when I wrote the post on Select Comfort's problems, I got angry. The market is completely hammering this company and it has gotten out of hand. Every DCF model I use suggests the market is pricing in zero growth—forever! Now if we were talking about First Marblehead, I suppose I could see how that might happen. The student loan business depends on a complex web of legal, political, financial, and societal conditions. If any one of these change, the business could cease to be profitable. But Select Comfort sells mattresses. People will always need them.

Right at this moment, people aren't buying mattresses. Or to be more accurate, people aren't buying mattresses unless they are really cheap or have Tempur-Pedic on the label. I think that's for exactly the same reason that houses in Bel-Aire are selling at record prices, but aren't selling at all in other parts of Los Angeles unless the price is rock bottom. Rich people haven't been hurt by inflation, housing prices, and risky loans the way the rest of us have, so they can buy premium products. I blame Select Comfort's management for not adjusting to the current reality, but I don't think they can screw this up so badly that sales won't come back in a year or two.

While we are on the topic, management has screwed up lately, but the results of the past year ought to shake them up and get them focused on the right things. From the business update this week, I think it has. To me, it was outstanding news that they refused to give guidance for the rest of this year or next. Wall Street hates that, but if management can't be sure what is going to happen, they really ought to stay quiet. Hopefully they have permanently stepped off of the beat-the-numbers game.

My purchase at $6.50 today increased my share count by a third, but only increased my cost basis by a sixth. I intend to aggressively sell call options on my shares in order to create a synthetic dividend. Maybe this isn't rational, but I think the market is mis-valuing Select Comfort and I want to capture some of that difference. I guess another way to put it is that the market is pricing Select Comfort as if it will screw everything up from now on and I think the odds are low that will happen. So I'm adding to my position. But I'm not so sure the market is wrong that I'm willing to take on more downside risk without getting paid.