Tuesday, July 31, 2007

My miserable July

This is the portion of the show where I normally discuss my exceptional portfolio return and modestly claim the results were the result of "good luck" or some one-time event that can never be repeated. My IRA was down 5.20% in July, which was on top of a -1.92% return for June. So which stocks ought I to have sold to avoid this calamity? Oracle, my largest holding, was down a modest 2.99%. Canon clocked down 9.48%. Select Comfort only lost 1.73% in July but for the last 3 months it has lost 14.02%. Berkshire nearly held steady at -0.66%. First Marblehead was the biggest loser: trimming 14.7%. Sally Beauty lost 10.78% and its brother, Alberto-Culver, lost 0.84%. So it was a clean sweep—everything lost market capitalization in July. Here's how I compared to my benchmarks so far this year:

Date     S&P 500 Delta   IRA   Delta  BRK A
07/31/07   2.61% -3.32% -0.71% -0.72% 0.01%

To be honest, I don't feel that holding onto these positions was a mistake. Each of these companies have performed well in my opinion and will likely rebound when the market starts to calm down a bit. First Marblehead in particular is wildly undervalued because of its perceived connection to mortgage bonds and other asset backed securities.

Update on BNS Holding

BNSIA has dropped to $10.50 a share from $12.75 just before the new reverse split procedure was announced last Friday. My guess is that 100% of the price cut is panic selling from people like me who bought shares for a quick cash-out. Most of us will probably not be cashed out unless the procedure is based on beneficial owners not shareholders of record.

Now my broker sent a message indicating that my shares will be cashed out sometime after the record date on August 2. Until then, I can't be sure that my shares won't be aggregated. So I'm pursuing another tact.

The letter I sent to BNS Holding on Friday resulted in a fairly quick response on Monday from one of the company's directors. This morning I was able to return his phone call and we talked about the situation for a few minutes. One of the good things about investing in very small companies is that you might actually have a chance to talk to principle people. Imagine trying to talk with a director of Oracle, for instance. At any rate, we had a good chat and the upshot is that I plan on sitting tight.

One thing this director mentioned is that the proxy that was mailed to shareholders was different than the one published by EDGAR. I don't really know how that happened, but since the proxy that was actually voted on contained language that allowed the company to aggregate shares, the SEC probably won't have a problem with the company's actions and disclosure. That's the bad news. The good news is that BNS Holding is aware of the issue and the director I talked to seemed willing to work on straightening it out. The bottom line seems to be that it's more trouble than it is worth to them to have a small disgruntled shareholder such as myself. (I can't decide if my letter was overly threatening or if that was one of the reasons it got noticed. If this situation happens with a different company, I plan to go easy for the initial contact at least.)

I should also mention, that holding on to the company wouldn't be a terrible bet. I haven't done a valuation, but company presentation at the annual meeting seemed very promising. This week represents the best and final opportunity to buy shares for a very long time. I'm mildly temped though I think it's just the lure of scarcity talking.

Once again, I think the key here is to not panic. I took a few moments to get my strategy in order and I acted in a way that kept my options open. I'm still 95% sure my shares will be cashed out sooner or later, but I would certainly have lost money if I'd immediately sold on Friday.

Friday, July 27, 2007

BNS Holding changes the rules in mid-stream

Here is the text of a complaint I just filed with the SEC:

BNS announced a 1-for-200 reverse split that was intended to result in fewer then 300 shareholders of record. This would allow the company to "go private". Shareholders of fewer than 200 shares would receive $13.62 in exchange for surrendering their shares.

According to the proxy statement (DEF 14A), the company would not be required by law to cash out holders of shares in street name. But the company did promise to instruct brokers to treat those shareholders in the same manner as shareholders of record:

"If your shares are held in street name, under Delaware law the proposed Reverse/Forward Stock Split would not impact your shares. However, we plan to work with brokers and nominees to offer to treat shareholders holding shares in street name in substantially the same manner as shareholders whose shares are registered in their names. To determine the transaction's effect on any shares you hold in street name, you should contact your broker, bank or other nominee."

According to the press release dated a week after the proposal passed a shareholder vote, stockholders holding their shares in street name would NOT be cashed out after all. The relevant passage is:

"MIDDLETOWN, R.I., July 27 /PRNewswire-FirstCall/ -- BNS Holding, Inc. (OTC Bulletin Board: BNSIA - News; the "Company") confirms that the Company has elected to require banks, brokers or other nominee to aggregate any fractional shares within the Depository Trust Company totals upon the consummation of the Company's proposed 200-for-1 reverse stock split immediately followed by a 1-for-200 forward stock split (the "Reverse/Forward Stock Split") scheduled to take effect on August 2, 2007. As a result, the Company need not provide for cash payout to any stockholders holding shares of Common Stock in street name (such as a bank, broker or other nominee). In addition, stockholders holding their shares in street name would retain the same number of shares they held immediately prior to the Reverse/Forward Stock Split. Following the consummation of the Reverse/Forward Stock Split, the Company intends to cease the listing and trading of the Company's Class A Common Stock, $.01 par value per share and Preferred Stock Purchase Rights on the Boston Stock Exchange and cease to be a reporting company pursuant to Sections 12(b) and 12(g) of the Securities and Exchange Act of 1934, as amended."

As a result, investors who bought shares in street name with the intention of being cashed out in the reverse split acted using false information from the company.

Meanwhile, shareholders who wished to remain shareholders may have performed unneeded transactions. Here is the advice from the company's proxy:

" If you would otherwise be a Cashed Out Shareholder as a result of your owning fewer than 200 shares of Common Stock, but you would rather continue to hold Common Stock after the Reverse/Forward Stock Split and not be cashed out, you may do so by taking either of the following actions:

o Purchase a sufficient number of additional shares of Common Stock on the open market and have them registered in your name and consolidated with your current record account, if you are a record holder, or have them entered in your account with a nominee (such as your broker or bank) in which you hold your current shares so that you hold at least 200 shares of Common Stock in your record account immediately before the Effective Date of the Reverse/Forward Stock Split; or

o If applicable, consolidate your accounts so that together you hold at least 200 shares of Common Stock in one record account immediately before the Effective Date of the Reverse/Forward Stock Split.

You will have to act far enough in advance so that the purchase of any Common Stock and/or consolidation of your accounts containing Common Stock is completed by the close of business prior to the Effective Date of the Reverse/Forward Stock Split. The Effective Date is the date upon which the Certificates of Amendment to our Certificate of Incorporation become effective and may not be prior to the date of the Annual Meeting."

If BNS intended for shares held in street name to not be cashed out, the company ought to have stated that in the proxy. Many companies follow that procedure and I don't see anything wrong with that. But there something wrong with announcing one procedure before a shareholder vote and announcing another after the proposal has already passed. It is a form of bait and switch.

I believe that BNS should be required to honor the earlier statement and work with brokers to cash out all shareholders of fewer than 200 shares whether those shares are registered in street name or not.

Thank you,

My next step is to talk to my broker about what is likely to happen to my shares. I don't believe it will be possible to register them in my name.


The company has more information about the shareholder meeting at their website. Besides recording the results of the vote, the only thing I've found pertaining to this issue is the following:
It is the Company’s intent that following the reverse/forward split that the Company will initiate the steps necessary to terminate the registration of our shares of Common Stock under Section 12(b) of the Securities and Exchange Act as last amended. As such, our obligations to file Form 10-K, and Form 10-Q, and the like will be immediately suspended within 10 days of the consummation of the reverse/forward split. This will be an advantage to the Company for a variety of reasons, inclusive of controlling the dissemination of certain business information, elimination of costs associated with the requirements of the Exchange Act, and elimination of the initial and continuing costs of compliance with Sarbanes-Oxley and related regulations. The Company intends that future financial information will be made available to our stockholders regularly and on a timely basis via our websites www.collinsindustries.com and www.bnsholding.com.

The second website isn't currently live.

Update #2:

I just sent a fax to the company's investor relations that included the text of my SEC complaint and the following:
I don't know if the SEC will be able to take action on my complaint between now and August 2, but there is still time to correct this unfair procedure, or to cancel or delay the Reverse/Forward Stock Split. As can be seen in today's trading (share price is down by over 10%), this mornings press release has had an averse effect on the market value of this company. Further, the procedure revealed this morning may permanently harm the rights of minority owners without proper compensation.

According to Hoover's, the fax number is 401-848-6444. Depending on what my broker recommends, I may also try calling the phone number that is listed (401-848-6300).

Thursday, July 26, 2007

Select Comfort levering up

Select Comfort released their 2nd quarter results and there isn't anything too surprising there. We already knew sales would be down and they were. Same-store sales dropped 14% from last year, which isn't good any way you look at it. But we've know it was coming for a month now, so that shouldn't be the focus today.

The first thing I notice is that gross profit margin has not suffered. It improved from 60.4% to 61.2% which indicates management has not panicked and slashed prices. Operating margin on the other hand has plummeted because of lower sales and increases in sales, marketing, and R&D. So looking at the Four Factors, profit margin is lower over the last twelve months (4.78%) than in 2006 (5.85%). David Kretzmann points out that the effect is "sacrificing short-term results for the long-term strength of the business." If those ad and research dollars are well spent, Select Comfort ought to reap a good return on investment over the next few quarters.

Moving on to the balance sheet, it's striking how much smaller the asset base has become since the beginning of the year. Select Comfort has shed $77.5 million of cash and marketable securities in that time. As a result, the sales to assets ratio has actually improved from 3.52 to 4.82 despite lower absolute revenue. There didn't seem to be much need for the money on the balance sheet, so most of it was returned to shareholders via a repurchase program. Turning to the liabilities side, management borrowed $10 million to buy even more shares. Altogether, Select Comfort has bought back $94.3 million of shares at an average price of $17.46 a share. As a result, assets to equity has improved from 1.89 to 3.75 which further leverages the business.

Current and prospective investors need to understand what this is—this is a "bet the business" moment by management. If sales pick up over the rest of the year, the boost to Select Comfort's value will be dramatic. But if sales continue to fall, expect share prices plummet even further and there won't be a cash cushion or a buyout offer to ease the pain. So far there is enough cash flow and not enough debt to worry about the price going to zero, but Select Comfort is significantly riskier than it has been in several years.

Is management making a good gamble? There are several reasons to think so. When Select Comfort released their new TV ads, I had high hopes. But since they haven't worked, the company has reverted to the original Sleep Number campaign for most markets. The old ads have worked in the past and there's no reason they won't work again. Next, the bed maker is rolling out some product updates that seem to target customers tempted by foam beds. Finally, the company is close to finishing their SAP integration. I hadn't grasped the full significance of the system until today: it will make international expansion possible. Select Comfort already sells some mattresses in Canada through a partner, but if they can start opening stores in Europe and maybe Asia, the growth will be astronomical.

Monday, July 23, 2007

Select Comfort option expired

So Select Comfort ended last week under $17.50, so the call option I sold expired worthless. As I mentioned previously, I'll be on the lookout for a chance to sell another option soon. One issue is that the company releases 2nd Quarter earnings on Wednesday afternoon. Selling a call option before then is at least partially a bet on there being no upside surprises in that release. I don't like to speculate on what is basically unknowable, so I will likely pass on the premium until Thursday at the soonest. If by some chance, the news on Wednesday exceeds my expectations, I might look at a higher strike price on later dated options.

One problem with selling call options on Select Comfort is that roughly a quarter of the outstanding shares are sold short. That's a lot of buying potential if relatively good news causes short sellers to unwind their positions. Paradoxically, extreme short interest tends to be a positive sign for companies that aren't scams or on the way to bankruptcy. All those short-sellers are going to need to buy back shares sooner or later, which means extra demand at some point down the road.

Thursday, July 19, 2007

Option expiration tomorrow

The call option against my Select Comfort shares expires tomorrow. Since the stock ended at $17.20, it must gain 1.7% tomorrow. Of the 1,685 trading days in my database, a little over a 1/4 have resulted in 1.7% or greater gain. So I must face the possibility that my shares will be called away. If so, the proceeds ought to be reinvested, though probably not in Select Comfort. My original thesis on selling the option remains intact and First Marblehead has gotten even cheaper.

The July option ended the day at 5¢ or essentially worthless. August $17.50 options ended at 70¢, so I may collect another nice premium next week if the shares are not called away. At this point Select Comfort is on a short leash for me, so I plan to continue selling options until the business improves.

Wednesday, July 11, 2007

Getting the customers you deserve

I pointed out that Canon has a better class of customers than its competitors. Today, I read about Sprint's efforts to improve customer quality by releasing problem customers from their contracts. A customer that calls support several times a day is clearly a customer that is not worth keeping. The letter makes the point a bit more lightly: "While we have worked to resolve your issues and questions to the best of our ability, the number of inquiries you have made to us during this time has led us to determine that we are unable to meet your wireless needs." One imagines these customers will be relieved to be let off the hook as well.

Sometimes companies ought to be selective in the people they take money from in order to avoid lower profit customers. Cutting off problem clients may be too extreme, but there are ways to attract "good" customers and avoid the bad. For instance, targeted advertising or limiting service to certain regions. Insurance companies and lenders often reject potential clients based on risk assessment. But the simplest solution is to charge higher prices. It isn't snobbish. People who pay more tend to be better customers if only because they are more profitable upfront.

With that in mind, let's turn to the mattress industry, which is in a rough patch due to the slowdown in home sales. Since mattress purchases can be delayed, consumers may chose to wait if they are worried about their financial future. As a result, mattress companies face the prospect of slowing sales. Select Comfort has refused to lower prices in order to boost sales and instead has focused on improving marketing and product features. On the other hand, Sealy has been offering discounts that average over 10%. As a result, Sealy's sold more and Select Comfort sold fewer mattresses.

Score one for Sealy, right? Not exactly. When you buy a mattress you are paying for the mattress itself, the brand on the label, possibly status, a short trial period, and a warranty of 10 to 20 years. In exchange, the company gets paid a premium upfront. If they are lucky, they won't hear from the customer for the next decade or so when they are ready to buy another bed. A really good customer might buy the company's bed for their children and vacation home, and tell all their friends about what a great mattress they bought. But for every good customer, there are several disgruntled customers. Bad reviews are one thing, but Select Comfort also warns, "We face an inherent business risk of exposure to product liability claims in the event that the use of any of our products is alleged to have resulted in personal injury or property damage."

Besides improving the product, the best defense against unsatisfied and litigious customers a company can deploy is to maximize the profit of the initial sale. Select Comfort is one part manufacturer, one part marketer, one part retailer, and one part insurer for its own products. Like any insurer, the temptation to write unprofitable policies during down markets can be difficult to resist. But resist it must or risk oversized losses for the sake of a few quarters of undersized earnings.

Tuesday, July 10, 2007

Why I bought BNS Holding

Yesterday, I bought less than 200 shares of BNS Holding for $12 a share. On July 19, shareholders will vote on a proposal to pay out $13.62 for partial shares in a 200:1 reverse split. Since there is a definitive proxy and since insiders control about 44% of the shares, the odds are very high that this transaction will go through. I put the odds at 95%. Since the shares traded at $12 a share just before the announcement, I'm getting a free option on the going-private transaction. My calculations based on the Kelly Criterion show that it would be rational to risk 93% of my funds on this investment. The worst case (a 5% chase the company falls to $0 instead of $12) would still be worth a 50% bet. By any standard, this is a good risk.

Thinking back on it now, I realize that I was a bit harsh on myself for buying Kaiser Group Holdings earlier this year. My arbitrage spreadsheet shows I estimated there to be a 75% the going-private transaction would occur. My purchase price implied a 14% chance. 75% was clearly too high in hindsight, but I still think 14% was a bit too low. Maybe 25 or 30% would have been accurate. In any case, the investment was well worth the minimal risk based on the Kelly Criterion. With relatively low odds and a high potential reward, I think I actually made a good decision even though I didn't get the desired outcome.

Monday, July 09, 2007

Ellison's NetSuite investment

Larry Ellison is very close to pushing his NetSuite venture onto the public markets and it's got folks worried about a potential conflict of interest. Before everyone gets carried-away-er, I'd like to point out that Ellison's fortune is almost fully tied to Oracle, so there is every reason to assume that he will put Oracle shareholders ahead of NetSuite shareholders. To illustrate, at the moment, Mr. Ellison's Oracle holdings are worth $24.5 billion. Assuming the NetSuite IPO sells at the high end of its range, his holdings in that company would be about $555 million. If NetSuite catches up to Salesforce.com in terms of market capitalization, Ellison's investment would be worth about $3.7 billion. In other words, NetSuite's current contribution to his net worth is a rounding error with the potential to become pocket change.

Ironically, the horses left the barn two years when Oracle bought Siebel and stepped more firmly in the on-demand side of business software. Before that, Ellison had reduced his role in NetSuite's operations and ended a licensing deal that allowed NetSuite to use the Oracle name to promote its service. NetSuite's IPO gives reporters an excuse to write about the situation, but in reality it's just another step on the path of disengaging from the smaller company. Once there is a public market for his shares, he'll be able to sell part of his stake.

At the moment, Oracle and NetSuite don't directly compete for business, which means they currently have a symbiotic relationship—Oracle sells database and middleware software to NetSuite and NetSuite fills a niche that Oracle has left vacant. But that relationship can't continue much longer. Hosted business software for small business is the next frontier for any number of software companies including Oracle, Microsoft, Google, and SAP. In addition, there are established companies like NetSuite, Salesforce.com, RightNow, and Intiut. So Ellison's two companies are on a collision course and he's jumping off the little ship to ride the bigger one.

As an Oracle investor, there isn't much to worry about here. Larry Ellison has far too much invested in Oracle financially, professionally, and personally. NetSuite offers him and his children an opportunity for a higher return than is currently available with Oracle, but there isn't much chance it will every rival Oracle in absolute terms. Future NetSuite investors must be aware of the issue, but that's just a part of due diligence.