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.

Thursday, December 13, 2007

Select Comfort not getting any better

Select Comfort gave a brief overview of 4th Quarter results and there is very little to like about them. The current advertising isn't working except for specials and sales. When a sale ends, the stores lose significant traffic. Worse, the company will be raising prices in January to cover increased materials prices. The last year and a half has been miserably poor for shareholders.

I'm listening to Winning by Jack Welch and it opened my eyes to where Select Comfort is going wrong. Traditionally, mattresses are a commodity business. According to Mr. Welch, there are only three things a commodity producer can change: a) price, b) quality, and c) service. Like the NASA mantra (cheaper, better, faster), you can only choose two. So, for instance, at Costco, you get price and quality (= value), but no service. At a traditional mattress store, you get more service, but sacrifice either quality or price. Until recently, Select Comfort was able to side-step that game because they had an innovative product that differentiated itself by being a completely separate category—adjustable mattresses.

This past year, other companies began to invade the category. I noticed that advertisers have started using phrases like "select your level of comfort" that are right out of Select Comfort's play book. Costco now sells mattress very similar to the Sleep Number bed. Further, other technologies such as memory foam are becoming mainstream. In other words, the air mattress is now a commodity.

Now there are two choices for the company: shift to a commodity strategy or find some other way to innovate. Now we don't know what direction management will take but I think we have some clues. Last month, Select Comfort hired a new Chief Marketing Office, Catherine Bur-Hall. Before that, Ms. Hall was a Vice President of Marketing at Midas Printing. Printing is even more of a commodity business than mattresses and from what I can tell, the Hong Kong company has focused on quality and service as its strategy. If it's going to be a commodity, those are the areas Select Comfort is likely to have greatest strength.

When I last bought this company, I made a mistake. I thought their product had a sustainable advantage that could be exploited for years to come. I thought they owned enough mind-share to propel the brand forward with a few tweaks to the advertising. I think management made the same mistake. The cost in terms of market value has been substantial and I think the board needs to hold management responsible.

But the market has clearly over-reacted. At $6.63, earnings would need to shrink by 5% or so over the next ten years in order to be justified. Given more reasonable growth rates, the price should be $15 to $18 a share. The market is assuming that not only will Select Comfort become a commodity business, but it will also fail to be competitive. Those are far from certain in my opinion.

Wednesday, December 12, 2007

Citizens Financial Corporation shares cashed out

My shares of Citizens Financial Corporation were cashed out at $7.25 this morning. That works out to be a 9% return and 68% annualized. This transaction took exactly 2 months and nearly a month from when the reverse split was effected. That took longer than I had planned and I'd started to worry that something had gone wrong. Today, it was as if a heavy load had been lifted from my shoulders. Intellectually, I knew this transaction would likely take a while since only rarely do they pay off quickly. But emotionally, it has been difficult to see those shares sitting and waiting to be cashed out. There is an emotional toll to investing in zero liquidity stocks.

Monday, December 10, 2007

More opinions on First Marblehead

I'm finding that many value investors are now focused on First Marblehead as a great investment. For instance, Whitney Tilson highlighted the company in his most recent Financial Times article. In general the gist of these opinions is that while student loan backed bonds might not be selling well right now, the longterm outlook of the industry is quite bright. Further, Marblehead has been tainted at least somewhat unfairly by the mortgage backed security brush.

The problem, however, is that all of us are excited about First Marblehead's value mostly because of the research done by Tom Brown. He could very well be wrong on this stock and so would all of us who have followed his analysis. So rather than having a diversity of opinion, value investors might be trapped by group think. On the other hand, Wall Street analysts seem to be trapped on the other side by Matt Snowling's research. One side is going to be shown correct and for the moment, my money is on Mr. Brown.

Friday, December 07, 2007

First Marblehead cuts its dividend

Finally some bad news from First Marblehead to justify its massive price drop. Here is the key paragraph from the press release:

"Due to uneconomic terms in the current capital markets, we have elected not to securitize private student loans this quarter. We are exploring non-securitization and securitization alternatives for future quarters to enhance our business model and provide long-term capacity to the private student loan market in a manner that benefits our shareholders. Our business volumes remain strong and we see many opportunities to facilitate and process private student loans," said Jack Kopnisky, Chief Executive Officer and President of The First Marblehead Corporation. "Our Board of Directors determined it was prudent to continue to return capital to our shareholders this quarter even during these challenging times."

Cutting the dividend is pretty close to a cardinal sin in my book, but I'm not ready to dump my shares yet. For one thing, the stock has dropped faster than the dividend, so the shares are still undervalued. For another, it isn't clear to me that this is a real cut. A year ago the dividend was 12¢ a share, which is what it will be this quarter too. Further, the press release makes the cut sound temporary and tied to the failure to securitize loans this quarter. If so, First Marblehead's earnings might be pushed into next year rather than cut off.

I don't think I've made a mistake here since I don't try to pretend to predict the market for privately placed bonds that Marblehead operates in. Clearly their raw material (student loans) are available in abundance, but customers (investors) are reluctant to buy. The good news is that these loans are probably higher quality than most others on the market so when buyers return, they will look at FMD bonds first.

Thursday, December 06, 2007

A losing year

2007 will almost certainly be a losing year for me. Here's where I stand as of this morning:

Date       S&P 500   Delta     IRA   Delta   BRK A
12/06/07      5.27% -10.95%  -5.68% -39.97%  34.28%
Total Gain   50.40%  74.55% 124.95%  20.38% 104.57%
Annualized    7.77%   8.25%  16.01%   2.00%  14.01%
Remember that I own Berkshire stock, so part of my portfolio is supported by this year's 34% gain. Berkshire is now well above the "inflation +10%" benchmark since the opening of my IRA. Select Comfort and First Marblehead have cost my portfolio the majority of the underperformance its experienced this year.

Select Comfort has not performed well in over a year in business terms. I think the company has been disproportionally impacted by the housing slump and management has made some disastrous mistakes. At this point, however, the market seriously undervalues the company even after accounting for very real degradation of fundamentals. There's no guarantee management will right the ship, but Wall Street is treating the mattress retailer as if it has no upside. I made a mistake by not selling a year ago, but I would be a buyer at this price if I didn't already own shares.

First Marblehead, which is down another 8% today, has not had any business problems to speak of and has plummeted almost from the moment I bought it. This is pretty clearly a case of Wall Street blinded by the company's association with other, more troubled financial stocks. As I've been pointing out, unless there is fraud we haven't heard about, this stock should not trade less than $30 a share. My hope now is that the low prices stick around until the next few dividends can be reinvested for me.

Wednesday, December 05, 2007

Business of charities

The end of the year is always the most important in terms of charitable giving, so I think I'll take a moment to look at what makes a charity worth giving to. First, you need to look at a charity qualitatively and then quantitatively. In other words, no matter how efficient a charity is financially, there's no point in giving to it if you don't support the cause or the way the charity pursues it. For instance, I'm fairly ambivalent about animal causes (I think we should focus on people first) so I wouldn't consider giving to one. And I don't much like PETA's tactics, so I definitely would avoid them even though they are fairly efficient about getting money to their cause.

I am interested in International Christian organizations, such as Samaritan's Purse. The link is to Charity Navigator, which rates the financial statements of charities. More about that in a minute. Two of my favorite programs are Operation Christmas Child, which let's donors give a shoe box of gifts to a poor child, and community development programs, that help people become self-sufficient. Qualitatively, it's a great organization, but what about the finances?

From a financial perspective, a charity isn't much different than a for-profit business. There are revenues, expenses, and a bottom line—only the bottom line is used to support some cause rather than owners or shareholders. The first expense, is fundraising, which corresponds to the cost of goods and services in a traditional business. Charity Navigator looks at this expense in two ways: as a percentage of expenses and as a percentage of revenues. Normally these are pretty close to the same ratio, but some charities spend more or less then they take in which causes one ratio to be higher than the other. In both cases the better charities will spend less on fundraising. Samaritan's Purse spends about 4¢ to raise a dollar of support and 6% of its expenses are related to fundraising. An excess of $67,924,383 accounts for the discrepancy.

It's important to compare apples to apples when you look at finances. For instance, every time there is a disaster in the news, the Red Cross gets a ton of free advertising. Meanwhile, my wife is the fundraising coordinator for a small pregnancy clinic that gets no government support. They hold a fundraising banquet every year that generates significant donations, but also costs a fair amount to put on. Comparing those charities by any objective measure isn't really sensible. In general, bigger charities and those with notable brands do better than others.

The next major expense is Administrative, which most correlates with operating expenses in the corporate world. As a percentage of expenses, the smaller the better. Samaritan's Purse spends about 5% on administering its programs, which means (after backing out fundraising) 89% of its expenses are directly related to programs. As a result, it has an excellent efficiency rating from Charity Navigator. I should point out that these measures of efficiency are closely tied and programs could be rated on what percentage of expenses are directly linked to programs with out losing too much information.

Besides efficiency, Charity Navigator also quantifies what it calls capacity based on revenue growth, program expenses growth, and working capital ratio. Roughly speaking, the faster a charity grows and the larger its ready reserve, the more people it will be able to help in the future. Again, its important to consider the context of a charity. Larger charities tend to have advantages in terms of growth and reserves. Samaritan's Purse's revenue has grown 24%, its programs 16% and it has about 5 months of working capital saved up for emergencies.

Personally, I like to donate to small charities that I have some personal connection to. For instance, my wife and I support several missionaries who are our friends. These small gifts have a much bigger impact than if we gave to larger organizations. We also think about how to get our contribution to the organizations we support as efficiently as possible. Usually, writing a check will help more than giving a credit card number to a telemarketer. Finally, we don't give to every charity that sounds good. Concentration helps keep costs down and increases the impact we can make.

First Marblehead just got cheaper

Well, another analyst has downgraded First Marblehead, which has caused the shares to fall once again. The downgrade hinges on a review of 16 notes by Moody's:

The ratings review is prompted by worse than expected performance of the underlying student loans. In particular, loans originated through the direct-to-consumer channel appear to default at a significantly higher rate compared to loans originated through school financial aid offices.
Also, it appears the company will not securitize any more loans this year, which pushes earnings into next.

Now there is no doubt that earnings in the short term will be hurt if the ratings of these notes are reduced and there is no further securitization this year. And I am troubled that direct-to-consumer loans, which are the most profitable for Marblehead, are the culprits. But none of these things are likely to be long-term problems for the company. As long as the dividend does not get cut (and considering cash flow, I don't see how it could), the company trades at least 2/3 of its fair value. Since I plan on reinvesting my dividends for years to come, today is actually good news.

Tuesday, December 04, 2007

Praising with faint damnation

An analyst downgraded shares of Oracle Corp. late Monday, saying a slowdown in spending on software by companies may pressure its earnings.

JMP Securities analyst Patrick Walravens downgraded the business-software maker to "Market Outperform" from "Strong Buy" and lowered his price target to $23 from $24.

"While we still believe Oracle will outperform the software industry, our due diligence suggests Oracle's business is slowing along with enterprise software spending," Walravens said in a client note.

JMP conducted a survey of 38 businesses across the economy and 61 percent said their software spending would stay the same or fall in 2008, he said.

"This survey result is the worst we have had since 2001 and is similar to the result in May 2003, which marked the beginning of a two- to three-year choppy period for Oracle's business," Walravens said.

Business in the Americas may be the slowest, he said, and should be helped by performance in Europe, the Middle East and Africa. Yet the slowing North American unit may make the company's forecast conservative, Walravens said. He lowered his 2008 earnings forecast to $1.21 per share from $1.23 per share.

From an AP story.

It's hard to get too worked up about this "downgrade". For one thing, I don't know what the difference between "Strong Buy" and "Market Outperform" might be. Second, $23 is still a pretty good premium over the current price. Third, the difference between $1.23 and $1.21 a share is well within noise, not much different from Wall Street's consensus, and nearly 20% up from this year.