Four of Two

Why Nintendo is in no hurry for Wii2

2011-03-10T17:07:00.001-08:00

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.

Nintendo's next console

2010-10-20T15:33:00.000-07:00

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:

Drop hardware GameCube compatibility
Retain Wii compatibility
Retain Virtual Console and WiiWare compatibility
Support HD output
Incrementally improve online functionality
Incrementally improve anit-piracy measures
Do something completely unexpected

Given those postulates, we can infer the new system will:

Support the Wiimote and have a sensor bar
Include a disk drive
Support transfer of Virtual Console and WiiWare titles from the Wii
Include HDMI and adequate processing power for HD graphics
Continue to include built-in WiFi support
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.

Why I bought Nintendo

2010-09-29T12:50:00.000-07:00

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:

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.
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.)
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.
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.
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.
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.

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.

The benefit of a concentrated portfolio

2008-11-25T13:36:00.000-08:00

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.)

Best one-day return ever

2008-11-21T13:24:00.000-08:00

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%.

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

2008-10-23T14:46:00.000-07:00

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.

Why I sold Canon

2008-10-14T16:05:00.000-07:00

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.

Shifting to stocks

2008-10-10T14:33:00.000-07:00

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.

Wait 'til next year!

2008-10-06T14:34:00.000-07:00

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.

First Eagle Overseas - 11.59/0.88/34 (CF)
T. Rowe Price Small-Cap Stock - 4.61/0.71/40 (SS)
Vanguard PRIMECAP - 7.27/0.31/11 (1B)
Dodge & Cox International Stock - 10.94/0.65/16 (RF)
Oakmark Global - 8.26/1.13/35 (LF)
Raytheon - 16.10/0.00/0 (DH)
S&P 500 Index - 3.24/0.01/4 & PIMCO Total Return - 4.66/0.43/226 (C)

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.

Turner Emerging Growth - 8.54/1.55/88 (2B)
Fidelity Equity-Income - 2.57/0.67/24 (3B)
Columbia Value & Restructuring - 5.36/0.94/11 (P)

recent interview

-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.

Why I bought a house

2008-08-21T16:44:00.000-07:00

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 Zillow.com, 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:

Added a son to the family.
Become active in a church in Burbank.
Added a second job in Glendale (Joy's job).
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.

USAA love

2008-06-13T14:37:00.000-07:00

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!

Price/Value ratio

2008-05-28T15:16:00.000-07:00

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.

First Marblehead's good day

2008-05-22T12:37:00.000-07:00

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.

Luxury Goods

2008-05-14T16:43:00.000-07:00

So here are three things I read today:

The Rich Drink Better Beer, Not More
There's a new thing called coolspotters that tracks what products celebrities endorse.
Consumers are incredibly stingy, except when it comes to luxury items.

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.

Biggest losers

2008-04-24T12:18:00.000-07:00

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."

Why I sold off my Oracle position

2008-04-21T12:08:00.000-07:00

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.

More good news and bad news

2008-04-09T11:51:00.000-07:00

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.

Good and bad news for Oracle

2008-03-27T10:40:00.000-07:00

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%

Why I sold another call option on Oracle

2008-03-19T10:40:00.000-07:00

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.

Here comes the activist

2008-03-10T13:06:00.000-07:00

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.

Portfolio volatility

2008-03-07T13:20:00.000-08:00

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.

2007 Look-through earnings

2008-02-20T16:46:00.000-08:00

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%

Portfolio news

2008-02-08T12:34:00.000-08:00

First, Footnoted.org 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.

Why I bought yet more First Marblehead

2008-02-05T12:50:00.001-08:00

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.

Four types of moats

2008-01-28T14:11:00.000-08:00

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

Economies of scale
The network effect
Intellectual-property rights
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.

Size
1. Economies of scale
2. The network effect
Knowledge
1. Intellectual-property rights
2. Brand
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?

Yield curve strategy nears turning point

2008-01-22T12:27:00.000-08:00

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.

Long-term results

2008-01-11T11:53:00.000-08:00

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
06/23/02     
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.

I think I understand the Goldman deal

2008-01-07T13:48:00.000-08:00

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.

2007 Year in review

2008-01-02T00:19:00.000-08:00

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.

Why I bought yet more Select Comfort

2007-12-14T09:47:00.000-08:00

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.

Select Comfort not getting any better

2007-12-13T13:37:00.000-08:00

Select Comfort gave a brief overview of 4^th 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.

Citizens Financial Corporation shares cashed out

2007-12-12T08:54:00.000-08:00

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.

More opinions on First Marblehead

2007-12-10T17:10:00.000-08:00

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.

First Marblehead cuts its dividend

2007-12-07T14:57:00.000-08:00

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.

A losing year

2007-12-06T09:07:00.000-08:00

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.

Business of charities

2007-12-05T13:09:00.000-08:00

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

2007-12-05T09:12:00.000-08:00

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.

Praising with faint damnation

2007-12-04T10:42:00.000-08:00

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.

Sally's first year

2007-11-29T15:51:00.000-08:00

Sally Beauty reported it's first year results since being spun off from Alberto-Culver. I'd say the results are very encouraging. If you recall, the massive debt load from issuing a $25 a share dividend has been partially balanced by a significant tax savings. For the year:

Year                          2007    2006    2005    2004
Net interest expense       145,972      92   2,966   2,250
Provision for income taxes  38,121  69,916  73,154  62,059

That's a pretty significant tax savings, though not enough to offset the bigger interest expense. Sally's ability to finance the debt out of cash flow has improved:

Free cash flow             138,991 126,379  63,219 107,265
Free cash flow margin        5.53%   5.33%   2.80%   5.11%

In fact, all the margins (except net earnings) have improved:

Gross margin                45.90%  45.80%  45.56%  45.33%
Operating margin             9.09%   7.59%   8.54%   8.09%
Net margin                   1.77%   4.64%   5.17%   5.02%

One of the reasons for this is that Sally has improved its inventory picture:

Inventory DIO               152.82  163.15  156.17
Receivable DSO                7.46    6.99    6.53
Payable DPO                  47.41   50.12   44.94
Cash Conversion             112.87  120.03  117.76

A large part of these gains come because same store sales increased 4.5% despite losing L'Oreal products from BSG.

Overall, Sally Beauty is doing everything they need to do in order to make the special dividend gamble pay off. I'm quite happy to hang onto my shares while the company pays down debt and exploits its leverage.

Only swing at soft pitches

2007-11-21T15:27:00.000-08:00

I've been working on a model for pricing options that does not rely on volatility as an input. (I know: I might as well try to design an airplane without wings.) Testing it out on real prices, I've found that it give vastly different answers for most options. But when the stock price is fairly close to the strike price and the expiration date is only a few months in the future, my estimate doesn't stray too far from the market quote. So as a general options pricing model, this one pretty much fails.

But today I realized that I really don't care. The vast majority of options are ones I don't really care to sell in the first place. For the most part, I want to sell options with strike prices near the price I would value a company. And options longer than a few months in duration are not interesting either since it would be hard to value the underlying shares. Further, I don't really plan on selling options that are less than 50 or 60¢ because commissions eat up too much of the premium. In essence, my model pins a value on the options I'd really like to sell and I don't care what it does to options I want nothing to do with.

Now I'm interested in selling a January $22.50 option on Oracle that currently trades for 50¢. It's pretty far out of the money, so my model does a rotten job of evaluating its price. It comes up with a negative price, which obviously won't work. On the other hand, my model values the $20 option at about $1.32 while the market says the option is worth $1.50. If I were interested in selling Oracle at $20, I'd take that price, which would amount to selling Oracle at $21.50 with a 67% probability.

As it turns out, if Oracle where trading at $22.50 today, I estimate that the $22.50 option would be worth about $1.24. Now there isn't much chance that Oracle will jump from $20.21 to $22.50 in one day, but it does exist. And if it did happen, I'd gladly sell an option on my Oracle shares for that price. It would be a pitch I'd know what to do with.

Value potential energy

2007-11-19T09:58:00.000-08:00

Recently Vitaliy Katsenelson was interviewed by Philip Durell and Bill Mann. I picked up a few ideas that apply to my investments.

Canon

In the interview, Mr. Katsenelson pointed out that international investing may actually reduce risk in an otherwise US-based portfolio. When I first bought Canon, hedging against a dollar decline factored into the decision. Since then as the dollar has strengthened from about 105 ¥ to 109.61 ¥ with a lot of fluctuation in the interim. Canon has been increasing their dividend which yields about 2.7% compared to the Japanese 30 year bond that yields 2.27%. If (when) Japan raises rates, Canon's price measured in yen will likely go up to push its yield down. At the same time, the yen dividend will likely be more valuable in terms of dollars. Since Canon has a very strong product line, the stock is very close to a sure thing.

Another point the interview touched on is that the address of corporate headquarters doesn't tell the whole story of what countries a company is exposed to. While Canon is largely a Japanese company, it sells products all over the world and has manufacturing and R&D facilities spread around Europe, the United States, and Asia.

First Marblehead

I'll just quote Mr. Katsenelson:

Another one, and I know you guys both like is First Marblehead. This stock trades at what, eight, nine times earnings? It has a phenomenal growth rate ahead of it and I think the investors still put it into the subprime mortgage category, even thought the average FICO score of its portfolio is 714, which is very high; 83% of it loans co-signed.
The part that I love about it [is] this whole speculation about major customers JPMorgan and Bank of America going away [and] you can quantify that easily. You can figure out what impact it would have on the portfolio if both Bank of America and JPMorgan dropped First Marblehead and actually I figured it out and kind of my worst case, a year after JPMorgan dropped; if JPMorgan and Bank of America leave First Marblehead, its revenues would be up 20% or 30% over where they are today. So my downside is basically none.
You could argue that the margins may become compressed, but that the JPMorgan and Bank of America business is growing so fast that it should overcompensate that. I know you guys will agree.

Potential energy

Quite a bit of the interview was actually about the importance of price when it comes to investing. I starting thinking of it like the potential energy in a spring or a hot air balloon. In Active Value Investing, Vitaliy Katsenelson suggests the QVG framework for examining investments. Quality (Q) could loosely be tied to earnings, Value (V) is related to price, and Growth (G) is how earnings (or cash flow) are likely to change in the future. (This is far too simplistic I'm sure.) To go back to the balloon analogy, price is the altitude the balloon floats at, earnings are the buoyancy of the balloon and growth is how fast that buoyancy is changing.

Now investors looking at the balloon from outside try to guess where it will be floating over some period of time. As management dumps ballast (cuts costs) or adds heat (increasing revenues), the balloon ought to rise. If it can't for some reason (investors holding the price down), the potential energy increases. The altitude (price) is fairly easy to see, but the buoyancy and its rate of change (earnings and growth) are much harder to judge. As a result, lower altitude (price) might actually be the best signal to buy assuming buoyancy (earnings potential) is increasing.

The surrounding environment contributes to the potential energy as well. A balloon will be more buoyant on cold day, while stocks have the greatest potential in markets that have low P/E ratios. The inverse of P/E ratios, earnings yields is a direct measure of potential energy. Since P/E ratios for the market as a whole are trending down, prices won't be helped as much as they once were, so it's important to have good earning yields in the individual stocks you buy and own. Canon (6.78%) and First Marblehead (13.28%) are currently have the most potential energy in my portfolio.

Why I won't be rolling my Oracle call options

2007-11-16T12:40:00.000-08:00

The November call option I wrote will be expiring this weekend and the December option is likely to expire too (35% chance). But instead of rolling them forward, I now plan on hanging on to my Oracle shares for a bit longer. I listened to the recent OpenWorld keynotes and also the analyst meeting and I think I've ignored some significant real options that Oracle might exploit.

According to my discount cash flow models, Oracle is well within the low range of its fair value. The market is assuming 10% growth for 10 years or 14% growth for 5 years. Safra Catz, Oracle's CFO, has set 20% as the goal and hinted at 26% as a possibility. Normally, there would be reasons to be skeptical of these claims, but Oracle has some unique attributes that make this sort of growth possible and even likely.

To begin with, much of Oracle's revenues are incompressible. In other words, once a client begins to depend on HR, accounting, CRM or other software as a critical element in their business, it isn't possible to reduce the licensing stream going to Oracle without shutting down altogether. As a result, there is a floor on how much revenues can fall. Also, the natural tendency is for margins to increase over time rather than decrease. Continuing licenses are nearly cost free to Oracle because of scale.

Now assuming there is a recession this year and next, Oracle will have a harder time growing organically. But the revenue stream shouldn't fall too much and it will have an opportunity to either lower costs or buy up other companies cheaply. If the recession doesn't occur or is mild, Oracle has the option to expand its offerings organically in addition. So because of the nature of its business, Oracle has more flexibility than most companies to deal with downturns. That flexibility represents a real option that I hadn't accounted for in the past. Being able to grow earnings in the face of economic headwinds could be a huge advantage.

I know I've flip-flopped on Oracle lately. Part of the reason is that its share price has been jumping around my lower edge of my value estimates. It hasn't gotten so expensive that I feel the need to sell right away, and it isn't so cheap I'm interested in buying more.

Did BEA's financial results make it more valuable?

2007-11-15T13:54:00.000-08:00

One of the tough things about evaluating BEA is that they have been delinquent in their SEC filings until today. For an Oracle investor trying to see if it makes sense to acquire BEAS, the only number that really matters is total revenue. Everything else is pretty much noise, since the purpose of such a deal would be allow much better operating margins. Over the last 12 months, revenues were $1,486,713,000 compared to $1,351,967,000 the twelve months before that. Given Oracle's operating margin (~33%), that would result in $491 million in operating income. That is a significant increase from the $206 million it made in FY 2006, which was the most recent filings investors have had access to. That would indicate Oracle would need to raise its price.

But I don't think that is going to happen. For one, only $541 million of the revenues are from licenses—the rest are from far less profitable services. Also, BEA's operating income was actually negative over the last 12 months. So independent of Oracle or some other buyer, BEAS may be worth less than it was before. Further, the profitable license reviews are decreasing while Oracle's middleware sales are increasing. In any case, Oracle is in an excellent negotiating position.

Can First Marblehead be worth $10?

2007-11-07T12:57:00.000-08:00

Seeking Alpha asks: First Marblehead: Worth $10 or $60? Without going into the arguments presented, which weren't particularly quantitative anyway, I don't see how you could value the stock at $10. $60 or $30 or nothing seem better guesses.

Let's take the case for the business being worthless. Basically, if management is somehow fraudulent and has stolen or wasted all of the cash in the coffers while rendering the residuals on the balance sheet valueless. Throw in a lawsuit or ten for good measure. In that case, the company is headed for bankruptcy court. Otherwise, cash and residuals are worth about $10.80 a share all by themselves. Perhaps the residuals are carried on the books at a higher price than if they were sold on the market, but First Marblehead doesn't need to sell them at market prices as long as it's still in business. And as long as the company is still in business, its value is higher than the $10.80 per share book value.

A dividend discount model prices the current $1.10 a year dividend at $33 1/2 even if the dividend never increased. To state it another way, income of $1.10 a year forever discounted to the present at 11% is worth more than $30. Forever sounds like a long time, but it's important to remember the discount model explicitly weighs income from distant years less than income in the near future. Because the dividend in 2100 is much less likely than the dividend in 2010 it also provides a much smaller portion of the present value of the dividend stream.

Ok, so if First Marblehead isn't a complete disaster or a static income stream, what other possibilities exist? Well, it could continue to grow at a healthy, though maybe not rocket-like, pace. Presumably, the dividend cannot continue to grow at 77% like it did last year nor can earnings increase by 57%, 48%, or 112% as they did in the last three years. So let's assume the dividend grows by 10% or earnings grow by 15% over the next five years. In those scenarios, I calculate First Marblehead shares are worth about $60 each. Given some growth in First Marblehead's business, I don't think many would consider these growth rates aggressive.

At this point, you could put together an expected value based on the odds of the $0, $30, and $60 scenarios panning out, but I don't think I'll bother. The $0 and $30 values are based on completely unlikely possibilities in my opinion. They might be 5% possibilities combined. I'd say my $60 scenario has a better than 5% chance of being far too conservative, but we don't need to consider that to see that at $33 1/2 FMD is a bargain.

Why I sold two more call options on Oracle

2007-11-06T10:54:00.000-08:00

This morning I sold November and December $22.50 call options that cover all of my remaining shares of Oracle for 60¢ and $1.05 respectively. I've already discussed a number of reasons for trying to sell, so I won't go into too much detail. I should note, that a) my call options have captured nearly a full year of Oracle's earnings and b) I find Wall Street's estimate of 20% earnings growth seems fairly unlikely. In fact, the next few quarters may very well be disappointing because of a global slowdown. Buying BEA, even at a discount, just isn't enough to justify Oracle's current market price and make up the difference.

I should point out that by writing calls for two separate expiry dates I'm raising my costs fairly dramatically. Assuming both options are assigned, I basically have doubled my costs. But I've also doubled my opportunities. Imagine a coin-flipping offer where you earn a prize each time you flip heads and lose the coin the first time you flip tails. If you can chose between one coin that earns $2 for heads or two coins that earn a dollar each, which is a better choice? Although the expected return on the first turn is the same ($1), taking two coins gives you a 3 of 4 chance to go to a second turn as opposed to a 50% with one coin. This won't change the expected return, but it does keep you in the game longer. With two coins, you have more expected options to leave the game if the odds were to shift.

Thanks to a 3.4% increase in Oracle today, the odds the November option will be used are 63% and for the December option 66%. There isn't much short interest to propel shares higher on unexpected news and the market is already expecting good news during next week's OpenWorld conference and Q2 earnings announced in December. Therefor, I feel these options are likely to be profitable for me even if my shares are called away.

Earnings yield of my IRA

2007-10-30T17:31:00.000-07:00

Currently, my IRA is flat on the year compared to an 8% or so gain for the S&P 500 and a 17% gain for Berkshire. Select Comfort (-37.5%) and First Marblehead (-28.25%) are the primary culprits, though Canon is somehow down 11% on the year too. Now I don't like the idea of seeing my portfolio stagnate, but there is a ray of hope here: my IRA's earnings yield is improving.

Here's how I calculate yield for my portfolio. Each quarter, I multiply the EPS for each company I own by the number of shares I hold at the end of the quarter. I add up those numbers and at the end of the year I have a value for "look-through" earnings. That's how much my stocks would have returned if they had paid out 100% of earnings in the form of a cash dividend. For 4^th quarter earnings, I use analyst or company estimates which are decent first-order guesses. Then I divide by the total value of my portfolio to get look-through yield.

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%

Since my account value has not changed significantly since the beginning of the year, the increase in yield is entirely due to increases in my companies' earnings. This measure does not include income from cash in the numerator, but it does include cash in the denominator. That means, cash-heavy portfolios are penalized. One solution would be to subtract cash from the denominator. A better solution is to add in interest earned to the numerator. I also add in premiums from call options, profits from short-term arbitrages, and cash dividends, while subtracting commissions, fees, and option losses. This produces a sort of operating earnings yield:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%

I know this double counts cash dividends, which are also reflected in look through earnings. Notice that my cash position has added to earnings in the last two years thanks to a number of arbitrage opportunities.

Higher yields indicate a sort of potential energy for a portfolio. Like the spring in a windup toy, increasing earnings give a portfolio a chance to run. Over a long period of time and given more or less efficient markets, an increase in earnings would represent a corresponding increase in price. Imagine what would happen to a company that earned 50¢ a share and sold for $10 were to increase earnings to $1 a share. If the yield remained at 5%, the stock would also double to $20. But until those gains are realized by selling the stock, that $10 a share increase will not be released. In order to calculate the effects of buying low and selling high, I add in realized gains and special dividends (like the one Sally Beauty distributed last year).

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%

Unfortunately, the net yield is extremely choppy. The simplest solution is to take the geometric mean, which is the best way to get an average of rates or percentages:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%
Geomean       6.89%  6.08%  4.62%  4.36%  4.74%  1.74%

This smooths the data to show that net yields are also creeping up for my portfolio.

So what does all this mean? In my opinion, these yields are a rough estimate of potential. As I make good investments in companies that are cheap and have high earnings, my portfolio potential goes up. When I'm able to make money with the cash potion of the account, as I have over the last few years, I increase my portfolio's potential a bit more. When I harvest some of that potential by selling positions or receiving special distributions from a position, I have a chance to reinvest in companies with increased earnings potential. As I make good choices in allocating assets, my portfolio's yield and potential increase.

It's important to look at measures besides stock value when considering changes in investments. At the moment, First Marblehead and Select Comfort have the highest earnings yield, but are my worst performers. Oracle has the lowest yield, but is also one of the bright spots in terms of price performance. A narrow focus on recent price movement (momentum investing) would lead me to cut my losers and ride my winners. But as a contrarian investor, I'm looking to sell Oracle (low potential) and buy First Marblehead (high potential).

Is Select Comfort a "scary stock"?

2007-10-30T09:20:00.000-07:00

This is a response to an article on the Motley Fool. I'd post it as a comment, but the site ate my post. (I think it filtered out everything after the '&' in "R&D", which is a pretty bogus behavior.)

First, operating profits are down because of increased marketing and R&D--other expense lines are down. Second, buybacks are good investments if the market is undervaluing shares, not because they raise EPS in the short-term. Third, the changes in capital structure are nearly riskless because of Select Comfort's massive and growing cash flows.

Ultimately, a lower stock price combined with a commitment to marketing, R&D, and share buybacks are very positive signs if you believe the company has a superior product. If the company's product turns out to be a fad or is overtaken by competitor copies or improvements, these moves hasten its eventual demise. The reason is that these changes are increasing the company's leverage. Small improvements will be magnified into big improvements and small declines will be magnified into big declines.

So the comparison with Tempur-Pedic is actually encouraging to Select Comfort investors. The Sleep Number bed shares more similarities to foam mattresses than traditional mattresses sold by other companies. In fact, some Sleep Number beds use similar foam to form the top layer over the air chambers. As far as price, Select Comfort offers additional features, such as firmness control, at nearly identical prices to Tempur-Pedic. (For instance, a 4000 Queen is $1,199.99 at Select Comfort and The Original Queen is $1,199 at Tempur-Pedic.) If compared to traditional beds, it's possible to buy a queen size for around $600, which is right in the sweet spot for quality mattresses.

Dickering over the price

2007-10-25T10:06:00.000-07:00

"Lady, you are about to be offered a bribe."
"How big? It'll take quite a chunk to keep me in style the rest of my life in Rio."
"Well . . . you can't expect me to outbid Associated Press, or Reuters. How about a hundred?"
"What do you think I am?"
"We settled that, we're dickering over the price. A hundred and fifty?"
Stranger in a Strange Land—Robert A. Heinlein

Well, BEA has responded to Oracle's Sunday deadline to take or leave a $17 a share buyout with a $21 a share counter offer. When the offer was originally announced, I estimated that $18.55 a share was a fair price, but considered the possibility of a $21 offer. The market is pricing BEAS at $17.67, which is a touch low in my opinion. The two companies have been rumored to be in merger talks for years, but only this month have the rumors been confirmed.

Here's my guess about what has happened since then: Initially, BEA rejected the Oracle offer because it hoped some other company would step in with a competing bid. When that didn't happen, management sent Oracle a letter rejecting the bid again saying it was too low. Oracle responded by setting a limit on the offer of this Sunday. Now BEA was in a bind: if it let the offer expire, it would be clear that there was no competing offer. But management needed to induce Oracle to bid more. That is why they produced the counter offer.

We know that Oracle will end up buying BEA. The only remaining question is the price.

Could monopolies be healthly for the software industry?

2007-10-16T16:10:00.000-07:00

Reading commentary about Oracle's BEA offer made me wonder if monopolies really are bad for software consumers. Logically, monopolies are detrimental in every industry because a single supplier is able to control prices that customers must pay. But there are some cases where a monopolistic structure seems to be not so bad or at least a natural result in certain industries.

In software, there are only two real factors in a purchasing decision: price and features. Price isn't just the amount that goes into the software company's pocket, but also the cost to implement and maintain a system. For large systems, the cost to simply train users might dwarf all other costs combined. As Microsoft has taught us, the biggest company tends to win out when price is the primary factor if only because training costs can be minimized. Nobody bothers to mention "Microsoft Windows" or "Microsoft Office" on a resume anymore, because every halfway qualified candidate has learned to use those programs already.

The other factor is features. Since the biggest companies have a huge advantage on the price side of the equation, upstart companies must compete on features. In my experience, it's fairly difficult to justify spending more on software on the basis of "nice-to-have" features. So in order to compete with bigger competitors, a small software company needs to create functionality that is so totally different and useful that its customers start to depend on it. For instance, a few years ago I purchased a copy of Quicken that downloads all of my transactions from my bank's website. Since I've grown to depend on this feature, Intuit has locked me into their software indefinitely.

The other lesson Microsoft has taught us is that big companies have an advantage when it comes to features as well, if the big companies catch the trend soon enough to copy the feature. For instance, Excel, Word, Windows, Money, Internet Explorer, and Outlook were introduced in order to outflank Lotus 123, WordPerfect, Macintosh, Quicken, and Netscape. There are dozens of smaller examples as well. Apple and Intuit survived only because they stayed under the radar long enough to lock-in a critical mass of customers before Microsoft moved in. Other competitors, such as Google, have thrived because Microsoft didn't understand their features until it was too late to emulate. Notice that these mistakes and oversights have occurred more often as Microsoft and the software industry have grown. It's just too hard for them to see everything that is going on.

From the customer's viewpoint, the Microsoft monopoly has been surprisingly benign. Sure, personal computers are probably too expensive because of the Windows and Office taxes, but cooperate America's software training costs are probably lower than they would be with more variety. It's hard to say if we are suffering from a lack of features, but until recently Microsoft has been the leader in distributing new types of software. Where they have failed, it seems like some other company has filled in the gap fairly quickly. In either case, innovation has thrived under the Microsoft monopoly to a greater extent than is possible to imagine under the IBM monopoly of the the 1970's.

Of course, once a monopoly develops, there is a new reason to buy software from a particular company: there is no other choice. And if everyone knows the monopolistic company will simply copy any new and revolutionary product, there is little reason for startups to startup. On the other hand, if the biggest companies are willing to buy up smaller players, like Microsoft in the 1990's and Oracle in the last three years, there is an incentive to fill functional gaps. From the market leader's perspective, purchasing successful competitors when they are small is both cheaper and more certain than developing their own copy. Customers also benefit, since the original products tend to be better than the imitations, at least for a while.

So the dynamics of the software industry may produce benevolent monopolies if:

Big companies drive down the total cost of software ownership.
Small companies have an incentive to compete on features and are not overly afraid of their ideas being copied by larger companies.

It's like a pond with two niches: small fish (that specialize in features) and big fish (that reduce overall price). Companies like BEA are in the uncomfortable middle: too big to be truly innovative and too small to be cost effective for customers. In this case, if the big fish swallows the medium-sized one, it might be best for the entire ecosystem.

Oracle's offer to BEA

2007-10-12T14:33:00.000-07:00

It looks like I won't sell Oracle for $22.50 this week (1 chance in 5). I plan to continue trying to write $22.50 call options on my shares because they continue to be fully-valued. I mentioned last month, that it is nice to have more than one reason to own a stock and the income from writing options is a good reason. Besides that, if the option is exercised, I feel I'm getting a fair price.

The big news for Oracle was their offer last week to buy BEA. I've learned a bit about how to evaluate mergers and I think the offer is pretty good, but is likely too be raised before all is said and done. If the premium offered is less than the expected value of the synergies produced, a transaction my be considered successful. In this case, the premium is at least $1.3 billion. Before the announcement, BEAS was priced at $13.62 a share and the offer price is $17—a premium of $3.38 a share times 392 million shares. Oracle hinted it considers the premium to be even higher: "Our proposed price is a substantial premium to an already-inflated stock price that reflected speculation of the potential sale of BEA and represents a more than 40% premium to BEA's stock price before the appearance of activist shareholders in mid-August of this year." Carl Icahn is, of course, the "activist shareholders" the letter refers to. I'm not going to factor that in, however, since the stock traded higher than $14 as recently as July 19 of this year and has been in the general range for most of the last twelve months.

Synergies are a bit harder to calculate. The market clearly thinks Oracle will need to raise its price since BEAS is trading at $18.55 a share (a $1.9 billion premium). An obvious source of synergy stems from Oracle's high operating margin (33%) compared to BEA's (14%). If Oracle simply trimmed BEA costs to match its own, it would earn an extra $205 million a year in synergies. Using an 11% cost of capital, that works out to about $1.9 billion. Further benefits, such as the ability to cross-sell products to BEA customers and technological improvements, are not included but are also less certain and harder to calculate. I'd assume they are a counter-balanced by integration costs, but they probably do exist.

I just read the chapter on Mergers and Acquisitions in Expectations Investing. One important concept it presents is Shareholder Value at Risk (SVAR), which quantifies how much of current shareholder's value the company is betting on an acquisition. For an all-cash offer, the math is pretty easy and works out to 1.2%. If the offer goes up to $18.55, as the market currently predicts, the SVAR is 1.7%. The highest offer I've seen speculated is $21 a share, which would risk 2.5% of shareholders current value. Any way you slice it, this offer will not have a huge impact on Oracle's long-term performance.

So to sum up, I like Oracle's prospects and the current offer to BEA, but I'm still trying to sell call options so that I can earn some extra income on this fairly-valued position. Got it?

Why I bought Citizens Financial Corporation

2007-10-11T13:52:00.000-07:00

This morning, I bought less than 250 shares of Citizens Financial Corporation for $6.55 a share. It is a small Kentucky insurance company that announced a 1-for-250 reverse split with fractional shares cashed out at $7.25 a share. I've been burned in two straight going-private transactions, but I think this one will work out. Here are my reasons:

This is a reverse split with no corresponding forward split. That was how the BNS Holding transaction burned me because it only temporarily produced fractional shares. Since there is no forward split and no fractional shares will be issued, my broker will need to cash my shares out whether I'm a shareholder of record or not.
Over 60% of shares are owned by insiders, so the vote will go their way. Most likely, they will not back out of the transaction because the company will clearly benefit from savings from eliminating public-company costs.
Book value per share is about $7.90, which means even the $7.25 offer is a discount to the company's value. In fact, since many shares will be retired, the book value per share will actually increase. For an insurance company, book value is a better guess at intrinsic value than any measure based on earnings. That's because the rules for recognizing earning don't work well for the insurance business.
Given a 95% chance of success and the pre-announce price of $6.42 as a base, the Kelly Criterion suggests I'd be safe putting 92%+ of my portfolio into Citizens Financial. Even if the company is worth nothing, the percentage would be nearly 40%. The market currently prices the odds at 15.66%, which is far too low in my opinion.

I need to remind myself that though the results have been less than I expected recently, my process has been sound. It's easy to claim that failures are due to bad luck, but in this case I believe it to be true.

Why I'm selling Oracle

2007-10-10T14:32:00.000-07:00

I'm now in the process of writing in-the-money call options on my remaining Oracle shares with the intention of closing my position soon. Today I sold a $22.50 October call for 60¢ when Oracle was selling for about $22.85. By my calculations, there is about a 63% chance the option would be exercised. Oracle ended the day at $22.92, which boosts the odds a couple of percentage points. After commission, I'll be selling Oracle for the equivalent of $23 a share in about 9 days. I'm also trying to sell November options to cover the rest of my Oracle position.

In my opinion, Oracle is no longer a good value. A conservative growth assumption of 10% a year for the next 5 years would come out to about $21 a share. Using more aggressive growth rates will produce higher estimates, of course, but we are now firmly in the range of reasonable valuations. That makes Oracle less attractive to hold and unattractive to buy. If there was a dividend, especially if there was a good chance it would be raised, I'd have more reason to hang on. But the share buybacks Oracle currently uses to return value to shareholders don't excite me at these prices.

I should note that Oracle will continue to be on my radar over the next few years because it is a business that is not well understood. Earlier this week, SAP made an offer to buy Business Objects, which was widely reported as a change in course to Oracle's acquisition strategy. The trouble with that statement is that Oracle's strategy isn't to just buy up competitors, but to get the best software even if it has to buy whole companies to do so. SAP might be doing the right thing, but only if Business Objects to improves SAP's own suite of products and doesn't cost too much. SAP's action doesn't "validate Oracle's strategy"—it merely increases the cost for Oracle to buy good businesses. So it's been odd to see Oracle's price going up this week rather than down.

The case for Select Comfort

2007-10-05T08:26:00.000-07:00

I think the crowd is wrong about Select Comfort because market participants are focusing on short-term, rather than long-term prospects. It seems to be the usual reason the market undervalues companies. In this case, Select Comfort has swung from a hot, growth stock to a company with troubles on several fronts. They had to take a big one-time expense because of an abandoned computer system. New fire-retardant regulations reduced company earnings to an extent. But the big news is the housing slump that slowed mattress sales. Also, Select Comfort's new ad campaign failed to bring in costumers. As a result, EPS for the last quarter was down 69.41% YoY and for the last 12-months EPS is down 19.48%. Sales last quarter were down 4.84% and for the last 12-months, sales are only up 5.06%—a far cry from management's 15% goal.

But the further back you go, the harder it is to see a problem. Over the last 5 years, sales have grown 25.23% and EPS has gone from -66¢ in 2001 to 85¢ last year. Gross and operating margins have improved dramatically. Management has predicted more margin improvements this year too. The company has a negative cash conversion cycle and new stores pay for themselves within a few months. The Four Factors are moving in the right direction, so earnings yield is higher than a year ago. So the question comes down to has Select Comfort's business changed so that the next five years will be much slower than the last five.

To be certain, growth in the last five years came on the back of fixing a broken sales and marketing system, expanding into new markets and controlling costs. Those low-hanging fruit are long gone. But the market is pricing in about 8.4% growth, which is nowhere close to the 14% projected by the most pessimistic analyst. I think the disconnect is that the market is looking out only one or two years. Because of the current macro-economy, the next two quarters look like they will be flat earnings-wise. But over the next five to ten years, Select Comfort has tremendous operational advantages.

Consider they way mattresses are traditionally bought and sold. Since people rarely buy more than once every decade or so, they don't have any reason to spend a lot of time thinking about how to do it. Unlike buying a car, mattress shopping seems boring and unimportant. Consumers look for things like brand, an in-home trial, manufacturer's warranty, and price. These are shortcuts that people use so that they can get a mattress they are comfortable with and get on with their lives. It's relatively easy to manipulate people using these shortcuts. For instance, there's a mattress store here in Southern California that advertises very heavily with the slogan, "We’ll beat any advertised price, or your mattress is FREEEE!" At first glance, one would assume the store is losing money (which is the way the commercials spin it) or is working on razor thin margins to avoid giving away the store. But the fact is each chain carries slightly different models with different names so that each store can claim to offer the lowest price. The low price message must be drilled into the consumer's consciousness because you never know when they might in the market for a mattress.

Since Select Comfort offers a unique style of mattress and controls the retail experience for the most part, it can differentiate itself without resorting to product name shenanigans. The key will be a long-term, consistent focus on the unique attributes of the product. Just having a storefront in the mall that people walk past year after year improves the odds that they will buy a Sleep Number bed. When combined with advertising (especially on the radio), it should be possible to encourage most people in a market to at least consider it. Management hasn't moved into non-US markets so far because they see plenty of potential in US markets they haven't tapped so far.

Sealy cut prices in the face of slow sales, but ended with a bad quarter in terms of earnings. Tempur-Pedic, on the other hand, recently raised prices yet sales increased. The purchase cycle is very long for mattresses, so its hard to read too much into a few quarters, but it seems foam has become a legitimate substitute for traditional innerspring models. Select Comfort might benefit since newer models come with improved foam toppers.

Bubble pricing

2007-10-02T13:23:00.000-07:00

Consider two stocks:

Trades in a range from $5 to $15.
Trades in a range from $9 to $11.

The not too difficult question is: which stock is riskier? And given no more information, A is the riskier stock. That's because the greater volatility means you could lose more money with A than trading in B—at least if you only had price information to work with.

But if you knew for certain that the actual value of each stock was $10, than A ought to be far less risky. Instead of trading randomly, an investor could begin buying once stock A is priced below its value and sell when the stock is above its value for a true arbitrage situation. This is Ben Graham's margin of safety principle. One little piece of information (the value of the stock) makes a huge difference.

Of course, we can never really be certain about anything, much less the value of a company that might have skeletons lurking in its metaphorical closet. The fact is, markets are often right. That's because of somewhat bizarre phenomenon known as the wisdom of crowds. In essence, the crowd is more likely than the individual to the answer to certain questions correctly if at least three conditions are true:

There exists a diversity of thought.
There exists an aggregating mechanism.
There exists an incentive to individuals for being right.

If any one of them is missing, an individual has a chance to do better than the crowd. But a well-designed market has all three of these conditions most of the time. Therefore, if we want to invest in stock A, we ought to make a case not only why $10 is the right price, but also why crowd wisdom doesn't apply.

A familiar case is the asset bubble. For instance, a group of investors might decide that stock A is worth $15, not $10. So they start to buy whatever shares they can lay hands on. Then some people decide the stock might be worth more like $20 and bid up the price further. The jump from $5 to $20 attracts speculators who don't know, and may not care, how much A is worth. At this point anyone who owned A and thought it was worth $10 or even $15 has taken a profit and anyone foolish enough to be short has either covered or lost their shirt. So both sides of each trade are people who believe in the company at any price. Condition I is thoroughly violated.

But there is also a problem with conditions II and III as well. Bearish opinions on the stock are not aggregated because there is no incentive to take a position. It is difficult to make money on negative opinions in the current stock market because short trading is both difficult and dangerous. The same can be said about the housing market, except substitute impossible for difficult and dangerous. Early on, when it might help with little pain, the crowd can't apply the brakes.

I've been playing the Motley Fool CAPS game and, even though I'm doing a terrible job there, I think its a pretty useful tool. Instead of judging success on an absolute basis, picks are compared to an investment in the S&P 500 over the same time period. So, a thumbs up pick might be losing even if the stock price has gone up if the index has gone up faster. If you read a mutual fund prospectus, the concept ought to be clear. More importantly, thumbs down picks win as long as the index does better than the stock.

You accomplish the same effect by selling as stock short and using the proceeds to buy an ETF that tracks the index. It would be somewhat expensive, however, since you would need to pay twice the number of commissions and there is normally a margin requirement. Perhaps some sort of ETF or derivative could be devised to solve the problem. It's also possible to simulate a relative return on a bullish position, but this wouldn't normally make sense unless you thought the index was due for a fall.

Having multiple reasons to own

2007-09-26T13:17:00.000-07:00

Looking at my overall portfolio performance, I feel pretty good, but two of my biggest positions are way down against the market (as defined by the S&P 500). First Marblehead doesn't bother me too much because I just bought shares and I can't believe how cheap they are. The first and primary reason to own a company for a value investor is that shares are worth far more than the price assigned them by the market. It's sort of the litmus test of value investing.

Select Comfort is a different story. Since I doubled-down, at the end of 2006, the price has gone down, but so has the value. Based on 85¢ EPS last year and 20% projected growth, a fair value would have been about $34 a share. But this year, 87¢ EPS seems pretty optimistic and 15% is a better guess for growth, which makes my best guess for Select Comfort's value to be $24 1/2. I wouldn't argue against a valuation as low as $20 or so. Even so, this is still less than the $18 I paid last year or the $13.30 (adjusted for a 3:2 split) I paid in 2005.

The other reason First Marblehead is easier to own is that it pays a regular dividend. I cheer for low prices since they mean I'm reinvesting at low prices. But Select Comfort doesn't pay a dividend. They do have a buyback program, which I expect is taking full advantage of the low prices the market is offering. I still prefer a dividend, however, since it is more certain and reliable. First Marblehead is buying back shares as well, so I'm doubly pleased.

One lesson I've learned from Select Comfort over the last year is that as a stock price approaches parity with its value, there needs to be another reason to own the stock. You can't force a company to pay a dividend and share buybacks become less worthwhile, so selling becomes a reasonable option even for a company that is operating on all cylinders. As I have done with Select Comfort and Oracle, you don't have to place a sell order in order to sell a stock—writing a call option works nearly as well. I missed that chance a year ago when Select Comfort was trading near $25, but I won't miss it next time.

I've already started practicing sell discipline with Oracle. Improving, rather than worsening, financial conditions make a company easier to own. But stock prices tend to peak around the time that performance peaks. If price are getting close to value, there has to be another reason to keep the company. At the moment, Oracle is priced to grow earnings at 14.5%. Though this is possible, I'm afraid there is a real possibility Oracle's business could falter like Select Comfort's did. I don't see any reason to take that risk when there are other investments that trade well under their current value.

Why I bought more shares in First Marblehead

2007-09-24T12:58:00.000-07:00

This is as close to a no-brainer as I've seen. Six months ago, I thought First Marblehead was cheap and now its business has improved and its price has dropped. Recently, the company raised the dividend 10% (which is on top of a 67% increase in June). Even if the dividend never goes up again, the dividend discount model suggests a value of $33 1/2 or so. A modest 10% increase for the next 5 years followed by no further increases is worth about $57 1/2 according to my model. According to the Quicken DCF model, Marblehead only needs to grow at 1.8% to justify its current price.

The only thing that has been missing for the last few months has been cash to augment my position. Thankfully, I was able to lighten up on Oracle just in time to collect a larger dividend on my shares this morning.

Update September 24:

I found another opinion of First Marblehead that echoes my feelings and assigns a range of values to the company. Even under the worst case when everything falls apart for the company, the author assigns a price per share of $42. I've found that my best investments occurred when I couldn't figure out how a company could be valued as low as the market price. For instance, when I first bought Oracle, it seemed like the market was operating under the assumption that the database business was dead. Both times I bought Canon, the market seemed to have factored in only minimal growth. If I had bought Select Comfort when I first looked into it and it was trading in single digits, that would have been the same story. In fact, the market scared me out of buying the mattress company until the price was more in line with its value.

In First Marblehead, I think the market is crazy and it thinks the same of me. One of us is right and the other will be shown wrong in the next few years. This is an ideal example of why value investing is normally contrarian investing as well.

Why I sold Oracle and how I wiped out my option profit

2007-09-21T13:27:00.001-07:00

So the Oracle September call option I sold is going to be exercised this weekend since Oracle finished the day at $21.98 a share. Using the rules I established for accounting option gains and losses, selling the option cost me $1.98 a share. Since I only received 55¢ a share of premium and also paid a commission, I took a pretty ugly accounting loss on the transaction. In fact, this single loss would nearly wipe out all the premiums I've earned since I began selling call options this year. When adding in costs, my combined ratio is an abysmal 121.92%.

Without this single transaction, my combined ratio was an amazing 24.74%. I don't really have a large enough sample to measure myself yet, but this tells me that I'm settling for too little premium when I write call options. In fact, I was pretty surprised to see that Oracle's price had jumped from $19.36 to $20.13 on the day I sold the option. Rather than a 35% chance of losing, I sold a option that was nearly a coin-flip. If options were my full time job, I would have noticed the price change and adjusted my limit order to capture more premium. Options are so much more volatile than the underlying stock that the full-time trader has a distinct advantage.

But even if I had written the call for a reasonable price, I would certainly have lost this particular bet. Oracle's stellar earnings release, that came on Thursday, assured that the option would be exercised at a loss. The market's response to lower rates didn't help either. Now, I don't really mind too much because I still have plenty of Oracle shares that are worth more than when I sold the option. Part of the reason I sold in the first place was because Oracle was a bit overweight in my portfolio.

My letter to Congress on H.R. 1852

2007-09-21T11:43:00.001-07:00

Senators Boxer and Feinstein,

I urge you in the strongest terms to vote no on H.R. 1852, which is titled the "Expanding American Homeownership Act of 2007". It would be a bad idea for American homeowners and a disaster for California.

The United States and particularly California are experiencing a housing crisis that is resulting in a number of families losing their homes. Lately, we've been seeing stories on the news of people who have taken a severe financial hit because they cannot pay their mortgages. But the crisis didn't begin this year or last. It started about seven years ago when the cost of buying a house began to rise faster than the income of potential home buyers.

For instance, although my family income is above the median for Los Angeles County, it would cost me well over half of my gross pay to buy the median house in this county. Despite very generous pay increases from my employer and my wife starting a part-time job, home ownership has become increasingly less obtainable for us over the last seven years. Financially and mathematically, it just doesn't make sense.

Now H.R. 1852, which was co-sponsored my own Representative Adam Schiff and recently passed the House, seems a gallant , but ultimately foolish attempt to solve the problem. This bill only addresses the problem of providing financing for expensive houses such as the L.A. County median house, and it does nothing to either lower the cost of buying a house or increase the income of prospective home buyers. That's a bit like trying to fix the Social Security system by issuing lottery tickets instead of checks--some people will be helped out, but most will be worse off.

Ultimately, we got into this mess because lenders made it easier for people to borrow money, so some people took advantage and spent more on houses then they should have. To those folks, I suppose making it easier for new buyers to take those homes off their hands seems like a pretty good deal. However, to those of us who are able to finance the purchase a house, but don't want to wreck our financial futures that way, this bill is slap in the face and an insult to our intelligence.

Thank you,
Jon Ericson

Why I sold BNS Holding

2007-09-18T15:59:00.000-07:00

It turns out that my BNS Holding shares were not cashed out. While this was disappointing, it didn't surprise me too much and I was able to sell my shares at $13. On an annualized basis, I earned 23.30% on the transaction. Not a disaster by any means, but not the profit I was hoping for. At several points after it became clear the transaction was falling apart, I could have panicked and sold at a loss. But I was able to stay (relatively) calm and evaluate what I should do next.

Now I might very well have ended up with a loss anyway. Staying calm doesn't guarantee a good return. But it does give you a chance to avoid loss when the situation turns against you. When I bought BNS, I gave it a 95% chance of making $13.62 a share, which I suspect was a bit generous. I also was aware I might need to sell at $12 a share or less. I'd even considered the possibility that this position might be worth nothing. Being aware of the range of possibilities helped me remain calm and step off of the ship when the tide was high, not low.

Why I sold a $20 September call option on Oracle

2007-08-30T15:09:00.000-07:00

Yesterday I sold a $20 September call option part of my Oracle shares for 55¢ a share. As of this afternoon, they are selling for 65¢. Last year, I sold an option that was not exercised for these shares at 70¢, so I've created a synthetic dividend of $1.25 on a stock that earned 81¢. Now there's a risk (50.6% or so) that I will lose a percentage of that premium in accounting terms when the option expires. This option likely to be exercised, so it might be better to think of this as a sale of Oracle. I think Oracle is still undervalued, but I'm willing to sell because First Marblehead is even more undervalued.

Sally Beauty: The Good, the Bad and the Ugly

2007-08-14T10:48:00.000-07:00

Last week Sally Beauty released its 3^rd Quarter results. There isn't really much news here except that L'Oreal has hurt Sally by pulling products from Beauty Systems Group's (BSG). In the spring L'Oreal bought Beauty Alliance, a BSG competitor, so it no longer made sense for them to continue selling through another company. The bad news is that this has cost Sally some sales and dropped the price of Sally shares to their when-issued price.

The ugly news, which isn't really news to anyone, is Sally's rather massive debt load. On the conference call, there were some questions about how quickly the debt can be retired. Unsurprisingly, the covenants for the senior notes limit the speed Sally can pay off higher interest junior notes. So the debt may be with us for many years. Remember that the debt lowers net earnings, but also lowers taxes. Enterprise value is about $10 a share higher than the current stock price because of the debt load. A company representative on the call said something like, "We are in the beauty supply distribution business, not the bond trading business." At the moment, cash flow more than covers debt service, so the result is ugly not outright bad.

Now for the good news. I think the L'Oreal moves are a net positive for Sally Beauty in the long run. When Alberto-Culver spun off Sally, one of the primary reasons was that the association hurt the BSG business. Companies such as L'Oreal and Proctor&Gamble weren't happy about using a competitor's subsidiary to distribute their products. Since the split, it appears more brands are interested in being distributed by Sally Beauty, with the obvious exception of L'Oreal. Since L'Oreal has entered the distribution business, its competitors will have a vested interest in keeping other channels, such as BSG, open so that their products can be sold in salons.

I don't know if L'Oreal's gamble to go into the distribution business will work out, but it seems like a pretty good risk for them. Conversely, the gamble ought to be good for Sally because although they have lost a major supplier, L'Oreal has essentially taken out a major competitor. Only if fashion continues to focus on L'Oreal professional products in the next few years will Sally be in serious trouble.

Technorati Profile

2007-08-14T10:05:00.000-07:00

I now have a Technorati Profile. They seem to have a better blog search tool than Google.

BNS update

2007-08-13T16:36:00.000-07:00

Today, BNS executed its reverse split. Last night, I noticed that my sell order at $13.62 was canceled. This morning, the ticker for my position had changed to BNSIA*, which is an excellent sign. According to Yahoo Finance, the new BNS ticker symbol is BNSSA. Now its just a matter of waiting for the cash to find its way into my account.

Valuing my house

2007-08-08T12:50:00.000-07:00

In a recent post Dr. Housing Bubble presented three ways to value a property. For a stock market investor, these valuation methods seem pretty basic. "The Cost Approach" is pretty much book value, "The Sales Comparison Approach v2.0" is a relative valuation close to P/B ratio, and "The Income Capitalization Approach" is a stable value DCF model. I'd like to take the third and try to get a value for the little guest house my family rents.

First, we pay $1,200 a month or $14,400 a year to rent our 2 bedroom/1 bath house. It's about 900 square feet on what would be a relatively small lot, if it were separate from the main house. Our landlord hasn't raised rent in 5 years and is willing to pay for normal repairs. I don't know what his expenses are, but I would imagine it would be no more than the 45% of his rental income. So his cash flow is something like $7,920 a year.

In a traditional DCF model, you'd divide that number by the discount rate minus the expected stable growth rate. In the real estate model, those rates are combined to create a standard "cap rate". Nearly every home will have a stable rental growth rate that matches inflation or 2-3%. The discount rate would depend on what return you might expect to make by investing in a different property in the area or making some other equivalent investment. Stock market returns are similarly risky and will probably return 10% or so. That makes 7% a fairly reasonable cap rate. So if it were possible to buy our house on its own, $113,143 would be the fair value.

According to Rentometer, the median in our area is $1,700. That works out to a fair value of just $160,286, which I would gladly pay.

FundAdvice.com's advice about my funds

2007-08-06T15:32:00.000-07:00

FundAdvice.com publishes advice on various 401(k) plans, including the one at Raytheon. A striking aspect of the suggestions is how few funds they picked—especially for the "Aggressive" portfolio. My comments on the funds I didn't pick:

Vanguard Windsor - 15.18/0.25/38
American Century Small Cap Value - 15.89/1.05/121
Real Estate Securities Fund - 27.55/?/?
BGI EAFE Equity Index - 20.37/0.10/7
Stable Value Fixed Income - 5.09/?/?

I have also put into place a fund allocation scheme that I think I can follow. With 10 funds, each would have a 10% or so share in my portfolio if I were equally comfortable with their prospects. But some funds (Excelsior Value & Restructuring, Vanguard PRIMECAP, and First Eagle Overseas) deserve an extra share (15%) since they seem better bets than the others. In order to make rooms, those funds are paired with funds (Turner Emerging Growth, Fidelity Equity-Income, and Oakmark Global) that I don't have as much confidence in which will receive a half share (5%). If I were to gain greater confidence in a fund (perhaps Value & Restructuring), I could assign it a double share (20%) and pair it with either two half-share funds or eliminate a position altogether.

Note that this allocation doesn't exactly match the "batting order" I presented last week, even if the pitcher spot is given a greater role based on defense. Diversification with my IRA holdings knocks down the value of owning Oakmark Global. I'm not happy with the small company choices Raytheon offers, including the T. Rowe Price Small-Cap Stock, and that segment is well-represented in my IRA.

I've also designated PIMCO Total Return as my "gateway fund". It receives all deposits initially and diverts them to funds that are getting underweight. I had planned on using another fund for this purpose, but I just learned that the redemption fee for short-term trading is no longer going to be charged.

Ten little mutual funds

2007-08-02T15:55:00.000-07:00

It's been a very long time since I looked at my 401(K) options. I have a hard time talking about these funds because there isn't a lot going on with them. Unlike a stock like Canon which has more news each week than I could possibly comment on, mutual funds barely look different from one year to the next. So I thought it might be fun to look at the 10 funds I currently hold as if they were a baseball lineup. The statistics are 5-year return/expense ratio/turnover ratio. Higher is better for return (obviously) and lower is better for the other two. The lineup (with the exception of the pitcher spot) is roughly the order I feel comfortable with these funds in the future. Overseas funds belong in the outfield, small-cap funds are middle infielders, large-cap funds play corner infield, index and bond funds play catcher, and the special-situation fund is pitcher.

First Eagle Overseas - 23.04/0.89/28 (CF)
T. Rowe Price Small-Cap Stock - 15.71/0.91/20 (SS)
Vanguard PRIMECAP - 17.53/0.31/10 (1B)

The Intelligent Investor

Dodge & Cox International Stock - 24.72/0.66/9 (RF)
Oakmark Global - 22.44/1.18/41 (LF)
Raytheon - 15.5/0.00/0 (DH)
S&P 500 Index - 10.73/0.01/4 & PIMCO Total Return - 4.84/0.43/257 (C)

a year and a half

Turner Emerging Growth - 19.81/1.54/78 (2B)
Fidelity Equity-Income - 13.80/0.67/24 (3B)
Excelsior Value & Restructuring - 19.18/0.84/13 (P)

My favorite funds are those that open up the black box just enough for investors to take a peek inside. My 401(k) doesn't have many funds that are as open as Pimco has been over the years, so I need to search a bit more than I'd like to get to know the managers and their styles. Ten funds seems like a lot when compared to the more compact portfolio of my IRA and much of that is due to the sparse information available. I don't want to assign strict 10% allocations to these funds, since they vary in quality and likelihood to outperform. I think this post will help me sort out what the final allocation ought to be.

My miserable July

2007-07-31T12:17:00.000-07:00

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

2007-07-31T11:16:00.000-07:00

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.

BNS Holding changes the rules in mid-stream

2007-07-27T09:13:00.000-07:00

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,
Jon

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.

Update:

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).

Select Comfort levering up

2007-07-26T10:59:00.000-07:00

Select Comfort released their 2^nd 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.

Select Comfort option expired

2007-07-23T11:01:00.000-07:00

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 2^nd 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.

Option expiration tomorrow

2007-07-19T13:06:00.000-07:00

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.

Getting the customers you deserve

2007-07-11T11:09:00.000-07:00

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.

Why I bought BNS Holding

2007-07-10T13:49:00.000-07:00

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.

Ellison's NetSuite investment

2007-07-09T15:01:00.000-07:00

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.

Oracle's blowout quarter

2007-06-28T13:14:00.000-07:00

I've owned Oracle for just over five years, which probably means I'm biased toward favorable information about the company. Oracle had an almost perfect 4^th quarter this year. I couldn't really find much to complain about, so I was interested to read about "Oracle's Mixed Message" in BusinessWeek. Here is the meat of the current bear case in the article:

Oracle's fourth-quarter sales of new business applications licenses, a predictor of future sales, rose just 5% in the region that includes the U.S., to $415 million. Excluding Oracle's $3.3 billion acquisition of Hyperion Solutions on Apr. 23, U.S. sales were essentially flat. "That's where people are a little concerned," says Peter Kuper, an analyst at Morgan Stanley (MS).
During the conference call, Ellison blamed slow U.S. applications sales growth on a tough comparison with the fourth quarter of 2006, when Oracle reported particularly strong results.
Oracle's overall new license sales for applications rose 13%, to $726 million. UBS (UBS) analyst Heather Bellini said in a research note that new applications license sales fell short of her expectation for 14% growth, and she wants to see more numbers from Oracle's recent acquisitions to figure out how quickly it's picking up share from SAP. Bellini expects SAP to post 10% new license growth for applications in its current quarter.
Oracle announced five acquisitions during the fourth quarter, including Hyperion Solutions, a maker of business-intelligence software, and Agile Software, which helps companies manage product portfolios (see BusinessWeek.com, 3/2/07, "Oracle: Consolidation Catalyst?"). Oracle said Hyperion contributed $43 million in fourth-quarter sales, but there's concern on Wall Street that chief information officers signed discounted multiyear contracts with Hyperion before the acquisition closed, leaving Oracle with less green field now. "The big question around this acquisition will be, did Hyperion drain the pipeline?" says Brent Thill, director of software research at Citi (C), in an interview earlier in June.

Peter Kuper's concern (5% increase in new application license revenue in the Americas) is nitpicking at its finest. Year over year quarterly results are valid numbers to look at for most companies, but it doesn't work quite so well in a business that is driven by a relatively small number of deals. It isn't unusual for a sale to finish just before the beginning of the quarter or get delayed past the end of a quarter. The problem gets exaggerated by looking at fine slices. Here's what the line looks like for the last two years:

                 Fiscal 2006           Fiscal 2007
                 Q1  Q2  Q3  Q4  TOTAL Q1  Q2  Q3  Q4  TOTAL
US Applications 150% 41% 61% 73%  67%  69% 19% 69%  5%  26%

Clearly growth was incredibly lumpy. Somehow I don't think Mr. Kuper wasn't highlighting the 69% growth a quarter ago or the 73% growth a year ago. Looking across all geographies, as Heather Bellini did, smooths the data somewhat:

Applications     84% 24% 77% 83%  66%  80% 28% 57% 13%  32%

But there is a deeper problem since analysts are focusing on new licenses, which are increasingly less important to Oracle's profitability. Since 2002 or so, renewals have accounted for the majority of overall revenue:

                2007   2006   2005   2004   2003   2002
Renewal share  58.61% 57.50% 56.58% 56.12% 54.58% 50.19%

Renewal revenue carries a much higher operating margin, since you don't need to woo customers with expensive sales calls to convince them to continue paying for software they've already installed. Also, renewals are less likely to be discounted. Overall, it's just a lot cheaper for Oracle to retain a customer than to sign a new customer. The easiest way to measure renewal rate is to compare the current period's "Software license updates and product support" line to the previous period's total sales:

Renewal rate   72.17% 70.44% 66.05% 62.91% 55.71%

Although this number might not strictly reflect the rate that customers are retained from one year to the next, it's likely to be a pretty good approximation. It shows that Oracle is getting better and better at holding onto the customers it has already won, which will improve profitability in the long run.

Now, I know why analysts focus on new licenses. The above quote makes clear that they are "a predictor of future sales". The last five years shows this to be at least somewhat true:

New licenses   19.92% 19.90% 15.53%  8.29% -6.92%
Revenue growth 25.15% 21.87% 16.18%  7.19% -2.05%

On the other hand, by focusing entirely on new licenses, Wall Street is missing the potential growth in revenues, which are growing beyond what would be expected by looking at licenses alone. The difference is customer retention.

My first five years

2007-06-22T14:06:00.000-07:00

As of today, I've been actively trading in my IRA for five years. It has been one of the better periods of time to be invested in the US stock market. Five years is a pretty standard span to measure performance, but I'll feel better about my record after looking at it from trough-to-trough not just trough-to-peak.

Here is my year-by-year performance updated to the market close today:

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
06/22/07     5.94% -1.58%   4.36%  6.35% -1.99% 1502.56 24.89 107,800.00
Total Gain  51.36% 97.54% 148.90% 99.59% 49.31%    
Annualized   8.64% 11.36%  20.01% 11.66%  8.35%

And here is the graphical version:

The green line labeled "Inflation+10%" represents a benchmark suggested over at Controlled Greed. To measure inflation, I'm using the Bureau of Labor Statistics Series CUUR0000SA0. As you can see, that's a pretty tough benchmark to beat. I don't find it to be quite as helpful as the other two benchmarks I use. I'm beating it now, but what would I do if I weren't? With the index and Berkshire, I could decide after a few years of under performance to give up stock picking and just buy the benchmark. But I can't do that with inflation + 10%.

Update:

I took a quick look a the funds my 401(k) plan offers and the only ones that would have beaten my IRA's return over the last five years are First Eagle Overseas (20.91%) and Dodge & Cox International Stock (20.81%). I have positions in both funds, but I only started buying them recently. The performance difference is well within the margin of error, so there's no real incentive to switch even if I weren't having fun managing my own portfolio. Also, I have confidence in my own selections, but I don't have any particular insight into the stocks those funds are holding.

How I made a small profit on Kaiser Group Holdings

2007-06-22T12:37:00.000-07:00

As it turns out, I did make a small profit on the busted Kaiser Group Holdings deal. This afternoon I sold my 19 shares for $28 a share and netted a $4.59 profit. After commissions, I would have lost $23.83 if I'd bought the S&P 500. (Not counting commissions, I would have broken even on the index, but that's not cricket.)

Besides luck, which is the overwhelming reason I made a profit, I credit this result to waiting for a good price before buying and not panicking before selling. If I'd sold immediately, I would have been out almost the cost of two commissions. On an annualized basis, my return was 6.69%, which is nothing to write home about, but better than if it had stayed in cash. Remember that these short-term deals are intended to beat the rate I earn in my sweep account.

More importantly, I've kept my streak of profitable closed positions alive. (That a joke, actually. I got lucky on a bad decision. Sometimes, it's best to sell a bad decision at a loss.)

Eveillard's tax device

2007-06-21T12:00:00.000-07:00

I just came across an interview with Jean-Marie Eveillard, who manages one of my 401(k) mutual funds—First Eagle Overseas. There is one little answer that immediately caused me to open the spreadsheets of each of my core holdings.

Fortune: You pay a lot of attention to companies' tax rates. Why? Particularly in the U.S., I don't like companies with very low tax rates, because it's a sign either that the Internal Revenue Service will catch up with them someday or that the profits they report are overstated. The average corporate tax rate is 35%. Any company that has a tax rate of 15% or 20% looks suspicious to me.

This suggests a simple device for estimating how much risk a company has because of trying to game the tax system. Companies with overly low tax rates are like ticking time-bombs. There aren't a lot of positive reasons for a company to pay low taxes. The device also warns of companies that exploit the US system that allows companies to use two sets of books. Oracle has the highest rating and it isn't exactly a blaring fire alarm.

Company        Tax     Device     
-------        ---     ------
Oracle         29.71%   5.29%
Canon          34.52%   0.48%
Select Comfort 37.78%  -2.78%
Berkshire      32.81%   2.19%
Sally          38.82%  -3.82% 
Marblehead     38.51%  -3.51%

Raytheon       31.79%   3.21%

Why I sold a call option on Select Comfort

2007-06-18T15:36:00.001-07:00

I already mentioned my intension to sell a covered call option at $17.50 a share and today the order was filled at 45¢ a share. I sold July contracts and the underlying stock ended the day at $16.68. Over the next 31 days, there is a 42% or so chance the option will be exercised.

The odds that I will break even are approximately 62%.

It's important to note that I've only written an option for a portion of my holdings, which means I can still profit from price increases over the next month. I might sell another option at a higher strike or an option that expires later in the year. It's also possible that I will sell shares outright if their price jumps unexpectedly. On the other hand, I could have sold options more cheaply if I'd sold more contracts.

Is seems to me that Select Comfort is undervalued because of a convergence of events that management has some control over. At a recent Analyst Conference, CEO Bill McLaughlin pointed out that the current marketing campaign does a good job addressing the "need" portion of Select Comfort's message, but not the "solution" portion. He mentioned at least twice that consumers don't always know where to buy the Sleep Number bed, which I found a bit surprising. He also said that the housing downturn has had an effect on sales since Labor Day last year because people tend to buy beds when they move into a new house and because the "wealth effect" has been reduced. He also revealed that Select Comfort has seen significantly more cannibalization than expected when it expand from 100 Retail Partner Doors last year to 800 this year.

Fortunately, management has committed to fixing these problems and to borrowing cash to buyback shares. They have a significant amount of control over the marketing and distribution of their own product. Also, there was an announcement today of upgraded products, which gives me encouragement that R&D efforts are starting to pay off.

Why I bought Kaiser Group Holdings (and wish I hadn't)

2007-06-18T13:26:00.000-07:00

On May 5^th, I bought 19 shares of Kaiser Group Holdings because of this preliminary proxy. I paid $26.50 a share in hopes getting cashed out at $36 a share. As of this 8-K, I will be forced to sell for much less than that. Today's closing price was $26.85, so I don't foresee making a profit on this position. I broke my rule of waiting for a definitive proxy, so I only have myself to blame.

According to Eric J. Fox and Eric Schleien, Kaiser Group is trading below NCAV. I get a liquidation value of about $33 a share, much of it in cash. Unfortunately, it's hard to know what management intends to do with that cash. Going private seemed like a reasonable choice for all the usual reasons—especially since there's no real operating business here. Since the company was unable to get the deal done over the last few years, it's hard to believe shareholders will get relief anytime soon.

Select Comfort's problems deepen

2007-06-15T14:22:00.000-07:00

According to their second quarter update, Select Comfort management is questioning the new marketing strategy. Rather than revive sales, as I anticipated, the company expects sales to decline 5% from a year ago. If that happens, Select Comfort will need to find ways to cut expenses to avoid reporting an EPS loss this quarter. For the year, management is projecting 87¢ to 93¢ a share compared to 85¢ in 2006. They have also lowered sales projections to be 4% to 7% growth over last year, which seems optimistic given the very slow start to the year.

On the flip side, the release also suggested management has found expenses to cut, plans to release upgraded products, and is committed to buying back significant numbers of shares. Also, the Motley Fool points out, it is encouraging that management is taking responsibility for the problem. I had missed this Financial Times article from a few days ago that suggested management is weighing acquisition of businesses that would expand Select Comfort internationally or into bedding accessories. My guess is that these plans are on hold for now, but those are obvious paths to growth in the future.

If Select Comfort doesn't cut Sales and Marketing costs, which would be difficult given their focus on fixing marketing, I'm guessing they will lose 15¢ this quarter and only earn 55¢ this year. I'd consider this to be a fairly conservative estimate. Management's low end 87¢ a share might be more realistic given their insight into the problems, but it's hard to give them much more benefit of the doubt. Given the various growth opportunities and that we are likely at a trough in sales, 15% growth over the next ten years is not unreasonable. Beyond that, I'll assume no more than 3% (or slightly more than inflation) growth in the terminal value. I always use a discount rate of 11%, which is the long-term average of the S&P 500.

Given those assumptions, my DCF model results in fair value between $15.67 and $24.58:

EPS                 0.87    0.55
Historical Growth   2.50% -34.65%
5-year Growth      17.73%   9.11%
  
Growth             15.00%  15.00%
1                  $1.00   $0.64
2                  $1.15   $0.73
3                  $1.32   $0.84
4                  $1.52   $0.97
5                  $1.75   $1.12
6                  $2.01   $1.28
7                  $2.31   $1.48
8                  $2.66   $1.70
9                  $3.06   $1.95
10                 $3.52   $2.24
  
Discount rate      11.00%  11.00%
NPV growth        $10.62   $6.77
  
Stable growth       3.00%   3.00%
NPV terminal      $13.96   $8.90
  
Total             $24.58  $15.67

Select Comfort traded up to $17.13 at the close, so the market is definitely leaning toward the lower estimate. (Not that I think any market participant uses anything like my estimates. More likely, investors are using management's EPS estimates and knocking the growth rate down a notch or two.) Back in December, I predicted this scenario as a possibility when I bought more shares at $18. Obviously, I'd prefer results were better—especially given the change in advertising. Due to this news, I'm going to try selling a covered call at $17.50, which would be a 4% loss on my recent purchase if exercised. I still like the long-term prospects of the company, but I like the prospects of First Marblehead even more.

First Marblehead raises dividend and buys shares

2007-06-06T15:24:00.000-07:00

First Marblehead just announced a substantial increase in dividend to a yield of about 2.6%. In the same announcement, the company reported purchasing about 1.39% of its own shares. If I use a dividend discount model to value FMD, I get a ridiculously high figure—as in 3 to 4 times more than the market price. Earlier in the week, the company released results of the most recent securitization, which were quite encouraging given the current point in the financial aid cycle.

It's hard to stand pat without any cash to add to my current position. But I don't know what I'm willing to sell. I suppose this is a good problem to have.

Canon sells to a better class of customer

2007-06-06T10:48:00.000-07:00

Every time I think about cutting back on my Canon position, I see an article like this one. Essentially, Canon has created a more efficient customer base than its competitors. It isn't completely clear how they were able to do this, but I have a few theories:

Canon does not have a personal computer business like HP does. Some of the printers bundled with PC systems will be heavily used, but consumers who purchase unbundled printers seem more likely to use them. Brother, Lexmark, and Epson printers also tend to get bundled with PCs.
Canon does bundle photo printers with digital cameras. Consumers may not be any more likely to be heavy users of these printers, but if they do, they will likely be using more costly color ink and photo paper.
Canon has a long history of supplying HP with the print engine for the LaserJet series of printers. This arrangement would artificially increase HP's market share number and decrease Canon's, and therefor alter each measure of efficiency. On the other hand, if Canon sells to HP with a greater profit margin than HP sells to the consumer, which seems likely, the aberration isn't that big a deal.
In the past, color printers used one cartridge to hold all three ink shades, so when you ran out of cyan (probably because you printed too many Word documents with random phrases underlined as if they were email addresses or web links), you had to throw out half a tank of yellow and red. Canon was fairly early in switching to separate cartridges for each color tank, which intuitively would make one think they sell less ink. But I suspect the opposite occurred. Rather than feeling ripped off by a printer company, Canon users felt free to print Word documents with lots of cyan because they knew they wouldn't be wasting a bunch of red and yellow ink.
I don't have any hard and fast evidence, but I feel like Canon printers are easier to use—especially if you want to print directly from a camera or memory card. It would be easy to assume that usability is most important as an initial selling point, and that customers are locked in, but that ignores how easy it is to get a new printer at a low cost.
Brand loyalty thanks to years of producing professional and "prosumer" cameras might encourage consumers to buy genuine Canon consumables rather than generics. I know for my family, we gladly pay more for Canon supplies on the assumption that they will produce better results.

Canon's dividend valuation

2007-05-23T09:42:00.000-07:00

Until recently, I've seen Canon's dividend as a nice, but not vital piece of the valuation puzzle. But in the last few years, Canon has raised its dividend to a point where the company can be valued on actual payments to shareholders rather than cash flows which might never reach investors. Here is a chart of dividend information for the last 10 years:

                2007    2006    2005    2004   2003   2002   2001   2000   1999   1998   1997  
Dividend        ¥150.00 ¥125.00 ¥100.00 ¥65.00 ¥50.00 ¥30.00 ¥25.00 ¥21.00 ¥17.00 ¥17.00 ¥17.00
Dividend growth 20.00%  25.00%  53.85%  30.00% 66.67% 20.00% 19.05% 23.53% 0.00%  0.00%  -
Expected growth 11.00%  11.75%  12.28%  13.14% 13.25% 10.49% 10.11% 9.18%  4.61%  8.13%  9.47%
DDM for 5 years ¥7,867  ¥6,813  ¥5,597  ¥3,800 ¥2,939 ¥1,533 ¥1,253 ¥1,003 ¥638   ¥769   ¥824
Price           ¥7,131  ¥7,050  ¥6,710  ¥5,560 ¥5,090 ¥4,580 ¥4,660 ¥4,250 ¥4,160 ¥2,320 ¥3,040

"Expected growth" is the mathematical maximum growth that can be sustained based on a Canon's financial information. It is composed of retained earnings rate multiplied by return on equity. Only earnings that are retained (about 75% of income) may be reinvested to fund future dividend growth and the return on equity over the next five years is likely to be about the same as it is this year (15% or so). Multiply those rates and you get a growth rate of about 11% a year. Notice that actual dividend growth has been somewhat better than that since 1999 in order to make up for some flat years in the late 1990s.

I discount that growth at 5% for the next 5 years. This rate seems appropriate for the low return on Japanese risk-free investment. At the end of 5 years, I assume Canon's dividend will grow at 2% compared to a discount rate of 5%. As you can see above, 2007 will be the first year in which the Dividend Discount Model values Canon higher than its market price. Since the dividend-only model is as conservative as you get in valuation, there's no particular reason to construct a more elaborate model when the value exceeds the current price. Converted to dollars, the DDM values Canon at about $64. Meanwhile, the Quicken model I've used in the past puts the value at $77. The current price is $58.59, so by either measure, Canon is still a good buy after doubling over the last 5 years.

Since this estimate is based on what Canon is already doing, I see at least two free options offered by the stock. First, SED TVs could add substantially to Canon's bottom line. Second, consumers in emerging markets such as China, India, Russia, Brazil, and Mexico may soon afford lower-end digital cameras and printers to replace traditional film cameras. Canon has pretty much eliminated the PC as a necessary part of the digital imagery work-flow and the upfront costs are within an order of magnitude of film costs. Over the long-term, digital pictures are vastly cheaper to process and far more convenient for most consumers than film, so I expect the switch-over will happen over the next five years or so. Kodak and Fujifilm sell billions of dollars of film equipment and services around the world and Canon has a shot at nearly all of that business now.

Cost of complexity

2007-05-14T13:48:00.000-07:00

I've been listening to Aswath Damodaran's valuation class online, which has been very informative. Near the end of Lecture 10, Professor Damodaran suggests an interesting adjustment to "punish" companies for having complex structures that are hard to understand and analyze. The argument goes the more complex a company is, the more places it can hide information about itself and the more likely some of those details will turn out to be bad news. The professor suggests counting the number of pages in a companies 10-K as a simple way to measure complexity.

I sort of assume my companies are more transparent than their peers, but I didn't have any way of measuring that. Now I do. Here are my core holdings with the first competitor I thought of for reference:

Company        Pages
-------        -----
Oracle         103
Canon (20-F)   122
Select Comfort  72
Berkshire       84
Alberto         99   
Sally           99
Marblehead      71+38F

SAP (20-F)     121+70F+1S
HP             152
Tempur-Pedic    48+30F
Citigroup      180
P&G             23
Regis          117
Sallie Mae     118+84F+12A

I don't know how to treat the extra pages (F-38, A-12 and so on), but my sense is that these are a sign of even more complexity than regular pages. Proctor & Gamble walk away with the prize in this group, but overall, the companies I own are objectively less complicated than the ones I don't. I had actually picked Citigroup as a foil to Berkshire because I expected it to have over a thousand pages. Perhaps that number includes all the supplementary documents that I don't plan on even opening. I only included the main 10-K.

One other reason to use this sort of test is that if a company's filings are too long or complicated, chances are you won't read it. My Alberto-Culver investment relied on that principle, since I hoped as few people as possible would have worked though the sum-of-the-parts valuation and I could buy in at a low price. Now that I've bought, I hope the Sally reports at least are going to become more clear and simple so that other investors can begin to appreciate the company's true worth. And since insiders have had these same goals, I'm pretty sure my wish will be granted.

First Quarter results

2007-05-10T16:02:00.000-07:00

All of my companies have reported earnings for the first quarter of 2007 (though some of them call it Q2 or Q3). With a single exception, I'm quite happy with the results. Here are the earnings per share adjusted for splits and spin-offs:

1st Quarter EPS      2007  2006  Change
                     ----  ----  ------
Oracle                .20   .14  42.86%
Canon                 .84   .69  21.74%
Select Comfort        .21   .21 -00.66%
Berkshire Hathaway  56.07 50.03  12.07% 
Alberto-Culver        .23   .16  43.75%
Sally Beauty          .06   .17 -64.71%
First Marblehead      .75   .62  20.97%

One quarter isn't really enough to give a clear picture of a company. But with the exception of Select Comfort and Sally Beauty, these companies are performing well on a multi-year basis. I've talked about Select Comfort's issues, so I won't go into them too much more. This Sunday, they ran a clever ad in Parade magazine that gets delivered with many paper in the US, which confirms my basically good opinion of the new campaign.

Sally Beauty is a more interesting story. Remember that I bought it before the split with Alberto-Culver. After the split, I owned one share of Sally, one share of New Alberto, and $25 for each share of Old Alberto. The $25 special dividend was paid for by borrowing huge amounts—in essence prepaying future earnings of Sally. I haven't seen the latest cash flow statement or balance sheet, but you can get a pretty good idea of the effect of the transaction from this portion of the income statement:

3 months ending March 30     2007    2006
                             ----    ---- 
Operating earnings         60,771  51,313
Interest expense           44,947     321
Interest income               300     300
Market interest rate swaps  1,700       -
Net interest expense       42,947      21
   
Earnings before taxes      17,824  51,292
Provision for income taxes  6,785  20,117

Net earnings               11,039  31,175

Operating earnings are up because of growth in the business and cost savings from no longer being part of Alberto-Culver. Interest expenses are up dramatically even after income from interest rate swaps because of the massive debt load. Sally shareholders owe roughly $12.45 a share to Sally bondholders after the special dividend. Fortunately, there is plenty of cash flow to cover the payments and plenty of growth to grow out from under the debt. You'd be forgiven for thinking the whole thing is a pointless exercise if I hadn't included the impact of taxes. Since interest payments are tax-deductible to Sally, net earnings are not as small as you might imagine. Over the life of the debt, this will amount to significant tax savings.

Although the market value of my companies have increased at a healthy rate, I'm not currently interested in selling any of them because I believe their potential has increased even more. That's the reward for buying good companies at a cheap price.

Update May 14

Sally released the balance sheet with their 10-Q and the debt is closer to $10 a share. Book value is about -$5 a share, which makes life a bit tough from a relative valuation perspective.

Value investing is arbitrage

2007-04-30T14:58:00.000-07:00

The other day, I talked about the reverse-split arbitrage I've been been engaged in for the past year. Thinking about the methods I use to evaluate the opportunities, I started to wonder if they could be applied to other investments. Certainly the concept of arbitrage can be extended to other realms such as sports betting. The key element is that there must be multiple markets for the arbitrageur to exploit. In the case of a reverse-split, the two markets are the open market where one normally purchases the shares, and the company market where the company buys the shares. The reason this arbitrage is profitable is that the second market is only available to those who hold a small number of shares. In mergers and tender offers open to unlimited amounts, the market adjusts almost immediately to the offered price.

Value investors do something similar when we attempt to profit on discrepancies between the price and the value of a stock. Of course, the value market is a theoretical one, at least in the short term. But the purpose of buying an "undervalued" company is the hope that eventually the market will change in such a way to properly value the position.

Let's take a look at Berkshire Hathaway, the classic value stock. First, we need an estimate of the payout if a bet on Berkshire is successful. The Berkshire Hathaway Intrisivaluator is as good a place to start as any. Currently, the "Cost of Capital" estimate puts BRK.B shares at $4754. This estimate assumes a healthy growth rate discounted at Berkshire's cost of capital. For an estimate of the minimum value, we'll use the "Liquidation" scenario of $3114 a share. Here the assumption is Berkshire sells off all its assets, settles all its debts, and distributes what's left to shareholders. There are other choices offered by the model, but for the sake of argument, let's assume that these are the payouts for success and failure.

The market values BRK.B at $3628 as of today's close. Using the method I described last week, that implies the market thinks there is roughly a 45% chance Berkshire will perform well enough in the future for "B" shares to be worth $4754 today. By elimination, that means there's a 55% chance Berkshire will stall out and only pay out $3114. Obviously any rational view of a company's future will be more nuanced and complicated than a simply success/failure trial. But it does provide a dead-simple method of calculating the odds of a stock investment. In this case, the market seems to think Berkshire doesn't have much gas left in the tank.

One issue with thinking this way for ordinary stocks is that there is no finite termination date. It's as if the coin keeps spinning and never comes down—or maybe the coin is flipped over and over again as shares are traded. But that's not a bad thing from a practical standpoint, since the company's value doesn't stop moving either. Each quarter there is new input into the value calculation, which often makes a good deal look even better. If you flip back in the Intrinsivaluator to 1981 ("B" shares, if they existed, were valued at $40), the value keeps climbing as you step through the years. Even in 1995, when Berkshire seemed most overvalued, a long-term investor would probably regret selling.

Select Comfort's new ad direction

2007-04-26T10:38:00.000-07:00

I've just had a chance to review two Select Comfort commercials from its new "Cure Tired" campaign. As I mentioned in the past, the most recent advertisements seemed more like they were hawking drugs not beds. The new ads are much better and get back to the key elements of the original ads: humor and product focused. True to form, McKinney produced one spot aimed at women and another aimed at men.

"Bright Eyed", the weaker of the two in my opinion, begins with scenes of women trying to cover up baggy eyes in the morning with the familiar "What the world needs now..." tune in the background. A voiceover suggests, "The world doesn't need a better way to fake a good night's sleep... It needs a better way to sleep." The payoff is a 5-second explanation of the Sleep Number bed followed by the new tag: "You Can Cure Tired." Since I'm not the target audience, I don't know if my judgment can be relied on, but the makeup and cucumber scenes seem less humorous and more pathetic than I'd like.

On the other hand, "Staying Awake" seems to hit just the right notes. The opening scenes this time represent over-the-top caffeine/energy drink/stimulant attempts to stay awake under the same music. The voiceover this time says, "The world doesn't need a better way to stay awake... It needs a better way to sleep." The spot is a full minute instead of 30-seconds and it uses the time to establish a bit more clearly that the first part is about covering up the real problem: being tired. It also introduces a protagonist who buys a moderate-sized cup of coffee and rejects the "moster caf 72" coffee mug. As he walks down the street, he observes in disbelief the Ka-Blowie stimulant-smoothie stand, Wakey'z Drugmall, a dog lapping up coffee abandoned by a napping newspaper seller, and so on. Finally, the man notices a helpful Select Comfort salesman waving to him from in front of his store. The ad ends with the same explanation and tagline.

"Cure Tired" is a pretty good tag, especially since the beds actually work. Every time I'm forced to sleep in some other bed, even a relatively comfortable bed, I'm quite happy to go home and rest in a bed that adjusts to fit me.

SCSS has just released their first quarter earnings which were fairly well described on the Fool. Obviously I'd prefer if comparable sales were better and it makes me nervous to have management back-load earnings so much. But I think there is a good chance advertising will make a difference.

How I added to Canon's results

2007-04-24T15:43:00.000-07:00

There's a pretty good summary of Canon's Q1 at the Motley Fool. As it happens, I feel partially responsible. You see, earlier this year I bought my wife a Canon Rebel XT . It was intended to replace the A85 I bought her a few years ago and the Rebel 2000 I gave her a few years before. For at least this consumer, Canon has been able to sell higher margin products as the years go by.

The financial statements support this. In 1999, the year the Rebel 2000 was first introduced in Japan, Canon converted ¥3 of every ¥100 in sales to profit. In 2006, it converted ¥11. There are lots of reasons for this, such as the move from film to digital, point & shoot to SLRs, black and white to color copiers and printers, currency benefits, and operating efficiencies. Meanwhile, Canon has taken a hit in asset turnover, which has fallen from ¥98 to ¥92 of revenue per ¥100 of assets. This is to be expected since higher margins usually imply lower sales. Fortunately, the overall effect has been positive as measured by ROA, which went from 2.71% to 10.07%.

Meanwhile, Canon has been de-leveraging over that same time-frame. Its equity to asset ratio dropped from 2.15 to 1.51 thanks to decreases in long-term debt and capital leases. Normally this has a negative effect on return on equity, but because of Canon's stellar margins, ROE has improved from 5.84% to 15.25%. Mathematically, it doesn't much matter which of the ROE component ratios improve, but financially its nice to "front-load" the ratios. In general, it is easier to improve asset turnover through discounting or leverage through borrowing than it is to increase margins. This is especially true in a highly competitive business like digital cameras and printers.

I don't imagine margins will improve much from here on out, but there is hope for further growth in new products. Currently the company is working on launching SED TVs and have announced a medical device initiative. I'm a bit worried about the plan to develop (and I'm not making this up) intelligent robots. Whatever that means. I'm confident that Canon's R&D investments will pay off over time, but it's nice to have such strong operations while we wait.

The business of beauty

2007-04-24T12:19:00.000-07:00

It's been a while since I wrote about Sally Beauty, but there were two stories that I thought were worth reading. First is a story from Forbes on starting a salon business. Sally got a mention as a supplier of salons, but what was more interesting to me was the advice to adopt a Whole Foods approach to employees. "In the salon world, the most precious resources are stylists, so keeping them around and happy is critical." The article suggested emulating Whole Foods' training program.

On a related note, Regis is dropping out of the beauty school business by merging most of its schools with Empire Education Group. The press release has more information including the suggestion that the need for IT investment was the reason for the merger. As you might recall, Regis was initially interested in buying Sally Beauty, but was rejected at the last moment because of operating weakness.

It seems to me that while the beauty salon industry as a whole resists consolidation, the supporting industries are successfully consolidating. Beauty schools and salon product distributors benefit from economies of scale, but salons themselves rely to a large extent on the services of talented stylists. Since talented stylists know they are an important part of the success of a salon, they demand a larger slice of the profits. There are dozens of professions with this dynamic including chefs, athletes, programmers, artists of all types, and so on. But unlike other professions, it's difficult for individual stylists to scale their work—they can only cut one head of hair at a time.

Arbitrage odds

2007-04-23T13:58:00.000-07:00

One of the ways I've been evaluating going-private and other arbitrage opportunities is to look at the market's implied probability of success. Like gambling situations and unlike most investment situations, arbitrage is essentially a binary, win-loss event. That makes it relatively easy to apply the Kelly Criterion.

To show how it works, let's take my first going-private transaction, Major Automotive. On October 14, 2005, the company announced plans to implement a reverse split that would pay $1.90 to shareholders of less then 1000 shares. On March 29, 2006, I bought 999 shares at $1.75 a share. After the $19.95 commission charged by my broker at the time, I hoped to make $129.90 when the reverse split was resolved. I guess that there was at least a 95% chance the split would succeed from that point since insiders owned 49.4% of the company. I don't like the idea of assigning higher odds because of Murphy's Law.

If the split failed to happen, what would my position have been worth? The most pessimistic choice would be to assign no value. It isn't unreasonable either, since I'd done basically zero research into the underlying value of the company. In that case, I'd have lost the entire $1,768.20 that the position had cost. The expected payout would be $129.90*0.95 + (0-$1,768.20)*(1-0.95) = $34.995, which isn't half bad for a zero-research investment. A slightly more realistic value would be the price of the shares just before the reverse split was announced. On October 13, 2005, Major Automotive was priced at $1.40 a share. Using that price as a floor, the expected payout was $103.93. If you are following along don't forget to include an extra commission as an added cost of failure.

As it turns out, you can calculate the odds the market is assigning to an arbitrage situation with a little bit of math. This is the equation for expected payout:

S*p + F*(1-p) = E

where:
S = price if split succeeds
F = price if split fails
p = split probablity
E = expected price

If the market is rational, you'd expect the market price to match the expected price. I used the Mathomatic Computer Algebra System to solve for p:

$ mathomatic
Mathomatic version 12.6.10 (www.mathomatic.org)
Copyright (C) 1987-2006 George Gesslein II.
50 equation spaces available, 960KB per equation space.

1-> S*p + F*(1-p) = E

#1: (S*p) + (F*(1 - p)) = E

1-> solve p

        (E - F)
#1: p = -------
        (S - F)

Now if you plug in the values for Major Automotive when I bought it, you get a 70% probability that the split would happen.

Since my probability estimate (95%) was much greater than the market's, my expected payout was correspondingly higher. Given enough of these situations profits would be astronomical for anyone who could identify them. According to the Kelly Criterion, the optimum allocation for even the pessimistic case is 27%. (This can be calculated by taking the expected payout and dividing by the maximum payout or $34.99/$129.90. The more optimistic case calls for a whopping 80% allocation.) Unfortunately, these situations are rare. The only reason reverse splits are so wildly mis-priced is that arbitrage positions are limited to a small number of shares. Unless you have a portfolio of only a few thousand dollars, it's impossible to allocate the optimal amount even under the pessimistic case.

First Marblehead gets cheaper and I couldn't be happier

2007-04-16T13:37:00.000-07:00

First Marblehead has lost 23.67% since I bought it in March (-98.36% annualized). Obviously, I would be happier if I had waited to buy, but getting cheaper is a good thing overall. Consider the Four Factors. The only one that has really changed since I bought is equity valuation, which has improved to 24¢ of equity per dollar of price. Other investors might have lowered their estimates of asset value and future earnings based on potential defaults or the potential acquisition of Sallie Mae. But I don't think those fears are warranted and I haven't changed my estimates.

Having already bought shares, how can the lower price help me? For one thing, I could buy more shares (double down). But as I'm short of investable cash, that isn't an option. If the price doesn't recover before First Marblehead distributes its next dividend, I'll be able to reinvest it at a lower cost. A more likely scenario is that First Marblehead will repurchase on the open market over the next few days.

There are potential disadvantages to a lower prices. For instance, if I needed to sell today, I would realize a substantial loss. Or a third party might attempt to takeover First Marblehead. Or if First Marblehead were to issue shares (perhaps as a part of executive compensation), it will get less value per share than it would have a few months ago. But as long as those things don't occur, lower prices can only be good for shareholders.

As for the "news" that has been driving down FMD's price, I'm not too worried. The default scare seems totally bogus. First Marblehead's estimate of residual value seems very solid.

The issue with the SLM buyout seems to be that two potential purchasers, JP Morgan Chase and Bank of America, are also two of First Marblehead's clients and might direct private student loan business to Sallie Mae. FMD's CEO has said that there will be no impact on his company. I don't see how there could be an immediate impact since neither company would control SLM. Two private equity investment companies, J.C. Flowers & Co. and Friedman Fleischer & Lowe LLC, hold majority stakes and I doubt they would be willing to give away Sallie Mae's competitive advantages to the giant banks. A scenario that seems more probably is that the banks will outsource their student loans to SLM over time. But they could have done that even before this buyout was proposed, so I don't see what the big deal is.

Four Factors of value creation

2007-04-03T13:51:00.000-07:00

Dean Oliver (the Bill James of basketball), describes the Four Factors of Basketball Success. They are shooting, taking care of the ball, offensive rebounding, and getting to to foul line. There are hundreds of other statistics that are of interest, but unless they measure aspects of these factors, they aren't all that important to actual basketball success. Think of the Four Factors as a framework for interpretation.

I believe that there are Four Factors for value creation as well. Obviously there are even more statistics that may be important to understanding a company, but these four represent a complete path from customer to shareholder. I'm going to use my new favorite investment, First Marblehead, to illustrate the concepts.

Most public companies derive their value from sales. (The exception are companies like biotechnology firms that hope to turn ideas or other assets into sales at a later date.) But not all sales are created equal. Companies need to charge more than the goods and services cost to produce. And there are other costs such as overhead and taxes that need to be considered. From a shareholders perspective, those costs add little to the value of the company. So the first factor is Net Profit Margin:

Earnings 
-------- = Net Profit Margin
Sales

In it's most recent 10-K, from June 2006, First Marblehead reported revenue of $563.572 million and, after subtracting costs, earnings of $235.960 million. Divide earnings by sales and the profit margin works out to 41.87%. In other words, 42¢ of each dollar in sales is profit to First Marblehead owners. Compared to the Consumer Financial Services industry average of 13.77%¹, FMD must be doing something right.

Specifically, what companies with high profit margins have done is a combination of raising prices and lowering costs. The risk is that customers don't like higher prices and that lower costs might mean lower quality products, which also don't go over well with customers. So if you've got two companies and one has a higher profit margin than the other, you would also expect it to have lower sales. But just as we compared earnings to sales, we need to compare sales to something else. If one company has two stores, you'd expect it to sell twice as much as a company with just one store. A company that sells to customers all over the world probably has more sales than a similar company that just operates in one city. So you have to compare sales to the company's size or potential.

Asset Turnover is the second factor:

Sales
------ = Asset Turnover
Assets

Every company has assets such as offices, factories, stores, patent portfolios, and so on, which it can use to generate sales. First Marblehead had $770.346 million worth of assets as of June, 2006. The bulk of those assets are residuals in its securitization trusts, which have the potential to contribute to future income as the underlying loans are paid off. For fiscal 2006, every dollar of assets produced 73¢ of sales. Since the industry average is about 21¢, First Marblehead looks even better.

How much better? Well if you multiply the first two factors, you get another ratio called Return on Assets:

Earnings   Sales
-------- X ------ = Return on Assets
Sales      Assets

This number measures how well management has balanced price, costs, quality and demand. Higher prices tend to depress demand, and lower costs tend to lower quality which lowers demand. But First Marblehead seems to be able to defy those tendencies since it has a ROA of 30.63% compared to the industry at 2.91%.² Given the first two factors, you might wonder how other financial service companies could compete with First Marblehead. There are several answers including some peculiarities in the way GAAP requires it to report earnings that affect the ratios. But the biggest difference is the third factor, which is Leverage:

Assets
------ = Leverage
Equity

Companies, especially financial companies, use debt an other liabilities to buy more assets that can in turn be used to generate sales. If you have one store and you've maximized its ROA, you can borrow money to open a second store. The result on the balance sheet is that you've increased you assets, but your equity has stayed the same. One the second store is operating as efficiently as the first, you will be generating twice as many sales and twice the earnings as well. As an equity investor, I don't really care how much debt a company takes on as long as there is a reasonable chance the company can pay it off with out hurting earnings.

First Marblehead's leverage is 1.34, which is wimpy compared to the industry average of 7.54. Sally Mae, a competitor, is leveraged at $26.6 of assets for each dollar of equity. This is serious leverage which can lead to serious returns. At this point, there is a possibility FMD is leaving money on the table by not taking on debt to increase leverage. In order to decide, we can calculate Return on Equity:

Earnings   Sales    Assets
-------- X ------ X ------ = Return on Equity
Sales      Assets   Equity

First Marblehead's ROE is 40.95% compared to 22.01% for its industry. Imagine a rich uncle offered to give you a fixed amount of equity in any company in the world. You pick the company and your uncle will give you enough shares so that the equity you own equals the fixed amount. It's obvious that you'd look for a company that has the best ROE and seems likely to continue to do well in the future. If you were limited to student loan companies First Marblehead looks a lot better than My Rich Uncle which has a ROE of -253.53%³. If this were the way you acquired shares, we could stop the analysis right here. But normally you have to buy them on the stock market. The final factor doesn't have a standard name, but I'm going to call it Equity Valuation:

Equity
------ = Equity Valuation
Price

In theory, if a company closed shop, sold off all its assets, paid off all its creditors, and distributed the proceeds to investors, shareholder equity would be the value of the company. But some assets (such as newly purchased manufacturing equipment) are overvalued on the books and other assets (such as goodwill from profitable acquisitions) are undervalued. Further, some assets like brand names don't show up on the books at all. So Equity Valuation is rarely equal to one. For First Marblehead on June 30, 2006 the market paid one dollar for just 16¢ of shareholder equity. The industry average is 28¢, so the market rightly considers First Marblehead to be a better than average company.

When you put together all of the factors, you get a familiar measure:

Earnings   Sales    Assets   Equity
-------- X ------ X ------ X ------ = Earnings Yield
Sales      Assets   Equity   Price

Earnings Yield is P/E ratio inverted. First Marblehead's earnings yield was 6.46% compared to 6.88% for the industry. Now you might argue the relative quality of FMD to industry earnings or the relative growth rates or relative risks that make the final numbers better or worse than they appear, but that's missing the point. When I really need to find a companies value, I'm better off running a discount cash flow model. This exercise is more about the way earning yields can be composed and what companies can do to increase their value.

Footnotes:

Reuters uses a different method to calculate these ratios, so we have to take these numbers with a grain of salt.
Remember, other methods of calculation give different results. The important thing to understand is what the ratios mean and to try to be consistent. In this case, the 5-year average assets that Reuters uses overstates First Marblehead's ROA, since it is growing so quickly.
MRU holdings seems an unbelievably bad investment. I suppose the thesis is that eventually it will grow its way into profitability.

Trembling with greed

2007-03-26T12:50:00.000-07:00

According to Whitney Tilson, the best time to buy a stock is when you are trembling with greed. That's exactly how I was feeling last week as I set my limit order on First Marblehead each evening. Obviously, given a choice, I prefer to pay at the low end of what the market offers each day. But as the price crept up day after day during the week, I realized that I'd be willing to pay a lot more to get into a position and that my window of opportunity might be closing up. As the sub-prime lending story peeks, its negative effect on financial companies' shares could subside.

Interestingly, the sub-prime meltdown could actually help First Marblehead. In the past, consumers might be tempted to pay for college with a mortgage equity withdrawal (MEW), but that option may be less attractive in the future. Banks in the midst of tightening housing loans, might see education loans as a partial replacement for growth. Bond investors might see education loans (which can't be wiped out by bankruptcy and are backed by third-party guarantees) as a safer alternative investment. It's kinda like how pushing down on one part of a water bed causes another part to be pushed up.

One item to watch as time goes on is the trend of the "trust updates" lines in the income statement. According to the 10-K: "Trust updates reflect changes resulting from the passage of time, which results in accretion of the discounting inherent in the fair value estimates of additional structural advisory fees and residuals, as well as changes in the assumptions, if any, underlying our estimates of the fair value of these service revenue components." In 2002 (the first year I can track down those numbers), the updates represented 1.23% of the total "service receivables" line on the balance sheet, which is First Marblehead's share of the trusts. Since then, the updates have fluctuated between 4.44% and 6.25%. If I understand it correctly, this number represents the sum of all previous years' conservative accounting. If the company gets too aggressive in the coming years or if lots of borrowers prepay their loans, that number could go down or become negative.

In a sense, First Marblehead's conservative estimation of it's trust assets is akin to other under-valued assets such as real estate carried at cost or Oracle's installed base. Analysts tend to discount these assets altogether since they can't be precisely valued. The Standard & Poor's report on First Marblehead says, "Cash generated from operations totaled 21% and 68% of net income in FY 06 and FY 05, respectively. We believe the relatively low percentage of net income converted into cash stems from the large portion of FMD's revenues that are derived from residuals from securitized loans." Now these statements are true, but I'm not sure they are the negative that the report implies. If the company, can't convert earnings to cash, there's an obvious problem. But it seems like management has gone out of its way to structure the trusts so that First Marblehead gets the residuals, which makes sense because it doesn't really need cash and nobody else can value them as well as First Marblehead can. They are eating their own dog food, which must be encouraging to lenders and bond investors.

Why I bought First Marblehead

2007-03-23T14:24:00.000-07:00

First Marblehead is an out-sourcer of private student loans. In order to understand why I believe Wall Street undervalues this company, it's important to understand what a difficult asset private student loans are to value:

Student loans are not backed by an asset that can be repossessed and sold as are mortgages and car loans.
Borrowers often have no income or even credit histories.
Student loans do not normally need to be repaid until after the student graduates and enters the workforce.
Loans do not normally carry a pre-payment penalty.
Loans may take 20 to 25 years to be repaid in full.
Private student loans are not backed by a government guarantee, but must compete (at least indirectly) with state and federal government-backed loans.
There is great variation in the ability and willingness of students to repay their loans upon graduation.
Student loans are highly regulated.
Securitization is required for the original lenders to transfer student loans to investors.

These "borrower-friendly" loans (as First Marblehead's CEO calls them) present many difficulties to lenders who would like to enter the market. The only way to be comfortable issuing these loans is to gather a few years (at least 10, I'd imagine) of experience and borrower data. That is exactly what First Marblehead offers. It's important to understand that the company doesn't originate or guarantee any loans, but provide outsourcing to lenders so that they can establish there own "private label" student loan programs.

Currently, First Mablehead provides these services at or near cost, and in exchange, the loan originators agree that if they sell the loans, they do it through First Marblehead. The process of selling loans to investors, called securitization, can be complicated and risky, but banks are generally eager to transfer loans to third parties so that the proceeds may be reinvested. Again, FMD has many years of experience. Once the loans are sold to investors, the originating banks are generally free of them altogether.

If you are observant, you'll notice that so far First Marblehead can't make any profit since it provides services to lenders at cost. When it structures a loan secutization, First Marblehead creates a trust where lenders deposit loans and divides the into tranches with different risks and returns. If the underlying loans are paid off as scheduled, the junior tranches will earn substantial returns on investment. If many of the loans go bad or are paid early, the junior tranches may earn less than expected or even lose principle. Setting up and administering these trusts is a difficult and complicated task, so First Marblehead is able to change substantial fees for these services.

The bulk of the fees are paid upfront by the trust. In the most recent securitization, First Marblehead claimed 13% of the trust balance upfront. It also receives ongoing fees (~1%) and residuals (~5%) of the trust. The later fees are estimates of the present value over the life of the trust, so if the loans default or get paid early, the result could be much worse. Residuals are the most junior tranche in the trust, so in theory, First Marblehead takes the greatest risk and earns the greatest return.

The beauty of the First Marblehead model is that it requires very little upfront and ongoing capital expenses. Most of its value to customers arises from its borrower database, the expertise of its employees, and the strong history of its securitizations. The market for private student loans is growing so quickly, there isn't any need to spend money to expand operations. In my opinion, this investment is a bit like buying Oracle a the start of the internet revolution. As the market increases, lenders are going to be more interested in taking advantage of the intellectual property First Marblehead already owns.

Based on explosive earnings growth, it wouldn't be too surprising to find that First Marblehead is priced to perfection. But my DCF model suggests that the shares are fairly priced even if earnings remain level for the next ten years. Part of the problem seems to be that current earnings are somewhat uncertain since a large portion are estimates of future cash flows from residuals and ongoing fees. The flip-side is that the estimates might under-value these future cash-flows. So far, the estimates seem to be on the conservative side.

One concern is the possibility that lenders will decide to hold onto loans rather than securitize them. If that happens, there's no profit for First Marblehead and the lenders might develop their own borrower databases. This (and many other) concerns are addressed by an excellent analysis from Tom Brown. (To be honest, I never would have found this company without reading his website.)

Is organic growth better?

2007-03-21T09:10:00.000-07:00

One response to Oracle's 3^rd Quarter earnings pointed out that we don't really know how much of Oracle's recent growth has been due to acquisitions and how much is organic. All other things being equal, organic growth is the best sort of growth. For one thing, acquisitions tend to be more expensive and can mask problems in the acquiring company.

Suppose, for instance, that Coke noticed problems in its flagship product. So management decides to acquire Budweiser at a steep premium. Then they refuse to break out the portion of revenues that was beer related so that investors won't notice the slowdown in Coke sales. Another issue is that this sort of growth isn't sustainable. Who would Coke buy next?

But not all acquisition strategies are created equal. Right now, Exxon Mobil is raking in huge amounts of cash for delivering gas to American drivers. But it's clear the ride won't last forever. Eventually existing reserves will be tapped and new sources of energy will be required. Although Exxon could use it's current resources to research and develop alternative energy, it might be cheaper and less risky to wait for a smaller company to develop a winning solution and buy that company.

This, in fact, is Oracle's strategy. Actually, the database giant does one better—they supply the platform that upstart companies use to develop new products. Most modern "Enterprise" applications use some sort of relational database to store vast amounts of information about an enterprise and its connections to the outside world. Generally, the Oracle database must be at least among the target platforms that applications support. Therefore, as new companies emerge to write software for specialized purposes, they are likely to target Oracle's database. And Oracle's R&D efforts to improve the Oracle platform will encourage more startups to target it.

But small software companies have several problems that a large company, such as Oracle, can solve. Small companies are required to spend a significant portion of their revenues selling to customers, supporting customers, and providing a productive work environment for employees. These activities scale particularly well, so larger companies have an edge over smaller ones. As a result, a new product has the potential to become significantly more profitable as part of the Oracle stack then it does on its own.

Ideally, Oracle would develop new products for new markets. But it's unreasonable to demand a company grow organically when it has the opportunity to acquire growth for a lower cost and lower risk.

On a mildly related note, there's news today that Oracle is suing SAP. The complaint accuses TomorrowNow, a company SAP bought shortly after the PeopleSoft acquisition, used support login information from customers who had or were about to switch away from Oracle support to download documents, patches and software. It seems there were numerous unnamed SAP employees involved in the project who are included among the defendants. I can't imagine legal documents normally are very good reads, but Oracle lawyers seem to have a knack for producing entertaining briefs. I throughly enjoyed the anti-trust briefs from a few years ago as well.

I am a bit concerned that the lawsuit will backfire in the court of public opinion, since Oracle is attempting a similar support contract end-around against Red Hat. Assuming Oracle has obtained and is using its support material legally, there won't be an actual lawsuit, but there might be questions within the open source community and the media.

Why I sold Alberto-Culver

2007-03-19T10:29:00.000-07:00

A few weeks ago, I sold a call option against Alberto-Culver and on Friday, the option was exercised. I can't think of a better way to sell my shares: I sold for $22.50, the price on Friday was $22.51, and I got paid 30¢ for the privilege. As a result, my total combined ratio (after taking a penny a share loss) is 25.92%.

I still have a few shares left, but I got out of the bulk of my position in Alberto, because my original thesis is no longer valid—Sally Beauty was spun off. As it happens, I estimate that I earned 17.47% (38.90% annualized) on the first purchase and 16.32% (46.72% annualized) on the second purchase. "New Alberto" did better than I prediced, so I'm quite pleased with the overall transaction.

I still think Alberto will outperform the market over the next 5 to 10 years, but I don't think it will be a dramatic overachiever. I'll maintain a minimal stake in the company for a long time, if only because it isn't cost-effective to sell. Based on the dividend discount model, I guesstimate the shares are worth closer to $25 apiece, but I'm happy to sell in order to free up cash for an even better opportunity that I hope to buy into within a few weeks.

Final possession on Alberto-Culver option

2007-03-15T15:05:00.000-07:00

Today was the penultimate trading day on my Alberto option and (coincidently) the first day of the NCAA Men's Basketball Tournament. Watching my option come down to the wire is a bit like watching the final possessions of a basketball game. Early in the game, "fundamental analysis" such as per-possession offense and defense are the best ways to predict the outcome. By the end of the game, however, nearly everything that has happened to that point in the season is meaningless. Often games come down to a handful of possessions in the final minutes that determine which team will come out ahead. In other words, close games are determined by luck.

Yesterday, the odds of avoiding a "loss" on the option where roughly the same as a team up by 2 points playing defense with the shot clock turned off. Today, Alberto-Culver shares jumped 1%, which is sort of like hitting a three pointer. Tomorrow is the final possession of the game, since the option will expire if not exercised. If I'm to record a profit on the option, I need Alberto-Culver to drop by 0.22 or more in tomorrow's session.

Notice that the curve is much smoother around the zero line than the graphs I showed yesterday. That's because I corrected the issue with excess 0% gains. (Basically, I use the adjusted close from Yahoo to avoid miscalculations due to splits and dividends. But that sacrifices precision, especially early in a stock's history. Therefore, if the two adjusted prices are the same and the actual closing prices are only a few percentage points from 0%, I now use the actual closing prices.)

Writing call options is a bit like playing a slightly better team. Over a long period of time, the stock market in general goes up. This graph is the odds that the S&P 500 will advance in a particular day.

On the other hand, call options pay a premium, which is a little bit like being spotted a few points (or betting with a point spread). For the ACV option, the game is coming down to the wire. I think I made the right decision based on fundamentals, but I still might be on the wrong side of the trade tomorrow.

The odds the option will be exercised tomorrow are roughly 80%, so by Monday I should have the cash to make another purchase.

Odds of my ACV option getting exercised

2007-03-14T15:35:00.001-07:00

As of the market close today, Alberto-Culver stands exactly at $22.50—my option's strike price. I would expect the option to be exercised if the price ends a penny or two higher on Friday. This graph shows that (if the past is any guide) there is a better-than-even chance I'll be selling my shares.

The horizontal axis shows the range of gains and losses experienced by ACV shares over any two day period. The vertical axis is the odds that the price will increase by a certain percentage or greater in two days. So for a 0% or greater increase, the odds are 56% or so. Actually due to rounding errors there are more 0% gains in my data then there ought to be. (You will notice that the curve becomes vertical on the 0% line. That's not an optical illusion, but an artifact in the data.)

If the increase is 0.89% or greater, my option will lose money compared to simply selling the underlying stock on Friday. This graph shows that the odds are roughly 34% of taking a "loss" on the transaction.

Ideally, the shares will end somewhere between $22.50 and $22.70 so that I will sell the shares at a gain (odds ~ 22%). If that happens, I am ready to roll the proceeds into a new investment. If the option is not assigned, I might sell outright or (more likely) sell another covered call for April.