Portfolio news

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Spokesman: Why buy an outdated spring mattress that needs to be flipped every year?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.

Did BEA's financial results make it more valuable?

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.

Why I sold two more call options on Oracle

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.

Dickering over the price

"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?

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:

1. Big companies drive down the total cost of software ownership.
2. 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

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?