Here comes the activist

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

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

Further, the Chief Executive Officer's agreement to forgo his base salary until same store sales increase by at least 1% for four consecutive weeks, while good for public relations, is inconsistent with shareholder interests, since improvement of the Company's financial performance requires a greater length of same store sales improvement than four weeks. Further, this limited, short test allows for alteration of marketing spending in order for the Chief Executive Officer to achieve his limited performance goals, which may have nothing to do with appropriate marketing spending for the Company and inconsistent with the Company improving its annual financial performance.

Looking at the text of Mr. McLaughlin's letter, I'm forced to agree with his critics—he seems to be an untrustworthy manager. At this point, he has set the bar so low that practically anyone with some business experience can clear it. I'm afraid I now agree with those who have called for him to resign.

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

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

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

Why I'm selling Oracle

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.

Select Comfort levering up

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.

Ellison's NetSuite investment

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

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

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

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

Cost of complexity

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.

Is organic growth better?

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.