Price/Value ratio

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.

Luxury Goods

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.

2007 Look-through earnings

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% 

2007 Year in review

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.

Sally's first year

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.

Earnings yield of my IRA

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).

Sally Beauty: The Good, the Bad and the Ugly

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.

My miserable July

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

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

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

Eveillard's tax device

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%

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.

First Quarter results

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.

The business of beauty

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.

Look-through earnings

"Merry Christmas!" At least that's what I feel like saying every year around this time. Warren Buffett likes to publish his annual report to shareholders on a Saturday, but we get Christmas a few days early thanks to new SEC regulations. Needless to say, Berkshire's actual results were almost as good as its Chairman's commentary and advice.

This year, I thought it would be fun to present my investment's results using one of Mr. Buffett's favorite tools—look-through earnings. Essentially, I calculate my share of each companies earnings by multiplying the quarterly earnings per share by the number of shares I hold each quarter. Then I aggregate four quarters into a year and divide by the number of "shares" in my IRA. (For an explanation, see this article). This way, I can focus on the economic value the various businesses have added as if I owned each one outright. All 2007 numbers exist only in the imagination of analysts; I use them as placeholders to get an idea of what the future holds.

Earnings         2007*   2006    2005    2004    2003    2002
Oracle           0.19    0.13    0.21    0.30    0.44    0.34
Canon            0.31    0.28    0.49    0.34    0.08 
Select Comfort   0.26    0.19    0.27   
Berkshire        0.19    0.25    
Alberto-Culver   0.12    0.08    
Sally Beauty     0.04    0.00    
Look-through     1.12    0.93    0.97    0.64    0.52    0.34

* 2007 numbers are consensus analyst estimates.

The 2006 results are down in part to my purchase of Alberto-Culver and its spun-off subsidiary, Sally Beauty. I bought these shares more for the value I hoped would be unlocked by the spin-off and for the large special dividend (see below). Oracle has slowly been losing its share in my personal look-through earnings because it is a smaller part of my overall portfolio. On an absolute basis, its earnings have increased smartly.

Last year was the first in which I made more than 2 trades. Besides three new positions, I added to one of my old positions, executed three going-private, arbitrage transactions, initiated two more and sold one option. Plus I left substantial (relatively speaking) sums in cash. So my non-look-through earnings and costs were significant for the first time. In the following chart, I've included actual year-to-date results in the 2007 column.

Interest         0.01    0.16    0.01    0.03    0.02    0.00
Costs           (0.05)  (0.19)  (0.04)  (0.06)  (0.22)  (0.12)
Arbitrage        0.39    0.41    
Options          0.06     
Operating        1.47    1.32    0.94    0.61    0.32    0.23
Gain            11.28%  40.94%  52.78%  89.99%  41.50% 

My "operating" earnings are more impressive, smooth and meaningful when presented this way. The market value of my IRA is substantially more lumpy due to market fluctuations. Note that while the arbitrage earnings are quite significant for last year's results (not to mention this year's), they would be partially offset by a tax cost if this were a taxable account. I'm also batting 1.000 with a pitifully small sample size. One day I will experience a setback and the loss may very well wipe out significant gains.

Finally, if you add in my sale of Oracle a few years ago and the large special dividend from Sally Beauty, you will arrive at some very lumpy net earnings. Once again, these earnings benefit greatly from the tax-deferred status of the traditional IRA.

   
Realized Gain                                    1.79 
Special dividend         2.99    
Net              1.47    4.31    0.94    0.61    2.11    0.23
Gain           -65.97% 360.84%  52.78% -71.01% 827.21% 

The fun part about looking at results this way, is that it's easy to imagine being at the helm of a large conglomerate controlling an array of subsidiaries. But this approach ought to also aid an investor's thinking about the businesses he partially owns. Clearly, I will need to consider eliminating my Alberto-Culver and Sally Beauty stakes in the next few years if they do not improve performance. I might want to increase my investment in Oracle instead. Arbitrage and option activities have added considerably to my bottom line.

Buying Alberto-Culver (and trying to sell it too)

I can't say I know very much about Alberto-Culver. It's a consumer products company that mostly caters to women, and my wife doesn't use their products. My original thesis was that the spin-off of Sally Beauty would unlock value in Alberto-Culver. As far as I'm concerned that has already happened.

But, as it turns out, I just bought a faction of a share of ACV. Why? Because I've instructed my broker to reinvest dividends. If your broker offers dividend reinvestment as a free option on your account, there's no good reason not to buy some fractional shares of a company you already hold. Alberto-Culver's earnings yield is about 4.22% versus 4.85% that cash would earn. But remember, companies have the potential to increase earnings over time.

Meanwhile, I'm attempting to write a call option on the bulk of my holdings. I've got better ideas than Alberto-Culver at this point and I'm overexposed on this particular stock at roughly 11% of my IRA. But I'm not quite ready to sell outright. I like the dividend I'm getting, management seems very shareholder friendly, and I think a few acquisitions combined with cost-savings could push earnings up over the next year or two. So the middle ground for me is to write slightly out of the money call options until something drastic changes.

January performance

I haven't written in a while, but my IRA portfolio turned in a spectacular January:

Date      S&P 500  Delta   IRA    Delta  BRK A  S&P 500   NAV    BRK A
01/31/07  1.41%    1.07%   2.47%  2.42%  0.05%  1,438.24  24.44  110,050.00

Here are a few highlights:

• Sold Pegasus Communications for $3.25 a share.
• Bought Eupa for 35¢ a share.
• Sold Meritage Hospitality for $5.50(!) a share. (That works out to a 295.71% annualized return.)
• My Oracle call option expired. The good news is that I was not forced to sell my Oracle shares. The bad news is that Oracle lost more than 12% of its value in that time. Fortunately, I didn't want to sell anyway.
• Select Comfort gained nearly 6% for the month. I guess the shock of bad news in December wore off.
• Sally Beauty gained 9% for the month. I guess the shock of bad news in December wore off.
• Alberto-Culver gained nearly 5% for the month based, I suppose, on a 5.5¢ a share quarterly dividend.
• Oracle and Canon had poor Januaries based on being large companies with little real news.
• Berkshire Hathaway, as you can see above, ended flat.
• Earned 4.85% (annualized) on any cash I had lying around.

All of this is to say that my stock prices bounced around randomly. I'd say the going-private transactions that I've participated in show true skill since they've worked exactly as I expected. My other investments have did well in January mostly due to luck. Long term, I expect to have more good months than bad ones and make more good decisions than bad, but one month isn't a big enough sample.

February is turning out to be my best month yet. My IRA balance right now is over $5 million. That easily surpasses the half million dollars I "had" back in September. But I expect my balance will return to earth shortly when my Eupa are cashed in.

2006 in review

2006 was a great year for my IRA portfolio (up 28.50%). Not only did I outperform both the S&P 500 (13.62%) and Berkshire Hathaway (24.11%), I also posted my best calendar year performance. After 4 1/2 years of out-performance, I feel confident that my results so far are not a fluke.

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
Total Gain  42.87% 95.63% 138.50% 86.16% 52.34%    
Annualized   8.20% 12.97%  21.17% 11.43%  9.75%    

A significant factor in my success this year was that my patience with Oracle finally paid off. I bought at a ridiculously low price and Oracle proceeded to perform quite well and account for nearly all of my IRA's gain for the second half of 2002 and all of 2003. 2004 and 2005 represented a fair amount of uncertainty for Wall Street, which refused to believe that "tech mergers" worked. This year, the various acquisitions started contributing to the bottom line and Oracle's shares followed (up 40%). The interesting thing is that Wall Street still undervalues Oracle. Too many analysts focus on new database licenses to the exclusion of higher margin renewals. Also, I think the Oracle database is under-appreciated as a platform for other businesses to develop new products on. It's nice that Oracle the company is standing in the wings to buy startups that succeed.

Canon, at 23% of my portfolio, is tied for my largest holding in large part due to its exceptional performance during 2006 (up 44%). Once again digital cameras and printer-related consumables continue to be the mainstays of Canon's business. The digital camera revolution is nearly over in my opinion—most people have a digital that meets their needs. Canon is going to have to have a new product boom in the next year or so to keep up their revenue growth. Perhaps YouTube will do for digital camcorders what Flickr did for still cameras. I think Canon's management is counting on its new flat-screen TV product to drive revenue growth.

Select Comfort endured a rocky ride this year and ended down 4.6%. Operationally, nothing much changed in my opinion. They are still the same company with the same management operating in the same business as when I first bought shares nearly two years ago. It's entirely possible that macro factors such as the slowing housing market and credit tightening will make 2007 a disappointment, but over the next ten years Select Comfort ought to do very well. After buying more shares, it is now tied for my largest holding.

Berkshire Hathaway is up 23.5% since I bought it. 2006 was a spectacular year to be a reinsurer since claims were low and premiums high. (The catastrophes of 2005 are largely to blame so its possible premiums will head down in 2007.) Auto insurance continues to be a good business since cars continue to be built safer. Berkshire's other lines of business seemed to perform well during the year. From now on, a portion of my portfolio will match Berkshire's results, which is something to keep in mind when I compare my results to it.

The year end spin-off math for Alberto-Culver is Alberto-Culver ($21.47) + Sally Beauty ($7.86) + the special dividend ($25) = $54.33. Given that I bought at a dollar-weighted average of $49.34 a share, I've made nearly $5 a share or 10% on the spin-off. Alberto-Culver and Sally Beauty together make up 15% of my portfolio, which is fairly significant. But I haven't yet decided if they will become core positions. Both companies have now released initial 10-K reports, which I hope to have a chance to read in-depth soon. But I think I'll have a better idea of how the new companies operate after a quarter or two. Also, I'd like to know what Alberto's dividend will be.

The rest of my portfolio is a smattering of going-private transactions and cash. I'm also short January 2007 options on Oracle at $20, which should expire without value. In some ways, this "short-term" portion of my portfolio is the least important. By their nature, going-private transactions are very profitable, but also very small. Last year I completed 3 and initiated 2. But if they were to make a significant impact on my portfolio, I would have had to have completed something like 10. This year, I'll need to complete even more, since my total portfolio has grown considerably. On the other hand, since they require little in the way of effort, risk or capital, I see no reason not to continue attempting to make a little profit there.

Accounting for spin-offs

Now that the Sally Beauty spin-off has occurred, it's time to figure out how to account for it. Thankfully, Quicken has a spin-off transaction type. Unfortunately, it isn't entirely clear how it works. After fiddling with it for a while, I think I understand the accounting.

The first principle is that you received both the parent and the spun-off company (plus the dividend) on the day you bought the original shares. So on September 18, 2006 I bought Alberto-Culver plus Sally Beauty (plus the dividend) for $49.40 a share (and on October 23, 2006 for $49.24). The spin-off event has a retroactive effect on the original transactions.

Second, the cost basis for each company is determined by the market on the day of the spin-off. For the sake of simplicity, I'll use the opening prices, but I have seen the average of the day high and low used. I believe Alberto-Culver will file the official ratio to be used for tax purposes sometime soon. At any rate, New Alberto traded at $20.10 and New Sally traded at $7.35 (and the dividend was $25). For our purposes, I'm going to lump the dividend into the value of New Sally, because the dividend was paid for through the money Sally borrowed. Therefore, the ratio to use is Sally—61.68% and New Alberto—38.32%.

Third, a "Return of Capital" transaction on the date of purchase lowers the cost basis of the parent company by cost basis of the spun-off company. So for September 18, Sally Beauty was acquired for 61.68% of $49.40 or $30.47 a share. (And on October 23 for $30.37 a share.) Therefore, Alberto's cost basis is reduced by the same amount.

Fourth, the dividend is recorded as a return on the Sally Beauty investment. Currently, Sally trades for $8.51 a share, which is quite a bit lower than my original cost. But when you add in the $25 dividend, those shares have returned about $3 each so far. Meanwhile, Alberto has gained a little over a dollar a share since I bought it.

I've been able to get my Yahoo portfolio to more or less work out, but it requires more faking since it doesn't properly account for dividends. I wish someone would provide a really useful online-portfolio tracking system.

Sally Beauty (when issued)

Alberto-Culver shareholders approved the Sally spin-off on Friday and as of today Sally shares are being bought and sold on the "when issued" market. Since there is also a market for both new Alberto and old Alberto, it's now possible to find out what the market says about the breakup math: $25 (cash) + $7.50 (Sally) + $17.85 (Alberto) = $51.35

But it is still possible to buy old Alberto for around $50, so there is still time to take advantage of a market inefficiency. (Basically, index funds that track the S&P 500 need to sell Alberto before the index drops Alberto and replaces it with some other company.) Although I have a little more cash to invest, I'm holding back for when Sally Beauty trades on the open market and after I have received the $25 dividend. I still think Sally conservatively is worth 30% more than $7.50. I suspect that when the company releases financials, the conservative value will be even higher.

Many salons in the US resemble malls in the way they operate. Each beautician rents a "chair" from the salon and keeps any profit they earn above that. Besides the basic services like washing, cutting and styling hair, salons are also an outlet for high end hair and beauty products. These are products that you can't buy at Wal-Mart or drug stores, because the makers of those products (e.g. Paul Mitchell) are aiming for a "Professional" market. As a result, there is a distribution problem—how do manufacturers get their products into the hands of beauticians?

Enter Sally Beauty Supply and Beauty Systems Group. BSG sells only to beauty professionals and Sally sells both to the general public and (under the Sally ProCard program) to professionals. Wal-Mart, Target and drug stores are more or less locked out of Sally's market pretty much by definition. On the other end of the spectrum, it's difficult to imagine another company building or buying a distribution network that competes with Sally.

The one exception is Regis, which is consolidating the salon industry through expansion and acquisitions. As you might recall, Alberto's original plan was to spinoff Sally and merge it with Regis. That plan failed in large part because Regis suffered some operational setbacks that made the merger unlikely to succeed. Ultimately, however, product sales are likely to be merely a sideline in Regis's business. (Humberto Barreto wrote an interesting paper that uses the salon business as a modern example of Ricardian Rent Theory.)

Why I bought more Alberto-Culver

On Friday, "Prudential Equity Group analyst downgraded her rating on" Alberto-Culver. According to the AP, her reasons were "that both Alberto Culver and the new Sally Beauty Holdings face deal-related risk, and that tax obligations from the $25 special dividend may not be known until 2008." As a result, shares of Alberto-Culver dropped from $51.25 to $49.94 that day.

To address the second issue, depending on New Sally's earnings, the special dividend might be taxed as a dividend, tax-free return of capital, taxable capital gain, or a combination of the above. The dividend must be reported this tax year (assuming the proposal passes), but the final determination of how it is taxed might not be made until after New Sally's first year in operation at the end of 2007. For most people, the accounting is going to be ugly. But since I hold Alberto-Culver in my IRA, the taxes are an interesting side-note.

The other issue ("deal-related risk") is more of a concern. Without access to the complete report, it is difficult to know what that phrase represents, but I'd imagine it is a reference to the costs and difficulty of splitting a company in half. Until they have been separate for a few quarters, investors can't be sure of the extent of "one-time-charges" on or both of the new companies may incur. On the other hand, it seems to me the businesses have been more or less independent for years and ought to be up to speed quickly.

Considering why I bought shares originally, Prudential's downgrade is actually a positive sign for me. In particular, this is further evidence for point "a. Institutions don't want the spinoff (and not because of the investment merits)." The deal is complicated and it will be a few quarters, if not years, before everything settles down. Until then, institutions may not be comfortable owning shares in a company that is largely unpredictable.

In the meantime, the downgrade and resulting price drop gave me an opportunity to roll the cash I received from two going-private transactions into Alberto-Culver stock. It seems like the great value investors have a simple capital allocation strategy that I'm trying to emulate. When you have capital and an investment idea, allocate the capital to the idea.

Alberto-Culver breakup value

Alberto-Culver shareholders are being asked to vote on a spin-off of the company's salon products distribution business (Sally Beauty) in November. Current owners will receive one share of New Alberto, one share of 52.5% of New Sally and $25 per Alberto-Culver share. The other 47.5% of New Sally will go to a private equity fund (Clayton, Dubilier & Rice Fund VII) in exchange for $575 million, which works out to about $6.73 a share. In order to pay the special $25 dividend, New Sally will take on $1.85 billion of new debt.

Based on the current market value of Alberto-Culver and the implied purchase price of New Sally, here is a chart showing the valuation of each piece compared to some competitors:

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.30       1.35        24.03          14.06 
New Alberto       19.57       1.39        25.70          17.89 
New Sally          6.73       0.50        37.21          13.68 
Cash              25.00    

Procter & Gamble  62.05       2.89        22.69          17.16 
Colgate-Palmolive 60.09       2.72        22.96          16.46 

Personal & Household Prods.   2.6         25.64 
Consumer/Non-Cyclical         2.4         22.1 
    
Regis             38.20       0.72        15.95          10.93 
CVS               31.25       0.69        20.96          15.56 
Walgreen          44.34       0.94        25.53          16.05 
Longs Drug        44.50       0.36        22.60          11.97 
    
Retail (Drugs)                0.72        24 

On this basis, New Alberto is not valued dramatically differently than current Alberto or other personal products companies. New Sally, however, looks cheap according to its P/S since it is closer related to drug stores and Regis (the salon company that tried to buy Sally last spring). Retailers, as middlemen, must carefully control profit margins in order to remain competitive, unlike consumer product companies that can nurture a brand to higher margins. The P/E ratio is less telling for Sally because it will take on so much debt. EV/EBIT, which removes the effect of leverage, puts Sally in the middle of the retail pack.

Now, let's look at how the pieces could be evaluated after the spin-off. I set New Alberto's price based on the P/E ratio of Consumer/Non-Cyclical companies and used the P/S ratio of drug retailers for New Sally's price.

                  Price/share Price/Sales Price/Earnings EV/EBIT
ACV               51.60       1.36        24.17          14.14 
New Alberto       16.83       1.20        22.10          15.38 
New Sally          9.76       0.72        38.56          13.87 
Cash              25.00

This isn't too far from the market value of Alberto-Culver, so the investment thesis is that the spin-off will allow both companies to operate more efficiently and will reveal the true value of the underlying businesses.

First, all fundamental data I've used is based on 2005 figures since only 9 months are available for 2006. So far, 2006 seems to be a fine year for the combined companies. EPS for the last 12 months is $2.37 versus $2.09 in the previous 12 months. I expect the initial financial statements from both companies will suggest a higher price per share as well.

Second, New Alberto will be debt-free and able to focus on building its portfolio of brands. The salon distribution business was a distraction and didn't provide any operating advantages since few of Alberto's products where sold in Sally stores or through Beauty Systems Group. Dumping debt on New Sally could allow New Alberto to pursue acquisitions like it recently made with Nexxus and St. Ives.

Third, CD&R has tremendous motivation to increase the post-spin-off value of New Sally. The private equity investment company has successfully invested in spin-off companies such as Lexmark and Hertz and only profits if the price of the highly leveraged stock appreciates significantly. It's helpful to view Sally as an LBO or the stub stock of a recapitalization.

Fourth, New Sally should be able to expand into new markets and increase current-store sales through advertising. Alberto's salon product distribution business has been hampered in the past because the parent company is a competitor with other vendors and predominately distributes through other retailers. Once free of the consumer products business, Sally should be able to promote itself more aggressively.

I see a purchase of pre-spin-off Alberto as a low risk opportunity to participate in CD&R's investment. Depending on how the market values New Alberto and New Sally, purchasing one or the other could be an even more rewarding investment.