Update on BNS Holding

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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.

Value investing is arbitrage

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

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

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

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

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

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

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:

1. Reuters uses a different method to calculate these ratios, so we have to take these numbers with a grain of salt.
2. 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.
3. MRU holdings seems an unbelievably bad investment. I suppose the thesis is that eventually it will grow its way into profitability.

Trembling with greed

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

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:

1. Student loans are not backed by an asset that can be repossessed and sold as are mortgages and car loans.
2. Borrowers often have no income or even credit histories.
3. Student loans do not normally need to be repaid until after the student graduates and enters the workforce.
4. Loans do not normally carry a pre-payment penalty.
5. Loans may take 20 to 25 years to be repaid in full.
6. Private student loans are not backed by a government guarantee, but must compete (at least indirectly) with state and federal government-backed loans.
7. There is great variation in the ability and willingness of students to repay their loans upon graduation.
8. Student loans are highly regulated.
9. 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?

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

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

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

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.

Why I doubled-down on Oracle

I've been planning on buying more Oracle off and on ever since I sold a portion a few years ago. Lately, I've held off because of price or because I had better ideas for the cash. As recently as last November, I was willing to sell another portion of my holdings. But since then, the price has fallen off far (15.97%) enough for me to switch back to buy mode.

I've borrowed some key ratios from Reuters:

Ratio                    Oracle  Industry*
-----                    ------  --------
P/E (TTM)                 24.02    31.08
Price to Sales (TTM)       5.39     5.96
Price to Cash Flow (TTM)  18.54    26.05
Price/FCF (TTM)           19.70    31.53
Operating Margin (TTM)    32.40    24.49
Net Profit Margin (TTM)   23.03    19.17
Return on Equity (TTM)    26.79    22.22

* Software & Programming 

The point is, Oracle is cheap compared to other software companies. But none of these ratios consider Oracle's superior growth. Year over year, Oracle has increased sales by 24.72% compared to 18.66% for the industry as a whole. Now much of the growth has come from the purchase of Siebel systems in January 2006, so we can't expect that growth to be repeated this year. But it's also becoming clear that the acquisition strategy is working. In particular, when a customer decides to buy one portion of the Oracle Suite, there is a strong incentive to buy all of their enterprise software from Oracle. Oracle the platform company is an even better business than Oracle the database company.

I also must admit that part of the reason I bought more Oracle was to round up an odd lot. Since Oracle doesn't currently pay a dividend, I intend to sell call options against my position. Of course, that requires Oracle to increase in price to where it is overvalued. That might take a few years, however.

Odds of successful call writing

Earlier today, I wrote a call option on my ACV stake. At the time, I was more concerned about getting paid to sell than loosing out on gains. This afternoon, I took a look the odds of exceeding my break-even price at the end of the two weeks. I calculated that if miss out on any increase of beyond 1.89%. First, I grabbed all the closing prices for ACV and loaded them into an SQLite database. Then I counted the total number of two week periods in my dataset:

sqlite> select count(*)
   ...> from (select * from acv_prices a
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14));

5503

Next I counted the number of those periods in which the closing price increased by 1.89% or more:

sqlite> select count(*)
   ...> from (select (a.close-b.close)/b.close increase
   ...>       from acv_prices a 
   ...>       join acv_prices b
   ...>            on (julianday(b.date) = julianday(a.date) - 14))
   ...> where increase > 0.0189;

2088

Therefore, if the past is any indication of the future, there is a 38% (2088/5503) chance my option will be called for a loss.

One of my goals in writing the option was that I would like to sell my Alberto-Culver shares. It's likely that a 1% increase will result in my option being assigned, so I also took a look at the number of fortnights in which the stock increased by that percentage or more. I won't show the code, but it turns out that 2551, or 46% of the periods resulted in greater than 1% increases. And just for kicks, I looked at the odds ACV will loose value over the fortnight, which is 43%.

Overall, the odds for each scenario shakes out like this:

ACV	Option	Odds
Down	Expire	43%
Up	Expire	11%
Up	Excerised for gain	8%
Up	Excerised for loss	38%
Total		100%

Why I sold an Alberto-Culver call option

Today I sold a call option on part of my Alberto-Culver position. Between now and March 16, I may be required to sell shares at $22.50. I'd be happy with a higher price, obviously, but I'm getting eager to use that cash to pick up shares of other companies that I have more confidence in. My current combined ratio is 24.92%.