Look-through earnings

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

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

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

* 2007 numbers are consensus analyst estimates.

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

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

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

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

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

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

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

Eupa International shares cashed out

My shares of Eupa International were cashed out yesterday for the expected price of 40¢ a share. My total gain was only 10.84%, but on an annualized basis the gain was 139.66%.

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

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

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

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

My stock option insurance business

Back in November, I wrote my very first covered call option. Since then I've been struggling to understand how I ought to evaluate these transactions—especially when the option expires worthless.

Oracle slid from $19.48 to $17, so there was no possibility that the option would be exercised. On the one hand, I certainly didn't lose any upside. On the other, if I had sold my shares instead of the call option, I would have avoided a worse than 11% loss. I'm not terribly upset about the "loss", however, since I wasn't committed to selling Oracle. $20 is at the low end of the stock's intrinsic value, and I'm interested in becoming at buyer again now that Oracle is priced under $17. From the perspective of the option buyer, the option was well worth its price. Instead of out-right buying Oracle and taking an immediate loss, the buyer has the luxury of buying at much cheaper price or taking a pass altogether. So who won and who lost in this transaction?

If you think of an option as an insurance transaction, it becomes more obvious that there don't need to be losers (though often there are). Although the option buyer lost the premium paid to me, their bigger concern was to avoid the sell-off that did, in fact, occur. And although I suffered a big, unrealized loss, I would have suffered it whether or not I'd sold a call option. So like an insurance contract, the party (me) that could afford a sudden price drop sold protection to the other party that couldn't afford it.

Insurance writing is usually evaluated with a metric called the combined ratio. It takes any losses, costs or dividends to policy holders and divides by total premiums. Ratios greater than 100% indicate underwriting loss. Insurance companies prefer to operate at the lowest possible combined ratio, but can still be profitable thanks to investment gains on the premium float, which is the money that has been paid in and has not yet been paid out in claims. Based on a single option, my combined ratio is 21.37%, so I'm currently making an underwriting profit.

The paper loss on the underlying asset (Oracle) is unfortunate, but not really relevant to the activity of writing call options. Think of the underlying asset as a reserve that is required to ensure that I can pay out a loss. When my reserve shrinks, it is the result of an investment decision to not sell not because I wrote a call option against it.

I expect that in the future, I will make a small profit on covered call options. Thankfully, USAA lowered my commissions, which will lower my cost. But I will also probably suffer some loses when options I write are exercised and I imagine I will accept smaller premiums than I did with Oracle.

January performance

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

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

Here are a few highlights:

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

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

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

Why I bought Eupa International

Eupa is using a reverse-split, going-private transaction as a lead-in to a merger with its majority shareholder, a Taiwanese company. Normally the merger would require some fairly expensive regulatory costs, but by executing a reverse split and suspending the reporting requirements (which require no proxy vote), those costs can be avoided. It seems to me the transaction is fairly safe now that the notice has been filed with the SEC since the benefits are fairly obvious and compelling.

I bought in at 35¢ and in a few weeks, I expect to get back 40¢ a share. This isn't the best profit (someone else bought at 30¢ later in the day), but it should be a fairly quick turnaround. One nice thing is that I was able to plow in my Pegasus cash which should result in an extra $44 gain.

Why I sold Pegasus Communications

I checked my brokerage website and it turns out I sold Pegasus Communications last Friday. Normally when I enter a going-private position like Pegasus, I initiate a limit-sell order near the cash-out price. It's sort of a safety valve in case the deal falls through later. Naturally, if the deal goes through (as this one had), I should raise the limit price to cover the commission cost which I won't have to pay when the reverse-split is paid. But the whole process is a bit silly since it's unlikely anyone will pay more than the cash-out price to purchase the shares. For some reason, someone did this time.

The final tally on the Pegasus Communications position was a 47.55% gain over 18 days. That works out to a 268,006.81% annualized return. If I had canceled or raised the limit order, I would have recorded a 111.80% gain, but my annualized return would have been much lower. Obviously, the total amount of this transaction is trivial. One nice thing about this deal is that my broker (USAA) recently lowered my commission from $19.95 to $11.95, which means I'm going to spend a lot less in the future.

Why I bought Pegasus Communications and Meritage Hospitality Group

In another going-private transaction, I bought 99 shares of Pegasus Communications. With this press release, the company announced the shareholders vote and a name change to Xanadoo Company.

I'm also waiting on the results from Meritage Hospitality Group, which will hold its meeting on January 23.

2006 in review

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

Date      S&P 500  Delta     IRA   Delta BRK A  S&P 500   NAV    BRK A
06/23/02                                         992.72 10.00  72,200.00
12/31/02   -11.37% 42.32%  30.95% 30.18%  0.76%  879.82 13.09  72,750.00
12/31/03    26.38% -1.49%  24.89%  9.08% 15.81% 1111.92 16.35  84,250.00
12/31/04     8.99% -2.16%   6.84%  2.49%  4.34% 1211.92 17.47  87,910.00
12/31/05     3.00%  3.23%   6.23%  5.42%  0.81% 1248.29 18.56  88,620.00
12/31/06    13.62% 14.88%  28.50%  4.39% 24.11% 1418.30 23.85 109,990.00
Total Gain  42.87% 95.63% 138.50% 86.16% 52.34%    
Annualized   8.20% 12.97%  21.17% 11.43%  9.75%    

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

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

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

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

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

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

Why I bought more Select Comfort on disappointing news

Yesterday, Select Comfort reported that it was seeing a massive slow-down in sales and lowered its 2006 estimate to 80 to 87¢ a share. Since the previous guidance was 95 to 97¢, this was a huge disappointment. Last year, Select Comfort earned 76¢ a share (after adjusting for a 3/2 split), so the growth this year is between 5 and 14%. Worse Q4 earnings look to be 21 to 46% lower than 2005.

What happened?

According to the press release:

“This quarter’s sales have been disappointing, as we’ve noted a closer correlation in our business with housing industry trends. Our sales programs and promotional offers have been consistent with prior years, and we are protecting product margins,” said Bill McLaughlin, Select Comfort chairman and chief executive officer.

For a high-end furniture company, this is actually a decent excuse (though not encouraging). People moving into a new house tend to want new furniture to go with it and have access to cash from home equity lines of credit. Also, if the soft housing market foretells a recession (and it seems to be doing just that), customers might be holding off on large purchases for the moment.

But I think the specific problem for Select Comfort is the new ad campaign, which started this year. Two of the new commercials are available on the company website ("Five Senses" and "Revere"). If you aren't paying attention, you might be forgiven if you think these are drug ads (probably for sleep aids, but maybe anti-depressants or ED treatments). The bed just isn't a big part of the commercial. Sure, the message is clear if you pay attention, but you've got to figure that the people who aren't fixing themselves a snack are TiVoing through the commercials. In contrast, the previous commercials were funny and focused on the mattress itself.

The good news it that Select Comfort has already addressed the problem by hiring a new ad agency. Poking around their website, I think Select Comfort made a pretty good choice with the one reservation that McKinney also has Southern Comfort as a client. Overall, they seem to produce polished, memorable commercials often using humor. Their Sony commercials are especially informative, because like TVs, men and women need to agree on buying the same bed.

Based on the low earning range ($42,160,000) and low growth range (20% a year), a DCF shows Select Comfort to be worth over $40 a share. $18 a share implies a growth rate of about 8%. A more conservative estimate works out to a fair value of $21. I'm concerned about a recession in the next year that could further hurt earnings, but I think the problems are likely to be temporary. In the meantime, Select Comfort will be able to buyback shares at a reasonable price, improve its advertising and find operating efficiencies.

Why I sold a call option on Oracle

Today I sold a January, 2007 call option on Oracle at a strike price of $20. The premium was 70¢ a share. Yesterday (when I placed the limit order for the option) Oracle closed at $19.48. After commisions and fees, I recorded 2.83% income on the transaction. On an annualized basis, that's 19.18%. If the option is assigned, I'll earn 4.47%, which is at least 24.53% annualized. For me, this is a win-win.

According to this calculator, the option was worth 62¢. I don't know if that's acurate or not, but it doesn't really matter to me. Option pricing models, such as the Black-Scholes model and the binomial options model, are interesting in the acedemic sense, but relying on them for actual options trading seems speculative. The problem with generic models is that they include volatility among their inputs. But the odds of a stock reaching a certain price are also influenced by the company's intrisic value and the probability of positive or negative news, which cannot be included in a generic model.

Writing a call option amounts to a soft sell of Oracle. I think $20 is a reasonable (though maybe low) selling price, but I'm not ready to put in a limit order. I also don't see any reason for the price to jump much higher in the next two months. Oracle Openworld, when Larry Ellison announced the company's Unbreakable Linux initiative, happened in October. There aren't many big aquisition targets on the horizon. I doubt the second quarter earnings release will be significantly better than expectations. In fact, given the persistent inverted yield curve, I suspect stocks in general will be flat at best.

Accounting for spin-offs

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

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

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

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

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

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

Sally Beauty (when issued)

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

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

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

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

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

Why I bought more Alberto-Culver

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

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

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

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

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

Alberto-Culver breakup value

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

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

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

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

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

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

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

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

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

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

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

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

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

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

HyperFeed Technologies "perilous financial decline"

Talk about honest. HyperFeed Technologies, which has been trading between 60 cents and $1.05 over the last three months, announced a merger with Exegy Incorporated that will cash out shareholders at $1 a share. In the SEC filing, the company decided this was the best course of action "because of the Company’s perilous financial decline". I think I'll pass on this one.

Advanced Nutraceuticals cashed out

Well, I don't think anyone could be as pleased as I was to lose a half-million dollars. My shares of Advanced Nutraceuticals were cashed out on Oct. 5 at $4 a share. On an anualized basis, it was 144.12% and one day short of beating Major Automotive, which was 144.21% annualized, as my best investment.

I was thinking about the comparsion with the S&P 500 and it occured to me that Berkshire Hathaway might be a reasonable benchmark to strive for:

Date      S&P 500  Delta    IRA    Delta  BRK A
12/31/02* -11.37%  42.32%  30.95%  30.18%  0.76%
12/31/03   26.38%  -1.49%  24.89%   9.08% 15.81%
12/31/04    8.99%  -2.16%   6.84%   2.49%  4.34%
12/31/05    3.00%   3.23%   6.23%   5.42%  0.81%
10/05/06    8.41%  20.51%  28.92%  17.21% 11.71%
Total Gain 36.31% 102.96% 139.27% 102.16% 37.11%
Annualized  7.49%  15.07%  22.57%  14.93%  7.64%

* First reporting date is 06/23/02

In a little over four years, I've managed to outperform both the S&P 500 and Berkshire, which astounded me. I can't imagine that will continue for the next four years however, because Berkshire is tremendously undervalued. Starting this year, some of my performance will be based on the performance of Berkshire thanks to the share I own. Also, it isn't a fair fight since Mr. Buffett and friends must allocate billions of dollars and can't invest in tiny companies like Advanced Nutraceuticals or even tinyer opportunities like going-private transactions.

Why I bought Alberto-Culver

Alberto-Culver can be divided into two lines of business—consumer products and beauty salon supply distribution. As it turns out, Alberto plans to split into two separate companies by spinning off Sally Beauty Supply and Beauty Systems Group, the distribution segment. The remaining company, New Alberto-Culver, will continue selling Alberto VO5, TRESemmé, Consort and Nexxus hair products, St. Ives skin care products, Mrs. Dash, Molly McButter, Static Guard, and a few other random products.

Spinoffs tend to be a good place to find exceptional value. In You Can Be a Stock Market Genius, Joel Greenblatt suggests "certain characteristics [that] point to an exceptional spinoff opportunity: a. Institutions don't want the spinoff (and not because of the investment merits). b. Insiders want the spinoff. c. A previously hidden investment opportunity is uncovered be the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation)." I believe Alberto-Culver possesses all three characteristics.

The transaction is a bit complicated, but the results are fairly straightforward: each share of pre-spinoff Alberto-Culver will be converted into a share of New Alberto, a share of New Sally and $25 cash. A private equity fund (Clayton, Dubilier & Rice Fund VII), will own 47.5% of New Sally, which will issue $1.85 billion in debt to pay for the dividend. So how does Alberto meet the criteria?

1. I don't think institutions want any part of the spinoff. Half of the value of the spinoff is a dividend, and who doesn't like cash? Well, institutions don't like like large dividends because they are taxable events and need to be reinvested. New Alberto will have a significantly less interesting growth story without Sally and will be compared to Proctor & Gamble and Unilever. New Sally is the worst of all: high debt, single-digit stock price, not part of the S&P 500 (so must be sold by index funds), competes against Wal-Mart, Target and drug stores (but not really), and who wants to say they invested in a company called "Sally"? (To be honest, the whole thing seems a bit "feminine", doesn't it?) One other problem is the stench of failure since an attempt to spin/merge Sally into Regis Corporation, which runs a chain of salons, when sour earlier this year.
2. Insiders will continue to be part of both surviving companies acting more or less in their current capacities. The family of Leonard H. Lavin, Alberto-Culver's founder, will continue to own a significant percentage of both companies and have agreed not to sell for at least a year in order to keep the tax-free status of the spinoff. CD&R has a history of guiding spinoffs to successful operations, such as Lexmark from IBM and Hertz from Ford. The only thing missing is option or restricted stock grants to increase insiders ownership.
3. Generally a vertically integrated company has tremendous advantages because they have control over every step from manufacture to the final customer sale (think Starbucks). But Alberto-Culver is not integrated with Sally Beauty Shops or Beauty Systems Group, because only a fraction of New Sally's sales are Alberto products. Sally can't give, for instance, TRESemmé products preferential treatment, because Clairol, Revlon, Conair and L'Oreal would be displeased and might pull their products. Also, Sally must limit advertisement since it competes with stores that carry Alberto products. Rather than being an asset to the other, each company is a potential liability.

I had a bunch of other great insights, but Blogger.com managed to corrupt this post. I'm sure I'll get around to posting them later.

American Education cashed out

My shares of American Education were cashed out this morning at 55¢ a share. Including the commision of my purchase, that's a 12.27% gain versus 0.33% if I had invested in the S&P 500. On an annualized basis, that's 78% which easily exceeds the 5% hurdle I use for these relatively safe going-private investments.

This sounds great, but I only made $30. Even if I were able to buy the 1999 shares I wanted to buy and didn't pay a commission, my grand total would have been $199.90, which isn't all that much. On the other hand, now that I've survived a few of these deals, I don't think it will take more than an hour or so to research new going-private situations. Mostly, I just need to read the proxy on the SEC's website and do a little math. If commissions continue to become a less important cost (because of inflation or my broker becomes more generous), these little investments could be even more profitable (though at no larger scale).

I've been reading Warren Buffett's Partnership letters, which provide an interesting "pre-history" to the Berkshire Hathaway letters. (Berkshire first appears in the January, 1966 letter, but Buffett has made purchases of its stock as far back as 1962.) One repeated theme in them is the categorization of investements into "general", "workout" and "control". General investments are purchased because they are cheap (either compared to their liquidation value or relative to similar companies) and tend to move in the same general direction as the market. Workout investments are purchased because some future event (not just rumored, but published in the paper) will unlock hidden value. Control investments are companies that the Partnership had influence over by reason of a large ownership stake. The last two investment types are largely uninfluenced by the general market.

Until this year, 100% of my investments have been in the general category (or cash), so my results ought to have followed the market. This year, I've been working in some special situation investments (workouts), so my results ought to be better in down markets and keep up (maybe) in up markets. (Joy and I do have "control" investments in a sense because of our careers and Joy's Pampered Chef business. It's difficult to assign a value to them, but they will provide far more earnings to us than our retirement accounts for a great many years.)

Here are my results since I opened my self-directed IRA:

Date       S&P 500   IRA    Difference   
12/31/02*  -11.37%  30.95%  42.32%
12/31/03    26.38%  24.89%  -1.49%
12/31/04     8.99%   6.84%  -2.16%
12/31/05     3.00%   6.23%   3.23%
09/29/06     7.01%  23.32%  16.30%
Total Gain  34.56% 128.88%  94.31%
Annualized   7.20%  21.39%  14.19%

* First reporting date is 06/23/02

The first "year" (actually closer to 6 months), was entirely the result of a single stock—Oracle. 2003 and 2004 were poor years as Oracle and Canon lost ground. In 2005, the addition of Select Comfort made up for the flat performance of the other two holdings. So far this year, the situation has reversed. In addition, I've purchased Berkshire, which has not done much so far, and some special situations, which have added to the account's returns. Beating the market by 14% a year isn't a realistic goal, but the wild swings are likely for a concentrated portfolio.

Canon innovations

One of the things that makes a consumer products company like Canon successful is finding ways to get the same consumers to buy new products over and over again. An example of how this can be done is found in a Fortune camera review:

Designed for serious amateur photographers but also friendly to the casual point-and-shooter, the Canon Rebel XTi also features a built-in cleaning system that reduces the chance that dust inside the camera will spoil a shot, a bugaboo that plagues most other cameras in its class. No matter how careful one is when changing lenses, dust can enter the camera body to ruin subsequent shots. The XTi literally shakes any dust off the sensor when the camera is turned on or off, using ultrasonic vibrations. The motes are then immobilized on a sticky trap. Also, the camera can "map" stubborn dust particles on the sensor and then erase them from images via software.

These seemingly minor innovations can add up to making older products completely obsolete every few years. The faster the innovation cycle, the more often consumers will want to get the latest thing and the more sales companies like Canon will make.