My miserable July

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

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

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

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.