Why I bought yet more Select Comfort

This might be a mistake. Yesterday, when I wrote the post on Select Comfort's problems, I got angry. The market is completely hammering this company and it has gotten out of hand. Every DCF model I use suggests the market is pricing in zero growth—forever! Now if we were talking about First Marblehead, I suppose I could see how that might happen. The student loan business depends on a complex web of legal, political, financial, and societal conditions. If any one of these change, the business could cease to be profitable. But Select Comfort sells mattresses. People will always need them.

Right at this moment, people aren't buying mattresses. Or to be more accurate, people aren't buying mattresses unless they are really cheap or have Tempur-Pedic on the label. I think that's for exactly the same reason that houses in Bel-Aire are selling at record prices, but aren't selling at all in other parts of Los Angeles unless the price is rock bottom. Rich people haven't been hurt by inflation, housing prices, and risky loans the way the rest of us have, so they can buy premium products. I blame Select Comfort's management for not adjusting to the current reality, but I don't think they can screw this up so badly that sales won't come back in a year or two.

While we are on the topic, management has screwed up lately, but the results of the past year ought to shake them up and get them focused on the right things. From the business update this week, I think it has. To me, it was outstanding news that they refused to give guidance for the rest of this year or next. Wall Street hates that, but if management can't be sure what is going to happen, they really ought to stay quiet. Hopefully they have permanently stepped off of the beat-the-numbers game.

My purchase at $6.50 today increased my share count by a third, but only increased my cost basis by a sixth. I intend to aggressively sell call options on my shares in order to create a synthetic dividend. Maybe this isn't rational, but I think the market is mis-valuing Select Comfort and I want to capture some of that difference. I guess another way to put it is that the market is pricing Select Comfort as if it will screw everything up from now on and I think the odds are low that will happen. So I'm adding to my position. But I'm not so sure the market is wrong that I'm willing to take on more downside risk without getting paid.

Select Comfort not getting any better

Select Comfort gave a brief overview of 4^th Quarter results and there is very little to like about them. The current advertising isn't working except for specials and sales. When a sale ends, the stores lose significant traffic. Worse, the company will be raising prices in January to cover increased materials prices. The last year and a half has been miserably poor for shareholders.

I'm listening to Winning by Jack Welch and it opened my eyes to where Select Comfort is going wrong. Traditionally, mattresses are a commodity business. According to Mr. Welch, there are only three things a commodity producer can change: a) price, b) quality, and c) service. Like the NASA mantra (cheaper, better, faster), you can only choose two. So, for instance, at Costco, you get price and quality (= value), but no service. At a traditional mattress store, you get more service, but sacrifice either quality or price. Until recently, Select Comfort was able to side-step that game because they had an innovative product that differentiated itself by being a completely separate category—adjustable mattresses.

This past year, other companies began to invade the category. I noticed that advertisers have started using phrases like "select your level of comfort" that are right out of Select Comfort's play book. Costco now sells mattress very similar to the Sleep Number bed. Further, other technologies such as memory foam are becoming mainstream. In other words, the air mattress is now a commodity.

Now there are two choices for the company: shift to a commodity strategy or find some other way to innovate. Now we don't know what direction management will take but I think we have some clues. Last month, Select Comfort hired a new Chief Marketing Office, Catherine Bur-Hall. Before that, Ms. Hall was a Vice President of Marketing at Midas Printing. Printing is even more of a commodity business than mattresses and from what I can tell, the Hong Kong company has focused on quality and service as its strategy. If it's going to be a commodity, those are the areas Select Comfort is likely to have greatest strength.

When I last bought this company, I made a mistake. I thought their product had a sustainable advantage that could be exploited for years to come. I thought they owned enough mind-share to propel the brand forward with a few tweaks to the advertising. I think management made the same mistake. The cost in terms of market value has been substantial and I think the board needs to hold management responsible.

But the market has clearly over-reacted. At $6.63, earnings would need to shrink by 5% or so over the next ten years in order to be justified. Given more reasonable growth rates, the price should be $15 to $18 a share. The market is assuming that not only will Select Comfort become a commodity business, but it will also fail to be competitive. Those are far from certain in my opinion.

Citizens Financial Corporation shares cashed out

My shares of Citizens Financial Corporation were cashed out at $7.25 this morning. That works out to be a 9% return and 68% annualized. This transaction took exactly 2 months and nearly a month from when the reverse split was effected. That took longer than I had planned and I'd started to worry that something had gone wrong. Today, it was as if a heavy load had been lifted from my shoulders. Intellectually, I knew this transaction would likely take a while since only rarely do they pay off quickly. But emotionally, it has been difficult to see those shares sitting and waiting to be cashed out. There is an emotional toll to investing in zero liquidity stocks.

More opinions on First Marblehead

I'm finding that many value investors are now focused on First Marblehead as a great investment. For instance, Whitney Tilson highlighted the company in his most recent Financial Times article. In general the gist of these opinions is that while student loan backed bonds might not be selling well right now, the longterm outlook of the industry is quite bright. Further, Marblehead has been tainted at least somewhat unfairly by the mortgage backed security brush.

The problem, however, is that all of us are excited about First Marblehead's value mostly because of the research done by Tom Brown. He could very well be wrong on this stock and so would all of us who have followed his analysis. So rather than having a diversity of opinion, value investors might be trapped by group think. On the other hand, Wall Street analysts seem to be trapped on the other side by Matt Snowling's research. One side is going to be shown correct and for the moment, my money is on Mr. Brown.

First Marblehead cuts its dividend

Finally some bad news from First Marblehead to justify its massive price drop. Here is the key paragraph from the press release:

"Due to uneconomic terms in the current capital markets, we have elected not to securitize private student loans this quarter. We are exploring non-securitization and securitization alternatives for future quarters to enhance our business model and provide long-term capacity to the private student loan market in a manner that benefits our shareholders. Our business volumes remain strong and we see many opportunities to facilitate and process private student loans," said Jack Kopnisky, Chief Executive Officer and President of The First Marblehead Corporation. "Our Board of Directors determined it was prudent to continue to return capital to our shareholders this quarter even during these challenging times."

Cutting the dividend is pretty close to a cardinal sin in my book, but I'm not ready to dump my shares yet. For one thing, the stock has dropped faster than the dividend, so the shares are still undervalued. For another, it isn't clear to me that this is a real cut. A year ago the dividend was 12¢ a share, which is what it will be this quarter too. Further, the press release makes the cut sound temporary and tied to the failure to securitize loans this quarter. If so, First Marblehead's earnings might be pushed into next year rather than cut off.

I don't think I've made a mistake here since I don't try to pretend to predict the market for privately placed bonds that Marblehead operates in. Clearly their raw material (student loans) are available in abundance, but customers (investors) are reluctant to buy. The good news is that these loans are probably higher quality than most others on the market so when buyers return, they will look at FMD bonds first.

A losing year

2007 will almost certainly be a losing year for me. Here's where I stand as of this morning:

Date       S&P 500   Delta     IRA   Delta   BRK A
12/06/07      5.27% -10.95%  -5.68% -39.97%  34.28%
Total Gain   50.40%  74.55% 124.95%  20.38% 104.57%
Annualized    7.77%   8.25%  16.01%   2.00%  14.01%

Remember that I own Berkshire stock, so part of my portfolio is supported by this year's 34% gain. Berkshire is now well above the "inflation +10%" benchmark since the opening of my IRA. Select Comfort and First Marblehead have cost my portfolio the majority of the underperformance its experienced this year.

Select Comfort has not performed well in over a year in business terms. I think the company has been disproportionally impacted by the housing slump and management has made some disastrous mistakes. At this point, however, the market seriously undervalues the company even after accounting for very real degradation of fundamentals. There's no guarantee management will right the ship, but Wall Street is treating the mattress retailer as if it has no upside. I made a mistake by not selling a year ago, but I would be a buyer at this price if I didn't already own shares.

First Marblehead, which is down another 8% today, has not had any business problems to speak of and has plummeted almost from the moment I bought it. This is pretty clearly a case of Wall Street blinded by the company's association with other, more troubled financial stocks. As I've been pointing out, unless there is fraud we haven't heard about, this stock should not trade less than $30 a share. My hope now is that the low prices stick around until the next few dividends can be reinvested for me.

Business of charities

The end of the year is always the most important in terms of charitable giving, so I think I'll take a moment to look at what makes a charity worth giving to. First, you need to look at a charity qualitatively and then quantitatively. In other words, no matter how efficient a charity is financially, there's no point in giving to it if you don't support the cause or the way the charity pursues it. For instance, I'm fairly ambivalent about animal causes (I think we should focus on people first) so I wouldn't consider giving to one. And I don't much like PETA's tactics, so I definitely would avoid them even though they are fairly efficient about getting money to their cause.

I am interested in International Christian organizations, such as Samaritan's Purse. The link is to Charity Navigator, which rates the financial statements of charities. More about that in a minute. Two of my favorite programs are Operation Christmas Child, which let's donors give a shoe box of gifts to a poor child, and community development programs, that help people become self-sufficient. Qualitatively, it's a great organization, but what about the finances?

From a financial perspective, a charity isn't much different than a for-profit business. There are revenues, expenses, and a bottom line—only the bottom line is used to support some cause rather than owners or shareholders. The first expense, is fundraising, which corresponds to the cost of goods and services in a traditional business. Charity Navigator looks at this expense in two ways: as a percentage of expenses and as a percentage of revenues. Normally these are pretty close to the same ratio, but some charities spend more or less then they take in which causes one ratio to be higher than the other. In both cases the better charities will spend less on fundraising. Samaritan's Purse spends about 4¢ to raise a dollar of support and 6% of its expenses are related to fundraising. An excess of $67,924,383 accounts for the discrepancy.

It's important to compare apples to apples when you look at finances. For instance, every time there is a disaster in the news, the Red Cross gets a ton of free advertising. Meanwhile, my wife is the fundraising coordinator for a small pregnancy clinic that gets no government support. They hold a fundraising banquet every year that generates significant donations, but also costs a fair amount to put on. Comparing those charities by any objective measure isn't really sensible. In general, bigger charities and those with notable brands do better than others.

The next major expense is Administrative, which most correlates with operating expenses in the corporate world. As a percentage of expenses, the smaller the better. Samaritan's Purse spends about 5% on administering its programs, which means (after backing out fundraising) 89% of its expenses are directly related to programs. As a result, it has an excellent efficiency rating from Charity Navigator. I should point out that these measures of efficiency are closely tied and programs could be rated on what percentage of expenses are directly linked to programs with out losing too much information.

Besides efficiency, Charity Navigator also quantifies what it calls capacity based on revenue growth, program expenses growth, and working capital ratio. Roughly speaking, the faster a charity grows and the larger its ready reserve, the more people it will be able to help in the future. Again, its important to consider the context of a charity. Larger charities tend to have advantages in terms of growth and reserves. Samaritan's Purse's revenue has grown 24%, its programs 16% and it has about 5 months of working capital saved up for emergencies.

Personally, I like to donate to small charities that I have some personal connection to. For instance, my wife and I support several missionaries who are our friends. These small gifts have a much bigger impact than if we gave to larger organizations. We also think about how to get our contribution to the organizations we support as efficiently as possible. Usually, writing a check will help more than giving a credit card number to a telemarketer. Finally, we don't give to every charity that sounds good. Concentration helps keep costs down and increases the impact we can make.

First Marblehead just got cheaper

Well, another analyst has downgraded First Marblehead, which has caused the shares to fall once again. The downgrade hinges on a review of 16 notes by Moody's:

The ratings review is prompted by worse than expected performance of the underlying student loans. In particular, loans originated through the direct-to-consumer channel appear to default at a significantly higher rate compared to loans originated through school financial aid offices.

Also, it appears the company will not securitize any more loans this year, which pushes earnings into next.

Now there is no doubt that earnings in the short term will be hurt if the ratings of these notes are reduced and there is no further securitization this year. And I am troubled that direct-to-consumer loans, which are the most profitable for Marblehead, are the culprits. But none of these things are likely to be long-term problems for the company. As long as the dividend does not get cut (and considering cash flow, I don't see how it could), the company trades at least 2/3 of its fair value. Since I plan on reinvesting my dividends for years to come, today is actually good news.

Praising with faint damnation

An analyst downgraded shares of Oracle Corp. late Monday, saying a slowdown in spending on software by companies may pressure its earnings.

JMP Securities analyst Patrick Walravens downgraded the business-software maker to "Market Outperform" from "Strong Buy" and lowered his price target to $23 from $24.

"While we still believe Oracle will outperform the software industry, our due diligence suggests Oracle's business is slowing along with enterprise software spending," Walravens said in a client note.

JMP conducted a survey of 38 businesses across the economy and 61 percent said their software spending would stay the same or fall in 2008, he said.

"This survey result is the worst we have had since 2001 and is similar to the result in May 2003, which marked the beginning of a two- to three-year choppy period for Oracle's business," Walravens said.

Business in the Americas may be the slowest, he said, and should be helped by performance in Europe, the Middle East and Africa. Yet the slowing North American unit may make the company's forecast conservative, Walravens said. He lowered his 2008 earnings forecast to $1.21 per share from $1.23 per share.

From an AP story.

It's hard to get too worked up about this "downgrade". For one thing, I don't know what the difference between "Strong Buy" and "Market Outperform" might be. Second, $23 is still a pretty good premium over the current price. Third, the difference between $1.23 and $1.21 a share is well within noise, not much different from Wall Street's consensus, and nearly 20% up from this year.

Sally's first year

Sally Beauty reported it's first year results since being spun off from Alberto-Culver. I'd say the results are very encouraging. If you recall, the massive debt load from issuing a $25 a share dividend has been partially balanced by a significant tax savings. For the year:

Year                          2007    2006    2005    2004
Net interest expense       145,972      92   2,966   2,250
Provision for income taxes  38,121  69,916  73,154  62,059

That's a pretty significant tax savings, though not enough to offset the bigger interest expense. Sally's ability to finance the debt out of cash flow has improved:

Free cash flow             138,991 126,379  63,219 107,265
Free cash flow margin        5.53%   5.33%   2.80%   5.11%

In fact, all the margins (except net earnings) have improved:

Gross margin                45.90%  45.80%  45.56%  45.33%
Operating margin             9.09%   7.59%   8.54%   8.09%
Net margin                   1.77%   4.64%   5.17%   5.02%

One of the reasons for this is that Sally has improved its inventory picture:

Inventory DIO               152.82  163.15  156.17
Receivable DSO                7.46    6.99    6.53
Payable DPO                  47.41   50.12   44.94
Cash Conversion             112.87  120.03  117.76

A large part of these gains come because same store sales increased 4.5% despite losing L'Oreal products from BSG.

Overall, Sally Beauty is doing everything they need to do in order to make the special dividend gamble pay off. I'm quite happy to hang onto my shares while the company pays down debt and exploits its leverage.

Only swing at soft pitches

I've been working on a model for pricing options that does not rely on volatility as an input. (I know: I might as well try to design an airplane without wings.) Testing it out on real prices, I've found that it give vastly different answers for most options. But when the stock price is fairly close to the strike price and the expiration date is only a few months in the future, my estimate doesn't stray too far from the market quote. So as a general options pricing model, this one pretty much fails.

But today I realized that I really don't care. The vast majority of options are ones I don't really care to sell in the first place. For the most part, I want to sell options with strike prices near the price I would value a company. And options longer than a few months in duration are not interesting either since it would be hard to value the underlying shares. Further, I don't really plan on selling options that are less than 50 or 60¢ because commissions eat up too much of the premium. In essence, my model pins a value on the options I'd really like to sell and I don't care what it does to options I want nothing to do with.

Now I'm interested in selling a January $22.50 option on Oracle that currently trades for 50¢. It's pretty far out of the money, so my model does a rotten job of evaluating its price. It comes up with a negative price, which obviously won't work. On the other hand, my model values the $20 option at about $1.32 while the market says the option is worth $1.50. If I were interested in selling Oracle at $20, I'd take that price, which would amount to selling Oracle at $21.50 with a 67% probability.

As it turns out, if Oracle where trading at $22.50 today, I estimate that the $22.50 option would be worth about $1.24. Now there isn't much chance that Oracle will jump from $20.21 to $22.50 in one day, but it does exist. And if it did happen, I'd gladly sell an option on my Oracle shares for that price. It would be a pitch I'd know what to do with.

Value potential energy

Recently Vitaliy Katsenelson was interviewed by Philip Durell and Bill Mann. I picked up a few ideas that apply to my investments.

Canon

In the interview, Mr. Katsenelson pointed out that international investing may actually reduce risk in an otherwise US-based portfolio. When I first bought Canon, hedging against a dollar decline factored into the decision. Since then as the dollar has strengthened from about 105 ¥ to 109.61 ¥ with a lot of fluctuation in the interim. Canon has been increasing their dividend which yields about 2.7% compared to the Japanese 30 year bond that yields 2.27%. If (when) Japan raises rates, Canon's price measured in yen will likely go up to push its yield down. At the same time, the yen dividend will likely be more valuable in terms of dollars. Since Canon has a very strong product line, the stock is very close to a sure thing.

Another point the interview touched on is that the address of corporate headquarters doesn't tell the whole story of what countries a company is exposed to. While Canon is largely a Japanese company, it sells products all over the world and has manufacturing and R&D facilities spread around Europe, the United States, and Asia.

First Marblehead

I'll just quote Mr. Katsenelson:

Another one, and I know you guys both like is First Marblehead. This stock trades at what, eight, nine times earnings? It has a phenomenal growth rate ahead of it and I think the investors still put it into the subprime mortgage category, even thought the average FICO score of its portfolio is 714, which is very high; 83% of it loans co-signed.

The part that I love about it [is] this whole speculation about major customers JPMorgan and Bank of America going away [and] you can quantify that easily. You can figure out what impact it would have on the portfolio if both Bank of America and JPMorgan dropped First Marblehead and actually I figured it out and kind of my worst case, a year after JPMorgan dropped; if JPMorgan and Bank of America leave First Marblehead, its revenues would be up 20% or 30% over where they are today. So my downside is basically none.

You could argue that the margins may become compressed, but that the JPMorgan and Bank of America business is growing so fast that it should overcompensate that. I know you guys will agree.

Potential energy

Quite a bit of the interview was actually about the importance of price when it comes to investing. I starting thinking of it like the potential energy in a spring or a hot air balloon. In Active Value Investing, Vitaliy Katsenelson suggests the QVG framework for examining investments. Quality (Q) could loosely be tied to earnings, Value (V) is related to price, and Growth (G) is how earnings (or cash flow) are likely to change in the future. (This is far too simplistic I'm sure.) To go back to the balloon analogy, price is the altitude the balloon floats at, earnings are the buoyancy of the balloon and growth is how fast that buoyancy is changing.

Now investors looking at the balloon from outside try to guess where it will be floating over some period of time. As management dumps ballast (cuts costs) or adds heat (increasing revenues), the balloon ought to rise. If it can't for some reason (investors holding the price down), the potential energy increases. The altitude (price) is fairly easy to see, but the buoyancy and its rate of change (earnings and growth) are much harder to judge. As a result, lower altitude (price) might actually be the best signal to buy assuming buoyancy (earnings potential) is increasing.

The surrounding environment contributes to the potential energy as well. A balloon will be more buoyant on cold day, while stocks have the greatest potential in markets that have low P/E ratios. The inverse of P/E ratios, earnings yields is a direct measure of potential energy. Since P/E ratios for the market as a whole are trending down, prices won't be helped as much as they once were, so it's important to have good earning yields in the individual stocks you buy and own. Canon (6.78%) and First Marblehead (13.28%) are currently have the most potential energy in my portfolio.

Why I won't be rolling my Oracle call options

The November call option I wrote will be expiring this weekend and the December option is likely to expire too (35% chance). But instead of rolling them forward, I now plan on hanging on to my Oracle shares for a bit longer. I listened to the recent OpenWorld keynotes and also the analyst meeting and I think I've ignored some significant real options that Oracle might exploit.

According to my discount cash flow models, Oracle is well within the low range of its fair value. The market is assuming 10% growth for 10 years or 14% growth for 5 years. Safra Catz, Oracle's CFO, has set 20% as the goal and hinted at 26% as a possibility. Normally, there would be reasons to be skeptical of these claims, but Oracle has some unique attributes that make this sort of growth possible and even likely.

To begin with, much of Oracle's revenues are incompressible. In other words, once a client begins to depend on HR, accounting, CRM or other software as a critical element in their business, it isn't possible to reduce the licensing stream going to Oracle without shutting down altogether. As a result, there is a floor on how much revenues can fall. Also, the natural tendency is for margins to increase over time rather than decrease. Continuing licenses are nearly cost free to Oracle because of scale.

Now assuming there is a recession this year and next, Oracle will have a harder time growing organically. But the revenue stream shouldn't fall too much and it will have an opportunity to either lower costs or buy up other companies cheaply. If the recession doesn't occur or is mild, Oracle has the option to expand its offerings organically in addition. So because of the nature of its business, Oracle has more flexibility than most companies to deal with downturns. That flexibility represents a real option that I hadn't accounted for in the past. Being able to grow earnings in the face of economic headwinds could be a huge advantage.

I know I've flip-flopped on Oracle lately. Part of the reason is that its share price has been jumping around my lower edge of my value estimates. It hasn't gotten so expensive that I feel the need to sell right away, and it isn't so cheap I'm interested in buying more.

Did BEA's financial results make it more valuable?

One of the tough things about evaluating BEA is that they have been delinquent in their SEC filings until today. For an Oracle investor trying to see if it makes sense to acquire BEAS, the only number that really matters is total revenue. Everything else is pretty much noise, since the purpose of such a deal would be allow much better operating margins. Over the last 12 months, revenues were $1,486,713,000 compared to $1,351,967,000 the twelve months before that. Given Oracle's operating margin (~33%), that would result in $491 million in operating income. That is a significant increase from the $206 million it made in FY 2006, which was the most recent filings investors have had access to. That would indicate Oracle would need to raise its price.

But I don't think that is going to happen. For one, only $541 million of the revenues are from licenses—the rest are from far less profitable services. Also, BEA's operating income was actually negative over the last 12 months. So independent of Oracle or some other buyer, BEAS may be worth less than it was before. Further, the profitable license reviews are decreasing while Oracle's middleware sales are increasing. In any case, Oracle is in an excellent negotiating position.

Can First Marblehead be worth $10?

Seeking Alpha asks: First Marblehead: Worth $10 or $60? Without going into the arguments presented, which weren't particularly quantitative anyway, I don't see how you could value the stock at $10. $60 or $30 or nothing seem better guesses.

Let's take the case for the business being worthless. Basically, if management is somehow fraudulent and has stolen or wasted all of the cash in the coffers while rendering the residuals on the balance sheet valueless. Throw in a lawsuit or ten for good measure. In that case, the company is headed for bankruptcy court. Otherwise, cash and residuals are worth about $10.80 a share all by themselves. Perhaps the residuals are carried on the books at a higher price than if they were sold on the market, but First Marblehead doesn't need to sell them at market prices as long as it's still in business. And as long as the company is still in business, its value is higher than the $10.80 per share book value.

A dividend discount model prices the current $1.10 a year dividend at $33 1/2 even if the dividend never increased. To state it another way, income of $1.10 a year forever discounted to the present at 11% is worth more than $30. Forever sounds like a long time, but it's important to remember the discount model explicitly weighs income from distant years less than income in the near future. Because the dividend in 2100 is much less likely than the dividend in 2010 it also provides a much smaller portion of the present value of the dividend stream.

Ok, so if First Marblehead isn't a complete disaster or a static income stream, what other possibilities exist? Well, it could continue to grow at a healthy, though maybe not rocket-like, pace. Presumably, the dividend cannot continue to grow at 77% like it did last year nor can earnings increase by 57%, 48%, or 112% as they did in the last three years. So let's assume the dividend grows by 10% or earnings grow by 15% over the next five years. In those scenarios, I calculate First Marblehead shares are worth about $60 each. Given some growth in First Marblehead's business, I don't think many would consider these growth rates aggressive.

At this point, you could put together an expected value based on the odds of the $0, $30, and $60 scenarios panning out, but I don't think I'll bother. The $0 and $30 values are based on completely unlikely possibilities in my opinion. They might be 5% possibilities combined. I'd say my $60 scenario has a better than 5% chance of being far too conservative, but we don't need to consider that to see that at $33 1/2 FMD is a bargain.

Why I sold two more call options on Oracle

This morning I sold November and December $22.50 call options that cover all of my remaining shares of Oracle for 60¢ and $1.05 respectively. I've already discussed a number of reasons for trying to sell, so I won't go into too much detail. I should note, that a) my call options have captured nearly a full year of Oracle's earnings and b) I find Wall Street's estimate of 20% earnings growth seems fairly unlikely. In fact, the next few quarters may very well be disappointing because of a global slowdown. Buying BEA, even at a discount, just isn't enough to justify Oracle's current market price and make up the difference.

I should point out that by writing calls for two separate expiry dates I'm raising my costs fairly dramatically. Assuming both options are assigned, I basically have doubled my costs. But I've also doubled my opportunities. Imagine a coin-flipping offer where you earn a prize each time you flip heads and lose the coin the first time you flip tails. If you can chose between one coin that earns $2 for heads or two coins that earn a dollar each, which is a better choice? Although the expected return on the first turn is the same ($1), taking two coins gives you a 3 of 4 chance to go to a second turn as opposed to a 50% with one coin. This won't change the expected return, but it does keep you in the game longer. With two coins, you have more expected options to leave the game if the odds were to shift.

Thanks to a 3.4% increase in Oracle today, the odds the November option will be used are 63% and for the December option 66%. There isn't much short interest to propel shares higher on unexpected news and the market is already expecting good news during next week's OpenWorld conference and Q2 earnings announced in December. Therefor, I feel these options are likely to be profitable for me even if my shares are called away.

Earnings yield of my IRA

Currently, my IRA is flat on the year compared to an 8% or so gain for the S&P 500 and a 17% gain for Berkshire. Select Comfort (-37.5%) and First Marblehead (-28.25%) are the primary culprits, though Canon is somehow down 11% on the year too. Now I don't like the idea of seeing my portfolio stagnate, but there is a ray of hope here: my IRA's earnings yield is improving.

Here's how I calculate yield for my portfolio. Each quarter, I multiply the EPS for each company I own by the number of shares I hold at the end of the quarter. I add up those numbers and at the end of the year I have a value for "look-through" earnings. That's how much my stocks would have returned if they had paid out 100% of earnings in the form of a cash dividend. For 4^th quarter earnings, I use analyst or company estimates which are decent first-order guesses. Then I divide by the total value of my portfolio to get look-through yield.

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%

Since my account value has not changed significantly since the beginning of the year, the increase in yield is entirely due to increases in my companies' earnings. This measure does not include income from cash in the numerator, but it does include cash in the denominator. That means, cash-heavy portfolios are penalized. One solution would be to subtract cash from the denominator. A better solution is to add in interest earned to the numerator. I also add in premiums from call options, profits from short-term arbitrages, and cash dividends, while subtracting commissions, fees, and option losses. This produces a sort of operating earnings yield:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%

I know this double counts cash dividends, which are also reflected in look through earnings. Notice that my cash position has added to earnings in the last two years thanks to a number of arbitrage opportunities.

Higher yields indicate a sort of potential energy for a portfolio. Like the spring in a windup toy, increasing earnings give a portfolio a chance to run. Over a long period of time and given more or less efficient markets, an increase in earnings would represent a corresponding increase in price. Imagine what would happen to a company that earned 50¢ a share and sold for $10 were to increase earnings to $1 a share. If the yield remained at 5%, the stock would also double to $20. But until those gains are realized by selling the stock, that $10 a share increase will not be released. In order to calculate the effects of buying low and selling high, I add in realized gains and special dividends (like the one Sally Beauty distributed last year).

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%

Unfortunately, the net yield is extremely choppy. The simplest solution is to take the geometric mean, which is the best way to get an average of rates or percentages:

Yield         2007   2006   2005   2004   2003   2002
-----        ------ ------ ------ ------ ------ ------
Look-through  4.57%  3.90%  5.22%  3.65%  3.20%  2.59%
Operating     6.21%  5.76%  5.46%  3.70%  1.97%  1.74%
Net          12.84% 18.31%  5.46%  3.70% 12.92%  1.74%
Geomean       6.89%  6.08%  4.62%  4.36%  4.74%  1.74%

This smooths the data to show that net yields are also creeping up for my portfolio.

So what does all this mean? In my opinion, these yields are a rough estimate of potential. As I make good investments in companies that are cheap and have high earnings, my portfolio potential goes up. When I'm able to make money with the cash potion of the account, as I have over the last few years, I increase my portfolio's potential a bit more. When I harvest some of that potential by selling positions or receiving special distributions from a position, I have a chance to reinvest in companies with increased earnings potential. As I make good choices in allocating assets, my portfolio's yield and potential increase.

It's important to look at measures besides stock value when considering changes in investments. At the moment, First Marblehead and Select Comfort have the highest earnings yield, but are my worst performers. Oracle has the lowest yield, but is also one of the bright spots in terms of price performance. A narrow focus on recent price movement (momentum investing) would lead me to cut my losers and ride my winners. But as a contrarian investor, I'm looking to sell Oracle (low potential) and buy First Marblehead (high potential).

Is Select Comfort a "scary stock"?

This is a response to an article on the Motley Fool. I'd post it as a comment, but the site ate my post. (I think it filtered out everything after the '&' in "R&D", which is a pretty bogus behavior.)

First, operating profits are down because of increased marketing and R&D--other expense lines are down. Second, buybacks are good investments if the market is undervaluing shares, not because they raise EPS in the short-term. Third, the changes in capital structure are nearly riskless because of Select Comfort's massive and growing cash flows.

Ultimately, a lower stock price combined with a commitment to marketing, R&D, and share buybacks are very positive signs if you believe the company has a superior product. If the company's product turns out to be a fad or is overtaken by competitor copies or improvements, these moves hasten its eventual demise. The reason is that these changes are increasing the company's leverage. Small improvements will be magnified into big improvements and small declines will be magnified into big declines.

So the comparison with Tempur-Pedic is actually encouraging to Select Comfort investors. The Sleep Number bed shares more similarities to foam mattresses than traditional mattresses sold by other companies. In fact, some Sleep Number beds use similar foam to form the top layer over the air chambers. As far as price, Select Comfort offers additional features, such as firmness control, at nearly identical prices to Tempur-Pedic. (For instance, a 4000 Queen is $1,199.99 at Select Comfort and The Original Queen is $1,199 at Tempur-Pedic.) If compared to traditional beds, it's possible to buy a queen size for around $600, which is right in the sweet spot for quality mattresses.

Dickering over the price

"Lady, you are about to be offered a bribe."
"How big? It'll take quite a chunk to keep me in style the rest of my life in Rio."
"Well . . . you can't expect me to outbid Associated Press, or Reuters. How about a hundred?"
"What do you think I am?"
"We settled that, we're dickering over the price. A hundred and fifty?"

Stranger in a Strange Land—Robert A. Heinlein

Well, BEA has responded to Oracle's Sunday deadline to take or leave a $17 a share buyout with a $21 a share counter offer. When the offer was originally announced, I estimated that $18.55 a share was a fair price, but considered the possibility of a $21 offer. The market is pricing BEAS at $17.67, which is a touch low in my opinion. The two companies have been rumored to be in merger talks for years, but only this month have the rumors been confirmed.

Here's my guess about what has happened since then: Initially, BEA rejected the Oracle offer because it hoped some other company would step in with a competing bid. When that didn't happen, management sent Oracle a letter rejecting the bid again saying it was too low. Oracle responded by setting a limit on the offer of this Sunday. Now BEA was in a bind: if it let the offer expire, it would be clear that there was no competing offer. But management needed to induce Oracle to bid more. That is why they produced the counter offer.

We know that Oracle will end up buying BEA. The only remaining question is the price.

Could monopolies be healthly for the software industry?

Reading commentary about Oracle's BEA offer made me wonder if monopolies really are bad for software consumers. Logically, monopolies are detrimental in every industry because a single supplier is able to control prices that customers must pay. But there are some cases where a monopolistic structure seems to be not so bad or at least a natural result in certain industries.

In software, there are only two real factors in a purchasing decision: price and features. Price isn't just the amount that goes into the software company's pocket, but also the cost to implement and maintain a system. For large systems, the cost to simply train users might dwarf all other costs combined. As Microsoft has taught us, the biggest company tends to win out when price is the primary factor if only because training costs can be minimized. Nobody bothers to mention "Microsoft Windows" or "Microsoft Office" on a resume anymore, because every halfway qualified candidate has learned to use those programs already.

The other factor is features. Since the biggest companies have a huge advantage on the price side of the equation, upstart companies must compete on features. In my experience, it's fairly difficult to justify spending more on software on the basis of "nice-to-have" features. So in order to compete with bigger competitors, a small software company needs to create functionality that is so totally different and useful that its customers start to depend on it. For instance, a few years ago I purchased a copy of Quicken that downloads all of my transactions from my bank's website. Since I've grown to depend on this feature, Intuit has locked me into their software indefinitely.

The other lesson Microsoft has taught us is that big companies have an advantage when it comes to features as well, if the big companies catch the trend soon enough to copy the feature. For instance, Excel, Word, Windows, Money, Internet Explorer, and Outlook were introduced in order to outflank Lotus 123, WordPerfect, Macintosh, Quicken, and Netscape. There are dozens of smaller examples as well. Apple and Intuit survived only because they stayed under the radar long enough to lock-in a critical mass of customers before Microsoft moved in. Other competitors, such as Google, have thrived because Microsoft didn't understand their features until it was too late to emulate. Notice that these mistakes and oversights have occurred more often as Microsoft and the software industry have grown. It's just too hard for them to see everything that is going on.

From the customer's viewpoint, the Microsoft monopoly has been surprisingly benign. Sure, personal computers are probably too expensive because of the Windows and Office taxes, but cooperate America's software training costs are probably lower than they would be with more variety. It's hard to say if we are suffering from a lack of features, but until recently Microsoft has been the leader in distributing new types of software. Where they have failed, it seems like some other company has filled in the gap fairly quickly. In either case, innovation has thrived under the Microsoft monopoly to a greater extent than is possible to imagine under the IBM monopoly of the the 1970's.

Of course, once a monopoly develops, there is a new reason to buy software from a particular company: there is no other choice. And if everyone knows the monopolistic company will simply copy any new and revolutionary product, there is little reason for startups to startup. On the other hand, if the biggest companies are willing to buy up smaller players, like Microsoft in the 1990's and Oracle in the last three years, there is an incentive to fill functional gaps. From the market leader's perspective, purchasing successful competitors when they are small is both cheaper and more certain than developing their own copy. Customers also benefit, since the original products tend to be better than the imitations, at least for a while.

So the dynamics of the software industry may produce benevolent monopolies if:

1. Big companies drive down the total cost of software ownership.
2. Small companies have an incentive to compete on features and are not overly afraid of their ideas being copied by larger companies.

It's like a pond with two niches: small fish (that specialize in features) and big fish (that reduce overall price). Companies like BEA are in the uncomfortable middle: too big to be truly innovative and too small to be cost effective for customers. In this case, if the big fish swallows the medium-sized one, it might be best for the entire ecosystem.