|Shares Out. (in M):||58||P/E||NM||NM|
|Market Cap (in $M):||280||P/FCF||NM||NM|
|Net Debt (in $M):||-31||EBIT||-13||-13|
MSO is a multi-pronged media company that has low prospects of generating meaningful positive cash flow at a level anywhere close to supporting its current valuation. A relentless pattern of insider selling, absurd compensation practices, a revolving door of senior executives and several unfavorable long-term secular trends are further lowlights. Nearer term catalysts loom that could have a significant negative impact on results. The stock currently trades at a 31 multiple of 2009 EBITDA, which benefited by a relatively massive $15 million (in Q4) final payout from a long-term deal with Kmart. This will not repeat in 2010. We believe that EBITDA will be negative going forwards, and thus have difficulty attributing significant value to the shares.
* Note: MSO often reports "Adjusted EBITDA" which adds back stock comp.
There are four primary units that make up Martha Stewart Omnimedia. Three are break-even or slight money-losers, and one, while profitable, has recently been greatly diminished. Below are the 2009 and projected 2010-11 revenues and operating income for the units and corporate overhead:
Martha Stewart currently publishes four magazines: the flagship Martha Stewart Living, Everyday Food, Whole Living, and Martha Stewart Weddings. We wont spent much time discussing the negative secular trends in magazine publishing, but suffice to say this is an industry that faces long and steady headwinds as advertisers and readers depart towards other media options. Martha Stewart Living comprises the bulk of the business (approx 75% of revenues). Annual revenue and circulation trends since the peak year of 2007 are stark and disturbing:
|Total Circulation (mil)||3.6||3.8||4.0||4.0|
|Circ revs per copy||1.83||1.52||1.17||1.05|
Circulation revenue per copy is down dramatically. MSO is clearly dropping price aggressively to maintain circulation levels. This is because ad revenue is tied to circulation levels. Advertisers pay based on a [rate per page] x [guaranteed # of copies in circulation]. The latter is called the "rate base" and any shortfall or drop in rate base means lower ad revenues. In the most recent quarter, the company announced a negligible (1%) annual increase in the rate base, but simultaneously a large direct mailing effort to make this possible. These lower quality eyeballs may maintain the rate base but further pressure circulation revenue per copy.
The predictive trends continue to be worrying. Deferred subscription income on the balance sheet, which represents 'pre-paid' subscriptions, has served as a very good predictor of future circulation revenues:
|% Chg in total def sub inc||-2%||-10%||-16%||-18%||-13%|
|% Chg in yoy circulation rev||2%||3%||-13%||-19%||-12%||???|
Underlying these circulation trends is a clear diminished interest in the MSO titles. Part of this is likely an industry-wide problem, but many in the industry state that Martha is becoming a less influential voice in an increasingly crowded sector. Whereas as few as five years ago, Martha Stewart Living was a leader in the space, in recent years it has been increasingly eclipsed by Oprah, Real Simple and a host of others.
This trend has not been lost on advertisers, who continue to put pressure on the rate they are willing to pay to advertise in Martha Stewart magazines. The company has acknowledged this in its most recent call, citing, "lower advertising rates in Martha Stewart Living". It is hard to see how this trend reverses itself.
The Martha Stewart Show has been a mainstay on television for many years, featuring Martha cooking, decorating and shopping with a rotating circle of friends and celebrities. This has formed the core of MSO's Broadcasting division. It is somewhat surprising therefore how innocuously management has attempted to explain away what, after careful examination, can only be described as a disastrous fall from grace in this property.
Until September 2009, the show was broadcast in syndication on NBC. Ratings dropped considerably over the course of the five-year contract. When the contract came due earlier in 2010, MSO announced a dramatic change, moving to the little-watched Hallmark Channel. Reflecting its small viewership, cable companies pay an average of only 6 cents per subscriber to Hallmark to carry this channel. This puts the Hallmark Channel in the very bottom quartile of roughly 170 channels commonly carried by cable networks. To put this in perspective, this is at the same level as "The Military History Channel" and "Retirement Living TV".
MSO management lauded the change as an opportunity to create a new channel around Martha. They shrugged off the massive viewership drop in the two platforms with the dubious claim that now Martha viewers wouldn't be 'confused' by the variety of start times around the country that had occurred on NBC. This programming shift was started in early September 2010.
The results of the shift from NBC to Hallmark, to-date, have been an unmitigated disaster. According to the Hollywood Reporter, dated 10/27:
"A look at Nielsen data shows that the 10 a.m. "Martha Stewart Show" airing may have averaged more than 220,000 viewers over the past two weeks, compared to about 200,000 in its opening weeks on Hallmark Channel. However, for its first six weeks, it remains about 50% below the "Golden Girls," which during the same period a year earlier drew 425,000 viewers for the network."
To put this in further perspective, when Martha Stewart launched on NBC in 2005, it premiered to approximately 2.7 million viewers. Within a week of launch, Hallmark had shuffled the lineup, dumped three hours of Martha programming per day, and fired the executive responsible for the project.
If ratings continue near current levels, we estimate that MSO could lose up to $10 million per year on this venture. Under the terms of the deal, MSO must lay out 100% of the production costs of the various shows upfront. We estimate this at $25 million (this level is referred to in the public deal contract). MSO then receives 100% of the advertising revenues until it recoups most (but not all) of its costs. Given that: (1) the company repeatedly has stated that their original economic goal of the deal was to break even (they had a similar goal with NBC) and (2) ratings are half of expectations[JA4] , we see the following basic scenario as likely:
|Original Plan||Current Level|
|Production costs of MSO||(25)||(25)|
|Ad revenue total||30||15|
|Ad revenue to MSO||25||15|
|Ad revenue to Hallmark||5||0|
|Net gain (loss) to MSO||0||(10)|
When asked about this on the most recent conference call, Chairman Koppelman acknowledged that the show would not be profitable at current ratings levels, but did not elaborate. One might ask why MSO does the show at all, if its goal is only to break even? Management has long said that the real purpose of the show is to serve as a "microphone" for the rest of the business. It goes without saying that the size of the microphone has diminished dramatically (by more than 90% since 2005).
Exacerbating the problems in this division is the loss of a very lucrative licensing deal with Turbochef, a maker of high end consumer ovens. This brought MSO an estimated $5-7 million in revenue (and likely profits) per year over the last 2 years (out of $46 million for the entire division in '09).
Recently released Q3 results in the division showed the early signs of these multiple problems, as revenues plummeted by nearly 50% from the prior year, and the division posted an operating loss of over $4 million for the quarter.
This is a small division that generates all of its revenue from advertising. It has yet to generate any annual profit, despite showing a solid growth trajectory. It seems a best case to treat this as a slight positive for the company going forwards, but the prospect of it being a meaningful profit contributor seems small at this point.
While this has been the one bright spot for the company, it is also the largest short-term source of year-on-year profit decline starting in Q4 2010. This business consists of Martha licensing out her name for products in a range of sectors at a variety of retailers. For several years, the company relied on a single cash cow to generate massive cash flow - a long term deal struck with Kmart that guaranteed a hefty minimum regardless of actual product sales. Here is a schedule of Kmart revenues received by MSO since 2004:
| Royalty earned as a result of sales
| Addl royalty paid by Kmart to reach contractual min
| Total royalties paid to MSO
Obviously MSO was coming nowhere close to delivering on its guaranteed minimums, and in 2009, Kmart cancelled the contract. In Q4 2009, MSO received $17 million of revenues (and probably close to that in operating profit) in a final payment from Kmart. This year in Q4 it will receive $0.
In 2010, MSO announced a deal with Home Depot, which the company claims will eventually 'replace' Kmart. This launched in spring 2010 and by all accounts, products are selling well across a wide range of categories. But what is the likely impact of this program? Industry executives estimate that MSO will receive 3% of retail revenues on products sold at Home Depot. To get back to 2009 Kmart levels, Martha would need to sell almost $850 million of product. We believe that a very optimistic scenario would be $500 million of sales by year 5 (making Martha Stewart one of Home Depot's largest brands). This would result in $15 million in revenues to MSO. Not bad, but well below Kmart royalty levels and not enough to push MSO overall EBITDA levels into positive territory. We think an optimistic target once all categories are launched (perhaps by end of 2011) is roughly $11 million in revenues, led by paint, carpet and patio furniture categories.
The second most successful merchandising partnership has been with Macy's. We estimate that this generates somewhere between $10-15 million of revenue to MSO. By all accounts, this seems to be growing nicely, but at a robust 10% growth rate it would only add $1 million in revenues per year. Other partnerships include Michael's Crafts, PetSmart (new this year), Hain, and some portions of the Emeril brand (MSO acquired this in 2008 for over $50 million).
Over the years Martha has had a revolving door of partnerships that rarely seem to pan out for one reason or another. They are announced by management with great fanfare, and then slowly are phased out of the commentary until several quarters later they are mentioned in passing as having run their course. Examples within the last 3 years include: 1-800 flowers (gift and accessories), Costco (food), Lowes (paint) and Walmart (crafts).
Overall, we see the merchandising revenues as follows, in a somewhat optimistic case:
|Other Current Partners||28||31||33|
* Includes one-time payments
Overhead / Mgmt
The overhead at MSO significantly overwhelms the company's economic footprint.
|% of Revs||16%||15%||18%||16%||15%|
|% of Segment Level Operating Profit||86%||103%||101%||155%||162%|
This has been caused largely by the infeasibility of supporting unrealistically high quality standards (to compete with rivals) at four subscale businesses with limited synergies. For example, the Manhattan office space alone is a massive 150,000 sf for 350 employees, or the equivalent of a studio apartment for each. This problem has been exacerbated by what can only be described as excessive executive compensation for a company of this size and profitability. According to company filings, Ms. Stewart received nearly $10 million in 2009 cash and stock. This included more than $100k for personal assistants, $50k for a 'weekend driver', $178k in personal security, and $100k in "non accountable expenses". Mr. Koppelman was paid just over $2 million (not counting the $60k per year the company pays for his full-time driver). Both have use of the company jet. Nepotism runs rapant. Margaret Christiansen, Ms. Stewart's sister-in-law, is a Senior Vice President of the Company and received approximately $200k compensation in 2009. Martha's daughter was paid $350k to be a media personality. Same goes for Jennifer Koppelman, the CEO's daughter. Of interest to note in the company's proxy statements is the following regarding executive compensation:
In 2009, FWC provided a peer group proxy analysis of twenty-four companies (the "peer group") selected with greater emphasis on industry rather than size for use in connection with evaluating the compensation of CEO Koppelman, Ms. Marino and Ms. Turner. (The Chairman, President of Merchandising, and CFO, respectively).
The problem is that peers are considerably larger (and more profitable) than MSO. Executives and directors receive large amounts of company stock. Over the past two years, there have been over 40 instances of insider sales, and just a single insider buy (that was by Fredrick Fekkai, celebrity hair stylist and debatably qualified board member). Throughout 2010, Martha has been selling roughly 85,000 shares each and every month in an automatic program
Simply put, there appears to be a severe lack of accountability to shareholders. Ms. Stewart owns a controlling interest and reportedly has assembled a hand-picked board (which cumulatively earned $1 million in cash and stock in 2009). The issue appears deeply ingrained in the company culture, and we see little reason to think that this is likely to change anytime soon.
There has also been a revolving door of well paid senior vice presidents, division presidents, etc., destabilizing the company and reflecting the difficulty in working with Martha, the declining stock price, and the low prospects for the company's future.
In the most recent quarter, the company did announce a reduction in rank-and-file sales and marketing staff that is expected to result in $2-4 million in cost savings. The impact on the already stressed sales results remains to be seen.
Projections & Valuation
Even if we assume that none of the larger negative possibilities we have outlined above occur, we see a relatively optimistic scenario for 2011 as follows:
|Publishing||Flat advertising rates and a moderating decline of circulation revenues|
|Broadcasting||A moderate loss in the division based on ratings improving from current levels (but no replacement for lost profits from Turbochef)|
|Internet||Continued improvement to first annual profit in history|
|Merchandising||Improvement vs 2010 in profit due to solid incremental sales at Home Depot, Macy's and PetSmart, but still well below 2009 levels that included Kmart|
|Overhead||Continued trimming of overhead from 2010 levels to account for recently announced cost cutting efforts|
This would result in EBITDA for 2011 of negative $6 million. Currently the business is trading at a market cap of $250 million and an enterprise value of $233. Peers in the space trade at roughly an 8x EBITDA multiple. So in order to be "fairly valued", MSO must achieve an additional $35 million of EBITDA. We see no prospects whatsoever for achieving this under the current business structure. Rather, we believe that there are significant risks to additional deterioration at the EBITDA level
Risks to Thesis
We see the primary risks to this thesis as follows: