Description

Despite the permanent negative impact to the underlying business that the Martha Stewart scandal has had on Martha Stewart Living Omnimedia (MSO), the company's stock has recently rallied from a series of headlines that will have little if any impact on the company's underlying business moving forward. The fundamental of the business continue to decline but a series of accounting shenanigans were orchestrated in order to beat earnings estimates enabled insiders to dump the majority of their economic exposure to the company on the public market. At the same time, management's hype has been the catalyst for a significant short squeeze, further inflating the price of the stock.

The availability of shares to short has been somewhat restricted. While we acknowledge the difficulty in both timing and establishing a short position, we believe that the stock will continue to be volatile throughout 2005 as the CEO continues to hype the stock, presenting a number of opportunities to patient investors to profit from the stock's decline via either through a pure short or derivative position. We expect shares to fall to significantly from current levels over the next twelve to eighteen months as the business continues to deteriorate and as it becomes apparent that the actual value generated from recently announced contracts will be minimal to the company.


Market Value: 1,409.0M
Cash: 151.2M
Long-Term Debt: 0.0M
Enterprise Value: 1,257.8M
52-Week Range: 8.25 / 33.50
Shares Out: 50.09
Float: 18.37(36.7%)
Short Interest: 6.07(12.1%)
Avg. Volume: 1.64(3.3%)
Liquidity (30% Volume):$13.8M

Employees: Around 500


INVESTMENT SUMMARY

-Extreme Overvaluation
-Publishing Business has been Permanently Impaired
-Kmart's Acquisition of Sears Will Have Minimal Impact on Fundamentals -Primetime Show Will Have Minimal Impact on Fundamentals
-CEO Resigned and Sold All of Her Shares
-Heavy Insider Selling *Accounting Shenanigans Boosted Earnings

Extreme Overvaluation

We believe that the current valuation suggests that each business segment will return to and then exceed peak levels. It also does not appear that investors have discounted the fact that the 63-year-old Stewart is still in jail, the new CEO has little experience operating a merchandising company, and the board of directors has been almost completely revamped.

Management has said that it expects to have $130M in cash at the end of 2004 which would represent a decline from $151M as of September 30, 2004 and $169M as of December 31, 2003. The company has had a series of increasingly unprofitable quarters but we wanted to be as optomistic as possible in our valuation just in case the current management team successfully turns the business around. Using the peak TTM numbers accomplished in any given quarter in the history of the company, MSO is still valued at nearly 100% more than 10x its peak TTM EBITDA of $50.8M. The business is also more than 100% overvalued if a 7% cost of capital is applied to its peak TTM FCF of $35.0M. Even if we were to add-back the $60M to $65M that the company expects to have in a NOL by year end, shares of MSO are still substantially overvalued.

REVENUES 1998 1999 2000 2001 2002 2003 2004E
Publishing 124 143 176 177 183 136 95
Television 23 31 32 30 27 26 10
Merchandising 15 20 24 36 49 53 51
I/DC 15 36 50 46 37 31 24
Total 177 230 282 289 295 246 180

EBITDA 1998 1999 2000 2001 2002 2003 2004E
Publishing 43 49 66 66 63 20 (25)
Television 5 6 8 4 4 0 (10)
Merchandising 15 20 25 30 34 38 34
I/DC (5) (15) (26) (25) (34) (15) (10)
Overhead (25) (31) (32) (32) (35) (40) (40)
Total 33 29 41 43 32 3 (51)

It may be more appropriate to value the individual businesses separately because MSO has discontinued its catalog which contributed the bulk of the costs associated with the Internet/Direct Commerce business segment.

Company Valuation Metric Multiple Value
Publishing Peak EBITDA of 66 10x EBITDA 660
Television Peak EBITDA of 8 10x EBITDA 80
Merchandising PV of Contract @ 7% Discount Rate 204
I/DC Internet Property Assumed Value 10
NOL Guidance of 60 to 65 Full Value 65
Cash Guidance of 130 Full Value 130
Corporate Overhead 5-Year Average(34) @ 10% Discount Rate (340)
Total Valuation $809 mm

If we wanted to be really aggressive we could make one further assumption. If we assume that the merchandising can get to the $65M level by 2008 and then carry that amount in perpetuity, the value of the merchandising business could be worth $840M, when discounted back at 7%, rather than $204M. Under this absolute best case scenario, the company could be worth no more than $1,445M. However, this number should probably be discounted at least 5% for share dilution.

'03A Rev Q4E Rev Q4E Earn '04E Rev '04E Earn
Publishing 135.9 25 (12) 95 (25)
Merchandising 53.4 22 17 51 34
I/DC 30.8 6 (2) 24 (10)
Television 25.7 <1 (2.5) 10 (10)
Overhead (9) (40)
EBITDA (31) (51)
D&A (1.7) (6.5)
Amor of Comp (1) (4.5)
EBIT (33.7) (62)

Publishing Business has been Permanently Impaired

The publishing business peaked in 2002 at $182.6M, but since then it has been declining, and it is not alone. Television and the Internet/Direct commerce segments have been falling since 2000. Stewart's association with the scandal does not justify the fact that MSO only grew 2.2% in 2001.

The company has cut the guaranteed circulation of Martha Stewart Living to 1.8M from 2.3M readers effective January 2004. Since then, management has claimed that circulation has held. It should be noted that the wholesale price of the magazine was cut during this period from $28.00 a year to $19.95. Ad pages have fallen 47% to 647 for the full year even though other monthly consumer titles have seen a 3% to 5% increase in ad pages. This comes on top of a 35% decline in ad pages in 2003 from 1,867 to 1,234. September ad revenue for Martha Stewart Living fell 63.1% year-over-year on a 55.6% decline in ad pages.

At the same time that ad pages have been falling, additional competition, such as Time Warner's Real Simple have entered the market place. The magazine was founded in 2000 and as of July, 2004, it had a paid circulation of 1.7M. Year-to-date through October, O, the Oprah Magazine took in $100M more than Martha Stewart Living in advertising dollars. A new Oprah magazine, O at home, was launched in May 2004. A smaller competitor called Dwell has grown to 200,000 circulation and House Beautiful, Metropolitan Home, and Budget Living are also competing for market share.

In September, ran a survey of the magazine's readers and found that nearly 67%of Martha Stewart Living subscribers said they planned to renew their subscriptions. MSO pointed out that this renewal rate is 19% better than the magazine industry average and that this marks a substantial improvement from the height of the Martha Stewart scandal when renewal rates were 10% below the industry average. However, we found that before the scandal, the magazine's subscription renewals were 24% above the industry average.

We believe that Martha Stewart Living may recover when Stewart is released but that it will be very difficult for the magazine to fully recover its lost market share, especially since the cost of paper, postage, and delivery are increasing. Interestingly, the company has claimed that readers purchase the magazine for the content and not for its affiliation with Martha Stewart. Using their own argument, investors would have to assume that the loss of subscribers is due to worsening content and increasing competition, factors unlikely to be resolved once Stewart is released from jail.

Kmart's Acquisition of Sears Will Have Minimal Impact on Fundamentals

There is a tremendous about of hype surrounding the manufactures of products sold at either Sears or Kmart based on the speculation that the deal will widen their distribution channels.

"This merger will create for us a broader retail presence that reaches millions of new customers." - Susan Lyne, CEO of Martha Stewart

"For Martha Stewart, it's got to be the best thing that ever happened to them. It just gives them dramatically more distribution and far more store fronts and a much more credible retailers. When you put a brand like that at Sears, you give it instant creditability." - George Whalin, President & Founding Partner of Retail Management Consultants

"We obviously book a lot of revenues from our merchandising division. The Kmart-Sears merger is another big opportunity for us not just to extend the 'Everyday' brand, but maybe to do some new brand extensions." - Susan Lyne, December 14, 2004

Despite management's comments, there is little evidence that a deal would actually improve Martha Stewart's financials from their current levels. The current deal between Kmart and Martha Stewart is based on a minimum-sales-guarantee and runs through 2010. Under this agreement, MSO receives royalty payments of 2% to 3.5% of total sales. The royalty payments increase by a few basis points every year. However, sales of Everyday products are well below the minimum which means that Kmart has been making up the difference with royalty payments to MSO. Short seller Jim Chanos recently pointed out that MSO would have to sell 50% more volume before it actually makes additional profit under the contract. With the Everyday line already carried in the approximately 1,600 Kmart stores, it is hard to believe that the expansion into Sears' approximately 860 mall-based and 1,100 non-mall stores will make up this difference. Martha Stewart products have been sold through Sears Canada's stores, catalog, and website for the last 18 months. In the U.S., Martha Stewart branded paint is already carried by Sears. Furthermore, if Lampert is successful creating the third largest retail store behind the Home Depot and Wal-Mart, he will likely enter into the same supplier pricing behavior as Wal-Mart, and thus squeeze margins.

Kmart is not exactly thrilled with the arrangement. On February 11, 2004, Kmart filed a legal action against MSO after MSO refused to reduce the minimum sales level. On April 23, 2004, MSO amended the contract and Kmart dismissed its lawsuit with prejudice. Under the amended agreement, the minimum royalty payments for individual products were eliminated and the amount Kmart is obligated to spend on advertising MSO properties was reduced. The aggregate minimum royalty payment for the period February 1, 2004 through January 31, 2005 was reduced to $49.0M from $53.4M. In addition, the contract was extended through 2010, but the minimum guarantees during the extended period are relatively low. For 2009, the minimum payment is equal to the greater of $20M or 50% of the royalty earned in 2008 and for 2010 the minimum payment is equal to the greater of $15M or 50% of the royalty earned in 2009. Furthermore, up to $10M in royalty payments will be deferred and subject to recoupment in the extension period. MSO does not expect actual royalties to exceed the minimum guaranteed royalty payments through 2007, and has admitted that they have no immediate financial incentive to exceed this minimum.

2002 2003 2004 2005 2006 2007 2008 2009 2010
15.3 40.4 47.5 49.0 54.0 59.0 65.0 20.0 15.0
(3.8) (3.8) (2.5) (2.5)
15.3 40.4 47.5 45.2 50.2 56.5 62.5 20.0 15.0

Martha Stewart products, despite all the hype, simply are not selling up to expectations. In Q3 2004, MSO only generated $8.0M in total merchandising revenue, down from $8.9M in Q3 2003 due to lower same-store sales at Kmart. Keep in mind that the actual decline was offset by a 5% increase in the Kmart royalty rate. In addition, MSO announced that it will discontinue its Catalog for Living by the end of 2004.

Primetime Show Will Have Minimal Impact on Fundamentals

Mark Burnett, the mastermind behind Survivor and The Apprentice has announced plans to develop a prime-time television show featuring Martha Stewart when she completes her jail sentence. For his efforts, Burnett received a warrant to buy 2.5M shares at $12.59. The options given to Burnett will not be recognized as an expense until in September 2005, when the program is expected to air. This show is entirely owned by Burnett and will run on all NBC and affiliate stations.

Burnett will also revamp Stewart's daily syndicated show, Martha Stewart Living Daily Show. This is the show that will essentially replace Martha Stewart Living. The program will run on NBC's owned stations which cover 35% of U.S. households. This show will feature a number of guest hosts helping Stewart craft household decorations and prepare food in a live audience format. There amount paid to Stewart under this contract is still under negotiation but will likely cost additional capital. Stewart will also personally receive 10% of the gross revenue for each re-run. It is interesting to note that while the company claims that Stewart's 60% ownership keeps her economic interest aligned with shareholders, Stewart receives 40% more by being paid directly and pays 40% less when she takes capital out of the business in the form of an expense. This is hardly an alignment of shareholder interests.

Looking at the Television business segment, it is hard to understand exactly what investors are getting so excited about. The business only generated $32M in revenues at its peak and is expected to generate only $10M in revenues for 2004. On December 8, 2004, news of a press conference discussing Martha's daytime television show for NBC running in the fall of 2005 sent shares up nearly 10%.

CEO Resigned and Sold All of Her Shares

On the October 28, 2004 conference call, then CEO Sharon Patrick led investors to believe that MSO represented a compelling investment.

-"We are becoming increasingly optimistic about an advertising recovery."
-"Despite the losses in the quarter, we continue to benefit from strong consumer support for our products."
-"We are becoming more optimistic about the prospects of an advertising recovery in 2005"

On November 11, 2004, the then 54-year-old Patrick resigned as CEO. According to Patrick, "for personal and professional reasons, I have decided to leave MSO and pursue other dreams." At the time of her departure, Patrick was making $900,000 a year in base salary and had previously received a bonus of $800,000. Patrick had known Martha for ten years and had been with the company for seven years. After resigning, Patrick began aggressively selling all of her MSO shares.

Patrick, has been a critical ingredient of Stewart's success since the duo met while climbing Mt. Kilimanjaro in 1993. The former McKinsey and Cablevision executive helped shape MSO's vision, execute its business strategy, and take it public. While Martha conceived the content, it was Patrick who often honed the details and completed the deals.

Heavy Insider Selling

Martha Stewart Living's board has been almost entirely reconstructed over the last 18 months. On December 2, 2004, Patrick also resigned from the board. Following Patrick's departure, only one director, Jeffrey Ubben, the company's largest outside investor and former chairman, had been on the board prior to Stewart's indictment last year. Ubben is a managing member of ValueAct Capital Partners which specializes in providing liquidity to large insiders by offering to buy shares at a discount in a private transaction. Ubben offered to buy 3M shares from Stewart in January 2002 at a double digit discount. Ubben then purchased additional shares at a discount from a director. Ubben was named the chairman in June 2003 and stepped down in July 2004.

In November, ValueAct sold 2M of its shares valued at $38.6M, or more than half of its stake at prices ranging between $17.47 through $19.67. The bulk of these sales, 1.43M shares, took place on November 17, 2004, the day Kmart announced its acquisition of Sears. According to Ubben, "we are taking our risk levels down. We made some money on half of our position. We expect to let the other half of our investment ride and benefit from Martha's return." On December, Ubben sold another 207,900 shares at around $29.50, bringing his remaining holdings to 1,524,083.ValueAct now owns 64% less than the 4.23M shares it owned on October 1, 2004. When ValueAct's sales are added to Patrick's and that of other directors, more than 75% of the shares held by insiders since December 31, 2003 have been sold in 2004. ValueAct has $1.4B under management and thus MSO represents less than a 2.5% position for the fund.

ValueAct had previously sold 500,000 shares on October 12, 2004, to director Charles Koppelman. However, Koppelman paid only $10.50 per share, representing a discount of 33% to the market price of $15.70 and was allowed to defer $4,725,000 of his purchase over the next three years with an interest rate of only 4%. The present value of this $7.9M purchase to Koppelman was only $4.7M. In 1991, Forbes magazine estimated that Koppelman's net worth was almost $100M. Shares of MSO climbed 21% on the news.

In order to keep top executives from leaving the company, an executive retention program that excluded Patrick and Stewart was implemented by the board of directors. Under this plan, Follo, Sobel, Stanich, and Towey will receive a guaranteed payment of slightly more than $300,000 on June 30, 2004 and again on June 30, 2005. In addition, each executive is also guaranteed a year-end bonus equivalent to at least 100% of their targeted bonus. So far in 2004, the company spent $3.4M on its retention program.

Since January, insiders other than Martha Stewart, Patrick, and Ubben have sold more than 200,000 shares. These sales appear even more substantial considering that directors and executive offers as a group held only 401,300 shares as of December 31, 2004.

Accounting Shenanigans Boosted Earnings

In late October, MSO reported Q3 EPS of $(0.30) versus consensus of $(0.45) and guidance of $(0.50). The stock sales mentioned earlier certainly help explain why management may have had an incentive to not only beat guidance and consensus estimates but actually changed its accounting policy in order to post a much lower than expected loss per share. During the quarter the company decided to change its policy for subscription acquisition costs which caused SG&A to be reduced, and thus earnings inflated, by $0.04 per share. Subscription-acquisition costs are now recognized in the period in which they take place rather than ratably throughout the 12 month life of the subscription. This change effectively shifted costs from the last three quarters back historically into the quarter ended December 31, 2003. This was a nice gimmick, but it was not the only trick used to beat estimates, the company also included a number of other items in its earnings. Specifically, MSO recorded higher-than-expected insurance recoveries related to the legal fees associated with class-action lawsuits of, canceled a promotional contract, delayed at least a contract for a Everyday Food marketing campaign, and recognized a tax refund of which was higher than estimates. Backing these out, we estimate that the company's EPS was actually $(0.42), and could have been $(0.47) depending on how much of the marketing campaign contract was delayed.

COMPANY HISTORY

12/26/01 - Waksal is tipped that the FDA will decline to review ImClone Systems' application for Erbitux
12/27/01 - Stewart sells all of her 3,928 shares of ImClone stock
12/28/01 - The FDA makes its decision public and ImClone shares fall 18%
1/7/02 - Stewart's broker, Peter Bacanovic, tells the SEC that he and Stewart agreed to sell on December 20, 2001, if ImClone shares fell to $60
2/4/02 - Stewart tells the SEC, federal prosecutors, and the FBI that she had an agreement with Bacanovic to sell if ImClone shares fell to $60
6/12/02 - Waksal is arrested and charged with insider trading and Stewart reiterates her former statements.
10/2/02 - Former Merrill Lynch assistant Douglas Faneuil pleads guilty to taking a payoff to keep quiet about the Stewart stock trade.
10/15/02 - Waksal pleads guilty to six counts, including bank fraud, securities fraud, conspiracy to obstruct justices, and perjury.
6/4/03 - Stewart and Bacanovic are indicted on nine federal counts. Stewart resigns as chairwoman and CEO but remains chief creative officer and a board member.
6/10/04 - Waksal is sentenced to more than seven years in prison.
1/27/04 - Prosecutors claim that Stewart sold ImClone based on an insider tip and then lied to cover it up.
2/3/04 - Faneuil testifies that Bacanovic ordered him to tell Stewart that Waksal was selling stock and was pressured to cover up the transaction.
2/10/04 - Stewart's assistant Ann Armstrong testifies that Stewart personally altered a log of a message left by Bacanovic on the day she sold her ImClone shares but then later ordered the message changed back.
2/11/04 - Kmart files a legal action against MSO to reduce its contract.
2/27/04 - Judge throws out securities fraud count against Stewart.
3/4/04 - Reported Q4 2003 revenues down 8.6% to $70.9M and EPS of $0.10 versus a loss of $0.03
3/5/04 - Stewart is convicted on all charges and Bacanovic is convicted on all but one charge.
3/15/04 - Stewart resigned from the board but retains the title of founding editorial director.
4/23/04 - Kmart dismisses its complaint against MSO with prejudice and the contract is amended.
5/5/04 - Judge denies Stewart and Bacanovic new trials based on allegations that a juror lied to get on the panel.
5/7/04 - Reported Q1 2004 revenues down 23% to $44.5M and a net loss per share of $0.41versus $0.09.
5/18/04 - Producers of Martha Stewart Living say that the show will be suspended after the current season.
6/9/04 - Federal grand jury indicts Larry F. Stewart, a Secret Service ink expert who prosecutors say lied while on the witness stand. Stewart and Bacanovic seek new trials.
6/11/04 Stewart sells 75,000 shares of MSO and announces plans of selling 425,000 to pay legal expenses.
7/8/04 - Judge refuses to grant Stewart and Bacanovic a net trial based on perjury charges against Larry Stewart.
7/16/04 - Stewart received the minimum sentence of five months prison followed by five months of home confinement, shares increase 40%
7/27/04 - Thomas C. Siekman replaced Jeffrey W. Ubben as chairman; Arthur C. Martinez, former CEO of Sears, left the board; and Charles A. Koppelman joins the board.
8/3/04 - Reported Q2 2004 down 33% to $44M and a loss per share of $0.39 versus EPS of $0.02.
9/22/04 - Burnett signs on as a consultant to turnaround Martha Stewart Living
9/23/04 - Stewart signs a five-year employment contract with MSO, shares increase 15% for the week.
10/8/04 - Stewart reports to prison for the first day of her five-month sentence.
10/12/04 - Koppelman buys 500,000 shares at a discount from Ubben.
10/13/04 - Bernhardt and MSO add 43 new SKUs to their furniture collections.
10/18/04 - Alywin Lewis becomes the CEO of Kmart, Kmart shares increase 5%, MSO shares increase 6.7%.
10/28/04 - Reported Q3 2004 revenues down 24% to $38.7M and a loss per share of $0.30 versus $0.08.
11/1/04 - Company restates numbers due to accounting change.
11/9/04 - Company discloses that Stewart requested to be reimbursed $3.7M in legal fees.
11/11/04 - Susan Lyne, a director since June 2004, becomes CEO.
11/17/04 - Shares of MSO surge 20% on news of Kmart acquiring Sears.
12/3/04 - Sharon Patrick resigns from the board of MSO."""

Catalyst

Continued financial decline, releast of Stewart will shift investor focus onto business execution, potential problems with TV shows & magazines""