I am recommending the short sale of Sharper Image as there exists profit potential in excess of 50% by initiating a position. 

Summary 

Sharper Image stock recently increased ~50% on misguided, overly optimistic profit potential and buyout hopes. Given the company’s rapidly deteriorating fundamentals and its high degree of difficulty to fund a meaningful turnaround, the stock is priced far beyond what such an improvement is likely to achieve. 

Thesis

• Core business is in trouble
• Company has been generating significant losses, which are expected to continue
• Lack of Liquidity--company has already used all of its intangible assets as collateral & only has $61 million of tangible equity
• Management may be capable but does not have the time, assets or balance sheet flexibility/strength to turnaround SHRP
• The recent sharp move up in the stock indicates shareholder expectation of an improvement far beyond what is possible
• New business plan, while possibly somewhat positive in the long-term, actually decreases the risk of a short position
• It would take almost a miracle for the company’s key new products to “bail out” the company--one causes 2/3 of its users to vomit and the other is Trump Steaks (need I say more?)
• Large deferred tax asset will likely have to be written down, inventory should also take a hit
• Current investors appear to be heading for a crash landing as they are not focusing on the fundamentals
• High Valuation

Core business is in trouble. Excluding one-time charges, SHRP had over $74 million in operating losses last year and same store sales are down about 24% YTD with direct sales (catalog and internet) doing much worse (May down 61% y/y).  

SHRP largely built its business around two products, the Ionic Breeze (air purifier) and massage chairs.  The two products have had sales fall by more than 57% since 2004 and represented 30% of total sales down from 49%.  It was around these two products that SHRP built its store base up from 127 stores at the end of 2002 to 186 today.  In my view, the company needs to get back to a store count of approximately 100 or at least below 150, if it is to have even a chance at sustainable profitability. I believe that, with its current store count, there are many underperforming stores, though the company does not provide further details.   It is important to note that the costs are likely to be prohibitive for the company to close stores under current leases.

The Ionic breeze and massage chairs are unlikely to make a comeback.  The Ionic Breeze was emitting ozone at one point, though that problem was fixed, it consistently has been shown by various studies to be ineffective and lagging its competitors’ products in terms of quality.  In any event, given its level of penetration among consumers and its maturity, it would be hard to imagine a significant increase in sales for this product in the future.  The massage chairs are a good product, but competition has increased and SHRP is no longer considered to be the best in class.

I would also point out that over its history SHRP has been a money loser with retained losses of over $9 million as of 1Q and no history of dividends in its 30 years of existence.

Company has been generating significant losses, which are expected to continue. You can see from what I believe are fairly optimistic assumptions on 2007 (below), just how bad business is going and how fast the balance sheet is deteriorating. I believe SHRP is at risk of having to file for bankruptcy by year end.  I believe the company has to make significant improvements in the immediate future in order to avoid bankruptcy or extreme shareholder dilution. The table below shows my 2007 estimate for net income.

I start with the 2006 operating loss of $99 million (EBIT). The company had $24 million in one-time items (mainly restructuring), so pro forma operating loss was $75 million. The company has virtually eliminated infomercials, which results in $27 million in annual savings. In addition, I estimate the company will reduce advertising (ex-infomercials) by another $15 million (10% of 2006 advertising spend). While these reduced marketing expenses will help the company’s ailing balance sheet, these cuts will make it harder for the company to increase its sales. In May 2007, direct sales (catalog and internet) were down 61% y/y. I have assumed a 50% y/y decrease, which is ($34) million. This subtotals to $67 million

In addition, I need to adjust for same-store-sales (SSS) decreases and store closings. I assume SSS decrease 13% y/y for the full year. This compares to a fiscal year-to-date SSS decline of 22% (FY ends Jan). Note, I assume some recovery in SSS. Therefore, I deduct $17 million gross profit from SSS declines (59.9% of sales are from stores x $525 million 2006 sales x 42% GM x 13% y/y decline).

I also assume $5 million in savings from store closures (pretty generous given the single digit store closures planned). The company stated on its most recent earnings call that it expects to close a handful of stores (single digits). I estimate about $3 million in additional gross profit loss (1% x 525M sales x 59.9% are sales from stores).Deducting the gross profit decreases from SSS and store count results in $82 million loss.

I then adjust for incremental interest expense ($2 million) and a decrease in SG&A ($8 million). Thus, my estimate for operating loss is $75 million. After tax (assuming a 39% tax rate) yields my $46 million net loss estimate.

The balance sheet impact shows 2007 ending shareholders’ equity of $77 million ($123 million at year end 2006 less our $46 million net loss estimate for 2007). SHRP had $35 million in deferred tax assets at year end 2006. I estimate the company increases deferred tax assets by $30 million in 2007. Therefore, year end deferred tax asset is $65 million. As you can see, deferred tax assets make up a majority of my estimated shareholders’ equity.

Company has already borrowed against its intangible assets. I note that the company has already borrowed $20 million against its intangibles.  This was done based on 25% of the appraised value of SHRP’s intangibles.  This appraisal is subject to change.  I would argue that intangibles are worth less given the company has generated a cumulative loss throughout its 30 year history.

SHRP had $1.3 million in cash as of April 30, 2007.  I believe SHRP’s $120 million credit line is misleading.  Though the formula by which the credit line is governed is not given out by SHRP, it is based on a percentage of the liquidation value of inventory and receivables.  SHRP had $88 million of combined inventory & receivables as of April 30, 2007. I assume a 60% liquidation value is used and up to 80% leverage against that, which would make the maximum credit line $42 million. SHRP had drawn $19 million of that credit line as of April 30^th and $26 million as of May 31^st.  Therefore, I estimate the credit line can support an additional $24 million ($42 million less $19M million already dran as of April 30^th). There are only two choices once SHRP maxes out or violates its credit line (which may be inevitable as it build inventories for Christmas): bankruptcy or a big secondary equity offering.  Below is how I believe SHRP’s liquidity will work going through year end.

As you can see SHRP should be pretty much tapped-out by year end.  With about $11 million left in borrowing capacity, facing a quarter that should eat up at least another $20 million of cash.  Also the appraised value of their intangibles is likely based on sales of proprietary products, which are falling fast so that credit could be cut as well.

Management may be capable but does not have the time, assets or balance sheet to turnaround SHRP. CEO Jerry Levin was brought in September 2006, and I do not feel the need to argue about his track record, though it is not perfect (Revlon).  I simply think, given the balance sheet and current rate of operating losses, Mr. Levin does not have the time or financial wherewithal to turn SHRP around without going through bankruptcy.  As Warren Buffett has said, bad businesses usually trump good managers—that seems to be the case here.

As of April 30, 2007, SHRP had $106 million in book value with over $45 million of that being a deferred tax asset.  I estimate that the total cost of SHRP eliminating each store (SHRP has 186 stores) is over $600,000, which includes exiting leases and all professional costs.  This is the reason why, despite the painfully obvious need to eliminate stores, SHRP simply cannot afford it, without the balance sheet or cashflows to borrow against.  Some quick moves like changing from commission based salesman to fixed salaries have been largely negated due to the company’s plunging sales.

Recent stock move is overdone. SHRP closed at $9.48 on May 23^rd it then hit a high of $14.16 June 6^th.  On May 24, 2007, news hit that Knightspoint Group had increased its stake to 21% of the outstanding shares.  Lost in the shuffle was who they bought shares from, Richard Thalheimer, the former CEO and company founder, who sold nearly his entire remaining stake for $9.25.  Who better to know about buyout prospects than the CEO?  I think a buyout at any premium from today’s prices, given the necessary costs for restructuring and the mounting losses, seems very unattractive.

Hype over new products is overdone. SHRP is going to have 50% new SKUS by September.  However, the company has already tried this at the end of last year and that turned out poorly.  Also management hinted that they are in talks with Apple.  Unfortunately, it’s them and half the planet competing for Apple products, so I see any significant exclusive products with Apple as highly unlikely.  Given that I are predicting $75 million in losses, a new hit product would have to generate over $200 million in revenue (38% operating margins * $200 million in sales) to get them back in to the black.  Given that a new product is likely not proprietary, the sales may have to be closer to $250 million (estimating a roughly 30% operating margin).

New business plan, while likely positive long-term actually decreases the risk of a short position. SHRP is pretty much switching from a primarily proprietary product model to third party goods.  This will drive down gross margins, but it will most likely reduce volatility, and seems to be a good move long-term.  However, this strategic move substantially dilutes SHRP’s distinguishing characteristics as a retailer and reduces or even potentially eliminates the chances of a much-needed hit product like the Ionic Breeze.  I think SHRP is in the bottom of the 9^th and they need a homerun, but instead is laying down a bunt.

Key new products, one makes 2/3 of users vomit the other is Trump Steaks. Zero G, the weightless experience, is a plane ride that can fly at a precise parabola, to induce weightlessness for periods up to about 25 seconds.  They do this approximately 15 times in a 90 minute flight.  Two-thirds of people can not stomach weightlessness and end up vomiting from the experience.  The price of this privilege is close to $3,700.  Wickipedia link (http://en.wikipedia.org/wiki/Vomit_Comet).  This does not seem like a product that will save SHRP.

Trump Steaks is a product I just do not see as fitting with SHRP’s image. The steaks are supposed to be pretty good, but are extremely expensive at roughly twice the price of the market leader Omaha Steaks.  I would also note that Trump seems to flood the market with his name – examples include Trump Vodka, water, luggage, University and even a board game.  None of these products have generated meaningful success anywhere close to the scale that SHRP needs.  It is important to note that these products are meant more as promotional items than real revenue drivers.  Although the headline “Trump steaks save Sharper Image” may provide some comic value, how many of these steaks can SHRP really sell?  My channel checks to date suggest that this will not be anywhere close to a blockbuster.  Even if the initial uptake by consumers is strong due to curiosity or other factors, it is hard to imagine Trump steaks as a long-term sales leader for SHRP.  Accordingly, the fact that these two products discussed above are the ones SHRP are leading their marketing with doesn’t bode well for its turnaround hopes.

Large deferred tax asset will likely have to be written down, inventory should also take a hit. Deferred tax assets are over $45 million as of April 30, 2007.  That is over 40% of their book value and sure to be rising (could grow to be 100% of book by January 2008).  Given the current operating performance, and the huge amount it represents on their balance sheet, I believe SHRP’s auditors may force them to write this asset down.  Deferred taxes were already written down $522,000 in 4Q06.  With sales falling and 50% new SKUs, you would figure that inventory would have to be written down at some point.  On their most recent conference call, SHRP said they had no plans to write down inventory.  However, it will be written down in one way or another, either through an actual writedown or lower margin sales through eBay, which is how they get rid of a lot of unwanted product. 

Current crop of investors appear to be heading for a crash landing. Somebody actually asked them about international expansion on the last call.  Most investors were focused on timing of the turnaround, not the plausibility of their plan.

Valuation 

I value SHRP at $6 per share, although the stock could go lower over time.  I assume SHRP will have to reduce its store count to 100 stores, this is our estimate and actual closings could be lower than this.  I get this number by looking at SHRP’s historical results which were much better when it was closer to 120 stores. Without the Ionic Breeze and massage chairs selling as strong, I cut another 20% to get to 100.  I assume the remaining stores generate more sales per store and assume it will be able to generate 2/3 of  projected 2007 sales. I then apply a generous 1x sales valuation. The subtotal is $182 million (= 2/3 x 525 million 2006 sales x 59.9% are sales from stores x (1-13% SSS decrease in 2007) x 1x sales).

I then add $30 million for the catalog business, subtract the costs of closing 86 stores ($600k x 86 = $52 million) and debt ($20 million). This totals $140 million or ~$9 per share.

Finally, I weight this outcome at 60% ($9 per share) and believe the other outcome, or 40% probability, is $0 (i.e., bankruptcy). Therefore, my target price is (60% x $9) + (40% x $0) or ~$6 per share.

Conclusion

SHRP is a deep value turnaround story that is trading well beyond deep value levels.  SHRPs weak balance sheet and current heavy losses will make it difficult to restructure without bankruptcy or a large secondary offering.  I recommend investors short shares of Sharper Image, my price target is $6.

Risks

• Short squeeze: short interest is 30.3% and short interest ratio is 39 days to cover. 
• Unexpectedly quick turnaround.
• Irrational buyer makes takeout offer.
• New products turn out to be huge and reverse the company’s fortune.

Business 

Sharper Image sells its gadgets and gizmos through a network of 186 US stores in nearly 40 states and the District of Columbia, as well as online and through its mail catalog. The product mix, which appeals mostly to upscale shoppers, includes electronics, personal care items, recreation and fitness accessories, housewares, toys, travel goods, and gift items.