The Little Things That Matter

By David Harper | October 26, 2005 AAA

Earlier this month we commented on how we felt Google (GOOG) is over-priced and how we wouldn't touch the stock with a pole as long as Bernie Ebber's nose.

Staying on a somewhat related topic we wanted to visit another company that steals headlines very consistently yet baffles us...Martha Stewart Living Omnimedia (MSO).

Within the last year Martha Stewart (the person) has gone to jail, been released from jail, created a new TV show, been under five months of house arrest (which was extended three weeks due to "unspecified" infractions) and has seen her company's stock rise 132% - a whirlwind year to say the least.

We are not here to debate the merits of Martha (the person), personally I have no opinion on Martha, I don't like her nor do I have much reason to dislike her. But the fact of the matter is her company is publicly traded and the question needs to be asked - does MSO's current price make any sense?

Similar to Google (GOOG) for us the answer is a resounding no.

Let's take a look at some recent financials.

When looking at the stock the first thing that has to jump out at you is the fact that the company has not reported a P/E since 2002. Why? Simple, they haven't made any money lately.

Therefore the "E" (earnings per share - EPS) portion of the equation has been '0'. The last time MSO reported a positive EPS was 2002 ($0.15). The current EPS for the trailing twelve months (ttm) has been -$1.15. Quite obviously, a negative EPS is not a great sign. Wait though, it gets worse.

Revenues have declined from $295.1M in 2002 to $181.6M (trailing twelve months), representing a 38.5% decline. Not making money and declining revenues, not exactly two elements we look for when searching for companies to add to our model portfolios.

So why has the stock gone up so much if everything looks so bleak? The reason - improved expectations. Currently Wall Street estimates suggest that MSO will post a loss for the year of $1.20 per share. To accomplish this the company would need to slow down their losses in the second half of the year as they have already posted two quarters of losses totaling $1.03 per share.

Standard & Poor Equity Research estimates suggest that in Q3 MSO will post a loss of $0.22 per share and a gain of $0.04 in Q4. Estimates for 2006 suggest that Martha (the person) will have turned the company around and post an EPS for the year of $0.24 per share. The 2006 estimate comes with some pretty extensive caveats such as 30% growth in publishing revenues and $52 million in revenues from TV.

This would be the first profitable year since 2002.

Let's look back at the historic P/E to help give us an idea of where the company should roughly be trading. The historic P/E (when this metric could be calculated) for the company was around 36 (36.6 in both 2001 and 2002). If the company were to trade around 36 times earnings in 2006 – if analyst expectations of $0.24 come to fruition - the price would roughly be $8.64 (36 x $0.24), less than 1/3 the current price of $26.07. If we assume that the EPS target is met and the company trades in this range ($25) for the next year the forward P/E becomes 104. This is nearly triple Google's current forward P/E and about 7 times the current forward P/E of MSO competitor Meredith (MDP)

The only way that MSO's current price makes any sense is if the future growth prospects turn into revenue generating areas of the business now, and by 'now' we mean 'like tomorrow'.

During the height of MSO when Martha was still an untainted household figure in the U.S. the company grew its EPS once from $0.43 to $0.45, this represented a 4.5% increase in earnings. This is way too low for the current price so let's assume that MSO can grow their earnings at 50% (something few companies could ever sustain) per year until 2011.

In 2011 the EPS would be a healthy $1.83 per share, the P/E assuming its price remains where it is, will be 14.25. Perhaps this is a little low compared to their historic P/E, so let's say that after 5 consecutive years of 50% earnings growth (assuming they first achieve the $0.24 in 2006) they trade at 15x earnings. In five years the stock would sit at $27.45 ($1.83 x 15 = $27.45). That represents a 5.5% price appreciation (in 5 years!) from its current level (at the time of this writing at the Advisor we currently have 4 out of 12 stocks sitting at unrealized gains larger than this 24% level in only 2-6 months, depending on the stock) . This does not even come close to keeping up with the historical average of a broad market indices like the S&P 500.

Another thing to look at is the current valuation of the company in terms of its market capitalization. MSO is currently trading at roughly $1.4B.. With the current market cap if we were to add this company to one of our model portfolios it would have to be placed in the Core Portfolio. This portfolio is comprised of companies with caps over $1 billion. Is this company a potential fit with its improved out look? Not even close.

The reasons why are simple, the basic goal of the Core Portfolio is to invest in companies with a wide margin of safety (something that clearly MSO lacks) and a wide economic moat, or competitive advantage (this is something that they may have, but has yet to be proven and sustainable). With its current valuation (way too high) and the past volatility in the stock – the stock is known for its wild fluctuations – it does not fit the basic criteria of the Core Portfolio.

This is a stock we consider to be highly speculative and an example of a company we would not currently suggest to our members.

Now, please do not take this rant as anything more than it is - a rant about a company we do not like at this price. But do note that right now investors are seriously betting the Martha Stewart the person is going to breathe life into Martha Stewart the company. If you like this bet, buy the stock, if you are still skeptical – like we are - then perhaps this is a good one to avoid at this price.

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