Saturday, April 29, 2006

Palatin Tech--Developing a New Aphrodesiac?

Melanocortin receptors (MC) are involved in the control of endocrine, autonomic and central nervous system functions. To date, five MC receptors subtypes have been identified. Targeting MC family of receptors provides therapeutic opportunities to treat a variety of conditions and diseases, including sexual dysfunction, obesity, cachexia (extreme wasting, generally secondary to a chronic disease) and inflammation. The 10Q Detective believes that MC-based therapeutics is one of the fastest growing areas of pharmaceutical research and development.

Palatin Technologies, Inc. (PTN-$2.58) is a biopharmaceutical company developing melanocortin-based therapeutics. The Company has a pipeline of product opportunities in late to early stages of development. To date, the Company has formed partnerships with Mallinckrodt, a subsidiary of Tyco Healthcare (TYC-$26.35), and King Pharmaceuticals (KG-$17.39).

NeutroSpec is the Company’s proprietary radio labeled monoclonal antibody product for imaging and diagnosing infection and is the subject of a strategic collaboration agreement with Tyco Healthcare Mallinckrodt. NeutroSpec was approved in July 2004 for use in the scintigraphic imaging of patients with equivocal signs and symptoms of appendicitis who are five years of age or older.

NeutroSpec includes a technetium-labeled anti-CD 15 monoclonal antibody that selectively binds to a type of white blood cell, neutrophils, involved in the immune response. When injected into the blood stream, the antibody binds to neutrophils present at the infection site, labeling these cells with a radioactive tracer. As a result, physicians can rapidly image and detect infection using a gamma camera, a common piece of hospital equipment that records radioactivity. Currently, this is [or was] the only significant revenue-generating stream for Palatin.

On December 19, 2005, Palatin and Mallinckrodt (sales and marketing partner) voluntarily suspended the sales of NeutroSpec and recalled all existing customer inventories. Palatin and Mallinckrodt acted at the request of the U.S. Food and Drug Administration (FDA). The decision to voluntarily suspend the sales, marketing and distribution of NeutroSpec followed the occurrence of several serious adverse events—including two deaths—in patients with severe underlying cardiopulmonary compromise who received NeutroSpec for off-label uses.

All ongoing clinical trials and regulatory approvals of NeutroSpec have been suspended. The Company and Mallinckrodt are reviewing data and assessing approaches for understanding the relationship between NeutroSpec use and the observed serious adverse events. The Company and Mallinckrodt are preparing for an FDA Advisory Committee meeting expected to be held later this year. As of April 2006, no final decision concerning future activities involving NeutroSpec has been made.

The Company’s internal research and development capabilities are anchored by its proprietary MIDAS technology. MIDAS is the first rational synthetic chemistry platform for the rapid conversion of peptides into therapeutics. MIDAS can quickly generate both receptor agonists (drugs that promote a particular response) and receptor antagonists (drugs that block a particular response), setting it apart from traditional combinatorial drug discovery methods. Key features of MIDAS are its ability to quickly and easily identify, and then stabilize, a desired conformation of a peptide for a specific drug target.

Bremelanotide (formerly PT-141), Palatin’s lead therapeutic candidate, is an MC receptor agonist, that has shown promise in effectively treating erectile dysfunction (ED) without the cardiovascular side effects found in ED drugs currently available (PDE-5 inhibitors). Bremelanotide is nasally administered, making it quick and easy to take and does not interact with other drugs, food or alcohol. According to published data, quality of erection, speed of onset, and duration of effect are what differentiate Bremelanotide from the PDE-5 inhibitor class of molecules. To date, Bremelanotide has been evaluated in four Phase 2 efficacy studies enrolling more than 300 men.

Of significance, too, was the fact that on February 8, 2006, the World Health Organization (WHO) formally recognized melanocortin agonists as a distinct therapeutic class and made Bremelanotide the first melanocortin agonist to have an approved generic name. The 10Q Detective believes that the formal recognition of the melanocortin pathway to modify biological processes validates MC-based R&D as an area worthy of big pharma interest (which will help Palatin facilitate future clinical partnerings).

Palatin is collaborating with King Pharmaceuticals to jointly develop and commercialize Bremelanotide in North America for both male and female sexual dysfunction. Financial terms of the collaboration are highly favorable to Palatin, with a potential for $250M in milestone payments and profit sharing on a worldwide basis. Under terms of the agreement, Palatin has retained the right to co-promote Bremelanotide to the urology specialty market and has operational responsibility for preclinical and clinical development and manufacturing, allowing Palatin to maintain a large interest in the value of the therapy.

In our last report, we mentioned that the current market for drugs to treat ED was estimated to grow from sales of US$3.8 billion in 2005 to approximately U.S.$6.6 billion by 2012. An even more sizable market exists in the treatment of female sexual dysfunction (FSD). According to the American Urological Association, more American women (43%; about 40 million) than men (31%) experience some form of sexual disorder, including both organic and psychogenic causes. Furthermore, the incidence of female sexual dysfunction increases after menopause when hormone production declines and neurovascular function is compromised. There are no FDA-approved medical treatments for FSD.

The Company is in the process of identifying a clinical candidate [MC therapeutic small molecule] for the treatment of obesity, and also has a program for the treatment of cachexia. The Company is also in the process of identifying a natriuretic compound for the treatment of congestive heart failure.

On April 17th the Company announced that it successfully closed on a stock/warrant offering that raised approximately $27.0 million in gross proceeds. The 10Q Detective estimates that with a monthly cash-burn rate pegged at about $2.8 million, Palatin currently has cash, cash equivalents and investments totaling approximately $25.0 million. The monthly cash-burn rate will obviously rise in the future as a result of spending on development programs. Nonetheless, management expects that existing cash reserves will be adequate to fund the Company’s operations for at least the next twelve months.

The near-term valuation of an emerging biotechnology company like Palatin is driven by the headlines. The share price will, therefore, be dependent upon the clinical success or failure of Bremelanotide.

Key factors in determining longer-term biotech valuations are time, cost, and peak sales/profitability estimates. The 10Q Detective believes that clinical development and approval by the FDA for Bremelanotide [in healthy males with mild-to-moderate ED] will take approximately five more years. The potential revenue stream to Palatin [less surrender value to manufacturing and marketing partners] could, in our estimates—top $2.0 billion annually (which includes off-label use in FSD, ‘lifestyle’ use, and co-use with PDE-5 agents).

According to historical industry standards, the odds of Bremelanotide’s ultimate success of moving through Phase III trials (balance between efficacy & safety) to market are about 67 percent. The risk-adjusted value of the revenue is 0.67 times $2.0 billion, or $1.34 billion. After discounting (at an internal rate of return of) 30.0%, using a price-sales ratio of 3, a trebling of shares outstanding to 180.0 million, our risk-adjusted 12-to-18-month price objective is $20.25 per share. Alternatively, an unsuccessful Phase III trial of Bremelanotide could depress the stock price to its cash value of $0.85 per share. BUY—but be aware.

Thursday, April 27, 2006

ED Market: Showing Flaccid Growth

Just back from a week’s vacation in sunny Florida, the following headline caught the 10Q Detective’s attention: “GM pays $17M for erectile dysfunction care.”

Charles E. Wilson, the former President of General Motors, said, “what was good for our country was good for General Motors and vice versa.” [Testimony, Senate Armed Services Committee, 15 Jan 1953]. Ergo, we thought it might be interesting to do a retrospective commercial analysis of currently marketed products for erectile dysfunction, and a prospective review of several pipeline products identified that are currently in clinical development.

According to the Massachusetts Male Aging Study (MMAS), erectile dysfunction is a condition that affects an estimated 52 percent of men between the ages of 40 and 70. Erectile dysfunction, or ED as it is commonly called, affects over 30 million men in the U.S. In fact, more than half of all men between the ages of 40 and 70 experience ED to some degree. The etiology of ED, frequently associated with psychogenic and/or vascular problems, is particularly common in men with diabetes and in those who have had a radical prostatectomy for prostate cancer. ED is defined as the consistent inability to get or maintain an erection that is hard enough for sexual intercourse.

Many therapeutic options are available to assist in the management of erectile dysfunction (ED). The types of medications can be divided into oral, injectable, topical, intraurethral insertion, and penile prostheses:

· Oral -- UPRIMA (apomorphine) is a dopamine receptor agonist that works in the brain to improve diminished erectile function by enhancing the natural signal to the penis following sexual stimulation, similar to the way men normally have erections. UPRIMA works through the central nervous system, producing a series of events that enhances the ability to achieve and maintain penile erection. The generic [branded drug, Ixense] is sold on the Internet and comes in the form of small flavored pills that dissolve on the tongue.

Phosphodiesterase (PDE-5) selective inhibitors are agents that act peripherally to induce smooth muscle relaxation of the corpora cavernosa. The most commonly used agents are sildenafil (Viagra), vardenafil (Levitra), and tadalafil (Cialis). Viagra was the first in this series of PDE inhibitors. These agents rely on the role of nitric oxide (NO) in inducing vasodilatation. NO relaxes smooth muscle by stimulating guanylyl cyclase activity, which raises the intracellular concentrations of the cyclic nucleotide cGMP, which, in turn, induces vasodilation.

· Injectables -- Agents that are injected directly into the penis and exert their relaxant effect directly on the corpora cavernosal smooth muscle. They can be used as single agents or in combination. The most commonly used agents utilize prostaglandin E1 (PGE-1), otherwise known as alprostadil (the generic name for the synthetic version of prostaglandin E1, a naturally occurring vasodilator present in the human body and at high levels in seminal fluid). These medications can be obtained commercially as Caverject, which is a vasodilator (PGE-1) that is injected into one of the corpora cavernosa. If the blood vessels are capable of dilating, a strong erection should develop within 5 minutes. Available since 1995, patients can be supplied with vials of a single agent or a combination of agents mixed in a single vial.

Intracavernosal injection of other drugs, such as papaverine and phentolamine (sometimes in combination), are also effective but invasive treatments.

· The Medicated Urethral System for Erections (MUSE), launched by VIVUS (VVUS-$3.20) in 1997 in the United States, is a small suppository placed into the urinary opening using a disposable plastic applicator. MUSE was the first minimally invasive therapy for erectile dysfunction available at a time when only more invasive therapies existed. With MUSE, an erection is typically produced within 15 minutes of administration and lasts approximately 30 to 60 minutes. MUSE is a relatively safe, local treatment that minimizes the chances of systemic interactions with other drugs or diseases. The commercial launch of Viagra in the United States in April 1998 significantly decreased demand for the injectables.

· TopicalAlprox-TD is an alprostadil-based cream treatment intended for patients with mild, moderate or severe erectile dysfunction. Based on proprietary transdermal penetration technology developed by NexMed Inc.’s (NEXM-$0.82), the medicine is currently approved for sale in China and in Hong Kong since October 2001 and April 2002, respectively, under the Befar trademark.

In December 2002, NexMed completed two pivotal Phase 3 studies for Alprox-TD, which tested over 1,700 patients at 85 sites throughout the U.S. Both studies demonstrated that Clinical studies have demonstrated that NexMed’s technology promoted the rapid absorption of alprostadil and improved clinical responses in men with varying degrees of ED. Prior to filing a New Drug Application for Alprox-TD, however, the Company, will be required to initiate a new 12-month open-label safety study. A past open-label study was halted in November 2002 due to FDA concerns about results found in transgenic mice study. The topical cream product is packaged in a pre-measured dose and is applied locally via an applicator to the tip of the penis with the onset of activity reported at 10-15 minutes.

· Penile Prostheses -- ACTIS, manufactured by VVUS, works by allowing blood to flow into the penis, but applied constriction latex band therapy restricts the outward blood flow. The result is an erection.

In the past, the placement of prosthetic devices within the corpora was the only effective therapy for men with organic ED. Now, given its limited appeal relative to other aforementioned therapies, it is a procedure of last resort.

Two types of devices are available, a semi rigid and a multicomponent inflatable system. With the semi rigid prosthesis, 2 matching cylinders are implanted into the corpora cavernosa. These devices provide enough rigidity for penetration and rarely break. The major drawbacks are the cosmetic appearance of the penis, the need for surgery, and the destruction of the natural erectile mechanism when the prosthesis is implanted.

The current market for drugs to treat sexual disorders is estimated at US$3.8 billion. Given the aging baby boomer population and direct-to-consumer advertising projecting the desire of seniors to maintain an active sexual lifestyle, as late as the 3Q:05, forecasters called for a 74% increase in sales to U.S.$6.6 billion by 2012, with most of this growth predicted to come from the PDE-5 inhibitor class. Actual prescription growth, however, has shown a decrease of 3%-5% in the overall ED market for the past five-months.

In the opinion of the 10Q Detective, the PDE-5 vitalized the market—and has strangled new RXs, too. In July 2005, FDA alerts about non-arteritic anterior ischemic optic neuropathy (NAION) were issued after the agency received 43 reports of varying degrees of vision loss, including blindness, among users of erectile dysfunction drugs.

NAION is a vascular event that occurs when blood flow to the small arteries that supply the optic nerve is decreased or blocked. The lack of blood supply to the optic nerve causes damage to the nerve, which may result in permanent vision loss in one or both eyes. NAION is usually permanent and often leads to legal blindness.

On July 5, 2005, the FDA approved updated labeling for Cialis, Levitra, and Viagra to reflect this potential risk of sudden vision loss. This news, coupled with the prior concern among health practitioners about the potential for cardiac risk of sexual activity in patients with preexisting cardiovascular disease [found in the Warning Label section of the Drug Package Inserts of PDE-5 agents] has adversely affected the way doctors and patients think about treating and using drugs, respectively, for ED or “recreational use.”

The 10Q Detective believes, however, that a thematic area currently being ignored by investors is the growth potential afforded by next generation ED drugs. The same factors that initially drove the explosive ED market growth in the past four years (the availability of effective oral therapy, growing worldwide awareness of ED and treatment options, and an aging population) will continue to influence the market over the next decade. Emerging novel agents that offer fewer side effects—and similar erectogenic efficacy to—Viagra (and other first-generation PDE-5 agents) will resuscitate the flaccid ED market.

Analysis of identified high-revenue yielding prospects for erectile dysfunction:

· VIVUS is developing avanafil, a fast-acting, highly selective phosphodiesterase type 5 (PDE-5) inhibitor, as an oral medication for the treatment of ED. The Company licensed avanafil from a leading Japanese pharmaceutical concern, Tanabe Seiyaku Co., Ltd, in 2001. VIVUS has exclusive worldwide development and commercialization rights for avanafil with the exception of certain Asian markets.

While PDE-5 inhibitors currently on the market are effective in treating ED, newer drugs that possess better specificity for the PDE-5 enzyme may be safer. In addition to PDE-5, there are at least ten other types of PDE enzymes in the human body. Drugs that inhibit more than one of these enzymes can potentially cause significant adverse effects, depending on the enzymes that are affected. In an in vitro study conducted by Tanabe comparing the activity of avanafil, sildenafil, tadalafil and vardenafil against all 11 of the known PDE enzymes, Tanabe found that avanafil demonstrated the best specificity for PDE-5, with little activity against the other enzymes.

Avanafil possesses a shorter plasma half-life than other PDE-5 inhibitors currently on the market. The plasma half-life of a drug is the amount of time required for 50% of the drug to be removed from the bloodstream. In general, the shorter the half-life, the less potential there is for the drug to interact with other drugs that may also be in the bloodstream. All approved PDE-5 inhibitors are required by the FDA to include warnings against taking nitrates after administration. For example, Cialis’ label warns patients not to take nitrates within 48 hours of administration. Approximately 5.5 million men take nitrates on a regular basis for angina pectoris and another half million annually will experience a heart attack and are potential candidates for emergency nitrate therapy. Sildenafil and vardenafil possess plasma half-lives of approximately four hours, and tadalafil has an extended half-life of 17 to 18 hours. The plasma half-life of avanafil, however, is approximately 90 minutes, which means that it is removed from the bloodstream faster than the other currently available PDE-5 inhibitors. VIVUS believes avanafil’s short half-life, high specificity and fast onset of action are ideal characteristics for an on-demand treatment for ED.

An End-of-Phase 2 meeting with the FDA for avanafil took place in November 2005. Corporate discussed the Phase 2 results and the proposed protocol for the Phase 3 trials. Based on this meeting, VIVUS will proceed with finalizing the Phase 3 protocol and it is corporate’s intention to request a Special Protocol Assessment from the FDA prior to the initiation of the pivotal Phase 3 trials.

A second generation of PDE agents, such as avanafil, and other newer drugs are coming to market that will provide men with increased options for successfully treating their problems with sexual function. Given the increased understanding of the physiologic mechanisms of ED, newer treatments are being developed that target the specific molecular dysfunctions and provide a mechanism of enhanced penile functioning. Possible new developments in the management of ED with a time frame of 5-8 years until their market approval are guanylate cyclase activators, Rho-kinase inhibitors, melanocortin receptor agonists, gene therapy, and tissue engineering.

In the next report of the 10Q Detective, we will examine a company developing a promising melanocortin receptor agonist, the revenue-yielding prospects of the agent, and place a valuation on the company developing this—and other—products.

Stay tuned....

p.s. It is nice to be back!

Wednesday, April 19, 2006

All in The Family at Martha Stewart Living

Boy the way Glen Miller played
Songs that made the hit parade.
Guys like us we had it made,
Those were the days.

And though profits continue to elude shareholders of Martha Stewart Living Omnimedia, Inc. (MSO-$19.50), rewards are aplenty for those closest to Martha Stewart, the $900,000 [per annum] paid ‘Founder.’ The Company employed Martha Stewart’s sister-in-law in the years ended December 31, 2005, 2004 and 2003 for aggregate compensation of $160,000, $157,000, and $181,000, respectively. The Company employed Martha Stewart’s brother-in-law in the years ended December 31, 2005, 2004 and 2003 for aggregate compensation of $146,000, $104,000, and $121,000, respectively. The Company employed Martha Stewart’s daughter in the year ended December 31, 2005 for aggregate compensation of $131,000. The Company paid Martha Stewart’s sister a consulting fee of $70,000 for editorial services in the year ended December 31, 2005.

And you knew who you were then,
Girls were girls and men were men,
Mister we could use a man
Like Herbert Hoover again.

The Company employed the daughter of Charles Koppelman, Chairman of the Board of the Company, during the year ended December 31, 2005 for aggregate compensation of $48,000.

Didn't need no welfare state,
Everybody pulled his weight.
Gee our old LaSalle ran great.
Those were the days.

The Company made a financial commitment of $100,000 to the VCU Adcenter with which Rick Boyko, a Company Director, is affiliated. The VCU Adcenter is part of the non-profit Virginia Commonwealth University.

Those were the days! [Song: All in the Family television show lyrics]

Monday, April 17, 2006

Martha Stewart Shareholders--Stuck with Hoop Wrinkle Stitches.

  • On February 22, 2006, Martha Stewart Living Omnimedia, Inc., (MSO-$19.80), a leading provider of original “how-to” information, inspiring and engaging consumers with lifestyle content and high-quality products, finally rewarded the faithful by reporting its first operating profit in eight quarters.

    For the three-month period ended December 31, 2005, the New York-based multimedia company (MSLO) posted net income of $2.95 million, or 6 cents per share, on a 40.4% rise in revenue to $84.5 million. That compares with a loss of $7.33 million, or $(0.15) a share, in the year-ago period (when its namesake founder was serving a five-month prison sentence for lying about a stock sale) on sales of $60.2 million.

    On the Martha Stewart Living Omnimedia Q4 2005 Earnings Conference Call, Susan Lyne, President & CEO, sounded equally sanguine about growth and income prospects going forward. Lyne told analysts that the company's strategy for sustaining long-term growth will hinge on three areas: rebuilding its Internet business; reaching out to the 25- to 45-year-old age group, a hot demographic for advertisers; and expanding its merchandise offerings through new categories like scrapbooks and through such partnerships as KB Home.

    MSLO has four operating segments:



    Martha Stewart Living, the Company’s flagship magazine, is the foundation of the publishing business. The magazine appeals primarily to the college-educated woman between the ages of 25 and 54 who owns her principal residence. Martha Stewart Living seeks to offer reference-quality and original how-to information from the Company’s core content areas for the homemaker and other consumers in a unique upscale editorial and aesthetic environment. Revenues generated by Martha Stewart Living magazine constitute the substantial majority of total magazine revenues. Martha Stewart Weddings targets the upscale bride and serves as an important vehicle for introducing young women to corporate brands. Martha Stewart Weddings is distributed primarily through newsstands.
    Body + Soul magazine and Dr. Andrew Weil’s Self Healing newsletter, are publications featuring “natural living” content. The newsletter generates substantially all of its revenue from subscriptions, while the magazine generates both advertising and circulation revenue.
    Publishing revenues increased $29.8 million, or 31%, to $125.8 million for the year ended December 31, 200, reflecting sharp gains in advertising revenues of $17.9 million. Advertising revenue in Martha Stewart Living increased $13.5 million primarily due to an increase in advertising pages, as well as an increase in advertising page rates.
    Circulation revenue increased $8.5 million in the period primarily due to the acquisition of Body & Soul group (Body + Soul magazine and The Dr. Weil Self Healing newsletter), which collectively contributed $3.7 million towards the increase as well as from improved circulation trends [a 4.1% increase] in Martha Stewart Living magazine which resulted in an increase in revenue of $3.3 million.
    Nonetheless, the Publishing segment posted an operating loss of $(15.3) million, as cash expenses rose 14.9%, or $17.6 million, reflecting higher paper, printing and distribution costs.
    In 2006, management expects to see continued improvements in advertising pages and circulation trends in its magazines, including the flagship, Martha Stewart Living.
    In May 2006, MSLO plans on publishing the first of a two-issue test of a new lifestyle publication for women ages 25-45. Blueprint: Design Your Life will be available on newsstands in May 2006 with an initial rate base of 250,000. A second issue is scheduled for August 2006. The company anticipates publishing six issues of Blueprint in 2007. The total investment currently budgeted in 2006 related to Blueprint is approximately $5 million.


    In September 2005, MSLO launched MARTHA, a syndicated daily lifestyle series hosted by Martha Stewart. Filmed in front of a studio audience, the show consists of several segments which feature inspiring ideas and new projects from one or several of eight core content areas.
    In November 2005, MSLO launched the Martha Stewart Living Radio channel on SIRIUS Satellite Radio. This channel provides programming designed for women listeners and their families, 24 hours a day, seven days a week. Under the terms of the four-year agreement, MSLO receives a fixed revenue stream earned evenly over the life of the contract.

    Broadcasting revenues, consisting of advertising ($6.1M) and licensing ($10.5M), increased $6.0 million, or 57%, to $16.6 million for the year ended December 31, 2005. The increase was primarily due to higher revenue from MSLO’s syndicated daily program, MARTHA, which launched on September 12, 2005. Corporate expects the launch of the program will result in an increase in revenue in 2006. Licensing and other revenue increased $4.1 million due in part to the launch of MARTHA on cable domestically and on a variety of distribution channels internationally. In 2006 the segment will also benefit from the shift of the Martha Stewart Living Radio from the Publishing group.
    The Broadcasting segment reported an operating loss of $(27.1) million in 2005. Expenses included a non-cash equity compensation of $16.8 million charge related to the vesting of certain shares covered by a warrant granted in connection with the new syndicated show.


    Martha Stewart Everyday
    Martha Stewart Everyday (“MSE”) is the brand under which merchandise is sold in the discount store channel of distribution. Currently, the label is associated with products that generally fall into the following categories: Home (which includes sheets, towels, pillows, bath accessories, window treatments and kitchen textiles), Garden (which includes outdoor furniture and accessories, garden tools, planting pots, bulbs and seeds), Kitchen (which includes cookware, bake ware, utensils, dinnerware, flatware, and beverage ware), Keeping (which includes organizational products relating to the pantry, closet and laundry), Decorating (which includes mirrors, picture frames, candles, and lamps), Ready-to-Assemble furniture (living, dining, bath and bedroom furniture), Holiday (which includes artificial Christmas trees, decorating products, wrapping and ornaments) and Colors (which consists of a line of interior paints available in 256 colors).
    In the United States and Canada, these products, other than the paint products, are sold pursuant to exclusive agreements. In the United States, MSLO has an exclusive license agreement with Kmart Corporation in the discount store channel of distribution. In 2005, Kmart represented 89% of total revenue in the Merchandising segment and 25% of total company revenue. In Canada, MSLO has an exclusive license agreement with Sears Canada, which launched the Martha Stewart Everyday brand label in September 2003.
    The line of interior paints is manufactured and distributed by The Sherwin-Williams Company to retailers, including Kmart and Sears in the United States. Although the agreement with Sherwin-Williams expired by its terms at the end of 2005, MSLO is in discussions to extend their agreement
    Martha Stewart Signature
    Paint. Through an agreement with The Sherwin-Williams Company, which expired on December 31, 2005, Martha Stewart Signature Color Palette, consisting of 416 colors, has been available at Sherwin-Williams stores nationwide. Consumers have been able to have any of the colors mixed in a wide variety of Sherwin-Williams paints. MSLO receives royalties on the sale of all paints mixed in a Martha Stewart Signature color. As mentioned, MSLO is in discussions to extend the agreement with Sherwin-Williams.
    Furniture. Beginning in March 2003, furniture products for the living room, bedroom, and dining room became available at furniture stores and department stores nationwide. Through an agreement with Bernhardt Furniture Company, Inc., these products are designed by MSLO and the Bernhardt design staff and manufactured and distributed by Bernhardt. The agreement provides for royalty payments to MSLO based on sales of MSLO products by Bernhardt and expires in early 2008.
    Merchandising revenues increased $2.5 million, or 4.6%, to $55.8 million for the year ended December 31, 2005, from $53.4 million for the year ended December 31, 2004. Royalty revenue based on product sales at Kmart declined $1.3 million primarily as result of store closings, partially offset by a higher royalty rate. The royalty rate under the agreement with Kmart increased by 3% on February 1, 2005. Sales of Martha Stewart Everyday products at Kmart decreased 7.9% on a total store basis and 4.3% on a comparable store basis year-over-year.
    The Merchandising segment posted a 7.2% increase to $30.0 million in its operating income in 2005, benefiting from stable SG&A expenses and “true-up” payments (where minimum guarantees exceed actual royalties earned from retail sales) from K-Mart that totaled $18.7 million. Readers should note, however, that these minimum guarantees [on which the Company is materially dependent] drop from $65.0 million in 2008 to $20.0 million in 2009. [ed. note. MSLO can still manipulate EPS by deferring certain percentages to future years.]
    The 10Q Detective wants its readers to note, too, that during the year ended 2005, 2004, and 2003, the revenues from Kmart Corporation were approximately 25%, 26%, and 22% respectively of the company’s total revenues. An agreement with K-Mart’s parent company, Sears (SHLD-$139.15), to put product in the 1000 or so Sears stores across the nation would seem to offer a natural outlet, but the sides haven't reached an agreement that would put Martha's stuff in Sears stores.
    Management expects recently announced merchandising contracts to be meaningful profit contributors in 2007 and beyond. The 10Q Detective believes that although these new alliances will help MSLO to diversify its revenue/profit streams from Kmart, we think that the trip ahead will be anything but smooth driving:
    · Federated Department Sores. The Company said last week it was launching an exclusive line of home products in Macy's stores (a move analysts see as an effort to move more upscale). The line, to be called Martha Stewart Collection and set for an autumn 2007 launch, will include bed and bath furnishings, casual dinnerware, flatware, glassware, cookware, garden furniture and holiday decorations.
    · KB Home. In October 2005, MSLO signed a co-branding deal with KB Home, Inc. (KBH-64.66) to design and style all interior and exterior components for 655 new homes in Carey, North Carolina. The companies say the homes are similar to the domestic diva's dwellings in New York and Maine, and many of the fixtures and design elements were selected by Martha Stewart. The first community of 655 Martha Stewart Homes in Raleigh, NC will open to the public on March 9th.
    In February 2006, MSLO announced an expanded agreement with KBH. In the first phase of the new agreement, MSLO will help design an additional 1,200 homes in and around Atlanta, Charlotte, Houston, Orlando and Daytona Beach. The contract also calls for MSLO to create a line of interior and exterior home products or design options in a range of categories, floor categories, lighting fixtures, bathroom fixtures, kitchen cabinets, hardware, window treatments, doors and closet organizers. These products, called Martha’s choices, will be available exclusively in KB studios nationwide.
    According to Susan Lyne: “the potential revenue of those homes that we’ve signed on for is in the range of $11-$15 million. And with all of our licensing deals, we have no inventory or capital costs. Our principal cost is our design staff and studios.” This may be true, but KB Homes, like other home-building stocks, is not immune to rising interest rates. In its 10-K filing last month, KBH said “during the first two months of the year, it saw an increase in home-order cancellations and a fall-off in net orders compared to the previous year.” The Company then went on to say: "There are signs . . . that consumer demand in the United States for residential housing at current prices is softening.”
    · Crafts. In January 2006, management announced that MSLO entered into a licensing relationship with EK Success, LTD and GTCR Golder Rauner, LLC to design a line of paper-based craft products. Corporate expects to launch these Martha Stewart Crafts—paper based crafts and scrap booking merchandise—products in the fourth quarter of 2006 or the first quarter of 2007.
    To frame the economics of this business, crafts and related hobbies (like sewing) is more than a $30 billion business, with the craft sector—the fastest growing segment— generating more than $3.0 billion in annual sales.
    Albeit MSLO is entering this market with a trusted and recognized brand-name, it is a highly competitive arena, dominated at the regional level by A.C. Moore Arts & Crafts, Inc. (ACMR-$18.24) on the East Coast & national level with the likes of Jo-Anne Stores (JAS-$12.50), which operates 838 stores in 47 states, Michael Stores (MIK-$37.00), the largest national arts & crafts specialty retailer with almost $3.7 billion in annual sales, and mass merchandisers like Wal-Mart.

    “Fiscal 2005 was a challenging year compared with the prior year, as the retail environment experienced softness throughout the year. The primary source of our softness was the home decorating portions of our business, such as finished seasonal, floral and home décor merchandise, as well as home decorating textiles,” quoting Jo-Anne Stores’ management in their recent 10-K filing. “The quilting and apparel fabrics portions of our business have softened as well, particularly in the third and fourth quarters. Our sales performance for the year was extremely disappointing, and occurred despite an increased level of marketing events and advertising, as well as more aggressive promotional pricing.”

    AC Moore Arts & Crafts Inc. on Thursday, April 6, said same-store sales fell 1.8 percent in the first quarter due to “weak yarn sales and warned earnings will likely come in shy of Wall Street's target.”

    New merchandising partnerships will help to expand MSLO’s product offerings and distribution channels. Nonetheless, if buyers are sitting on their hands instead of crafting or sewing, economies of scope could end up being a drag on the bottom-line. Readers have been warned!

    In 2005, MSLO repositioned its website,, to focus principally on the online content of its operating segments, as well an online floral business, Advertising is the primary source of revenue for the online content business.
    Internet segment revenue fell 59.1% to $11.2 million in FY 2005. The decline in commerce sales was largely attributable to the discontinuance of the catalog, Martha Stewart: The Catalog for Living in early 2005. The operating loss decreased modestly by $5.3 million to $(3.5) million, attributable to cuts in production, distribution and editorial costs expenses related to discontinuation of The Catalog.
    Management is looking for a “halo” effect from the Martha Show. Renewed for a second season, and with 1.8 million viewers, corporate expects migration to the Internet site. Although we do expect a double-digit increase in unique visits and page views in the coming quarters, we do not believe that the web business will contribute any significant growth to either sales growth/EPS.
    Given everything that has been collectively written so far in this blog, it is not clear to us yet that an argument can me made that MSLO is a stock worth buying. A big problem that the 10Q Detective has unearthed is that although management is purportedly focused on creating value—the only shareholders that seemingly benefit from management’s actions year-in and year-out is management themselves!
    Greed is a bottomless pit which exhausts the person in an endless effort to satisfy the need without ever reaching satisfaction. –Erich Fromm (1900 – 1980), Escape from Freedom, ch. 4 (1941)

    · Martha Stewart controls the company through her stock ownership, enabling her to elect who sits on the board of directors, and potentially to block matters requiring stockholder approval, including any potential changes of control. Ms. Stewart controls all of the outstanding shares of Class B common stock, representing approximately 92% of total voting power. The Class B common stock has ten votes per share, while Class A common stock, which is the stock available to the public, has one vote per share. Because of this dual-class structure, Ms. Stewart has a disproportionately influential vote. As a result, Ms. Stewart has the ability to control unilaterally the outcome of all matters requiring stockholder approval, including the election and removal of our entire board of directors and any merger, consolidation, etc.
    · Rental Payments. The Company has a location rental agreement with Martha Stewart, whereby the Company uses various properties owned by Martha Stewart. Under a location rental agreement dated September 2004, the Company pays Ms. Stewart $500,000 annually for use of her properties, which increases to $750,000 in years in which the Company is producing any original network, cable or syndicated television program for which Martha Stewart serves as on-air talent. The fees for use of these properties under the location rental agreements amounted to $583,000, $1.44 million, and $2.5 million in 2005, 2004 and 2003, respectively.
    · GREED. During 2005, the Company paid $186,000 to a company owned by Martha Stewart, principally for reimbursement of expenses incurred on the Company’s behalf in connection with business meetings and entertainment. The Company also paid $177,000 for reimbursement of a portion of the cost of a computer network and telecommunications system, as well as $99,000 for security gates, all at her primary residence.
    · Employment Agreement With Martha Stewart.
    Martha Stewart served as Chairman of the Board and CEO until 2003, when she resigned her erstwhile positions to become the Chief Creator Officer. Ms. Stewart continued to serve as Chief Creative Officer until March 2004 when she resigned as Chief Creative Officer and assumed the position of Founder, a non-officer position. As Founder, Ms. Stewart receives a salary of $900,000. In 2005, she received a cash bonus of $512,588. Ms. Stewart is entitled to reimbursement for all business, travel and entertainment expenses. MSLO is also required to provide Ms. Stewart with automobiles and drivers. In addition, Ms. Stewart will receive an annual non-accountable expense allowance of $100,000 per year. [ed note. Maybe she can go out and buy some ImClone stock.]
    · Hollywood calling. During 2005, the Company paid Ms. Stewart $500,000 for her work on “The Apprentice: Martha Stewart” and approximately $75,000 for representing the Company on “MARTHA”, her syndicated television show. (She was entitled to receive $500,000 for her talent services, but in a gesture of ‘goodwill,' asked to be paid standard actor’s union scale wages.)
    · Intellectual Property License Agreement. Under the license agreement, MSLO has the right to develop and register in the Company’s name, trademarks that incorporate the image, look, and goodwill of the Martha Stewart name, such as Martha Stewart Living, and to use exclusively these marks in its business. Ms. Stewart receives a royalty of 3% per annum of the revenues derived from any of the products or services bearing any of the licensed marks used by MSLO.
    · Executive Compensation Agreements. In 2005, despite another year of inconsistent financial performance [ROE/ROA were both negative], Susan Lyne, CEO & President, was awarded a cash bonus of $625,500; Robin Marino, President-Marketing, was awarded $250,000…. etc, etc. [ed. note. To Ms. Lyne’s credit, she voluntarily chose to forego that cash bonus, requesting that the Compensation Committee take $200,000 in cash that otherwise would have been payable to her and allocate those funds to the general bonus pool.] In November 2004, Ms. Lyne was paid $447,120 to compensate her for the forfeiture of equity compensation awards relating to her prior employment with The Walt Disney Company.
    · Reward Failure. Although “The Apprentice: Martha Stewart,” died an early death on television because of a lack of viewers, the producer Mark Burnett (of Survivor fame), the Company vested him in a 1/3 of a warrant to purchase a total of 2.5 million shares at an exercise price of $12.59 per share—even though MLSO did not have a direct financial ownership interest in this show!
    · “Please, sir, may I have more…porridge?” In October 2005, the Company entered into a separate three-year consulting agreement with CAK Entertainment, Inc. an entity for which Mr. Charles Koppelman serves as Chairman and Chief Executive Officer. Pursuant to the terms of the consulting arrangement, CAK Entertainment will make the consulting services of Mr. Koppelman available on a non-exclusive basis to assist the Company’s President and Chief Executive Officer in identifying and addressing strategic opportunities for the Company, including, helping to identify, develop, design, structure and negotiate transactions or other business collaborations involving merchandising (through catalogs, direct marketing, internet commerce, and/or retail stores); book publishing; magazine, radio and television ventures; and other areas in which the Company may seek to do business. In consideration for Mr. Koppelman’s services, the Company agreed to pay CAK Entertainment $725,000 per annum. In addition, Mr. Koppelman received 200,000 options to purchase shares of the Company’s Class A common stock (which had an aggregate value of $3.31 million on the date of issuance).
    · “You want MORE?” As part of his services as Chairman of the Board, Mr. Koppelman also receives an annual retainer of $75,000. In addition, Mr. Koppelman was granted 25,000 shares of the Company’s Class A Common Stock for agreeing to serve as Chairman of the Board.

    Management provided guidance for FY 2006 suggesting that revenue between $270.0 and $280.0 million was possible with OIDA in the range of $10-$12 million. Analysts call for a loss of $0.10 per share. In FY 2007, on estimated sales of approximately $312.10 million, consensus estimates call for a profit of $0.19 per share. [ed. note. Earn-out from interest income, net was $0.06 per share in 2005.]

    To quote a recent Motley Fool article: “And that's the continuing problem with these shares. This is a company that continues to reward insiders, while investors sit on the sidelines and hope for illusory profits.”

    Although management is taking steps to lessen its dependence on Kmart, the 10Q Detective still believes that the stock is expensive, selling for a staggering 104 times 2007 EPS estimates.

    On an enterprise value, the 10Q Detective is of the opinion that MSLO should be valued as a TimeWarner (TWX-$16.80) – Michael Stores (MIK-$37.00) hybrid—an emerging entertainment Company providing Internet/pulp content & a retail merchandise. TWX and MIK sell for EV/EBITDA and EV/ Revenue of 2.12x, 9.5x and 2.12x, 1.21x, respectively. Compare this to MSLO, with no profits, has an EV/EBITDA of (35.8) and an EV/Revenue of 4.43 times. MSLO shares are too expensive for all but insiders. The share price reflects potential—not reality: AVOID/SELL.

Thursday, April 13, 2006

RadioShack--We Recommend the Movie, Mr. Roberts, instead.

RadioShack Corp. (RSH-$18.50) Executive Chairman Leonard Roberts will retire after the May 18 shareholders’ meeting, the electronics retailer said Wednesday.

Under the consulting agreement, which was signed in 2005 when Roberts transitioned from chairman, CEO and president to executive chairman, he will earn $41,667 a month for 31 months, the company revealed in recent filings with the SEC.

In addition, during the term of the Consulting Agreement, RadioShack has agreed to provide Mr. Roberts with an administrative assistant and office space for him and his administrative assistant, selected by him but at a location other than RadioShack’s corporate headquarters. RadioShack will pay up to a total of $100,000 a year towards the cost of the rent and parking for the office space and the cost of Mr. Roberts’ administrative assistant’s base annual salary.

Strengthening demand for high-end electronics such as flat-panel televisions and MP3 players have lifted the shares of competitors Circuit City (CC-$26.65) and Best Buy (BBY-$56.90) to 52-week highs. Meanwhile, RadioShack is bouncing of its 52-week low, abandoned by investors, as analysts cite the absence of any cogent “merchandising strategy.”

At December 31, 2005, RadioShack operated 4,972 company-operated stores under the RadioShack brand, located throughout the United States, as well as in Puerto Rico, and the U.S. Virgin Islands. These stores are located in major shopping malls and strip centers, as well as individual storefronts. Each location carries a broad assortment of both private label and third-party branded consumer electronics products, including wireless telephones; residential telephones, DVD players, computers and direct-to-home satellite systems; home entertainment, wireless, imaging and computer accessories; and digital cameras, radio-controlled cars and other toys, satellite radios, memory players and wellness products.

The consumer electronics retail business is highly competitive, primarily driven by technology and product cycles. Principal competitors include consumer electronics retailers Circuit City and Best Buy; department and specialty stores, such as Sears and The Home Depot (which compete on a more select product category scale), and mass merchandisers such as Wal-Mart and Target.

According to management, RadioShack’s core-competence is grounded on three building blocks: (1) the extensive physical retail presence with convenient locations throughout the United States. (2) A specially trained sales staff capable of providing cost-effective solutions for customers’ routine electronics needs and distinct electronics wants, assisting customers with service activation, when applicable, and assisting with the selection of appropriate products and accessories. (3) The ability to accelerate the adoption rate of new technologies. To be blunt—no wonder RadioShack’s ship is listing—none of these integrant elements is unique to RadioShack!

RadioShack’s business strategy is to offer a “cost-effective solutions to meet everyone’s routine electronics needs and families’ distinct electronics wants.” Sadly, as witness to the Company’s deteriorating fundamental outlook, management has failed—(26,310) shareholders and customers alike—in identifying emerging growth opportunities [keeping stores stocked with the correct merchandise] and leveraging its assets and distribution network to create new streams of revenue and profit.

To be blunt—this management team is clueless! RadioShack has lost relevance to many a consumer electronics shopper. When was the last time you went to RadioShack looking to buy a new flat-panel television or an MP3 player? If readers are like us, on a shopping trip to other stores in the mall, you stumbled upon a RadioShack store and decided to stop in to buy some batteries or to play with their electronic toys.

RadioShack reported an approximate five percent rise in sales year-over-year to $5.1 billion in 2005, while net income fell 22.2% to $267.0 million [despite an effective income tax rate of 16.0% for 2005 versus 37.8% for 2004]. Comparable store sales grew an anemic 1.0% versus 2004.

At year end 2005, Total Debt as a percentage of Total capitalization jumped 870 basis points to 47.6%; tangible book value lost $1.47 to $4.36 per share; and return on equity and return on assets fell 460 basis points and 290 basis points, respectively, to 35.3% and 11.3 percent.

Cash flow from operating activities was a healthy $362.9 million. Free cash flow, defined as cash flows from operating activities less dividends paid and additions to property, plant and equipment, was $158.5 million in 2005, up from $83.4 million in 2004.

In February 2006, management announced a turnaround strategy with three end-objectives: (1) increase the average unit volume of its store base; (2) “rationalize” the corporate cost structure [does this include senior executives’ salaries/bonuses?]; and, (3) grow profitable square footage in the store portfolio [ed. note. The average store size was 4,972 square feet in 2005, down from 5,121 in FY ’03.]

This envisioned turnaround has four components:

· Store Rationalization. It is anticipated that the number of RadioShack company-operated stores will decline by approximately 400 to 700 stores through the first half of 2007. The Company expects that the costs of these closures will total approximately $55 million to $90 million. Corporate does expect, however, that the closures will result in a net positive future cash flow.

· Update inventory [translation: stock shelves with merchandise that customers will buy]. Corporate has identified a significant amount of slow-moving inventory for replacement. Management expects to incur additional inventory-related charges of approximately $5 million to $10 million during 2006. These charges, if incurred, would increase cost of products sold and adversely impact margins accordingly.

Stock turnover in 2005 and 2004 was constant at 135 days (versus 47 days and 69 days for Best Buy and Circuit City, respectively). Ultimately, the Company anticipates that this inventory update will help to increase the average unit volume of its store base. The average sale per ticket was $34.51 in 2005, up $0.67 from the prior year.

Wireless (which includes wireless handsets and communication devices such as scanners and two-way radios), accessories (home entertainment products, wireless handsets, digital imaging products and computers), and personal electronics (digital cameras, camcorders, toys, wellness products, digital music players and satellite radios) contributed 34.3%, 20.5%, and 14.7% to net sales, respectively, in FY ’05. [ed. note. Batteries and chargers contributed 6.5% to net sales in 2005!]

· Distribution Center Consolidation. Management intends to close its distribution centers in Charleston, South Carolina, and Southaven, Mississippi, in 2006. Management anticipates that total charges for consolidation will total approximately $4 million. Again, corporate expects that the consolidations will result in a net positive future cash flow.

· Reduce Overhead Costs. SG&A expenses in 2005 rose 70 basis points to 37.4% as a percentage of sales compared to the prior year. The dollar increase for 2005 was primarily due to an increase in payroll and commissions’ expense, plus rent expense.

Company-operated store sales per labor hour fell $1.24 to $80.00 compared to 2004.

In our opinion, competitive pressures will continue to dampen margins. Ergo, success in RadioShack’s turnaround strategy is highly dependent on driving average unit volume sales higher and containing internal cost structures.

Going forward, just in case the Company fails to improve its financial results, corporate has already come up with innovative defenses. Listed in its 10-K filing with the SEC as as being material:

  1. If severe weather, such as a large hurricane, tornado or earthquake, occurs in a particular region and damages or destroys a significant number of stores in that area, overall sales would be reduced accordingly [ed. note. The 10Q Detective calculated that 380 stores, or 9.1% of the Company’s total stores/kiosks were located in “Hurricane Alley”—Florida up North Carolina].
  2. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility could cause greater uncertainty…. these events could cause or contribute to a general decline in equity valuations, which, in turn, could reduce the market value of RadioShack.

Getting back to Mr. Roberts for a minute—as he was at the helm when RadioShack’s ship was battered by its financial squall--the 10Q Detective questions what ‘value’ he could possibly bring to the Company as it refurbishes itself on dry-dock? The Company responds that Mr. Roberts will focus on industry, civic and philanthropic activities for the company.

Mr Roberts—the 10Q Detective finds ironic parallels to the movie of the same name. Mr. Roberts—the movie released in 1955—starred Henry Fonda in the title role. A cargo officer and second in command on a supply ship during World War II, the easygoing Lt. Roberts is excluded from a much desired combat role. Instead, he plays second fiddle to the elaborate pranks of Ensign Frank Pulver (Jack Lemmon) and his younger crew. The young crew tries every available means of killing boredom, including eyeballing the nurses on a nearby island through a telescope, and Roberts does what he can to get them the R&R they badly need....

Our Mr. Roberts, now in retirement—and away from the corporate battles, both in the boardroom and in the field, is given similar gladhandling duties to justify his new paycheck.

Ironically, the movie got better reviews than RadioShack is getting now.

In conclusion, the 10Q Detective applauds RadioShack for its focus on rationalizing its cost structure. Our concern, however, remains the same: management’s acumen in identifying high-margin product winners. The flat panel business forms the backdrop fueling top-line growth at peer rivals like Best Buy and Circuit City. Prices for big-screen televisions are starting to drop—which means margins are falling, too. Going forward, RadioShack will need more than flat-panel sales to tip its EPS lever.

Granted, from a valuation perspective, RadioShack looks attractive, selling for only 12 times forward 12-month consensus 2007 EPS estimates of 1.53 per share (versus the Electronic Store Industry P/E 19 multiple). It would not surprise us to hear talk of an LBO, too.

Sadly, given so many hints being dropped by management that this transitional year will probably yield erratic financial performance, the 10Q Detective prefers to put RadioShack on our “Watch” list, for we do not see any catalysts [save for buyout rumors] driving the stock price higher--for now.

Tuesday, April 11, 2006

Sonic Automotive--Bear Stearns Says Buy.

Sonic Automotive, Inc. (SAH-$26.86) is one of the largest automotive retailers in the United States. As of March 1, 2006, SAH operated 175 dealership franchises at 152 dealership locations, representing 37 different brands of cars and light trucks, and 38 collision repair centers in 15 states. Each of the Company’s dealerships provides comprehensive services including (1) sales of both new and used cars and light trucks; (2) sales of replacement parts and performance of vehicle maintenance; warranty, paint and repair services; and (3) arrangement of extended service contracts, financing and insurance and other aftermarket products for its automotive customers.

On April 5, 2005, Bear Stearns, Inc. initiated coverage on SAH with an outperform rating. The nominal definition employed by Bear Stearns is as follows: "Stock is projected to outperform analyst's industry coverage universe over the next 12 months [i.e. auto retailing industry index which includes the likes of AutoNation (AN-$22.44), Group 1 Automotive (GPI-$50.31), and United Auto Group (UAG-$41.10)]."

The brokerage firm argued that four factors exist that should act as valuation catalysts: 1) a recent focus on improving core operations of existing stores and successful new store integration, combined with 2) continued growth through acquisitions at a manageable pace; 3) strong growth and margin opportunities associated with the company’s over-weighting of foreign and luxury franchises; and, 4) a de-leveraging story.

The 10Q Detective respectfully disagrees with Bear Stearns’ investment thesis.

Historically, SAH has grown through acquisitions. In 2005, however, the Company acquired only five dealerships, representing five franchises, disposed of 13 dealerships, representing 20 franchises, and terminated two franchises. Going forward, corporate expects to continue to limit its acquisition activity to approximately 10% of annual revenues each year. Management [and Bear Stearns] believe that this strategy will allow SAH to continue to reduce its financial leverage, maintain liquidity for its dividend and share repurchase activities, and also allow management infrastructure to focus on improving operating performance and integrating acquired dealerships.

Prior to 2004, SAH maintained a long-term debt to total capital ratio of approximately 48% to 52%, depending on the timing of its acquisitions. Corporate believes that the current acquisition pace will allow SAH to reduce its long-term debt to total capital ratio to 40% over the next few years. At December 31, 2005, the long-term debt to total capital ratio net of cash and cash equivalents was 46.0 percent.

According to Bear Stearns: “Our sense is that investors will be more comfortable with the less aggressive capital structure.

As a potential investor, we agree with that statement. What Bear Stearns has failed to mention, however, is that O. Bruton Smith, chairman and chief executive officer, and his affiliates have previously assisted SAH with obtaining most of the Company’s financing. Our readers will recall that Mr. Smith is also the Chairman & CEO of Speedway Motorsports, Inc. (TRAK-$22.42), a publicly traded owner and operator of automobile racing facilities.

SAH’s obligations under its New Credit Facility were secured with a pledge of shares of common stock of Speedway Motorsports, Inc. Sonic Financial Corporation (SFC), an entity controlled by Mr. Smith, beneficially owns these shares of Speedway Motorsports common stock. Presently, the $350.0 million borrowing limit of the Revolving Credit Sub-Facility of the New Credit Facility is subject to a borrowing base calculation that is based, in part, on the value of the Speedway Motorsports shares pledged by SFC. Consequently, a withdrawal of this pledge by SFC or a significant decrease in the value of Speedway Motorsports common stock could reduce the amount that SAH can borrow under the Revolving Credit Sub-Facility of the New Credit Facility.

Mr. Smith has also guaranteed additional indebtedness incurred to complete certain dealership acquisitions. Mr. Smith may not be willing or able to provide similar guarantees or credit support in the future.

The 10Q Detective is not comfortable with this disclosure.

Bear Stearns is “comfortable that Sonic’s earnings performance has turned the corner." The analyst then went on to say: "We view late 2003 as the point at which management identified the problems associated with its prior growth profile, 2004 as the transition year when many of the company’s initiatives to fix the business went into place, and 2005 as the year that Sonic delivered operational and financial improvements. Moreover, the portfolio enrichment strategy Sonic is following should serve as a platform for solid organic growth, while the company continues to build its business with acquisitions, albeit at a moderate, more conservative pace than seen in the past."

Indulge us as we translate. Gross Profit, Operating Income, and Income from Continuing Operations [as a percentage of net revenue] have remained flat the past three fiscal years, at 15.4%, 3.2%, and 1.3% as a percentage of net revenue [within a variance of twenty basis points], respectively.

The aforementioned “portfolio enrichment” strategy refers to the higher, margin import auto markets. “Sonic Automotive has been actively managing its brand portfolio toward luxury and import brands,” said Bear Stearns. “Industry market share gains of brands falling into these categories drive multiple benefits for operators, including higher organic growth and leaner inventory levels.”

For the year ended December 31, 2005, 79.4% of SAH’s total new vehicle revenue was generated by import and luxury dealerships compared to 76.7% for 2004. The import dealerships experienced an increase of same store new vehicle volume of 6,826 units, or 7.4%, while domestic dealerships experienced a slight decrease of 379 units, or 0.7 percent.

The top performing import brands for 2005 were Honda, BMW and Lexus, which posted increases of 3,512 units, or 13.0%, 997 units, or 7.4%, and 1,006 units, or 16.1%, respectively. These increases were attributed to the introduction of new models, in addition to new body styling and design on existing models. In addition, management stability at the Company’s Honda dealerships contributed to the improvement in new vehicle sales volume.

As expected, domestic dealerships continued to experience market share declines and continued to show a decline in sales volume during the current year. The majority of the domestic dealership declines were from Cadillac dealerships (down 499 units, or 4.4%), which was mainly the result of declining SUV sales. GM (excluding Cadillac) and Ford dealerships also experienced considerable declines in new retail unit volume, but were offset somewhat by strong fleet sales.

In total, SAH’s sales price per unit increased by $168, or 0.6%, during 2005. This can be mainly attributed to the fact that the higher priced luxury vehicles generated a larger percentage of sales. Many of SAH’s import dealerships experienced price per unit increases, most notably being Honda, BMW and Lexus (up 5.8%, 3.4% and 3.0%, respectively). GM and Cadillac dealerships experienced the most significant decreases in sales price per unit (down 4.9% and 4.1%, respectively). The decreases at these dealerships were attributed to both the various pricing strategies put in place by GM during 2005 and a shift from truck and SUV sales to car sales during the year.

Despite the Company’s shift in product mix, approximately 28.5% of new vehicle revenue was derived from the sale of new vehicles manufactured by General Motors (including Cadillac) and Ford in 2005.

As of December 31, 2005, SAH owned 25 Ford franchises (including Volvo, Land Rover, Lincoln and Mercury) and 41 General Motor’s (including Cadillac, Saab, Saturn, Chevrolet, Buick, GMC, Hummer and Pontiac) franchises, respectively. Should the financial condition and operating results of either Ford or General Motors continue to significantly deteriorate, it is possible that an interruption in the flow of inventory to SAH could have a material adverse effect on the Company’s future results of operation, financial condition or cash flows.

Rising interest rates, gas prices, and an economic downturn—all are known material risks that could adversely affect the profitability of SAH in the coming quarters. The 10Q Detective would like investors to consider one other factor before making a buy purchase: the weather. SAH owns 20 dealerships in North/South Carolina & Georgia, 15 dealerships in Florida, and 17 dealerships in Houston, each geographic area contributing 11.2%, 9.6%, and 14.9%, respectively, to total 2005 revenues—and each a part of the U.S. landscape predicted to be buffeted severely by Grade Level 4 & Grade Level 5 Hurricanes come June 01, 2006.

One potential soft spot on SAH’s books that we wanted to bring to our readers’ attention is the Company’s tax tinkering. Management has done a decent job in squeezing a little extra out of its bottom line—taxes owed to the IRS. Despite the Company’s effective tax rate hovering around 38.0% the last two reporting years, SAH has seen its net deferred tax liability rising approximately $(31.5) million to $(116.9) million from 2004 to year end 2005. Much of this deferment was attributable to a basis valuation difference in goodwill. To date, the IRS has not raised any objections….

Multiple Expansion is Likely to Bring Valuation in Line with Better Peers,” said Bear Stearns. “The key to our investment thesis on Sonic Automotive is understanding that, while not currently the “best” at any one thing in particular, Sonic is a balanced, solid performer that is undervalued by the market. Our sense is that the company’s valuation discount reflects Sonic not standing out in any one area, and that this discount should recede as the market recognizes the company’s all-around strength.”

Bear Stearns has set a 2006 year-end price target of $33 per share. “Our target is based on a 2007 EPS estimate of $2.74 and a 12-month forward P/E ratio of 12.0x. This represents an 10% expansion from Sonic’s current multiple of 10.9x, but would still value the company at a 19%, 19%, and 28% discount to the peer group average multiple and those of AutoNation and UnitedAuto, respectively — the other peer group companies to which we feel comparisons with Sonic are most appropriate. Our price target represents upside of 17% from current levels.”

Technically, the stock price is at the key pivot point on a “cup-and-handle-chart pattern.” This pivot point, $27.00 per share, is also the 50-day moving average. First Support is $24.00 per share (100-day moving average). Trading volume has averaged 369,000 shares over the last three-months. It will take more than an auto analysts’ positive comments to drive the stock to a new closing high.

Contrary to Bear Stearns conclusions, the 10Q Detective believes that the current price of Sonic Automotive has already discounted any potential top-line sales gains to be had by over-weighting its brand portfolio toward luxury and foreign imports. Further, we believe that rising interest rates, competitive pressure on auto margins from Internet retailers, and a continued deterioration in the financial condition of domestic auto manufacturers will negatively influence the operating performance and future profitability of Sonic Automotive—and its peers. SELL.

Saturday, April 08, 2006

Spectrum Brands--Stepped in its Own "Doo-Doo."

On March 29, 2006, citing competition from private label brands, the 10Q Detective warned our readers that—contrary to corporate prouncements—we did not believe that Spectrum Brands would see any meaningful top-line growth in their battery business.

The 10Q Detective also expressed concerns that management activities (disclosed in Spectrum’s recent proxy statement) flashed a warning that management was more interested in egocentric than shareholder concerns.

Foreshadowing potential problems, too, were to be found in a recent posting [on] by our good friend, Michele Leder, on “alleged creativeness by Spectrum’s management with its five-year [price] performance in the DEF 14A filed with the SEC.

To our readers who were also erstwhile shareholders, glad that Michele and we could be of value!

Battery maker Spectrum Brands (SPC-$15.00) fell to a new 52-week low Friday after the company slashed its second-quarter earnings forecast.

On Thursday, Spectrum lowered its quarterly guidance to net income between 3 cents and 6 cents a share, citing weak battery sales in North America and Europe. The company previously forecast profit of 35 cents to 40 cents per share. Analysts expected 37 cents a share, according to a Thomson Financial poll.

Spectrum also said it continued to be pressured by commodity costs. Spot prices of zinc, a primary component in making batteries, doubled over the last 12 months, and jumped more than 10 percent in the last month, the company said. Spectrum expects the trend of high zinc prices to continue.

Corporate forecasts on the forward price of zinc is one of the few statements made by Spectrum that the 10Q Detective can embrace as truth. Today, on the London Metals’ Exchange, zinc powered to a new high, topping $2,872.50 per metric ton. Commodity analysts predict that fundamentals and overall bullish momentum make $3,000 per metric ton an attainable target.

The 10Q Detective previously said that current management only knew how “to spend” its way to growth via acquisitions. Given that both Moody’s and S&P are reviewing Spectrum’s credit rating for possible rate cuts, future-buying sprees will be more costly.

Readers who heeded our advice and sold-short the stock on March 29 are sitting on a 29.4% gain. The Company stepped in its own “doo-doo,” and we se the stock slide continuing.

We only see a short-term price rebound if management takes action to unload the albatross around its collective neck—the battery business. HOLD SHORT POSITION.

Thursday, April 06, 2006

How to Make a Million--Follow the Schedule 14A.

The 10Q Detective thought that it was time to do a self-help column for our readers. Money: Not how to spend it—but how to get it.

Plugging in the words “million, dollars, get,” on several Internet search engines pointed us to hundreds of URL addresses with inventive, resourceful, and/or mundane action-oriented ideas including: How to Use Your Mind to Make a Million Dollars; Learn How to Make a Million Dollars on Just $1 per Day; Adult Home Entertainment—How to Get Started; Work at Home—Earn $10,000 a Month; or, Make a Million Dollars in Real-Estate with Less than $2,000 to Start.

All of the aforementioned websites rang with specious reasoning, but sadly the only ones these sites guaranteed to make money for were the individuals proffering the advice.

Albert Einstein is credited with having said: The greatest mathematical discovery of all time is compound interest. The problem with this truism is time itself. Unfortunately, if one invested one dollar per day at an APR of five percent, it would take 100 years to earn one million—and [increasing one’s risk] and investing at a guaranteed 15 percent yield would still take years (40) to get the one-million dollars.

Ergo, the odds of one amassing the purchasing power to afford a $370,000 Pagani Zonda C12S (a 200-mph Italian racer built in Italy and powered by a Mercedes-Benz AMG V-12), or even a Lamborghini Murciélago—while still having the visual acuity to drive—are probably on par with one witnessing a wormhole opening in the fabric of four dimensional space-time continuum!

Having read hundreds of SEC filings, the 10Q Detective proffers serendipitous insight as to how even billionaires seek to “get theirs”:
  • · Inheritance. Sam Walton was a J.C. Penney clerk who opened his first discount store in Rogers, Ark. 1962. Wal-Mart Inc. had its IPO, offering 300,000 shares on Oct. 1, 1970, at $16.50 per share. Today, Wal-Mart (WMT-$46.87) is the world’s largest retailer. In the last three decades, the stock has had eleven two-for-one splits. This means every one share owned in the initial offering would have become 2,048 shares. From 1970 to 2003, the stock price increased 6,950 times, 30 percent compounded growth per annum. When Sam Walton died of cancer in April 1992, he left his family with a 40% stake in the company, which is worth an estimated $78.4 billion today. According to 2006 Richest People in the World survey, six of the top 21 wealthiest people in the world are Walton heirs.

  • · Salary Negotiations. Meg Whitman led the Playskool unit of Hasbro (HAS-), but left in 1998 to sign on with a fledgling Internet auction site. Whitman agreed to a compensation deal that gave her options to buy 14.4 million shares at just 3.5 cents a piece. Ebay went public six months later, helping Whitman make The Forbes Four Hundred Richest in America list in 1999. Today, the President & CEO owns approximately 31.2 million shares, or 2.3%, of Ebay (EBAY-$38.53), and Meg Whitman has risen to 224th place (in the World), worth an estimated $1.1 billion.
    · Second Job (Parallel career). Ms. Whitman also receives remuneration for serving on the Board of Directors of Procter & Gamble (PG-$57.62), DreamWorks Animation (DWA-$27.87), and until the summer of 2005, Gap, Inc. (GAP-$34.91). DEF 14-A filings reveal that Meg earned spending monies of $197,000 from P&G last year. As a non-employee Director of DreamWorks, Meg’s initiation rights included $100,00 in restricted stock and life insurance coverage in the amount of $750,000, payable in the event of her accidental death [from eating too much popcorn?] or disability.
    · Two-Income Family. In the past few years, Michael Dell, the founder and former chief executive of Dell Computer (DELL-$29.83) has seen his net worth fall an estimated $900 million to $17.1 billion [Forbes ranking-#12]. Michael’s wife, Susan, has gone to work. She created the fashion label Phi, which is distributed through Neiman Marcus.

  • · Ask Your Parents. John R. Egan, the son of EMC founder Richard Egan (#606, $1.3 Billion), owns approximately 2.3 million shares in Dad’s Company. Like other high-tech heirs, John has seen the value of his EMC stock plummet approximately 80% in value from a September 2000 (split-adjusted) price of $104 per share [versus to a 30.5% drop in value for the S&O 500 Information Technology Sector Index]. Can one blame him them, for looking to boost his discretionary income by other means?

    From October 1986 to September 1998, Mr. Egan, 48, served in a number of executive positions with EMC, including Executive Vice President, Operations and Executive Vice President, International Sales. Mr. Egan resigned as an employee of EMC in July 2002. Mr. Egan has been a principal in a venture capital firm since October 1998. Mr. Egan, age 48, has been a Director of EMC since May 1992, and is the Chair of the Mergers and Acquisitions Committee of EMC.

    A look at EMC’s Schedule 14A, filed with the SEC last month, disclosed some of the efforts John-John has made to “get his.” As a non-employee Director, he receives an annual retainer of $30,000; $24,000 ($3,000/meeting) for Board of Director meetings per annum; and, an annual retainer of $10,000 for the committee that he chairs. The 10Q Detective calculates that Egan made about $64,000 for serving on the Board in 2005.

    In 2005, EMC leased certain real estate from Carruth Management LLC., for which payments aggregated approximately $3,816,000. John and his siblings are the beneficial owners of Carruth.

    In 2005, EMC purchased from Nexaweb Technologies, Inc. a prepaid license to software products for approximately $3,500,000. John Egan is the managing partner and general partner in a limited partnership, which is a shareholder of Nexaweb.

    · Serial Entrepreneur. Ollen Bruton Smith, the founder and CEO of Speedway Motorsports, Inc. (TRK-$37.95), owns 63%, or 29 million shares of Speedway stock, worth an estimated $1.10 billion. Among other things, Speedway owns and operates the following NASCAR racetracks: Atlanta Motor Speedway, Bristol Motor Speedway, Lowe’s Motor Speedway, Las Vegas Motor Speedway, Infineon Raceway and Texas Motor Speedway.

  • Mr. Smith with a total net worth of approximately $1.42 billion was recently cited by Forbes magazine as number 562 in the rankings of the world’s richest men. Aside from the $1.75 million Mr. Smith made in salary and cash bonus’ last year, he also has founded several other companies that count Speedway as a customer. (Given undisclosed investment stakes in a plethora of related-network of subsidiaries, we believe that Mr. Smith’s real net worth is much higher than that which is stated.)
600 Racing, Inc and SMI Properties, both wholly owned subsidiaries of the Company, each lease an office and warehouse facility from Chartown, an affiliate of the Company through common ownership by Mr. Smith, under annually renewable lease agreements. Rent expense in 2005 for 600 Racing was approximately $197,000 and for SMI Properties was approximately $333,000.

Mr. Smith is also the Chairman & CEO, and a controlling stockholder in Sonic Automotive (SAH-$28.53), which is engaged in car retailing in the United States. As of March 1, 2006, the company operated 175 dealership franchises at 152 dealership locations, representing 37 brands of cars and light trucks, as well as 38 collision repair centers. Shareholders in Sonic Automotive must be happy to pay Mr. Smith’s $1.8 million in base & bonus, given the Company can count on Speedway being a reliable customer. According to public documents, each year Sonic Auto sells new vehicles to certain employees of Speedway.

Mr. Smith, 79, is a busy man. He also owns a related-finance company, Sonic Financial, with William Brooks, Speedway’s CFO. Speedway has made loans to, and paid certain expenses on behalf of Sonic Financial for “various corporate purposes.” Sonic Financial controls 59.1% of the voting class shares of Sonic Automotive and [among other activities] also leases various aircrafts to Sonic Automotive for business-related travel by Sonic executives. Sonic incurred costs in an aggregate amount of approximately $766,130 for the use of these aircraft during FY 2005.

· Perquisites are Requisite. Country Club dues, financial planning services, car & gasoline allowances, travel & award payments, entertainment accounts, personal time on the corporate jet—all these are examples often cited in the “Other Compensation” column of the Schedule 14-A proxy documents that publicly-traded companies file annually with the SEC.

In the DEF 14-A recently filed by Allergan Inc. (AGN-$107.15), the global healthcare company best-known for its ophthalmic and dermatology products, we noticed that the Company disclosed approximately $71,000 in such compensation for the top five executives in the company (from the Chairman down to the VP-Human Resources).

Our hats we tip to our readers who will earn an annual pay package comparable to the $750,000 to more than $3.0 million—exclusive of “other”—that these men at Allergan earned in 2005.

For the rest of us, ignoring the country club dues and personal time on the corporate jet, there are many jobs in our economy that do afford the luxury of “other” compensation. Sales jobs in pharmaceutical, software, and manufacturing—all offer varying perks (including gas & car allowances and entertainment accounts). True, a sales rep will not earn a base compensation equaling $375,000—but earning $12,0000 per year in “other” compensation is possible. And, remember the magic of compounding—thirty-two dollars saved a day over 20 years makes for a nice nest egg!

Monday, April 03, 2006

Dec. 2005 Stock Updates: Part II

12-22-05. Taser Int’l (TASR-$7.20) /$10.42/ 44.72%
BUY. “TASER Device Ends Armed Stand-Off…. Prevents Suicide…. Study Shows No Harm From Shock”—among the recent positive spins being dispensed by the IR Department at the Company.

To date, aggressive litigation defense to protect brand equity has resulted in a total of 12 cases dismissed or defense judgments in the Company’s favor. The 10Q Detective continues to view a continued record of successful litigation defense a key catalyst in driving both sales and the share price higher

Many of Taser’s prospective customers from the Law Enforcement and Corrections markets (core business markets) are showing signs of moving forward again with evaluation and implementation of TASER programs.

In FY ’05, the Company increased R&D spending $776,00, or 91%, to $1.6 million, compared to the prior year. First pay-off to drive incremental sales will be the TASER CAM, an audio-video capture device, which is in the final transition from development into production and is expected to begin shipping in the second quarter of 2006.

Technically, key price support remains at $7.93 per share—the stock’s 200-day moving average.

12-24-05. Nobility Homes (NOBH-$26.20) /$25.37 /
Performance metrics—like operating margins & ROE—remain positive compared to its peer group, but the 3-5 year growth prospects of the manufacturing housing industry “bore us.” Discontinuing Coverage.

12-27-05. Sirius Satellite (SIRI-$6.99) /$5.06 / 27.61%
SHORT SALE. Higher promotional spending forced the radio broadcaster to post an unexpectedly wide loss this past quarter. Even with the “[Howard] Stern Effect, our readers made a nice three-month gain. CLOSEOUT.

12-29-05. Raser Tech. (RZ-$9.40) /$16.50 /
On April 3, 2006, Raser filed for an extension with the SEC for its FY ’05 -10-KSB form, citing corporate need to assess the impact of certain derivative accounting rules on some of its convertible preferred stock. Trailing-twelve month revenue was $0.006 per share—enough said!

Dec. 2005 Stock Updates: Part I

12-13-05. Coinstar (CSTR-$23.90)/ $25.91/ (8.41)%
SHORT. “Hold Your Quarters.” Our opinion has not changed. Coinstar still remains vulnerable due to distributor concentrations, for coin and entertainment services agreements with Wal-Mart, Inc. and the Kroger Company still account for approximately 25.3% and 10.5% of consolidated revenue.

12-14-05. Hemosense (HEM-$7.65)/ $5.25/
SHORT. The INRatio [self-testing] System (for managing patients on warfarin therapy) is the Company’s only product. The majority of PT/INR testing has historically been—and continues to be—performed by large hospitals or commercial laboratories.

Hemosense does not have a proprietary sales and marketing team in place to achieve commercial success. Three distributors, Quality Assured Services, Medline, and Cardinal Health, accounted for approximately 24%, 19%, and 13%, respectively, of total revenue in FY ’05.

12-15-05. Books-A-Million (BAMM-$9.05)/ $11.51/ (27.18)%
SHORT. Two initial concerns: balance sheet and conflicting interests of insiders [related party transactions].

Directors declared an increase in the Company’s quarterly cash dividend, up 60% to $0.08 per common share.

The Company has not yet filed its 10-K with the SEC. However, with an earning’s retention ratio of 74% in FY ’05, the 10Q Detective notes that the sustainable growth rate of 2.58% last year was less than the actual growth rate in sales of 6.3 percent. What does that mean? If sustainable growth is less than actual growth over a protracted period, BAMM will not be able to sustain paying both the dividend and “funding” future sales growth without improving operating efficiencies or increasing the debt level.

12-16-05. J.M. Smucker (SJM-$44.26)/ $39.70 / (10.30)%
Shareholders going hungry. The annual "Fall Bake" season—holiday baking by us neophytes—was a bust. The Company reported unexpected declines in both sales and profit in its 3Q:06. Cisco-branded and other consumer oils and baking business sales were impacted by some key customers reducing inventories.

Gross margin declined 120 basis points, primarily due to the volume decrease in the consumer oils and baking business area, increased trade merchandising expenses, and higher commodity and freight costs.

We did warn our readers, however, back in December that it would take “steady top-line growth and improving margins [to] provide the necessary catalyst for an upward move in Smucker's common stock. Until investors witness the latter, [continue to] snack on the 2.7% dividend yield ($1.06 dividend) and a Crustable sandwich!”

12-19-05. H&R Block (HRB-$24.22)/ $21.65/ 10.61%
SHORT. Citing a slow start to the tax season & a tough mortgage market, HRB cut its EPS outlook—as we predicted would happen! CLOSE-OUT.

12-20-05. Indevus Pharm. (IDEV-$4.54)/ $6.20/ 36.56%
BUY. IDEV announced last week that enrollment has been completed in the Company's second Phase III trial for SANCTURA XR (the once-daily formulation of SANCTURA, which is currently marketed for overactive bladder).

The second of the two Phase III trials is fully enrolled with over 560 patients and the Company anticipates reporting results in July of 2006. Both Phase III trials are 12-week, double-blind, placebo-controlled studies, evaluating the effect of SANCTURA XR in reducing frequency, urgency, and incontinence episodes in patients with overactive bladder. Consistent with previous guidance, the Company expects to file a New Drug Application with the U.S. Food and Drug Administration by the end of the calendar year.

Outlook boosts visibility. Strong BUY.

12-21-05. Brookdale (BKD-$31.00)/ $37.75/ (21.77)%
SHORT. Priced at approximately 69 times FY ’07 earnings of $0.55 per share, the stock valuation remains vulnerable to a negative EPS call.