Martha Stewart Shareholders--Stuck with Hoop Wrinkle Stitches.

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  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:
  
  1) PUBLISHING
  
  Magazines
  
  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.
  
  
  2) BROADCASTING
  
  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.
  
  
  3) MERCHANDISING
  
  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.
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  · 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.
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  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!
  
  4) INTERNET
  In 2005, MSLO repositioned its website, marthastewart.com, to focus principally on the online content of its operating segments, as well an online floral business, marthasflowers.com. 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.