Martha Shares Overcooked - TheStreet

Martha Shares Overcooked

A buyout looks unlikely and a major profit-driver is drying up.
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Shares of

Martha Stewart Living Omnimedia

(MSO)

have been held aloft by speculation that it will be the next target of the leveraged buyout spree that has gripped corporate America.

That deal, however, may never materialize. The company's CEO, Susan Lyne, tells

TheStreet.com

that a buyout is "unlikely."

Where, then, is the stock headed?

It has already dropped 14% this year as some of the takeover speculation has died down, and given the upcoming decline in revenue from the company's merchandising deal with

Sears Holdings'

(SHLD)

Kmart chain, it could have further to fall.

Ivan Feinseth, director of research with Matrix USA, holds a sell rating on the stock. With the stock trading around $18.78, roughly 67 times Wall Street's earnings estimates through 2007, he calls the market's current valuation "insane" and believes shares will drop to $12.

"They're losing money," Feinseth says. "They're free cash flow negative. They don't earn their cost of capital. So, why would anyone buy this thing at this price, unless they're going to sell it short?"

For most people, any mention of Martha Stewart gives rise to images of the domestic diva, her much-publicized legal travails, her cooking shows and her "good things." But when it comes to the operating profits at her company, Martha Stewart is really about merchandising -- and right now, that means Kmart.

The company's relationship with Kmart dates to before Stewart's fall from grace and before hedge fund star Ed Lampert rescued the retail chain from bankruptcy and merged it with Sears Roebuck.

Now, the Martha Stewart deal is little more than a headache that Lampert has to endure as he cuts costs out of his retail empire and squeezes out cash. But for Stewart's namesake company, it's the main engine of profitability, at least until next year.

Amid store closures and same-store sales-declines, sales of Kmart's Martha Stewart Everyday Living line of household products have fallen short of its expectations. The retailer, however, is still required to pay Stewart's company minimum guaranteed royalties in return for the merchandise.

The amount of those royalty payments has grown steadily since 2001, and this year it will jump to $65 million, up 10% from last year's $59 million.

In the first three quarters of 2006, revenue from Martha Stewart's merchandising business, the majority of which comes from Kmart, totaled $34.3 million, or 18% of its total operating revenue. The lion's share of its revenue, $113.4 million, came from the publishing business.

Merchandising, however, is much more profitable than the media business. The merchandise division accounted for 61% of the company's operating profits for the first nine months of 2006.

Those operating profits are more than wiped out by the company's corporate expenses. Martha Stewart Living, which will report its fourth-quarter results later this month, is expected to post a loss of 3 cents a share for 2006, according to Thomson First Call.

This year, Wall Street expects the company to return to profitability, but in 2008, the minimum payments guaranteed by the Kmart deal shrink by nearly 70% to $20 million, which means the bulk of Martha Stewart Living's most profitable business will go away.

That leaves the company with the task of filling in the Kmart falloff just to get back to where it is now -- mired in red ink.

To remedy the situation, Martha Stewart Living has announced a string of merchandising deals with the likes of

KB Home

(KBH) - Get Report

,

Federated's

(FD)

Macy's chain and

Lowe's

(LOW) - Get Report

.

Given the newness of these deals, the company hasn't recorded much in the way of revenue from them yet. Martha Stewart will be hard-pressed to sign a deal on terms that are anywhere near as favorable for the company as the Kmart agreement and its royalty minimums, but Lyne says the new relationships have big potential.

On a recent interview on Bloomberg TV, Lyne said the new deals will result in 2008 merchandising EBITDA, or earnings before interest, taxes, depreciation and amortization, that is roughly equivalent to 2006 EBITDA from merchandising. That suggests a decline for the company's most profitable business in 2008 compared to 2007, but it also displays optimism that the new deals will make up some ground relatively quickly.

"So we feel our ability

is to manage through that gap quite comfortably," she said.

To be sure, a buyout remains a possibility. Jefferies analyst Robert Routh, Wall Street's lone bull on shares of Martha Stewart Living, says that potential is part of the stock's allure.

"This is a perfect takeout for private equity," says Routh. "You have a unique name-brand with improving fundamentals. You have an overcapitalized balance sheet. They have no debt. They have a ton of cash. They could easily be levered up and taken private. Then, wait a little while and take it public again or sell it piecemeal, and you would not have to deal with the cost of being public."

But even taking aside Lyne's assertion that a sale is unlikely, private-equity investors tend to look for stocks that cheap.

That said, Routh's positive outlook on the stock isn't solely based on buyout potential. Aside from the merchandising business, advertisers that deserted Stewart's publishing business when she was prison-bound have flocked back to

Martha Stewart Living

magazine following her return, and the company has launched a new title,

Blueprint

, targeted at a younger audience to tap into new growth.

Also, amid the advertising industry's mad dash for the Internet, Martha Stewart's online potential is a wild card. The company is in the midst of overhauling its Web site, but it has a virtual library of quality content, like recipes and video demonstrations, that could attract heavy traffic in cyberspace.

For Routh, it all comes down to Stewart's public persona and the untapped potential of her brand.

"Martha's going to jail dramatically increased the public's interest level of Martha," says Routh. "The average age of her audience has gone way down. Why? Because she went to jail. Now she's a regular person. She's one of us. She is mortal. It dramatically increases the interest level in Martha Stewart relative to what it was."

But such talk also drove the wave of speculation that pushed up the company's shares when Stewart was getting out of prison and

NBC

was publicizing its deal to produce her version of Donald Trump's reality-TV show,

The Apprentice

.

What happened? The show was a flop, and investors took a bath.