Financial Murkiness for Martha Stewart Living - TheStreet

Financial Murkiness for Martha Stewart Living

The company has shed little light on new deals' impact, and its stock has paid the price.
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With its stock down about 27% so far in 2007,

Martha Stewart Living Omnimedia

(MSO)

is scrambling to patch together a quilt of merchandising deals to cover up the hole of profitability that will open up next year when its lucrative merchandising deal with Kmart unravels.

Guaranteed royalty payments from Kmart's parent company

Sears Holdings

(SHLD)

for MSLO's branded line of home-furnishings products are set to drop from $65 million to $20 million next year. Those payments have increased steadily since 2001 to become the company's chief source of profitability.

In anticipation of the decline, the company has lined up a series of new merchandising deals with major retailers and manufacturers, but little has been revealed about the financial gains that can be expected as a result. Now, the company's new partners are suffering a slowdown, particularly in housing-related goods like Stewart's, and concerns about consumer spending have fueled MSLO's stock swoon.

With Wall Street expecting MSLO to replace the missing Kmart profits next year and then some, can the domestic diva's company thread the needle amid these headwinds?

"Martha will have to overcome a decline of roughly $30 million in Kmart payments next year," says Bear Stearns analyst Michael Meltz (his firm has no interest in shares of MSLO and it has no banking relationship with the company). "We're expecting profitability at the company's merchandising business to be about the same next year as it is this year, which will be impressive."

Analysts expect the company to earn 46 cents a share this year before charges, according to estimates compiled by Thomson First Call. Then, they expect profitability to increase 33% to 61 cents a share in 2008, which would be spectacular performance for a company that hasn't posted a profit since 2002 -- when its founder became a target for federal prosecutors due to allegations of obstruction of justice.

That means that Wall Street is expecting it to fill in the Kmart gap in 2008 at its merchandising business and add about another $8 million in profits from its publishing, broadcast and Internet units. Anything short of those targets could result in more losses for shareholders.

MSLO is investing heavily in its future based on the potential of its universally recognized brand. It recently revamped its Web site and hired an online ad sales veteran from

Yahoo!

(YHOO)

, Wenda Harris Millard, to be its president of media.

"Where most publishers view their Web sites these days as a complement to their magazine, Martha Stewart Living is really looking at its Web unit as a stand-alone business, and there's a lot of potential there to drive ad dollars with things like online recipes, gardening tips and cooking videos," says Meltz.

It also launched a new magazine,

Blueprint

, targeting a younger audience that the company hopes will offer a new growth opportunity.

A source familiar with the company says its

Martha Stewart Living

and

Everyday Food

magazines are poised to show 25% growth in ad sales in the second quarter.

Howard Hochhauser, the company's chief financial officer, declined to comment except to say, "the ad market is robust and it continues to be strong."

But replacing the profit declines from its Kmart deal at its merchandising unit next year may be the company's biggest challenge.

Macy's

(M) - Get Report

, where MSLO has a new agreement to sell a line of high-end home goods, already scrapped plans with

KB Home

(KBH) - Get Report

to build 3,000-square foot mock "Martha Stewart homes" in key stores, including its New York, Chicago and San Francisco locations.

The plan was part of Macy's strategy to rejuvenate its slumping sales of furniture and other home goods, but the retailer shelved the move last month, citing the sharp declines in the housing market. It will still go ahead with its merchandising deal with MSLO, which is already being tested at the Palisades Mall in upstate New York to rave reviews from UBS analyst Michelle Tan.

Tan said in a recent report that the MSLO product line amounts to a "big upgrade" for Macy's home-furnishings business.

Meltz estimates that the deal will result in revenue of more than $10 million for MSLO in 2008, making up for about a third of the loss from Kmart. For Macy's, the line of products is expected to make up about 10% of its home-furnishings business, which typically generates about $4 billion in annual revenue. MSLO will collect royalties of an undisclosed amount on the sales.

On Thursday, Macy's reported a larger-than-expected decline in June same-store sales, and it slashed its second-quarter earnings guidance. A spokesman for the retailer declined to comment on its relationship with MSLO.

KB Home, another MSLO partner, has felt the brunt of the housing slump. It recently reported a second-quarter loss of $148.7 million, with revenue tumbling 36% from a year earlier. The homebuilder reports that its line of Martha Stewart branded homes are selling well despite the slumping market, but a spokeswoman declined to provide sales data on its performance.

A source familiar with the matter says MSLO gets paid around $10,000 for every Martha Stewart home that is sold, but those payouts depend on the sale price, which vary from market to market.

The company recently started selling a line of paints at

Lowe's

(LOW) - Get Report

, the No. 2 U.S. home-improvement retailer that has also suffered sales weakness due to the housing downturn, and it inked a deal with

Costco

(COST) - Get Report

to sell a line of prepared foods. The terms of both deals have not been disclosed.

MSLO will soon have its brand on a line of lighting products manufactured by Generation Brands, a line of area rugs from Safavieh, crystal from Waterford Wedgwood and carpet tiles from Flor. Also, it designs a line of furniture for Bernhardt's and crafts for EK Success.

With the new deals, MSLO has won fans. A Portland, Ore.-based hedge fund called Mazama Capital Management recently disclosed in a regulatory filing that it raised its stake in the company to 20% of its Class A shares, which amounts to about 6.7% of the overall shares outstanding.

A spokesman for Mazama declined to comment for this story.

For this year, MSLO says it expects revenue of $330 million to $340 million, up from last year's $288 million. It also expects to record operating income of $9.5 million to $12.5 million, up from last year's loss of $2.8 million.

For 2008, when its income from the Kmart deal is reduced, the company has offered no guidance except to say that earnings before taxes, depreciation and amortization from its merchandising business will be in line with the $45 million it recorded last year, excluding a one-time gain.