Updated from 11:24 a.m. EST

The fourth quarter was better than expected for Martha Stewart Living ( MSO), but the company's future remains clouded by its founder's legal troubles.

The media and merchandising company beat analysts' expectations by 2 cents, but its core publishing revenue fell 28%. While a royalty payment by Kmart ( KMRT) helped salvage the quarter, the company expects its recent red ink to return in its current period as the difficulty of luring advertisers outweighs any benefit from its Kmart relationship.

Advertisers have steadily fled the company since allegations first surfaced that company founder Martha Stewart lied about the circumstances of a December 2001 stock trade. Stewart's trial on charges of obstructing justice is now before jurors.

The company and its management appear to be frozen, awaiting the outcome of the trial, said Scott Rothbort, president of LakeView Asset Management and a contributor to TheStreet.com's professional investing site, Street Insight. While the company's outlook is already below expectations, things might get worse, he said.

"They certainly can. If she goes down the river, the company has no paddle," said Rothbort, who is short shares of Martha Stewart Living and long puts.

On a conference call with investors and analysts, company CEO Sharon Patrick said Martha Stewart Living is preparing several contingency plans depending on the outcome of the trial.

"We're still operating on the uncertainty regarding the trial ," Patrick said. "We're going to have to wait until there's a verdict and we'll have to proceed from there."

In the meantime, at least some investors are willing to give the company the benefit of the doubt.

"What they earn this quarter, what they'll earn next quarter is irrelevant in the context of what's going on" with Stewart's trial, said one investor who is long the stock. If the trial is resolved in a positive way for Stewart, the company "could be quite attractive," added the investor, who asked to remain anonymous.

Weathering the Storm

In the latest quarter, Martha Stewart Living earned $4.64 million, or 9 cents a share. Excluding a loss from its discontinued operations, including a wedding registry, the company would have earned 10 cents a share.

In the year-ago period, the company lost $2.0 million, or 4 cents a share. The company lost 3 cents a share in the period on continuing operations.

Although the company's merchandising revenue nearly doubled due to Kmart's $10.2 million royalty payments, Martha Stewart Living's overall revenue slipped 8.6% from the same period a year earlier to $70.86 million.

The company's results topped Wall Street's bottom-line expectations, but fell short of its top-line forecast. Analysts were expecting the company to earn 7 cents a share from continuing operations on $72.13 million in sales, according to Thomson First Call.

The company warned that its first-quarter earnings will fall well short of analysts' current estimates. The company projected a loss of 20 cents a share on $45 million in total revenue; Wall Street had forecast a loss of 13 cents. In the first quarter last year, Martha Stewart Living lost $4.51 million, or 9 cents a share, on $58.02 million in sales.

The company has about $169 million in cash and short-term investments and no debt, noted Patrick. "We know that we haven't seen the end of our losses, but we believe we are well-positioned to weather the storm," Patrick said.

The company's cash level was the only real bright spot in the quarter, said T.K. MacKay, who covers Martha Stewart Living for Morningstar.

"That gives them a lot of financial flexibility to really pursue the new products that they have been launching," MacKay said.

MacKay doesn't own shares of Martha Stewart Living and Morningstar doesn't do any investment banking.

But investors focused on the company's immediate outlook, not its cash balance or its outperformance in the fourth quarter. In recent trading, the company's stock was off 38 cents, or 2.6%, to $14.08. The company's stock hit a 52-week high last week after a judge threw out a security fraud charge against Stewart. That was the most serious charge she faced, carrying the longest potential prison sentence.

In the fourth quarter, revenues fell in three of Martha Stewart Living's four operating divisions. At its publishing division, which produces the company's flagship Martha Stewart Living, revenue fell to $33.11 million from $45.57 million in the year-ago period. The segment's operating income fell even further, dropping 75% to $3.94 million. The company blamed the revenue and income declines on falling advertising and circulation at its flagship publication and a slump in profitability at its specialty magazines.

On the conference call, company CFO James Follo noted that advertising pages at Martha Stewart Living fell 38% from the fourth quarter of 2002 to 267 pages. Advertising revenue fell even more precipitously, he said.

Meanwhile, circulation at the flagship magazine fell 3% from the holiday quarter a year earlier. That decline was less than the industry's average, Follo noted. But circulation revenue at Martha Stewart Living dropped an even steeper 20%.

The company's upstart Everyday Food magazine offset some of the revenue and advertising pages declines at the flagship title, Follo said. But the operating loss on Everyday Food swelled to $2.5 million from $800,000 in the prior year's quarter as the company tried to solicit customers for the magazine.

Sales plunged 31.8% in the company's direct commerce segment, which includes its Internet and catalog businesses. Martha Stewart Living has cut back the circulation of its catalogs and has experienced a similar decline in advertising in its direct business as it's seen in its publishing segment. The segment posted a loss of $1.0 million, but that was down 86% from a loss in the fourth quarter of 2002.

Revenue from the company's television division dropped 6.8% from the fourth quarter a year earlier to $5.92 million. The company blamed the decline on a drop in license fees for its syndicated television show. The drop in revenue and rising production costs turned the segment's bottom line from a $586,000 profit in the year-ago period to a loss of $852,000 in the just-completed quarter.

And the outlook for the company's television division grew dimmer in the quarter, as cable station HGTV and a station in Canada declined to renew their syndication deals with Martha Stewart Living.

The loss of those agreements will cost the company about $4 million in earnings before interest, taxes, depreciation and amortization, Follo said. Without those deals, the company's television segment will likely post another operating loss in the first quarter, he said.

"TV doesn't look too good, and publishing looks horrible," said Rothbort.

The only segment that showed a gain in revenue was Martha Stewart Living's merchandising division. That division licenses Stewart's name for home-living products sold at Kmart and for a line of furniture. Revenue in the segment rose to $22.45 million from $11.79 million in the year-ago period.

But much of the revenue from the company's Kmart relationship was deferred from previous quarters. And the company didn't recognize the full amount it felt was due from Kmart. Kmart has sued Martha Stewart Living contesting the minimum royalty due under their contract; as a result, Stewart's company did not recognize about $3.3 million in disputed royalty revenue.

However, due to the outsized Kmart payment, the division's bottom line swelled 153% over the same period a year earlier, to $18.48 million.

Stewart's trial relates to her December 2001 sale of shares of ImClone Systems a day before a regulatory setback sent the drug company's stock tumbling. Prosecutors charge that Stewart's sale was the result of an illicit stock tip that Stewart and her broker lied to cover up.

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