For Stewart's Stock, This Sentence Is a Reprieve

Martha Stewart may be "very sorry," but for short-sellers betting against her stock, Friday's relatively light sentence is proving to be the source of a different kind of regret.

Shares of Martha Stewart Living ( MSO) were recently up $2.52, or 29%, to $11.16, boosted by perceptions that Stewart's ability to promote the company won't be destroyed by her prison term. Traders were also conscious of another possibility: Given Stewart's still-huge position in the stock, she might be inclined to take the company private after she gets out.

Under the sentence, Stewart will serve five months in prison, five months in home confinement and will pay a $30,000 fine -- a far cry from the maximum 16-month sentence the court could have imposed. In the meantime, Stewart remains free and won't have to serve time until her appeal receives a ruling.

Twelve million shares traded, more than 40 times its usual daily volume and the second-heaviest day in the stock since it went public. (The first was March 5, the day of the verdict.) The shares are up about 16% from when Stewart was convicted.

"It's really a rally that started yesterday," said Richard Hastings, retail analyst at Bernard Sands. "The speculation was building up that if her sentencing was light, that would help the perception of the company and hopefully improve Ms. Stewart's ability to participate as the creative director after her sentencing is finished."

Hastings also pointed to the enormous level of short interest in the company's shares, which have been high throughout the scandal, as investors bet the stock will continue to suffer. Indeed, at the end of June, investors had shorted more than 5.9 million of the company's shares -- more than the company's entire float. (Shares can be borrowed and sold short more than once.)

Martha Stewart Living's short interest ratio, the short interest divided by average volume, is 13.7%, and the company's stock was ripe for a squeeze. As a stock rises, shorts exaggerate moves in stocks as they are forced to cover bets with shares that are going up.

The sentence has been good for the shares and it could help boost business, too. Because of the lighter sentence, Martha Stewart Living Omnimedia may have Martha Stewart back promoting her brand well ahead of schedule. Going forward, Hastings said it's critical that the company start doing new things -- and perhaps the sentencing will be a catalyst to do it.

"I would stress that regardless of what happens, Martha Stewart Living has to get busy with new products, new services, new designs," Hastings said. "They can't sit still. If they're going to wait for her house arrest to be over, then my outlook for Martha Stewart Living is not positive."

Indeed, the company's track record without Martha has not been stellar. In the first quarter, the company announced a loss that was double what Wall Street expected and said second-quarter losses would be deep as well. Even more telling, revenue slumped 30% to $23.9 million as advertisers began disassociating with the company, which has been disassociating itself with Stewart, rolling out the Martha-free Everyday Food.

Even analysts that dislike the company have said that once the sentencing passes, the worst could be behind Martha Stewart Living. In a research note from May, Morgan Stanley analyst Douglas Arthur, who rates the company at underperform, said that advertisers would likely come back once the sentence was handed down and noted "customer loyalty remains firm, setting the stage for recovery in 2005-2006."

With so many pretenders to Martha's throne emerging with their own magazines, TV shows and home products, customer loyalty is a crucial component of the company's business. And because Martha got a five-month term instead of the maximum 16 months, it will be easier for the cult of Martha to continue shrugging off the verdict and look for more of the company's products on newsstands and store shelves -- a trend the company has already noted.

"Our research shows that magazine subscribers, in particular, were unfazed by the verdict immediately afterward and remain so roughly six weeks later," the company said two months ago, in a conference call discussing first-quarter results.

Ultimately, Stewart's ability to ride out the scandal could result in a new public persona as a survivor that could further endear her to fans.

"Nothing fundamentally changes for the company or for Martha -- their founder has a felony conviction," said Barry Ritholtz, chief market strategist at Maxim Group and a contributor to TheStreet.com's sister site, RealMoney.com. "But maybe this makes her more human and fallible. And she can come back as a felon. She owns 70% of the company."

She may be the company's largest shareholder, but at the moment, Stewart holds the title of founding editorial director and is little more than a former employee, albeit one whose name, face and persona are inextricably linked to the company's business. In mid-March, Stewart relinquished her spot on the company's board and role as creative director, and last year resigned as chairman and CEO of the company.

Martha Stewart Living said in a statement Friday afternoon that it is "saddened" for Stewart but "heartened that Judge Cedarbaum recognized Martha's strong public support and her lifetime of contributions to others."

"After 26 months of uncertainty, we see this as an important step toward closure for Martha Stewart Living," the statement continued. "In the face of difficult events, our talented employees continue to develop inspired and original 'how-to' information and products for the home. We thank them, our loyal customers and advertisers and our stalwart distribution and manufacturing partners for sticking with us through these challenging times."

With so much invested in the company, Ritholtz thinks Stewart will eventually take the company private, at least once her jail time and house arrest have wilted from the public's memory. In the interim, Stewart will likely remain involved in the company's present business in some capacity, even though it is technically prohibited by law. Ritholtz said it would be foolish to think she is not involved, seeing as she built the company from the ground up.

"To say she can't cook, can't design" is ridiculous, said Ritholtz, whose company does not own shares of Martha Stewart Living.

"She strikes me as someone who's a fighter, who's not going to roll over and die," said Ritholtz, who is also an attorney. "She will take this challenge and come clawing back. I will be very surprised to not see her after a period of self-realization and self-reflection."

Since Stewart owns more than half of the company's shares, taking it private would not be very difficult, he said. Doing so "pulls her out from under the NYSE regulation. At that point, it becomes a private thing."

After two years of grilling in the public spotlight, that's something Stewart might savor.

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