Month: February 2006

Tough as Nails!

That’s the headline on the cover of the new Business Week, over a photograph of a crew-cut, orange-apron-wearing Home Depot employee, crisply saluting with his right hand while his left holds a shovel, rifle-style.

“Skip the touchy-feely stuff,” the text informs us: “The Big Box retailer is thriving under CEO Bob Nardelli’s military-style rule.”

But what looks on the cover to be a glowing review of GE veteran Nardelli’s military-infused makeover of one of the most successful companies in American retailing history offers a cautionary tale about the downside to managing-by-numbers when it comes to the “touchy-feely” world of retail.

“Nardelli,” the article begins by telling us, “loves to hire soldiers.” And it’s not kidding: almost half the 1,100 store leadership trainees hired since 2002 have been “junior military officers.” One Home Depot manager actually describes Nardelli as “the general.”

Now, my nephew is a soldier. He just came back from Iraq. And I’d love to see him get into a training program like Home Depot’s when the time comes for him to transition to civilian life.

But if you’re wondering whether a military-style organization is the best way to run a home improvement retailer, the Business Week article will not entirely answer your question.

After starting out with the usual hoopla and glowing factoids of the Nardelli-inspired revival at the world’s largest home center, the article describes the Nardelli culture as paralyzed with fear; quotes an ex-manager who calls the company “a factory”; and reports that “Home Despot” is the nickname given by some insiders. My favorite, “Bobaganda,” is what others call the television programming in the break rooms owing to “its constant drone of tips, warnings, and executive messages.”

Me, I have no insider’s knowledge of whether such “Bobaganda” is in fact helping the company “thrive.” But I know at least one customer who’s seen the short-run impact of Nardelli’s “military-style rule” at the store level.

A friend called recently about a weird experience at the local Home Depot: he was looking for carpet, but when the sales lady pulled out those big rolling carpet-holders, there wasn’t much carpet on them.

“I’m sorry,” she told him. “We’ve been running low.” She blamed it on problems “with the trucking company,” and said new carpet inventory would be on its way.

I told my friend that knowing the problems truckers have been having holding onto drivers in this tight labor market, maybe that was in fact the problem—but just to make sure called a friend who used to run a Home Depot store and is now at a competitor.

Even before I finished telling the story, he began to laugh. “It’s not the trucks. It’s some bean-counter at corporate,” he said. The way he’d heard it, Home Depot’s fiscal year was coming up, and corporate had cut back store-level inventory—he supposed to show Wall Street’s Finest how well the company was managing inventory.

“There’s only one problem with that,” he said with deep irony. “You run out of what you sell.”

Interestingly, just last week Home Depot reported its fiscal year end, and Wall Street’s Finest did indeed take note of the company’s crisp inventory management. As Morgan Stanley wrote:

“Inventory levels…grew slower than sales…. We note that inventory growing slower than sales is consistent with comments from suppliers who cited strong sell-through but slower sell-in particularly towards the end of the quarter [emphasis added].”

Now, I’ve walked Home Depot stores with its founders, Bernie Marcus and Art Blank. It was their baby: they lived and breathed Home Depot. Bernie especially wore his heart on his sleeve—he’d get choked up just talking about how a particular employee had gone out of his way to help a customer install a sink.

And to their credit, both founders knew the business had outgrown the highly decentralized way they had managed the business—hence, the GE-trained, Six-Sigma promoting Nardelli.

But retail is not just about computer-generated numbers. Home Depot stores sell GE light-bulbs—they don’t manufacture those light-bulbs…and if a nearby Lowes does at least as good a job selling the same light-bulbs, not to mention carpets, then the Home Depot customer has a choice.

How that customer chooses in the future will determine the success or failure of “Bobaganda,” not whether the CEO and the soldiers carrying out their marching orders are “tough as nails.”

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

Ms. Rieker, who joined Enron in 1990, clarified testimony from Mr. Koenig that as far back as January 2000, Mr. Skilling had directed last-minute changes to earnings results to put them in line with analysts’ expectations.—New York Times


Thanks to Paula Rieker, the former board secretary of the former Wall Street Favorite known as Enron, the world now knows how certain large, complex, multinational companies manage to “beat the number” by a penny or two, quarter after quarter after quarter, until they don’t.

When the consensus expectation of analysts suddenly rose by 1 cent a share, to 31 cents, she said she “panicked.” But a day later, when she was told that Enron would report 31 cents a share, Mr. Koenig explained that Mr. Skilling and the chief accounting officer, Richard A. Causey, had decided that the numbers should be changed. She modified the news release that went out that day.

Anybody who has ever worked at a real company—as opposed to the bright bean-counters who move straight from grad school into the ranks of Wall Street’s Finest—knows that companies are inherently messy affairs, what with people to manage and budgets to meet and judgment calls to make and accounting rules to bend…not to mention currency swings and interest rate movements and hurricanes, droughts, wars and government policy changes.

But to Wall Street’s Finest, who view nearly everything through the prism of a quarterly earnings-per-share number that is almost as meaningless as the paper on which it is printed, the messiness vanishes, its place taken by a “Number” that becomes the all-encompassing target, almost regardless of how that “Number” is reached or exceeded.

Take Dell, for example: Dell “made the number” last week thanks entirely to a lower-than-expected tax rate. Wall Street’s Finest, as reported here, liked “the number” but not Dell’s forward guidance, which seemed light to the so-called analysts whose job it is, presumably, to divine trends before they are glaringly evident and already priced into their stocks.

Where, the readers of this blog who have experienced terrible service problems at the hands of that once-great company might ask, have those analysts been for the last year? How can they be surprised at Dell’s weak revenue growth, the declining earnings growth rate, and the lack of a full year forecast?

They’ve been spending too much time on useless models and not enough time talking to customers, that’s how.

Every investor should read carefully the account in today’s New York Times of how one complex multi-national corporation “beat the number,” according to Enron’s Ms. Rieker in yesterday’s testimony:

Then in June 2000, with Enron prepared to meet analysts’ earnings expectations of 32 cents a share, Ms. Rieker recalled that Mr. Koenig came into her office and said he had “just come back from a meeting with Skilling where he had said he wanted to beat earnings by 2 or 3 cents.”

Four days later, Enron reported 34 cents a share. Analysts were never told about the sudden change.

The next time a company “beats the quarter” by a penny or two, think about how Enron used to “beat the number.”

And ignore the analysts who actually care about it.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

Disney Shopping, a $160 million a year direct-to-consumer purveyor of Disney merchandise, announced a change in its business model that to anybody on Wall Street—and to consumers under the age of 30—should come as no surprise: it is eliminating its paper catalogue.

According to an interesting article in this weekend’s New York Times, “Disney spent $18 million to mail 30 million catalogs last year,” with half the catalogs going out in the fourth quarter holiday season.

The result was a whopping 45% decline in peak season telephone orders.

Now, you might expect that a 45% decline in telephone orders from a catalogue mailing would lead to a fairly big decline in overall sales for the Disney Shopping business, but thanks to the overwhelming proportion of internet-based orders, sales actually increased 5% for the year.

You don’t have to be a math whiz to figure out the general direction of the variables in the equation embedded in this discussion: catalogue-based sales down, internet-based sales up.

Why, you might wonder, would anyone spend $18 million to contact consumers using a labor and resource-intensive method when the response to that method was a collapse in customer response at a near-50% annual rate?The answer is you wouldn’t—unless of course you happen to be a college professor.

While the folks at Disney have taken the highly logical step of paying attention to the data and putting an end to the $18 million catalogue operation, Donna Hoffman, a professor of marketing at Vanderbilt University, told the Times the move was “really short-sighted” and said the company ought to reconsider.

As if the trend is a momentary blip.

Ms. Hoffman, to her credit, provides a statistic to back up her point of view: the purported fact that consumers who use a retailers’ store, catalogue and web site spend 15% more at that retailer than customers who use only one shopping method. “Disney’s just leaving all of that on the table,” she told the Times.

But what, precisely, does “all that” amount to here?

Let’s assume Professor Hoffman is correct, and Disney is realizing a 15% sales lift from the shrinking base of customers who shop in Disney Stores, order online and peruse those catalogues—say, one quarter of the $160 million total Disney Shopping sales.

So perhaps $40 million out of those sales were boosted by Professor Hoffman’s 15% synergy number—implying Disney generated an extra $4 million of sales thanks to the catalogue mailings.

Now let’s try to figure out what it cost to get that extra $4 million in sales.

Without detailed access to Disney’s books we’ll have to guess, but there’s an interesting data point inside the article: 80%—or roughly $130 million—of Disney Shopping’s $160 million sales came from online customers.

Which means only about $30 million came from the telephone-based catalogue customers.

Assuming a 50% gross mark-up on $30 million of merchandise sales (a generous assumption), Disney Shopping’s catalogue might have generated $15 million in gross profits.

$15 million in gross profits which does not even cover $18 million in catalogue mailing costs.

Then there’s the call centers where operators take down the information and transform a customer order into a sale (Disney has closed one call center already), and Disney’s catalogue operations are clearly bleeding cash—I’d guess $5 to $10 million last year.

All for the sake of Professor Hoffman’s theoretical $4 million in extra sales lift Disney might experience by mailing 30 million catalogues straight to 30 million recycle bins around the United States.

Which is why the Disney Shopping VP told the Times there is no way Disney would ever revive the catalogue business, despite Professor Hoffman’s concern that Disney might eventually “decide it was a mistake.”

I give the Professor credit for taking a contrarian point of view. But when it comes to The Professor versus the Real World, my money’s on the Real World.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

When one of Wall Street’s Finest begins a question on a conference call by saying “I’m struggling to understand…” you know there’s trouble brewing.

Wall Street analysts hate to express anything but goodwill towards the companies they follow—the better to retain access to the management of those companies. Especially those companies which generate banking fees.

Which is to say, of course, every public company in America.

Thus, when one of Dell’s biggest boosters began a question on last night’s Dell call that way, you knew it was going to be a long, ugly evening. And it was.

Among the questions asked by the disappointed analysts were the following:

“I’m struggling to understand why gross margins deteriorated so significantly, both sequentially and year-over-year…”

“Do you still feel the [direct] model has advantages [over HP]?”

“Should we assume that the new, lower operating margins are really part of a process of resetting the bar?”

“Why are the new lower margins not driving higher revenue…?”

“How would you assess your own execution this quarter?”

“When should we see the consumer business basically bottom out?”

“I’m a little bit puzzled by the effects of the 14th week [in the quarter]…”

“Is it fair to say that HP is making it a lot more difficult for you guys to grow on the printer side, and is it a really big disappointment for you?”

I must admit that, personally speaking, I’m struggling to understand why Wall Street’s Finest expected so much more than Dell delivered last night.

For one thing, Mark Hurd has clearly stopped the hemorrhaging at HP, which used to be the SPECTRE to Dell’s James Bond—grand plans of World Domination that always ended in failure, big explosions, and Bond getting the girl.

For another thing, Dell’s service problems appear to be so widespread that my own bad experience (see “Dell Screws Up a Good Thing”) is a pretty good reflection of the decline in Dell’s brand name.

Here’s how Dell CEO Kevin Rollins wrapped up the call last night:

“Our focus is going to be, as we mentioned at the outset, continuing to work on our customer experience…”

My advice—not that anybody at Dell is asking—is this: less time on conference calls with Wall Street’s Finest, more time on customer calls.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

Inflation pressures increased in 2005….

Nevertheless, the increase in prices for personal consumption expenditures excluding food and energy, at just below 2 percent, remained moderate, and longer-term inflation expectations appear to have been contained.

—2/16/06 Bernanke testimony.

Shortly after the new Federal Reserve Chairman Ben Bernanke presented the above testimony to the Eco-1 dropouts in Congress, a far more relevant sort of testimony was presented to Wall Street’s Finest by a publicly traded company which, unlike the folks at the Fed, consumes food and energy and all kinds of materials that do not seem to appear in the government inflation statistics.

The company was Guitar Center, a large musical instrument retailer whose stores carry pretty much anything a musician could want to play—with high end guitars lining the walls and drums crowding the floors.

The stores are staffed with actual musicians, which is good except that these musical junkies tend to prefer playing their chosen instrument on the sales floor, which they do as much as possible, to actually ringing up a sale. So the stores can be a little intimidating to a novice, what with all the Hendrix-type guitar solos wailing in the background.

Whether the stock itself has merits is a different discussion, but, being a hack drummer myself, I can say that it is almost impossible to leave a Guitar Center without either buying something or craving an expensive new piece of equipment.

In any event, the company’s inflation ‘testimony’ came during yesterday’s fourth-quarter earnings call after the market close, when management discussed the real-world pressures many retailers are now seeing as a result of the higher costs of not only energy but building materials, labor and money itself.

According to Bruce Ross, the CFO:

In terms of the cost of building out the [Guitar Center] stores, we have seen a roughly 20% increase of [building out] a large format store…and roughly a 10 to 12% increase in the costs on the [smaller store] format.

So take Bernanke at his word: that inflation is well-contained. After all, Guitar Center is not raising prices on, say, Gibson Les Paul Classic guitars or Pearl MMX Masters drum kits by 20%.

Still, when costs go up 20%, somebody, somewhere, eats the cost. Somebody like Guitar Center.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

“Our results to date in fiscal year 2006 reflect these broader market trends. In the first two months of the year, we experienced and increase in home order cancellations and a decline in net orders for new homes when compared to the same period last year.”—KB Homes 10K

One of the big headlines in today’s Wall Street Journal is that KB Homes is seeing a surge in order cancellations amidst a cooling real estate market.

Now, it’s only fair to point out that statement was made in a 10K filed on February 10th so this is not exactly breaking news.

But the change in direction is notable, particularly in comparison with KB’s optimistic outlook a mere 60 days ago.

Back in its December earnings call, KB Home’s management told Wall Street’s Finest all was well in the housing bubble.

“Housing demand remains solid in the vast majority of our markets,” CEO Bruce Karatz said on the call, despite a moderation in the overall housing market which he characterized “as expected.”

Asked for specifics, the KBH COO said the company was “still seeing incremental small [price] increases in both” Phoenix and Las Vegas. “We are not seeing a lot of buildup in the resale inventories.”

When asked if “there are any markets that you guys are maybe seeing very different slow conditions today versus what you were seeing maybe a few months ago…?” the company’s COO said this:

“No. As a matter of fact I would say—I mean you are comparing it to a few months ago. I would say generally improving conditions in the weaker markets.”

That was then. This is now.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

Far and away the most interesting—and meaningful—conference call I’ve listened to the last couple of weeks was the Blue Nile on Tuesday night.

Blue Nile is what investors like to call “a nice little company”—with good sales growth, healthy margins, actual earnings, and real free cash flow.

Blue Nile also happens to be an internet retailer (of jewelry), and it learned about real free cash flow the hard way, having started up during the internet bubble and survived the internet crash thanks to the extreme diligence and sharp focus of its founder, Mark Vadon.

Unlike, say, Overstock.com, whose CEO went out and bought $7 million worth of diamonds and cobbled together a clunky “Design Your Own Jewelry” site to attempt to sell the stuff, Blue Nile operates as a virtual jewelry store with a terrific, user-friendly site and a well-developed supply chain.

Gross margins are half the brick-and-mortar model—but because Blue Nile carries almost no finished inventory and gets paid via credit card before whatever it sells (usually an engagement ring) is assembled and shipped, it generates good margins and real free cash flow that piles up on the balance sheet and goes into share buybacks when the stock gets beat up, as it occasionally does when the company misses quarters, which it occasionally does.

As it did this week.

Being an Internet pioneer that survived the bust, Blue Nile has also witnessed the rise of the Google/Overture keyword advertising model, whereby advertisers buy “keywords” and then pay Google or Overture (now Yahoo!) every time a user “clicks-through” the ad that pops up during a search of those keywords.

And ever since Google came public, Blue Nile has been answering questions about click fraud, cost-per-click and Microsoft’s intentions in the space, always reaffirming the value of keyword advertising to Blue Nile’s business model.

Just last November, Vadon told analysts the following:

And what we really have to do is not go out and run television commercials like an Overstock.com, but what we need to do is stay focused on delivering a great experience and let the market mature and let people grow comfortable with the Internet. If we do that, I think you’ll see us continue to grow at the rates we’re growing now for at least five more years.

But that was then, and this is now. Blue Nile missed its fourth quarter revenues and earnings by a wide mark, in large part owing to higher search-related marketing expenses. Specifically, Vadon said the following:

During December, we saw extremely aggressive increases in the cost of online advertising. Our cost per click on Google, for example, rose by over 50% from a year earlier. While the cost of online marketing grew significantly in Q4, we remain disciplined in our spending, in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done.

If this sounds familiar, it should be. In “The Most Interesting Press Release You Didn’t Read” I highlighted comments from FTD Group in late December, which said essentially the same thing.

When asked for specifics, Vadon discussed “irrational behavior” in Google search pricing:

To give you perspective, in our top five keywords, our cost per click was up over 80% compared to a year ago. To us, it looks like, frankly, some irrational behavior in the marketplace. I think, if you follow our business, you know that we monetize Internet traffic for jewelry better than anybody in the world, and if we are getting nervous about the pricing of search, it means there’s some people out there who are deficit spending and perhaps are back to the mentality of 1999….

As far as who is out there bidding, it’s slightly different in Q4 as opposed to Q1. I think in Q4 — you asked about Amazon. We haven’t seen them at all in the online search market. We saw a couple larger players; I think Zales was pretty aggressive, Macy’s was pretty aggressive. And then we see just a tremendous number of small players, and these are very small companies. And they don’t play for very long. They will come into search for a week or a couple weeks. And I think there’s just a lot of — and then I think they burn through their budget fairly quickly and fall off the screen. But we just saw a lot of those types of players coming out.

The problem is not limited to the cost of keywords themselves: it extends to the diluted quality of the internet users clicking through to the Blue Nile web site, following Google’s move last summer to place more paid ads per search:

So an important matter is how well you can convert. Over time from search, we see slight declines, and it’s not tremendous but slight declines in the conversion rate. I think, to some extent, that has to do with the search engines placing more ads. So, when you went to a search term a year ago versus going to it today, you are going to see more paid search placements today than you did a year ago.

Furthermore, as more companies advertise on search engines, the value of the incremental customer is dropping:And as there’s more people there competing for the same traffic, if one consumer is shopping — so if you’re shopping for a plasma TV, you are probably going to go to many merchants, or at least a handful of merchants, before you make your purchase. And so you will be clicking on multiple ones of those, but only buying one plasma screen. And the more paid placements there are, probably the more click-throughs you’re going to have.So what that results in for merchants is downward pressure on the value of those customers

Having always thought highly of the Blue Nile CEO and his company’s business model, I’d say something has changed, quickly and significantly—in ways not discussed on Google’s own quarterly earnings call last week.

This is most apparent in the fact that Blue Nile, which has almost exclusively marketed online, is, like FTD Group, considering a shift away from online search:

Given these results, we will be looking to broaden our marketing efforts beyond search in the future. As we seek alternative marketing vehicles to complement our efforts in paid search, I would expect growth to be relatively conservative as we ramp our efforts toward broadening our marketing outreach. This is the right long-term solution for our business. As I’ve stated before, throughout all of our marketing efforts, our focus is on the maximization of gross profit contribution, in keeping with our overarching objective of free cash flow generation….

So what that results in for merchants is downward pressure on the value of those customers. So just as bidding is going up, you’re seeing downward pressure in conversion. Again, this points to our desire in the channel to be less aggressive with our bidding. And if that means giving up some volume to other people who perhaps are not measuring that and doing that ROI calculation, as well, we will do that until it rationalizes somewhat.

I’ll be the first to say I didn’t expect to hear comments like these for another year or two. Just two weeks ago (“Google: ‘Our Thesis is Still Intact’“) I reported that various sources within the corporate Google-using community, with one exception, saw no FTD Group-style slow-down in their marketing spend on paid search.

But with Blue Nile easing off the Google search pedal, it looks like the internet search market is indeed rationalizing—not because of Microsoft and not because of click fraud, but because of good old-fashioned free markets.

And it’s happening now, in Internet Time.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

No doubt the PowerPoint slides are being reviewed, critiqued, and reworked at the Pfizer corporate office in preparation for Friday’s Big Analyst Meeting.

Pfizer, hailed Company of the Year by Forbes Magazine in its January 11, 1999 issue, has lately fallen on very hard times—both business-wise and stock price-wise, and analysts, widows, orphans and brokers are eagerly looking for guidance at tomorrow’s first post-collapse presentation to Wall Street’s Finest.

Is it any coincidence that Pfizer’s stock peaked at $50.04 on April 16, 1999—just three months after the Forbes Cover Story?

Everybody on Wall Street has either experienced first-hand or knows examples of the “Cover Story Curse”—the tendency of major publications to recognize a major trend, fad, or corporate success precisely as that trend, fad, or corporate success has bred the seeds of its own destruction—and Pfizer is Exhibit A of the Cover Story Curse.

[As readers might recall (see “The Last, Best Hope for Prosperity” on June 12), Time Magazine provided the most recent “Cover Story Curse” last summer, when its “Home Sweet Home” cover story (“Why we’re going gaga over real estate”) preceded the top in the house-buying mania by maybe three months.]

And so it was that Pfizer-the Great slowly lost its way, until earlier this year anxious callers to “Mad Money” asked Cramer for advice on their holdings in what had once been regarded as the bluest of blue-chip stocks.

“I am giving you permission to sell Pfizer!” Cramer would scream, slamming the “Sell-Sell-Sell” button and no doubt contributing to the wash-out bottom in the stock, shortly before welcome litigation news and a huge dividend boost sent the stock up, and altered the mood among Pfizer investors from feeling we’re-all-doomed to the more hopeful it’s-not-dead-yet.

And now the Wall Street Journal reports that Pfizer may be preparing to sell the old Warner-Lambert consumer franchise, comprised of Listerine, Visine and other stalwarts that have lately been knocking the cover off the ball in comparison to the drug business.

Numbers being tossed around are as high as $11 billion, and interest is said to be high.

But why stop there? Why stop at selling off $4 billion or so worth of Pfizer’s $50 billion in sales? Why not sell the whole thing? And I don’t mean a merger with, say, P&G or some Big European Drug company.

I mean a good old fashioned leveraged buyout.

The idea is probably as farfetched as it sounds, and the probability is next to nil. I would never buy the stock on the assumption that some private equity group could round up the quarter-trillion or so that it would cost to leverage-up the company.

Also, Pfizer guys are corporate guys—they like the company, they like the lifestyle to which it has accustomed them, and they have probably become too accustomed to being the buyer to ever think about being the seller, despite the fact that they have granted themselves something like a half a billion shares worth of stock options.

And they are probably not the most entrepreneurial management in America.

I say that because I once sat on the train to New York next to a Pfizer executive. He spent the entire train ride—more than an hour—working on his laptop computer moving boxes around on an organizational chart.

I am not making that up.

But a leveraged buyout of the ex-Company of the Year is worth thinking about, if for nothing else than trying to understand the valuation currently accorded to Pfizer on the market.

The math is really pretty simple:

1. Pfizer had EBYYY—“Earnings Before Yadda-Yadda-Yadda”—of around $22 billion last year. (In serious terms, EBYYY is what Wall Street calls “EBITDA”—earnings before non-cash charges, such as depreciation, and capital-related charges, such as interest and taxes.)

2. Pfizer has no debt, net of cash. In fact, Pfizer has a lot of cash, thanks to the repatriation of $30+ billion from overseas entities as part of the so-called “Jobs Act.”

So let’s pretend a leveraged buyout group paid $32 a share for PFE—just pretend. Call it 7.4 billion shares outstanding, and that would cost the buyers $237 billion.

Now, pretend the buyers put up $37 billion of their own equity and borrow the remaining $200 billion, upon which they might theoretically pay, what, 9% interest—about $18 billion annual interest expense?

(Hey, Russian Federation bonds yield roughly 6%—and which credit would you rather own, a country run by an ex-KGB agent or a company whose business is keeping aging Baby-Boomers alive?)

So, under these assumptions, Pfizer’s EBYYY of roughly $22 billion would cover the $18 billion annual interest tab, with $3 billion available for capital expenditures (which amounted to something under $2.5 billion last year) or dividends to the new owners.

Furthermore, the new owners—being rapacious high-leverage types—could immediately set about selling off assets (the Listerine franchise, for example) to the highest bidders, in order to reduce debt or, more likely, pay themselves fat dividends and the kind of “advisory” fees that LBO groups grant themselves once they control the piggy bank.

Far-fetched? Yes.

But here’s the most compelling part: figure that the average LBO generates legal, banking and advisory fees of up to 5% of the value of the deal.

5% of $237 billion is $11.9 billion—$11.9 billion of fees for Wall Street’s lawyers and bankers and analysts!

Dream away! But don’t expect an announcement tomorrow.

Jeff Matthews
I Am, In This Case, Making It Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

“We have to defend our fatherland.”

Who said that recently—Hitler? Stalin? Hunter S. Thompson?

Of course not—they’re all dead. So here’s a hint: the man who said that also said this:

“We still need a higher number of rifles. The 100,000 Russian rifles are not enough, Veneuzuela needs to have one million well-equipped and well-armed men and women.”

That’s right: it was Hugo Chavez, President of Venezuela, the largest oil exporter in the Western Hemisphere.

I’m not making this up. The leader of a country in the Western Hemisphere actually said he needs a million well-armed men and women, to prepare for an invasion by the United States.

But that leader, who just as well might be Hunter S. Thompson, what with all the guns and paranoia flying around, does not lead just any country—he runs Venezuela.

And Venezuela, as I have discussed before (“Instability Adds Up”) supplies 11% of the crude oil imports to which we are “addicted,” as our President, who has heretofore done exactly zero to reduce that addiction, noted in his State of the Union speech recently.

Not only does Venezuela supply crude oil, but years ago that country bought Citgo, the United States-based refining and marketing company which happens to operate four refineries with about a million barrels-a-day capacity.

In other words, Venezuela produced about a gallon of the gasoline currently sloshing around in the average American’s gas tank.

And Chavez has threatened to close down those refineries:

“I could easily order the closing of the refineries that we have in the United States…I could easily sell the oil that we sell to the United States to other countries in the world…”

Meanwhile, on the other side of the world, the leader of another major oil producing country—slightly less daffy and therefore more scary—is moving ahead with plans to develop nuclear weapons. Oh, and he has said, publicly, that Israel should be “wiped out.”

Finally, and being perhaps the Reggie Jackson of this dangerous mix—the “straw that stirs the drink,” as the Yankees ex-slugger once described himself—Muslims are burning embassies over cartoons.

Yet, in the midst of what looks to me like the most combustible mixture of political, social and religious issues since the Shah of Iran fled his palace in 1979, private equity firms are rushing to buy up U.S. companies—not at bargain-basement prices in the midst of depressed operating conditions—but at all-time record prices in the midst of all-time record operating margins.

Jon Huntsman, the cancer-surviving, charity-supporting family man from Utah whose chemical company survived a harrowing brush with bankruptcy during the last down-cycle in that notoriously cyclical business put it well in yesterday’s Wall Street Journal:

“It appears to me that many of the private-equity shops are going to reach into some very marginal businesses with all the available capital,” he said. “Any time you have to reach too far to put your money to work, you’re going to take a higher risk.”

And with the Latin American Hunter S. Thompson running Venezuela and his soon-to-be nuclear-equipped counterpart running Iran, the risks may be higher than anyone thinks.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.

Okay, let’s get it over with right up front: I couldn’t care less about the Super Bowl. World Series, yes; Super Bowl, no.

Which is why I didn’t quite believe it when one of my daughter’s friends called from the college dorm where they were watching the Super Bowl to tell me Overstock.com had run an ad during the Big Game.

“Overstock?” I asked him.

“Yep,” he said. “The guys in your blog.”

“What kind of ad? The lady in white?

“Sexy lady. She was in bed.”

Sounded like Overstock, but I still didn’t quite believe that a web retailer with negative operating margins had bothered spending money on a Super Bowl ad.

That is so, as they say, 1990’s.

But sure enough, in my USA Today today is a “Super Bowl Ad Meter” ranking every single ad shown last night—and there it is, described thusly: “Overstock.com: O as part of life.” (Overstock’s web site calls it “Red Objects.”)

Unfortunately for Overstock, however, this description appears under the heading “5 least popular.” In fact, the USA Today Ad Meter ranks Overstock’s sexy bed-lady 56 out of all 58 ads.

(According to the paper, the “Ad Meter” comprised “207 adult volunteers in Phoenix and McLean, Va” whose reactions were “electronically charted” during the game.)

Their favorite ad came from Bud Light, and scored an 8.39. The top ten ads—six from Budweiser alone—averaged in the high 7’s. The least favorite, from Gillette, scored a 4.05. The second least favorite, from Slim-Fast, scored a 4.28.

Next was Overstock’s “O as part of life,” at 4.91.

All of this is eerily reminiscent of last year’s so-called “binomial marketing experiment,” which is how the Overstock CEO described a mysterious, not-quite-defined $2.6 million expenditure that added to the 2005 first quarter’s woes.

Long-time readers will recall that following the earnings report some of Wall Street’s Finest dutifully wrote “$2.6 million binomial marketing experiment” in their research reports, despite the fact that not one of them appeared to understand what that actually meant. But it sure sounded cool.

While I took plenty of math in school, my own memory of binomial coefficients and how they bear on marketing expenditures is a little shaky—unless, perhaps, “binomial” comes from the Greek roots “bi” meaning “buy” and “nome” meaning “very little.”

I am, of course, making that definition up. But I am not making up the cost of a Super Bowl ad, according to USA Today today:

“The evening didn’t come cheaply for the winners—or losers. Each 30-second time slot cost a record $2.5 million—or $83,333 per second.”

I don’t know what Overstock actually spent on last night’s ad. Nor can the opinions of 207 individuals be said to accurately reflect the 50 billion or however many people watched the Super Bowl. And I assume that more than a handful of individuals will, as a result of the sexy bed-lady, check out the site and pump up the numbers.

It will be interesting to hear the spin on tomorrow’s conference call…but beware “binomial marketing experiment” and other euphemisms.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.