A friend of mine, having heard me rant several times about the impending doom of Blockbuster(BBI), sent me an article from everyone’s favorite source of fake news, The Onion. The article, entitled “Struggling Blockbuster Eliminates Rental Fees,” contemplates a desperate attempt by Blockbuster to retain customers by eliminating all charges and even paying customers for renting videos. It concludes:

Miami resident Scott Patterson, however, was only one of many consumers who said they were unimpressed with Blockbuster’s new offers, including “Two-Dollar Tuesdays,” in which customers are handed $2 cash for every new release they rent. “I don’t know,” Patterson said. “Something about that place just rubs me the wrong way.”

The problem in a nutshell. The service Blockbuster offers is quickly becoming so unattractive that customers might not come even if they were paid to do so.

The video rental market has faced steep declines in the face of mail-based subscriptions and pay-per-view. The emergence of internet-based delivery will accelerate this trend. Netflix(NFLX) already has over 5 million subscribers who pay a monthly fee to rent DVDs by mail. Netflix’ turnaround is quick and its selection dwarfs that of your local Blockbuster store. The only disadvantages: you won’t always get your top choice of movie and some amount of planning ahead is required. That’s okay though, because your local cable company has vastly expanded the number of movies available for you to watch immediately without leaving your couch.

Blockbuster’s only advantage here is the exclusive window studios continue to give to DVD sales and rentals before they make their films available on Pay-Per-View. However there have been signs that this is eroding and it is inevitable that Pay-Per-View and Internet will soon have movies available as soon as they are released to DVD.

Making matters worse for Blockbuster is that those consumers who have opted to sign up for a subscription service tend to be high-volume movie watchers. Casual renters have no need for such a subscription service.

Blockbuster has responded with its own subscription service which has garnered 1.4 million customers, but will have difficulty competing given the twin albatrosses of $1 billion of debt and a $2 billion liability for store leases. Besides that, the mail-based subscription business will come under pressure from the “instant gratification” formats of cable and internet delivery.
Blockbuster has attempted placing more emphasis on DVD sales, but has difficulty competing with behemoths such as WalMart(WMT), Best Buy(BBY), Amazon(AMZN) and Costco(COST).

As valiantly as it may try, Blockbuster cannot cut costs fast enough to regain sustained profitability. There is no new product or service they can leverage their retail footprint to sell. A failed 2002 experiment with another doomed retailer, Radio Shack(RSH), is instructive in this regard.

Carl Icahn has taken a stake in the company and agitated for change, but I’m unclear as to what value he hopes to unlock. One need only look at Movie Gallery(MOVI) to see where Blockbuster will end up. It is the rare company that can successfully transition when its core business becomes obsolete. Blockbuster looks to be of the more common variety of company that can’t make the transition.
Disclosure: I own none of the companies mentioned in this article

In an earlier post, I warned that Hewlett Packard(HPQ) should be sold it as it had only gone up in the face of increasingly bad news. More than a week later, the stock has finally begun to descend(down $1.91 to $34.87 on 9/21), but with the news continuing to get worse and clear questions unaddressed, the stock continues to be too dangerous to own.

After much hesitation, it was finally announced last week that Patricia Dunn was stepping down as Chairwoman, but she continues to remain on the board. This depsite new allegations of additional questionable investigative techniques including an attempt to install spyware on a reporter’s computer.

More recently, the Washington Post reported that CEO Mark Hurd was involved in the investigation. Hurd has been credited with turning the company around, and his alleged involvement casts doubt on HP’s continued turnaround. California Attorney General Bill Lockyer had complained early Thursday that HP had stopped cooperating in his investigation, but his office later reported that cooperation had resumed. Hurd has also agreed to testify before a Congressional committe next week on the matter.

Reuters reports that Lawrence Bossidy has called on the entire HP board to resign, and I second that. As long as there are no changes, and those who executed such incredibly poor judgement are still at the helm, there is too much risk here to justify owning this stock.

Disclosure: I own no HPQ

Update: Dunn resigned effective immedaitely Friday afternoon(9/22/06). This is certainly a positive sign, but it’s not enough. The board that allowed this to go on, and allowed her to stay on for weeks after these disclosures, needs to follow her.

Kevin Kelleher agrees and his eloquent article is a must-read. Meanwhile, the chorus of Wall Street analysts continues to be positive on the company.   They still seem content that this scandal has run its course.  It’s unclear why the believe this, and oddly, they seem unconcerned that those whose poor judgement allowed this to go on are still in decision making roles at the company.  So much for the renewed focus on business ethics.

Like all investors, I’m always looking for a chance to buy a dollar for eighty cents. Rarely though, have I found a company where the value is as easy to understand as is the case with Cadus Corporation(KDUS).

Cadus is a tiny company with a market cap of only $19.7 million at today(9/21/06)’s close of $1.50, yet it has cash and equivalents of over $24 million. In addition, the company owns several hundred thousand dollars of marketable securities, mostly in Sequenom(SQNM) While unusual, Cadus is certainly not the only company with cash exceeding market value. What is unusual is that the company has no debt or other liabilities, and is cash flow positive. The company has no employees(even the CEO is a consultant), leases nothing more than a storage space, and the interest on the cash hoard plus its one small revenue stream more than covers expenses, leaving a small profit.

Cadus was formerly a biotech company engaged in research and development until it sold all research assets to OSI Pharmaceuticals(OSIP) in July 1999. OSI continues to pay $100,000 per year in a contract that continues until 2010 to license Cadus’ patent portfolio. The portfolio is also licensed to another, undisclosed company which may extend the agreement for $250,000 per year once the current term expires this year. There are also potential milestones if drugs based on Cadus patents move towards approval. The company has done nothing substantial to monetize these assets, and it is probably reasonable to assign them a value of zero, and allow any upside to be a pleasant surprise.

One potential area of concern is ownership. Carl Icahn controls the company by virtue of a 38% stake. Icahn originally invested in Cadus in a private financing in 1993. He later purchased ImClone(IMCL)’s stake in 1995 which helped fund ImClone’s development of Erbitux. Icahn continues to be involved in ImClone, having just become a director and called on the Chairman to resign as a result of poor performance.
Oddly, though Icahn is well-known for taking stakes in companies and forcing changes to unlock value, nothing has been done to unlock value at Cadus despite years of Icahn control. The company claims in its 10-K that

The Company is presently seeking to use a portion of its available cash to acquire or invest in companies or income producing assets. To date the Company has not been able to identify an appropriate acquisition or investment and there can be no assurance that it will do so. There also can be no assurance that acquisitions or investments by the Company will be profitable.

Cadus has a large loss carryforward and could prove an attractive merger partner for a small, profitable company.

Cadus faces limited downside given its large cash position. Value could quickly be unlocked if the company decided to liquidate, found an appropriate merger or acquisition target, or unexpectedly monetized its dormant intellectual property. That is, if Carl Icahn finally decides to pay attention to the stock he already owns.

Disclosure: I own KDUS. I own no IMCL, SQNM or OSIP

There’s an old scam where an enterprising prognosticator sends out many thousands of his newsletters unsolicited. Being a friendly chap, our prognosticating protagonist personalizes his newsletters. Choosing a binary event, perhaps a football game, or the direction of a particular stock index that week, he predicts for half of his recipients one outcome. Ever eager to please, for the remaining half, he predicts the opposite outcome, guaranteeing a customer satisfaction rate of 50%, on par with cable companies and far exceeding that of the President.

Our entrepeneur, not one to be deterred by a 50% churn rate, dashes on, dropping his disgruntled readers and sending out an additional set of personalized missives to the gruntled ones. After repeating this several more times, the intrepid CEO of our fledgling enterprise becomes alarmed by his dwindled customer base and embarks on a restructuring plan. Those customers who remain are asked to send substantial remuneration in order to consider receiving these money-making predictions. Having received an improbably long series of correct predictions many are happy to oblige. All is well until subscribers realize that performance has suddenly worsened. Ideally, by the time this happens, our visionary has retired and is comfortably ensconced in his well-appointed mansion.
This came to mind when I heard about the dramatic and sudden reversal of fortune at Amaranth Advisors. The Greenwich, Connecticut-based hedge fund reported to investors this week that its fund had fallen 50% since August as a result of a highly leveraged long position in natural gas. After spiking to $7.50 in August on fears of a Gulf hurricane cutting production, natural gas has steadily fallen to yesterday’s close of $4.88, near 2-year lows.

There are 9000 hedge funds out there, and most of them are run by people who have had good track records- but how many of these track records reflect skill(and are reproducible), and how many reflect luck(which will run out)? Hedge fund managers are self-selected from those who have had success, but I suspect that many of them aren’t any more prescient than our scammer. They’re the coin flippers who’ve gotten 10 heads in a row, and given the huge amounts of leverage in use, I think we will continue to see additional falls from grace.

If you’re going to fail anyway, you might as well fail spectacularly. Amaranth didn’t quite fail in spectacular fashion, but only because the bar was set so high by the 1998 collpase of Long Term Capital Management. Anytime the Fed begs banks to bail you out because your failure may trigger a collapse of the global financial system, you’ve definitely failed spectacularly(and if you haven’t already read it, When Genius Failed, Roger Lowenstein’s account of LTCM, is a must-read for every investor).

While perhaps not spectacular, the failure has had a major impact on the market. The sheer volume of positions Amaranth has been forced to unwind have exacerbated the problem, pushing down natural gas even further. Amaranth continues to liquidate positions, and as it does so, natural gas will continue to drop.

Natural gas will stop its fall when Amaranth’s liquidity crisis ends. This will happen in one of several ways. Amaranth will liquidate everything and close up shop, sell enough to restore solvency, or sell distressed assets to a buyer with greater liquidity. Bloomberg reports that another hedge fund, Citadel Investment Group, is in talks with Amaranth to take over open energy trades. Were this to happen, Citadel would be in a position to sit on trades and close the book over time, removing downward pressure from the market.

Natural gas prices would appear to be near a bottom and should rise somewhat once this situation is resolved. In order to take advantage of this, there are several stocks with a natural gas focus in North America that are good buys, but my favorite is Cimarex(XEC).

Cimarex is an oil and gas exploration company with all of its activity in the United States. The product mix is 70% natural gas and 30% oil. Cimarex has historically not hedged but announced in August that it had begun hedging natural gas, locking in about 15% of production above $7. At yesterday’s close of $35.02(within $1 of the 52-week low and well off the high of $47.80), the company has a P/E of 7 against last year’s earnings. With oil and gas prices down it’s likely that profits will decline as well, but even at 2004’s level of $3.59 per share, the P/E is below 10. Of course, this is offset somewhat by higher production levels than last year given the mild Gulf hurricane season.
Cimarex has been very successful in developing new wells. In 2005, the company drilled 382 wells with a remarkable 88% success rate, resulting in the replacement of 183% of production. The company has announced that it will be spending $1 billion on exploration and development this year up 50% from last year’s number. So far the company has continued its high success rate(134 wells with an 89% success rate in Q2). 60% of the company’s acreage is undeveloped so there are plenty of remaining opportunities for growing the already impressive proved reserves 1.4 trillion cubic feet equivalent.

Cimarex is poised to perform well even with oil and gas prices below current levels. The company recently instituted a dividend, has been buying back stock and paying down debt. Would I bet the house on it? No, Amaranth shows the danger of that. But if you can buy at these levels and have the wherewithal to wait out(and perhaps buy on) any further drops, I believe you will be amply rewarded.

Update:

According to CNBC, Amaranth has transferred its entire energy portfolio to Citadel and JP Morgan Chase(JPM).  There’s still a lot of volume to unwind, but now that we’re out of crisis mode, the natural gas market should settle down.
Disclosure: I own XEC

Wow! I have to admit, when I wrote my piece on First Marblehead (FMD) late last night, the stock was at $52.35, and while I expected it to go up today, it has blown past my most optimistic guess of where it would go. As I write this, the stock has just passed through 60, up over 15%.

I still am bullish on the company , but in the short term, caution is probably in order. The stock is likely to have a significant move once the deal closes and final numbers are in, and while I believe it will be to the upside, given today’s gains, short term expectations may be too high. That said, I expect to add to my position on any pullback.

Disclosure: I hold a position in FMD

First Marblehead(FMD) is one of those stocks that people either love(First Marblehead: A Bull’s Thorough Defense) or hate(First Marblehead Proves Us Right). Count me in the love category.

The company announced today updated details on its upcoming securitization of student loans. The total loan volume being securitized has increased to an estimated $1.84 billion up from last week’s estimate of $1.56 billion. Much more interestingly, the company estimated that its up-front structural advisory fee would be $175 million or 12.6% of loan volume. Previous securitizations had consistently yielded up-front fees totaling approximately 8% of loan volume. What’s happening here?

It looks like the company has structured this deal to give them more cash up-front and less in the future. In past securitizations, additional structural fees have been about 1.5% of loan volume, and residual revenue has been discounted to around 7.5% of loan volume. Though the discounted value has been recognized as earnings, no cash is received for these revenue streams until 5-6 years after close. The company has not given guidance on those values for this loan and it seems likely that they will be lower than in the past to compensate for the huge increase in up-front revenue.

Taking more of the money up-front has several important benefits. Restructuring these deals to allow for more money up-front dramatically improves cash flow without impacting earnings and introduces more certainty into the company’s balance sheet as it becomes less dependent on present value of future residuals. This addresses some of the persistent complaints of critics who contended that First Marblehead’s estimates of residual revenue were inaccurate and inflated earnings.

First Marblehead has consistently and strongly grown revenue and earnings. The company has been making excellent progress signing up new partners like GE and National City to reduce its dependence on a handful of large partners. It is also awaiting approval for its bid to purchase a small bank which would allow it to expand the array of services offered. The stock has a reasonable valuation with a P/E of 12.5 against fiscal ‘07 numbers. There is currently a 1.1% yield and management has raised the dividend as earnings have grown. Despite more than doubling over the past year, I believe this stock still has ample room to continue its upward march.

Disclosure: I hold a position in FMD stock

You may not have heard of Lifetime Brands(LCUT), but you almost certainly own one of their products. The company owns or licenses a broad array of brands including Farberware, Sabatier, Hoffritz, Pfaltzgraff, KitchenAid and Cuisinart. Lifetime is the largest supplier of cutting boards, silicone bakeware, and pantryware, the second largest supplier of household cutlery and a significant player in the tabletop market.

Lifetime has shown an ability to grow quickly and profitably. Revenue has climbed from $131 million in 2002 to $307 million in 2005, and EPS from $0.34 in 2002 to $1.23 in 2005. The company’s guidance for 2006, most recently given on August 3, $480-500 million in sales and $1.50 to $1.70 in EPS.

Lifetime has been agressive in purchasing brands and assets. Last year the company purchased Pfaltzgraff which instantly made it a major player in the tabletop space. Pfaltzgraff doubled the number of outlet stores the company operates(88 after closing overlapping stores) and gave the company a direct-to-consumer business to complement the existing wholesale business. Lifetime also acquired Salton’s(SFP) tabletop business which expanded the product line to fine china and crystal and included licenses of premium brands such as Calvin Klein Home. More recently, the company acquired the assets of Syratech to move into the home decor and picture frame business.

With each acquisition completed, Lifetime has been able to quickly improve cost structure through its extensive experience with global sourcing, expand distribution through its extensive distribution network, and reinvigorate product lines with new products and designs by its in-house design staff.

Lifetime has also moved aggressively to enter into licensing deals for trusted brands like KitchenAid and Cuisinart, both of which it has successfully extended into new markets like cutlery and kitchenware.

The company has been agressive in introducing new products, planning to introduce 1400 in 2006, double the number released in 2005.

Though the company has been agressive in taking advantage of opportunities, it has been disciplined. Earlier this year, Lifetime reached an agreement to purchase the assets of WearEver, a bakeware company, out of bankruptcy for $21 million. At the mandatory court auction, the company lost out to another bidder who paid $36.5 million.

What’s not to like? The company recently sold $75 million worth of convertible debt, increasing long-term debt to $80 million, but this hardly seems unreasonable for a profitable company with a $270 million market cap. The stock dropped when the company warned of a second quarter loss, but the company’s earnings are historically extremely seasonal, with almost all earnings coming in the third and fourth quarter, and the company has maintained its guidance for the full year. There have also been reports critical of the number of family members employed in senior roles at the company. While this certainly gives one pause, the numbers seem ample evidence of the job management is doing.

Lifetime trades at 14x 2006 earnings, and 10x 2007 estimates. The company also features a 1.24% yield. With a 5 year EPS growth rate of 27.3%, and well off its 52 week high of $30.10 the stock seems quite cheap at Wednesday’s close of $20.10. As the company’s earnings come in Q3 and Q4, I believe the stock can quickly rebound towards the mid-20s, and to continue to rise over the next several years.

Disclosure: I own LCUT stock

For nearly a week the scandal at Hewlett-Packard(HPQ) has dominated the headlines. Each day has brought progressively worse news. What began as news that George Keyworth had been identified as the source of a leak and would not stand reelection, quickly escalated with the revelation that investigators hired by board Chairwoman Patricia Dunn had obtained information about directors and reporters illegaly.

Subsequent reports brought news that Tom Perkins had resigned from the board in May in objection to this unethical act, that the California Attorney General was investigating criminal charges, and that the FCC, FBI, US Attorney, and Congress were also conducting investigations.

Despite this, Dunn has maintained that there is no need for her to resign, though she has said she will do so if asked by the board.

What is most interesting to me about this is the market’s reaction. Hewlett Packard stock has deflected each piece of news, closing Monday at $36.36, just short of its 52 week high. So while the headline writers and journalists(particularly those who had their phone records illegally obtained by Dunn’s henchman) have determined that this is a serious matter, investors have decided it’s immaterial.

What are the possible impacts that investors should be concerned with?

Impact to Business
Hewlett Packard is a well-established vendor it is hard to imagine this having a material impact on revenues. Purchasers will view this is an internal company matter, irrelevant to their purchasing decisions

Impact to Mark Hurd
Since taking the CEO position at Hewlett Packard, Hurd has been credited with vastly improving the company’s performance. Any indication that Hurd were involved that might jeapordize Hurd’s future role at the company would be viewed as a negative by the street. There has been no suggestion that Hurd played a role in this, and in fact, the investigation began during his predecessor, Carly Fiorina’s tenure. I view it as unlikely that Hurd will be adversely impacted by this.
Criminal Charges or Lawsuits against the Company
With the number of investigations underway now, criminal charges against one or more individuals seem likely. I suspect that the investigators are the most likely target. From waht is currently known, it would seem difficult to make a case against Patricia Dunn and even more difficult to make one agianst other board members. Lawsuits against the company by those journalists whose records were illegaly obtained seems possible, but of uncertain outcome.

Patricia Dunn’s Job Status
While it is unclear what Dunn knew when about the illegal activity, she ultimately should be held responsible by the board for the investigation that she ran. Dunn hired the investigators, managed communications with them, and received reports from them. Proof that Keyworth was the leak source must have included phone records. If she didn’t ask how they were acquired, she certainly should have. And if Tom Perkins knew what had happened in May, she certainly did, yet there is no evidence that she did anything at that time to rectify the situation. She may not have done anything illegal, but she has failed utterly at her job an ought to be fired.
Bottom line, the market has weighed these and other factors, and yawned. If I owned HPQ though, I would view this as an opportunity to sell. The stock has moved up significantly both over the last month and the last year, there remains risk of additional revelations, and I don’t want to own a company whose board allows this Chairwoman to remain.

Update: HPQ announced this morning that Dunn will be stepping down as chairwoman effective January 18 but remain on the board. Mark Hurd will become Chairman. This is puzzling to me. If Dunn isn’t fit to serve as Chairwoman after January, she isn’t fit now, and she isn’t fit to be a director. There had been some speculation that Tom Perkins might be brought back to replace her, but with Dunn remaining on the board seems unlikely. It would seem to me that as long as Dunn and those board members who allowed her to stay remain, HPQ should be approached with caution.
Disclosure: I do not own HPQ

George at Fat Pitch Financials has begun a blog carnival called Festival Of Stocks. The first edition is currently up and our post on Consolidated Tomoka has been selected as Editor’s Choice. There is much other worthwhile reading featured, and all are encouraged to visit.

Rob Zenilman has a recent post on SeekingAlpha on warehouse club membership fees. Though the post is titled “Are Warehouse Stores Too Dependant On Membership Fee Income?” this post merely shows that this is the case, but doesn’t suggest any conclusion. I would maintain that not only is this desirable, it is an integral part of the business model.

There are 3 major players in the warehouse club market, BJ’S Wholesale(BJ), Costco(COST) and Sam’s Club(part of WMT). These businesses offer a wide range of product catgeories but typically limit brand and size selection for any given product. Costco, for example, sells only 2 brands of diapers, 1 of which is their house brand and in only 1 size package. Compare this to a local supermarket which will offer 4-5 national brands, different styles within brand, and several package sizes per brand as well. BJ’s carries more SKUs than Costco, but still far fewer than traditional stores. Limiting product selection gives warehouse clubs additional leverage with suppliers as there is great value in being the only choice. Warehouse Clubs pass this value on to consumers; Costco is famous for never marking up prices more than 14%.

Rob noted:

For the 12 months ending with 2006’s second quarter, Costco’s membership fee revenue was 72.7% of operating income and BJs was 83.9%. BJs has already reported Q3 numbers – the TTM ratio went up 4.5% to 88.4%

So, the bulk of operating income is not from selling merchandise, but from selling memberships. Bad news, right?

Wrong. There’s no great secret being uncovered here, this is the warehouse club business model.

Reasons why dependence on membership fees is good

1) Float

Members pay $45 at BJs or $50 at Costco per year. They pay this up front at the beginning of their membership year, and though it gets recognized over the next 4 quarters, the Comapny has all the cash up front. This is an attractive source of low cost working capital. Money can be used to develop inventory, open new clubs, market memberships or can just be allowed to accrue interest. One result of this may be that unlike many retailers, both BJ and COST have little long term debt, and none net of cash.

2) Ability to “underprice” competitors
Since over 70% of profit comes from membership fees, warehouse clubs have the ability to price items at lower margins and still make money. The typical customer will compare the price on their receipt to other stores. They won’t first allocate a percentage of their membership fee. This creates a perception for customers that warehouse club prices are lower than their actual cost to the consumer.

3) Repeat Customers

Customers who have paid a membership fee are likely to shop more frequently and conduct more of their purchasing at the club in order to take full advantage of their membership fee. Since they have already paid in, there is a “switching cost” during the membership term.

4) Elasticity in Membership Fee

Costco recently raised it’s membership fee by $5 to $50 and BJs may well follow. BJs raised rates from $40 to $45 several years ago and renewal rates remain above 80%. In addition both clubs have had success in offering their premium membership levels($80 forBJs, $100 for Costco).

Both stocks are well off recent highs, but BJ looks to me like the much better buy. BJ trades at only 13.5 times next year’s earnings, has a strong balance sheet with only $10MM in long-term debt, and owns substantial real estate assets to support it’s value. In addition, as Rob points out, there have been persistent rumors that it might be a takeover target.

Unlike Costco, BJs does not have a national footprint, and some have expressed concern about its ability to compete. However it continues to do well in markets where it is competing with Costco, continues to expand, and has differentiated itself somewhat. BJs has focused on the consumer as opposed to the small business, and as a result, stocks a larger number of SKUs and somewhat smaller package sizes.

Recent drops in gasoline prices are likely to lower revenues and earnings as BJS operates gas stations at many of its clubs, so there may soon be an opportunity to buy lower. Even at $26 though, I think this is good for the long term.

Disclosure: I own shares of BJ