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Geoff Gannon April 28, 2006

April Issue on its Way

The April Issue of the quarterly newsletter has finally been mailed out. I was very pleased with the printing job done by the second print shop. I will continue to use them. In the future, the newsletter should arrive on or about the 15th of the month.

I’ve also updated the newsletter section of the website. You can now purchase the July Issue. If anyone is still interested in purchasing the April Issue (for immediate delivery), please send me an email – I have a few extra copies.

All subscribers should have already received a PDF for the first quarter. If you purchased the April Issue and did not receive a PDF, please send me an email and I will provide the PDF at once.


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Geoff Gannon April 27, 2006

Overstock’s First Quarter Results

For the quarter ended March 31st, (OSTK) reported a net loss of $15.9 million or ($0.82) per share. Total revenue increased by 8.62% to $180.2 million from $165.9 million. The company reported gross profit of $25.2 million; gross profit had been $24.8 million in the year ago period. Gross margins dropped from 14.9% in the year ago period to 14.0% in the first quarter of 2006.

Analysts had much higher expectations. As a result, shares of OSTK are down a little over 7% today. I had expected slightly higher revenue growth coupled with slightly lower gross margins. Overstock’s gross profit for the quarter exceeded my expectations, but not by a meaningful amount. More importantly, gross margins held up well, and are still in the high range of the 12-15% range I believe represents the company’s highest sustainable gross margins.

Overstock consumed a fair amount of cash during the quarter. Cash and securities fell from $112 million to $52 million during the period. Meanwhile, current liabilities were at $94 million at the end of the first quarter. Overstock had current liabilities of $155 million at the end of 2005.

The difference between Overstock’s performance in the first quarter of this year and its performance in the first quarter of last year was primarily attributable to higher technology expenses.

Patrick Byrne wrote:

We lost $15.9 million in Q1. I anticipate Q2 will look about the same, before we start climbing out of this hole in the second half of 2006. Our theme for this year is to slow growth during the first half of the year so we can work on improving internal business processes in preparation for stronger performance in Q4 and beyond. We continue to anticipate things will look better in Q3, and to be out of the ditch by Q4. Nothing that has happened recently suggests to me that we should change course.

We ended Q1 with $52 million in cash and marketable securities, including $20 million of borrowings on our inventory lines. We have an additional $30 million of availability on our lines, and are continuing to reduce inventory to turn it back into cash.

In summary, I’m committed to stay the course: slowing growth while we improve our systems and enhance the service we provide to our customers. Unfortunately, Q2 will be another disappointing quarter at the bottom line; then the tide should start coming back in by Q3 and we should be afloat in Q4.

Related Reading (OSTK)

An Analysis of (OSTK)

On the Rationale for the Overstock Post

On Overstock (Again)

On Overstock’s Fourth Quarter

Suggested Link: Overstock Sell Rationale

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Geoff Gannon April 26, 2006

Suggested Link: Value Discipline on Engelhard Recapitalization

Rick of Value Discipline just wrote a good post on the developing Engelhard recapitalization / BASF cash tender story. A review of Engelhard’s financials lead Rick to conclude that “the price being bid for EC appears quite fair, but certainly not generous”.

I agree with that conclusion. When I first looked at the original $37 offer, I thought it wouldn’t be particularly attractive as anything but an arbitrage commitment (in other words: if a deal couldn’t be worked out, there was no value in Engelhard).

Since then, the market price of Engelhard (EC) shares has not provided a good spread. In fact, if you look at a chart, you’ll see that the consensus has been that BASF (BF) was being a little cheap here. Shares of Engelhard have traded above the BASF offer, so there was zero opportunity for an arbitrage commitment based on public information (i.e., the announced BASF bid).

If you wanted to play the BASF offer, you had to engage in speculation. Only a higher bid would provide a profit if you were to buy shares at the market price.

Unfortunately, this is a contested takeover, not a bidding war. While buying above the announced tender offer is always a speculation, doing so when there isn’t another bidder is far riskier.

There’s the risk that the potential acquirer will walk away without a deal that would allow you to tender all of your shares. There’s also the risk that some adverse development will permit the acquirer to do a friendly deal below the expected offer. Finally, there’s the risk that a deal will be done along the lines of the already announced offer. If you were to buy shares in the market above the offer price, you would incur a small loss when the target’s board agreed to the previously proposed terms.

If no agreement was ever reached, you’d have two possible problems. The first is that you might not want to sell your shares when it became clear the potential acquirer was backing off, because there could be a lot of other sellers at that moment. Some owners of the target’s shares might be unwilling or unable to hold their shares for long after it was clear there wouldn’t be a deal, because they don’t want to be involved in a general investment. These investors only want to hold shares of a target or potential target; they don’t want to hold a stock that will rise and fall along with the general market.

The other possible problem with these contested situations is that the target’s board might do damage to the long-term health of the company. In this case, I’m not convinced the board is dead set against a deal. They may just be holding out for a bit more money.

Of course, Engelhard may still be wrong to engage in this recapitalization, because BASF won’t bite. However, I think the situation at Engelhard is a bit different from one where the board …

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Geoff Gannon April 25, 2006

Journal Communications to Spin Off Telecom Unit

Journal Communications (JRN) announced it plans to spin-off its telecom business. Shareholders of JRN will receive shares representing 100% ownership in Norlight Telecommunications.

This is a positive development for Journal Communications. It makes an already attractive stock even more attractive. Shares of Journal Communications were up about 6% on the news. The current share price still represents something on the order of a 33-50% discount to Journal’s break-up value.

I don’t expect the company will sell or spin-off any of its other assets. Journal owns a major daily newspaper (The Milwaukee Journal Sentinel), a collection of community newspapers, over three dozen radio stations, over half a dozen television stations, and the aforementioned telecom business. At a minimum, these properties are worth somewhere between $15 a share and $18 a share. JRN currently trades at less than $12 a share.

The company says the Norlight spin-off will likely take place in about six months. Ultimately, I expect the two securities (combined) will trade above the current market price for shares of JRN. However, the size and nature of the business being spun off may result in a lot of indiscriminate selling. Follow the news on this for more details about the planned spin-off.

Shares of JRN are attractive right now. Although I wouldn’t want to own the telecom business, the spin-off may actually make shares of Norlight attractive as well, because I doubt many holders of JRN will want to keep their Norlight shares.

My advice would be to buy shares of Journal Communications now and follow the spin-off to see if there is an opportunity to buy shares of Norlight for less than they’re worth. But, don’t wait to buy shares of JRN, because you can get the media properties at a discount by buying now.

Also, if you currently own shares of JRN or plan to buy shares of JRN such that you will receive a distribution of Norlight shares, I would strongly suggest you do not immediately sell your Norlight shares even if you have no interest in owning the telecom business.

You should probably decide on a certain amount of time during which you will not sell your Norlight shares for any reason. If you don’t insist on this kind of discipline, you’ll likely be selling at the same time as many other investors who received shares in the spin-off. Alternatively, you could just do the homework and figure out what Norlight is worth. There should be plenty of information forthcoming in the months ahead. This is a story you’ll want to watch.

(Note: Journal has not yet announced the record date or the distribution date.)

Related Reading

An Analysis of Journal Communications

On a Possible Cause for JRN’s Undervaluation


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Geoff Gannon April 25, 2006

Engelhard Corporation Announces Recapitalization Plan


New Jersey based chemicals company Engelhard Corporation (EC) has announced a recapitalization plan in response to the unsolicited offer made by rival BASF (BF). The shareholder response to BASF’s tender offer had been very limited. BASF originally offered $37 a share. That bid was later raised to $38 a share.

This morning Engelhard announced it will repurchase 26 million shares at $45 a share. This is about 20% of the shares outstanding. The company also announced certain “incremental cost savings”. All of this seems to be the result of a plan to study alternatives to the BASF bid.

Additional Information

The company’s preliminary proxy materials to be filed today with the Securities and Exchange Commission (SEC) – and the self-tender offer materials to be filed with the SEC and distributed to shareholders — set out in greater detail the reasons for the belief that the recapitalization plan represents the best value-creation alternative for Engelhard shareholders…Additional material on the plan is also available on

Engelhard is increasing its board from 6 members to 9 members. The increase is related to the BASF bid and the reorganization plan.

Shares of Engelhard closed at $38.30. They were at $38.65 in pre-market trading.

Other Details

The self-tender offer is expected to commence during the week of May 1, 2006 and expire at a date following the Annual Meeting of Shareholders set for June 2, 2006. If, following the Annual Meeting, individuals nominated by BASF constitute a majority of the Engelhard board, the board will have the ability to withdraw the self-tender offer. Closing of the self-tender offer would also be subject to the Engelhard board not recommending acceptance of an amended offer that BASF may choose to make as well as to receipt of financing and other customary conditions.

Note: Please research this matter before taking any action. The information provided above is not sufficient to make an informed investment decision.

I would suggest you start by visiting Engelhard’s website and reviewing any SEC filings. This post was written in the early morning; new information may have become available after it was written.…

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Geoff Gannon April 21, 2006

On Inflexible Enterprises

Yesterday’s Wall Street Journal had an interview with Anne Mulcahy, CEO of Xerox (XRX). I’m not mentioning the article because of Xerox itself. I don’t see any margin of safety in the stock.

Xerox isn’t particularly cheap on an enterprise value-to-EBIT basis. The company did earn good returns on equity in the late 90s; but, those returns were largely the result of leverage. So, investors who buy Xerox are betting on a turnaround with limited upside.

Considering the situation at Xerox and the current market valuation, it’s hard to say whether the stock is overvalued, undervalued, or fairly valued. Regardless, it doesn’t look like an especially attractive opportunity – it seems to be trading within that rather broad gray range that forces me to withhold judgment.

However, the article was worth reading, because it reminded me of a particular problem I had not yet discussed here.

Over time, a business puts down roots. It engages in activities that require it to take on economic and moral obligations. Often, investors find extricating the business from these obligations proves far more difficult than they ever imagined.

One answer in the interview contained an important lesson for investors. Said Mulcahy:

This is the pain of technology transitions. You can either sit and wait like Kodak or Fuji…and fall off a cliff when it happens. Or you can migrate…It’s always more attractive to stay in the old technology from a profit standpoint. Always. But you’ll be going out of business.

This problem isn’t limited to technology. Whenever a large investment has been made in a particular area, whenever there is a lot of capital, people, and ego tied up with some operation, the transition away from that operation is apt to be far slower than what an objective observer would have expected.

As an investor, it’s easy to look at a corporation from afar and see the business the way a rational capital allocator would see it. But, very few people within the organization are able to take such a farsighted view. They are not able to asses the matter dispassionately. There are jobs at stake. There is the admission of defeat. And there is the question of identity. Just as importantly, these problems hang over the managers every day. Staying too long in a dying business is rarely the result of one major misstep – rather, it is the result of a series of seemingly innocent steps that merely serve to delay the inevitable.

Recognizing the terrible importance of the inflexibility of an enterprise that is tied to a particular line of business, mode of production, or labor force is a difficult task. Many value investors have been caught in this trap. Some business appears to offer excellent value today; but, if it should cling too long to its old ways, that value will be destroyed. It’s tempting to think that managers will see the obvious danger, act to remedy the problem, and forever change the organization, before

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Geoff Gannon April 20, 2006

On Special Situations

I don’t discuss special situations investing on this blog both because it is not my forte and because I don’t think special situations investing is something most readers are interested in.

However, investing in special situations can be very profitable. In fact, if not for its demands on time and temperament, special situations investing might be the best way for individual investors to put their money to work.

Unfortunately, the demands on time and temperament are real, and they do preclude most investors from successfully pursuing this strategy. Simply put, you have to be willing to put some extra time and effort into such investments.

There is an almost constant flow of possible opportunities. Like any kind of investing, you are going to have to say no a lot more often than you say yes. That isn’t a lot of fun for most people. In fact, many investors will not succeed in this area, simply because they will be too eager to do too much too quickly.

But, if you’re still interested in special situations investing, I’d recommend you do two things:

1. Read “You Can Be a Stock Market Genius” by Joel Greenblatt

2. Visit Fat Pitch Financials

Greenblatt’s book is a good introduction to special situations investing, because it discusses the topic in a way that will make sense to investors who have never considered this area before. There are some other books that treat select subjects in greater detail, but they aren’t the best place to start – this book is.

George of Fat Pitch Financials discusses some excellent special situations on his blog. There’s a membership access area that discusses current situations. But, if you just want to learn more about special situations investing, the free content at Fat Pitch Financials is more than sufficient. To give you some idea of what I’m talking about, here’s an excerpt from George’s most recent post:


As you might recall, I purchased AutoNation on March 31, 2006 for the Special Situations Real Money Portfolio. This was my first odd-lot tender offer opportunity that I’ve taken advantage of.


Odd-lot tender offers provide small individual investors a unique opportunity that the big boys don’t have. By owning less than 99 shares of the stock that is being tendered, my shares received preference in this tender offer since there was an odd-lot provision to the tender. The AutoNation Inc tender was very oversubscribed and most shareholders that tendered their AutoNation shares only had 26 percent of their shares cashed out. However, since I had an odd lot, my tender was not subject to being prorated. This presented a very nice opportunity.

Let me show how nice. I purchased 95 shares on March 31, 2006 for a total cost of $2,056.10. This morning I received $23 per share for a total of $2,160.00. My broker charged me a $25 dollar fee in addition since this tender was a voluntary action. My total profit was $103.90 or a 5.1 percent

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Geoff Gannon April 19, 2006

Suggested Link: Price and Value

Bill of Absolutely No DooDahs has written an excellent discussion of price and value:

“Value is subjective. The price at which goods are exchanged is at the nexus of a disagreement over value, and while prices provide an objective history, prices provide little true information about value.”

This disagreement over value has interesting implications in the stock market, where we often consider only the small number of shares that trade on any given day. We talk about why these shares traded at a different price than they had the day before, and yet we ignore the fact that a great many owners chose to turn down Mr. Market’s latest offer.

With a few rare exceptions, buyers and sellers of stock do not just disagree over value; they have wildly different views of the stock’s value. Of course, they may also have different reasons for buying or selling, especially where the money they are directing is not their own.

Anyway, it’s a good post. I encourage you to read it.

Visit Absolutely No DooDahs

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Geoff Gannon April 18, 2006

News Item: Berkshire Hathaway Buys Russell Corporation

Warren Buffett’s Berkshire Hathaway (BRK.B) will acquire publicly held Russell Corporation (RML) for $18 a share. Berkshire will also assume about $400 million in debt.

The deal values Russell at roughly $1 billion ($600 million cash + $400 million debt). In 2005, Russell’s EBIT was $84.37 million. Earnings before interest and taxes had been higher in five of the last ten years.

Russell has signed a definitive merger agreement. The deal is expected to close by October 1st. RML opened above $18 today.

For more information see Value Discipline’s most recent post: “Berkshire Buys Russell – The Advantage of Long Term Horizon”…

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Geoff Gannon April 18, 2006

On The New York Times

The New York Times Company (NYT) isn’t just reporting the news – it’s making the news. At yesterday’s annual meeting, shareholders withheld 28% of their votes for the four directors elected by holders of the company’s common stock. Nine other directors are elected by holders of the Class B shares, effectively granting control of the company to a group holding less than a 1% economic interest in the business.

Most of the large newspaper companies have not done a great job of earning the best returns for their shareholders. Some of these companies overdid acquisitions. The New York Times Company illustrates the danger of adding to the empire – you dilute the crown jewel.

In 1993, the company bought The Boston Globe. Unfortunately, this is exactly the kind of paper that will be hurt by online news sources. Second-tier major city dailies are not in a strong position, because they try to be all things to all people.

A newspaper can thrive by dominating a specific niche. That niche can be geographical or topical. Community newspapers can thrive, because they still have no real competition. The news they report is unique. It is very important to a very small group of people.

A company that owns clusters of these papers in wealthy suburbs will do fine. By reporting on local schools, sports, and events these publications set themselves apart from all other news sources. They have a mini-monopoly both on the news they provide and on the ads they run.

There are places in states like New York, New Jersey, Connecticut, and Pennsylvannia where advertisers benefit from targeting specific communities, because the demographics of the next town over are not nearly as attractive. A lot of this has to do with public schools. I don’t see that system changing anytime soon. So, I imagine these properties will fare much better than big city newspapers.

The New York Times Company has one great asset – its brandThe New York Times and The Wall Street Journal each have a very valuable national brand. People all over the country have been exposed to them through other media outlets. The value isn’t really in the size of the circulation. If you think of the entire country as their potential market, their circulations are tiny (the news business is very fragmented).

A few years ago, it would have been crazy to think of the entire country as a potential market for these publications. But, I don’t think that’s the case today. These papers could earn a lot of money online. Of course, they have to figure out how to earn money online.

Long-term, I don’t like the idea of expensive online subscriptions. It looks like a great idea now, but it could limit future ad revenue. Becoming a dominant online news destination would prove extraordinarily profitable. Unfortunately, no one is going to capture more than a tiny sliver of the online news market by charging a lot of money for their …

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