Martha Stewart Living Headed Back to the Slammer

• Buy MSO March ‘08 $15.00 Puts around $5.00

I’ve never been a Martha Stewart fan. I have to admit, I was happy when her arrogant smile disappeared as she and her nauseatingly perfect arts & crafts were hauled off to prison.

So I’m doubly happy to see her company, Martha Stewart Living Omnimedia (NYSE: MSO) now such an appetizing target for selling short.

MSO recently reported a quarterly loss of $4.4M, which actually beat expectations. But a closer look at the report shows that the future may not be so bright…

1. MSO reduced 2007 revenue guidance to $330M from $340M.

2. TV revenue dropped 13% YoY on lower ratings for Martha’s shows. To me, this is a clear reflection of her waning popularity and cultural relevance. While she may have a hardcore group of loyalists who will continue to subscribe to her magazine and buy her licensed products, a lower TV audience means that customer growth will likely be limited.

3. MSO is counting on a new deal with Macy’s to license home goods to replace the $40M in guaranteed annual revenue it no longer will get from Sears. However, I don’t believe that this is the ideal time to be counting on home goods as a major growth engine given the slumping housing market. Just look at the stock charts of leading home furnishing retailers Pier One (PIR), Bed Bath and Beyond (BBBY), and Cost Plus (CPWM), and tell me that you think this is a great space to bank on.

4. MSO’s one impressive feat was its 40% increase in ad revenue in its publishing segment. But are magazines really going to drive MSO’s growth? Ad spending is increasingly being pulled away from print towards digital (see recent Financial Times article), where MSO still has a weak presence (internet contributed <5% of total revenue).

5. MSO has a forward P/E of 21 and a P/S of 1.8, valuing the stock as a high- growth company. Yet analysts are only expecting MSO to grow sales by 5.6% next year. Despite it’s trading at a substantial premium to leading publishing and media companies like Meredith (MDP), Time Warner (TWR), and Disney (DIS). This for a company that’s not yet cash flow positive.

And I have yet to touch on the biggest risk of all faced by MSO- Martha Stewart herself. Like any company so dependent upon one person, any tragedy (or in her case, criminal recidivism) would decimate the stock.

As always, I recommend buying puts to limit the downside risk of selling a stock short- you never know when some head of a PE shop will get a crazy idea from his Martha Stewart-loving wife.

In this rocky market, there’s always a chance that the Fed may raise rates and spark a rising tide that lifts all boats, including MSO. For that reason, I’d look to scale into MSO puts- buy some now, and possibly more in a few weeks once the Fed’s action is clear.

Disclosure: SmartGuyAB owns MSO March ‘08 puts

Selling MCD Options to Lock in Profits

• Sell MCD March ‘08 45 Calls around $14

Although I still like McDonald’s (NYSE: MCD) the business, I am concerned about the stock in the current market environment. Given that options are much riskier than equities, I recommend selling the MCD March ‘08 45 Calls into strength around $14.

MCD’s rich valuation (Forward PE 19 v. S&P Forward PE 16) is predicated on the successful rollout of premium coffee and smoothies. I believe the objective will be successful, but I am afraid the expectations have ignored the possibility of any kinks during the rollout. I have heard that franchisees have challenged the initiative because they will be asked to invest $100,000-200,000 in new equipment. If the challenge lasts longer than anticipated, we may be able to buy more options at a better price in the future. Either way, I like locking in gains when faced with a very dark macro environment. Now let’s go grab a coffee at McDonald’s …

Disclosure: SmartGuyDH no longer owns MCD options

Selling 1/2 DXPE to Lock in Profits

• Sell 1/2 DXPE around $47.30

I’ve written a lot about one of my favorite companies for the long-term, DXP Enterprises (NASDAQ: DXPE). I initially recommended DXPE in the low 40s, only to watch it get punished by the market due to what was perceived as a lackluster quarter. At that point, with the stock languishing in the low 30s, I recommended doubling down on the stock to take advantage of the market overreaction.

I was right: the stock has climbed back above 47. While my original thesis of industry consolidation is still sound and I still believe in the company over the long-term, my reason for doubling down on the stock is now gone as we have made over 40% on the second trade in less than 4 months.

DXPE is a small cap whose only major catalysts are quarterly earnings. Until that time, it will fluctuate based on general market conditions. Given the current market uncertainty, I am closing our second trade on DXPE in order to lock in profits. If the stock dips again to unreasonably cheap levels, we will be buyers again. Depending on your risk tolerance, you may wish to sell or hold all of your DXPE holdings now and re-evaluate around next quarter’s earnings report.

Disclosure: SmartGuyAB is long DXPE

Update: Selling CVA on US Energy Bill Issue

• Sell CVA around 26.60

This morning I was informed that Senate Majority Leader Harry Reid and House Majority Leader Nancy Pelosi have reportedly decided to remove the federal renewable portfolio standard (RPS), as well as all tax provisions benefiting renewables from the proposed US Energy Bill. Thus, I recommend selling Covanta Holding Corp. (CVA) and locking in gains until the issue has been decided.

The issue matters because if the federal tax credits for renewable energy are gutted from the bill, no projects will receive financing until tax credits are guaranteed. Thus, the entire industry will come to a halt (like it did a few years ago when the credits were allowed to expire before being renewed).

Legislators say they will deal with the tax credits and RPS next year, but the simple act of creating an unknown will have the practical effect of destroying the sprouting renewable energy companies in solar, wind, biomass, and more. Moreover, nothing gets done in an election year, so financiers will be even more skeptical about funding clean energy projects.

I hope the Democrats do not sell out the entire renewable energy industry, but I cannot afford to bet on politicians. I will keep you updated as things proceed.

For more information on the issue, check out the detailed report at Renewable Energy Focus.

Update: Closing BBI Puts Position

•  Sell BBI Jan ‘08 7.50 Puts around 3.40

After eight trading days, I recommend closing your position of BBI puts at $3.40 to lock in a 36% gain. I still believe BBI is in major trouble. Therefore, if your risk tolerance permits, feel free to ride your puts longer. Personally, after watching the stock’s price action since their earnings announcement on November 1st, I would rather lock in my gains and trade the puts on daily pops and drops.

If you are raising cash, do not rush to jump back in this schizophrenic market. Better to see whether the bulls or bears will control Q1 …

Let PETS purr its way into your portfolio

• Buy PETS around 12.55

Successful investing, especially for the long-term, is all about spotting societal trends. So it was with great interest that I looked at the recent bestselling business book, Microtrends, which seeks to highlight some of the biggest current cultural shifts. Not only is the book an interesting read, but it validates two major trends that we have highlighted at SmartGuyStocks: the growing demand for video games among adults (see SGS picks Nintendo and Activision), and the increasing popularity and importance of pets in our lives. It is this latter trend that I would like to revisit.

When I made PetMedExpress (NASDAQ: PETS) a SmartGuyStocks selection in June, I cited the fact that people are increasingly likely to think of their pet as a member of the family. They are thus more apt to not only put money into Fido’s health care expenses, but to think of those expenses as a necessity. I reasoned that PetMedExpress, the leading retailer of pet medications, stood to benefit. Recent press has re-affirmed that this trend is still strong: the American Pet Products Manufacturers Association (APPMA) reported that pet ownership has again reached a new high in 2007, and spending on pets overall and medications in particular are expected to rise in the high-single digits. In an article for the website Small Business Trends, the CEO of Embrace Pet Insurance predicted, “online veterinary pharmaceuticals will become more main stream. Pet lovers want, and are demanding, the same treatment options for their pets as they can get for themselves.”

Since my selection of PETS, the company certainly hasn’t disappointed. They’ve reported two stellar quarters of top and bottom-line growth, handily beating analyst expectations each time. As I recently noted, the company is successfully retaining its customers and actually reducing advertising as a % of sales, ensuring a sustainably profitable business. Most importantly in this time of credit turmoil, PETS is cash flow positive and has zero debt. In addition, they are actively buying back shares. Yet the stock has inexplicably dropped over 20% from its highs, much of that in recent weeks.

With the recent credit panic in the market, it appears that investors must be thinking of PETS as a consumer discretionary stock, lumping it in with Petsmart (NASDAQ: PETM) and other struggling retailers. Let me see if I can follow the logic: oil prices high, dollar low, consumer confidence suffers… Fido has to die of heartworm? I can see how penny-pinching consumers might not want to buy that expensive Coach (NYSE: COH) purse or even that newfangled birdhouse from Petsmart, but I highly doubt that they will deprive their beloved family pet of necessary medication.

In fact, if anything, PETS stands to benefit from any consumer thriftiness. With lower prices than vets, consumers are more likely to jump online and order from PETS if money is tight. This is not unlike Jim Cramer’s recent rationale for jumping on the bandwagon and recommending SGS pick McDonald’s (NYSE: MCD). If a recession hits, consumers will still have to purchase necessities like food or medication, but will be more likely to seek out the low-cost providers like MCD or PETS.

With impressive growth and financials and the tailwind of a strong macro trend, I recommend taking advantage of this recent market downturn to double-down on our long-term bet on PETS.

Disclosure: SmartGuyAB is long PETS.

Living on a Prayer: Blockbuster is the New Tower Records

After mulling through the transcript from Blockbuster’s (BBI) conference call and listening to today’s analyst day, I cannot help but think of another business that stubbornly focused on physical sales in an increasingly digital and internet dominated world: Tower Records. In case you are unaware, Tower Records was a flagship store to music like Blockbuster is to movies. However, the company got too far behind the curve as consumers shifted purchasing habits online, and the business ultimately went bankrupt.

Although I am not foretelling Blockbuster’s bankruptcy, I think the current quarter held many ominous signs. First, management has decided to surrender to Netflix (NFLX) in the online rental battle. This is a mistake. More people will still shift to online rentals as they get comfortable conducting more of their lives online. It’s easier to pick a movie at the office and not worry about stopping anywhere on the way home. Habits are slow to change, but they are changing (as evidenced by the success of Amazon – AMZN).

These same people are more likely to move from in-store to online delivery before jumping all the way to downloads. If they weren’t ready to rent online, do you think they have top quality broadband for a two-hour stream? Do you think they want to watch on their PC screen? These people are probably not tech savvy enough to have the computer hooked into the entertainment center, otherwise, why was renting online such a challenge for them? Thus, Blockbuster has erred in giving NetFlix the next wave of online renters.

Second, people who had horrible experiences with Blockbuster Total Access are surely not interested in trying out the BBI download service. Those dissatisfied customers are already moving over to NetFlix, which has its own download service that is already superior to Blockbuster’s. Please, go to blockbuster.com and tell me if you can figure out how to download a movie. You cannot because on analyst day CEO James Keyes said we shouldn’t expect the move until late Q1 ’08. That gives NFLX almost a year head start on downloads (and Redbox, Walmart (WMT), and Walgreens (WAG) already have a first-mover advantage with kiosks).

Third, Blockbuster has a new CEO James Keyes who did a brilliant job at 7-11, but his focus on in-store retail compliments is not new. Although in-store promotion may be more aggressive (and annoying), Blockbuster has been selling movies, candy, ice cream, and magazines for as long as I can recall. In fact, two weeks ago my local Blockbuster started selling movie posters. Sounds like a good idea if you don’t get out much. But if you noticed that they are $39.99 and you can buy the same posters on posters.com for $3.99, you know it’s a dumb move. The move is so bad that after 14 days, more than half the posters in my local store are already 50% off. Analysts were skeptical about retail since they too know BBI has offered these extras for a long time. Further, one of the worst signs for an investor is when companies shift focus from their core business to incremental revenue opportunities. Such a shift is occurring at BBI.

Bottom line: retail is not new and BBI is not the place to pick up soda and candy if you are not renting a movie. That’s what 7-11 is for. And with gas prices starting to rise again, I doubt people will pay extra at Blockbuster for what is cheaper at the quickie mart, Target (TGT), or posters.com. Shareholders want store closures, online rentals, kiosks, and downloads (basically, they want BBI to move with consumer behavior trends instead of grasping the dying past). Keyes is on the wrong track by focusing on bringing more customers into the store and selling them extras, and analysts are well aware. Like President Bush said, “Fool me once, shame on … shame on you … a fooled man can’t get fooled again.”

Keyes may have been great at 7-11, but he is not the messiah. Shareholders have been hearing this same hype for a couple years. On analyst day Keyes revealed very few details. He drastically overused the words “hope,” “potential,” and “brand value.” Analysts pointed out bad same store sales, customer base erosion, increasing competition from Walmart, Redbox, Walgreens, and NFLX. One analyst asked about domestic same store sales being down 9-10%, and Keyes responded that he wants to get more people back in the store. Genius. So does every CEO who loses customers. And when asked how, he again used the magic red flags “hope,” “potential,” and “our powerful brand.” That great brand hasn’t done anything for BBI to fend off competition and a dying business model. Why now? Keyes had no good reasons. But he is “excited” to be working at Blockbuster and has a lot of “hope” about the “limitless potential.” I could almost hear the soundtrack in the background playing Bon Jovi’s classic “Living on a Prayer.”

Fourth, Blockbuster announced a new advertising relationship with Facebook, but college students get their movies free. If you know anyone in college, you know they have all their illegally downloaded free movies on their hard drive or copied onto blank DVDs. This is the same anecdotal evidence that the music business ignored. I noted how Warner Music Group (WMG) has been pained by their missteps, and BBI seems to be following suit. BBI’s relationship with Facebook is nothing more than a set of elder executives trying to catch some of the white-hot buzz surrounding Facebook. Contrary to Blockbuster’s opinion, getting poked by Blockbuster is probably not very cool. And I have read numerous articles interviewing Facebook users who declare they have used the site since near inception and never clicked on an ad. WMG has been marketing on MySpace and Facebook since the sites were new, and look what that has done for their stock. Lastly, Netflix and movie critic sites are free to create their own Facebook widgets and profiles. The return on investment (ROI) for this marketing plan will be as stellar as BBI’s nonexistent revenue growth.

BBI is now trading with a forward multiple of 40. Such a multiple is warranted for a super-star turnaround that has been growing the top line. Unfortunately, revenues at BBI have been decreasing steadily year-over-year and the bricks-and-mortar rental business model is heading toward extinction. At best, I would pay 20 times earnings as a spec flyer that something extraordinary may happen. That would put the current price at $2.40 and close to book value.

On a technical basis, trading volume on the two recent up days has been below average. This is a clear indication that buying was simply shorts taking profits as we head back toward $4. I do not anticipate strong buying any time soon because the big players have already given BBI a ride and big money does not have big patience. Thus, most are selling and will move on to greener pastures.

I think CEO Keyes said it best at the end of analyst day when he nervously stated, “I assure you that all the moving parts will come together at some point.” Not exactly the beacon of confidence and clarity. As I wrote the other day after BBI’s earnings announcement, Blockbuster can play lots of MBA tricks for a while. However, shareholders and customers alike know when they see another Tower Records.

Disclosure: SmartGuyDH owns BBI puts

DXPE’s third quarter brings redemption

The last week in October was a good one for SmartGuyStocks. Two-time pick DXP Enterprises announced third quarter earnings that trounced analyst expectations, sending the stock up over 15%. The announcement must have been extra sweet for DXPE CEO David Little, who just months prior was derided as a bumbling idiot as he struggled to account for the second quarters’ “unexplained” June sales softness.

Little feebly tried to mention that DXPE still expected top-line growth of 30+% in the third and fourth quarters, and that the acquisition pipeline looked stronger than ever, but the analysts had apparently already checked out. Disgusted that DXPE had “only” reported 22% sales growth, they sent shares down over 25% in one day. At that point, we decided to re-recommend DXPE at a bargain price in the low 30s. It looks like Little has been true to his word, first by landing a major acquisition of Precision Industries, and then by announcing a 56% increase in third quarter sales and a 25% jump in EPS. He also noted that the Precision acquisition has been exceeding expectations, expediting DXPE’s ambition to be a national distribution powerhouse.

Now that Little has redeemed himself to his critics, at least temporarily, it’s back to the thankless work of consolidating the industrial distribution industry.  I continue to recommend buying on any weakness as we watch this growth story continue to progress. This is going to be fun.

Disclosure: SmartGuyAB is long DXPE

Activate Activision

• Buy ATVI Jan ’08 17.50 calls around 6.10

Blue chip video game publisher Activision Inc. (Nasdaq: ATVI) will announce earnings this Monday, November 5^th. Given recent market turbulence, shares are trading lower than they should given Activision’s complete domination in the publishing space and their recent launch of blockbuster Guitar Hero III. Like Microsoft’s (Nasdaq: MSFT) stock pop following the successful launch of Halo 3, ATVI should experience a similar pop when they announce better-than-expected earnings, awesome initial sales numbers for GHIII, and exciting forecasts for other holiday blockbuster releases.

ATVI shares have also seen resistance as a result of Electronic Arts’ (Nasdaq: ERTS) distribution deal for a new music game called Rockband. Near-term concerns about Rockband are overdone for the following reasons:

1) ATVI beat EA to the punch by releasing GHIII much earlier than Rockband (release Nov. 20). I believe most gamers have been impatiently awaiting a new music game, and ATVI has captured such demand.

2) GHIII is more than 50% cheaper than the $199 Rockband. Given that parents already complain about video game prices like businesses complain about rising energy costs, I think Rockband has the wrong price point for mass sales. I think the more expensive game will appeal to music aficionados, while GHIII will maintain its phenomenal mass appeal.

3) GHIII is available on all three game consoles, while Rockband is not available on the most popular console, Nintendo’s (OTC: NTDOY.PK) Wii.

Although I think Rockband has potential to compete with GHIII in the long-term, I do not think the new competitor will hurt GHIII sales this holiday. That is why I am recommending the January ’08 call options for a short-term trade, and we will reevaluate ATVI sometime in late January once industry holiday sales are tallied. If you want to buy stocks in this sector, see my previous article about Nintendo at SmartGuyStocks.com.

Disclosure: SmartGuyDH owns Jan ’08 17.50 calls

BBI: Trick? Or, Treating Shareholders & Customers like Busters?

• Buy BBI Jan ‘08 7.50 Puts around 2.50

Blockbuster Inc. (NYSE: BBI) reported a 30% increase in losses yoy to $0.15 a share. The video rental company also saw revenues drop 5% to $1.24 billion, missing analyst expectations of $1.28 billion. The major blemish with Blockbuster’s frightful post-Halloween announcement was the scary drop in online subscribers to 3.1 million from 3.6 million only one quarter earlier.

Bulls and bears have been battling over whether incumbent BBI or newer online video rental company Netflix Inc. (Nasdaq: NFLX) will win the video rental war. Today’s subscriber numbers show that BBI may be fatally falling behind. Management has continued failing experiments with their Blockbuster Total Access online plan. As a current member who plans on canceling next month and joining Netflix, I know every reason why Blockbuster continues to fail.

First, Blockbuster’s online service is like a high school student’s final project for an ‘Intro to E-commerce’ class. During the first three months, my wife and I have sent customer service six complaints regarding failures for our next movies to ship when others were returned, the unbelievable 3-4 days it takes for a movie to arrive after it supposedly shipped (Cf. Netflix arrives in 1-2 days), and failures for our movies to be registered online as ‘returned’ when they were scanned at the store days earlier. When I complain at the in-store locations they blame the “online people,” and when I spoke to a customer service rep from Blockbuster Total Access, she blamed the store employees. The only buster in this scenario was me!

Second, I recently upgraded my plan to receive an extra DVD in the mail at the expense of my unlimited free in-store exchange rentals (which reminds me of another NFLX advantage: cheap unlimited online downloads). I made this choice because the online selection is better than in-store (although still far inferior to the availability of titles on Netflix – by the way Blockbuster, “Long Wait Time” does not count as an available title). To my great dismay, for more money a month I now receive less rentals because BBI takes forever to send my next rentals. I do not want to declare a conspiracy theory, but since Blockbuster Total Access has been bleeding money like a victim in Friday the 13^th, I would not be surprised if internal strategy involves delaying shipments just long enough to make the business more profitable. Should the customer receive crappy service because a business started selling first and thinking second? I, like 500,000 other subscribers, seem to think not.

My favorite moron analyst comment of the day goes to Sterne, Agee & Leach analyst Arvind Bhatia who said Blockbuster is shifting the focus away from its online service because the company believes their first quarterly loss of subscribers is a sign that online DVD rentals may be peaking and facing a slowdown. If this is true, why is Netflix growing? I’ll give you a hint Arvind: they are taking business from BBI. Yet another example that BBI management and their crony I-bankers have no idea where they are steering the ship.

But we should feel safe as a babe in mother’s arms because Arvind said “Blockbuster is going to be improving the profitability of its business rather than focusing on online subscriber growth … That’s a good thing.” Really? Losing market share and decreasing revenue is good? Did you learn that in college or at your Sterne, Agee & Leach training? Seems like BBI thinks both shareholders and customers are busters for the taking.

Disclosure: SmartGuyDH owns Jan ‘08 7.50 Puts