Crunch Time for the Martha Mess

The outcome of Stewart's trial, just weeks away, could have a bigger impact on the stock than MSLO's mostly solid fundamentals do

By Eric Wahlgren

Log on to www.marthastewart.com, and you'll see the word "JOY" featured prominently on the lifestyle maven's site, which has been spiffed up for the holidays. But few Martha Stewart Living Omnimedia (MSO ) staffers are likely to be caroling fa-la-la-la-la at Manhattan headquarters this season. Stewart, the media company's founder, is weeks away from criminal trial on her alleged role in an insider-trading scandal.

Her legal woes continue to weigh on the performance of the company she built from scratch. MSLO, which went public with great fanfare in 1999, posted a 28% drop in revenue, to $51 million, in the third quarter ended Sept. 30, in part because of a big decline in advertising and circulation revenue at its flagship Martha Stewart Living magazine.

As a result, MSLO lost $3.8 million in the quarter vs. a $2.8 million profit a year ago. Analysts had actually been expecting worse. Nevertheless, since the stock's $39.75 closing high shortly after the initial public offering four years ago, the stock has deflated like a botched ginger-pear soufflé, down 76%, to about $9.45 recently.

NOT SO BAD.

  Investors do have some reason for cheer, though. MSLO is performing better than Wall Street had anticipated amid the negative publicity surrounding Stewart's problems with securities' regulators. That's largely a testament to "the fine management" that remains in place after Stewart turned the reins over to longtime associate Sharon Patrick, now president and chief executive, says Morningstar stock analyst T.K. MacKay in Chicago.

Says Roderick Powell, a senior equity analyst at independent research firm Weiss Ratings in Jupiter, Fla.: "To be honest, I don't think the company is in such bad shape." Retail sales of Martha Stewart Everyday products fell 12% in the third quarter. Most of that, though, was because Kmart (KMRT ), the main outlet for the goods, continues to shutter stores. Sales of these wares rose an encouraging 3% at Kmart stores open at least one year (same-store sales), wrote Kevin Gruneich, a Bear Stearns analyst in a note to investors. He has an underperform rating on the stock.

Powell, who rates the shares hold, says same-store results are a clear sign that consumers like MSLO products. And Gruneich writes: "It was impressive that revenue in each of the four operating sectors was better than we had anticipated, even if each sector beat our revenue expectations by less than $1 million." MSLO's other three units are publishing, TV, and Internet/Direct Commerce.

PREFERRED SCENARIOS.

  However, surviving in the increasingly crowded homemaking field isn't the same thing as growing at a rate that's attractive to investors. Most analysts now have little better than a hold rating, or the equivalent, on the stock. Wall Streeters and other experts who watch MSLO say several things will need to happen for it to climb out of its funk.

Topping the list of preferred scenarios would be a favorable outcome, such as a not-guilty verdict, in the Stewart trial, slated to begin in mid to late January. Fallout from Stewart's December, 2001, sale of ImClone Systems (IMCL ) shares on the day before the biotech company announced that the Food & Drug Administration had rejected a drug application has tainted MSLO. (Stewart faces obstruction-of-justice and securities-fraud charges on comments she made about her sale. If found guilty, she could get 10 years in prison.)

"The brand has taken an enormous hit," says Robert Passikoff, president and founder of Brand Keys, a New York-based customer-loyalty and branding consultancy. Third-quarter publishing revenues plunged more than 37% as advertisers continue to be wary of some MSLO titles in the run-up to the court battle. "A vindication would help heal a lot of sores," Passikoff says. By Eric Wahlgren

"ALL BETS ARE OFF."

  However, anything short of that will be problematic, Passikoff and others say. Stewart insists she's innocent, saying the reason she got rid of the stock is that she had a standing order to sell once it dipped below a certain price. If the court finds otherwise, the brand will suffer further, Wall Streeters agree. "If Stewart is led away in handcuffs, all bets are off," says Powell.

He and others are quick to add that they believe MSLO will pull through, even in this worst-case scenario. Still, the repercussions could be severe in the short term. MSLO execs were not immediately available for comment. But CEO Patrick has been quoted saying the company would rebound even if Stewart goes to jail, although the comeback would cost more and take longer. In MSLO's third-quarter earnings statement, Patrick said "consumer demand for our products indicates that we are retaining our large core of loyal readers, viewers, and shoppers."

The impending trial highlights what analysts had been suggesting even before Martha's legal dust-up: MSLO, which logged nearly $295 million in revenues in 2002, needs to reduce its reliance on Stewart's name -- not just because of the trial but because she won't live forever. "The company has to distance itself from Martha Stewart the person," MacKay says.

ANOTHER OUTLET?

  "They've already taken some steps," he adds. Among them, MSLO has launched a syndicated weekly TV show called Petkeeping with Marc Marrone, which has been well received. It has also launched Everyday Food. "The new magazine has done well so far, but I think they could do better in creating non-Martha-branded products," says Dennis McAlpine, managing partner of Scarsdale (N.Y.) independent research firm McAlpine Associates.

MSLO has the financial wherewithal for new endeavors. It has no debt and about $175 million in cash on the balance sheet. "It gives the company a lot of financial flexibility" to plow money into new areas that aren't directly associated with Stewart, says MacKay.

Another step several MSLO observers say they want it to take is looking for another retailing partner. With some 600 fewer stores than a year or so ago, Kmart is selling less Martha Stewart products. The deal, which provides generous royalty payments to Martha Stewart, runs for four more years, but Kmart has its own set of daunting problems even though it has emerged from bankruptcy. "These deals are renegotiated a lot," Powell says. "Going forward, I think the company would help itself by partnering with other retailers that have a more upscale image."

EXTREME MEASURES.

  A priority, too, should be stanching the red ink at the money-losing Internet/Direct Commerce business, analysts say. Cost-cutting and other initiatives have helped narrow EBITDA (earnings before interest, taxes, depreciation, and amortization) losses in the unit to $1.7 million in the third quarter from $5.9 million a year ago. But analysts say MSLO has backed off from a goal of having the segment break even in 2004.

"When a company is in trouble, the obvious thing to do is cut back on money-losing operations," says Peter Cohan, a management consultant in Marlborough (Mass.) and author of management book Value Leadership. "It's not clear to me that they can't outsource some of these operations."

If the trial's outcome proved disastrous for Martha Stewart, MSLO might have to consider more extreme measures. Selling the company or changing its name could be possibilities, says Powell.But, cautions Cohan: "I would not count out Martha Stewart. One of the beautiful things about America is that there are a lot of second or third acts for people who are smart and talented."

At this point, the same could be said for the company developed by Stewart, who already has a couple acts under her own belt -- she's a former model and a former stockbroker. But investors looking for a promising stock might want to see if MSLO's next act is a comeback before investing.

Wahlgren covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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