Tuesday, May 31, 2005

"There Was Something Really Missing With This Guy"

He liked publicity, he liked the limelight, and, most of all, he liked seeing his name on things.

He was a charismatic, well-spoken man with an interesting and oft-told personal story (“I happen to be a Cuban refuge,” he would say, even though his father had been a Cuban businessman who settled in New Jersey—not exactly the strap-the-Chevy-to-some-inner-tubes-and-row-through-the-shark-schools variety “Cuban refuge”).

Nevertheless, he made his fortune in technology stocks, and it was that money he used to fund his favorite cultural institution—specifically, the opera.

He spoke freely and often about his own generosity. It was, he said, about leaving a “moral and intellectual legacy.” Those high ideals prompted him to encourage others to be as generous as he: “My goal is to keep this extraordinary part of my culture alive.”

Despite the high profile he himself maintained, he had a thin skin when openly criticized:

“They said I only give money to people I like,” he grumbles [in an interview]. “You want me to give to people I hate?”

In fact, at times, if you ignored the expensive suits and the money and listened to what he actually said, Alberto Vilar, the world-famous, globe-trotting, recently-arrested-for-alleged-fraud co-founder of Amerindo Investment Advisors, sounded like a good case study for some doctors in Vienna.

He “liked his name writ large,” as one opera buff put it, slapping his name not only on Opera House halls but on the tiers inside the halls. He even suggested—I am not making this up—that opera donors should get bigger program billing than composers.

He also complained vocally about others not as generous as he: “I cannot do everything myself,” he once wearily proclaimed. He called Bill Gates “hopeless” and said Gordon Getty “gives peanuts.”

As Donald Trump put it more perceptively than anyone, in today's New York Times, “there was something really missing with this guy.”

Vilar always insisted the dot-com implosion had not crimped his style, despite slow-paying some of the more visible gifts he had made, and the beneficiaries of his largess tended to believe him, because they wanted to. “He reckons he can give away $50 million a year without feeling the pinch,” one opera magazine interviewer reported in 2001. Ominously, the Denver Post reported he was behind on mortgage payments for three Vail-area vacation homes, and facing foreclosure, in 2003.

Nevertheless, investors trusted Alberto Vilar. So they gave him their money—$8 billion worth, at the peak. They liked his story, they liked his early success in technology stocks, and many stayed with him way too long.

He was arrested at Newark Airport on Thursday, after returning from giving a speech at an investment conference, and is being held at the Metropolitan Correction Center in Manhattan, because the man who could “give away $50 million a year without feeling the pinch” could not make his $10 million bail.

It is yet another cautionary tale, in a world full of them, about the dangers of believing what we want to believe, and ignoring the reality behind the words.

Jeff Matthews
I Am Not Making This Up

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.

Saturday, May 28, 2005

Weekend Edition: Where Would They Go?

They're back.

"They" are a pair of Yellow Warblers--small, quick, pretty birds that winter south of Mexico and return, each May, to a little patch of earth located in Southeastern Rhode Island, to breed.

The male, a deep yellow infused with red streaks on his breast, is the most visible--establishing the territory, helping build the nest, and feeding the nesting female. The female is a duller yellow-green, and not very active once the nest is built.

The patch of earth this pair inhabits each summer is in fact a mere quarter of an acre of bayberry, rugosa and beach plum that sits next to our house, in a quiet neighborhood on a sandy little spit of land located about 20 miles across Block Island Sound as the warbler flies from Sagaponack and the investment banker-laden traffic jams on Route 27 in Eastern Long Island.

Each year this quarter acre of non-descript scrub land gets more precious, as the last remaining open lots of land in our area get bid up and bulldozed flat, to make way for yet another three-story Sagaponack-style McMansion with fake stone foundations and enough wood shingling to clear an Amazon rain forest.

Our quiet little area gets less and less quiet each summer.

It would be easy enough--and profitable enough--to auction off a quarter acre of still-virgin land 75 yards from the water. It needs no advertising: cars slow down on the way to beach as the drivers look at the arrowwood and rugosa and poison ivy and bayberry, wondering. People around here ask me all the time what my plans are.

My plans are to keep it the way it is.

This year, for the first time, I saw the pair of warblers flying together. Usually I see only the male, alone--singing from a branch or feeding on insects. Some days in the hottest afternoons of July he comes out when I'm watering the raspberry canes and grape vines and blueberry bushes, and takes a shower, flitting in and out of the spray.

Yesterday, however, I saw both the male and female: they took off out of the bayberry and flew an undulating path across our neighbor's back yard, abruptly diving into a stand of rugosas about fifty yards away. Probably the weather has been so cold and the spring so late that they had not started their nest.

It's quite something to think of these two tiny feathered creatures--after spending all winter somewhere in Bolivia or Brazil or Peru--making their way over Mexico and Florida, all the way back to this little quarter acre of land to nest.

So, the way I see things, it's not my quarter of an acre, it belongs to the yellow warblers right now, and others that will join them. Soon I expect to see the Common Yellowthroat--another warbler, only the male has a kind of black face mask, which makes the throat look especially yellow--preparing a nest in the rugosas. And there's a robin that has his eyes on an arrowwood bush for a nest, while the cardinals are stripping the thin, flexible bark from the grape vines for their nest in a tree across the road.

Before summer ends, the goldfinches will feed on the thistle and the swallows will bulk up on the waxy bayberries before heading south. And the quarter acre will be mine again.

That's when I'll start clearing out the bittersweet and other invasive vines that always threaten to overwhelm the food producing plants and the good nesting bushes that feed and nurture these little guys.

So that this little quarter-acre will be ready for next spring, when they come back.

Jeff Matthews
I Am Not Making This Up

Friday, May 27, 2005

AutoZone: A Tale of Two Companies, Part II

Whatever its current investment merits, AutoZone used to be a great company.

The company’s philosophy was summed up in the acronym “WITTDTJR”—whatever it takes to do the job right—and employees proudly refer to themselves as AutoZoners.

Reflecting the Wal-Mart cultural DNA of its founder, “Pitt” Hyde, who served on Wal-Mart’s board, a gaggle of clean-cut AutoZoners would materialize at investment conferences and wow the audience by doing the AutoZone cheer.

Nowadays, the main corporate cheerleader on the conference circuit is CFO Mike Archbold, a scrappy sort of fellow with a ready answer—no matter how silly—for any question, especially any question that sounds even vaguely critical of the company.

Archbold is probably a very competent CFO, and he certainly is convincing when it comes to explaining the company’s aggressive share repurchase plan and its strict adherence to requiring a 15% internal rate of return on “everything we do.”

But his slide show is often unintentionally funny—such as the slide which shows “$60 billion in unperformed maintenance each year” on U.S. automobiles. The genesis of the notion that there is such an untapped gold mine for the auto parts industry lies in the fact (according to the slide) that there are “25 million activated CHECK ENGINE lights” blinking in U.S. vehicles.

The logic being, apparently, that if everybody actually had their engines checked after the “Check Engine” light went on, it would generate $60 billion in revenue. That would be double the annual sales of the entire do-it-yourself auto aftermarket industry.

As anybody with a car knows, of course, the “Check Engine” light goes on pretty much every time you slam the door too hard. Drivers become trained to ignore the “Check Engine” light until the engine fails to turn over when you turn the key, or sparks start flying out of the dashboard when you press the accelerator.

In fact, there is probably a “Check Engine” light on in the Space Shuttle at this very moment.

But getting to the point here: as we touched on in yesterday’s introduction, AutoZone—the market leader in do-it-yourself auto parts retailing—has been losing market share for more than two years. And nothing in Archbold’s slides get to the heart of the problem.

It was not always this way; in fact, AutoZone used to outperform its peers. Its same-store-sales were consistently higher than other public chains, despite its larger base of stores (3,505 at last count) and longer operating history.

Then, along around late calendar 2002, that began to change. When industry sales softened along with a weak economy, AutoZone’s same-store-sales dropped into negative territory and have lingered in that region, slightly plus or minus, ever since—despite a strong industry recovery beginning in late 2003.

After four or five straight quarters of this widening gap, CFO Archbold—the man with the “Check Engine” slide—began adding another humorous slide to his show, this one depicting how movements in the price of gasoline have affected AutoZone’s sales.

It’s a very pretty chart, with colored lines and lots of data—and Archbold explains it both earnestly and with a straight face. But rising gasoline prices have nothing to do with the reason AutoZone is falling behind its peers. After all, they share the exact same customers.

And, as far as I know, pretty much everybody in America runs their cars on gasoline.

Plus, in the most recent quarter, AutoZone's same-store-sales fell through the floor, down 5%, while its largest competitor's same-stores rose 9%. The gap is widening, gasoline prices or not.

The reason AutoZone has fallen behind its competitors is, I believe, that use-any-spare-cash-to-repurchase-our-stock share buyback program, and the 15% IRR “on everything we do.”

Based on the company’s 10K’s, AutoZone has been paring back on advertising expense as well as maintenance capital spending, reducing inventory per store and adding potato chips and soda displays—all in an effort to either conserve capital or add to sales.

Maintenance capital spending, for example, dropped from an estimated $100,000 per store in the late 1990’s to roughly $20,000 each in recent years, and it shows when you walk into the store.

The disinvestment did not stop there, however. It has reared its head most clearly in the company’s efforts to move vendors to something called “pay-on-scan.”

Two years ago the company began widely touting “pay-on-scan” as a way for AutoZone to dramatically reduce the carrying cost of inventories in stores and enhance the company’s cash flow.

“Pay-on-scan” is, essentially, consignment inventory. A vendor of spark plugs and timing belts would no longer sell that stuff to AutoZone’s Memphis distribution center: the vendor would keep ownership of that stuff until it was sold (scanned) at each store, at which time AutoZone would pay the vendor.

Naturally, this would be a cash flow boon to AutoZone, shifting inventory costs to the point of sale rather than the point of distribution. The company suggested “pay-on-scan” would benefit the vendors, too, because they would have more control over how their products were merchandised and sold.

AutoZone management promoted “pay-on-scan” to Wall Street, and Archbold had another slide for his expanding show. By the end of 2004, the company expected to move $200 million worth of inventory to pay-on-scan.

Last quarter, however, the number was only $141 million, and the program has been a bust, for good reason.

The reason vendors do not want to retain ownership of their spark plugs and timing belts until the time of sale goes beyond the simple cash flow drain of carrying their own inventory longer: it becomes a tax and accounting nightmare.

This is because under a “pay-on-scan” arrangement, the vendor of those spark plugs and timing belts sold through each of AutoZone’s 3,500 stores in all 50 states becomes responsible for reporting to tax authorities in all 50 states.

Furthermore, since those spark plugs and timing belts stay on the vendor’s books while they sit in all 3,500 stores, they become part of the vendor’s inventory, for reporting purposes.

How does the vendor’s auditor verify its client’s inventory valuation when spark plugs and timing belts are spread around 3,500 AutoZone stores? And what CEO and CFO can verify, for Sarbanes-Oxley compliance, a company’s books when inventory is sitting in 3,500 AutoZone stores?

These issues with “pay-on-scan” are not theoretical. I have discussed “pay-on-scan” with a number of executives whose companies sell to retailers like AutoZone. Staples, for one, tried to get its vendors to do “pay-on-scan,” and the vendors refused. Those that have gone along with AutoZone tend to be vendors trying to gain shelf space and dislodge other products.

If 20% of AutoZone’s vendors are doing “pay-on-scan,” as the company reported last quarter, it means, of course, that 80% have refused.

Like the $60 billion of so-called “unperformed maintenance” and the fact that rising gasoline prices only seem to hurt AutoZone stores and not Advanced Auto Parts or CSK or O’Reilly, “pay-on-scan” in my opinion merely represents another distraction away from the heart of the AutoZone problem—its accelerating loss of market share.

The real issue is simple: as a retailer with high margins and low growth opportunities, AutoZone must choose to invest in stores or invest in its own stock, or do some reasonable mix of both. And AutoZone has made its choice.

It will be interesting to see if, and when, the resulting deterioration in sales begins to affect the surplus cash flows that the company depends on to buy back its own stock. In which case the choice will become starker.

Meanwhile, those AutoZoners who used to wow ‘em at investment conferences no longer show up—probably because they don’t generate a 15% internal rate of return, which is too bad.

Corporate culture can’t be measured like the decision on whether to refurbish a hundred old stores or buy back a million shares of stock.

But it shows up every day, behind the counter.

Jeff Matthews
I Am Not Making This Up

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.

Thursday, May 26, 2005

A Tale of Two Companies

This about two companies: each is a mature, publicly-traded retail-related entity having a long history of operating several thousand stores, with veteran management overseeing a store culture of customer service and deep product knowledge.

But the similarities end there.

Company A is a financial marvel. It generates a 50% gross margin, 19% operating margin and a 14% return on assets—in an industry where a 45% margin, a 10% operating margin, and high single-digit return on assets are considered exceptional.

So tight-fisted and bottom-line focused is management that Company A never invests in a project that does not provide a minimum 15% return on capital. Consequently, Company A generates surplus cash flow with which it routinely buys back stock.

Company B, on the other hand—remember, each operates in the exact same business—is an operational weakling. It generates negative same-store-sales (the standard industry measure of retail growth), in good times and bad—and blames all manner of outside factors for the poor store results, rather than its own business practices.

Indeed, Company B is losing market share at an increasing rate: the gap between its own same-store-sales and that of its competitors has been widening, virtually quarter-by-quarter, for two and a half years.

Back in the December 2002, Company B’s same-store-sales were lagging its largest competitor by 2%. This past quarter, that same gap had exploded to 14% as Company B’s same-store-sales dropped 5% while its largest competitor’s jumped 9%.

In fact, Company B’s total sales, including new store openings, declined 1.6% last quarter, while that same large competitor grew total sales by 12%.

Who are these companies—Company A and Company B—and in what business do they operate?

They are one and the same company: they are Autozone, the largest specialty retailer of do-it-yourself auto parts and supplies.

Tomorrow we will explore the two faces of Autozone in greater depth, to see how a retailer’s financial success can not only mask its operational weakness, but, in the long run, be its own worst enemy.

Jeff Matthews
I Am Not Making This Up

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.

Wednesday, May 25, 2005

Of Toilet Paper and Misleading Statistics: Is Cuba Next?

You did not read about it in the New York Times—which prefers op-ed pieces extolling the virtues of Cuba’s health care system to wasting ink exposing the rot and decay beneath the surface of El Maximo Lider’s dictatorship—but for the first time in 46 years there was, last week, a gathering in Havana of dissidents working to undermine the dictatorship of Fidel Castro.

Typically, Cuba tried to keep things under control by barring European legislators, of the recently-freed countries Czech Republic and Poland, from attending the rally. While disappointing behavior for a dictatorship which for some bizarre reason enthralls so much of the Hollywood treat-Saddam-nicely crowd, it’s a lot better than the beatings Cuban citizens get when they try to protest in public.

In any event, Times let the modest gathering of Cuban dissidents pass without comment, which is too bad, because it might be the sign of something happening that could have terrific consequences, not only for human rights, but for investors as well.

I have a theory that much of the good will towards Castro is based entirely on the fact that Cuba’s infant mortality rate is lower than the United States’ infant mortality rate.

It’s true: the U.S. rate of infant mortality is 7 per 1,000 live births; Cuba’s is 6. Cuba touts the number every chance it gets, because it’s really about the only good news coming out of Fidel’s 46 years of oppressive rule.

And it is a damning statistic, given our country’s great wealth and vast resources, on the surface.

However, anyone who has looked at the data knows that the U.S. suffers an even greater deficiency in comparison to every fully-developed nation in the world. Austria, Belgium, Finland and France—just to go down the list alphabetically—each have 4 infant deaths per 1,000. Sweden has 3. The U.K. has 5.

Why the gap between the U.S. and the others? The key is immigration and diversity of population.

The U.S. has a far higher immigration rate than any comparable country, and is, consequently, a more heterogeneous population than any of its Western European peers (despite looming immigration pressures in France, Holland and the U.K.). And Cuba is about as homogeneous as a country can get.

Heterogeneous populations, as might be expected, have widely varying infant health care patterns related to different ethnic groups and their living standards. Infant mortality rates in New York City, for example, averaged 6 per 1,000 live births in recent statistics. However, “children born to black non-Hispanic mothers have an infant mortality rate of 10.0, more than twice the rate of those born to white non-Hispanic mothers (4.2),” according to the New York Department of Health and Hygiene.

That’s a despicable gap—two to one, black to white. But given that gap, is the fact that Cuba (population 11 million) has an infant mortality rate equivalent to New York City (population 8 million), really all that special?

There are, after all, no immigrants going to Cuba. In fact, Cuba’s population growth is negative 0.1%, despite a modest 0.1% rate of natural growth. The difference, of course, being people fleeing on boats.

Why bother at all, here, with Cuba’s infant mortality rate and its modest, barely-noticed gathering of dissidents? Two reasons: the first is personal, the second is business.

For starters, I know one of the Cubans who fled the country. His name is Manny, he lives a block away from us, and he is quite an amazing guy. He came to America in 1978 on a boat, speaking no English; he settled in our town, met a girl and married her and now runs a hair salon. Manny’s a home-owner, a tax-payer, and an employer.

Over the years, Manny has helped several of his brothers escape Cuba—although one died in the straits off Florida. Our daughters grew up together. Manny’s house is a mad, wonderful cacophony of Cuban English and Cuban Spanish, with food cooking and kids running in and out, and—every time a new relative flees Cuba—a young Cuban refugee looking for work and adjusting to a new life in America.

Manny roasts a pig in the back yard on special days—such as the day his daughter, Jeanette, graduated from high school. I helped Manny invest his savings for Jeanette’s college education when she was in second grade. Jeanette will graduate from college next year.

Tell Manny about Castro’s great health care system, as reported in the January New York Times op-ed blather by non-Cuban-health-care-system-user Nicholas Kristof, and Manny will snort and ask why, if it’s so great, does his wife have to bring toilet paper with her when she visits his family in Cuba? (Manny is not allowed back to see his relatives.)

It’s a great question, but you won’t see it asked in the Times, and I suspect—like the atrocities in Iraq—the bad news of Castro’s rule will not be fully revealed until he is gone.

The second reason I bother with Cuba relates to making money. Specifically, what happens if Castro goes?

It’s only 112 miles across the Florida Straits to Cuba. Cruise ships, casinos, home builders, construction material companies—all would likely benefit if Castro goes.

It’s worth thinking about, worth asking companies in those businesses what they might be planning, and worth putting together a list.

After many years of speculation on the end of Castro’s regime, the time may be coming sooner rather than later.

Manny, for one, certainly hopes so.

Jeff Matthews
I Am Not Making This Up

Tuesday, May 24, 2005

You Can’t Underprice Free

Bill Gates is not used to losing.

But his company and its government-sanctioned monopoly on desktop operating systems is losing big time as the world moves away from doing things on computers to doing one main thing with computers.

That one main thing being, of course, getting on the Internet.

Once on the Internet, people can read the news, visit their friends, plan trips, buy cars, order the groceries, trade stocks, get a college degree, run their business—and when they flick on their computers, what people care about is finding all that stuff quickly and easily.

What people used to care about when they flicked on their computers was using the newest versions of Excel and Word, Start-buttons and tabs and self-adding tables and insertable charts—stuff that, nowadays, is taken for granted while you're searching for something out in the real world.

And since Microsoft really excels at things like Start-buttons and tabs and self-adding tables—the stuff that's taken for granted—but does a horrible job helping people use the Internet, Google is running away with the ball.

Actually, Google is running away with the advertisers who want to reach those internet users utilizing Google to find what they want. So what we have is an internet-based company in business not to generate “eyeballs” or “reach” but to generate real revenue.

And Google generates plenty of real revenue.

Two years ago, Google’s first quarter advertising sales were not quite $250 million, while the New York Times generated $783.7 million in advertising sales.

This year, however, Google’s first quarter sales exceeded $1.2 billion. Meanwhile, the Times generated $805.6 million in sales.

In other words, Google’s sales grew almost a billion over a two year period, while the Times’ sales grew a little over $20 million.

Oh, and the Times was founded in 1851. Google was incorporated in 1998.

This is why the newspaper industry—and I have owned McClatchy, a very well-managed California newspaper chain, for many years—is in more trouble than it wants to know.

But it is also why Bill Gates is getting—excuse the word—bitchy. He’s not accustomed to losing, and his company is losing ground very quickly.

Just yesterday Gates, like a whiny rich guy—hey, he is a whiny rich guy—whined about Google at a Wall Street Journal technology conference.

Reports today’s New York Times:

“Google is still perfect, the bubble is floating and they can do everything,” Mr. Gates told the moderator sarcastically…

Meanwhile, Gates was announcing the availability of…drum roll…satellite imaging technology that would be available—as always, with Microsoft, some time in the future.

Google, of course, has had satellite imaging up and available since last year.

“There’s going to be a lot of competition in the mapping area,” Gates said, ominously. He promised Microsoft’s mapping service would take things to “a whole new level.”

What Gates doesn’t get, however, is that it’s not about satellite mapping. It’s about search. The maps—Google’s maps are far better than anything Mapquest offers—and the satellite images and the rest of what Google offers is all about keeping you on their search engine.

And since Microsoft’s basic business is encouraging people to buy computers loaded with Microsoft software which does stuff nobody really cares about any more, while Google’s basic business is providing people the best way to navigate the internet—which is what everybody cares about—Gates is probably going to be whining for a long time.

I’m not saying Microsoft will never catch up to Google, technology-wise. One thing about Microsoft—and I made a career out of shorting companies such as Lotus, Netscape, Borland and Novell after Microsoft targeted them for certain death—is they always spend the money and they always, eventually, get the technology good enough for a user to switch to the low-priced version.

But in the case of Google—as with Adobe’s PDF technology—Google is available for free. Therefore, Google has no price structure to defend, except in the advertising world. And as long as Google has the user base to attract the advertisers, Bill Gates will be hard-pressed to undermine Google’s position as the Interstate Highway System of the Internet.

Because you can’t underprice free.

Jeff Matthews
I Am Not Making This Up

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.

Sunday, May 22, 2005

Harry Truman’s Drive

In the winter of 1940-1941, before Pearl Harbor brought America into what would become World War II, mail arrived on the desk of a United States Senator detailing waste and profiteering at a new military camp going up in his home state of Missouri.

The Senator was Harry Truman, commonly known not as the Senator from Missouri, but the Senator from Pendergast—T.J. Pendergast being the despicably corrupt Kansas City politician whose political machine first selected Truman for public office.

Had Senator Truman been the “go-along, get-along” politician most Washington insiders had taken him for, he would have let the disturbing letters go, like every other U.S. Senator did.

But T.J. Pendergast—who would go to jail for tax evasion and later gamble away his ill-gotten fortune—had given Truman probably the best advice ever spoken to a newly elected Senator: “Work hard, keep your mouth shut, and answer your mail.”

Truman did all three, and the letters he received (and answered) described widespread waste and corruption in the production boom spreading throughout a country gearing up to be the “Arsenal of Democracy,” as Roosevelt called the work to supply England in its desperate battle with Germany.

Incensed, Truman decided to see for himself what wasn’t being reported in the Washington Post: so, he got in a car and drove around the country, alone.

Truman drove 10,000 miles, south to Florida, up through the Midwest and on into Michigan, visiting plants and military installations, taking notes on what he saw with his own eyes. He took no aides, hired no planes, visited no golf courses and stayed in no first-rate hotels. And this was before the interstate highway system.

What Truman saw was even worse than the letters had described. Contractors were paid cost-plus to build plants and warehouse—and so they not only inflated their costs, but they built things badly. Surplus equipment was left out in the snow, to rust, owing to no controls and no accountability. Surplus workers with nothing to do were getting paid to sit around playing cards and smoking.

Truman came back to Washington and reported his findings to President Roosevelt, who smiled and chatted amiably and waved him goodbye. Sensing nothing was going to happen, Truman reported to the Senate what he had seen—alone and through his own eyes—during 10,000 miles of traveling across the United States.

It was a bombshell, and it changed everything, not only for Truman but for the country as a whole.

The Senate established what became known as The Truman Committee to look into waste and excess in the war boom, and Truman himself set forth the ground rules: there would be no grandstanding by the Senators and no whitewash by the Admininstraion. Above all, the committe would be driven by one thing:

"There will be no substitute for the facts."

The Truman Committee produced 50 reports over time, each voted out unanimously ("Men tend to agree when presented with the facts," one of the Republican Senators noted) and proved invaluable to exposing flaws in, and suggesting fixes for, the American war effort.

Harry Truman was no longer known as the Senator from Pendergast. In time, he became the President from Independence.

Investors, I think, should keep in mind those Senators who chose to stay within the District of Columbia while Harry Truman was driving himself to factories and military bases around the country.

Human beings find instinctive comfort in the company of crowds. To separate from the herd is to invite attack from predators. In nature it is physical attack; in the civilized world of Wall Street as well as the polite, rules-bound world of Congress, it is emotional attack: ridicule, humiliation, ostracizing.

Like those Senators who stayed in town, skirt-chasing and drinking themselves stupid at the Willard Hotel while trusting the newspaper articles and what their “leadership” assured them was a valiant drive to increase the nation’s productive capacity, investors who rely on company press releases, reassuring conference calls, optimistic analyst reports and the safety of the crowd are, in fact, risking more than they know.

Because crowds, like those senators, can be stupid, mediocre, timid beasts.

There are no group thinkers at the top of the Forbes 400 list of wealthiest Americans—just a college dropout who started a software company and his childhood friend; an investor who makes only one or two huge investments a year; and the descendants of a guy from Oklahoma who built a quarter-trillion dollars a year retail chain from a single store in Bentonville, Arkansas.

In Harry Truman’s case, he too left the crowd behind—risking his entire political career to investigate first-hand the facts behind the disturbing accounts contained in letters nobody wanted to believe might be true. And the reward, in time, was the Presidency.

All because he answered his mail.

Jeff Matthews
I Am Not Making This Up

NB: This came out of re-reading David McCullough's excellent Truman biography, in anticipation of his new book, 1776. The insights about Truman are his.

Friday, May 20, 2005

Of Hunter S. Thompson, Giant Deformed Hedgehogs, and Doctor Patrick Michael Byrne

Overstock.com CEO and CBMG (Chief Binomial Marketing Guru), Patrick Byrne, was at the J.P. Morgan technology conference this week, answering questions about all things Overstock.

Actually, he only answered questions about a few things Overstock, because the questioners did not really get to all aspects of what Inspector Clouseau might have called “The rich tapestry of Overstock.com.”

Therefore, we will have to do it ourselves.

But before we get into the Top 10 List of Questions We Would Like Somebody To Ask Patrick Byrne, let me point out here that another mystery in the casebook of Overstock has been cleared up.

Specifically, the Case of the Reappearing Merchandise, in which we noted that furniture highlighted as “Almost Sold Out—Act Fast” in pop-up ads, mysteriously reappeared weeks after first being identified as “Almost Sold Out.”

This despite the fact that Overstock is supposedly a closeout buyer of overstocked merchandise—not a private label manufacturer.

Recall that we noted the product in question was sourced from Sitcom Furniture, a direct-import outfit offering product to U.S. retailers, and that the appearance of this kind of private label merchandise appeared to coincide with the dramatic rise in gross margins at Overstock, about which Patrick Byrne boasted on conference calls throughout 2004, crediting it almost entirely to better “logistics.”

Well, one of the questions Byrne got at the J.P. Morgan conference earlier this week concerned the $50 million Asian currency hedge Overstock put on the first quarter.

“Why hedge?” Byrne was asked.

“We do some buying in Asia,” he answered. “Not a tremendous amount, but we do…and we hedged what we felt was an adequate amount of currency.”

Since we have learned that it is better to watch what Patrick Byrne does rather than what he says, let’s ignore his protest that Overstock doesn’t buy “a tremendous amount,” and do the math ourselves:

Overstock did about $215 million of direct sales last year, with a $185 million cost of goods. Assume the cost of goods grows 50% in 2005, to roughly $270 million. By hedging $50 million worth of currency, Byrne is hedging almost a quarter of his
company’s entire direct cost of goods.

Therefore, based on the math—not on Patrick Byrne’s spin—Overstock is in reality sourcing almost a quarter of its so-called over-stocked, closed-out merchandise from Asian manufacturers.

No wonder that stupid Newport Coffee Table, list price $434, “our price $179.99”—which began popping up back in March as “Almost Sold Out—Act Fast!” is still popping up on my Overstock.com web page.

Thus The Case of the Reappearing Merchandise and its sister mystery, The Wonder of the Rising Gross Margins, have been solved: Overstock.com sources product from Asia.

Moving on to the “Steal of a Lifetime” diamond purchase, not much new ground was broken at the J.P. Morgan conference.

Bizarrely enough—at least during the ten minutes or so of the question and answer session I listened to—Byrne never fully explained the profit-sharing scheme outlined in the Overstock.com 10Q, whereby the company splits profits on the diamonds with an unnamed special purpose entity (SPE).

Recall that according to the 10Q, the company cut a deal with an SPE for the purpose of buying diamonds in August, 2004—months before the sudden arrival on Byrne’s doorstep of two partners having a “nasty split” who, the way Byrne described it on April’s conference call, wanted to dump their diamonds at almost any price.

Those two fellows must be real players in the diamond business, don’t you think?

Instead of the logical, easy, and more profitable move, which is to simply get on a plane to either New York City or Tel Aviv and—as one of my diamond contacts who scoffed at Byrne’s story said—“just open up the briefcase and sell them,” this pair decided it would be better to give Overstock.com and its CEO, Patrick Byrne, the “Steal of a Lifetime.”

Can’t you just see these two guys, dirty and unshaven, driving across the Utah desert on Route 80 in a drug-addled, Hunter Thomspon-esque haze of Maui Wowie and 22 caliber gunsmoke, veering south on 215 to avoid the Giant Deformed Hedge Hog suddenly rising up before them blocking the entire mountain pass to the East and leading cops on a wrong-way chase down the entrance ramp at Route 190, bouncing off cars and fire hydrants before screeching to a halt in front of 6322 South 3000 and stumbling into the lobby of Overstock.com, banging the door shut behind them—loose diamonds and Peruvian flake spilling out of their pockets, pupils dilated and eyelids twitching, one firing at the blinking electric bats swooping down from the light fixtures while the other screams at the receptionist to “get Patrick out here right now!”…

And suddenly Byrne appears, a vision to behold, serene in his Buddhist-like detachment, sizing up the situation in a second and offering the cowering dogs $7.2 million on the spot—just like that.

Deal done, he scornfully whips the pair with his belt and drives them from the lobby into the strong arms of the waiting, grateful Utah troopers—the “steal of a lifetime” safely done, the loot on its way to a vault on 47th Street in the heart of New York’s diamond district.

After all, who in their right minds would dump diamonds for $1.3 million less than their actual current value?

For that is what Byrne claimed on the conference call about the diamonds for which he paid $7.2 million, and he repeated that claim this week: “We…could turn around and flip them for $8.5 million and they probably have a good retail value of $10-$12 million.”

While not exactly the Hunter S. Thompsonish scenario envisioned above, Byrne also repeated his statement that it was a deal quickly done: “It was just an exceptional deal that happened sort of in an afternoon.”

And so, with no further ado, the Top 10 List of Things We’d Like To Hear Somebody Ask Patrick Byrne (the presumption being, of course, we would get a straight answer):

1. Who bought the diamonds? You said “we did do a very large diamond buy” on your call, but the 10Q says it was a special purpose entity (SPE). Did you buy them, or did friends of yours buy them?

2. If you in fact bought the diamonds, and considering the fact that you yourself have admitted blowing substantial deals in the past (an electronics deal last quarter, the Franck Muller watches, FarenHYPE 9/11 etc.), why would the board let you buy $7.2 million worth of diamonds anyway?

3. How much money did Overstock actually commit to the diamonds? You said “we paid” $7.2 million, but the 10Q says Overstock loaned the diamond-buying entity $8.4 million. What happened to the extra $1.2 million?

4. You made it sound like you had scoped it out yourself and it was such a great deal…why split the profits? Why not keep all the profits for the benefit of Overstock.com and its shareholders?

5. Why did you say that Overstock could “flip” the diamonds for a $1.3 million profit, when it appears that Overstock would receive only half of any profits from the SPE? Furthermore, 50% of $1.3 million is $650,000, and a $650,000 profit on a $7.2 million diamond purchase is about an 8% gross profit, which is almost half the current 15% gross margin at Overstock.com. How does a deal that is only half as profitable as Overstock’s existing business qualify as the “steal of a lifetime”?

6. Do you or anyone related to you or anyone in management or on the board of Overstock have an interest in this SPE? Who actually owns the equity of the SPE? What equity did they contribute?

7. How did you set the $3 million strike price for the 10-year 50% option…and who were the counterparties to the negotiation?

8. Why did the SPE buy $264,000 worth of PP&E? That’s a lot of furniture for an entity whose sole apparent purpose is “buying inventory,” as per the 10Q. What else did the SPE buy besides the diamonds?

9. If the SPE is not owned by Overstock.com, but supplies the diamonds for the “Build Your Own Jewelry” site on Overstock’s web site, who gets the profits from the diamond sales on the web site? Does the SPE sell the diamonds to Overstock.com at a mark-up?

10. Stepping back and looking at the entire “steal of a lifetime,” the 10Q says your company loaned the SPE $8.4 million to buy inventory. The SPE bought diamonds which, supposedly, you could “flip” for $8.5 million. What’s so great about generating $8.5 million on a capital investment of $8.4 million?

Those are the questions.

Expect no straight answers.

Await the spin on the next conference call.

And beware the Giant Deformed Hedgehogs on Route 80.

Jeff Matthews
I Am Not Making This Up

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.

Thursday, May 19, 2005

On The Road

Amazing what you learn on the road.

Anybody want to guess what the single biggest selling item for Interline Brands, a large distributor of over 45,000 different maintenance, repair and remodeling products for the apartment and institutional markets, happens to be?

Toilet seats.

That's right. In a 300,000 square foot warehouse on the outskirts of Nashville, Tennessee stands a two-story high stack of them near the loading dock, ready for quick turnaround to all parts of the country.

The reason being that by law toilet seats have to be changed when apartments are remodeled.

Otherwise, the most interesting observations after two days of visiting companies and stores in that part of the country are these:

Best Buy stores seem awfully big, now that the contents of the entire middle of the store--music, movies and software--are being electronically distributed. The only parts of the store that look like Best Buy stores used to look like--i.e. crowded--were the satellite radio, iPod, and digital tv sections. Now I understand why the company wants to open smaller stores.

Speaking of satellite radio, I learned that Sirius requires new users to sign a one-year contract, with a $75 cancellation penalty. XM does not, although it offers a one-year plan if the customer wants it. I am wondering if this helps Sirius boost its revenue recognition. In any event, XM outsells Sirius 3 or 4 to 1.

Finally, those new Pep Boy stores, with all their newly merchandised scooters and race-cars sitting around gathering dust, look like an inventory write-off waiting to happen.

Jeff Matthews
I Am Not Making This Up

P.S. Tomorrow I will sum up the Overstock.com question and answer session--both the one our readers would like to have with Patrick Byrne, as well as the real thing that took place earlier this week in San Francisco. Those of you hoping to hear some tough questions for Doctor Byrne from the J.P. Morgan guests...well, don't hold your breath.

Tuesday, May 17, 2005

Serious Business

It’s been amusing, I admit, to report on Overstock.com CEO Patrick Byrne in these pages.

After all, how hard is it to poke fun at a guy who touts his new auction site as taking off “far faster” than eBay, only to have it hit the proverbial wall, and then says “This may become a long war of attrition with eBay”?

Of course, it’s deeper than just “poking fun.”

From “The Mystery of the 38 Diamonds,” in which we broke the story that Overstock had in fact wholesaled a slug of diamonds rather than sell them one at a time on its “Build Your Own Jewelry” site…through our fictional “Grandma” and her quest to untangle the “decrapitation” of what Byrne had previously touted as Overstock’s “scaleable” and “leading edge” technology, we have, in my opinion, exposed plenty of faulty wiring capable of sparking a short circuit in a company that some on Wall Street still believe is firing on all cylinders.

But now it gets serious.

The Overstock first quarter 10Q came out last week, and, as with the 10K, it contains facts not disclosed in Patrick Byrne’s shareholder letters, press releases, or earnings conference calls with Wall Street, relating to Overstock’s diamond purchase—the “steal of a lifetime.”

On January 28th, 2005, Overstock.com CEO “Doctor” Patrick Byrne described the diamond purchase this way during the company’s earnings call:

We did do a very large diamond buy, sort of a deal of a lifetime diamond buy at the end of the year.

Nobody questioned him on it at that time.

On April 22nd, 2005, Byrne described the diamond purchase in more detail, explaining it as an opportunistic, “overnight” deal that came to Overstock via “a friend of a friend” and was turned around in the space of two weeks.

First, in his shareholder letter on that date, Byrne wrote to investors:

We got lucky with a diamond buying opportunity that came to us just before we launched DYOJ [Design Your Own Jewelry, launched January 28th, 2005].

Second, during the conference call on that date, Byrne said:

1. “This deal came about because two people in the diamond business were splitting and they asked a friend of mine to value the inventory. Actually that’s a friend of a friend…. And they were having a nasty split.”

2. “They called…and we went in and said yes, we will pay it. We paid 7.2 million and I think we took a turnaround the next two weeks [sic]. So we came up with a wire for 7.2 million and got it. And it was on (an) overnight basis.”

3. “That’s how we got the diamonds. And we could I’m sure flip them…for 8 million. We can probably piece them out in fairly large blocks for 8.5 million, but instead, we decided to sit on it.”

4. “It is with a colleague, not a shareholder partner…but it’s with somebody we’ve done business before—quite a bit of business…So that’s the story of the diamonds.”

Yet based on Overstock’s own SEC filings that is not the whole story of the diamonds. Based on Overstock’s 2004 10K and recent Q1 2005 10Q filing, the story of the diamonds really began in August of 2004, when Overstock established the mechanism by which it would buy up to $10 million worth of inventory.

This is how Overstock described the set-up for the diamond purchase in the 10Q that came out Friday:

1. In August 2004, the Company entered into an agreement which allows the Company to lend up to [$10 million] to an entity for the purpose of buying inventory, primarily to supply a new category within our jewelry store which allows customers purchasing diamond rings to select both a specific diamond and ring setting.

2. In November 2004, the Company loaned the entity [$8.4 million].

In plain English, Overstock.com set up an agreement with a legal entity to make the diamond purchase in August, and loaned money to that entity in November.

Here we go again…Patrick Byrne tells shareholders the company did the diamond deal “at the end of the year.” He says it “came to us just before we launched” on January 28th, 2005. He says the deal’s “turnaround” took “two weeks” after “they called” and “we went in and said yes.” He tells investors “we got lucky.”

Meanwhile, over in the 10Q…Overstock appears to have prepared for the deal in August, well before the rainbow broke through the cloudy skies and planted the magical pot of diamonds into Patrick Byrne’s lap “at the end of the year.”

But here’s the capper: Overstock apparently does not own the company that owns the diamonds. Overstock merely lent it money—$8.4 million, for which it receives 3.75% annual interest and 50% “of any profits of the entity”—due next year.

It appears, based on the 10Q, that Overstock simply has a ten year option to buy 50% ownership of the company.

So many questions, so little information.

But instead of me asking the questions, I’m going to let you, our readers, post the questions that we would like to see Overstock.com, or Patrick Byrne, or Wall Street’s Finest answer.

Remember, this is not a message board: no infantile message board language, no fluff. Just the questions this disclosure should raise.

Have at it.

Jeff Matthews
I Am Not Making This Up

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.

Monday, May 16, 2005

The Second Easiest Trade in the World

The second easiest trade in the world might just be keeping a few investors around the world up at night.

I say second easiest, because there is one other macro trade that seems to be more popular than being short the U.S. Dollar. But if there ever was a way to make a guaranteed profit, it would appear to be shorting the Dollar.

After all, the U.S. is, as we all know—putting it in precise macroeconomic terms, based on our horrible trade deficit, bloated budget deficit, broken Social Security system, not to mention our decrepit Medicare/Medicaid/Health Care funding system—totally screwed.

And hasn’t the Oracle of Omaha—Warren Buffett—shorted twenty billion Dollars for his own account? Even Bill Gates, who probably never shorted anything in his life, except maybe Lotus and Netscape and Borland and Novell and Quarterdeck and Software Publishing and…well, he’s probably never shorted a currency before, but even Bill Gates is short the Dollar.

So, if Bill Gates and Warren Buffett—two of the smartest men in the world, let alone the smartest guys in a particular room—are both short the Dollar, how could a big, swinging London-based currency trader lose by putting on that trade?

Well, one way he could lose is this: what if everything the smartest guys in the world already know about the Dollar is priced into it? And what if the Euro—the alternative currency of choice—is overvalued? And what if that imbalance starts to correct itself?

I mean, it’s not as if Europe is rip-roaring along, adding value to the world’s economic well-being.

Germany is stuck in no-growth-land, Italy is officially in recession, and France is a basket case. Half a dozen U.S. companies have missed numbers in recent weeks, and blamed Europe. Drug companies are removing research and development from Germany, and IBM is shutting down high-cost operations all over the continent.

I’m no currency guru, and I don’t particularly admire the fiscal policies of the United States. But what’s so great about Europe? And why does everybody want to own its currency?

I know what some of you are thinking: buy gold. But I’m not a gold bug. My friends who actually are gold bugs tend to be nervous, excitable people who think Alan Greenspan ranks right up there with funeral directors and variable annuity salesmen.

They refer darkly to “The Powers That Be” and watch every tick in Federal money flows as proof of a vast conspiracy to manipulate the price of Amazon.com’s stock price in order to benefit Alan Greenspan’s personal account.

I’m not making that up, by the way—I know people who think Greenspan times his various pronouncements to affect the market, for his own benefit. Last year a guy complained Greenspan had made negative comments about the economy just before option-expiration Friday. He was long Lucent call options, and they expired worthless.

He blamed Alan Greenspan.

I don't particulary care who runs the Fed, and as far as I can tell gold and silver just sit there and impart no particular value except what other investors ascribe to the desirability of owning gold and silver at any given moment.

So call me an agnostic when it comes to the world’s monetary plight.

But I’d be willing to bet the ranks of the Dollar atheists far outweigh the Dollar believers right now. As I said, it’s probably been the second easiest trade in the world, up until now.

The easiest? Oh, that would be the “market-neutral” convertible arb trade. Which, as we now know, is blowing up all around us.

Just today, The Times of London is reporting some ugly data from the London hedge fund world:

GLG in recent weeks had demands for more than $500m (£270m) from investors wanting to pull out of its $4 billion market-neutral fund…Cheyne is thought to be down by at least 10% in its credit fund after the downgrading of debt at General Motors and Ford. Ferox, another of London’s most successful funds, is thought to be down nearly 20%. Bailey Coates, Polygon, Rubicon, Vega, Moore Capital and Brevan Howard are all nursing heavy losses of about 5% each in April.

Makes you wonder, if that stuff was the easiest trade in the world, how the second-easiest trade is going to work out.

Jeff Matthews
I Am Not Making This Up

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.

Sunday, May 15, 2005

Google Saves The Day, and Sting Makes The Night...but Ticketmaster Rules The World

If there had been a roof over Jones Beach Theater—the 14,000-seat open-air amphitheater on the edge of the Atlantic Ocean where, come spring, bands not big enough for six nights at the Meadowlands start playing in a great venue mixing salt air and good acoustics—Sting would have blown it off Friday night.

It was the last night of his six-week U.S. tour, and he played with a stripped-down band, half the size of last year’s eight-piece, bells-and-whistles (actually synthesizers and bongos) group, ripping through a wide swath of his catalogue, back to early Police and new Sting, with the Beatles thrown in for good measure.

It was the best of him I’ve seen—but I might not have made it without Google.

For some reason this tour didn’t generate much exposure for the man who once led the biggest band in the world before going on to that rare thing in rock music: a long and highly productive career, along the lines of Clapton, Bruce, Bob Marley (until cancer got him) and Van Morrison.

Consequently, I went in with no expectations. Since I hadn’t seen a review anywhere of the tour, I figured it was another Sting show, with some new semi-Moroccan noodling alongside the usual mix of old Police and middle Sting.

In fact, I was so out of it I’d forgotten what I’d done with the tickets. Usually I do will-call, but when the time came to get ready to go, I realized there was no record of it on the receipt I’d printed out and stuck on the wall.

Since we were leaving in a half hour, and since I’d invited friends along, I was especially frantic trying to find where the tickets were—had they mailed them? If so, I was dead, because we didn’t get any Sting tickets in the mail. Were they email tickets? Could be, but I had no idea where the email might be.

Enter Google.

I remembered downloading Google’s “Desktop Search” program a few weeks ago. It had taken two minutes to download—none of this “fill out the registration form” and “restart your computer now” and “would you like to receive annoying email updates every three minutes.” Just download and forget.

A couple of days after downloading “desktop search” and forgetting about it, I did a Google search that brought up—along with the usual list of search results—a term paper my daughter had written that contained whatever it was I’d typed into the search bar.

I thought that was pretty cool—an unobtrusive and very logical way of doing desktop search. But I still couldn’t think why I’d use it…until I was trying to find those tickets.

I typed “Ticketmaster Sting” into the search bar, because I had bought the tickets through Ticketmaster, the ticket-selling service that Pearl Jam tried to go around a few years ago, before discovering that Ticketmaster has a monopoly that makes DeBeers and Microsoft jealous.

(Pearl Jam soon realized that Ticketmaster is more powerful than most Government Agencies as well as Russian President/Czar/Dictator Vladimir Putin, and backed down. The bad publicity, however, made Ticketmaster so sensitive to appearances that, in return for taking your order over the internet for tickets that they send to you via email—a process that costs Ticketmaster as much as seven or eight cents to accomplish, what with using up all those electrons—they charge you a “Processing Fee,” a “Service Charge,” a “Delivery Tithe” and an “Enjoyment Surcharge” which in aggregate may by law amount to no more than triple the actual cost of the tickets.)

As I was saying, I typed “Ticketmaster Sting” into the search bar.

(This is a bit off-topic, as we say on Wall Street, but, my solution to the airline crisis in America is to have Ticketmaster handle all airline tickets and rebate half their airline-ticket fees to the airlines. This would give Ticketmaster a monopoly on air travel in the same manner they have a monopoly on concert tickets, and along with the “Processing Fee” and “Service Charge” and “Delivery Tithe,” Ticketmaster could add an “Airplane-Wings-Secured Fee” and a “Pilot-Wearing-His-Contact-Lenses Charge” and “Engines-Not-Inspected-By-English-Majors Surcharge.” Prices would immediately triple or quadruple, and the airlines would be healthy again.)

In any event, after typing in “Ticketmaster Sting” into the Google search bar, up popped the usual search results, plus, at the very top, the email from Ticketmaster containing the PDF file with the Sting tickets.

I clicked on the email, printed out the tickets and we were ready to go. Very slick.

We made it to the venue, got our seats…and Sting and his band ripped through most of the best of his entire catalogue, including a bunch of Police stuff I’d never heard him play—Demolition Man and Voices Inside My Head among them—as well as some terrific newer stuff, including I Hung My Head and a great version of the Beatles’ Day in the Life.

He brought the house down.

And thanks to Google, we were there in time to see it.

Now all the gang in Mountain View has to do is come up with an alternative to Ticketmaster, and they will rule the world.

Jeff Matthews
I Am Not Making This Up

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.

Friday, May 13, 2005

David Stockman, S&P Victim

Poor David Stockman.

One day Standard and Poor’s changes its mind about something, and a week later the former Budget Director of the entire United States loses his job.

Here’s how the linkage worked, as outlined in a brief, insightful article in today’s Wall Street Journal, with background from my own experience following Collins & Aikman, the auto-parts supplier over which Stockman had presided as Chairman and CEO until S&P changed its mind about something.

Dating back to a window-shade manufacturer in 1843 (no kidding), Collins & Aikman makes floors and roofs and door panels for DaimlerChrysler, GM and Ford, in about 100 plants around the world. GM and Ford are, unfortunately, around 50% of C&A’s revenue.

The current incarnation of C&A was shmooshed together by Heartland Industrial Partners, following ownership changes in the 80’s and 90’s that did nothing so well as remove value from the company, for the benefit of private equity partnerships.

Consequently, C&S is a highly leveraged company—not a great capital structure for an auto parts supplier—and depends on the kindness of banks as well as on more esoteric forms of debt to keep the lights turned on, not to mention the plants humming.

And one of those forms of debt involves borrowing against the money its customers owe it for the products its plants are producing, i.e. receivables.

Since C&A was already maxed out on its senior credit facility, the company needed to be able to access those receivables—sort of like borrowing against your future hoped-for income tax refund from H&R Block to buy tonight's dinner for the kids.

Then, S&P changed its mind about something. Specifically, about GM and Ford credit-worthiness.

S&P cut its debt ratings for both companies to junk, which triggered a reduction in the amount C&A could draw on its receivables facility with GM and Ford, which triggered violations in C&A’s own capital structure, for which it had to get waivers to keep buying the groceries.

Hence, the Chairman and CEO of C&A, David Stockman—whose main credentials for those job titles appear to be that he is a founder of Heartland, which still owns a big chunk of C&A stock and had the bright idea of loading up a capital-intensive, highly cyclical company with debt—resigned his positions after the company disclosed that it faces major liquidity issues following the S&P downgrades.

And what about Standard & Poor’s, which triggered the whole mudslide when it downgraded GM and Ford debt?

Well, yesterday S&P helpfully warned that Collins & Aikman itself might have to seek bankruptcy protection, “in the near term.”

In the grand scheme of things, the travails of a relatively small auto parts supplier in Troy, Michigan, do not mean a whole heck of a lot outside the terrible consequences for the employees who are going to get screwed thanks to the short-sighted machinations of the private equity groups that drained the company of whatever liquidity they could find.

But the next time the Fed raises the Fed Funds rate and a talking head on CNBC says “rates don’t matter…”—remember how David Stockman lost his job.

Jeff Matthews
I Am Not Making This Up

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.

Thursday, May 12, 2005

Who Will Shout “Fire”?

The theater is full, everyone’s in their seats with a bucket of popcorn in their laps and a soft drink in the holder, and the lights are down.

The movie is about to start.

Ominously, though, the emergency exit signs are on the fritz, and while most of the crowd is oblivious, a few of the more perceptive movie-goers are squirming in their seats, looking for the fastest way out in case somebody shouts “fire.”

That’s the way the convertible arb hedge fund business feels to me, after listening to a Merrill Lynch conference call on the state of that business and talking to friends who would know.

Yes, the rumors have been flying around the Street for a couple of weeks about one or another hedge fund being in trouble, and some big funds are having rough years—even though it’s nothing like Long Term Capital’s infamous collapse.

After all, the Dow Jones Convertible Arbitrage index is down only 7.5% this year (although I did hear of one small outlier down a cool 90%)—hardly enough to cause a hedge fund to turn off the lights.

But these are funds designed to limit volatility by hedging against interest rate risk and market risk and all kinds of other risk—and the fund-of-funds managers that were tossing dollars into these so-called market-neutral pools of money are not used to watching the pool evaporate, even slowly. Especially when there doesn’t seem to be a very good excuse. No collapse in the Thai Baht, no Russian default…not even an Argentina currency crisis.

So they are getting anxious.

That’s how it sounded on yesterday’s Merrill Lynch conference call—even though I didn’t understand more than three sentences in the Merrill analysts’ presentation or in the question and answer session that followed. Being an old-fashioned equity guy, I don’t measure alpha or beta or theta, or even the covariance of the delta. So I don’t have a clue when it comes to this black-box stuff.

But what I did understand is that the questions all had a single underlying theme: where are the exit doors?

What it all smelled like to me was a lot of people trying to figure out how to get out of their positions, or worrying about what other people are going to do to get out of their positions.

I heard a lot of answers from the Merrill convertible rocket scientists that seemed to begin, “well, what they can do is sell the third deviant tranche into the fourth derivative market through a hedged put sub-convertible relaxed-fit jean…” or something like that.

Whatever it was they were saying, it all sounded to me like one question: how to get out.

The basics are this: the convertible arb guys, who had it so good for so long buying converts and shorting the underlying equities with various ratios and various hedges, attracted enough capital to make the business unattractive.

Consequently, volatility compressed so that managers had to put on more leverage to get the returns they’d been accustomed to getting. Plus, as the hedge funds grew in size, they began trading more with each other rather than with the funds that actually own convertible bonds for a living.

End result: nobody left to buy.

Now, a few people are looking for their money back. And the question becomes where to sell this paper to raise the money to give back to the investor, now that the inflows into the pool have reversed flow.

These situations are not fun. They are not fun for the guys stuck with the paper; they are not fun for the investors stuck in the fund; they are not fun for the brokers stuck with relationships that are starting to come apart; they are not fun for innocent bystanders caught in markets that start to come apart when everyone rushes for the exit at the same time.

But they seem to happen with some regularity, and nobody seems to learn the previous lesson. 1980, when the Hunt Brothers got nailed trying to corner the silver market; 1987 when nearly everybody, including the smartest investors in the world, got caught long the Friday before the crash; 1989, when everybody was going to get rich doing LBO’s…and the United Airlines LBO fell apart; and of course, Long Term Capital Management in 1998, and the dot-coms in 2000.

Does the convertible arb bubble (ironic, isn’t it?: everybody, including me, is screaming about a housing bubble while all the while this huge convertible arb balloon has been slowly inflating right over our heads) have to end badly?

No, it doesn’t. But it probably will.

Right now, the fund-of-funds are watching this pool evaporate slowly and reading the articles and re-thinking their commitment…and probably submitting their notices of withdrawal for the end of this quarter, right now, as I write this.

And the funds themselves are looking at the calendar and evaluating their positions, trying to figure out what they can sell in order to meet the redemptions they know they will have to meet in a month and a half.

And the legit convertible funds and the market makers are watching the whole drama, and waiting. They see a lot of sellers and not a lot of buyers…and they know the opportunity to make money is not now.

It’s when the exits are clogged and people are trying to get out…price be damned.

Jeff Matthews
I Am Not Making This Up

P.S. For those of you following Grandma’s quest to nail down the truth behind the technology “decrapitation” at Overstock.com, and other credibility issues she has with the company…Grandma is hard at work and will report back when she finds out what happened.

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.

Wednesday, May 11, 2005

Part III: Some Like It Hot

When we left Grandma—our fictional “widows and orphans” investor who had looked to Overstock.com CEO Patrick Byrne to follow through on his promise to set “the gold standard in communicating with candor” to shareholders—she had been struck by the onset of a terrific headache.

Going through the big pile of shareholder letters and conference call transcripts, Grandma had discovered—far from the promised “gold standard”—a record of what seemed to her obvious flip-flops and turnarounds that made her increasingly nervous about the state of affairs within the company.

Anybody can tout a new product—as Byrne did with his auction site and his build-your-own-ring site—and be wrong, Grandma reasoned.

But to tell shareholders in letter after letter about how the company’s IT systems were “flexible” and “scaleable” and “leading edge,” and how this fellow Shawn Schwegman was a “star” and to brag that only five companies in the whole world had the same kind of large Oracle cluster something…

And then one day—just like that!—he says we can’t be doing things with hand calculators any more, and says that nice fellow Shawn had a word about their systems, he said they were “decrapitating.”

Decrapitating! Grandma pops another Tylenol just thinking about that word.

And all those people he used to brag about—that “team” and that “star” and he “could not be happier” with them—it turns out they were “nursing the systems along” and that ridiculous Oracle “cluster” had turned into “an enormous ball of spaghetti.”

Enormous ball of spaghetti! Grandma is shaking now. She picks up one of the reports from that nice man, the stock broker in Des Moines—it’s a report from something called WR Hambrecht—and reads it.

“The company is stepping up its IT hiring. All of this capex is designed to enable Overstock.com to scale to revenues of $4-8 billion.”

“What a load of manure,” Grandma says to the cat. “Patrick Byrne said it right in his conference call with those Wall Street flunkies, his systems are decrapitating. All that nonsense he spewed about Oracle-is-showing-us-a-lot-of-love (Grandma does like that Ellison fellow from Oracle) and then it turns out it’s “an enormous ball of spaghetti”

She looks at another report from a place called Piper Jaffray. The headline is Solid Revenues but Increasing Costs… “Not a word in here about their systems decrapitating,” Grandma tells the cat, tossing the report in the blue recycle bin at her feet.

She skims a third report, from Thomas Weisel Partners. “OSTK made significant expenditures on new IT systems, which the company believes is necessary [the boy can’t even write, Grandma muses] to handle future growth.”

Grandma drops it on top of the Piper Jaffray report. “Not a word about the enormous ball of spaghetti.” She ponders this for a moment. “This is a company that does all its business on the Internet, and says their systems are decrapitating. And yet none of these fellows on Wall Street are writing about it. I wonder why.”

She retrieves the reports. A sentence in the back of one catches her eye: “Piper Jaffray has received compensation for investment banking services from Overstock.com within the past 12 months.”

“No wonder,” she mutters. “And I thought they’d cleaned up that place, after Enron and Worldcom.”

Grandma sighs and tells the cat, “If you want something done right…” She takes a pad of paper out of the telephone drawer. It is the old, faded pad with the John Deere tractor on top, above the phone number for the Grange in Prairie City where Grandpa had worked.

She begins to set down all the nonsense she’s already read about—that “star” Shawn Schwegman and that “cluster” that only five companies have and that great “scaleable” and “flexible” technology…. It takes a while to get it all down and her wrist aches, but she keeps going, all the way through the “enormous ball of spaghetti.”

Then she looks for more. It does not take long to find it.

Overstock’s IT Programming Capabilities

Grandma reads about how Overstock does its own technology work:

Q3 2004 Call: We practice something called extreme programming, where we have very small teams of two or three people taking on enormous projects and it seems to be working.

That was in October, Grandma realizes. She reads on and sees that by April, just six months later, this Patrick Byrne was changing his tune:

Q1 2005 call: And here we’re tying to build a business that does a billion and 2 billion…we were stretching things very thin…. So this early February we just decided to pull the trigger. We had gotten everything pretty well architected and we just said we’re going to make these changes now.

The consultants and the teams have to come in and build it with us. And then we are hiring people within technology. No sense buying all this rocket scientist equipment and not having…enough rocket scientists to run it.

Grandma counts on her fingers: from October to February is just four months. “Just four months after talking about this extreme programming he says they were stretched thin and had to hire people!”

Grandma’s tired of reading about technology. She remembers the thing that nice broker had told her—about the new projects the Overstock people were working on…something about a travel web site. She finds it.

Overstock’s Travel Site

Q3 2003 Call: The travel store was launched to provide our customers a convenient and price competitive one stop shop for all of their needs…it is a work in progress.

Hmmm…Grandma shuffles papers, looking for the “travel store” that was “launched” in 2003, but finds no mention of it until this:

Q2 2004 Letter: Stormy Simon…responsible for our TV and radio commercials, our Book, Music, and Video, and our nascent travel department.

Grandma’s stomach is churning again. Is this one more of those “all hat, no cattle” things? Ah, here we go:

Q4 2004 Letter: Two more projects, Travel and Propeller, have made good progress.

“Good progress” sounds awfully vague, Grandma thinks. Sure enough:

Q4 2004 Call: On January 1st the [travel] tab went live again and now just has cruises, which are doing very nicely. You will see in the next four to 12 weeks, the rest of those categories fill in.

Hmmm…just as she thought. Promises, promises. She reads the April letter and her stomach settles down as she finds what she expected—more delays:
Q1 2005 letter: Travel — While cruises are live, the tab completion date slid from April to June.

“Figures,” she tells the cat. “If your technology systems are decrapitating, how on earth are you going to get all these great new products out the door?”

She glances back at that reference to “Propeller.” Hmmm….looks like another one of those phantom projects, she thinks. Let’s have some fun and see what happened to this one…

Project Propeller

Q3 2004 Letter: Propeller - Collaborative filtering. We have spent eight months building the system: we are in the initial stages of rolling it out.

Yes, Grandma thinks. I remember that now. It sounded impressive, whatever collaborative filtering is. Then she reads the transcript of the conference call from that very same quarter and is shocked—it doesn’t sound nearly so impressive:

Q3 2004 Call: We have finished a good first pass model for the collaborative filtering, and we're actually sort of testing it in different parts of our site this week.
“How about that!” Grandma says to the cat. “He writes to us shareholders we are in the initial stages of rolling it out…and then he goes and tells those knuckleheads on Wall Street we’re sort of testing it…”

She bangs her fist on the kitchen table. “What does he take me for?!” The cat jumps up, alarmed. Grandma mutters to herself “Rolling it out…sort of testing it…rolling it out…sort of testing it…” and reads on...

Q4 2004 Letter: "Propeller" (our statistical modeling engine) turned out to be too computationally intensive to be of use within our architecture: we re-architected our system to some degree, but not in time to go live in Q4. Doing so is our highest priority now.

Grandma no longer wears knickers, but if she did, she thinks, they be in a twist right now. She can not believe the twaddle she’s reading about “Project Propeller.” But it gets worse:

Q1 2005 Letter: Propeller -- Our collaborative filtering initiative is live and showing lift, but that is with flaws in the A/B testing that cause it to have a headwind. Once it is fully live and testing is improved, we should be able to tune it in (over the summer).

Grandma swats the cat off the table. She’s enraged at this nonsense: first it’s in the initial stages of roll-out…but it’s really just sort of testing…then it’s being re-architected, whatever the heck that means…then it has flaws in something called A/B testing…

Grandma remembers a line from her favorite movie, Some Like It Hot, when that playboy fast-talker Tony Curtis spins a tall tale to the sharp-tongued secretary he stood up on Saturday night, and then whispers in her ear,
“Nellie baby, I’ll make it up to you.”

Nellie eyes him suspiciously and says,

“You’re makin’ it up pretty good so far.”

But Grandma doesn't laugh. Instead, she finishes her notes, almost sick. She can’t take any more of this. It’s time to talk to a few people. She makes a list on the John Deere pad while the cat stretches and wonders what hit him.

The first on Grandma’s list is that nice man in Des Moines—the one who gave her all those reports for free, which turned out to be a lot of eye-wash. Next is her niece, the big shot analyst who works on Wall Street. Grandma doesn’t like to bother her niece, but this is important: she wants to understand how they can write all this nonsense and ignore what seems to be a problem in the technology systems this company needs to run its business.

And third on her list is her grandson in San Francisco—the one who works for that place she never quite understood what it meant…a hedge fund. He’s the skeptical one. Maybe he can help her.

Grandma wants to get to the bottom of all this.

Jeff Matthews
I Am Not Making This Up

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.

Tuesday, May 10, 2005

Part II: What Would Grandma Think?

Patrick Byrne likes to say he runs Overstock.com not for the satisfaction of the Wall Street “jackanapes” who nit-pick his company’s income statement and question whether his growth now, profits later mantra is good business or just good spin.

Instead, he talks about things around Overstock passing something he’s called “the grandma test”—a sort of What Would Grandma Think? standard of honesty and decency when it comes to reporting the facts behind Overstock.com’s numbers.

He particularly dislikes the notion that “widows-and-orphans” may, when it comes to stock market fluctuations, be at the mercy of “Wall Street criminals” (Byrne’s term), and saves his most potent venom for hedge funds:

“They inject noise into attempts to have adult conversations with our shareholders. And the thought that any widow-and-orphan money gets invested based on the work of such hedge fund lickspittles makes me nauseous.”

If anything should make Patrick Byrne nauseous, however, he might look to the persistent inability of his company to hit targets he has set publicly in shareholder letters and on conference calls—targets for new web offerings (travel, build-your-own-ring, auctions), new ventures (mCommerce), and new technology (“Project Propeller”).

While we explored some of these missed targets in “The Mystery of the 38 Diamonds,” yesterday in Part I of “Patrick and the Amazing Technicolor Dreamcoat” we began looking deeper into the largest Overstock.com mystery of all: whether the company's growth now/profits later mantra is in fact good business strategy, or merely good spin.

However, since I run a hedge fund, let’s not look at this from the point of view of a lickspittling jackanapes like me. Let’s look at it from the point of view of the “widows-and-orphans” for whom Patrick Byrne expresses such tenderness.

Let’s ask “What Would Grandma Think?”

Well, for starters, just last month Overstock shocked Grandma by announcing a Q1 loss of $4.2 million. Grandma was shocked because only three months before, Patrick Byrne had announced a $2.5 million Q4 profit, using words like “superb,” “brilliant,” and “flawless” in his January letter to Grandma and other Overstock investors.

In that letter, Byrne had written to Grandma: “For several quarters my letters and conference calls have described at length our internal work building an Ark: the waters came, and our ark floated magnificently.”

He ended it by telling Grandma that Overstock was “up on a plane from which I believe only our own inattention or mistakes will knock us for some time.”

So as Grandma reads Patrick's April letter, she is naturally wondering what, in the space of three months, caused the “ark” to spring a $4.2 million leak. The letter starts with “eight items of interest,” including the incomprehensible-to-Grandma “large binomial marketing experiment,” by which Byrne explains much of the loss.

But Grandma smells a rat. She reads the letter carefully and concludes that at the heart of the reversion to red ink is a sudden, huge increase in technology-related spending. She is, of course, confused, because she remembers how “the ark floated magnificently” only three months before. So Grandma decides to go back and thoroughly comb the record of Patrick Byrne’s letters to shareholders, as well as the conference calls.
And here’s some of what she's finding.

Overstock’s Information Technology Department

Grandma always liked reading about Shawn Schwegman, the “star” of the Overstock technology team. Patrick talked about him so glowingly:

Q2 2004 Letter: Shawn Schwegman (VP, Technology) remains a star. This year Shawn has assembled a team of mature, experienced Database Administrators (DBA's). Our network has become quite stable… By the end of July, I think I will be able to say, "I could not be happier with the IT team nor the level of understanding between it and its internal customers."

Q3 2004 Letter: I could not be happier with the IT team nor the level of understanding between it and its internal customers. I have never worked in a company where the president could say that about the IT department. This took Shawn Schwegman one year to achieve.

Q4 2004 Letter: Shawn Schwegman (VP, Information Technology) and his team saw us through Q4 with an almost spotless record. In addition, Shawn has arrived at a wonderful vision of how our systems can be modularized to support growth with flexibility for years to come. There will be quite a bit of internal development and re-architecting over the next six to nine months, but some changes are necessary, and at our present size we believe the payoff can be enormous in terms of customer experience and cost savings.

So far, so good: Shawn was doing wonderful things with Overstock’s IT department. He had this modularized vision that could support growth “for years to come.” Yes—there would be “some change,” but nothing alarming, it seemed.
Now, imagine the shock Grandma gets reading the transcript of the April 2005 conference call:

Q1 2005 Call: Shawn has a term—decrapitate. And our internal systems, to be honest, are decrapitating. That’s why we’re switching to this other. We’ve got people nursing the systems along here, the systems we used to manage marketing campaigns and things like that are decrapitating, in Shawn’s word.

How, Grandma asks herself, did Patrick Byrne go from telling me “our network has become quite stable” and promising “growth with flexibility for years to come”…to all of a sudden telling the Wall Street jackanapes “Our internal systems, to be honest, are decrapitating.”?

Grandma scratches her wig. This “nursing the systems along” doesn’t make sense. Patrick had written so many times about “leading edge” equipment and “robust” systems. She digs out more old letters and conference call transcripts, and finds Patrick's discussion of Overstock's technology systems.

Overstock's Information Technology Systems
Grandma quickly finds what she is looking for:

Q2 2003 Call: We have dramatically expanded our capacity in the last three months…. And our servers—we’re moving to a clustered Linux environment. We are actually just days away from turning on—switching to a clustered Linux environment. We had outgrown HP N-class and rather than go to a large Sun or an IBM Superdome or something…

And again! Right here, Patrick says his IT systems are cheap and scaleable!

Q2 2004 Call: … As far as IT systems are concerned…I cannot say enough good things about it now. I know I sound like a commercial for Oracle, but it truly has given us remarkably cheap, scaleable computing power.

Then Grandma reads the transcript of the April 2005 conference call. It doesn’t make sense:

And here we’re tying to build a business that does a billion and 2 billion…we were stretching things very thin…. So this early February we just decided to pull the trigger. We had gotten everything pretty well architected and we just said we’re going to make these changes now.

It’s just that we’ve grown past the stage that we can do things with Excel spreadsheets and hand calculators

“Excel spreadsheets?” Grandma mutters. “Hand calculators? What about those large Sun or IBM Superdomes he was talking about?”

She recalls something about Oracle, that big database company run by that Larry Ellison-fellow. She was always so impressed when Patrick talked about his big Oracle system.
Overstock's Oracle Database System
She finds the first mention of it:

Q3 03 Call: We threw the switch on a project…an Oracle database cluster. I am given to understand that there are only about 10 companies who are successfully operating on this platform and only five that have built as large a cluster as we have. That just went live a few weeks ago.

Only five companies! Imagine that!:

Q1 2004 Call: We're doing things somewhere between the leading edge and the bleeding edge I'm afraid to say. For example, the Oracle cluster. We know of other companies that are trying to get their cluster live. We've been live with it for six months. Oracle is showing us a lot of love and they've actually been a very good partner with us in building this out.

Grandma knew that Ellison fellow was a decent man. She reads on...:

Q2 2004 Letter: Last year our database server reached its limits: we migrated to an Oracle cluster solution that is now highly (and cheaply) scaleable. We have outgrown our data storage solution, so we are buying a robust SAN (Storage Area Network) that should carry us to several times our current size. … As far as IT systems are concerned…I cannot say enough good things about it now. I know I sound like a commercial for Oracle, but it truly has given us remarkably cheap, scaleable computing power.

It all sounds so wonderful, but Grandma's hands are sweating and her wig is slipping off: after the let-down with that nice Shawn fellow, and all that IBM Superdome stuff, she is getting nervous about what might come next. And sure enough:

Q1 2005 Letter: A good way to think of it is this: we had a huge database with all our product information, customer information, even logistics and financial information, contained in it. That database grew into an enormous ball of spaghetti. It became difficult to manage the computational "bowl" needed to hold that ball, and the situation is getting unstable. Our answer is to untangle the spaghetti into smaller bowls, each of which is itself a cluster (so we end with clusters of clusters).

Grandma is shaking. From “leading edge” to “an enormous ball of spaghetti”…in only one year!
In the manner of a person who buys a car that is, in fact, a lemon, and has suffered the first few minor headaches with growing nervousness, Grandma is beginning to wonder if she's getting the whole story on Overstock.com.
She is beginning to question whether its CEO does indeed, as he writes, set the gold standard in communicating with candor the results of her company.
Tomorrow we'll look over Grandma's shoulder as she digs deeper into the question of what really is happening behind the scenes at Overstock.com.
Jeff Matthews
I Am Not Making This Up
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.