Monday, January 24, 2005

EBAY, BARBER SHOPS AND DOUGHNUTS

My barber and I discussed EBAY and Krispy Kreme the other day. Krispy Kreme was founded and is headquartered in my home town so it is frequently discussed around here. My family owned a few shares of the stock in the past few years. We made money off some but held some too long and sold them on the way down. As a sentimental home town favorite, we actually held a few shares all the way down to $14 per share. It took too long for us to recognize just how bad the apparent abuse of accounting. The SEC investigation may result in criminal charges.

When a growth stock breaks its growth trend, it gets hammered. It usually takes many years to recover--if it ever does. I am not a buyer of Krispy Kreme even after the recent good move to "retire" Scott Livengood and to replace him with a "turn-around" expert. The expert will rationalize the business; the costs will be great.

When a turn-around expert comes to town, the company in question often gets chopped into pieces. Sometimes the biggest remaining piece is sold to a larger company. Often times when the remaining piece is sold, the company taking over assumes debt and pays a relatively small amount of money because the size of the company has been whacked and the buyer is not willing to buy at high multiples of sales or earnings. In other cases, a buy-out firm takes the firm private. This can be worst of all for the most optimistic of the current shareholders as they believed they would one day recover all their investment once the company turned. (Many of those who eat the doughnuts and own the stock are Krispy Kreme fanatics). I still love the doughnuts but not the stock.

I should remember the details better (I have know members of the founding Rudolph family for many years) but years ago Krispy Kreme had a great run and was then sold to Beatrice Foods. Beatrice struggled trying to expand the company for years before spinning it off to a private group. I suppose the point is that the business has faddish tendencies. The doughnuts are the best in the world but a tight distribution network seems to be the key. Just like grocery stores that over-expand their distribution centers, Krispy Kreme seems to be able to invade a territory just so far before running into fierce competitors.

EBAY is a very different situation. EBAY has not broken its growth trend. It's earnings for the last quarter were up something like 44% and only missed analyst projections by about a penny. The company forecast very strong earnings growth for the coming year, just not as strong as the analyst were forecasting.

The first point one could make is, "What is new about analysts missing a forecast"? The analyst record is a dismal one to say the least. The more important point is that the company has planned slower growth on purpose!

My barber quickly understood this point completely. I said to him, has your business ever expanded to the point that you raised your price knowing that you might lose some customers. Of course he has. That is the way barbershops set their prices. Whenever they go up in price, they often temporarily experience a few vacant appointments but if the price increase is 10% and the volume decline is only 5%, they still make more money.

This is exactly what EBAY did and EBAY has even more to gain on a percentage basis. EBAY raised the price of an "EBAY Store" from $9.95 per month to $15.95 per month. EBAY also raised the price of several other fees. In doing so, EBAY knew that some sellers would close up shop. The increase from $9.95 to $15.95 is 60%! Sixty percent of the shops will not close! Revenues per shop will go up! Volume sellers will stay open for business and their volume will even go up! The shops that do close will temporarily cause growth to slow at EBAY but the value of a store will go up to those that stay open as the competition is decreased. For the store operator the scenario is similar to having three barbershops in one area and because of a rent increase one shop closes down. The surviving two shops will net more even after paying the higher rent.

The other big difference in the recent decline in EBAY and the decline in Krispy Kreme is the difference in expansion and contraction. Krispy Kreme expanded too fast and is now being forced to get out of areas that are not profitable. EBAY is very profitable in its secure market and is still expanding rapidly into others. The company just decided to spend an extra $100 million to expand in China. The companies investment in China will exceed $300 million. Who else will spend this kind of money securing yet another growth market?

EBAY is very expensive in terms of price to earnings, price to book value and other value measures. The current price reflects the probability of strong growth for many years to come. Science and common sense say that the growth rate must slow as the company gets to the monster size category. Marketing expenses to reach the masses will cost more. All of these factors suggest that should the company stub its toe, for example in the execution of the move into China, that the shares could drop to a fraction of their current price in a heart beat.

On the other hand, the company appears to have a lock on its fast growing business. The internet will experience dramatic growth in just the next few years. The internet is going mobile. Consumers who want to buy will be able to comparison shop EBAY while standing inside a brick and mortar store. The majority of the the 60% increase in prices will fall right to the bottom line!

EBAY is a buy! Buy the stock and let me know your purchase price. Set up a monitored account and I will help you watch the performance. Please remember to not pay more than $11 to make the trade as transaction cost are an important part of performance.

BIG PICTURE COMMENTS
The current correction may have already run its course. Oil prices are back near their highs. The "war" premium may decline after the Iraq elections. Another catalyst to the next market run, although a long shot at this time, is the possibility that the Fed will stop raising short rates.

Those of us old enough to remember the hyper-inflation of the late 70's can appreciate just how far a market can go before it corrects. It took major changes by the Fed and the Congress to turn the market. Just last year, the Fed was concerned about dis-inflation.

In the late 70's, the very definition of inflation was changed by Milton Friedman of the Chicago School. His definition of inflation being too much money chasing too few goods gained wide acceptance. Do we now approach the opposite side of the coin?

You may have heard the stories of how a lottery winner still enjoys going to the local dinner to get the $3 blue plate special. This is the way workers in developing countries often react to newfound prosperity. They may "hide their money in a mattress" and only slowly ramp up their spending. Next thing you know, under the new free trade rules, we may have Chinese and Indian workers making more goods than we can consume. How many car choices, cell phone choices, MP3 Player choices do we need?

For some time, I have suggested that one should add consumer staple companies to ones portfolio. Companies like Colgate Polmolive that have wide moats and that will continue to sell goods no matter what happens to interest rates or to the economy. These additions have helped my portfolios hold up reasonably well during the current correction. The addition of the oil drilling firms should have been made sooner but those are my big gainers during the past few weeks.

One needs to be cautious as many firms have no pricing power. Long interest rates are low which means there are a couple of bad things that can happen; the economy can slow or long rates can go up. Either could be bad news for the market.

The low long rates are forecasting a slowing economy. The good news is that the market usually takes off during a slow economy. I have done a short term 180 in regard to gold and gold shares. I covered my gold stock shorts and am tempted to go long for an intermediate term trade. I must admit that I did not see the latest big decline in long rates coming. Now it is up to the Fed. If the Fed were to not raise short rates or were to talk about moderating its current stance, the market could be off to the races.

I remain 100% invested in stocks with a zero percent long bond allocation.




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