Martha: The Doyenne of Dilemmas

Here is something that can be said about shares of Martha Stewart Living Omnimedia Inc., even after a sharp fall Friday: They still aren't a good thing.

At least that's the view widely held on Wall Street. But Friday's raucous trading activity underscored how complicated the Martha Stewart stock story has become. After rallying sharply in anticipation of an acquittal, shares ended 23% lower in heavy trading in the wake of her conviction on four counts of obstruction of justice and making false statements to investigators.

Despite having a rock-solid balance sheet, strong merchandising lines and more than 500 employees, Martha Stewart Living's stock has traded on the fate of its eponymous founder for the past several months. After getting battered in the wake of her indictment last year, the stock has risen smartly in recent months and is still up almost 50% in the past year. But much of the buying has come from investors betting that the doyenne of domesticity would be exonerated.

Speculation about her fate sent the stock on a roller-coaster ride Friday. Shares, down early in the day, began to soar after 2 p.m. EST, when word emerged that a verdict was reached -- but before the jury's decision was made public. Buying on the rumor, some investors figured a relatively short jury deliberation meant acquittal. Their buying sent the stock up 16% to $16.31 on the New York Stock Exchange -- and higher elsewhere -- before the exchange briefly halted trading at around 3 p.m., just before the verdict was announced.

Trading was especially heated in the options market, where market makers and others regularly turn to protect their own positions in the stock. Some hedge funds stepped up buying of "out-of-the-money" short-term puts and calls, or options that pay off if the stock either soared or tumbled. Their hope was that any decision would send the stock climbing, or plunging, in price. The stock's March 17.50 calls, for example, which allow an investor to buy the stock at $17.50 a share in the next month, soared above $2 at one point. (See related article⁴.)

But investors began to bail out just after 3 p.m. when it turned out that Ms. Stewart was found guilty, leading to steep declines. The March 17.50 calls ended the day valued at about a nickel.

Now, Martha Stewart Living's stock will track its founder through the appeals process. Many investors believe the share price will keep falling in the days ahead, as investors digest the court's ruling. A number of large investors said they would avoid the stock until it drops well below $10 a share. The stock closed at $10.86 on Friday.

"You won't see deep-value players looking at the stock until it gets beaten up more from these levels," says Mike Pausic, a portfolio manager at hedge fund Maverick Capital in Dallas. "I'd be surprised if it doesn't reach the single digits pretty quickly."

A big part of any investor's decision will stem from the company's actions in the coming few days. Martha Stewart Living said in a statement Friday that its senior management, brands and financial strength are "more than sufficient" to continue the company's growth.

Still, media buyers, who purchase ad pages and TV time on behalf of advertisers, already say they are going to caution their clients about working with the company's properties.

"Advertising in her magazine is akin to being on the losing team and brands want to be perceived as winners," says Bill Koenigsberg, president and chief executive of Horizon Media, a New York firm that purchases about $900 million in media for marketers.

Media buyers are especially concerned about the company's magazines. Publishing is Martha Stewart Living's largest revenue source. "We are raising the red flags at the moment," says Rich Hamilton, CEO of Publicis Groupe's Zenith Optimedia Group.

"Those advertisers who remained and waited for a verdict are likely to pull out now," said Robin Steinberg, vice president, director of print at Aegis Group PLC's Carat, which buys advertising for clients including Pfizer Inc. and Time Warner Inc. "All factors are working against the company right now."

Another problem: At current levels, the stock is expensive in relation to many of the yardsticks investors look at, such as earnings and cash flow. Before Friday's decision, analysts expected Martha Stewart Living to post a loss this year, and earn 23 cents in 2005. That means it currently trades at about 47 times 2005's expected earnings, compared with a multiple of just 17 for stocks in the Standard & Poor's 500.

So at what point is the stock a buy? Probably at about $6 a share, some media-oriented investors say. Martha Stewart Living has no debt and almost $170 million on its books, or about $3.50 a share in cash.

Fans of Ms. Stewart's products could yet show surprising allegiance. And investors say Ms. Stewart isn't the only senior executive at the company with creative experience. Some expressed confidence that the company could rebound, especially if it is renamed, dropping Ms. Stewart's name. If revenue can just stay flat in the next year, the stock could respond.

"As long as consumers respond well to the company then we will continue to support them," says Tami Jones, a spokeswoman for Procter & Gamble Co., one of the world's largest ad spenders.

Certain assets, such as the list of subscribers to the magazines, could entice companies, though most are skeptical of an outright acquisition any time soon. Ms. Stewart's majority ownership of the company presents a big obstacle to any purchaser.

Bulls cite the example of Steve Madden Ltd., the shoe company that has seen shares storm back since the company's founder, designer Steve Madden, went to prison on money-laundering and securities-fraud charges in 2002.

But investors remain wary.

Morris Mark, president of Mark Asset Management, which specializes in media stocks, says: "On first blush this is not the first thing I would look at."

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com¹⁹

Updated March 8, 2004