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Friday, August 14, 2009

Bidding on BIDZ (Part Two) - Backstory: The Hair on the Name and Mitigating Factors

BIDZ continued - this is Part Two of our analysis - first part found here and still more to come. Brief update on recent results found here.

Backstory - the Hair on the Name

Problems for Bidz (BIDZ, $3.64) began in November 2007 following a rapid, three-month stock move from the high single digits to almost $20 per share on Friday 11/23/07. On Monday 11/26/07, Citron Research -- a research/trading firm that was also short the stock -- published an article questioning Bidz's business model and related party transactions - link here.

One of the points was that the company had numerous related party transactions with Mr. Aframian at LA Jewelers and that Mr. Aframian is a "convicted felon and has served time in the Federal System for fencing stolen goods" in the 1980s.

The stock declined 17% that day. Although Bidz CEO quickly defended the company and answered/refuted all points (summarized by Eric Savitz here), the market didn't believe him and the stock continued to slide. For much of the following year, the stock was range bound around $10 despite continued earnings growth and excess cash generation. Then, on 9/1/08, Barron's chimed in with a feature story on Bidz titled "Putting BIDZ.com Shares on Sale".

This time, Barron's raised questions not about the business model, but about the origins of the company and personal relationships of CEO David Zinberg as well as action of co-founder/ director Garry Itkin. The article is well-written, researched, and worth a read to understand issues surrounding Bidz.

The negative Barron's story was compounded by the ensuing economic decline and shares moved to the low/mid single digits. Earlier this year, the SEC initiated a formal investigation into Bidz's inventory accounting practices and, in May, the company announced the FTC probe into its marketing practices. Preying on the situation, a flurry of lawsuits emerged alleging management misconduct and material misrepresentations about business prospects, among other things.

Addressing the Concerns

All of the above items create a negative "first impression" for investors and, therefore, represent major overhangs. To emerge from the tarnish, Bidz needs time, along with continued, favorable operating results. Fortunately, time is marching onward and consistent profitability reveals the advantages of an asset light, variable cost operating model through economic cycles.

We won't spend much time on what appears obvious: we understand that the corporate and consumer de-leveraging will continue for some time to come, with significant consumer headwinds in the face of fewer jobs, lower wages for those who have jobs, and -- probably -- higher taxes everywhere. All in all, a wonderful environment for jewelry retailers over the near- and medium-term.

Regarding the other reasons, our view is that points (1) through (4) will likely go away, while points (5) and (6) are sufficiently mitigated by the strength of Bidz's established online franchise and large insider ownership (as noted above, 67.3% for management and directors).

(1) Questions surrounding management/director relationships

Like any disciplined investor, we prefer to invest in squeaky clean management teams with no blemishes and strong corporate governance. Further, we agree with Bruce Berkowitz of The Fairholme Fund who says, "Usually if you see one roach in the cupboard there are many behind the wall". In this case, we don't have all of the answers around past relationships/dealings and never will. Still, focusing on the facts of the business give us comfort.

Mitigating factors: despite questions regarding relationships, it's not clear if any impropriety occurred at Bidz by management, personnel, or the board of directors. Also, financial results tell a positive story through the years and related party transactions are decreasing: per 2008 10-K, "We purchased approximately 26.4%, 11.9%, and 9.9% of our merchandise in 2006, 2007, and 2008, respectively, from LA Jewelers". We also can understand one of CTO/President Kuperman's statements to Barron's regarding issues raised: 'Tell us how we could run our business differently, knowing this information'.

(2) SEC investigation into inventory practices

Bidz provides the following information regarding inventory accounting in the 10-K:
  • Inventories - Inventories consist mainly of merchandise purchased for resale and are stated at the lower of first-in, first-out (FIFO) cost or market.
  • Inventory Reserve - The unique nature of our business model where customers set the prices they are willing to pay may result in items selling below our cost, and we provide reserves against our inventory based on the difference between the average selling price and the cost of inventory if the average selling price is lower than the cost of inventory. We also provide reserves for obsolescence and slow moving inventory.
We can see how forecasting and applying reserves for items sold below cost could complicate accounting. No doubt, this is what the SEC is reviewing. Management relayed the following on its 4Q08 call (sourced from Seeking Alpha.com):
  • Now turning to another topic I would like to discuss. We were recently notified by the SEC of a formal investigation about certain aspects of our inventory accounting practices. These questions are not new and we have addressed them before and we are confident our inventory accounting is correct and in full accordance with GAAP.
  • We openly welcome the opportunity to finally put this issue behind us. We think it is important to note that when we first received questions on this subject from the SEC both I and our outside counselors proactively and voluntarily met with the SEC staff. We believe the SEC now seeks to confirm by reviewing the documents that our inventory accounting policies and methodologies are indeed conservative and sound.
  • We welcome the investigation so we can in a clear, open and transparent manner discuss our business and accounting methodology and provide further clarity to our investors. We have also repeatedly had our independent public accounting firm, Stonefield Josephson, look into these matters. We have proactively and transparently responded to all inquiries into any specific business practices that have been questioned.
  • In each and every case there were no incidents of wrongdoing. While we are disappointed these accusations continue we also understand that as a small company that did not undergo a traditional IPO we will be subjected to additional scrutiny. We expect this investigation to take time to resolve itself as is usual in these cases. We will keep you apprised of any updates.
Mitigating factors: a long operating history using the auction format should provide fairly reliable benchmarks and internal controls on how to account for Bidz's inventory. In our recent conversation with management, they again emphasized what was relayed above. Not a surprise for management to stick by their story, but we think the company's ongoing share buyback program expresses confidence that Bidz may soon move past this concern (potential positive catalyst number one). See 7/1/09 buyback update from company, with the following highlights:
  • Approximately 714,000 shares repurchased during the second quarter at an average price of $3.50
  • Approximately 2.9 million shares repurchased at a cost of approximately $17.0 million since plan inception at the end of 2007
  • Approximately $16.5 million still remaining under authorized plan
  • Company intends to continue to make additional share repurchases
In addition, we believe it may behoove management to hire a Big Four auditor (in place of Stonefield Josephson) to improve investor perception of Bidz's accounting and controls (another potential positive catalyst) -- similar to the recent move by American Oriental Bioengineering (AOB, $5.65).

3) FTC probe into marketing practices

Like most companies today, Bidz uses email communications and various forms of direct marketing. We have no special insight into the FTC probe, but like the SEC investigation, management expressed confidence that the company is cooperating with the FTC to expeditiously resolve any concerns (potential positive catalyst number two). Below, we include a slide from Bidz's September 2008 management presentation:

Mitigating factors: we believe the share active repurchase program provides comfort.

(4) Flurry of me-too, bandwagon lawsuits related to management, business model questions, and the share price decline

See recent headlines. However, interestingly, if you click on many of the press releases on Yahoo! Finance announcing a suit against Bidz, they no longer open. Instead, we see "Yahoo - Document Has Expired - The requested document, `/iw/090616/0511274.html', is no longer available."

The company's response to the various suits was as follows:
  • The plaintiff's allegations are solely based on a report published by Citron Research on November 26, 2007. After issuing the report, Citron Research, previously known as StockLemon.com, publicly acknowledged that it held a short position in the common stock of Bidz.com, Inc. The Company has publicly refuted all the claims made in the report.
  • The Complaint is another in a series of allegations against Bidz.com in the aftermath of the Citron Report, including complaints made to the Securities and Exchange Commission and the Federal Trade Commission. Bidz.com has previously disclosed the investigation by the Securities and Exchange Commission and has recently received a Civil Investigative Demand for information from the Federal Trade Commission relating to email marketing practices. Bidz.com is cooperating and responding to these investigations.
  • Bidz.com believes the plaintiffs' claims are entirely without merit and intends to defend the action vigorously.
Mitigating factors: we don't know for sure, but think at least some of the suits have fallen by the wayside as lead plaintiffs may not have materialized (potential positive catalyst number three).

(5) Concerns surrounding competition

Bidz March quarter sales were down ~50% Y/Y versus down 10% for BlueNile and down 20% for Zales. Bidz notes in its 10-K:
  • "Our competitors currently include various online auction services and retailers that offer jewelry, including eBay, Blue Nile, Overstock, and uBid. We also encounter competition from national jewelry retail chains, such as Zales, Kay Jewelers, and Finlay Fine Jewelry, and mass retailers and other enterprises that sell jewelry, such as Wal-Mart, Target, J. C. Penney, Costco, QVC, and Home Shopping Network."
In addition, we see a few other competitors: Jewelry.com, LiquidationChannel.com, Signet (Kay, plus Jared, Marks & Morgan, etc.), Tiffany, Ross Simons. Is Bidz losing share?

Mitigating factors: First, Blue Nile mostly targets a different market segment - engagement rings - which isn't as discretionary as Bidz merchandise. Second, we think there will always be consumers who prefer to purchase jewelry in person (see, touch, etc.), possibly explaining a better performance by Zales. Also, Bidz is choosing to preserve margins over chasing sales in the current market and sales/marketing expense was down 38% Y/Y in the March quarter. The reported number of "new buyers" was 51,021 in the quarter, well below 83,179 in 1Q08 but not too far below 58,056 in 1Q07. Finally, as shown below, a sample of Internet traffic trends from Alexa (may be inaccurate, but okay as quick proxy), reveals Bidz.com traffic -- while down from levels one to two years ago -- remains approximately twice that of Blue Nile, Zale's, and Kay.com, with Jewelry.com barely registering. Thus, the brand/site clearly seems to garner significant mind share.

(6) Modest amount of insider selling

We prefer to see NO insider selling for long positions. CEO Zinberg and his sister Marina have been fairly steady sellers under automatic plans over time. CFO Kong also sold 20 thousand shares in mid-July.

Mitigating factors: we are unaware of personal circumstances, especially for Ms. Zinberg, who receives an annual salary of $100,000 and was formerly Bidz's corporate secretary and treasurer. CEO Zinberg's sales have been fewer in number than those of Ms. Zinberg. Since both Zinbergs control ~62% of the company, we are not too alarmed by the small level of selling.

Please stay tuned for our third and final part on BIDZ.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, AOB.

© 2009 Jeffrey Walkenhorst
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