Better than expected merchandise revenue at MSO offsets waning subscription sales. We remain nuetral as we expect publishing ad sales to remain weak.

Thesis:

While 2Q:08 merchandise sales were better than we expected weak ad sales and uncertainty regarding MSO's radio contract will weigh on MSO shares in 2h:08.

Key points:

*Merchandise sales were $16 million versus our $10 million estimate.

*The upside is due to: MSO's recent Emeril acquisition (which was not in our model) and a better than expected performance of the Martha Stewart Collection at Macy's. We note, the Martha Stewart Collection, has trended above plan since its launch.

*MSO's robust 2Q:08 merchandise performance in part seasonal, in our opinion, owing to the synergy between MACY's very strong wedding bridal franchise (roughly 10% of M's non-holiday season revenue) and the Martha Stewart Collection.

*MSO also benefited in 2Q;08 from the US tax rebate(as we predicted the company would as early as December 2008!). According to economic studies roughly 30% of the tax rebate was spent on consumer non-durable items and food, MSO's key merchandise categories.

*Unfortunately while we are impressed by MSO merchandise and broadcasting performance, we predict weakness in publishing and uncertainty in MSO broadcast division will offset solid execution in merchandise.

*We expect investor concerns about MSO's $10 million contract with Sirius Satellite radio, which will expire in 2009 and a decline ad sales will offset any progress MSO makes in merchandise.


*Thus we are cutting our 4Q;08 estimate to $0.35 from $0.40 and only fine tuning our 2009 EPS estimate to $0.57 from $0.55.

Outlook and Valuation

We are disappointed with MSO new guidance and outlook. MSO basically lowered its revenue guidance to $300 million from $312 million (including the Emeril acquisition). Due to a recessionary consumer economy, we predict MSO's new merchandise lines will not offset the contractual decline in mechandise sales. We expect MSO's KMART contract sales will decline to $15 million in 2009 and $20 million in 2008 from $65 million in 2007. While MSO has a history of trying to low ball guidance we think our $304 million estimate (as compared to $327 million in 2007) is reasonable given the 6% publishing revenue decline we expect.

We predict improved operating margins (to 4.5% from 2.5%) will allow MSO to remain profitable and we forecast EPS of $0.27 in 2008.

*We derive our $9.00 price target by applying a 15x multiple to our revised EPS estimate of $0.57 for 2009. The multiple we apply is in-line with MSO's publishing and merchandising peers such as MDP.