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An Analysis Of Lenox (LNX)

Below is a letter from Mr. John L. Morgan, beneficial owner of approximately 7% of Lenox (LNX), to Ms. Susan E. Engel, Chairwoman and CEO of Lenox.

Dear Susan,

When your board offered me a directorship on September 18, 2006, we discussed the reasons that made it unacceptable. At that time, I reiterated that I could best serve the shareholders of Lenox Group by assuming a leadership role on the Board of Directors and playing an active role in formulating and guiding the strategic direction of the Company. Furthermore, I expressed my intention to not make changes in the management or Board of Directors. My views were based on information I had at that time.

The Board’s rejection of my offer to help the Company create a successful strategy has given me a different perspective. I now feel that the Board has decided to pursue a course of action that is not in the best interests of the shareholders and is a continuation of the strategies that have failed to create value over the past ten years.

The management team and Board of Directors continue to behave like the Company is a large, successful Company that has margin for making more mistakes. I do not agree. My offer to assist the Company in changing its strategy to benefit shareholders has been rejected although I proposed to work with the existing management and Board of Directors. You have made your position clear and I hope this letter will do the same for me and other likeminded shareholders.

Very truly yours,

John L. Morgan

The Ownership Situation

First, let me explain the ownership situation. The reporting persons are John L. Morgan, Kirk A. MacKenzie, Jack A. Norqual, and Rush River Group. Rush River Group is a limited liability corporation (LLC) of which Morgan, MacKenzie, and Norqual are members.

Rush River was formed in December 1998 in Minnesota and "its principal business activities involve investing in equity securities of privately owned and publicly traded companies, as well as other types of securities." As far as I can tell, the only members of Rush River are the three aforementioned men: Morgan, MacKenzie, and Norqual.

According to a recent SEC filing, Morgan beneficially owned 6.1% of the outstanding shares of common stock in Lenox, Rush River owned 0.79%, MacKenzie owned 0.07%, and Norqual owned 0.07%.

Please keep in mind that this 7% stake in Lenox is controlled by Mr. Morgan; but, not Winmark Corporation (WINA), a publicly-held franchisor of retail stores. This is an important distinction to keep in mind (especially since Winmark is a public company).

Morgan is the Chairman and CEO of Winmark; MacKenzie is the Vice Chairman. However, their stake in Lenox has nothing to do with Winmark. In fact, last time I checked, Winmark did not have any material investments in marketable securities.

The reported position amounts to 989,300 shares of Lenox. Shares of Lenox last closed at $6.23 a share. So, the position would be worth a little over $6.16 million. Since Winmark only has a market cap of $126 million, I want to make it clear Winmark does not have a position in Lenox – Morgan does. He just happens to be the Chairman and CEO of Winmark. I hope this clears up any possible confusion about Winmark.

Lenox

Now, I can move on to discussing the truly interesting aspect of this news, Lenox itself.

Lenox is the result of a September 2005 merger between Department 56 and Lenox Incorporated. Prior to the merger, Department 56 was known for its "Village Series of collectible, handcrafted, lighted ceramic and porcelain houses, buildings and related accessories that depict nostalgic scenes". That last sentence was taken directly from the company's 10-K, simply because I couldn't write a better description myself. I assume most of you have seen the series. Even if you haven't, I'm sure you can imagine the concept of a little porcelain Christmas scene.

Obviously, the Lenox name is much better known than the Department 56 name. Therefore, when Department 56 acquired Lenox, it changed its name to Lenox.

In its 10-K, the company calls the Lenox acquisition a "transformational event". This term is too often applied to mergers that are far from transformational. In this case, however, it’s a perfectly accurate description.

Whether the transformation is for better or worse is debatable; however, the fact that the merger has transformed the company is not debatable. To put the size of this transaction in perspective, consider this: Today, Lenox (the combined company) has a market cap of $88 million. In September 2005, Department 56 paid $204 million to acquire Lenox Group. Immediately, this should tell you two things. One, the acquisition was probably quite large relative to the existing business. Two, the combined company's stock price has tanked.

Both of these statements are true. Even when shares of Department 56 were a lot more expensive, the Lenox acquisition was very large relative to the existing business when considered from the perspective of market cap, enterprise value, sales, and just about any other meaningful measure of the size of a business.

Obviously, the combined company's stock price has been falling hard since the merger. After all, the enterprise value of the entire company is not much greater than the amount Department 56 paid for the Lenox business.

The market is assigning a value of close to zero to the newly acquired Lenox business. This is remarkable considering the fact that Department 56 rarely traded at a lofty multiple when it was a stand alone business. In fact, the company's shares often traded at a P/E multiple in the high single digits or low double digits throughout the past decade.


The New Business

You probably already know what Lenox does. If you don't, a quote from the company's 10-K does a good job of explaining what the newly acquired business does:

"The company sells dinnerware, crystal stemware and giftware, stainless steel flatware, and silver-plated and metal giftware under the Lenox and Gorham brands. Dansk is the company's contemporary tabletop, houseware and giftware brand. The company sells premium causal dinnerware and fine china dinnerware, giftware and collectibles under the Lenox trademark, and sterling silver flatware and sterling silver giftware under the Gorham and Kirk Stieff trademarks. The company believes that it is the largest domestic marketer of fine tabletop products."

I'm sure you noticed a bad omen in the above paragraph. One of the company's brands (Dansk) is described as the company's "contemporary" brand to differentiate it from the other two brands. Obviously, having fine products that are not considered contemporary is a bit of a problem.

In fact, it may be a very large problem in the years ahead. Overall, it seems the market is moving away from formal dinning and towards more upscale casual dinning. This is not a new phenomenon; nor, is it likely to be a short-lived one.

On the other side of the scales, you do have the simple, undeniable fact that the company has one of the best brand names in its industry. It is also a big player in a very small industry. Those are both advantages that are difficult (if not impossible) to duplicate. For a $200 million business, Lenox has a lot of history – and perhaps, a lot of potential.


The Old Business

A big part of the problem with the performance of the company's shares (both over the short-term and the long-term) has been the performance of Department 56. In 2005, sales from Department 56's Village Series declined 21%, "which was consistent with the longer term trend" according to the company's 10-K. In fact, sales had clearly been declining each and every year from 1999-2005. Furthermore, sales in 2004 were substantially less than sales in 1996. So, even though there wasn't a continuous, straight-line decline in sales over the past ten years, the general trend for sales of the Village series has been decidedly negative for a full decade now.

To combat the "substantial attrition of the Gift and Specialty channel" the company has settled on two strategies intended to both "offset the decline of the Village business" and "to grow revenues long term". Those strategies are "expanding the company's channels of distribution outside its traditional Gift and Specialty channel" and "expanding the company's product offering to include year-round gift products." The former strategy sounds promising; the latter strategy sounds implausible.

Lenox is already moving to implement both strategies. In fact, the company made a small acquisition that should help expand Lenox's year-round product offerings. But, I remain highly skeptical of attempts to transform the gift products business into anything other than a highly seasonal business.


The Acquisition

At the time it was announced, I thought the Lenox acquisition sounded like an interesting move for the company. Department 56's operations looked lean; the operations at Lenox did not. Furthermore, the price paid for Lenox didn't look unreasonable, especially when compared to the kinds of prices many public companies have often paid to make such large ("transformational") acquisitions.

In September 2005, Department 56 acquired Lenox in a $204 million deal (including $7.6 million in transaction costs). Department 56 funded the acquisition "through a $275 million senior secured credit facility consisting of a $175 million revolving credit facility and a $100 million term loan".

As mentioned earlier, the combined company adopted the more recognizable Lenox name.


Restructuring

As a result of the merger, the company closed approximately half of the stores belonging to its new Lenox subsidiary. In total, the company closed 31 Lenox retail stores. As of February 1st, 2006, this left the company with only 36 retail stores. Six stores were operated under the Department 56 name; the remaining 30 stores were operated under the Lenox name.

After the merger, the company consolidated some of its operations. For instance, Lenox sold its Langhorne, Pennsylvannia facility when it moved certain operations to Bristol, Pennsylvannia. The company has used the cash proceeds of such sales to pay down debt incurred in the Lenox acquisition.


New Concept Stores

Lenox plans to launch a new mall-based chain of stores that will sell all of the company's brands (Department 56, Lenox, Gorham, and Dansk). The company plans to open three "All The Hoopla" stores during 2006. A fourth store will be opened in 2007.


Opportunities

The combination of Department 56 and Lenox presents several interesting opportunities. Perhaps most importantly, there's the hope that Lenox will become a leaner operation. Aside from any cost-savings made possible by the merger, there is also the simple fact that Department 56 was always a leaner operation than Lenox, and that the management at the new company might be more adept (or more determined) to keep costs down.

There is also some promise to the idea of selling all of the company's brands together. To a large extent, the distribution channels are similar. The "All The Hoopla" concept proves the company is committed to this bundling of its products. However, it's hard to see how the company's products are going to be much of a draw on their own. Is there really enough demand for these Lenox operated retail stores? The company's current plans call for a very limited launch. So, the price of failure would not be very great. Obviously, a success here would greatly benefit the company in the long run.


Conclusion

Lenox is an interesting opportunity. The business looks very cheap based on averages of past sales, EBIT, pre-tax earnings, etc. However, Lenox is now an entirely different company. The old Department 56 business faces rapidly declining sales. Neither Lenox nor Department 56 looked like a very promising business at the time of the merger. Today, they don't look a whole lot more promising together.

On the other hand, it's important to look past the company's recent results (which include a large write-off). It will take time to see the full effects of the merger. At present, it's difficult to judge either company independently, because of the acquisition.

Still, this is clearly a cheap business by most measures. There are problems at Lenox (as there were problems at Department 56). But, if the business can be run right, it should reward shareholders who buy at today's extraordinarily low levels.

Morgan's letter presents both the hope that there will be change and the realization that such change will not be easy. Clearly, the company's past performance has been unacceptable. The stock has never been as cheap as it is today; but, the problems have been just as bad.

Lenox offers an interesting opportunity for patient investors. Nonetheless, being a Lenox shareholder is certain to frustrate you even if it does eventually reward you.

Submitted by:

Geoff Gannon

Geoff Gannon writes a daily value investing blog and produces a weekly (half hour) value investing podcast at Gannon on Investing.




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