Paris, France (December 28, 1998) -- Welcome to the final week of 1998. During the next three days, we're going to review our companies' performances over the past 51 weeks. We'll begin with Intel and Campbell Soup today, then move to a more detailed look at our most complex company (based on product diversity), Johnson & Johnson, tomorrow. Finally, on Wednesday, we'll consider our newest purchase, Mellon Bank.
So, without further ado...
Intel: "I Surprised You this Year, Didn't I?"
This was the first year in a decade that Intel (Nasdaq: INTC) didn't grow earnings per share from last year. Earnings actually declined. That surely spelled "disaster" -- we should have written the company off after its first quarter 1998 results, right? The company said as long ago as April that the rest of the year would trail last year and that it had many challenges (and declining margins) to face. We should have "downgraded" the stock and sold it like so many money managers and mutual funds. Correct?
And then watched in dumb horror as the stock rose 72% by December 28th.
You see, this is why all the education in the world -- and all the brains -- can't help you outsmart the stock market. It was perfectly LOGICAL that Intel's stock would experience a very lackluster year (or longer). Criticism of the Drip Port was persistent as this year began. It went along the lines of: "Intel is a great company guys, but even it will have bad years. This is obviously one of them. The company said so itself. So why are you buying the stock now? It's dead money."
We would steadily respond to each e-mail: "Perhaps it is 'dead money' for now, but we're Drip investors and we dollar-cost average into our investments, so we actually appreciate the opportunity to buy great companies during slower periods of growth. Beyond that, nobody truly knows what the stock market will do this year, let alone any particular stock." The response back, if there was one, often went like this: "Intel won't have any earnings growth at all this year. It will have negative earnings growth! The writing is on the wall. The stock is dead money." More than a few people admitted that they were shorting Intel because of this. (Arguably, shorting any high-quality company based on already widely known information isn't the best idea.)
As it turned out, Intel sluggishly reported three quarters of revenue averaging around $6 billion each (imagine that: $6 billion in 90 days being sluggish!), and now fourth quarter '98 revenue should grow 8% to 10%, to $7.3 billion. Early in the year, management predicted that business would accelerate in the second half of 1998, and it did; it did more so than expected, causing analysts to trip all over themselves in order to raise earning estimates for 1998 and 1999. And 2000. In fact, we probably saw a near-term high for the stock last week after the last bear standing (and the most prominent) finally threw in the towel (without admitting that he had been woefully wrong, of course) and went bullish on the stock.
This year the average personal computer declined in price by over 7%, pressuring Intel's margins at the same time that competitors make headway in the new low-end PC market. Intel's gross margin dipped below 48% by midyear, but it is expected to climb to 55% this quarter. Intel is aggressively focused on cost-cutting while high-margin sales of more expensive chips (such as Xeon) are boosting its profitability, too, despite the company's entry into the low-margin sub-$1000 PC market. (A market in which Intel is quickly gaining ground, now holding total market share of above 30%.)
A large reason why Intel's business performed as well as it did this year is its 1997 strategy of splitting itself into divisions to focus on specific markets. This was a risky, "first-time" move for Intel to make, but it's paying off in spades. This 1997 initiative made it possible for the company's divisions to doggedly address each market's needs and then supply those needs. Meanwhile, the marketing blitz behind the Intel name (gotta love those new Pentium commercials!) maintained the company's leading brand as it fingerpunched its way into each specific niche of the PC market.
This strategy also granted the company selling power in high margin, high-end chips, which goes to offset new sales of low-margin chips. The company was actually able to hold its average selling prices flat this year despite the sharp decline in PC prices. Its average chip sold for $210 this year, with Celerons going for as low as $85 and Xeon workstation chips for as high as $2,000. All of the Pentiums in the middle-range were the giant important ballast.
In the first six months of 1999, Intel will move completely to 0.18 micron technology (down in size from 0.25), allowing the company to produce 75% more chips per wafer and cut costs significantly (again). To save even more money, Intel is reusing over 65% of its current equipment in the transition to 0.18 micro, rather than buying new equipment. The company is also saving money through attrition of employees and reduced headcount. Finally, Intel is booking over $1 billion in sales per month over the Internet, which lowers expenses, too.
All told, next year Intel could achieve nearly $1 billion in cost savings from the above initiatives. Meanwhile, sales could rise to $31 billion and net income could soar to $8 billion. A majority of Intel's revenue will be derived, once again, from high-margin Pentium II and Xeon chips. It will offer faster versions of all (and of Celerons) in 1999. (A note: We -- "we" meaning "I" in this case -- expect the Internet to fuel more computer buying than conventional Wisdom currently foresees for the next five years. This is proving to be true in 1998.)
After earning $3.87 per share in 1997, Intel should earn over $3.73 this year, down marginally. For 1999, the I/B/E/S earning estimate is $4.58 per share, though estimates vary and $4.28 is just as likely -- after all, who knows? At a recent $125 per share, the stock trades at 27 to 29 times the above estimates. Conventional Wisdom holds that this is "very expensive for a semiconductor company." Foolish wisdom, on the other hand, argues that these company classifications and the "boxes of reasonable and unreasonable multiples" that they impose on stocks is Wise. I don't know what a "fair" earnings multiple for Intel might be, but as Dale Wettlaufer pointed out last week in a Fool on the Hill column, cash itself is trading at a 31 multiple.
Whatever might be fair, we're such long-term investors that we're not incredibly concerned about near-term valuations. Our cost basis of $80 per share is priced at 17 to 18 times 1999 earning estimates. Groovy. We'll be investing more in Intel when possible.
Campbell Soup: "NO [MONEY] FOR YOU!"
Unfortunately for our modest (but above the U.S. average!) savings and investing regimen, this year Campbell Soup (NYSE: CPB) instituted fees for optional cash payments that discouraged us from sending money its way, so we haven't for several months. Fortunately, the stock has underperformed Intel and J&J -- where we sent our money instead -- so for now anyway, no love lost. Campbell's business, meanwhile, has performed quite well.
We recently covered the company's first quarter 1999 results. In mid-November, Campbell reported a strong 7% increase in soup sales, with a 4% rise in U.S. soup volume. This indicates that the company's strategy is working. Its soup volume is rising in a soup market that's happy just simmering -- flat. Campbell is increasing its sales with new products and renewed advertising. Its increased advertising will continue in 1999, as will its annual 2% share buyback.
The profitability improvements at Campbell have been nothing short of outstanding. Management has executed wonderfully. And finally, this year Campbell spun-off its last "large business" to Vlasic (NYSE: VL). Management is now able to focus on increasing soup volume: its number one priority. In conjunction, management's intense focus on cost cutting and efficiency (following a focus on high-margin products) is placing Campbell among the best of the best of all American corporations when it comes to profitability ratios, from gross margins to net margins. For more on this and the business overall, check out the Fool's Dueling Fools on Campbell.
At a recent price of $56, Campbell trades at 26 times 1999 earning estimates of $2.15 per share, and at 23 times year 2000 estimates. Earnings per share are expected to grow about 13% annually. Again, what is a fair price to pay for Campbell? Clearly, like Coca-Cola, the stability and certainty of this business merits it a significant premium. (For more on Campbell Soup, the food and beverage industry and 19 other industries, check out the Fool's new Industry Focus 1999 book. To discuss Campbell, Intel, or Drip investing, please visit the message boards linked in the top right of this page.)
Tomorrow, a closer look at Johnson & Johnson. Fool on!
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