GATEWAY 2000 (NYSE: GTW) rose $4 7/16 to $34 1/4 after receiving an upgrade from Prudential Securities to "buy" from "hold." Prudential noted the company's "compelling valuation" and "potential for takeover" as reasons for upgrading the direct seller of PCs. Last month Gateway warned that third quarter earnings would be lower than expected due to price cuts on burgeoning inventory, which resulted in earnings estimates dropping to $0.18 a share, down 54% from the third quarter of 1996. Gateway's overexposure to the consumer desktop market has resulted in some competition-related gyrations over the last couple of months. Contrast that with direct sales leader DELL COMPUTER (Nasdaq: DELL), which actually reported an increase in gross margins in its latest quarter due to sales of higher-end desktops and servers to corporate customers. Takeover speculation aside, Gateway's "compelling valuation" may have something to do with it looking cheaper on a trailing basis than going forward. Gateway trades at 19x trailing earnings and 23x forward estimates. The forward estimate is 16% lower than the trailing EPS, which is not a discount to its projected annualized 13% growth rate (six quarters away at $2.22 EPS for FY1998). However, a comparison to Dell will always make it a "compelling" value.

STAC INC. (Nasdaq: STAC) gained $2 3/16 to $7 3/16 on announcing that it has entered into an alliance with INTERNATIONAL BUSINESS MACHINES (NYSE: IBM). Stac's information recovery Software Replica 3 for NetWare and Windows NT will be leveraged with IBM's distributed storage management product, ADSTAR Distributed Storage Manager (ADSM). IBM's product is used with storage devices, and offering Stac's software, which can restore crashed systems and duplicate the contents of servers, is a natural fit. Stac also announced today that its subsidiary, Hi/fn Inc., began sampling the industry's first single-chip compression/encryption engine at the Networld+Interop show in Atlanta this week.

It seems that the dental products arena is plagued with players that have met with some success, despite often being just one step ahead of inflated expectations. Notable examples include GUMTECH INTERNATIONAL (Nasdaq: GUMM), PREMIER LASER SYSTEMS (Nasdaq: PLSIA), and ENAMELON INC. (Nasdaq: ENML). These companies' products speak volumes about the dominant reaction to dental visits, and that is pain. MILESTONE SCIENTIFIC (Nasdaq: WAND), maker of a device touted to replace painful injections with traditional syringes, jumped $2 1/2 to $25 after announcing distribution arrangements with "some of the largest full service dental dealers." The first step in any company analysis is making sure the product works... so, Milestone Scientific will be holding a press conference demonstrating its product, The Wand, on Thursday, Oct. 16 from 8:45-9:30 a.m. at Nasdaq's offices in Manhattan. If you are interested in attending, contact Susan Bolen at (212) 370-4500.

QUICK TAKES: The largest U.S. breeder and producer of cotton planting seed DELTA & PINE LAND (NYSE: DLP) surged $4 3/4 to $43 1/8 on takeover rumors... Liquid crystal displays and light emitting diodes company THREE-FIVE SYSTEMS (NYSE: TFS) rose $2 1/4 to $26 1/2 after reporting earnings of $0.19 per share for its third quarter... NATIONAL STEEL (NYSE: NS) climbed $1 1/8 to $17 on an upgrade from Deutsche Morgan to "buy" from "hold"... UNITED HEALTHCARE (NYSE: UNH) moved $3 3/16 higher to $53 3/8 as the healthcare provider received an UBS Securities upgrade to "buy" from "hold"... Biopharmaceutical company CUBIST PHARMACEUTICALS (Nasdaq: CBST) rose $7/16 to $6 3/8 on announcing that it has expanded its alliance with MERCK & CO. (NYSE: MRK) to discover and develop antibacterial drugs.

Electronic design automation firm ANSOFT CORP. (Nasdaq: ANST) continued its rise, gaining $3 5/16 to $18 5/16 after yesterday's exposure in Investor's Business Daily and today's interview with the company's CEO on CNBC... SCM MICROSYSTEMS (Nasdaq: SCMM) gained $6 1/4 to $25 3/8 after yesterday's IPO... Document management systems company IMNET SYSTEMS (Nasdaq: IMNT) gained $5 11/32 to $24 3/4 after confirming last night that its 10-K for the fiscal year ended June 30, 1997 was accepted by the SEC, clearing up previous questions about the company's filings... LERNOUT & HAUSPIE SPEECH PRODUCTS (Nasdaq: LHSPF) exploded $9 7/16 higher to $58 7/16 after BancAmerica Robertson Stephens initiated coverage of the voice recognition software company with a "buy" rating.

INTEGRATED SILICON SOLUTION (Nasdaq: ISSI) said it believes it will "meet or exceed" analysts' consensus estimate of a loss of about $0.07 per share for the fiscal 1997 fourth quarter, which boosted shares $1 11/16 to $13 13/16... ENERGY CONVERSION DEVICES (Nasdaq: ENER) rose $1 7/8 to $15 15/16 after it was awarded a two-year multi-million dollar contract to support development of a new, low-cost manufacturing system for digital versatile disks (DVD), a high-storage-capacity optical memory product.


Brokerage HAMBRECHT & QUIST GROUP (NYSE: HQ) dropped $2 3/4 to $37 1/4 after Smith Barney lowered its rating on the investment banker, brokerage, and venture capital firm to "sell" from "neutral." Smith Barney had raised its rating on the company to "neutral" from "underperform" in early August, but that was after issuing the "underperform" following a run up in the company's shares after two of its San Francisco peers were acquired by huge banks. Prior to that, the analyst had been sitting on the sidelines earlier this summer with a "neutral" rating even though the stock was trading around $16, or around 1.5 times book value. While some caution might be warranted with the stock trading at 3.5 times book value (with minuscule debt on the books), a record of issuing a "neutral," then "underperform," then "neutral," and then "sell" while the stock has moved from $16 to $40 is amusing for investors to behold.

QUINTEL ENTERTAINMENT (Nasdaq: QTEL) lost $1 7/16 to $8 15/16 after announcing that it expects to report third quarter earnings below those of the year-earlier period when it earned $0.20 per share. The Psychic Readers Network company blamed the lower earnings on a higher incidence of customer chargebacks for its telecommunications entertainment programs. Normally, the company records revenues at the time of a billable call and nets out chargebacks based on historical chargeback rates. An increase in chargebacks isn't a favorable development for the company. Today's blip means that either the company will have to record larger reserves down the road, its return on marketing expenditures is falling, or the quality of its customer base is falling.

Software development tools company RATIONAL SOFTWARE (Nasdaq: RATL) lost $3 5/16 to $11 1/2 after Cowen & Co. lowered its revenue growth forecast following a conversation between the firm's analyst and company management. Lo and behold, about 25 minutes after the close of trading, a Rational Software press release came across the wires saying that company management expects revenues to come in at or slightly below expectations for the remainder of fiscal 1998 and those earnings will miss estimates because of increased competition in its markets. That guidance also applies to fiscal 1999, the company said.

QUICK CUTS: TRAILER BRIDGE (Nasdaq: TRBR) was run over for a $3 13/16 loss to $9 3/8 after the shipping company said it will see a nearly 5% decline in Q3 revenues... Shares of restaurant operator APPLEBEE'S INTERNATIONAL (Nasdaq: APPB) fell $2 1/16 to $22 9/16 after the company said it expects 1997 third quarter earnings to exceed last year's results but fall short of analysts' estimates... Nursing home and retirement center operator ADVOCAT INC. (NYSE: AVC) lost $2 to $10 13/16 after announcing that it expects third quarter earnings to be $0.20 to $0.22 per share as a result of issues related to licensure surveys... Car dealership empire aspirant REPUBLIC INDUSTRIES (NYSE: RII) lost $2 1/8 to $33 3/4 as brokerage Robert M. Cohen lowered its rating on the company to "hold" from buy" as the stock hit Cohen's target price.

Yearbooks and class rings purveyor JOSTENS INC. (NYSE: JOS) flunked today, losing $2 13/16 to $24 13/16 on stating that its financial results for the quarter ended Sept. 27 will be below year-earlier levels and will miss analyst's estimates... Many multinational firms lost ground following Federal Reserve Chair Alan Greenspan's appearance before the House Budget Committee today. IBM (NYSE: IBM) lost $1 9/16 to $105 1/4; PHILIP MORRIS (NYSE: MO) was smoked for a $1 loss to $41 5/8; COKE (NYSE: KO) was pushed back $1 1/16 to $62 3/4; and CHRYSLER CORP. (NYSE: C) conked out for a $1 1/16 loss to $34.

An Investment Opinion by Louis Corrigan

The Franchisor as Lender

The financial media love to find well-paid, high-profile Wall Street pundits to opine on the risk of history repeating itself. Because the October 1987 crash -- and the ensuing recovery -- has served as a touchstone for the current generation of investors, we've recently been treated to various prognosticators reading the market's tea leaves as we approach this ten-year anniversary. All of this discussion is interesting, of course, but hardly very useful when someone goes looking for an actual investment idea.

After all, history never repeats itself, but business models typically do. That's why studying the history of businesses rather than the history of markets is generally more productive for investors. Looking closely at how a business model has succeeded or failed in the past often proves instructive when considering the latest incarnation of that same model. That's true almost regardless of what goods or services a given company is actually selling. For a Fool, then, what's happening in the stock market overall is of secondary importance to what's happening at an individual company. And a company's actual business is to some extent secondary to the basic model on which it's based.

One could highlight this point by comparing two leading PC manufacturers, COMPAQ (NYSE: CPQ) and DELL (Nasdaq: DELL). While both companies have delivered exceptional results, Dell's has been a better business because it is based on a made-to-order, direct-sales model that permits remarkably fast inventory turnover and thus extraordinary return on assets. For an industry that's seen accelerating price pressures over the last decade, Dell's model has proved so successful and, indeed, necessary for survival, that competitors have tried to adjust their operations to mimic Dell's success. Compaq even considered purchasing GATEWAY 2000 (NYSE: GTW), Dell's more consumer-oriented but less successful direct-sales rival.

What's got me thinking about business models, though, are the related franchising disasters that are BOSTON MARKET (Nasdaq: BOST) and its majority-owned sidekick EINSTEIN-NOAH BAGELS (Nasdaq: ENBX). For those who haven't followed the story, both of these former highflyers have collapsed over the last year, with many consumers who loved the restaurants left hating the stocks. What happened? The financial press, from Fortune to Business Week, finally offered some astute reporting on the charade that began in these corporations' SEC filings and was perpetuated by certain Wall Street analysts who couldn't get enough of these stocks.

These analysts just happened to work for firms that made a lot of money underwriting financing deals that raised hundreds of millions of dollars for these companies in just the last year, reinforcing a powerful if perhaps misguided belief that the supposed firewall between the investment bankers and the presumably objective sell-side analysts at most firms is quite porous. In the past ten weeks, both the "Chicken" and the "Bagel" have been hit with a spate of class-action lawsuits charging that the firms' top managers falsified earnings reports, hiding the fact that the companies overall were actually losing money despite reports of rising earnings. At least one lawsuit also names underwriters Alex. Brown, Morgan Stanley, and Merrill Lynch.

Franchising is as American as MCDONALD'S (NYSE: MCD). Among the hot stocks every year, you'll find a handful of chains, from restaurants to smoothie shops, looking to expand by franchising. Done right, franchising obviously can work beautifully. The franchisor builds a brand and shares the risks and the rewards of a new business with its franchisees. Taking advantage of low per-unit costs for a large operation, the franchisor usually sells products directly to its franchisees, or works out manufacturing or distribution arrangements for the individual stores to get a steady supply of the company's standard items, whether that be burgers or oil filters. A company built on franchising can be a cash cow. It typically collects initial fees from individual franchisees or area developers that pay the company for the right to open new stores. Longer term, the franchisor pockets regular royalty payments from the individual store operations. The franchisor worries about making the whole system more efficient and profitable, but the cost associated with managing each location is the responsibility of each franchisee.

The key to a successful franchise is a business that has strong growth prospects because it's profitable enough for the franchisees to make money even after paying their dues to the corporate office. It's the opportunity for profits at the franchise level that drives the growth in new store openings, at least in theory. What that means is that while a franchisor may contribute some financial support (on top of other forms of support) to get individual franchisees started, the corporation generally demands that the franchisees risk their own dough, too. After all, the franchise owner may be just a cookie-cutter capitalist, but as a capitalist, he needs to put his own money at risk.

Both the "Chicken" and the "Bagel," though, have taken a different approach. Instead of working with a bunch of individual franchisees, they've concentrated on growing their lead brands by working with a handful of supposedly more seasoned and professional area developers, each responsible for opening dozens of stores. To manage this type of growth, the companies have loaned these developers the necessary start-up money. To do so, they've had to raise millions from the public, mostly through stock or debt offerings. The money loaned from the public company to the franchisee then shows back up on the public company's books in the form of interest payments. Those interest payments get counted as part of operating income, and thus earnings.

To take a specific example, in the first two quarters of 1997, Einstein took in $30 million in total revenue. Of this, $2.1 million came from a few company-owned stores now jettisoned. Most of it, however, came from royalties (5% of gross sales for the chain, or $7.3 million), franchise-related fees ($10 million), and interest income ($10.6 million). Subtracting $14.6 million in expenses, Einstein's results show operating income of $15.4 million, or $0.30 in earnings per share. Not bad given the company earned just $0.25 for all of fiscal year 1996.

Operating income, however, usually means continuing income, but that's not the case here. The franchise fees are a one-time deal. They will remain strong only as long as the company, now with over 500 stores, continues its breakneck growth. The interest payments have nothing to do with operations, unless you imagine that Einstein is actually a bank operating under the disguise of a bagel retailer, which is not a completely ridiculous way of looking at it. When all is said and done, the royalties represent the only real source of continuing income since the interest payments are really just covering Einstein's own cost of capital. But corporate expenses dwarf the royalty payments. Even worse, a close look at the SEC filings shows that the area developers are still losing money, meaning that even the royalty payments reported by Einstein are essentially loans from the corporate office recycled as income.

These dubious accounting practices, then, hide the fact that Einstein's operations, including the franchisees, are losing a lot of money and that the risks fall overwhelmingly on the public equity and debt holders rather than on the franchisees. Since the company is, to a large extent, in the business of making loans to its developers, one would assume the company would have a loan loss reserve for bad debt. It doesn't.

For a company like this to survive and eventually thrive, the individual stores need to become profitable. Since that may take some time, the company must continue selling franchises to bring in the one-time fees that help keep earnings looking good. But it can't keep selling franchises unless it has the money to develop them and that money only comes from public investors convinced that the earnings look good and are only getting better. That's why just pointing out that the emperor has no clothes may be enough to bring the kingdom down. That hasn't happened yet, but the shorts see the populace wising up. The deathblow might be some loan defaults from the area developers necessitating either a write-down of assets (most of which are actually just loans), or a demand from the auditors for the company to restate earnings.

If you know the business model, you can at least look for signs of the death rattle if not actually predict it. In The Art of Short Selling, Kathryn F. Staley recounts the story of one-time highflyer Jiffy Lube, the oil-change franchisor eventually taken under by Pennzoil. Here was a consumer-friendly concept that enjoyed lightening fast store expansion, a soaring stock price, and then, eventually, disaster. Backing out the company's nonrecurring earnings income, the steadily rising earnings clearly should have been losses. Like Boston Market and Einstein Bagels, the company went repeatedly to the debt and equity markets to raise cash, and managed to do so for a surprisingly long time despite the criticisms of short-sellers. But since most of the company's assets were essentially loans to franchisees, the company faced a massive write-down once the franchisees faced price competition, stumbled, and couldn't pay back the loans. The result: the stock that had traded around $25 in early 1987 ended up at $2 1/2 less than three years later.

Oil changes vs. bagels and chicken dinners. Is there a difference? Next week we'll take a closer look to see whether the demise of Jiffy Lube and its franchisor-as-lender model really does spell the eventual doom of these two restaurant chains.


10/09/97 (Thursday)
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Every day, News writers Dale Wettlaufer and Randy Befumo engage in an impromptu discussion about the stories they find most compelling from the day's news, adding color, fresh commentary and the occasional wisecrack for your listening enjoyment. Check it all out in the Motley Fool's Evening Report on RealAudio, produced by partner Westwind Studios and sponsored by Mapquest.

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