Gee! No, GTE. Integrated telecommunications company MCI COMMUNICATIONS CORP. (Nasdaq: MCIC) gained $1 9/16 to $36 7/8 after a "GTE advisor," according to most accounts, floated a trial balloon on GTE (NYSE: GTE) making a $40 per share all-cash offer to acquire MCI. That undercuts by $1 1/2 per share the valuation WORLDCOM (Nasdaq: WCOM) has put on MCI. Unlike WorldCom's proposed stock swap for MCI, a cash offer doesn't carry a "collar." (The collar would have WorldCom increase the number of shares it will exchange if its stock price drops, and vice versa.) Additionally, the value of each dollar offered isn't going to change unless there's a world currency crisis sometime soon, which is doubtful. MCI shareholders, therefore, are torn between two lovers: one with hard currency and the other with a very valuable stock to swap. Since WorldCom can afford to up the stock swap offer for MCI by nearly one billion more shares before the deal becomes dilutive to cash flow per WorldCom share, there's room to up its bid for MCI. [For a Windows Excel 5.0/7.0 spreadsheet on this sector, including GTE, MCI, WorldCom, BELL ATLANTIC (NYSE: BEL), SBC COMMUNICATIONS (NYSE: SBC) and FRONTIER CORP. (NYSE: FRO), from last week's Industry Snapshot, feel free to e-mail [email protected]).
PINNACLE FINANCIAL SERVICES (Nasdaq: PNFI) picked up $2 1/8 to $42 1/4 after the Midwest bank holding company agreed to be acquired by CNB BANCSHARES INC. (NYSE: BNK) in a deal valuing Pinnacle shares at $46.32 apiece (as of last night's close). CNB lost $2 9/16 to $42 3/16 on the announcement. The deal comes at a discount to the valuations on smaller banks in this region of the country, at 25% of assets. At 3.5 times book value, though, it's actually slightly more pricey than comparable deals. For ceding to Pinnacle shareholders 39% of the combined company, CNB increases assets by 50% and deposits by the same amount. Plus, CNB will have more opportunities to market its consumer finance business and commercial products through Pinnacle's network. Looking at the company's capital adequacy ratios, though, this is another example of an overcapitalized bank where cash can be taken out and given back to shareholders via share repurchases.
Attention frenzied traders! The trading symbol for TELE-COMMUNICATIONS INC. is (Nasdaq: TCOMA). That's the big cable company into which cable-happy MICROSOFT (Nasdaq: MSFT) is rumored to be investing $1 billion. TRANSCONTINENTAL REALTY INVESTORS, on the other hand, is represented by the ticker symbol (NYSE: TCI). Neither Microsoft nor the cable company commonly referred to as "TCI" has anything to do with this real estate investment trust that trades under the symbol "TCI." It's interesting that Tele-Communications Inc. would rise only $11/16 to $23 11/16, or 3% on the Microsoft rumor, while Transcontinental Realty would advance $1 1/2 to $20, or 8%. Confused investors? You make the call.
RAMBUS INC. (Nasdaq: RMBS), a designer, licenser, and marketer of high-speed processor-to-memory interfaces and other chip-to-chip interfaces, gained $5 15/16 to $58 7/16 on reporting Q4 revenues of $7.8 million and EPS of $0.04, doubling the mean estimate of $0.02. Hambrecht & Quist, one of the underwriters of the company's recent IPO along with Morgan Stanley and Robertson Stephens, reiterated its "buy" rating on the company. This was possibly due to product announcements made today and the company's hitting its stated goals for this part of the gauntlet that faces all high-flying new issues.
QUICK TAKES: Auto paint and accessories distributor THOMPSON PBE (Nasdaq: THOM) surged $1 11/32 to $7 23/32 after agreeing to be acquired for $8.00 per share in cash by FINISHMASTER INC. (Nasdaq: FMST), a similar company... Healthcare software and systems company MEDPLUS INC. (Nasdaq: MEDP) gained $1 1/8 to $10 as its Universal Document Management Systems distribution unit gets ready to sell 2.6 million shares in an IPO, for which price talk is currently running from $11 to $13 per share... Mentioned in today's "Heard on the Street" column of the Wall Street Journal, Sam Zell's eighth public company, CAPITAL TRUST (NYSE: CT), jumped $2 7/16 to $13 5/8. The real estate investment company is selling eight million shares and converting from a REIT to a corporation... 360 COMMUNICATIONS (NYSE: XO) rose $1 5/8 to $21 1/4 after the wireless communications company reported Q3 EPS (before a gain) of $0.24, up 20% over last year and $0.05 per share above estimates.
RED BRICK SYSTEMS INC. (Nasdaq: REDB) popped up $1 13/32 to $9 5/8 after the data warehousing software company reported Q3 revenues of $11.7 million, up 30% from last year. EPS came in at $0.03 (before acquisition-related charges), beating the consensus analyst estimates of a per-share loss of $0.11... DUFF & PHELPS CREDIT RATING CO. (NYSE: DCR) was upgraded $2 7/16 to $35 3/16 after the insurance and corporate bond rating company reported Q3 EPS of $0.44, up 26%, and revenues of $16.7 million, up 37% over last year's third quarter... Office equipment distributor and service company IKON OFFICE SOLUTIONS INC. (NYSE: IKN) pressed ahead $2 to $29 on turning in Q4 EPS of $0.35 (before "transformation charges"), beating estimates of $0.35 and saying that it sees EPS growth of 20% in the coming year... Industrial equipment manufacturer GRAHAM CORP. (AMEX: GHM) added $2 3/4 to $22 1/8 on reporting that it squeezed a 57% increase in Q2 EPS of $0.55 out of a 15% increase in revenues of $14.6 million... High-end print server software company SPLASH TECHNOLOGY (Nasdaq: SPLH) rose $5 1/8 to $44 3/4 on reporting Q4 revenues of $25 million and EPS of $0.40, beating estimates by 21%.
SYNOPSYS INC. (Nasdaq: SNPS) fell $3 1/8 to $39 13/16 after the electronics design automation (EDA) software company announced an agreement to merge with VIEWLOGIC SYSTEMS (Nasdaq: VIEW), which gained $2 11/16 to $25 3/16 on the news. Synopsis will issue 0.6521 of one of its shares for each Viewlogic share, valuing Viewlogic at roughly $28 per share (an aggregate transaction value of over $500 million). Until recently, the lament heard throughout the design industry was that EDA tools were not keeping pace with the needs of designers. With chips rapidly moving toward more system level integration and roughly 80% of EDA revenues coming from the semiconductor segment, EDA firms are seeing the writing on the chip. Synopsis, with its strength in deep sub-micron chip design, took over Viewlogic primarily to round out its offering, snatching up Viewlogic's growing application-specific integrated circuit (ASIC) design tools. Synopsis is positioning itself to offer integrated tools and methodologies to fulfill its role as "virtual component" integrator.
Shares of INTEL CORP. (Nasdaq: INTC) plunged $5 3/16 to $86 11/16 today after the company released third quarter earnings last night. The semiconductor behemoth earned $0.88 EPS in the quarter, up 20% over year-ago levels, but two to three cents below consensus estimates. The company also offered some guidance for expectations in the fourth quarter. Intel said it expects sales in the fourth quarter to only be slightly above those in the third quarter, putting it in the neighborhood between $6.2 billion and $6.5 billion, flat with last year's tough comparison of $6.4 billion in revenues. All this is primarily a result of price cuts, as well as softening demand from "box" makers, which are trying to tighten up their inventories.
QUICK CUTS: Electronic distributor of travel-related services SABRE GROUP (NYSE: TSG) dropped $5 5/16 to $29 after posting 3Q EPS of $0.43, even with expectations... Silicon wafer manufacturer MEMC ELECTRONIC MATERIALS INC. (NYSE: WFR) dropped $2 3/4 to $22 1/4 after pre-announcing a Q3 per-share loss of $0.10, double the First Call per-share loss estimate... BARNES & NOBLE (NYSE: BKS) lost $2 7/8 to $28 7/8 after Furman Selz lowered its rating on the seller of books to "neutral" from "buy."... Engine manufacturer CUMMINS ENGINE INC. (NYSE: CUM) downshifted $7 3/16 to $72 7/16 on reporting Q3 revenues of $1.4 billion and EPS of $1.40, which more than doubled last year's EPS of $0.67 but fell short of the consensus estimate of $1.45... PaineWebber said today it lowered its rating on shares of CYPRESS SEMICONDUCTOR (NYSE: CY) to "neutral" from "attractive," slamming shares of the company $1 3/16 to $12 15/16... SBARRO INC. (NYSE: SBA), the Italian restaurant/fast food chain, lost $2 3/8 to $27 1/4 after warning that it sees Q3 earnings per share coming in flat compared with last year's results... Medical device maker GUIDANT CORP. (NYSE: GDT) tumbled $4 1/2 to $60 after posting 3Q EPS of $0.32, versus expectations of $0.33... Data warehousing AT&T spin-off NCR CORP. (NYSE: NCR) lost $2 5/16 to $35 5/8 despite reporting a narrowed, estimate-beating third-quarter loss of $9 million, or $.09 per share.
Information services firm NATIONAL DATA CORP. (NDC) crashed $2 1/2 to $39 3/16 after it announced the acquisition of PHYSICIAN SUPPORT SYSTEMS INC. (Nasdaq: PHSS) for about $176 million, sending shares of that company down $1 1/4 to $16 5/8... Shares of energy concern NUEVO ENERGY CO. (NYSE: NEV) fell $2 1/2 to $42 1/2 after PaineWebber lowered its rating to "attractive" from "buy"... COHERENT INC. (Nasdaq: COHR) was beamed down $12 13/16 to $44 1/16 after the laser manufacturer pre-announced Q4 EPS of $0.54 to $0.58, which will miss the mean First Call estimate of $0.80... Consumer finance company CITYSCAPE FINANCIAL CORP. (Nasdaq: CTYS) was litigated down $1 1/16 to $7 15/16 after it was announced that "another" class action lawsuit has been filed against it... HOME PRODUCTS INTL. INC. (Nasdaq: HPII) lost $1 3/8 to $11 7/8 today after it said last night that its third- quarter net earnings are likely to be in the range of $0.22 to $0.23... Engineered lumber manufacturer TJ INTERNATIONAL INC. (NYSE: TJCO) was shaved down $2 3/16 to $25 after it posted 3Q EPS of $0.47... Utilities meter reading equipment company ITRON INC. (Nasdaq: ITRI) fell $1 7/8 to $24 3/4 on reporting a 51% increase in Q3 revenues and EPS of $0.11, just below the mean estimate of $0.12.
Einstein's Genius in Question
Last week, this column made the hardly controversial point that business models often matter a great deal in any company's success or failure. In turning to franchisors, I suggested that looking at a firm's business model might reveal the inherent risks of an investment. The demise of one-time highflyer Jiffy Lube, the oil change company that grew by financing its franchisees, suggested that there might be significant risks for any firm adopting the franchisor-as-lender model to grow its system. The examples at hand were the related fast-growing franchise cousins BOSTON MARKET (Nasdaq: BOST) and EINSTEIN-NOAH BAGELS (Nasdaq: ENBX), both of which have left investors with some painful heartburn over the past year despite these companies' success at opening new stores and building strong consumer brands. Since the "Chicken" owns a majority stake in the "Bagel," it's worth focusing first on the latter. Are we looking at an overly criticized genius, or should we prepare for the stock to be hit with more flooding?
One of the great things about the online world is that when you're wrong, you're likely to get corrected in short order. Last week, I argued that Einstein's "corporate expenses dwarf the [firm's] royalty payments." This would be significant because while the company has been reporting solid earnings, the majority of its revenue comes from one-time initial franchise fees and interest income on the money Einstein has loaned its area developers. Excluding those interest payments as simply necessary to service the company's own $125 million in long-term debt, royalties from franchisees become the main source of recurring operating revenue and thus the key for determining the Bagel's long-term prospects. But relying on the company's consolidated statement of income, I had made some rough calculations that proved wrong given the more clearly delineated data under "royalties and franchise-related fees" in its latest SEC filing. "WallSt2001," a poster to our Einstein message folder on AOL, was quick to provide the proper numbers and to make the bullish case for Einstein.
Comparing Einstein's 112-day first quarter to its 84-day second quarter, this poster highlighted some important signs of improvement once you back out first quarter revenues and expenses related to company-owned stores the franchisor has now sold. Excluding these stores, total revenue fell 9.2% to $13.3 million during the second quarter, but total continuing expenses dropped 41.6% to $5.13 million. Royalties were sliced just 6.5% to $3.95 million. That means these franchisee payments are still a ways from covering expenses. Yet the trend definitely appears to be a long investor's friend. "WallSt2001" also provided other bullish arguments based on earnings.
For one thing, the consensus third quarter earnings estimate of eight analysts covering Einstein is $0.16, a 6.7% increase over last quarter's results. That suggests 26.8% annualized earnings growth. For comparison, the analysts put year-over-year growth at 32% based on the consensus $0.62 per share estimate for FY97 and the FY98 estimate of $0.82 (range $0.75 to $0.85). Compared to trailing earnings of $0.58 per share, those numbers also point to 26% annualized growth over the next six quarters. At the stock's recent price of $10 5/16, those numbers suggest an attractive PEG ratio of .68. With three analysts estimating five-year growth of 35%, the YPEG fair value based on FY98 estimates is about $29. Assuming Wall Street is right, Einstein appears wildly undervalued based on the standard measures for valuing growth stocks based on earnings.
The real question is whether earnings are an even vaguely adequate means for valuing Einstein-Noah. More than doubling its system this year to over 500 retail stores, all of them owned and operated now by five area developers, the company has grown system-wide revenue 149% in the last year, from $58.7 million in the first half of 1996 to $146.4 million for the first half of this year. The overall system, though, is still losing money: $1.3 million in 1995, $40.6 million last year, and perhaps more this year. Einstein's latest quarterly filing argues that "the Company does not consider these start-up losses to be a meaningful financial measure during this rapid expansion phase" when "new stores constitute a significant percentage of the store base." The problem is that this "phase" is expected to last 3 to 4 years "from the time significant development commences in an area developer's markets." So system losses could continue for 2 to 3 more years.
These losses are being financed largely by Einstein, which requires that the area developers put up just 20% of the money needed to build new stores. By the end of the second quarter, Einstein had loaned the developers $259.2 million. Much of the franchisees' contributions have come from Bagel Store Development Funding, a firm partially owned by Einstein insiders and managed by the company. As of July 13, it had loaned the developers $89.5 million. Einstein's loans are secured by the stores themselves, since the firm can ultimately convert its loans into a 70% equity stake in the area developers. Plus, Einstein charges the developers a profitable 9.5% for the revolving loans, despite having obtained $125 million of the cash by selling 7.5% convertible subordinated debentures in May and receiving much of the rest through the sale of stock.
The financing challenge is twofold. With no reserve for loan defaults, Einstein is banking on the continued financial health of it developers. But every rapidly growing chain inevitably needs to close or relocate stores from time to time. In the past, the cost of doing so has run from $60,000 to $400,000 for each company-owned store and $260,000 to $520,000 for developer-owned stores, or roughly in the $240,000 to $625,000 range of what it costs to develop a new store. A large number of store closings could put a real damper on new store openings. At the same time, while the company has recently said it planned to slow the pace of new store openings next year, Einstein's latest filing reiterates the fact that it anticipates "a continuing need for additional capital" as it moves toward 615 to 665 stores by year-end and up to perhaps 1,500 over the next 2 1/2 years. Finding a financially reasonable way to raise the needed capital would seem to be a challenge if not a problem.
The real bottom line is not Einstein's reported earnings but whether the individual stores can turn a decent profit. At this point, it's difficult to answer this question without plugging in a host of assumptions and reading between the lines of the financial reports. Despite the fact that 77 stores had been opened more than a year as of April 21, the company does not provide same store sales data, presumably because many of those stores are from the comparably strong Noah's chain acquired in February 1996 and might create overly optimistic expectations. Still, if you take the $76.5 million system income reported for the first quarter, divide it by the 112 days in the quarter and then by the 354 average number of stores open during the quarter and then multiple that per-day per-store sales figure of $1,928 by 365 days, you arrive at annualized sales of about $704,000 per store. Using the same method for the 84-day second quarter and adjusting for the 451 average store count, you get $1,846 revenues per day per store or about $674,000 in annualized sales per store. Given that most of these stores are less than a year old, Merrill Lynch's forecast that Einstein's stores will do $690,000 in sales this year and $720,000 per store next year seems reasonable.
Assuming they will, what kind of cash flow will these stores need to cover the costs of being franchisees, most of which Einstein records as revenue? If the $259.2 million in loans to developers as of July 13 simply paid for the 487 stores then opened, each store owes Einstein about $532,000. Since the developers are not yet paying off principal, interest payments on their adjustable-rate loans, recently at 9.5%, would cost them $50,540 per year. Royalty payments vary between 6% of net revenues for the company's founding stores and 5% for the stores opened in new markets over the past 18 months. Assuming 5.5% royalties on $720,000 in annual revenue, the royalty payment per store amounts to $39,600, meaning that $90,140 or about 12.5% of annual sales go to Einstein.
On top of that, each store must contribute 2% of sales to national advertising and 4% of sales for local advertising, though Einstein itself doesn't see this money. That adds another $43,200 in costs for a total of $133,200. On average, then, each individual store needs to report at least 18.5% in margins to cover these costs. Assuming that happens and that Einstein hits Merrill's per-store revenue target for FY98 on just 650 stores, then the company would record $468 million in sales, good for $25.7 million in royalties. That would be a 50% increase over the $17.2 million royalty run-rate reported in the second quarter, suggesting royalties could grow at an annualized rate of 31% over the next six quarters. If that happens, the royalties that now fall just 23% short of expenses would likely exceed them.
If that happens, Einstein will also look like a genius and today's stock price will look cheap. Still, such an outcome depends on a number of assumptions. Plus, Einstein's filings show it has in the past sold 118 stores for $59.7 million, or $506,000 a piece, roughly the start-up cost of a new store. Assuming the company can expand to 640 stores using its $70.2 million in cash, the chain would then be valued, on a similar basis, at just $324 million, substantially below its post-expansion enterprise value of $491 million, assuming the shares trade around $11. Also, Einstein only has the right to convert its debt into a 70% ownership interest in its stores.
Then there's the example of Bruegger's Bagel, the now extraordinarily troubled bagel franchise that QUALITY DINING (Nasdaq: QDIN) acquired in June 1996 for over $140 million. Quality spent $38 million through its Bagel Acquisition Company to purchase and try to re-sell 48 retail stores. When that failed and Quality finally moved to consolidate those store operations into its overall financial statements, the result was a reduction in royalty revenue but also a substantial loss in Quality's book value since the underlying assets -- the bagel stores -- weren't worth as much as the company had paid for them. In the end, Quality took a $185 million write-down charge plus a $15.5 million charge to close stores. In the recently announced deal allowing Bruegger's founders to take back the business, Quality expects to receive just about $45 million, $26 million of that in Quality stock based on a price of $6 per share. When the deal was announced in August, Bruegger's had 476 retail bagel stores, 317 owned by franchisees and 159 by Quality. In the second quarter, Quality reported $18.6 million in revenues from its 159 company-owned stores, suggesting annual sales of about $509,000 per store, significantly less than the typical Einstein store.
Is the downfall of Bruegger's a cautionary tale for Einstein investors, or perhaps a sign that Einstein is on the way to winning the bagel wars? From most accounts, Quality badly mismanaged Bruegger's rapid expansion. Plus, while there are risks in Einstein's franchisor-as-lender model, there are also advantages to cultivating a handful of area developers rather than hundreds of individual franchisees. The decreasing number of these developers are presumably in better financial condition overall than your mom-and-pop franchisee, so they are better able to weather any short-term troubles. Still, Bruegger's is a bagel franchise about three-quarters as large as Einstein will be by year end. And it's in the process of being sold for about a tenth of Einstein's probable enterprise value a few months from now, assuming Einstein stock just stays around $11 per share.
It's too early to tell whether Einstein's stores can actually make enough money to support the company's financial obligations, or how much more time the company can buy in new financing commitments. If its plan works, the stock could rise substantially from here. But with the company's high-wire financing act, the risk still seems great that the Bagel could just as easily end up as toast. The company will report results the last week of October. Einstein's spokesperson Gary Gerdemann said the company's earnings reports and press releases can be obtained at that time via fax by calling 1-800-321-3768. Next week, we'll look at the Chicken.
FORD (NYSE: F)
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