Gallium arsenide (GaAs) semiconductor maker VITESSE SEMICONDUCTOR (Nasdaq: VTSS) gained $2 13/16 to $48 9/16 after reporting Q4 EPS of $0.26, slightly topping estimates of $0.25. Vitesse is one of the "big three" pure-play GaAs chip makers (the other two being TriQuint and Anadigics), and sports the richest valuation of the group, trading at 22x sales, 56x trailing earnings, and 42x forward earnings. The company's premium valuation has come largely as a result of the its industry leading trailing operating margins of 25% and its return on invested capital of 20%. Another GaAs technology company in the news today was radio frequency integrated circuit maker RF MICRO DEVICES (Nasdaq: RFMD), which gained $3/4 to $16 1/2 after reporting Q2 EPS of $0.05 versus estimates of $0.04 (which were guided down earlier in the month by the company). Strength in the gallium arsenide segment will accelerate as manufacturing processes continue to improve and as the performance merits of the technology are recognized.

Taiwanese PC soundcard and multimedia technology company CREATIVE TECHNOLOGY LTD. (Nasdaq: CREAF) rose $5 5/8 to $26 3/8 in the wake of its Q1 earnings report of $0.55 per share, well ahead of estimates of $0.45. Best known for its Creative Labs subsidiary, the company has been the leader in sales of PC multimedia upgrade kits and soundcards with its ubiquitous line of Soundblaster products, and its stock has taken off as a result. The company's graphic boards are in demand due to shortening product cycles that put a premium on the flexibility of quick upgrades via add-ins (as opposed to graphics functionality built onto the motherboard). Only a small portion of the company's revenues actually come from graphic boards, and for those products Creative uses chips from 3DLABS INC. (Nasdaq: TDDDF), which was up $3 1/4 to $27 5/8 today on a number of design wins and an agreement with IBM (NYSE: IBM).

QUICK TAKES: The Dallas-based unit of the USX Corp. involved in natural gas, USX-DELHI GROUP (NYSE: DGP), rose $2 11/16 to $19 3/16 after it was announced by USX that the Delhi Group is being sold to Koch Midstream Enterprises for $762 million... WAINOCO OIL (NYSE: WOL) gushed $1 1/16 higher to $7 after third quarter net income came in at $0.42 per share... NEXTLEVEL SYSTEMS (NYSE: NLV) reported last night that it was "encouraged" by the growth in demand for its digital cable system, which helped shares rise $1 7/16 to $15 1/16 today... Corrosion control engineering services company CORRPRO CO. (NYSE: CO) scraped off some rust, rising $1 3/16 to $14 1/4 after reporting Q2 EPS of $0.35 versus prior period EPS of $0.09... Professional and technical data services provider GRC INTERNATIONAL (NYSE: GRH) climbed $5/8 to $7 1/16 after posting Q1 EPS of $0.12, compared with prior year EPS of $0.09.

Out-of-home advertising displays company OUTDOOR SYSTEMS (NYSE: OSI) rose $1 7/8 to $28 7/8 after posting Q3 EPS of $0.09, even with estimates... IMPERIAL BANCORP (NYSE: IMP) rose $2 5/8 to $42 1/4 after posting 3Q EPS of $0.52, topping estimates of $0.45... MINNESOTA MINING & MANUFACTURING CO. (NYSE: MMM) rose $5 3/4 to $100 3/8 after announcing that it expects fourth-quarter earnings to be within the range of analysts' estimates. In addition, Goldman Sachs raised its rating on the company today... Building products distributor SHELTER COMPONENTS CORP. (AMEX: SST) jumped $2 5/16 to $17 1/4 after announcing that it is being acquired by KEVCO INC. (Nasdaq: KVCO) for $17.50 per share in cash. Kevco was also up $2 1/4 to $14 3/4 on the news... General contractor supplier WHITE CAP INDUSTRIES (Nasdaq: WHCP) rose $6 1/8 from its IPO price of $18 to close at 24 1/8.

Client/server billing software company LHS GROUP (Nasdaq: LHSG) added $8 1/4 to $54 1/4 after reporting 3Q EPS of $0.14 versus estimates of $0.12... Metalworking tools company JLK DIRECT DISTRIBUTION (NYSE: JLK) rose $3 to $31 3/16 on reporting Q1 EPS of $0.27, beating estimates of $0.21... Disposable medical and surgical gloves maker SAFESKIN CORP. (Nasdaq: SFSK) jumped $2 7/8 to $44 5/8 after reporting 3Q earnings of $0.39 a share, topping estimates of $0.32... BISYS GROUP (Nasdaq: BSYS) gained $2 1/2 to $32 1/4 after the financial services outsourcing firm reported first quarter operating income of $0.32 per share, below the mean estimate of $0.33, but said things are on-track... Financial services company MONEY STORE (Nasdaq: MONE) rose $2 13/16 to $30 5/8 after reporting Q3 EPS of $0.55 versus estimates of $0.48... Enterprise-wide software and services company PEOPLESOFT INC. (Nasdaq: PSFT) added $4 1/4 to $66 on reporting Q3 EPS of $0.23, beating estimates of $0.20.


Commercial aerospace leader BOEING INC. (NYSE: BA) was taken down $4 1/8 to $49 7/8 after reporting that it expects to take a loss this quarter with a $1.6 billion charge to position the company for its explosive order growth. Boeing's backlog now stands just under $80 billion, and to accommodate that the company has to train scores of new employees, give its suppliers time to ramp up production, and adjust its fixed asset cost structure to hit peak profitability at a higher revenue level. In addition to this quarter's charge, the company will record charges of $1 billion next year. Near term, this shouldn't be unexpected, as the company has made numerous announcements that should have tipped off analysts and investors that the transition to a higher production level was not going to be easy. One to two years out, though, earnings may be higher than currently expected as the company makes the necessary adjustments over the coming three to four quarters.

Long-term healthcare provider VENCOR INC. (NYSE: VC) dropped $12 1/8 to $30 1/2 after the company said it expected Medicare reimbursement changes and a resulting drop in demand for services to hurt the company's upcoming earnings. In addition, the company will be stepping up marketing expenditures and spending for information systems. A number of home healthcare companies have pre-announced poor earnings in response to prospective changes in Medicare reimbursement. Among others, AMERICAN HOME PATIENT (Nasdaq: AHOM), APRIA HEALTHCARE (NYSE: AHG), and HEALTHCOR HOLDINGS (Nasdaq: HCOR) have all warned in the last 90 days that Medicare changes would hurt results. Geriatric care provider GENESIS HEALTH VENTURES (NYSE: GHV) fell $4 3/8 to $34 on this news and on news yesterday that the company is acquiring Maryland HomeLink, a medical equipment and respiratory services company.

Troubled nonstandard mortgage and home equity lender CITYSCAPE FINANCIAL CORP. (Nasdaq: CTYS) fell another $23/32 to $2 3/4 after the company said it expects to report third quarter EPS "materially below" the analysts' mean estimate of $0.55 because of whole loan sales and continuing problems in the U.K. The company has been hounded by the Blair government in that country, as apparently the Labor government doesn't realize that no one will lend to higher risk mortgage borrower unless fees are high enough to compensate for those who default. Those borrowers will have to find loan sharks from now on, because it doesn't seem as though lending has been profitable in the U.K. for Cityscape since new regulations were put into effect in July. To remain liquid, Cityscape will also be selling whole loans rather than securitizing loans, which will hurt margins. The company's largest investor, Michael Price, may want to put his bankruptcy experts on this one, as tangible shareholder's equity after convertible share liquidation preference looks to drop below the approximately $3.76 per share reported last quarter.

QUICK CUTS: SUNQUEST INFORMATION SYSTEMS (Nasdaq: SUNQ) lost $3 to $8 7/8 after the healthcare information systems company reported Q3 EPS of $0.04 before the write-off of purchased R&D related to an acquisition, which was well below the mean estimate of $0.16... Managed healthcare provider MAXICARE HEALTH PLANS (Nasdaq: MAXI) slid $2 15/16 to $15 1/2 after reporting a loss of $0.97 per share, missing the estimate of a loss $0.17 per share because of taking reserves for unanticipated healthcare costs... Mortgage insurance provider AMERIN CORP. (Nasdaq: AMRN) fell $2 15/16 to $28 1/4 on reporting third quarter net income of $10.5 million, or $0.40 per share, which matched estimates... Impotency treatment company VIVUS INC. (Nasdaq: VVUS) dropped $3 15/16 to $28 9/16 after being downgraded by CS First Boston to "hold" from "buy."

Geophysical data acquisition company DAWSON GEOPHYSICAL CO. (Nasdaq: DWSN) lost $2 5/8 to $23 after announcing that it plans to sell one million shares, along with 500,000 being sold by the company's President... SPECIAL METALS CORP. (Nasdaq: SMCX) gave back $2 3/8 to $20 3/4 after the supplier of superalloys for jet engines reported Q3 EPS of $0.36, missing estimates of $0.37... Terminal block maker AXSYS TECHNOLOGIES (Nasdaq: AXYS) lost $2 5/8 to $26 5/8 after the company reported that it was issuing 1,528,550 shares of common stock in a public offering at $27.00... Long-term care provider HEALTH CARE & RETIREMENT (NYSE: HCR) lost $3 to $38 15/16 as investors fear changes in Medicare reimbursement.

An Investment Opinion by Louis Corrigan

Chicken Guts

In the past two weeks, I've discussed the risks facing any company that adopts the franchisor-as-lender model to build a business. Last week, we looked at the challenges confronting one such company, the fast-growing EINSTEIN-NOAH BAGELS (Nasdaq: ENBX), a one-time stock market darling that has collapsed in the last year along with its once-admired majority owner BOSTON CHICKEN (Nasdaq: BOST). With traditional franchises, individual franchisees put up the majority of the money for new stores. What makes these two companies different is that they've quickly expanded their systems by providing hundreds of millions of dollars in loans to a small number of area developers responsible for opening dozens of stores in a short period of time.

As we've seen, this strategy permits an Einstein to start off reporting earnings in the form of royalty payments, one-time franchising fees, and interest on the loans it hands out. Startup costs and operating losses are pushed off the public company's income statement because they properly belong to the area developers. The beauty of orchestrating soaring earnings out of the company's growth is that an Einstein finds it easier to go back to Wall Street for more financing. That's exactly the idea, because the system growth depends on a steady source of fresh cash.

For this strategy to work, the individual stores must be able to become profitable enough for the developers to cover all their costs. Otherwise, the developers might end up defaulting on the loans. That could wallop these public companies' financials since neither has any loan loss reserve. The problem is that, at the store level, both of these companies continue to lose money. Increasing fear over what that might mean for their long-term prospects has shaved their stock prices. That, in turn, has raised their cost of capital, forcing these companies to face new constraints on their ability to expand and thus keep the revenues and reported earnings growing.

Still, with Einstein 71% off its 52-week high of $35 and Boston Chicken 66% off its high of $41, it's worth asking whether the selling is overdone. Last week, I rehearsed the argument that Einstein-Noah looks cheap based on earnings. Despite the fact that analysts have been trimming estimates, a similar case could be made for Boston Chicken. At $14 a share, the stock trades at just 13.5 times this year's consensus earnings estimate of $1.04 per share and just 10.8 times next year's estimate of $1.30 per share. The dozen analysts offer a wide range of projections ($1.20 to $1.45 for FY98). Still, multiplying even the lowball number by the projected five-year growth rate of 28% gives us a YPEG fair value of nearly $34. In fact, earlier this month, Forbes magazine's neo-contrarian columnist David Dreman offered up the Chicken as one stock with a low price-to-earnings multiple that appears undervalued. He said it "takes guts" to go against the grain of general opinion and buy such an out-of-favor stock.

At the risk of being called a chicken, it's worth saying that finding stock market bargains isn't such a macho game. Rather than guts, what you really need is sound analysis and enough confidence to act on that analysis. And as I suggested with Einstein-Noah, investors should question whether earnings are a sufficient tool for examining Boston Chicken.

As a majority owner of the Bagel, Boston Chicken consolidates Einstein-Noah's results in its own financial statements. As a result, my analysis of Einstein last week is directly pertinent to evaluating the Chicken. For example, the Bagel contributed 63% of the Chicken's total reported franchise fees in the latest quarter and 26% of its royalty revenues. So if Einstein sneezes, the Chicken will likely catch a cold.

Also, Einstein's business model is essentially identical to that employed in growing Boston Market, the Chicken's principal restaurant chain that features home-style meals such as rotisserie chicken and fresh cooked vegetables. So the discussion of risks facing the bagel franchise apply as well. For starters, consider that the 14 remaining Boston Market financed area developers (FADs), which now operate 75% of the system's 1208 stores, owed the franchisor about $700 million as of July 13. In the process of expanding the chain from just 34 stores in 1992, these FADs lost $51.3 million in FY94, $148.3 million in FY95, and another $156.5 million in FY96.

What separates Boston Market's huge loans to money-losing FADs from Einstein's huge loans to money-losing FADs is that there have recently been very clear signs of trouble at Boston Market. When we compared Einstein's last two quarters and backed out its company-owned stores, we found that a 9.2% decline in revenue was more than made up for by a 41.6% drop in expenses. With the Chicken we see something quite different: revenues down 12.2% to $58.5 million in the second quarter and expenses up 6.3% to $55.3 million. Unlike Einstein's financials, the Chicken's public filings offer a way to gauge Boston Market's overall store performance: net weekly per store average (WPSA) revenue. In the second quarter, WPSA revenue actually dropped 9.3% to $20,334 for the second quarter of 1997 from $22,420 in the year-ago period.

Boston Market's troubles have been blamed on misguided marketing strategies and ineffective product offerings. In expanding beyond the so-called home meal replacement market, the company started pushing sandwiches, which quickly cannibalized sales of its more profitable dinner fare. In the past few months, the company has brought back former co-founder Saad Nadhir as Co-Chair, spent millions to improve operations, and recommitted itself to quality food, as witnessed by the latest advertising campaign featuring the new double-marinated chicken.

Through its interest in Atlanta-based HARRY'S FARMERS MARKET (Nasdaq: HARY), Boston Market is also experimenting with broadening its product mix to include cold entrees to cook at home and even some produce and grocery items. As a frequent customer of Harry's-in-a-Hurry, I can tell you that this formula is very popular with consumers, but it has repeatedly failed to make money for Harry's, a sad truth reflected in the company's stock performance over the last three years.

Nonetheless, Boston Chicken expects the just-ended third quarter to be the bottom of its slide, with greater focus leading to improved profitability hereafter. Yet in September, the company was forced to renegotiate the terms of its senior credit facilities since the WPSA revenue had continued falling so that it sank below the allowed levels. The new agreement requires Boston Market to deliver WPSA net revenue of at least $18,000 by November 2, suggesting the level to which sales may have slumped since the second quarter.

Also, the above cost/revenue analysis probably should not exclude company-owned stores since Boston Market, unlike Einstein, has been buying back FADs. It's picked up 4 FADs along the northeastern corridor in the last three years, so it now owns 296 stores. On average, these stores are losing money. Indeed, the latest acquisitions will "have a negative impact" on earnings according to the second quarter report. Including the company-owned stores, that report showed an 8.5% jump in expenses despite flat revenues.

Boston Market has yet to admit that any of its FADs are in trouble, but it's hard to understand why the company would have put a couple of hundred unprofitable stores on its books if it could have avoided it. Boston Market appears to be headed down the road of other franchisors that find they must repurchase franchisees to keep them going. In the next stage, they find they must close stores to stop the hemorrhaging. Finally, they take a write-down charge and acknowledge that things went badly amiss. Boston Market has already said that 50 stores systemwide would be closed during the last half of the year at a cost of $20 million to $40 million. How much of this falls to the FADs rather than the company is unclear, but as a result of these store closings, lower store sales, and declining margins, the net FAD losses this year are expected to be greater than originally projected, exceeding the $156.5 million lost last year.

The company now plans to open just 150 to 200 stores this year and 150 to 250 next year, down from the 300 new stores originally scheduled to open each year. This slowdown will no doubt help the company focus on operating the existing stores, but it will prolong the FADs' "rapid expansion phase" that is now expected to last 6 to 8 years from the time the developers really got going, or perhaps another 3 to 5 years. The second quarter filing says the company "anticipates its financed area developers will continue to incur losses during a significant portion of their rapid expansion phase." As a result, Boston Market is extending the loan agreements with the FADs, meaning it will be a while before they have to start paying back principal.

The simple formula is that write-downs decimate earnings, especially when the earnings are something of an artifact of the accounting. Although neither Boston Chicken nor Einstein-Noah has yet taken this step, it's reasonable to consider the possibility that they will be forced to, particularly since neither company has a reserve to provide a safety net. Earnings estimates just may not be very reliable when you're talking about a company that continually needs more cash to lend to developers that keep losing it. That's not to say that these stocks couldn't rally on signs of operating improvements when these companies report earnings next week. But investors bottom fishing for bargains should understand that the earnings estimates simply don't capture the risks embedded in the financial structures undergirding the Einstein-Noah and Boston Market franchises.


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Randy Befumo (TMF Templr), Fool One
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