Monday, December 29, 1997
DJIA:           7792.41  +113.10     (+1.47%) 
S&P 500:         953.36   +16.90     (+1.80%)
Nasdaq:         1537.45   +26.07     (+1.72%)
S. Korea         375.15   +23.70     (+6.74%)
30-Year Bond  102 26/32    -9/32  5.92% Yield


Auto parts, aerospace equipment, and chemical maker Allied Signal (NYSE: ALD) gained $2 7/16 to $38 1/4 after receiving favorable coverage in this weekend's issue of Barron's. In the article it was suggested that the firm could make $3 per share by the year 2000 (lower, actually, than what analysts' long-term growth models indicate, according to First Call), and that its share price could reach $50 to $52 in the next 12-18 months. Company CEO Lawrence Bossidy laid out some of the company's growth strategies for coming years, which include growth through intelligent acquisitions, the deployment of excess capital through acquisitions and not share buybacks, and a continuation of the company's "fix it or sell it" strategy. Investors trust that the former philosophy applies to the company's auto parts unit, which is still undergoing a move to consolidation and which caused the company's third quarter EPS of $0.52 to miss estimates of $0.53.

While spot crude oil fell 2.5% today, the spot price of natural gas increased 2.5% as Mid-Atlantic states prepared for a nor'easter and heavy snowfalls expected through West Virginia into North Carolina. Of particular note was strength in 1998 gas contracts and heavy volume and a sharp upward move in the Jan 2000 gas contract. In that constructive atmosphere, oil and gas drillers gained ground, albeit on very light volume. Jackup rig operator Noble Drilling (NYSE: NE) gained $1 3/16 to $28 5/8 and diversified offshore driller Reading & Bates (NYSE: RB) rose $3 1/16 to $38 11/16, accompanied by merger partner Falcon Drilling (NYSE: FLC), which added $2 3/16 to $32 9/16. While drilling equipment manufacturer Varco International (NYSE: VRC) jumped $1 5/8 to $20 3/8 and Maverick Tube (Nasdaq: MAVK) gained $3 to $23 15/16, other heavy infrastructure companies such as offshore pipeline construction firm Global Industries (Nasdaq: GLBL), shipyard company Halter Marine (AMEX: HLX), and drilling rig construction and retrofit firm Friede Goldman (Nasdaq: FGII) made smaller moves higher. Some industry watchers believe that these companies have more leverage in their operating models than many of the drillers and services companies, which have seen their moves from the earnings floor and which are heading for more steady, normalized growth.

QUICK TAKES: Computer Motion (Nasdaq: RBOT) gained $3 11/16 to $11 13/16 after the company's voice-controlled robotic arm capable of positioning an endoscope for minimally-invasive thoracic surgical procedures was granted 501(k) market clearance by the FDA... ONSALE Inc. (Nasdaq: ONSL), an Internet firm that conducts interactive online auctions, gained $2 5/16 to $16 7/16 after the company reported selling more than $1 million worth of disk drives as part of Singapore Technology's liquidation of its Micropolis storage products unit... EMC Corp. (NYSE: EMC) gained $1 1/2 to $25 5/8 as investors realized that cheaper disk drives mean lower component costs for the maker of enterprise storage systems. SoundView today raised its short-term rating on the company to "buy."

Netscape Communications (Nasdaq: NSCP) rose $3 1/16 to $26 3/4 after the developer of intranet applications and web browers was mentioned, among a group of stocks that had a rough go of it in 1997, by Salomon Smith Barney analyst Jeff Warantz as a potential winner in the coming year... Consulting company Right Management Consultants (Nasdaq: RMCI) moved $1 1/2 higher to $13 after the company's Chair said it might take a restructuring charge in the coming quarter, that it could double revenues in 1998, and that it has the potential to achieve EPS of $0.75 in 1998... Fashion retailer Gadzooks (Nasdaq: GADZ) gained $3 to $22 3/8 after the company announced that sales in November and the first 28 days of December gained 37% over the prior year period. Same-store sales gained about 3% during the period.

Oilfield equipment suppliers Tuboscope Inc. (NYSE: TBI) gained $2 1/16 to $21 3/4 and Dril-Quip Inc. (NYSE: DRQ) rose $2 1/8 to $31 1/2 on higher gas prices, as did oil & gas driller Bayard Drilling Technologies (NYSE: BDI), which rose $1 7/16 to $15 9/16. Specialty pipe company Shaw Group (NYSE: SGR) added $1 1/2 to $22 5/8 and oilwell services company BJ Services (NYSE: BJS) moved up $2 9/16 to $67 1/2... Seen as a beneficiary of strong sub-$1000 PC demand, Gateway 2000 (NYSE: GTW) gained $2 1/8 to $34 3/4 on reportedly strong holiday sales... After successfully launching eight ORBCOMM communications satellites into low-Earth orbit last Tuesday, Orbital Sciences Corp. (Nasdaq: ORBI) rocketed $2 5/16 to $29 1/4 today after the satellite launch company announced that it is ahead of schedule with respect to performance testing of the eight satellites.


Hong Kong-based Asia Satellite Telecommunications (NYSE: SAT) lost $3 1/2 to $16 15/16 today after the Russian launch of its AsiaSat3 satellite failed at the end of last week. The satellite failed to enter its orbit, and the company cannot launch a replacement for at least 12-18 months. Asia Satellite's growth will hinge on the capacity available through its two existing satellites (already at roughly 90%) and contract price appreciation. However, thanks to insurance, the company expects no write-off for the $200 million satellite and is currently in negotiation with Hughes Space and Communications to build AsiaSat4. AsiaSat3 was expected to pick up the slack from AsiaSat1 after it is decommissioned -- hence, much of its capacity was expected to be bought up by existing clients. Meanwhile, Merrill Lynch upgraded the company to "near-term buy" from "accumulate" as a result of what it deemed an "overreaction" to the news.

Neoprobe (Nasdaq: NEOP) lost $1 5/16 to $6 9/16 after the company announced that the FDA's Center for Biologics Evaluation and Research could not approve its RIGScan cancer detection system until the company provides "additional information." The medical device maker intends to submit additional clinical and manufacturing information as an amendment to its Biologics License Application as soon as it meets with FDA officials and determines the exact nature of the request. Considering that the FDA action was merely a request for additional information and not a denial of the product, the $147 million market cap haircut is a tad premature. The RIGScan uses a tumor-specific targeting agent and a medical device to ensure that surgeons don't miss any part of a cancerous tumor, and is expected to generate $280 million in sales by the year 2000. Neoprobe's share price has been more than cut in half over the last year, falling last month after European officials made a similar information review request.

QUICK CUTS: Holmes Protection Group (Nasdaq: HLMS) lost $1 3/16 to $16 13/16 after the electronic security systems provider announced that it had entered into a merger agreement to be acquired in a "take-under" by Tyco International (NYSE: TYC) for $17 per share in cash... Heartstream Inc. (Nasdaq: HTST) fell $1 1/8 to $10 3/4 after the maker of external defibrillators agreed to be acquired by Hewlett-Packard (NYSE: HWP) for $11 per share in H-P stock.

An Investment Opinion by Randy Befumo

The Importance of Growth

On Friday we examined how many of the Best and Worst Stocks of 1997 began their impressive performances from rather low valuations -- or their unimpressive performances from extraordinarily high valuations. Buying a company when the valuation the market has put on the business is low relative to the actual sales, earnings, and cash flow the business generates is one of the key variables for success when investing. However, in a multivariable world, absolute valuation relative to historical financials is hardly the only number that you should concern yourself with. Today we will examine another characteristic that the best stocks seemed to have an excess of and the worst stocks seemed to suffer from a dearth of -- growth.

Looking again at Jackson Hewitt (Nasdaq: JTAX), the primary example used in Friday's column, we can see how the growth combined with a state of extremely low valuation to make for an annual return of approximately 1527.44%. Jackson Hewitt may have begun the year trading at 0.85 times sales and 9.7 times trailing earnings, but the company had also just reported a second fiscal quarter where revenue growth was only 5.3%. Although the company cut its losses to 24 cents per share from 32 cents per share, for many investors the quarter was not all that impressive. Underneath the ugly income statement there were a few good points, the best of them being that the company had trimmed its losses while decreasing shares outstanding -- an impressive feat as often companies that decrease losses per share do so by increasing the number of shares out, thus splitting the loss up among more shares. However, investors were obviously not impressed, as Jackson Hewitt did not do all that much in the first six weeks of the year.

Keeping in mind that Jackson Hewitt does income tax preparation work for individuals, it is not that surprising that the fiscal second quarter (ended in October) was slow. In fact, looking at the company historically, the October quarter is the slowest it experienced each and every year. In what is its second strongest quarter seasonally, Jackson Hewitt reported an impressive performance in mid-February when it announced fiscal third quarter results. Revenues had climbed 56.4% while profits were an astounding $0.24 per share versus a loss of $0.11 in the prior year. In each other year since the company came public, all profits had been made in the fourth quarter ended April. However, in this year Jackson Hewitt had begun aggressively selling franchise licenses before the tax preparation season boomed, causing a concomitant increase in revenues and earnings. The foundation of better cost control evident in the second quarter's results led to impressive growth in the third quarter, the kind of growth that is the subject of our examination today.

The week that Jackson Hewitt reported these results, the shares closed at $9 3/4, more than twice where they started the year. However, because of increased earnings and revenues, the valuation relative to those two key numbers had deteriorated a bit. The price/sales ratio had climbed to 1.63 while the price/earnings ratio had risen to 18.1 as the stock price had doubled. However, because the results still contained the weak first and second quarters, if one assumed that Jackson would post a fourth quarter with the benefit of new franchisees that was the same level of improvement as the third quarter had shone, there was certainly a ways to go. The reason is that incredible financial performance reduces the valuation by the same degree, assuming that the price stays constant. This is why sometimes fast-growing companies that appear rich relative to historical results actually may be cheap relative to what they can do in next quarter.

This is not to say that there is no risk here -- whenever you start to make assumptions about the future, the risk increases. However, when you understand the economics of business, the risk inherent in some estimates of future earnings performance can be substantially reduced. Take Jackson Hewitt, mainly a franchise business. If its first third quarter profit ever was the result of much higher franchise sales, assuming those franchises are up and running in a few months you will have markedly increased revenues for the parent company. Jackson Hewitt makes money on each franchise by collecting a fixed percentage of the revenues. This means that each franchise sale is more than a one-time income gain, but is the creation of a long-term stream of cash the company will collect.

In addition, the company also had been buying out franchisees in the first and second quarters, meaning that it was going to benefit by reporting those revenues as well. The combination of higher franchise sales and reporting revenues from stores that were now company-owned were what pushed the company firmly into the black in the third quarter. These factors were not going away, and making assumptions about year-over-year growth being up by 20% or so -- less than half the rate of revenue growth in the third quarter -- seemed reasonable. By that token, Jackson would report earnings of $0.70 per share on about $21 million. Assuming these estimates were "in the bag," you had a stock trading at 1.4 times sales and 14.8 times earnings that was growing at least 15% to 20%.

When Jackson reported its actual returns of $0.77 per share on $21.6 million in revenues, the valuation was actually made even lower. It is after this point that the stock started to shoot up, although for a good month it still traded at around $15 to $18 a share in spite of reporting the great results. The growth and the low valuation continued to reinforce one another until the market went nuts and ran the valuation up. Although after September it became difficult to call the valuation low, the eventual buy-out by HFS that no one could have predicted (without inside information) pushed it up further. While a valuation sensitive investor might have sold in the $30 range, he still would have captured most of the excess returns provided by seeing the combination of low valuation and high growth in action.

A look down the list of other 1997 winners shows other companies where growth accelerated while the company was at a low valuation. Investors too reliant on historical financials alone did not see the opportunity until it had already passed them by. On the flip side, companies with high valuations and negative growth were most of 1997's biggest disasters. Thus, valuation and growth are two of the key levers that investors should look for to generate the same level of returns shown by the best performing stocks of 1997.


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