<THE EVENING NEWS>
Friday, February 27, 1998
DJIA: 8545.72 +55.05 (+0.65%) S&P 500: 1049.34 +0.67 (+0.06%) Nasdaq: 1770.51 -6.60 (-0.37%) Value Line ndx 936.46 +1.05 (+0.11%) 30-Year Bond 102 26/32 +11/32 5.92% Yield
Newspaper publisher and TV and radio station operator Pulitzer Publishing (NYSE: PTZ) gained $16 3/8 to $84 on saying that it has hired Goldman Sachs and Huntleigh Securities to explore "strategic alternatives" for its broadcasting business, which may include a possible sale of the division. The company operates a total of nine network-affiliated TV stations in cities such as New Orleans, Louisville, Kentucky, and Omaha, Nebraska. It also has five radio stations located in Louisville, Phoenix, and Winston-Salem, N.C. Over the last 12 months, the company recorded $227 million in revenues from its broadcasting businesses, up marginally from the unit's 1996 revenues. As a percentage of total operating revenues, however, broadcasting revenues slipped to 38.8% in 1997 from 42.1% in 1996. Despite the falling revenues, broadcasting is a relatively inexpensive operation, accounting for only 15% of the company's total operating expenses last year. Given the frenzied consolidation of the broadcasting industry over the past year, if Pulitzer decides to sell the division, it probably won't be going at a budget price.
Hewlett-Packard (NYSE: HWP) gained $2 to $67 after Merrill Lynch upgraded the diversified electronics manufacturer to "accumulate" from "neutral." The Merrill analyst believes the Year 2000 problem will stimulate demand for the company's server business. Also, Morgan Stanley started coverage of the company with an "outperform" rating. H-P also announced that it is teaming up with IBM (NYSE: IBM) to export U.S. cryptography software, having received the requisite federal approval to do so. H-P can start shipping the technology to Great Britain, Germany, France, Denmark, and Australia, where implementation of the software is expected to take place in the next few months.
Several companies that do business over the Internet were up today, continuing the sector's recent rally. Yahoo Inc. (Nasdaq: YHOO) picked up $5 1/16 to $73 3/16, Amazon.com (Nasdaq: AMZN) tacked on $4 1/4 to $77, Excite (Nasdaq: XCIT) climbed $3 1/16 to $47 1/4, Infoseek Corp. (Nasdaq: SEEK) added $1 7/16 to $16 7/16, and Netscape Communications Corp. (Nasdaq: NSCP) advanced $9/16 to $19 3/8. Helping the stocks out was President Bill Clinton's decision yesterday to endorse a five-year moratorium on taxing Internet commerce. The Prez is urging Congress to pass the Internet Tax Freedom Act during its current session, which will prohibit federal taxes on products sold over the Net but will have no effect on similar taxes already enacted by municipalities and states. With sales of $2.4 billion last year and double that expected in 1998, according to Forrester Research, the Internet commerce industry is heaving a sigh of relief. However, Clinton is probably unwilling to spend any political capital to push the issue, so the bill's ultimate disposition will hinge on the prevailing climate in the legislature.
QUICK TAKES: Armstrong World Industries (NYSE: ACK) gained $3 1/16 to $78 1/2 after Merrill Lynch reiterated its "buy" rating on the floor coverings maker... ContiFinancial Corp. (NYSE: CFN) tacked on $2 to $27 1/8 after the consumer finance company said it would buy back one million of its outstanding shares... J.P. Morgan & Co. (NYSE: JPM) advanced $2 1/2 to $19 1/2 after the investment bank said it had fired 100 employees in Asia, or 6% of its workforce in the region... Paint retailer Sherwin-Williams Co. (NYSE: SHW) rose $1 9/16 to $33 7/16 after Salomon Smith Barney upgraded the stock to "buy" from "outperform"... Gas utility holding company Pennsylvania Enterprises (NYSE: PNT) added $1 13/16 to $25 1/8 after announcing yesterday that one of its subsidiaries filed to cut its customers' gas prices. Gilford Securities upgraded the stock to "buy" from "attractive."
Information technology services firm Intelligent Electronics (Nasdaq: INEL) rose $11/32 to $6 23/32 after receiving a favorable write-up in Business Week's "Inside Wall Street" column... Prepaid calling card manufacturer SmarTalk TeleServices (Nasdaq: SMTK) gained $6 3/16 to $33 5/8 after reporting Q4 EPS of $0.17 (excluding R&D and restructuring charges), beating the First Call mean estimate of $0.14... Network security services firm Information Resource Engineering (Nasdaq: IREG) jumped $13/16 to $7 1/16 after reporting a Q4 loss of $0.09 per share, which was in-line with the First Call consensus estimate... Grilled chicken restaurant operator and franchisor Pollo Tropical (Nasdaq: POYO) gained $1/2 to $8 3/4 after reporting Q4 EPS of $0.19, which topped the street estimate by a penny.
Siebel Systems (Nasdaq: SEBL) rose $1 15/16 to $61 1/2 after the software developer announced a two-for-one stock split after the bell yesterday... PC manufacturer Dell Computer Corp. (Nasdaq: DELL) advanced $6 5/8 to $139 7/8 after Lehman Brothers raised its price target for the stock to $156 per share... Biopharmaceutical products firm EntreMed Inc. (Nasdaq: ENMD) gained $13/16 to $12 9/16 after Lehman Brothers started coverage of the stock with a "venture" rating, setting a price target of $18 per share... Coulter Pharmaceutical (Nasdaq: CLTR) advanced $2 1/8 to $23 1/4 after Lehman Brothers began coverage of the drug maker with a "buy" rating and a 12-month price target of $32 per share... Sodak Gaming (Nasdaq: SODK) added $1 3/8 to $7 5/8 after Prudential Securities began coverage of the gaming products distributor with a "buy" rating... PaineWebber Group (NYSE: PWJ) gained $6 1/8 to $41 on speculation that the financial services company will be acquired by Chase Manhattan (NYSE: CMB) or another large bank for over $50 per share.
VLSI Technology (Nasdaq: VLSI) short-circuited for $5 7/16 to $19 5/16 after announcing late yesterday that the specialty semiconductor manufacturer expects first quarter revenues and earnings per share to be "significantly below" analysts' expectations and lower than the preceding quarter and Q1 1997. The weaker earnings result from fewer orders and shipments of its wireless communications and set-top box integrated circuits, the economic downturn in the Asia/Pacific region, and inventory adjustments by some of its customers. VLSI expects to see shipments return to more normal levels in the second half of the year. On VLSI's announcement, Deutsche Morgan Grenfell lowered its rating of the company to "hold" from "buy.
Advanced Micro Devices (NYSE: AMD) lost $1 5/8 to $23 1/2 after announcing that it has signed a two-year foundry agreement with International Business Machines (NYSE: IBM) to "somewhat augment" AMD's production of its K6 microprocessors. AMD has not been able to meet its own production targets for the K6, which is used in low-priced personal computers made by IBM and Compaq Computer Corp. (NYSE: CPQ), since introducing it last April. While a company being pressed so hard with demand that it can't turn out enough products is ostensibly a good thing, in this case it means the company is still having yield problems. Going to an outside fab means gross margins will be lower. At the same time, though, absolute operating income should increase with a higher output of its low-cost CPUs, so it's not the end of the world for AMD if its margins decline on a much larger sales volume. Heck, it could even mean it has a shot at sustained profitability.
Railroad giant Union Pacific Corp. (NYSE: UNP) continued to lose steam today, slipping another $15/16 to $51 1/8 after announcing yesterday that it expects to report a first quarter loss due to traffic congestion-related problems and the costs of implementing its recovery plan. The company said the congestion and delays could also hurt its second quarter business. The latest data from the Association of American Railroads seems to confirm this. The overall industry saw a 1.1% gain in high-speed freight traffic and a 3.7% rise in commodity business in the first seven weeks of the year. During this time Union Pacific lost 12.9% and 2.9% of its traffic in these areas, respectively. Union Pacific is clearly giving up market share to competitors, as evidenced by the fact that the largest private user of the rails, the United Parcel Service, has moved "virtually all" of its traffic from Union Pacific and shunted it over to Burlington Northern (NYSE: BNI) and various long-haul truckers.
QUICK CUTS: Glaxo Wellcome (NYSE: GLX) plunged $3 3/16 to $54 5/16 on newspaper reports that the pharmaceutical giant is considering making a hostile bid for SmithKline Beecham (NYSE: SBH) after their merger talks collapsed earlier this week. Glaxo declined to comment on the news... Glass products maker Apogee Enterprises (Nasdaq: APOG) was shattered for $1 5/16 to $12 15/16 after announcing late yesterday that excluding charges the company expects fourth quarter earnings to fall short of current analysts' estimates. Weak industrywide demand for replacement auto glass and higher-than-expected losses from its international curtainwall operations are depressing the company's earnings.
Semiconductor memory components maker Micron Technology (NYSE: MU) slid $1 7/8 to $33 3/16 after a South Korean semiconductor trade group dismissed as "unfounded" the company's allegation that the South Korea's chipmakers had begun dumping into the world markets following the won currency's steep depreciation against the dollar... Motorola Inc. (NYSE: MOT) slumped $1 5/8 to $55 5/8 after Cowen & Co. downgraded the company to "neutral" from "buy"... Oil refinery and gas station operator Crown Central Petroleum (AMEX: CNP.A) dropped $1 to $18 5/8 after reporting a fourth quarter loss of $0.07 per share on sales of $404 million, compared with a profit of $1.12 per share on sales of $435 million in Q4 1996. While retail sales enjoyed a strong fourth quarter, refining margins dropped significantly due to an excessive supply of gasoline.
CFM Technologies (Nasdaq: CFMT), which manufactures advanced cleaning equipment for the semiconductor and flat panel display industries, slipped $1 5/8 to $17 1/2 after yesterday reporting a first quarter loss of $0.09 per share compared with earnings of $0.21 per share in the prior-year period and the First Call estimate of a loss of $0.10 per share... Allergy and asthma drug company Dura Pharmaceuticals (Nasdaq: DURA) lost $1 1/4 to $25 1/8 after Standard & Poor's revised its outlook on the company to "stable" from "positive" in the wake of the company's announcement earlier this week that it expects lower-than-expected revenues and earnings in 1998... Japan's Nippon Telegraph & Telephone Corp. (NYSE: NTT) was disconnected for $3 15/16 to $44 after the company warned that it expected to see a sharp drop in profits in the 1998-99 fiscal year. The company blamed the projected fall on increased competition and rate cuts.
Applied Materials (Nasdaq: AMAT), which makes machinery for manufacturing computer chips, slipped $1 1/16 to $36 13/16 after its chief financial officer said yesterday that capital spending on semiconductor manufacturing equipment will be flat or slightly lower in 1998. The economic turmoil in Asia and falling prices for memory chips are forcing major chip makers to delay buying new equipment... Kellwood Co. (NYSE: KWD) dropped $2 3/16 to $32 7/16 after SBC Warburg Dillon Reed downgraded the apparel manufacturer to "outperform" from "buy"... Grupo Iusacell (NYSE: CEL) tumbled $15/16 to $19 1/4 after Morgan Stanley Dean Witter cut its rating on the Mexican telephone company to "neutral" from "outperform"... Triangle Pharmaceuticals (Nasdaq: VIRS), which specializes in the development of new drugs for the human immunodeficiency virus (HIV), declined $1 1/4 to $16 1/2 on news that the company plans to offer for sale up to 2.8 million shares of common stock belonging to certain stockholders... Networking support provider TechForce Corp. (Nasdaq: TFRC) was cut $1/2 to $7 5/8 after yesterday announcing fourth quarter earnings of $0.05 per share, missing the First Call mean estimate of $0.08.
Disk drive suspension assemblies supplier Hutchinson Technology (Nasdaq: HTCH) dipped $1 1/8 to $23 1/8 after announcing late yesterday that through the first eight weeks of its second quarter it has recorded a loss of $0.56 per share on sales of $52 million. The First Call estimate for the second quarter is a loss of $0.57... Superior Consultant Holdings (Nasdaq: SUPC) dropped $1 7/8 to $36 7/8 after the management consulting company reported fourth quarter earnings of $0.20 per share before merger costs, which matched the mean estimate listed in First Call... Hotel and casino operator MGM Grand (NYSE: MGG) lost $1 1/16 to $36 1/8 after announcing that it anticipates first quarter earnings per share to be between $0.25 to $0.35 per share, below expectations. The shortfall is due to an unusually low hold percentage in table games at the MGM Grand Las Vegas and lower earnings at the company's 50%-owned New York-New York Hotel and Casino.
Return on Marginal Capital
You might have noticed terms such as inventory turnover, capital management, and return on invested capital used in this column and elsewhere in the Fool. We use these terms because most of the people who write for this column are investors who believe that investing is not a simple process. There is no single measure that will inform you of the quality of a business or its fair value. Shorthand valuation measures like the PEG, YPEG, and price/earnings ratio (P/E) can give you a notion of how attractively valued a business currently is. Liquidity measures that focus on the quality of the balance sheet, like the current ratio, are also shorthand measures. An investor putting hard-won savings into a company's stock probably wants to go quite a bit further if they plan on making any money.
To understand things like inventory turnover or return on invested capital, you first have to learn how to calculate them. You'll find the above links take you to the Fool's School "How to Value Stocks" area where our articles await the attention of Fools who are new to the site or who need a refresher course. Learning how to construct these measures takes but a moment in an investing lifetime. Learning how to interpret these measures takes considerably longer, but is ultimately how your understanding of investing evolves. Assuming that you are familiar with the valuation material in our archives, here are some more thoughts on how to assess the underlying quality of a business -- a project that ultimately is directly related to valuation.
There are numerous ways to look at return on capital. Return on invested capital looks at the efficiency of net working capital a business employs, regardless of whether that capital is financed through debt or equity. Return on total capital compares cash or earnings generated by the business to all capital invested in the business, which is the sum of all debt (long- and short-term) and shareholders' equity. You can use any of these measures or other capital productivity measures for one period in comparison to another period to tell what's going on in a business. You can also use these measures across industries to judge which companies are most productive and thus most worthy of your investment dollar. As such, it's not inappropriate to compare a software company with a pharmaceutical company and a food company. Whichever generates the best rate of return on capital employed in the business and generates the best return on marginal capital employed by the company deserves your consideration.
The term "marginal capital return" bears some explanation. First, the word "marginal" means "additional" relative to something else -- in this case, additional capital invested in the business. If, for instance, a company increases its capital base by 10% and return on capital only increases 5%, that additional capital investment wasn't as productive as the company's previous capital investment. If you put 10% more money into any investment, whether it be a factory, capitalized R&D on software, or a brokerage account, and that additional capital only generates a 5% return, your investment is only half as productive as the capital you invested before. If you are in a situation where investing further capital in a business will decrease your rate of return, as a business you need to consider whether or not that capital should just be given back to the shareholders through a dividend or share buyback.
The only time a company with a mature business not requiring further investment should not give back the capital is if it has found more productive investments to make. This is why mature companies tend to invest in new lines of business or start making acquisitions. Management discovers the core business is pretty much built up and they must either admit they can do nothing else and return the money to shareholders or decide that they are actually smart people and can find other businesses offering rewarding investment return possibilities. Given the ego that normally comes with being in charge of a large, mature company, more often than not management will decide they can think of something keen to do with the cash. Unfortunately for shareholders, it is not always good.
Such has been the case with Eastman Kodak (NYSE: EK) over the last couple years. Eastman has poured money back into the business to no avail -- shareholder money that probably would have been much better spent on dividends or stock buybacks. Another company that has seen a decline in capital productivity and marginal capital productivity is Hewlett-Packard (NYSE: HWP). Despite its much-ballyhooed success with regard to unit volume in its new PC business, the company's return on marginal capital has gone through the floor since it started this business. While making PCs is not capital intensive in and of itself, carrying the huge inventories required to distribute PCs through resellers does chew up a lot of working capital. H-P's lagging shareholder return over the last couple years isn't the result of investors failing to give a great company its due. Rather, it is because H-P has gone from being a highly productive company (with regard to return on capital) to being one that is less productive that has caused the share price to lag.
Let's go back to 1993-1995 for Hewlett-Packard. Average capital invested in the business (the average of all common and preferred equity plus all interest-bearing debt ascertainable on the balance sheet). For the 1994 fiscal year, average capital devoted to the business was $12.156 billion, or $11.67 per share. Operating income after taxes (backing out one-time charges and identifiable goodwill amortization) was $1.683 billion, or $1.62 per share. After-tax operating income per share for 1994 divided by $11.67 in average capital per share equals 13.65%. That covers the cost of debt and equity for any company with a good credit rating. It also covers the cost of equity, which is basically the long-term rate of return on the S&P 500, or 10.8%.
In the go-go 1990s, it might be a little light, but let's look at the return generated on marginal capital that year. 1993 capital per share was $11.23 and 1994 capital per share was $12.42. The addition to capital per share from year to year was 10.6%. After-tax operating income for 1993 was $1.24 billion, or $1.22 per share. After-tax operating income per share grew 32.8% in 1994 ($1.62/$1.22). The marginal after-tax operating income per share generated that year was $0.40 ($1.62 minus $1.22) and the addition to capital per share for the year was $1.20 per share. The rate of return on marginal capital per share, then, was 33% (marginal return of $0.40 divided by marginal capital of $1.20).
Back then, the dollars that were being retained or invested in the business were more productive than the business as a whole. Management was finding new opportunities for growth in computers, storage, peripherals, semiconductors, metrology, and scientific equipment. Whatever H-P was doing at the time was working quite well, and a rational investor would have bid it up. Let's see what has happened in the last year.
1996 total capital per share was $17.24, 1997 total capital per share was $19.43, and average total capital per share for 1997 was $18.34. 1996 after-tax operating income per share was $2.48 and 1997 after-tax operating income per share was $2.87. Growth in capital per share was 12.7% in 1996 and growth in after-tax operating income per share was 15.7%. Return on average total capital per share for the year was 15.6%, up nicely since 1994, but there were mitigating factors that might not be repeated. Namely, the company's tax rate dropped close to five percentage points. Holding the tax rate constant from 1994 to 1997, return on capital per share for 1997 would have been 14.8%.
One can't begrudge good tax planning, though, and in any case, return on capital per share increased from 1994. Since after-tax operating income growth was much closer to per-share capital growth, though, we would expect that the rate of return on marginal capital has slowed. Marginal after-tax operating income per share for 1997 was $0.39, down slightly from 1994. Marginal capital devoted to the business was $2.19 per share and the rate of return on marginal capital per share, then, was 17.8% (marginal return of $0.39 divided by marginal capital of $2.19).
While overall H-P's numbers are hardly terrible, which is why the company is currently valued at approximately 23.0 times trailing earnings, you can see that over the past few years the company's new investments have yielded progressively lower and lower returns. If you extrapolate this out very far, you begin to see overall returns deteriorate, inevitably resulting in lower margins and lower earnings growth. This is the sort of insight you can garner when you look at returns on capital instead of simply looking at earnings growth alone or slapping multiples on earnings based on that growth (i.e. saying a company should trade at X times earnings because it is growing at Y rate). The quality of the earnings growth is more important than earnings growth alone. Looking at return on marginal capital plowed into a business is one way to assess the quality of earnings growth.
[Note: The reason that Merrill Lynch and Morgan Stanley released positive research notes on Hewlett-Packard today is precisely related to opportunities to increase return on marginal capital]
Please see the Motley Fool's Conference Calls page for call information and links to synopses.
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