Friday, August 21, 1998
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Information technology services company Cambridge Technology Partners (Nasdaq: CATP) rose $4 15/16 to $42 15/16 after Morgan Stanley Dean Witter raised its rating on the company to "strong buy" from "outperform" and Donaldson, Lufkin & Jenrette (DLJ) reiterated its "top pick" rating today. Apparently, Cambridge shares have been killed since July on worries of accounting irregularities. DLJ said this presents a good opportunity for investors to buy into what it calls "one of the leaders in the emerging IT services sector." In a research note, Morgan Stanley said the firm's 14% decline yesterday was due to the rumored release of a report on the company by the Center for Financial Research and Analysis, which spends its time looking at accounting practices at firms it deems as having questionable fundamentals. The alleged report notwithstanding, Morgan Stanley apparently felt confident enough in Cambridge's fundamentals to set a 12-month price target of $63 per share.

Wind River Systems (Nasdaq: WIND) took flight today, rising $3 9/16 to $38 3/8, after the embedded systems software company reported a 42% increase in Q2 revenues of $31.2 million and EPS of $0.21, up 50% year-over-year and beating the First Call mean estimate by $0.02. Among the new customers acquired during the quarter was audio processing products company Dolby Laboratories, which plans to use Wind River's Tornado product suite as the backbone for its next generation of cinema and professional audio products. Japan's Seiko Instruments, which also joined the company's stable of clients during the quarter, said it plans to use Tornado to help develop a new line of color printers aimed at professionals in the graphic arts, digital proofing, and medical technologies fields. Seiko joins other big-name imaging clients such as Eastman Kodak (NYSE: EK), Xerox (NYSE: XRX), and computer printer maker Hewlett-Packard (NYSE: HWP).

QUICK TAKES: Computing products maker Apple Computer (Nasdaq: AAPL) picked up $2 3/8 to $43 on continued optimism that its new iMac home computer, launched last week, will be a solid revenue generator for the company... Fiber optic communications infrastructure supplier Metromedia Fiber Network (Nasdaq: MFNX) gained $2 1/2 to $68 5/8 after being selected along with Switzerland's Carrier 1 Holdings and Viatel Inc. (Nasdaq: VYTL) to build a national fiber optic network in Germany... Online discount brokerage E*Trade Group (Nasdaq: EGRP) gained $1 11/16 to $25 15/16 after Japanese information keiretsu SOFTBANK completed its acquisition of a 27.2% stake in the company for $400 million.

Consumer textiles company Fruit of the Loom (NYSE: FTL) gained $1 3/4 to $28 1/4 after the company cancelled a $250 million high-yield bond offering, spurring takeover talk... Cincinnati Milacron (NYSE: CMZ) jumped $3/4 to $22 3/4 after announcing that it has agreed to sell its machine tools operation to UNOVA Inc. (NYSE: UNA) for $178 million in cash. Cincinnati Milacron will change its name to Milacron Inc. and will concentrate on its remaining plastics processing technologies and industrial products units... Database connectivity software company Wall Data (Nasdaq: WALL) gained $2 1/16 to $15 1/4 after reporting yesterday first quarter revenues of $40.4 million and EPS of $0.22, up 20% and 38%, respectively, from last year.

Specialty chemicals maker Cytec Industries (NYSE: CYT) gained $2 9/16 to $28 3/8 after saying it is unaware of "any undisclosed activity or development" to explain yesterday's high trading volume, which was five times greater than normal. Today, Deutsche Bank Securities started the company with a "buy" rating... HRPT Properties Trust (NYSE: HRP) climbed $5/8 to $16 11/16 as the company priced $160 million of four-year senior notes, which will be used to pay off part of the real estate investment trust's revolving credit line... Electric and natural gas utility Illinova Corp. (NYSE: ILN) rose $15/16 to $26 1/4 thanks to a Morgan Stanley Dean Witter upgrade to "outperform" from "neutral."

Supermarket operator Dominick's Supermarkets (NYSE: DFF) added another $3 to $48 7/8 after saying late Wednesday that it has hired an investment bank to explore "strategic alternatives," which could include a merger or sale of the company... FirstPlus Financial Group (NYSE: FP) bounced back $13/16 to $26 5/16 after the Michigan Attorney General's office said yesterday that it would bring a cease-and-desist order against the mortgage lender for making "false, misleading and deceptive solicitations to the public"... Embedded processor modules and PC card maker Smart Modular Technologies (Nasdaq: SMOD) climbed $7/8 to $20 5/8 after reporting fiscal Q3 EPS of $0.20, beating the Street's mean estimate by a penny.

Pharmaceutical company SuperGen Inc. (Nasdaq: SUPG) advanced $15/16 to $7 7/16 after saying it is "unaware of any internal fundamental reason" for the stock's increased trading volume recently... Internal combustion engine parts maker Turbodyne Technologies (Nasdaq: TRBD) rebounded $5/16 to $7 3/16 after investment bank Asensio & Co. questioned the company's technologies in a press release yesterday. Today, Turbodyne called Asensio's allegations "false and malicious"... Enterprise resource planning software firm System Software Associates (Nasdaq: SSAX) picked up $1/2 to $5 1/2 after reporting a fiscal Q3 loss of $0.19 per share (before restructuring charges), which wasn't quite as bad as the First Call mean estimate of a $0.20 per share loss.


Ciena Corp. (Nasdaq: CIEN), which provides bandwidth enhancement technology for fiber-optic communications networks, was bombed $25 17/32 to $31 1/4 after adjourning a scheduled shareholder meeting regarding its proposed merger with voice and data transmission and access systems designer Tellabs (Nasdaq: TLAB) until Sept. 9. Tellabs also adjourned its merger vote after AT&T (NYSE: T) said it "will not pursue further evaluation" of Ciena's dense wavelength division multiplexing (DWDM) systems. Ciena investors had been hoping orders from AT&T would fill in the revenue hole created when WorldCom (Nasdaq: WCOM), a big Ciena client, announced earlier this year that it would cut back on its purchases from the company. What AT&T's decision means for the proposed one-for-one stock swap with Tellabs is still anyone's guess. With today's fall, Ciena is trading 46% below its $57 9/16 share price on June 2 -- the day before the Tellabs deal was announced.

Several large banking stocks dropped on uncertainty in emerging markets, as rumors of impending currency devaluations in Venezuela and Brazil cast some doubt over loans made in emerging economies. BankBoston Corp. (NYSE: BKB), which has a sizable Latin and South American presence, fell $2 7/16 to $41 15/16; Chase Manhattan Corp. (NYSE: CMB) lost $1 11/16 to $63 11/16; and Citicorp (NYSE: CCI) slid $4 9/16 to $134 1/2. Earlier this week, Russia decided to devalue the ruble by as much as 30% amid worries that the country would soon be unable to repay its debts. While few U.S. companies are heavily exposed to the Russian market, some observers are fretting that Russia's problems may spread to other emerging nations and touch off a global slowdown for the financial services industry. On those fears, Travelers Group (NYSE: TRV) dropped $1 9/16 to $54 5/8, Merrill Lynch (NYSE: MER) retreated $2 to $84 1/8, Lehman Brothers (NYSE: LEH) slid $5 1/4 to $60 5/8, and Bankers Trust Corp. (NYSE: BT) fell $4 15/16 to $96 5/16.

Aerospace and auto parts manufacturer AlliedSignal (NYSE: ALD) dropped $1 11/16 to $37 7/16 after electronics connector maker AMP (NYSE: AMP) told its shareholders not to accept AlliedSignal's $44.50 per share cash bid for the company. Newly installed AMP CEO Robert Ripp called the hostile bid "inadequate" and "clearly an opportunistic attempt to grab a world industry leader at a bargain price." Instead, Ripp tried to reassure AMP's shareholders that he can orchestrate a turnaround at the company, predicting that recent plant closings and layoffs will yield EPS of $2.30 in fiscal 1999 and about $3.00 in fiscal 2000. Ripp joined AMP from IBM (NYSE: IBM) in 1994, when that company was hitting the skids. That means he missed out on seeing CEO Louis Gerstner's celebrated turnaround of Big Blue firsthand. In contrast, AlliedSignal CEO Larry Bossidy already has a proven turnaround track record -- his company's stock has appreciated 557% since he came on board in 1991.

QUICK CUTS: Pittsburgh-based bank holding company PNC Bank Corp. (NYSE: PNC) slipped $1 1/4 to $47 11/16 after agreeing to buy privately held investment firm Hilliard-Lyons Inc. for $275 million in cash and stock... Financial services company Amresco Inc. (Nasdaq: AMMB) was knocked down $1 1/2 to $19 1/8 after denying reports yesterday that it would write down its retained interests from securitization in the third quarter... Digital document embedded imaging systems supplier Peerless Systems Corp. (Nasdaq: PRLS) tumbled $13 3/8 to $7 1/4 after saying its quarterly results will likely be "below prior year results for the remainder of fiscal 1999 and into early fiscal 2000"... Computer aided design (CAD) software firm Autodesk (Nasdaq: ADSK) slid $5 3/16 to $27 7/16 after announcing it would acquire visual effects software developer Discreet Logic (Nasdaq: DSLGF) in a stock swap valued at about $531 million. Discreet Logic lost $3 to $13 on the news.

Pork processor Smithfield Foods (Nasdaq: SFDS) was hog-tied for a $1 1/2 loss to $21 15/16 after reporting a fiscal Q1 loss of $0.14 per share, which was lower than the $0.06 per share gain expected by the Street... Printed circuit board and electronics contract manufacturer IEC Electronics Corp. (Nasdaq: IECE) was knocked down $1 3/16 to $5 1/2 after saying it will take a $2 to $5 million charge to its fiscal Q4 earnings to close its plant in Arab, Alabama. Additionally, the company said that its Q4 operating loss will be "significantly greater" than the $0.18 per share loss logged in Q3... Threaded fastener and industrial supplies firm Fastenal Co. (Nasdaq: FAST) fell a fast $1 3/4 to $36 1/8 following a Schroder & Co. downgrade to "perform in line" from "outperform."

Urologic disorders diagnosis and treatment products company UroCor Inc. (Nasdaq: UCOR) gave back $5/16 to $5 7/8 after rising yesterday on news that anatomic pathology company Dianon Systems (Nasdaq: DIAN) submitted a $7.50 per share bid for the company. Today, UroCor said it is not for sale and called Dianon's bid "speculative in nature"... Insurance and financial services firm Hartford Life (NYSE: HLI) was dumped $3 5/8 to $58 9/16 following a downgrade from Morgan Stanley Dean Witter to "neutral" from "outperform"... German chemical and drug giant Hoechst AG (NYSE: HOE) slid $1 7/16 to $42 after a class action price fixing lawsuit was filed against the company and generic drug developer Andrx Corp. (Nasdaq: ADRX) on behalf of users of the Cardizem CD hypertension treatment, which is made by Hoechst Marion Roussel. Andrx fell $2 5/8 to $35.

Argentina-based oil and gas exploration and production company YPF Sociedad Anonima (NYSE: YPF) was drilled $2 7/16 to $22 1/16 on South American currency devaluation fears... Bookseller Barnes & Noble (NYSE: BKS) was burned $3 5/16 to $36 3/4 a day after announcing it will spin off its barnesandnoble.com online unit this fall... Small business lender Sirrom Capital Corp. (NYSE: SIR) slipped $2 5/8 to $8 3/4 after being slapped with a securities fraud lawsuit from shareholders, who allege the company artificially inflated its share price earlier this year... Fitness center operator Bally Total Fitness Holding (NYSE: BFT) was trimmed $2 1/4 to $20 13/16 courtesy of a downgrade by Schroder & Co. to "neutral" from "buy."

Potash distributor IMC Global (NYSE: IGL) lost $1 11/16 to $19 1/8 after being downgraded by J.P. Morgan to "long-term buy" from "buy" due to an unclear near-term demand for the firm's products... Network security products maker Network Associates (Nasdaq: NETA) slid $4 1/8 to $40 3/8 on reports that rival Symantec Corp. (Nasdaq: SYMC) will launch a software suite consisting of four of its Norton brand products next week priced at $99.95 per suite, or about 50% less than what the programs would cost individually. Symantec also fell $1 3/32 to $21 29/32... Telecommunications company WorldCom (Nasdaq: WCOM) lost $1 5/8 to $52 7/16 after Dresdner Kleinwort Benson lowered its rating for the soon-to-be-combined MCI WorldCom to "hold" from "add"... Digital video disk (DVD) programming distributor Image Entertainment (Nasdaq: DISK) lost $1 3/16 to $7 3/4 after agreeing to acquire the online DVD retailing business of privately held Ken Crane's Home Entertainment for $6.5 million in cash, stock, and assumed liabilities.

Rio Hotel & Casino (NYSE: RHC) was tossed for a $3/4 loss to $16 3/4 after receiving a downgrade to "long-term attractive" from "strong buy" from BancAmerica Robertson Stephens... Oil and gas drilling bits and systems provider Smith International (NYSE: SII) lost $1 5/8 to $22 1/16 after agreeing to buy Halliburton's (NYSE: HAL) 36% stake in drilling fluid products and services supplier M-I for $265 million, giving Smith full ownership of M-I... Semiconductor and board level input/output (I/O) products designer QLogic Corp. (Nasdaq: QLGC) was squashed $2 1/4 to $58 after announcing it will acquire privately held server management controller chips maker Silicon Design Resources for $2 million cash and up to $8 million in future performance-related payments over the next four years.

An Investment Opinion
by Dale Wettlaufer

ROE, ROE, ROE Your Boat (Pt. 4)

Today we wrap up our look at return on equity (ROE) by proposing that return on equity should not be the ultimate indicator of a company's profitability and economic viability. As we have pointed out in the first three parts of this series, return on equity can be manipulated by the leverage a company assumes, defining leverage as average assets divided by average shareholders' equity. Rather than giving a clear picture of a company's profitability, this only distorts the true economics of a business.

One of the best ways to increase a company's ROE is to write down the value of assets, which by the rules of accounting will bring down the value of shareholders' equity by a like amount. This is known as "big bath" accounting and can really give a false portrayal of a company's economics. For instance, if I have a plant for which the balance sheet value is higher than the estimated net present value of future cash flows it can earn, I must write down the value of that plant to at least match the net present value of the cash flows it can earn. Say my balance sheet looks like this:

Shareholders Equity...$50

If I write down the value of the plant by $20, I have to take that $20 loss on the income statement and decrease retained earnings by that amount so that assets will still equal liabilities plus owners' equity after the write-down. After taking the big bath, the balance sheet will look like this:

Owners' Equity...$30

Not only is this going to help my calculated profitability based on lower asset values and a lower amount of owners' equity, but the depreciation on this written-down asset will be low. Whereas if my business earned $11 on revenues of $110 before the write-down and now earns $11.50 on the same revenues because of a lower depreciation expense, my return on assets will go from 11% to 14.4% and my return on equity will go from 22% to 38.3%. All the while, though, there has been no change in the real economics of the business. The cash flows don't change, my competitive position hasn't changed, and my revenues haven't changed. My GAAP (Generally Accepted Accounting Principles) profits have changed, but there really should not be a change in the way my company is valued just because I can make ROE go from 22% to 38.3% with the wave of my accounting wand.

Another problem with owners' equity is that it often understates by a good deal the amount of equity-like capital a company has at its disposal. While it's helpful to know the rate of return on net assets of a corporation, one should seek to ascertain the rate of return on all invested capital in a company, or at least the equity-like capital in a company. For instance, Avon Products (NYSE: AVP) appeared as the second-most profitable Fortune 500 company in Fortune magazine's 1995 survey. While the economics of a good cosmetics company are solid, the company's 133.1% (according to Fortune) 1995 ROE can be explained.

Effective in 1993, Avon took a charge to establish on balance sheet liabilities for non-pension postretirement benefits according to Financial Accounting Standards Board Statement 106. For Avon, that added $194.4 million in liabilities, immediately reducing owners' equity by a like amount. Since assets minus liabilities equals owners' equity (or graphically: A - L = OE), an increase or decrease in one side of the equation must be matched by an increase or decrease in the other side. For 1995, average owners' equity was $189.2 million while the average postretirement liability was $378.7 million. Of that, an average of $214.3 was unfunded, meaning those benefits will be paid out of the general assets of the corporation. These unfunded obligations are like capital -- a rate of return must be earned on this capital.

In this case, we should adjust the company's shareholders' equity by adding the amount of unfunded pension obligations to shareholders equity. At this point, we're not looking at ROE per se, but we are approaching a better indicator of a company's industry and specific economics. What we're trying to get to is a return on invested capital (ROIC), a measure of a company's profitability on all invested capital. Measured as net operating profit after tax (fully taxed operating profit) divided by the sum of assets minus noninterest-bearing current liabilities minus excess cash and securities, this gives an investor a better idea of how profitable the company is before taking into account the cost of the funds invested in the company. For a further explanation, please see our series on ROIC.

For Avon, we could calculate ROIC, but it should be enough of an illustration of the concept to add these equity equivalents to shareholders' equity to get a better idea of what the company's return on capital was for 1995. Adding average shareholders' equity and just the unfunded pension liabilities to that, total equity equivalents were $403.5. With net income of $256.5 million, return on equity and equity equivalents was 63.6%. That's much less than the calculated ROE, but it is a better reflection of the real economics of Avon's business.

Berkshire Hathaway (NYSE: BRK.A) has constantly confounded people who have run back-of-the-envelope calculations to show that it is overvalued. In one famous instance, Barron's published a valuation of Berkshire that left out one of the company's major areas of profits in its deliberations of value. On its most recent balance sheet, Berkshire showed shareholders' equity of $36.92 billion and a market capitalization of just over $96 billion. Some valuations would just compare the two to come up with a price-to-book ratio of 2.6 and say it's overvalued. But one should consider that Berkshire makes extensive use of liabilities that act more like equity. The largest of these is the company's deferred tax liability that arises from the appreciation in investments such as Coca-Cola (NYSE: KO) and Gillette (NYSE: G) stock. At $12.4 billion, the bulk of this liability won't come due tomorrow or the next year.

The lower shareholders' equity number isn't the amount of capital Berkshire has at its disposal. A higher amount that includes not only the deferred tax liability but the nearly perpetual insurance loss reserves and unearned premiums constitute what the company actually has under its control to generate a rate of return to fund all its sources of capital. Adding the company's most recent shareholders' equity of $36.9 billion to the deferred tax liability of $12.4 billion and $8.7 billion in insurance loss reserves and unearned premiums gives us shareholders' equity and equity-like capital of $58 billion. With a current market capitalization of $85.9 billion, this gets us closer to a price-to-economic book value ratio of 1.48.

The way a creditor or a liquidator of the company would look at it, the unadjusted book value would be more appealing because they are interested in the true net asset value of the company in the absolute worst case scenario. The investor looks at a company, though, on the basis of how much it can return on real economic capital as a going concern. The creditor and the investor, then, are interested in different price-to-capital calculation methodologies, which is why James Grant's organization and others get it wrong when they're looking at something like Berkshire Hathaway on the basis of price-to-book value.

Now, any time investors want to look at price-to-book and ROE, they're trying to see if they're overpaying for each dollar in capital and earnings power they are buying. If the price isn't right, the return to that shareholder may suffer. But a price-to-book ratio on shareholders' equity isn't going to quite capture the real price of the company, especially when there are lots of equity equivalents that show up on the balance sheet as liabilities that ostensibly reduce the amount of capital at management's disposal.

One could switch to return on assets (ROA) to try to get a better picture of return on capital, but that can overstate the amount of capital that a company has actually invested in the business. Return on net assets (RONA), which is net income divided by total assets minus excess cash minus noninterest-bearing current liabilities, gets us closer to a more precise indicator of a company's economics. In the case of Costco Companies (Nasdaq: COST), RONA would give us a better picture of the company's economics than ROA because the company operates with perpetual financing from its inventory vendors. In other words, each dollar of assets does not represent a dollar of investment in operations by the company.

To answer the proposition put forth in Buffettology and to wrap up this series, calculating straight ROE doesn't quite get you there in assessing a company's economics. ROE can be manipulated by big-bath accounting and excess leverage. This must be said, though -- looking at return on capital, however you define it, is preferable to just looking at EPS growth. There are lots of expenses one can defer or capitalize and lots of ways to define sales that miss the point of revenue recognition. By looking at return on capital, a management can't slip through the cracks by running up receivables and capitalized expenses just for the sake of ramping EPS. That sort of activity will be penalized by increasing the denominator in return on capital calculations. An investor can also make adjustments for a company that has bombed out equity value by taking huge write-offs.

This is all left to the investor's discretion, though. One should be skeptical if ROE for a notoriously commodity-like business is very high unless the process control at the company is absolutely superb. Under the heading of asset turns on the DuPont ROE decomposition, one should look at turnover of inventory, total capital, receivables, and fixed assets to see what sort of process control a company is showing. One should also look inside the leverage ratios to analyze the actual components that are in the A - L = OE accounting tautology. If liabilities for a company are totally comprised of high-interest debt, then a 2-1 leverage ratio is going to be less preferable than a 2-1 leverage ratio for a steady retailer of basic goods that normally runs with lots of noninterest-bearing accounts payable.

Finally, there is a better measure of capital for the purposed of assessing return on capital than just assets and shareholders' equity. While the decomposition of ROE into ROA and leverage is useful and gives the investor a better idea of what's going with a particular company's business model, return on invested capital (ROIC) is the superior metric of a company's performance, in my opinion. It requires more work on the investor's part, so call us Puritans if you'd like. I believe that spending time looking inside a company's balance sheet to assess capital in use, return on capital, and the real cost of capital will reward an investor with a better understanding of a company's economics and with better investment returns.

Related articles:
ROE series -- Part 1 | Part 2 | Part 3


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Yi-Hsin Chang (TMF Puck), a Fool
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Dale Wettlaufer (TMF Ralegh), Final Fool

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