<THE EVENING NEWS>
Thursday, February 18, 1999
DJIA 9298.63 +103.16 (+1.12%) S&P 500 1237.28 +13.25 (+1.08%) Nasdaq 2260.55 +11.64 (+0.52%) Russell 2000 391.09 +1.55 (+0.40%) 30-Year Bond 98 1/4 -13/16 5.37 Yield
Office products retailing powerhouse Office Depot (NYSE: ODP) tacked on $3 to $33 7/8 this morning after turning in adjusted Q4 earnings of $0.34 per share, up 31% from $0.26 per share a year ago and a penny ahead of the consensus estimate. Gross margins improved to 29.9% from 27% while inventory dropped 10%, impressive considering the company's 10% sales growth and 100-store year-over-year expansion. As a superstore retailer, Office Depot appears to be firing on all cylinders, but as the Fool's Louis Corrigan points out in today's Lunchtime News, the transition to online retailing -- where wholesale-level pricing has become a rallying cry for many merchants -- may mean that prices and gross margins will need to fall for the company to remain competitive in the new retail economy. "Like other major hard goods retailers," Corrigan notes, "the company has only begun to grapple with what the Web might do to its business."
Waste services company Superior Services (Nasdaq: SUPR) "picked up" a gain today, moving ahead $1 3/4 to $19 1/2 on the heels of releasing its fourth quarter and full year 1998 numbers. Today, Morgan Stanley Dean Witter upgraded the stock to "outperform" from "neutral" in conjunction with a $22 price target, noting that "management has begun to execute on its new strategy of more disciplined growth." Morgan's target puts Superior at roughly 18 times its 1999 EPS estimate of $1.20. Superior actually announced its intention to focus on existing operations over acquisitions at the end of its last quarter -- which, in the trash hauling business, can often yield better returns than looking for growth externally -- after falling short of Street expectations. The firm has attracted some talent away from the bigger names in the industry to act as regional managers in the endeavor, and if Superior can successfully manage the density and integration issues, it should continue to see more positive results.
QUICK TAKES: Chipmaker Intel Corp. (Nasdaq: INTC) rose $3 1/2 to $128 1/8 after Donaldson, Lufkin & Jenrette set a 12-month price target of $175 on the shares, reiterating a "buy" rating... U.S. financial services company Transamerica Corp. (NYSE: TA) jumped $15 1/4 to $72 7/8 after Dutch insurer Aegon NV (NYSE: AEG) agreed to buy the company for $9.7 billion in cash (30%) and stock (70%), representing a 35% premium over Transamerica's closing price yesterday of $57 5/8. Aegon will assume about $1.1 billion of Transamerica's debt. Aegon added $5 1/8 to $99 7/8 today... AT&T (NYSE: T), which won the blessings of federal regulators regarding its acquisition of cable operator Tele-Communications Inc. (Nasdaq: TCOMA) and thus cleared the final major hurdle to the deal, took on $1 9/16 to $85 7/8. The companies' shareholders approved the transaction yesterday.
Mobile phone maker Nokia (NYSE: NOK.A) rang up gains of $3 5/16 to $131 3/16 today. The company announced the purchase of privately held U.S. wireless network products developer InTalk Corp.; no terms were disclosed... Credit card lender Providian Financial Corp. (NYSE: PVN) cashed in gains of $7 to $100 9/16 after it said it bought GetSmart.com, a privately held online marketplace for consumer borrowing, for $33 million in cash, and the formation of a new e-commerce division... Cable operator Comcast (Nasdaq: CMCSK) spread $3 3/4 to $70 7/8 after it agreed to buy Greater Philadelphia Cablevision, a cable system with 79,000 customers, in exchange for 4.2 million shares of its Class A stock.
Disk drive thin-film media maker Komag Inc. (Nasdaq: KMAG), which agreed to buy Western Digital Corp.'s (NYSE: WDC) disk media business for $80 million in stock, advanced $11/16 to $7 5/16 today... Bank holding company Prime Bancorp (Nasdaq: PBNK) added $7 to $25 after Summit Bancorp (NYSE: SUB) agreed to buy the company in a stock swap valuing Prime at about $26.58 per share, a 48% premium over yesterday's closing price... Component and supply management software company Aspect Development (Nasdaq: ASDV) spread $2 7/16 to $24 1/8 after Hambrecht & Quist initiated coverage of the company with a "buy" rating... Titanium mill and fabricated products maker RTI International Metals (NYSE: RTI) advanced $13/16 to $11 15/16 after it said a court order temporarily halted operations at its RMI Titanium subsidiary.
Canada-based gold exploration company Sutton Resources (Nasdaq: STTZF) rose $3 9/16 to $8 3/16 after gold producer Barrick Gold (NYSE: ABX) said it would buy Sutton in a stock swap valuing the company at C$525 million, or C$13.25 a share. Barrick's shares fell $7/16 to $18 1/4 today... Telecommunications equipment maker Lucent Technologies (NYSE: LU) moved up $4 3/4 to $101 as Warbug, Dillon, Read & Co. reiterated a "buy" rating and a $130 12-month price target on the stock... Brokerage giant Merrill, Lynch & Co. (NYSE: MER) ticked up $2 1/16 to $69 7/8 following reports that the company will roll out online stock and bond trading service to some of its customers in the next several weeks.
Computer-based medical diagnostic equipment maker Elscint Ltd. (NYSE: ELT) added $1 7/16 to $13 after majority owner Elbit Medical Imaging Ltd. (Nasdaq: EMITF) announced the intent to buy the rest of the company's shares for $14 in cash each, a 21% premium over yesterday's closing price... Streaming media aggregator Broadcast.com (Nasdaq: BCST) ran up $9 15/16 to $68 1/8 after Donaldson, Lufkin & Jenrette analyst Jamie Kiggen raised his rating on the shares to "buy" from "market perform," upping his price target to $100 per share from $40... Telecommunications services company CoreComm Ltd. (Nasdaq: COMMF) dialed up a gain of $4 13/16 to $26 3/16 after it announced the purchase of privately held Megsinet Inc., an Internet network and regional telecommunications provider, for $18.5 million in cash and 1.5 million shares of common stock.
Pratt & Whitney aircraft engines, Carrier air conditioners, and Otis elevators parent United Technologies (NYSE: UTX) added $1 5/16 to $123 1/16 on reports that Federal-Mogul Corp. (NYSE: FMO) may bid for its auto parts division... Personal care products network marketer Nu Skin Enterprises (NYSE: NUS) took on $13/16 to $22 1/16 after a Utah federal judge said the company can market Cholestin, a nutritional supplement developed by its Pharmanex subsidiary, without the FDA's regulation of the substance as a drug. The ruling reverses a May FDA decision... Biopharmaceutical company The Liposome Co. (Nasdaq: LIPO) rose $1 5/8 to $12 1/2 after it said the FDA accepted its new drug applications (NDA) for Evacet, a form of the doxorubicin anti-cancer drug. The company hopes to earn full FDA approval for the drug within the year. Liposome also announced the initiation of Phase I trials of TLC ELL-12, another cancer fighter.
Nortek Inc. (NYSE: NTK) up $3 7/16 to $28; Q4 EPS $0.92 vs. $0.57 last year; estimate: $0.44
SLI Inc. (NYSE: SLI) up $1 7/8 to $25; Q4 EPS $0.43 vs. $0.22 last year; estimate: $0.41
SMART Modular Technologies (Nasdaq: SMOD) up $2 1/16 to $15 15/16; fiscal Q1 EPS $0.26 vs. $0.35 last year; estimate: $0.28
Analog device maker SIPEX Corp. (Nasdaq: SIPX) was jolted for a $11 fall, or $46.2%, to $12 13/16 after warning that it was "cautious" about its short-term revenue prospects. Although the company will open a new wafer fabrication facility in Q2, the company's CEO cautioned that "our ability to grow in this market will be dependent upon a higher level of orders received and shipped in the same quarter than has historically been our experience." Not too encouraging when the analog market is "relatively soft overall" and experiencing pricing pressure. SIPEX also announced Q4 earnings per share (EPS) below estimates. Adjusting the reported results to exclude one-time charges and tax-loss carryforwards and include a normal tax rate of 35%, the EPS figure was $0.15, $0.02 shy of the First Call consensus estimate of $0.17.
Dialysis centers operator Total Renal Care Holdings (NYSE: TRL) plunged $12 1/4, or 58.3%, to $8 3/4 after reporting lower-than-expected fourth quarter earnings of $0.30 per share, up from $0.19 a year ago. Analysts projected EPS of $0.37, however, and investors were clearly disappointed with the result, particularly since the company had at least met market projections for several quarters running. Adding to the ill will today was the news that the SEC asked the company to clarify, among other things, statements from the company's Q3 filing involving merger expenses of $92.8 million taken in Q1 in connection with the acquisition of Renal Treatment Centers. Total Renal said it answered all the SEC's questions on Tuesday. At least four brokerages downgraded Total Renal today.
QUICK CUTS: Highway civil contractor Granite Construction (NYSE: GVA) crumbled $7 3/4 to $22 5/16 after announcing Q4 EPS of $0.36, well ahead of last year's $0.21 mark but not the $0.40 projection thaseven analysts gave First Call... Textiles designer, maker, and marketer Dan River Inc. (NYSE: DRF) spun off $1 1/16 to $8 after the company said it expects first-half EPS of $0.25 compared to First Call's three-analyst $0.40 projection... Computer chip templates maker DuPont Photomasks (Nasdaq: DPMI) hid $3 3/4 to end at $42 1/8 after it announced plans for a secondary offering of 2 million shares of common stock to be offered by its principal stockholder, E.I. du Pont de Nemours (NYSE: DD).
Travel Services International (Nasdaq: TRVL) sank $8 5/8 to $13 3/8 after warning it expects net revenue growth in the first quarter of this year to be slower in certain areas than the company's aggressive growth targets... After soaring in its first two days of volatile trading, nutritional supplements company Mannatech Inc. (Nasdaq: MTEX) lost $10 3/4 to $21 today. Yesterday the company's shares plunged 50% but then rose and ended the day 41% higher. The stock initially priced at $8 a share... Healthcare information technology firm QuadraMed (Nasdaq: QMDC) slid $4 15/16 to $18 1/8 after posting Q4 EPS of $0.29 (before one-time items) versus $0.15 last year. Analysts expected EPS of $0.28.
Industrial products direct marketer MSC Industrial Direct (NYSE: MSM) fell $2 3/16 to $21 7/8 after Prudential Securities downgraded the company's shares to "accumulate" from "strong buy"... Luxury goods maker Gucci Group N.V. (NYSE: GUC) frayed $2 5/16 to $64 5/16 after the recent Daily Double subject launched an employee stock ownership plan in response to the "creeping acquisition" by 34.4% stakeholder LVMH Moet Hennessy Louis Vuitton (Nasdaq: LVMHY), which wants a designate on Gucci's board... Wound treatment programs operator Curative Health Services (Nasdaq: CURE) lost $8 1/8 to $11 1/2 after reporting Q4 EPS of $0.27, missing the year-ago mark and the projected $0.35. The company's board authorized a 2 million-share buyback plan, about 16% of the total outstanding.
Information technology services company Nichols Research Corp. (Nasdaq: NRES) rusted $4 1/4 to $17 1/4 after saying it doesn't expect fiscal Q2 EPS to meet First Call's $0.29 consensus estimate... Paging company SkyTel Communications (Nasdaq: SKYT) fell $3 13/16 to $20 1/16 after reporting a Q4 loss of a penny per share, in line with Street estimates but well ahead of the year-ago $0.46 loss. Three-month net income of $1.8 million represented the company's first quarterly net profit since 1993... Telecommunications network management tools maker DSET Corp. (Nasdaq: DSET) shed $1 3/4 to $9 3/4 after CFO Paul Lipari resigned. Susan Boykas, principal of a New Jersey CFO services firm, will replace Lipari in an acting capacity.
Gene transcription company Ligand Pharmaceuticals (Nasdaq: LGND) gave back $2 1/16 to $10 5/16 after it said Eli Lilly & Co. (NYSE: LLY) decided not to pursue the development of three first-generation anti-diabetes compounds in favor of two others... Promotional products distributor and telemarketing services company HA-LO Industries (NYSE: HMK) darkened $5 3/8 to $14 3/16 after turning in Q4 EPS of $0.36, ahead of last year's $0.28 but short of analysts' estimates by $0.02... Concrete products maker and marketer Lafarge Corp. (NYSE: LAF) was dumped $2 1/8 to $32 5/8 after Warburg, Dillon, Read & Co. downgraded the stock to "buy" from "strong buy."
Amazon and the Future of E-Commerce
Yesterday, I highlighted Onsale's (Nasdaq: ONSL) atCost site, which is now selling a broad line of new computer equipment for a low, flat-fee markup. In short, it's now competing directly with CompUSA (NYSE: CPU) and everybody else in PC retailing, online or off. In the near future, atCost will no doubt venture into consumer electronics, competing even more completely with Best Buy (NYSE: BBY), Circuit City (NYSE: CC), and everybody else in that notoriously tough but recently booming business. While Onsale's strong customer base makes it well positioned for this fight, the company won't be alone in this move toward a light, high-volume, low-margin online business model. Many other firms will use the same game plan to try to capture a piece of the e-commerce pie.
A few observations seem obvious. First, every store-based retailer of commodity-like hard lines will have trouble competing with the atCosts of the world. Their brick-and-mortar cost structure is just too high to slash prices low enough. People will browse for PCs, TVs, or boomboxes at Best Buy, but they'll increasingly buy from a reputable, low-cost online vendor. This change may be gradual, but the market will begin to discount the extraordinary competitive pressures on these well-known retailers. After all, it's begun to discount the fact that Borders (NYSE: BGP) was too slow in launching its online bookstore and thus fell way behind Amazon.com (Nasdaq: AMZN) and Barnes & Noble (NYSE: BKS), leaving it simply caught in a bind. Borders must now pay up to promote its website, cannibalizing its store revenues with low-margin online sales that may not necessarily expand its market. Or, it can simply hope that the Web goes away. Shareowners of many still-strong retailers should ask what Borders has to teach them, and the lesson may be, "Get out now!"
Second, e-commerce has generally been thought of as a process of disintermediation whereby buyers and sellers can now bypass those parties that once took a slice of the profits despite adding little or no value to the transaction. The clearest example may be the way discount brokers like Schwab (NYSE: SCH) reduced stock transaction fees by convincing millions of investors that full-service (that is, high-priced) brokers didn't add enough value to justify their commissions. Now, online brokers like E*Trade (Nasdaq: EGRP) have convinced millions more that even talking to an order-taker over the phone is of minimal value.
What the gold rush in the online brokerage business really suggests, though, is that traditional business-to-consumer commerce is undergoing a process of re-intermediation. Old business is being conducted through new (or simply different) intermediaries that offer customers a new value proposition and thus depend on different profit centers. What used to cost a lot of money (a stock trade) is increasingly inexpensive or free. Companies that provide excellent service and a competitive price on this repeat, commodity business will be positioned to benefit from other revenue streams (say, getting you to invest in their own mutual funds) or from a greater volume of traditional, though once-downplayed revenue streams (say, from interest on margin loans). You have to be lean, though, to make money this way.
Third, despite Onsale's experience, sound management, and established customer base, it too could have a difficult time competing in this game without additional financing. The key here is the unusual nature of competitive advantage in the world the Web is creating. In short, brand matters, and matters hugely, but in two very specific ways: its ability to produce an increasing volume of customer traffic and transactions, and its related ability to ensure that a company has access to unlimited financial resources. Brand won't ensure that a company enjoys (much) pricing power up front. But it will definitely help a company survive in an environment where no one is supposed to have pricing power but where someone eventually will.
What I'm suggesting is that e-commerce may work like a poker game in which the players capable of raising the stakes high enough will never lose because competitors will simply have to fold. Clearly, Amazon may be best-positioned to play this game. Although the Amazon bears have repeatedly argued that there are no barriers to entry on the Web and that price competition will destroy the company, they're not just wrong, but diametrically wrong. The dynamics they identify as a threat actually speak to precisely why Amazon is so strong.
Nonetheless, because we're all still coming to grips with competitive advantage on the Web, Amazon's stock will likely take a huge hit at some point. For FY98, Amazon reported gross margins of 21.9%, up from 19.5% in FY97. Despite fears that lower-margin CD sales would cause gross margins to decline, they still increased to 21.1% in Q4 versus 19.6% a year ago (though they did decline sequentially from 22.7% in Q3). Jeff Fischer, co-manager of the Fool's Rule Breaker portfolio, is not alone in projecting that gross margins should continue to rise, perhaps to 25% by 2001. Yet, at least in terms of product sales (as opposed to commission or advertising revenues), I now think the atCost model will exert tremendous pressure on gross margins.
Ask yourself how investors would react if Amazon's CEO Jeff Bezos said the company would pursue a strategy of achieving zero gross margins on product sales for a period maybe measured in years. That would be a shock. Investors would be seriously stumped about how you can operate a business in such a fashion. Yet, if e-commerce becomes as competitive as everyone seems to believe, then such a strategy could well be Amazon's most rational response, a natural extension of the current strategy of accepting net losses while growing the business.
A pithy way to summarize Amazon's competitive advantage is to say that it may be the only company capable of adopting a sustained zero gross margin strategy on product sales without simply going out of business. Amazon's first-mover cachet, stellar brand, smart management, and daunting 6.2 million customers (1.7 million new customers in Q4 alone) have allowed it to raise a stunning amount of cash via convertible debt offerings: $326 million last spring and $1.25 billion in February. It's now got about $1.62 billion to use however it likes to remain the top online retailer. Competitors can probably get their hands on more cash, but a quick snapshot of a few shows Onsale with $46.7 million, N2K (Nasdaq: NTKI) with $36.2 million, CDNow (Nasdaq: CDNW) with $49.0 million, Best Buy with $409.4 million, and Circuit City with $118.0 million. So Amazon has a lot of money to build out its distribution infrastructure (as announced), boost ad spending, make acquisitions, create content, or whatever.
Amazon could even use its cash hoard to support cutthroat pricing that drives competitors out of the market. On an operating basis, Amazon reported a FY98 net loss of $74.4 million, a gross profit of $133.8 million, and sales of $610 million. Even adjusting for tremendous sales growth, Amazon could afford to drop gross margins substantially without risking its future. Indeed, it may be one of the only companies for which such a strategy would not only not be suicidal but might even be smart. How many competitors could afford to suffer massive losses for years to come while simultaneously finding a way to eventually make money in a low gross margin environment where Amazon already enjoys a huge head start and greater economies of scale?
To be clear, I'm not saying Amazon will pursue this strategy, only that it can if it must. However, Bezos probably will decide at some point that lowering gross margins makes more sense than increasing advertising spending, though these are really just two sides of the same coin paying for long-term market share. The main point is simply that e-commerce will likely remain a game of who can afford to lose the most money for the longest time while keeping investors convinced that its strategy makes sense. Keeping Wall Street hooked is really the only reason why any of these companies wants to turn a profit sometime soon. From a pure business angle, it would probably be smarter for Amazon to postpone profitability for another decade.
That's not a joke either. Whether you imagine Amazon continuing to grow its infrastructure largely by allowing its vendors to fund its working capital needs or whether you imagine Amazon moving increasingly toward a kind of atCost fee-for-service model (which seems likely), the fact is that Amazon is positioned to be a player when everybody who wants to lose money venturing into e-commerce has thrown the dice and come up snake-eyes. At that point, margins from product sales will firm and then climb. Meanwhile, the stream of advertising revenues that Amazon has only begun to tap should just get bigger and bigger so that it becomes a significant if not the major source of profits.
Working out the actual numbers and putting a valuation on the business is a challenge, but I think these tasks can only be addressed once you figure out where the industry is going in terms of price competition and what firms can maintain good financing options. I've personally come around to the view that the Web will prove so competitive that competition will disappear. That's a bizarre formulation that's not literally true, but it at least points to the logic of the system. E-commerce may simply be so weird that we had better re-wire our brains if we hope to understand it.
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