<THE EVENING NEWS>
Friday, February 26, 1999
MARKET CLOSE
DJIA            9306.58       -59.76     (-0.64%)
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30-Year Bond   95 11/32       +28/32  5.57 Yield

HEROES

Truck and bus manufacturer Navistar International Corp. (NYSE: NAV) motored ahead $3 9/16 to $43 after a report in a Swedish newspaper reignited speculation that heavy duty trucks maker Volvo (Nasdaq: VOLVY) will make a bid for the company. Volvo, which is staying mum, fell $3/4 to $25 1/2. Anticipation of a bid is building, since Volvo President and CEO Leif Johansson is catching a plane to the States next week to make a scheduled appearance in New York. At first blush, a bid seems to make good sense -- Navistar has really gotten its business in gear over the past few years, increasing return on equity from 7% in fiscal 1996 to 33% in 1998, while Volvo will soon find itself sitting on $6.45 billion in cash if the planned sale of its auto unit to Ford (NYSE: F) closes as expected later this spring. A sticking point may end up being the price tag, since the buyout rumors have helped boost Navistar's shares nearly 30% over the last two weeks.

Specialty integrated circuits maker VLSI Technology (Nasdaq: VLSI) jumped $4 3/4 to $15 1/2 after the Netherlands' Philips Electronics (NYSE: PHG) offered to buy the company for $17 per share in cash, or about $777 million. VLSI is reportedly considering the bid. The deal suggests Philips may readying itself to make a major push into the global mobile phone market, which is controlled by the Ericsson (Nasdaq: ERICY), Nokia (NYSE: NOK.A), and Motorola (NYSE: MOT) wireless troika. Philips could leverage VLSI's System-Level Silicon chips in its own mobile phones, enabling it to cut costs through vertical integration. However, such a scenario would probably result in VLSI losing its historical number one customer, Ericsson, which by itself accounted for 29% of VLSI's $712.7 million in fiscal 1997 revenues.

QUICK TAKES: Wireline and wireless network synchronizing products maker Datum Inc. (Nasdaq: DATM) gained $1 11/16 to $8 7.16 after reporting Q4 EPS of $0.01, flat with last year's results but ahead of the First Call mean estimate of a loss of $0.07 per share... Embedded integrated circuits development tools provider Wind River Systems (Nasdaq: WIND) sailed ahead $2 1/16 to $22 13/16 after posting Q4 EPS of $0.20 (excluding charges), up from $0.15 a year ago and ahead of the First Call mean estimate of $0.19... Valassis Communications (NYSE: VCI), a printer of newspaper advertising inserts, tacked on $1 to $48 after Merrill Lynch raised its near-term rating to "buy" from "accumulate."

Internet telephony technologies firm NetSpeak Corp. (Nasdaq: NSPK) added $3 to $15 3/8 after Business Week's dubious "Inside Wall Street" column speculated that Motorola (NYSE: MOT) may expand its 32% stake in the company or just buy the whole shebang outright... Credit card lender Capital One Financial (NYSE: COF) charged ahead $3 3/4 to $127 5/8 after Piper Jaffray started coverage of the firm with a "strong buy" rating and a 12-month price target of $157 per share... Brokerage and investment bank Donaldson, Lufkin & Jenrette (NYSE: DLJ) advanced $3 to $57 after agreeing to buy Citigroup's (NYSE: C) Newbridge Securities trade processing services unit for unspecified terms. Separately, Citigroup rose $2 1/8 to $58 3/4.

Paging company SkyTel (Nasdaq: SKYT) climbed $1 3/4 to $18 after Salomon Smith Barney started coverage of the company with a "buy" rating... Financial planning software developer Intuit (Nasdaq: INTU) quickened its pace and sprinted $9 3/8 higher to $98 15/16 after posting fiscal Q2 EPS of $1.34 (before gain), topping last year's $0.95 and analysts' estimates of $1.30... Cancer drug developer SuperGen (Nasdaq: SUPG) advanced $1 1/8 to $9 3/4 after filing a supplemental New Drug Application (NDA) with the FDA to receive additional approvals to use its existing Nipent drug to treat various mature T-cell lymphomas.

International engineering and construction firm Fluor Corp. (NYSE: FLR) picked up $1 7/16 to $35 3/16 following a Salomon Smith Barney upgrade to "buy" from "neutral"... Computer products e-commerce technologies provider pcOrder.com (Nasdaq: PCOR) rose $26 1/8 to $47 1/8 in its first day of trading after the company sold 2.2 million shares in an initial public offering at a price of $21 per share... Business software consultant and services provider Intraware (Nasdaq: ITRA) gained $2 7/8 to $18 7/8 following its initial public offering of 4 million shares at a price of $16 per stub.

Drug developer Sepracor (Nasdaq: SEPR) moved up $6 1/2 to $124 3/4 after reporting a Q4 loss of $1.10 per share, which was not quite as bad as the loss of $1.21 per share expected by the 10 analysts surveyed by Zacks... Truckee, California-based SierraWest Bancorp (Nasdaq: SWBS) climbed $1 5/8 to $30 1/2 after agreeing to merge with BancWest Corp. (NYSE: BWE) in a stock swap valued at $194 million... Ear, nose, and throat surgical products maker Xomed Surgical Products (Nasdaq: XOMD) gained $2 1/4 to $36 3/8 after posting Q4 EPS of $0.26 (excluding charges), up from $0.21 last year and ahead of the First Call mean estimate of $0.24.

GOATS

PC companies fell en masse today with the proximate cause being a couple of Compaq (NYSE: CPQ) downgrades and the contributing factor being the assumption of a slower growth rate for the PC market. Compaq was slammed for a $5 5/8 loss to $35 3/8, Dell Computer (Nasdaq: DELL) was off $1 5/8 to $80 1/8, Gateway (NYSE: GTW) was off $7 7/16 at $72 11/16, IBM (NYSE: IBM) was blown over $3 7/8 to $169 3/4, and Micron Electronics (Nasdaq: MUEI) fell $3/16 to $14 3/8. Merrill Lynch analyst Steven Milunovich got the ball rolling after he dropped his first quarter revenue estimate for Compaq from $10.1 billion to $9.8 billion and decreased his EPS estimate 14%, to $0.30 from $0.35. However, hitching the entire PC industry's fortunes to a slowing Compaq wagon is probably not a strategy investors should embrace, as Dale Wettlaufer (TMF Ralegh) explains in today's Fool Plate Special.

Dragged down amid the PC fallout was chip giant Intel (Nasdaq: INTC), which fell $7 13/16 to $119 15/16. Not helping Intel's case was the release of a report by computer sales data compiler PC Data that stated that rival Advanced Micro Devices (NYSE: AMD) accounted for 43.9% of all desktop PC processor unit sales last month, topping Intel's 40.3% share. This is the first time that AMD's chips have outsold Intel's desktop PC offerings during any month in this category, which is much more narrowly defined than International Data Corp.'s quarterly microprocessor sales round-ups. In fact, with the rabid popularity of sub-$1,000 PCs, Intel may never regain the top share in the low margin "cheap chip" business, so long as AMD doesn't completely blow apart. According to today's report, sub-$1,000 PCs accounted for 65% of the market in January, up strongly from 51% of the market the month before.

QUICK CUTS: Biotechnology firm Emisphere Technologies (Nasdaq: EMIS) moved back $2 1/4 to $13. The company said the FDA asked for additional information about the development of oral heparin, meant to help prevent deep vein thrombosis following hip replacement surgery. The request is expected to delay the start of the company's Phase III clinical testing... Securities market maker Knight/Trimark Group (Nasdaq: NITE) darkened $5/8 to $34 3/4 after it announced a secondary offering of 9 million shares at $35 per share... Entertainment and consumer products retailer and direct marketer K-tel International (Nasdaq: KTEL), which launched a German e-commerce site targeting the central European market, lost $2 11/16 to $9 15/16 today.

Signal processor chip maker Analog Devices (NYSE: ADI) dropped $2 to $25 1/16. Yesterday afternoon the company announced the purchase of Scotland's Edinburgh Portable Compilers, a privately held company that develops high performance C/C++ and Fortran language compilers... Boston-based equity investment firm Affiliated Managers Group (NYSE: AMG) dumped $1 1/8 to $26 after it priced an offering of about 5.5 million shares of company stock at $27 1/8 per share, yesterday's closing price. The company intends to use proceeds from the sale to pay down debt... Enterprise resource planning software developer Platinum Software Corp. (Nasdaq: PSQL), which received downgrades from Donaldson, Lufkin & Jenrette and First Albany today, fell $1 5/16 to $7 1/4.

Chip maker Micron Technology (NYSE: MU) shed $8 13/16 to $58 after Goldman, Sachs & Co. downgraded the company to "market outperform" from its "recommended list"... International long-distance phone service provider Star Telecommunications (Nasdaq: STRX) moved down $1 to $13 after ING Baring Furman Selz downgraded the stock to "buy" from "strong buy," lowering its 1999 EPS forecast to $0.38 from $0.48... Network software developer Novell Inc. (Nasdaq: NOVL) slid $1 1/2 to $19 3/8 after reporting fiscal Q1 EPS of $0.08, up from $0.04 last year but a penny shy of the First Call mean estimate... Supplemental cancer painkiller developer Anesta Corp. (Nasdaq: NSTA) fell $1 7/16 to $19 13/16 after putting up a fiscal 1998 net loss of $1.59 per share, which was worse than the loss of $1.38 per share expected by the six analysts surveyed by First Call.

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Financial Karma, Part 2

Would you like to know how much a company is earning before you invest in that company? You should, because without that information, it gets difficult to understand how to value that company. By that, I don't mean just coming up with a P/E that seems right and plunking down your cash. I mean, it's difficult to assess how much to pay for a company if the form of earnings does not portray the economic substance of a business.

This frames the issue I put forth in yesterday's Fool on the Hill. In that column, I discussed the issues behind the Financial Accounting Standards Board's (FASB) decision to recommend a change in the method of accounting for mergers and acquisitions for research and development-intensive companies. Today I want to first look at the cash flow aspects of the issue, and then on Monday I'll deal with the balance sheet aspects of merger and acquisitions accounting.

To begin with, the issue of in-process R&D write-offs has generated a lot of light and heat because executives believe the market is preoccupied with reportable earnings. Anything that reduces reportable earnings is undesirable, the thinking goes, because the market discounts earnings. As an ontological framework, that's not correct. Many CEOs and CFOs contemplating their company's place in the financial universe think "earnings and EPS growth." Many Wall Streeters do, too. The enlightened investor, however, thinks "free cash flow." And that is where your thinking should be directed.

At issue is this: If I am Dale Systems Inc. and I make data switches using superconductor technology, I might want to acquire another company whose software will really advance my product. Say this acquisition target has $15 million in revenues but the going price for such a concern is $200 million. The target company has $20 million in appraised book value. Most of the value of this company lies in its intellectual property. I'm obviously not buying it to liquidate its workstations, desks, leases, and other hard assets.

As the CEO of Dale Systems, I want to attribute 90% of the excess purchase price over book value to "in-process R&D" and expense that immediately. So this year I take a write-off equal to 90% of the $180 million excess. For the purposes of this example, let's leave taxes out of it. So that $162 million write-off reduces my net income by the same amount and it also reduces my company's book value by $162 million because it reduces retained earnings by that amount. Not to worry here, as "the Street" looks at "earnings before extraordinary items."

Now, say my company earned $100 million before the write-off this year and next year it will earn $200 million because the product synergies we forecast were extremely well received by customers. Let's also say Dale Systems would have earned $150 million next year without the new software. Wall Street's happy, my options are worth a whole lot more, my employees are happy, my engineering classmates know now that I'm The Man and not the geek they thought I was, and my kids are bouncing around like little kangaroos because they can get the G.I. Joe with the kung-fu grip for Christmas.

But now the accountants and economists at FASB and the Securities and Exchange Commission want to change all that. I can't write off the in-process R&D when I make the acquisition. I have to capitalize the acquired R&D and amortize the asset over a number of years. In this case, let's say by standard industry practices and our best judgment that turns out to be five years. So, on the acquisition date, I have to mark up on the asset side of the balance sheet an intangible asset of $162 million called "in-process R&D." On the liabilities and equity side of the balance sheet, my shareholders' equity is $162 million higher because there was no write-off to reduce my retained earnings.

Nothing is different with the product synergies. Silicon Valley is still quaking because some upstart company from Buffalo, New York, just strengthened its market share in the extremely important superconductive data switching market. I'm bummed, though. These accountants and FASB ninnies caused my earnings to be $32.4 million lower than they would have been had I been able to write off the R&D. How that works is simple. If I have to capitalize the $162 million of in-process R&D and I must write it off over its useful life of an estimated five years, then each year I charge off 20% of that capitalized asset. That's $32.4 million per year charged to earnings. So my earnings this year are $167.6 million instead of $200 million. Ninnies.

You know what, though? The market doesn't care, because accounting methods don't alter cash flow. Sure, there will be the occasional analyst on your conference call that can't quite get it straight and downgrades you because your earnings growth didn't fit into his or her price-to-earnings-growth model. But the market as a whole isn't going to get hung up on the form of your earnings. The economics of your cash flows are simple enough to see under the two methods of accounting. Let's look at cash flows for the year after the acquisition under the two scenarios (both in thousands of dollars):

Write-off method

Cash flows from operating activities:
Net income.....................................................$200,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation........................................................8,000
Provision for doubtful accounts..........................9,000
Change in operating assets and liabilities:
Accounts receivable........................................(43,000)
Inventories........................................................(13,150)
Prepaid expenses and other current assets......(5,000)
Accounts payable..............................................12,500
Accrued payroll and related expenses................7,000
----------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES...$175,350

Capitalization and amortization method

Cash flows from operating activities:
Net income.....................................................$167,600
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation.........................................................8,000
Amortization of in-process R&D........................32,400
Provision for doubtful accounts...........................9,000
Change in operating assets and liabilities:
Accounts receivable.........................................(43,000)
Inventories.........................................................(13,150)
Prepaid expenses and other current assets.......(5,000)
Accounts payable................................................12,500
Accrued payroll and related expenses..................7,000
------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES...$175,350

There's no difference in the cash flows. That means there's no difference in the cash economics of the business. As for taxes, you might get to record a tax asset if you write off the R&D immediately, but if you only get to use the tax asset at the same rate as the deductible amortization expense over the asset's life it still doesn't make a difference to cash flows. But some IRS rules are even more screwed up than the most demented Generally Accepted Accounting Principle (GAAP) dictates, so we'll just move past the tax issue.

Amortization is a financial accounting memorandum. Some people treat all amortization as the same -- as in "don't worry about it, it's a non-cash expense." To my mind, there's a big difference between the goodwill that gets marked up on the balance sheet in a bank acquisition and the R&D intangible that gets marked up on the balance sheet in an industry with five-year or shorter product cycles. If you're turning over your entire product line in five years and you must replace that intellectual property with new acquisitions or homegrown R&D, the amortization is a memorandum that tells you about the amount of resources you need to expend to maintain your economic position. That assumes the return on future projects exhibits the same return characteristics as aged investments. If returns on future projects are higher, then you'll need to invest less to maintain your position.

For a depreciable asset like a drill press or something, if it's charged off over 20 years, it's not like it's going to fall part in year 21. Generally, though, if your depreciation schedule matches the useful life of an asset and inflation is not raging out of control, your depreciation expense will be directly offset by the amount of cash your need to spend to replace your assets. Goodwill is a little different, though, depending on the company.

For a bank holding company, goodwill amortization does not signify that it needs to spend a like amount of money to keep the customers it gained through the acquisition that gave rise to the goodwill. For a company in the superconductive data switching business, the asset is probably going to run its useful life over a much shorter period of time, during which you'll have to spend money to replace it. The purchased intangibles that arise from the acquisition of Coca-Cola are a lot more durable, if you run the business correctly, than the purchased intangibles in a software acquisition.

These are generalizations and, of course, there are exceptions. The problem with high-tech business is that the cash expended to replace assets shows up on the income statement right away. You're not replacing capitalized assets with more capital expenditures. That seems to be the big hang-up with a lot of executives in R&D-intensive industries. As I showed above, though, the market looks through that problem. When it comes to cash flows, the market is over the long run a suave sophisticate. It doesn't appreciate cartoonish portrayals of earnings. It can tell the difference between GAAP earnings and real cash flows.

Bottom line: The method of accounting doesn't change the gross cash flow, except possibly for small changes to the tax situation. How you think the non-cash amortization expense reflects a need to maintain those assets is something different. The form of the accounting chosen does not change the substance of the gross cash flow you have to work with to reinvest in the business. On Monday, I'll look at some of the balance sheet aspects of acquired R&D accounting and poolings versus purchase. I'll also nail down a little harder the economics of cash flows.

Discuss this column on the FOTH message board.

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