<THE EVENING NEWS>
Monday, March 1, 1999
DJIA 9324.78 +18.20 (+0.20%) S&P 500 1236.16 -2.17 (-0.18%) Nasdaq 2295.18 +7.15 (+0.31%) Russell 2000 394.39 +2.13 (+0.54%) 30-Year Bond 93 29/32 -1 12/32 5.67 Yield
Disk drive maker Quantum Corp. (Nasdaq: QNTM) spun ahead $3 1/8, or 19%, to $19 9/16 today on news that it plans to enter the network storage device market later this year, setting the stage for a rumble with file servers power Network Appliance (Nasdaq: NTAP). Quantum is hoping the foray into new territory will position it to answer storage needs related to the Internet and the proliferation of network computers. The company also believes the move will rally investors -- the shares are essentially flat in 1999 amid a general malaise among drive makers -- and intends to complement the strategy by listing its hard disk drive and storage systems businesses as separate tracking stocks. This isn't a spin-off, however, as the company will retain one management team and board. Quantum may back away from the tracking stock plan if a U.S. Presidential proposal to make the creation of tracking stocks taxable is approved.
Shares of health benefits management services company Advance Paradigm (Nasdaq: ADVP) raced ahead $7 7/16 to $43 1/2 after the company announced plans to buy Foundation Health Pharmaceutical Services, the parent company of managed care provider Foundation Health Systems' (NYSE: FHS) pharmacy benefit management (PBM) company, Integrated Pharmaceutical Services, for $70 million in cash. While nice for Advance Paradigm shareholders -- who stand to see their earnings boosted within about a year as a result -- the deal is small potatoes compared to the $700 million Express Scripts (Nasdaq: ESRX) recently paid for drug maker SmithKline Beecham's (NYSE: SBH) Diversified Pharmaceutical Services subsidiary, or the $1.5 billion Rite-Aid (NYSE: RAD) gave Eli Lilly & Co. (NYSE: LLY) for PCS Health Systems.
QUICK TAKES: Having tired of the scrutiny faced by public companies, apparel marketer The North Face (Nasdaq: TNFI) today announced a recapitalization through which public shareholders will receive $17.00 per share in cash. The stock climbed $3 3/4 to $16 5/8 on the news, reported in greater detail in today's Lunchtime News... Hotel holding company Patriot American Hospitality (NYSE: PAH) moved ahead $1/2 to $5 15/16 on the news that it will change its name to Wyndham International Inc. -- the name of its operating company -- and drop its status as a real estate investment trust. Patriot has reached an agreement to receive an equity infusion of up to $1 billion from an investor group headed by Apollo Real Estate Advisors of New York, along with $2.45 billion in financing commitments from Chase Manhattan Bank (NYSE: CMB) and the Bear Stearns (NYSE: BSC). Founder Paul Nussbaum will step down as chairman and CEO.
Information technology education centers operator Computer Learning Centers (Nasdaq: CLCX) posted gains of $2 5/16 to $6 5/8 after Illinois' superintendent of education allowed the company's Schaumburg operation to resume normal advertising, marketing, and enrollment activities, ending a cease-and-desist order issued in December... Chemicals and life sciences company DuPont (NYSE: DD), which closed the $1.9 billion purchase of Herberts, the coatings subsidiary of Hoechst AG (NYSE: HOE), rose $1 1/8 to $52 7/16 today... Online brokerage E*Trade Group (Nasdaq: EGRP) was bid up $2 9/16 to $48 9/16 after being added to the S&P MidCap 400 Index... Financial services giant American Express Co. (NYSE: AXP), which reportedly intends to offer Goldman, Sachs & Co. mutual funds to its customers, improved $3 to $111 1/2 today.
Shares of telecommunications systems, products, and services company Reltec Corp. (NYSE: RLT) jumped $7 3/8 to $29 1/8 after London's General Electric Co. PLC agreed to buy the company for $29 1/2 per share in cash, a 36% premium over Friday's finish... Bank holding company Imperial Bancorp (NYSE: IMP) rose $1 1/2 to $19 3/4 after announcing plans to sell its stake in financial services holding company Imperial Credit Industries (Nasdaq: ICII) to Leucadia National Corp. (NYSE: LUK) for $9.25 per share, a 7% premium over Friday's closing price... Car rental company Hertz (NYSE: HRZ) added $3 1/16 to $42 7/8 following the news that it will raise rates on all of its U.S. non-contract car rental prices by $3 per day effective today... Marketing services firm Intelliquest Information Group (Nasdaq: IQST) rose $1 3/8 to $12 1/4 following news that it is in talks with "certain parties which are potentially interested in acquiring all or part of the operations of the company."
Electronic communications media systems maker Aydin Corp. (NYSE: AYD), which agreed to be bought by L-3 Communications (NYSE: LLL) for $13 1/2 per share -- a 39% premium over Friday's closing price -- took on $3 3/16 to $12 7/8... Biopharmaceutical firm NeXstar Pharmaceuticals (Nasdaq: NXTR) advanced $1 5/16 to $15 1/8 after Gilead Sciences (Nasdaq: GILD) agreed to buy NeXstar in a stock deal valuing the company at about $17.53 per share, about a 27% premium over Friday's closing price... Travel services provider Preview Travel (Nasdaq: PTVL) soared ahead $2 5/8 to $23 after announcing deals with five advertisers: AT&T (NYSE: T), Hewlett-Packard (NYSE: HWP), Ticketmaster Online-CitySearch (Nasdaq: TMCS), Discover Brokerage and AutoConnect.
Powertrain components specialist Borg-Warner Automotive (NYSE: BWA) powered up $2 3/16 to $45 3/4 after completing the purchase of Automotive turbochargers maker Kuhlman Corp. (NYSE: KUH)... Implants maker Collagen Aesthetics (Nasdaq: CGEN) swelled $2 3/16 to $13 3/8 after announcing an unsolicited buyout proposal from medical products company Mentor Corp. (Nasdaq: MNTR). Collagen will review the offer... Bank holding company Emerald Financial (Nasdaq: EMLD) glowed $4 1/8 to $18 5/8 after Fifth Third Bancorp (Nasdaq: FITB) agreed to buy the company for $19.82 per share, a 37% premium over Friday's close... Disk drive suspension assemblies supplier Hutchinson Technology (Nasdaq: HTCH) recorded a gain of $6 1/4 to $37 3/8 after Goldman, Sachs & Co. started the company on its "recommended list," setting a $60 per share 12-month price target.
A quartet of semiconductor capital equipment makers fell today on downgrades from Salomon Smith Barney. Even though January's equipment book-to-bill ratio topped the key 1.00 threshold for the first time since late 1997, Reuters reported today that analyst Milind Bedekar is worried that a possible slowdown in the PC industry will hurt smaller front-end and back-end chip equipment firms alike. Automated test equipment manufacturer Credence Systems (Nasdaq: CMOS) lost $1 7/16 to $19 11/16 on a downgrade to "outperform" from "buy." On the front end of the business, process equipment maker Silicon Valley Group (Nasdaq: SVGI) fell $13/16 to $12 1/2, automated manufacturing systems designer Asyst Technologies (Nasdaq: ASYT) slid $2 1/2 to $19, and thin film materials and equipment provider ATMI Inc. (Nasdaq: ATMI) slipped $2 7/8 to $19 7/8.
Propane and natural gas distribution company UGI Corp. (NYSE: UGI) tanked $4 3/8 to $15 15/16 after agreeing to merge with printing and imaging paper distributor Unisource Worldwide (NYSE: UWW) in a deal valued at $1.5 billion in stock and assumed debt. UGI also announced a plan to repurchase 6.6 million of its shares, or 20% of the total shares outstanding, cut its annual dividend by 49% to $0.75 per share, and divest its UGI Utilities gas and electric utility unit. The merger is expected to add to UGI's earnings in the first year, as the new company becomes the country's largest distributor of two seemingly unrelated products: propane and printing paper. Unisource rose $1 to $8 on the news, even though analysts and institutional UGI shareholders have questioned the deal's rationale, raising concerns that the transaction will not receive the necessary approval from shareholders.
QUICK CUTS: PC and computing products maker Compaq Computer (NYSE: CPQ) lost another $1 27/32 to $33 17/32 after leading most of the PC box-builders lower on Friday with a 14% drop. Today, the company said it is cutting the U.S. estimated selling prices of selected Deskpro EP models by as much as 9%. The prices of selected Armada PCs are being cut by as much as 11%... Ambulance and busing services provider Laidlaw (NYSE: LDW) dropped $1 5/16 to $6 3/8 after saying losses at its ambulance business and weather-related operating losses at its school bus unit will result in fiscal Q2 EPS between $0.10 and $0.13, missing the $0.18 or $0.19 the company said analysts had been expecting... Computer products e-commerce technologies provider pcOrder.com (Nasdaq: PCOR) slipped $5 3/16 to $41 15/16 after rising 55% in its first day of trading on Friday.
Investors called the cops on Party City Corp. (Nasdaq: PCTY) today, sending the party supplies retailer's shares down $15/16 to $10. The company said its forthcoming fiscal 1998 financial results will show that Q4 operating expenses were about $1 million higher than expected, which will have a "corresponding effect" on earnings... State and local government consulting firm MAXIMUS Inc. (NYSE: MMS) was knocked down $2 1/16 to $25 7/8 after agreeing to acquire privately held fleet management software developer Control Software for $23.1 million in stock... Biopharmaceutical company Hollis-Eden Pharmaceuticals (Nasdaq: HEPH) slumped $2 5/8 to $18 3/4 after President and Vice Chairman Terren Peizer resigned. On the bright side, the company said that the FDA has given the green light to start dosing patients in a Phase I/II clinical trial of its HE2000 HIV and AIDS treatment.
Drinking water vending machines supplier Glacier Water Services (AMEX: HOO) was soaked for a $1 7/8 loss to $21 1/4 after reporting a $971,000 Q4 charge to relocate 1,450 underperforming machines... Chip giant Intel (Nasdaq: INTC) moved down $2 7/8 to $117 1/16 after Donaldson, Lufkin & Jenrette lowered its opinion on the firm to "market perform" from "buy." The brokerage also cut Intel's fiscal 1999 earnings estimate to $4.50 per share from $4.65 per share, reportedly on worries of slowing PC sales... Telecommunications services firm MCI WorldCom (Nasdaq: WCOM) slid $1 13/16 to $80 11/16 after saying it will spend $6.5 billion this year to expand its global network... Business software developer Smallworldwide PLC (Nasdaq: SWLDY) got a little smaller today, falling $3 3/4 to $13 following a Ladenburg Thalmann downgrade to "long-term buy" from "buy."
Ad agency Grey Advertising (Nasdaq: GREY) was canned $17 1/2 to $352 1/2 after saying reduced spending by clients in emerging markets and losses at a subsidiary resulted in Q4 EPS of $4.61, down from $8.65 a year ago... Mental health services provider PMR Corp. (Nasdaq: PMRP) fell $1 5/8 to $5 5/16 after start-up expenses at a managed care pilot program and several new outpatient programs led to fiscal Q2 EPS of $0.02, missing the $0.14 expected by the two analysts surveyed by Zacks... Credit and debit card information processor Total System Services (NYSE: TSS) slid $2 3/8 to $20 3/8 after Citigroup's (NYSE: C) Universal Card Services unit said it will not renew its processing contract with the company after its current agreement ends next year.
Natural gas pipelines and fiber optic network operator Williams Cos. (NYSE: WMB) moved $1 7/16 lower to $35 9/16 after an additional review of the company's energy marketing and trading unit resulted in a reduction of fiscal 1998 net income to $0.28 per share from the $0.31 per share originally reported last month... Vitamin maker and retailer NBTY Inc. (Nasdaq: NBTY) dissolved $25/32 to $5 7/32 following a pair of downgrades from Piper Jaffray and Adams, Harkness & Hill... Drug developer BioChem Pharma (Nasdaq: BCHE) slipped $1 13/16 to $22 3/4 after Lehman Brothers cut its rating on the stock to "neutral" from "outperform."
Financial Karma, Part III
In the last two Fool on the Hill columns (part 1, part 2), I talked about the question of immediately expensing in-process R&D versus capitalizing it and amortizing it over a number of years. I went on to posit that the market discounts free cash flows and not just earnings. Earnings are subject to accounting distortions that take a creditor's view of the enterprise rather than an investor's point of view.
Generally Accepted Accounting Principles (GAAP) are set up in such a way as to make the cost of interest-bearing obligations explicit on the income statement, but GAAP is not consistent in the way it sheds light on the cost of equity. In some situations, deployed equity has a cost that shows up on the income statement, according to GAAP. In others, the cost of equity is not seen. And in some cases, the cost of equity is immediately seen but ignored by investors, as in the current method of writing off acquired R&D. It's not easy to deal with for beginning investors because the logic underlying the different accounting methodologies is not consistent.
To make it consistent, we have to first accept a basic premise -- that all capital has some cost, whether it's equity, debt, or liabilities other than debt. The cost in such a system of thinking could very well be zero, though. In fact, when you look at an insurance underwriter that is able to avoid underwriting losses over 50 years, on average you could say that the cost of the "float" portion of its capital is zero. Deferred tax liabilities with an indefinite maturity are also another example of zero-cost capital. For equity, there is an implicit cost to the firm and its shareholders. It's not stated on the balance sheet, but the cost of equity is the return on equity that investors expect.
The evidence of deployed equity according to GAAP is found in the "equity" portion on the right side of the balance sheet. After all other claims of the enterprise are taken care of, the residual income is divided by equity to arrive at return on equity. Return on total capital looks at after-tax operating income divided by all equity plus debt plus equity equivalents. When you mess with either of these things, you can get a bad idea of how much resources it will take in the future to enhance shareholder value. That's why accounting for R&D-related mergers and acquisitions demands a different accounting treatment than just writing off the acquired R&D.
In a pooling of interests, there is no evidence of equity being deployed even when a company can more than double its shares outstanding. But in a purchase, even when a stock swap is treated as a purchase, goodwill equal to the excess purchase price over appraised net asset value of the acquired company is put on the balance sheet. Then it's amortized over a number of years. As in the cash flow example I gave on Friday, which illustrated the cash resources the firm creates as a return on investment, the market is able to look through these two methods of accounting. It is also able to assess the amount of resources that are put into the firm.
As far as return on capital and cost of capital go, a pooling and a purchase should be no different in economic substance, especially when both are stock-for-stock transactions. For the purpose of conceptualizing the economics of the two cases, assume that you are first selling your stock to raise cash and then using the cash to make the acquisition. In this case, the cash is going to show up on the resulting balance sheet as common stock, par value, and additional paid-in-capital. Return on capital is then measured on the resulting capital and equity bases.
The whole thing gets complicated, however, for R&D-intensive enterprises. Going forward, you're amortizing capitalized R&D and you're not capitalizing the spending that is intended to replace those acquired assets. Therefore, the consumption of the capitalized R&D shows up as an expense in the same period that the spending to replace that R&D shows up as an expense, understating net cash flow available to shareholders.
If the income statement and balance sheet were to truly depict R&D investments that do not have an immediate pay off, all R&D spending would be capitalized and amortized over its estimated useful life. Net income would be immediately higher, of course, but net cash flow available to shareholders (not considering the vital point of what is discretionary capital spending and R&D spending and what is maintenance spending) wouldn't be any different. The depiction of return on capital -- the cash that comes out of the business relative to the resources that go into the business -- would also be the same no matter whether the R&D was acquired or home-grown. Economically, it shouldn't matter how it's acquired.
In summary, mixing a capitalization/amortization expense framework for R&D with a framework in which the maintenance spending is immediately reflected on the income statement is a bad idea from the standpoint of there being hope for the income statement to depict free cash flow. From the standpoint of depicting the resources invested in a company, capitalizing in-process R&D that arises from consolidating two companies is a great idea. It would save a lot of people a lot of time in adjusting GAAP statements to reflect economic reality. It would also wake up people to the fact that if a company wants to write off a huge hunk of deployed capital, its financial statements won't depict the true economics of the business.
The market measures cash flows and return on capital. It does not measure earnings that have been massaged into meaningless Silly Putty, and it does not ignore unrecorded goodwill. Otherwise, fewer roll-up companies would be in the gutter. Only when the reported earnings of a company faithfully reflect the cash flow economics of a business should earnings be taken at face value. You can pretty much forget all the accounting vocabulary above if it gives you a headache. There's not enough space here to really demonstrate it well, either, for the more numerically inclined.
Just remember that it takes money to make money. Masking the amount of money it takes to generate a return by writing it off or by engaging in a pooling transaction that understates the market value that is traded for future earnings doesn't fool the market. For technology executives, don't worry. The market is smart enough to look through the accounting treatment of acquisitions to assess your real cash flow. The market is also smart enough to know if you are underspending if your stated goal is to replace the assets. In all, there is both upside and downside to the Financial Accounting Standards Board's direction on accounting for acquired R&D. And investors are a pretty hardy species. They will adapt and will not be fooled by accounting gimmickry just as they are not lured into believing now that companies that write off all R&D are necessarily more profitable than companies that home-grow their R&D.
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