<THE EVENING NEWS>
Wednesday, March 10, 1999
DJIA 9772.84 +79.08 (+0.82%) S&P 500 1286.84 +7.00 (+0.55%) Nasdaq 2406.00 +13.06 (+0.55%) Russell 2000 401.12 +1.92 (+0.48%) 30-Year Bond 95 19/32 -11/32 5.55 Yield
Oil and gas companies of all shapes and sizes got a boost today after the oil ministers of Saudi Arabia, Kuwait, Oman, and Qatar issued a statement saying they will take "all important means" to prop up oil prices, increasing hopes that new production cuts to offset the current oil glut will be implemented when the OPEC member countries meet later this month. Major integrated firm Exxon (NYSE: XON) tacked on $3 3/8 to $73 5/16, Mobil (NYSE: MOB) added $3 3/8 to $91 3/8, Texaco (NYSE: TX) was lifted $4 1/2 to $54 1/8, and Atlantic Richfield (NYSE: ARC) advanced $2 5/8 to $60 7/8. Oil services firm Halliburton (NYSE: HAL) rose $4 1/4 to $36 1/2, Baker Hughes (NYSE: BHI) added $2 3/8 to $22 1/2, and BJ Services (NYSE: BJS) gained $1 13/16 to $18. Among the contract drillers, Transocean Offshore (NYSE: RIG) moved up $3 3/16 to $25 9/16, Noble Drilling (NYSE: NE) advanced $1 7/8 to $15 1/2, and Diamond Offshore (NYSE: DO) climbed $2 3/8 to $27 3/8.
Chemical giant DuPont (NYSE: DD) gained $3 13/16 to $57 3/8 after announcing plans today to issue tracking stock for its life sciences (pharmaceutical and biotechnology) businesses. A life sciences tracking stock (which won't be issued until at least the early part of 2000) should receive a much higher multiple of earnings and cash flow than DuPont overall because of its better growth prospects. This security can then be used to more efficiently acquire companies that have promising technology. Prospects for strategic alliances with other pharmaceutical companies also bode well, as they would give DuPont Pharmaceutical a more significant business presence. For more details on the news and DuPont's new look, see today's Fool Plate Special.
QUICK TAKES: Online retailer Amazon.com (Nasdaq: AMZN) picked up $7 3/16 to $137 1/8 after announcing an online cross-promotional agreement with PC direct marketer Dell Computer (Nasdaq: DELL). New Merrill Lynch hire Henry Blodget reinstated coverage of Amazon this morning with a near-term "attractive" rating and a 12-month price target of $150 per share... Women's apparel catalog retailer Brylane (NYSE: BYL) moved up $2 11/16 to $24 1/8 after agreeing to be acquired by its controlling shareholder, French retailer Pinault-Printemps-Redoute, in a deal valued at about $211 million, or $24.50 per share in cash -- 22% higher than the questionable bid PPR originally submitted last year... Marketing firm Marketing Services Group (Nasdaq: MSGI) gained $7/16 to $8 11/16 after agreeing to acquire CMGI's CMG Direct Corp., including its PermissionPlus Internet marketing services unit.
Web portal Lycos (Nasdaq: LCOS) jumped $13 3/4 to $110 after The Wall Street Journal reported that Internet investment firm and Lycos shareholder CMGI Inc. (Nasdaq: CMGI) has hired Morgan Stanley Dean Witter to help thwart USA Networks' (Nasdaq: USAI) bid for Lycos, which CMGI considers "inadequate." For more details on today's developments, see this morning's Breakfast With the Fool... Online and video lottery systems software and equipment maker Powerhouse Technologies (Nasdaq: PWRH) generated gains of $3 1/16 to $17 7/8 after agreeing to be acquired by slot machine maker Anchor Gaming (Nasdaq: SLOT) in a deal valued at $280 million in cash and assumed debt, or $19.50 per share. Anchor gained $3 13/16 to $38 3/8 on the news.
Israeli-based software maker Oshap Technologies (Nasdaq: OSHSF) charged ahead $2 7/8 to $13 3/8 after agreeing to be acquired by computer service and application software firm SunGard Data Systems (NYSE: SDS) for $210 million, or roughly $15.50 per share in stock... Consumer financial services company Household International (NYSE: HI) tacked on $4 to $45 13/16 after announcing plans to repurchase up to $2 billion of its stock, or about 10% of its outstanding shares... Rural phone services provider Century Telephone Enterprises (NYSE: CTL) rose $3 13/16 to $67 1/4 on news that it will replace Rubbermaid (NYSE: RBD) in the Standard & Poor's 500 Index after Rubbermaid completes its merger with fellow S&P 500 component Newell Co. (NYSE: NWL).
International telecommunications and Internet telephony services firm IDT Corp. (Nasdaq: IDTC) rang up a $3 7/8 gain to $19 5/16 after its Net2Phone subsidiary signed a multi-year agreement to have its PC-to-phone services bundled with Netscape's (Nasdaq: NSCP) Communicator browser and featured on Netscape's Netcenter portal... Business Internet service provider (ISP) PSINet (Nasdaq: PSIX) climbed $7 1/8 to $42 1/4 following an ING Baring Furman Selz upgrade to "buy" from "hold"... Mexican telecommunications company Telefonos de Mexico (NYSE: TMX) rose $3 1/2 to $65 1/2 after Mexican regulators allowed the company to boost its local and long-distance service rates.
Online business-to-business printed information provider RoweCom (Nasdaq: ROWE) gained $5 3/4 to $30 1/4 after rising 53% in its first day of trading yesterday following its initial public offering of 3.1 million shares at a price of $16 per share... Online computer hardware retailer Cyberian Outpost (Nasdaq: COOL) added $1 15/16 to $20 5/8 after saying it will become a "premier merchant" in GeoCities' (Nasdaq: GCTY) "Pages That Pay" affiliate program... Fiber optic network operator Qwest Communications (Nasdaq: QWST) rose $3 3/8 to $69 after signing a $10 million three-year bandwidth access contract with high-speed cable-based data services provider Road Runner.
Telecommunications and networking equipment supplier Nortel Networks (NYSE: NT) moved up $4 to $62 after AT&T (NYSE: T) named the company a "potential supplier" of advanced switching systems as AT&T looks to convert its network from circuit-based technologies to packet-based technologies. An eventual deal would be a blow to former AT&T subsidiary and Nortel rival Lucent Technologies (NYSE: LU), which dropped $2 5/16 to $106 5/8 today.. Offshore drilling platforms builder J. Ray McDermott (NYSE: JRM) gained $3 3/4 to $28 1/8 after majority owner McDermott International (NYSE: MDR) offered to acquire the remaining stake in the company it does not already own for about $27 per share in stock... Russian wireless communications firm Vimpel-Communications (NYSE: VIP) added $1 1/16 to $15 15/16 after Merrill Lynch raised its intermediate-term rating to "accumulate" from "neutral."
Computer Associates (NYSE: CA) fell $5 1/16 to $34 15/16 after Morgan Stanley Dean Witter lowered its rating on the enterprise software developer to "neutral" from "outperform," citing near-term demand softness, increased competition fears, and margin pressure. These worries are not new, considering the company said last July that its business would take a hit over the next several quarters as it deals with fallout from the economic trouble in Asia and deferred software purchasing by some clients due to Y2K. More proof of the recent tough times in the enterprise software business can be found within the enterprise resource planning (ERP) sector, where share prices have been hurting for months. ERP heavyweight SAP (NYSE: SAP), which hit a new 52-week low today following reports that its first quarter results will miss analysts' expectations, sank $1 1/8 to $26 1/4.
Medical supplies distributor PSS World Medical (Nasdaq: PSSI) dropped $2 1/4 to $9 3/4 after it said fiscal Q4 EPS (ending April 2) isn't expected to exceed a range of $0.19 to $0.21. Wall Street was looking for a $0.24 per share profit. The company's Gulf South Medical Supply unit said its nursing home customers have altered historic purchasing patterns due to federal changes in Medicare reimbursement policies, hurting its business. Also, the unit has seen higher-than-expected expenses while reorganizing its distribution centers and operations following its acquisition by PSS last year. Further down the line, PSS sees EPS growth of 18% in fiscal 2000 and 20% in 2001, down from analysts' previous growth estimates of 25% in 2000 and far below the 30% growth originally forecasted for this year. The lower growth forecasts didn't seem to surprise Wall Street, as nary a downgrade was issued from the seven brokerage firms with "buy" ratings on the stock.
QUICK CUTS: Global engineering and construction firm Fluor Corp. (NYSE: FLR) lost $4 15/16 to $30 after Goldman Sachs downgraded the stock to "market performer" from "market outperformer." Yesterday, the shares fell 5% after the company announced a restructuring and forecasted fiscal 1999 EPS of $2.65 (excluding restructuring charges), below the current First Call mean estimate of $2.99... Nissan Automotive (Nasdaq: NSANY) slowed $13/16 to $6 15/16 on news that DaimlerChrysler (NYSE: DCX) won't pursue an equity stake in the Japanese automaker after three months of talks... Analog and mixed-signal chip maker Unitrode (NYSE: UTR) retreated $1 3/8 to $13 after turning in Q4 EPS OF $0.18, a penny above estimates. However, Adams, Harkness & Hill downgraded the stock to "accumulate" from "strong buy" today.
Republic Group (NYSE: RGC) lost $1 9/16 to $13 3/8 after the maker of recycled paperboard products said fiscal Q3 EPS is seen coming in 35% to 40% below the December 1998 quarter's $0.32 mark, well below the $0.49 consensus estimate three analysts gave First Call... Commercial and information technology staffing firm Personnel Group of America (NYSE: PGA) was pummeled $2 5/8 to $6 13/16 after pre-announcing Q1 EPS between $0.21 and $0.23, missing the First Call mean estimate of $0.25. In sympathy, staffing firm Metamor Worldwide (Nasdaq: MMWW) lost $2 3/4 to $13 5/16, Interim Services (NYSE: IS) fell $1 1/4 to $17 15/16, and Robert Half International (NYSE: RHI) sank $2 1/4 to $33 11/16... Casual clothing retailer Abercrombie & Fitch (NYSE: ANF) slid $2 3/16 to $85 after BancBoston Robertson Stephens lowered its rating to "buy" from "strong buy," citing valuation.
Metal working and mining tools maker Kennametal (NYSE: KMT) was hammered for a $1 loss to $19 7/16 after saying lower-than-expected sales will lead to sequentially flat fiscal Q3 sales and earnings, with EPS (before charges) $0.23 to $0.28 below the Zacks mean estimate of $0.73... Automotive wheels and brakes parts maker Hayes Lemmerz International (NYSE: HAZ) skidded $1 1/8 to $20 1/2 after reporting fiscal Q4 EPS of $0.31, down from last year's $0.38 and well below the Zacks mean estimate of $0.56... Data management software firm Fair, Isaac and Co. (NYSE: FIC) lost another $4 13/16 to $34 1/4 after falling 14% yesterday on fears that its recent decision to start new e-commerce and telecommunications initiatives will erode margins in fiscal 2000.
Why New Economy Companies Are Different
Many have commented on the allegedly ridiculous valuations of the best-known Internet stocks. Yet, it's discouraging to see naysayers still using terms that betray an intellectual framework that's incapable of seriously addressing the matter. Traditional metrics like book value, the price-to-earnings (P/E) ratio, or even the price-to-sales (P/S) ratio are of limited use in valuing start-ups. They are particularly worthless in examining Internet start-ups. The bears just don't seem to understand the bull case well enough to make a real stab at refuting it. Of course, even the bulls have more trouble explaining their faith than maintaining it.
So the top Internet stocks keep going up, and the market screams that there's something hugely different about these businesses. Meanwhile, the critics insist in authoritative tones that bubbles get created by exactly such a gullible insistence that this time is different -- when it never really is. It's worth asking, then, what's different, and how do we know? Put another way, is there really such a thing as a New Economy company, and if so, does it require that we use new valuation metrics?
In short, yes and no. At least, that's the answer Michael Mauboussin, the well-regarded head of value-based research at C.S. First Boston, gives in a recent paper called "Cash Flow.com: Cash Economics in the New Economy," co-authored with his assistant Bob Hiler.
In Mauboussin's view, Amazon.com (Nasdaq: AMZN) and Yahoo! (Nasdaq: YHOO) are New Economy companies with dramatically more attractive business models than their Old Economy counterparts like Barnes & Noble (NYSE: BKS) and The New York Times (NYSE: NYT). He concludes this from applying the same valuation standard -- free cash flow -- to all of these stocks. "We disagree with the consensus view that hype and hysteria drive the highflying valuations of Internet stocks," Mauboussin writes in the introduction. "Like all businesses, Internet companies are valued on their ability to generate cash."
By free cash flow (FCF), Mauboussin means something quite specific: cash earnings plus or minus cash investments. Cash earnings differ from "accounting earnings" -- regular old net income or earnings per share -- in that you back out the distortions created by goodwill amortization and financing costs. To get cash earnings, you basically begin with earnings before interest and taxes and then subtract cash taxes (or what the company would pay in taxes if it wasn't getting a tax break from its debt financing). By cash investment, he means the outflow or inflow of cash as the result of changes in working capital and fixed assets. Most businesses require lots of cash to pay for new property, plant and equipment (PP&E) and to fund inventory and other working capital needs. Unless suppliers are offering very attractive payment terms while customers are paying immediately, such investments typically result in a significant cash outflow, which must be subtracted from the FCF.
The nitty gritty adjustments one can make to these figures can get complicated, but what's of crucial interest to us here is the rationale behind this approach. Reported earnings, per se, just don't tell you what you really want to know -- which is how much net cash a company can generate for its owners over the long haul after subtracting what it takes to run and grow the business. To answer that, investors must focus not just on the income statement but on the balance sheet. For example, managers can improve a business by producing the same cash earnings with fewer assets. Even though the income statement might look the same, the balance sheet will tell shareowners that they're actually getting more bang for their buck. Doing as well with less is the same as doing better. Doing more with less is even better. This is why P/E ratios and earnings growth rates are, at best, mere surrogates for measuring real value creation.
Mauboussin takes this insight a step further by showing why earnings are a woefully inadequate surrogate for evaluating New Economy companies. These firms are far more capital efficient than their Old Economy counterparts. Indeed, cash earnings alone typically overstate the real FCF of the latter while understating the FCF of an Amazon or a Yahoo!
According to Mauboussin, Barnes & Noble produced around $150 million in cash earnings for the twelve months ending October 31. Yet, this retailer invested about $245 million net in long-term assets (like new stores) and working capital (like books to stock the stores). The result was FCF of negative $95 million. Barnes & Noble has operated with negative FCF every quarter since it went public. By contrast, Amazon delivered negative cash earnings of $58 million in FY98, but negative FCF of just $4 million overall. That's because it costs a lot less to scale an online store once the major infrastructure is in place. You don't have to spend a lot on construction, leases, and inventory. Also, Amazon pays its suppliers long after it gets paid by its customers, meaning that customers and suppliers are funding Amazon's working capital, as fellow Fool Dale Wettlaufer has pointed out repeatedly. So Amazon generated a $54 million inflow of cash investments that nearly wiped out the negative $58 million in cash earnings last year.
Amazon -$4 million
Barnes & Noble -$95 million
On the only performance metric that really counts to Mauboussin, Amazon is already kicking its competitor's butt. Yes, profitable old-line businesses like Barnes & Noble could curtail its growth, cutting its cash investment outflow and producing a positive FCF overnight. However, a New Economy firm's ability to leverage current assets means that rapid expansion should actually accelerate its generation of cash investment inflows and, ultimately, positive cash earnings. That's why New Economy companies really are different.
Mauboussin offers a useful grid to depict this difference and to highlight the distinct "cash economics lifecycles" at play.
Investment Outflow Investment Inflow
Earnings Profitable Buildout Super Cash Flow
Inflow (Barnes & Noble) (Yahoo! today; Amazon in future?)
Earnings Value Destruction or Turnarounds or Emerging Capital
Outflow Start-up (Amazon Q1 FY98) Efficient Company (Amazon today)
The horizontal cross-sections focus on cash earnings (the income statement) where inflows are better than outflows. The vertical segments focus on cash investments (the balance sheet) where inflows are better than outflows. So the sweet spot is the upper right quadrant.
Both Old and New Economy companies typically start in the bottom left quadrant by spending a lot to build basic infrastructure and inventories while still reporting earnings losses. Successful Old Economy companies eventually jump to the top left box where they hopefully remain for years, investing lots in the business while delivering healthy cash earnings. At some point, marginal returns on new invested capital start looking less attractive. After all, there's probably no point building Barnes & Noble bookstores across the street from each other. That's when investment spending declines to the level required simply to maintain existing facilities, dropping investment outflows toward zero while boosting cash earnings and bumping overall FCF higher.
Successful New Economy businesses act quite differently. After the start-up phase, they first move toward the bottom right quadrant (investment inflow, earnings outflow) rather than up into positive cash earnings. The most dynamic businesses then move up into that prime real estate occupied by Super Cash Flow companies that generate both earnings and investment inflows. Mauboussin notes that Yahoo! and Dell (Nasdaq: DELL) have occupied this sacred space of late. (Dell has recently, and perhaps only temporarily, veered into the Profitable Buildout quadrant since it has willingly sacrificed investment inflows in order to win more business from large corporate customers demanding looser payment terms.) Yahoo!'s super high gross margins and readily scalable business allowed it to move with lightning speed from the bottom left quad to the top right. Amazon's business model provides less leverage, but the logic of this New Economy lifecycle suggests Amazon could end up in the Super Cash Flow camp as well. The market agrees.
Mauboussin's work ultimately instructs investors to focus on FCF, to account for the whole cash economics picture. It's a picture that simply looks different for New Economy companies than it does for traditional firms. Cash inflows from the balance sheet make an Amazon or Yahoo! more attractive than cash earnings alone would suggest. Meanwhile, outflows from cash investments make a Barnes & Noble, New York Times, or Wal-Mart less attractive than they seem from their cash earnings alone. This means that even if an Old Economy company sports the same earnings per share and same earnings growth rate as a New Economy firm, the latter likely deserves a higher P/E, perhaps a much higher P/E, because its overall cash economics are almost certainly superior. This is why Mauboussin concludes that "there are solid fundamental underpinnings behind the high valuations in the Internet sector."
-- Michael Mauboussin, Cash Flow.com
-- Momentum vs. "Value" Options 1/29/99
-- Amazon Impresses Again, 10/30/98
-- Amazon On My Mind, 5/5/98
-- Valuing Hypergrowth, 5/1/98
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