<THE EVENING NEWS>
Thursday, April 22, 1999
DJIA 10727.18 +145.76 (+1.38%) S&P 500 1358.83 +22.71 (+1.70%) Nasdaq 2561.61 +72.53 (+2.91%) Russell 2000 428.85 +2.28 (+0.53%) 30-Year Bond 94 29/32 -1 5/32 5.60 Yield
Computing products and services giant IBM (NYSE: IBM) jumped $22 5/8 to $194 1/2 after reporting Q1 EPS of $1.55 late yesterday, up from $1.05 a year ago and $0.14 ahead of the First Call mean estimate. The better-than-expected results were due in large part to an increase in hardware sales to $8.6 billion and growth in services revenues (excluding maintenance) to $6.3 billion. IBM's Global Services business unit has really been stepping on the gas pedal lately and is largely responsible for the company's 63% increase in market value over the past three years. Consisting of information technology consulting, strategic outsourcing, and e-business services, the unit's Q1 revenues were up 24% from a year ago, up 54% from two years ago, and up 96% from three years ago. In contrast, IBM's better known hardware unit, which makes PCs, servers, and data storage systems, has only seen its Q1 revenues rise 11% from their 1996 level.
1998 stock market "Disaster of the Year" award winner Cendant Corp. (NYSE: CD) was back in the news today, but this time the dreaded "accounting irregularities" phrase that has hung over the company like a black cloud since last April was nowhere to be found. Cendant moved up $2 3/16 to $20 3/4 after reporting Q1 operating income of $0.22 per share, even with last year's results and $0.03 above the Zacks mean estimate, on a 17% rise in continuing revenues to $1.3 billion. The company also said it has sold its Entertainment Publications coupon book and National Leisure Group vacation package units as part of its ongoing divestment plan. Other possible sales could produce $1.3 billion in proceeds by the end of Q3 if all goes well, the firm said. After the divestitures, Cendant will look much like its predecessor company HFS, except with a large contingent of discount shopping and travel club members. Those members were the key to the 1997 merger of HFS and CUC to begin with, although those assets were acquired for what in hindsight was a very heavy price.
QUICK TAKES: TV and Web content provider CNET (Nasdaq: CNET) gained $13 1/4 to $133 after reporting Q1 pro forma earnings of $0.09 per share (excluding goodwill amortization and gains), beating analysts' estimates of $0.03 per share. The company also said it will split its stock two-for-one on May 28... Online software retailer Beyond.com (Nasdaq: BYND) advanced $5 to $32 1/8 after posting a pro forma Q1 loss of $0.66 per share, which was not quite as bad as the loss of $0.74 per share expected by analysts surveyed by First Call... Telecommunications and network access products maker Tellabs (Nasdaq: TLAB) tacked on $13 5/16 to $115 7/8 after setting a two-for-one stock split. The company also announced a new company-wide objective of tripling annual revenues to $6 billion by 2003.
Drug maker Bristol-Myers Squibb (NYSE: BMY) rose $3 3/4 to $68 thanks to a Lehman Brothers upgrade to "outperform" from "neutral"... Media giant Time Warner (NYSE: TWX) added $3 1/2 to $71 3/4 following a Morgan Stanley Dean Witter upgrade to "strong buy" from "outperform"... ZDNet (NYSE: ZDZ), the tracking stock for the Internet-related businesses of information technology media and marketing company Ziff-Davis (NYSE: ZD), gained $4 1/2 to $39 1/4 after Donaldson, Lufkin & Jenrette started coverage of the company with a "buy" rating and a 12-month price target of $70 per share. Parent Ziff-Davis rose $1 3/16 to $17 9/16. DLJ was an underwriter for ZDNet's initial public offering last month.
Medical products and services provider Baxter International (NYSE: BAX) picked up $6 11/16 to $68 after posting Q1 EPS of $0.61 (excluding charges) versus $0.58 a year ago, matching the First Call mean estimate. CEO Harry Kraemer told Reuters that he is "very comfortable" with the Street's EPS estimates of $2.85 for fiscal 1999 and $3.21 for fiscal 2000... Communications chipsets supplier Conexant Systems (Nasdaq: CNXT) rose $7 1/4 to $41 1/4 after saying it has returned to profitability six months ahead of schedule with fiscal Q2 earnings of $0.08 per share, topping analysts' expectations of a loss of a penny per share for the quarter.
Telecommunications, cable, and Internet services provider Log On America (Nasdaq: LOAX) rose $25 to $35 after selling 2.2 million shares in an initial public offering at a price of $10 per stub... Water chemical content test kits and instruments maker Hach Co. (Nasdaq: HACH) jumped $6 7/8 to $17 3/8 after agreeing to be acquired by Craftsman tool maker Danaher Corp. (NYSE: DHR) in a stock swap valued at $325 million, or $18.50 per Hach share. Danaher was up $1 3/16 to $63 1/2... Business diagramming and technical drawing software maker Visio Corp. (Nasdaq: VSIO) added $4 1/4 to $27 after reporting fiscal Q2 EPS of $0.34 versus $0.27 (excluding charges) a year ago, topping the Zacks mean estimate of $0.32... Online financial brokerage company Internet Financial Services (Nasdaq: IFSX) gained $3 5/8 to $19 3/8 after rising 43% yesterday in its first day of trading following its initial public offering of 2 million shares at a price of $7 per share.
CDW Computer Centers (Nasdaq: CDWC) up $16 1/2 to $89; Q1 EPS: $0.90 vs. $0.68 last year; estimate: $0.85
Exodus Communications (Nasdaq: EXDS) up $19 13/16 to $103 13/16; Q1 EPS: loss of $1.09 vs. loss of $0.96 last year; estimate: loss of $1.14
Footstar Inc. (NYSE: FTS) up $1 11/16 to $33 11/16; Q1 EPS: $0.30 (excluding charge reversal) vs. $0.20 last year; estimate: $0.24
i2 Technologies (Nasdaq: ITWO) up $2 13/16 to $30 1/2; Q1 EPS: $0.05 (excluding charges) vs. $0.05 last year; estimate: $0.05
ISS Group (Nasdaq: ISSX) up $13 11/16 to $67 15/16; Q1 EPS: $0.05 (fully taxed) vs. loss of $0.19 last year; estimate: $0.02
Lucent Technologies (NYSE: LU) up $2 5/8 to $61 3/4; fiscal Q2 EPS: $0.17 (excluding charge) vs. $0.07 last year; estimate: $0.15
Mail-Well (NYSE: MWL) up $13/16 to $14; Q1 EPS: $0.28 vs. $0.20 last year; estimate: $0.26
MedImmune (Nasdaq: MEDI) up $4 3/16 to $55 1/8; Q1 EPS: $0.45 vs. $0.21 (untaxed) last year; estimate: $0.34
Net.B@nk (Nasdaq: NTBK) up $28 1/2 to $176; Q1 EPS: $0.09 vs. loss of $0.02 last year; estimate: $0.09
Providian Financial (NYSE: PVN) up $7 3/8 to $126 7/8; Q1 EPS: $0.78 vs. $0.39 last year; estimate: $0.72
Quaker Oats (NYSE: OAT) up $4 1/4 to $67 3/16; Q1 EPS: $0.51 (excluding gain) vs. $0.36 last year; estimate: $0.42
Tandy Corp. (NYSE: TAN) up $2 13/16 to $72 5/16; Q1 EPS: $0.51 (excluding adjustments) vs. $0.39 last year; estimate: $0.48
Today's entry into the "Sure, why not?" file is genomic-related technologies developer Incyte Pharmaceuticals (Nasdaq: INCY), which watched its shares pedal down $3 9/16 to $17 11/16 on news that CFO and Executive Vice President Denise Gilbert will retire at the end of May to prepare for a bicycle ride around the world. Well, OK, there is a little more to the story. Incyte lowered its full-year 1999 revenue target to between $170-$175 million from $190 million because of delayed sales cycles in its microarray business, although it didn't change its full-year loss estimate of $20 million. Q1 losses were $0.07 per share, down from EPS of $0.12 a year before but significantly better than First Call's projected $0.17 per share loss. The company still expects to be unprofitable until Q3 of 2000, breaking even for that year.
Despite today's cross into penny territory with a loss of $1 13/16 to $4 15/16, there may be opportunity for investors looking to cash in on the MP3 craze in the form of Diamond Multimedia (Nasdaq: DIMD), a company that has tried its hand at the graphics accelerator card and PC modems business but now hopes to become the consumers' choice for digital music. For Q1, EPS wasn't thrilling, as revenues fell by nearly a quarter and EPS, at $0.04, missed estimates by a dime. But new products like RioPort, a website looking to become a hub for the distribution of digital music, could become a growth area -- particularly if products like the company's Rio portable MP3 player catch on. There's competition out there, though, particularly from record labels and companies like IBM (NYSE: IBM) and Microsoft (Nasdaq: MSFT) that are developing alternatives to the easily pirated MP3 format, which has a devoted following somewhere between cult and mainstream. The Fool's Louis Corrigan inspected Diamond in today's Lunchtime News.
QUICK CUTS: Lattice Semiconductor (Nasdaq: LSCC) dumped $13 3/16 to $45 5/16 after agreeing to buy Advanced Micro Devices' (NYSE: AMD) Vantis logic-chip division for $500 million in cash... Telecom Italia (NYSE: TI) lost $4 13/16 to $105 3/16 after agreeing to an $82 billion mega-merger of equals with Deutsche Telekom (NYSE: DT) that will create the world's second-largest telecommunications company after Japan's Nippon Telephone & Telegraph Corp. (NYSE: NTT). For more on the news, head back to today's Breakfast With the Fool... Enterprise application integration software company New Era of Networks (Nasdaq: NEON), a February Foolish Double, gave up $10 1/2 to $41 despite turning in Q1 EPS of $0.11, up from $0.03 last year and a penny above estimates. The company also agreed to buy privately held SLI International AG for $22 million in cash and stock plus the potential for $3 million in future considerations.
Wireless communications and application-specific integrated circuit (ASIC) maker Mitel Corp. (NYSE: MLT) lost $1 7/16 to $5 15/16 after announcing that it expects to report Q4 EPS of $0.13 before charges, down from $0.23 last year, in part because of poor markets in the Asia-Pacific region... Soda and chip company PepsiCo Inc. (NYSE: PEP) fell $2 to $36 15/16 after reporting Q1 EPS of $0.25, a penny above last year's mark and Street estimates, as profit from continuing operations fell slightly. The company also guided analysts toward full-year EPS of between $1.20 to $1.24 per share; $1.24 is the current consensus... Swedish mobile communications technologies firm Ericsson (Nasdaq: ERICY) lost $1/2 to $25 9/16. The company said Q1 net income fell to 905 million kronor from 1.806 billion kronor a year ago and said full-year 1999 earnings will be below last year's levels despite an expected "stronger second half."
Consumer products maker Sara Lee Corp. (NYSE: SLE) fell $1 7/8 to $24 after the company said it expects to report full-year fiscal 1999 EPS between $0.03 and $0.05 below Wall Street's current $1.25 estimate in large part because of a product recall at one of the company's packaged meat plants... Nuclear medical imaging systems maker Adac Laboratories (Nasdaq: ADAC) lost $5 11/16 to $6 7/8 after it said it expects Q2 revenues to be between 2% and 8% lower than Q1's $94.3 million, leading to "a significant decline" in EPS. Adac expects Q3 and Q4 revenues to disappoint as well... Wireless handsets wholesaler and retailer CellStar Corp. (Nasdaq: CLST) dimmed $2 1/8 to $6 15/16 after the company said last night that President and COO Richard Gozia and CFO Evelyn Miller resigned to pursue other interests.
Thermal imaging and broadcast camera systems company FLIR Systems (Nasdaq: FLIR) floated down $4 1/16 to $12 1/16 after announcing that the company expects to report a Q1 loss of as much as $0.18 per share. Five analysts surveyed by First Call were looking for a $0.03 per share profit... Consumer products giant Procter & Gamble (NYSE: PG), which told analysts in a conference call today it expects fiscal Q4 EPS to grow less than anticipated -- low teens instead of the 17% consensus -- gave up $4 3/4 to $94 3/16 today... Global satellite and paging company Iridium World Communications (Nasdaq: IRID) dropped $1 9/16 to $17 1/16 after Chairman and CEO Edward Staiano resigned. His post will be temporarily filled by John Richardson, CEO of Iridium Africa.
Pen maker A.T. Cross Co. (NYSE: ATX) dried up by $1 3/16 to $6 after President and CEO Russell Boss announced plans to retire after 38 years with the company. The company expects the 1999 operating loss at subsidiary Pen Computing Group to be higher than last year's $9.4 million loss... Cable TV and Internet access customer billing services firm CSG Systems International (Nasdaq: CSGS) dropped $3 15/16 to $34 1/2. The company announced Q1 EPS of $0.24, up from $0.10 last year and $0.02 better than Street projections... Network connectivity products maker Osicom Technologies (Nasdaq: FIBR) tacked a loss of $4 15/16 to $5 9/16 onto yesterday's $8 3/8 loss on news that it hasn't received any purchase orders from a Japanese client under a previously announced contract for a wireless personal data assistant (PDA) product.
Bell Atlantic (NYSE: BEL) down $5/8 to $7 7/8; Q1 EPS $0.73 (before charges) vs. $0.66 last year; estimate: $0.73
Black & Decker (NYSE: BDK) down $4 7/16 to $54 1/16; Q1 EPS $0.44 vs. $0.29 last year; estimate: $0.35
Drug Emporium (Nasdaq: DEMP) down $1 11/16 to $7 3/4; fiscal Q4 EPS $0.04 vs. $0.05 last year; no estimate
Hilton Hotels Corp. (NYSE: HLT) down $3/8 to $16 7/16; Q1 EPS $0.16 vs. $0.14 last year; estimate: $0.16
Hypercom Corp. (NYSE: HYC) down $3/4 to $6; fiscal Q3 EPS loss of $0.11 vs. gain of $0.11 last year; estimate: loss of $0.08
Inter-Tel Inc. (Nasdaq: INTL) down $1 9/16 to $12 5/16; Q1 EPS $0.19 vs. $0.19 last year; estimate: $0.24
Xerox (NYSE: XRX) down $1 9/16 to $58 9/16; Q1 EPS $0.48 vs. $0.42 last year; estimate: $0.48
Get Out of the Pool!
Non-fans of poolings of interests knew their day would come. And it has. Yesterday, the Financial Accounting Standards Board made its announcement: "The Financial Accounting Standards Board announced today that it would eliminate pooling of interests as a method of accounting for business combinations. In a unanimous vote, the Board tentatively decided that using the purchase method is preferable to allowing more than one method to be used when businesses combine. The change will be effective for business combinations initiated after the FASB issues a final standard on the issues, which is expected to be late in 2000." The only problem with that is that it doesn't come soon enough.
Let's get to the heart of the matter. Rather, let's let FASB Chairman Edmund L. Jenkins do that: "The Board decided that it is hard for investors to make sound decisions about combining companies when two different accounting treatments exist for what is essentially the same transaction. We believe that the purchase method of accounting gives investors a better idea of the initial cost of a transaction and the investment's performance over time than does the pooling of interests method.''
You go, Ed. Exactly. There is no difference in the two methods except that many companies jump through ridiculous hoops that kill long-term value and restrict capital management alternatives when they decide that they must absolutely use the pooling-of-interests transaction accounting instead of the purchase method.
A little history, courtesy of my colleague Alex Schay, who is even more of an accounting geek than I am:
"Ironically, pooling accounting gained currency as a result of abuses that were occurring under the purchase method. According to Tony Cope of FASB, back in the days when utility companies could pretty much receive a steady, guaranteed return on their asset bases -- thanks to sympathetic regulators who would help hike rates if returns were not growing with assets -- there was a strong incentive to boost assets by means of acquisition (and the subsequent goodwill that was created in the purchase). Rate boards began to catch on to the abuse, hence the pooling methodology began to wend its way through corporate America -- resulting in the skein that we see today."
The big worry for some CFOs and CEOs is that they'll now have to contend with goodwill amortization cluttering up the income statement and goodwill cluttering up the balance sheet. Here's the news flash on that: The market already discounts merged entities as if they were effected under the purchase method. How in the world, if it doesn't, does the market figure out when a roll-up company isn't generating the return on capital necessary to add economic value to that capital? The market's not dumb -- Ben Graham wrote that and Warren Buffett believes that, as well. The market might be bi-polar, but its episodes are more rare and are not the norm.
The market equates poolings versus purchases by marking up "unrecorded goodwill" on the combined balance sheet of the pooled entity. Say, for instance, that Company A had book value of $60 and acquires Company B for $61.60 in stock. Company B has an appraised net asset value of $40 before the transaction. Before the transaction, Company A was earning $9.60 and company B was earning $5.60.
Under the purchase method, the pro-forma earnings of the combined equity would be $14.66. That's $9.60 + $5.60 minus goodwill amortization of $0.54 (1/40th of the $21.60 premium to appraised net asset value of Company B). Under the pooling-of-interests method, the company's net income would be $15.20. All these are under current Generally Accepted Accounting Principles, not prospective GAAP.
Leaving off the vital, but complicating, issues of accretion/dilution (it's not as vital, by the way, if it's just bookkeeping accretion), the market's going to put two companies on the same footing. Personally, I used to take all the goodwill off the combined company's balance sheet and look at return on assets and return on equity using earnings before goodwill amortization. In that vein, we would have the following:
Equity, including goodwill: $121.60
Goodwill brought on through purchase: $21.60
Pre-purchase book value of Company A: $60
Pre-purchase book value of Company B: $40
Tangible book value of combined entity = Book value - goodwill = $100
1. Return on tangible equity before goodwill amortization would be 15.2%.
2. Return on equity before goodwill amortization, leaving goodwill in book value = 12.5%
The poolings CEO might want you to look at the first example, because that's what their balance sheet and income statement would yield, but that's not the real economic earnings of the company. The purchase CEO would tell you to look at the second, because goodwill amortization means nothing unless that goodwill is an asset that declines in value and continually needs to be replaced at the 2.5% yearly rate.
The proper way to adjust the two is not to deduct goodwill from the purchase method company and look at return on tangible book equity before goodwill amortization. The proper way is to look at the poolings method company as having gone out and sold $61.60 in equity and then used that cash to acquire company B. In that case, book equity would be the same as the purchase company's owners' equity: $121.60. We would then look at return on deployed equity without including the arbitrary 2.5% goodwill charge or any other arbitrarily selected goodwill expense. Again, the expense means nothing if the asset does not have to be replaced.
The market is going to award a higher multiple to the artificially depressed earnings and a lower multiple to the goodwill-free earnings under the two GAAP methods now in place. In addition, the goodwill-free company will get a higher multiple to book and the company with goodwill will have a lower multiple to book, all else about the companies' prospects being equal.
I'll say right now that I've been taken in by the poolings game. For instance, First Union (NYSE: FTU) and BankAmerica (NYSE: BAC) have done tons of poolings over the years, which pump up return on equity (ROE) because the companies have gained tremendous platforms that have very low average costs per dollar of income. But their book equity tells nothing about their deployed equity. That's to say that it would be much more economically accurate to look at their ROE based on the value of equity actually deployed over the years. To do that, you would have to add back not only unrecorded goodwill, but all goodwill that has been amortized off the balance sheet over the years. And hey, far be it for me to just penalize the Charlotte banks. I think they're great. You'd have to get Chase Manhattan (NYSE: CMB), Citigroup (NYSE: C), the new Wells Fargo (NYSE: WFC), U.S. Bancorp (NYSE: USB), and all the rest of the international and mega-regional acquirers in there. Bank One (NYSE: ONE), get out of the pool!
The analyst's job is to figure out how much capital will need to be deployed to generate future cash flows, prospective returns on investment, what the capital costs, and then internal rates of return inside the operations of the business. Sure, it's stupid to charge your line managers for goodwill, because it's the capital allocators at headquarters that make the acquisition decisions. If I'm the vice president of credit card operations at Bank One, I'm not the guy who makes the decision to acquire First USA, though I might contribute. I have to look at operating assets and the capital allocators have to look at all the capital they've deployed.
I don't know if this sounds lame, but I've really not had the time to convert the entire universe of large banking companies to stand together on a purchase method basis. In the past, I've always deducted goodwill to make everything equal. But that's not the way the market discounts it, I am convinced. In trying to discount cash flows within an EVA (economic value added) framework, under which equity is not free (and this is a basic economic principle), I'm not counting book value acquired when two companies merge. I'm counting the total value of capital traded in return for another entity. That's the market value of the stock issued by the acquirer, not the book value of the acquired company. The market discounts the cost of all the shares issued, which is why EVA or SVA on just book value at BankAmerica, First Union, Chase, or Bank One is so large. If you add back unrecorded goodwill, you get a better picture of what's going on.
All of this is distinct for R&D-intensive companies. They have their own issues, under which amortization of purchased R&D is an economic expense when that acquired R&D is consumed and obsolete within five or ten years or whatever it is. That's another matter at which I've taken a stab at writing about in the past. I called that "Financial Karma's Gonna Get You, Part 1 and Part 2," because I believe the market is not so inefficient as to buy the whole concept of writing off immediately huge chunks of assets representing deployed capital.
For goodwill that is not consumed, you never write it off, because it represents equity and equity is perpetual. For acquired R&D, you're most likely going to have to amortize it, because the acquired R&D usually goes obsolete. That's an entirely different can of worms, since the replacement spending is not capitalized -- it's immediately expensed. I sympathize with Cisco Systems (Nasdaq: CSCO) there. But for pretty much everything outside of R&D-intensive industries, it's time to get out of the pool. The market has always known how to discount you properly. Good to see that the FASB is doing the right thing.
Now, if only the FASB would do the right thing on FAS #125.
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