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Monday, October 26, 1998

An Investment Opinion
by Warren Gump

Listen, Investigate, and Profit

Investment ideas are everywhere. Some folks get them from newspapers or magazines and lots of people turn to on-line forums, while others simply observe their environment. (Hey, I love eating at Steak 'N Shake, who owns that company?) One of my favorite places to find stocks to investigate is in the listings of the biggest winners and losers found in the business section of most newspapers. These ideas are not necessarily ones to act on right away, but rather stocks to investigate further and see if they are companies worthy of investment. You never know exactly what information is behind the story, but at a minimum you'll expand your universe of potential investments.

Last week I noticed that K2 (NYSE: KTO) had been pummeled on news that its Q3 earnings would not meet expectations. Among other problems, the company's press release pointed out that its bike group was having problems as "the high end of the full-suspension market declined rapidly." Due to the widespread nature of the problems, I decided not to delve further into K2 at this time.

The day after the K2 warning, I saw a headline that caught my eye: "Cannondale Corporation (Nasdaq: BIKE) Announces Increased Revenue and Earnings." This bicycle maker crossed my radar last March when it issued an earnings warning of its own (and fell around 25% in one day). I snooped around at the time, but didn't look into it further until this week. Heck, a company growing earnings and revenue while its competitors are not sounds worthy of further investigation to me. A quick check of the Fool website snapshot and estimates indicated that Cannondale is trading at 0.9x book value, has anticipated earnings growth of 17%, and carries a P/E ratio on fiscal 1999 estimates (ending in June) of 10x. Those attractive valuation statistics piqued my interest even more.

The first line of Cannondale's most recent 10-K states that it is one of the leading makers of high-performance bicycles. Hey, isn't that the same market segment in which K2 is suffering? How is that happening? Cannondale has significant international exposure, with 51% of its fiscal 1998 sales coming from abroad. About 90% of these sales come from Europe, with the remaining portion coming from Japan and Australia. During 1998, the company experienced 16% sales growth in Europe while U.S. sales were down slightly. Gross margins fell to 35.8% from 37.6% due to adverse currency moves and an unfavorable product mix in the U.S. It looks like the company is doing fairly well because it is focused on the European market, which is stronger than the domestic one. This hypothesis is supported by the fact that K2 has much less international exposure than Cannondale.

Beyond weaker margins, why did Cannondale's EPS fall from $1.51 in 1997 to $1.08 in 1998? A big portion of the decrease is related to increased spending on research and development (R&D), which jumped from $3.6 million to $6.8 million during the period. It turns out that beyond normal R&D for bicycles, the company is working on developing motocross motorcycles. The company believes that this product line will build on its core competencies of aluminum frame fabrication, Headshok needle bearing suspension, and short-development cycles. The product line should be introduced in the summer of 1999. My initial reaction to this move is that while Cannondale might have the manufacturing prowess, motorcycles have a completely different distribution channel that the company will need to conquer. Nonetheless, only time will tell if this investment proves to be a worthwhile product expansion or a value destroying di-worsification.

I have decided to hold off on making an investment decision on Cannondale. Characteristics such as the company's respected brand, its seemingly attractive fundamental valuation, and improving Q1 results are appealing. On the other hand, the first quarter is a small portion of the company's full year earnings (less than 10%). I want to see the year-on-year profit improvement continue into the more important later quarters of its fiscal year.

Another concern is that the company's inventory is increasing more than sales. The $39 million inventory level at the end of June was up 30% from the year earlier level, while sales increased 6%. Without some stabilization of inventory growth, the company might find it necessary to make one of those painful write-offs of obsolete stuff. Finally, I need to learn more about the motorcycle move. Is this going to rev up growth or cause a crash and burn? Despite not taking action now, I have socked away some information about the company and will be prepared to take action down the road if my questions and concerns are satisfactorily answered.

Why, dear Fool, did I take you through this exercise? Hopefully to demonstrate that keeping a keen eye on happenings around you will lead to numerous worthwhile investment ideas. My love of greasy food in college led me to Consolidated Products (NYSE: COP), the owner of Steak 'N Shake. I didn't buy the stock after falling for its food, as the company was highly leveraged and counting on an unproven ad campaign to jump-start sales. I did, however, keep my eye on the company. After a couple of quarters delivering on its promises, I took the plunge and have enjoyed annualized returns of 25%+ over the past six years.

If you find something interesting, but aren't sure whether the stock will work out, put it on a watch list. Cannondale may never become part of my portfolio. Then again, it may become a valuable contributor. As a long-term investor, wait until you're comfortable that a particular investment is one you want to hold. Watch developments and listen to what others have to say. When you become confident that the company's prospects are attractive, add it to your portfolio and reap the profits of investing.

By the way, a great place to find information about a company you are investigating is on the Fool Message Boards. You'll find Fools around the world willing to help you out!