Rule Breaker Portfolio

Trump and 3Com
Trump's loss grows, 3Com reviewed

by Jeff Fischer (JeffF@fool.com)

JUPITER, FL (Aug. 13, 1998) -- The Fool Port surrendered Wednesday's gain to end the past two days about even -- like most stocks in the volatile market. And yet, how many thousands of collective hours have been spent watching and reading about the stock market's daily moves this week? It's like watching an ocean's tide -- it rises, it falls, it rises, it falls. There's no reason to waste your entire life on the beach watching it, though. Once you're ready, jump in and enjoy.

The Fool fell 2.24% after being hit and run over by Amazon.com and America Online. The S&P declined 0.86% while the Nasdaq dropped 1.26%. Yeah, it's been a volatile week, but we have ground to cover and these numbers will be old news by tomorrow, so onward we go...

Trump Hotels (NYSE: DJT) reported, in Paul Larson's words, "Dismal results." Paul -- TMF Parlay on the message boards -- focuses on the gaming industry. He's written in this space many times, and he'll soon be providing some thoughts on today's results as well. In fact, some words from Paul are already on our Trump Web message board.

Trump reported declining revenue and a substantially higher loss than last year. Revenue fell to $344 million from $368 million. Both gaming and hotel revenue fell (it's called "competition"). The company lost $10.9 million compared to a loss of $3.2 million last year.

Yes, even the lovely and bright summer months didn't help "Lil' Penny," as we're now considering calling Trump (with credit for the name going to TMF NoClue). At nearly $5 per share, Trump is falling into dreaded Penny Stock Land, a place from which many stocks never return. Our old short, Quarterdeck (Nasdaq: QDEK), is now at $1/2! Why did we cover! Ugh! (Of course, Iomega is in Penny Stock Land, too, but it put itself there with excessive stock splits.)

Trump's earnings before interest, taxes, depreciation and amortization (known as EBITDA, or "blah blah blah") fell $9 million from last year to $59 million, while the company's interest expense rose $3 million to $55 million. Consider that: earnings before all those deductions: $59 million. Interest expense alone: $55 million. That doesn't leave much room for anything else. This is like paying 93% of your earnings (after your mortgage and food costs) on credit card interest. Ouch!

The company -- facing lower revenue and larger losses and a relentless interest expense -- is, according to management, "focusing on lowering its costs and refinancing debt."

Well, of course! What else can management do? When you're in a sinking ship, you focus on bailing out water. Eventually, though, you're still going to sink. Meanwhile, in Trump's case, you certainly can't focus on building a better future or improving your business when you're having trouble merely surviving and paying the bills. Yes, momentum works both ways: up and down. Plus, management states that the recent refinancing of some debt will only remove $9 million from Trump's annual interest expense. That hardly scratches the $220 million in annual interest that Trump pays, so this canoe continues to fill with water ever more quickly.

Of course, there's no guarantee that Trump Hotels is sinking, but it's certainly more likely to sink than land on Fortune magazine's "Most Respected Companies" list. Larger losses, slower business, same giant debt, older property that ages more each passing year, more competition on the horizon... Ugly.

Even with Trump at $5, I'd rather buy the currently ailing DuPont (NYSE: DD) at $55 -- of course! Today DuPont announced that third quarter results will be at the low end of expectations. As we reported last quarter, the company is facing pressure in many of its business lines and its second quarter was weak, too. DuPont quickly went from being our Foolish Four darling to a near-term disappointment.

But we need to review a different and intermediate-term disappointment today.

STOCK REVIEW

In our methodical review of each Fool stock, it's time for...

   3Com (Nasdaq: COMS) 
    Stock Price: $28 
    Market Cap: $10 billion 
    Trailing Sales: $5.42 billion 
    Price/Sales: 1.84 
    Last Qtr Sales: $1.37 billion  
  
    Book value: $7.33 per share 
    Price/book value: 3.8 
    Recent return on equity: 2.5% 
    Recent Gross Margin: 45% 
    Recent Operating Margin: 1.8%  
    (usually around 16%) 
  
    5-year est. growth rate: 25% 
    Earnings Est: $1.28 in FY99 (ending May) 
    Earnings Est: $1.93 in FY00   
    P/E on far earnings estimate: 14.5
What caused the Fool to buy it? Two years ago to the day, the Fool Port sold the Gap (NYSE: GPS) to buy 3Com (Nasdaq: COMS), a company that was (and still is) second only to Cisco Systems (Nasdaq: CSCO) in the networking world.

Unfortunately, 3Com is second to Cisco in several ways, including product mix (3Com's is far less enviable), margins, and growth. In the last three years, Cisco's stock has compounded 72% annually, while 3Com has lost nearly 10% annually (the Fool is down 38% on the stock). During the same time, the S&P 500 gained 28% annually. $10,000 invested in Cisco in 1995 is now worth $50,000. $10,000 invested in 3Com is worth $7,300. Ouch!

OK. Enough bellyaching. But when there's a Cisco in the world, why invest in 3Com?

Well, 3Com is no slouch. It's actually one of the most successful technology companies of the past decade. When 3Com was bought, the company's earnings estimates made one think of a Swiss Gondola -- this baby looked like it could only go higher and then higher. Indeed, within months 3Com had nearly doubled for the Fool Port. Then something happened.

What has happened since the purchase? Like a meteorite streaking across the sky, 3Com was afire as it fell. Many people (myself included) found themselves wishing on this falling star and thinking that an opportunity was afoot as we watched 3Com fall from $80 to $60, then $50, then $40... until finally it hit the ocean and its fire was snuffed, sputtering to an eventual bottom $18 below the sea, at $22.

Growth of the networking industry was slowing for all but the leader (you guessed it, Cisco). 3Com, Bay Networks, Cabletron, and other networkers paid the price. Meanwhile, 3Com has primarily been relegated to lower-end product sales (although network systems sales do represent about half of its revenues, and growing), and it bought U.S. Robotics just in time for an inventory correction in modems (which represent almost another half of its sales).

When the networking industry began to slow even modestly, many second tier players had to fight hard and eventually slashed prices in order to win product orders away from Cisco. Turns out, Cisco is continuing to win anyway. It's one of the few networkers still granted a hefty premium price to its growth rate, and it's still (of late) putting up very impressive sales and earnings growth quarter-over-quarter and year-over-year, despite Asian woes.

Jump to the present...

We sit, as we have been, on a losing position in what is widely recognized as a strong, niche leading, usually very profitable company with a respected name. In history, most fundamentally strong companies have seen their stocks experience a period of years that they'd rather forget. 3Com might care to forget the past few years, and why not? The company certainly isn't living in the past. As shared in the recent conference call, 3Com has a completely renewed line of networking products now, all launched in the last few quarters. Fiscal 1999 promises to be considerably stronger than last year, management believes, and the company is sitting on $1 billion in cash and continues to develop new, often performance leading and award winning products.

What lessons have been learned? Our 3Com experience reminds one to always buy the business first, not the "YPEG valuation." I believe if the overall business and margins were the focus, Cisco might have been bought rather than 3Com. Sure, 3Com had an attractive YPEG valuation, and if earnings estimates had been met, this investment could have been a raging success. But, as it turns out, 3Com's business couldn't meet the earnings estimates.

Go back a few years and Cisco might have been considerably more expensive than 3Com, but it was also (arguably) the stronger business and most likely to meet its earnings estimates. This reminds that a Fool should always at least consider the perceived industry leader first, before considering investing in second- and third-tier players. Thinking of Venus's column from yesterday, do you marry a second- or third-tier spouse? I certainly hope not. I hope that you marry the very best that you've found in your life. Likewise, in most cases you want to invest in the number one leader of any industry. Entire books have been written on the topic explaining why.

What could cause the Fool to sell? I love to say this, but I also dislike saying it: 3Com has become such a small part of the portfolio (less than 3%) that it currently hardly matters what we do with it. In a way, that's good. It's survival of the fittest applied to an individual investor's portfolio. Buffett has this, you probably have it, and the Fool has it -- your leading stocks become the leaders of your portfolio. They grow in importance while the significance of your losers withers, pales, and all but disappears. Perhaps there's a Foolish reminder for living in this. In your life, amplify the victories and the things that you have to be happy about, and move beyond and leave behind the failures or imperfections of your life. In a way, I believe that this is why the Fool Port writers (consciously or not) give far less attention to the portfolio's losing stocks, be that right or wrong.

So what might cause us to sell? You've probably perceived by now that the Fool usually only sells if it finds something better to buy. Even so, it seems anti-climactic to sell 3Com now. Perhaps the worst is behind it. The stock trades at 14 times fiscal year 2000 earnings estimates (the company is currently in its first quarter of fiscal 1999). If estimates are met, we should see a rising share price. Also, margins should begin to improve again. In fact, on some levels, 3Com's situation reminds me of Intel (Nasdaq: INTC), which I wrote about tonight in the Drip Port.

Fool on,

Jeff Fischer

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Bookmark Live Fool Port Quotes

08/13/98 Close
Stock Change Bid ---------------- AMZN -2 7/8 127.50 AOL -3 3/8 106.31 T + 5/16 57.31 DJT - 7/16 5.31 DD -5 3/8 55.13 XON + 69/73 68.19 INVX --- 12.88 IP --- 43.13 IOM - 1/16 5.06 KLAC -2 27.50 LU -2 3/8 88.13 SBUX + 3/16 41.94 COMS -1 1/4 28.75 TDFX - 13/16 13.06

Day Month Year History Annualized FOOL -2.24% 0.23% 47.41% 394.71% 48.81% S&P: -0.86% -4.08% 10.77% 134.49% 23.60% NASDAQ: -1.26% -3.73% 14.79% 150.29% 25.62% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 106.31 2823.54% 9/9/97 580 Amazon.com 19.11 127.50 567.16% 5/17/95 1960 Iomega Cor 1.28 5.06 295.38% 10/1/96 84 LucentTech 23.81 88.13 270.15% 8/12/96 130 AT&T 39.58 57.31 44.81% 4/30/97 -1170*Trump* 8.47 5.31 37.27% 2/20/98 200 Exxon 64.09 68.19 6.39% 2/20/98 215 DuPont 59.83 55.13 -7.87% 2/20/98 270 Int'l Pape 47.69 43.13 -9.58% 7/2/98 235 Starbucks 55.91 41.94 -24.99% 8/24/95 130 KLA-Tencor 44.71 27.50 -38.49% 8/13/96 250 3Com Corp. 46.86 28.75 -38.65% 1/8/98 425 3Dfx 25.67 13.06 -49.11% 6/26/97 325 Innovex 27.71 12.88 -53.54% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 75481.88 $72900.01 9/9/97 580 Amazon.com 11084.24 73950.00 $62865.76 5/17/95 1960 Iomega Cor 2509.60 9922.50 $7412.90 10/1/96 84 LucentTech 1999.88 7402.50 $5402.62 4/30/97 -1170*Trump* -9908.50 -6215.63 $3692.88 8/12/96 130 AT&T 5145.11 7450.63 $2305.52 2/20/98 200 Exxon 12818.00 13637.50 $819.50 2/20/98 215 DuPont 12864.25 11851.88 -$1012.38 2/20/98 270 Int'l Pape 12876.75 11643.75 -$1233.00 8/24/95 130 KLA-Tencor 5812.49 3575.00 -$2237.49 7/2/98 235 Starbucks 13138.63 9855.31 -$3283.31 8/13/96 250 3Com Corp. 11715.99 7187.50 -$4528.49 6/26/97 325 Innovex 9005.62 4184.38 -$4821.25 1/8/98 425 3Dfx 10908.63 5551.56 -$5357.06 CASH $11876.47 TOTAL $247355.22

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Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.