Back from Sacramento (Bore Port) February 8, 1999

<THE BORING PORTFOLIO>
Back from Sacramento
Announcing a Buy and Sell, Too.

by Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (Feb. 8, 1999) -- I'm back from Sacramento today, having visited the Sacramento Bee Money Counts investors conference, which gives me the opportunity to present my:

Investors Conference Likes/Dislikes

Likes

1. Meeting individual investors and reaffirming that the mutual fund industry has it all wrong when they assume people are not smart enough to allocate capital rationally. Heck, most mutual funds can't do so. Why does mutual fund marketing portray people to be so dumb? That could be total projection on the industry's part.
2. Seeing our Fool's School Principal Dayana Yochim (TMF School) kick it with her presentation on investing in index funds.
3. Doing the radio show with Tom and David Gardner -- a treat I enjoy very much. We talked about eBay (Nasdaq: EBAY).
4. Boeing's 757 and 777, especially the emergency exit row -- the frugal Fool's first class seating.

Dislikes

1. Talking about trading with individual investors who are trying to make a small nest egg big, fast. Bad idea for almost anyone.
2. Setting up the booth. Luckily, our TMF Speedy makes things more fun.
3. Boeing's 737.

So I guess the Portfolio took a beating while I was away. I don't doubt that we'll be more volatile with three core holdings in the portfolio. We don't want to be in 18% cash or whatever it is right now, but we're not in any hurry to deploy capital until we can do so in a company where the value proposition is an easy one.

On that subject, the Boring Portfolio was very interested to see American Power Conversion (Nasdaq: APCC) fall on Friday. APC, if you're not familiar with it, makes uninterruptible power supplies, power conditioning equipment, and surge protectors for everything from PCs to workstations to entire rack rooms and telecom equipment.

The company's growth rate at its core is similar to the PC industry, about 15% a year. In all the years I've followed it, its sales growth has outperformed this number, but this is what I see as the base case assumption here. Add to that the number of IT managers that upgrade their power management equipment and a richening product mix in terms of features and the size of equipment that APC products protect, and you've got a company that grew revenues 29% last year and per-share operating earnings 23%.

The company's overall return on capital is in the mid-30% range, due more to excellent margins than extraordinary capital management. Nevertheless, there's nothing wrong with the company's cash flow characteristics and we have no quality of earnings questions.

APC's continuing margin performance speaks to a misperception that I've seen since I started following the company in 1994. That is, that they just make commodity products and that they're vulnerable to competition. I haven't seen it. I remember Hewlett-Packard (NYSE: HWP) tried to get into this business a couple years ago. APC whacked them.

One of the keys to APC, as I see it, is the fact that it offers more than just a box with a battery in it. The company's products for workstations, servers, and enterprise support systems also include software that allows a network manager to monitor and control hardware across an enterprise. That creates a switching cost that a company does not want to bear unless they need to. If APC executes, it keeps its customers and gets their add-on business. There's a psychological lock-in, as well. In the 1970s, people didn't get fired by ordering IBM products because that was the industry standard. People don't get fired for building an IP network with Cisco Systems (Nasdaq: CSCO) equipment. People don't get fired protecting their multi-million dollar communications networks for ordering APC power management products. APC's products have overwhelming market share and mind share in their industry.

I don't think we have to work too hard on the numbers here. We're talking about a company that is priced at 28 times trailing EPS and about 23 times the EPS number the company is comfortable with for this year. We also think there's upside in that number, given the company's movement into larger systems and given the possibility that IT managers will want to really bulk up their systems with Y2K issues. When we say it's attractive at the current P/E, a number of things play into it: The attractive natural growth rate in its market opportunity, the company's return on capital characteristics, its demonstrated execution abilities, as well as the lock-in characteristics mentioned above. Doing a ten year discounted earnings model indicates a value of $54 1/2 per share, under the following assumptions:

• Years 1 and 2 EPS growth: 20%
• Years 3-7 EPS growth: 15%
• Year 8-10 EPS growth: 12%
• Terminal multiple: 14 times earnings
• Discount rate: 11%

Using a discount rate of 14% gets us a present value of $44.11. The only immediate questions we would have on APC is on the patent infringement lawsuit that the company commented on last Friday. These sorts of things aren't unusual at all in this industry, so it doesn't worry us on its face, but we would want to hear from the company about the details before doing anything. The other question I would have is on the inventory buildup the company saw last year. I would think that comes from their acquisition of Silicon A/S, a Swedish company that manufactures large three-phase UPS systems. We will ask the company about that as well.

A Boring Buy and Sell

Boring Portfolio readers know that we've been sizing up Gateway (NYSE: GTW) for a while. One of the two leaders in the PC industry direct model, along with Dell Computer (Nasdaq: DELL), Gateway has improved its business over the last year and has shown excellent strategic thinking and execution with its Country Store retail model and the YourWare program. We believe the intrinsic value of Gateway is above $90 per share and that it will continue to outperform the unit growth rate of the industry, due to its richening product mix and tendency to capture second-time PC buyers who usually upgrade the features they purchase. The $1,000 PC trend does not bother us because of two things: 1) It widens the market of people who will make second-time PC purchase decisions down the road; and 2) You can generate good returns on capital selling $1,000 PCs.

We will talk about our valuation work on Gateway in future Boring Port reports and on the boards, but our view of what the company has to do to reach what we see as its intrinsic value right now is actually under consensus expectations for this year. So the valuation difference we see lies in the out-years of people's expectations. Namely, the expectations built into the price of Gateway are that the PC industry or Gateway will drop off a cliff in a few years. While we expect that this year will be one of robust growth and that comparing year 2000 performance to 1999 will be difficult, we think in the meantime that the company's price will reflect its intrinsic value. In other words, we don't need a smooth growth path in every year to appreciate the value the company can generate.

One can view Gateway as a commodity producer, which is fine with us. We do think there are commodity elements to the PC industry. But we believe Gateway is one of the most efficient producers in the industry and that the PC industry is still not a mature one. We also think there are non-commodity elements to Gateway, such as the innovative retail strategies the company has come up with and its richening product and customer mix. We are looking at appreciation above 30% itself just to get to intrinsic value, plus at least 15% yearly return to shareholders over an appreciable time horizon. This more than meets our investment principles. We will therefore acquire at least $7,000 of Gateway over the next five days. We will finance part of the purchase with the sale of our entire interest in Pentair (NYSE: PNR). The comparisons in the value and market growth opportunities between the two companies heavily favor Gateway. We like Pentair, but we could better use the capital elsewhere. Related Articles:

• The Lunchtime News 01/22/99: Gateway Q4: It Gets Even Better
• Industry Focus 1999

We hope to see you on the message boards!

• Discuss Boring Investing on the Boring Port message board.
• 10/01/98: The New Boring Port Transitions Facts

Make a Living Foolin' Around.

Stock  Change    Bid
BRKb  +52      2428.00
CSL   +  3/16  45.00
CSCO  +  11/16 101.94
PNR   -  1/4   38.13

                   Day    Month   Year  History
        BORING   +0.89%  -0.40%  -2.04%  31.53%
        S&P:     +0.35%  -2.80%   1.50% 107.43%
        NASDAQ:  +1.32%  -4.03%   9.68% 131.03%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    101.94   325.53%
  8/13/96  200 Carlisle C    26.32     45.00    70.94%
 12/31/98    8 Berkshire   2244.00   2428.00     8.20%
  4/14/98  100 Pentair       43.74     38.13   -12.84%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  22935.94 $17545.95
  8/13/96  200 Carlisle C  5264.99   9000.00  $3735.01
 12/31/98    8 Berkshire  17952.00  19424.00  $1472.00

  4/14/98  100 Pentair     4374.25   3812.50  -$561.75


                             CASH  $10594.54
                            TOTAL  $65766.98