<THE EVENING NEWS>
Friday, May 1, 1998
MARKET CLOSE
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HEROES

Integrated oil companies headed higher today as the Organization of Petroleum Exporting Countries (OPEC) announced that they had cut oil production in March as promised. Exxon (NYSE: XON) gained $2 9/16 to $75 5/8, Chevron (NYSE: CHV) added $3 11/16 to $86 3/8, and Mobil (NYSE: MOB) rose $3 7/16 to $82 9/16. Amoco (NYSE: AN) climbed $2 5/8 to $47 after announcing a "significant" oil and gas strike off the northern coast of Norway. Oil drilling and services firms were also lifted as the OPEC announcement gave crude oil prices a boost and helped dispel fears of an oil oversupply problem. Diamond Offshore (NYSE: DO) picked up $2 7/8 to $53 1/2 and R&B Falcon (NYSE: FLC) tacked on $1 15/16 to $34, while EVI Inc. (NYSE: EVI) moved $4 5/8 higher to $57 7/8 and Smith International (NYSE: SII) added $4 9/16 to $63 5/16. Global Marine (NYSE: GLM) jumped $1 7/16 to $24 13/16 after a certain weekly magazine with the initials "BW" said the firm may be a takeover target.

Several companies rose in their first day of trading as the markets scrapped May Day celebrations in favor of an Initial Public Offering (IPO) blitz. Client-server and Internet software firm Brio Technology (Nasdaq: BRYO) rose $2 5/16 to $13 5/16 after offering 2.9 million shares today at $11 per share, while semiconductor packaging and testing services provider Amkor Technology (Nasdaq: AMKR) climbed $2 5/16 to $13 5/16 following an offering of 35 million shares at $11 per share. Auto towing, impounding, and storage firm United Road Services (Nasdaq: URSI) rose $5 to $18 from its initial public offering price of $13 per share, and specialty finance company Rock Financial Corp. (Nasdaq: RCCK) jumped $2 1/4 to $12 1/4 from its offering price of $10 per share. Heller Financial (NYSE: HF), the U.S. commercial financing arm of Japan's Fuji Bank Ltd., moved up $3 to $30 after selling 33.5 million shares at $27 per share.

Long-term care provider Vencor (NYSE: VC) finalized a restructuring today, which made it look like its shares dropped $15 3/4 to $11 3/8. What actually happened, though, was that its shareholders received one share of a new company, Ventas (NYSE: VTR), which retained the real estate holdings of Vencor, for each share of Vencor they owned. The new company will convert into a real estate investment trust (REIT) next year. Meanwhile, Ventas holders will retain just the shares of Ventas, and not any shares of the old Vencor, which will operate as a healthcare management company and lease real estate from Ventas. The economic reality of today's situation is that a Vencor share was worth $27 1/8 at the close yesterday. The new Ventas shares issued today closed at $28 5/8, resulting in a $1 1/2 per share improvement over yesterday's Vencor price.

QUICK TAKES: PC direct marketer Dell Computer (Nasdaq: DELL) continued to rise, picking up $3 1/2 to $84 1/4 today after announcing Tuesday that it had formed an alliance with chipmaker Intel (Nasdaq: INTC) to develop enterprise and Internet computing technologies... Cable TV companies rose as analysts made positive comments about the industry ahead of next week's National Cable Television Association convention, according to Bloomberg News. Microsoft gooroo Bill Gates will be the keynote speaker. Tele-Communications (Nasdaq: TCOMA) rose $2 1/8 to $34 3/8, Comcast Corp. (Nasdaq: CMCSK) gained $1 9/16 to $37 3/8, and Cablevision Systems Corp. (AMEX: CVC) added $2 15/16 to $64 3/8.

Number-one personal computer company Compaq Computer (NYSE: CPQ) gained $1 1/4 to $29 5/16 after being upgraded to "buy" from "neutral" by Salomon Smith Barney... Aerospace company Boeing (NYSE: BA) rose $1 11/16 to $51 3/4 on news that it has been awarded a $1.6 billion contract from the Defense Department to develop a national ballistic missile defense system... Genetically enhanced seed developer Mycogen Corp. (Nasdaq: MYCO) sprouted $2 5/16 higher to $22 13/16 after Dow Chemical's (NYSE: DOW) Dow AgroSciences subsidiary said it will talk with Mycogen about buying the 31% stake in the company it does not already own for $20.50 per share in cash... Film and camera manufacturer Eastman Kodak (NYSE: EK) climbed $1 3/16 to $73 3/8 after announcing a series of agreements with semiconductor firm Intel Corp. (Nasdaq: INTC) relating to digital photography, including a joint development effort, a patent cross-licensing arrangement, and a joint marketing agreement to promote products resulting from the collaboration.

Long-distance and local phone service company Bell Atlantic Corp. (NYSE: BEL) rose $3 11/16 to $97 1/4 after saying that president and COO Ivan Seiderberg will replace current CEO Raymond Smith, who is stepping down June 1. It also set a two-for-one stock split... Year 2000 problem solver Data Dimensions (Nasdaq: DDIM) climbed $1 9/16 to $16 5/16 after reporting Q1 EPS of $0.08, which was in line with the First Call mean estimate... Telemarketer and customer service outsourcing firm APAC TeleServices (Nasdaq: APAC) rang up a $15/16 gain to $10 7/16 after agreeing to acquire privately owned ITI Marketing Services for $155.2 million in cash... TV and radio station operator Sinclair Broadcast Group (Nasdaq: SBGI) rose $2 13/16 to $54 11/16 after reporting Q1 after-tax cash flow of $0.23 per share and setting a two-for-one stock split. The firm's CFO said total revenues in Q2 are on a pace to come in 7.5% higher than last year, but broadcast cash flow margins will be hampered in the quarter by promotional expenses.

Telecommunications software firm GeoTel Communications (Nasdaq: GEOC) gained $6 1/2 to $34 1/8 after long-distance phone giant AT&T (NYSE: T) said it will use GeoTel's Intelligent CallRouter software as the backbone for its program to create "virtual call centers" for businesses... BankBoston (NYSE: BKB) rose $2 15/16 to $110 7/8 after The Boston Globe reported that the company came close to merging this week with Fleet Financial Group (NYSE: FLT) before talks fell apart. Fleet added $3 1/8 to $89 1/2. Other banks and financial services firms were also up today, as J.P. Morgan (NYSE: JPM) advanced $3 7/8 to $135 1/8; American Express (NYSE: AXP) gained $3 5/8 to $105 1/2; BankAmerica (NYSE: BAC) was lifted $2 11/16 to $88 1/16; and NationsBank (NYSE: NB) tacked on $2 3/16 to $78 3/16. Wells Fargo & Co. (NYSE: WFC) rose $18 3/4 to $387 1/4 on speculation the firm may be ripe for a merger, possibly with U.S. Bancorp (NYSE: USB).

British aviation and industrial turbine components maker Doncasters PLC (NYSE: DCS) jumped $2 7/8 to $33 5/8 after reporting Q1 earnings of $0.64 per American depositary share versus $0.40 per share a year ago... Online services provider America Online (NYSE: AOL) gained $3 9/16 to $83 1/2 after Reuters reported the firm took a 20% stake in privately owned FamilyEducation Co., a provider of Internet services linking schools and parents... Restaurant operator Boston Chicken (Nasdaq: BOST) moved up $23/32 to $5 after J. Michael Jenkins was named the company's new president and CEO. Mr. Jenkins is the former CEO of Vicorp Restaurants (Nasdaq: VRES), operator of the Bakers Square and Village Inn chains.

3D graphics accelerator chipset maker S3 Inc. (Nasdaq: SIII) climbed $21/32 to $7 31/32 after IBM (NYSE: IBM) selected the firm's Trio accelerator to be integrated into IBM's 300PL line of PCs... Hyde Athletic Industries (Nasdaq: HYDEA), maker of Saucony brand sneakers, moved $1 1/2 higher to $6 after reporting Q1 EPS of $0.16 versus $0.10 a year ago.

Ratings Movers: Akron, Ohio-based bank holding company FirstMerit Corp. (Nasdaq: FMER) picked up $1 7/8 to $30 1/4 on an A.G. Edwards upgrade to "buy" from "accumulate"... St. Jude Medical (NYSE: STJ) popped up $1 13/16 to $37 1/4 after Bear Stearns upgraded the maker of cardiac medical devices to "buy" from "neutral"... Novoste Corp. (Nasdaq: NOVT) advanced $2 3/8 to $27 1/8 after BancAmerica Robertson Stephens started coverage of the catheter delivery systems developer with a "long-term attractive" rating... Jabil Circuit (Nasdaq: JBIL) added $1 7/8 to $37 after Adams, Harkness & Hill started coverage of the contract circuit board manufacturer with an "attractive" rating... Phoenix International (Nasdaq: PHXX) rose $1 3/4 to $31 1/4 after Wheat First Union placed the developer of software for financial services firms on its top 30 list of best recommendations.

GOATS

Eli Lilly & Co. (NYSE: LLY) fell $3 1/4 to $66 5/16 after Merrill Lynch cut its rating on the company to "accumulate" from "buy." Analyst Richard Vietor cited lower-than-expected sales of the company's new osteoporosis drug Evista, but added that the drug has a potential for generating $1-$1.5 billion in sales by 2001. His 12-month target price for the stock is $80 to $82. The downgrade comes as no surprise considering that the stock has risen roughly 60% in the past year largely on hopes that Evista will be some sort of blockbuster miracle cure-all. Evista won FDA approval last December for treating and preventing fragile bones. The company started a study in late March to see if Evista can also reduce the risk of heart attacks, stroke, and breast cancer, but it will take some time to test the drug on 10,000 women in 25 countries as the company intends. Researchers are expected to present study results at a conference later this month indicating that Evista reduces the risk of breast and uterine cancer, but as analyst Vietor told Bloomberg, "they [the results] are adequately reflected in the stock price."

Electronic Data Systems (NYSE: EDS) dropped $4 1/4 to $38 3/4 in heavy trading after reporting first quarter earnings of $0.43 per share excluding a $42.5 million charge. That compares with EPS of $0.39 last year and the analysts' mean estimate of $0.44. What concerns investors is that the discounts the information technology services firm is offering General Motors (NYSE: GM), its largest client and former parent, are hurting profits. EDS said it expects to generate a disproportionately large share of operating profits in the latter part of this year. As part of GM, EDS delivered steady profit growth, but now the company is struggling just when GM is cutting prices -- and therefore wanting better terms from EDS -- in the face of stiff competition amid slower demand at home and overseas. EDS shares are now trading about 30% down from when it spun off in mid-1996.

QUICK CUTS: Northwest Airlines (Nasdaq: NWAC) was brought down $1 11/16 to $50 13/16 after BT Alex. Brown downgraded the airline to "buy" from "strong buy"... Bandwidth management technologies company Adaptec Inc. (Nasdaq: ADPT) slid $3 15/16 to $19 3/4 after reporting Q4 EPS of $0.20, down from $0.48 (before charges) in the prior-year quarter and short of expectations of $0.29... PC multimedia accelerator developer STB Systems (Nasdaq: STBI) plunged $3 7/16 to $10 7/8 after announcing that it expects Q2 EPS to fall short of analysts' estimates by roughly 30%. That would be around $0.22 per share, compared with the First Call mean estimate of $0.32... Semiconductor wafer stepper maker ASM Lithography Holding (Nasdaq: ASMLF) shed $3 5/8 to $88 after Morgan Stanley Dean Witter lowered its 1998 EPS estimate to $3.10 from $3.60.

Mask pattern generation systems company Etec Systems (Nasdaq: ETEC) tanked $8 7/8 to $47 7/8 after announcing that it expects flat Q3 revenue of about $69.7 million and earnings to be lower than the $11.5 million (before charges) reported in Q3 1997. The company blamed a delay in shipment of an ALTA 3500 system as a result of not meeting one specification... NewsEdge Corp. (Nasdaq: NEWZ) sank $1 3/4 to $15 3/8 after the news integrator and provider reported a Q1 loss of $0.82 per share (before a $11.1 million charge) versus a loss of $0.25 per share in the year-earlier period. Excluding charges, the company's Q1 loss was $3.4 million compared with a loss of $2.7 million a year ago... Fluids management, environmental and oilfield services company Newpark Resources (NYSE: NR) dropped $2 1/16 to $22 after reporting Q1 EPS of $0.18, meeting expectations.

Database technology developer Informix Corp. (Nasdaq: IFMX) slid $23/32 to $9 5/32 after reporting Q1 EPS of $0.03 compared with a loss of $0.95 in Q1 1997 and the First Call mean estimate of a loss of $0.03... Diamond Multimedia Systems (Nasdaq: DIMD) tumbled $1 13/16 to $9 13/16 after CIBC Oppenheimer lowered its rating on the maker of PC multimedia accelerators to "hold" from "buy"... Extracorporeal shockwave therapy (ESWT) company Medstone International (Nasdaq: MEDS) declined $1 1/4 to $10 1/8 after announcing that the FDA's Gastroenterology and Urology Device Advisory Panel has recommended conditional approval of the company's submission to treat gallstones using the company's lithotripter in combination with Actigall, a drug used to dissolve gallstones.

Asarco Inc. (NYSE: AR) dipped $1 to $23 15/16 on news that its 54.3%-owned subsidiary Southern Peru Copper Corp. expects to spend $45 million to expand its solvent extraction-electrowinning plant due to come on line by the end of next year. The expansion comes on top of another $1 billion expansion plan to increase capacity... Gold mining and metals exploration company Pittston Minerals Group (NYSE: PZM) fell $7/8 to $6 1/2 after announcing a reduced quarterly dividend of $0.025 per share, down from $0.1625 as the company's earnings continue to be hurt by weakness in coal, gold, and nickel prices.

Earnings Movers

Big Dog Holdings (Nasdaq: BDOG) down $1 to $6 1/2; Q1 EPS: loss of $0.17 vs. loss of $0.20 last year; Estimate: loss of $0.17

CDnow Inc. (Nasdaq: CDNW) down $2 1/4 to $29 3/4; Q1 EPS: loss of $0.78 vs. loss of $0.07 last year; Estimate: loss of $0.67

CORE Inc. (Nasdaq: CORE) down $5/8 to $11 1/8; Q1 EPS: $0.03 vs. $0.02 last year; Estimate: $0.08

Curative Health Services (Nasdaq: CURE) down $2 9/16 to $28 7/16; Q1 EPS: $0.29 vs. $0.28 last year; Estimate: $0.28

Discreet Logic (Nasdaq: DSLGF) down $2 1/8 to $15 3/4; Q3 EPS: $0.17 vs. $0.11 last year; Estimate: $0.19

The Dixie Group (Nasdaq: DXYN) down $1 3/16 to $11 3/8; Q1: $0.21 vs. $0.26 last year; Estimate: $0.21

ICG Communications (Nasdaq: ICGX) down $1 3/4 to $33 1/4; Q1 EPS: loss of $2.30 vs. loss of $1.81 last year; Estimate: loss of $2.03

Sunrise Assisted Living (Nasdaq: SNRZ) down $8 9/16 to $36 1/4; Q1 EPS: $0.18 vs. $0.01 last year; Estimate: $0.16

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Valuing Hypergrowth

This week wraps up the Hambrecht & Quist Technology Conference, still one of the most-attended conferences with the best lineup of companies each year. There was the usual parade of chief financial officers and CEOs, some presenting their stories in a contrite manner, trying to win their way back into investors' and analysts' hearts after blowing up sometime over the last 12 months. And some executives come like conquering kings telling stories of conquest on the frontier.

This year, Amazon.com (Nasdaq: AMZN) CFO Joy Kovey presented, amidst other remarks, a proposal for looking at Amazon's value, according to Jon Markman at Microsoft Investor. Kovey proposed that investors look at a company's EBITMA-generating capabilities. EBITMA, by the way, is just an adaptation of EBITDA, or interest before interest, taxes, depreciation, and amortization. In this incarnation, it is earnings before interest, taxes, marketing, and amortization. While this makes some sense, which we'll get to in a moment, it does kind of beg the question: If we're putting a multiple on operating earnings before marketing expenses, why not just project sales a number of years out, put a sensible multiple on that, and discount it to the present?

Anyway, back to Ms. Kovey's suggestion. It's an interesting one that a couple of well-regarded, or at least well-known, California investment thinkers and money managers have dealt with in their public writings. Ken Fisher, son of legendary investor Phil Fisher, took on the issue of looking at a company's price-to-sales and price-to-research ratios in his book Super Stocks. Fisher says, "Price Sales Ratios [PSR, or the market capitalization of a company divided by trailing twelve months' revenues or sales] are the most powerful single valuation methods with which I am familiar." Although one might disagree with what Fisher says about finding super stocks: "Never ever buy any stock with a PSR greater than 3. A stock selling at a PSR this high can increase rapidly, but only based on hype," since this excludes consideration of capital efficiency, profit margins, and qualitative factors, Fisher's discussion of PSRs is especially enlightening to the beginning investor who wants to start evaluating growth stocks.

Fisher and California Technology Newsletter publisher Michael Murphy also talk about price/research ratios. This valuation method essentially goes along with what Amazon's CFO proposed, which is to look at a growth company's operating earnings minus the enormous amount of funds the company has plowed back into research & development (or marketing) in order to drive the topline growth and get to the mature, highly profitable stage of corporate life. Both Murphy and Fisher add back those expenses to operating earnings, capitalize that number to get to the company's intrinsic value, and divide by the number of shares outstanding to generate a target price for that stock.

In all of these situations, these expenditures are looked at as necessary to create the growth that investors are looking for. In a static viewpoint of value, a company that cuts off all R&D spending might fall to 10 times earnings and look great to some investors, but without reinvestment, growth will likely stop. A common misperception among value investors is that without growth and without distribution of the earnings that are capitalized at such a low level by the market, there is little value.

When expenditures for marketing are necessary for creating growth, and where a company's fixed, long-lived assets are primarily intanigble, such as a brand name and reputation, capitalizing those expenses as assets to be charged off over a number of accounting cycles is a realistic way of portraying the economics the economics of that business. America Online (NYSE: AOL) had its share of detractors when it went about accounting for its economic model in this way. Cendant (NYSE: CD) is another company that has taken some lumps over the years and especially lately because it engages in what one can contend effectively to be a sensible way of accounting for its business model.

In the case of Cendant, the company needs to engage in very little investment in assets such as plant, property & equipment to generate future revenues and earnings. Its most crucial economic assets are its reputation with franchisees and its brand name and brand satisfaction with customers. That's where the spending must go to maintain and grow revenues. Rather than totally erasing these necessary expenditures from the valuation picture, one could choose to look at these things as capital expenditures. Sure, GAAP adherents will freak out. Oh, well. I'm not an accounting professor, and I'm not ruled by Ben Graham, who didn't have much to say about valuing hypergrowth situations.

The way to look at Amazon.com would be to capitalize marketing expenditures and charge them off (amortize them) over a period of time. That period of time is totally open to debate because it's very difficult to say which revenues can be attributed to which expenditures. In the case of acquisition-related intangibles, however, goodwill can be amortized on a schedule no longer than 40 years. That implies that a brand name (whether consumer brand names or trade brands) is a fungible resource on which the company feeds in creating and, equally important, retaining new accounts. While it would be aggressive to totally unrealistic to charge off Amazon.com's capitalizing marketing expenditures over 40 years, 5 years is in the ballpark, even given the fact that most look at one Internet year as five normal years (or whatever).

The first thing we look at is total marketing and sales expenditures for the company.

For fiscal years 1995, 1996, and 1997, marketing and sales expenditures were $200,000, $6,090,000 and $38,964,000 respectively. Capitalizing 1995's marketing expenditures would have resulted in yearly amortization of $40,000 over the next five years. 1996's capitalized amount would have resulted in yearly amortization of $1,218,000, and 1997's expenditures would have resulted in yearly amortization expenses of $7,793,000.

To look at what sort of valuation proposition we face, let's look at results for Q1 1998. Operating earnings as reported were negative $8,874,000. On an annualized basis, there's nothing against which we can value the company on an earnings basis. On annualized sales, it's 6.5 times sales.

Looking at adjusted earnings, we back out sales & marketing expenses and add in amortization expenses from capitalized sales & marketing. The residual amounts for each year (cutting them into quarters now because we're looking at one quarter) are $10,000, $304,500, and $1,948,200. Adding in amortization from Q1 1998, as well, we have total amortization for the quarter at $2,262,700 + $975,200 = $3,237,900.

Operating earnings then look like:

(in 000s)

Gross profit.......$19,321
Prod't Devel.........6,729
Amortization.......3,237.9
G&A..................1,963
--------------------------
Operating Income..$7,422.1
Interest Expense....$2,025
Tax Provision........1,889
Net Income..........$3,508
EPS.................$0.145

Annualizing that (though it misses part of the point to annualize the earnings of a company growing sales in the 30%+ range sequentially), we get EPS of $0.58. That puts us at a P/E of 162.9. Not very satisfying for the value investor at the current price, but if this company were trading at the 52-week low -- a 25.8 P/E of these earnings in an exploding Internet market would be absurdly low, if all else about the company's quality were equal. In addition, that represents economic earnings on a negative base of invested capital, which is always a very powerful combination. Dell Computer (Nasdaq: DELL) could tell you about that and negative cash conversion cycles, which is the amount of days sales in inventory plus days sales in accounts receivable less days of cost of goods sold in accounts payable. (CCC = Days in Inventory + Days Sales Outstanding - Days in Payable.)

Thinking back on similar enterprises that generate huge returns on low invested capital bases, there are only a few companies that come to mind. Dell, again, is one example of that, and GEICO or Wal-Mart (NYSE: WMT) are two others. That Amazon ended its last quarter with negative invested capital and created economic profits are two tip-offs that this company deserves some leeway in the multiples that are considered "fair" in determining its intrinsic value at this time.

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Contributing Writers
Yi-Hsin Chang (TMF Puck), a Fool
Brian Graney (TMF Panic), Fool Two
Alex Schay (TMF Nexus6), Fool, too
Dale Wettlaufer (TMF Ralegh), Final Fool

Editing
Brian Bauer (TMF Hoops), another Fool
Jennifer Silber (TMF Amused), Fool at last

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