Tuesday, May 5, 1998
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Cancer and AIDS treatment developer Agouron Pharmaceuticals (Nasdaq: AGPH) jumped $2 1/2 to $36 7/8 after saying it has started a new phase of clinical trials for an experimental anticancer agent for patients with advanced lung or prostate cancer. In initial tests with rodents, the orally administered agent prevented the formation of new blood vessels (angiogenesis) and the spread of tumors to other parts of the body (metastasis). It also enhanced the tumor-fighting abilities of certain conventional chemotherapy agents, the company said. Agouron is not alone in the race to find a cancer cure using angiogenesis disruption agents, as the concept also helped fuel yesterday's rise of fellow drug developers EntreMed Inc. (Nasdaq: ENMD), Boston Life Sciences (Nasdaq: BLSI), and Magainin Pharmaceuticals (Nasdaq: MAGN).

Managed care provider Foundation Health Systems (NYSE: FHS) moved up $2 5/8 to $32 1/8 after reporting Q1 EPS from continuing operations of $0.22 per share compared to $0.38 per share a year ago, which was in line with the First Call mean estimate. Revenues jumped 23% to $2.2 billion in the quarter, but income from continuing operations slipped 81% to $26.2 million. Chairman and CEO Malik Hasan called the results "not satisfactory or indicative of potential future profitability," as the company is in the midst of a restructuring program. Today, Foundation said it would help the restructuring along by selling its workers' compensation insurance unit to Superior National Insurance Group (Nasdaq: SNTL) for about $290 million in cash.

Several semiconductor equipment companies rose today after Salomon Smith Barney analyst Milind Bedekar assigned "buy" ratings in new coverage. Asyst Technologies (Nasdaq: ASYT), which makes material tracking products used in semiconductor cleanrooms, rose $15/16 to $21 13/16. Laser-based yield improvement systems maker Electro Scientific Industries (Nasdaq: ESIO) moved up $1 11/16 to $38 11/16, and thin film measurement systems manufacturer Nanometrics Inc. (Nasdaq: NANO) added $1/4 to $9 3/4. Also, automatic test equipment maker Credence Systems (Nasdaq: CMOS) picked up $1 7/8 to $27 7/8 and KLA-Tencor Corp. (Nasdaq: KLAC) added $1 15/16 to $41 1/2.

QUICK TAKES: Application software company Netscape Communications (Nasdaq: NSCP) advanced $9/16 to $30 1/8 after announcing a strategic partnership yesterday with Excite Inc. (Nasdaq: XCIT) to develop Internet content and search services and sell advertising... Casino operator Mirage Resorts (NYSE: MIR) rolled $2 higher to $22 1/2 after reporting Q1 EPS of $0.20 versus $0.28 a year ago. However, the most recent quarter included a $3.5 million charge to pay off debt and open two new resorts, while the year-ago quarter included a $3.6 million gain from the sale and exchange of land... Clothing designer and retailer Donna Karan International (NYSE: DK) climbed $1 3/4 to $16 after reporting Q1 EPS of $0.10, which was a nickel ahead of the Street estimate. CEO John Idol said the company's restructuring program is going well and he expects pre-tax profit for fiscal 1998 "to fall within our previously announced target range."

Consumer Portfolio Service (Nasdaq: CPSS) moved up $9/16 to $12 15/16 after Piper Jaffray upgraded the consumer finance company to "buy" from "neutral"... Enron Corp. (NYSE: ENE) was lifted $2 3/16 to $52 1/4 after the power producer said it was comfortable with the Street's Q2 earnings estimates of $0.38 per share, according to Reuters. The company also signed a contract to provide electricity to defense contractor Lockheed Martin Corp. (NYSE: LMT)... Protein Design Labs (Nasdaq: PDLI) gained $1 1/4 to $33 3/8 after the developer of antibodies for disease treatment granted a worldwide license to Irish pharmaceutical and drug delivery company Elan Corp. (NYSE: ELN) to use its patents for Elan's Antegren multiple sclerosis treatment. Elan will pay an up-front $1.3 million fee for the license.

Local telecommunications services provider Hyperion Telecommunications (Nasdaq: HYPT) rose $1 3/8 to $17 3/8 after the company sold 12.5 million shares in an initial public offering at $16 per share... Specialty paper maker Crown Vantage (Nasdaq: CVAN) picked up $2 7/16 to $12 after saying it is considering the possible divestiture of its St. Francisville, Louisiana, pulp and paper mill. The company also said it would lay off 5% of its workforce by the end of this year in order to cut costs... Low level-radiation cancer therapy developer North American Scientific (Nasdaq: NASI) rose $3 1/2 to $28 1/4 after appointing a former Price Waterhouse manager as its new CFO. Also, Dain Rauscher started coverage of the company with a "strong buy" rating... Online and telephone movie ticketing service MovieFone Inc. (Nasdaq: MOFN) added $1 1/8 to $11 3/4 after signing an exclusive agreement with movie theater operator General Cinema Theatres (NYSE: GCX) to provide advance ticket buying services to General Cinema patrons.

Concentrix Network Corp.
(Nasdaq: CNCX) advanced $3 to $25 1/8 after Bear Stearns started coverage of the provider of Internet protocol and Web hosting services with a "buy" rating... Remington Oil & Gas Corp. (Nasdaq: ROILA) climbed $5/8 to $7 1/8 after the oil and natural gas exploration company announced that it has discovered natural gas off the coast of Louisiana. Prudential Securities started coverage with a "buy" rating... Pawn shop operator Cash America International (NYSE: PWN) tacked on $1 7/8 to $18 1/2 after its Mr. Payroll check cashing unit entered into a joint venture with Wells Fargo & Co. (NYSE: WFC) to develop a device offering check cashing services via automated teller machines.

Sterilization products maker Balchem Corp. (AMEX: BCP) rose $2 3/16 to $22 1/16 after setting a three-for-two stock split, effective June 3... Corporate graduate level education services firm Caliber Learning Network (Nasdaq: CLBR) rose $3 5/16 to $17 5/16 after selling 5.7 million shares in an initial public offering today at $14 per share... CMP Media (Nasdaq: CMPX) gained $2 3/8 to $26 5/8 after the media company agreed to buy the information technology and communications unit of publisher McGraw-Hill Companies (NYSE: MHP) for $28.6 million... Semiconductor maker Cirrus Logic (Nasdaq: CRUS) added $1 1/16 to $11 3/16 after Bloomberg News reported the firm's largest shareholder, Alfred Teo, wants to take control of the company. Yesterday, Cirrus adopted a shareholders' rights plan aimed at warding off a potential hostile takeover.

Earnings Movers

Cal Dive International (Nasdaq: CDIS) up $2 1/4 to $37 3/8; Q1 EPS: $0.35 vs. $0.17 last year; Estimate: $0.16

Merrimac Industries (AMEX: MRM) up $1 1/2 to $16 7/8; Q1 EPS: $0.26 vs. $0.18 last year

PacifiCare Health System
(Nasdaq: PHSYB) up $5 5/8 to $77 1/2; Q1 EPS: $0.90 vs. $1.12 last year; Estimate: $0.73

Polk Audio (AMEX: PKA) up $5 7/8 to $17 3/4; Q4 EPS: $0.71 vs. $0.15 loss last year

Primus Telecommunications Group
(Nasdaq: PRTL) up $2 7/8 to $22 1/2; Q1 EPS: $0.62 loss vs. $0.28 loss last year; Estimate: $0.64 loss.

PXRE Corp.
(NYSE: PXT) up $1 1/2 to $31 3/4; Q1 EPS: $0.72 vs. $0.74 last year; Estimate: $0.66

Track 'N Trail
(Nasdaq: TKTL) up $7/8 to $8 7/8; Q1 EPS: $0.12 loss vs. $0.16 pro forma loss last year; Estimate: $0.14 loss


EntreMed Inc. (Nasdaq: ENMD) dropped $8 11/16 to $43 1/8 after several brokerages downgraded the biopharmaceutical company's stock after it more than quadrupled in price yesterday on no new news. The data regarding the company's potential cancer drugs had already been published in the journal Nature last November (and the stock rose 28%), but exposure to the wider audience of the New York Times prompted a cancer-killing frenzy. Today, Lehman Brothers cut its rating to "neutral" from "venture," citing that the prospective drugs haven't even been tested on humans and "media frenzy has caused the stock to rise beyond our estimation of fair value." However, Lehman did raise its 12-month target price for EntreMed to $25 from $18. Dubbing yesterday's run-up "irrational exuberance," SBC Warburg Dillon Read also lowered its rating on EntreMed to "neutral" from "buy." SBC said clinical data on the drugs are unlikely before 2000, and FDA approval is unlikely before 2002. SBC's 12-month target price is $30. Even EntreMed executives are trying to quell rampant speculation that the drugs might cure cancer. "We don't use the C-word here," EntreMed CFO Nelson Campbell said, "We won't know until we are in human trials whether we have a drug."

MacroChem Corp. (Nasdaq: MCHM) tumbled $3/4 to $12 after The Wall Street Journal's "Heard on the Street" column reported that the drug company is a favorite among short sellers and has risen on the coattails of Pfizer's (NYSE: PFE) fast-selling impotence drug Viagra. MacroChem has risen more than 40% since mid-April, just before the first reports of the immensely successful sales of Viagra. Short interest in the stock soared 66% between mid-March and mid-April. The company claims that clinical tests of its Topiglan gel impotence treatment show a 75% to 80% efficacy rate. Investors shorting the stock are probably focusing on rumors that the gel didn't yield decent results when applied in small dosages and caused burning when larger amounts were used during clinical trials. MachroChem acknowledges that men suffered some discomfort in early tests, but says that has been remedied by applying the gel to a limited area. The drug has yet to break out of the development stage.

QUICK CUTS: NationsBank (NYSE: NB) fell $1 to $76 after yesterday agreeing to pay $6.75 million in fines for allegedly misleading customers. The company's securities unit, NationsSecurities Inc., will pay $4 million to settle charges by the SEC and $2 million under a National Association of Securities Dealers action, while NationsBank NA will pay $750,000 to settle charges brought by the Office of the Comptroller of the Currency... Other banks slid today on concerns of higher interest rates. BankAmerica (NYSE: BAC) dipped $1 15/16 to $84 9/16; Bank of New York (NYSE: BK) lost $1 1/4 to $58 5/16; Chase Manhattan (NYSE: CMB) shed $2 1/16 to $137; Citicorp (NYSE: CCI) was down $2 15/16 to $149 11/16; Mellon Bank (NYSE: MEL) slipped $1 1/8 to $69 7/8; and First Chicago NBD (NYSE: FCN) fell $1 5/8 to $91 1/2.

Bookseller Crown Books (Nasdaq: CRWN) sank $2 15/16 to $4 9/16 on news that it is trying to increase its borrowing ability and defer payments to stay in business. The company's majority owner, Dart Group (Nasdaq: DART), slipped $4 1/2 to $155 1/2... Outsourced telephone and Internet-based customer service company SITEL Corp. (NYSE: SWW) dropped $1 7/8 to $8 13/16 after reporting Q1 EPS of $0.03 (excluding charges), down from $0.10 for the prior-year period. BT Alex. Brown lowered its rating on the company to "market perform" from "buy"... Baan Co. (Nasdaq: BAANF) slid $5 5/8 to $42 5/8 after the software developer announced that new accounting rules could have "adverse" effects on earnings and revenue.

Apple Orthodontix (AMEX: AOI) plummeted $5 3/4 to $7 3/16 after the orthodontics practice management firm reported Q1 EPS of $0.10, short of analysts' expectations of $0.11. The company said its own earnings projections had been "aggressive"... Demand-chain management software company Industri-Matematik International (Nasdaq: IMIC) plunged $5 1/4 to $15 1/4 after announcing that it expects Q4 EPS of $0.03 to $0.05 per share, below analysts' mean estimate of $0.14, in part because of a shortfall in licensing revenues... Air delivery services company AirNet Systems (NYSE: ANS) was deflated $4 1/4 to $22 1/4 after announcing that it anticipates Q1 EPS will be 20% to 25% below analysts' estimates of $0.30.

Homebuilder M/I Schottenstein Homes (NYSE: MHO) fell $2 7/16 to $22 1/6 after announcing it will sell 1.2 million shares to Salomon Smith Barney for net proceeds of about $24.6 million... Compuware Corp. (Nasdaq: CPWR), which provides software and information technology services, dipped $2 5/8 to $45 1/4 after reporting Q4 EPS of $0.40 (before charges) compared with $0.25 a year ago, beating analysts' mean estimate of $0.36... Rehabilitation programs developer RehabCare Group (Nasdaq: RHBC) lost $3 1/4 to $28 1/4 after reporting the resignation of President and CEO James Usdan, effective June 1. Chief Financial Officer Alan Henderson will succeed Usdan. The company also announced Q1 EPS of $0.40 versus $0.31 (before $0.11 one-time gain) for the year-earlier period. The First Call mean estimate was $0.38.

Consumer services company Cendant (NYSE: CD) lost $1 to $25 after pre-announcing Q1 EPS of $0.26, exceeding analysts' mean estimate of $0.25. The company first said the results may be affected by the previously announced investigation into accounting irregularities, but then issued a statement clarifying that the Q1 results reflect the elimination of any potential historical accounting irregularities... Watch and jewelry retailer Little Switzerland (Nasdaq: LSVI) dropped $2 1/4 to $5 11/16 after announcing that its merger partner Destination Retail Holdings' financing commitment letters from DLJ Bridge Finance and Donaldson, Lufkin & Jenrette terminated on April 30, and Destination is continuing to work with DLJ to obtain the necessary financing to consummate their proposed merger.

Contract electronics manufacturer Sanmina Corp. (Nasdaq: SANM) shed $2 5/16 to $91 7/16 after Morgan Stanley Dean Witter cut its rating on the company to "outperform" from "strong buy," citing that the stock has already gained 38% this year... Recreational vehicle maker and seller Thor Industries (NYSE: THO) skidded $1 11/16 to $24 1/2 after announcing it will take an $820,000, or $0.06 per share, charge to write down assets at its General Coach unit... Homebuilder Kaufman & Broad Home (NYSE: KBH) lost $1 5/16 to $29 7/16 after announcing an offering of $150 million (plus an over-allotment option granted to the underwriters) of Feline Prides and capital securities.

Health insurance recovery services Healthcare Recoveries (Nasdaq: HCRI) fell $2 11/16 to $20 7/8 after reporting Q1 EPS of $0.18, up from $0.14 a year ago and ahead of the First Call mean estimate of $0.17... Oil and gas drilling equipment company UNIFAB International (Nasdaq: UFAB) was drilled for $2 5/16 to $20 15/16 after announcing plans to merge with Allen Tank Inc., which makes oil and gas processing systems at its facility in New Iberia, Louisiana.

An Investment Opinion
by Dale Wettlaufer

Amazon on My Mind

Rather than waiting a few months to talk about Amazon.com (Nasdaq: AMZN) after discussing it last Friday, I thought there would be no harm in talking about the company again today. This is obviously a controversial stock, judging by some of the intense emails I received. I think there are a few reasons for the intensity that people feel about the company's stock.

If It goes up quickly, its value isn't real. If you don't know a situation well, then you tend to be skeptical of a explosive rise in the stock price. Take K-tel International (Nasdaq: KTEL), for instance. I am guilty of being skeptical of the value of this stock, especially when the only analyst coverage out there capitalizes revenues that have nothing to do with the Internet, compares that valuation to the valuations of pure-play Internet companies, and then proclaims it as undervalued. K-tel might be a great company and could cash in huge on the Internet, but just hanging a shingle up on the Internet is not a guarantee of a darn thing. But K-tel's run shouldn't mean that an a priori judgment should be made that it's selling above intrinsic value. If one had perfect foresight on its future cash flows, then one could make a highly informed judgment on that.

Amazon.com sells a commodity. The reasoning that a company needs patent protection or high-margin products to do well is fallacious. Here's a list of names of companies selling commodity items that make their money from service and efficient capital management: Wal-Mart (NYSE: WMT), Home Depot (NYSE: HD), Kroger (NYSE: KR), Fred Meyer (NYSE: FMY), Costco (Nasdaq: COST), Dayton Hudson (NYSE: DH), Citibank (NYSE: CCI), Charles Schwab (NYSE: SCH), Dell (Nasdaq: DELL), Compaq (NYSE: CPQ), and GEICO, a subsidiary of Berkshire Hathaway (NYSE: BRK.A and BRK.B), all built brand names and shareholder returns not by selling proprietary things but by selling non-proprietary things better and cheaper than anyone else. Amazon.com doesn't need huge margins and huge barriers to entry to succeed.

This can be borne out in the most basic capital efficiency model, the DuPont ROE formula:

Leverage * asset turnover * net margins = ROE

Expressed mathematically, assets/equity * revenues/assets * net income/revenues. Canceling out the common numerators and denominators, this equation turns back into the familiar net income/shareholders' equity ratio that goes by the name "return on equity" (ROE). However, it is instructive to work through the various elements to see that asset turnover is many times more important than margins. Asset turnover is due to operating acumen, not inheriting killer intellectual property from previous management or operating a natural monopoly with lots of pricing power.

If you look at a bank such as Norwest (NYSE: NOB), its net margin is lower than other big banks and it carries lower leverage than the average large bank or financial services company. Its ability to generate super-normal returns on equity capital comes from its asset turnover, which is a good 35% higher than average. American Express (NYSE: AXP), despite having a great brand name, operates in a similar way. Its margins are extremely low compared to other financial services companies, and its leverage is low, too. But its ridiculously high asset turnover ratio allows it to generate extraordinary returns on equity capital.

Amazon.com is modeling itself this way. Its bricks-and-mortar competitors may be able to underprice them in the short run, but that would put their land-locked businesses in trouble, since the bricks and mortar part of Borders (NYSE: BGP) isn't a cash cow that can feed a cutthroat Internet price leader indefinitely. Borders, the mature company that people like to point to as a reasonable investment in comparison to Amazon, only turned free cash flow positive (considering working capital changes) last year, with approximately $3 million in free cash flow in 1996 and $34 million in free cash flow in 1997.

No one should be under the illusion that the bookselling business is attractive. It's not. No commodity business is an inherently attractive business. Neither is selling grills and duct tape, a la Wal-Mart, nor milk and rice, a la Kroger. There will always be room for very good operators, though, which is where people make a mistake on Amazon. This is taken as a ceterus paribus assumption by the Amazon.com bears out there, which is crazy. Strength in execution of a business plan on a daily basis can be the deciding factor in an investment. Wal-Mart kicked the daylights out of Kmart (NYSE: KM) on this count, and McDonald's (NYSE: MCD) Ray Kroc pounded all the other quick-serve restaurants in its growth phase. When you get to a mature size, the growth slows, sure, but if an investor been around for the ride to maturity, he can do well, especially if the company has been able to finance its growth internally or without excessive equity issuance.

The one part of my column the other day that rubbed a few people wrong was my use of "new age" accounting where I capitalized marketing outlays and charged off the capitalized asset over five years. The reason why this was done was not simply to show profits. Economic profits are in many cases distorted by Generally Accepted Accounting Principles anyway. The goal of the exercise was to look at the company's marketing expenditures as if they were capital expenditures. Since the company's capital expenditure needs are minimal by design, its capital allocation efforts elsewhere in the business are necessarily effected. While the company is in its immature hypergrowth phase, its marketing spending will naturally outstrip earnings. When and if it gets to maturity, its marketing spending will be oriented to maintaining its brand name presence.

In the interim, whether you want to expense all marketing immediately or capitalize those expenditures and charge them off over five years, the net free cash flow of the company doesn't change. The amortization expenses will be non-cash and the marketing spending would be looked at as capital expenditures. This should have been implicit in what I was saying, but assumptions can pave the road to hell when good intentions are taking the day off. In addition, the tangible shareholders' equity of the company would not change by capitalizing the marketing spending. The asset resulting from the capitalization would be totally intangible. Looking at economic profits as I spelled them out is not supposed to be an exercise in delusion and it's not supposed to mask real cash flow needs, it's supposed to be a management decision-making tool and a tool an investor can use to look at the progress of a hypergrowth company. Too many people get hung up on earnings as the final arbiter of a company's value.

Earnings are meant to portray the economics of a business and to represent a return to capital. However, earnings become distorted by various subjective management and GAAP adjustments. Cash flows hardly ever lie. So, only a delusional management would ignore cash flows and take as the only indicator of return to capital the methodology that I described the other day. The management that wants to think in a number of different ways about the economics of their business could step outside the box for a moment and look at their business in such a way and not be bothered by the hobgoblins of foolish (small "f") consistency and devotion to GAAP.


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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

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

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