<THE EVENING NEWS>
Thursday, April 29, 1999
DJIA 10878.38 +32.93 (+0.30%) S&P 500 1342.83 -8.08 (-0.60%) Nasdaq 2528.44 -21.93 (-0.86%) Russell 2000 432.85 -0.68 (-0.16%) 30-Year Bond 95 31/32 +25/32 5.53 Yield
Houston-based independent oil and gas exploration and production (E&P) company Apache Corp. (NYSE: APA) blew in for a $2 7/8 gain to $31 1/2 today after agreeing to buy 22 producing fields and 16 exploration leases in the Gulf of Mexico Shelf from Shell Exploration and Production for $715 million in cash and 1 million Apache shares. Based on Apache's closing price of $28 5/8 per share last night, the total consideration works out to $744 million. Management reportedly believes the deal will add "significantly" to earnings this year, which is good news for a company that has built absolutely zero shareholder value over the past three years. On the other end of the oilfield, the divestiture helps further streamline Shell and its parent Royal Dutch/Shell Group, which is cutting costs to remain competitive in an oil environment soon to be dominated by super-majors such as the proposed Exxon/Mobil and BP Amoco/Arco combinations.
Pharmaceutical contract research organization (CRO) Parexel International Corp. (Nasdaq: PRXL) jumped $3 15/16 to $23 1/4 after agreeing to be acquired by larger rival Covance (NYSE: CVD) in a stock swap valued at about $827 million, or $32.56 per share. Covance, which some believe may have overpaid for Parexel given the 69% premium implied by the purchase price, slumped $5 3/16 to $22 5/16. The deal builds Covance's business both horizontally and vertically, strengthening its existing pre-clinical trial business while adding much-needed medical launch, marketing, and education services to better compete with industry leader and drug services supermarket Quintiles Transnational (Nasdaq: QTRN). With combined trailing 12-month revenues of $1.1 billion, Covance Parexel will be on par with Quintiles. But comparing the new company's expected market cap of $2.5 billion with Quintiles' current valuation of $4.4 billion underscores the premium the market places on the probability that Quintiles will realize supra-industry growth rates by leveraging its breadth of service offerings.
QUICK TAKES: Computer Reseller News and Electronic Engineering Times publisher CMP Media (Nasdaq: CMPX) moved ahead $4 9/16 to $38 7/16 after British publisher, market research company, and PR Newswire operator United News & Media (Nasdaq: UNEWY) agreed to acquire the company for $39 per share, or $920 million in cash (excluding cash on hand). United News & Media rose $1 1/2 to $23 3/4... Wireless local area networking (LAN) technologies company Proxim Inc. (Nasdaq: PROX) was boosted $2 3/4 to $35 1/8 after chipmaker Intel (Nasdaq: INTC) said it will work with the company to develop wireless home networking products. Intel has also purchased 320,000 Proxim shares, which works out to a 2.9% stake... Truck maker Navistar (NYSE: NAV) rolled $4 1/4 higher to $53 1/4 thanks to a Goldman Sachs upgrade to "trading buy" from "market outperform."
Electronic manufacturing services (EMS) firm SCI Systems (NYSE: SCI) moved up $5 to $40 after posting fiscal Q1 EPS of $0.48, which was above the downwardly revised $0.45 expected by analysts surveyed by Zacks. The results seemed to quell some recent worries about the company's questionable business direction, as evidenced by at least five upgrades from brokerages today... Big Bertha golf clubs maker Callaway Golf Co. (NYSE: ELY) impressed the gallery with a $11/16 rise to $15 5/8 after posting Q1 EPS of $0.18, up from $0.16 a year ago and ahead of the Zacks mean estimate of $0.12... Cable set-top box maker Scientific-Atlanta (NYSE: SFA) gained $3 to $31 1/2 after reporting fiscal Q3 EPS of $0.25 (excluding gains), topping the First Call mean estimate of $0.19.
Composite-based materials and products maker Advanced Technical Products (Nasdaq: ATPX) climbed $3 to $13 after saying it has signed a memorandum of agreement with an unspecified third party regarding the sale of the company at a price of $13 per share in cash, which does not include an additional $3 per share payment contingent on earnings this year... Restaurant operator IHOP Inc. (Nasdaq: IHOP) leapt $3 3/16 to $47 after reporting Q1 EPS of $0.65 compared to $0.47 a year ago. The company, which was recently profiled in the Fool's Stocks for Mom feature, also set a two-for-one stock split... Aluminum producer Alcoa (NYSE: AA) gained $2 11/16 to $64 11/16 following an upgrade to "buy" from "hold" by CIBC Oppenheimer.
Enterprise software developer Computer Associates (NYSE: CA) added $2 7/16 to $42 3/8 ahead of saying after the close that its fiscal Q4 EPS will come in at $0.83, $0.02 ahead of the current Zacks mean estimate... Pepsi-Cola beverage bottler and distributor Pepsi Bottling Group (NYSE: PBG) advanced $1 1/16 to $21 11/16 after setting an initial quarterly dividend of $0.02 per share... Online live communities operator Mpath Interactive (Nasdaq: MPTH) jumped $32 5/8 to $50 5/8 on its first day of trading after selling 3.9 million shares in an initial public offering at a price of $18 per share... Secure e-commerce technologies provider VeriSign (Nasdaq: VRSN) moved up $6 3/4 to $110 after BancBoston Robertson Stephens raised its rating on the firm to "buy" from "long-term attractive" based on "strong" fundamentals and its relative valuation compared to other Internet infrastructure companies.
Applebee's International (Nasdaq: APPB) up $2 1/2 to $26 5/16; Q1 EPS: $0.44 (excluding charges) vs. $0.39 a year ago; estimate: $0.42
Furniture Brands International (NYSE: FBN) up $2 7/8 to $25 7/8; Q1 EPS: $0.52 vs. $0.40 last year; estimate: $0.49
Geon Co. (NYSE: GON) up $3 3/8 to $31 1/2; Q1 EPS: $0.50 (excluding charges) vs. $0.25 last year; estimate: $0.40
Hollywood Entertainment (Nasdaq: HLYW) up $1 3/4 to $25 3/4; Q1 EPS: $0.31 (excluding Reel.com results and charges) vs. $0.21 last year; estimate: $0.29
LCA-Vision (Nasdaq: LCAV) up $7/8 to $7 3/8; Q1 EPS: $0.04 vs. loss of $0.04 last year; estimate: $0.02
Reader's Digest Association (NYSE: RDA) up $1 1/2 to $34; fiscal Q3 EPS: $0.20 (excluding pension plan benefit) vs. $0.13 last year; estimate: $0.17
Service Corp. International (NYSE: SRV) up $1 11/16 to $21 3/16; Q1 EPS: $0.36 (excluding charges) vs. $0.42 last year; estimate: $0.35
Satellite systems designer Orbital Sciences Corp. (NYSE: ORB) veered off course today, losing $7 7/16, or 25.7%, to $21 1/2 after the company reported a first-quarter loss of $0.43 per share, missing Wall Street's projected $0.02 profit badly, in part because of disappointing results from the company's Orbcomm data and messaging joint venture. Only a small fraction of Orbcomm's subscribers have begun paying for the service, illustrating the distinction between contracts and actual revenue. "We expect significant losses to continue for at least several more quarters as we work to convert Orbcomm's growing backlog of orders into installed subscriber units and to add new customers to the network," said CEO and Chairman David Thompson, dealing a blow to Wall Street's hopes for a 1999 in the black. Orbital also said it let auditor KPMG go (KPMG had raised questions about the company's internal controls and prompted a recent restatement of past results). For more, the Fool's Alex Schay took a closer look at Orbital in the Boring Portfolio last February, beginning with this column.
Worries about slowing sales growth battered programmable logic chip maker Actel Corp.'s (Nasdaq: ACTL) shares today, as the company's stock gave up $5 13/16 to $13 5/16 on news of Q1 EPS that missed Street estimates by a penny at $0.19. Sequential revenue growth at Actel hasn't kept pace with that of competitors like Altera Corp. (Nasdaq: ALTR) and Xilinx (Nasdaq: XLNX). Although Actel President and CEO John East counseled patience, noting new product introductions slated for this quarter and later this year, those products probably won't generate significant revenue until sometime next year. In the meantime, Q1 sales of the company's field programmable gate arrays rose in unit terms, but the average selling price of each fell several percentage points off both Q4 and year-ago levels.
QUICK CUTS: Online services giant America Online (NYSE: AOL) lost $1 5/8 to $141 3/8 today on reports that AOL was to take a $250 million stake in radio station operator and outdoor advertiser Chancellor Media Corp. (Nasdaq: AMFM) that would result in online broadcasts of Chancellor's radio content. Chancellor got $1 7/16 to end up at $53 3/8... Pharmaceutical firm Pharmacia & Upjohn (NYSE: PNU) lost $1 13/16 to $55 1/2 on news of Q1 EPS of $0.42, flat with estimates. An FDA advisory panel reportedly recommended against approval of Freedox, a drug that combats stroke damage...
E-commerce snowball Amazon.com (Nasdaq: AMZN) lost $25 1/4 to $168 1/4 today on news of red ink to come. Call up today's Lunchtime News for an in-depth look by the Fool's Louis Corrigan... Mega-retailer Wal-Mart Stores (NYSE: WMT) shelved $2 5/16 to $46 7/8 following a downgrade to "hold" from "accumulate" by Prudential Securities analyst Wayne Hood. Hood also cut Lowe's (NYSE: LOW) to "hold" from "strong buy," sending the stock down $3 3/4 to $52 1/4... Shares of Tricon Global Restaurants (NYSE: YUM) gave up $1 to $65 after Jeffries & Co. lowered its rating on the stock to "accumulate" from "buy" because of difficult year-over-year sales and margin comparisons.
Semiconductor assembly equipment firm Kulicke & Soffa (Nasdaq: KLIC) softened $4 1/2 to $23 5/8 following news of a fiscal Q2 loss $0.06 per share narrower than projected, at a loss of $0.32 per share before one-time items. Other semiconductor equipment companies losing ground today included Applied Materials (Nasdaq: AMAT), off $2 5/16 to $51 7/8; Lam Research (Nasdaq: LRCX), down $1 3/8 to $31 3/8; Teradyne (Nasdaq: TER), which fell $4 11/16 to $49 5/16; and PRI Automation (Nasdaq: PRIA), a loser of $1 13/16 to $25 3/8... Traffic-control systems, industrial refrigeration equipment, and commercial cooling and cogeneration systems company Thermo Power Corp. (AMEX: THP) lost $9/16 to $11 5/8 following news that it is considering a $12 per share cash buyout offer from 78% owner Thermo Electron Corp. (NYSE: TMO). The price is a slight discount to yesterday's $12 3/16 close.
Document management software company Mobius Management Systems (Nasdaq: MOBI) lost $4 7/8 to $9 1/8. Last night, the company reported fiscal Q3 EPS of $0.07, better than last year's nickel profit but a penny below First Call's four-analyst consensus estimate... Electronic hardware and software design tools maker Mentor Graphics (Nasdaq: MENT) slumped $1 15/16 to $12 9/16 despite reporting Q1 EPS of $0.07 before charges, up from last year's breakeven result and $0.02 better than market projections. "We remain bullish on the state of our business,'' said CFO and COO Gregory Hinckley... Airfoil and turbine castings maker Precision Castparts Corp. (NYSE: PCP) lost $2 13/16 to $44 5/16 after Chairman and CEO William McCormick said, "the downturn in the aerospace cycle, the overall weakness in the petroleum-related industries, and the impact of the not-yet-recovered Asian economy will all exert downward pressure on the company's performance, particularly in the first half of the year."
Digital imaging and printing plate technologies firm Presstek (Nasdaq: PRST), which announced a Q1 loss of $0.10 per share, down from EPS of $0.07 last year, shed $1 9/16 to $8 today... X-ray systems marketer Hologic Inc. (Nasdaq: HOLX) gave up $1 to $7 7/8 after reporting a fiscal Q2 loss of $0.08 per share, down from last year's $0.20 per share profit and well off First Call's $0.19 consensus estimate of four analysts. Latin American sales and U.S. densitometry revenues were disappointing... Direct retailer Shop At Home (Nasdaq: SATH) ended down $1 9/16 to $13 5/16 after it said its shareholders approved plans to more than triple the number of authorized common shares to 100 million from 30 million. Just under 25 million shares are currently outstanding... Needle-free drug injection systems company Medi-Ject Corp. (Nasdaq: MEDJ) lost $1 3/8 to $5, giving back some of yesterday's $5 1/16 leap on news of FDA approval for over-the-counter sale of its Choice no-needle insulin injector.
Compuware Corp. (Nasdaq: CPWR) down $2 1/4 to $23 11/16; fiscal Q4 EPS $0.31 vs. $0.29 last year; estimate: $0.29
DSET Corp. (Nasdaq: DSET) down $2 3/8 to $11 7/8; Q1 EPS: $0.05 vs. $0.03 last year; estimate: $0.05
Global DirectMail Corp. (NYSE: GML) down $3 1/4 to $14 7/8; Q1 EPS: $0.30 vs. $0.34 last year; estimate: $0.30
NCS HealthCare (Nasdaq: NCSS) down $2 to $13; fiscal Q3 EPS $0.29 vs. $0.22 last year; estimate: $0.29
MCI WorldCom (Nasdaq: WCOM) down $3 13/16 to $83 7/8; Q1 EPS $0.37 vs. $0.10 last year; estimate: $0.34
Oxford Health Plans (Nasdaq: OXHP) down $1 1/8 to $19 5/8; Q1 EPS loss of $0.40 vs. loss of $0.37 last year; estimate: loss of $0.35
Tower Semiconductor Ltd. (Nasdaq: TSEMF) down $11/16 to $7 1/16; Q1 EPS: loss of $0.50 vs. loss of $0.11 last year; estimate: loss of $0.40
Unilever (NYSE: UN) down $3 3/16 to $66 9/16; Q1 EPS: $0.60 vs. $0.61 last year; estimate: $0.59
WellPoint Health Networks (NYSE: WLP) down $3 5/8 to $71 3/8; Q1 EPS: $1.04 vs. $0.95 last year; estimate: $1.04
The P/E and Bond Yields: A Valuation Conundrum
Warren Buffett has said that equities are bonds in drag. With one, the yield is known, because it's usually fixed and it's printed on the instrument or in the prospectus. With the other, starting invested capital (face amount of the bond, to identify the bond analog), price, and current return on invested capital (the bond's face yield) are known. Thus, you know the current earnings yield (earnings divided by price) of the equity. What you don't know is what the coupon (earnings) stream will look like in the future. To figure that out, there are a heck of a lot of variables to consider, but the one that always gets the most play in figuring out what a company is worth is the earnings yield (or, inverting back, the P/E).
Single-point valuation analysis, i.e. the "P/E ratio" is about the least effective way to look at a company. The reason why the Rule Maker approach to valuation makes sense is because it eschews single-point valuation metrics. They're really not informative at all on their own, and when you have the data necessary to give enough context to this data point, then it becomes pretty much unimportant alongside more informative data points. Price/book, price/sales, price/forward P/E really mean little if you don't have data on margins, capital turns, cash conversion cycle, the plan for the company's capital buildout, and some idea of how much resources the company will need to grow its earnings by the ubiquitous "15% consensus EPS growth rate" that seems to be the equivalent of "I don't know" when you poll people on the company's forward plan. It's massively important to look at the income statement in relation to the balance sheet and cash flow statement in figuring out what today's P/E or earnings yield means.
The yield on invested capital is a constant condition for a bond. It's the face yield on the bond. A 6% $1,000 bond is going to pay $60 per year for the duration of the bond, assuming it doesn't get called or converted. Out to the maturity of a fixed coupon bond, that doesn't change. The only thing that's going to change the value of the bond, assuming its credit quality doesn't change and there are no weird call features, is prevailing interest rates. That changes the yield to maturity of an equity, too, because it changes the company's cost of capital and the discount rate used to deflate the future earnings stream to a present value, and it can also effect the amount of future cash flows the company can generate.
If you're paying 4.5 times invested capital and the company returns 14% on invested capital, then your current modified earnings yield (I'm calling it modified because it's not quite earnings divided by price because the common factors don't cancel each other out if you divide the one ratio by the other) is 14% divided by 4.5 = 3.1%.
If you pay par for a bond that has a face yield of 6%, then you're paying one times invested capital for an instrument yielding 6% on invested capital. Ignoring for purposes of simplicity the tax issues (which are, I caution, substantial), the Bore ratio on that would be 6% divided by 1 = 6%.
On the initial capital outlay -- the price the investor pays for that interest in the company -- the current yield can be low, just as if you're buying a 9% bond in a 6% interest rate environment. With equities, however, your return on incremental capital can be huge multiples of the return on capital that you're getting on your initial outlay. If you're investing in a company with a 40% return on capital and good growth prospects, you'll likely be paying around 10 times or more the amount of capital currently invested in the business. That would put your current modified earnings yield at 4%.
But the reinvested earnings, or coupon income in this example, is being reinvested in new capital projects (or new bonds, to round out the comparison), at par, that yield 40%. If you run that out over a long period of time, then you can pay a big multiple of earnings today and still show supernormal returns on your initial investment. Think of it this way: In an 8% interest rate environment, you would jump at the change to buy a special 5% bond that gave you the right to reinvest that coupon income at par in bonds of equal quality that paid a face rate of 40%.
One reason many value investors won't invest in the most dynamic enterprises today is due to their unwillingness to pay above certain arbitrary multiples to earnings or book value. The reason why the Rule Maker portfolio makes sense in many ways is because Tom Gardner and the guys that run it are very cheerfully optimistic about the future. They figure these globally dominant companies can keep on pouring on the capital and generating huge returns on capital. If you have a company growing invested capital at 25% per year for 30 years and returning 25% on invested capital, you can pay huge multiples to earnings or capital today and do very well over that holding period. Value investors by nature feel uncomfortable forecasting those growth rates, because they often don't happen. It is uncommon, but the whole point of the Rule Maker approach is to narrow your investment universe down to the companies that have the best chance of making that happen.
But it doesn't mean that sort of growth doesn't happen. It has and it does. The value investor wants a margin of safety, however. The goal of the value investor, though, shouldn't be to purposely underestimate what a company can realistically do, just as no "investor" should purposely overestimate what a company can do and then attach a big discount rate to that to compensate for over-enthusiasm.
The goal of investors should be to develop the best guess possible as to what a company can do going forward and then attach whatever hurdle rates they feel match their requirements. With a company like Wal-Mart, you would have been called insane by your colleagues if your 20-year model of the company in 1970 forecasted exactly what the company did do over the ensuing 20 years. But you could have discounted your cash flows at 20% per year and still have derived a huge multiple to 1970's market price as your intrinsic value.
So again, this points out that you can't really tell what the heck a company is about by just looking at the P/E. You've got to have some sort of return on equity, return on net assets, or return on invested capital information, as well as a forecast of a capital buildout plan, to really have an idea of how to value something. Just as in valuing a bond, you need to know how much capital is being used, the yield on that capital, and your own hurdle rate for discounting that to the present. Looking at just P/E without considering what the company can do in the future, specifically, is like looking at a bond's current yield without having any idea what interest rates are today, what they will be tomorrow, and what the coupon income from that bond will look like until maturity. It's impossible to value a bond that way, so I don't know why people try it with equities.
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