Friday, January 29, 1999
DJIA 9332.82 +51.49 (+0.55%) S&P 500 1270.88 +5.51 (+0.44%) Nasdaq 2493.56 +16.22 (+0.65%) Russell 2000 424.96 +0.99 (+0.23%) 30-Year Bond 102 1/32 -5/32 5.12 Yield

An Investment Opinion
by Dale Wettlaufer

Momentum vs. "Value" Options

You know what's great about Federal Reserve Chairman Alan Greenspan? If you're a spinmeister, you can spin his obtuse public comments on almost any subject in almost any way. What if he says the U.S. economy is slowing? Well, if you're a stock market reporter, you can spin it either way. If the equity markets are up the next day, you can say the market moved up on the back of a possible easing of short-term interest rates. If the market is down the next day, you could say the market didn't like the outlook for corporate profits.

So how about yesterday's testimony before the Senate Budget Committee. If you work for Grant's Interest Rate Observer, you probably can't wait to spin the Chairman's comments on how ridiculous the Internet stocks are. In a Wall Street Journal article this morning, the spin is that Internet stocks are like a lottery, an analogy that Mr. Greenspan brought up yesterday: "What lottery managers have known for centuries is that you could get somebody to pay for a one-in-a-million shot more than the [pure economic] value of that chance." Juicy.

And, of course, there's Greenspan's sound bite on investing in Internet companies: "Is that investing?" The premise of the question being posed by a committee member was patently ridiculous though: "...one of the principal steps that the baby boomers are taking to plan for their retirement is to invest massively in the Internet stocks." That's like saying all the baby boomers were at Woodstock and all of them marched on Washington in the 1960s. It's a minority of people, and it's an absolutely wrongheaded notion that they are principally investing in Internet stocks.

But what about this lottery theory? CS First Boston analyst Michael Mauboussin wrote some very interesting things about this recently. "Standard finance theory say[s] that the greater the uncertainty, the higher the appropriate discount rate, and the lower the present value. Uncertainty, expressed as volatility, lowers value." Got it. Next: "Based on the widely used Black-Scholes model, option value is a function of the value of the underlying asset, a strike price, time, the risk-free rate and volatility. As options have asymmetric payoff schemes, volatility increases value." By asymmetric, he's talking about the fact that an option can only lose 100% of its value versus the possible increase in value in the thousands of percentage points.

"So an Internet company with lots of real options will be much more valuable than a standard discounted cash flow analysis would suggest. We believe it is reasonable to think of Internet companies as a combination of current, known businesses and a portfolio of real options. The question then becomes: who has the most options and what are they worth? Market signals analysis -- reading from stock prices what expectations are imbedded in shares can be helpful in this appraisal." As Mr. Greenspan said yesterday, most of these companies will do poorly. That's not unusual. Most publicly traded companies will be mediocre investments over their lifetime and by definition, half will be below average. Yes, the "options premiums" in Internet companies are high. However, the so-called "value investor" who scoffs at these companies is guilty of the same investing philosophy..

A price-to-book ratio of 1:1 and a low P/E makes some investors salivate. Many of these cigar butt-types of companies will never earn returns on their book value high enough to justify their multiple to book value. Many rightfully should be valued at a large discount to book value because most won't just liquidate and send the capital back to shareholders. They'll continue to fritter away year after year in the hope of the business becoming better. What you're getting when you buy these sorts of businesses is the net present value of the free cash flows (which would put them below book) plus an option that the company will either turn it around or liquidate the business (in which case you hope the assets are worth their book value). So the so-called value investors are buying the same sorts of options as the Internet investors at which they scoff with such alacrity. The day traders might be accused of being caught up in a mania by purchasing these options and realizing their value so quickly. I contend that many "value investors" do the same. It's just that their profit realization cycle is a little slower than that of the Internet traders.

Note: Many of Mauboussin's articles are available at the website he and BancBoston Robertson Stephenson analyst Paul Johnson (co-author of The Gorilla Game) use to disseminate materials for classes they teach at Columbia University. The URL is www.capatcolumbia.com .


Shaver maker Gillette (NYSE: G), which reported Q4 EPS of $0.39 -- $0.03 above last year's mark and even with analysts' projections -- lathered up $2 3/8 to $59 3/8 this morning. "Led by the MACH3 shaving system, which is exceeding our expectations," said CEO Alfred Zeien, Gillette expects "further progress throughout 1999 and targets a return to 15%-20% earnings-per-share growth in the second half."

Internet portal company Lycos Inc. (Nasdaq: LCOS) advanced $7 1/8 to $130 1/4 this morning as a company official told Reuters in an interview that it has held discussions with every major media company about alliances and is also considering acquiring several smaller companies to boost its presence. Attention has turned to Lycos now that Excite (Nasdaq: XCIT) linked with recent Duel subject @Home (Nasdaq: ATHM) last week and Yahoo! (Nasdaq: YHOO) plans to buy GeoCities (Nasdaq: GCTY).

Fiber-optic components and modules manufacturer Uniphase Corp. (Nasdaq: UNPH) added $8 5/8 to $89 3/8 after announcing plans to merge Canada-based competitor JDS Fitel in an all-stock deal valued at around $3.2 billion. For more on the deal that will create the biggest maker of parts for telecommunications fiber-optic equipment, return to today's Breakfast With the Fool.

Enterprise application testing company Mercury Interactive (Nasdaq: MERQ) rose $4 5/16 to $61 7/16 after turning Q4 EPS of $0.47, beating First Call's consensus estimate by $0.06 and crushing the year-ago $0.28 mark. The company also announced plans for a 2-for-1 stock split effective Feb. 26.

Online and TV-based specialty retailer Shop At Home (Nasdaq: SATH) bagged gains of $3 3/8 to $15 1/4 after announcing plans to unveil its Internet expansion strategy and partnerships on a live broadcast scheduled for Feb. 10. The broadcast, which will also include a second-quarter earnings report, will be made over various television services and will be simulcast on the Internet.

Chuck E. Cheese's pizza restaurants operator CEC Entertainment (NYSE: CEC) partied its way up $2 3/4 to $27 1/2 after saying Q4 EPS is expected to be $0.33, ahead of the year-ago $0.30 result and a penny above First Call's consensus estimate. The company most commonly associated with robot mice, whack-a-mole games, and pizza expects to open or acquire from franchisees about 25 stores in 1999.

Photography giant Eastman Kodak (NYSE: EK) snapped up $2 1/16 to $65 5/8 after Goldman, Sachs & Co. upgraded the stock to "trading buy" from "market outperform."

Next generation Internet video company FVC.COM (Nasdaq: FVCX), which reported Q4 EPS of $0.07 compared with a loss of $0.03 last year and Wall Street's estimated $0.04 profit, added $2 7/8 to $13 7/8 this morning. The company also said telecommunications equipment giant Lucent Technologies (NYSE: LU) agreed to resell the company's entire product line.

Men's and boy's sportswear maker Supreme International Corp. (Nasdaq: SUPI) stitched up gains of $1 5/8 to $16 after agreeing to buy privately held Perry Ellis International for about $75 million in stock. Supreme said Perry Ellis brands have about $900 million in annual sales.

Restoration Hardware (Nasdaq: RSTO) added $2 1/8 to $20 3/8 after NationsBanc Montgomery Securities boosted its rating on the stock to "buy" from "hold."

Biotech bellwether Amgen (Nasdaq: AMGN) gained $6 3/8 to $125 15/16 after posting Q4 EPS of $0.90, beating the year-ago $0.67 mark and Wall Street's $0.84 consensus projection. The company said it plans to split its stock 2-for-1 on Feb. 26.

Earnings Movers

AFLAC Inc. (NYSE: AFL) up $15/16 to $43 3/4; Q4 EPS $0.42 vs. $0.35 last year; estimate: $0.40

Anadigics (Nasdaq: ANAD) up $2 1/8 to $18 1/4; Q4 EPS loss of $0.01 (before charges) vs. profit of $0.30 last year; estimate: loss of $0.02

Collagen Aesthetics (Nasdaq: CGEN) up $4 1/4 to $14 1/8; fiscal Q2 EPS $0.27 vs. $0.23 last year; estimate: $0.24

Diamond Multimedia Systems (Nasdaq: DIMD) up $11/32 to $7 31/32; Q4 EPS: $0.15 (before charges) vs. $0.20 last year; estimate: $0.16

Digital River (Nasdaq: DRIV) up $3 3/4 to $54 1/2; Q4 EPS loss of $0.26 vs. loss of $0.16 last year; estimate: loss of $0.27

First Data Corp. (NYSE: FDC) up $2 3/16 to $38 5/16; Q4 EPS $0.48 vs. $0.45 last year; estimate: $0.48

Lam Research (Nasdaq: LRCX) up $4 7/16 to $36 3/4; Q4 EPS loss of $0.64 (before charges) vs. profit of $0.09 last year; estimate: loss of $0.94

LSI Logic (NYSE: LSI) up $1 3/4 to $26 1/2; Q4 EPS $0.05 (before gain) vs. $0.22 last year; estimate: loss of $0.03

Scientific-Atlanta (NYSE: SFA) up $1 1/16 to $31 1/6; fiscal Q2 EPS $0.16 (before gain) vs. $0.19 last year; estimate: $0.12

Veritas Software (Nasdaq: VRTS) up $2 1/8 to $81 5/8; Q4 EPS $0.24 vs. $0.12 last year; estimate: $0.21


Enterprise resource planning (ERP) software firm PeopleSoft (Nasdaq: PSFT) was trampled for a $3 3/8 loss to $19 1/16 after reporting Q4 EPS of $0.16 (excluding acquisition-related charges), flat with last year's results and a penny below the First Call mean estimate. The company said it is restructuring to compete better globally, which will result in the elimination of 430 jobs, or 6% of its workforce. Management expects revenues to increase 20% to 30% in fiscal 1999, with 20% to 25% year-on-year sales growth forecasted for Q1. Bear Sterns cut its rating to "neutral" from "buy."

Food and construction materials processing equipment maker Gencor Industries (AMEX: GX) was thrown for a $1 loss to $6 11/16 after canning both the chairman and CFO of its British Gencor ACP Ltd. unit after an internal investigation uncovered certain "improprieties" and the dreaded "accounting irregularities." The discoveries will force Gencor to reduce its previously reported fiscal 1998 EPS of $1.52 by as much as $0.35 to $0.50.

Enterprise network and data security software company Security Dynamics Technologies (Nasdaq: SDTI) dropped $4 3/8 to $20 9/16 after saying higher sales commission expenses from a higher-than-expected sales mix resulted in Q4 EPS of $0.08 (excluding charges), compared to $0.17 last year and missing the Zacks mean estimate of $0.12. Prudential Securities cut its rating this morning to "hold" from "accumulate."

Office furniture supplier Herman Miller (Nasdaq: MLHR) slid $5 13/16 to $18 3/16 after saying that order weakness in December and January will lead to fiscal Q3 earnings and revenues below expectations. The company forecasted Q1 EPS between $0.31 and $0.36 and fiscal 1999 EPS between $1.49 and $1.60, shy of the First Call mean estimates of $0.40 and $1.66, respectively. On the bright side, the firm said it will buy back an additional $100 million of shares on top of its current $120 million repurchase plan.

Online advertising software provider NetGravity (Nasdaq: NETG) fell $1 1/8 to $25 11/16 after reporting a Q4 loss of $0.20 per share compared to a loss of $0.88 per share last year, which was a penny worse than the loss expected by analysts surveyed by First Call. The company added that higher R&D and sales and marketing expenditures will result in quarterly operating losses through the first half of 2000, and a shift in its revenue mix toward lower margin outsourcing revenues will produce lower gross margins.

Streaming media aggregator Broadcast.com (Nasdaq: BCST) slipped $3 5/16 to $176 11/16 after posting a Q4 loss of $0.21 per share (excluding charges) versus a loss of $0.18 per share last year. The company also said it will acquire privately held NetRoadshow, a provider of Internet initial public offering and financial roadshow services, for $50 million in stock.

Utility holding company Wisconsin Energy Corp. (NYSE: WEC) was zapped for a $2 1/4 loss to $26 1/8 after saying unusually warm weather resulted in Q4 EPS of $0.45, up from the $0.18 (excluding charges) earned during the same period last year but short of the Zacks mean estimate of $0.56. Merrill Lynch cut its near-term and long-term ratings for the company this morning.

Cable TV operator Cablevision Systems (AMEX: CVC) was scrambled for a $2 13/16 loss to $67 11/16 after Salomon Smith Barney reduced its opinion of the company to "outperform" from "buy."

Bank holding company Republic New York Corp. (NYSE: RNB) slid $2 1/8 to $38 1/4 after announcing that Vice Chairman Robert Cohen resigned, effective immediately.

Medical diagnostic applications developer Cytyc Corp. (Nasdaq: CYTC) dropped $4 7/8 to $18 5/8 after NationsBanc Montgomery Securities cut its rating to "hold" from "buy," citing concerns that additional expenses will cut into near-term earnings.


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