Friday, June 18, 1999
DJIA 10833.08 -8.55 (-0.08%) S&P 500 1337.68 -2.22 (-0.17%) Nasdaq 2542.09 -2.06 (-0.08%) Russell 2000 445.11 +1.73 (+0.39%) 30-Year Bond 90 6/32 unch 5.96 Yield

An Investment Opinion
by Matt Richey

Has Gillette Lost Its Edge?

Last night, for the second quarter in a row and the third time in the past year, Gillette (NYSE: G) issued an earnings warning after market close. Today, the company's stock is taking a big hit, off $5 at $42 5/16. The company blamed softer sales of Braun appliances, stationery products, and toiletries, as well as continued weakness in overseas markets. Back in April, the company preannounced lower-than-expected first quarter earnings and issued the same set of excuses. At the time, the company stated that it was on track to return to 15% - 20% earnings-per-share (EPS) growth by the second half of this year. Apparently, that's not going to happen. Yesterday's statement avoided any specific numerical guidance, only saying that the company expects a return to "traditional sales and profit growth rates by the end of 1999."

That's bad news. Traditional growth rates are no longer stellar for this former Wall Street darling. Over the past five years, sales growth has averaged 13.2%, with average EPS growth not much better at 14.6%. For years, Gillette has guided analysts towards long-term average EPS growth of 17%. With yesterday's announcement, Wall Street is coming to the reality that that level of growth simply is not achievable, at least not for the foreseeable future.

Gillette's modest growth would not be nearly so painful, except that the company has been investing very heavily for the past several years in an attempt to create growth. Looking at the company's balance sheet, invested capital has expanded at an 8.2% annual rate since 1996, but sales have grown at only a 1.8% rate over that same period. Translation: the company is pouring money down the drain in its efforts to chase growth. The company's cash flow statement reveals the damage. From 1996 to 1998, the company generated total free cash flow of only $769 million, on total net income of $3,457 million. With only 22% of net income turning into free cash that can be distributed to shareholders, Gillette is proving to be anything but a cash cow.

The problem is lagging worldwide demand for expensive, albeit state-of-the-art, razors and toothbrushes. Gillette invested over $700 million in the development of its Mach3 shaving system. It's a very good razor, but not overwhelmingly better than the former top-of-the-line SensorExcel and Sensor. The same can be said for the $5 Oral-B CrossAction toothbrush. Consumers simply are not finding enough product advantages to justify the higher prices for these products. And that's the opinion of a relatively affluent American. I doubt that consumers in suffering overseas economies are taking too well to Gillette's fancy lavatory gear.

Opinions of Gillette's product strategy aside, the company's balance sheet is showing serious weakness. In the company's first quarter, receivables and inventories were on the rise, even as sales were declining. That is not a good sign. Having cash tied up in inventory and receivables prevents it from being put to more productive uses elsewhere. Overall, the company's cash conversion cycle (the time it takes for cash to move thru the entire product cycle) rose from 229 days to 274 days -- a nearly 20% increase. Also troublesome is the rapid accumulation of debt. Over the past year, net debt (debt minus cash) has grown from less than $2 billion to over $3 billion. Some of this additional debt has been used to repurchase shares in a desperate attempt to boost EPS by reducing the "S" in the denominator.

Until this company begins using its cash more productively, an investor should exercise caution. Gillette has a great daily repeat-purchase business model, but at 32x estimated fiscal 1999 earnings, the shares are not yet cheap.


Desktop publishing software developer Adobe Systems (Nasdaq: ADBE) picked up $5 3/8 to $79 1/4 after posting fiscal Q2 EPS of $0.70, up from $0.41 last year and a nickel better than Wall Street's mean estimate. "There is positive momentum for the remainder of the year with a strong product release cycle ahead of us," Chairman and CEO John Warnock said. The company also announced version 5.5 of its Photoshop image editing program last night.

Fiber optic network operator Qwest Communications (Nasdaq: QWST) voyaged $1 1/4 higher to $37 1/4 after local and long-distance phone company Frontier Corp. (NYSE: FRO) said it will "take no action... at this time" regarding Qwest's unsolicited dual bid for Frontier and Baby Bell US WEST (NYSE: USW). In a statement, Frontier CEO Joseph Clayton said he is determined to move Frontier's proposed merger with Global Crossing (Nasdaq: GBLX) "toward a prompt closing."

Disk drive maker Quantum Corp. (Nasdaq: QNTM) leapt $1 7/16 to $23 7/16 following a Prudential Securities upgrade to "strong buy" from "hold." The brokerage firm's 12-month price target for Quantum's shares is $35 per share.

Department store operator Kmart Corp. (NYSE: KM) marched up $1 5/8 to $16 13/16 after Business Week's "Inside Wall Street" column speculated that the company may be acquired by a big supermarket chain such as Kroger (NYSE: KR) or Safeway (NYSE: SWY) in order to counter the grocery threat posed by Wal-Mart (NYSE: WMT). Internet business services company Rare Medium (Nasdaq: RRRR) also rose $7/8 to $13 13/6 and fire and ambulance services company Rural/Metro (Nasdaq: RURL) added $1 1/16 to $9 3/16 after both firms received favorable ink from the magazine.

Network infrastructure management software developer Micromuse (Nasdaq: MUSE) tacked on $5 to $49 3/8 after CE Unterberg Towbin started coverage of the firm with a "buy" rating. Credit Suisse First Boston also reiterated its "strong buy" rating and raised its price target for the company to $70 per share from $38 per share.

Pickup truck bedliners and rollback car carriers maker Durakon Industries (Nasdaq: DRKN) jumped $3 9/16 to $15 5/8 after agreeing to be acquired by private investment fund Littlejohn & Co. Littlejohn will launch a cash tender offer for the company's shares at a price of $16 per share, or a 33% premium to Durakon's closing price of $12 1/16 per share yesterday.

Farm equipment maker Deere & Co. (NYSE: DE) harvested a $2 1/16 gain to $40 5/8 following a J.P. Morgan upgrade to "buy" from "market perform." Fellow agricultural machinery maker Agco Corp. (NYSE: AG) received an identical upgrade and rose $15/16 to $11 9/16.

Office furniture maker Steelcase (NYSE: SCS) advanced $7/8 to $17 5/16 after reporting fiscal Q1 EPS of $0.37, up from $0.35 a year ago and ahead of the First Call mean estimate of $0.30. Consolidated net sales were up 2.9% to $691.8 million, thanks to a 3.4% increase in domestic sales.

Truckload carrier Covenant Transport (Nasdaq: CVTI) rolled $1 1/4 higher to $14 after saying strong demand and "exceptional" equipment utilization rates will result in Q2 earnings $0.03 to $0.05 per share higher than the current First Call mean estimate of $0.36 per share.


Chipmaker Intel (NYSE: INTC) retreated $3 to $55 after Morgan Stanley analyst Mark Edelstone cut his rating on the stock to "market outperform" from "strong buy." "Based on potential earnings and competitive risks," the company said in a note about Edelstone's downgrade, "it appears that technical issues will cause the company to delay introduction of 0.18-micron versions of its Pentium III microprocessors (MPUs). This is likely to lead to a lower-than-expected average selling price for Intel's overall MPU portfolio.... Still," read the note, "Mark believes that Intel remains undervalued."

Specialty retailer Wet Seal (Nasdaq: WTSLA), a recent Foolish Double, found some trouble this morning. The company slipped $1 1/4 to $25 1/8 after it said same-store sales for fiscal Q2 to date -- the period ends July 31 -- are down in the mid-single digit range. While the company has seen better sales trends in recent weeks in all of its markets except California and Florida, if current conditions prevail quarterly EPS could end up closer to last year's $0.35 than to First Call's $0.44 four-analyst estimate.

Enterprise resource planning (ERP) systems implementation consultant DA Consulting Group (Nasdaq: DACG), which said this morning it expects Q2 EPS between break-even and $0.02, lost $3 to $5 3/4. Three analysts surveyed by First Call were looking for EPS of $0.23, up from $0.16 last year. "Projects that we expected to begin this quarter have been delayed, in some cases until next year," said Chairman and CEO Nicholas Marriner. "We are currently examining cost control measures in an effort to properly align our costs with expected revenue generation.''

Music, video, and DVD distributor Valley Media Inc. (Nasdaq: VMIX) fell $5 1/2 to $16 1/4 after it said it expects to report a per share loss of between $0.08 and $0.10 for fiscal Q1. Two analysts surveyed by First Call were looking for EPS of $0.02. The company is incurring unexpected expenses in connection with the move of its distribution facility, said CEO Rob Cain.

Information technology consulting firm Cotelligent Group (NYSE: CGZ) was dumbed down $2 1/8 to $6 3/8 after saying it expects to report a net loss for fiscal Q1 of between $15 and $20 million after pre-tax writedown of goodwill of $20 million. Wall Street was expecting EPS of $0.30. The company reported a broad-based downturn in demand that was especially pronounced in the financial services sector.

Financial services holding company and online discount broker National Discount Brokers (NYSE: NDB) moved back $2 13/16 to $37 1/8 this morning. The company said it decided not to withdraw a registration statement for the sale of 2.6 million shares of company stock. The new shares would boost the total outstanding by about 19%.

Golfing apparel maker Cutter & Buck Inc. (Nasdaq: CBUK), which said it plans to sell 1.7 million shares to the public -- an approximately 20% jump that will boost the total outstanding to nearly 10 million -- sliced off $3 1/4 to $17 3/8 today. The company reported full fiscal year EPS of $0.98 today, up from $0.72 last year and a nickel better than expected by Wall Street.

Electrical power distribution devices maker Woodhead Industries (Nasdaq: WDHD) lost $1 5/8 to $12 1/8 after it said last night it expects fiscal Q3 EPS of between $0.18 and $0.21. Four analysts gave First Call a $0.28 consensus projection. Chairman and CEO C. Mark DeWinter noted a laundry list of problems with sales slow across the company's divisions, both domestically and in Europe.

Online lottery services company GTECH Corp. (NYSE: GTK) paid out $1 9/16 to $24 on news that the New York State Lottery went with another vendor for a two-year contract for instant ticket telemarketing and distribution services. That had been GTECH's territory since 1994. The company's instant ticket services contract ends in January, but it expects to continue providing the New York State Lottery with online products and services through February of 2002.

Entertainment and consumer products developer and marketer K-tel International Inc. (Nasdaq: KTEL) returned $1 1/16 to $7 7/16 this morning. The stock moved up $2 9/16 yesterday on news that it signed a series of distribution agreements for its online store.


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