Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

Ah, Iomega!

By Louis Corrigan (TMFSeymor@aol.com)

ATLANTA, GA (Jan. 22, 1999) -- While speculation in Internet stocks, especially the no-name wannabes, leaves Fools uneasy, I have to applaud the way the folks involved in all of the Internet names thumbed their noses today at Barton Biggs, Morgan Stanley's chief global strategist. Internet stocks sagged yesterday after Biggs declared that the bubble was about to burst. Yet, Biggs has been so wrong about the U.S. stock market the last two years (see the Fortune section of our Eyes on the Press feature), investors now seem convinced that he's a wonderful contrary indicator. When Biggs talks up gloom and doom, it's time to buy!

Well, maybe not, but the Rule Breaker's main Internet holdings pretty much reflected that sentiment. Though America Online (NYSE: AOL) lost fifty cents to $140 1/2, Amazon (Nasdaq: AMZN) rebounded $17 to $123 and @Home Corp. (Nasdaq: ATHM) edged up $3 5/8 to $101, partly on news the company may acquire AT&T's (NYSE: T) WorldNet Internet dial-up service. Add in a $4 5/8 gain from Amgen (Nasdaq: AMGN), and the Rule Breaker rose 4.1%, versus slight declines in the S&P and the Naz, despite post-earnings-release declines from Lucent (NYSE: LU), Starbucks (Nasdaq: SBUX), and Iomega (NYSE: IOM).

Ah, Iomega! If it's not one thing, it's another. The news last night from this little engine that once could was pretty mixed. The disappointment was reflected in today's $1 13/16 drop to $8 1/16. Investors had been hoping to see some momentum, but it appears that any turnaround at the world's top removable storage maker will simply take longer.

First, the good news. While Q4 revenue declined 8% to $501 million from $547 million last year and earnings fell to $19 million, or $0.07 per share, versus $36.1 million, or $0.13 per share, the company did beat the consensus earnings estimate of $0.05 per share. For the first quarter all year, Iomega turned a profit.

Better yet, cash flow of $106 million was strongly positive, as promised, boosting the firm's cash position to $90.3 million from $45.6 million at the end of Q3. A $25 million tax refund contributed to the strong number, but Iomega is also managing its assets better, with days sales outstanding (DSOs) dropping to 42 from 46 a year ago and 52 at the end of Q3. Days payable remained flat.

Sequentially, inventories declined 16% to $165.1 million despite a 28% increase in sales. Annualized inventory turns doubled from a year ago to 8.8, up from 6.2 in Q3, thanks to process improvements such as continuous flow manufacturing, just in time delivery, and all the other catch phrases associated with the "virtual enterprise model." With its new Oracle (Nasdaq: ORCL) system and the addition of i2's (Nasdaq: ITWO) logistics software, Iomega expects continued improvements in inventory turns. Also, the Sigma Six program seems to be improving quality as new CEO Jodie Glore said today that the return rate for faulty Zip and Jaz drives has been cut in half since last year.

Three months ago, Iomega projected a business model reflecting increased OEM sales: gross margins in the mid to upper 20% range; sales, general and administrative expenses (SGA) in the mid to upper teens; R&D around 3% to 5% of sales; and net margins in the mid-single digits. That's still the model.


As a percent of sales  Q4 '98  Q4 '97  Q3 '98
Gross Margins           27.7%   33.4%   22.4%
SGA                     16.2%   19.0%   18.5%
R&D                      4.8%    4.3%    6.1%
Net                      3.8%    6.6%     N/A

The year-over-year decline in gross margins resulted largely from price reductions and the fact that 59% of Zip drives went to OEMs versus 34% in the year-ago period. The sequential increase in gross margins resulted partly from reductions in production costs for both Zip and Jaz, and the introduction of higher-margin Zip USB and 250 MB drives.

Crucial to Iomega's razor/blade model, disk unit shipments looked pretty great, rising 47% from last year for both Zip and Jaz. (Meanwhile, Zip drive unit sales jumped 26% but Jaz drive unit sales dipped 7%). The company now has sold over 21 million Zip drives, with a total Zip and Jaz installed base of more than 23 million. In mid-December, Iomega announced it had shipped over 125 million Zip disks sold, suggesting a tie ratio around 6, roughly in line with what investors had predicted three years ago.

In a report released yesterday, research firm International Data Corp. figured that, including sales by Iomega's partners NEC and MCI, a total of 9.9 million Zip drives were shipped in 1998. So Zip claimed a 86.2% share of the "low end removable magnetic market." Unit shipments in the overall market shot up 55% to 12 million, but with falling prices, revenue increased only 4% to $707 million. Meanwhile, high end magnetic storage unit sales increased just 18% last year (down from a 34% increase in 1997) to 1.6 million units. Jaz's market share rose only slightly to 61%, partly because SyQuest's (Nasdaq: SYQT) market share shot up to 37% from 29% in 1997. Still, if Iomega's planned buyout of SyQuest's intellectual property rights and manufacturing facilities clears, Iomega will simply own this niche.

Iomega also rolled out its long-expected 40 MB Clik! drive for digital cameras in mid-December. Glore announced yesterday that the company's just started shipping the Clik! for mobile computers and the Clik! Plus, which can be used for both cameras and PCs. The market opportunities here are presumably vast, but Glore didn't have much flavor to offer on sales.

Perhaps the most important news was Iomega's move to embrace a functional organization built on unified sales, marketing, and research units rather than the current structure built around product units. The move is expected to cut costs by eliminating institutionalized redundancies; boost topline growth by fostering cross-selling in the sales channels; and improve operating processes.

As the strong unit growth but lame revenue growth in the overall low end storage market suggests, Iomega simply has to cut costs and find more growth if the company is to deliver the results shareowners expect. While some, including Jim Porter of industry newsletter DiskTrend, have expressed skepticism about this reorganization, it certainly suggests Glore's determination to make major changes if necessary.

The negatives must begin with the departure of Ted Briscoe, president of the Zip team, and Fred Forsyth, head of the Jaz team. Glore said these guys didn't like their potential new roles within the reorganized company so they said adios (though it sounds like Briscoe will stick around in some consulting role). While new CEOs often instigate management shakeups, the departure of Briscoe in particular left Emerald Research's Joseph Besecker sounding rather shell-shocked on last night's conference call. Perhaps justifiably so. In the last year, we've seen the departure of Iomega's CEO, its CFO (no replacement yet), and the heads of its two major operating units. Iomega's pretty much turned over its entire top management team.

Negative #2: The seasonally slow second quarter should produce roughly breakeven results, missing the $0.04 per share consensus estimate. For a company looking to get right with analysts and investors, that's a disappointment. One problem is that the organization will be restructuring this quarter, which can create some "hiccups." Also, despite apparently strong demand for the higher margin 250 MB Zip, Iomega is suffering from supply constraints that won't be fully resolved until the end of Q1. The new Clik! is also experiencing a component shortage resulting from a "supplier issue" that will keep the new product on back order for several more weeks. Ramping new products is always a challenge, but these problems don't quite jibe with the image of the new, more efficient Iomega.

Negative #3: Neither do the higher-than-plan channel inventory figures: 9 weeks for Zip drives, 10 weeks for Zip disks, 8 weeks for Jaz drives, and 10 weeks for Jaz disks. Yikes! Iomega recognizes revenue only on 30 days worth of channel inventory. Anything above that won't get recorded as revenue until later. The advantage of shipping what's essentially excess inventory into the channel is that customers still pay Iomega for it on normal terms (assuming they requested it, which they supposedly did). So Iomega can turn product into cash faster than would otherwise be the case if the stuff were just sitting in its warehouses. Still, there ain't nothing "build-to-order" about 10 weeks of channel inventory. One question worth asking is how the channel inventory might have boosted cash flow for the quarter.

On balance, the Q4 results were solid, but the announced organizational changes and forward guidance left the future looking a little murkier than bulls had expected. Also, Glore didn't make an overwhelming impression, despite his obvious commitment to continue Iomega's new emphasis on asset management and operating improvements initiated by former interim CEO James Sierk. But he's only been on the job for three months, so shareowners perhaps should cut him some slack until he's had a chance to get fully up to speed on the business.

What it comes down to is that the Iomega market share story has played out pretty much as expected despite inroads lately, mainly by Imation's (NYSE: IMN) SuperDisk. Yet falling costs per megabyte throughout the storage market has pressured Iomega's margins. Assuming FY99 revenue picks up to $2 billion from $1.69 billion in FY98 and the company delivers net profits between 4% and 6%, we're looking at earnings per share in the $0.28 to $0.43 range. Iomega probably needs to hit the higher end of that range just to justify the current share price.

One impressive side note is that over 4,000 investors listened to Iomega's Thursday evening conference call live over the Internet via Vcall.com. Obviously, Iomega has a powerful online following among individual investors. Still, that's an amazing response and really gives the lie to the notion bandied about by even some large tech companies that there isn't demand for webcasts of conference calls. We have to salute Iomega for helping to lead the way.

If you missed last night's call, you can access it by dialing 800-446-4927. Or go to vcall.com, where you will find the conference call as well as a follow-up interview today with Iomega's Glore.

01/22/99 Close
Stock  Change    Bid 
 ---------------- 
AMZN  +17     123.00
AMGN  +4 5/8  114.63
AOL   -  1/2  140.50
T     +  1/16  88.31
ATHM  +3 5/8  101.00
DJT   -  1/4    4.75
DD    +  1/16  54.31
XON   +  1/4   71.38
IP    -1 5/16  41.00
IOM   -1 13/16  8.06
LU    -3 1/2  103.50
SBUX  -2 11/16 50.06
TDFX  -  1/32  13.34

 
                   Day   Month    Year  History  Annualized 
      R-BREAKER  +4.08%   3.58%   3.58%  939.62%   68.94%
        S&P:     -0.78%  -0.30%  -0.30%  180.06%   25.94%
        NASDAQ:  -0.25%   6.67%   6.67%  224.76%   30.19%
 Note:  Yearly, historical and annualized returns for the 
S&P include dividends

    Rec'd    #  Security     In At       Now      Change
   8/5/94  1100 AmOnline       1.82    140.50    7629.55%
   9/9/97  1320 Amazon.com     6.58    123.00    1769.52%
  5/17/95  1960 Iomega Cor     1.28      8.06     529.68%
  10/1/96    84 LucentTech    23.81    103.50     334.73%
  8/12/96   130 AT&T          39.58     88.31     123.14%
  12/4/98   450 @Home Corp    56.08    101.00      80.10%
  4/30/97 -1170*Trump*         8.47      4.75      43.91%
 12/16/98   290 Amgen         85.75    114.63      33.67%
  2/20/98   200 Exxon         64.09     71.38      11.37%
  2/20/98   215 DuPont        59.83     54.31      -9.23%
   7/2/98   235 Starbucks     55.91     50.06     -10.46%
  2/20/98   270 Int'l Pape    47.69     41.00     -14.03%
   1/8/98   425 3Dfx          25.67     13.34     -48.01%

    Rec'd    #  Security     In At     Value      Change
   9/9/97  1320 Amazon.com  8684.60 162360.00  $153675.40
   8/5/94  1100 AmOnline    1999.47 154550.00  $152550.53
  12/4/98   450 @Home Corp 25236.13  45450.00   $20213.87
  5/17/95  1960 Iomega Cor  2509.60  15802.50   $13292.90
 12/16/98   290 Amgen      24867.50  33241.25    $8373.75
  10/1/96    84 LucentTech  1999.88   8694.00    $6694.12
  8/12/96   130 AT&T        5145.11  11480.63    $6335.52
  4/30/97 -1170*Trump*     -9908.50  -5557.50    $4351.00
  2/20/98   200 Exxon      12818.00  14275.00    $1457.00
  2/20/98   215 DuPont     12864.25  11677.19   -$1187.06
   7/2/98   235 Starbucks  13138.63  11764.69   -$1373.94
  2/20/98   270 Int'l Pape 12876.75  11070.00   -$1806.75
   1/8/98   425 3Dfx       10908.63   5671.09   -$5237.53

                              CASH  $39332.55
                             TOTAL $519811.39

</THE RULE BREAKER PORTFOLIO>

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