Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

AOL, AMZN, TDFX Earnings
One of these stocks just doesn't fit

by Jeff Fischer (TMFJeff@aol.com)

Paris, France (Jan. 27, 1999) -- Amgen and our Internet monsters triumphantly lifted the Rule Breaker far above the crowd, and in the process the portfolio's historical return topped 1,000%. The S&P 500 over the same time: 183%.

America Online (NYSE: AOL) announced earnings that were instantly shot round the world over the Internet, talked about in chat rooms, posted on message boards, googled at with wonder, and echoed across cyberspace with the important beauty of mass bells ringing over an Italian countryside. Another record quarter saw AOL's membership grow by 1.6 million (which compares to Amazon adding 1.7 million customers in the same period, except Amazon customers don't become subscribers), lifting our company to 17 million members, 2 million of them at CompuServe.

Second quarter revenue soared 62% to $960 million (almost one billion in one quarter!), while net income reached $88 million and earnings per share of seventeen cents topped estimates by 21%, though that means nothing to a long-term investor. The company also announced yet another 2-for-1 stock split for February 22. This'll be the sixth split in the company's seven-year public history. (To learn about stock splits, visit our Foolish FAQs.)

High-margin ad and commerce revenue rose 66% to $181 million, a record, meaning that AOL could achieve almost $800 million in ad and commerce revenue this year, alongside about $4 billion in subscriber revenue. The company's press release is singing the praises of success; after we have time to digest it, we'll talk about it more. For now, the AOL message board is (as usual) the best place for active discussion. Beyond that, to listen to the company's conference, you can visit broadcast.com for the next 30 days, or dial 888-433-2208 tonight (for the next 48 hours).

What's next for AOL: keep growing, keep making money, and focus on high bandwidth solutions. What's next for the Rule Breaker Port and AOL: keep holding. No thoughts of anything else.

Amazon.com (Nasdaq: AMZN) is growing so quickly that it's embarrassing the old growth estimates that were put to paper. Those estimates have now fulfilled their early promise of standing forever in error. As of October 1998, a much respected (and rightfully so) analyst at SG Cowen Securities estimated revenue of $153 million for Amazon in the fourth quarter. At least he was correct on the 5 and the 3. Just change the 1 to a 2: $253 million. Fourth quarter sales have been known since early January, but the stock rose today on other vital numbers released yesterday with its official report: the company's margins and marketing expenses, customer account growth, cash flow, and news that first quarter sales should top the fourth quarter.

Let's talk impressive. All major booksellers -- as the Wise still call Amazon -- experience a downswing in first quarter sales from the holiday-bloated fourth quarter. Amazon didn't experience this last year, however, and it won't this year, either. Splendid! I was thinking about this in early December, believe it or not, while strolling down the street. I thought: the fourth quarter will be a blowout, and then the first quarter will be lower. No, wait. Maybe the first quarter will be higher just like last year. Why? Because so many people buy computers over the holidays. Yes, that could be. (I left it at that. Frightening to see into the mind of a simpleton, no? My next thought was: "Mmmm... apples," as I walked by a fruit stand.)

We'll run through the important factors listed above. First, the loss was lower than expected, at $0.14 cents per share. Therefore, estimates for Amazon are being raised and at least one analyst published an expected profit for the year 2000 today. (His guess is as good as anyone's.) In the fourth quarter, Amazon lost $17.8 million, or 7% of sales, compared to an $11.3 million loss last year, which was 17% of sales. In all of '98, the company lost $46 million on $610 million in sales. Given the current sales run-rate (last quarter multiplied by four), Amazon should easily surpass $1 billion in sales this year, well ahead of the common year 2001 estimate, and surpassing our hope, too, which was $1 billion in sales in the year 2000.

In the fourth quarter, the company registered 1.7 million new customers, while 64% of sales came from repeat buyers. Both numbers are important. One year ago Amazon had 1.5 million registered customers. Now it has 6.2 million. In the fourth quarter alone it added more customers than it had in total one year ago. And while adding customers, adding new business lines, and marketing itself sufficiently enough to be the largest online retailer in the world, Amazon was able to improve margins through economies of scale (the more people buying, the lower the fixed cost per purchase). Consider these numbers from 1998 compared to 1997.


                     1998   1997
Gross Margin         21.9%  19.4% (of sales)
Sales, market. exp.  21.8%  27.3%
Product Devel. exp.   7.6%   9.4% 
Gen, Admin. exp.      2.5%   4.7% 

The one figure that should rise (gross margin, which represents the company's revenue from sales after it covers the cost of the product it sold), rose, while the three that should decline, did. (In the next few years, sales and marketing expenses should decline all the way to about 10% of sales, product development to around 4%, and general and administrative to about 1.5% of sales.)

As for cash flow, Amazon achieved positive cash flow from operations in 1998 to the tune of $38 million. Free cash flow was $29 million. Today Dale Wettlaufer obtained the following cash flow figures from Amazon. Reading them shows how cash flow is obtained, but if you have questions about it, the best place to ask is on the Boring Portfolio message board, hosted by Dale and Alex Schay. Amazon's cash flow:

 
(Numbers in 000s)

Net income (-$46,427)
Adjustments

Depreciation $3,500
Goodwill amortization $24,000
Non cash interest expense $8,516
Inventories (-$9,729)
A/R ppds (-$6,379)
Deposits (-$87)
A/P $53,827
Accrued advertising $1,200
Other liabilities and accruals $10,400

Net cash flow from operations $38,821

Fixed assets investment (-$9500)

Free cash flow $29,321
Free cash flow counting interest expense as cash item $20,805

Let's propose a prediction that is already becoming quite true: Like AOL and Yahoo!, Amazon will become the next widely accepted Internet stock. Stop and think about that. It is amazing when you consider how quickly mass perception swings. One year ago, Amazon was the most commonly insulted stock on the market. It was in everyone's firing line. Amazon was the joke-of-a-bookseller, destined to have low margins and quickly lose to large competitors. When Amazon's valuation rose to twice that of Borders (NYSE: BGP) and Barnes & Noble (NYSE: BKS), the fact was incessantly cited as ludicrous. Have you noticed that nobody does that anymore now? No. Now all the bears have conveniently upped the ante: now they compare Amazon's price to the valuation of Sears or Wal-Mart.

There is wonderfully Foolish amusement to be gained from this evolution. The bears have basically admitted that if the shoe no longer fits, you throw it out and buy a larger one. They're admitting growth; they're admitting (without saying it) that they were wrong to compare Amazon to booksellers. Now they'll compare it to something larger: say, Sears. So when Amazon begins to sell electronic multimedia offerings, will the bears mock its valuation by comparing it to, say, Time Warner? Maybe. We certainly wouldn't mind! (Speaking of competing booksellers, Alex Schay wrote an excellent Boring Port column on Amazon and book-side competitors on Monday.)

Amazon begins 1999 with $375 million in cash and equivalents, a promise that first quarter sales should surpass fourth quarter's results, and the admittance that it will certainly enter at least one new business line this year, if not more. Amazon wants to offer the ideal shopping experience, not a specific product experience. In ten years it could be selling anything -- babies, if that were legal. To hear Amazon's fourth quarter conference call (it's great that the company has opened it to everyone), visit this page from broadcast.com.

Next for Amazon: keep growing, keep expanding, let economies of scale work for it (and buy more distribution centers to meet demand). Next for Rule Breaker and Amazon: keep holding. This is just getting interesting. And only beginning. (And at this valuation, you need our five year or longer outlook.)

3Dfx (Nasdaq: TDFX) remains an enigma. The company almost turned its five-cent per share earning estimate into 3D, reporting $0.13 per share, well above expectations. Yet the stock tumbled. Fourth quarter results for 1998 were two cents lower than earnings in '97, even though revenue grew 170% to $60 million. What's down? The company's gross margin fell to 36% from 48% last year because it's selling more low-end and less expensive product.

3Dfx now has $1.33 in trailing earnings per share, putting the $12 stock at a P/E of 9. Unfortunately, this isn't unusual for a small chip-related technology company. With $95 million in cash, however, the company has nearly $6 per share of value backed by green money, so how much lower can the stock go? Hmm. It trades at 19 times the earning estimate for 1999. To hear the company's conference call, dial 800-633-8284 (access code: 11550030) for 24 more hours.

What's next for us and 3Dfx? You tell us. Is 3Dfx still a Rule Breaker, or is it a Tweener (meaning, there are very viable alternatives to its products)? Share your thoughts on the Rule Breaker message board. Also related to Rule Breaking, today's Dueling Fools is on @Home (Nasdaq: ATHM). And finally, another special feature well worth your visit discusses Shareholder Rights.

One last note: Are you a wordsmith with financial savvy and Foolish to the core? The Fool is currently looking for a Financial Editor. There are other great Fool jobs posted, too. Pass the openings around to your friends.

Until tomorrow, Fool on!

01/27/99 Close
Stock  Change    Bid 
 ---------------- 
AMZN  +10 17/32  125.63
AMGN  +3 1/8  115.88
AOL   +7      162.00
T     -1 3/8   85.50
ATHM  +6 1/8  116.00
DJT   -  3/16   4.50
DD    -  3/4   53.13
XON   -1 3/8   71.00
IP    -1 15/16 40.88
IOM   -  1/16   7.13
LU    +2 1/16 111.63
SBUX  -2       48.88
TDFX  -2 1/4   12.75

 
                   Day   Month    Year  History  Annualized 
      R-BREAKER  +4.34%   9.98%   9.98% 1003.83%  70.94%
        S&P:     -0.73%   1.14%   1.14%  183.91%   26.23%
        NASDAQ:  -1.08%   9.78%   9.78%  234.24%   30.92%
 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    162.00    8812.36%
   9/9/97  1320 Amazon.com     6.58    125.63    1809.41%
  5/17/95  1960 Iomega Cor     1.28      7.13     456.46%
  10/1/96    84 LucentTech    23.81    111.63     368.85%
  8/12/96   130 AT&T          39.58     85.50     116.03%
  12/4/98   450 @Home Corp    56.08    116.00     106.85%
  4/30/97 -1170*Trump*         8.47      4.50      46.86%
 12/16/98   290 Amgen         85.75    115.88      35.13%
  2/20/98   200 Exxon         64.09     71.00      10.78%
  2/20/98   215 DuPont        59.83     53.13     -11.21%
   7/2/98   235 Starbucks     55.91     48.88     -12.58%
  2/20/98   270 Int'l Pape    47.69     40.88     -14.29%
   1/8/98   425 3Dfx          25.67     12.75     -50.33%

    Rec'd    #  Security     In At     Value      Change
   9/9/97  1320 Amazon.com  8684.60 165825.00  $157140.40
   8/5/94  1100 AmOnline    1999.47 178200.00  $176200.53
  12/4/98   450 @Home Corp 25236.13  52200.00   $26963.87
  5/17/95  1960 Iomega Cor  2509.60  13965.00   $11455.40
 12/16/98   290 Amgen      24867.50  33603.75    $8736.25
  10/1/96    84 LucentTech  1999.88   9376.50    $7376.62
  8/12/96   130 AT&T        5145.11  11115.00    $5969.89
  4/30/97 -1170*Trump*     -9908.50  -5265.00    $4643.50
  2/20/98   200 Exxon      12818.00  14200.00    $1382.00
  2/20/98   215 DuPont     12864.25  11421.88   -$1442.38
   7/2/98   235 Starbucks  13138.63  11485.63   -$1653.00
  2/20/98   270 Int'l Pape 12876.75  11036.25   -$1840.50
   1/8/98   425 3Dfx       10908.63   5418.75   -$5489.88

                              CASH  $39332.55
                             TOTAL $551915.30

</THE RULE BREAKER PORTFOLIO>

Are you a Foolish investor?
The Motley Fool Recommends... Check Out These Other Fool Products...

Subscriptions
Primers
Reports
Investing Tools
Books
Fool Gear

Rule Breaker Portfolio Reports
The nightly scoop on the Rule Breaker Portfolio, delivered straight to your e-mailbox. Get more info or order.
Industry Snapshot
New format! A stock idea, industry overview, top players, and financials -- every two weeks! Get more info or order.
Foolish Eight Stock Screen
Here at Last! Foolish Eight Stock Screen. Get more info or order.
Shop FoolMart!

Read More Rule Breaker Reports