Rule Breaker Portfolio

<THE RULE BREAKER PORTFOLIO>

Grading Earnings
...and you've got upgrades

by Paul Larson (TMFParlay@aol.com)

Chicago, IL (Jan. 29, 1999) -- The Rule Breaker Portfolio, with its ever volatile components, went the opposite way of the market today, largely thanks to Amazon (Nasdaq: AMZN) dropping about six bucks. Let's see just where the portfolio's performance stacks up on the last trading day of January:

Day
Nasdaq  +1.15%
S&P     +1.10%
RB      -0.64%

Week
RB      +8.30%
Nasdaq  +7.14%
S&P     +4.38%

Month
Nasdaq +14.28% (new high today)
RB     +12.17%
S&P     +4.07% (close to a new high)

Jeesh, keeping up with the market is no easy task these days! There aren't many months where your portfolio rises over 12% and you still end up losing to the market.

The portfolio's two newest Rule Breakers, @Home (Nasdaq: ATHM) and Amgen (Nasdaq: AMGN), are also off to smoking starts since they were added a little over a month ago. Just how well have they performed thus far? Check it out:


       Bought    Cost Basis  Today    % Increase
@Home  12/4/98   $56.08      $124.38   +121.78%
Amgen  12/16/98  $85.75      $127.75    +48.98%

Not that performance over two measly months really means anything, but it sure does feel good to have paper profits right out of the gate.

Since we've had a plethora of earnings releases to digest over the past two weeks, today I thought I'd grade some of the companies on their performance with some commentary on what numbers we're focusing on. Of course, we have a variety of writers scribing this column, and I'm sure each of us has slightly different impressions, analyses and grades. Nevertheless, we have similar enough styles that I'm certain my thoughts aren't very far away from David or Jeff's.

Without delay, here's the report card:

Amazon: B+

Comments: It's hard to give a company that comes in with negative earnings an A, but there is still plenty to like with what Amazon turned in. The company had sales in the fourth quarter of $253 million, which was nearly triple last year's $66 million figure. On a sequential basis from the third quarter the company booked roughly $100 million more in sales. Nice.

Behind the relatively good grade are the increasing margins at the company. These numbers were posted here earlier in the week, but I think they are worth repeating.


(annual)             1998   1997
Gross Margin         21.9%  19.5% (of sales)
Sales, market. exp.  21.8%  27.4%
Product Dev. exp.     7.7%   9.4% 
Gen., Admin. exp.     2.6%   4.7% 

(quarterly)        Q4 1998  Q3 1998
Gross Margin         21.1%    22.7%
Sales, market. exp.  19.2%    24.4%
Product Dev. exp.     6.8%     8.7%
Gen., Admin. exp.     2.2%     3.2%

Notice that not only are gross margins on the rise, but the fixed costs as a percentage of sales are also declining. If the company is to post positive earnings in the future (and we think they will), the margin improvement must continue down this path.

As Jeff also pointed out, the company had positive cash flow from operations as well as free cash flow. Albeit, these figures were relatively small, but this could be the tip of the proverbial iceberg.

Needs Improvement: The slight decline in gross margin from the third quarter is not welcomed. This is most likely due to the company now selling a broader line of products including music, videos, software, etc. Since this was the first quarter the company entered many of these lines of business we'll give it a little leeway.

It's also worth noting that Amazon opened for business less than four years ago. Think about that for a moment -- from zero sales to over a billion in annual sales and a household name in less than four years. Amazing. As the company gets some more experience under its belt, I wouldn't be surprised to see some further operational efficiencies show up with its concurrent margin improvements.

What we're hoping for next time: Keeping the sales growth on track and maintain the margin improvement. If you don't change your direction, you will end up where you are headed (towards profits).

America Online: A

Comments: What's not to like about these earnings? The company is hitting on all cylinders and is finally starting to turn its years of marketing and positioning into bona fide profits. AOL is now just shy of having $1 billion in revenue per quarter.

Some highlights:

  • AOL membership grew by 1.6 million subscribers in the quarter. Total membership under the AOL umbrella is now more than 17 million worldwide. We'll keep smiling if the subscriber base keeps growing. The company's members are the foundation upon which all the rest of the good stuff is built.
  • Revenue from e-commerce and advertising not only more than doubled over last year, but strong demand has pushed this segment's backlog to a tall $729 million. Healthy demand mixed in with a solid indication of future revenue growth foretells good things to come.
  • Cash Flow! Cash flow from operations was $208 million in the quarter, nearly triple that of last year's fourth quarter. Increasing cash flow precedes increasing earnings, and this is exactly what we've seen. The company has more than enough cash on hand to not need to hit the equity markets again for some time. Also, there's plenty of green stuff to potentially go shopping for another acquisition or two, should AOL so choose.
  • Margins. Operating margins in the quarter were 13.6% and rising. For comparison's sake, operating margins were at 5.4% last year. Growing sales combined with rising margins make for explosive earnings.

Needs Improvement: The "auction a keyword" contest with Nieman Marcus (NYSE: NMG) was rather lame and the only thing preventing the grade being an A+. We have high hopes the company will get this grade next quarter, however.

What we're hoping for next time: Keep the momentum going!

3Dfx: C+

Comments: With 3Dfx we have a truly mixed bag of results. Sales have exploded to over $60 million versus $22 million last year, but EPS actually declined to $.13 against the $.15 reported last year. Sure the profits were far above estimates, but the company really disappointed on this accord last quarter. Be sure to take those forward profit estimates with a pinch of salt.

Like we did with Amazon, let's see where the margins are headed.


                              Q4 1998   Q4 1997
Gross Margin                  36.7%     48.9%
R&D exp.                      16.3%     21.8%
Selling & Admin. exp.         17.8%     19.5%
Inventory/Sales (quarterly)   39.5%     17.2%      
Receivables/Sales (quarterly) 59.8%     60.0%

                              Q4 1998   Q3 1998
Gross Margin                  36.7%     24.8%
R&D exp.                      16.3%     30.2%
Selling & Admin. exp.         17.8%     21.0%
Inventory/Sales (quarterly)   39.5%     76.7%      
Receivables/Sales (quarterly) 59.8%     80.0%

Yet again, a mixed bag. Notice that compared to last year's fourth quarter margins show a slight improvement, but quite a drastic upward swing compared to the third quarter. Christmas has something to do with this, as does the extremely short product cycles the company is faced with.

Needs Improvement: We'd like to see margins get back up near the level they were when the portfolio first bought the stock -- near 50%. We'd also like to see inventory and receivables as a percentage of sales continue to decline.

What we're hoping for next time: We are questioning whether or not 3Dfx really is a Rule Breaker or not, so there may not be a next time here. Is the company's branding strategy enough of a "sustainable advantage" for the years ahead? Are there viable alternatives to the company's products? These are the questions we are asking and discussing on the Rule Breaker message board.

If the stock is still a member of the Rule Breaker portfolio in three months we can only hope for increasing sales, better margins, and forward movement concerning the company's next generation of accelerators, Voodoo 3.

For the actual earnings reports of the three companies graded today, click below:

What grades would YOU give these three companies? Post your thoughts on the Rule Breaker message board and I'll compile the results here on Monday. More importantly, how would you grade this column? We always welcome constructive feedback on what you liked and what we you think we can improve, so email us.

Have a great weekend, Fools!

-- Paul Larson

Some relevant news that space and a looming deadline didn't allow me to discuss:


Check Out the New Harry Jones Portfolio

01/29/99 Close
Stock  Change    Bid 
 ---------------- 
AMZN  -6      116.88
AMGN  +8 3/16 127.75
AOL   +  9/16 175.25
T     +  7/8   90.75
ATHM  +2 1/2  124.38
DJT   -  1/16   4.31
DD    -1 7/16  51.25
XON   -  9/16  70.44
IP    -  1/2   39.56
IOM     ---     7.13
LU    -  13/16112.56
SBUX  +3 1/16  52.00
TDFX  -  5/16  12.63

 
                   Day   Month    Year  History  Annualized 
      R-BREAKER  -0.64%  12.17%  12.17%  1025.89%  71.58%
        S&P:     +1.10%   4.07%   4.07%  191.78%   26.97%
        NASDAQ:  +1.15%  14.28%  14.28%  247.95%   32.05%
 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    175.25    9541.30%
   9/9/97  1320 Amazon.com     6.58    116.88    1676.42%
  5/17/95  1960 Iomega Cor     1.28      7.13     456.46%
  10/1/96    84 LucentTech    23.81    112.56     372.79%
  8/12/96   130 AT&T          39.58     90.75     129.30%
  12/4/98   450 @Home Corp    56.08    124.38     121.78%
  4/30/97 -1170*Trump*         8.47      4.31      49.08%
 12/16/98   290 Amgen         85.75    127.75      48.98%
  2/20/98   200 Exxon         64.09     70.44       9.90%
   7/2/98   235 Starbucks     55.91     52.00      -6.99%
  2/20/98   215 DuPont        59.83     51.25     -14.35%
  2/20/98   270 Int'l Pape    47.69     39.56     -17.05%
   1/8/98   425 3Dfx          25.67     12.63     -50.81%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  1100 AmOnline    1999.47 192775.00  $190775.53
   9/9/97  1320 Amazon.com  8684.60 154275.00  $145590.40
  12/4/98   450 @Home Corp 25236.13  55968.75   $30732.62
 12/16/98   290 Amgen      24867.50  37047.50   $12180.00
  2/20/98   200 Exxon      12818.00  14087.50    $1269.50
  5/17/95  1960 Iomega Cor  2509.60  13965.00   $11455.40
   7/2/98   235 Starbucks  13138.63  12220.00    -$918.63
  8/12/96   130 AT&T        5145.11  11797.50    $6652.39
  2/20/98   215 DuPont     12864.25  11018.75   -$1845.50
  2/20/98   270 Int'l Pape 12876.75  10681.88   -$2194.88
  10/1/96    84 LucentTech  1999.88   9455.25    $7455.37
   1/8/98   425 3Dfx       10908.63   5365.63   -$5543.00
  4/30/97 -1170*Trump*     -9908.50  -5045.63    $4862.88

                              CASH  $39332.55
                             TOTAL $562944.68

</THE RULE BREAKER PORTFOLIO>

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