RULE MAKER PORTFOLIO

Rule Maker Portfolio
AOL -- Where to From Here?
And... a confession

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (Oct. 14, 1999) -- Today, I'm going to elbow my way into the Rule Breaker Portfolio to talk about its top holding: America Online (NYSE: AOL). It's pretty well agreed upon that AOL is no longer breaking rules, but rather making the rules in the Internet world. The BreakerPort's 12,000% return on AOL since 1994 demonstrates the riches that await investors who buy a Breaker and hold, hold, hold all the way to Makerhood.

Before jumping into an analysis of AOL's investment potential at the current price of $114 3/4, I have to confess some emotional conflict related to this stock. In the fall of 1996, after months of studying investments and reading The Motley Fool Investment Guide, I made my first stock investment ever -- AOL. It was shortly after the stock became listed on the NYSE and took its namesake ticker symbol. I bought shares that, adjusted for three two-for-one splits, had a basis of $4. But, sadly enough, I sold those shares at a split-adjusted $5.60 to pursue "something better." I used to keep track of what my portfolio would be worth if I hadn't made that bone-headed decision, but through counseling, I've been able to overcome that habit.

In fact, several months ago, I finally overcame the trauma and resumed AOL ownership once again. Yes, 1,900% after first selling my entire AOL position, I bought the stock once again. The real question is: Why didn't I accept my mistake and buy sooner? I'm not a psychologist, but let me spend a moment trying to play one on the Internet. As I sat on the sidelines in 1998 and watched AOL shares set one new high after another, I knew full well that the company was superbly executing its business. But, the hard truth is I kept thinking that the stock was due for a fall. A fall that never happened -- until this year.

The lesson is that I didn't do my stock portfolio any favors by watching a great investment opportunity take 10 steps forward before buying after the stock took a few steps back. Another lesson: As hard as it may be, an investor's focus should be on a company's business, not its stock price. Here in the MakerPort, we call it the principle of QuaVa -- that business quality is a hundred times more important than the stock price.

But what about now? At a price tag of $146 billion, does AOL still hold market-beating potential for investors with a 5- to 10-year time horizon?

Let's take a look. And since AOL is now a confirmed Rule Maker, it's high time we scrutinize its business on Rule Maker terms, using our 10 criteria.

When it comes to the criteria of brand, repeat-purchase business, convenience, expanding possibilities, and my interest, America Online passes with flying colors. As for brand, AOL is the #1 Internet online service, the #1 website according to Media Metrix, and has 20 million worldwide members. As for a repeat-purchase model, AOL members average more than 52 minutes of use per day. As for convenience, executives Steve Case and Bob Pittman are hell-bent on making AOL available from any device, anywhere. Already, the AOL service is available in approximately 1,500 cities in more than 100 countries. Expanding possibilities run the gamut from AOL TV to international expansion in Brazil, Mexico, Argentina, and Hong Kong, just to name a few.

AOL's mission is "to build a global medium as central to people's lives as the telephone or television... and even more valuable." Sometimes mission statements can be overly grand and corny, but I believe AOL is truly on track to make their mission a reality. And the financial payoff is already beginning to peak through the financial statements.

Looking first to the income statement, AOL's recently completed fiscal 1999 included 58 multiyear advertising and commerce agreements, each worth more than $1 million, including a deal with First USA worth up to $500 million. All told, AOL generated $1 billion in advertising and commerce-related revenues for the year. Most interesting is the fact that the worldwide market for traditional advertising (TV, radio, newspapers) is worth $200 billion, and growing 5-8% per year. As more of those advertising dollars shift to the targeted marketing capabilities of the Internet, AOL is well-positioned to take a disproportionate share of the market.

Total revenues for AOL rang in at $4.8 billion, up 54% over the prior year. That growth rate soundly beats our 10% hurdle. The material costs for AOL's business are relatively light, giving AOL gross margins of 44%. That's not quite up to our 50% standard, but as e-commerce revenues grow as a percentage of total revenues, AOL's gross margins may well be able to increase.

AOL's net margins came in at a solid 15.6%, well ahead of our 7% benchmark. But, AOL critics would rightly point out that AOL's bottom line has benefited from substantial one-time gains. Fair enough. Let's look to the cash flow statement for an even better picture. AOL's cash from operations amounted to $1,099 million, and free cash flow equaled $749 million. As always, cash profits are what really matter to investors. By taking cash from operations and subtracting the $350 million of capital expenditures, we arrive at AOL's free cash flow, or the cash that's really available for the benefit of shareholders. So, as a substitute for the net margin, AOL's free cash flow margin would be 15.7% -- a notch ahead of the net margin!

Moving on to the balance sheet, AOL completed 1999 with $1.4 billion in cash and only $348 million in debt. That gives us a cash-to-debt ratio of a healthy 4.09, up from 2.21 a year ago -- both ahead of our usual standard of 1.5 times more cash than debt. In the working capital management department, AOL is keeping the cash rolling in, and paying it out much more slowly. That can be seen in the flow ratio of only 0.32, down from an already stellar 0.38 a year ago. Of course, our standard for the flowie is anything under 1.25. But, considering that direction is more important than location, AOL impresses with its year-over-year improvement in the flow. As I've discussed in a number of recent articles, a declining flow ratio translates into more cash in the bank -- hence, the excellent operating cash flow mentioned above.

That does it for tonight. What can I say? AOL is a Rule Maker. I only wish I'd acted on that knowledge a lot sooner. At a market value of $146 billion, and with a potential annual advertising market of $200 billion (and growing), AOL doesn't seem irrationally priced. And most importantly, management is executing the business in a manner that well surpasses our rigid Rule Maker standards.

Tomorrow night, I'll be back with a report on my search for great business models.

One final note: This weekend, The Donald (Trump, that is) will be the guest on The Motley Fool Radio Show. You can listen online by going here.

Fool on!


 




Rule Maker Portfolio

10/14/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESSUnch.$142.00
CHVCHEVRON CORP1/4$88.00
CSCOCISCO SYSTEMS-15/16$69.38
DPHDELPHI AUTOMOTIVE SYSTEMS3/16$16.00
EKEASTMAN KODAK9/16$72.25
GMGENL MOTORS-1/8$65.00
GPSGAP INC-7/8$34.50
INTCINTEL CORP7/32$73.34
KOCOCA-COLA CO7/8$50.56
MSFTMICROSOFT CORP-3/8$90.69
PFEPFIZER, INC-5/16$37.69
SGPSCHERING-PLOUGH-1 7/8$44.44
TROWT.ROWE PRICE ASSOC9/16$30.38
XONEXXON CORP3/4$74.38
YHOOYAHOO INC13/16$173.38

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker -.07% -4.45% 1.67% 10.02% 37.50% 20.64%
S&P 500 -.17% -3.94% .06% 4.41% 30.92% 17.20%
S&P 500(DA) -.17% -3.94% .06% 4.99% 32.69% 18.13%
S&P 500(DCA) n/a n/a n/a n/a 17.93% 10.21%
NASDAQ .20% -2.76% 2.21% 28.01% 73.33% 38.27%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$69.38111.09%
2/3/9859MSFT49.352$90.6983.76%
2/13/9852INTC46.928$73.3456.29%
5/1/9882GPS22.708$34.5051.93%
2/3/9866PFE27.433$37.6937.38%
2/17/9916YHOO126.309$173.3837.26%
5/26/9818AXP104.067$142.0036.45%
3/12/9820XON64.335$74.3815.61%
3/12/9820EK63.148$72.2514.41%
3/12/9817GM60.399$65.007.62%
3/12/9815CHV83.343$88.005.59%
3/12/9811DPH17.202$16.00-6.99%
8/21/9844SGP47.993$44.44-7.41%
2/3/9856TROW33.673$30.38-9.79%
2/27/9827KO69.107$50.56-26.83%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$5,203.13$2,738.26
2/3/9859MSFT$2,911.79$5,350.56$2,438.77
2/13/9852INTC$2,440.28$3,813.88$1,373.60
5/1/9882GPS$1,862.06$2,829.00$966.94
2/17/9916YHOO$2,020.95$2,774.00$753.05
5/26/9818AXP$1,873.20$2,556.00$682.80
2/3/9866PFE$1,810.58$2,487.38$676.80
3/12/9820XON$1,286.70$1,487.50$200.80
3/12/9820EK$1,262.95$1,445.00$182.05
3/12/9817GM$1,026.78$1,105.00$78.22
3/12/9815CHV$1,250.14$1,320.00$69.86
3/12/9811DPH$189.22$176.00($13.22)
8/21/9844SGP$2,111.70$1,955.25($156.45)
2/3/9856TROW$1,885.70$1,701.00($184.70)
2/27/9827KO$1,865.89$1,365.19($500.70)
  Cash: $181.37  
  Total: $35,750.25  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.