Workshop Portfolio

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End-of-Year Margins

by Louis Corrigan (TMF Seymor)

Atlanta, GA. (Dec. 29, 1998) -- Not a lot to choose from on this week's Rising Margins screens. Guess most folks were too busy celebrating the holidays. Or maybe they just didn't want to pay their accountants overtime.

First up, a "pure" play on water. Yep, though it's hard for me to understand why people love to buy water from a city utility and then buy more from a beverage company, they do. And Vermont Pure Holdings Ltd. (Nasdaq: VPUR) appears to be making a pretty penny off this ultimate thirst quencher. Located in Randolph, Vermont, the company bottles and distributes natural spring water throughout New England, New York, and the mid-Atlantic states.

The company announced last week that Q4 sales flowed 74% higher to $9.5 million thanks to higher per capita water consumption. That produced EPS of $0.20 versus $0.11 a year ago. For the year, sales increased 65% to $29.2 million, or 35% excluding acquisitions, pushing EPS up to $0.28 from $0.11. So for the year, revenues grew rapidly with and without the acquisitions.

A few things to note, though. First, pre-tax income increased just 13% in Q4 to $0.64 million, quite a ways from the reported net income of $2.1 million for the quarter. Though Vermont Pure didn't issue a full income statement with the press release and the Q3 filing doesn't break out taxes, it appears that the company is enjoying a massive gain related partly to huge losses in the past.

Strictly speaking, then, Vermont Pure shouldn't be on our margins screen. We go with EPS over net income when figuring margins, but we always need to check the tax rate to make sure that the company is becoming more profitable at the operating level. On the other hand, the pre-tax income for the year does show rising margins, suggesting some mitigating seasonality to the company's Q4 profits.

Rather than look closer at that issue right now, I turn to the Fool Snapshot, where I see a high return on equity (ROE) that's the product of a high debt-to-equity ratio and the funky net income we've already seen. Next, I check another recent press release from October 3 and see that Coca-Cola Enterprises (NYSE: CCE), which distributes about 31% of Vermont Pure's total sales volume, has revised its contract with the company. As of January 1, CCE can now terminate its arrangement with Vermont Pure on just 30 days' notice rather than 90 days.

This could prove very bad news for Vermont Pure, because Coca-Cola (NYSE: KO) has plans to assault the bottled water market and it's pretty likely that Coca-Cola Enterprises won't distribute a product that competes with KO's water. Without doing any more research, I would conclude that what initially sounded like a good story actually could prove worth investigating further as a short-sale opportunity. With Vermont Pure flying near its 52-week high, it could be susceptible to an emergency water landing if Coca-Cola Enterprises bails out and Vermont has no other distributor to take that company's place.

Next up, Cognos (Nasdaq: COGNF), a Canadian company that produces software that helps customers analyze database information. Last week it reported Q3 sales soared 23% to $76 million, pumping up EPS to $0.36, a penny ahead of estimates and up 33% from last year's results, excluding one-time items. The fact that the stock has risen from $17 5/8 to around $23 in the last week suggests the results were unexpectedly good.

Looking at the company's 21% net profit margins in the quarter, you should note immediately that Cognos is worth investigating: classic software company with massive 95% gross margins. The Fool Snapshot reveals that Cognos has no debt, $3 per share in cash, and a high 33% ROE. Terrific.

The market's enthusiastic reception of the results seems tied to an unexpectedly strong $11.3 million in licensing deals for the company's Web products. That's triple year-ago levels and 75% better than even the Q2 numbers. Meanwhile, sales of its legacy systems were flat and stable.

The stock trades at 16 times estimated earnings of $1.47 per share for the year ending February 2000. That number might be revised up, though, if the Web products continue their strong growth. Enterprise software companies are difficult to get a hold of unless you've got some special knowledge of the field. Still, Cognos has been around since 1969. Though its five-year chart shows a company that's been bouncing about in a wide trading range for a while after an explosive run, it certainly seems like a solid contender for further research.

Finally, longtime Fools should note the appearance of 3Com (Nasdaq: COMS) on our screen. The one-time Rule Breaker holding has begun recovering some from its merger with U.S. Robotics. Q2 sales increased 29% to $1.54 billion as adjusted EPS rose to $0.36, five cents better than estimates and much better than either the $0.24 reported in Q1 or the meager $0.01 per share delivered in the year-ago period. About 60% of sales came from products introduced this year, including the super popular Palm Pilot (now on version VII).

With that, I'll wish you a happy and prosperous new year!

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