The Boring Portfolio, Feb. 26, 1999

<THE BORING PORTFOLIO>
Bore Week in Review
Plus, say hello to the Value Port

By Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (Feb. 26, 1999) -- It's deep thoughts day at the Boring Port. So I guess I'll have to let Alex write the column. No, no, just kidding. What has been pre-occupying our thinking time? Well, Alex has been churning out some excellent work on Orbital Sciences Corp. (NYSE: ORB), a Washington, D.C.-area company that is involved in the assembly of satellites and delivering those satellites to orbit. The company also provides satellite tracking services, global positioning system receivers and the satellite data, and it's developing businesses such as utility meter reporting via satellite. Here are Alex's two reports so far:

• 02/19/99: The Bore Blasts Off
• 02/24/99: More on Orbital

It's pretty exiting stuff. Speaking of exciting, very soon we're changing the name of this portfolio to reflect how we think about things. I originally liked "The Boring Portfolio" as the name because it describes how we think about things. We're methodical plodders that have no problem looking at a company for years before we invest in it. Originally, though, the Boring Port was chartered to invest in boring stuff like aggregates, steel, and that sort of thing. We find the businesses we invest in to be really interesting, though. Insurance, data transfer, PCs, and golf cart tires may really give rise to a huge feeling of ennui for some people, but I get excited about these things. I don't want to speak for Alex, who is in Calgary, Alberta right now, but I think I'm safe in saying this is true for him, too.

So, the name change we're putting in place in the near furture will reflect this. We're simply going to change it to "The Value Portfolio." (Nothing about the historical accounting for the portfolio will be changed.) This reflects our charter to seek out the best business values, whether that's in communications equipment, chocolate bars, retail, satellites, or whatever. We'll buy companies that are growing, staying the same size, or shrinking. It doesn't matter. We will always insist on value for the cash capital we deploy, however.

Believe me, though, that doesn't mean we won't pay a big multiple to current earnings or invested capital. As long as we feel the company is undervalued to fairly valued based on our best estimate of the future value a company can create, we don't get hung up in stock screens, arbitrary multiples to revenues, what is called "growth" and what is called "value," and so forth. The investor that looks for growth without assessing value should really take a look at The Intelligent Investor, by Benjamin Graham. Graham is one of the intellectual giants of security analysis and investing. While we're on the topic of intellectual underpinnings -- and I'll get off that in two seconds -- I also recommend reading Common Stocks, Uncommon Values, by Philip Fisher. As a statement on value investing (we're going to pull Fisher's approach into the category of value investing, because that's what it really is), it's a must.

If I can bounce back to satellites for a second, I wanted to relay a story. The other night I was sitting at home when the phone rang. The caller was from USSB, my satellite programming provider, and he wanted to know if I would like to order Showtime for the next year. It turned out that I didn't, but his sales pitch was very effective. That got me to thinking of the economics of satellites right away. Here you have a business with tons of inventory that it can sell. But the inventory is virtual. Delivering the goods to the customer consists of nothing more than USSB sending a burst of data to my satellite receiver that decodes a digital signal. The marginal cost of these revenues is completely overwhelmed by the marginal revenues. Heck, there's not even a receivables problem for USSB, as they have my credit card number and just charge it when my bill is due. That gets my blood going as an investor. OK, so I had a strange childhood, what can I say?

The owner of USSB and DirectTV is Hughes Electronics Corp. (NYSE: GMH), a unit of General Motors (NYSE: GM). Just think of this as a cable system that orbits the planet. But also think of it as a cable system that makes terrestrial cable look like soup cans connected with baling twine. The available bandwidth (at higher capacity utilization levels, especially) and customer utility of digital satellite dish systems blow away cable systems. Marginal returns on capital can be very big in a business with a fixed cost base (the satellites) and relatively small variable costs (incremental operating expenditures needed to generate sales).

We're going to have to get another day on the Value Port publishing schedule, because I'd like to talk soon about the difference between discretionary capital spending and discretionary operating expenditures such as marketing, and what is necessary spending. A lot of people will take a growing company and look at earnings and just slap whatever P/E on it that looks right to them and say "yup, that's what it's worth." But if you can separate the discretionary spending that increases future cash flow from the spending that is necessary to maintain your company's current position, then you have a better idea of what the company's free cash flow is.

Many investors will deduct all capital expenditures from net cash flow from operations and call that free cash flow, but that understates it. Free cash flow is net cash flow from operations minus discretionary capital expenditures. It does not include additional expenditures that are not made to expand the company and not just merely maintain it. A crucial difference for the valuation of a growing company.

Speaking of cash flows, if you're looking to be thoroughly confused this weekend, check out parts one and two of my three-part series on merger and acquisition accounting for R&D-intensive companies.

Also, I didn't want to spend much time on Gateway's (NYSE: GTW) nasty move down today. What I had to say can be found in today's Lunchtime News. Regarding Gateway, check out the posts on the Fool's Gateway board on the activity in Gateway Country stores. This is the highest-return portion of the company that I can discern, running at return on invested capital of 100% per year. I am disappointed to hear that Gateway wants to retain some of the receivables from its wildly popular YourWare financing program. You know, some things are very obvious and some things are not. Although the interest rate on the receivable is attractive, Gateway is not a finance company. In addition, after credit losses and financing costs, the economic return on holding these receivables is far below the average economic value added at Gateway.

I certainly hope the company exercises its share repurchase authorization. One thing that I really dislike is the tendency of companies to say they'll buy back stock and then not follow through on it. The best use of excess capital right now would be a share repurchase, not holding consumer finance receivables.

That being said, Gateway's management is on the cutting edge of consumer preferences and its business model in the core business of manufacturing and marketing PCs is a finely tuned machine. Gateway ended the fourth quarter with less than 8 1/2 days in inventory and turned its inventory 39 1/2 times (annualized) in the fourth quarter. Cash conversion cycle for the fourth quarter was negative five days, which led to net cash from operations far in excess of net income of $346 million for the year. Based on my reading of the (unaudited) fourth quarter financials, net cash from operations for the year was $951 million, or a little under three times net income. Economic earnings for the year in this very capital un-intensive business was far higher than net income. But now I'm dwelling on a subject that I didn't want to waste space on. I'll believe the end of the PC growth cycle when I see it, and so far the only thing the bears have to go on are some very noisy fourth quarter data.

On a completely different topic, and this is where I have to wrap it up, Alex mentioned American Bankers Insurance (NYSE: ABI) the other day. Here's how the company describes itself: "Our specialty product lines include a variety of credit-related insurance programs, extended service contracts, flood insurance and surety bonds. Traditional products, such as life insurance, annuities, and property insurance, are marketed by agents." You probably have seen what they do on credit card applications. This company ensures that your credit obligations are met when you have lost your job or pays off your obligations in case you die. This is a very high margin insurance business that has shown the following combined ratios over the last few years:

1997: 78.9%
1996: 79.4%
1995: 79.8%

American Bankers is a company that generates a significant underwriting profit, which means the capital it raises through underwriting costs nothing. A good underwriter with high market share and even middling investment results is a difficult franchise to beat. When Alex and I look at a business, one of the things we're most concerned with, in addition to cash flows, is the company's competitive advantage period. That is defined as the number of years over which the company is expected to generate a return on capital higher than its cost of capital. When you get half your capital for free and there's a good chance that will continue, you have a possible franchise. However, we're nowhere near done looking at this company yet.

We hope to see you on the Boring message board sometime this weekend.

• Discuss Boring Investing on the Boring Port message board.
• 10/01/98: The New Boring Port Transitions Facts

Change the World... work for the Fool.

Stock  Change    Bid
BRKb  -19      2379.00
CSL   -  7/16  41.38
CSCO  -  11/16 97.81
GTW   -7 7/16  72.69

                   Day    Month   Year  History
        BORING   -1.74%  -2.71%  -4.31%  28.48%
        S&P:     -0.54%  -3.23%   1.06% 106.56%
        NASDAQ:  -1.67%  -8.69%   4.35% 119.80%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     97.81   308.31%
  8/13/96  200 Carlisle C    26.32     41.38    57.17%
 12/31/98    8 Berkshire   2244.00   2379.00     6.02%
   2/9/99  100 Gateway 20    72.38     72.69     0.43%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  22007.81 $16617.82
  8/13/96  200 Carlisle C  5264.99   8275.00  $3010.01
 12/31/98    8 Berkshire  17952.00  19032.00  $1080.00
   2/9/99  100 Gateway 20  7237.50   7268.75    $31.25


                             CASH   $7658.52
                            TOTAL  $64242.08