The Boring Portfolio, Mar. 31, 1999

<THE BORING PORTFOLIO>
Why Invest in a Tough Business?
Int'l Speedway's '98 results

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (March 31, 1999) -- Today I'm talking about Gateway, NASCAR, and linearity of performance for companies and investors. First up is the PC discussion, which I originally started as a message board reply to someone who asked why we had bought something in an industry as competitive as PCs. So here we go:

When we bought Gateway (NYSE: GTW), we were fully aware that it's a tough business. It's just that the writers who cover the industry only realize this in the first and second quarters.

Ever since I started to pay attention, computer prices have dropped 15-20% per year, on average. Some years more, some less. But the components that go into PCs have dropped more than that. That's been the big hang-up for the indirect PC manufacturers and the three-tier model. I realize that sometimes it doesn't matter how hard management pulls on the oars, the industry boat they've chosen to climb into still dictates performance. Perhaps that will happen in PCs next year. I had to consider the probability of that when we bought Gateway. In an industry where there are some companies earning 10% on invested capital and some earning 175% on invested capital, I concluded the higher probability was that there would be some narrowing of performance from top to bottom -- not due to Compaq or IBM improving performance, but due to competitive pressures weighing on Dell.

You've just got a very different set of dynamics in the PC industry. It's 15% unit growth with 15% price deflation. So that's 1.15 units times $0.85 next year off a unit and price base of 1 this year. That's $0.9775, or a 2 1/4% revenue decline for those companies standing still. What mitigates that to some extent is a larger decline in the price of components.

Say cost of goods sold (COGS) in the base year is $0.85 and say that's 10 components at $0.085 apiece. Let's say 2 components decline in price at a 30% rate, 3.5 decline at 15%, 3 show no decline, and 1 goes up 10%. In the next year, then, COGS looks like this:

(1.15) * 2 * (0.7 * $0.085) -- $0.13685
(1.15) * 3.5 * (0.85 * $0.085) -- $0.29081
(1.15) * 3* ($0.085) -- $0.29325
(1.15) * 1 * (1.1 * $0.085) -- $0.10752

The first number above is unit growth. The second is number of inputs per computer. Inputs do not grow 15% because of integration and miniaturization of components. The third number is the year-over-year price deflator and the fourth is the base year price.

COGS of $0.82843, or a 2.54% decline in COGS.

Base year: Revenues = $1.00 and COGS = $0.85. Gross profit = $0.15
Year 1: Revenues = $0.9775 and COGS = $0.82843. Gross profit = $0.14907
Gross margin = 15.25%
Gross profit growth = (0.62%)

Gross profit dollars are flat if you grow at the industry rate and gross margin is down slightly. If you grow units faster than the industry, then you're going to grow absolute gross profits. Say the above company grows units at a 25% rate:

1.25 * 0.85 = $1.0625

COGS

(1.25) * 2 * (0.7 * $0.085) -- $0.14875
(1.25) * 3.5 * (0.85 * $0.085) -- $0.31609
(1.25) * 3* ($0.085) -- $0.31875
(1.25) * 1 * (1.1 * $0.085) -- $0.11688

Base year: Revenues = $1.00 and COGS = $0.85. Gross profit = $0.15
Year 1: Revenues = $1.0625 and COGS = $0.90047. Gross profit = $0.16203
Gross margin = 15.25%
Gross profit growth = 8%

Click here for the spreadsheet on that (Excel 97/5.0-95). This simple model ignores the fixed cost structure of PC manufacturing, by the way, which gives a company leverage on profit growth. I wanted to deal only with component cost declines and break down revenue growth into unit and ASP movements.

Scale that up into the billions of dollars and you're looking at the direct model. If you can't control your operating expenses and move your inventory, however, you're going to be eating more of the COGS decline yourself. That's exactly what happened with Compaq last year. Its units didn't go down and end-user demand wasn't the problem. Because of price protection offerings, the company had to suck up credits to accounts receivable through contra-revenues.

With Gateway or Dell, you're getting the same sort of dynamics above. Absolute gross profit dollars are increasing and these companies have bettered margins inside of what is always a tough pricing environment in the computer industry. Dell's a different story because its product mix has improved and it has implemented process improvements. Combine its ability to price competitively with giving the customer better service and logistics support and you have the best stock performance of the decade.

Not to drag on with an old story, but again, I look at the direct PC companies as having the following economics:

1. They are precision manufacturers with service and logistics components.
2. They are distributors (second and third tier).
3. They are retailers.

You could combine two and three, but the fact is that there are profit levels out there -- at Ingram, Mom & Pop VARs and integrators, and at places like CompUSA -- that are captured by the direct PC companies. The fourth economic component is an option on other economic activities these companies can get involved with. I think we've seen that pretty clearly in Dell and Gateway over the last year. And Compaq fits in there, too, but I'll just stick to the direct model. That Compaq is selling DEC machines, services corporate accounts, and makes fault-tolerant computers doesn't play into my analysis of Gateway beyond the possibility that the top PC company is stretched in a lot of different directions.

If you can get by the business model differences, I think buying a direct PC company today is like buying a direct writer of auto insurance in the 1980s or early 1990s. In other words, just as GEICO and Mercury General changed or are changing the rules in the moribund auto insurance industry, Gateway and Dell have changed and are changing the rules of the PC industry. I hate to use a cliche, but I think our view of the insurance and PC industry is much more the result of bottom-up analysis than top-down. Please cut off our food and oxygen supply when we start to focus exclusively on top-down analysis.

A Note on the NASCAR article

I mentioned on Monday Fortune's cover story on NASCAR. I suggested this so people could easily get a feel for the sport and the product presented by International Speedway Corp. (Nasdaq: ISCA), which is one of the companies we pay attention to. Overall, I think the article does that job, but I disagree with some of the conclusions:

1. Average ticket prices get skewed -- somewhat like average selling prices at a company like Dell -- by the high end of product line. If corporate box sales and club level seating accommodations are growing at two times the rate of grandstand and infield seating, then average ticket prices are going to go up. As I pointed out in this year's installment of "Stocks to Love," grandstand seating capacity at International Speedway increased 13% and luxury suite capacity increased 40% in 1997. From this year's 10-K:

"During fiscal 1998, the Company continued to expand and enhance its existing facilities. The Company added approximately 41,800 grandstand seats, growing the Company's seating capacity by approximately 11%. In addition to grandstand seating, 43 luxury suites were added at the Company's superspeedways. This 43 percent increase in luxury suites includes 28 "Superstretch" additions at Daytona, marking the first time that suites have been added on the famed backstretch of the historic facility."

The source of revenue increases isn't a mindless pricing policy at ISC:

"Admissions revenue increased approximately $17.5 million, or 25.1%, for fiscal 1998 as compared to fiscal 1997. This increase was primarily attributable to increased seating capacity and attendance, and an increase in the weighted average price of tickets sold for the events conducted at Daytona International Speedway ("Daytona"), Talladega Superspeedway ("Talladega"), Phoenix, Darlington Raceway ("Darlington") and Watkins Glen."

The composition of revenues last year is the more important issue for me. Motorsports-related income -- broadcast rights and promotional revenues -- made up 38% of revenues in 1998, up from 33% in 1997 and 29% in 1996. Revenues increased 33.7% and motorsports-related income increased 54%. Motorsports-related expenses increased 44% year-over-year, but I would much rather have a management accounting summary than a financial accounting summary. The costs of the additional motorsports related revenues aren't going to fall neatly into one line of a five-line summary of operating expenses.

There's also a factoid/opinionoid box on page 68 of the Fortune article that I wanted to comment on. It's titled "Playing the Stock-Car Market." "Playing" the market is a mindset that is antithetical to the approach of the people we admire and try to emulate, but more importantly, the "fact" presented that "International Speedway is a consistent leader, though it also the most expense stock" is really an opinion. It might have the higher P/E, or price to sales, or whatever, but the more germane fact is that net cash flow from operations was $79.5 million in 1998, about twice net income of $40.2 million. Net cash as a percentage of net income was over 197% this year, up from 184% last year.

A big part of that was a 90.2% increase in deferred income, which is principally cash the company receives for advance ticket sales. That's akin to float in the insurance business, except it's not encumbered the way float is in, say life insurance, by state regulations. To the point, the $12.9 million increase in deferred income covered better than 1/6 of total capital expenditures and just about 100% of maintenance capital expenditures. I'm not as concerned about how that stacks up against the current price/cash flow of other NASCAR companies. However, I do want to note that there are elements to the economic progress of International Speedway, which affect its intrinsic value, that need to be considered beyond just looking at the price/earnings ratio of all the companies in an industry.

Barron's Online's "Weekday Trader" column addressed the motorsports stocks yesterday. Click here for that article if you have access to the site or a Wall Street Journal online subscription. I'll say this, some of the same points above apply. I don't disagree that the prices of these companies are not as attractive as before. I don't agree that valuations are "stretched" thin, either.

Linearity of Performance

Someone on the AOL Berkshire Hathaway (NYSE: BRK.A) message board pointed out the other day that Berkshire's share price has gone nowhere over the last year. Legg Mason fund manager and author Robert Hagstrom provided some excellent data on the nonlinearity of performance by investors who have outperformed the market over significant time periods. In his new book, The Warren Buffett Portfolio, Hagstrom quotes portfolio manager Eugene Shahan: "It may be another of life's ironies that investors principally concerned with short-term performance may well achieve it, but at the expense of long-term results. The outstanding records of the Superinvestors of Graham-and-Doddsville were compiled with apparent indifference to short-term performance." Click here for the rest of that discussion and some excellent data on the subject.

Oh, and I can't fail to recommend Selena Maranjian's Rule Breaker report from yesterday. She addresses the above question, totally by coincidence, through the poetry of T.S. Eliot and Theodore Roethke.

Finally, on a random note, here's an audio greeting (WAV format: 113K), intercepted by the Boring Intelligence unit, from the federal government and the Oregon jury to the tobacco companies.

Have a great long weekend. If you have time, we'd love to see you on the Boring message board.

• Discuss Boring Investing on the Boring Port message board.

Stock  Change    Bid
BRKb  -35      2351.00
CSL   +2 1/2   46.75
CSCO  -  3/8   109.56
GTW   -1 5/8   68.56

                   Day    Month   Year  History
        BORING   -0.04%   4.80%   0.28%  34.65%
        S&P:     -1.11%   3.88%   4.97% 114.29%
        NASDAQ:  -0.75%   7.59%  12.27% 136.49%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    109.56   357.36%
  8/13/96  200 Carlisle C    26.32     46.75    77.59%
 12/31/98    8 Berkshire   2244.00   2351.00     4.77%
   2/9/99  100 Gateway 20    72.38     68.56    -5.27%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  24651.56 $19261.57
  8/13/96  200 Carlisle C  5264.99   9350.00  $4085.01
 12/31/98    8 Berkshire  17952.00  18808.00   $856.00
   2/9/99  100 Gateway 20  7237.50   6856.25  -$381.25


                             CASH   $7658.52
                            TOTAL  $67324.33