Fool Portfolio Report
Thursday, September 19, 1996

by Tom Gardner

ALEXANDRIA, VA., Sept. 19, 1996 -- Blam.

The beaten down stocks of our two technology leaders drove The Fool savings account up 6.37% versus a 0.22% gain for the S&P 500.


That marks the fifth consecutive day that The Fool Portfolio has risen more than a percentage point. It's been a great week. Just seven days previous, belled-cap investors were enduring 5% losses for September. At market close this afternoon, Foolishness is showing 8.27% gains for the month. The 1996 Fool is now positioned in a Heisman-like gliding stance, with our portfolio up 36.9% versus S&P growth of 10.9%.

What happened out there?

America Online rose $3 1/4 to $33, on nearly twice its average daily volume. No news. And Iomega rose $3 1/8 to $17 7/8, on over four times average daily volume. Iomega's ascent came within thirty-six hours of JP Morgan's sales-and-earnings downgrade and the restatement of its "Buy" recommendation.

There was some news out of Iomega HQ today. They issued a release via PR Newswire this morning announcing that their Zip drive is expected to be fully bootable as "drive A:" for its OEM agreements. This inspired Timothy L. Hill, vice president of worldwide marketing for Iomega, to offer this:

"There are currently more than 2 million Zip drive owners around the world, and many of the world's top personal computer manufacturers now build Zip drives into their computers as either standard or optional features. Clearly, no other storage solution combines the capacity, price, performance, and ease of use of the Zip drive. The additional ability to make it bootable will better position Zip as the logical choice to replace the floppy drive."

That's certainly notable, earning drive A: status, but it's probably not wholly responsible for the more than 20% rise in the value of Iomega today. Nope.

So why did IOMG and AMER explode on the upside today? Consider that these are the two most actively shorted stocks on the NASDAQ. Iomega has 22.4 million shares short. America Online, 21.0 million shares. This represents around 18% of their respective companies shorted. And that means buying power and a lot potential for kinetic energy on the upside.

High short-interest ratios held over the heads of beleaguered promotional companies have the sheen of a death blade. But when we talk about expanding, profitable businesses heading out of summer doldrums and into their stronger seasons, then the high short-interest ratio takes on the orange glare of overhot stove coils. The boiling comes as support from below rather than the blade and demise from above.

We have some important questions to ask ourselves about both America Online and Iomega: Will these businesses regain fundamental momentum? Are they doing so even as we speak? Will America Online pile on new subscribers with the touchdown of every snowflake? Are the Jaz and Zip drives going to be hot-ticket items when those Winter bells go jingle jangle? Or are these outfits buoyed by short-term business models, faced with oncoming competition that is too fast, too fierce, too well-financed? What profits lie in these woods? Ten cents on the dollar? Or eight? Or five? Or, gasp. . . less?

These and other questions need be answered in the months ahead. The market spoke to a few of them today. Without news, both stocks rallied. Looking left over our motley-hued and sueded shoulder, our left eye falls on some outstanding returns. In just over two years, America Online has risen 353%. In just over sixteen months, Iomega is up 609%. When we go hunting for world-beater stocks, we look for businesses driving one or more industries headlong into inflection points. We look for operations that are spearheading change, profitably. And we closely follow them as their stories unfold. What of the future?

Well, in the immediate future, America is headed back to school. That has a special meaning in Fooldom. As we pull out our pocket protectors, protractors, spiral notebooks, and slide rules, we'd do well to review some of the basic valuation principles that permeate Foolish scholarship. The running of PEGs and YPEGs, the scrutiny of balance sheets, that gazing at statements of cash-flows, in all their glory. A couple pranks here and there, good fun on the athletic field, and some social time, too, for certain... but it's important to get back in the LEARNING groove, Foolishly.

When the following question appeared in our 3Com folder yesterday, I knew it was time for The Back to School Review!

3COM Stock Folder

Subj: Re:PE ratio
Date: 96-09-18 20:06:08 EDT
Posted on: America Online

Is this a good time to buy?

At Fool University, we can help. We want to. It's our business to. Our motley band of 200 staff-members rummage through every corner of this digital thorp looking to help you with the management of your money. But, this enormous undertaking to redirect our collective financial future, to beat or at least meet market average growth rather than to drive substantial commission dollars into Manhattan, is a collaborative venture. In other words, we need your diligence and insight as much as you may need ours. So let's head back to school together this afternoon, and work through the valuation on 3Com Corporation (NASDAQ:COMS).

For starters, if you haven't read through our August 13th 3Com Fool Transaction Report, please do. It gives a backdrop to the world of networking, provides an outline of 3Com's business, and presents some financial data along with valuation work. I'd like to walk through some of that work again today, since there's been some confusion surrounding the application of the YPEG.

Let's consider some of the numbers. 3Com has $2.3 billion in trailing sales, over 12% profit margins, just short of $500 million in cash, $110 million in long-term debt, and healthy working capital numbers of nearly $800 million. That's the underlying capital might that we look for -- high profit margins, a bankful of money, manageable debt or no debt, and a steady stream of cash flowing through the enterprise.

From there, we begin working on the estimates for future growth. Zack's consensus of analyst estimates for 3Com call for $2.33 in fiscal 1997, ending in May. Mean estimates run to $3.00 for fiscal 1998. And the average projected long-term earnings growth rate for the Company is 31% per year. Are the numbers getting you down, Fool? Let's put 'em in a box:

1997 1998 5-Year Est. Est. Est. $2.33 $3.00 31%

Now it's time to do some YPEGging. Remember that the YPEG, or Year-Forward PEG, is a valuation tool designed for rapidly growing, financially healthy companies with more than $1 billion in sales. It posits that due to the girth, might and momentum of a giant growth business, Wall Street tends to value the equity off estimates further out than it does for the smaller-capitalization growth outfit. The earnings and cash flows are more predictable. The business is, presumably, more defensible.

To be more specific, Jimmy's Networking Company with $100 million in sales, 12% profit margins, more cash than debt, a wide flow of working capital and estimated growth of 30% per year should be priced more cautiously than 3Com, with that one unique variable: its revenue base of $2.3 billion. So, when valuing Jimmy's business for a present fair price, we use the PEG, assessing growth off existing earnings per share. And when we evaluate 3Com for a present fair price, we use the YPEG, assessing growth off earnings per share one year forward.

Which is all longhand for: Push the earnings base forward a year for profitably growing, billion-dollar businesses.

Back to 3Com.

Estimates for May, 1997 sit at $2.33. Growth through into 1998 is estimated at 28%. Use that as your p/e multiple. Thus, 28 x $2.33. And you come up with $65.24. Given that 3Com has not had trouble meeting estimates, we believe the company is reasonably priced today at $65 1/4, or capitalized at $11 billion. We purchased 3Com at $46.86 per share five weeks ago, when it looked undervalued in the here and now by 39%.

Fools who aspire to long-term stakeholding positions usually take the few necessary minutes to put together expectations for the year(s) ahead. As unpredictable as the world of networking is today, there's much more that's predictable about Eric Benhamou, 3Com's CEO, and the rest of the COMS managerial and operational squad.

3Com's decision to reach their networking packages from corporate behemoth down into small business and home PC users has won them praise and earnings upgrades. The aggressively deregulating world of communication -- and thus networking -- plays right into our Company's integrated approach. And 3Com's consumer marketing push should attract loyal customers of every size.

If you're thinking about long-term shareholding, look with us for a moment out beyond the here and now, beyond the $2.33 EST of 1997 over to the $3.00 EST for fiscal 1998. Let's assume that 3Com meets those 1997 estimates, is financially solid, and is still slated for three bucks in EPS this May, with guidance of 31% annual growth going forward. What's the YPEG tell us?

31 x $3.00 = $93.

Our fair price for 3Com heading into May -- if the Company meets estimates and is growing ever more secure financially -- is $93 a share. The Company would be capitalized around $16 billion, or on the order of 5x sales, certainly a high multiple off sales but one that would reflect the enormous prosperity that appears to await well-managed, well-marketed, profitable businesses dedicated to networking the world.

Ladies and gents, Fools all, the networking of communications, of reams of data, the linking of satellite offices to corporate headquarters, of students to experts halfway around the world, this giant connection is demanding huge investment, requiring an ambitious and educated workforce, and it will dole out not a trivial reward. 3Com is in fine position to participate in the mother of all inflection points... but we're only in the first or second inning here.

So, getting back to the message folder query: Is 3Com a buy here?

The best we can do as investors is to keep our eyes on their performance as it flows through each quarter. Apparently, next Tuesday, 3Com will announce figures for its most recent quarter. Mean estimates call for $0.50 EPS. This performance, reflected in the financial statements, offers the next chapter in the story of our company. A click of this hyperlink -- 3Com's 7-Year Record -- shows how the company and stock have done through the 1990s. Margins, cashflows, marketing, product developments -- all things we can follow together in the 3Com stock folder -- will help us value the enterprise going forward.

In its first five weeks, 3Com is up 19.5% for us. But Dave's indicator was right last night. The San Francisco Giants lost to the San Diego Padres 8-5 at 3Com Park. And the stock fell a buck today. And the Giants are kicking around the cellar of the NL West, with a 61-90 record.

Hey, maybe this isn't about business growth at all. Dag-gum, let's get the 49ers in the stadium already.

Tom Gardner, Fool

Today's Numbers

Day Month Year History FOOL +6.37% 8.27% 36.94% 155.71% S&P 500 +0.22% 4.76% 10.89% 49.00% NASDAQ +0.53% 6.18% 15.20% 68.30% Rec'd # Security In At Now Change 5/17/95 2010 Iomega Cor 2.52 17.88 609.62% 8/5/94 680 AmOnline 7.27 33.00 353.74% 8/11/95 125 Chevron 50.28 61.88 23.05% 8/13/96 250 3Com Corp. 46.86 56.00 19.51% 8/12/96 110 Minn M&M 65.68 70.50 7.34% 8/12/96 130 AT&T 54.96 57.13 3.94% 8/12/96 280 Gen'l Moto 51.97 48.63 -6.44% 8/24/95 130 KLA Instrm 44.71 20.75 -53.59% Rec'd # Security Cost Value Change 5/17/95 2010 Iomega Cor 5063.13 35928.75 $30865.62 8/5/94 680 AmOnline 4945.56 22440.00 $17494.44 8/13/96 250 3Com Corp. 11714.99 14000.00 $2285.01 8/11/95 125 Chevron 6285.61 7734.38 $1448.77 8/12/96 110 Minn M&M 7224.44 7755.00 $530.56 8/12/96 130 AT&T 7144.99 7426.25 $281.26 8/11/95 280 Gen'l Moto 14552.49 13615.00 -$937.49 8/24/95 130 KLA Instrm 5812.49 2697.50 -$3114.99 CASH $16258.37 TOTAL $127855.25 Transmitted: 9/19/96