Fool Portfolio Report
Friday, April 11, 1997
by Jeff Fischer (TMF Jeff)
ALEXANDRIA, VA, (April 11, 1997)-- After stabilizing for a short period, stocks continued along a path of destruction to end the second week of April. Friday was particularly unstable, with the Nasdaq dropping 2.34% and the S&P falling 2.73%, an amount which hasn't been shed in one day since last summer.
The selling was initiated by interest rate concerns, once again. This promises to be an ongoing theme for the foreseeable future, though rates are currently not near a level which would hurt the economy, nor which significantly diminishes the relative attraction of stocks, yet. The market is assuming rates will continue to rise in the near-term.
For the week, the S&P and Nasdaq fell 2.67% and 2.41%, while the Fool tread water and finally sunk 1.83%, ending comparatively strong on Friday as America Online rose. The Nasdaq is down 6.52% for the year, while the S&P finally slipped into negative territory on Friday.
After a strong two years of dropping rates and rising stocks, the reverse appears to be the case for now. Inflation is low, though, so perhaps this will be short-lived before a balance is found. Meanwhile, as always, if you're investing look for value. If you're familiar with your current stocks, you realize that their fall is an extension of the market, not the fault of the company which the stock represents.
WEEKEND. On weekends many readers have more time to cozy up with the Fool recap, so frequently the writing "digs in" a bit more than usual. In some parts of the world the weather promises to be nice this weekend. In that case, you may want to print this recap and read it slowly at a park, enjoying the sun and a cup of mocha. This recap digs in and then looks out, five years ahead, regarding one industry -- though the thoughts involved can relate to most stocks.
Computer networking is one of the fastest growing industries of the decade, and it promises to continue growing at speeds unheard of for most industries. The stocks have fallen from top-performers to the very bottom of the list -- literally -- in the past three months. Why? Growth is slowing to a more moderate pace, though still a market-crushing pace. Competition is increasing, resulting in mergers between leading companies. Some product prices have come down, but new high-end products still grant gross margins around 60%. Big picture considered, the long-term scenario appears much brighter than is implied by the current valuations granted the stocks.
We now look at the values given the leading networking companies and, projecting growth rates on the conservative side, estimate where the stocks might trade in five years time, all in the Foolish aim of finding market-beating investments.
CISCO SYSTEMS (Nasdaq: CSCO) $52
Market Cap: $34.5 billion 12-month sales: $5.3 billion Price-to-Sales Ratio (PSR): 6.5 Trailing net margins: 19.3% Earnings estimate: $2.72 at 7/98,5 quarters out Trailing earnings: $1.55 Current P/E: 33 P/E on estimate: 19 Five-year est. annual growth rate: 35% YPEG value: $95.20
Cisco is expected to grow 35% per year. That's unlikely. Fifteen to twenty percent is more conceivable. Being "conservative," if the company grows earnings 20% per year over the next five years, earnings would total $5.64 in the year 2003. The stock trades at 9 times that estimate. For the stock to trade at a multiple identical to its growth rate, it would appreciate 117% over the coming five years, to $112. The risk involved appears moderate. Meanwhile, it's extremely doubtful the market will gain 20% per year over the next five years (the average annual gain being around 11%). Cisco, a world-leading company, is poised to remain a market-beating stock.
3COM (Nasdaq: COMS) $32Market Cap: $5.6 billion 12-month sales: $2.97 billion Price-to-Sales Ratio (PSR): 1.88 Trailing net margins: 10.6% Earnings estimate: $2.51 at 5/98, 5 quarters out Trailing earnings: $1.73 Current P/E: 18 P/E on estimate: 12.7 Five-year est. annual growth rate: 30% YPEG value: $75.30
US ROBOTICS (Nasdaq: USRX) $55Market Cap: $4.89 billion 12-month sales: $2.25 billion Price-to-Sales Ratio (PSR): 2.17 Trailing net margins: 8.7 Earnings estimate: $4.37 at 9/98, 6 quarters out Trailing earnings: $2.07 Current P/E: 26 P/E on estimate: 12.58 Five-year est. annual growth rate: 35% YPEG value: $152
Combined 3Com and US Robotics:Market Cap: $10.49 billion 12-month sales: $5.52 billion Price-to-Sales Ratio (PSR): 2.0 P/E on combined estimates: 12.6
Cisco Systems, while attractive looking five years out, trades at more than three times the price-to-sales ratio of 3Com and U.S. Robotics. Figuring Enterprise Value on each stock (subtracting cash and securities, and adding long-term debt) Cisco's valuation isn't quite as high comparatively, but is still three times the multiple given its largest competitor. 3Com hasn't seen a lower valuation in over five years.
Attaching a "conservative" 20% earnings growth rate onto 3Com and US Robotics for the next five years, we have 3Com's stock trading at 6 times earnings of $5.20 five years out. To trade at 20 times those earnings, the stock would appreciate to $104 per share, or 225%, in five years. The stocks of 3Com (and US Robotics) appear to be "curled up" with the possibility of walloping the market over the coming five years.
ASCEND COMM (Nasdaq: ASND) $44Market Cap: $5.28 billion 12-month sales: $657 million Price-to-Sales Ratio (PSR): 8.03 Trailing net margins: 21% Earnings estimate: $2.02 at 12/98,7 quarters out Trailing earnings: $1.12 Current P/E: 39 P/E on estimate: 22 Five-year est. annual growth rate: 40% YPEG value: $80.80
CASCADE COMM (Nasdaq: CSCC) $29Market Cap: $2.71 billion 12-month sales: $375 million Price-to-Sales Ratio (PSR): 7.22 Trailing net margins: 21% Earnings estimate: $1.56 at 12/98, 7 quarters out Trailing earnings: $0.77 Current P/E: 37 P/E on estimate: 18.6 Five-year est. annual growth rate: 45% YPEG value: $70
Ascend and Cascade combined:Market Cap: $7.99 billion 12-month sales: $1.03 billion Price-to-Sales Ratio (PSR): 7.75 P/E on combined estimates: 20.8
Ascend and Cascade, destined to merge, trade at the highest multiples of the group, but are considerably smaller and expected to grow more quickly (around 42% annually). Let's cut that down. Slice it to 25% annual growth, and in about five years the stock of Ascend alone (for simplification) would be trading at 9 times earnings of $4.93 per share. To trade at an earnings multiple of 25 (the given growth rate) the stock would rise to $123, or 180% from the current price, over the next five years. Ascend (and so Cascade) also have the strong possibility of being healthy market-beaters going forward.
Of course, all of these numbers rely on forward-looking analysis. Networking is expected to grow 30% to 50% annually the next five years, though many analysts see that number drifting lower. Consensus among those analysts currently calls for 23% annual growth. Cisco Systems supports the 30 to 50% number.
Above, we granted 20% earnings growth to the leaders, leaning on the conservative side. Ascend (and Cascade) were given 25% growth rates, much below the 42% expected from them. Still, five years out, the underlying stock could appreciate 180% -- market-beating. 3Com, at 20% earnings growth for five years, could appreciate 220%, and Cisco over 115%.
Aside from having to estimate growth rates, we haven't (and can't) speculate on where networking is headed, and which companies will benefit and which may be hurt in the next five years. Another concern is pricing and margins, especially as lower-end products suffer price cuts. Meanwhile, though, new high-end technology rolls out and allows leaders to keep margins high. 3Com has lacked in high-end sales, though, and so has lacked the ability to support higher margins. That could be improving with the coming merger and resulting product lines. Cisco and Ascend have sector-leading margins.
Over-all, stepping back and looking ahead, the networking sector doesn't look awry, but the investors selling out near the current lows might be. Perhaps they don't want "dead money" for however long the stocks may not move, even though over the long haul the sector is attractive for its growth rate and the high margins that leaders possess. The stocks of those leaders should continue to beat the market over the next five years, though the recent selling requires that an investor be a direct contrarian to the prevalent sentiment. "Contrarian-style" investing has given the Foolish Four 23% annual returns for the last twenty-five years.
LESSONS: More lessons will surely be learned from networking stocks going forward, but now is as good a time as any to briefly consider some lessons taught from current Fool portfolio stocks:
AMERICA ONLINE (NYSE: AOL): Through consistent bad news in 1997, of lawsuits, access problems, and content-related restructuring, the stock has risen 25% since January 2nd, and 100% since last fall. Lesson?
ATC COMMUNICATIONS (Nasdaq: ATCT): Having over 40% of its business with one client (AT&T), stating that quarters are sporadic, and margins as well, while just having hired a new management, we bought the stock anyway. We wrote out all the warnings and then more or less bet against them, while buying a stock with a visibly rich valuation. Many readers "called us" on this buy from day one, which is good to see.
3COM (Nasdaq: COMS): Over 40% of its sales come from low-end products, so it competes with INTEL (Nasdaq: INTC) and others on price-sensitive "commodities." But the stock still reached valuations in line with peers possessing margins nearly twice those of 3Com's. In the long-term, though, the lesson here may be similar to the lesson taught by KLA Instruments.
KLA INSTRUMENTS (Nasdaq: KLAC): Patience pays if you're invested in the right companies.
IOMEGA (NYSE: AOL): A tremendous investment for the Fool. The stock has risen 600% in less than two years. That's all there is to it for us. Friday the company signed an additional license agreement for Zip drives with Matsushita of Japan, giving further non-exclusive rights to the company for Zip drive technology and products. The agreement was first signed in September of 1996.
Have a Foolishly enjoyable weekend!
1) www.fool.com: message boards and company snapshots (from which I retrieved nearly all the trailing numbers for the networking stocks -- very handy!).
2) Fool's Rogue Articles, this weekend on IPO's
2) Buffett's annual report, quickly summarized.
3) Online Commerce: where might it be going?
4) Microsoft & Microhard?
Stock Change Bid -------------------- AOL + 1/2 47.13 T - 3/4 33.75 ATCT --- 5.44 CHV -2 1/4 62.25 GM -1 1/2 53.00 IOM - 1/2 17.38 KLAC -2 5/8 41.38 LU -1 7/8 51.13 MMM -2 1/8 81.25 COMS - 5/8 32.00Day Month Year History 5/17/95 2010 Iomega Cor 2.52 17.38 589.77% 8/5/94 680 AmOnline 7.27 47.13 547.95% 8/11/95 125 Chevron 50.28 62.25 23.79% 8/12/96 110 Minn M&M 65.68 81.25 23.71% 10/1/96 42 LucentTech 47.62 51.13 7.37% 8/12/96 280 Gen'l Moto 51.97 53.00 1.98% 8/24/95 130 KLA Instrm 44.71 41.38 -7.46% 8/12/96 130 AT&T 39.58 33.75 -14.72% 8/13/96 250 3Com Corp. 46.86 32.00 -31.71% 10/22/96 600 ATC Comm. 22.94 5.44 -76.29% Rec'd # Security In At Value Change 8/5/94 680 AmOnline 4945.56 32045.00 $27099.44 5/17/95 2010 Iomega Cor 5063.13 34923.75 $29860.62 8/12/96 110 Minn M&M 7224.44 8937.50 $1713.06 8/11/95 125 Chevron 6285.61 7781.25 $1495.64 8/12/96 280 Gen'l Moto 14552.49 14840.00 $287.51 10/1/96 42 LucentTech 1999.88 2147.25 $147.37 8/24/95 130 KLA Instrm 5812.49 5378.75 -$433.74 8/12/96 130 AT&T 5145.11 4387.50 -$757.61 8/13/96 250 3Com Corp. 11714.99 8000.00 -$3714.99 10/22/96 600 ATC Comm. 13761.50 3262.50-$10499.00 CASH $5240.09 TOTAL $126943.59