Fool Portfolio Report
Friday, May 9, 1997
by Randy Befumo (TMF Templr)
ALEXANDRIA, VA, May 9, 1997-- AMERICA ONLINE (NYSE: AOL) has enjoyed a solid rally since touching $42 a share in late April, mostly on the strength of the company posting a profit in its fiscal third quarter -- a quarter earlier than expected. By showing even a measly two cents of profit per share the company confounded a host of detractors who have been boldly claiming that the company would never earn a penny. For years America Online shareholders have been rebuffed by Luddites who claimed the accounting policies were a farce and that the company would never earn any money if it expensed its marketing costs immediately.
Despite the fact that America Online's prior accounting system was in line with the American Institute of CPA's Statement of Position 93-7, "Reporting on Advertising Costs," business columnists across the country regularly lambasted the company for expensing its customer acquisition costs over the expected life of the customer's business. What did SOP 93-7 require to allow a company like America Online to capitalize advertising?
1.) The primary purpose of the advertising is to elicit sales to customers who could be shown to have responded specifically to the advertising.
2.) The direct-response advertising results in probably future benefits.
Although America Online met the two requirements for capitalizing advertising costs stipulated in SOP 93-7, joining names like Brad Ragan, Brown-Forman, Carnival Corp., Countrywide Credit, CUC International, Deluxe Corp., Franklin Quest, K III Communications, Lilian Vernon and New England Business Services in treating their customer acquisition costs this way, for some reason it was too much for ol' AOL. While certainly these capitalized assets swelled to a prodigious 33% of total assets as of June 30th, 1996, subscriber levels still outpaced any other competitor by a factor of two or more.
Of course, with the switch to "gold standard" accounting in late 1996, the multitude of short-sellers had to find something else to harp on. America Online remains one of the most shorted companies in America, with 22.4 million of its 113.8 million currently outstanding shares borrowed from trading desks across America. No doubt some of these shares have been shorted against the box by employees of America Online who own options, rich beyond their wildest dreams and willing to lock in a profit here. However, a good deal of these are held by those who do not believe the company can maintain its hybrid network and who believe Internet Service Providers (ISPs) will somehow gobble all of AOL's customers at some point in the future.
Forrester Research's prediction in 1995 that America Online would have no subscribers by 1997 seems laughable in retrospect, but the prevailing belief among the shorts is that the company will eventually lose to the Internet. Any outage or dial-up congestion is wheeled out to support this claim. Questions of whether ISPs can ever get one dollar of advertising, merchandise, or transaction revenue never seem to be asked. No one ever muses over the sustainability of the ISP economic model, although much ink has been wasted on predicting the demise of America Online. Flat-earthers and Luddites can remain short -- even as America Online maintains its base of eight million subscribers -- asking the Nocera-ian question of whether or not it will "all end badly?"
How much is America Online worth, though? In spite of the fact that the company will start making money from here on out, I still like the per subscriber valuation metric. Acquisitions of the future in online space will be done for subscribers and for network capacity, not for earnings. With each account generating $240 in access fees and $30 in advertising, merchandise and transactions fees, valuing the company at $750 per subscriber seems relatively reasonable if one believes America Online will continue to gain members. This would put AOL Networks at $6 billion, or $53 a share. Append to that $300 million for AOL's ANS subsidiary and its AOLNET network, about half of the purchase price of BBN earlier this week, and you get up to $56 a stub really quick.
All this is only with 8 million subscribers. Assume 13 million subscribers in two years and you are in the $85 range in the next twenty-four months, a 30% compound annual growth rate. Looking at the numbers this way, the target prices of $80 to $100 promoted by full-price brokerages like Lehman Brothers, Goldman Sachs and Hambrecht & Quist start to make more sense. Those with the stamina to buy in the low $20s last year when it seems that a full 90% of the short positions were initiated are no doubt sitting pretty today and looking forward to the profitable months to come.
Another name in the Fool Portfolio has unfortunately been going in the other direction, namely ATC COMMUNICATIONS (Nasdaq: ATCT). At $4 5/16 a share, ATC has been a devastating event for many a portfolio. Although it appears dozens of investors choose to ignore the 13 Steps to Investing Foolishly and made ATC their first investment instead of the S&P Index or the Foolish Four, one cannot be too hard on any swayed by the incredibly optimistic buy report. However, here today things do not look all that good for the teleservices provider.
ATC's revenues flattened out this quarter and earnings dropped again, the worst performance of its peer group. Whether you are looking at APAC TELESERVICES (Nasdaq: APAC), TELETECH HOLDINGS (Nasdaq: TTEC), SITEL (NYSE: SWW), PRECISION RESPONSE (Nasdaq: PRRC), RMH TELESERVICES (Nasdaq: RMHT) or WEST TELESERVICES (Nasdaq: WTSC), all of them grew revenues and profits in the last quarter -- every last one of them, to the company, with the exception of ATC. Even ITC GROUP (Nasdaq: ITCG), a company that exploded about two months before ATC dropped from the $20s, reported revenue and earnings growth.
Looking at ATC for positives, they are few and far between. The company is losing business with two of its biggest customers, AT&T and America Online. The recently hired CEO managed to lose millions in a bizarre purchase of company stock on margin -- a purchase that later became a sizable sale when he got a margin call and could not meet it. With this gentleman planning strategy and allocating capital for the entire company, one is not filled with confidence in its long-term potential. Claims of the inbound teleservices being less commoditized than outbound teleservices seem to be patently untrue -- both AOL and AT&T were inbound accounts.
With a market cap of $76.5 million, the company has a price-to-sales ratio of 0.72, only verging on bargain basement just now at $4. The company is still priced at 16 times trailing earnings with earnings falling faster than revenues. Although the company says it can make $0.34 EPS in fiscal 1998, these predictions are coming from the same crowd that has been wrong on what the company would make the last three quarters running. Although bankruptcy is not a possibility, a long, sustained period of below market, unprofitable growth is. A recent Fortune "Special Advertising Section" on the teleservices industry listed more than 20 private firms, all fighting for the same business as ATC. The Fool premise of buying cash-strong, market-leading, brand-name companies in strong industries that have something proprietary about their product or service is not being met by ATC... and will probably never be met by ATC.
Finally, a word about KLA TENCOR (Nasdaq: KLAC), the Fool Portfolio holding that is the least talked about. With indications growing that the semiconductor equipment industry has hit its bottom, here at $49 a stub the company could be considered reasonably priced if the next upturn lasts two or three years like the last one. Now that it has merged with its largest competitor, the only blemish on KLA's future is APPLIED MATERIALS' (Nasdaq: AMAT) decision to enter into the automation, metrology, and wafer inspection business through the acquisition of Orbot Instruments.
Current estimates for this year of $1.77 EPS and $2.29 EPS for next year
could easily start to be notched up once the cycle turns, especially if KLA
and Tencor Instruments achieve some nice cost savings with the merger. Although
buying the stock seems a bit of a stretch right now, someone holding for
1999 and $3.00 to $3.50 EPS could see the stock at $60 to $70, 15% annualized
growth. Given that any sale of the holding would result in immediate tax
consequences that would require your next investment do at least 23% just
to get the same amount of money you started with, there are much better things
to do with a growing, high-margin company with dominant market share than
Stock Change Bid -------------------- AOL + 1/2 50.75 T + 1/4 32.75 ATCT - 1/8 4.31 CHV + 3/4 71.38 DJT - 1/8 9.88 GM +1 1/8 57.88 IOM - 1/16 18.81 KLAC - 5/8 48.75 LU +1 1/4 63.25 MMM + 3/8 91.50 COMS + 1/8 38.38Day Month Year History FOOL +0.50% 5.20% 0.83% 169.09% S&P: +0.55% 2.93% 11.35% 79.93% NASDAQ: +0.32% 5.89% 3.41% 85.38% Rec'd # Security In At Now Change 5/17/95 980 Iomega Cor 2.52 18.81 646.53% 8/5/94 355 AmOnline 7.27 50.75 598.07% 8/11/95 125 Chevron 50.28 71.38 41.94% 8/12/96 110 Minn M&M 65.68 91.50 39.32% 10/1/96 42 LucentTech 47.62 63.25 32.83% 8/12/96 280 Gen'l Moto 51.97 57.88 11.36% 8/24/95 130 KLA Tencor 44.71 48.75 9.03% 4/30/97 -1170 *Trump* 8.47 9.88 -16.60% 8/12/96 130 AT&T 39.58 32.75 -17.25% 8/13/96 250 3Com Corp. 46.86 38.38 -18.11% 10/22/96 600 ATC Comm. 22.94 4.31 -81.20% Rec'd # Security In At Value Change 8/5/94 355 AmOnline 2581.87 18016.25 $15434.38 5/17/95 980 Iomega Cor 2594.53 18436.25 $15841.72 8/12/96 110 Minn M&M 7224.44 10065.00 $2840.56 8/11/95 125 Chevron 6285.61 8921.88 $2636.27 8/12/96 280 Gen'l Moto 14552.49 16205.00 $1652.51 10/1/96 42 LucentTech 1999.88 2656.50 $656.62 8/24/95 130 KLA Tencor 5812.49 6337.50 $525.01 8/12/96 130 AT&T 5145.11 4257.50 -$887.61 4/30/97 -1170*Trump* -9908.50 -11553.75 -$1645.25 8/13/96 250 3Com Corp. 11714.99 9593.75 -$2121.24 10/22/96 600 ATC Comm. 13761.50 2587.50-$11174.00 CASH $49020.02 TOTAL $134543.40