The Rule Breaker Portfolio, Buying IOM, 05/16/95

Foolish Figures

Iomega Corporation
NASDAQ:IOMG
Type: Mid-Cap Growth
Phone: (800) MY-STUFF

Closing Prices, May 16th, 1995:
Bid $14 1/2 Ask: $14 5/8

Trailing 12-month revenues: $147.0 million
Trailing 12-month EPS: $0.09 (excludes 1Q two-cent tax benefit)
Last quarter reported: March 1995 (FY: Dec)
Next quarter reported date: 2Q, July 20, 1995
Consensus EPS estimates for quarter: $(0.03)e vs. $(0.01)
FOOL ratio: .21, though not very applicable (see writeup)

Trade: Buying 335 shares, May 17th

The Overview

Iomega Corp. (NASDAQ:IOMG), based in Roy, Utah, may need little introduction for our regular readers. That's because this has been the most talked-about stock in Fooldom for more than a month. It also happens to have more than doubled in value since April 1st. This is one hot stock.

Iomega provides personal computer information storage solutions that help people manage their stuff anywhere. These solutions include the once-award-winning Bernoulli line of removable drives and disks, the Ditto tape-backup line, and recently and significantly, the ZIP drive and disks. Iomega's products---if you can find them---are available primarily through computer retail stores.

Skeptics initially, Fool HQ has become convinced over the past several weeks that Iomega is a good company that, due to a critical new product introduction, offers investors a fine opportunity for rapid share-price appreciation over the next couple of years. IOMG used to be just a dull company with single-digit sales growth in a commodity field. And over the past couple of years to boot, Iomega has lost money. In fact, the company's almost 19 million shares outstanding cruised down below $2 per share in latter-end 1994. Ah, but that was all well before. . . The ZIP!

The ZIP is simply a removable, external floppy disk drive (it sports a cobalt blue color, for those who haven't seen it) that combines the large-storage capacity of a hard drive with the portability of floppy disks. The standard 3.5" disk you probably have sitting near your machine holds just 1.44 megabytes. . . these disks, which are virtually the same size, hold 100 megs of storage. The ZIP is quick and reliable and has drawn some of the highest product endorsements we have ever seen for a piece of computer hardware, having been crooned about both in industry trade publications and the popular press. (Walter Mossberg, soon after writing kind words about The Fool in SmartMoney magazine, then went on in a Wall Street Journal column dated April 6th to praise the ZIP for its low cost, minimal set-up time, and ease of use. Iomega stock proceeded, by our estimation, to appreciate more rapidly and noticeably than shares of The Motley Fool.)

On the face of it, we may appear to have missed the boat on this stock. . . hey, what's The Fool doing showing up at $15 when the thing traded at $3 a couple of months ago? But one of our Foolish precepts is not to worry about past appreciation when we invest. . . America Online had risen in value five times over the two years prior to our purchase, and many thought back then that we'd missed the boat and bought late. Conventional wisdom will always hold little allure for us. We think that if this company can succeed in ramping up production to meet the demand for its products, that we can double our money in the next 12 months. That is our aim with this investment.

The Business

The Iomega message folder is so active in Fooldom, receiving about 40 messages a day, that there's almost nothing we can tell you here that's new. In fact, within minutes of this report being published, our Iomega folder will probably contain some new scrap of information that we have not included. (This is one of cyberspace's best features.) Anyway, we can perhaps filter out the most relevant current information for you and organize it in the best manner.

Iomega's business is in the medium of computer storage, in this case for personal computer users (PC and MAC). Iomega makes the drives that hold the disks that you use to save your work on. Until recently, this industry was divided between heavy storage hardware (like hard disks, which typically hold 200 megabytes and up) and light, portable storage (like floppy disks, whose standard remains the 3.5" disk that holds 1.44 megs---you may have a lot of these kicking around your office.) What Iomega has succeeded in doing with its ZIP drive is to create a hybrid storage form, combining the ease and portability of floppies with the capacity of hard drives. The ZIP is like a high-capacity, higher-speed version of your good ol' floppy disk drive, only each ZIP disk, as noted above, holds 100 megs! (The disks, by the way, will fit in your shirt pocket.) The external drive, which is a cinch to set up, costs just $200; 100-meg disks are $18 individually, $150 per ten-pack. Computer City president Alan Bush was quoted yesterday on the Dow Jones newswire calling the ZIP "one of the hottest-selling products I've seen in a long time." We also want to draw a likeness between the ZIP drive and the Gillette razor. . . both are lower-margin products that set up their respective companies to make the REAL money off disks and razor blades.

For owners, the two primary uses of the ZIP include (1) using it to transfer information between two separate computers in a quicker, easier way than ever before, and (2) using The ZIP as a superior form of data backup and retrieval, as it's much quicker than most tape-backup drives. Both of these advantages, combined with its low cost, give PC users major reasons to get their hands on this product; gone will be the days of maintaining dozens of 3.5" floppies in a storage box in your office. With the ZIP, you can hold ALL that info on a single disk, and use another few ZIP disks to back up your hard drive at regular intervals. In fact, you can now put off spending money to upgrade your hard drive with additional memory, because you can store stuff right on your ZIP disks instead. In time you may not even bother with a hard drive. . . you can just use your ZIP disks in lieu of it! (You won't see us doing this anytime soon, but we need to make clear how revolutionary this product is.)

Armed with a hot new product and industry recommendations that would look good even read in reverse, Iomega has drawn the attention of the technophilic public and done some brisk sales in the first and (especially) second quarter. Only problem is, they can't build the things fast enough. Go over to the Iomega area on AOL (keyword IOMEGA) and you'll find some of your fellow Americans flaming the company for not filling its orders. This is somewhat similar to America Online getting flamed by people who are having trouble logging on. . . in both cases you have a hot product in such high demand that the provider cannot always reliably meet it. Iomega will not release preliminary sales or production figures, simply cautioning investors that it expects a loss in the second quarter.

That's more of the same since, as its 9 cents in trailing earnings per share demonstrate, the company hasn't made any real money yet. Iomega just reported a loss of 10 cents per share in its first quarter, vs. a loss of 29 cents per share in 1Q '94. And Iomega is a distinctly cash-flow negative operation. In the quarter just reported, IOMG's balance sheet shows a decrease in cash and cash equivalents of $4.1 million, primarily as a result of capital expenditures relating to The ZIP. The danger is that Iomega may lack the cash necessary to enable The ZIP to clinch the market. Our purchase of this stock suggests our faith in management's ability to get the job done.

Now, we don't mean to make it sound as if the ZIP is the only product Iomega offers, because truth be told this company did $141.4 million in sales last year without any ZIP drive at all. A large chunk of 1994's sales came from IOMG's Bernoulli drive, a removable "high-end" disk drive, meaning that it costs more and holds more and is therefore aimed at businesses, not consumers. (The company's number one customer in recent years has actually been the federal government, representing another example of the way in which management is redirecting the company.) The Bernoulli is, however, being rendered obsolete. The ZIP is one future reason; the primary past reason has been competing products from Syquest Technology (NASDAQ:SYQT). Due to inroads made by Syquest and others, the Bernoulli actually did less business for Iomega in 1994 than it had the year before. Fortunately, the company's Ditto line of tape-backup drives (the third bestseller in the industry, priced at $99) kept the losses from being too bad.

But the company also has several new products in the pipeline. The research & development team announced its first plan to follow up on the ZIP's success by providing a new removable disk drive similar to the ZIP but aimed directly at high-end "power" users. That product shipped in test units this week, and should contribute to 1995 sales. And plans are in place for a fourth-quarter launch of a 25-meg "mini-ZIP" disk priced at $12. . . software companies could conceivably use these as storage media for selling their word processors, spreadsheets, games, etc.

Thoughtful Fools will be curious about competition. There is presently no competition. Syquest is supposed to come out with a competitive offering in June, but a look at the product suggests a certain amount of desperation on the part of Iomega's competitor. The external version of Syquests EZ-135 drive will cost about $30 more, and crucially, it will run off cartridges, not disks. Unfortunately, cartridges are much more expensive to produce than disks and afford Syquest little latitude for competitive pricing and profitability. And there's no guarantee that Syquest will bring any of this to market on time. (Regardless, we expect the cartridges to be priced $5 or more above the ZIP disks.) Meanwhile, a triumvirate of Compaq, 3M, and Matsushita are expected to come out with a competitive product "later this year," as well. But by then Iomega will probably have an even faster product. Our company should continue to enjoy the benefits of being first to market; through past experience we believe this advantage is worth more than a ZIP drive's weight in gold.

The Financial Side

Iomega closed 1994 with sales of $141.4 million, and lost 10 cents per share. The first quarter of this year looked like this:

*reported EPS were -$0.08, but that included a one-time tax benefit of $0.3 million, or 2 cents per share, which we have Foolishly subtracted from IOMG's net earnings as this is not a recurring item.

The sales increase was 16% for the first quarter, which Iomega attributed to an increase in its Ditto tape-backup product. . . it derived only tiny gains from the quarter-end release of the ZIP. These sales gains offset a revenue decrease in the company's Bernoulli products. The company's gross margin---revenues minus cost of revenues---increased by 10.5%, but again, this does not fully reflect the potential that the Zip drive can add to earnings.

A Foolish glance at the balance sheet reveals a current ratio of 2.0 and a quick ratio of 1.4, meaning that the company possesses adequate cash to pay its bills. The company has $31.8 million in "working capital," which is more than sufficient to cover current business expenses. Iomega has no long-term debt, surprising in a hardware company of this size that has lost money over the past couple of years.

What excites us, of course, are the few earnings estimates that exist for the company. Not followed by any Wall Street firm, Iomega's best known follower is the esteemed Red Chip Review, which just published earnings estimates of 60 cents per share for the year ended 12/95, and $1.42 per share for 12/96. These numbers obviously factor in tremendous growth for the ZIP, a supposition which we believe to be well-justified considering the almost unprecedented positive publicity on this product, and the lack of serious visible competition.

We expect the company to report a slight loss or flat quarter for its second quarter (6/95), followed by substantial gains in the latter half of the year as production ramps up to profitable levels. Estimates on the margins for the disk drive suggest a profit of maybe $10 out of the $200 retail price. . . the disks, on the other hand, may be about $3 to produce and retail in the $15-$18 range. These numbers are speculative, since Iomega is tight-lipped about its finances, but you can see that the company plans to make money on the disks. Estimates for 1995 sales of the ZIP range from about 300,000 to 500,000 units. And to give you a sense of disk sales, an Iomega representative recently reported that the ratio of ZIP disk-to-ZIP drive sales is 9-to-1.

The Stock's Performance

Inspired by the Mossberg article in The Journal which pushed the stock up to $10, IOMG rocked the April nights away. Early May has been even better, as the stock has risen more than 40% in the past couple weeks. These shares underwent a one-day rise of greater than 20% when it was announced on May 4th that CEO Kim Edwards had added a block to his own holdings at $10 5/8 some weeks earlier. (Lucky dog bought four points below The Fool; but that's as nothing compared to many of our readers, who were buying in the single digits.)

There is no Wall Street analyst covering this company yet. This is a MAJOR reason we like the stock right here. . . we know institutions have been buying in recent weeks, but no official "coverage" is in place for Iomega. We love underfollowed stocks. . . we spend a fair amount of time looking for them. This is one of them, and institutional ownership is well below 50%. Insiders own 22%.

We are buying these volatile and high-risk shares with the aim of doubling our money in the next 12 months. The crux of the matter is, as noted earlier, whether the company can supply the ZIP's demand. Iomega is said to have hired 200 workers in the past month, just to run their factory at full capacity cranking out about 1500 ZIPs a day. The company's success or failure in meeting the demand will become more evident as we move through the course of this year. The competition currently visible on the horizon is not something we are taking seriously.

Our PEG of .21 isn't terribly meaningful in this situation, since the company is currently so near breakeven. What we consider most significant about the PEG is simply that it is below .50. . . we're not hung up or pedantic about the particular number at present. The PEG will take on more meaning as earnings begin to appear. However, one can notice the estimate of $1.42 for 1996, and apply a fairly standard multiple of 15 times earnings to that figure. The result is a suggested stock price in the low $20's. However, we believe that in time the Market will concede Iomega an above-average multiple for its prospects, resulting in our 12-month target price of about $30.

Prospects

Fool HQ believes in the little innovator that gets first to market. . . we think this is the best situation to invest in, as these innovators are so often nimbler and smarter than the lumbering giants that try to copy their success. Good, nimble, little innovators stay one step ahead. That is one of our themes here. . . a little company that, out of nowhere, filled a hole in the market with a product consumers were waiting for without realizing it. Iomega has thrown the floppy-drive world for a loop, and is well ahead of the competition. The earnings estimates are still few, but reputable. . . another situation a Fool looks for. This is not a tiny company by any means: $10 million worth of stock traded hands on today's market. And Iomega is getting noticed by traders and institutional types alike, well after our own dear (and now well-heeled) readers were raving about IOMG's prospects. But for the most part, a fair amount of naysaying is still factored into this stock even after it's trebled in two months and many, many people have still never heard of a ZIP drive. Or realize its benefits. Yet.

A warning to investors. . . as mentioned earlier, Iomega is a volatile stock. If you're not prepared to take a 20%-30% hit from time to time, stay well away. We are, because we recognize that shares like these can get flipped around a bit and we maintain a long-term investment mentality. And, also importantly, we're DIVERSIFIED. From our reading of the message folder, we've divined that some less Foolish investors have slapped a whole big piece of pie down on this stock. This holding will merely be one of eight separate holdings for The Fool Portfolio. Every Foolish investment portfolio should contain at least six well-balanced holdings. . . if you haven't spread your money around, you're a gambler, not a Fool. In our experience, gamblers brag about their gains and omit mention of the losses that in most cases more than wipe out their gains. Invest; don't gamble.

We consider $14 5/8 an attractive price to pick up this stock, whatever we could have bought it for in the past. We're picking up 335 shares tomorrow.