November 21, 1995
I. PROLOGUE: SELLING SNIC
It was back on December 23rd, 1994, two days before Santa broke his leg falling down our chimney. We called up our then broker, Charles Schwab, and ordered up 340 shares of a little-known technology outfit in Novato, California trading at around $14 a share. It was called Sonic Solutions, and it's ticker symbol---one of our astute and witty readers pointed out (with more astuteness and wit than we possessed!)---was SNIC, which looked very, very much like StNICk. Coincidental, but we thought of it as a great omen.
We were excited. Sonic was in the right industry. The world has been moving out of analog and into digital, and you don't have to read Negroponte to recognize that. Sonic's Mac-based audio and video digital workstations were being used in radio, television, recording, film, and video studios. MediaNet, its networking platform, was due out soon.
Heck, it seemed like every single Grammy-nominated CD was edited on a SNIC system. And the systems were receiving high-rankings in trade magazines, from high-profile artists, and in messages to our Sonic folder. At this point, we hadn't even heard that Tom Hanks was going to star in Apollo 13, and that Sonic systems would be used for the sound editing.
But what really caught our attention was the apparent financial strength of the company. A series of 100%+ sales growth years with trailing twelve month sales growth of 50%, double-digit profit margins, working-capital growth, and no long-term debt. The one danger sign was a single quarter---their most recent and 2Q of 1994---in which cash-flows were negative. But we assumed we were looking at a product-transition stage, and that management would shore that up promptly.
Management? Well, we got fooled here. Insider holdings totaled more than 50%. The Company was sporting directors with MBAs from Wharton, Harvard Business School, Stanford Business School, and one with a Phd. in Computer Science from Stanford, who had done work at MIT as well.
We forgot to recognize that these business schools are some of the most overpriced, overhyped outfits in the land---home to the dreaded efficient markets theory. At one point, a Fool wrote in our SNIC folder: "Well, I lost $3,000 in Sonic and learned a hard lesson. But hey, at least I didn't get snaked into spending $60,000 over two years to attend business school---and that doesn't even include lost salary! I'll take my lesson over theirs. :)"
But you put it all together: new markets, rapid sales growth, positive product reviews, financial strength, apparently strong management. . .and you overlook the recent cash-flow dip. . . and it looks like a pretty nice investment.
II. SO WHAT WENT WRONG?
Uhh, everything did. They immediately underperformed estimates by a penny in their third quarter of fiscal 1995 (ended March), announcing that industry-wide component shortages had locked Sonic out of potential sales. The stock tumbled from over $16 a share---a buck and a half above where we'd purchased it---down to the low-teens. Profit margins shrank a bit; receivables hopped up a notch; and the Company opined that troubles would be behind them before the next quarter's report.
At that point, SNIC had 38 cents trailing and estimates sat at 41 cents for the year, and 62 cents for fiscal 1996. That priced the stock around $18 a share, and SNIC was sitting down around $12-$13. We were willing to wait, confident that if the supplies came flowing in, SNIC would beat estimates, as they had before. And our target prices would rise.
Guess what? The fourth quarter came rolling 'round, Sonic was expected to announce 13 cents versus 10 cents the previous quarter. Boom!!? They turned Foolish and crushed estimates? Yeah. . . right. Sonic announced a piddling 4 cents in earnings, on quarter-over-quarter sales DECLINES. Profit margins collapsed, down from 14.5% to 5.8%. The Company cited bugs in their new Ultra-Sonic Processor cards. The stock plunged below $10 a share.
In retrospect, this was the time to sell the stock. Management had projected that there would be NO problems in the fourth quarter. The 4th quarter report then meant that either management was not being forthright with their shareholders OR management was not on top of their business. When this happens, if you don't feel comfortable---and Sonic Solutions was not going out of its way to make the peoples who were funding their operations feel comfortable---it's time to get out of your investment and put the money with a proven and seemingly forthright team.
Did we sell around $10 a share last summer? Nope. And Sonic kept the earnings disasters flowing, announcing a flat first quarter of 1996, then a loss in their second quarter. Sales were dying. Inventories rose. The balance sheet wobbled. Profit margins. . . what profit?
And today, the stock sits at $7 a share, down 50% from where we purchased it last December. You want to know why we didn't sell it earlier? Ok.
III. SO WHY DIDN'T WE SELL EARLIER?
Yes, why didn't we? The first and overriding reason that we didn't is simply because as long-term investors we prefer to give our holdings more than enough chance to prove out our initial rationale.
We know the Foolish saying: "Cut the losers, let the winners run." But we abhor formulaic sell rules---get out when your stock has fallen, say, 20%. That would have gotten us out of America Online before the end of 1994; we'd be out of Applied Materials now---a great company; and we might have missed out on a real turnaround in Sonic Solutions after a disappointing third quarter, hurt by component shortages.
Now, the financial situation DID begin telling us to get out between the 4Q 1995 and 1Q 1996. But we hesitated because of the buzz about new partnerships, the relationship with Silicon Graphics, and actually, very importantly, because we just didn't have that much money in Sonic relative to the rest of our portfolio. It was and is far more important for us to stay on top of what is proving to be a very fluid, very compelling, and to date, very profitable situation with Iomega Corporation (NASDAQ:IOMG), a holding that is now worth more than $11,000, than it was and is to dedicate ourselves to picking the perfect exit point in Sonic, which is now worth $2380.
In recognizing the value of our investments at their *present* price, rather than at our cost basis, we know how best to allocate what are necessarily---for everyone perhaps but Fidelity---limited resources for research. With The Fool Portfolio totalling over $94,000, our Sonic holding is a mere 2.5% of our overall account. Our portfolio was up 2.68% yesterday! And if Sonic now dropped to $6 from $7, we'd lose around $300, or less than 0.30% of our portfolio.
Recognizing the relationship between individual positions and an overall portfolio is one of the great challenges to the individual investor. It is one of the core concepts tied to a Business Management approach to equities investing.
Now before moving to the final sections. . . we want to make it clear that while the above are explanations, they are not meant to be airtight justifications. As portfolio managers, we're going to err on occasion. We were, in this case, reminded of two VERY important investment lessons along the way: a) When management says the problems are over, and then they aren't, it's probably time to move on; b) Keep your eyes on the balance sheet!
Had we been more committed to these, we'd have cashed Sonic a long time ago and had a chance to make money elsewhere. We weren't, and didn't, and that's just an example of a good, old-fashioned mistake.
IV. WHERE TO FROM HERE?
Where to from here for our approximately $2300 worth of SNIC stock? It will go into our pot of $6000 cash, and we'll begin looking for more market-beating investments.
Some here at Fool HQ don't think it's a bad idea for individuals to require that out of every bad investment they make, the remaining capital should go into a proven and great company---a multi-billion-dollar behemoth sans debt and loaded up with spinach. Others think that, as losing investments come with the territory, you stick with your market-beating model, go with other great small-cap or short opportunities if they present themselves, and try to crush the market, Beating the Dow etc. Why become a less aggressive investor after one miss. . . particularly when you have decades in front of you to compound extraordinary growth in the most profitable of all capital universes---the US Stock market. . . why alter a winning approach?
Those are the sorts of matters that can only be resolved at Fool HQ's foosball table.
To close, the only possible reason to hold our Sonic Solutions shares at this point is because we believe that within 18-24 months, given our growth rate and their deterioration rate (Webster's 3rd definition for "solution": a bringing or coming to an end or into a state of discontinuity), we should be in position to buyout the whole darned company. This could have been the beginning of our buyout. At that point, we'd sell off inventory at its salvage value, halt all manufacturing, and fire management freeing them up to teach for Vanguard at business schools across the land.
And what would we be left with? The Sonic Solutions brand name and a big shell, under which The Fool would sell SonicJumper shoes and exercise apparel, scientific calculators, hearing aids, aircraft engines, high-technology odometers and speedometers, all without component shortages, bug problems, never-ending product-transition tangles, and a management team that loathed to interact with customers and shareholders. Kind of our own General Electric. In a phrase, it would be everything that Sonic Solutions does not appear to be at present.
So. . . should we hold and try to buy them out? Naa, we'll pass. We've been SNICked; it's time to move on.