<THE RULE MAKER PORTFOLIO>
What Happened to Cash-King?
AOL as Rule Maker
By Phil Weiss (firstname.lastname@example.org)
Towaco, NJ (Jan. 7, 1999) -- From a stock market perspective, 1998 could easily be referred to as the year of the Internet stock. If you look through any list of the best performing stocks of last year, you'll see a preponderance of companies that are commonly referred to as "Internet" stocks. Picking some of the right ones as our friends in the Rule Breaker Portfolio did lead to some rather large gains. The Rule Maker Portfolio did beat the S&P 500 Index last year, but some may wonder if and when we plan to add any Internet stocks to our portfolio. As a matter of fact, a Fool recently asked about that in a post on our Message Boards.
This is really not an easy question to answer. The first thing to consider is that our investment strategy is inherently much more conservative than that in the Rule Breaker Portfolio. Many of these "hot" companies don't have the history behind them that we really look for in selecting Rule Makers. As a matter of fact, many of them have never even had any earnings, so they fail our net margin test rather handily. Although failing one of our tests doesn't automatically knock a company out of the running, as a general rule, companies that are not yet profitable have a tough time making it into our portfolio.
Last July I started to think about the net stocks and whether any of them fell under the Rule Maker heading. After some analysis, I concluded that there were two that could fit the bill -- America Online (NYSE: AOL) and Yahoo! (Nasdaq: YHOO). I purchased some shares of what I considered to be the stronger of the two on two different occasions this past August. The stock that I chose was in Tom's Simpleton Portfolio. It is also the #1 holding in the Rule Breaker Portfolio -- AOL.
Ironically, AOL is a stock that I sold at a profit after holding it for about 6 weeks back in 1995, when I was a lot less Foolish in my investing style than I am now. Hmm... maybe I should post something about this in the My Dumbest Investments Folder, though I will say that my reasons for selling AOL at that time proved to be right, as it fell by 60-70% after I sold it. Actually, my biggest mistake was not buying the shares back after the stock fell. Ouch! Kind of makes it sound like I'm talking about market timing there doesn't it.
Let's take AOL through the paces and see why I think it can be considered a Rule Maker. Normally I focus more on the numbers when I do this kind of analysis, but tonight I'm going to focus more on what I see as the beauty of the business model.
1. Repeat Purchase Business -- This is pretty easy. AOL now has over 15 million subscribers. There are also another 2 million or so on CompuServe and around 2.5 million internationally. Each paying a monthly subscription fee month after month after month. That doesn't even count all the advertising and e-commerce revenue the company gets. I'd say passing this one is a no-brainer.
2. Global Consumer Brand -- As I noted above, AOL has around 2.5 million subscribers internationally. Plus, the Web is available around the globe. Looks like we're 2 for 2.
3. Sporting Strong Historical Performance -- AOL had only one million subscribers in 1994. On November 12th of last year, it hit the 14 million mark. By December there were 15 million subscribers -- the last million were the fastest in AOL's history. According to Value Line, over the last five years AOL's revenues have grown at an average rate of 70% per year. Earnings during that time have grown by an average rate of 35.5% per year. That sounds like pretty strong historical performance to me as well.
4. Super-Size the Company -- Piece of cake. Market cap over $70 billion. Sales for the latest fiscal year were over $2.6 billion.
5. A direction that exceeds the location -- Recently AOL released a survey in conjunction with Roper Starch Worldwide in which it was found that nearly half of Internet users said that the Internet is becoming a necessity. As a matter of fact, 67% of those surveyed said that they would prefer an Internet connection as opposed to TV or a phone if they were stranded on a desert island. This is just one more indication of how the Internet is becoming a part of the daily life of so many people.
Those figures I presented on the number of users above mean that subscribers have grown by a growth factor of 15 in four years (an annualized growth rate of about 580%)! Combine that with the advertising revenues and the 68,000 new people a day logging on to the Internet. Makes AOL sound like a gorilla doesn't it?
There is also the fact that as PC prices continue to fall PC's are becoming more and more accessible for home use. And, it's probably true that many of the people that are purchasing these PC's are less experienced users, which makes them more likely to veer towards AOL. I know that when I first got on the net I used AOL because it was easier than any of the other alternatives. That's probably a common reason that so many new users sign up with AOL, and it's a big part of its marketing appeal.
There's one other thing that shouldn't be overlooked here -- all the deferred revenues sitting on AOL's balance sheet. This represents revenue that has already been paid to AOL, but for which AOL hasn't yet delivered all the related services.
6. Gross Margin that Exceeds 50% -- Oops, we fall a bit short here. Right now gross margins sit at only 36%. As a matter of fact, this is where Yahoo! and its lighter business model have a big edge over AOL. I see AOL's gross margins growing over time, due to increased operating efficiencies as well as the benefits that I believe will be realized from the Netscape (Nasdaq: NSCP) acquisition.
7. Net Margins of at Least 7% -- Recently AOL has reached this target and even more importantly net margins have been growing consistently. I see this trend continuing as well.
8. Cash No Less than 1.5 times debt -- No problem here at all. Cash has been growing. There is some debt, but not all that much. Right now this ratio is at 3.34.
9. Efficient Use of Cash -- AOL's flowie rivals that of Microsoft (Nasdaq: MSFT). Right now it's at 0.37. It's easy for this company to have a great flowie as it carries no inventory and has little in the way of receivables.
So, to me AOL is a Rule Maker. However, I will say that it is a riskier stock than the rest of the holdings in our portfolio. I think that for the long-term investor this is a great company to own. Not many companies can match its economics and from what I can see it has a great future as well.
Do you agree or disagree with my thoughts on AOL? Do you think that Yahoo! would have been a better choice? Maybe some other company? Please share your thoughts on our Companies Message Board.
Phil Weiss, Fool
Stock Change Bid AXP +1 3/16 104.81 CHV + 5/8 83.88 CSCO +3 1/2 103.63 KO - 13/16 69.44 GPS --- 63.13 EK - 9/16 72.63 XON - 1/8 74.75 GM - 1/2 77.56 INTC - 1/4 129.25 MSFT - 3/4 150.50 PFE -1 13/16 124.50 SGP - 3/16 56.81 TROW - 1/16 37.38
Day Month Year History R-MAKER +0.10% 6.24% 6.24% 38.26% S&P: -0.21% 3.30% 3.30% 26.22% NASDAQ: +0.23% 6.08% 6.08% 39.59% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 150.50 92.29% 5/1/98 55.5 Gap Inc. 34.06 63.13 85.33% 6/23/98 34 Cisco Syst 58.41 103.63 77.41% 2/13/98 22 Intel 84.67 129.25 52.64% 2/3/98 22 Pfizer 82.30 124.50 51.28% 8/21/98 44 Schering-P 47.99 56.81 18.38% 2/6/98 56 T. Rowe Pr 33.67 37.38 10.99% 5/26/98 18 AmExpress 104.07 104.81 0.72% 2/27/98 27 Coca-Cola 69.11 69.44 0.48% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 74.75 16.19% 3/12/98 20 Eastman Ko 63.15 72.63 15.01% 3/12/98 17 General Mo 72.41 77.56 7.12% 3/12/98 15 Chevron 83.34 83.88 0.64% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 3612.00 $1733.55 5/1/98 55.5 Gap Inc. 1890.33 3503.44 $1613.11 6/23/98 34 Cisco Syst 1985.95 3523.25 $1537.30 2/13/98 22 Intel 1862.83 2843.50 $980.67 2/3/98 22 Pfizer 1810.58 2739.00 $928.42 8/21/98 44 Schering-P 2111.7 2499.75 $388.05 2/6/98 56 T. Rowe Pr 1885.70 2093.00 $207.30 5/26/98 18 AmExpress 1873.20 1886.63 $13.43 2/27/98 27 Coca-Cola 1865.89 1874.81 $8.92 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1495.00 $208.30 3/12/98 20 Eastman Ko 1262.95 1452.50 $189.55 3/12/98 17 General Mo 1230.89 1318.56 $87.67 3/12/98 15 Chevron 1250.14 1258.13 $7.98 CASH $120.62 TOTAL $30220.18 Note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.