Friday, January 26, 1996
MARKET CLOSE
INDEX:
I. Market News: Nervous Traders Buy Back Yesterday's Sales
II. Heroes: Harley-Davidson, Cypros Pharmaceutical, MICOM, Gateway 2000
III. Goats: Exide, Seer Technology, Applied Voice, Hogan Systems
IV. Investment Perspective: The Digital World---Part Four
V. Calendar: Monday's Economic Events
MARKET CLOSE
DJIA: 5271.75 +54.92 (+1.05%) -- RECORD
S&P 500: 621.62 +4.59 (+0.74%) -- RECORD
NASDAQ: 1040.96 +5.01 (+0.48%)
MARKET NEWS
A week of volatility, indeed. Still not sure about the budget battle and the debt ceiling, bond traders drew encouragement from the agreeable tone of the Washington bunch today and jumped back in where they were diving out yesterday. And the stock markets followed, finishing with a strong afternoon push toward new records for both the Dow Jones Industrial Average and the S&P 500 Index. For the week, the DJIA gained 1.68%, the S&P 500 gained 1.60%, and the Nasdaq Composite gained 2.21%.
HEROES
Harley-Davidson <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:HDI)") else Response.Write("(NYSE:HDI)") end if %> motored ahead $3 5/8 to $33 7/8 today after posting record sales and earnings for the fourth quarter and the year ended December 31. And you thought that the company could not top dumping the doggy Holiday Rambler division? For the quarter, the hog maker posted earnings of $0.42 a share versus $0.33, and for the year, $1.50 versus $1.37. The Street was looking for $0.37 and $1.45. In the release, Harley-Davidson reported that it boosted its daily production rate to an average of 470 units a day for the first quarter of 1996. You'll be hearing them roll by any day now.
Cypros Pharmaceutical Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CYPR)") else Response.Write("(NASDAQ:CYPR)") end if %> continues to enjoy the afterglow of its shareholders meeting this week, up $1 to close at $5 today. At its meeting, Cypros detailed the positive clinical data it is getting from its coronary-artery bypass grafting trial on CPC-111. The company also announced the signing of a non-binding letter of intent on a marketing partnership with a national pharmacy alliance to provide unit-dose forms of its Glofil product, currently available only in multi-dose forms. The company also signed a non-binding letter of intent with Merck & Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:MRK)") else Response.Write("(NYSE:MRK)") end if %> to acquire an additional small renal product to complement Cypros's existing renal-product portfolio. Cypros Pharmaceutical develops and markets acute-care, hospital-based products. The company's preclinical and clinical development programs focus on cytoprotective drugs designed to reduce ischemia (low blood flow)-induced tissue damage in acute-care settings. Ask MF Uptrend; he'll know.
MICOM Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MICM)") else Response.Write("(NASDAQ:MICM)") end if %> picked up $1 3/4 to close at $8 5/8 today after announcing an agreement with Dow powerhouse AT&T. MICOM will provide a private-labeled version of its Marathon 3K, 5K, 20K data/voice integration multiplexers. The units provide excellent voice quality and feature robust functionality over many services, including frame relay, satellite, ISDN and analog and digital leased lines. At least that's what they tell us non-technical Fools. MICOM Communications is the worldwide market leader in the design, development and manufacture of products that integrate remote data, voice, fax and LAN traffic over private and public networks.
Gateway 2000 <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:GATE)") else Response.Write("(NASDAQ:GATE)") end if %> beat Street estimates, and was rewarded with a $3 5/8 pop in its price, closing at $25 3/4. Gateway is the leading direct marketer of personal computers in the country, reporting their first-ever $1 billion quarter. Gateway has been hosed recently because of concerns about Christmas sales and competition for first time buyers---boy, were they wrong. Revenues for the fourth quarter were $1.25 billion (51% growth over last year), while annual revenues totaled $3.7 billion (36% growth over last year). Net income for the quarter was $0.74 per share, 4 cents a share better than estimates. Oppenheimer, Montgomerey, PaineWebber, Salomon. . . all of them upgraded the stock on the news. Sure Gateway sells over a billion a quarter now, but we think they're piggy-backing on Susie's Souvenirs!
GOATS
Exide Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:EX)") else Response.Write("(NYSE:EX)") end if %> was powered down today, dropping $14 3/8 to $33 3/8 after warning the Street that it won't meet earnings expectations of $1.60 a share. The auto battery maker blamed slow December sales and unexpected start-up problems at a British plant for the shortfall, and as a result, the company expects to lay off 700 more workers. Apparently the weather in December was too *good* in many regions, not killing enough car batteries for Exide to meet its expected goals.
Seer Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:SEER)") else Response.Write("(NASDAQ:SEER)") end if %> joined Exide in an earnings warning today, getting hammered $4 1/2 to $6 1/4 as a result. Seer forecast a net loss for the first quarter of roughly $5.5 million ($0.42 a share). In the year-ago quarter, Seer made a profit of $0.08 a share. After the warning, analysts poured fuel on the bonfire. Merrill Lynch cut its rating from "above average" to "neutral" and First Boston cut the stock from "buy" to "hold." Seer develops and markets software products.
Applied Voice Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:AVTC)") else Response.Write("(NASDAQ:AVTC)") end if %> dropped $3 3/4 to $9 13/16 after announcing disappointing earnings and a warning for next quarter. The company expects to report "substantial" write-offs and restructuring charges in the first quarter as a result of its purchase of RightFAX. Applied Voice earned $0.23 a share but the Street was expecting $0.26. Margins also slipped for the quarter, always a danger signal for Foolish investors. On the news, Cowen & Co. downgraded the stock from "buy" to "neutral."
Hogan Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:HOGN)") else Response.Write("(NASDAQ:HOGN)") end if %> dropped $3 1/16 to $9 3/8 after it and Continuum Company <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:CNU)") else Response.Write("(NYSE:CNU)") end if %> announced that they have mutually agreed to postpone the special shareholder meeting needed to approve their previously announced merger. Both companies remain convinced, however, that the combination is in the best interests of both companies, but delays of any kind make investors nervous that they're not hearing the whole story. Hogan Systems develops, markets and supports integrated on- line applications software and related services in use by more than 130 financial institutions in 20 countries.
INVESTMENT PERSPECTIVE: The Digital World--- ISPs and Biotechnology
Many commentators like to make what appears on the surface to be a valid correlation between the advance of Internet-related shares and the frantic pace set by biotechnology companies from 1989 to early 1992. The reason for this is as much sensational as it is intellectual or historical: forecasting that the digital companies will suffer a crash as profoundly as the biomedical corporations did in the second quarter of 1992 makes really good copy. When U.S. Bioscience failed to get FDA approval for its premiere product, Ethyol, Synergen choked on Antril in Phase III trials and Centocor got the thumbs down from the FDA as well, and the entire biotech sector crumbled. Declines of as much as 80% were felt in many a portfolio that bought into these no-earnings, story stocks.
In its broadest sense, the analogy between the digital and the biomedical worlds is a pretty weak one. Biotechnology companies are development stage concerns that consume capital to pay for research and development. Their value is derived from their theoretical market share of the potential markets that they might serve. Develop a drug that no one else has, that costs $10,000 a day to treat a disease that one million people suffer from and you have a company that could, in theory, have $10 billion in potential revenues. Big numbers in potential markets coupled with huge market share drives the shares of biotechnology companies.
Because of this structure, however, biotechnology companies do not earn any money while they are in development. Unfortunately, this does not stop their bill collectors from demanding payment. As a result, they "burn" cash, to quote the prevalent term analysts use, at a given rate. Once the cash runs out, the biotechnology company has to come back to the Street and issue more shares, diluting shareholder value and depressing the worth of their stock. It is no surprise that biotechnology IPOs in 1991 have doubled their market cap, in total, since the companies went public but still sport the same share prices (source: "The Internet Report," Morgan Stanley). This means that the shares have not moved an inch, even though there are now twice as many---a real bust for investors.
Most companies involved in the digital world, by contrast, are making money right now---today. The companies we looked at in yesterday's article on digital "railroad ties" are raking in money hand over fist, with huge margins and incredible market share. The bear story there is not the same as it was for biotechnology, which was that the shares were trading on froth and extremely optimistic potential markets for products that did not even exist. The bear story is really that these companies will face more competition because what they are doing is already so lucrative you'd have to be a fool not to think jumping in the game.
There are a group of digital companies, however, that on deeper examination, look just like biotechnology stocks---the Internet Service Providers (ISPs). These companies include UUNet Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:UUNT)") else Response.Write("(NASDAQ:UUNT)") end if %>, Netcom On-Line Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:NETC)") else Response.Write("(NASDAQ:NETC)") end if %>, PSINet <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:PSIX)") else Response.Write("(NASDAQ:PSIX)") end if %> and BBN Corp <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:BBN)") else Response.Write("(NYSE:BBN)") end if %>---formerly known as Bolt, Beranek and Newman, the company that built the first "Internet," ARPANet.
These companies, taking out exceptional one-time gains, all have negative trailing earnings in spite of rapidly growing revenues. The reason for this is because the network infrastructure that I detailed yesterday is expensive stuff to build. These regional powerhouses are like cellular and cable companies that plow money dramatically in excess of revenues into building up their service area, deferring any profits today for potentially larger profits tomorrow. Just like the railroads in the late 19th century, the ISPs are consuming capital at a rapid clip in an all-out battle for market share.
Traditional valuations get thrown out the window with this group since they completely lack earnings and have dramatically negative cash flows. Investors for the last few months, however, have been ignoring these conventional yardsticks and looking at "potential markets," computing a future service area and multiplying that times a future revenue per subscriber. These stocks have been choppy of late because the Street has begun to realize, just like with cellular and cable companies, that the big profits are not coming very soon, despite how fast this gang builds their network.
Why not? Because it is just too darn easy to become an ISP. All you need is to build some POPs, customize a browser you can license from Netscape, Microsoft, Spyglass or somebody else, and you are in business. Heck, today there are even ISP networks that lease their POPs rather than building them in order to cut down on the capital required. In some way, shape or form, over 300 companies provide direct access to the Internet, focusing on the consumer market, the business market, the ex-circus performer market, and so on. Global Village <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:GVIL)") else Response.Write("(NASDAQ:GVIL)") end if %>, for instance, offers Internet connections mainly to Macintosh-networked businesses as part of its overall business plan.
With low barriers to competition in the Internet Service business, some of these companies can expect a world of pain coming. Netcom On-Line Communications, for instance, does not even have a hand in the Internet "backbone," focusing solely on the "booming" consumer market. To read the Journal or SmartMoney last week, you would think the company is raking in the bucks as a result of the defection of "a lot" of users from Online Services like America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:AMER)") else Response.Write("(NASDAQ:AMER)") end if %> or CompuServe <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:HRB)") else Response.Write("(NYSE:HRB)") end if %> to Internet Service providers. Guess again. With heavy competition due to a complete lack of a "moat" around their core business, Netcom had all of 250,000 to 300,000 subscribers at year-end, still losing about $0.49 a share in the quarter.
No "moat?" What the heck does that mean? Moat is a Warren Buffett/Charlie Munger term that describes how secure a company's business is. Coca-Cola, for instance, maintains a worldwide franchise for soft drinks that no one has been able to penetrate. All sorts of cola knock-offs has been around for decades, but these low-budget players have been unable to get across to castle Coke---eaten by the darn alligators, we suppose. Coca-Cola is a brand name that makes a value-added product. Unless ISPs can add some sort of value to the Internet experience, they remain pure commodities.
Adding value is something that these too-rapidly growing, poorly staffed companies have difficulty doing. Service desks are overwhelmed with the volume of calls and much of the software is anything but plug and play, if you take the recent SmartMoney article's word for it. Competing purely on cost, these guys are lining up against a pretty tough team---not America Online, Prodigy and CompuServe, but MCI Communications, Sprint and AT&T. Any of the major long distance companies could start their own Internet service in a heartbeat---even MCI, which has pretended to recently but I am unable to take their difficult-to-install and overpriced service seriously, preferring to believe it is just a clever joke by those wily competitors.
In total, there were about 600,000 direct Internet access subscribers at the end of 1995 compared to 10.5 million for the online services. I know, you see a lot of flames in the Journal and Barron's about how online services will get smashed once people go to the Web. All that tells me is that a lot of these reporters have never been near the Web, a confusing place where information can be difficult to find and which is definitely not fun unless you are up and running on a T-1 line (56000 baud). Everything I have seen with the ISP stocks makes me think of it as "the new biotech," with one crucial exception---there is no onerous regulatory agency holding all the strings, meaning that you could make some intelligent investment since at least one of these companies is bound to succeed. Even so, the perceived loss of a monopoly can hurt big time; UUNet was down 16% yesterday simply because Microsoft, a tiny Internet provider located in Seattle, said it would shop around for other vendors in addition to its services.
If you are dead-set on investing in an ISP, the first thing to do is go big. That means ignoring a lot of the little pip-squeaks running around building POPs and trying to compete on price; go for the big boys---the guys running the backbone. The Group of Six (UUNet, PSINet, AOLNet, Sprint, MCI and AGIS-Net99) all are on pretty equal footing when it comes to the massive T-3 lines that crisscross the country, bunching up in four geographical locations (California, Chicago, Washington, D.C. and New York). In fact, if the ISP you are looking at is not based near one of those four places, you can pretty much bet it is not a major player. The reason for this cut is because these are the guys that can make money renting out surplus network space to other ISPs, just like the Seven Sisters (the seven largest worldwide oil companies) trade crude back and forth to each other whenever they need it. All of these companies derive significant revenues from renting out their networks, viewing their own proprietary services as a sideline and not the mainline.
The next step I would take is to cull from this list any company that does not have a sufficient critical mass of subscribers to make them cash-flow positive while they build their network. This is vital because otherwise you are going to get crushed by continued new stock offerings like you have seen with Netcom. Netcom is one of those companies that in four years will trade at the same price but will have tripled its market cap; this does not bode well for investors. Sprint and MCI definitely are cash-flow positive, and MCI's goal of stealing 10-20% of all retail markets by selling stuff over the phone is interesting, although I have to admit I am somewhat skeptical.
The clearest investment to me in an ISP which has a major part in the "backbone" is---drum roll, please---America Online. Yes, much-besmirched America Online, on the verge of being brought down in flames by the World Wide Web. For the record, I know AOLNet did not meet my cash-flow criteria until it hit 4 million subscribers, the low end of most analysts estimates for the number of subscribers required for the Online Service Provider (OSP) to generate cash instead of consuming it. But now with America Online/AOLNet controlling the largest high-speed network in the world, according to a recent AOLNet newsletter, we are talking big guns here. (The guys who control the low-speed networks are better known as the Regional Bell Companies.)
A lot of investors conflate CompuServe, Prodigy and AOL in the same breath, ignoring the fact that AOL is actually part of the Group of Six responsible for upkeep on the Internet backbone, owning a significant share. You could persuade me in a heated conversation that MCI and Sprint are gonna make money off the Internet; the fact that America Online says that profit margins will stay the same even if it cuts prices because more people are using AOLNet instead of SprintNet tells me that SprintNet was a profitable venture for Sprint. Of course, SprintNet now pretty much maxes out at 14400 baud whereas AOL has the capability to go as high as modems can---about 40000 baud without connection static or grounding, according to industry sources. In the end, the companies that own the fastest networks will be the hands-down winners. With modem speeds maxing out right at what AOLNet can support, I see no reason to be concerned about somebody building a faster telephone network. And despite the promise of cable and ISDN, telephone hook-up will remain dominant for consumers for at least the next three years. (I will return to AOLNet in more detail on Tuesday when I look at America Online.)
Internet Service Providers, despite all the hype, remain terribly risky for investors. They share many of the characteristics of the early railroads (many of which went out of business) and biotechnology stocks. Although many investors rush towards them as Internet "plays," it only bespeaks their lack of understanding about what a "moat" is and how it can be maintained, as well as ignorance about how much these companies are going to spend building their networks. As long as companies can rent POPs from the large providers, they are going to compete at cut-rate prices, keeping overall industry margins low. Restricting yourself to companies that participate in the critical backbone and only looking at companies whose other operations keep them cash-flow positive will add some degree of sanity to your portfolio.
MONDAY: The Digital Word, Part Five: Online Service Providers---Mostly A Bunch Of Losers
CALENDAR: Monday's Economic Events
---Treasury announces results of its auction of $28.0 bln in 13- & 26-Week Bills (about 1:30)
Byline: Randy Befumo (MF Templar)