Tuesday, January 30, 1996
MARKET CLOSE

INDEX:

I. Market News: More Record Highs
II. Heroes: DVI, Money Store, Varitronic, Daig, Zoran
III. Goats: Mentor Graphics, CompDent, Exide, Sync Research, Ascend Comm
IV. Investment Perspective: The Digital World---Part Six
V. Calendar: Wednesday's Economic Events

MARKET CLOSE

DJIA: 5381.21 +76.23 (+1.44%) -- RECORD
S&P 500: 630.15 +5.93 (+0.95%) -- RECORD
NASDAQ: 1051.30 +8.79 (+0.84%)

MARKET NEWS

Hopes that the Federal Reserve will cut interest rates during tomorrow's final day of the Open Market Committee meeting were bolstered today after the release of yet more data suggesting that the economy needs a kick-start. Both consumer confidence and retail sales numbers were weaker than expected. In addition, earnings season continues to wind out and General Motors posted surprisingly strong earnings, spurring the cyclical Dow components to new highs for the year. Both the DJIA and the S&P 500 shattered their previous closing highs---set only yesterday. The Nasdaq trails the other two indices, but is drawing closer to its record high of 1069.78.

HEROES

Finance companies had a field day on the eve of the Federal Reserve's rate cut decision. Among the biggest percentage movers was DVI Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:DVI)") else Response.Write("(NYSE:DVI)") end if %>, up $1 1/8 to $14 1/4 today. The company recently completed the redemption of 91% of its outstanding warrants, putting $6.1 million in the coffers to finance medical equipment at lower rates should the Fed move. The Money Store <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MONE)") else Response.Write("(NASDAQ:MONE)") end if %> also had a powerful surge today, moving up $1 1/2 to $19 as investors perceived the consumer finance company's chance of maintaining its delinquencies below the crucial 5% level as directly tied to prevailing interest rates. To sum up, if it lends money, it probably had a heck of day.

Consider the recent courtroom squabbles between W.H. Brady <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:BRCOA)") else Response.Write("(NASDAQ:BRCOA)") end if %> and Varitronic Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:VRSY)") else Response.Write("(NASDAQ:VRSY)") end if %> as nothing more than prenuptial jitters; W.H. Brady offered $14 in cash today for Varitronic, causing the shares to rally $2 7/8 to $12 5/8. Brady and Varitronic are currently battling in court, placing the offer in a strange context. For its part, Varitronic is "optimistic" about its business prospects and sees the value of its shares as "substantially more than $14." The courtroom proceedings are the result of allegations by Varitronic that Brady interfered with contractual arrangements and defamed the company over marketing suppliers for lettering systems. Varitronic makes printers and W.H. Brady makes labels, among other things.

St. Jude Medical <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:STJM)") else Response.Write("(NASDAQ:STJM)") end if %> announced today that it is snapping up all of the shares of Daig Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:DAIG)") else Response.Write("(NASDAQ:DAIG)") end if %> in order to enhance its line of cardiovascular products. The news launched Daig ahead $2 3/4 to $26 3/4. Daig is being bought out for ten million shares of St. Jude stock, or $427.5 million as of today's close. Daig makes catheter introducers and diagnostic electrophysiological catheters, items that fit well with St. Jude's rhythm management offerings. By joining with St. Jude, Daig suddenly gets the benefit of St. Jude's worldwide distribution network, lifting Daig out of the ranks of niche players.

Zoran <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:ZRAN)") else Response.Write("(NASDAQ:ZRAN)") end if %> was soarin' today when OppCo. initiated coverage with an "outperform" rating, boosting the shares by $4 9/16 to $37 1/16. Only "outperform" for a company that they helped to bring public not all that long ago? Zoran makes semiconductor chips, an industry most analysts are running away screaming from these days.

GOATS

Another battle is brewing between two players in the contentious semiconductor Electronic Design Automation (EDA) market. Mentor Graphics <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MENT)") else Response.Write("(NASDAQ:MENT)") end if %> got a double whammy today, releasing earnings a bit below consensus estimates with revenue and order growth not up to snuff, and then getting whacked when Quickturn Design <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:QKTN)") else Response.Write("(NASDAQ:QKTN)") end if %> decided to file for an injunction against a recently-acquired Mentor subsidiary, France's Meta Designs. Quickturn says that Meta hardware logic emulation systems infringe on five Quickturn patents, eerily similar to a claim against Avant! <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:AVNT)") else Response.Write("(NASDAQ:AVNT)") end if %> by Cadence Design Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:CDN)") else Response.Write("(NYSE:CDN)") end if %> a few months back. Mentor was down $2 5/8 to $12 3/8.

A hot IPO has turned sour after it missed its earnings projections by a penny. CompDent <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CPDN)") else Response.Write("(NASDAQ:CPDN)") end if %> took it in the teeth today, down $6 5/8 to $38 after a huge run-up since its initial public offering a few months ago. CompDent does "managed" dental care in the southeast and the midwest in the same way that many health maintenance organizations (HMOs) do managed care, making it a very nice "story" stock since it is currently the only player in the niche. Reality, however, intruded today, as it often does when the story is just too good to be true. Managed dental care is an interesting line of business, but in the end one that will be valued like any other business, no matter where short-term hysteria takes it.

More bad news from battery manufacturer Exide <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:EX)") else Response.Write("(NYSE:EX)") end if %> caused the shares to run out of power today, down $3 3/8 to $30 1/8. The company had a volume shortfall in North America of about 700,000 to 800,000 units---hardly unexpected given Duracell's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:DUR)") else Response.Write("(NYSE:DUR)") end if %> recent poor showing. The CEO blamed mild winter weather for Exide's woes, as less car batteries were killed. Troubled European operations are supposedly finally coming into line, however, and the maker of car batteries for the automotive aftermarket has had rough sledding for the past year and will be difficult to turn around quickly.

Cisco's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CSCO)") else Response.Write("(NASDAQ:CSCO)") end if %> rapid expansion has come with a price---to its competitors. Sync Research <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:SYNX)") else Response.Write("(NASDAQ:SYNX)") end if %> was down $4 3/4 to $29 1/4 today as the Street fretted about Cisco challenging Sync in the mainframe-to-Internet connection market. Ascend Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:ASND)") else Response.Write("(NASDAQ:ASND)") end if %> also took a hit, down $2 7/8 to $37 7/8 on the news that Cisco has licensed ISDN-products to use Madge Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MADGF)") else Response.Write("(NASDAQ:MADGF)") end if %>. Many analysts feel that Ascend and Sync still have superior products, but the threat from a powerhouse like Cisco is enough to make many investors lose their nerve and cash in their chips.

INVESTMENT PERSPECTIVE: The Digital World, Part VI---America Online

I. Introduction

Our progressive exploration of the digital world reached the world of Online Service Providers (OSPs) yesterday. I did a quick accounting of the surprisingly large population of losers among those ranks, from GEnie to CompuServe. The overwhelming evidence suggests that, contrary to conventional wisdom, getting an online service "right" is a highly complex undertaking at which very few companies have been successful. The one shining light among the OSPs is America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:AMER)") else Response.Write("(NASDAQ:AMER)") end if %>, whose pricing structure has set the trend that its competitors are forced to match as best they can. Prodigy, for instance, reduced its rates in late 1994 to match America Online while CompuServe more recently revamped its complicated pricing structure last September. (Yesterday, I incorrectly suggested that CompuServe still had its a la carte system, an error which prompted an e*mail from none other than Robert Seidman of Seidman's Online Insider. My thanks to Robert for keeping me honest.)

America Online was not always the dominant force in online services. In fact, it was not even all that well known before 1994. Created ten years ago, its original name was "Quantum Computer Services" and the company focused on the Macintosh segment of the market. Although it was not funded by giants like Prodigy or CompuServe were, the company had something they lacked: a vision for its online service. "Content, context, community, commerce and connectivity at a low cost," is how America Online CEO Steve Case has put it. Understanding how each of these aspects is achieved allows one to understand that America Online is a lot more than just an OSP; it's a company that combines infrastructure, software and content in a convenient package.

II. Infrastructure

America Online brings together rich content to fill out the service, creating communities of users that tend to cluster around this content. The company then leverages itself from these communities of users, generating money through the sales of products and services. Before any of this is possible, however, the company needs the ready availability of connections---an infrastructure that allows the company to deliver its crucial online services at the lowest cost.

The single most overlooked element of America Online is AOLNet, the result of the company's February 1995 acquisition of Advanced Network Services (ANS). Among other things, ANS had tremendous experience in maintaining the Internet backbone, allowing it to become part of the Group of Six infrastructure providers two months later---the companies designated to inherit responsibility for the Internet from NCSA (see the Digital World, Part II for details). With AOLNet, America Online now has 100,000 modems and 300 POPs, leading the pack of OSPs in this regard.

POPs (Points of Presence) are the phone numbers AOL users call up to connect to the system. By owning many of its POPs rather than licensing them from SprintNet or TymNet (MCI Communications' network), America Online can deliver its services at a significant cost reduction compared to its competitors who lack their own networks. America Online can also use its prodigious cash flow to fund the expansion of this network; right now the word is that there will be 20% more POPs by March and 60% more by June, keeping the number of available ports to a healthy 2-3% of total subscribers. This network should not be disregarded; by March, AOLNet should account for more than 50% of AOL's total traffic. It is this factor that allows AOL to consider a pricing scheme of $20 for 20 hours, while still predicting that its margins would be unaffected.

III. Software

America Online is classified as a computer services company by most of the Street, a label which often leads analysts to ignore the fact that the company is heavily involved in Internet infrastructure and software development. An interesting example of the software development potential is AOL for Windows Version 3.0, being beta-tested now and set to ship at the end of the first quarter. AOL 3.0 will have an enhanced browser that recognizes HTML 3.0 and Netscape tags, enhancing the Internet browsing experience---playing into a crucial trend as more and more people want to jump onto the Web easily. You also get the addition of icon-based interactions on the Web, courtesy of Ubique, a recent acquisition. Ubique allows users to see the self-selected icon's of other people out on the Web if they are viewing the same page, enabling them to double-click that icon and begin an "instant-message" conversation.

For those who do not go out on the Web, AOL 3.0 still offers some neat features. Progressive rendering of graphics eliminates painful download times while a new Games API system will deliver graphical, real-time, multi-player games to subscribers. This graphical multi-player interface can be leveraged into the applications market as well after it is perfected in the entertainment market, a fact that many analysts are too quick to discount. Hypertext also comes to AOL with 3.0; the user will be able to write e*mail messages with special links, allowing the reader to double click a link to go to the area being discussed---a huge promotional development which can only increase usage. All of this development is only possible because of the crack team of software developers AOL has, as valuable as any bunch in the hallowed halls of Microsoft.

America Online has developed a formidable infrastructure to publish content online. AOL 3.0 for Windows and the new addition on the content provider side, Rainman's Visual Publisher, only make it easier for content providers like The Motley Fool to throw up cool stuff that can't be matched by the Web. People will want to come and see! It is the software that America Online develops which allows it to maintain an edge over the classic publishers and producers of content, who need costly equipment like printing presses and editing studios to create their end products. The relatively low fixed costs for creation of content and an excellent distribution system that literally lands at the user's doorstep is possible because AOL is not only a software and infrastructure company, but also a service and content company.

IV. So What Is America Online, Then?

America Online is an Online Service Provider (OSP), an Internet Service Provider (ISP) through GNN, a network infrastructure provider with AOLNet, an owner and programmer of content, a provider of venture capital to Greenhouse applicants, a creator of online development tools, and most importantly, 5 million pairs of eyes. America Online is used by about 500,000 people simultaneously during "prime time," between the hours of 8:00 PM and 11:00 PM, about the same number that Viacom's MTV and TimeWarner's CNN draw. With the number of new subscribers each month tallying about 300,000 and *growing,* America Online will become 8 to 10 million pairs of eyeballs sometime around the end of calendar 1996, a number probably more important to the Street than any other fact about the company. In fact, the number could conceivably go higher when the number of POPs are increased by 60% in June, as evidenced by AOL's claim that it has not tried volume pricing schemes in the past because it could not handle the expected traffic they would generate.

The statistics AOL releases about its users are surprising and aren't easily digested. Right now, for instance, from a quarter to a third of AOL subscribers (according to the analyst reports) do not even use their five free hours a month. These are the folks that Steve Case has jokingly called "AOL's best customers"; they do not take up costly network space very often, forking over $10 a month basically just to read their e*mail. It is because "low cost" is a core part of AOL's strategy that these readers find the service useful at all. Here are some statistics showing what users really do on America Online: 15% Websurf, 25% Chat, 20% Write e*mail, 30% View AOL content, and 10% "Other." This correlates well with AOL's description of three "levels" of users: basic, normal and heavy. Basic users are writing e*mail and chatting, normal users are on from 10-20 hours a month, while the heavy users are chugging along for 20 hours or more.

With an average tab of $17 a month and an average life-span of 40 months (according to AOL), its greatest asset is its expanding subscriber base, expected to go from five million members to nine million or so this year. With America Online positioned to go in any direction (a result of what Morgan Stanley analyst Mary Meeker has termed "Steve Case's paranoia"), no matter where the money goes AOL can get there and bring a lot of people with it. The company gets revenues from providing infrastructure (renting out excess network capacity during the day), OSP services, ISP services, content, and off-line revenues like advertising and online transactions for goods and services. America Online also has a number of new ventures that are compelling: owning content companies through the Greenhouse program, creating networks for private corporations like Century 21 and building Digital Cities in dozens of locations nationwide (all to be detailed in tomorrow's installment of the Digital World). All this combines to make AOL the most diversified digital property going.

V. The Worldwide Reach Of AOL

It is this very diversification of products and services that allows America Online to create a brand name for online services that has worldwide value. Just ask Coke or Pepsi how important creating a brand name is for a core business---it allows a company to compete on a basis other than price. Such a "branded" company can effectively charge twice as much as its competitors and still dominate its market. America Online has recently taken its American dominance in online services and shipped it overseas in a rapid series of developments marketed under the "AOL" brand name.

AOL Germany began in November, the product of a much-publicized joint venture between America Online and Bertelsmann, the German media giant. AOL UK just recently launched with 100% geographic coverage estimated by March 1st. For Francophones, AOL France is coming in late March and AOL Canada is being expanded dramatically with the assistance of recently acquired AOLNet. Starting this month, the cost of access dropped from $12.00 an hour to $1.80 an hour for Canadians in 18 cities, according to an analyst report on the subject.

All this expansion drives a stake in the heart of CompuServe, which has maintained some prestige in the industry because of its worldwide reach. Some optimists see AOL UK, for instance, overtaking CompuServe in number of subscribers. AOL Japan, which has been in the works for months, will eventually pop up as well, challenging CompuServe's last stronghold---the 500,000 plus users of NiftyNet in the land of the rising sun. Just like Coke and Pepsi, America Online can use the process it has perfected in the United States and export it overseas.

America Online is a vertically integrated online services company with a worldwide reach, unparalleled in its industry. No other company combines such a potentially lucrative collection of core competencies, with Microsoft as the single possible exception, and it's a relative late-comer to the digital party. With AOL's worldwide reach and almost ten times the number of subscribers using MSN, Microsoft has an uphill battle if it really wants to assert its software muscle in the online world. Tomorrow, I will examine in more detail how America Online's combination of infrastructure, software and subscriber base allow it to focus its business plan on building an online brand which can be used in multiple markets simultaneously.

TOMORROW: The Digital World, Part VII: AOL -- Brands and the Business Plan

CALENDAR: Wednesday's Economic Events

---December Producer Price Index (8:30)
---December Leading Economic Indicators (8:30)
---Third-quarter 1995 Retailers' Profits (10:00)
---January Chicago Purchasing Managers Survey (10:00)
---Treasury quarterly refunding details, size of 3- & 10-Year Notes & 30-Year Bond offerings (1:30)
---ABC/Money Magazine Consumer Confidence Polls (6:30)
---Federal Open Market Committee meets in closed session

Byline: Randy Befumo (MF Templar)