The Lunchtime News examined America Online's earnings announcement. This weekend, Fool's Gold, our weekly news-and-research magazine, will feature essays from Rogue, the Weekend Research Center, Weekly Industry Updates, and a Sector Snapshot on Bank Services Companies.
MF Merlin's Economic News today discusses the Bureau of Labor Statistics' news release on Producer Price Indices for July. You'll find the Economic News, as well as all our Special Sections, FoolWires, and earnings reports, on either the Evening News or Stock Research screens. In tonight's Fool on the Hill, MF Templar examines the PEG, or Fool Ratio, and why it works. Enjoy!
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That big sigh of relief you heard came from HORIZON/CMS HEALTHCARE CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HHC)") else Response.Write("(NYSE: HHC)") end if %> shareholders, as they watched their stock climb $1 1/2 to $12 5/8 today. The U.S. Justice Dept. ended its investigations into Horizon/CMS subsidiary Continental Medical Systems (CMS) without filing any charges or taking any actions against the company. Horizon/CMS provides rehabilitation and long-term care services through 37 hospitals in 16 states.
While AMERICA ONLINE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: AMER)") else Response.Write("(NASDAQ: AMER)") end if %> stock tumbled on strong earnings, fellow Internet concern BBN CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BBN)") else Response.Write("(NYSE: BBN)") end if %> shares rose $1 5/8 to $20, with the company posting a loss of $0.60 per share, including reorganization-related charges. BBN's revenues from continuing operations rose 45% from the year-ago quarter and 33% over the full fiscal year. The company's network management contract with America Online yielded $25 million, over 200% more than in the year-ago quarter. In addition to other bullish comments, the firm noted that, "orders during the quarter for new high-speed connections grew by 50% to record levels as businesses developed new applications for using the Internet.
USA DETERGENT'S <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: USAD)") else Response.Write("(NASDAQ: USAD)") end if %> impressive rise of $4 to $33 today occurred as a result of a J.P. Morgan upgrade from "long-term buy" to "buy", as well as news that Rachamin Anatian, Chairman and Chief Executive Officer (CEO) of the Global Shopping Network, holds an 8.88% stake in the sudsy firm. Anatian's 350,000-plus shares were bought at prices ranging from $30 1/4 to $38 9/16, so there is a chance that at the moment, he's taking a bath in USA Detergent. Last month the company reported sales off sharply from year-ago levels.
QUICK TAKES: Speculation that MCAFEE ASSOCIATES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: MCAF)") else Response.Write("(NASDAQ: MCAF)") end if %> might acquire fellow software concern QUARTERDECK <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: QDEK)") else Response.Write("(NASDAQ: QDEK)") end if %> has pushed Quarterdeck shares up $1 to $8 3/4 , despite the fact that Quarterdeck denied the rumor... MOVIEFONE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: MOFN)") else Response.Write("(NASDAQ: MOFN)") end if %> shares soared $7/8 to $5 1/8 after Alex. Brown upped the company from "neutral" to "buy"... Healthcare resource management system developer ENTERPRISE SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: ESIX)") else Response.Write("(NASDAQ: ESIX)") end if %> withdrew its planned secondary stock offering, citing dissatisfaction with current price levels. Investors rejoiced as the threat of dilution dissipated and shares soared $6 to $25.
Tobacco shares were chewed up today, as chunks of market cap went up in smoke. The reason? A Florida jury awarded the first verdict against a tobacco company today, in a case tying health problems to smoking. This apparently took the Street by surprise, as investors hurriedly lopped off $11.3 billion in market cap from PHILIP MORRIS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %>, which fell $13 5/8 to $91 7/8. RJR NABISCO HOLDINGS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RN)") else Response.Write("(NYSE: RN)") end if %> lost $1.16 billion, dropping $4 1/4 to $28, and US TOBACCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UST)") else Response.Write("(NYSE: UST)") end if %> was off $2 1/8 to $31 3/4.
Online service giant AMERICA ONLINE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: AMER)") else Response.Write("(NASDAQ: AMER)") end if %> got less gigantic today, disconnecting to the tune of a $4 1/8 to $29 1/4 fall. Why? Well, the company reported its earnings last night, posting $0.19 per share (excluding a $0.05-per-share charge), fully three cents ahead of estimates. The earnings, deemed a "blowout" by a Lehman analyst, were good, so that couldn't have dropped the stock. The company's gross margins rose to 46.6% from 42.4% in the year-ago quarter, also good. Half of AOL traffic is now on its own AOLnet, with this figure expected to rise to 85% by the end of fiscal 1997. Subscribers more than doubled in fiscal 1996. Good news, as well. Could the dip have anything to do with two California women suing SurfLink and AOL for allegedly posting pictures of them in bikinis without permission?
Enterprise information system developer SYSTEM SOFTWARE ASSOCIATES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: SSAX)") else Response.Write("(NASDAQ: SSAX)") end if %> tanked $3 9/16 to $8 3/4 after warning of disappointing upcoming earnings and receiving an Alex. Brown downgrade from "strong buy" to "buy." Roger E. Covey, CEO of SSA, explained that, "The principle factor contributing to the revenue and earnings decline was the postponement of decisions on many software opportunities. Many of these delays were due to prospective clients wishing to more fully evaluate SSA's new BPCS Client/Server version 6.0. This was, in many cases, related to difficulties inherent in any major new software version." He also noted that the company will not be changing its strategy, as it remains bullish about its future prospects.
Circuit board-maker BOCA RESEARCH <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: BOCI)") else Response.Write("(NASDAQ: BOCI)") end if %> slumped $2 1/8 to $13, downgraded from "near-term buy" to "near-term market performer" by Robinson-Humphrey, which maintained a "long-term buy." Analyst Robert Anastasi cited concerns about pricing pressures in the modem industry and investor skittishness about modem concerns. Modems-and-much-more company US ROBOTICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: USRX)") else Response.Write("(NASDAQ: USRX)") end if %> also retreated, down $3 1/4 to $52 1/4, while ZOOM TELEPHONICS dropped $3/8 to $8 3/4. Modem-related companies have plummeted significantly in the past few months.
QUICK CUTS: INTEGRATED PROCESS EQUIPMENT <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: IPEC)") else Response.Write("(NASDAQ: IPEC)") end if %>, which earned $0.37 per share in the year-ago quarter, posted only $0.13 this year, a penny below estimates. It was punished with a $2 1/8 to $13 3/8 fall... Shares have been discounted and are on sale at NORDSTROM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: NOBE)") else Response.Write("(NASDAQ: NOBE)") end if %> after the company severely disappointed analysts, posting $0.55 per share, compared to estimates of $0.70. Merrill Lynch downgraded the firm to "short-term neutral" and "long-term accumulate," and shares dropped $3 1/2 to $38 1/4... Furniture and home furnishing concern RHODES INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RHD)") else Response.Write("(NYSE: RHD)") end if %> shares dropped $1 3/8 to $6 7/8 after the company announced that it's cutting back operations sharply and expects sales and earnings to fall in the upcoming quarter... I-STAT <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: STAT)") else Response.Write("(NASDAQ: STAT)") end if %> slipped $1 7/8 to $13 1/2 after beating estimates with $0.38 per share but warning of slowing near-term sales.
An Investment Perspective by
Randy Befumo
(MF Templar)
FOOL ON THE
HILL
Why Does the PEG Work When It Does?
Fool founders David and Tom Gardner are pragmatists to the core. Rather than saddle their investing approach with all sorts of questionable academic baggage, they cut through a lot of the investment world baloney with a "do what works" approach. Does history and idiosyncratic experience imply that the Dow Dividend Approach works? Then use it. Does history and idiosyncratic experience imply that the P/E-to-Growth Ratio (PEG) works? Then use it. As many an over-complicated investment approach has proven, much teaching offers little understanding. To seek the simplest cause has been the goal of many of history's greatest philosophers and investors since time immemorial.
The arbitrary nature of the PEG, also known around the office as the Fool Ratio, has always excited debate in Fooldom. "Why does it work?" has been the uniform query. Although it seems to fly in the face of the hard-nosed pragmatism I just celebrated in the opening paragraph, I have been pondering this question for some time and wanted to share the handful of ideas I have developed towards explaining this. I think that the PEG works because of (1) the predominance of the Fidelity "Growth-at-a-Reasonable-Price" (GARP) money managers and (2) the fact that it offers a truly comparative way to see how much the market is discounting future cash-flows.
The first idea can be summed up in two words, Peter Lynch. Lynch's great success managing Fidelity's Magellan fund ushered his promotion to Fidelity's board, but long before that, the former chemicals analyst became director of research at Fidelity, not to mention the guy that budding portfolio managers wanted to study under. Lynch's written approach is undergirded by the growth-at-a-reasonable-price approach, shortened to GARP by many professional money managers. The GARP methodology is the inheritor of earlier insights articulated by Phil Fisher (author of Common Stocks, Uncommon Profits) and T. Rowe Price, founder of the family of mutual funds that bears his name.
When generations of portfolio managers look to price stocks relative to their growth potential by using the P/E ratio to compare with the growth rate, it creates a de facto standard that feeds on itself. This alone would argue for individual investors to at least pay attention to it, at least in regard to pricing "growth" stocks. It also goes a long way to explain why there are so many industries for which the PEG does not work very well -- mostly cyclical and financial concerns. However, this alone does not provide the logical cause to explain why the approach started to work in the first place, or why it has not been cast to the wayside like so many other failed investment approaches (a la Gerry Tsai, etc.).
Any investor who focuses on earnings has probably heard this phrase before: earnings are a proxy for cash-flow. Within a late 20th-century growth company where there are not high depreciation, amortization or capital expenses, earnings really do approximate free-cash flows, less the company's ability to manage inventories, receivables and other Statement of Cash Flows components. Again, we see the earnings school of valuation clearly located in the growth stock arena -- the principle reason why low P/E investors who invest in cyclical companies are so often frustrated underperformers. It truly requires a different valuation methodology.
If earnings and cash flows are similar for a growth company, then the P/E effectively prices current cash flows. The P/E, which originally appeared in Ben Graham's book Security Analysis as the E/P, or earnings yield, effectively prices the security in question like a bond. For instance, a stock with a P/E of 5 has a 20% earnings yield, and for every dollar of stock price has $0.20 EPS of earnings to back it up. Pricing a security relative to historical earnings/cash-flows is only part of the exercise of earnings/cash-flow analysis -- you have to relate this number to future cash flows. This is where the growth component comes in.
The P/E tells you what a company's earnings yield is, relative to historical earnings. Growth estimates tell you what that yield will be in the future, if you do the appropriate math. P/E over growth puts the inverse of a percentage (a whole number) over a percentage that someone intuitively converted into a whole number. Thus, you get an apples to apples comparison that lets you transform the current valuation of historic earnings/cash flows into an implied valuation of future earnings/cash flows. This lets you compare one company's implied future earnings yield with those of other companies, allowing you to spot market inefficiencies.
In the end, the PEG appears to have sound pragmatic, historical and philosophical backing within the universe of growth stocks, contingent on the accuracy of analysts' estimates. Although some thrive off the reported inaccuracy of analyst estimates as a way to slam analysts, I actually think the numbers more often reflect bad guidance from the company... the same guidance any investor would get if they called up and asked. Regardless, the PEG and its various cousins definitely have a place in the valuation pantheon.
Randy Befumo (MF Templar),
a Fool
Fool On the Hill
Selena Maranjian (MF Selena),
a Fool
Heroes & Goats & Editing
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