DJIA 8834.94 +23.17 (+0.26%) S&P 500 1098.84 +4.26 (+0.39%) Nasdaq 1745.08 -4.67 (-0.27%) Value Line Index 928.04 -4.17 (-0.45%) 30-Year Bond 106 15/32 -7/32 5.67 Yield
Falls Church, Va.-based financial services company Capital One Financial <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: COF)") else Response.Write("(NYSE: COF)") end if %> moved up $2 3/8 to $103 3/8 after announcing the latest version of its unusual -- not to mention very investor friendly -- senior management compensation program that ties individual pay to the company's stock performance. Under the new program, its top 26 senior executives will get stock options instead of compensation. The options will vest only if the stock gains 20% compounded annually over the next three years, and the share price must reach or surpass $175 for at least 10 trading days in any 30 calendar-day period by June 11, 2001. The options also vest immediately if the company is acquired before that date. Some argue that such a compensation model builds investor confidence and aligns management's interests with those of shareholders, while others assert that it breeds a short-term mentality and squelches any necessary risk taking. Time will tell.
Entertainment and consumer products company K-tel International <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KTEL)") else Response.Write("(Nasdaq: KTEL)") end if %> surged $1 1/2 to $15 1/4 in heavy trading on no apparent news save a ratings upgrade for competitor CDnow Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CDNW)") else Response.Write("(Nasdaq: CDNW)") end if %> and Amazon.com's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> launch yesterday of its online music store. CDnow, which gained $1 to $18, was raised to "strong buy" from "buy" at BT Alex. Brown. Though one can make the leap that K-tel would benefit as investors are reminded about the online music industry, a quick look at its top management's personal investment decisions of late shows why investors should beware. In May, Chairman Philip Kives sold some 1.48 million shares, but at least he still has about 4.1 million shares to his name. But K-tel President David Weiner sold 390,000 shares at between roughly $22 and $33, which left him holding just 5,200 shares. (The company has more than 7.6 million shares outstanding.) Company director Louis Scheimer ditched 12,000 shares at $31 to $32, senior vice president of purchasing and operations Jeffrey Koblick sold 138,978 shares at $32 to $34, and CFO Corey Fischer sold 6,000 shares at $31 to $34 -- leaving all three with nil, nada, NO stake in the company (according to the Washington Service, which tracks purchases and sales of common stock). Which begs the question -- who really does have a stake in the firm?
QUICK TAKES: SmithKline Beecham <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SBH)") else Response.Write("(NYSE: SBH)") end if %> gained another $2 1/4 to $60 7/8 on reports speculating that the British drugmaker may be in merger talks. A company spokesman, however, said the company has "no plans for any mergers." SmithKline ended merger discussions with American Home Products <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AHP)") else Response.Write("(NYSE: AHP)") end if %> and with Glaxo Wellcome <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GLX)") else Response.Write("(NYSE: GLX)") end if %> early this year... Chevron <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CHV)") else Response.Write("(NYSE: CHV)") end if %> added $3 5/16 to $81 3/8 after Paine Webber upgraded its rating on the oil company to "attractive" from "neutral," citing that OPEC and non-OPEC producers will "find conviction" and announce further production cuts, which would lead to a gradual recovery in oil prices... Borders Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BGP)") else Response.Write("(NYSE: BGP)") end if %> booked $2 to $32 15/16 after Standard & Poor's announced that the book and music retailer will replace Culligan Water Technologies <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CUL)") else Response.Write("(NYSE: CUL)") end if %> in the S&P MidCap 400 Index after Monday's close. Culligan is being acquired by U.S. Filter Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: USF)") else Response.Write("(NYSE: USF)") end if %>.
Games developer THQ Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: THQI)") else Response.Write("(Nasdaq: THQI)") end if %> scored another $1 5/16 to $27 1/16 after signing a 10-year exclusive agreement with privately held Titan Sports Inc. to produce World Wrestling Federation (WWF) electronic games in conjunction with toy manufacturer JAKKS Pacific <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: JAKK)") else Response.Write("(Nasdaq: JAKK)") end if %>... Computer- and electronic-testing equipment company Genrad Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GEN)") else Response.Write("(NYSE: GEN)") end if %> rose $1 5/16 to $18 3/8 after announcing it will buy back up to 8%, or 2.5 million, of its outstanding shares and that it is "comfortable" with analysts' full-year earnings estimates of $0.80 to $1 a share. The company also said it will take a $40 million Q2 charge, in part to cut 10% of its workforce, or 140 jobs... ITT Educational Services <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ESI)") else Response.Write("(NYSE: ESI)") end if %> picked up $1 3/4 to $28 1/4 after Morgan Stanley Dean Witter initiated coverage on the technology-oriented postsecondary degree programs company with an "outperform" rating.
Orthodontic Centers of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OCA)") else Response.Write("(NYSE: OCA)") end if %> added $1 7/8 to $20 1/8 after BancAmerica Robertson Stephens reiterated its "buy" rating on the orthodontic practices management firm, saying that the company will probably axe its proposed $100 million private convertible debt offering... Computer connectivity solutions company Cybex Computer Products <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CBXC)") else Response.Write("(Nasdaq: CBXC)") end if %> advanced $2 3/8 to $23 1/8 after announcing it has a new OEM partner, Rittal, which will use the PolyCon Console Switching and Management System made by Cybex subsidiary Elsner Computertechnik of Steinhagen, Germany... Call center management services company Davox Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DAVX)") else Response.Write("(Nasdaq: DAVX)") end if %> climbed $1 5/16 to $18 after announcing that it has promoted Thomas Chamberlain, director of technical sales and support, to vice president of customer services, and Joseph Venskus, director of systems engineering support, to the new position of director of technical services and support.
Brunswick Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BC)") else Response.Write("(NYSE: BC)") end if %>, maker of bowling balls, Igloo brand ice chests, and Mercury outboard boat motors, tanked $3 5/8 to $25 3/16 after saying fiscal Q2 earnings will be flat compared to the $0.84 per share earned a year ago. The Street had been expecting earnings of $0.92 per share. The company blamed the poor results on bad weather conditions, inventory problems at major retailers, and weakness in demand for bowling products in China. The situation in China, which is seen as a major growth area for the firm's indoor recreation group, is not expected to improve through the rest of the fiscal year and will lower the group's earnings as much as $0.20 per share below fiscal 1997 levels. In light of these developments, the firm said it has reduced the bowling unit's workforce by 6%, adding that it plans to shutter a German manufacturing plant ahead of schedule by the end of the year.
Dutch semiconductor wafer stepper maker ASM Lithography Holding <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASMLF)") else Response.Write("(Nasdaq: ASMLF)") end if %> plunged $5 3/16 to $29 1/8 after saying its fiscal 1998 earnings will fall below last year's levels due to the soft chip market and reduced orders from customers in Taiwan. Total shipments in fiscal 1998 are expected to be about the same as in fiscal 1997. The company was downgraded by no less than five brokerage firms, including ING Barings, which cut the company to "sell" from "hold." Other firms in the chip manufacturing equipment business were hit today as well. KLA-Tencor Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KLAC)") else Response.Write("(Nasdaq: KLAC)") end if %> slid $2 3/16 to $24 15/16 and Applied Materials <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMAT)") else Response.Write("(Nasdaq: AMAT)") end if %> slid $3/8 to $28 5/8 after both firms were downgraded by Morgan Stanley Dean Witter. Also, Novellus Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NVLS)") else Response.Write("(Nasdaq: NVLS)") end if %> lost $1 13/16 to $31 1/4, Lam Research Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LRCX)") else Response.Write("(Nasdaq: LRCX)") end if %> dropped $1 1/16 to $20 9/16, Photronics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PLAB)") else Response.Write("(Nasdaq: PLAB)") end if %> sank $1 1/2 to $20 1/2, and Cymer <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CYMI)") else Response.Write("(Nasdaq: CYMI)") end if %> slumped $1 3/8 to $15.
QUICK CUTS: Dynamic random access memory (DRAM) chip maker Micron Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MU)") else Response.Write("(NYSE: MU)") end if %> slipped $1 3/8 to $21 3/16 after Needham & Co. started coverage of the company with a "sell" rating, citing continued intense supply challenges in the DRAM sector... Number 1 U.S. automaker General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %> slipped $3/8 to $69 7/8 after members of the United Auto Workers went on strike at a Delphi auto parts plant in Flint, Michigan, which supplies parts to virtually every GM vehicle made in North America... Northwest Airlines Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NWAC)") else Response.Write("(Nasdaq: NWAC)") end if %> slumped $1 3/16 to $38 3/4 on reports that the Federal Aviation Administration was conducting a "fact-finding" analysis of the firm's maintenance program for its DC-9 aircraft based on alleged maintenance deficiencies. The air carrier said its maintenance program has already been reviewed by the FAA twice.
Networking products maker 3Com Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> fell $31/32 to $24 1/32 amid speculation that recent price cuts for some of its telephone-based modems will hurt its fiscal Q4 results, which are expected sometime during the week of June 22... Lithium primary and rechargeable battery maker Ultralife Batteries <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ULBI)") else Response.Write("(Nasdaq: ULBI)") end if %> sank $1 9/16 to $8 3/16 after saying it expects a fiscal Q4 loss lower than the $0.14 per share loss projected by analysts... Cardiovascular medical products maker Kensey Nash Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KNSY)") else Response.Write("(Nasdaq: KNSY)") end if %> fell $6 to $10 3/16 after saying lower-than-expected orders for its Angio-Seal device will result in fiscal Q4 revenues "significantly below" analysts estimates... Therapeutic human-based tissue products maker Advanced Tissue Sciences <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ATIS)") else Response.Write("(Nasdaq: ATIS)") end if %> was flayed $3 1/8 to $3 15/16 after the FDA requested additional clinical trial data for the firm's Dermagraft treatment for diabetic foot ulcers, thereby delaying the product's approval by at least 12 to 24 months.
Steel maker Bethlehem Steel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BS)") else Response.Write("(NYSE: BS)") end if %> dropped $7/8 to $11 5/16 after Donaldson, Lufkin and Jenrette lowered its rating on the stock to "market perform" from "buy." Mini-mill steel producer Nucor <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NUE)") else Response.Write("(NYSE: NUE)") end if %> fell $1 1/2 to $46 3/4 and Steel Dynamics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: STLD)") else Response.Write("(Nasdaq: STLD)") end if %> slipped $1/2 to $15 3/4 on DLJ downgrades as well... Industrial automation and electrical control products maker Woodhead Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WDHD)") else Response.Write("(Nasdaq: WDHD)") end if %> slipped $1 1/2 to $14 13/16 after saying its fiscal Q3 EPS will come in between $0.24 and $0.26, which is less than the $0.28 expected by the Street... Internet-based telecommunications software developer NetSpeak Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NSPK)") else Response.Write("(Nasdaq: NSPK)") end if %> fell $2 3/4 to $13 1/4 after Raymond James Financial cut its rating on the company to "accumulate" from "buy."
Electronic interconnect products maker Rogers Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ROG)") else Response.Write("(NYSE: ROG)") end if %> moved down $1 3/4 to $31 1/4 after saying the Asian financial crisis will result in fiscal Q2 EPS of between $0.30 and $0.32, missing the First Call mean estimate of $0.60... Silicon wafer producer MEMC Electronic Materials <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WFR)") else Response.Write("(NYSE: WFR)") end if %> slid $2 5/8 to $10 after saying lower net sales and greater-than-expected participants in its "voluntary separation" program will result in a fiscal Q2 loss surpassing the $0.72 per share loss in Q1... Specialty paper maker FiberMark Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FMK)") else Response.Write("(NYSE: FMK)") end if %> was reamed for a $3 1/8 loss to $16 1/4 after saying slow sales in the office products market and lower productivity levels at some of its facilities will result fiscal Q2 EPS between $0.45 and $0.50, which is below analysts' estimates of $0.56 to $0.58.
Simione Central Holdings <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SCHI)") else Response.Write("(Nasdaq: SCHI)") end if %>, which provides consulting and support services to home healthcare companies, lost $1 7/8 to $6 5/8 after its CEO resigned and its chairman retired. CIBC Oppenheimer downgraded the firm to "buy" from "strong buy"... Emergency and ambulance transport services provider Rural/Metro Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RURL)") else Response.Write("(Nasdaq: RURL)") end if %> lost $5 to $12 3/8 after saying it expects fiscal Q4 EPS (including charges and gains) of between $0.25 and $0.30, which is below the First Call mean estimate of $0.48... Printed circuit board manufacturer Hadco Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: HDCO)") else Response.Write("(Nasdaq: HDCO)") end if %> lost another $1/2 to $27 3/8 after yesterday being downgraded to "hold" from "buy" by NB Montgomery Securities. The company is still integrating its acquisition of Continental Circuits and is being hampered by slow production at key customer Compaq <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %>.
FOOL
ON THE HILL
An Investment Opinion
by
Dale Wettlaufer
Return on Marginal Capital
[Back by popular demand, the Motley Fool presents a rerun of the following Fool on the Hill that was originally written on February 27, 1998. This was a time when Dale was just beginning to emege from his controversial "Blue Capital Period." Notice the bold, articulate strokes that convey a sense of renewed confidence and authority, yet all the while rejecting the world-weary ennui of his prior work.]
You might have noticed terms such as inventory turnover, capital management, and return on invested capital used in this column and elsewhere in the Fool. We use these terms because most of the people who write for this column are investors who believe that investing is not a simple process. There is no single measure that will inform you of the quality of a business or its fair value. Shorthand valuation measures like the PEG, YPEG, and price/earnings ratio (P/E) can give you a notion of how attractively valued a business currently is. Liquidity measures that focus on the quality of the balance sheet, like the current ratio, are also shorthand measures. Investors putting hard-won savings into a company's stock probably wants to go quite a bit further if they plan on making any money.
To understand things like inventory turnover or return on invested capital, you first have to learn how to calculate them. You'll find the above links take you to the Fool's School "How to Value Stocks" area where our articles await the attention of Fools who are new to the site or who need a refresher course. Learning how to construct these measures takes but a moment in an investing lifetime. Learning how to interpret these measures takes considerably longer, but is ultimately how your understanding of investing evolves. Assuming that you are familiar with the valuation material in our archives, here are some more thoughts on how to assess the underlying quality of a business -- a project that ultimately is directly related to valuation.
There are numerous ways to look at return on capital. Return on invested capital looks at the efficiency of net working capital a business employs, regardless of whether that capital is financed through debt or equity. Return on total capital compares cash or earnings generated by the business to all capital invested in the business, which is the sum of all debt (long- and short-term) and shareholders' equity. You can use any of these measures or other capital productivity measures for one period in comparison to another period to tell what's going on in a business. You can also use these measures across industries to judge which companies are most productive and thus most worthy of your investment dollar. As such, it's not inappropriate to compare a software company with a pharmaceutical company and a food company. Whichever generates the best rate of return on capital employed in the business and generates the best return on marginal capital employed by the company deserves your consideration.
The term "marginal capital return" bears some explanation. First, the word "marginal" means "additional" relative to something else -- in this case, additional capital invested in the business. If, for instance, a company increases its capital base by 10% and return on capital only increases 5%, that additional capital investment wasn't as productive as the company's previous capital investment. If you put 10% more money into any investment, whether it be a factory, capitalized R&D on software, or a brokerage account, and that additional capital only generates a 5% return, your investment is only half as productive as the capital you invested before. If you are in a situation where investing further capital in a business will decrease your rate of return, as a business you need to consider whether or not that capital should just be given back to the shareholders through a dividend or share buyback.
The only time a company with a mature business not requiring further investment should not give back the capital is if it has found more productive investments to make. This is why mature companies tend to invest in new lines of business or start making acquisitions. Management discovers the core business is pretty much built up and they must either admit they can do nothing else and return the money to shareholders or decide that they are actually smart people and can find other businesses offering rewarding investment return possibilities. Given the ego that normally comes with being in charge of a large, mature company, more often than not management will decide they can think of something keen to do with the cash. Unfortunately for shareholders, it is not always good.
Such has been the case with Eastman Kodak <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EK)") else Response.Write("(NYSE: EK)") end if %> over the last couple years. Eastman has poured money back into the business to no avail -- this was shareholder money that probably would have been much better spent on dividends or stock buybacks. Another company that has seen a decline in capital productivity and marginal capital productivity is Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %>. Despite its much-ballyhooed success with regard to unit volume in its new PC business, the company's return on marginal capital has gone through the floor since it started this business. While making PCs is not capital intensive in and of itself, carrying the huge inventories required to distribute PCs through resellers does chew up a lot of working capital. H-P's lagging shareholder return over the last couple years isn't the result of investors failing to give a great company its due. Rather, it is because H-P has gone from being a highly productive company (with regard to return on capital) to being one that is less productive, which has caused the share price to lag.
Let's go back to 1993-1995 for Hewlett-Packard. For the 1994 fiscal year, average capital devoted to the business was $12.156 billion, or $11.67 per share. (Average capital invested in the business is the average of all common and preferred equity plus all interest-bearing debt ascertainable on the balance sheet.) Operating income after taxes (backing out one-time charges and identifiable goodwill amortization) was $1.683 billion, or $1.62 per share. After-tax operating income per share for 1994 divided by $11.67 in average capital per share equals 13.65%. That covers the cost of debt and equity for any company with a good credit rating. It also covers the cost of equity, which is basically the long-term rate of return on the S&P 500, or 10.8%.
In the go-go 1990s, it might be a little light, but let's look at the return generated on marginal capital that year. 1993 capital per share was $11.23 and 1994 capital per share was $12.42. The addition to capital per share from year to year was 10.6%. After-tax operating income for 1993 was $1.24 billion, or $1.22 per share. After-tax operating income per share grew 32.8% in 1994 ($1.62/$1.22). The marginal after-tax operating income per share generated that year was $0.40 ($1.62 minus $1.22) and the addition to capital per share for the year was $1.20 per share. The rate of return on marginal capital per share, then, was 33% (marginal return of $0.40 divided by marginal capital of $1.20).
Back then, the dollars that were being retained or invested in the business were more productive than the business as a whole. Management was finding new opportunities for growth in computers, storage, peripherals, semiconductors, metrology, and scientific equipment. Whatever H-P was doing at the time was working quite well, and a rational investor would have bid it up. Let's see what has happened in the last year.
1996 total capital per share was $17.24, 1997 total capital per share was $19.43, and average total capital per share for 1997 was $18.34. 1996 after-tax operating income per share was $2.48 and 1997 after-tax operating income per share was $2.87. Growth in capital per share was 12.7% in 1996 and growth in after-tax operating income per share was 15.7%. Return on average total capital per share for the year was 15.6%, up nicely since 1994, but there were mitigating factors that might not be repeated. Namely, the company's tax rate dropped close to five percentage points. Holding the tax rate constant from 1994 to 1997, return on capital per share for 1997 would have been 14.8%.
One can't begrudge good tax planning, though, and in any case, return on capital per share increased from 1994. Since after-tax operating income growth was much closer to per-share capital growth, though, we would expect that the rate of return on marginal capital has slowed. Marginal after-tax operating income per share for 1997 was $0.39, down slightly from 1994. Marginal capital devoted to the business was $2.19 per share and the rate of return on marginal capital per share, then, was 17.8% (marginal return of $0.39 divided by marginal capital of $2.19).
While overall H-P's numbers are hardly terrible, which is why the company is currently valued at approximately 23.0 times trailing earnings, you can see that over the past few years the company's new investments have yielded progressively lower and lower returns. If you extrapolate this out very far, you begin to see overall returns deteriorate, inevitably resulting in lower margins and lower earnings growth. This is the sort of insight you can garner when you look at returns on capital instead of simply looking at earnings growth alone or slapping multiples on earnings based on that growth (i.e. saying a company should trade at X times earnings because it is growing at Y rate). The quality of the earnings growth is more important than earnings growth alone. Looking at return on marginal capital plowed into a business is one way to assess the quality of earnings growth.
Please see the Motley Fool's Conference Calls page for call information and links to synopses.
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Contributing Writers Yi-Hsin Chang (TMF Puck), a Fool Brian Graney (TMF Panic), Fool Two Alex Schay (TMF Nexus6), Fool, too Dale Wettlaufer (TMF Ralegh), Final Fool
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