Fool.com: Margins Screen on the Losers (Workshop) September 18, 1998

Margins Screen on the Losers

Note: Due to troubles with the data feed from Value Line, this week's data update won't be available until this evening or perhaps Saturday morning. We apologize for the inconvenience.

Atlanta, GA. (Sept. 18, 1998) -- In the last couple of weeks, I've proposed a theorem for making use of the Fool Workshop's margins screens and tested it against Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, then Best Buy <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BBY)") else Response.Write("(NYSE: BBY)") end if %>, and finally the Gap <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GPS)") else Response.Write("(NYSE: GPS)") end if %>. These were the three top performing stocks from the workshop's mechanical model portfolios as of my August 26 study date and were responsible for virtually all of the gains in these portfolios.

The margins theorem appears to work pretty well, particularly if we lower the sales threshold to catch companies delivering significantly better profits on even so-so sales gains. That's because each of these stocks began their runs after a stumble, and lucrative turnarounds often begin when a company starts to pay more attention to making money than to simply cranking out ever higher revenues. With this modification, though, the theorem would have found you each of these stocks early in their ascent, sometimes well before they appeared in the model portfolios.

As we also saw, the theorem would have helped you avoid each of these companies during their times of trouble. Since preservation of capital is one key to creating wealth, a screening method that helps you avoid dogs should help keep your tail wagging. To follow up on this defensive aspect of the margins screen, I'm going to test the theorem on some of the model portfolios' losers.

Today we look at ICN Pharmaceuticals <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ICN)") else Response.Write("(NYSE: ICN)") end if %>, a biopharmaceutical company with a storied history and a penchant for trouble. ICN began the year at a split-adjusted $32 1/2. Early on, it rose sharply on positive news concerning use of its antiviral agent ribavirin (marketed as Virazole) as a hepatitis C therapy used in combination with Schering Plough's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SGP)") else Response.Write("(NYSE: SGP)") end if %> Intron-A. Since then, the stock has plunged 57% to $14 1/8, in part because of the company's decision in June to take a $172 million charge ($1.65 per share) related to the Yugoslavian government's default on some notes. About 22% of ICN's 1997 sales went to Yugoslavia, and 80% of those sales were to the national government. Longtime company Chair and CEO Milan Panic served as prime minister of Yugoslavia between July '92 and March '93.

Before adding to this story, we should look at the numbers. Here are the net margins for the past few years:

 
 FY95     13.3% 
 FY96     14.2% 
 FY97     15.1%

That looks good until you see that earnings per share have not kept pace, given that the number of fully diluted shares jumped 28% over this period. While sales rose 20.9% in FY96, EPS gained just 15.9%. Sales were up 22.5% in FY97, but EPS increased just 10.4%. In other words, margins were falling.

Looking at quarterly results during FY97 and the first quarter of FY98, though, we run into a more complex picture:

 
  
 Quarter     Sales     EPS 
 1Q97         15%      -25% 
 2Q97         12%       22% 
 3Q97         12%       32% 
 4Q97         47%       25% 
 1Q98         51%       38%

Margins seemed to rise in the second and third quarter of FY97. Though the sales gains didn't surpass the 15% threshold to make the current margins screen, our revised theorem seemingly would have given a "buy" signal after the second quarter results were in and a "sell" signal after the fourth quarter results were in. While that would have been a profitable trade that would have saved you from the ensuing collapse, I wouldn't have made it because I don't think the margins increase was legit.

Looking more closely at the quarterly numbers, it's clear that the sharp jump in reported earnings in the second quarter was due to a substantial tax benefit related to previous losses. Operating profits actually plummeted 34% in the second quarter. Without getting into more details, though, we can just call the third quarter figures legit. So just following the revised theorem (rising margins on any sales growth is fine), you would have bought after the Q3 results were in and sold after the Q4 results came out. (We're bracketing for now the question of whether we should apply the theorem at all to a biopharmaceutical company.)

Only, an investor who spent any time looking into ICN's fundamental story would have been leery of touching it -- ever. Back in 1987, ICN played an instrumental role in funding some of the first community-oriented clinical research into AIDS therapies. The story is told in detail in Jonathan Kwitny's book Acceptable Risks (1992). The drug under study was the very same ribavirin. In a remarkably politicized (and suspect) process, the Food and Drug Administration ultimately rejected ribavirin's request for a Treatment IND (investigational new drug), an early step in the approval process. Amidst the uproar, though, the SEC launched an investigation into possible stock manipulation and insider trading in ICN. Panic had a reputation as a promoter, and the SEC was interested in nabbing him.

This might seem like ancient history, but the company's quarterly filings have made it plain that the SEC is still after Panic. This time, the charge was that Panic and others had traded on insider information between June 1994 and February 1995 related to ICN's new drug application (NDA) for the use of ribavirin as a treatment for hepatitis C. More news about this investigation and a subsequent grand jury investigation came out in January and March of this year. While the SEC just this week dropped the probe of insider trading, it's still seeking to remove Panic from his position, alleging that back in 1994 he failed to disclose adverse information about ribavirin.

With hundreds of potential cases to pursue, the SEC doesn't usually waste time following dead ends. Where there's smoke, there's usually fire. Investors should just stand clear of companies run by people the SEC has a problem with. In addition, the public filings made the credit risk of doing business with the Yugoslavian government pretty clear, too. In other words, even a minimum amount of checking would have made ICN look like a good stock to avoid regardless of what type of screen it showed up on.

Yet even if you had blindly bought ICN based on the margins theorem, you wouldn't have held it for long and you would have avoided much of the ensuing collapse.

[Correction -- In yesterday's column on the Dozens, I mistakenly used Capital One Financial as the Keystone Dozen pick for the end of August. The # 1 Keystone stock is still Dell Computer, but the Dozens port already has that, so the next stock would be Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>. Using the dozens model, you'd have added 18 shares of Cisco at $54.06. Even with this correction the Keystone Dozens performance is 15.16% versus a loss of 3.98% for the S&P 500. -- TMF Bogey]

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