Watch for Falling Margins

by Louis Corrigan (TMF [email protected])

Atlanta, GA. (Oct. 20, 1998) -- What do a fast-food operator, a uniform manufacturer, a pharmaceutical firm, and a life insurance company all have in common? In this case, they are among the stocks listed in the current Workshop Rankings that have recently reported falling margins. While margins alone don't make or break an investment, a general spin on the margins theorem I've discussed is that investors might do well to avoid these stocks.

CKE Restaurants <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CKR)") else Response.Write("(NYSE: CKR)") end if %> owns, operates, and franchises Carl's Jr. and Hardee's restaurants. It's one of the current picks in the Unemotional Growth (UG) portfolio. That's curious because CKE shares have imploded over the last three months, losing 63% of their value from the July peak of $44 5/8 to last week's trough of $16 1/2 (though the stock has since bounced to $23 1/16). It's a mystery to me how this issue could qualify under the UG criteria for timeliness and relative strength.

What's more, CKE's margins as determined by earnings per share (EPS) declined in the second quarter. Net income jumped 114% on a 96% revenue gain, pushing net margins to 4.8% from 4.4%. However, diluted EPS increased just 84% to $0.46 from $0.25, as the number of diluted shares outstanding soared by 26%. Part of the story at CKE is that the firm acquired Hardee's in July 1997, and it's been trying to turn around that chain ever since. But same-store sales at Hardee's continue to be weak, down 9.7% in the quarter after falling 10.8% in the first quarter. That's bad news given that Hardee's is CKE's largest chain.

What's even worse is that the firm's COO Thomas Thompson reportedly told a BancBoston Robertson Stephens conference last week that Hardee's same-store sales would drop 7% in the third quarter and 2% in the fourth quarter even after plunging 9.3% in the latter half of 1997. This continued weakness is bad enough, but I don't like to invest in companies that violate the securities laws by revealing material nonpublic information to a small group of professional investors without simultaneously issuing a press release to the broader investment community. Quite simply, such selective disclosure stinks, and it reveals a disregard for individual shareowners.

I don't know when CKE first appeared in the UG model portfolio, and I haven't checked its margins history, but the margins theorem would have at least kept you from buying the stock (or it would have instructed you to sell it) after the second quarter results were announced prior to trading on September 9. The stock opened that day at $36 1/2.

As I've said before, all of the Workshop models appear to pick up stocks with falling margins. Others in the current update include uniform manufacturer G&K Services <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GKSRA)") else Response.Write("(Nasdaq: GKSRA)") end if %> in the Investing for Growth-Relative Strength portfolio, off-patent drug maker Watson Pharmaceutical <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WPI)") else Response.Write("(NYSE: WPI)") end if %> in the Relative Strength 26-Week portfolio, and insurance outfit AEGON Ins. Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AEG)") else Response.Write("(NYSE: AEG)") end if %> in the Relative Strength-IBD model.

Taking just a quick look, we see that G&K reported June quarter revenues rose 40% to $128 million while diluted EPS increased just 16% to $0.43. In this case, operating margins actually increased as income before interest and taxes jumped 41%. Yet because of a significant acquisition, fourth quarter interest expenses soared to $5.6 million from just $2 million a year ago as long-term debt more than quadrupled, pushing the debt-to-equity ratio to 1.19 from just 0.32 a year ago. While accelerated integration costs may be a good reason for the margins decline, a cursory glance suggests the company's terrific revenue growth has come through leveraging the balance sheet, which leaves me disinclined to cut G&K any slack.

Turning to Watson, we see that second quarter results showed a fantastic 123% increase in sales thanks to acquisitions made in the latter half of 1997 and in February of this year. However, adjusted EPS was juiced up just 29% to $0.36 versus $0.28 a year ago, which means margins fell.

Finally, Aegon is a Netherlands-based company and doesn't file complete financials with the SEC. That alone is enough to make me avoid them, just because it's harder to find out everything I'd like to know (assuming I knew enough about insurers to want to invest in one). Yet just looking at the six-month results reported August 13, I see that while total revenues rose 39% to 19,808 million guilders, net income per share increased just 34% to 2.21 million guilders. The numbers in dollars look different but still produce the same result. It seems that margins declined due to acquisitions.

Without doing further research on these companies, I wouldn't feel comfortable saying much more. Each appears to operate in a generally non-cyclical business, but that's certainly worth investigating. And being less comfortable with financial services firms, I'm not sure how useful the margins theorem is for dealing with them. I'd want to check with the Fool's Dale Wettlaufer (TMF Ralegh) or someone else who knows financial companies to get a better idea of how the EPS metric stacks up against metrics of operating efficiency and return on assets.

Yet if I were blindly following my margins theorem, I would sidestep (or have sidestepped) these four stocks because their margins are falling. Thus far, avoiding CKE Restaurants would have been a smart move. The others have been as choppy as the market, but perhaps they will show strength in the future. We'll check back in with these in a few months. In the meantime, I'm struck by the margin theorem's usefulness in regard to CKE. I'm also surprised by that stock's appearance in the UG portfolio. If anybody happens to know when it entered the UG port, I'll love to find out.

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