FOOL ON THE HILL
An Investment Opinion

One of My Biggest Holdings Warns

By Warren Gump (TMF Gump)
September 28, 1999

Today started off pretty well. Mark Haines was at the anchor desk of CNBC's Squawk Box, adding intelligence and insight as he normally does. Cheerios, milk, and Tropicana Pure Premium orange juice were waiting for me as I sleepily wandered into my kitchen, saving me the all-too-common early morning trip to the store to pick up the breakfast items I forgot to buy the previous night. My walk to Fool HQ was pleasant. Although it's overcast and drizzling here in Northern Virginia, the temperature has dropped and you can sense the crisp, pleasant wisps of fall starting to wash away the heat and humidity of summer. Everything pointed to a great day.

When I hit HQ, I rolled my chair over to the Bloomberg to scroll through the morning's news and see if there was a good topic for today's column. Nothing popped out at me in the top business headlines of the day, so I then clicked through the news headlines related to earnings announcements. It looked like it was going to be pretty slow, with no eye-catching headlines. As I was about to scroll back through the news to see if there was something I missed, one of the worst press release headlines I could imagine for my portfolio stood out: CONSOLIDATED PRODUCTS, INC. ANNOUNCES REVISED FOURTH QUARTER EARNINGS ESTIMATES.

Consolidated Products <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: COP)") else Response.Write("(NYSE: COP)") end if %>, the operator of the Steak 'N Shake restaurant chain, is one of the larger investments in my portfolio. I have been a fan of this company for quite some time, as it has been posting strong earnings growth throughout the decade. In its quarterly earnings releases, the company tracks the number of consecutive quarters that it has achieved record revenues and operating earnings. Last quarter was number 53, representing over 13 consecutive years of posting improved operating results. Last November, I wrote an overview of the company. It is in both of my online portfolios managed in our Speaker's Corner -- one focused on value investing, the other on growth. (Wanna open up your own personal message board? -- go ahead; it's free!)

Seeing the headline of the press release, I knew that this was going to be bad news rather than good. It is late September, right before the end of the company's fiscal year, a time when management realizes there's no way analyst expectations can be met. In addition, Consolidated Products had missed fiscal third quarter earnings estimates by a penny due to rising labor costs, an issue that has become increasingly problematic over the past year. These types of issues rarely turn around abruptly. As I read through the release, my expectations proved to be accurate:

- Q4 earnings to be only slightly better than last year's $0.21 per share (estimates were at $0.23).
- Quarterly new restaurant openings occurred later than expected.
- Labor costs were higher than expected.
- Same-store sales were up nearly 4% (at least there was some good news).
- The company will no longer attempt to grow unit base at 20% per year because of staffing challenges.
- The company will try to open 40 restaurants in fiscal 2000, representing 15% unit growth.

In reality, the news wasn't nearly as bad as it could have been (although the stock's 20% drop belies that fact). The company didn't say that earnings were going to fall -- they were just going to be flat or up slightly. While costs are obviously a big issue for the company, a price increase at the beginning of the quarter does not appear to have significantly weakened customer demand. Same-store sales are still rising at a nice pace -- although most of that increase is caused by higher prices rather than more customers. Some had feared that a price hike at the beginning of the fourth quarter might impact sales more adversely.

The news that the company was slowing down unit expansion was somewhat of a surprise. At first blush, I was bummed at realizing that the slowdown in unit growth expansion (which has been a good proxy for profit growth over the past few years) meant that my estimate of long-term earnings growth needed to be lowered from 18%-20% down to 13%-15%. That's a seemingly small number, but it makes a big difference when compounded over several years. In fifteen years, $1,000 grows to $7,138 compounded at 14%, whereas it hits $13,590 compounded at 19%. This is a fundamental change that significantly alters the company's valuation potential.

I realized, however, that the company was making a smart decision. While it would be nice to have 20% growth, the company can't successfully execute an expansion plan at that pace. Right now, that growth is resulting in flattish earnings -- and the trend is deteriorating. If the company can throttle back its expansion plans to 15%, yet do it successfully, it would be much better off than trying to grow faster and enduring serious operational problems. I tip my hat to Consolidated Products management for evaluating their capabilities and deciding to temper their growth plans to increase the likelihood of maintaining long-term success.

While the pullback in growth rate has been primarily driven by management and labor resources, the company's financial profile should benefit from it. To hit its 20% unit growth targets, Consolidated Products had been spending more on capital expenditures than it had been generating from operations. To fund the difference, the company was relying on the debt and equity markets, as well as sale/leaseback transactions, to provide additional capital. Lowering the growth pace to 15% will bring the company much closer to self-funding status, meaning it doesn't have to increase its debt and won't need to tap into the equity markets to continue growing. Ongoing operations and sale/leaseback transactions should provide sufficient capital to proceed with 15% unit growth. This means its debt level should remain flat (unless it decides to embark on a stock buyback program) and it won't need to worry about how it will fund its growth.

Today's news is certainly disappointing, but it has not caused me to lose confidence in the Consolidated Products management team. In some ways, I have even more confidence in their managerial abilities since they so decisively addressed their biggest challenge -- finding enough capable workers -- before it started having a disastrous effect on company performance. (The company is not just reducing its demand for new managers -- it has also been significantly enhancing managerial recruiting and training programs in an attempt to boost supply.)

Despite my confidence in the company's long-term outlook, I am going to have to part with the company shares held in my hypothetical online growth portfolio. I'm sad to see the stock leave the portfolio, but I really don't have any choice in the matter. One of the tenets with which I manage that portfolio is that the companies within it should be capable of sustaining at least 15% compound annual earnings growth. Today's news of the slowdown in expansion plans now makes 15% growth the top-end of realistic possibilities, meaning that there is no "margin of safety." I don't keep stocks in my portfolios without a comfortable margin of safety, so this decision is simply a matter of investing discipline.

In my value portfolio, which focuses on finding stocks that are priced inexpensively relative to reasonable expectations about future prospects, I'm going to continue holding onto Consolidated Products. Even if the company were to achieve only 13% compound annual growth over the next few years, the stock seems attractively prices at 13x current year earnings expectations. It probably won't be a smooth ride for stockholders -- particularly over the next few months as the company struggles to bring its manager supply/demand equation back into balance -- but the patient investor should be rewarded if the company gets on a sustainable 13%-15% growth track within the next year or two. The stock will stay in this portfolio unless clear signs emerge that the company will not be able to resume modest growth, such as falling same-store sales for a couple of quarters or a plethora of weak new restaurant openings.

Taking a step back from my situation, I asked myself what I would do if I didn't have any money already invested in Consolidated Products. I probably wouldn't put any new money in the company today. Instead, I would place the stock on my "watch list" to track developments. I would then make the decision to invest once I saw concrete signs that the company's situation has stabilized and its operations are strong again. Some things to look for would include management staffing returning to levels sufficient to cover growth plans, continued positive same-store sales, and the resumption of detectable earnings growth.

This relatively conservative strategy keeps me from taking an initial stake in a company with deteriorating fundamentals. The only "cost" of using it is that I will never buy into the company's stock when it is at a low since the stock will invariably have rebounded a bit by the time clear signs of stabilization have emerged. The benefit of using the strategy is that it keeps me out of stocks of companies where a bad situation only becomes worse. You know, the "dirt cheap" stock at $15 that trades for $8.50 a year later.

While today has been disappointing, I do need to keep it in perspective. Despite today's stumble, Consolidated Products' stock has still quadrupled over the seven years I've been following it (a compound annual 21% return). The profits any investor can earn from finding good growth companies at reasonable valuations are still in tact. In that light, today really isn't so bad after all.