<FOOLISH WORKSHOP>

Management Buy-Out

by Louis Corrigan (TMF Seymor)

Atlanta, GA. (Feb. 23, 1999) -- We're still seeing a long list of candidates on our Rising Margins screen. But before sifting through them, we'll begin with another instructive flashback.

In my January 5th column, I took up a lot of space to talk about Equitrac <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ETRC)") else Response.Write("(Nasdaq: ETRC)") end if %>, a small cap company that sells computer system products that automatically track, record, and report usage of office equipment by law firms and other professional services outfits. Part of the story was that the company was selling off an unprofitable business, which would soon make the already rising margins rise faster in the future. I concluded that Equitrac looked like "a sleepy stock and a boring business" -- both positives for a Lynchean investor -- "but one worth further investigation."

The stock then traded around $18. Last Wednesday, Equitrac received a management-led buyout offer of $25 1/4 a share, a 25% premium to the then current price. Cornerstone Equity Investors, a company that assists management-led buyouts, is also involved in the deal, which has been approved by Equitrac's board and should close by May 31. The stock is now trading at $23. So Equitrac is up 28% in the last seven weeks and will return about 40% in just five months, assuming the deal closes as planned.

The lesson here is not just that the margins screen can find promising investment candidates but that many of the long-ignored small caps will simply be taken private if they continue to be ignored. Money managers are increasingly avoiding these issues in part because they're afraid that other money managers will avoid them. They all worry, then, that the intrinsic value of these stocks won't be recognized in a timely fashion and that it will be hard to trade out of them. Equitrac is just one example, but it suggests that real value does get appreciated eventually by someone.

First up on this week's list, juggernaut apparel retailer Abercrombie & Fitch <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ANF)") else Response.Write("(NYSE: ANF)") end if %>, where quality is as high as the prices -- which are so high that they could sell me some great sweaters for about 70% off in late January and still report a blowout quarter. With a slick marketing campaign driven by Bruce Weber photos of buff young men and women, Abercrombie has become a lifestyle brand making a huge impression on the college crowd and now, the pre-teen aspirational set. Due to the Generation Y demographic bulge, this is a sweet spot to be in, and Abercrombie is sucking down nectar by the gallon.

Q4 revenue soared 44% to $305 million. EPS shot up 65% to $1.12 from $0.68 last year. That was 15% ahead of the $0.97 per share analyst estimate. Same-store sales increased 26%. Gross profit margins rose to 49.3% from 45.4%. Operating expenses declined to 16.9% of sales from 17.5%. For the full year, sales jumped 56% to $816 million on a 35% same-store sales hike. EPS hit $1.92, up a stunning 104% from $0.94 a year ago.

The balance sheet reflects this strength. Cash increased to $164 million from $43 million a year ago. Inventories rose more slowly than sales while accounts payable rose faster. Abercrombie has jettisoned $50 million in debt in the last year. All of this just rocks, as you can tell by looking at the Fool Snapshot.

At year-end, the company had 196 stores, including 13 abercrombie stores for the 7-14 year old crowd. It plans to open 36 new flagship stores and 15 to 20 abercrombies this year. Current estimates call for earnings of $2.45 per share for the year ending next January and $3.18 for the following year.

Though Abercrombie will come up against increasingly tough comparisons given its astonishing same-store sales gains, the retailer is clearly on a roll and should top these estimates. Goldman Sachs, for example, just raised its projections to $2.50 for this year and $3.50 for next year. At around $76, the company does trade for 30 times forward estimates, in line with its growth. While not an obvious bargain, Abercrombie still looks like a winner, with upside potential. I still think their prices are too high, but no one else seems to care in these roaring good times.

Next up, Roberts Pharmaceutical <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: RPC)") else Response.Write("(AMEX: RPC)") end if %>, a firm that searches for late development-stage or underperforming drugs, buys the rights to them, then brings them to market. It specializes in the fields of gastroenterology, urology, oncology/hematology, and cardiology/neurology. Fellow Fool Jeff Fischer offered a great profile of this hot performer in our recent year-end special.

For the fourth quarter, Roberts saw sales jump 49% to $55.5 million. EPS vaulted 91% higher to $0.21 from $0.11 last year. That was 50% ahead of the consensus earnings estimate of $0.14 per share. Solid sales of new high-margin drugs boosted revenues, but gross margins sank year-over-year to 58.7% from 65.7%. Apparently, a planned price hike on its lower-margin Noroxin drug led wholesalers to step up their orders, boosting sales but cutting into gross margins. Still, operating expenses dipped to 32.4% of sales from 43.5%.

Revenue for the year popped up 43% to $175.5 million as strong sales of the company's Agrylin, ProAmatine, and Pentasa drugs pumped gross margins to 62.2% for the year versus 58.1% last year. Operating expenses also declined to 39.4% of sales from 48%. As a result, EPS hit $0.53, crushing the $0.06 reported for FY97 and beating the consensus estimate calling for $0.48 per share.

Though the company had $75 million in cash at year-end, the latest full balance sheet published in the company's Q3 report shows $132 million in debt. Still, the Fool Snapshot doesn't do the company justice, since 1998 was really a pivotal year. The somewhat stale estimates call for Roberts' EPS to leap 47% to $0.78 this year and up to $1.02 next year. So at $23 the stock trades at 29.5 times forward projections, a discount to this year's growth but roughly in line with the long-term trend of 32.5% projected growth. For a pharmaceutical company, albeit a second-tier outfit, that's not bad. I'd rate this worth a closer look.

There are a few more on our screen that deserve a quick mention. Despite the "disappointing" results from Dell <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> last week, that company actually delivered another quarter of rising margins (sales up 38% to $5.17 billion, EPS up 55% to $0.34). Our margins theorem says hold on. Dell is seeing some pressure from increased competition and the return to more stable component pricing. (Dell's quick-turn model means it benefits more than most PC companies from falling component prices). We'll see how our margins theorem does on this call. Dell remains a model of operating efficiency.

Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %> is another market bellwether that turned in continued stellar results. Sales rose 15% to a stunning $40.8 billion and EPS increased 23% to $0.70. To state the obvious, if you haven't looked at Wal-Mart as an investment candidate, you should. Though I do think retailing on the Web will throw this behemoth some curveballs in the years ahead, this slugger has put together a pretty great career no matter who's been pitching. The past is surely prologue.

On the flipside, Able Telecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ABTEE)") else Response.Write("(Nasdaq: ABTEE)") end if %> shows up on our screen but really shouldn't. It hasn't filed its annual form 10-K report yet as required by the SEC (that's why it's got another "E" added to its ticker symbol). It also didn't bother to include Q4 FY97 comparison figures when it issued its earnings release last week. The company remains a prime target of well-known short-seller Manuel Asensio, who has put together an impressive record of shorting dubious enterprises. At the very least, his press releases make for entertaining reading -- unless, of course, you own one of the companies he's after. Investors should avoid Able like the plague.

Check out the latest file updates for the Workshop:
New Rankings | Workshop Returns