<FOOLISH WORKSHOP>

Margins in Earnings Season      

by Louis Corrigan (TMF Seymor)

Atlanta, GA (May 11, 1999) -- It's still earnings crunch time, with some 86 stocks on our Rising Margins screen this week.

First up, TMP Worldwide <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TMPW)") else Response.Write("(Nasdaq: TMPW)") end if %>, one of the more interesting plays on the Internet and yet one that hasn't been bid up too extravagantly.

TMP is a marketing services firm, with more than 17,000 clients, including most of the Fortune 500. It's the top yellow pages ad agency. It also creates and places recruitment ads in classified sections of newspapers. Plus, it's become a major job search and selection firm. But the real growth story here is Monster.com, the leading global online job network. It made a splashy debut earlier this year with some terrific Super Bowl ads.

Monster.com attracts 7.6 million unique visitors a month, good for 82 million page views. Job seekers post their resumes (1.3 million thus far) and search the site's 200,000 employment opportunities. Monster.com is the market leader in this business of providing Internet classifieds for employment.

To put a sexier spin on the story, though, one might call Monster.com a global market maker for jobs. Dig this recent headline: "Monster.com Creates World's First Auction-Style Marketplace For Free Agents." Having built a critical mass of traffic that can now feed on itself, Monster.com enjoys the kind of network effects discussed by Tom Gardner in explaining why eBay <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EBAY)") else Response.Write("(Nasdaq: EBAY)") end if %> offers such a compelling story.

For the first quarter, TMP's sales increased 18% to $180 million, but adjusted net income shot up 47% to $6.6 million and EPS increased 50% to $0.18. That beat the $0.16 per share IBES consensus estimate. The growth came mainly in temporary contracting revenues (up 33% to $55 million), thanks to internal growth in its operations in Australia and soaring revenue from its Internet operations, mainly Monster.com. Internet sales rose 161% to $20.1 million, well on the way to meeting the analysts' target for the year.

TMP has been on an acquisition spree as it builds share in the executive search and recruitment markets. For example, it recently signed a smart deal to buy LAI Worldwide <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LAIX)") else Response.Write("(Nasdaq: LAIX)") end if %>, which was trading for a bargain price. Still, such dealmaking, and increased spending to promote Monster.com, has had an impact on the balance sheet and profit margins, as the Fool Snapshot reveals. At $61 1/2, TMP trades for 64 times the FY99 earnings estimate of $0.96.

That's rich, even for a company projected to grow at an impressive 38% over the next few years. But investors need to take a long-term view with leading Internet players since it's in the long-term that the operating leverage inherent in online commerce should materialize. Does $2.4 billion seem like a lot for a company that's the clear global leader in connecting employers with potential employees via the Internet? No, especially given it has other solid revenue streams. TMP is worth a closer look. Those interested might want to check out our recent Daily Double and this Daily Trouble on LAI.

Although Media Arts Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MDA)") else Response.Write("(NYSE: MDA)") end if %> appears on our screen, it really shouldn't. Earnings per share before an extraordinary loss last year actually inched ahead just 7% to $0.32 while Q4 sales painted a 23% gain to $31 million. So margins actually fell. This should remind you that our screen is just a start and that you should always look closely at the actual earnings report to check for one-time gains or losses or major changes in the tax rate.

Still, Media Arts is such an interesting story that's it worth a quick look. The company is built around the artwork of Thomas Kinkade, the "Painter of Light," who specializes in cheesy romanticized images of nature. Through its company-owned Thomas Kinkade stores and 169 independently owned Signature Galleries, the company sells the painter's works in a variety of limited edition canvas and paper lithographs. The images also decorate every imaginable form of home accessory, from calendars to coffee mugs.

Media Arts has been a wonder, as I noted in a Daily Double last year, because it's simply hard to believe there are so many people willing to shell out so much money for such ridiculously bad "art" -- or that this business could be so profitable. But it has been. Even for the year just ended, the company pocketed profits of $18.4 million on sales of $126.3 million, good for a 14.5% net profit margin.

After an awesome run from the low single digits to well over $20 a share, the stock has spent the last year sliding as short-sellers began making bets that this madness couldn't last. At $7, the stock now stands at a 52-week low, having lost two-thirds of its value since last May.

Even so, a cursory look at the Fool Snapshot would suggest that the stock could be insanely cheap. With trailing earnings of $1.32, it now trades at just 5.3 times earnings. And analysts apparently still expect earnings of $1.60 for FY 2000 (though NationsBanc Montgomery's Shelly Hale has reportedly cut her estimate to $1.50).

Plus, Media Arts delivered an impressive 42% return on average equity over the last twelve months, with virtually no debt. Moreover, it now sports a market cap of just $91 million, giving it a price-to-sales ratio of 0.72. That's about what you would expect from a company with net margins of 3% or less.

However, there are signs of trouble. For starters, same-store sales for Q4 were flat. The company said it was still a great quarter considering that comp-store sales jumped 29% last year thanks to the "hugely popular 'Garden of Prayer'" image introduced in Q4 FY98. Yet accounts receivable and inventories have also ballooned, by 41% and 83%, respectively, far outpacing the 23% sales increase. Though the company has said that changes in its distribution system (it has plans to launch an online store) and timing issues play a role here, these are classic signs that supply is outstripping demand.

If that's actually the case, the company could soon report sharply lower sales and earnings, making mincemeat of the attractive valuation metrics just cited. Since the ostensibly stunning demand for Kinkade's work never made sense to me, negative news on that front wouldn't seem very surprising. Indeed, if consumer demand of Kinkade's work actually declines, look out below. Many folks have bought his work with misty visions of its investment value. I'd suggest you avoid Media Arts unless you can see more in the painter of light than I do.

Finally, we'll look at Activision <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ATVI)") else Response.Write("(Nasdaq: ATVI)") end if %>, an international designer, publisher and distributor of interactive entertainment, including a new title based on the new Star Wars flick The Phantom Menace.

Fourth quarter revenues exploded by 69% to $115 million, pumping up EPS to $0.22 versus $0.03 per share in the year-ago period. That bested analyst estimates calling for earnings of $0.20 per share. For FY99, revenues popped 40% to $436 million, with earnings nearly tripling to $0.66 per share from $0.23 in FY98. (The FY98 figures have been restated to account for acquisitions.)

The upcoming lineup of interactive products could be Activision's strongest yet. The top titles include Toy Story 2, A Bug's Life, Tarzan, X-Men, some Star Trek titles, and Quake III. The company has tried to reposition itself for the broad consumer market, inking deals with entertainment companies like LucasArts, Disney <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %>, Marvel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MVL)") else Response.Write("(NYSE: MVL)") end if %>, and Viacom <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: VIA)") else Response.Write("(AMEX: VIA)") end if %>.

The balance sheet looks good, with accounts receivable and inventories up 59%, or less than sales. Activision also has $33 million in cash balanced out by $60 million in convertible notes. The company also seems to have balanced out its risks. About two-thirds of its business now comes from international markets. Meanwhile, its own titles accounted for 53% of sales in Q4 and 47% for the year, whereas the distribution of third-party titles accounted for the balance of sales.

The market for interactive entertainment has generally disappointed investors as it's experienced the hit-or-miss dynamics of Hollywood in combination with persistent price pressures. (Activision itself has had to return from the dead.)

So it's no surprise that the industry has continued to consolidate. For instance, top consolidator The Learning Company <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TLC)") else Response.Write("(NYSE: TLC)") end if %> acquired Broderbund last year. Now even it is being acquired by Mattel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MAT)") else Response.Write("(NYSE: MAT)") end if %> as the giant toymaker looks for new ways to interest kids, who are moving from dolls and other traditional toys to interactive games at a much earlier age.

At $12, Activision trades for 18 times trailing earnings and 11 times the $1.06 per share estimate for the year ending next March. That's ostensibly attractive. Still, the stock has gone sideways for the last three and a half years. Given the fierce competition in this industry, it's hard to get that excited about Activision.