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INVESTMENT QUALITY TRENDS
7440 Girard Ave., Ste. 4, La Jolla, CA 92037.
1 year, 24 issues, $310. 2 month trial, 4 issues, $55.
Aim your sights on Honeywell
Joseph McKittrick: "Honeywell (HON) might be best known for its ubiquitous T-86 "round" thermostat invented in 1953, it is by no means a company stuck in its past. In 1957, Honeywell purchased a fire and security alarm company and began placing its recognizable security stickers in windows across the U.S. During the 1960's, Honeywell made important instruments used by Neil Armstrong and Buzz Aldrin to land on the moon. By 1986, Honeywell acquired Sperry Aerospace and instantly became the leading integrator of avionics systems.
In the year 1999 AlliedSignal and Honeywell merged to form a new company known as Honeywell. After the merger, the company found itself forced with the dilemma of merging 50 different businesses under the same corporate rooftop. The resulting conglomerate today operates several major divisions including Specialty Materials, Aerospace, Automation and Control Solutions, and Transportation and Power systems.
In 2001, Specialty materials accounted for 14% of total company sales. Product lines include materials such as fluorocarbons, polyester, nylon, polyethylene and other chemicals. Notable proprietary products include Anso carpet fiber, Lumilux luminescent pigments, and Capron nylon resin. Besides being a top five provider of materials to the electronics industry, Specialty Materials caters to manufacturers in need of specialty chemicals, and performance fibers. Among its list of customers are Goodyear, IBM, Samsung, General Motors, Ford, Cisco, and Ericsson.
Aerospace represents the largest portion of Honeywell sales, accounting for 41% in 2001. Since the blending of Honeywell and AlliedSignal's Aerospace businesses, a new leader in the aerospace industry has emerged. Honeywell's Aerospace supplies avionics, airliner products, and aircraft engines to virtually every major company in the industry. The U.S. Government is a leading customer, but other notables include everyone from Boeing to Airbus and Sikorsky.
Automation and Control Systems carries the legacy from Honeywell's original thermostats and regulator business. Modern product lines have been expanded to also include security/fire alarms, software to control computerized homes/buildings, sensors, control systems, and industrial safety systems. Second only to Aerospace, Automation & Control Systems comprised 30% of total 2001 sales.
Although Transportation and Power systems is one of the smaller divisions of Honeywell, its products are perhaps the best known among the general public. Brands manufactured and marketed by Transportation & Power systems include Fram Filter, Autolite Spark Plugs, Prestone Anti-Freeze, and Garrett Turbochargers. Headquartered out of Torrance, California, this division currently has 16,000 employees and accounted for 15% of 2001 sales.
Interesting Qualities To Note: 1. Honeywell has 120,000 employees; 2. Company cash was $2 billion for the most recent quarter; 3. Recent market capitalization was $19.6 billion; 4. Telephone number: (973) 455-2000; www.Honeywell.com.
At a recent price of $24, Honeywell is in a Rising Trend with a 22% downside risk to its Undervalue price of $19, high yield of 4.0%. From current levels Honeywell has a 108% upside potential to its Overvalue price of 50, low yield of 1.5%. At a price of $24, Honeywell is notably trading at slightly less than twice its book value of $13. HON earnings also support a dividend yield of 3.1% with a 45% payout ratio. From current levels, Honeywell has all the indicators of good value, but with a 22% downside risk and a recent 52 week low of $18.77, we feel that its potential to return to Undervalue has not been exhausted. Investors seeking a well-diversified company that holds the promise to bounce out of its current glut should aim their sights onto HON at Undervalue."
LOW PRICED STOCK SURVEY
7412 Calumet Ave., Hammond, IN 46324.
Monthly supplement to Dow Theory Forecasts.
Promising pipeline bolsters KV Pharmaceutical
Richard Moroney: "KV Pharmaceutical (NYSE KVa $19) offers impressive growth at a reasonable price. Boosted by robust demand for its branded drugs, earnings growth has accelerated in recent quarters. Moreover, a favorable political climate and patent expirations bode well for the company's generic drug unit. Earnings should climb about 14% for fiscal 2003 ending March, followed by another 15% to 20% in 2004. Sales should grow at a double-digit clip for the next several years. With the stock down about 40% from its 52-week high of $32 set in May, there is ample room for advancement. The shares are rated Best Buy.
Company Profile
KV develops, acquires, and manufactures prescription products through its Ther-Rx branded unit (20% of fiscal 2002 sales) and ETHEX generic division (69%). In addition, KV operates Particle Dynamics (10%), which develops raw materials for the pharmaceutical, nutritional, food, and personal-care industries. Over the last four years, total sales have more than doubled to $204 million.
KV offers drug-delivery and formulation technologies covering four major areas: tastemasking, controlled release, quick-dissolving tablets, and bioadhesives. Ther-Rx products target women's health care and cardiovascular disease. The unit is the leading maker of branded prescription prenatal vitamins in the U.S. ETHEX sells more than 80 generic drugs, most of which are category leaders, geared toward cardiovascular ailments, women's health, pain management, and respiratory illness.
A robust pipeline of new products should drive sales and earnings. Over the past year, KV has received seven FDA approvals for new drugs. Last month, the company said it would begin marketing the first product using its OraQuick dissolving technology. In October, KV said it would partner with FemmePharma to develop new treatments for women. The first product is expected to be a treatment for endometriosis, a disease affecting some 90 million women worldwide.
The company's innovative delivery technologies help differentiate its products and boost profit margins. In fiscal 2002, gross profit margins reached 62%, up from 44% in1998. Niche acquisitions should bolster results. Spurred by ongoing consolidation in the industry, many large drug companies are divesting smaller or nonstrategic product lines. At the end of the September quarter, the company had $96 million in cash sufficient funds to spend on acquisitions.
Conclusion
KV earns an 86 overall score in the Quadrix stock-rating system, keyed by high quality (88) and financial strength (99). At 18 times trailing earnings, the stock trades below its five-year average P/E ratio of 30 and has a PEG ratio (P/E divided by expected five-year growth) of 0.7 below the sector average of 1.0 KV should be able to support a higher valuation, given its sales and profit momentum. Moreover, a solid balance sheet provides the company with flexibility, as long-term debt is negligible. Using expected earnings per share for the next 12 months and assuming the stock trades at a P/E in line with its expected long-term growth rate of 25%, the stock could reach $30, about 58% above current prices. December-quarter earnings are due Feb. 3."
PEARSON INVESTMENT LETTER
6431 Rubia Circle, Apollo Beach, FL 33572.
Published for clients of Pearson Capital, Inc.
Sound fundamentals and solid yields
Donald Pearson: "In today's difficult times it is nearly impossible to sustain a portfolio of stocks that maintains growth without income. We shifted our strategy nearly a year ago, and believe our clients are better off today for this. In almost every portfolio we have included at least one gold stock and in many cases two. This is done simply to prioritize safety. We are also looking for companies with outstanding management, sound fundamentals, and solid yields. Some of the stocks that we believe meet these criteria are:
Pfizer (PFE), the world's largest drug company. This stock has recently dropped about 20% from its high and currently yields around 2 percent. With its current p/e, and growth projected for 2003, this should bean outstanding choice for safety.
Another company worth looking at in the medical sector is Merck (MRK). Merck reported fourth quarter earnings that matched expectations while revenue exceeded forecasts. Its five largest selling products Zocor, Fosamax, Cozaar and Hyzaar, Singulair, and Vioxx produced collective sales of 18 percent. This drug giant has also provided a 2003 outlook that is above current forecasts. Merck's p/e of 17, while yielding 2.6%, makes this another standout.
Johnson & Johnson (JNJ), is another company in the medical sector worth considering. JNJ recorded fourth quarter sales of $9.4 billion, up 14.3%. For all of 2002, sales rose 12.3% to $36.3 billion, and net earnings increased 17% to $6.7 billion. Profit margins were all up from last year: gross margin, 71%; operating margin, 26%; net, 18%. Continued strong sales of anemia drugs drove pharmaceutical sales 15% higher last year to top $17 billion. JNJ currently yields around 1.5% and could be added to anyone's portfolio. We currently have all of these in our client base."
THE CONTRARY INVESTOR
309 South Willard Street, Burlington, VT 05401.
1 year, 24 issues, $125.
Spotlight: Marathon Oil
Michael Huffman: "Marathon Oil (NYSE MRO $21.28, www.marathon.com) engages in the exploration and production (E&P) of oil and gas internationally in Canada, the U.K., Ireland, northern Europe and West Africa. In the U.S., E&P activities are conducted in Texas, Oklahoma, Wyoming, Alaska and the Gulf of Mexico. Marathon also refines and markets energy products through its 62%-owned joint venture with Ashland Oil Co. (NYSE ASH). This operation, known as MAP, was created in 1998 and has a market-leading position in the Midwestern U.S.
Marathon was purchased in 1982 by U.S. Steel Corporation (NYSE X). Marathon did not prosper in the marriage as the company failed to replace (through exploration or acquisition) the oil and gas it produced in each of the five years up until 2001. Reserves equal future production and Marathon's reserves are low compared to large integrated oil companies. In 2002, the year it separated from U.S. Steel, the company used most of its cash flow to grow internally (130% reserve replacement) and to purchase liquid propane gas fields and facilities in Equatorial Guinea, West Africa (equal to 120% of 2002 production). At the present time, Marathon receives no credit for replacing these reserves for the low price of $5 barrel of oil (or its equivalent). Instead, the focus is on production volumes, which fell 2% to 3% in 2002 and are projected to do so again in 2003, in our opinion a legacy of a weak exploration focus during the U.S. Steel days.
It appears that expectations are low for the company's business prospects. On the upstream (E&P) side, we cannot predict which projects are likely to provide upside surprises. We think it's a plus that Marathon is weighted toward North American gas assets relative to its larger peers. Non-domestic E&P activities are not involved in the Middle East. Downstream activities provided about 30% of Marathon's earnings in 2002. Refining margins are soft. Oil supply disruptions resulting from the strikes in Venezuela have raised raw material prices and reduced throughput. We feel that margins will improve by the middle of 2003 as demand improves and industry capacity shrinks due to plant closures or downtime.
Debt stands at 45% of capital, probably a constraint on huge capital projects or acquisitions. Cash flow is about $8 a share, certainly enough to pay a dividend, fund E&P and other capital projects and service and pay down debt. We expect 2003 earnings of $2.40 a share, implying a P/E of 9. Integrated oil stocks (most have refining and marketing businesses that's what makes them "integrated") traded at P/E's of 13 or 14, on average, Independent refiners had a poor 2002, but should fare much better in 2003.
Marathon's CEO, Clarence Cazalot, joined Marathon after 28 years at Texaco. He is a geologist by training. The company's mission is "sustainable value growth," and Marathon has reported on its performance in accordance with the guidelines promulgated by the Sustainable Growth Initiative. Pension funding is not an issue. Target: $28 in 18 months. Catalyst: Higher refining margins and/or E&P success."
SUPERSTOCK INVESTOR
1900 Glades Road, Suite 441, Boca Raton, FL 33431.
Monthly, 1 year $395.
WMS Industries: Very large upside
Charles LaLoggia: "International Game Technology (IGT), the leading slot machine maker, moved to a new all-time high of $80.70 on February 3. We have been following IGT here each month since October 2002, when we ran a chart of the stock and suggested that IGT was on the verge of a significant breakout above $70 - $71. We suggested that IGT would be an interesting situation for short-term traders with a target price of $80 - $85 off that potential breakout. But more than that, we have been following IGT as a bellwether for the other slot machine companies we are recommending here: WMS Industries (WMS); Alliance Gaming (AGI); and Mikohn Gaming (MIKN), based on the theory that the same bullish industry forces that are propelling IGT to new highs in the face of a very sloppy stock market will ultimately move the rest of the group higher. We have been documenting the steady march of many states facing massive budget deficits to move toward expanded gaming, either through "racinos" (racetrack slot machines) or full-fledged casino gaming. Each month brings new items of interest from across the country; last month we presented a long list of developments in states that appear to be moving close to expanded gaming, and we could do the same again this month, but we won't except for this major story: Governor Gray Davis of California, who faces a nearly $35 billion budget deficit (unbelievable, but true), may be about to agree to double the existing statewide limit on Indian casino slot machines, which currently stands at 61,000. According to a major story in the February 2 New York Times, Mr. Davis is seeking to renegotiate agreements with Indian casinos in order to increase the fees it receives from the state's 50 Indian casinos, which made an estimated $5 billion in profits in 2002. California currently receives under $100 million annually from Indian casinos under the current 20-year agreement and Governor Davis wants a huge increase in fees to as much as $1.5 billion. In order to reopen negotiations to raise these fees, however, Governor Davis may be forced to raise the state's slot machine limit in a major way, and some observers in California believe that in order to get that concession, Governor Davis would have to allow the number of slot machines in California to at least double. This is the only leverage Governor Davis has, say observers, and he may be forced to accept this massive expansion of slot machines as a tradeoff whether he wants to or not.
Meanwhile, chuck DiRocco's Gaming Today (www.gamingtoday.com), an authoritative gaming industry newspaper, reports that Innovation Group, a research and consulting firm, is projecting that new gaming expansion in states like Florida, Maryland, Massachusetts, Texas, California and New York will lead to $21.6 billion in gaming industry revenue growth over the next five years and that the biggest winners will be companies that manufacture slot machines. Innovation Group projects that 200,000 new slot machines will be put in play during the next five years, report Gaming Today and that replacement rates on those 200,000 new machines will accelerate over current rates because of increased competition in neighboring states and casinos, which will create even greater demand for new slot machines. Unless the state budget deficit situation suddenly miraculously disappears and that doesn't seem likely we think gaming expansion is inevitable all across the country, even in states where politicians have temporarily blocked expanded gaming over "morality" concerns. We see nothing but increased demand for slot machines, not only in the U.S. but also in other countries, such as the United Kingdom, which is planning a major expansion of gaming. For these reasons, we continue to recommend the slot machine makers.
Update on WMS Industries: WMS reported a net loss of $1.8 million, or ($0.06)/share in its second fiscal quarter ended December 31, 2002, mainly as a result of a $2.8 million non-cash write-off that was actually the result of good news. If that sounds like a contradiction, please read on. WMS wrote off the $2.8 million as the termination fee of a licensing agreement that allowed it to use the slot machine operating system of a third party. This third-party operating system was a back-up system to WMS' own system, which has been undergoing upgrades since a software problem with WMS' own operating system temporarily prevented WMS from shipping new slot machines to several important jurisdictions. WMS now says that its upgrades are on schedule and working fine and that it no longer needs the third party software system as a backup thus the write-off. WMS also said its Q2 results were hurt somewhat by a delay in approvals to begin shipping its machines again by certain regulators. These approvals finally began to arrive in late December, too late to help Q2 results, and more approvals are expected in the current quarter. In it's conference call, WMS officials noted that although the company reported a loss in Q2, it's cash flow was actually positive to the tune of $3.3 million because the $2.8 termination fee write-off was a non-cash charge and also because WMS recorded a non-cash depreciation charge of more than $7 million in the quarter. As of December 31, WMS had $85.1 million in cash (around $2.78/share) and no debt.
WMS also noted in its conference call that some of its customers are delaying orders until WMS unveils its new operating system, which is expected to be approved by regulators beginning in mid-2003. WMS officials said on the conference call that their game plan is to have the new operating system in place by mid-year and to have the approval process well underway going into the September "G2E" trade show, when the company will unveil its new product lineup just in time for what WMS expects to be a burgeoning demand for slot machines as new gaming jurisdictions come online through the United States (see the story on this subject earlier in this report). WMS also reported that its backlog in Q2 declined, but explained on the conference call that the company does not take orders from customers until regulatory approval to ship those games is in place. Since WMS began receiving these approvals in late December and expects additional approvals in this current quarter and continuing through the first half of 2003, WMS' backlog has hit bottom and should rise dramatically from here, according to comments on the conference call.
Looking ahead, WMS says it expects to essentially break even in the current quarter and that results should improve thereafter. The company is still stuffing its pipeline with new games, officials said, and by late 2003 WMS says its results will be back to normalized levels. Essentially, WMS expects to come blasting out of the gate in the second half of 2003 with its brand new operating system and a slew of new games, including 9 new "participation" games expected to be approved in calendar 2003. On the conference call, WMS CEO Brian Gamache correctly pointed out that WMS has operated at an essentially breakeven rate over the past year even as sales plunged up to 51% due to the software problem, which at one point virtually dried up WMS' shipments. Without directly saying so, Mr. Gamache implied that the operating efficiencies WMS implemented during this difficult time that allowed the company to virtually break even during extremely difficult circumstances would serve the company well once sales returned to normal levels, raising the possibility that in the long run this experience could actually benefit WMS in a big way on an earnings basis once the situation returns to normal later this year and in 2004. Our view on WMS is unchanged: We believe this company, which is the #2 slot machine maker in the U.S. behind International Game Technology (IGT), would be making new highs right along with IGT were it not for the software fiasco. Once the new software system is in place in mid-2003, we believe WMS will begin to make up for lost time and that this stock has very large upside for those of you willing to invest with a 12 18 month time horizon."
THE PURE FUNDAMENTALIST
7412 Calumet Avenue, Hammond, IN 46324.
Monthly, 1 year, $195. Hotline included.
See the forest from the trees
Al Toral: "Forest Laboratories (NYSE FRX $52), is one of the largest of its kind in the United States, making branded and generic ethical drugs. The company is selective and niche-oriented in the manufacturing of branded and generic prescription drugs and also has a big market in over-the-counter products and medications.
With the advent of higher standard generic drugs and the high cost of regular prescription drugs this company is taking full advantage of the huge market potential. The company's big key antidepressant drug Celexa accounted for more than 69% of its revenues in 2002; it also develops drugs to treat asthma, analgesics, respiratory conditions, urinary tract infections, antihypertension and medicines for other key conditions.
FRX's revenues have dramatically increased over the past six years, from $474 million in 1998 to more than $2 billion expected in its fiscal 2003 year, which ends in March. Revenues for fiscal 2003 could easily increase to more than 40%. For the first nine months of its 2003 fiscal year, revenues were $1.58 billion and earnings almost doubled to $1.20 against $0.65 for the same period last year. The company has no long-term debt and its current ratio is an excellent 3.7. Profit margin is almost 22%, which is outstanding for a maker of generic drugs. We give the company a .1 VISCA rating. Telephone: 212-421-7850. (VISCA .1: Stocks selected for the very aggressive investor. This rating reflects fast-growing companies with strong fundamentals.)"
THE LANCZ LETTER
2400 N. Reynolds Road, Toledo, OH 43615.
1 year, 15-17 issues, $250.
Costco: Good growth potential
Alan Lancz: "Costco Wholesale Corp. (COST $28.77) is the dominant membership based warehouse wholesaler second only to Sam's Club, a subsidiary of Wal-Mart. Costco's growth potential is better than Sam's in that they have not tapped a majority of America's non-coast states nor much internationally. The company is exceptionally well managed to the point that we feel comfortable accumulating these shares as a "core" holding for the long-term. Over the past 3 4 years the stock has thrice fallen to the mid-to-upper twenties initially from over sixty and more recently from the forties and each time the stock proved to be a worthy investment from these current depressed levels. Wall Street currently feels Costco cannot compete with Sam's, but in actuality Costco enjoys an average of $100M annual sales per store, which is nearly double the sales per square foot of Sam's. Costco has decided to maintain its sold health care plan for its employees as well as not lay off anyone despite the economic slowdown. While this will hurt margins over the shorter term, management feels such long-term focus is what makes Costco the sales leader. We also like the wholesale warehouse concept, as opposed to the risk with most retailers, because of their consistent source of revenues via annual membership fees. More than 1/2 of Costco's earnings comes from its ongoing membership fees, which enjoy a healthy 86% renewal rate. This will soften the blow should it take longer than expected for the U.S. economy to recover. We would be particularly aggressive buyers should the stock weaken to the low twenties a level management indicated to us where they would likely buy back shares as well. Our buy limit is $32 a share with a 1-2 year price target back to the $40 a share area."
INVESTOR'S VALUE VIEW
2254 Winter Woods Blvd., Suite 2000, Winter Park, FL 32792.
Monthly, 1 year, $129.
L-3 Communications: Excellent buy
R. Scott Pearson: "L-3 Communications (LLL) has received over $135 million in new contracts since this newsletter was last printed, which is the reason for its position as our top stock pick 2 months in a row. The company has received a contract with the Republic of Singapore's Changi International Airport, and has a potential value of $45 million. This is the largest international hold baggage screening contract to date, and includes delivery, installation, integration, training and maintenance requirements, as well as contract options for additional systems and overall maintenance contract for all baggage screening systems. In the meantime, L-3's Security and Detection Systems division has received individual contracts totaling approximately $8 million in Austria, where major airports have ordered automated Level 1 hold baggage screening systems. L-3's Communication Systems-East division recently received a $52 million contract modification from the U.S. Government for the U.S. Military's secure global communications system. L-3 Communications Holdings Inc. acquired Connecticut-based software company Ship Analytics Inc. for about $11.4 million, including $4.7 million in assumed debt. Ship analytics' homeland security management and ship simulation software were attractive complements to L-3's product line. In spite of recent successes, L-3's stock prices remain very reasonable and extremely attractive. Considering the political and economic climate both globally, and here at home, we recommend this stock an excellent buy at these prices."
Russ Kaplan's HEARTLAND ADVISER
1016 North 47th Ave., Ste. 11, Omaha, NE 68132.
Monthly, 1 year, $150.
Carver Bancorp: Get in ahead of the crowd
Russ Kaplan's recommendations of late have been large capitalization stocks. This month's recommendation, Carver Bancorp (CNY), is a small capitalization stock that passes all of his value criteria with flying colors.
"Carver Bancorp is a small New York bank which caters to the African American and Caribbean communities in the City of New York. With fifty years of serving this market the bank has developed a customer loyalty exceeded by few banks.
In addition to its long history, Carver Bancorp runs a tight ship with emphasis on traditional banking activities. It has avoided some of the esoteric activities that have gotten other banks in trouble.
Carver Bancorp is a very undervalued stock with solid financials such as low price earnings ratio, and a price that is below its intrinsic value. So far this stock has kept a low profile, but we do not expect this situation to last.
Why not get in ahead of the crowd?"
DOW THEORY FORECASTS
7412 Calumet Ave., Hammond, IN 46324.
Monthly, 1 year, $259. www.dowtheory.com.
Spinning sales from assets
Richard Moroney: "Investors make better decisions when they frame investing as buying a company, not a stock. Company buyers ask the type of questions that stock buyers often ignore. Is the business regulated? What are the inventory requirements? What are the barriers to entry?
Another critical question prospective owners ask is the following: How effective is the company in spinning sales from its fixed assets (property, plant, equipment)?
The reason owners want to know about the relationship between sales and fixed assets is simple. All other things equal, it's better to own companies that don't require lots of fixed assets to generate revenue. Such companies operate with less business risk.
Indeed, a firm that requires huge amounts of fixed assets to generate every dollar of revenue is much more vulnerable to shifting market conditions and financial pressures than a company that doesn't require as much up-front and ongoing investment in plant, property, and equipment to generate sales.
Fortunately, stock investors can evaluate how well a firm generates sales from its fixed assets by examining a company's fixed asset-leverage ratio.
The fixed asset- leverage ratio is calculated by dividing a company's annual sales by average property, plant, and equipment (PP&E). For example, a firm with $10 billion in revenue and average PP&E of $2 billion has a fixed asset-leverage ratio of 5. To calculate average PP&E, divide by two of the sum of beginning and ending PP&E.
Industry sectors sporting the highest asset leverage are technology, health care, and consumer staples. That these industries rank the highest should not be a surprise.
Technology companies in particular, especially software makers, have tremendous asset leverage. Microsoft (Nasdaq MSFT $47), for example, has a fixed asset-leverage ratio of 5.1. In other words, Microsoft generates more than $5 in revenue for every dollar invested in PP&E. This compares to the asset leverage ratio of BP (NYSE BP $39), which is less than 2.
When you look at the respective fixed asset-leverage ratios for these companies, it's easy to see why software companies generally trade at much higher price/earnings multiples than the oil sector. The oil industry requires huge outlays for fixed assets to keep running. Software, on the other hand, is a far more efficient business lots of revenue from a relatively small asset base. That means lots of fixed asset leverage, which usually translates to big profit margins. No surprisingly, BP's operating margin is less than 7% versus an operating margin for Microsoft of nearly 44%.
The fixed-asset leverage ratio is also an extremely useful tool for comparing companies within the same industry. Presumably, companies in the same industry face the same macroeconomic conditions. Thus, if one firm is more adept at squeezing sales from PP&E, that firm is likely to be accorded a higher valuation on Wall Street.
As is the case with any financial metric, trends matter."
Richard Moroney listed 13 monitored stocks for which fixed asset-leverage ratios in the most recent period have held up well relative to the firm's three-year average. In addition, average annual sales growth for each of these companies has outpaced growth in PP&E over the last three years.
Five of the stocks are reviewed below.
"Biomet ((Nasdaq BMET $28), a leading maker of hip and knee replacements, has consistently generated strong sales from its fixed assets. In fiscal 2002 ended May, the asset-leverage ratio reached 3.3, up slightly from a year earlier and well above the median for health-care companies. Over the last three years, sales growth has handily outstripped growth of property, plant, and equipment. A robust line of new, higher-margin products should drive revenue and earnings. Moreover, the company should capitalize on favorable pricing trends and expanding customer base. The current valuation seems attractive for a company poised to grow both sales and earnings at a 12% to 15% annual clip for the foreseeable future. A rock-solid balance sheet, strong cash flow, and visible earnings help qualify Biomet as one of the Forecasts' top picks for year-ahead gains. The stock is a Focus List Buy.
Gannett (NYSE GCI $72) represents a fairly inexpensive media stock. This publisher of USA Today trades at less than 16 times 2003 earnings estimates. That price/earnings ratio seems on the low side given Gannett's earnings-growth potential. Gannett has done a good job of growing revenues faster than fixed assets. Sales growth has averaged 7% over the last three years versus 5% annual growth in fixed assets over the same time frame. Gannett traded in the $80s in 1999 and 2000 and should return to those levels with expansion of the P/E ratio to the company's historical levels in the upper teens/low 20s. The Forecasts is adding Gannett, already on the Long-Term Buy List, to the Focus List.
Johnson & Johnson (NYSE JNJ $53) has pulled back recently. One reason is the apparent delay in the approval of the company's drug-coated stent. Investors had hoped for an approval early in the first quarter, but approval now appears likely at the end of the first quarter or early in the second quarter. The company has a head start on the competition and will be the only provider of coated stents until at least the fourth quarter of this year. J&J could generate $2 billion or more from coated stent sales in 2003. The company has been successful at squeezing revenue from its fixed assets. Revenue as a percentage of plant, property, and equipment has increased in each of the last three years, and that streak should continue as new products hit the market. J&J is not cheap at 20 times fiscal 2003 earnings estimates. However, the company has been posting solid revenue and earnings-growth numbers, and healthy gains in the top and bottom line are expected this year. The stock, a Buy and a Long-Term Buy, offers a quality selection for price gains over the next 12 months.
Mylan Laboratories (NYSE MYL $26) has been an excellent performer in recent weeks, moving to new highs. Although per-share profits dipped more than 9% in the December quarter, results still bet the consensus estimate by nearly 9%. Trimming earnings was a 71% increase in research and development spending in the quarter. For fiscal 2003 ending in March, the consensus profit estimate is $1.42 per share. Over the past two years, the company has won FDA marketing approval for 20 generic drugs. New products have helped boost Mylan's market share to more than 14% of the generic drug market as measured by total prescription unit volume. With a well-stocked pipeline of drugs awaiting approval, Mylan should continue to see healthy gains in the top line and further improvement in its asset leverage. This Focus List Buy, which trades for 18 times fiscal 2003 earnings estimate and 16 times fiscal 2004 estimates, could pull back in the near-term following its recent price breakout. However, regulatory and demographic trends favor the generic drug sector.
PepsiCo's (NYSE PEP $41) fixed-asset leverage ratio hit 2.5 last year the highest level since the mid-1980s. The 10-year average is 1.9. Despite its bulk, the company has done an impressive job growing sales and has kept a lid on property, plant, and equipment. PepsiCo was slated to announce year-end and December-quarter results on Feb. 6, a day after the Forecasts went to print. Wall Street expected per-share earnings of $0.50, up from $0.44 a year earlier. Full-year earnings per share should climb 14% to $1.96. Looking ahead, Pepsi's drink sales should benefit from greater distribution of the Sierra Mist brand. At Frito Lay, new products and easier comparisons should bolster profit growth. For 2003, earnings are expected to reach $2.19 per share. Using that figure puts the estimated P/E ratio at 19, below the five-year average of 29 and lower than rival Coca Cola's (NYSE KO $40) forward multiple of 21. PepsiCo is a Focus List Buy and a Long-Term Buy."
GROWTH STOCK OUTLOOK
P.O. Box 15381, Chevy Chase, MD 20825.
1 year, 24 issues, $235.
ADP: Revenues and earnings up 53
consecutive years, dividends up 28 years
Charles Allmon: "Automatic Data Processing (NYSE ADP $53.71) is one of the world's largest providers of computerized transaction processing, data communications, and information-based business solutions. Employer services provide 60% of revenues and brokerage services 25%. ADP serves over 500,000 clients worldwide.
When management reported on August 12, they had this to say as they forecast mid-single-digit growth in fiscal 2003 (June):
- " Return on equity was over 22%.
- " Our Board increased ADP's dividend for the 28th consecutive year by 12% to $.46 per share.
- " We introduced a significant number of new products and services in '02.
" Most of ADP's businesses set new highs in client satisfaction even though client retention weakened, primarily from increased bankruptcies.
" Our associate retention was at the best level in over a decade although our associate retention scores declined slightly. We recognize that associate retention is aided by the weak market alternatives and we continue to work toward being an employer of choice.
" As the economy stayed soft for the second year in a row, we instituted tight cost containment and reduced our expense run rate for '03 by about $100 million from where it would have been. This is in addition to the reduction of $150 million in '02.
"As we look at our results, the surprise is not Employer Services, where the business trends are not that unusual compared to our experience in prior recessions and recoveries. The big surprise and challenge is Brokerage Services. While our Employer Services business typically lags an economic recovery, Brokerage Services has performed well ahead of economic rebounds. This clearly has not happened.
"An unprecedented series of events including the collapse of the dot com boo, the September 11th tragedy, the well-publicized corporate accounting scandals, and the loss of confidence in stock analysts have led to a serious erosion of individual investor confidence, significantly lower retail trading activity, and less growth in the number of different stocks held by street name shareholders. We will have to see how these stock market-related issues evolve in the future.
"As we focus on the longer term, ADP remains remarkably strong and well positioned. Our markets are solid and growing. We have leading market share in most of our markets. Our financial position is excellent. We have very strong direct sales capabilities. Our service levels and reputation are very good and improving. Our service offerings are robust and getting more so. Associate retention a key to building our long-term client relationships is at record levels. Furthermore, our productivity bolstered by tight cost containment is also at record levels, and should position us well as revenue rebounds with an economic recovery."
In August, we acquired Avert, Inc., a leading pre-employment background verification and human resource help desk company, and have integrated Avert's employment screening solutions with our core payroll, tax filing, human resource, and benefit services capabilities.
"In October, we acquired IBM's Output Services business, which expands our statement printing capacity, and strengthens our position as a market leader in statement production and distribution to the financial services industry.
"In April, we acquired Digital Motorworks to provide the integration of key automotive data across multiple dealer management systems utilized by automotive manufacturers and the dealer consolidators.
"You can expect us to increase our acquisition activity even further, as we look to supplement our internal growth with strategic acquisitions that extend our markets and add applications to our product sets."
"ADP is rated AAA by Standard & Poor's and Moody's in fact, we are one of only seven U.S. companies with that rating. Our financials are consistently conservative and we intend to keep them that way. We do not have unusual unconsolidated ventures or unusual or undisclosed off balance sheet financing. Our consistent results over the years are a result of the strength of our recurring revenue model.
"We have long-term client relationships with most of our clients, and we receive revenue each period for our high quality services. We also have consistently generated strong cash flows from operations. We are proud of our financial record and our Company's integrity.
"We are confident that ADP is well positioned for long-term growth and profitability. For fiscal 2003, despite the continuing uncertainties created by the macroeconomic environment, we are forecasting mid-single-digit growth in revenues and earnings per share. While this will break ADP's track record of consecutive years of double-digit growth in earnings per share, we believe the benefits from the investments we are making in our future are more important than continuing the record."
On 6/30/02 total assets before funds held by clients were $7,051,251,000, current assets $2,817,257,000, current liabilities $1,411,102,000, cash and short-term marketable securities $1,475,815,000, long-term debt $90,648,000, deferred income taxes $237,633,000, deferred revenue $138,893,000, shares outstanding 616,317,000, shareholder equity $5,114,205,000 ($8.30 per share), return on shareholder equity 21.5%, positive cash flow. [Company address: One ADP Boulevard, Roseland, NJ 07068-1728. (973) 974-5000.]"
Allmon's Comment: Assuming management's forecast is correct, we're looking at 2003 revenues around $7.4 billion and earnings of $1.75 - $1.85.
Let's look at the extraordinary balance sheet. Debt is less than 2% of equity. Cash of $1.4 billion about matches current liabilities, with a 2 to 1 current ratio. As management noted, they are one of only seven companies rated AAA by Standard & Poor's.
ADP has made GSO a big bundle of money over the years. I'll be an ADP buyer again at the right price. When you see ADP rated "A" in GSO again, you should plan to buy a 5% - 7% position and plan to hold for five to ten years. This is a remarkable company, which was first recommended in this service in 1966, when revenues were under $5,000,000. Now they're over $7 billion and growing."
THE TURNAROUND LETTER
225 Friend St., Ste. 801, Boston, MA 02114.
Monthly, 1 year, $195.
Great franchises at bargain prices?
George Putnam, III: "One of the hallmarks of the last bull market was the introduction of new "valuation metrics." These new metrics were needed because no one could justify the incredibly lofty price levels using historical methods of valuation. The Internet provided new terms such as "hits" and "click-through-rates," and many analysts argued that earnings were immaterial. It was argued that the Internet age was so dynamic that companies had to capture market share at all costs.
The bear market has corrected many of the excesses. And as we pointed out in the preceding article, many of these "corrections" may be permanent. Many valuation measures ultimately provide to be ephemeral.
One measure of a business that is more lasting is the value of its "franchise." The franchise consists of many factors, both tangible and intangible, that give the business an edge over its competitors. These factors include things such as well-known brands, a good reputation and advantageous locations.
Bear markets batter great franchises along with the more ephemeral businesses. But the great franchises usually bounce back. While we are wary of even the currently depressed valuations of some of the "new economy" companies, we think this could be a great time to invest in companies with powerful franchises but battered stock prices.
Of course, not every well-known company rebounds. The graveyard of business history is full of many once-great names such as Western Union, Howard Johnson, Trans World Airlines, Penn Central Railroad and numerous others. Shifts in technology or consumer tastes can make even former greats obsolete. But we believe the risks in investing in companies with great franchises are much lower than investing in most other kinds of stocks.
Below are a group of companies whose names are familiar to all. As their price declines suggest, they've all encountered some bumps in recent years. And in each case, there are real challenges to maintaining the value of the company's franchise. But all of the companies are taking steps to meet those challenges, and we expect most if not all of them to eventually rebound.
Walt Disney (DIS $16.80) is a truly great franchise that appears undervalued. That conclusion drove our purchase recommendation last September, and it remains true today. Theme parks will likely continue to be under pressure due to domestic and international concerns, but ABC showed a nice improvement in ratings during the company's fiscal first quarter. Recent movies have been disappointing at the box office, but videotape and DVD sales can pull out an otherwise lackluster theatre performance. International expansion is moving forward, and Disney is continuing to focus on cost control.
Eastman Kodak (EK $31.14) recently went from darling to dog in a matter of days. Following year-end acclaim as the best performing Dow stock in 2002, the company reported lower-than-expected earnings, and the stock tumbled sharply. Despite the volatility, our recent purchase recommendation remains intact. The company is reducing debt $594 million in 2002 its health and commercial segments are holding up, expansion in China is moving along, and the company continues to rollout new imaging technologies. We continue to like the turnaround prospects being offered patient investors.
Ford (F $9.75) is no longer just an American franchise, as it also owns Jaguar, Land Rover and Volvo. Despite the great names, the stock traded at a 10-year low in late 2002, and has only slightly recovered. Cars, trucks, mini-vans and SUVs have been moving off the showroom floors, just not with the hoped for profit margins due to persistent rebates and incentives. Ford initiated a restructuring in 2002 and "launched a massive acceleration" of cost-cutting efforts. The biggest concerns right now are Ford's debt load and unfounded pension liability.
Home Depot (HD $20.60), founded just 24 years ago, is going through more of a mid-life crisis. In a sense, the first $50 billion in sales was easy. To get to the next $50 billion, a new CEO has shaken up operations, thus far with mixed results. The old, freewheeling local-control model is giving way to more centralized oversight. And that has ruffled some feathers without yet providing results, as evidenced by sharply lowered targets for sales and earnings. Home Depot is still profitable, and it has built a stash of $4 billion in cash.
McDonald's (MCD $14.78) just posted its first quarterly loss since going public 37 years ago. Much of the loss is attributable to the costs associated with closing stores. McDonald's management has been tested by issues ranging from mad cow disease in Europe to price wars at home. Competition and saturation are two buzzwords that concern investors. Are Americans abandoning fast food for more upscale concepts? Maybe, maybe not. With a great brand, numerous prime locations and a solid balance sheet, we wouldn't want to bet against McDonald's.
Xerox (XRX $8.13) recently announced that it had found a way to hide information within a digital image. Some, no doubt, wondered if they'd applied the technology to their financial statements. When we recommended selling Xerox last June, we did so largely on the basis of the difficulty in trusting Xerox's numbers. As late as December, they were still uncovering accounting problems, but they finally seem to have their books in order. With the accounting problems largely behind them, Xerox should be able to refocus on their business. The brand and the technology are still powerful."
COMMON CENTS
P.O. Box 126354, Benbrook, TX 76126.
1 year, 6 issues, $48.
Four Buys having increased
dividends for 25+ consecutive years
Roland Carter's Buy recommendations for February are BBT, PFE, SWK, and JP. Each of the companies have increased annual dividends for 25 consecutive years or longer.
"BB&T Corp. (BBT) is a regional bank holding company, one of the largest in the southeastern U.S. We came across this bank while researching for dividend increasers several years ago. The more one looks at BBT, the better it looks, as all banking financial ratios are top-notch (net loan losses = .49% of loans, loan loss reserves = 1.36%, problem assets to loans = .68%). In the same manner, we found another smaller operator named First Virginia Banks of the same outstanding quality. Last week acquisitive BBT made a buyout offer for banks of the same outstanding quality. Last week acquisitive BBT made a buyout offer for FVB, to result in the nation's 11th largest bank. If one wants to own a large regional bank as a buy-and-hold, dividend-increaser, here's now our #1 choice. 10-year dividend growth = 15% compounded. In 6 months their dividend should rise to $.32 quarterly, so BBT has recently been near a 4% yield @ 32+. The stock's high of 40+ in 1999 was a P/E of 23, so we're at half that valuation today. This acquisition will be a little dilutive to EPS for two years, but not to quality!
Pfizer (PFE), with its pending acquisition of Pharmacia, PFE will soon be the world's largest drug company and arguably the best, both in track record and current lineup. Look at that dividend-increase record one miss in 61 years! 10-year EPS growth of 18% should continue @ 15%+ for several more years. PFE owns 10 of the world's 30 best selling drugs, each generating sales of at least $1 billion/year. Cholesterol-lowering Lipitor, the world's largest-selling drug, does $8 billion/year and may see $10 billion by 2004. The launch of Viagra six years ago gave PFE a run, peaking @ 50 in 1999 at a P/E of 75. Patience now gives us one of the world's greatest B/H stocks at a P/E of 19.
Stanley Works (SWK). This old-line maker of hand tools now also offers doors, hardware and home décor. This is not the thoroughbred that Pfizer is but a wonderful, quality company with quality products having paid continuous dividends since 1877 125 years! SWK has very strong finances and is an excellent vehicle at this 4% yield area with which to ride out any market storm. SWK hit 57 in 1998 (P/E of 27) and 52 last year (P/E of 22). Buy SWK to trade someday their 5% dividend growth rate is too slow for me, and the shares have too big of ups and downs to consider it a buy-and-hold stock. A return to a P/E near 20 on higher earnings in 3 6 years should see SWK in the 60 80 range by then.
Jefferson Pilot (JP) is a leading life insurance (60% of earnings) provider, offers annuities/investments (15%), and owns 3 T.V. and 17 radio stations (7%). JP is the U.S. leader in universal life insurance. Carried for years on our master list, but never formally recommended. We're now near a 4-year low while earnings keep climbing. We should see a dividend increase next quarter to perhaps $1.32 (4% yield @ 33). JP gets great marks for financial strength, but like all insurance companies, finances are complicated and far from bulletproof. Their huge bond portfolio would suffer if interest rates rise. Still, don't expect them to go away dividends have been paid annually since 1913."
THE BLUE CHIP INVESTOR
575 Anton Boulevard, Suite 570, Costa Mesa, CA 92626.
Monthly, 1 year, $249.
Bard is experiencing growth
Peter Hughes: "C.R. Bard (NYSE BCR $57) produces instruments for the medical profession, accounting for 90% of its sales. The company has four major product groups: vascular diagnosis (21% of sales), urological diagnosis (33%), oncological diagnosis (23%) and surgery products (18%). Most of Bard's products are disposable and must be repurchased on a regular basis, making Bard's sales relatively stable and predictable. Because of the specialized nature of these products, the company has a high net profit margin 14%.
Bard is experiencing strong growth and did so throughout the recession. In the December quarter, earnings per share rose 11%, while adjusted sales rose 8%. The company has strengthened its balance sheet considerably. Long-term debt was 60% of total capitalization in 1997 but is now just 15%. Furthermore, the company is producing excess cash, which management is using to repurchase stock. Bard's stock price is 13% off its all-time high. Buy below $58."
NATE'S NOTES
P.O. Box 667, Healdsburg, CA 95448.
Monthly, 1 year, $150. www.natesnotes.com.
Celgene will emerge as one
of the leaders of the biotech rally
Nate Pile: "Celgene's (Nasdaq NM CELG 24.00) stock has been acting much better lately, thanks to a couple of important pieces of news that have been released. At the annual JP Morgan H&Q Healthcare Conference earlier this month, Celgene was able to provide the investment community with an update on the numerous clinical trials now underway using the company's SelCIDs, ImiDs, kinase inhibitors, and other compounds (including thalidomide). In addition to making a presentation at the H&Q conference, the company also announced that it has completed the purchase of privately held Anthrogenesis, and perhaps, more importantly, has reached an agreement with EntreMed under which Celgene will make an equity investment in EntreMed in exchange for exclusive rights to the thalidomide analogs that EntreMed has been working with. This agreement is important because it terminates all litigation between the two companies regarding these analogs and frees Celgene up to more aggressively focus its efforts on product development rather than patent litigation.
Despite the fact that thalidomide is technically only approved for the treatment of a form of leprosy, off-label usage in the cancer area is growing at a rapid clip, and given the company's deep product pipeline and solid cash position (over $250 million in the bank, we expect the stock to emerge as one of the leaders of the biotech rally that we believe will materialize in 2003. Celgene is a strong buy under $24 and a buy under $28."
STRATEGIC INVESTING
1905 Beacon St., Waban, MA 02468.
Monthly, 1 year, $157.
Volatile trend will continue until mid-year
Richard Geist: "We believe that the combined economic factors, internal market dynamics, seasonal trends, and corporate earnings picture are now aligned to produce a more sustained period of upward market momentum. Our best guess is that this trend, although volatile, will continue until mid-year, and then consolidate.
The danger for investors lurks in the normal hesitation to return to the market until after the first leg of this uptrend. If you enter at that point, there will be no margin of safety when the market corrects. Therefore, we feel it best to commit part of your idle cash to the market before the general public acknowledges the return to a bullish trend.
The stocks to buy now include: Surebeam (SURE), Education Lending Group (EDLG), Openwave Systems (OPWV), SeeBeyond Technology (SBYN), Pennexx Foods (PNNX), Leading Brands (LBIX), Titan (TTN), Air Methods (AIRM), Sun Microsystems (SUNW), Express Scripts (ESRX), Applied Materials (AMAT), Perma-Fix Environmental Services (PESI), and Sicor (SCRI). More speculative are Zi-Corp (ZICA), Aura Systems (AURA), Entrust Financial Services (ENFN), Hain Celestial Group (HAIN), Rita Medical Systems (RITA), Impax Labs (IPXL), Qualcomm (QCOM), Siebel Systems (SEBL) and DynTek (DYTK)."
BARRY'S BULLS
5509 Monroe Rd., Charlotte, NC 28212.
Monthly, 1 year, $48. www.barrysbulls.com.
For short sellers
Barry Ferguson: "With war and peace in our face every day, what do we do with the stock market? Well, if the January principle is still in effect, (as January goes, so goes the rest of the year) we are in for another down year. January of 2003 has started out going south. This coincidence has been pretty accurate in the past. However, the indices were up in January of 2001 and, need I say more? The market is still trending lower to sideways and remains a difficult investment animal. Technical trends can be your friend but take years of study to master. However, it appears to me that we may lose more ground as war becomes a reality. An ensuing victory or a sign of peace would be a positive for the market to rally on but it could be short lived. The reality is the stock market ultimately moves up or down based on corporate earnings and their coming prospects. So, here are a couple of ideas for the short sellers amongst us:
IBM (NYSE IBM $78) Full year results reported 1/17/03. Sales: $81b vs. $83b. Income: $6.8b vs. $8.1b. EPS: $3.95 vs. $4.59. P/E: 22 Gth: minus 14%. Profit: 8%. This is a company that I think has something to do with computers. Yeah, of course it does. But is that a good thing right now? IBM is probably the pre-eminent computer/technology company in the world. Yet, growth has not only slowed but is now sliding. So are sales. So is everything else. That doesn't bode well for the rest of the technology sector either. So take an objective look at our friend IBM and see what you see in the price chart. Yep, that's a possible head and shoulders formation that it has developed over the past few months. A drop below the $80 mark would seal the deal and short selling would be in order. I still believe the stock could trade for half of what it is right now before it is all over so there is money to be made on the downside. However, you must be cognizant that IBM is a top five high-priced Dow stock. What does that mean? It means that since the Dow is price weighted, IBM is currently some 7% of the Dow, not simply one-thirtieth. That means that the Wall Street manipulators will get behind IBM in rally attempts. Short it but cover quickly if the big money turns against you.
Jabil Circuits (NYSE JBL $15), 1st qtr. results reported 12/20/02. Sales: $1b vs. $884m. Income: $30m vs. $22m. EPS: $.15 vs. $.11. P/E: 30. Gth: 9%. Profit: 3%. This company makes circuit boards for many different electronic companies in the world. There's nothing wrong with that except that outsourcing is a way of life and the business goes to the lowest bidder. That hurts manufactures in two ways. First, it puts pressure on profits. Second, business is slow and there are a lot of foundries in the world that are searching for business. It could be tough environment for companies like Jabil for a few years to come. Actually, this is a great company and the fundamentals aren't too bad. They have had their nose bloodied in previous quarters but the ship is still floating. However, the technical chart shows another head and shoulders and that's a bad sign. They have already broken below the neckline and this could very quickly become a single digit stock. Lookout below! Short sell this one too.
KLA Tencor (Nasdaq KLAC $33). 3rd qtr. results reported 12/31/02. Sales: $335m vs. $404m. Income: $29m vs. $49m. EPS: $.15 vs. $.25 P/E: 56. Gth: minus 30%. Profit: 9%. This company makes chip testing equipment and software. It is a billion dollar sales company that got some bad news last week. One of their customers is Applied Materials and their orders are down some 35%. Most likely, other chip equipment makers like Applied Materials are suffering too. That doesn't bode well for KLA. While their equipment is necessary, again we are producing more with less and they might be the `odd man out'. As the price drops below $35, short selling is in order due to another head and shoulders formation.
This is getting ugly and we are only moving into February. This makes two straight newsletters that I have had only short sell candidates to share. Again, you have to be objective about the market much like a jury in a court case. All of the major indices have head and shoulder formations. We are still in a downtrend. The economy is soft at best and while many corporations reported decent fourth quarter earnings, many have warned about the first quarter of 2003. You just have to go with the flow. Short sell only with professionals and be quick to cover in case you are wrong. Good luck and may your pockets bulge with Franklins!"
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-- March 2003