First Quarter Report and Company Visits

 

 

The stock market needs a big dose of Pfizer's new anti-psychotic drug, Zeldox.  In the past year, the market has put on one of its finest displays ever of manic-depressive behavior.  A year ago, most investors just could not buy technology stocks fast enough, at any price, and now, they just can't resist dumping them.  This shows how the market's casino mechanism works.  Those who understand that when you are buying a stock you are really buying a business, and that businesses have tangible intrinsic values, for which you should not overpay, have kept their money.  And those who were buying the techs blindly when they were expensive and are selling them now that they are finally getting cheap have permanently lost huge amounts of money.  We are experiencing the transfer of wealth from the foolish to the wise.  Those who know how to figure out the intrinsic value of a business have the advantage of setting the odds in the Wall Street gambling house.  And the losers are the ones with no sense of value and weak willpower, who cannot resist the siren song, amateurs and professionals alike.

 

We now know the economic contraction is for real.  I believe most of the market decline is over, but not all.  A more tangible sense of the depth and duration of this contraction is needed before the market can recover. I would speculate that it is too late to sell.  Virtually all of our companies’ stock prices have held up fantastically so far, especially Enron, Coke, Wrigley, Church and Dwight (Arm and Hammer baking soda) and our assorted pharmaceutical and medical issues.  Despite being a technology company, QUALCOMM has performed well over the past six months.  The most sensible way to spend time now is looking for the opportunities being created in the media and technology sectors, which lead us both into and out of recessions.  The following companies have fantastic business economics and are cheap:  Disney $32 down from $42, Intuit $35 down from $90, QUALCOMM $80 down from $200, Cisco $27 down from $82, Nortel $19 down from $89, and Verisign $56 down from $258.  Lucent $13 down from $84 may not have fantastic business economics, but it is cheap and the spin-off of its Microelectronics Group is very interesting.

 

My Company Visits Follow This Bargain Hunting Strategy

 

The Walt Disney Company (DIS 32) held a pre-opening financial analysts meeting at the new California Adventure Park that I was fortunate to attend (one of the perks of this job.)  The new park is beautiful, and represents the high quality we associate with Disney, perhaps the world’s most revered brand name.  “Disneyland” invokes the nostalgia of good memories and cares forgotten.  In movies, people will go see Disney movies because of the Disney name creating an expectation of a decent family story.  No other studio can say that.  Management understands the magic of this brand name and works to propagate the feeling of well being it generates in people throughout the world.

 

Disney actually is involved in various interrelated businesses: theme parks and resorts, media networks, consumer products, and studio entertainment (production of movies and television shows.)  California Adventure entailed the investment of $1.5 billion to transform Disneyland in Anaheim from a one-day visit into a destination resort, a la Disney World in Orlando.  This allows Disney to multiply the revenue earned from an average visitor by adding to the park admission the somewhat higher cost of several days’ food and lodging.  Disney is also employing this strategy elsewhere in the world by building new parks adjacent to existing parks in Tokyo and Paris.  Hong Kong also is getting a new Disneyland.  The goal is to raise return on capital employed in the park segment from 18% to 24%.

 

Disney owns the ABC media network, which consists of eight of the top ten network television stations in the US, 225 affiliated TV stations, and 51 radio stations, 39 of which are number one in their markets.  Obtained through the purchase of Capital Cities/ABC five years ago for $9 billion, this business has an opulent 50% operating profit margin and requires minimal capital expenditures.  ESPN, the leading brand name in sports broadcasting, was a part of the purchase.  It has grown so rapidly that is now is alone worth most of the purchase price.  Strategically, the network is a great negotiating lever for a producer and seller of programs like Disney, because if an outside buyer will not pay enough for a show, it can be sold to the in-house network instead.

 

The Consumer Products segment has been weak, and the ongoing renovation of the Disney Stores is hopefully the cure.

 

Studio profitability has been flat, because of the escalating price of talent.  Disney is refocusing on the quality of the story and away from expensive talent.  Salaries for stars have been reduced in trade for a share of film profitability, and this should help profit growth in the studio segment.  Upcoming films with blockbuster potential like Pearl Harbor should also help.

 

Management believes that return on investment is the main driver of shareholder returns, leading to a focus on improving return on capital in each segment of the business.  Cash flow is another important metric at Disney, and management expects it to grow nicely now that the peak phase of park building is past.  A continuation of an aggressive stock repurchase plan should allow some reduction in equity capital. Although it is easy to underestimate the value of relatively timeless brands like those composing Disney, I estimate the intrinsic value of the company to be in the mid-20 dollar range.  The negative effect of the current economic contraction on advertising spending has pulled the stock price of this grand company down to $32.  I find the stock attractive below $30, and expect it to lead us out of the recession.

 

Verisign (VRSN $56) owns two very valuable Internet usage-enabling assets that produce large amounts of recurring income on a minimal level of incremental capital investment.  Seasoned readers of these reports know that I search high and low for such assets, but find few.  Verisign’s products have “toll bridge" characteristics.   They are inexpensive, a virtual necessity, and customers use them on a recurring basis.  Verisign’s corporate mission is to “enable everyone everywhere to use the Internet with confidence.”

 

Verisign dominates the market for web security certificates that are used to identify and authenticate users.  Online banks and brokerage firms use these to verify an online customer is who he says he is.  In time, this will grow into a payment system that will record e-commerce transactions, enable online signature execution and notarization, and handle payments. A secure and automated payment system is a prerequisite of the Internet developing the capabilities we dream about today, including e-commerce, music purchase, and video rental.  A proliferation of web devices that perform different tasks will be introduced over coming years.  These devices can transparently use Verisign’s certificates to identify the user and automatically entitle the user to perform a task with the device.  If you have purchased items on the Internet, you have probably seen the name Verisign pop up, the purpose being to give you a sense of security.  Verisign is introducing additional “toll bridges” this year that should prove excellent long-term generators of economic profit.

 

Through last year’s overly expensive acquisition of Network Solutions, Verisign owns the dominant Internet domain name registry and registrar, effectively making it the trademark office of the Internet.  The registry maintains the database, while the registrar enters new names into the database.  28 million individuals and organizations have used these services to establish a unique Internet presence from which to communicate and conduct commerce.  For example, my company has registered the name “qgmi.com”.  The registry database and supporting functionality assures that when a web user types in “qgmi.com” his browser will take him only to Quality Growth Management, Inc.’s website.  Since most domain names in existence have been registered through Network Solutions, the acquisition brings Verisign a potential customer base of over 20 million to whom a number of security related services could be sold.

 

The actual registry database is regulated by a non-profit entity called The Internet Corporation for Assigned Names and Numbers (ICANN) formed by the US Department of Commerce, which grants the registry an exclusive right to operate.  ICANN views the business of selling registered names, the registrar, as an entity that should be separated from the registry itself.  Accordingly, it is requiring Verisign to divest one or the other, so as to diversify the ownership of the web’s largest registrar from control of the database itself.  If the divestiture is completed by May 9, 2001, ICANN will extend the exclusivity of the registry through 2007.  In any case, Verisign will keep the customer list.  The outcome of this event is creating great uncertainty for investors in Verisign, helping to push down the stock price.  Also, the end of the Internet gold rush is slowing down the name registration business.  Verisign projects new name registrations will decline in 2001, although, the total number of registered names will continue to grow dramatically.

 

Although Verisign is down from an Internet rage high of $258, it is still expensive compared to earnings.  Future projections are always chancy on technology companies, making the determination of a figure for intrinsic value difficult.  However, the exciting potential for economic profit growth with only a modest investment of new capital supports an intrinsic value estimate only modestly below the current stock price.  This is a very special company, with a business plan that ranks up in the “rare air” of QUALCOMM and Intuit.  These business plans are "scalable", meaning revenues grow somewhat faster than offsetting expenses, and require minimal capital investment.  If the above-mentioned uncertainty continues to pressure the stock price, this kid might find himself in the candy store on Verisign.

 

ChipPAC (CHPC $4) attracted my attention when QUALCOMM invested $25,000,000 in the company.  So, I decided to pay them a visit.  As it turns out, the motivation behind the investment was to help fund the infrastructure expenditures required to produce QUALCOMM wireless chips in China.  ChipPAC has several unique characteristics.  It has leading capabilities and technology in the manufacturing and testing of the ball grid array (BGA) packages used in state of the art wireless phone chips.  It already owns an established chip business in China called ChipPAC, Ltd.  It possesses more completed designs than its competitors, allowing it to get customer products to market faster.  It has long-term packaging agreements with clients such as Intel, Lucent, and QUALCOMM.  The rise of major semiconductor companies, such as QUALCOMM, that outsource the production of their chips, is driving the growth of contract manufacturers such as ChipPAC.  This trend appears to be accelerating as great chip design companies decide not to invest capital in fabrication infrastructure that has to be retooled when designs change – about every six months.

 

These positives are offset by the boom/bust nature of the semiconductor business.  Profit margins are poor, and industry contractions, which come along regularly, can really hurt.  Prices of packaging and test services have declined historically, so unit volumes and efficiency must be continually improved or profitability declines.  These characteristics make the stock highly volatile, as the $19 high several months ago demonstrates.

 

Not for the faint of heart, semiconductor stocks can be traded speculatively by purchasing them when the rate of decline of the new business bookings growth rate bottoms, and sold when the rate of growth of bookings peaks.  Of course, there are many analysts following this sector, and even for them the timing is a guess.  There is a certain measure of luck involved, a variable some of us prefer not to depend on.

 

Financially, one could expect ChipPAC to make $1.00 per share in the good times, and to lose money in the poor times.  A high debt level in this company leverages the earnings results.  In the last six months that translated into a stock price range of $19 to $3.  Attempts to figure out intrinsic value cannot be reliable due to the difficulty of projecting future economic profits for this company.

 

Steven L. Ré, CFA                    February 16, 2001

 

 

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities.  The above information is from sources deemed reliable but is not guaranteed.  It should not be assumed that investments in any of the above mentioned securities will be profitable, and past performance is not a guarantee of future results.  Earnings projections often miss, and markets don’t always go up.  The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.