The stock market generally follows capitalized economic profits, defined by the following equation:
|
Operating profit - cost of
capital |
|
Interest
rates |
Interest rates have now fallen sufficiently to make the quotient of this equation larger, even though operating profits are likely to drop a little more this quarter. For that reason, I believe we have seen the bottom of the market's recent decline. To clarify, we have seen the market's bottom, but we have yet to see the bottom of this economic contraction. So, do not be surprised if the market's return to health continues, even as you read bad economic news in the newspapers. Most importantly, I am delighted with how our portfolios are positioned and look forward to the next five years with a very high degree of optimism.
Wm.
Wrigley Jr. Co. (WWY 48) is still 35% owned by the Wrigley
family, with the 37-year-old grandson of the founder succeeding his father last
year as President and CEO. The
succession initiated significant improvements in the aggressiveness of this
102-year-old company, marked by the retirement and replacement of the complete
second level of command. Three new
Senior Vice Presidents were hired from outside Wrigley, having previously had
successful careers with top consumer brand name companies. I have felt that brand name recognition and
an international distribution system second only to Coca-Cola should eventually
make Wrigley capable of several times the current $2.1 billion in
revenues. New management has greatly
accelerated new product introductions, including entering the gigantic health
care category with an antacid chewing gum.
Wrigley just acquired Gum Tech, the contract manufacturer of Aspergum,
to obtain gum capacity that meets FDA standards. New phrases circulating around Wrigley include “venture teams”,
“getting people out of the box”, “steady stream of new products”, and “stock
repurchase.” I like the sound of those.
They describe an attitude for accelerating the long-term return to
shareholders. In this case, there is no
questioning the self-motivation of top management for increasing the stock
price.
I expect revenue growth to meet or exceed 10% compounded over the next five years before foreign exchange adjustments. Combining that with a little margin improvement and steady stock repurchases should lead to earnings per share growth in the low to mid teens. The stock has appreciated a lot over the past year and now is selling over my calculation of intrinsic value. This is a great holding, but I would postpone purchases until the stock is priced more reasonably. For those who already own it, the next five years should be a lot of fun.
Church
and Dwight (CHD 26) is the very nice little consumer products company that
owns the name that made baking soda famous, Arm and Hammer. Additional products include Arm and Hammer
laundry detergent, toothpaste, whitening chewing gum, deodorants, kitty litter
and pet deodorants. It owns Brillo,
Scrub Free, FabriCare, and Nice and Fluffy.
Management that took over the floundering company 6 years ago has
tripled the size of the business and should be able to double it over the next
5 years.
Acquisitions have played a part in this growth, and the pending acquisition of Carter-Wallace's consumer products will grow both revenue and profits. The brand name products acquired include Arrid and Lady's Choice deodorants, Nair depilatory, Trojan condoms, and First Response and Assure pregnancy and ovulation tests. Revenues this year should grow to about $1.4 billion, and I think the brand names are eventually good for at least twice this amount. Management grows this miniature Proctor & Gamble (PG 65) by taking deliberate steps to introduce new product lines, by acquiring new product lines at prices that will increase earnings, by entering into joint ventures, and by controlling costs. In comparison, Proctor & Gamble management seems enslaved to a huge distended international organization boxed in by the opposing pressures of operating expenses, competitive product pricing, profitability, and stock price. They cannot price products more competitively until they cut costs, or profits and stock price will continue to suffer, but revenue growth suffers because they cannot price competitively. That is why we are making substantially more money owning Church and Dwight than P & G.
Intrinsic value currently approximates the stock price. The steady growth of profitability and hoped for success of the above-mentioned acquisition should push intrinsic value higher over the next several years. Management is to be commended for the steady, grind-it-out increase in shareholder value it has created.
Leap
Wireless (LWIN 34) originally came into our portfolios as a
distribution from QUALCOMM, with a cost basis of $6.875. Leap operates a cellular network called
"Cricket" in medium sized American cities that provide subscribers
with unlimited local calls for a fixed rate of $30 per month. Long distance calls cost an additional 10 to
15 cents per minute. Roaming is very
limited. Basically, the Cricket service
is a substitute for the typical home wireline phone service that we are all
familiar with. In fact, we have heard
of new neighborhoods constructed in Cricket cities that have no built-in wired
phone service. The builder instead
gives the homebuyer Cricket phones, home phones with mobility.
Leap takes the unique viewpoint that the wireless phone is simply a mass consumer product that will have an assortment of constituencies. Cricket is targeted at the blue-collar consumer who wants the least expensive service available, the ability to carry their phone around with them, and does not travel far from home with the phone. Because of the efficiency of the CDMA networks that Cricket uses, its customers can use over 1100 minutes per month without stressing network capacity. Cricket owns licenses to operate in 36 US cities, covering 72.6 million potential customers.
Marketing and distribution costs for Cricket are unusually low. The phones are sold in grocery and discount stores rather than in mall stores incurring high commissions and high rent expense. Larger carriers such as Sprint and Verizon are simply not able to compete at $30 per month, leaving this particular customer segment solely to Cricket.
The negative for this type of business is that a huge investment in network assets has to be made before the first phone call can be completed and the first revenue dollar collected. This leads to high debt levels in the early years of the business, along with dependence on lenders. This can prove very dangerous if the business takes a little too long to get up and running. It takes a number of years for the business to attract enough subscribers to turn cash flow positive. However, when the cash flow turns, it turns in a big way.
Due to Cricket, Leap's subscriber growth is exceptional. Ending 2000 with 190,000 subscribers, Leap projects it will have 1,000,000 subscribers by the end of 2001. 7,000,000 subscribers five years from now is not an unreasonable possibility. 7,000,000 subscribers should produce about $2.5 billion in revenues and an awful lot of cash flow. Leap also owns 20% of the Pegaso PCS system in Mexico. A rough estimate of intrinsic value, based on a discounted cash flow analysis, is somewhat above the current share price.
May 16, 2001
Sonera is planning to switch on
its 3G service even without any 3G handsets available for consumers, as there
are technical problems with the handsets from the manufactures. However its rival Radiolinja asked Sonera
not to turn on its 3G service. But the licenses were awarded to operators in
Finland on a condition the 3G service went live on 1st January 2002. The deadline is difficult to meet said
Radiolinjas' spokesperson and added without any handsets it will not be
feasible to switch on the service.
BT Manx and NTT DoCoMO were forced
to delay their 3G services due to handset problems as well. A spokesperson from
Sonera said, "there will be no handsets for the live 3G services, we are
having the same problems with the handsets as with NTT DoCoMo and BT
Manx."
A BT spokesman said the NEC
handsets are losing their connections when a caller moves into a new cell
therefore stopping the call passing from the original cell to the new cell.
This is the same problem that forced DoCoMo to delay its 3G launch.
Steven L. Ré, CFA May 21, 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.