August 2000 Update and Company Visits

 

This is a continuation of the last report, which reports on presentations by the top management of a number of leading companies.  Originally written early in July, it has been updated as of August 8 to reflect recent developments in Lucent and Disney.

 

Lucent (LU 41) was a pleasant surprise; even though it was obvious that execution problems still exist, and that the current quarter would not be anything to write home about.  After five years of spectacular growth, Lucent is in a process of assimilation.  Lucent has had problems this year delivering optical networking products on time, costing them leadership in the hottest area of telecommunications infrastructure.  For example, Qwest, discussed later in this report, pulled its OC-192 network buildout away from Lucent and gave it to Nortel when Lucent failed to deliver on time.  Efforts to fix these problems have led to the recently announced restructuring of the optical division, including dividing it into two separate divisions and changing its top management.  Lucent recently hired Deborah Hopkins as its new Chief Financial Officer.  She has a strong track record in internal control and management reporting systems.  Finally, the company is shedding divisions characterized by low return on capital employed.

 

Lucent, which owns Bells Labs, the largest private research laboratory in the world, is capable of a high revenue growth rate for the large company that it is.  Revenues of $38 billion last year could double in five years.  Lucent vies for leadership in two very important product areas.  Allwave Fiber is the capacity leader in optical fiber.  There is little lack of optimism about the optical fiber buildout.  Lucent is the clear leader in building CDMA wireless networks.  B.E. Veraayen, Vice Chairman of Lucent, believes the wireless Internet buildout starting late this year is vastly underestimated.  Unlike optical networks, wireless will be built everywhere in the world.  It will enable a new level of global business and competition.  It will engender social change and make distance irrelevant.

 

Lucent recently signed a broad-ranging contract with China-Unicom.  Also, $1 billion in optical orders alone signed in the last quarter included an order from Telia, significant because Lucent beat Ericsson on its home turf of Sweden.  The risk for Lucent and other infrastructure suppliers is that financing the equipment purchases is a part of the sale.  This leads to credit exposure - those networks had better attract lots of customers.  Another risk is the rising cost of attracting and retaining talented employees.

 

Lucent is now priced at half of its old $84 high.  Analyst consensus earnings estimates are $1.16 for the September 2000 fiscal year and $1.39 for 2001.  Intrinsic value is estimated in the high $30's.  This high quality company is attractive at the current price; the risk is that it must recapture its former leadership aura from hard-charging Nortel.  The plumb here is the potential spin-off of the Microelectronics and Communications Group, which manufactures components and integrated circuits for fiber optic and wireless networks.  This division is growing much faster than Lucent as a whole, and is likely to trade at very high price/earnings ratio as an independent company.

 

McDonald's (MCD 33) Chairman and CEO Jack Greenberg elucidated his company's plan to grow revenue 8% per year and earnings per share by 10 -15% per year for the foreseeable future.  1,750 stores were added worldwide last year and 1800 to 1900 will be added this year, adding 6% to revenue growth.  There are 244 stores in China and 3,000 in Japan, out of a total of 30,000 worldwide.  Menu additions are expected to increase comparable store sales by 2%.  Expense vigilance and share repurchases will supply the remainder of the earnings per share growth objective.  McDonald's is an investment that rates very highly both for quality and safe growth.  The stock is reasonably priced in the low 30's, compared to a consensus eps estimate of $1.54.  The risk is saturation in the US and that menu additions do not sell.

 

Medtronic (MDT 55) Chairman Bill George expressed a highly optimistic view of the coming ten years, with an objective of quadrupling revenues.  EPS should grow even faster, following up the track record of 24% compounded annual growth over the past 15 years.  The expansion of implantible defibrillators to prevent congestive heart failure is expected to be a huge product opportunity.  Heart failure, as one might imagine, is one of the health systems greatest costs.  Acquisitions have broadened the base of business for Medtronic over the past two years.  Sofamor Danek's neurological and spinal business, currently growing over 30%, is expected to maintain 25% annual growth for the next ten years.  Physio Control intends to put an external defibrillator in every government building, fire truck, airplane, and police car.  AVE's stents and grafts grew 70% the last two years, and are expected to grow rapidly in the future.  Smaller product lines include AVECOR tissue heart valves and the Octopus 2 tissue stabilization device, which facilitates suturing a beating heart during bypass surgery.  Medtronic's original product, Brady pacing devices, grew only 8% last year.

 

This company, which invented the implantible medical device industry, has a track record of excellent management.  I hope for an opportunity to add this stock in the future.  As you might imagine, a company like this does not come cheaply, trading at about a 50 PE.  This is in part justified by the high growth rate, unquestioned industry leadership, exceptional management track record, and high return on capital employed.

 

Merck (MRK 72) chairman Ray Gilmartin spoke optimistically about this great pharmaceutical company's future.  But to me, it just did not feel right.  Mr. Gilmartin was reluctant to detail the basis of his optimism, especially in view of the relatively short patent lives remaining on many of Merck's big drugs.  A great deal of pride was expressed regarding Vioxx closing the market share gap with competing COX 2 inhibitor Celebrex, but some of the marketing over the past year included product comparisons that bordered on misrepresentation.  One marketing piece highlighted a study stating that taking one Vioxx per day worked better than one Celebrex.  They just forgot to mention that the dosage of Vioxx is supposed to be one a day, while Celebrex is two a day.  Merck also crowed about the increased selectivity of its second generation COX-2 inhibitor, which soon will be its most important drug class with patent protection.  At the same time, Pharmacia says its 2^nd generation Cox-2 inhibitor, Valdecoxib, will be 1000 times as efficacious as Celebrex.  It has a better side effect profile than Merck's 2^nd generation, and is likely to be approved sooner.  Merck will be fighting uphill in the COX-2 competition once again.

 

Merck just does not seem to be the classy, confident company I fondly remember.  Merck shareholders have to hope Merck has something big up its sleeve.

 

Palm, Inc. (PALM 38)  CEO Carl Yankowski said they cannot make enough of the leading pocket-sized organizers.  Adding wireless connectivity will expand the role of the device to include instant messaging, e-mail, serving as a secure e-wallet for electronic commerce, and acting as its owner's web calendar portal.  More important is the Palm Operating System, employed on many web-connected devices.  This operating system is simple to use and does not require as much space as Windows CE.  Revenues are growing rapidly, but negligible profitability is the best hope for this year's bottom line.  In the long run, the devices are likely to be produced in vast quantities by bigger consumer electronics companies than Palm.  While the competition limits profitability of the device itself, it opens a huge market for sales of the operating system.  This is Palm's big opportunity, and the reason the stock is interesting.

Pfizer (PFE 45) Chairman and CEO Bill Steere, Jr. described the best pipeline and longest-lived patent portfolio in the pharmaceutical industry.  He projected 25% annual eps growth for the next three years as the Warner Lambert acquisition is assimilated.  Savings should build to $1.6 billion annually.  Pfizer's post-acquisition $4.7 billion R&D effort will lead the pharmaceutical business.  He pointed out that the ability to do drug research on a huge scale would be a crucial competitive factor in the genomic future.  Drug candidates are discovered by screening compounds against receptor sites.  The mapping of the human genome raises the number of receptor sites from 500 to between 10,000 and 25,000; hence the probability of finding a drug first is a function of research capability.  Pfizer has superb management, a super future, and deserves its 45 PE.

Qwest (QWST 52) Chairman and CEO Joe Naccio has built the lowest operating cost fiber optic network in the U.S. and is expanding it overseas.  The huge capacity of Qwest's network makes it ideal for broadband data transmission.  However, lots of data will be needed to meet the debt payments of this deeply leveraged company.  So herein lay the potential and the risk:  if the network adds lots of customers, Qwest should be a big success.  If not, it could fail.  Its weakness is its balance sheet.  Its strength is that the network it owns has higher pricing flexibility and profit potential than those of ATT and Worldcom, its two biggest competitors.  The lowest cost operator can use price as a weapon to attract customers.  It is sensible that Qwest should win the long distance price wars, but I am not convinced it's sensible to take the risk.

Staples (SPLS 17) can be described as a "growth through replication" story.  Every time a new store is opened, revenues and profits rise.  Chairman and CEO Tom Stemberg is of the opinion that North America has a capacity of 5000 office superstores compared to the current 2800 store population.  Because of the proliferation of home offices into 50% of American homes, he feels the long-term market growth is 10%.  He made it perfectly clear that he believes that Wall Street has under-priced that growth, to say nothing of his company's fast-growing e-commerce business, staples.com.  At 20 times this year's projected earnings per share of $.88, with a 28% eps growth rate, it's not too expensive, but it's not a giveaway either.  The company has attempted to exclude the losses of the Internet business from its Income Statement, but a good financial analyst will not fall for that one.  The chairman made clear his displeasure with the decline of his stock from a $35 high last year, but let's face it; this business is not looking at 10 to 1 growth potential like CDMA phones.  I think the stock is reasonably priced here and low in risk at $17.  While I would not expect p/e expansion with 13% return on assets, eps growth potential of 25% per annum over the next five years makes it an attractive investment candidate.  In the future, I will study the opportunity for the company to grow its return on assets and its e-commerce profitability and make investment judgments based on those drivers of p/e ratio.

 

Walt Disney Co. (DIS 42) Chairman Michael Eisner discussed the company's ongoing major turnaround and exceptional future.  How do you value the goodwill generated by the Disney name, the enjoyment of the parks, and the characters we all grew up with?  How do you value the world's finest library of movies and TV shows, especially when new worlds of distribution are opening up on the Internet?  Certainly, the AOL acquisition of Time Warner is an indication of the value of content to an Internet service provider.  In fact, it is the proprietary nature of quality media content that it is resistant to commoditization, even on the best driver of commoditization ever invented: the Internet.  Indeed, the growth of the Internet into a ubiquitous content distribution mechanism gives Disney and its "go.com" portal the opportunity to be Internet giants.

 

Disney has invested a great deal of capital over the past several years in building new parks in Anaheim, Tokyo, and Hong Kong.  By adding a second park next to an existing one, Disney hopes to extend the stay of its visitors.  Rather than making one-day visits, guests can view these as destination resorts and stay longer, benefiting the revenues of both the parks and the Disney-owned accommodations surrounding the parks.

 

Growth of earnings sagged for a couple years at Disney, as did the stock price.  The earnings growth recovery reported in last quarter's financial results manifests the vitality of this great company.  The "Millionaire Show" demonstrates the leverage of content.  The approaching completion of expensive park build-outs will lower expenses and raise revenues.  Increased park attendance will enhance all Disney businesses that feed off of goodwill synergies.  Management's focus on revitalizing all Disney assets is improving profitability and return on assets, driving up the p/e ratio of the stock.  This year's earnings are estimated at $.90 and next year's at $1.10.  I expect eps growth to average 15% over the next five years, and view the stock as fairly priced at $42.

 

Steven L. Ré, CFA                 August 8, 2000

 

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.