Third Quarter 2000 Update and Company Visits

Our objective as investors is to buy businesses with great economics at a price reasonable enough to allow us to earn a superior long-term return on invested capital. The stock market is a marvelous place to shop for businesses, because it frequently, and usually without any notice, develops a negative consensus and declares a clearance sale. In sharp contrast to the market's emotions a year ago, the then overpriced Internet sector is in that repricing process right now. Frankly, a number of those companies are still overvalued. The market in the long run does a pretty good job of valuing businesses and will proceed with this correction until the job is done. Although it is not humanly possible to predict the bottom, I do not think it will be a drastic one.

The urge to get into the Internet sector was overwhelming a year ago. So, we stood firm, knowing that the emotion would create overpricing, and then losses, for those who could not resist. So, our portfolios appeared as though they lacked an Internet presence. It is different today. Our portfolios actually have a lot of money invested in Internet winners! Enron, Cardinal Health, and Intuit jumped on the opportunity to make themselves gorillas in certain Internet niches. Enron has the best business plan in broadband access, Cardinal operates the best pharmaceutical and medical product Internet distribution business, and Intuit is the leading enabler of Internet financial transactions for its 25 million strong customer base. And, these stocks have performed very well this year.

Meanwhile, the Internet glory names of a year ago are struggling to stay solvent. The billions lost in that sector will negatively impact the liquidity of the economy and restrain GDP growth over the next year.

Company Reviews and Visits

QUALCOMM progress report: Paralleling the October 16 announcement of China Unicom's increased commitment to CDMA was the announcement by Chinese government-owned phone maker ZTE Corp. of a mobile phone for the Chinese market with SIM card capability. This phone, which will operate both on China's CDMA and GSM networks, is enabled by chipsets from QUALCOMM. As I anticipated, news of the Chinese build-out of CDMA only awaits Chinese capability to build a healthy portion of the system themselves. Why should they give billions of build-out revenues to foreign companies, as they did their old GSM build-out? They admire South Korea's example of learning the CDMA business by building the home country's system. Then, like the Koreans, they can use this experience to compete with Nokia, Motorola, and the rest of the world's established infrastructure builders and handset manufacturers. The international 3G CDMA build-out will be huge, and they intend to get a share of it.

The 3G CDMA vision is clear at QUALCOMM. Meanwhile, members of the W-CDMA camp, with their contrived volumes-long W-CDMA specification, appear to be in disarray. Huge sums just paid for 3G spectrum in Germany ($60 billion) and the United Kingdom ($35 billion) apply excruciating pressure on old loyalties between European system operators and European system builders. Spectrum investment earns no income until systems are built and customers are signed up. I cannot see into the R&D labs of the W-CDMA builders, but the paucity of concrete information from them implies there is not much to show. Can system operators afford to wait? Will QUALCOMM come to the rescue of W-CDMA? 'Sorry, Nokia, but 3G CDMA is not 2 or 3 years away. QUALCOMM's CDMA2000 went commercial last week in South Korea!

Over the next year, the stock price of QUALCOMM will be powerfully influenced by the comparative 3G CDMA accomplishments of QUALCOMM vs. that of the W-CDMA camp. I will keep you posted.

The Walt Disney Company's (DIS 37) earnings reacceleration is well under way. The "Millionaire's Show" has brought in a deluge of ad revenues, and is anticipated to continue several more seasons. ABC is also working on several shows that are outgrowths of Millionaire.

A period of great expenditure on theme parks is reaching its conclusion. The addition of second parks in locations where there is already a successful first park is a proven formula for increasing park stays, park revenues, and hotel revenues. This is expected to lead to growth of earnings, cash flows, and return on capital employed in the theme park division.

Consumer product sales provide a great annuity for Disney, although the Disney stores are still at least a year from a profit turnaround. Disney management expects the division to start a revival that could make it the company's fastest growing division in a couple years.

The film division is being carefully managed to reduce exposure to expensive live-action films. The objective is to increase the number of moderate budget films that produce consistent returns. The number of expensive films per year is being reduced, and their budgets are designed to lower risk. Big name talent is paid only scale wages, but receives a handsome share of the profits, after Disney has recouped its investment in the film.

Disney's per share earnings should be about $.90 in the September 2000 fiscal year, and about $1.10 in 2001. $1.80 is an aggressive possibility in 5 years. I think the stock is attractive under 30.

Pixar (PIXR 30) is the leading producer of animated three-dimensional computer-generated family movies. Its creations include A Bug's Life, Toy Story, and Toy Story 2. These movies have initiated the process of building a brand name franchise for Pixar - a name parent's can trust for quality family entertainment. Next year it will bring out Monsters, Inc. The objective is to tell a great story, one that children enjoy, but one that also appeals to adults by conveying a deeper meaning or insight into life.

The objective is to make one major movie a year, thereby gradually building a recurring revenue stream and movie library. In a new movie's first year of life substantial revenues are produced from the domestic theatrical release. In the second year more revenue is produced from international theatrical release and worldwide domestic videotape/DVD release. In future years, continued video sales, television pay-per-view, movie channels, and network television continue to bring in smaller amounts of revenues. Producing one major movie a year, in time, results in the creation of an annuity stream, a steadily recurring stream of revenues.

Toy Story and A Bug's Life each produced foreign and domestic box office of about $350 million, and Toy Story 2 produced about $450 million. These revenues are first split with the theatres, then with Disney, Pixar's joint venture partner. Pixar has agreed to produce four more major pictures with Disney. The relationship with Disney jump-started the success of Pixar, but at a high price. Pixar makes the movie with costs split evenly between the two companies. Disney then distributes the movie for a cash fee plus 10-15% of the film's revenues. By the end of this agreement Pixar should be well enough established to either distribute the movies itself or cut a much more attractive deal with Disney or another distributor. This will dramatically increase the intrinsic value of Pixar.

This niche has few players. Disney produces about one animated movie every nine months and Dreamworks produces the occasional movie, but has not had a blockbuster yet. The care with which Pixar crafted its first three blockbusters has established it as the ultimate home for the rare person who can both create animated stories and convey it using computer 3D graphics. This intangible is an important part of the value of Pixar.

Earnings fluctuate significantly because of the time between movie releases. This difficulty of timing and understanding earnings creates high stock price volatility. It is selling at less than half its old $64 high, because no new movie releases are expected for the next year. The analysts' consensus estimates are $1.36 for the year ending September of 2000 and $.47 for 2001. The potential exists to earn over $2.00 in five years. The company has $5 per share of cash today, and should have about twice that in five years.

Because of Pixar's unique franchise and annuity characteristics, I would be attracted to the stock at the right price.

Steven L. Ré, CFA October 17, 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.