As QUALCOMM continues its dramatic price appreciation, it has become an over-weighted position in portfolios. If you are concerned about this, please give me a call. I remain very optimistic about the company; ownership of an undisputed proprietary product franchise is something very rare. The appreciation over the past year reflects a 180° turn in sentiment. Only a couple of us financial analyst types liked QUALCOMM last year, the majority disparaged it, but now everyone loves it! The stock is no longer undervalued, and could be subject to a significant correction that would hurt the value of your portfolio.

The market itself is unusually dangerous. 20% of stocks sell at prices that reflect the most optimistic consensus I have seen in 25 years of investing, and 80% have been mediocre performers this year. A big problem is that many of those in the 20% category make very little, if any, profit, and someday the market will require profits. Interest rates have risen this year with no commensurate market adjustment, and the election next year inserts a certain degree of uncertainty. The correct strategy is to commit capital only when there is evidence that a real bargain has been found.

Cardinal is a direct beneficiary of pharmaceutical sales growth. Patent drug sales have grown in the low-teens in the past several years and show no signs of abating with over 1000 drugs under development. A special opportunity is created by a record number of drugs coming off patent in the next few years. As a contract drug manufacturer, Cardinal stands to benefit from generic drug growth, because manufacturing margins are 4 times as high on generics as on patent drugs.

Cardinal’s management is exceptional. They manage with a sense of urgency and are financially and operationally disciplined. They are incessantly mindful of the concept of return on capital. This is music to the ears of long-term investors. Unlike the managements of Autodesk and Mattel, they do not make dilutive acquisitions, nor get duped into buying a "bag of goods." Cardinal buys bargains, and then doubles the new property’s business. Employees are incented to meet objectives and beat personal and department P&L’s. The result is average earnings per share growth of 23% per year for the past ten years. Management is firmly committed to 20% EPS growth over the next several years. Cardinal just reported EPS growth of 23% in the quarter just ended. Management is comfortable with estimates of operating earnings per share in the June 2000 fiscal year of $2.53, compared to $2.06 last June.

Cardinal’s competitors have, for the most part, reported dismal third quarter earnings, precipitating a large decline in the stocks of all companies in the group. Cardinal, near half its 83 high, is actually less beaten up than its competitors. However, Cardinal has been managed around the problems besetting its comparables, with the exception of a moderate slowdown at its Pyxis unit, discussed below, which contributes 10% of profits.

There are two current specific concerns regarding Cardinal. First, pharmaceutical inventories have built up somewhat recently. Inventory builds in most businesses presage sales slowdowns, but we do not think this is the case here. Pharmaceutical sales can hardly be characterized as slow. In fact, drug manufacturers are allocating products. In the past, Cardinal has built inventories in anticipation of pharmaceutical price increases in order to make inventory profits. Cardinal views its inventories as just another aspect of their business on which they can earn a return in excess of the cost of capital. Management says they have built the inventories to assure their hospital and pharmacy customers of uninterrupted supplies in case of "Y2K" dislocations. I believe they have built the inventory so that they can turn around and sell it in Y2K at a profit.

The second issue is a slowdown in sales at the Pyxis unit. Acquired in 1996 for $600 million net of cash and liquidation value of the Pyxis lease portfolio, it now makes an annual profit of $120 million, generates $150 million in cash, and owns an additional $200 million of liquid leases. So it was a great acquisition. However, Pyxis’ sales growth slowed from the mid-teens to just 5% last quarter, stimulating fears amongst the momentum investors who had pushed the stock into the 80’s. (Woops!) This is a valid concern, because Pyxis has great margins compared to the low-margined distribution businesses that dominate Cardinal’s revenues. Management says the slowdown is due to hospitals belatedly redirecting their budgets towards Y2K compliance and away from buying productivity-enhancing Pyxis machines. They project a return to strong sales in the New Year and have pre-announced a January price increase to stimulate year-end ’99 sales. See, these guys just don’t sit around on their duffs and take it. Sales reportedly were up nicely in October.

To those who do not delve deeply, the aforementioned two concerns make Cardinal look troubled like its comparables. On the contrary, we believe the inventories are an opportunity, the Pyxis problem is short-lived, and the stock is cheap.

A couple years ago Enron’s stock price took a pretty substantial slide, giving us an entry opportunity. At the time, Enron had chosen to invest an enormous amount of capital in the deregulating electricity industry. Although this obliterated earnings, we felt investing early to lead this business would lead to growth for Enron. Five factors were important:

1. Enron has terrific management, capable of competing in tough markets.
2. Enron learned about deregulation when natural gas was deregulated about 12 years ago, and made itself and its shareholders a fortune.
3. Enron should be able to do it again in electricity, a deregulating market 16 times as large as natural gas.
4. Enron’s competition would be electrical utilities, companies and managements that were used to having a monopoly, didn’t worry much about controlling expenses, and certainly did not know how to swim in waters inhabited by a shark like Enron.
5. Enron has access to enormous amounts of capital at very competitive prices.

The shark attacked and ate up the best part of the market, becoming the shadow that old-line electric utilities look over their shoulder at, shuddering. Enron now dominates the deregulated portion of the electricity market.

Let’s discuss Enron in terms of the equation: Earnings = Return on capital x capital employed. Heavy investment in the wholesale power industry doubled Enron’s capital employed between 1996 and 1998, driving earnings growth into the 35% range. The stock doubled. However, return on capital declined from the low-teens to the high single digits. Now, Enron’s management is working to raise the return on capital by growing Enron’s best businesses and pruning businesses that earn a low return. Accordingly, Enron Oil and Gas and Portland General Electric have been sold, reducing capital by about $3 billion. Improving return on capital is expected to power earnings growth of about 15%. A notable improvement of return on capital is necessary to maintain the current lofty 35 P/E on 1999 estimated eps.

We view Enron as an excellent long-term holding, but do not think it is attractive for purchase at the current $42 price.

Steven L. Ré, CFA November 15, 1999