Newsletter Q2 1999
April 1, 1999
A Divergent Market
The
stock market has been the beneficiary of a combination of factors that may be
difficult to sustain. The S&P
500 Index is currently trading at 34X trailing earnings and offers a dividend
yield of 1.3%. Federal Reserve policy has been accommodative.
M2 has been increasing at a rate of 9%, which is 6% higher than the
middle of the target range established by the Federal Open Market Committee.
Consumers, who account for 68% of gross domestic product, have been
willing to spend more than they earn. Finally,
significant foreign investment capital flows have allowed the United States to
continue to have a large trade deficit without a decline in the value of the
dollar.
As
the Dow Jones Industrial Average hovers near its all-time high, new lows
outnumbered new highs by three to one on the New York Stock Exchange for the
week ending April 1. As many
commentators have noted, the advances of the market are concentrated in fewer
stocks. Hot internet stocks such
as America Online sell for 643X earnings while other stocks are ignored.
The valuation divergence appears to be greatest between large
capitalization stocks that are purchased by index funds and smaller
capitalization stocks. If
earnings still matter, the valuation divergence should reverse sometime in the
future but I don't know when. In
the meantime, I continue to prefer good businesses that sell at attractive
valuation levels.
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Updates
Qualcomm
(QCOM) has recently surged on the news of an agreement with Ericsson (ERICY).
Ericsson has agreed to support the third generation CDMA2000 standard
that Qualcomm has proposed to the International Telecom Union and the European
Union. This development means that QCOM should eventually be able to
sell its products in Europe, a market that has been off limits in the past
because of the European Union mandate requiring the GSM standard for cellular
phones.
CDMA
has been the fastest growing wireless technology. The number of worldwide subscribers tripled in 1998 to 23
million and other markets besides Europe are opening up. U.S. Commerce Secretary William Daley recently
announced that China would allow companies to introduce CDMA networks
nationwide. The CDMA standard had
been limited to trials in four cities while the rest of the country used the
GSM (Global System for Mobile Communications) standard.
China Unicom, a small state-owned company, has submitted a proposal to
the State Council to help it compete with China Telecom.
If Unicom's five-year goal of 40 million subscribers is met, one
executive estimates that it would result in $16 billion of total market sales
for wireless equipment manufacturers.
Many
of QCOM's current licensees are not licensed for the third generation
standard, CDMA2000. As new
products with internet and data applications are introduced, license fees and
royalty income should increase rapidly. In 1999, the company expects to deploy
a standard bandwidth version of CDMA2000, which will double system capacity
and improve "medium" data rate performance (up to 144 kbps).
Sometime in 2000, QCOM should introduce its "high" data rate
technology that will provide data delivery at speeds up to 1.5 mbps.
Although QCOM is no longer a cheap stock in terms of its price/earnings
valuation, the fundamentals for the company remain quite strong and rapid
earnings growth can be expected.
ICN
Pharmaceuticals (ICN) reported a net loss of $4.71 per share for 1998.
Excluding the Eastern European charges, ICN would have earned $.58 per
share. The company had a third
quarter writedown due to the Russian economic crisis and completely wrote off
its investment in Yugoslavia in the fourth quarter after the illegal seizure
of its subsidiary by the Yugoslav government.
The company is now seeking a more balanced global operation, with less
emphasis on Eastern Europe and Russia. Its
revenues in North America, Western Europe, and Latin America grew by 46%, 31%,
and 31% respectively for 1998.
The
good news is that Rebetron(r), Schering-Plough and ICN's combination therapy
is quickly becoming the treatment of choice for Hepatitis C, the leading cause
of chronic liver disease. The
combination therapy involves ICN's Rebetol(r) (ribavirin) and
Schering-Plough's Intron(r) A (interferon alfa-2b).
The therapy serves a large market.
Approximately 170 million of the world's population are infected with
Hepatitis C, of which 12 million are in the U.S., Western Europe and Japan. In December, Schering-Plough received FDA approval for
previously untreated patients and in February, the European Agency for the
Evaluation of Medicinal Products issued a positive opinion recommending
approval for the European Union. Goldman
Sachs estimates that ICN should earn royalties of $.07 pretax per share for
each 10,000 patients on the Rebetron(r) therapy.
Current consensus estimates are $1.98 per share for 1999 and $2.71 for
2000.
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Recent
Additions
OmniQuip
International (OMQP) is the largest North American manufacturer of telescopic
material handlers, with 31% market share.
While construction equipment shipments increased at an annual rate of
6% for 1990 to 1996, telescopic material handlers increased at a rate of 21%.
Reasons for the high rate of growth have included increased
productivity, safety, versatility and increased use for non-construction
applications. Sales for the
December quarter were 34% higher than a year ago with some help from
acquisitions. The order backlog
was 23% higher than a year ago. In
spite of the company's favorable results, the stock is currently selling for
5.5X the current fiscal year estimate of $2.15.
Telefonos
de Mexico (TMX) has moved up since January's Brazilian currency concerns.
In March, Mexico's Federal Telecommunications Commission approved a 14%
increase in rates for long distance rates and a 4% increase for installation
and monthly service charges. Consensus
earning estimates have increased to $4.54 for 1999 and $5.55 for 2000. Given its strong balance sheet and cash flow, TMX is expected
to continue its share buyback program.
Holly
Corporation (HOC) is a refiner and marketer of petroleum products.
The company has refineries in New Mexico (61,000 bpd capacity) and
Montana (7,000 bpd). HOC
transports 50-60% of its products by pipeline to the Tucson and Phoenix
markets for sale. The company's
share price declined sharply last summer after a competitor, Longhorn
Partners, filed a billion dollar lawsuit and a proposed merger with Giant
Industries subsequently fell through. HOC
paid some legal bills for ranchers who wanted an environmental impact study
completed by Longhorn Partners for a proposed product pipeline to El Paso.
The case has been dismissed in the federal court and was filed again
with some modifications in the Texas State Court.
I agree with HOC's management that the lawsuit is without merit and
expect the stock to recover after the case is settled.
In the meantime, HOC sells at 13.125, or 6X the current consensus
fiscal year estimate of $2.20.
Ducommun
Inc. (DCO) manufactures components and assemblies for the aerospace industry.
The trend in the aerospace industry is to outsource more subassembly
work to niche suppliers and to use fewer suppliers to reduce administrative
costs. DCO's order backlog has declined recently due to an order
slowdown from Boeing and the end of a NASA space shuttle contract.
DCO is currently negotiating with NASA for a follow-on contract, and is
seeking additional business from Airbus and defense contractors to make up for
the reduction in sales from Boeing. The
company has a strong balance sheet with almost no long-term debt and has
reduced the number of shares recently through stock buybacks.
DCO sells for 5.9X the current consensus estimate of $1.65 per share.
Maxwell
Shoes (MAXS) designs and markets casual and dress footwear for women and
children under several brand names. Revenue
for the January quarter was flat compared to last year.
The company recently announced a licensing agreement to market a line
of footwear with the Dockers trade name.
MAXS will test market the Dockers line in the third and fourth quarter.
If results are positive, they will begin to sell Dockers shoes in the
next fiscal year. Management has
a good track record, the company has no long-term debt, and the stock
currently sells for 6X this year's estimate of $1.44.
Herley
Industries (HRLY) is a small niche company that manufactures flight
instrumentation components and systems for space launch vehicles and unmanned
airborne vehicles. Products
include command and control systems, transponders, telemetry transmitters and
receivers. They are the sole
source provider for over 60% of their revenues.
The number of satellite launches is expected to quadruple over the next
few years and HRLY will be a direct beneficiary. HRLY is currently selling for 8.9X the current fiscal year
estimate of $1.31.
Inacom
(ICO) is a provider of information technology products and technology
management services, primarily for Fortune 1000 clients.
ICO is one of the largest global providers of Intel-based client-server
and Lucent products. Vanstar recently merged into Inacom and ICO will be taking a
pretax charge of $150 million for the merger and an additional $40-80 million
to align and integrate operations. The
company expects to realize annual savings of $150 million from the merger.
Consensus estimates are $.97 for 1999 and $1.89 for 2000.
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Recent
Sales
British
Steel PLC (BST) has recently experienced significant pricing pressure due to
imports from Southeast Asia, Brazil, and Central Europe.
Prices have declined by as much as 40% for commodity products and
10-25% for other products. Based upon recent conversations with the Director of Investor
Relations in London, the company is now expecting a loss for the current
fiscal year and breakeven for next year, which are below the current consensus
expectations. Management has done
a good job in attempting to deal with the circumstances by reducing costs but
alternative investments offer higher expected returns for now.
Revenues
and earnings for DeBeers (DBRSY) declined more than expected and diamond
inventory levels at the end of 1998 were about 1.1X 1998 sales.
Since De Beers has always attempted to support the price of diamonds,
it will be necessary for them to cut production if demand does not pick up
soon.
If you have any questions regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert G. Kahl,
CFA, CPA, MBA
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Sabino
Investment Management, L.L.C.