Future Stocks – financial forecasting

Manuel Schiffres

COVER | Their soaring growth and leading positions make these the PREMIER PICKS of this decade.

YOU FIND THE GREAT INVESTMENT successes of the coming decade in the unlikeliest places. Like South San Francisco, an industrial suburb abutting the airport. It’s home to Genentech, a premier post-Industrial Age biotechnology pioneer. Or in a nondescript red-brick building in a Richmond, Va., suburb, where Capital One is conducting an entirely different set of experiments: to put and keep its credit card in your wallet.

The point is, tomorrow’s investment success stories are sometimes being created today, right under your nose. You just have to become aware of their presence. That’s the purpose of this in-depth look at nine companies standing on the brink of enormous gains in revenue and profits. There are no guarantees in investing, but these firms are as close as it gets to slam dunks in coming years.

Each of the nine offers great products or services that are to some degree insulated from competition. Each possesses either great technologies or the know-how to make use of technology to its benefit. Each is expected to deliver earnings (or cash-flow) growth of at least 20% per year over the next three to five years. Each is big enough to have staying power, yet small enough to have plenty of room to grow.

To reduce your risk, we picked only those companies that (with one exception) are already profitable. But their success means they’re not exactly cheap–in fact, they would be considerably more attractive if a market correction gave their stock prices a haircut of 25% or more.

Biotech: Success stories

WITH ALL THE HOOPLA over the mapping of the human genome (see “The Payoff for Genebusters”), it’s not surprising that investors are trying to identify the companies most likely to convert this research breakthrough into real revenue-generating products. Many players are doomed to fail, and it may be many, many years before even the winners come through with products. Nonetheless, many biotech stocks have raced heavenward as though profits were just around the corner. Instead of speculating on a profitless genomics outfit, why not put your money on a company that supplies the bricks and mortar to the biotechnology industry? That’s where Applied Biosystems comes in.

Applied Bio, of Foster City, Cal., is a leading developer of instruments, reagents and software used in biotech research. “All of this research that’s occurring today is enabled by their products,” says analyst Rob Olan of Chase H&Q brokerage.

Among its wares, which can cost as much as $300,000, are so-called DNA sequencers used in analyzing genetic material and mass-spectrometry devices used in analyzing and purifying proteins and related molecules. For example, the ABI Prism 3700 DNA Analyzer is the principal instrument used by the Celera Genomics Group, one of the two entities that announced in late June that they had completed rough drafts of the human genome.

The tie between Applied Bio (PEB, $84; www.appliedbiosystems.com) and Celera Genomics is no accident. The two are siblings, each representing a tracking stock of PE Corp. But while its human-genome success may give Celera lots of glamour, Applied Biosystems is where the revenues and profits are. The company, formerly called PE Biosystems, generated $1.2 billion in sales in the fiscal year ended June 1999 and earned 67 cents per share. It was expected to have earned 86 cents per share in fiscal 2000. Analysts expect it to earn $1.03 in fiscal 2001, according to Thomson/First Call. The consensus of analysts pegs its three-to-five-year earnings-growth rate at 23% annually.

The stock, selling at 82 times fiscal 2001 earnings estimates, may be worth the price to gain a toehold in this exciting new industry. Michael Weiner, at the One Group funds, says he likes Applied Bio’s business model because it’s a lot like the razor-blade business. “When you buy their products, you tend to come back and buy more of the other products that go with that unit,” he says. Another plus, says analyst Olan, is that for Applied Bio to succeed, “its customers need only to believe that the breakthrough discovery is just around the corner” and be willing to spend more money on research to achieve those advances.

WHEN ANALYZING drug and biotechnology companies, current profits are nice but the potential for future profits is what really whets the appetite. In Genentech, you get both. It’s a pioneer in recombinant DNA technology, which involves recombining DNA from different organisms to form new organisms that can make proteins. Genentech, which specializes in products to treat heart disease and cancer, should generate sales of $1.7 billion this year.

Fueling growth today are such newer drugs as Rituxan, for treatment of patients with non-Hodgkins lymphoma, and Herceptin, for breast-cancer patients. Genentech also sells several products for treating growth failure, and in June won government approval for TNKase, its second-generation clot-buster for treating heart attacks. Among substances now being tested are products for allergic asthma and growth-hormone deficiency, as well as additional treatments for cancer. In particular, says Credit Suisse First Boston, the anti-IgE product for treating asthma could score big, with the potential to generate annual sales of 81 billion.

Genentech (DNA, 8154; www.gene .com), which was founded in 1976, has “a huge pipeline of new products,” says Brian Clifford, co-manager of SunAmerica Growth Opportunities fund. “There is much higher growth potential with Genentech than with Amgen [the largest biotech company], and Genentech is a much more established company than MedImmune [see below].”

Like most other biotech stocks, Genentech has had a strong run of late. The stock sells at 100 times consensus 2001 earnings of $1.53 per share (the consensus for 2000 is $1.19). On average, analysts peg the long-term profit growth rate at 28% per year.

AMONG BIOTECH STOCKS, the combination of current profitability and sizzling growth prospects is perhaps best epitomized by MedImmune. The Gaithersburg, Md., company focuses on drugs that treat cancer, infectious diseases, and immune-system problems. It already has one blockbuster drug, Synagis, on the market, and its pipeline of new products is widely considered one of the most promising in the industry.

Synagis is a monoclonal antibody used to prevent pneumonia in infants and toddlers. In 1999, its first full year on the market, it generated nearly $300 million in sales (more than three-fourths of MedImmune’s revenues), making it “the most successful pediatric product launch in pharmaceutical history,” according to Prudential Securities.

The story gets better. Merrill Lynch analyst Eric Hecht estimates that by 2003, more than 125,000 patients will use the drug and that it will generate $680 million in sales. Moreover, MedImmune is working, with a partner, on an inhalable version of Synagis that would be used by elderly patients. Approval for this use would represent a “huge opportunity” for MedImmune, says Hecht.

MedImmune (MEDI, $71) owns five other drugs already on the market, including three cancer-related products it acquired with the purchase of U.S. Bioscience in 1999. Among treatments still being researched or in clinical trials is a vaccine against the viruses that cause genital warts and cervical cancer; a vaccine to prevent urinary tract infections; and a therapy for patients undergoing bone-marrow or stem-cell transplantation whose immune systems attack the transplanted tissues.

MedImmune’s rosy prospects certainly haven’t gone unnoticed. The stock, adjusted for splits, is up 33-fold since April 1997. With the consensus earnings estimate at 92 cents per share for 2001, up from an expected 62 cents this year, the stock sells at 77 times next year’s forecast. But the estimated three-to-five-year profit-growth rate is 40%, making today’s price a bit more palatable.

Tech: Wired and wireless

IMAGINE THAT FORD or General Motors had someone else build their cars. Increasingly, such farming out is what the technology world is coming to. The result is explosive growth for so-called electronics manufacturing services (EMS) companies. In a recent survey by Bear Stearns of 101 high-tech companies, respondents said they aim to contract out 75% of their manufacturing, about five times the current level.

One of the beauties of the EMS business, says Lehman Brothers analyst Ravi Suria, is that the companies can prosper no matter which technologies are in ascendance at a particular moment. And a major beneficiary of the outsourcing trend is Singapore-based Flextronics. It has been growing aggressively through acquisitions, having announced or completed a dozen since 1999. Flextronics (FLEX, $85; www.flextronics.com) is now the world’s third-largest EMS company, with eight million square feet of manufacturing capacity at 63 sites around the world.

Such far-flung production and wide variety of services appeal to customers. Revenues and profits have grown exponentially. Sales totaled $5.7 billion in the fiscal year ending last March, up from $3.3 billion the previous year, and Wall Street expects $9 billion during the current fiscal year. Analysts on average expect profits of $1.57 per share in the current fiscal year, up from $1.14. The anticipated long-term growth rate: 30% a year.

The long-term picture brightened with the recent announcement of a $30-billion, five-year deal with Motorola. Flextronics will produce a wide array of communications products (including wireless phones, pagers and phone-network equipment), and Motorola in turn will effectively take a 5% stake in Flextronics.

UNLESS YOU SPENT the past 15 years on another planet, you’re aware of the growing ubiquity of wireless phones. Investors have rung up big profits on stocks of wireless-service providers and handset makers. But there’s a way to play the wireless revolution without putting your chips on such hotly contested areas as phones and wireless carriers: Invest in companies that own the towers that house the wireless-service providers’ antennas.

The largest tower operator in North America is the straightforwardly named American Tower, which operates more than 10,600 sites in the U.S., Canada and Mexico, including 9,400 that it owns or leases. The company’s goal is to raise that number to 20,000 by 2005, which it expects to achieve by building new towers and acquiring existing ones from wireless-service and other companies.

American Tower (AMT, $44; www.americantower.com) is a “picks and shovels” company for the wireless industry, says Tony Rosenthal, a midcap fund manager at Fiduciary Trust Co. International in New York City. He expects it to become huge, both because of the industry it serves and its own leading position. “The beauty of this business is that you don’t have to worry about which wireless technology will be successful,” he says. “The business has very predictable growth.”

Stephen Pesek, who runs MFS Massachusetts Investors Growth fund, says that within a few years the number of towers needed to serve the growing demand could double from the current level of 65,000 in the U.S. Moreover, Pesek notes, the value of existing towers is enhanced by the “not in my backyard” syndrome, the opposition to construction of new towers from nearby residents.

Because of large depreciation and interest expenses associated with its growth, American Tower is not currently profitable. It does, however, generate positive cash flow (earnings before interest, taxes, depreciation and amortization), and Pesek expects cash flow to grow 40% per year over the next five years. Salomon Smith Barney expects revenues of $597 million this year, more than double the $258 million of 1999.

MENTION COMPUTER chips and most people assume you’re talking about those digital circuits that decipher ones and zeros. But there’s a different class of semiconductor products known as analog chips, which process data about such real-world phenomena as light, sound and heat waves. With advances in communications technology seemingly springing up daily, demand is surging for the products made by Maxim Integrated Products. Those products include analog chips for use in wireless phones, central-office switches, satellite communications systems, measuring instruments, bar-code readers and a plethora of other devices.

The wonderful thing about analog chips is that they won’t soon become obsolete. The market for an analog-chip model can last as long as seven years, says Chris Bonavico, manager of Transamerica Premier Aggressive Growth fund. That contrasts with the 18-months-or-so life span of a digital chip. The result, says Bonavico, is steadier growth. “You avoid the boom and bust that tends to occur in the digital world,” he says. “Once analog makers design their chips, they earn high profit margins for a very long time.” Maxim’s wares are the “antithesis of commodity products,” says William Keithler of Invesco Technology fund.

Earnings growth, at 50% annually over the past five years, has certainly been impressive. The company also has $670 million in cash on its books. Maxim (MXIM, $76; www.maximic.com), based in Sunnyvale, Cal., recently traded at 61 times estimated earnings of $1.25 per share for calendar 2001 (the company is on a June fiscal year). Analysts expect three-to-five-year earnings growth of 27% per year. Despite its seemingly high valuation, Maxim is less expensively priced than its peers, say analysts.

REMEMBER Network Solutions, the leading registrar of Internet domain names? We recommended its stock in our June 1999 cover story. The stock performed admirably and then disappeared following Network’s acquisition by another highflier, called VeriSign. Now it’s time to give VeriSign, a provider of Internet-security software, its due. The combined company represents one of the most promising plays on the construction of the Internet. “It has ambitions that, if realized, will make this a monster company,” says Invesco’s Keithler.

VeriSign (VRSN, $187; www.verisign.com) has 90% to 95% of the market for digital certificates, estimates analyst John Puricelli of A.G. Edwards. Digital certificates are attachments added to electronic messages to ensure the messages’ security. Their most common use is to verify that the sender of a message is who he or she claims to be and allow the message’s recipient to send back a secure response. VeriSign, located in Mountain View, Cal., has already issued more than 215,000 digital certificates to such customers as Bank of America, Visa, US West and even the IRS. The potential market is 12 million, says Puricelli.

Meanwhile, the market for Internet domain names–those strings that typically start with “www” and end with “.com,” “.ors” and the like–is soaring. About 14 million have been registered to date, and Pesek, the MFS manager, says the total number of registrations could hit 150 million in the next five years. Network Solutions collects a $6 annual fee for every name registered on the Internet. Analysts expect VeriSign to offer package deals to entice customers.

The combined company should generate sales of $385 million this year, according to J.P. Morgan estimates. That figure will grow 71% per year through 2003, to nearly $2 billion. And Morgan forecasts that operating earnings (excluding goodwill amortization for acquisitions) should total 9 cents per share this year, 41 cents next year and $ 1.47 by 2003. Keithler suggests that VeriSign could generate free cash flow (cash flow before capital expenditures) of $1 billion in 2001. By that yardstick, the stock, which is absurdly expensive on a P/E basis, is more defensible.

Aboard the money trail

CHARLES SCHWAB & CO. isn’t exactly undiscovered. It’s nearly 30 years old, and it’s already plenty big. By the end of the year, barring a market collapse, assets in Schwab accounts could exceed $1 trillion. Schwab’s stock has market value of $47 billion.

Schwab (SCH, $37; www.schwab.com) is in the right business at the right time with the right leadership. “More than any other large-scale financial-services firm, Schwab is benefiting from the growth of the mutual funds business and increased participation of the retail investor,” says Bear Stearns analyst Amy Butte. Under the leadership of Charles Schwab himself and president David Pottruck, the San Francisco company has transformed itself from a discount brokerage into an asset-gathering machine by tapping the growing wealth of a populace that has discovered the joys of investing. Transamerica fund manager Bonavico says “few management teams have the vision to look three-plus years into the future and see where they have to take their business to be competitive.”

Consider a few of Schwab’s strategic moves. It pioneered the mutual fund supermarket of no-load funds that can be purchased without transaction fees. The company has been a leader in the move to online brokerage services and has been able to maintain a leadership position despite charging more than the superdiscounters. And Schwab recently purchased U.S. Trust, a private money-management firm that caters to wealthy investors.

The U.S. Trust deal shows that Schwab aims to hold on to its customers as they pass through the stages of their lives. As Christopher Perras of the Aim funds notes, Schwab appeals to freshly minted college graduates by offering small, mutual fund-oriented accounts. “Many of these people will be very successful,” Perras adds. “They’ll eventually have millions, and you don’t want them to leave you.” That’s where a company like U.S. Trust can come in.

By the standards of financial-services stocks, Schwab certainly isn’t cheap. It sells at 48 times estimated 2001 earnings per share of 77 cents. Its P/E ratio is 2.5 times the estimated three-to-five-year earnings-growth rate of 20%. Typically, notes Jeffrey Morris, manager of Invesco Financial Services fund, Schwab’s P/E ratio has ranged over time from being equal to the overall market’s to three times the market’s P/E. By that measure, the stock is fairly priced, he says.

LIKE SCHWAB, the much-less-well-known Capital One Financial is a blend of the old economy and the new. One of the largest credit card issuers in the U.S., Capital One (COF, $50; www.capitalone.com) has relied heavily on technology to fuel spectacular growth in customer accounts and loans outstanding, which in turn has driven up profits and the share price. The stock has risen tenfold since late 1994, not long after Signet Bank spun off part of its card unit to the public.

Chief financial officer David Willey says Capital One’s willingness to pursue customers across the credit spectrum is one explanation for the company’s growth. “It’s all about mass customization of products and being able to meet people’s individual needs and wants, and to deliver products of value to all different kinds of people,” he says from the company’s Falls Church, Va., headquarters. Take this approach, combine it with a huge marketing budget and constant testing of what products will fly with consumers, and the number of customers obtaining credit cards from Capital One has grown 40% a year since 1995, to 27 million.

On top of the usual sources of income for a credit card company–interest payments, annual fees and the like–Capital One is making a big push to cross-sell other products and services. It has relationships with Liberty Mutual to sell insurance, MCI WorldCom for long distance, Sprint for wireless-phone service and Countrywide for mortgages. Willey expects cross-selling revenues to increase 65% to 75% this year.

Technology plays an important role in Capital One’s success. The company employs an “information-based strategy” that helps it get the most appropriate credit card into the hands of the right borrower in the most efficient manner possible, and does so in a way that minimizes the likelihood of borrower defaults. Indeed, despite its wide array of customers, the rate at which Capital One charges off uncollected bills is about two percentage points below the industry average. As for the Internet, the company is making a big push to sign up new customers over the Web and get existing ones to check their accounts and pay credit card bills online. By the end of the year, Capital One expects to be servicing two million accounts online, up from 370,000 at the end of the first quarter.

Capital One’s stated goal is to deliver earnings growth of 20%-plus per year and generate a 20%-plus return on equity (a widely watched measure of profitability). According to Willey, a 30% earnings gain this year, from $1.72 per share in 1999, is virtually assured. As for the longer term, says Lehman Brothers analyst Thomas Hain, it is “very difficult to envision a scenario in which the company would fail to reach its publicly stated goals.” The stock sells at 22 times estimated 2000 earnings of $2.25 per share.

–Reporter: JUSTIN WISER

Kiplinger.com

Track these stocks. To follow prices, earnings, growth prospects and key ratios, click on “Kiplinger’s Porfolios.”

COPYRIGHT 2000 The Kiplinger Washington Editors, Inc.

COPYRIGHT 2000 Gale Group