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Course 403
Speculative-Growth Stocks

Introduction

Speculative-growth stocks can inspire dreams of wealth--and nightmares of poverty. These companies are often new ventures selling something people want, generating rapid revenue growth, but incurring high expenses as they strive to become a permanent fixture of the corporate landscape. One might be the next Microsoft MSFT. Or the next Atari. Their defining characteristics are rapid revenue growth but slower or spotty earnings growth--strong sales, in other words, but a lagging bottom line. In fact, many speculative growth companies lose money--lots of it. That's not much inducement to invest. Still, corporate America's future heavyweights and best investments may lurk in this high-risk, high-reward corner of the market. It's possible to curb some of the risk, too. To do that, we'll take a look at Yahoo YHOO, the World Wide Web portal that was one of the hottest Internet stocks of the 1990s.

Is Sales Growth Outpacing Asset Growth?

The speculative-growth market is full of companies that are doubling their sales by doubling their assets. This is a legitimate way to expand. Investors pour additional capital into the business, which drums up new sales. Eventually (we hope), the company reaches a critical mass at which it becomes a big moneymaker. But to limit risk, we can focus on companies that are making more efficient use of their assets as they expand, generating rising sales on each $1 of capital. Yahoo has done pretty well on this front. Between 1997 and 1998, its sales grew 189%, but its assets grew even faster, at 333%. In 1999, though, Yahoo's sales started to grow faster than its assets, indicating that it's starting to squeeze more growth out of its assets. That tells us that Yahoo is growing quickly, but prudently.

What's the Growth Trend?

Rapid sales growth won't do us any good if it can't be sustained. We want staying power, not sales growth of 50% one year and shrinkage the next. Even though it has only been around for a few years, Yahoo has been one of the most consistent Internet stocks around, growing steadily without a lot of wild swings from quarter to quarter. The pace of that growth has been steadily declining (from 230% in 1997 to 120% in the first quarter of 2000), but that's to be expected as a company gets bigger and grows from a larger base. Yahoo has demonstrated a lot of staying power, at least by the standards of Internet stocks.

Are Net Margins on the Rise?

Although Yahoo is profitable, many speculative growth companies--including most Internet companies--lose money. Of course, that is to be expected from a new venture. It's investing heavily to exploit profit opportunities, and if those investments pay off, earnings will materialize. But to curb risk, we want to find companies that are making progress toward profitability. Even if a company is losing money, net margins should be improving, even if that means becoming less negative. (You can find net margins in the Company Performance section of the stock's Quicktake Report.) Yahoo shows an encouraging trend. After losing money in its first three years, Yahoo made a profit in 1998, with a net margin close to 5%. Furthermore, it had net margins above 20% in the third and fourth quarters of 1998 and the first quarter of 1999. Net margins declined over the next few quarters because of non-cash charges resulting from mergers, but operating margins (which exclude such charges) remained solid. Yahoo appears to have left its money-losing phase behind.

Is the Business Generating Cash?

A company can make a profit without generating any cash. It might, for example, plow every penny that rolls through the door into inventory. Or it may slash prices in order to log sales. Receivables will rise, but the sales won't bring in any cash. Neither of these decisions is necessarily bad, but each raises the risk that a company will face a financial crunch. The inventories won't sell, or a company will fail to collect on its receivables. That's why it's often a good idea to look at cash flow in addition to earnings. To find a company's cash flow from operations, go to the Financials page of its Morningstar Quicktake Report. For Yahoo, we find that its operating cash flow improved from $-15 million in 1997 to $216 million in 1999. That means that the company has generated even more cash than its net income indicates--generally a good sign.< /FONT> If we take cash flow from operations and subtract capital spending (money spent on property, plant, and equipment), the result is free cash flow, or the cash left over after investing in the growth of the business. Yahoo's business doesn't require a lot of capital to grow, so its capital spending has been modest. Its free cash flow was a healthy $59 million in 1998 and $167 million 1999. Yahoo is generating plenty of cash.

What Has Growth Done to the Balance Sheet?

Like most speculative-growth companies, Yahoo doesn't generate enough cash internally to pay for an aggressive expansion. It must look outside for capital--either by borrowing, or by issuing stock in the equity markets. Given the market's ravenous appetite for Internet stocks over the past few years, Yahoo has understandably financed most of its expansion with equity. It had its initial public offering in 1996, and since then it has issued stock to pay for its many acquisitions. It has little long-term debt, which means it doesn't have to worry about interest payments. Overall, its balance sheet looks very healthy. In contrast, Amazon.com AMZN, another highly successful Internet company, has borrowed over $2 billion and is highly leveraged.

How Has the Stock Performed?

Since it started trading in 1996, Yahoo's stock has shot into the stratosphere along with many other Internet stocks. It returned over 500% in both 1997 and 1998, and more than 200% in 1999. Such performance is certainly impressive, but will be hard to maintain. Speculative growth stocks in general, and Internet stocks in particular, are fragile. They can crumble on a whisper of bad news and rally on an encouraging rumor, so be prepared for plenty of volatility. There's not much you can do about that; to get those highs, you have to risk the lows.

Is it Fairly Valued?

Valuation is tough for speculative-growth companies, and it's especially tough for an Internet company like Yahoo. Many of these companies have no earnings, and even when they do, ordinary valuation methods such as price/earnings ratios tend to go out the window. One popular way to value Internet companies is to look at the price/sales ratio (which we discussed in a previous session) and compare them with similar companies. At the end of 1999, Yahoo traded for more than 200 times sales. That's more expensive than any of the other major Internet stocks, such as eBay EBAY (120 times sales), America Online AOL (30 times sales), or Amazon (22 times sales). Even among the notoriously pricey Internet stocks, Yahoo is expensive--but you could make a case that its huge audience and consistent profitability make it worth a premium.

Conclusion: Numbers Matter

Some investors like to have a gut feeling about the business they are buying. In the speculative-growth market, unfortunately, that's often difficult. Many of these companies are bringing new concepts to market, and in the case of Internet companies, they're doing it in a new and evolving medium. Experience can be a poor judge of their viability. Five years ago, it would have been hard to believe that an Internet company (Internet? What's that?) would have a market capitalization of more than $100 billion by the end of 1999. And that may be a good lesson for investing in the speculative-growth market: Trust the numbers, not your gut. Sure, Yahoo is a risk. The Internet is still evolving, and could look very different a few years from now. But a disciplined analysis of its financial statements indicates that Yahoo is making increasingly efficient use of its assets, generating consistent sales growth, increasing net margins, and delivering cash from operations. That's what we want from a speculative-growth stock.

Quiz 403
There is only one correct answer to each question.

1 Which of the following is <em>not</em> a characteristic of speculative-growth companies?
a. They are very risky.
b. Their earnings are growing as fast as their revenue.
c. Their revenue is growing quickly.
2 What does it mean when a rapidly expanding company's growth rate slows over time?
a. It's a warning sign that the company may be in serious trouble.
b. It's a normal development for a growing company and nothing to be alarmed about.
c. It's a positive sign that the company is about to become profitable.
3 It's a good sign if a speculative-growth company's operating cash flow is:
a. Higher than its net income.
b. Lower than its net income.
c. The same as its net income.
4 It's most common for speculative-growth companies to get cash for expansion from:
a. The internal operations of the company.
b. Borrowing, by issuing bonds.
c. The equity markets, by issuing stock.
5 When valuing a speculative-growth stock, be sure to:
a. Divide all valuations in half.
b. Use P/E ratio as your primary yardstick.
c. Compare the stock's valuations to those of its peers.
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