SMARTMONEY.COM: Rich In ROE
By ANNA SNIDER
(This report was originally published late Wednesday.)
NEW YORK -- Return on equity (ROE) is a metric that's familiar to Wall
Street pros and other sophisticated investors who tend to view Saturday
afternoons as a great time to catch up on their annual report reading.
But the measurement doesn't make the hearts of many average investors go
pitter-patter. It should - at least in some cases. The return-on-equity ratio
is a company's net income divided by its net wealth and tells you just how
much profit a management team can squeeze from its equity capital. It is
calculated by dividing net income by stockholders' equity at the beginning
of the fiscal year.
A high ROE 'tells you the company is in a business or in a position where it
is operating very well and is therefore able to earn a good profit,' says
Arum Kumar, a senior equity strategist at Lehman Brothers. Generally, a
ROE above 15% is considered strong. 'The higher it is, the better it is,'
Kumar says. If it goes up over time, he adds, it's a good indication that
management is doing its job better all the time.
In this week's screen
(http://www.smartmoney.com/smt/screen/index.cfm?story=2000062
1screen), we went hunting for companies with improving, but already
strong, ROEs above 20%. We also threw in a slew of other criteria -
including an earnings growth rate above 15% and increasing operating
margins - to ensure that we were coming up with quality companies. (See
recipe at
smartmoney.com
recipe.)
Our efforts yielded 24 companies, ranging from a large-cap tech favorite
like Qualcomm (QCOM) to a relative unknown like the
video-conferencing and broadband developer Polycom (PLCM). While
16 of the 24 companies with improving ROEs have seen their stock prices
increase over the last year, not every stock did, so it's clear that a ROE
analysis is not by itself a method for picking winning stocks. But, then
again, no single measurement passes that test.
Among the stocks that survived our ROE screen and have other promising
qualities are Polycom, Business Objects (BOBJ) and Semtech (SMTC).
Polycom's return on equity of 30.80% is a big improvement over its
five-year average of 17.25%, and it coincided with a dramatic increase in
share price over the last 12 months from $26 to $94. The company's
earnings doubled to about $30 million from 1998 to 1999, and the First
Call long-term consensus growth rate is 40%.
Morgan Stanley analyst Alkesh Shah says Polycom's earnings growth
reflects the fact that the company 'dominates its markets,' with a 50% share
in video conferencing and an 85% share of high-end audio conferencing.
Since acquiring Atlas Communications Engines last December, Shah says,
Polycom is now in a new line of business: developing routers and other
access devices for digital subscriber lines in a market that is expected to
grow by 2,700% over the next three years.
Shares of Business Objects, which writes data mining software used in
e-commerce, have gone up from about $16 to $91, while its ROE
increased to 22.6% from a five-year average of 14.19%. E-commerce
companies use its programs to sift through their orders to learn more about
customers' shopping habits.
Net income more than doubled to $23.8 million last year, and revenues
increased 45% to $241.1 million. What's more, says CIBC World
Markets analyst Scott Phillips, the outlook for Business Objects is even
better because a key rival, MicroStrategy (MSTR), has been preoccupied
with the debacle over restating its earnings. (Nonetheless, MicroStrategy
may reemerge as a force, since earlier this week it got a much needed
$125 million cash infusion from private investors.)
Semtech, a semiconductor and electronics maker, has gone from $23 to
$76 on an improving ROE. Why the big bump? The company has spent a
lot of money hiring 80 new design engineers to increase its product
offerings. 'They have twice as many [engineers] as other companies their
size,' says Todd Cooper, an analyst with Stephens Inc. 'That kind of talent
is truly the lifeblood of an analog semiconductor company like Semtech.'
The investment is paying off. Last year, the company had sequential
revenue growth of 15% in the second quarter, 22% in the third quarter and
18% in the fourth quarter, Cooper says. 'That's not year over year - that's
quarter over quarter,' he says. 'And that's phenomenal.'
But solid and improving ROEs don't always translate into higher share
prices. Take the case of Philip Morris (MO), whose ROE of 51.21%, the
second highest of any company in our group, went up 14.3% over the last
year at the same time its stock price fell 34%. Credit Suisse First Boston
analyst Bonnie Herzog says the avalanche of tobacco lawsuits has kept
people away. 'Even though a big part of their business is packaged foods,
it trades a bit like a tobacco stock,' she says. 'Investors know the company
has strong cash flow and great ROE, but it doesn't always trade on
fundamentals.'
Another thing to keep in mind: ROE figures are historical, so the metric is a
snapshot of yesterday as opposed to a look into the future. Citrix Systems
(CTXS), a high-tech company with a robust ROE of 29%, turned up in
our screen even though it has been a disaster story of late. In a significant
stumble, the company warned last week that its second-quarter profit
would be about half of what analysts were expecting, which sent its stock
price down 46% to the low $20 range.
Last year, Citrix soared as word spread about its technology - which
allows any type of desktop or mobile computer to run Microsoft Windows
or Unix applications from a central server. But in this quarter, it started
having trouble closing deals, in part because it has been trying to go after
larger customers who take longer to decide on new contracts.
The point is, even if a company has a ROE that demonstrates success in
having found a profitable niche, it still has to keep executing. ROE is a
good starting point.
Nonetheless, investors who take the time to study metrics such as ROE
will be better equipped to choose their investments wisely.
For more information and analysis of companies and mutual funds, visit
SmartMoney.com at smartmoney.com
Briefing Book for: BOBJ | CTXS | MO | PLCM | QCOM | SMTC | F.BOB |
