Barrons - January 11, 1999
Irrational Complacency
By Alan Abelson and Rhonda Brammer
The Internet Effect.
That, as much as anything, explains the explosive start of the stock-market
year.
If stocks like America Online, Amazon and Yahoo, not to mention a host of
lesser-fry, can sell at incredible and often infinite multiples and boast market
capitalizations that run well into the tens of billions, why, everything else by
comparison looks like a wild bargain.
So powerful was the Internet Effect that in Wednesday's brilliant run to new
highs -- by the Dow finally, as well as the S&P 500 and Nasdaq --
presumably sentient people were induced to buy steel stocks.
Since there is no evidence of disenchantment with the Internet shares --
indeed, quite the opposite -- Thursday's modest decline can only be traced to
a generous desire on the part of the market masters to give investors addicted
to buying the dips a chance to indulge their fancy.
Besides the sheer size of their surge, notable about the Internet stocks is that
the usual order of investment has been reversed. Usually, the institutions buy
early and then the public pours in, attracted by the rise in prices. This time,
however, it was the public, particularly computer nerds who use the Internet
to buy Internet stocks and then talk them up on the Internet, that was first in,
and the institutions were the Johnny-come-latelys.
They had no choice. How could they explain to their investors why their
portfolios lagged so egregiously the performances of e-this and e-that? And,
of course, when America Online joined the Standard & Poor's 500, both
overt institutional indexers and the closet variety were compelled to add that
worthy to their portfolios.
Institutional demand stoked the Internet rage, since the number of shares
available for anyone hot to buy these sizzling stocks is quite limited. On that
score, we think it's awfully nice of the men and women who run the Internet
companies to try to accommodate would-be shareholders. Insider selling of
the group has been heavy.
The Internet Effect, which makes the rest of the market look irresistibly
cheap, deserves most -- but not all -- of the credit for the market's burst out
of the starting gate in the opening days of 1999. A big bow also should go to,
in the neat phrase of our friends at Smith Barney, "irrational complacency."
Such complacency is especially evident among investors who are totally
convinced that the market has nowhere to go but up. By way of proof, they
point to the second half of last year when the faint of heart got faked out of
their long positions, only to come back in sheepishly at much higher prices in
the inevitable recovery.
Symptomatic of such complacency are the folks who put out market letters.
Investors Intelligence, the estimable service that tracks their views, reports
that in its latest survey, the letter writers were 58.3% bullish. That's the highest
percentage in seven years. In other words, they're more bullish now than they
were when the market was at 3300.
But irrational complacency also extends to the economy. Despite the
deflationary tide sweeping over much of the world and despite a further
decline in the purchasing managers' index, for non-manufacturing as well as
manufacturing, the prevailing sentiment is that our economy is immune to ills,
abroad and at home. And even should it prove not to be, said sentiment is
confident, the gods of the economy, led by Zeus Greenspan, will make it all
better.
We're doubly lucky because that attitude, as well as blithe assumptions about
the stock market, were on full display last week at a gathering of economists,
dues-paying members all of the American Economic Association. One of the
eminences from Harvard said, in effect, that if there really was a stock-market
bubble, it would have occasioned more talk at the meeting. But remember,
he's an economist, not a logician.
Besides, he added, if, by some weird chance, it turns out that there is a
bubble and it bursts, "there is a sense that the Fed will lower interest rates and
everything will be fine." Zeus Greenspan to the rescue!
To further quote the New York Times' report on the conclave, the received
wisdom among the attendees was that the stock market isn't a big reason for
the economy's strength nor much of a threat to the expansion as it heads into
its ninth year. And they're right!
The stock market isn't a big reason for the economy's strength, it's the biggest
reason. And if it collapsed, it wouldn't have all that great an impact on the
expansion: It would stop it dead in its tracks.
Not a small part of Wall Street's irrational complacency, as intimated, springs
from last year's stock- market action. Not only did the market weather some
very rough seas in late summer-early fall, but it wound up with a real kick, the
averages racking up double-digit gains for the fourth year in a row. So, why
worry?
In fact, 1998 was fine for the lucky souls who owned the averages or, even
better, the high-techs, whose index was up a mere 80%-plus. But alas, 1998
was not the best of years for an awful lot of investors.
Truth is, as our friend Bob Farrell, Merrill Lynch's astute market watcher,
points out, the majority of stocks suffered a losing year in 1998. Losers on the
year outpaced winners both on the Big Board and, more dramatically, on
Nasdaq, where the 1,690 stocks that registered higher prices for 1998 were
handily outnumbered by the 3,351 that fell.
That sort of experience normally would encourage rumination, reflection, a bit
of grumpiness, perhaps-anything but complacency. But of course, we're
talking "irrational," aren't we?
Not everyone, happily, has succumbed. The redoubtable Abby Cohen, who
never met a stock market she didn't like, last week demonstrated her
remarkable cool by cutting sharply the portion of stocks she recommended
for Everyman's portfolio.
Specifically, she urged slashing the stock component a whole 2%, to 70%,
from 72%. Alas, try as we might to follow brave Abby's advice, our stocks
keep going up so fast that we can't get them down to less than 71% of our
humble portfolio. But we're determined not to be complacent.
Great demographics! At least if you happen to run a drugstore chain. The
population of geezers -- those who pop the most pills -- is soaring.
Retail prescription sales jumped 15% last year, to over $100 billion. And
more than 60% of those sales were made by chain pharmacies, which
continue to muscle business away from small independents.
Tipping the scales in favor of the big guys is the growing role of health
maintenance organizations, preferred providers and insurance companies -- in
the jargon, third-party payers -- which now account for seven out of every 10
prescriptions filled and, for various reasons, prefer to do business with major
chains.
In particular, sponsors love to team up with the big guys because the latter
offer lots of locations and sophisticated computer systems that streamline
claims-processing.
All of this has not been lost on Wall Street. In the past three years, shares of
the three largest drugstore chains -- Walgreen, CVS and Rite Aid -- have
more than tripled.
Wall Street analysts, always an optimistic bunch, forecast steadily climbing
earnings for all three chains. But even the most bullish are projecting growth
rates ranging only around 15% to 17%.
And where are the stocks? Walgreen, CVS and Rite Aid, even after getting
roughed up a bit last week, are selling, respectively, at 45, 36 and 30 times
forward earnings.
Not quite in the class of Walgreen, CVS or Rite Aid in terms of size, but right
up there in stock market popularity, is Duane Reade.
Founded in 1960, the company is New York City's largest drugstore chain.
In 1992, the family sold out to Bain Capital, which launched an aggressive
expansion program, and the chain fell on very hard times.
In June 1997, investment funds affiliated with DLJ Merchant Banking Partners
II acquired 91.5% of the outstanding stock for $79 million, or the equivalent
of about $8 a share. Eight months later, in February 1998, DLJ, Goldman
Sachs and Salomon Smith Barney took Duane Reade public at $16.50 a
share, selling about 40% of the company to the public for $120 million.
Insiders sold about $9 million of stock.
Thanks to a new management team led by Anthony Cuti, a former president
of Pathmark, Duane Reade has managed to report two profitable quarters --
after years of abysmal losses. (Duane Reade's accumulated deficit is still over
$113 million, or $6 a share.)
In the third quarter, on 36% higher revenues, it earned 31 cents a share
compared with a loss of 18 cents in the year-earlier span. First Call's
consensus for last year is $1.05 a share and for this year, $1.55. Duane
Reade is being hailed as a great turnaround story and likely buyout target.
Shares, which have sold as high as 45, currently fetch 33-plus.
And while we'd never say never to the possibility of a takeover --
consolidation is rampant in the industry -- it's far from a sure thing that the
company would go out at a premium valuation.
First, those estimates are entirely untaxed, thanks to big tax-loss
carry-forwards. But apply a normal tax rate, and they drop to 63 cents for
1998, 93 cents for this year. By way of comparison, then, Duane Reade is
selling at 36 times this year's estimate -- at a discount to Walgreen but on par
with CVS and at a premium to Rite Aid.
It's worth noting, too, that Duane Reade's sparkling gain in revenues last
quarter owed heavily to new stores. At the end of September, Duane Reade
was operating 134 pharmacies, compared with only 65 in September 1997.
Same-store sales in the third quarter advanced a far more modest 6.3%,
down from 7.6% last year and 8.3% in 1996. Again, by way of comparison,
recent same-store sales at Walgreen are running ahead 10%; at CVS, 13%,
and at Rite Aid, 8% -- though on the East Coast, where Rite Aid competes
with Duane Reade, same-store comps were up 11%.
For years, the huge chains pretty much ignored Duane Reade's territory in
New York City, particularly Manhattan. Why bother with the headaches of
high real-estate costs, shrinkage and expensive labor -- particularly when
managed care had yet to take hold? But all that has changed.
Though Duane Reade still reportedly has 21% of the New York City market,
Rite Aid now lays claim to 16% and CVS, to 15%. Moreover, Melville, New
York-based Genovese Drug Stores, which had about a 13% share, is likely
to be a much fiercer competitor: It was recently acquired by Eckerd, a
subsidiary of J.C. Penney and the fourth-largest drug chain.
Trouble is, Duane Reade appears to lack the financial muscle to go
head-to-head with its aggressive rivals. Its balance sheet, even after last year's
offering, is pretty dreadful. At the end of the third quarter, equity amounted to
a minuscule $12.5 million, or 75 cents a share, compared with over $300
million, or $18 a share in debt. Worse still, tangible book is a negative $7 a
share.
So, again, while somebody may well buy the chain -- it's not all that clear that
somebody will pay up for it.
Penney's Eckerd agreed to buy Genovese Drug Stores for about 60% of
sales. CVS paid about 68% of sales for Revco, while Rite Aid acquired
Thrifty PayLess for 50% of sales.
But be generous, suppose a big spender pays 75% of sales for Duane Reade.
And assume further, to be even more generous, that it pays not 75% of
trailing sales (as in the examples cited), but 75% of analysts' forecast revenues
of $800 million.
An offer of $600 million for Duane Reade, including the assumption of debt,
would mean that stockholders would get $300 million. Which works out to
just over $17 a share.
And that's about half the current price of the stock.
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