Some Fundamental Analysis October 13, 2002 PICL Jim Mueller, Financial Partner

We are going to use Sportsman’s Guide, Inc. (SGDE) as an example for this lesson. This is a stock which I own and did analysis on for the TMF on-line seminar/class When To Sell. So I know it more thoroughly than most of my stocks (unfortunately for the rest of my holdings, but I’m getting better).

I reserve the right to have mistakes in this document, though I have done my best to avoid them. If you find a mistake or a different definition than what is given for a term, please let me know, so we can all learn together.

Throughout this are little Evaluation Notes. These are things to think about or watch out for on particular topics as they come up. You will notice a lot of “in general” phrases. Stock and company evaluation is more an art than a science, since much of it is subjective, especially when future values are estimated. There are no hard and fast rules (except how to calculate some of the numbers), but there are a lot of guidelines.

Where to find information about a stock:

There are many websites out there which contain information of different types (see note near the end). The one we will use for this example is www.yahoo.com. Go to that website, and in the list of all the other sub-sites, such as Shop: Auctions, Autos and Connect: Chat, Geocities, find the one that says Info: Finance and click on that link. You can also reach this via http://finance.yahoo.com/?u.

In the “search” box, enter the stock symbol, SGDE, and click Get. This pulls up a real simple page, giving the last trade price and the amount of change from the opening. Under that information is a list of links, including Chart. Click that to reach this page: http://finance.yahoo.com/q?s=sgde&d=c.

Charts: The charts are usually semi-log, that is the x-axis is time (linear) and the y-axis is share price (log). The price is shown on a log scale, so that the same vertical linear distance represents the same factor of change. For instance, on this chart, the distance from 2 to 4 is the same as from 4 to 8, a two-fold increase in price each time. The horizontal lines help in tracking this.

Underneath the price/time graph is an activity/time graph, showing the number of shares traded on any given day.

Underneath that is a table containing some numbers. These are what they are, though I reserve the right to be mistaken. This is for Yahoo. Other websites will show similar information. Reading each column downwards, left to right: Last trade – the last trade price, usually delayed by 15 – 20 minutes (thanks to Oct 1987). Day’s range – range of prices stock has traded at during the day 52-wk range – range of prices stock has had during the last year, starting back from today 1 y target estimate – the future stock price a year from now, taken from a consensus of several analysts. Take this with a grain of salt. Change – amount of change in stock price, in dollars and percent, from the closing price of the day before Bid and Ask – the most recent buy and sell prices. The difference between the two represents the cut the stock exchange gets. Bid Size and Ask Size – size of block of shares used in the above EPS (ttm) – Earnings Per Share (trailing twelve months): company net earnings, summed for the most recent four quarters (which is how often companies report this data), divided by the number of shares outstanding. Usually in the range of cents to a few dollars and sometimes negative. EPS Est – estimated EPS for the future 12 months (I think) Prev Cls – the previous closing price (at 4 pm Eastern – when the markets close). Used in the “change” calculation. P/E – the famous “price to earnings” ratio. Only reported if EPS is positive. Take the Prev Cls share price and divide by the EPS (ttm). Can also take the Mkt Cap and divide by the total net earnings to get the same number. The former is on a ”per share” basis, the latter is on a “total company” basis.

Evaluation note: In general, to buy a stock this should be low. It should be compared to something, such as the P/E for the stock market as a whole (S&P500 is one indicator) or to the industry the company belongs to or to its competitors.

P/S – it’s “price to xxxxxx” and I’m not sure what “S” stands for. Oh, S means Sales. I think it is the Mkt Cap divided by the Gross Sales (ttm) PEG – “price to earnings growth”. Not sure how this is figured. (I think) Open – the opening price of the stock for the current day’s trading. Note that this can vary from Prev Cls due to after hours trading. Mkt Cap – “Market Capitalization” is the current value of the company. Take the stock price and multiply by the number of outstanding shares. M stands for million, B for billion. Small-cap, mid-cap, and large-cap comes from this value, dividing it into ranges, but I’m not quite sure of the boundaries. I think small-cap is < $1 B. SGDE is definitely small-cap, might even be called micro-cap. Div/Shr – the amount of money paid to shareholders as dividends, per share that they own. Done quarterly. Yield – the TTM Div/Shr divided by the share price, expressed in percent. Usually a few percent. Volume – number of shares traded so far that day. Avg Vol – average daily number of shares traded for that stock Div Date – the date upon which the dividend will be / was paid out Ex Date – the date upon which you must own shares of the stock if you want to receive the dividend; always set before the Div Date Profile: Underneath this table is that list of other information links about a company. Click the one marked Profile to reach this page: http://biz.yahoo.com/p/s/sgde.html.

This gives a snapshot view of the company, including a brief statement about what the company does (Business Summary), a bit of information from the most recent SEC filing (Financial Summary), who the officers are and what they are paid, some address information, etc. Down at the bottom is another table, giving much of the same information given on the Charts page, but in a bit more detail (Statistics At A Glance).

In the left column, underneath the miniature price chart, is an indication of the Shares Outstanding (4.75M, or 4,750,000) and the Float (4.0M). The float is the number of shares available for trading by the public (you and me).

In the right column is the Shares Short. As of Sep 9, 50.0K (50,000) shares were being sold “short”. Percent of Float is next (1.2%). Then the prior month’s number is given. Shares Short is only available on a monthly basis. Evaluation note: Look for a relatively small number and stable or downward trend. A 20% short position should be considered as a strong sell signal, but other factors would also need to be considered.

Short vs Long: There are two types of positions on a stock, “short” and “long”. Long is the traditional view. Buy a stock, hold it, hope the price goes up and/or lots of dividends are given, sell someday and make your profit. Short is a riskier way of making profit. Borrow someone else’s stock, sell it, wait for the stock price to go down, buy the same number of shares at the lower price, give the shares back to that person, pocket the difference. It is riskier because the stock does not always go down in price, and at the end of the short contract, you are required to return the shares to the person you borrowed them from, at whatever cost to you. If the stock price has increased a lot, you could lose your shirt. In a long position, the most you can lose is whatever you put into the stock in the first place. In a short position, you can lose everything you own. Generally, those who short stocks are among the more intelligent investors, but this is not always true. There can be stupid decisions here, as well.

Financials: At the top, just above Business Summary, is a list of links, the same list we have been using. Choose Financials to get to this page: http://biz.yahoo.com/fin/l/s/sgde.html.

This displays the Income Statement, the Balance Sheet, or the Cash Flow Statement (“tabs” to the left, just above all the $$ numbers) for either the last four quarters or the last three years (toggle link to the right in the upper gray/blue bar). Evaluation note: For quarterly data, it is best to compare the numbers from one quarter to the same quarter of the previous year. This avoids changes due to seasonal fluctuations. From the Income Statement:

(All dollar amounts in millions) For the last three years, SGDE had the following sales (Total Revenues) and gross profits:

2001 2000 1999 Sales 169.7 154.9 162.5 G Prof 56.6 51.5 64.9

After Operating Expenses (primarily Research and Development, R&D, and Sales, General, and Administrative, SG&E) are taken out, they have operating income of:

2001 2000 1999 Op Inc 4.3 (2.4) 1.1

(Remember that numbers in paranthesis are negative.)

After taxes and other charges, they had a net income of:

2001 2000 1999 Net Inc 2.7 (3.2) 0.01

Net Income is the same as “earnings”. Evaluation note: You want to see very small and/or very few “Extraordinary Items” on this statement. These usually mean that management has screwed up and had to write off something as a loss.

Evaluation note: In some cases, companies report EBITDA (earnings before interest, taxes, debt, and amoratization). This is a riskier number to use in evaluation because it is more easily manipulated by the company. But it is used by companies to make themselves look better.

Evaluation note: You generally want to see these numbers increase, year to year. You can calculate their yearly change by the following (multiply by 100 to get %): ( (number @ year A) – (number @ year A-1) ) / (abs value of number @ year A-1)

2001 2000 1999 Sales 169.7 154.9 162.5 % Growth 9.51 (17.6) ---

Net Inc 2.7 (3.2) 0.012 % Growth 186.3 (26675) ----

Yes, that is a negative 26,675% growth from 1999 to 2000. (NB: the percent numbers come from using more significant digits than is presented here.) From the Cash Flow Statement:

Click the Cash Flow Statement “tab” to go here: http://biz.yahoo.com/fin/l/s/sgde_ac.html.

Note that the first line is Net Income and is the same value as the last line from the Income Statement (at least it better be).

Go down a few lines until you reach “Cash Flows From Operating Activities”. This value is also called the “Operating Cash Flow” (OCF). The OCF is the amount of cash brought into the business during the reported period.

2001 2000 1999 OCF 13.0 10.2 (6.3) % Growth 27.4 263.2 ----

OCF takes into account spending for things like R&D, SG&E, the office Christmas party bash, etc. It does not take into account capital expenditures (CapExp -- buying office equipment, buying new plants or new property; CapExp may also listed as PP&E, for plants, property and equipment). To get Free Cash Flow (FCF), the amount of cash brought in that could theoretically be returned to investors as a dividend, the amount spent on CapExp must be taken out.

CapExp can be found not much further down the sheet and should always be negative. Adding the (negative) CapExp to OCF results in FCF, which is always less than OCF.

2001 2000 1999 OCF 13.0 10.2 (6.3) CapExp (0.56) (1.5) (2.8) FCF 12.5 8.7 (9.1) % Growth 42.9 196.7 ----

Now we can calculate P/FCF. Take FCF and divide by the number of shares outstanding (don’t forget we’re working with millions of dollars). Then divide the Prev Cls by the FCF per share.

FCF = 12.5 M ShrOut = 4.75 M FCF/Shr = 12.5 / 4.75 = 2.63 P/FCF = 6.96 / 2.63 = 2.65 (used PrevCls price)

Evaluation note: This ratio can be used when P/E is not available (due to negative earnings). It is generally smaller than P/E and some consider it a more reliable indicator than P/E because cash is more difficult to manipulate than earnings on the statements. Just like P/E, P/FCF should be compared to some group, either the market, the group of similar-sized companies, the industry, or the competitors.

Evaluation note: One should generally look at a longer time line. Here we have 3 years, but can only calculate growth for the last two years. Therefore, Yahoo may not be the best site for getting more historical numbers. For a short time “www.simplystocks.com” was available for free, but that changed. “quote.fool.com” gives one more year’s worth of data (to 1998). “www.nasdaq.com” also gives 4 years worth of data (drop-down menu choice of “fundamentals”). If one wanted to, one could go through the 10-Q and 10-K reports for the last several years to pull out the numbers. A future seminar will cover where these numbers can be found in those reports.

Finally, one should look at some information about the company. What has it been doing? Where is it headed? What are management’s plans for the future? Is there anything serious going on, such as an SEC investigation? How much debt is there and is there enough cash to cover it? Much of this information can be found on-line and by reading parts of the SEC filings (the 10-Q, quarterly, or 10-K, annual reports). Here is a summary review I made of SGDE back in mid-August.

Review of Sportsman’s Guide: Sportsman's Guide (SGDE) is a small ($32.5 M market cap) catalog / on-line retailer selling clothing, outdoor gear and general merchandise aimed at the hunter, camper, outdoor enthusiast and those who want to live that lifestyle. They use direct mail catalogs and two websites, www.sportsmansguide.com and www.bargainoutfitters.com.

The company was founded in 1970, selling primarily to deer hunters. They have since expanded to the outdoors person in general and have included government surplus (e.g. military) and manufacturers' close-out lines. They aim to be a value-oriented supply for outdoors lifestyle purchases.

Since 1992, with sales of $43 M, they have grown at an annualized rate of 16.5%, reaching sales of $170 M in 2001.*

They have two main things going for them: a Buyer's Club and an increasing amount of sales over the internet.

The Buyer's Club, at $29.99 annual membership fee, gives members a 5 - 10% discount off of merchandise, as well as the option to extend payments out for 4 billing cycles, interest free. They have promoted heavily to add new members and the current (2Q2002) total is 270,000, up about 6% from 2001 ending total of 254,000 (which was up 91% from end of 2000). Through a study of purchasing patterns, Club members are known to make two to three times more purchases than non-members. As long as club member purchases do not exceed 10 times the revenue generated by the membership fees ($81 M, or roughly 50% of their 2001 sales level), SGDE makes money on the fees.

Internet sales, first launched in 1998, have grown rapidly since then. From a beginning of less than 1% of total sales in 1998, it reached >21% of sales for 2001 and has continued to increase, reaching 27% in 1Q2002 and 30% in 2Q2002. In late 2000, they trimmed their catalog mailings to reduce those sent to non-buying people and started heavily promoting their Buyer's Club. Starting in 4Q2000, they have seen a turnaround in their profitablity, which has been increasing steadily. For 2Q2002, they realized net earnings of $317,000, or $0.06 per fully diluted share, compared to a loss of $(207,000) or $(0.04) per diluted share for the same quarter 2001. For the first half of 2002, the per share earnings were $0.22 compared to $(0.08) a year ago.

Gross sales for the first two quarters of 2002 were up 6% and 10%, respectively, over the previous years' quarters, and 2001 revenue was up 17.8% over 2000**. Considering that Q1 and Q2 are historically their slowest quarters (fall and winter being best for hunting season and gifts), this year's early growth is especially encouraging.

SGDE has no debt and a (2001) FCF of $12.5 M. As of Aug 8, the shares (at $6.84 per) were trading at about 2.6 times FCF with a P/E of 8.8.

Pessimistically, assuming a 10% growth per year in sales, a 1.5% net profit margin (similar to 2001), and a P/E of 8.8 to 10, stock price would be $7.60 to $8.80 in 5 years (assuming no increase in shares outstanding). On the other hand, assuming a 15% growth per year in sales (closer to the last 9 years' average), same profit margin and P/E range, stock price would be $9.50 to $10.75 in 5 years†.

If the P/E goes higher (the range of its competitors is 7.50 to 75.0, average of 34.2; 11 of 22 showing earnings for 2001), the stock price, of course, would go higher as well. If the P/E did climb to the industry average, this stock would be a five-bagger††.

With no SEC investigations, a stock option grant rate of 5.25% (2001, compared to 0.5% in 2000 and 2.5% in 1999), just barely above the 5% limit goal for a small cap company‡, very few institutions (10) interested, the paying off of the last of their debt (only $5000 at end of 2001), and all of the above, this company looks pretty good (but keep an eye on those options granted).

Notes for this seminar:

* CAGR (compounded annualized growth rate) is calculated as follows: ( ( (number at later date) / (number at earlier date) ) ^ (1/number of years between them) ) – 1

( (170 / 43) ^ 1/9 ) – 1 = 0.165 or 16.5%

** I think that percent growth is wrong. According to the data we found above, it should be 9.5%. I must have misread a number from the spreadsheet I was using at the time.

† This comes from some projection studies, using the CAGR formula (solving for “number at later date”) and the assumed changes indicated, to calculate future stock prices. Net profit margin is net income divided by gross revenue. †† Five-bagger means the stock price will increase five-fold. Ten-bagger is a 10-fold increase. A term popularized by Peter Lynch.

‡ Options granted come from Employee Stock Options programs. These give employees stock in the company, which they can get at a (hopefully) lower price than the stock is trading for when the options become vested (in the future, usually a couple of years). The employee could then sell the stock and pocket the difference. The idea is to make the employees more loyal to the company by giving them a “stake” in the company. However, the effect of too many options is to dilute the number of shares out there (by creating more), which lowers the value of each share. Doing this to excess can worsen the dilution factor. The 5% per year value for a small, growing business is somewhat arbitrary, but is reasonable in the light that such a company should be able to grow by 10 to 15% per year, which overcomes the 5% dilution effect.